Top 5 Tips for a Successful 1031 Exchange: Maximize Your Investment and Defer Taxes

Real-estate ownership is a significant source of income and wealth for many Americans. In fact, of the nearly 50 million rental units in the U.S., more than 70 percent are owned by individual investors. These properties generate an average income of $82,530 for individual owners and landlords each year. What’s more, as of September 2024, the gross profit from real estate investors’ property sales ranged from $57,025 in Alabama, to $135,725 in Delaware, and $115,250 in California.

Without advance planning, though, profits from property sales can quickly subside due to applicable state and federal capital gains rates. For example, in 2025, married couples who file jointly and have income between $96,701 and $600,050 may be subject to a federal, long-term capital gains rate of 15%. States’ long-term capital rates can vary, ranging from as high as 5% in Alabama to 6.6% in Delaware, and 14.4% in California.  Eight states, including Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas and Wyoming, do not currently assess capital-gains taxes.

Let’s say a couple, Diane and Don, purchased a rental property in North Carolina for $150,000 back in 1990. Diane and Don retired in 2023, and decided they no longer wanted to take on the daily responsibilities of property ownership—tenants, toilets and trash. They listed their rental property for sale in early January 2024, and accepted an offer for $400,000 in late February. After factors such as commission, depreciation recapture and state (4.5%) and federal capital-gains taxes (15%) are applied to the sale, Diane and Don walk away with $329,167. 

As an alternative, let’s assume Diane and Don determined they’d like to explore the benefits of a 1031 exchange before they sold their property. How much of an impact would that decision have on their financial plan? For starters, a well-planned 1031 exchange would allow Diane and Don to defer their capital gains and reinvest a larger amount—$376,000—into a “like-kind property” that could potentially produce income and growth in the coming years, still without the daily hassles associated with ownership.

For a deeper dive into 1031 Exchanges, join (or watch on demand) our Compound Conversation with IPX 1031— Everything You Need to Know About 1031 Exchanges.

What is a 1031 exchange?

The 1031 exchange was first introduced to the U.S. tax code back in 1921. It allows  individuals or entities to sell an investment real-estate property, reinvest the proceeds into another “like-kind” property and defer the capital-gains taxes, depreciation recapture and other types of taxes that would otherwise be required in a common, cash-sale transaction. 

What are the benefits of doing a 1031 exchange?

There are at least five potential benefits for investors who implement a 1031 exchange in their financial plan:

• Tax-deferral—As referenced earlier, a 1031 exchange allows an investor to defer any capital gains.
• Cash flow—More money to invest in a replacement investment, plus any potential income generated by the replacement property.
• Portfolio diversification—the variety of replacement investments, especially within a diversified DST, can help an investor mitigate risk and create a more balanced portfolio.
• Consolidation—an investor can exchange multiple properties into a single, replacement investment, which can significantly streamline management responsibilities.
• Estate planning—an investor can potentially preserve any exchange profits and pass them down through his or her estate.

To qualify for the benefits of a 1031 exchange, a taxpayer must follow certain rules. Here are five tips to help stay on the right track with your next 1031 exchange:

Tip #1:  Plan ahead for a 1031 exchange

An effective1031 exchange requires foresight, objectivity and competence. Whether a 1031 exchange is a good fit for your financial plan depends on a variety of key variables, including:

• Do you have any net operating losses (NOL) or passive activity losses (PAL) that will expire if they are not used? The answer to this question may impact any potential capital gain you may realize with the sale of your property, so discuss this topic in advance with a qualified tax professional.
• What are your financial objectives for the exchange? Are you looking for potential income, growth or estate benefits—or a combination of all three to some extent?
• What are your liquidity needs? To qualify for the tax benefits of a 1031 exchange, an investor must invest all of the proceeds from the relinquished property.
• Do you have a plan for how you’ll identify a “like-kind” investment property within the required time frame? 

Tip #2:  Know the key deadlines

There are two key deadlines to keep in mind with a 1031 exchange:

• 45-day deadline: After the real-estate property has been sold, the investor has 45 calendar days to identify at least one replacement property.  
• 180-day deadline: An investor must close on the replacement property by either midnight on the 180^th calendar anniversary day when the relinquished property was closed, or the due date of the federal tax return that includes the relinquished property. 
• Special Note: For investors affected by the California wildfires who began a 1031 exchange between November 23, 2024 and January 7, 2025, the IRS extended the 45-day identification deadline to October 15, 2025. The extension also allows investors who began a 1031 exchange between July 11, 2024 and January 7, 2025 to extend the 180-day replacement deadline to the later of October 15, 2025 or 120 days after the original 180-day deadline date.

The 180-day deadline encompasses calendar days and does not permit exceptions for weekends or holidays, unfortunately.  

There are three acceptable approaches for replacement properties within these two deadlines:

• Three-properties rule:  An investor can identify up to three eligible properties as a contingency plan and select the best option for his or her needs.
• The 200% rule:  An investor can identify an unlimited number of eligible properties as long as their cumulative value does not exceed more than 200% of the net sales value of the relinquished property.
• The 95% rule:  An investor can identify an unlimited number of eligible replacement properties with an unlimited, aggregate fair market value as long as the investor actually purchases 95% of the value associated with the identified properties. 

Tip #3:  Work with a qualified intermediary

A qualified intermediary, also known as an exchange accommodator or facilitator, is an independent agent that can help an investor remain compliant with the 1031 exchange rules each step of the way. Once the sale of the relinquished property has closed, the proceeds are sent directly to the qualified intermediary. And once the investor has identified a suitable replacement property, the qualified intermediary will help facilitate the closing requirements. 

One common mistake is for an investor to sell a property without having an agreement established with a qualified intermediary first. If an investor has constructive receipt of the proceeds in any capacity, then the 1031 exchange option will be nullified. 

Here are a few guidelines to consider for a qualified intermediary (QI):

• The QI has experience and expertise with the type of exchange you have in mind.
• The QI provides clear, straightforward information about fees.
• The QI will hold proceeds in a secure escrow account and can provide details about insurance and fraud protection.
• The QI is listed in good standing as a member of a national trade organization, such as The Federation of Exchange Accommodators (FEA).

Tip #4:  Reinvest all proceeds to fully realize tax advantages

If the value of the replacement property is greater than proceeds from the relinquished property, then the investor will need to add some cash or additional mortgage debt to complete the purchase. That’s fine. 

If, however, the amount from the relinquished property is higher than the value of the replacement property, then the excess cash will be returned to the investor as “boot” at closing. “Boot” is an old English term that means “something that is given in addition to,” and is treated as taxable income in an exchange. 

For example, Ben received $500,000 for his relinquished property and decided to purchase a replacement property for $465,000. In this case, the excess amount of $35,000 would not qualify for the exchange and would be reported as taxable income for the year.

Tip #5:  Understand the “like-kind" requirements

Prior to the Tax Cuts and Jobs Act (TCJA) of 2017, personal property items, like franchise licenses, aircraft, livestock and equipment, were eligible for the 1031 exchange. Now, only real property (real estate), as defined in the 1031 tax code, qualify for the exchange. 

A key qualification for the “like-kind” designation is that both properties are used for business, productive use in a trade, or investment. Some examples that qualify for a 1031 exchange, include: 

• Commercial property
• Investment property
• Vacation and rental property
• Farmland
• Conservation property
• Delaware Statutory trusts (DSTs)
• Timberland investment property 

As an example, could Judith sell her farmland in Idaho, and exchange the proceeds for a DST investment? Yes, because Delaware Statutory Trusts often invest in large properties, like storage buildings, medical offices and multifamily apartment communities, so they have a defined business purpose like farmland. 

While this article addresses many of the key issues associated with the 1031 exchange, there are a variety of important nuances to consider before moving forward with one. Please consult your qualified tax professional about your specific circumstances, and feel free to reach out to us about how a 1031 exchange can impact your financial plan.

Compound and IPX 1031 are teaming up for a Compound Conversation on March 19th, 2025 at 2pm ET / 11 am PT. Join us live to learn Everything You Need to Know About 1031 Exchanges.

Sources:

[1] U.S. Census Bureau

[2] Comparably

[3] Attom

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