Why Serious Landlords Rely on the 1031 Exchange

If you are a rental property owner and aim to become a big-time landlord, use the Section 1031 exchange to

Sell appreciated properties, pay no federal income taxes, and reinvest all proceeds;
Trade up into larger or better-performing properties, such as moving from one-door rentals into multifamily rentals.
Avoid taxes during your lifetime; and
Bequeath the property at death to your heirs, who receive a step-up in basis to fair market value.

Example: Jimmy bought his first rental property a few years ago for $100,000. Later, he sold it for $175,000 and bought a replacement for $200,000. He continued this pattern until he died this year, leaving a $10 million real estate portfolio. During this time, Jimmy never paid taxes on any of his rental property sales.

At death, Johnny, his son and only heir, inherits Jimmy’s property with a stepped-up basis of $10 million. No tax needs to be paid by the estate or by Johnny here either. The estate tax exemption for 2025 is $13.99 million, and that’s more than Jimmy’s estate value.

Critical Step 1

To get your Section 1031 exchange on track, engage a qualified 1031 real estate exchange intermediary.

Before a sale or purchase process involves your property, do this: the intermediary will not start working until you buy or sell. The intermediary will tell you what to do. Therefore, it is important to choose an intermediary carefully, just as you would when investing significant funds. Your tax and financial advisors can give you guidance.

Reverse or Forward Exchange?

It is important to decide whether your exchange is forward or reverse as soon as you have a qualified intermediary in place, or even before that.

Forward 1031 exchange

In a standard forward 1031 exchange of rental property, you first sell your existing rental property and then buy a replacement rental property. Note that “you” are doing this. You are making the decisions. Your intermediary is in the mix as a facilitator to help you pay zero federal income taxes on the deal.

The required forward exchange timeline works like this:

Trigger date: The day you close escrow on the sale of your existing rental is your trigger date.

Drop-dead identification date: You must formally identify upto three replacement properties to the intermediary within 45 days of the close of escrow on the relinquished property. Failure to buy an identified property kills the 1031 exchange.

Purchase date: You must close escrow on the replacement property by the earlier of (a) 180 days after close of escrow on the relinquished property or (b) the due date of your tax return.

The forward 1031 exchange is easy to execute with your intermediary. It’s also not expensive, generally costing less than $1,500 or, in some markets, even less than $1,000.

The downside of the forward exchange is that if you miss the 45-day or 180-day deadline, your exchange will fail. If you are sure you can meet those deadlines, then the forward exchange is for you.

Reverse 1031 Exchange

A reverse 1031 exchange is a like-kind exchange in which you buy the replacement property first. The property is ‘parked’ by your intermediary with an exchange accommodation titleholder.

You and the intermediary do this in accordance with the IRS safe harbor under Rev. Proc. 2000-37 as modified by Rev. Proc 2004-51. This sounds technical, and it is. But don’t worry: your intermediary does all the heavy lifting.

The heavy lifting part is why the reverse exchange is (1) far more expensive and (2) far more complicated than the forward exchange. Fees for the reverse exchange can range from $5,000 to $10,000 or more.

The added expense comes from the extra entity/parking structure, added risk and complexity for the accommodator, and ongoing holding and financing costs during the parking period.

One big deal in the reverse exchange is the creation of an LLC to hold (park) your newly purchased rental while you sell your existing rental. That will also cause you some trouble, such as getting insurance on the new property that protects the LLC. At this point, the new property belongs to the LLC, but again, not to worry: the paperwork will be replaced with the paperwork for the new property coming to you.

During the parking period, you get the economic benefits and burdens of ownership via a triple-net lease and management agreement.

When the exchange is complete, either you will own the LLC that has title to your replacement property or the exchanger can transfer the deed to you. With some exchangers, you will own the LLC and handle the title if you want to change it.

Recommendation: Holding a rental property in a single-member LLC is a good idea because it gives you strong liability protection.

Timelines: In a reverse exchange, you buy the replacement property first, before selling your relinquished property. As a result, the IRS imposes two key deadlines that begin when the replacement property is parked.

45-day identification rule: You must identify the property you intend to sell in writing to the intermediary. This is falling-out-of-bed easy because it’s your existing rental.
180-day completion rule. You have 180 days from the close of escrow on the parked property to sell your existing property.

Key point: From an execution standpoint, the reverse exchange is easy because you have no issues with the 45-day identification rule. You are selling your existing rental.

BergerCPAFirst, with over 30+ years of experience, offers comprehensive tax preparation services for individuals and businesses nationwide. Our commitment is to provide personalized attention while ensuring compliance and maximizing tax benefits. If you have any questions or would like to schedule a consultation, please call (201) 587-9200 or send us an inquiry.