The 1031 exchange, explained: a planning guide for real estate investors

If you've owned a rental house, a small apartment building, or a commercial property for a long time, selling it can feel like a tax event first and an investment decision second. Between federal capital gains tax, depreciation recapture, the 3.8% net investment income tax, and state tax, a large share of your gain can go to taxes in the year you sell.

A 1031 exchange, named for Section 1031 of the Internal Revenue Code, is the main tool real estate investors use to keep that money invested. Done well, it lets you sell one investment property, buy another, and push the tax bill into the future. Done poorly, with a missed deadline or cash that touches your hands, it can leave you owing the full bill anyway.

This guide walks through how exchanges work, in plain English, and where a financial plan fits around the transaction. I've written about these ideas for U.S. News & World Report, including in 8 Smart Tax Strategies for Investors, and in Compound's step-by-step guide, How to Prepare for a 1031 Exchange.

What is a 1031 exchange?

A 1031 exchange, also called a like-kind exchange, lets you sell real property held for investment or for use in a business and reinvest the proceeds in other like-kind real property without recognizing the gain right away. Instead of paying tax now, you carry your old tax basis into the new property. The gain is deferred, not forgiven.

That deferral matters because the money you would have paid in tax stays invested and can keep working for you. Investors can repeat the process over many years, exchanging from one property into the next. And under current law, if you still own the property when you die, your heirs generally receive a step-up in basis to market value, which can wipe out the deferred gain for them. That is why you'll sometimes hear the phrase "swap until you drop." Tax law can change, so that last step belongs in your estate plan, not just your exchange plan.

What taxes can a 1031 exchange defer?

When you sell investment real estate outright, several layers of tax can apply to the gain:

• Federal long-term capital gains tax at 0%, 15%, or 20%, depending on your income.
• Depreciation recapture, taxed at up to 25% on the depreciation you claimed (or could have claimed) over the years. For long-time owners this can be a large number, because depreciation lowers your basis every year you own the property.
• The 3.8% net investment income tax for higher-income taxpayers.
• State income tax. Alabama, for example, taxes capital gains as ordinary income, at rates up to 5%.

A properly structured exchange that reinvests all the proceeds can defer all of these. A partial exchange defers some of them, and the rest is taxed. Your CPA can estimate what an outright sale would cost you, and that number is the starting point for deciding whether an exchange is worth the effort.

What property qualifies for a 1031 exchange?

Since 2018, Section 1031 applies only to real property. Both the property you sell (the "relinquished" property) and the property you buy (the "replacement" property) must be held for productive use in a trade or business or for investment. "Like-kind" is broad for real estate: you can generally exchange a rental house for a retail building, raw land for an apartment complex, or a warehouse for an interest in a Delaware Statutory Trust.

A few common things don't qualify:

• Your primary residence (it may qualify for a separate home-sale exclusion instead).
• Property held mainly for resale, such as a fix-and-flip.
• Stocks, bonds, partnership interests, and other securities, other than qualifying real estate interests like a Delaware Statutory Trust.
• Exchanges between U.S. property and property outside the United States.

The same taxpayer that sells must generally be the one that buys. If an LLC or a trust holds the property you're selling, plan the ownership of the replacement property with your attorney before you close.

The 45-day and 180-day deadlines

Most exchanges are "delayed" exchanges: you sell first and buy later. Two clocks start the day your sale closes, and they run at the same time:

1. Day 0: your sale closes. Your proceeds go to a qualified intermediary, not to you.
2. By day 45: identify. You must identify potential replacement properties in writing, signed by you, and deliver the list to your qualified intermediary or another proper party.
3. By day 180: close. You must acquire the replacement property within 180 days of the sale, or by the due date of your tax return for that year (including extensions), whichever comes first.

The days are calendar days, weekends and holidays included. The 180 days are not "45 plus 180"; the identification period sits inside the exchange period. There are generally no extensions, other than limited relief the IRS sometimes grants after federally declared disasters. If you sell late in the year, check the tax-return rule with your CPA: you may need to file an extension to keep the full 180 days.

In practice, the 45-day window is where most of the stress happens. Good replacement properties can be scarce, financing can slip, and a deal that looked certain can fall apart. That's why the planning should start before your property is listed, not after it sells.

The identification rules: three-property, 200%, and 95%

You can't simply name every property on the market. The regulations give you three ways to identify:

• Three-property rule. Identify up to three properties of any value. This is what most investors use.
• 200% rule. Identify any number of properties, as long as their combined fair market value doesn't exceed 200% of the value of the property you sold.
• 95% rule. Identify any number of properties of any value, but you must then acquire at least 95% of the total value you identified. This is hard to meet and rarely relied on.

Many investors use one of their three slots for a backup. A Delaware Statutory Trust offering is a common choice, because it is typically available on short notice. I'll come back to that below.

Why you need a qualified intermediary

If you receive the sale proceeds, even briefly, the exchange generally fails. To avoid that, a qualified intermediary (QI), sometimes called an exchange accommodator, holds the money between the sale and the purchase and documents the exchange. You need to engage the QI before the sale closes; it can't be set up afterward.

Your QI must be independent. Generally, someone who has acted as your agent in the past two years, such as your own attorney, accountant, real estate broker, or employee, can't serve as your QI. Ask how the QI holds funds, whether accounts are segregated, and what bonding or insurance it carries. A QI handles the mechanics of the exchange; it doesn't decide which property fits your goals. That's where your CPA, attorney, and financial planner come in.

Boot, debt, and getting full deferral

"Boot" is anything you receive in the exchange that isn't like-kind property. Cash you keep is boot, and so is debt relief that isn't replaced. Boot is taxable, up to the amount of your gain.

As a rule of thumb, to defer all of the tax you need to:

• Buy replacement property of equal or greater value than the property you sold (net of selling costs), and
• Reinvest all of your net equity, and
• Replace any debt that was paid off at the sale, either with new debt or with additional cash.

This is where the exchange meets your financial plan. If you need some cash for retirement income, a home project, or a child's wedding, you may decide a partial exchange makes sense and accept tax on the cash you keep. If you're nearing retirement and don't want a new mortgage, you'll need to see how that affects the debt-replacement math. Those are planning choices, and they're easier to make calmly months before closing.

Delayed, reverse, and improvement exchanges

Delayed (forward) exchange. Sell first, then buy within the 45-day and 180-day limits. This is by far the most common structure.

Reverse exchange. Sometimes the right replacement property appears before your current property sells. In a reverse exchange, an exchange accommodation titleholder takes title to ("parks") the new property under IRS Revenue Procedure 2000-37. You then identify the property you'll sell within 45 days and complete the exchange within 180 days. Reverse exchanges cost more and usually need financing that the lender is comfortable with, so start early.

Improvement (build-to-suit) exchange. If you want to use exchange money to improve the replacement property, an accommodation titleholder can hold it while the work is done. Only improvements completed while the titleholder holds the property generally count toward your replacement value, and that still has to happen within 180 days.

Both reverse and improvement exchanges are complex territory. A QI experienced with them, and your CPA, should be involved from the start.

Where Delaware Statutory Trusts fit

A Delaware Statutory Trust (DST) is a legal structure that lets many investors own fractional interests in large, professionally managed properties, such as apartment communities, distribution centers, or medical office buildings. Since IRS Revenue Ruling 2004-86, a properly structured DST interest can qualify as like-kind replacement property in a 1031 exchange.

Investors use Delaware Statutory Trusts in three main ways: as the main replacement property for someone who wants to stop managing property, as a partial allocation alongside a property they buy directly, or as a backup named during the 45-day window. They also carry real trade-offs: they are illiquid, often for five to ten years; you give up control; there are upfront and ongoing fees; distributions aren't guaranteed; and they're generally limited to accredited investors. Read the full picture in my guide to Delaware Statutory Trusts and 1031 exchanges.

If you're ready to stop being a landlord

Many of the people I talk with aren't looking for a bigger building. They're in their late 50s or 60s, they've owned rentals for decades, and they're tired of tenants, repairs, and late-night phone calls. They want income and simplicity, and they don't want to hand a large share of their gain to taxes on the way out.

There's no single right answer. Some options to compare with your CPA and planner:

• Hire a property manager and keep the property, which avoids a sale entirely but keeps you exposed to one asset.
• Exchange into more passive real estate, such as a net-leased property or one or more Delaware Statutory Trusts.
• Sell and pay the tax, which gives you full liquidity and flexibility, and may be the right call for smaller gains or if you need the money.
• Hold until death so heirs may receive a step-up in basis, if the property and your health and family situation support that.

For example, a retired owner who is done being a landlord might exchange a rental property into one or more Delaware Statutory Trusts to step away from day-to-day management, giving up control and liquidity in return. That's one path, and individual results vary. The right one depends on your income needs, your other assets, your estate plan, and how much control you want to keep. For more on real estate income options, see How to Build Passive Income With Real Estate Investing.

A pre-sale checklist

1. Get clear on goals before you list. More income? Less work? Diversification? A smoother estate? Your goals should drive the replacement choice, not just the tax.
2. Estimate the tax on an outright sale with your CPA, including depreciation recapture.
3. Assemble the team: a qualified intermediary, your CPA or tax attorney, a real estate agent who knows investment property, and a CFP® professional to tie the decision to your overall plan.
4. Engage the QI before closing and add exchange language to your sale contract.
5. Line up replacement options early, including a backup, so day 45 isn't a scramble.
6. Run the numbers on cash and debt so you know whether you'll have boot, and decide whether that's acceptable.
7. Plan your exit from the replacement property: holding period, liquidity needs, and estate goals.

Working near Birmingham? See 1031 exchange planning in Birmingham and across Alabama. If you're a qualified intermediary, agent, or CPA, here's how I work alongside you.

Scott Ward and Compound Planning do not act as qualified intermediaries. See the disclosures below.

Further reading from Scott in U.S. News

• U.S. News & World Report · Sep. 20268 Smart Tax Strategies for Investors
• U.S. News & World Report · Oct. 2026How to Build Passive Income With Real Estate Investing
• U.S. News & World Report · Oct. 2026What Does a Financial Advisor Do?
• U.S. News & World Report · Apr. 20265 Alternative Investments Every Investor Should Consider in 2026

Next: Delaware Statutory Trusts: pros, cons, and how they work in a 1031 exchange →