1031 Exchange Rules in Real Estate: The Risks for Investors

What a 1031 Exchange Is and How It Works

A 1031 exchange, also called a like-kind exchange, allows an investor to sell a business or investment property and reinvest the proceeds into another qualifying property—deferring capital gains taxes in the process. Both properties must be for business or investment use, not personal use.

The process is often presented as a “tax-free” strategy, but that is misleading. The taxes are deferred, not eliminated, and errors in execution or advisor misconduct can leave investors with an unexpected tax bill.

Core Facts About How the Exchange Works

• Like-kind requirement: The property sold and the property purchased must be similar in nature and purpose (for example, an apartment complex can be exchanged for a retail building). Exchanging for stocks, bonds, or other assets disqualifies the deferral.
• Strict deadlines: Investors must identify a new property within 45 days and close the purchase within 180 days of the original sale. Missing either deadline—by even one day—can result in full taxation of the original gain.
• Equal or greater value: The replacement property (or combination of properties) must be of equal or greater value to fully defer taxes. Any difference, called “boot,” becomes immediately taxable.

When an advisor promotes 1031 exchanges as a low-risk or guaranteed strategy, that can create serious problems. The complexity of these transactions and their rigid requirements make them susceptible to financial missteps and abuse—especially when investors rely on bad advice.

Common 1031 Exchange Structures and Their Risks

There are several types of 1031 exchanges, each offering flexibility—but also potential pitfalls when mishandled or misrepresented.

The Four Primary Exchange Types

• Delayed exchange: The most common format. The original property is sold, and a replacement is purchased within the 180-day window. If funds are mishandled or not properly transferred through an intermediary, tax deferral is lost.
• Simultaneous exchange: The sale and purchase occur at the same time. These require precise coordination, leaving little margin for error.
• Reverse exchange: The investor buys the replacement property before selling the original one. Financing issues can arise, and improperly structured deals can violate IRS guidelines.
• Build-to-suit exchange: The proceeds fund a new construction project, which introduces valuation and timing risks if the build isn’t completed on schedule.

Each variation requires adherence to IRS regulations. When financial advisors or firms fail to disclose the potential drawbacks—or push clients into these exchanges for commissions rather than sound investment reasons—investors can face severe losses.

Mistakes That Can Trigger Taxes or Losses

Even experienced investors can lose their tax-deferral benefits if an exchange is not handled precisely. In many cases, these errors stem from poor oversight or negligent advice.

Key Pitfalls to Watch For

• Missing IRS deadlines: Failing to identify or close on the replacement property within the required time frame immediately disqualifies the exchange.
• Improper property identification: Advisors or intermediaries who misclassify properties as “like-kind” risk disqualification and taxation.
• Direct receipt of funds: If the investor—or advisor—takes control of sale proceeds instead of using a qualified intermediary, the IRS treats the funds as taxable income.
• Inappropriate use of Delaware Statutory Trusts (DSTs): DSTs, which offer fractional ownership in large institutional properties, are sometimes marketed as “safe” 1031 options. In reality, they can involve high fees, limited liquidity, and complex risks that investors may not fully understand.

When investors are misled about these risks or sold inappropriate 1031-related investments, they can face devastating tax exposure or long-term financial harm.

Real-World Example of 1031 Tax Exposure

To understand how quickly losses can escalate, consider a simple example.

An investor sells an apartment building for $3 million, originally purchased for $1 million. Without a 1031 exchange, they owe:

• 20% federal capital gains tax: $400,000
• 3.8% net investment income tax: $76,000
• Up to 13.3% state tax in high-tax states like California: $266,000

That totals between $534,000 and $742,000 in taxes owed.

If a financial advisor fails to execute a proper 1031 exchange or misrepresents the tax implications, the investor may owe this full amount unexpectedly—along with potential penalties and interest. For many investors, this turns what was supposed to be a tax-saving opportunity into a financial crisis.

The Bottom Line: Know the Risks and Your Rights

While a 1031 exchange can be a powerful tool for deferring taxes and growing real estate wealth, it also presents significant risks if mishandled or misrepresented. Many investors are persuaded into unsuitable exchanges or illiquid investment products—often under the promise of guaranteed returns or “tax-free” benefits.

If you lost money because your financial advisor or brokerage firm failed to disclose the risks of a 1031 exchange, you may have legal options for recovery. Meyer Wilson Werning represents investors nationwide in cases involving financial advisor misconduct, unsuitable recommendations, and mismanagement of investment strategies. Contact us today so that our firm can help you understand what went wrong and pursue recovery for your losses.

Frequently Asked Questions