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Meet Sarah McDonald, a software engineer from Austin who bought her first rental property in 2018 — a modest three-bedroom house for $280,000.
Fast-forward to today, Sarah now owns a 24-unit apartment complex worth $3.2 million. The secret to her transformation from small-time landlord to commercial real estate investor? She discovered the power of using 1031 exchanges to systematically scale up her real estate empire.
Sarah’s journey illustrates one of the most overlooked strategies in real estate investing: The step-up approach.
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Rather than getting stuck in the single-family rental hamster wheel — collecting modest rents while dealing with midnight toilet emergencies — smart investors use 1031 exchanges to gradually migrate toward larger, more profitable commercial properties that generate institutional-quality returns.
If you’re currently managing a handful of rental houses and wondering whether there’s a better way to build wealth through real estate, the answer might be hiding in plain sight within Section 1031 of the Internal Revenue Code.
Why bigger really is better
Don’t get me wrong — single-family rental properties can be excellent investments. They’re typically easier to finance, understand and sell. But managing multiple single-family properties often becomes a second full-time job that doesn’t scale efficiently.
Think about it this way. Whether you own one rental house or 10, each property requires individual attention for maintenance, tenant screening, lease management and the inevitable 2 a.m. phone calls about broken water heaters.
Your time investment experiences linear growth with each additional property, but your per-unit profitability doesn’t always improve — and sometimes gets worse.
Commercial real estate operates under different rules. A well-managed 20-unit apartment building typically generates better cash flow per dollar invested than 20 separate single-family homes scattered across town.
Why? Economies of scale.
One roof to maintain instead of 20. One HVAC system instead of 20. Professional property management becomes cost-effective, and your role shifts from hands-on landlord to strategic real estate investor.
The challenge: How do you make the leap from owning a rental house to owning serious commercial real estate without getting crushed by capital gains taxes? That’s where the magic of 1031 exchanges comes into play.
The step-up strategy
The beauty of using 1031 exchanges to scale up lies in the compounding effect. Each exchange allows you to defer capital gains taxes while moving into larger, more valuable properties. Over time, this creates exponential growth in both your net worth and your passive income.
Let’s walk through Sarah’s actual progression to see how this works in practice.
Step No. 1: The foundation (2018-2021)
Sarah started with a $75,000 down payment on that $280,000 single-family rental in Austin. After three years of appreciation and mortgage paydown, the property was worth $420,000 with a loan balance of $180,000, giving her $240,000 in equity. Rather than paying capital gains taxes on her $140,000 gain, Sarah executed her first 1031 exchange.
Step No. 2: The duplex move (2021)
Using her 1031 exchange, Sarah acquired a duplex for $450,000 in a rapidly growing suburb. This single move doubled her rental income while only marginally increasing her management responsibilities. The duplex appreciated quickly in Austin’s hot market.
Step No. 3: The fourplex upgrade (2023)
Two years later, Sarah’s duplex was worth $650,000. She had paid down the mortgage to $280,000, creating $370,000 in equity. Another 1031 exchange moved her into a fourplex valued at $850,000. Now she was generating rental income from four units under one roof — a much more efficient use of her time than managing four separate houses.
Step No. 4: The commercial leap (2024)
This is where Sarah’s strategy really paid off. Her fourplex had appreciated to $980,000, and with mortgage paydown, she had $520,000 in equity. But instead of buying another small residential property, Sarah made the jump to true commercial real estate: A 24-unit apartment complex for $3.2 million.
The numbers tell the story. Sarah’s original $75,000 down payment had grown into more than $500,000 in equity through a combination of appreciation, mortgage paydown and — crucially — tax deferral through 1031 exchanges.
Had she paid capital gains taxes at each step, she would have lost thousands of dollars to the IRS along the way, significantly hampering her ability to scale up.
Understanding the like-kind requirements
One of the biggest misconceptions about 1031 exchanges is that you need to swap identical properties. In reality, the “like-kind” requirement for real estate is remarkably flexible. The IRS considers virtually all investment real estate to be like-kind to all other investment real estate.
This means you can exchange:
- Single-family rental homes for apartment buildings
- Raw land for retail shopping centers
- Office buildings for industrial warehouses
- Residential duplexes for medical office buildings
The key requirement is both properties must be held for investment or use in a trade or business. Your personal residence won’t qualify, nor will the vacation home you use for family getaways more than 14 days per year.
Why commercial properties win
Let’s talk about why this scaling strategy makes financial sense. Commercial real estate typically offers several advantages over residential rental properties:
Potential higher total returns. Commercial properties typically offer multiple advantages that can lead to superior overall returns compared to single-family rentals.
While single-family rentals generally average gross rental yields of 5% to 6%, commercial properties can sometimes offer cash flows of 7% to 8% or higher (though it’s important to keep in mind that these figures can vary dramatically by market, and by market conditions).
Professional management. Once you reach a certain size, professional property management becomes economically viable. This transforms you from an active landlord into a more passive investor collecting monthly checks.
Longer leases. Commercial tenants typically sign multi-year leases, providing more predictable cash flow than residential tenants who might leave annually.
Triple net leases. Many commercial properties operate under triple net lease structures, where tenants pay property taxes, insurance and maintenance costs in addition to rent. This shifts many ownership responsibilities to the tenant.
Institutional financing. Commercial properties often qualify for better financing terms and longer amortization periods, improving cash flow and returns.
What can go wrong
Of course, scaling up through 1031 exchanges isn’t without risks. Here are the most common mistakes I see investors make:
Moving too fast. Some investors get exchange-happy and jump into commercial properties before they understand the market. Commercial real estate requires different skills and knowledge from residential investing.
Ignoring cash flow. Bigger isn’t always better if the cash flow doesn’t improve. Some investors get so focused on property values that they forget to analyze whether the new property will actually generate superior returns.
Overleveraging. The ability to defer taxes through 1031 exchanges can tempt investors to take on more debt than they can safely handle. Always stress-test your investments against potential vacancy rates and interest rate increases.
Timeline pressure. The 1031 exchange rules are unforgiving. You have exactly 45 days to identify potential replacement properties and 180 days to complete the purchase. This timeline pressure can lead to poor investment decisions. Always have backup plans and work with experienced intermediaries.
The Delaware statutory trust option
What if you want to move into commercial real estate but aren’t ready to manage a large property yourself? Delaware statutory trusts (DSTs) offer an elegant solution for investors transitioning from hands-on residential properties to passive commercial real estate ownership.
A DST allows you to purchase fractional ownership in institutional-quality commercial properties — think Class A office buildings, medical centers or regional shopping centers — without the headaches of direct management. You receive monthly distributions and potential appreciation, but a professional management company handles all operational aspects.
DSTs are particularly attractive for 1031 exchanges because they:
- Qualify as like-kind property under Section 1031
- Provide access to commercial properties you couldn’t afford individually
- Offer geographic diversification across multiple markets
- Eliminate management responsibilities while maintaining real estate ownership benefits
The estate planning bonus
Here’s where the 1031 exchange strategy really gets interesting from a wealth-building perspective. If you never sell your final commercial property — instead holding it until death — your heirs receive a “stepped-up basis” equal to the property’s value at the time of your passing.
This permanently eliminates all the deferred capital gains taxes from your years of 1031 exchanges.
Essentially, the 1031 exchange becomes a wealth transfer strategy that allows you to build a commercial real estate empire while deferring taxes indefinitely … or eliminating them entirely. Your heirs inherit valuable income-producing properties without the tax burden you would have faced during your lifetime.
Getting started
If you’re currently stuck in the single-family rental grind and want to scale up to commercial real estate, here’s your road map:
Educate yourself. Begin by learning about the fundamentals of commercial real estate. Understand cap rates, net operating income and commercial lease structures. Books, seminars and mentorship programs can accelerate your learning curve.
Analyze your current portfolio. Calculate the total equity in your existing properties. This will determine your buying power for commercial properties after a 1031 exchange.
Build your team. Assemble professionals who understand both 1031 exchanges and commercial real estate. You’ll need a qualified intermediary, a commercial real estate broker, an attorney and a CPA experienced in real estate taxation. The importance of your financial team’s skill and experience can’t be overstated.
Start your market research. Begin identifying potential commercial properties or DSTs that fit your investment criteria and risk tolerance.
Plan your timeline. Remember, the 1031 exchange deadlines are non-negotiable. Plan your strategy well in advance of any property sales.
The journey from single-family rental properties to commercial real estate ownership doesn’t happen overnight, but with patience, education and strategic use of 1031 exchanges, it’s entirely achievable.
Sarah McDonald’s story isn’t unique — thousands of investors have used this step-up strategy to build substantial wealth while minimizing their tax burden.
The question isn’t whether you can scale up from single-family to commercial real estate through 1031 exchanges. The question is: What’s keeping you from starting today?
