Level Up Your Portfolio—Tax-Free—with 1031 Real Estate Swaps
So, it’s time to sell that real estate investment property you own. Maybe the property value has appreciated significantly. Maybe you’re tired of the hassles of property management. Or perhaps you think you can better optimize your funds with a different investment. That’s exciting!
But there’s one potential downside: taxes. Specifically, the gains from the sale of a rental property are subject to capital gains tax. That can take a big bite out of your profits.
Fortunately, there’s a solution — a 1031 exchange. This strategy allows you to defer paying capital gains taxes when you reinvest the proceeds from the sale into a similar “like-kind” investment property. It’s a smart way to keep your money working for you.
Traditional 1031 Exchange
The most common approach is to sell one investment property and purchase another. If you’re planning to continue investing in and managing real estate, this can be a seamless transition.
However, timing is critical. You must:
- Identify a potential replacement property within 45 days of the sale.
- Close on the new property within 180 days.
These deadlines are strict, so it’s important to plan carefully.
Important Considerations
It is important to know that taking control of the proceeds before the exchange is complete may disqualify you from a like-kind exchange, making gain immediately taxable.
One way to avoid this is to use a neutral third party, called a qualified intermediary, to hold the proceeds until the exchange is complete. If using a qualified intermediary, please be sure to use caution and diligence in your selection, verifying the party is reputable.
Estate Planning Advantage
Another major benefit of a 1031 exchange is its impact on estate planning. When you pass away, your heirs receive the property at its stepped-up market value. That means the deferred capital gains taxes are effectively erased, and your heirs won’t owe taxes on those gains. It’s a powerful way to preserve wealth across generations.
1031 Exchange Without Managing a Property
What if you’re ready to step away from the daily responsibilities of managing real estate—no more tenant calls, maintenance issues, or property oversight? The good news is that you don’t need to give up the tax benefits of a 1031 exchange just because you no longer want to be an active landlord.
Instead of purchasing and managing a new physical property yourself, you can redirect your 1031 exchange proceeds into passive real estate investments. Two of the most popular options include:
- Delaware Statutory Trusts (DSTs)
A Delaware Statutory Trust (DST) is a legal entity that holds title to investment real estate. Multiple investors can purchase fractional ownership in the trust, which in turn owns and manages large-scale properties—such as apartment complexes, medical offices, industrial facilities, or retail centers.
Why DSTs Work for 1031 Exchanges:
- IRS-Approved: DSTs are considered “like-kind” property under IRS rules, making them eligible for 1031 exchanges.
- Fully Passive Ownership: You own a beneficial interest in the trust, not the property itself, which means no management responsibilities.
- Diversification: DSTs often include institutional-grade properties in various locations, spreading risk across sectors and geographies.
- Professional Management: The trust is managed by a sponsor or asset manager with expertise in operating and optimizing the properties.
Considerations:
- Investments are typically illiquid and long-term (often 5–10 years).
- You have no control over property decisions (e.g., when to sell or refinance).
- Minimum investments usually start around $100,000.
- 1031-Eligible Real Estate Funds / REITs via UPREITs or TICs
While traditional Real Estate Investment Trusts (REITs) generally do not qualify for 1031 exchanges because they are considered securities (not real property), there are specialized structures that can allow for similar diversification and passive income:
Two Main Workarounds:
- Tenants-in-Common (TIC) Investments: These allow multiple investors to hold fractional undivided interests in a property. They are eligible for 1031 exchanges and often used for high-value commercial or multifamily properties. Like DSTs, TICs are professionally managed.
- UPREIT Structures (Umbrella Partnership REIT): While not directly compatible with a 1031 exchange, some property owners can contribute their real estate to an operating partnership of a REIT in exchange for units (similar to shares). This allows for tax deferral, but it’s a more complex strategy and often used in institutional or high-net-worth scenarios.
Benefits:
- Passive income through distributions.
- Exposure to professionally managed, income-generating real estate.
- Diversification across property types and geographic markets.
DST vs. TIC vs. UPREIT vs. REIT Comparison Table
| Feature | Delaware Statutory Trust (DST) | Tenants-in-Common (TIC) | UPREIT (Umbrella Partnership REIT) | REIT (Real Estate Investment Trust) |
| 1031 Exchange Eligible | Yes – Qualifies under IRS Revenue Ruling 2004-86 | Yes – Qualifies under IRS Rev. Proc. 2002-22 | Indirect – Property contributed in exchange for OP Units | No – Shares are not “like-kind” property |
| Ownership Type | Beneficial interest in a trust | Direct fractional property ownership | Partnership units (OP Units) in REIT operating partnership | Shares in a trust or corporation |
| Minimum Investment | Typically $100,000+ | Typically $250,000+ | Typically requires high-value property contribution | As low as $100 (public REITs) |
| Management Control | None – Managed by sponsor/trustee | Limited – Major decisions require consensus | None – REIT manages properties | None – Investors have no control |
| Liquidity | Illiquid – 5–10 year hold typical | Illiquid – No active resale market | Illiquid initially; OP Units may convert to REIT shares | High – Public REITs are exchange-traded |
| Diversification | Often across multiple properties and tenants | Typically one property | Yes – Through REIT holdings | Yes – Across sectors, properties, and regions |
| Financing Complexity | Sponsor arranges non-recourse debt | All co-owners must qualify and sign loan docs | REIT handles all financing | Handled entirely by REIT |
| Tax Reporting | 1099 or K-1 depending on structure | Typically 1099 or K-1 | K-1 for OP Unit holders | 1099-DIV issued to shareholders |
| Estate Planning Advantage | Step-up in basis eliminates deferred capital gains | Step-up in basis eliminates deferred capital gains | Step-up in basis applies to OP Units | Step-up in basis applies; no 1031 deferral unless via UPREIT |
| Investor Role | Fully passive | Semi-active – co-owner decisions may be required | Passive | Passive |
| Typical Use Case | Passive 1031 exchange solution | 1031 investors co-owning a property | Large investors deferring gains into REITs | General investors seeking liquid real estate exposure |
Conclusion
Nobody enjoys paying more taxes than necessary. A 1031 exchange, you can defer capital gains taxes, reinvest your profits, and even create long-term benefits for your heirs. Whether you want to stay in real estate or step away from active management, a 1031 exchange is a valuable strategy to explore.
Sources:
IRS Revenue Ruling 2004-86 (DSTs): https://www.irs.gov
IRS Revenue Procedure 2002-22 (TICs): https://www.irs.gov
NAREIT – UPREIT Structure Overview: https://www.reit.com
IRS Estate Tax FAQs (Step-up in Basis): https://www.irs.gov