What is a 1031 exchange, in plain English?

Question

Turnrow Capital · Accepted Answer

A 1031 exchange lets you sell investment real estate and buy replacement real estate without paying capital gains tax now. The tax is deferred, not erased — it rolls into the new property. You must follow strict rules: a qualified intermediary holds the money, and you face 45-day and 180-day deadlines.

The name comes from Section 1031 of the Internal Revenue Code. The logic is simple: if you sell one investment property and put all the proceeds into another, you have not really cashed out — you have just changed what your capital is parked in. So the IRS lets you defer the gain instead of taxing it in the year of sale.

The deferral can be substantial. On a $1M gain, federal capital gains tax plus depreciation recapture and state tax can easily exceed $250,000. An exchange keeps that money working in the replacement property instead of going to the IRS this year.

The catch is procedure. You cannot touch the sale proceeds, you must identify replacement property within 45 days, and you must close within 180 days. Miss a step and the entire exchange can fail, making the full gain taxable. Most failed exchanges die on financing or deadlines, not on the tax rules themselves.