What is a 1031 Exchange in New Jersey?

A 1031 exchange is one of the most powerful tax strategies available to real estate investors in New Jersey. Under Section 1031 of the Internal Revenue Code, property owners can defer capital gains taxes when they sell an investment or business property and reinvest the proceeds into another qualifying property. By postponing taxes, investors can preserve more capital, grow their portfolios faster, and maximize long-term wealth. For anyone considering buying, selling, or upgrading investment property in New Jersey, understanding how a 1031 exchange works is essential.

Because the rules governing 1031 exchanges are detailed and time-sensitive, working with an experienced New Jersey real estate lawyer can make all the difference. A knowledgeable attorney can guide you through eligibility requirements, help structure the transaction properly, and ensure compliance with both federal and state tax laws. Call The Matus Law Group at (732) 785-4453 today to schedule a consultation.

The Strategic Advantage of a 1031 Exchange

For savvy real estate investors in New Jersey, portfolio growth is as much about smart financial strategy as it is about property selection. One of the most powerful tools available is the like-kind exchange, governed by Section 1031 of the Internal Revenue Code. Commonly known as a 1031 exchange, this provision is not a loophole; it is a congressionally sanctioned strategy that has been part of U.S. tax policy since the Revenue Act of 1921. Its enduring purpose is to encourage reinvestment and market fluidity by allowing investors to defer capital gains taxes that would otherwise be triggered upon the sale of an investment property.

Using a 1031 exchange, an investor can reinvest the proceeds from the sale of one qualifying property into another, ensuring that their equity continues working for them. Instead of having their capital eroded by immediate taxation, investors can compound growth by maintaining a larger investment base across transactions.

The Core Principle: Tax Deferral, Not Tax-Free

A crucial point for investors to understand is that a 1031 exchange is tax-deferred, not tax-free. The tax liability does not vanish; instead, it is carried forward through the mechanism of the property’s cost basis. When a property is sold and exchanged for another, the cost basis of the relinquished property transfers, subject to adjustments, to the replacement property.

This means that the deferred gain remains embedded in the new property and will eventually be recognized when the investor chooses to sell for cash rather than exchange again. The guiding legislative philosophy behind this deferral is the “continuity of investment” principle. When an investor exchanges property, they have not truly cashed out but merely shifted their capital from one real estate asset to another. This framework keeps capital actively invested in real estate, encouraging liquidity, property improvement, and economic growth.

Strategic Benefits for the New Jersey Investor

A properly executed 1031 exchange offers a wide range of long-term advantages:

• Wealth Compounding: Deferring taxes allows investors to retain 100% of their sale proceeds for reinvestment. This allows them to acquire larger or higher-value properties, accelerating wealth accumulation compared to conventional sales, where tax obligations immediately reduce available equity.
• Portfolio Diversification and Upgrading: The “like-kind” standard is broad, providing flexibility to reposition investments. For example, an investor might exchange a single-family rental in Summit for a low-maintenance commercial property in Newark under a triple-net (NNN) lease. Alternatively, they could trade one industrial property for several multi-family buildings across different New Jersey municipalities, spreading risk and optimizing income streams.
• Estate Planning and the Stepped-Up Basis: Perhaps the most significant long-term benefit is the ability to use 1031 exchanges throughout a lifetime. Investors can continually defer capital gains, and upon death, their heirs inherit the property at its fair market value through the stepped-up basis rule. This effectively wipes away decades of deferred tax liability, enabling tax-efficient wealth transfer to the next generation.

Strategic Benefit	How It Works / Mechanism	Key Advantage / Example
Wealth Compounding	Deferring capital gains taxes allows investors to reinvest the full proceeds from a sale, increasing purchasing power and long-term returns.	Investors can acquire higher-value properties and grow wealth faster through compounded returns.
Portfolio Diversification and Upgrading	The broad like-kind standard enables exchanging between different property types or locations without triggering taxes.	Investors can shift from one property type to another or diversify holdings to balance risk and income potential.
Estate Planning and the Stepped-Up Basis	Deferred gains are eliminated when heirs inherit the property with a stepped-up basis to fair market value.	Heirs can sell inherited property with little or no capital gains tax, preserving family wealth.

Qualifying for a 1031 Exchange

The significant tax advantages of a Section 1031 exchange are available only if the investor complies with a set of foundational rules established by the IRS. Both the properties involved in the exchange and the investor’s intent must meet specific criteria.

The “Qualified Use” Test: Investment or Business Property Only

The cornerstone of a valid 1031 exchange is the qualified use test. This rule requires that both the relinquished property being sold and the replacement property being acquired are “held for productive use in a trade or business or for investment.”

This requirement excludes certain categories of real estate from eligibility:

• Personal Use Property: A primary residence, a second home, or a vacation property used mainly for personal enjoyment does not qualify. However, there are circumstances in which personal-use property can be converted into qualifying investment property. For example, IRS safe harbor guidance allows property owners to establish investment intent by renting the property at fair market value for a specified period before completing an exchange.
• Property Held Primarily for Sale: Real estate held by a developer, builder, or “flipper” is considered dealer property, or inventory. Because these assets are intended for sale in the ordinary course of business, they do not meet the requirements of Section 1031.

The “Like-Kind” Property Rule

The Tax Cuts and Jobs Act of 2017 (TCJA) introduced a pivotal change to Section 1031. Effective January 1, 2018, the law restricted 1031 treatment exclusively to real property. Personal property such as vehicles, machinery, artwork, or intellectual property is no longer eligible for tax-deferred exchange treatment.

While this narrowed the scope of the rule, it strengthened the 1031 exchange as a real estate-specific strategy. The broad definition of “like-kind” for real property provides New Jersey investors with considerable flexibility. The IRS evaluates “like-kind” based on the nature or character of the property, not its quality or condition.

Examples of qualifying like-kind exchanges include:

• An apartment building for a commercial shopping center
• Vacant land for an improved office building
• A single-family rental for an industrial warehouse
• New Jersey farmland for a multi-family complex in another state

Special Property Interests and Geographic Limitations

The category of qualifying real property is not limited to traditional ownership. Certain specialized property interests also qualify for a 1031 exchange, such as:

• Delaware Statutory Trust (DST) interests: Treated as direct ownership of real property for federal tax purposes.
• Tenant-in-Common (TIC) interests: Fractional ownership in a property that can be exchanged for another TIC or a full ownership interest elsewhere.
• Leasehold interests: A lease with 30 or more years remaining, including optional renewal terms, qualifies as like-kind to fee-simple ownership.
• Other property rights: In some states, perpetual rights such as mineral, water, or development rights may also qualify.

One critical limitation applies to geography: U.S. property cannot be exchanged for property located outside the United States. For a transaction to qualify, both the relinquished and replacement properties must be within the U.S.

The Exchange Process: Timelines and Intermediaries

The most common type of 1031 exchange is the deferred exchange, where the sale of the relinquished property and the acquisition of the replacement property do not occur on the same day. To protect the integrity of the process and to prevent investors from having control over funds, the IRS requires strict adherence to procedures involving a neutral third party and fixed deadlines.

The Role of the Qualified Intermediary (QI)

In a deferred exchange, the investor cannot have actual or constructive receipt of the sale proceeds. If the investor gains access to the funds, even briefly, the exchange is immediately disqualified and the capital gain becomes taxable.

To prevent this, the process must be facilitated by a Qualified Intermediary (QI), sometimes called an Accommodator or Facilitator. The QI is an independent third party who ensures that the exchange complies with IRS rules. Their key responsibilities include:

• Preparing Exchange Documents: The QI drafts the Exchange Agreement that formally establishes the 1031 exchange, along with assignments for the sale and purchase contracts.
• Holding Exchange Funds: The proceeds from the sale are wired directly to the QI, who keeps them in a secure escrow account until needed.
• Facilitating the Transaction: The QI receives the investor’s written identification of the replacement property and transfers funds at closing to acquire the replacement property.

IRS rules are very strict about who can serve as a QI. The investor cannot act as their own facilitator. In addition, a “disqualified person” cannot serve as a QI. This includes anyone who has acted as the investor’s agent within the past two years, such as an employee, attorney, accountant, investment banker, or real estate broker. The goal is to ensure the use of a truly independent intermediary with no conflicts of interest.

The 45-Day and 180-Day Rules

The IRS imposes two strict deadlines for a deferred exchange. These deadlines begin the day after the relinquished property closes and cannot be extended, except in the rare case of a presidentially declared disaster.

The 45-Day Identification Period

Investors have 45 calendar days to identify potential replacement properties. The identification must be written, signed by the investor, and delivered to the QI before midnight on the 45th day. Each property must be described clearly, typically with a legal description or street address.

The 180-Day Exchange Period

Investors must acquire and close on the replacement property within 180 calendar days of the sale of the relinquished property, or by the due date of their federal tax return for that year (including extensions), whichever comes first.

It is important to note that these two periods run at the same time. If the full 45 days are used for property identification, only 135 days remain to perform due diligence, obtain financing, and complete the closing. Investors must also be cautious with transactions that close late in the year. A sale that closes between October 17 and December 31 will be cut short by the April 15 tax filing deadline, unless the investor files an extension.

The Identification Rules

To provide flexibility, the IRS allows three different methods for identifying replacement properties. An investor must comply with one of these rules to preserve the exchange.

• The Three-Property Rule: An investor may identify up to three replacement properties of any value. This is the most common and flexible option because it allows for backup choices without complicated calculations.
• The 200% Rule: An investor may identify more than three properties, as long as the total fair market value of the properties identified does not exceed 200% of the value of the relinquished property. This rule works well for investors who want to diversify into several smaller assets.
• The 95% Rule: An investor may identify any number of properties without a value cap, but they must acquire at least 95% of the total fair market value of all the properties identified. This option is risky because failing to meet the 95% threshold will disqualify the entire exchange.

New Jersey Real Estate Lawyer Christine Matus

New Jersey’s Recognition of 1031 Exchanges

New Jersey law conforms to the federal framework of IRC Section 1031. This means that when an investor structures a 1031 exchange properly, they can defer not only federal capital gains taxes but also New Jersey’s state-level capital gains tax. With state income tax rates that can reach 10.75%, the ability to defer state tax is a major financial advantage for real estate investors in New Jersey.

Understanding the New Jersey “Exit Tax”

One of the most common sources of confusion for sellers of New Jersey real estate is the so-called Exit Tax. Despite its name, this is not an additional tax. Instead, it is a mandatory prepayment of estimated gross income tax on any gain realized from the sale of real property. The purpose of this requirement is to ensure that the state collects its share of taxes, particularly from sellers who are non-residents or who plan to leave the state after the sale.

At closing, the amount withheld is whichever is greater:

• 2% of the total selling price, or
• the gain multiplied by New Jersey’s highest Gross Income Tax rate

This amount is held in escrow and credited to the seller’s account. The final liability is reconciled when the seller files their New Jersey income tax return, and any overpayment is refunded.

The GIT/REP Forms: What Investors Must Know

To record a deed in any New Jersey county, the seller must submit a GIT/REP form. These forms notify the state about the sale and determine whether estimated tax must be prepaid. For investors completing a 1031 exchange, understanding which form to use is critical.

Form GIT/REP-3 (Seller’s Residency Certification/Exemption)

This form is used by New Jersey residents who are exempt from prepayment because they will report the transaction on their state tax return. It is also the correct form for both residents and non-residents conducting a 1031 exchange, provided the investor is reinvesting 100% of the proceeds and is not receiving any taxable boot.

Form GIT/REP-1 (Nonresident Seller’s Tax Declaration)

This form is required when a prepayment must be made. In the context of a 1031 exchange, it applies if the investor receives taxable boot, such as cash or debt relief, because the exchange is not a perfect reinvestment.

How the Rules Play Out in Practice

New Jersey’s dual-form system often surprises investors because it treats the deferred and taxable portions of an exchange separately. Even though federal law views the transaction as a single exchange, the state requires separate reporting at closing.

For example, consider a non-resident investor who sells a New Jersey investment property for $1 million in a 1031 exchange. They acquire a replacement property for $900,000, which leaves $100,000 in taxable boot. At closing, the investor must:

• File a GIT/REP-3 to claim an exemption for the $900,000 portion of the transaction that qualifies for deferral, and
• File a GIT/REP-1 to declare the $100,000 of taxable boot and make the required prepayment on that gain.

Failure to file both forms correctly and to remit the necessary prepayment can delay or even jeopardize the closing. It can also result in penalties from the state, even if the federal requirements of Section 1031 have been fully satisfied.

Secure Your Investment with the Right Guidance

A 1031 exchange can be a game-changing tool for real estate investors in New Jersey, offering the ability to defer taxes, preserve capital, and build long-term wealth. Yet, the rules are strict, and even small mistakes can put your tax benefits at risk. Understanding the federal framework and New Jersey’s specific requirements allows investors to take full advantage of this strategy while avoiding costly pitfalls.

If you are considering a 1031 exchange, the guidance of an experienced New Jersey real estate lawyer is invaluable. The Matus Law Group has extensive knowledge of both state and federal tax laws and can help you structure your exchange with confidence. Call The Matus Law Group at (732) 785-4453 today to schedule a consultation.