How to Report a 1031 Tax-Deferred Real Estate Exchange to the IRS

How to Report a 1031 Tax-Deferred Real Estate Exchange to the IRS

A 1031 exchange, named after Section 1031 of the Internal Revenue Code, allows real estate investors to defer capital gains taxes when exchanging investment or business-use properties for similar properties of equal or greater value. While this strategy helps preserve capital, it requires strict IRS reporting to ensure compliance. Investors must properly document the exchange on their tax return using Form 8824, Like-Kind Exchanges. Below is a step-by-step guide on how to report a 1031 exchange to the IRS.

Step 1: Obtain Form 8824 (Like-Kind Exchanges)

To report a 1031 exchange, investors must complete IRS Form 8824 and attach it to their annual tax return (Form 1040, Form 1065, or Form 1120). This form helps the IRS track the deferred gain and ensures the exchange meets the legal requirements.

You can download Form 8824 directly from the IRS website (www.irs.gov).

We strongly encourage you to seek guidance from a qualified tax professional in reporting a 1031 exchange and tracking your depreciation. Nevertheless, understanding this process can reduce billable time from your tax professional, and increase the likelihood that your transaction will be reported accurately.

 

Step 2: Complete Part I – Description of the Exchange

In Part I of Form 8824, investors must provide:

 Description of the relinquished property (property given up).

 Description of the replacement property (property received).

 Date the relinquished property was transferred.

 Date the replacement property was received.

Key Rule: The replacement property must be identified within 45 days of selling the relinquished property and acquired within 180 days (or less if you file your taxes before 180 days).

 

Step 3: Complete Part II – Realized Gain or Loss Calculation

This section determines the potential capital gain or recognized gain if the exchange was partially taxable. Key entries include:

 Fair market value (FMV) of the replacement property.

 Adjusted basis of the relinquished property.

 Cash received or non-like-kind property received (if any).

 Liabilities assumed or given up in the exchange.

 

Important Consideration: The IRS uses tax-accounting terms that are not intuitive. It is possible to “receive” taxable funds without seeming like you actually receiving anything. For example, suppose you sold a rental property and agreed to have the escrow company pay your buyer—from the purchase proceeds—the amount of tenants’ security deposits you are holding. While this arrangement may seem like an easy way to handle a nuisance transaction, such a payment to the buyer would redirect funds that are supposed to go to your Qualified Intermediary. And unlike commissions or other customary transaction costs, you cannot deduct security deposits from the sale price to reduce the net proceeds in a 1031 exchange.

In tax terms, an IRS auditor would say you “received cash boot” in this scenario, and the amount paid to the buyer would be taxable as recognized gain. The better approach in this scenario would be to handle the payment of any non-customary transaction costs outside escrow.

Similarly, if your replacement loan is less than your relinquished loan, and you don’t contribute the difference to your exchange in the form of cash, you will be treated as “receiving” a taxable debt reduction. To defer all taxes, not only must you reinvest all the net cash proceeds of your sale (equity), but you must also replace your debt, with some combination of debt or cash.

 

Step 4: Complete Part III – Related Party Exchanges (If Applicable)

If the exchange involved a related party (e.g., family members, business entities with common ownership), Part III must be completed. The IRS requires disclosure because related-party transactions must comply with additional restrictions and are subject to a two-year holding period.

 

Step 5: Report on Your Tax Return

After completing Form 8824, investors must:

1. Attach it to their tax return (Form 1040, Schedule D, Form 1065 for partnerships, or Form 1120 for corporations).

2. Report any recognized gain (if applicable) on Schedule D (Capital Gains and Losses).

3. If depreciation recapture applies, report it on Form 4797 (Sales of Business Property).

 

Step 6: Maintain Proper Documentation

The IRS may audit 1031 exchanges, so keep records for at least three to seven years, including:

 Exchange agreement with a Qualified Intermediary.

 Closing statements for both properties.

 Identification notices of replacement property (unless purchase was completed within 45 days of selling the relinquished property).

 Loan documents, if applicable.

 

Final Thoughts

A properly executed 1031 exchange can significantly reduce tax liability by deferring capital gains tax. However, to comply with IRS rules, investors must accurately complete Form 8824, properly report any taxable portion, and maintain supporting documents.

And don’t forget to establish a revised depreciation schedule for your replacement property. If your new investment has a higher ratio of depreciable improvements, or if you added significant capital to your exchange (either with cash or higher debt), you likely will be able to increase your annual depreciation deduction.

Regardless of whether the exchange is complex or simple, consulting a tax professional is highly recommended.

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For more information about passive real estate investments and 1031 exchanges, please call 1031 Capital Solutions at 1-800-445-5908 or visit our website, 1031capitalsolutions.com. Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services offered through Concorde Asset Management, LLC (CAM). 1031 Capital Solutions is independent of CIS and CAM.