5 questions to ask when considering a 1031 exchange

By Kory Reynolds May 12, 2025

In the dynamic world of real estate investing, the 1031 exchange stands out as a strategic tool that investors and developers can use to defer capital gains taxes.

What is a 1031 exchange?

Named after Section 1031 of the Internal Revenue Code, this provision allows investors to sell a property and reinvest the proceeds in a new property, effectively postponing the tax liability into the acquired property.

What do I need to consider before using this strategy

While the 1031 can be an attractive strategy, it is important to consider all aspects of the exchange and not just the gain deferral. Here are some key questions to consider before utilizing this tax tool:

1. Is there a suitable replacement property?

The availability of a suitable replacement property is paramount. It must not only be like-kind but also align with your investment goals and growth prospects – don’t let the tax tail wag the dog. Consider the non-real property parts of your sold property or acquired property such as furniture, fixtures, equipment, or goodwill. Consider the general rule that the replacement property should be at least equal in fair market value to the sold property, and the debt load is the same or greater – is there enough meat on both sides of the equation to avoid recognition of boot?

2. What fees are involved?

Be mindful of the fees associated with more complex exchanges. These can include costs for intermediaries, legal and accounting advice, legal structures, accounting fees to report the transaction on the tax returns, and processing, which can add up and impact the overall benefit of the exchange. The exchange is a time value of money consideration – less tax now, and you pay a cost for that (exchange related fees and less depreciation on the acquired property).

3. What is your holding structure?

The existing and planned holding structure of the property plays a significant role. Whether the property is held as a partnership, tenancy in common (TIC), or is wholly owned, each comes with its own set of implications for the exchange process. There can be significant flexibility with a 1031 exchange even with a more complex holding structure or with partners who want to cash out instead but be aware of the additional fees and complexities that exist with these exchanges.

4. Do the timing requirements work for you?

Adhering to the strict timelines set by the IRS for identifying and closing on a replacement property is critical to qualify for the tax deferral. For many investors, those timelines do not work in the current low inventory market – you have only 45 days to identify up to three potential properties that will be the replacements, and a total of 180 days to actually close on one or more of those three.   There may be other tax deferral strategies available to you if the strict 1031 timing isn’t going to work, which could include Qualified Opportunity Zones or cost segregation studies on other owned properties, or properties to be acquired later in the year beyond a normal exchange period, or just utilizing loss carryforwards.

5. What are your long-term goals?

Consider how the exchange fits into your long-term investment objectives. Are you looking to diversify, consolidate, or perhaps shift to a different market? Are you looking for a value-add property with a specific construction timeline? Are some partners looking to cash out while others continue to invest? Again, we are looking to not have the tax tail wag the dog – depending on the goals it could make sense to recognize the gain and then either pay the tax or look at other deferral strategies.

Where to go from here

A 1031 exchange is not just a tax strategy; it’s a business decision that requires careful planning and consideration of both the immediate and future impacts on your investment portfolio. As always, consult with a tax professional or financial advisor to navigate the complexities of a 1031 exchange and make the most informed decision for your circumstances.

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