Key Takeaways
- Capital gains taxes apply when you sell investment or business-use property at a profit, reducing potential returns.
- A 1031 exchange allows investors to defer federal capital gains, depreciation recapture, and (in many cases) state taxes by reinvesting in like-kind real estate.
- To qualify, replacement property must be identified within 45 days and purchased within 180 days using a Qualified Intermediary, and it must meet IRS value and use requirements.
- Alternative strategies—such as DSTs, Opportunity Zones, and cost segregation—may also reduce or defer taxes.
Selling investment property often comes with a hidden cost: capital gains tax. Depending on your situation, this tax can take a significant bite out of your profits and reduce the capital you have available for your next investment.
Fortunately, there are financial and tax strategies that allow you to defer capital gains taxes and keep more of your money working for you. One of the most powerful tools available to real estate investors is the 1031 exchange.
In this article, we’ll break down the current rules, options, and strategies that investors can use to defer capital gains taxes on real estate. We’ll focus specifically on investment properties (not primary residences) and show you how a properly executed 1031 exchange can help you preserve capital, build wealth, and plan for long-term financial goals.
Understanding Capital Gains in Real Estate
When you sell an investment or business-use property, any profit over your adjusted basis is considered a capital gain and may be subject to taxation.
Adjusted Basis = Purchase Price + Capital Improvements – Depreciation Taken
For example, if you purchased a property for $400,000, made $50,000 in capital improvements, and claimed $75,000 in depreciation, your adjusted basis would be: $400,000 + $50,000 – $75,000 = $375,000
There are two key types of capital gains:
- Short-term gains: Profits on properties held for one year or less, taxed at your ordinary income rate—ranging up to 37% depending on your income bracket.
- Long-term gains: Profits on properties held for more than one year, taxed at preferred rates of 0%, 15%, or 20%, depending on income level. For 2025, these thresholds range from roughly $47,026 to $518,900 for single filers.
Real estate investors also face depreciation recapture, which taxes the portion of gain attributed to depreciation deductions during ownership—capped at 25%. This can result in part of the gain being taxed as ordinary income and part as long-term capital gains.
Deferring Gains with a 1031 Exchange
A 1031 exchange, named after IRS Section 1031, is often used by investors looking to avoid paying capital gains tax on property by reinvesting proceeds into another like-kind property, deferring the tax liability indefinitely. Because profits are rolled into the new property, they are not immediately realized for tax purposes.
Requirements to Qualify:
- Investment or business-use property only: Both the sold and replacement properties must be held for investment or business purposes.
- Like-kind property: Replacement property must be similar in nature or character, even if it differs in grade or quality (e.g., rental building for raw land, multifamily residence for senior housing facility). Importantly, Section 1031 only applies to investment or business-use real estate, not personal residences.
- Equal or greater value: To fully defer taxes, the replacement property must match or exceed the value and equity of the relinquished property. Any difference (called boot) is taxable.
- Strict deadlines: Identify replacement property within 45 days and close within 180 days.
- Qualified Intermediary (QI): Proceeds must be held by a QI to avoid constructive receipt; touching the funds invalidates the exchange.
Taxes Deferred with a Proper 1031 Exchange:
- Federal capital gains tax (up to 20% for long-term holdings)
- Depreciation recapture tax (up to 25%)
- State capital gains taxes, where applicable
This strategy can result in significant tax savings, especially for long-held, highly appreciated properties.
Alternative Strategies for Tax Deferral or Reduction
While these strategies focus on real estate, investors with insurance products should also consider 1035 exchanges for tax-deferred transfers of life insurance policies and annuities. Check out our article on 1031 vs 1035 exchanges to learn more.
Delaware Statutory Trusts (DSTs)
A Delaware Statutory Trust (DST) is a legal structure that allows multiple investors to co-own fractional interests in professionally managed real estate. DSTs qualify as like-kind property under IRS guidelines, making them eligible as replacement property in a 1031 exchange. For investors, they provide a turnkey 1031 exchange solution—offering access to institutional-grade real estate and the ability to defer capital gains taxes, without the responsibilities of active property management.
Opportunity Zones
Opportunity Zones (OZs) are federally designated areas that encourage long-term investment in underserved communities through special tax incentives. Investors can participate by placing eligible capital gains into a Qualified Opportunity Fund (QOF), which invests in qualifying real estate or businesses within these zones. Doing so allows investors to defer those gains—and thanks to the One Big Beautiful Bill Act (signed July 4, 2025), the Opportunity Zones (QOZ) tax incentives are now permanent instead of expiring in 2026.
Here are the key changes starting in 2027 for OZ investments:
- The program is now permanent, so there’s no fixed sunset date for new investments.
- For gains invested after December 31, 2026, deferral of the initial capital gain happens over a five-year rolling window, rather than until a fixed deadline.
- The basis step-up (the portion of the gain that’s excluded from taxes) is 10% after 5 years (for standard QOFs); the extra step-up at 7 years under the old law has been removed.
- A new category called Qualified Rural Opportunity Funds (QROFs) gives enhanced benefits: a 30% basis step-up after 5 years and a lowered “substantial improvement” requirement (50% instead of 100%) for properties in rural Opportunity Zones.
- Opportunity Zone designations will now be re-evaluated every 10 years. Governors must designate new or confirm zones, and those designations will take effect in cycles (new cycle begins July 1, 2026, with zones effective January 1, 2027) under updated eligibility thresholds.
Cost Segregation and Bonus Depreciation
On newly acquired property, cost segregation studies allow investors to accelerate depreciation deductions into earlier years. When paired with bonus depreciation, these deductions can offset other taxable gains, making it a helpful companion strategy alongside a 1031 exchange.
Step-Up in Basis at Death
If an investor holds property until death, heirs inherit it with a “stepped-up basis”—resetting the property’s value to fair market value at the date of death. This effectively wipes out deferred gains, making it a cornerstone of long-term estate planning often referred to as “drop and swap.”
Common Risks and Mistakes in 1031 Exchanges
A 1031 exchange can be a powerful tax-deferral tool, but it comes with strict IRS requirements. Even minor errors can disqualify an exchange and trigger an immediate tax bill. Below are the most common risks investors should watch for:
Missing timelines
The IRS enforces strict deadlines: 45 days to identify potential replacement properties and 180 days to complete the purchase. Missing either deadline disqualifies the exchange.
Constructive receipt of proceeds
At no point can an investor take control of the sale proceeds. Doing so creates “constructive receipt” and triggers a taxable event. A QI must hold and transfer funds throughout the process.
Underestimating boot
If the replacement property is of lesser value—or carries less debt—than the relinquished property, the difference (boot) is taxable. Many investors unintentionally trigger partial capital gains this way.
Overlooking state-level rules
While Section 1031 is federal, states vary in how they treat exchanges. Some have special reporting requirements or clawback provisions. Investors should always confirm state-specific implications with a tax advisor.
Liquidity challenges
Because real estate is illiquid, investors who do not plan for liquidity may struggle to cover taxes, fees, or unexpected expenses. Overcommitting exchange funds without a reserve strategy can create financial strain.
Work closely with a qualified tax advisor and a reputable Qualified Intermediary to avoid costly errors and maximize the long-term benefits of a 1031 exchange.
Preserve Wealth, Defer Taxes
Capital gains taxes can erode your investment returns, but strategies like the 1031 exchange allow investors to keep more capital compounding over time.
Early planning, understanding IRS rules, and working with the right professionals are essential for a successful, tax-efficient real estate strategy.
Explore 1031-eligible real estate investments today. Register for a free investor account to access DST offerings and other opportunities designed to help preserve wealth and grow your portfolio.
This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees, and other expenses. This literature must be accompanied by and read in conjunction with a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results, forward-looking statements and projections are not guaranteed to achieve the results described, and your actual returns may vary significantly. Investments in private placements are illiquid in nature, and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice, and you should consult with your tax advisor, as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC.
