A 1031 exchange (named for IRC Section 1031) lets you sell a rental property, reinvest the proceeds into another investment property, and defer capital gains tax and depreciation recapture. For small multifamily investors, it is the standard engine for trading up — selling a $300,000 duplex and rolling everything into a $550,000 fourplex without writing a six-figure check to the IRS.
What Qualifies
Both the relinquished (sold) and replacement (bought) properties must be held for productive use in a trade or business or for investment. A duplex you have rented for three years qualifies. Your primary residence does not (that is the Section 121 exclusion instead). House hacks are a gray zone — consult a CPA before exchanging a property you lived in.
The Two Clocks (Non-Negotiable)
- 45-day identification period: from closing on your sale, you have 45 calendar days to identify replacement property(ies) in writing.
- 180-day exchange period: you must close on the replacement within 180 days of the sale (or the due date of your tax return with extensions, whichever is earlier).
Miss either deadline by one day and the exchange fails — all gains become taxable.
The Identification Rules
You may identify replacement properties using any one of these tests:
- 3-Property Rule: identify up to 3 properties, regardless of value
- 200% Rule: identify any number of properties as long as their combined value does not exceed 200% of the relinquished property's sale price
- 95% Rule: identify any number, but you must close on 95% of the total identified value (rarely used)
Identification must be unambiguous — a written notice to your Qualified Intermediary with legal descriptions or exact addresses.
The Qualified Intermediary (QI)
You cannot touch the money. Sale proceeds must go directly to a Qualified Intermediary — a third-party exchange facilitator who holds funds and acquires/disposes of properties on your behalf. Choose a QI with bonding, insurance, and a track record; if a QI goes bankrupt mid-exchange, your money is at risk.
Worked Example: Duplex to Fourplex
Sale:
- Duplex sells for $340,000; mortgage payoff $180,000; selling costs $22,000
- Net proceeds to QI: $138,000
- Original basis after depreciation: $190,000; gain + recapture: ~$150,000 (deferred if exchange completes)
Replacement:
- Fourplex purchase: $560,000
- Identify within 45 days (three fourplexes identified under the 3-Property Rule)
- Close within 180 days
To fully defer tax, you must reinvest:
- All net proceeds ($138,000) as part of the purchase
- Equal or greater debt — new mortgage of at least $180,000 (or add equivalent cash)
New loan: $336,000 (60% LTV) + QI funds $138,000 + $86,000 of fresh cash = $560,000. Tax deferred on the entire gain.
Boot: The Taxable Leakage
Anything of value you receive instead of like-kind real estate is boot — taxable immediately:
- Cash boot: leftover proceeds paid to you at closing
- Mortgage boot (debt reduction): replacing a $180,000 loan with a $120,000 loan means $60,000 of debt relief that must be offset with extra cash, or it is taxable
- Personal property received in the deal
- Not-like-kind services (seller financing received from your buyer is boot unless structured properly)
Common Failure Modes
- Missing the 45-day deadline while "still looking" — identify something valid, even if you plan to swap
- Touching the proceeds — even a brief deposit into your own account can blow the exchange
- Buying a lesser property and pocketing the difference without realizing it is boot
- Using the same attorney/agent on both sides in ways that create agency problems (allowed, but disclose to the QI)
- Reverse or improvement exchanges without experienced QIs — legal, but far more complex
The Strategy for Small Investors
The classic ladder: house hack a duplex → 1031 into a fourplex → 1031 into an 8-12 unit building, deferring tax at each step. Each exchange resets your depreciation clock on the new property, compounding the tax shelter (see our depreciation guide and cost segregation guide).
Underwrite the Replacement Before You Sell
Before listing your duplex, model the fourplex you are targeting — rents, expenses, NOI, and debt service — in the Multifamily Cash Flow & NOI Calculator and verify financing coverage with the DSCR Loan Calculator. The 180-day clock is a terrible time to discover the replacement does not cash flow.
Educational content, not tax or legal advice — always work with a CPA and a Qualified Intermediary.