What is a 1031 Exchange in Real Estate?

Section 1031 of the Internal Revenue Code, or just "1031 exchange," is the most important law in real estate investing. It's hard to imagine scaling your wealth through real estate investing without the ability to exchange without paying capital gains.

Without section 1031, selling your investment or business property (i.e., non-primary residence) would result in a hefty taxation on your capital gains and some depreciations you've made. That would significantly reduce most investment returns, arguably to the point of wasting money on the whole endeavor. Now there are exceptions to almost everything, so there are situations of lower taxation on capital gains AND some where you have a reason to just pay the taxes.

But in the end, the IRS has provided 1031 exchanges as a tool to defer those taxes completely, albeit with some important restrictions. An important detail is that you have to exchange all of the proceeds from the sale into a replacement property of equal or greater value (or you get the boot, literally).

The "Normal" 1031 Exchange Strategy

The "normal" situation is that a rental property investor wants to sell their property because they've built a decent amount of equity in it. Then, using the 1031 exchange, they'll replace the relinquished property with an equal or greater value property. They won't pay taxes on the transfer, so usually have built up more equity than their original down payment, so they'll try to get a higher value property in order to cash flow more. Then the investor will repeat these upward exchanges repeatedly, which is basically "swap 'til you drop" in Latin.

This investment strategy doesn't only apply to rental properties; you can 1031 exchange into a variety of real estate assets. But as there are "different strokes for different folks," there are different investment objectives, levels of experience, timelines, risk tolerances, and starting capitals. Therefore, individual investors should always assess what works for them with a financial professional or the due diligence of one.

That being said, one of the 1031 exchange options that some investors will match well with is the DST. In 1031 terms, it's simply another choice of replacement property. Learn more about what a DST is and how it can work in your 1031 exchange strategy.