1031 Exchanges: A Win-Win for Both Taxpayers and the Economy

This is the second installment of our four-part series on 1031 exchanges. To read the first installment, where we explore how investors can make use of the tax advantages offered by 1031 exchanges, click here. 

In a slow and cautious real estate market, one of the few types of transactions that have been moving forward is those involving 1031 exchanges.

The rules found in Section 1031 of the Internal Revenue Code allow taxpayers to defer payment of certain taxes when they sell a business or investment property, and to promptly replace it with another investment property of greater or equal value. Section 1031 has been part of the federal tax code for almost a century. An investor fully utilizing a 1031 exchange will defer their capital gains tax, depreciation recapture, and federal taxes such as those imposed under the Affordable Care Act.

1031 exchanges provide taxpayers with financial incentives and a degree of control over timing. Furthermore, they also help to stimulate the economy by creating more tax revenue than the amount of the gains deferred, and encouraging more investment in real estate and the community around it.

Investor Benefits of 1031 Exchanges

1031 exchanges provide obvious short-term economic benefits to investors because they postpone the due date for many taxes when they sell their real estate. So how do you quantify the benefit at both the time of the transaction and in the long run?

In the recent past, interest rates have been comparatively high. This has led some investors to question whether they are better off paying their taxes and deploying their net proceeds in some other type of investment vehicle. A savings bond or money market account may provide short-term cash flow similar to a stabilized real estate investment with less risk and the benefit of liquidity. However, if the primary goal is to maximize revenue in the form of cash flow, then the 1031 exchange into more real estate is a better bet.

Here’s an example to illustrate why. Let’s assume you sell an investment property for $900,000. Your sale expenses are $80,000, your adjusted tax basis in the property was $220,000, and your capital gain on the sale is $600,000.

Assuming a 5% state-level capital gains tax, you will pay more than a third of your gain ($202,800 in this example) if you take the sale proceeds in cash at closing. Your net proceeds from the sale will be $617,200.  However, if you choose to do a 1031 exchange, you will have $820,000 in proceeds to reinvest in another property.

To be sure, a money market account or a savings bond provides more liquidity and less risk than real estate. The stock market also provides liquidity. These types of investments may be good choices if you intend to spend your proceeds, or if you need to have cash readily available.

However, if you are planning to invest your proceeds for more than a few years, a 1031 exchange into cash-flowing real estate is a smart option.

As of the date of this article, the average year 1 annual cash-on-cash yield for a Delaware statutory trust (1031 exchange compatible) is about 5%.  As of August 2025, the highest-yielding money market accounts pay up to 4.40%.

Using the example above, if you do the 1031 exchange, in the first year, you should earn $41,000 ($820,000 x 5%) in income from that investment.  If you want to earn the same $41,000 on the cash you receive without the exchange, you will have to find an investment with an annual yield of 6.64%. The money market account will only yield $27,157 ($617,200 x 4.40%).

In addition, a portion of your income from the Delaware statutory trust may be sheltered by depreciation, so you will not pay income tax on the full $41,000. There is no similar tax shelter available for the income from the money market account.

Section 1031 is one of the few incentives available to, and used by, taxpayers of all sizes. Individuals, partnerships, limited liability companies, and corporations can all do exchanges, and virtually all types of real estate are eligible. In fact, more than half of like-kind exchanges involve properties worth under $1 million. With the rise in popularity and availability of Delaware statutory trusts, accredited investors can often participate in an exchange with as little as $100,000 in equity.

This kind of analysis, therefore, is important to do with your financial, legal or tax advisor before you sell your investment property.

1031 Exchanges Do Not Completely Eliminate Tax

While the example above illustrates how a 1031 exchange may save on current taxes and leave you more money to invest, it is not tax forgiveness.  Section 1031 provides a mechanism to defer tax, not to evade or eliminate tax liability. There is no limit on how many times you may exchange, but most people eventually stop, in whole or in part, and pay the capital gains and other deferred taxes. Only death of the taxpayer can wipe out the deferred tax obligation completely. Thus, like-kind exchanges only affect the timing of when most real estate investors pay these taxes.

There are numerous requirements to obtain any relief at all under Section 1031. To completely defer capital gains and federal taxes at the time of sale, the IRS requires that a taxpayer strictly comply with all of the rules, including:

• The taxpayer cannot take any cash proceeds from the sale directly. The property must be literally swapped for another, or else all sale proceeds must be held by a qualified intermediary.
• All replacement property must be identified and acquired shortly after the first property is sold.
• The owner of the replacement property must be the same taxpayer as the selling party.
• The replacement property must be ‘like-kind’ to the relinquished property.
• The replacement property must be held for investment or business use rather than for personal use.

Investors who do not adhere to all of these requirements will be taxed on the transaction for the year they sold or transferred their property. Even if all necessary steps are followed, the tax deferral is only temporary. If replacement property is later sold without an exchange, all of the deferred taxes relating to the original property, as well as its replacements, will come due. An overwhelming 80% of properties acquired through like-kind exchanges are later disposed of through fully taxable sales.

Your Replacement Property Must Be of Greater or Equal Value

To completely defer all taxes, your replacement property must be of greater or equal value than the original property you sell. If your replacement property costs less, you will pay taxes attributable to the difference in value.

Investors sometimes make this mistake when they sell a property that had a mortgage. Approximately one-third of taxpayers end up paying some tax in the year of the exchange because they purchase property worth less than the fair market value of what they sold. The value of the property attributable to the mortgage debt must be replaced, either with another mortgage or with new equity.

Here’s an example to illustrate this. You sell a property for $1 million. At the closing, you pay off a $400,000 mortgage, with the $600,000 balance going to the qualified intermediary for the exchange. If you use the $600,000 to buy a $600,000 replacement property, you will pay tax attributable to the $400,000 in value that you did not reinvest.

To avoid this result, you must either:

1. Take on mortgage debt of at least $400,000 (i.e., buy a $1 million property with $600,000 equity and a $400,000 loan); or
2. Contribute an additional $400,000 of equity from outside the exchange to buy $1 million of replacement property.

In sum, a 1031 exchange can defer all or a portion of your capital gains and related taxes, but only so long as you continue to ‘trade up’ and reinvest in like-kind property.

1031 Exchanges Stimulate the US Economy

Exchanging investors are not the only ones who benefit from these tax-deferred transactions. 1031 exchanges also encourage investment, create jobs, and stimulate the economy. One reason is the rule that replacement property must be of greater or equal value than the property sold. 1031 exchangers are essentially ‘trading up’ and investing in more (or more expensive) property than they started with.

The tax deferral also encourages people to sell instead of holding on to assets that need significant improvements. A recent industry study of 1031 activity concluded that 1031 buyers invest substantially more capital in their replacement properties than non-1031 buyers. Let’s say your property needs renovations or repairs and you lack the time, expertise, or resources to make them yourself. Section 1031 incentivizes you to sell to a buyer who has the means to improve the old property. This allows you to acquire property that does not need improvements beyond your capabilities, or to invest passively in a real estate project managed by others.

Even if you purchase a ‘turnkey’ investment property, most owners make some changes when they buy something new — a coat of paint, new decor or furnishings, or even a new tenant. Consequently, each real estate sale generates business for a range of transactional professionals (e.g., surveyors, environmental consultants, escrow officers, brokers or realtors, and public utility workers). The sale also results in expenditures for goods and services such as flooring, landscaping, appliances, and furniture.

A 2022 macroeconomic study by Ernst & Young found that 1031 exchanges supported 976,000 jobs, generating $48.6 billion of labor income, and added $97.4 billion to the GDP. Capital invested from 1031 exchanges spurs recovery in all sectors of commercial real estate at the time of sale by diverting capital gains tax revenue to productive use.

Further, taxpayers who do exchanges are limited in the amount of depreciation they can deduct on their replacement property by their original cash basis.

In our first example, the investor deducted $100,000 of depreciation on their original property. They will therefore be limited to $220,000 in depreciation on their replacement property. Once that $220,000 is depleted, the investor will no longer be able to take depreciation deductions without infusing new capital. Ernst & Young estimated the additional tax revenue from depreciation recapture paid by investors who have exhausted their depreciation to be about $6 billion annually.

Use a 1031 Exchange To Benefit You and the Economy Today

Simply put, a 1031 exchange is a useful tool employed by a broad cross-section of America. It encourages investment in the US economy, through both the purchase of property and the goods and services generated around the sale.

As with any real estate investment, it is wise to consult with your own personal tax advisor to assess whether a 1031 exchange may be beneficial to you.

We think you’ll also like:

1. Putting off the Tax Collector – The Basics of 1031 Exchanges
2. Real Estate Terminology Every Investor Should Know
3. Exploring Opportunity Zone Tax Benefits

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Ethical Issues in Real Estate-Based Bankruptcies
2. Digital Assets in Commerce & Bankruptcy
3. The Start-Up/Small Business Advisor

This article was originally published on August 27, 2025.]

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