The Power of 1031 Exchanges: It Does More Than Defer the Gain

Posted by Margo McDonnell, CRE, CES® | Wed, Mar 20, 2024

You have owned your rental property in Stone Harbor for nearly two decades. It provides a nice income for you, but with many newer properties on the rental market, yours is not as sought after as it used to be. You have many options to consider. Do you renovate, tear down and rebuild, or sell the property as is? While they are all worthy options, a 1031 exchange may be the right solution. A 1031 exchange enables the seller of an investment or business use property to defer the gain when buying replacement property and structured correctly. Section 1031 of the tax code is known as a tax-deferral strategy, but its ability to help investors solve problems, create opportunities, and build wealth is what makes exchanges so much more powerful. 

A 1031 exchange would allow you to exchange that property for one closer to the water, newer, bigger, and with more amenities, allowing you to generate a greater annual cash flow. Selling without an exchange would require you to pay state and federal taxes on the gain and recognize all depreciation taken during your twenty years of ownership at 25%, leaving you with a fraction of your equity. 

While this is a great tax strategy to help you roll all of the gain and depreciation into the new property without paying the tax now, there are many problems 1031 exchanges can help you solve. 

Desire for a vacation home: While a 1031 exchange will not allow you to buy a vacation and use it more than 14 days per year, it will enable you to acquire a property as a rental and, after using it as a rental for two years, convert it to your dream vacation home. No tax is due at the time of the conversation, but remember, the deferred gain is still in the property.  

Hope for diversification: A 1031 exchange would enable you to acquire two or three replacement properties, diversifying the types of properties and/or their locations.   

Steadier cash flow: While the Stone Harbor rental property has been an excellent investment and enjoyed significant appreciation, most of your wealth is tied up in this property, and its annual cash flow depends on the economy and the rental market. An exchange will allow you to acquire replacement property with steady year-round cash flow.  

Require less management: Being a landlord is not easy, but hiring a good listing agent can relieve some of the stress. A Triple Net Lease (NNN) property or a Delaware Statutory Trust (DST) could be a good option if you want a more passive investment. A NNN example is a CVS location where you own the land and building, and the tenant pays rent, insurance, utilities, taxes, maintenance expenses, etc. A DST is a fractional interest in a trust that owns institutional-grade investment property. These passive investments eliminate the headaches of property management while generating steady cash flow. 

Yearning for retirement home: Another snowstorm coming and another reminder that you want to retire someplace much warmer. A 1031 exchange will allow you to split the Stone Harbor proceeds into another Stone Harbor rental and a rental in Florida. After two years of renting the Florida property, you can move into it (or become a snowbird) without triggering tax. Perhaps you can find a new housing development in Florida, buy the sample home, lease it back to the builder, and know your tenant will take great care of your future residence. 

Time for estate planning: As we age, estate planning is a must. Many do not realize their heirs inherit all their assets on a stepped-up basis when they pass away. The basis resets to its value at the time of death, and any gain deferred in a 1031 exchange is forgiven. A 1031 exchange will enable you to grow your real estate portfolio with pre-tax dollars while building wealth and preserving equity.  

Following is a quick overview of the requirements of a successful exchange: 

Like-kind property: Like-kind refers to the use or character of a property, not the specific kind or type of property. Any kind of real property held for investment or use in a trade or business can be exchanged for any other real property held for investment or use in a trade or business. The property must be located in the U.S., and you can buy or sell more than one.  

Timelines: Beginning on the date the old property is transferred to a buyer, you have 45 days to identify replacement property and, running concurrently, 180 days to acquire the replacement property.  

Need for a Qualified Intermediary: An independent party, referred to as a Qualified Intermediary (QI), is required to facilitate a 1031 exchange. The QI will ensure all exchange requirements are satisfied and keep the exchange process easy. The QI cannot be your attorney, accountant, real estate professional, or a close relative and must be in place before the old property is transferred to a buyer. This is the role 1031 CORP. provides.

No access to exchange funds: When completing an exchange, you cannot have actual or constructive rights to your sale proceeds. The QI will hold them on your behalf. (Note: 1031 CORP. will deposit your funds in a 100% FDIC-insured account, and you can view your account on the bank’s website.) 

Maximizing the deferral: To maximize your tax deferral, you must (1) acquire replacement property equal or greater to the net selling price of your old property and (2) reinvest all net equity. A trade-down in value or equity is taxable and referred to as “boot.” Your tax and/or legal advisors can help determine if an exchange is best for your situation.  

Same owner: The old and new property must be owned by the same taxpayer who has reported the property on their tax return. Any taxpayer can complete an exchange (individual, married couple, partnership/LLC, trust, or corporation).  

A 1031 exchange is a powerful tax strategy; the more you learn about it, the more advantageous it is.   


1031 CORP. cannot provide tax or legal advice, but our knowledgeable Exchange Team is here to educate Exchangers and work with their advisors. 

Topics: 1031 Exchange, 1031 Exchange Benefits, Live

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