Learn everything you need to know about 1031 exchanges and selling a home in under two minutes with expert Cubie Hernandez! Or keep reading for an in-depth discussion about the pros and cons of 1031 exchanges.
A 1031 tax-deferred exchange can help bring success to your real estate investing plans by scaling your portfolio and maximizing different benefits.
However, understanding how these exchanges work and knowing their pros and cons is necessary before making a decision — we’re here to help you make the best financial decision for your situation.
The decision to pursue a 1031 exchange often comes down to your current financial situation and long-term investment goals. Many investors find themselves wondering whether to cash out or leverage their property's growth for bigger opportunities.
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If you sell an investment property instead of agreeing to a 1031 exchange, you’ll have to pay capital gain taxes when you make the sale. This amount depends on your income, but federal capital gains tax could take between 15 and 20%.
In addition, depending on your location, you may also have to pay state capital gains taxes or have your gains taxed as income.
On the other hand, if you execute a 1031 exchange, you can defer those capital gains taxes by taking the money from the sale and reinvesting them into one or more properties of equal or greater value.
You can do as many 1031 exchanges as you want; however, you have to hold the properties you buy for a minimum time as determined by the IRS (typically two years).
Named after Section 1031 of the Internal Revenue Code, this strategy requires using a qualified intermediary who holds your sale proceeds during the transition. Understanding what is a 1031 exchange becomes crucial when you consider the compounding effect of reinvesting your full proceeds instead of losing 15-20% to taxes.
Another important detail is the role of a qualified intermediary. This third-party professional holds your proceeds during the exchange and ensures you follow IRS guidelines. Without one, your transaction won’t qualify for tax deferral. Intermediaries also help structure the timeline so you don’t miss critical deadlines, like identifying properties within 45 days or closing within 180 days. Working with an experienced intermediary gives investors confidence that their paperwork, funds, and deadlines are handled correctly.
Generally, doing a 1031 exchange is ideal when you’re in a high tax bracket and want to keep investing in and expanding your real estate portfolio.
If you’re in a low tax bracket and expect to make more money in the future, it might be best to hold off on a 1031 exchange and pay taxes at that lower rate.
Market conditions and property availability also factor into your decision. In hot seller's markets with limited inventory, finding suitable replacement properties within required timeframes becomes more challenging.
Consider a practical example: An investor who bought a $400,000 rental property a decade ago might now sell it for $700,000. If they simply sell, they could face a six-figure tax bill. By doing a 1031 exchange, they can roll the full $700,000 into a new property, perhaps a small apartment building, without losing capital to taxes. This reinvestment not only grows the portfolio faster but also generates higher rental income streams. Real-world scenarios like this show why high-bracket investors often favor exchanges.
Other than avoiding paying capital gains taxes right now, 1031 exchanges come with some significant benefits.
If you own a real estate asset, you can write off depreciation, gaining compensation for wear and tear. The value of the building and your taxable income affect how much you can write off each year.
However, assessors don’t usually get information about improvements you make to the property unless it gets reassessed — like in the event of a sale. So, even if you make significant property improvements, you’ll likely only get compensation for depreciation based on its value when you made the purchase.
But, if you execute a 1031 exchange, you basically get to reset the depreciable amount each year, bringing significant tax benefits. We recommend asking your accountant to explain how this process would work in your specific situation.
Here's how it works: Your new property's depreciation schedule starts fresh at the current market value, potentially increasing your annual tax deductions significantly.
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Another 1031 exchange benefit is flexibility. You can trade up for one or more properties that are a better fit for your investment goals — like bringing higher returns without paying taxes on that new investment immediately.
1031 exchanges can make investing in higher-value properties much more accessible.
This flexibility extends beyond property values. Consider current interest rates for buying a home when planning your exchange strategy, as favorable financing can provide additional advantages.
Diversifying your risk is one of the biggest reasons people turn to real estate investing, and 1031 exchanges help you capitalize on that advantage.
You can perform a 1031 exchange anywhere in the US, making it simple to get into a market with high potential growth, even if it’s across your state line. However, don’t forget that some states make you pay capital gains taxes, and some do not.
Geographic diversification protects against localized market downturns. Many successful investors follow population and job growth trends, exchanging expensive coastal properties for multiple properties in emerging Sun Belt markets.
Real estate assets are the only investment that allows you to defer capital gains taxes, thanks to 1031 exchanges. The properties must be in the US, cannot be your primary residence, and must be “like-kind,” meaning they are of a similar nature to the property you’re exchanging.
One massive benefit of 1031 exchanges is the ability to generate more returns and invest in/diversify your real estate portfolio.
For example, if you own an investment property in an area with a highly appreciated market, you could exchange it for multiple properties in a more affordable state, resulting in better cash flow due to less market volatility.
You can also exchange properties based on how involved you want to be, like swapping a high-maintenance property with lots of turnovers for a single-family rental with long-term leases.
You can diversify by tenant base, lease structures, or property condition. The ability to exchange one property for multiple properties spreads risk across different neighborhoods or markets.
Remember when we said there’s no limit to how many 1031 exchanges you can do? This means you can start with a more affordable investment and trade up properties multiple times.
With a 1031 exchange, you can swap properties for ones that better match your investment goals, bringing you higher returns. Higher-value properties become much more accessible when you take advantage of 1031 exchanges.
This "pyramiding" strategy allows investors to build wealth over time, starting with small properties and gradually exchanging into larger, more valuable assets.
Ready to take advantage of reinvesting in a property with higher growth potential? We can help. Whether you want to apply for a new loan right now or have questions about 1031 exchanges, reach out to us at 949-489-8300.
While there are plenty of benefits of a 1031 exchange, there are some cons to consider.
If you do a 1031 exchange for a property less worth than the one you’re selling, you’ll have to pay accumulated depreciation and capital gains taxes on the boot any money left over from your sale that didn’t go toward purchasing the new property.
Boot can include cash received, debt relief, or any non-like-kind property. Even property management deposits can create taxable boot if not handled properly through your qualified intermediary.
The most common timeline for a 1031 exchange is 45/180 days; after the sale, you have 45 days to identify the new property (or properties) you plan to purchase as part of the exchange.
Then, you’ll have 180 days from your sale date to close on the replacement property. 1031 exchanges require you to make fast decisions and work quickly.
These strict deadlines can pressure you into suboptimal decisions. Smart investors often identify potential replacement properties before listing their current property to avoid time pressure.
The properties part of the 1031 exchange must be like-kind — they must have the same characteristics or nature. However, they do not have to be of the same grade or quality.
The difficulty lies in finding a like-kind property that matches your goals within 45 days of selling your property. If you don’t, you’re on the hook for paying capital gains taxes when selling your real estate asset.
Competition for quality investment properties can make this timeline challenging. Consider whether you need a home improvement loan for your replacement property, as renovation plans affect your timeline.
Many investors worry about scenarios where their 1031 exchange can go wrong. Working with experienced professionals and understanding current home interest rate trends helps minimize these risks.
Another challenge is the strict definition of like-kind. While the IRS gives some flexibility, confusion often arises. For instance, exchanging a single-family rental for a strip mall usually qualifies, but swapping U.S. property for overseas real estate does not.
Misunderstanding these rules can result in disqualification and unexpected taxes. Many investors lean on tax advisors to clarify what counts as like-kind and to document every step carefully.
Beyond the basic requirements, 1031 exchanges involve several professionals and fees that can add up quickly:
The complexity also increases with multiple properties or out-of-state exchanges, requiring coordination across different markets and legal jurisdictions.
Successful 1031 exchanges require careful planning and realistic expectations. Consider your investment timeline, local market conditions, and available replacement properties before committing to sell your current asset.
Start by identifying potential replacement properties early, even before listing your current property. This preparation helps avoid the pressure of making rushed decisions within the 45-day identification period.
Instead of trying to manage a 1031 exchange on your own, it’s wise to bring in people who handle them every day. A qualified intermediary can oversee the funds, a real estate agent who knows investment properties can help you find the right fit, and a tax professional can explain how the rules apply to your situation. Having this kind of team lowers the risk of costly mistakes and makes it easier to get the full tax advantages.
So, for many real estate transactions, going through a 1031 exchange brings many benefits, but you should also be aware of the potential disadvantages before making a decision.
Ready to explore your financing options? Contact our mortgage experts to discuss how 1031 exchanges might fit into your investment strategy.
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