What Is a 1035 Exchange in Real Estate vs. 1031?

A 1035 exchange does not apply to real estate. Section 1035 of the Internal Revenue Code governs tax-free exchanges of life insurance policies, annuities, endowment contracts, and long-term care contracts. If you’re selling investment or business property and want to defer capital gains tax, the provision you’re looking for is Section 1031, which authorizes like-kind exchanges of real property. The two sections share adjacent numbers and a similar structure, and that’s where the confusion begins.

What Section 1035 Actually Covers

Section 1035 lets you swap one insurance-type contract for another without recognizing gain on the transfer. The permitted swaps run in one direction: life insurance can be exchanged for another life policy, an endowment, an annuity, or a qualified long-term care contract; an annuity can be exchanged for another annuity or a long-term care contract; long-term care can be exchanged for long-term care. You can move down that list, not up. Both contracts must cover the same insured.¹

Nothing in Section 1035 reaches real property. If an advisor or article refers to a “1035 exchange” on a rental building or land, they mean a 1031 exchange and have the number wrong.

How a 1031 Exchange Works

Section 1031 lets you sell investment or business real estate, reinvest the proceeds into replacement real estate, and defer the capital gains tax you would otherwise owe. The IRS treats the transaction as a continuation of your original investment rather than a taxable sale.²

The “like-kind” label sounds narrower than it is. Nearly any real estate qualifies as like-kind to any other real estate held for the same purpose. Raw land can be exchanged for a commercial building, a warehouse for an apartment complex, a strip mall for a single-family rental. What matters is that both properties are real estate held for productive use in a trade or business or for investment.

The tax break is deferral, not forgiveness. The gain carries forward into your replacement property through a carryover basis, and it stays there until you sell without doing another exchange. As a later section explains, that “until” can effectively become “never” with the right estate planning.

Which Properties Qualify

Both the property you give up (the relinquished property) and the property you acquire (the replacement) must be held for business or investment. That requirement rules out several common situations:

Your primary residence, because you’re living in it rather than holding it for investment. A separate exclusion under Section 121 may apply when you sell your home.
Fix-and-flip properties, because the IRS treats them as inventory. Intent at the time of purchase controls.
Partnership interests, with a narrow exception for partnerships that have elected out of partnership tax treatment under Section 761(a).²
Exchanges between U.S. and foreign real estate. Both properties must be in the same country.

Vacation Homes and Mixed-Use Property

A property you rent out most of the year is clearly investment; a cabin you use every summer and never rent is clearly personal. Most vacation homes fall between. The IRS published a safe harbor with a bright line: you must rent the property at fair market rates for at least 14 days during each of the two 12-month periods before the exchange (relinquished property) or after it (replacement property), and your personal use during each period cannot exceed the greater of 14 days or 10 percent of the days it was rented.³ Meeting the safe harbor doesn’t guarantee 1031 treatment, but it stops the IRS from challenging it.

You Can’t Touch the Money: The Qualified Intermediary

If the sale proceeds land in your bank account, the exchange fails. A Qualified Intermediary (QI), also called an exchange facilitator, holds the funds in escrow after the sale and uses them to acquire the replacement property on your behalf.⁴

Not just anyone can serve as your QI. Anyone who has acted as your employee, attorney, accountant, real estate agent, or investment broker within two years of the sale is disqualified, and the restriction extends to everyone in the same firm or brokerage.⁵ You’ll need a dedicated exchange company, not your closing attorney.

One risk investors often miss: QI companies are largely unregulated at the federal level. Your funds sitting with a QI are not covered by FDIC insurance or any federal guarantee. If the QI goes bankrupt or misappropriates the money, you absorb the loss. Look for QIs that use segregated accounts at FDIC-insured banks, carry fidelity bonds and errors-and-omissions coverage, and have a real track record. Fees for a standard forward exchange typically run $600 to $1,200.

The 45-Day and 180-Day Deadlines

Two statutory clocks start on the day you transfer the relinquished property. Miss either and the whole exchange collapses.

Within 45 days, you must identify potential replacement properties in writing to the QI or another non-disqualified party. A street address or legal description works; something like “a property in Phoenix” does not.⁶
Within 180 days, or by the due date of your tax return for the year of the sale including extensions (whichever is earlier), you must close on the replacement property.²

The two periods run at the same time, not back-to-back. You get 180 total days from sale to closing, with identification locked in by day 45. The deadlines are statutory. The IRS can’t extend them for hardship, a deal falling through, or inconvenience. The only recognized exception is a presidentially declared disaster.⁴

Watch the tax-return trap. If you sell on December 1 and file your return on April 15 without an extension, your 180-day window shrinks to roughly 135 days. Filing for an extension restores the full period, and most exchange advisors treat that extension as routine.

The Three Identification Methods

You must satisfy one of these three rules during the 45-day window:

Three-property rule: identify up to three properties regardless of value. Most investors use this one because it leaves room for a deal to fall through.
200-percent rule: identify any number of properties as long as their total fair market value doesn’t exceed 200 percent of the relinquished property’s value.
95-percent rule: identify any number of properties at any value, but you must actually acquire at least 95 percent of the total identified value. It’s a safety net rather than a planning tool.

Exceed all three rules and the IRS treats you as having identified nothing, which ends the exchange.⁷

Boot: The Part That Gets Taxed

A clean exchange defers all gain. Anything that falls short creates “boot,” which is taxed in the year of the exchange.

Cash boot is straightforward. If leftover proceeds land in your pocket, or the replacement property costs less than the relinquished one and you keep the difference, that money is taxable.

Mortgage boot catches more investors off guard. If the debt on your replacement property is lower than the debt on the property you sold, the IRS treats the debt reduction as if you received cash. Sell a property with a $500,000 mortgage, buy a replacement with a $350,000 mortgage, and $150,000 in debt relief is mortgage boot, taxable up to the amount of your realized gain. You can offset it by adding your own cash to the exchange. For full deferral, the replacement property must be equal or greater in value, and your total debt plus cash invested must be at least what you had in the relinquished property.

Basis Carryover, Depreciation Recapture, and Step-Up at Death

Your basis carries over. The basis in the replacement property equals your old basis, plus any additional cash invested or new debt, minus any boot received. That carryover preserves the deferred gain and, importantly, the depreciation you’ve already claimed.

When you eventually sell a property in a taxable transaction rather than exchanging again, two separate taxes apply to the gain:

Capital gains tax on the appreciation above your original purchase price, at a long-term rate that tops out at 20 percent for high-income taxpayers.
Depreciation recapture on all the depreciation claimed over the years (the unrecaptured Section 1250 gain), taxed at a rate capped at 25 percent.

High-income investors also face a 3.8 percent Net Investment Income Tax on capital gains once modified adjusted gross income exceeds $200,000 (single) or $250,000 (married filing jointly).⁸ Stack these together and the exit tax on a chain of exchanges can be substantial.

Then comes the estate planning payoff. Under Section 1014, when a property owner dies, heirs receive the property with a basis stepped up to its fair market value on the date of death.⁹ The deferred gain from every prior 1031 exchange, and the accumulated depreciation recapture along with it, disappears.

An investor who bought a rental for $200,000, exchanged into progressively larger properties over 30 years, and died holding a $2 million property leaves heirs $1.8 million of gain that is never taxed. The heirs take a $2 million basis and can sell the next day with no federal tax on the appreciation, or begin a fresh depreciation schedule and their own chain of exchanges. That combination of lifetime deferral and step-up at death is why many investors keep exchanging even when the transaction costs feel heavy.

Related-Party Exchanges and Reverse Exchanges

You can exchange with a family member or related entity, but a two-year holding period applies on both sides. If either party sells within two years, the deferred gain becomes taxable in the year of that sale.¹⁰ Death of a party during the holding period, and involuntary conversions like condemnation or natural disaster, are the two recognized exceptions.

If you need to buy the replacement property before selling the old one, the IRS allows a reverse exchange under a safe harbor set out in Revenue Procedure 2000-37. A special-purpose entity called an Exchange Accommodation Titleholder parks title to whichever property is waiting.¹¹ The same 45- and 180-day clocks apply, running from the day the parked property is acquired. Reverse exchanges are more expensive than forward exchanges because of the extra entity, financing, and legal work.

Reporting the Exchange

Every 1031 exchange is reported on Form 8824, filed with your tax return for the year you transferred the relinquished property. The form calculates deferred gain, any recognized gain from boot, and the basis of the replacement property.⁶ For related-party exchanges, you must also file Form 8824 for each of the two tax years following the exchange, whether or not anything else happened. The basis and boot calculations are complex enough that most investors have a tax professional prepare the form.

1
Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies
2
Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment
3
Internal Revenue Service. Revenue Procedure 2008-16 – Safe Harbor for Dwelling Units in Section 1031 Exchanges
4
Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031
5
Internal Revenue Service. Miscellaneous Qualified Intermediary Information
6
Internal Revenue Service. Instructions for Form 8824 (2025)
7
eCFR. 26 CFR 1.1031(k)-1 – Treatment of Deferred Exchanges
8
Internal Revenue Service. Net Investment Income Tax
9
Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent
10
Office of the Law Revision Counsel. 26 U.S. Code 1031 – Exchange of Real Property Held for Productive Use or Investment
11
Internal Revenue Service. Revenue Procedure 2000-37 – Property Held for Productive Use in Trade or Business or for Investment