The April 15 tax deadline is a timely reminder for CRE investors to start strategizing how to optimize their portfolios in the year ahead. One tool that has been effective for institutional capital and individuals alike is the 1031 tax-deferred exchange (also known as a Like-Kind Exchange or LKE). Named after Section 1031 of the Internal Revenue Code, this highly effective tax-deferral strategy allows real estate investors to defer capital gains taxes when selling investment or business property — provided the proceeds are reinvested into a “like-kind” property within the prescribed period of time. While a 1031 exchange is sometimes erroneously referred to as a tax loophole, it’s actually not a tax exemption but a tax deferral on which taxes will be paid at a later date. 1031 exchanges are commonly used by high-net-worth CRE investors and institutional capital recalibrating their portfolio strategy but can also be used by business owners who own and occupy their commercial facilities.
Why Use a 1031 Exchange?
Investors use 1031 exchanges for a variety of reasons. The single greatest benefit is that these exchanges allow investors to defer 20–35% in taxes — including federal capital gains, the 3.8% Net Investment Income Tax (NIIT), state taxes, and 25% depreciation recapture — provided they reinvest the full proceeds into another investment or business property while adhering to strict IRS guidelines (described later).
Deferring Income Taxes
Below is an example of the tax deferral that can be achieved through a hypothetical 1031 exchange, assuming no capital improvements or sales expenses.
For instance, if an investor in California purchased a property in 1995 for $800,000 and sells it today for $3 million, the net capital gain would be $2.8 million. Without a 1031 exchange, the investor could face significant taxes on this gain. By using a 1031 exchange and reinvesting in like-kind property, the investor can defer the capital gains taxes that would otherwise be due upon sale, preserving more capital for reinvestment.
Additional Benefits of a 1031 Exchange
Beyond tax deferral, 1031 exchanges offer benefits such as:
Portfolio Consolidation: Selling multiple properties to purchase a larger single property of equal or greater value.
Portfolio Diversification: Selling a single property and reinvesting in multiple properties.
Reduction in Management Burden: Older investors and second-generation owners often seek to maintain income while reducing the stress and operational demands of property management. For example, selling a multifamily property to acquire a more passive-income asset, such as a NNN retail building, or investing in a DST (Delaware Statutory Trust).
Increase Cash Flow: Swapping poor-performing assets for those with greater NOI, including changing asset classes, such as office for industrial or grocery-anchored retail.
Geographic Shifts: Exchanging an asset in a state with a high cost of doing business for an asset in a lower-cost state.
How Do 1031 Exchanges Work?
While 1031 exchanges offer many benefits, they require compliance with IRS rules. Below is an overview of basic rules. Contact a 1031 specialist (Qualified Intermediary, or QI) for a more in-depth explanation. The largest national operators are IPX1031 and Asset Preservation, Inc. (API), both of which operate in Southern California. There are also several Southern California-based QIs, such as Southern California Exchange Services (SCES) and Corcapa 1031 Advisors.
Core Requirements Every Investor Must Follow
You MUST Use a Qualified Intermediary: A Qualified Intermediary (QI) is an independent third-party fiduciary that facilitates 1031 exchanges by holding sales proceeds from a relinquished property and using those funds in acquiring replacement property on behalf of you. The QI must be engaged before closing on the sale of your relinquished property. The QI holds the sale proceeds in a segregated account and directly transfers them to acquire the replacement property. It’s important to note that you cannot take receipt of the funds at any point, or the exchange is invalid. Because QIs are not federally regulated, choosing an experienced, reputable firm is critical to protect your capital.
45-Day Identification Window: Starting from the closing date of your sale, you have exactly 45 calendar days — not business days — to formally identify potential replacement properties in writing to your QI. You can identify up to three properties of any value, or more than three if their combined fair market value does not exceed 200% of the sold property’s value (the “200% rule”). Missing this deadline by even one day invalidates the entire exchange, so investors should line up candidates well in advance and have backups ready.
180-Day Close Deadline: You must close on the replacement property within 180 calendar days of the sale of the relinquished property, or by your tax return due date (including extensions) for that year, whichever comes first. The IRS does not grant extensions for holidays, weekends, financing delays, or due diligence issues, so timing your acquisition aggressively is essential.
Equal or Greater Value: To defer 100% of the capital gains taxes, the replacement property’s price must be equal to or greater than the net sale price of the relinquished property, and all net proceeds must be reinvested. If you take cash out, reduce mortgage debt, or buy a cheaper property, the difference is treated as taxable “boot” and subject to immediate capital gains tax and depreciation recapture. This rule ensures the exchange is truly a reinvestment, not a partial liquidation.
Like-Kind Property: Only real property held for investment or productive use in a trade or business qualifies — personal residences, property held primarily for resale (flips), and foreign real estate do not. In the United States real estate market, the definition is broad: you can exchange an apartment building for industrial space, raw land for a retail center, or an office building for a triple-net-lease property. The key is that both properties must be located in the U.S. and held with investment intent.
Same Taxpayer Rule: The legal entity or individual that sells the relinquished property must be the same one that acquires the replacement property, as reflected on the title and tax returns. You cannot sell in your personal name and buy in an LLC, or exchange out of a partnership and into an individual name, without breaking the exchange.
Because mistakes or missed deadlines can trigger immediate taxation on your capital gains, working with an experienced QI is essential. Consult one before listing your property to ensure your exchange is structured properly from the start.
Selling and Identifying Properties
Voit Real Estate Services specializes in helping our clients navigate the challenges of buying and selling properties. Whether you are a business owner looking to trade an owner-occupied facility for a larger operational base or an investor seeking to pivot from a management-intensive asset into a stable, passive triple net (NNN) asset, we provide the market intelligence and “off-market” access required to meet your 1031 requirements. Contact one of our trusted real estate advisors to discuss your 1031 exchange strategy or to learn more about optimizing your CRE portfolio.
Read our previous blog post for more information on triple-net assets.