How Many Properties Can Be Relinquished in a 1031 Exchange?

For an investor contemplating the prospect of a 1031 exchange, the rules are complex, but the potential rewards are attractive. For example, if you are considering the sale of a real estate asset but prefer not to pay capital gains taxes on the increased value presently, a 1031 exchange may be an option to evaluate. Among the considerations are the role a particular asset plays in your overall investment strategy, the potential for continued appreciation, the alternatives available, and individual goals not currently being optimized.

Completing a 1031 exchange (the name refers to the relevant section of the Internal Revenue Code) may allow a taxpayer to reinvest sale proceeds without surrendering a portion for the payment of capital gains taxes. While it is essential to keep in mind that the exchange does not eliminate the taxes but rather defers their payment, sequential exchanges can continue the deferral indefinitely. If desired, the taxpayer could persist until they bequeath the final property to an heir, who would benefit from the step-up in basis, thus avoiding the tax on the accrued appreciation.

How Does the 1031 Exchange Work?

Let’s examine a sample scenario:

Investor A wants to sell a single-family rental home and invest in an office building. The investor has a property that they bought for $100,000 but is now valued at $600,000. Using a Qualified Intermediary, the investor can sell the rental home, with the QI ensuring that they have no access to the proceeds. The capital gain, which would be subject to tax, is $500,000, but if the taxpayer completes a 1031 exchange, they can defer payment. The IRS allows the taxpayer 45 days to identify a replacement property (or properties) and 180 days from the sale to complete the purchase (including the 45 set aside for identification). The timeline looks like this:

Day 1: Sale of the relinquished property

By day 46: identification of potential replacements formally made to QI

By day 180: replacement(s) purchased

The investor may want to initiate the search for attractive office properties even before completing the sale of the residential property to improve the chances of finding and completing the office building purchase within the designated time.

Can More than One Property Be Involved?

1031 exchanges typically satisfy the investor's interest in selling a designated asset and reinvesting in one or more replacement properties. For example, if an investor wants to change the composition of their portfolio or alter the geographic distribution, asset class, or sector, using a 1031 exchange strategy allows them to reinvest funds that might otherwise be used for paying taxes.

While the IRS has strict rules about some aspects of the exchange, such as using a Qualified Intermediary and meeting timelines, other pieces are less rigid. For example, the number of properties involved is flexible on both sides of the exchange. An investor can identify one asset to sell and replace it with one asset or sell more than one and buy one or more. What is crucial is that both the purchase price and the debt be at least as much for the new property as the sales price and debt for the relinquished asset. If it is less, the difference is considered "boot" and is subject to capital gains tax. Under some circumstances, the boot could also be subject to depreciation recapture taxes. An investor might deliberately transact a partial exchange to access cash but should only do so knowing they will need to recognize the gain and pay the taxes due.