In commercial real estate, tax efficiency often separates the good investments from the great ones. While appreciation and cash flow typically draw the spotlight, sophisticated investors know that managing tax consequences is equally critical to long-term success.
Among the tools available, few are as powerful—or as misunderstood—as the 1031 exchange.
At Alakai Capital, we’ve helped numerous investors use 1031 exchanges to grow portfolios exponentially while deferring their gains along the way. This guide explains how the 1031 exchange works, why it matters, and how experienced investors maximize its benefits while avoiding common pitfalls.
What Is a 1031 Exchange?
A 1031 exchange, named after Section 1031 of the Internal Revenue Code, allows an investor to sell an investment property and reinvest the proceeds into another “like-kind” property without immediately triggering capital gains taxes.
Importantly, “like-kind” is broadly defined. It does not mean an office building must be exchanged for another office building. Rather, any investment real estate—such as a retail strip center, an industrial warehouse, or a medical office property—can qualify, provided it is held for investment or business purposes.
The key advantage is that 100% of the investor’s equity continues to work toward compounding returns, instead of being eroded by a significant tax bill at each sale.
Why the 1031 Exchange Matters for Long-Term Wealth Building
Imagine selling a property for $2 million with a $1 million cost basis. Without a 1031 exchange, a substantial portion of the $1 million gain could be consumed by taxes:
- Federal capital gains tax can range from 15 – 35%, depending on your income bracket and length of hold, according to IRS capital gains guidance.
- State capital gains tax, such as California’s additional 13.3% rate outlined by the California Franchise Tax Board.
- Depreciation recapture tax, typically at a 25% rate, as described in IRS Publication 544.
- Net Investment Income Tax of an additional 3.8% for high-income individuals, detailed by the IRS Net Investment Income Tax information page.
Combined, taxes can consume 15–50%+ of the gain, leaving significantly less capital available for reinvestment.
By utilizing a 1031 exchange, investors preserve that capital—allowing their dollars to continue to work for them which allows them greater buying power to move into larger assets. Over multiple investment cycles, the compounding effect has the potential to become transformative.
How a 1031 Exchange Works: Step-by-Step
Executing a 1031 exchange properly requires precise adherence to IRS guidelines. Here’s the process:
1. Sell the Original Property
The relinquished property must be held for investment or business use. After the sale, proceeds must be transferred directly to a Qualified Intermediary (QI)—never to the seller personally—according to IRS Section 1031 rules. Thus, a 1031 intermediary must be identified during the contract period of the sale and lined up to accept the sales proceeds upon closing.
2. Identify Replacement Properties Within 45 Days
Within 45 days of selling the relinquished property, the investor must identify potential replacement properties. Two standard methods are allowed:
- Three-Property Rule: Identify up to three potential properties, regardless of value.
- 200% Rule: Identify any number of properties as long as the total fair market value does not exceed 200% of the relinquished property’s value.
Once you have your properties identified you will need to send them to your 1031 intermediary and receive signed approval prior to the 45 day mark.
3. Close on the Replacement Property Within 180 Days
The investor must acquire the replacement property (or properties) within 180 days of the sale date. The identification and acquisition periods run concurrently.
*In situations when there is a natural disaster (hurricane, tornado, etc.) during the identification or closing period that has been designated a National Disaster, both periods are commonly extended so inquire with your intermediary if more time has been allocated to your 1031.
4. Reinvest All Proceeds and Match Debt
To fully defer taxes, the investor must reinvest all net sales proceeds and either take on equal or greater debt—or add cash to replace any debt relief—to avoid generating taxable “boot.”
Any misstep in this process—such as missing deadlines or improperly handling proceeds—invalidates the exchange and triggers immediate taxation.
Real-World Example: Multiplying Wealth with 1031 Exchanges
To see the power of tax deferral in action, here’s a simplified example.
Let’s say an investor purchases a commercial property for $500,000. Over time, the asset appreciates and he/she sells for $1,000,000, resulting in a $500,000 gain.
Here’s a side-by-side comparison of the outcomes when the investor sells the property with—and without—a 1031 exchange:
Without a 1031 Exchange
- Capital gains tax paid (assume 20%): $100,000
- Remaining proceeds to reinvest: $900,000
- Target annual return (assume 6%): $54,000 in yearly cash flow
By paying the capital gains tax, the investor gives up $100,000 in reinvestment capital, reducing future income and compounding potential.
With a 1031 Exchange
- Capital gains tax: $0 (deferred)
- Total proceeds reinvested: $1,000,000
- Target annual return (assume 6%): $60,000 in yearly cash flow
By deferring the tax, the investor retains full buying power and generates an additional $6,000 in annual income, simply by keeping more capital at work.
And over a 10-year hold period, that’s $60,000 in additional income (without accounting for appreciation, rent growth, or reinvestment gains from future exchanges.)
In short, the 1031 exchange isn’t just about deferring taxes. It’s about unlocking greater buying power, compounding returns, and building wealth that would otherwise be lost to the IRS.
Advanced Strategies to Maximize 1031 Exchange Benefits
A. Trading Up to Larger Assets
By exchanging smaller assets into larger, more diversified investments, investors can hedge their risk by owning an investment with multiple tenants and/or more institutional assets.
B. Using Delaware Statutory Trusts (DSTs) for Passive Investing
Investors looking for a hands-off approach can 1031 exchange into DSTs, which provide fractional ownership in institutional-quality properties while maintaining tax deferral benefits. This strategy is usually best for those looking for a place to park their capital in a safer, lower return structure.
C. Portfolio Diversification Through Multiple Properties
Instead of rolling proceeds into one replacement property, investors can split investments across multiple assets to spread risk and increase cash flow.
D. Reverse 1031 Exchange
Investors who find a new property before selling their current one can leverage a reverse exchange. This is a challenging strategy due to the juggling of timelines between both the purchasing and selling contract. It is easier during high activity periods in the market cycle or with more liquid assets or like single tenant net lease properties.
Common Pitfalls That Can Undermine a 1031 Exchange
Despite its advantages, mistakes can easily derail a 1031 exchange:
Missing IRS Deadlines
Both the 45-day and 180-day windows are strict. Even federally declared disasters rarely extend deadlines, except under rare conditions like those outlined in IRS Notice 2020-23.
Taking Control of Proceeds
Even brief personal possession of the sale proceeds invalidates the exchange, making it critical to work with a qualified intermediary.
Overpaying for a Replacement Property
In a rush to meet deadlines, some investors settle for poor acquisitions. Investment discipline should never be compromised for the sake of timing. A 1031 replacement property should be underwritten with the same scrutiny as an original investment.
Creating Taxable “Boot”
Failure to fully reinvest proceeds—or mismatch debt—results in immediate taxable gains.
At Alakai Capital, we help our clients navigate these nuances, ensuring their exchanges align with long-term strategic goals—not just tax deferral.
How Alakai Capital Executes 1031 Exchanges
At Alakai Capital, we invest alongside our investors, ensuring we are aligned with their interests in tax strategy and continuing to roll gains into future investments.
As such we have successfully executed several rounds of 1031 strategies that have created significant impact on the investment returns for investors:
Case Study #1:
Alakai Capital acquired a single tenant property all cash at a time when financing was tight. It sold the property 14 months later, 1031ing into two value-add strip center investments. After stabilizing the two strip centers, it sold one of them and again performed a 1031, taking the sales proceeds and reinvesting them into two more strip centers.
As a result, the original investors, who only invested in the first single tenant investment, now are owners in three strip centers in different metros with 13 total tenants. Not only have we increased our cash flow and value to investors with each 1031, but we have also diversified our investments and risk profile.
Case Study #2:
Alakai Capital acquired a single tenant value add investment in early spring. The team jumped on the value add component, getting the tenant open and operating within 5 months, selling the asset in 8 months. In order to avoid short term capital gains we 1031’d the property into two single tenant investments, each in strong locations with long term leases with tenants.
The investors now own two properties in two different markets with two different tenants – diversifying their risk and increasing their cash flow on original investment.
Using 1031 Exchanges for Long-Term Wealth Creation
If you’re exploring strategies to build long-term wealth through real estate while minimizing tax friction, 1031 exchanges offer a powerful advantage. Yet successful execution demands strategic planning, disciplined timing, and deep market knowledge.
The tax advantages of commercial real estate are unmatched compared to other investment asset classes. By leveraging depreciation, 1031 exchanges, and strategic entity structures, our investment philosophy is focused on minimizing taxes and increasing returns over long-term holding periods.
For accredited investors and family offices interested in tax-advantaged commercial real estate opportunities, we invite you to explore our current offerings.
About Alakai Capital
At Alakai Capital, we believe that what you keep matters more than what you make. Our tax-optimized approach to commercial real estate investing helps accredited investors, family offices, and institutional partners maximize after-tax returns while building long-term wealth.
Nick Jones is the founder and CEO of Alakai Capital, bringing over 20 years of commercial real estate experience. He has overseen the acquisition, development, or redevelopment of more than 70 investments, creating over $100 million in value across industrial, retail, office, and medical office properties.