How Does a 1031 Exchange Work?

A 1031 exchange is a mechanism under Section 1031 of the Internal Revenue Code. It permits an owner of an investment property to sell that property and then purchase a replacement property.

By Ilyce Glink and Samuel J. Tamkin

Q: I have a contract offer for my primary residence that is about 10 times what I thought the home was worth. The county I live in is changing the zoning from agriculture residential to commercial. The entire community is most likely becoming a data center campus. If I sell the home, I would have a sizable capital gains tax to pay. I was hoping with the change of zoning designation I can convert my primary residence to a business. Then as a business I could sell the home using a 1031 like kind exchange to roll over the entire sales proceeds into a different real estate investment. Does this sound possible and if so who should I get to help me?

Avoiding your profit being taxed

A: Excellent question. It sounds like you might have won the real estate lottery, so let’s unpack some options.

First, there is a way to shield a substantial amount of your profit from being taxed. If you’re married. You and your spouse can exclude up to $500,000 in profit on the sale of your primary residence from capital gains taxes (or any federal income taxes). If you’re single, you can exclude up to $250,000 in profits. A few (of a handful of) pertinent rules. You must have lived in the home for at least two out of the last five years to qualify. The home must have been your primary residence for that time. 

We’ll assume that your sale will far exceed the $500,000 threshold for you to want to do what you’re asking. 

Primary residence as personal or investment

When it comes to your primary residence. You can’t just wave a magic wand. Then turn it into an investment property when the designated zoning changes in your area. The Internal Revenue Service looks at the way you used your property prior to selling it to determine whether you owned it for personal use or it was an investment. 

Having said that, a lot of people have worked from home during the pandemic. If you’ve owned your home for some years. And used part of your home as a home office. Then took the home office deduction on your federal income tax return. You could say that most of your home was owned for your personal use. And a smaller part was used for business purposes. You could then sell the home and get the home sale exclusion of $250,000 (if you are single, or $500,000 if you are married) and then use the 1031 exchange for that portion of the home that you used for business purposes.

1031 Exchange

A 1031 exchange is a mechanism under Section 1031 of the Internal Revenue Code that permits an owner of an investment property to sell that property and then purchase a replacement property. When it is done correctly, the owner of the property would pay no federal income taxes on the sale of the first property and could defer paying taxes on gains until the property is sold down the line. 

There are a number of rules to qualify for a 1031 exchange — sometimes called a like kind exchange or, less frequently, a Starker Trust. First, the property that you are selling must have been used for investment or business purposes. You must use a qualified intermediary (or 1031 exchange intermediary or company) to handle the transaction. Third, you must designate a replacement property no later than the 45th day following the sale of the property. And, finally,  you must close on the replacement property no later than the 180th day following the closing of the sale (or a shorter period of time, if you are required to file your income tax return for the year in which you sold the property).

You can download information about like-kind exchanges from the IRS website ( or from the many companies that assist investors with these exchanges (

Consult with professional help

Sound good? Here’s the caveat: If you never used the property for business or investment purposes, you would not qualify for the 1031 exchange. You might have to rent the property for a period of time. Maybe at least 2 years, and then sell it using a like-kind exchange. You might not need to rent your house, but if you leased the land to a farmer, for example, that would count. But as it stands now. Your property is not set up for you to use as a property under the like-kind exchange rules. 

You should consult with a company that specializes in like-kind exchanges. Even a local attorney that handles these exchanges for other property owners. They can go over the rules with you and help you understand what options you have. They will know how long you have to rent or lease the property for it to be considered an investment property. Then review how much profit you might expect in a sale. You can then determine whether a 1031 exchange will work. What the costs will be to hire the team you need to successfully conclude a 1031 exchange.

Good luck. 

©2022 by Ilyce Glink and Samuel J. Tamkin.