Is a 1031 Exchange Right for You? Pros, Cons, and Risks
Marcus had done everything right.
He had bought a small strip mall in 2011, managed it through two recessions, survived a pandemic that emptied three of his five tenant bays and come out the other side with a property worth nearly four times what he paid for it. He was 61, his wife was ready to travel, and he was tired.
When he finally sold, his accountant looked up from the numbers and said the words Marcus had been expecting: “You need to do a 1031 exchange.”
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more – straight to your e-mail.
Profit and prosper with the best of expert advice – straight to your e-mail.
Of course he did. Everyone does a 1031.
Except … did he?
Why so many investors default to a 1031 exchange
The 1031 exchange is one of the most powerful tools in the real estate investor’s toolkit. Used correctly, it lets you defer capital gains taxes indefinitely, compound your wealth inside the investment and, if structured right, potentially pass a stepped-up basis to your heirs and eliminate the deferred gain entirely.
As chief investment strategist at Provident Wealth Advisors, I’ve written about it extensively, I use it with clients regularly, and it belongs in the conversation for almost every investor facing a real estate sale.
Almost every investor.
The problem isn’t that 1031 exchanges are overrated; they’re absolutely not. The problem is that “you sold a property” has become automatic shorthand for “you’re doing a 1031,” and few people stop to ask whether the math and their life actually support it.
Here’s the honest conversation more investors need to have.
The tax tail and the investment dog
There’s a version of the 1031 exchange that works beautifully: You sell Property A, you’ve identified a strong replacement property you would have bought anyway, and the exchange lets you do it with pretax dollars. That’s the dream. That’s the brochure.
Here’s what happens more often than advisers admit: The investor sells Property A, the 45-day identification clock starts running, and suddenly the goal isn’t “find the best investment,” it’s “find something that qualifies before time runs out.” In a thin, overpriced market, that pressure is dangerous.
When interest rates are elevated and property prices haven’t fully adjusted to reflect that reality, replacement properties are expensive on a cash-flow basis. You may be buying a $2 million asset that yields 4% annually, in a world where Treasury bills pay 4.5%. You’re not buying because it’s a great investment. You’re buying because the alternative is writing a large check to the IRS.
That’s the tax tail wagging the investment dog.
The real question Marcus, and every investor in his position, should ask: If I ignore the tax bill entirely, would I still want to buy this replacement property?
If the answer is yes, do the exchange. If the answer is “not really, but it beats paying taxes,” slow down and think about the options.
Running the actual numbers
Let’s say Marcus’s adjusted basis in that strip mall is $400,000, and he sold it for $1.5 million. His capital gain is roughly $1.1 million. At combined federal and state rates — long-term capital gains, net investment income tax (NIIT) and depreciation recapture — he might face a tax bill in the neighborhood of $280,000 to $350,000, depending on his state and income situation.
That feels catastrophic, unless you reframe it.
He would net somewhere between $1.15 million and $1.2 million after taxes. Invested conservatively at a 6% annual return, that $1.15 million becomes about $2.06 million in 10 years.
That’s a real number. But here’s what that comparison misses.
A $1.5 million replacement property generating 4% annual income produces $60,000 in income per year before debt service and expenses. Add even modest appreciation — say, 3% annually, a conservative assumption by historical real estate standards — and that property is worth about $2 million at the end of year 10.
Stack the cumulative income on top of that, and the total picture is closer to $2.6 million over the same period.
The 1031 path, in other words, puts higher numbers on the board over time, because it keeps the full pretax capital working in an appreciating asset rather than a reduced post-tax sum.
The honest caveat: The deferred tax liability doesn’t disappear. It follows the asset until you sell, exchange again or die holding it. If Marcus holds the replacement property until his death, his heirs receive a stepped-up basis, and the entire deferred gain is eliminated forever.
If he sells without a plan, the IRS eventually collects. The 1031 is a deferral tool, not a permanent solution on its own.
Which is exactly why the choice of what to exchange into matters as much as whether to exchange at all.
The burnout problem nobody talks about
There’s also a conversation that almost never happens in the exchange paperwork: Do you actually want to be a landlord again?
For investors like Marcus — in his mid-60s, two decades into managing tenants, watching his peers downsize their lives rather than expand their portfolios — the traditional 1031 exchange can become a trap.
You defer the taxes, sure. But you also defer the exit. The next property has its own lease expirations, its own roof and its own tenant who stops paying rent in month eight of a five-year lease.
This is where the Delaware Statutory Trust deserves a serious look, not as a footnote, but as the actual solution.
A DST allows Marcus to complete his 1031 exchange into a fractional ownership interest in institutional-grade real estate — a professionally managed multifamily community, a medical office portfolio, a net-lease industrial facility — without taking on any management responsibility whatsoever.
He owns real estate. A professional sponsor runs it. The 1031 deferral is fully preserved. The passive income distributions keep coming.
And here’s the part that ties the numbers together. Because the full pretax proceeds go to work inside a real, appreciating asset, not a reduced post-tax sum in a brokerage account, Marcus gets the full benefit of both income and long-term appreciation that make the 1031 math compelling in the first place. He just doesn’t have to unclog a drain to earn it.
For the investor who is done with active management but not done with real estate, the DST is often not a compromise. It’s the upgrade.
The structure requires a genuine long-term commitment — typically five to seven years — and is not the right fit for someone who wants liquidity or operational control. But for Marcus, who wants passive income, preserved wealth and a legitimate exit from the landlord business without a tax catastrophe? The DST isn’t Plan B. It may well be Plan A.
That said, if you truly want out — clean, simple, liquid — sometimes paying the tax is the honest answer.
The estate planning equation
Here’s the angle that changes the math for many older investors — and that most people discover too late.
When you die holding an appreciated asset, your heirs receive a stepped-up cost basis equal to the fair market value at the date of your death. The embedded capital gain — all of it, including decades of deferred 1031 gain — effectively disappears.
That means that if Marcus holds his replacement property until his death, his heirs inherit it at $2 million (or whatever it’s worth then), with no taxable gain. The IRS never collects what Marcus spent his entire investment career deferring.
If Marcus is 61 and in good health, that math looks very different from how it looks for a 74-year-old investor with a modest estate. For investors who are doing their estate planning alongside their 1031 planning — and those two conversations should absolutely be happening simultaneously — the decision calculus shifts considerably.
The takeaway isn’t that you should plan to hold until death; it’s that a complete picture of the 1031 decision has to include your age, your estate plan, your health and your heirs’ tax situation.
That’s a bigger conversation than most people realize when they’re sitting across from a qualified intermediary (QI) signing exchange documents.
The right questions to ask before you file the 1031 exchange
Before any investor pulls the trigger on a 1031 exchange, here’s the short list of questions worth answering honestly:
- Am I buying to defer taxes, or because this is genuinely a good investment? There’s a meaningful difference.
- What does my estate plan say about what happens to this property when I’m gone? The step-up in basis may change the entire analysis.
- Am I actually willing to be a real estate owner for another decade? There are passive alternatives if the answer is uncertain.
- Have I run a complete after-tax comparison across both paths — not just the deferral headline, but what my net proceeds actually do over time? The full picture often looks different than the tax bill alone.
Marcus, for what it’s worth, did end up doing a 1031, but not into another strip mall. After sitting down to run the real numbers and finally having the estate planning conversation he’d been putting off for years, he exchanged into a passive DST structure.
No tenants. No leases. No roof calls. And best of all, his wife booked the trip.
That’s not the right answer for every investor. It was the right answer for him, but only because someone asked the right questions first.
The 1031 exchange is one of the most valuable tools in American tax law. Use it when it serves your goals.
Just make sure you know what your goals actually are.
