How a 1031 exchange works

A 1031 exchange lets you sell one piece of qualifying investment or business real estate and roll the proceeds into another qualifying property without recognizing the gain right away. You keep your capital working instead of handing a chunk to the IRS this year. A few ground rules:

• It is real estate only. Since the Tax Cuts and Jobs Act, Section 1031 generally applies only to real property held for business or investment, not your primary residence and not personal or intangible property.
• “Like-kind” is broad. Most U.S. business or investment real estate is like-kind to other U.S. business or investment real estate. An apartment building can be exchanged for raw land; a retail strip for a warehouse. The like-kind test is rarely the hard part.
• The mechanics are the hard part. You cannot touch the cash. If you receive the sale proceeds before getting your replacement property, the IRS generally treats it as a sale and the deferral is gone. That is why nearly everyone uses a qualified intermediary to hold the funds.
• The clock is unforgiving. You have 45 days from the sale to identify replacement property in writing, and 180 days (or your tax return due date, whichever is earlier) to close. Miss the deadline and the exchange fails. (See the IRS like-kind exchange fact sheet for the full rules.)

Short version: sell, keep your hands off the cash, identify quickly, close quickly, and lean on a competent intermediary and tax adviser.

Why people do a 1031 exchange

There are genuinely good reasons to do one, and the best ones are all about the investment, not just the tax bill. A 1031 exchange makes great sense when you want to stay invested in real estate but improve your position: upgrading to a newer property with better tenants, consolidating several small headaches into one cleaner asset, relocating your exposure to a stronger market, or improving cash flow while reducing the day-to-day management burden.

In all of those cases, the tax deferral is a nice bonus on top of a move you would want to make anyway. That is the sweet spot: keeping your capital fully invested and stepping into something better.

Why people shouldn’t do a 1031 exchange

A 1031 exchange does not make your tax bill disappear. The replacement property carries over the old, lower basis, so the deferred gain is still sitting there waiting. When you eventually sell in a taxable transaction, that gain comes right back, plus any new gain. Deferred is not forgiven.

That is why we tell clients: don’t let the tax tail wag the investment dog. The real trap isn’t buying a bad property. It’s letting the tax bill narrow your options before you’ve even considered them. If you are relocating, tired of being a landlord, or you think that property has run its course, that is the moment to weigh all your investment choices, not just swap into another building that is incrementally better but still leaves you fielding tenant calls or managing the property manager. Anyone who has owned real estate for more than a few years knows it is rarely the passive income it is made out to be. Exchanging into another property just to defer taxes can quietly keep you tied to that same job.

It is hard to imagine Warren Buffett ever saying, “We can’t sell this business because of the taxes.” When the investment thesis has run its course, you move. Taxes are what you pay when you win. Deferring a gain purely because you don’t want to write the check rarely makes sense from a pure investment standpoint.

Feeling trapped by a concentrated asset

Here is the part too few people talk about: many real estate owners feel stuck. They sense a 1031 exchange is their only move, so they keep rolling into the next property, and the next, because paying taxes feels like the enemy.

But step back. Real estate is a concentrated asset, and just like a single stock that grows into an outsized chunk of a portfolio, a property (or a pile of them) can quietly become a huge slice of your net worth, leaving you exposed to one asset class, one market, one set of risks. It is the same principle we apply to concentrated stock positions: when one holding dominates, diversification isn’t a luxury, it is prudent risk management. Sometimes an asset class simply runs its course, and the trap is believing you have no choice but to keep deferring. You do have a choice, and the tax you would pay is more favorable than most people assume.

The tax is more favorable than you think

When you sell real estate you have held for years, the tax bill isn’t the disaster people imagine. The portion of your gain tied to depreciation, the “recapture,” is generally capped at a maximum federal rate of 25%. That is a ceiling, not a floor. A bigger recapture doesn’t push you higher; the most that slice can be taxed at is 25%, period. (One caveat: certain aggressive or bonus depreciation on specific components can be treated differently, which is why modeling the sale ahead of time matters.) The rest of your gain, the actual appreciation, is taxed at long-term capital gains rates, generally 0%, 15%, or 20% depending on your income, meaningfully lower than ordinary income rates.

Rates referenced above: see the IRS on capital gains rates (Topic 409), the Net Investment Income Tax (Topic 559), and depreciation recapture (Publication 544). Brackets and thresholds are set annually and are subject to change.

The upshot: a capped rate on the depreciation piece, plus a favorable capital gains rate on the growth. That is not the end of the world. For many investors, it is a very reasonable price to unlock liquidity, diversify, and simplify their lives.

And sometimes that is exactly the right answer: pay the tax and move on. Maybe you are done being a landlord, or you want less hassle heading into retirement. Choosing not to do a 1031 exchange isn’t a defeat. It can be a smart, intentional success, the natural result of years of appreciation finally turning into freedom.

A few tax wrinkles worth knowing

Even when a 1031 makes sense, watch for these:

• Boot. This turns a “tax-free” exchange into a partly taxable one. Boot is anything you receive that isn’t qualifying replacement real estate, leftover cash or net debt relief. You’ll recognize gain to the extent of that boot. A clean exchange keeps it to zero.
• Net Investment Income Tax and phase-outs. Higher earners may owe an extra 3.8% surtax on capital gains once income clears $200,000 (single) or $250,000 (married filing jointly), and a large gain can push you past thresholds that phase out other deductions and credits. It is why you should always run the numbers with your tax professional before selling.
• IRMAA, a big one for clients near 65. A large taxable sale can also raise your future Medicare premiums. Medicare uses a two-year income lookback, so a sale at 63 can affect what you pay at 65. In 2026, surcharges kick in above $109,000 of income for singles and $218,000 for couples, one more reason to plan the timing of a big sale carefully. (See the 2026 Medicare premium figures from CMS.)

What about DSTs and REITs?

If you want to stay invested but step away from active management, you may hear about Delaware Statutory Trusts (DSTs) and REITs.

• A DST can qualify as 1031 replacement property, so it is a legitimate option. But the structure that makes it qualify also makes it rigid: the trustee can’t really renegotiate debt, raise new money, or adapt to changing markets. That is fine if you want hands-off and predictable, frustrating if you want control or discretion over the exit. Read the fees carefully too.
• A REIT is a real company you can invest in, and publicly traded REITs are liquid. But REIT shares are securities, not direct real estate, so buying them generally isn’t the same as buying 1031 replacement property. And non-traded REITs deserve real caution: the SEC notes they can be illiquid for a decade or more, carry up-front fees that often run 9% to 15%, and sometimes pay distributions out of your own invested capital. Go in with eyes open.

How we think about it at Babb

A fiduciary approach starts with a different question. Not “How do I avoid the tax?” but “Does this fit your written plan?” A 1031 exchange is a fantastic tool when it serves a genuine investment goal, and a poor reason to buy something you don’t really want. Run the numbers on the next property first. Make it earn its place on its own merits. Then let the tax treatment be the tiebreaker, not the driver.

There is a bigger lesson here too. A single property, like a single stock, concentrates your risk in one story. We have written more about the risks of holding too much in one place and why spreading your money out matters. For many investors, a diversified plan is a way to manage that risk rather than concentrate it.

That is the kind of clear, investment-first thinking we have brought to clients since 1981.

Frequently asked questions

This article is for educational purposes only. It is not investment, tax, or legal advice and does not constitute a recommendation to buy or sell any security or property. 1031 exchanges involve complex rules and strict deadlines. Tax rates, thresholds, and treatment described here reflect current federal law, which is subject to change, and tax outcomes depend on your individual circumstances. Individuals should consult a qualified tax adviser and financial professional before making decisions. Opinions contained herein are subject to change without notice.