Selling an investment property can trigger a significant tax bill, but it does not have to. In a recent webinar, Matt Schumacher, Director of Tax Planning at Tavola Group, and Daniel Osman, Head of Growth & Partnerships at Deferred, explained how 1031 exchanges help real estate investors defer taxes, preserve capital, and reinvest for long-term growth. The session covered the fundamentals, common pitfalls, and strategic opportunities that can turn a property sale into a powerful wealth-building move.
Here are the key takeaways from the discussion.
What a 1031 Exchange Does
A 1031 exchange, named after Section 1031 of the IRS tax code, allows investors to sell an investment property and reinvest the proceeds into another investment property while deferring capital gains taxes. Instead of paying taxes immediately, the investor keeps more capital working in the market, which supports portfolio growth and long-term compounding.
The IRS allows this deferral based on the concept of continuity of investment. If the proceeds remain invested in qualifying real estate, the tax liability can be postponed.
To complete a valid exchange, several requirements must be met. A qualified intermediary must hold the sale proceeds so the investor does not take possession of the funds. Investors have 45 days after the sale to identify potential replacement properties and 180 days to complete the purchase. To fully defer taxes, the replacement property typically must be equal to or greater in value, and all net proceeds must be reinvested.
The Real Tax Impact of Selling Without a Plan
Many investors underestimate the tax consequences of selling a property. In addition to capital gains tax, depreciation recapture is taxed at a rate of up to 25 percent. Higher-income investors may also be subject to the Net Investment Income Tax, and state taxes can further increase the total liability.
When these factors are combined, the total tax cost can approach 35 to 40 percent of the gain. This is why proactive tax planning before listing a property is essential. If a sale closes without a qualified intermediary already in place, the opportunity to complete a 1031 exchange is lost.
Common Mistakes Investors Make
Several misconceptions can create problems for investors attempting a 1031 exchange. One of the most common issues is waiting until after closing to explore the option. Another frequent mistake is assuming that only the gain must be reinvested. In reality, the full net sales price must be used to achieve full deferral.
Some investors also believe that 1031 exchanges only make sense for large transactions. In fact, any investment property with a gain can qualify. Others assume the process is all or nothing, but partial exchanges are possible if an investor chooses to take some cash out and pay tax only on that portion.
Understanding these rules early helps investors avoid costly surprises.
Strategic Options Beyond the Standard Exchange
A traditional exchange involves selling one property and purchasing another, but the structure is more flexible than many investors realize.
A reverse exchange allows an investor to acquire a replacement property before selling the existing one. This approach can be helpful when a strong opportunity becomes available but the current property has not yet sold.
An improvement exchange allows investors to use exchange funds for renovations or value-added work on the replacement property. This strategy can help meet value requirements while increasing the property’s long-term potential.
Some investors who want liquidity may consider a cash-out refinance after the exchange is complete. Because loan proceeds are not taxable, this approach can provide access to funds without creating immediate tax liability.
Another strategy involves purchasing a future retirement or vacation home as an investment property. After meeting the required holding period and use guidelines, the property may later be converted to personal use.
For investors seeking a more passive approach, Delaware Statutory Trusts allow ownership in institutional-grade real estate without day-to-day management responsibilities. These structures can also help diversify across multiple properties or asset types.
Understanding the Like-Kind Requirement
The term like-kind often creates confusion. It does not mean the replacement property must be the same type as the property sold. The rule simply requires that both properties be U.S. real estate held for investment or business purposes.
An investor can exchange a single-family rental for a commercial building, raw land for multifamily property, or one property for several others. The flexibility allows investors to reposition their portfolios as their goals evolve.
However, certain assets do not qualify. Primary residences are not eligible. Properties held primarily for resale, such as fix-and-flip inventory or development held as part of an operating business, generally do not qualify. Partnership or LLC ownership interests also do not meet the requirements.
The IRS focuses heavily on intent. Even a short holding period may qualify if the property was acquired with the intention of holding it for investment.
Special Situations Investors Should Know
Several common scenarios were addressed during the webinar. Undeveloped land qualifies if it is held for investment purposes. Investors can rent a property to family members, but the arrangement must reflect fair market rent with proper documentation and actual payment.
Vacation homes must meet strict rental and personal-use limits to qualify as investment property, and they typically need to be held as an investment for at least two years. Reverse exchanges can also help investors who find a replacement property before their existing property sells, provided the transaction is structured properly.
In all cases, strong documentation and professional guidance are essential.
A 1031 Exchange as Part of a Larger Tax Strategy
The most important takeaway from the webinar is timing. The greatest risk is not complexity but waiting too long. Once a sale closes without proper planning, the opportunity to defer taxes is gone.
If you are considering selling an investment property or exploring ways to optimize your real estate portfolio, now is the time to take action. Tavola Group offers a complimentary tax strategy consultation to help you uncover opportunities, reduce unnecessary tax exposure, and create a plan tailored to your goals. Schedule your free session today to get expert guidance and take control of your financial future.
