What Is a 1031 Exchange?

A 1031 exchange, authorized under Internal Revenue Code Section 1031, allows an investor to sell an investment or business-use property and defer all capital gains taxes by reinvesting the proceeds into a replacement property of equal or greater value. The exchange does not eliminate the tax obligation. It defers recognition of the gain to a future taxable event.

Through sequential exchanges over a lifetime, the deferred gain accumulates across replacement properties. At death, IRC Section 1014 provides a basis step-up to fair market value, which under current law may eliminate the entire deferred gain for heirs. As discussed in "Billionaire Wealth Strategies" (Jim Dew, 2024, Chapter 10), this combination of deferral and basis step-up creates one of the more significant legal wealth-building tools in real estate.

How Does a 1031 Exchange Work?

When an investor sells appreciated real estate, the IRS imposes multiple layers of federal tax. Under IRC Section 1(h), long-term capital gains rates reach up to 20% for taxpayers with taxable income above $518,900 (single) or $583,750 (married filing jointly) in 2025. Under IRC Section 1411, the 3.8% Net Investment Income Tax (NIIT) applies to taxpayers with modified adjusted gross income above $200,000 (single) or $250,000 (married filing jointly) in 2025. Under IRC Section 1250, depreciation recapture is taxed at 25%.

On a property with $1M in gain and $300K in accumulated depreciation, the combined federal tax liability can exceed $300,000 before state taxes. A 1031 exchange defers this entire amount by following a structured process governed by Treasury Regulation 1.1031.

The exchange requires four steps. First, the investor sells the relinquished property, and the proceeds go to a Qualified Intermediary (QI). The QI is required under IRS rules, and the seller cannot touch or control the funds at any point during the exchange.

Second, within 45 calendar days of closing the sale, the investor must identify potential replacement properties in writing to the QI. The IRS three-property rule allows identification of up to three properties regardless of their value.

Third, within 180 calendar days of the original sale (or the tax return due date, whichever is earlier), the investor must close on a replacement property. Missing either deadline by even one day causes the exchange to fail entirely, with all gains becoming immediately taxable.

Fourth, to defer all gains, the replacement property must be of equal or greater value, and all equity proceeds must be reinvested. Any cash received (known as "boot") is taxable to the extent of the gain.

The tax basis of the relinquished property carries over to the replacement property, reduced by any depreciation claimed. This means the deferred gain remains embedded in the new asset. If the investor later sells without completing another 1031 exchange, all accumulated deferred gains become taxable in that year.

However, the limitation of IRC Section 1031 is significant: since the Tax Cuts and Jobs Act of 2017 (TCJA), like-kind exchange treatment applies only to real property. Personal property, equipment, artwork, and other asset types no longer qualify. Investors must also be aware that related-party transactions face additional holding period requirements under IRC Section 1031(f).

When Do Entrepreneurs Use a 1031 Exchange?

Entrepreneurs use 1031 exchanges in several strategic scenarios, each requiring coordination with tax and legal advisors.

Upgrading investment properties. An entrepreneur exchanges a smaller property for a larger one, or transitions from residential to commercial real estate, while deferring all federal and state capital gains taxes. The replacement property must be held for investment or business use under IRS guidelines.

Geographic repositioning. Selling property in one market and acquiring in another state or region avoids triggering a taxable event. State tax rules vary, and some states (such as California under the Franchise Tax Board clawback rules) may require withholding or reporting on deferred gains from properties originally located in that state.

Transitioning to passive management. Entrepreneurs exchange actively managed properties into Delaware Statutory Trusts (DSTs), which are Securities and Exchange Commission (SEC) registered offerings that provide passive income with no management responsibilities. DSTs qualify as replacement property under IRS Revenue Ruling 2004-86.

Estate planning. Building a portfolio of exchanged properties with significant embedded gains positions the estate for the IRC Section 1014 basis step-up at death. The deferred gains accumulated across multiple exchanges may be eliminated entirely for heirs under current law. This strategy carries the risk that Congress could modify or repeal the basis step-up provision in future legislation.

Exiting concentrated real estate. Entrepreneurs who own business-use property can exchange into diversified real estate investments to reduce geographic or sector concentration, spreading risk across multiple properties and markets.

How Does Dew Wealth Approach 1031 Exchanges?

The 1031 exchange is among the more significant legal tax deferral tools available under the Internal Revenue Code, but the strict IRS timelines create pressure that frequently leads to poor investment decisions. Entrepreneurs who wait until after selling their property to identify replacements often scramble to meet the 45-day identification deadline, settling for inferior properties simply to preserve the tax deferral.

Within the Wealth Wheel, the 1031 exchange requires coordination between the tax advisor (structuring the exchange for maximum deferral and ensuring compliance with Treasury Regulation 1.1031), the investment advisor (identifying quality replacement properties that meet CLERIC standards), and the estate planner (ensuring the replacement property is titled within the appropriate entity or trust structure). The Linchpin Partner coordinates these timelines to prevent the 45-day rush from overriding sound investment judgment.

Pre-identifying replacement properties before initiating the sale is the approach Dew Wealth recommends. The Fractional Family Office^® maintains a pipeline of vetted replacement properties and DST sponsors so that clients are not forced into a suboptimal investment by the exchange deadline. This preparation addresses the primary risk of 1031 exchanges: time pressure causing capital deployment into properties that do not meet CLERIC evaluation standards.