Like-Kind Exchange: Definition, Example, Pros & Cons

What is a like-kind exchange?

A like-kind exchange (commonly called a 1031 exchange or Starker exchange) lets an investor sell investment or business real estate and acquire another qualifying property without recognizing capital gains at the time of the sale. Taxes are deferred—not eliminated—and become payable when the replacement property is later sold (unless another 1031 exchange is completed).

Since tax law changes in 2017, like-kind treatment applies only to real estate held for productive use in a trade or business or for investment. Personal residences do not qualify.

How it works (high-level)

• Sell qualifying investment or business real estate.
• Use a qualified intermediary (third-party) to hold proceeds—direct receipt of proceeds by the seller will disqualify the exchange.
• Identify replacement property within 45 days of the sale.
• Close on the replacement property within 180 days of the sale (or by the due date of the seller’s tax return for the year of the transfer, if earlier).
• File IRS Form 8824 to report the exchange.

If the exchange meets IRS rules, gain on the relinquished property is deferred. Any non-like-kind property or cash received in the exchange (“boot”) may trigger recognized gain and taxable income.

Key rules and considerations

• Eligible property: Real estate held for investment or business use. Vacation homes used personally typically do not qualify.
• Timing: 45-day identification window and 180-day exchange completion window (strict; extensions are generally not allowed).
• Qualified intermediary: Required to hold sale proceeds and facilitate documentation; direct receipt of funds by the seller breaks the exchange.
• Boot: Cash, mortgage relief, or other non–like-kind property received will generate taxable gain to the extent of the boot.
• Depreciation recapture: Depreciation previously claimed may be recaptured; recognized gain from recapture can be taxed as ordinary income if boot or other circumstances cause recognition.
• State rules: Some states offer exemptions for like-kind exchanges from mandatory withholding or state income tax; requirements and deadlines for exemption certificates vary by state.

Taxes and reporting

• Form 8824: Used to report a like-kind exchange to the IRS.
• Recognized gain: Reported on applicable forms (e.g., Form 8949 and Schedule D, or Form 4797), depending on the nature of the property and gain.
• Deferral, not elimination: Capital gains and depreciation recapture are deferred; if the replacement property is later sold outside of a 1031 exchange, taxes become due.
• Losses: Losses are deferred in the same manner as gains—no immediate tax benefit if the exchange is successful.

Advantages

• Defers capital gains tax, freeing up more capital to reinvest.
• Allows investors to consolidate, upgrade, or reposition real estate holdings without an immediate tax hit.
• No limit on the number of 1031 exchanges an investor may perform over time—tax deferral can be repeated indefinitely.
• Can defer depreciation recapture.

Disadvantages and risks

• Strict IRS rules and tight deadlines; failure to comply results in immediate taxable sale.
• Boot can create partial tax liability.
• Deferred losses offer no current tax benefit.
• Transaction costs (qualified intermediary fees, closing costs, professional advice) can be significant.
• Eventually, taxes are due unless stepped-up basis strategies (e.g., at death) apply.

Example (concise)

An investor sells a rental building for $1,000,000 and uses a qualified intermediary to acquire a replacement rental property for $1,200,000 within the 45/180-day windows. Because all proceeds are reinvested into like-kind real estate and IRS rules are followed, the investor defers recognition of the capital gain and depreciation recapture from the sale. If instead the investor took $100,000 in cash as part of the transaction (boot), that amount would generally be taxable to the extent of gain.

Common FAQs

Q: Why use a qualified intermediary?
A: To prevent the seller from receiving sale proceeds directly (which would disqualify the exchange) and to ensure documentation meets IRS requirements.

Q: What happens if the exchange closes in the next tax year?
A: Report the exchange on Form 8824 for the year the exchange began. Specific reporting for funds or installments may require additional forms (consult a tax professional).

Q: Are losses recognized in a like-kind exchange?
A: No—losses are deferred while the exchange qualifies. A loss is recognized only when the transaction becomes a taxable sale.

Bottom line

A like-kind (1031) exchange is a powerful tax-deferral tool for real estate investors who want to sell and reinvest in similar property. It preserves capital for reinvestment and defers both capital gains and depreciation recapture, but it requires strict adherence to timing, documentation, and qualification rules. Consult a qualified intermediary and a tax professional before initiating an exchange to ensure compliance and to evaluate the long-term tax implications.