(Image credit: Getty Images)
A client sold a property for $2.5 million that they had owned for more than 30 years. Their basis was low enough that the estimated tax bill was just over $800,000. Before we talked about anything else, they asked the question most people ask: “Should I do a 1031 exchange?”
It sounds like a tax question. It isn’t. It’s a portfolio decision.
The fork in the road
At a high level, they had two paths:
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more – straight to your e-mail.
Profit and prosper with the best of expert advice – straight to your e-mail.
- Pay roughly $800,000 in taxes and invest the remainder wherever they wanted
- Defer the taxes and reinvest the full $2.5 million into real estate through a 1031 exchange
On paper, the second option looks better. More capital stays invested. No immediate tax hit. But that only works if the investment that follows actually makes sense.
So, we paused the tax discussion and I asked a different question: “What are you trying to accomplish from here?”
What had changed?
For years, this client had been a hands-on owner. They dealt with tenants, maintenance, financing — everything that comes with direct real estate. But by the time they sold, their priorities were different.
They didn’t want another property to manage. They didn’t want to be tied to one location. They still liked real estate — but not the way they had owned it.
That distinction mattered, because a 1031 exchange doesn’t just defer taxes — it commits you to another real estate investment.
A typical 1031 exchange
Most investors don’t think about a 1031 exchange that way. They think: Avoid the tax, find a replacement and move on.
In reality, the structure introduces a constraint. Once the sale closes, the 45-day identification window starts. That timeline tends to drive behavior.
People don’t always choose the best option. They choose what fits. That might be:
- Another property they can close quickly
- Something familiar
- A structure that solves the exchange without fully considering the long-term outcome
The focus shifts from “What should I own?” to “How do I complete this?”
A different approach
In this case, the client still wanted real estate exposure, but not direct ownership. So instead of replacing one property with another, they used the 1031 exchange to transition into a more passive structure.
That meant moving into professionally managed real estate rather than operating it themselves. For them, that solved two problems at once:
- It deferred the taxes
- It removed the day-to-day burden of ownership
That’s where structures like Delaware statutory trusts (DSTs) are often used. They allow investors to participate in institutional real estate without managing it directly, and they fit within the 1031 framework.
But that still wasn’t the full picture.
What happens after matters
A 1031 exchange answers the tax question. It doesn’t answer the longer-term one.
Over time, this client’s thinking evolved again. They weren’t just trying to simplify ownership — they were trying to diversify beyond a single asset class.
That’s where the next phase of the strategy comes into play.
Some investors eventually transition from direct or fractional property ownership into broader real estate portfolios through structures like a 721 exchange. Instead of owning individual properties, they own interests in diversified real estate at the portfolio level.
It’s not something you have to decide on day one. But it’s part of the arc for investors who want to move from concentrated ownership to something more diversified and liquid over time.
The trade-offs are real
None of these paths is perfect. Staying in real estate — whether directly or through a structure — means:
- Less liquidity than traditional investments
- Less control, especially in passive structures
- Committing capital for a longer period
Paying the tax, on the other hand, gives you flexibility but reduces the amount you’re investing.
There isn’t a universally “better” option. There’s only the option that aligns with what you’re trying to do next.
The decision most people skip
When we stepped back, the client realized something simple: They didn’t actually need to decide whether to do a 1031 exchange first.
They needed to decide:
- Did they still want real estate exposure?
- If so, in what form?
- And how should this capital fit into the rest of their portfolio?
Once those answers were clear, the path followed. In their case, they used the 1031 exchange, but not in the way they initially expected.
It wasn’t about replacing a property. It was about repositioning.
What this means for you
If you’re facing a large gain, it’s easy to fixate on the tax. But that’s only one part of the decision.
The more important question is what you want to own after the transaction is complete — and how that choice affects your flexibility, your risk and your overall portfolio.
A 1031 exchange can be an effective tool. So can stepping back and rethinking your approach entirely.
The key is understanding that you’re not just solving for taxes. You’re deciding what comes next.
For advisers and investors working through this decision, the challenge is less about identifying the tools and more about sequencing them correctly. The difference between a 1031, a DST or a 721 structure is not just technical — it’s how each fits into the broader portfolio and long-term plan.
