What Is a 1031 Exchange?

A 1031 exchange is a provision of the U.S. tax code (Section 1031 of the Internal Revenue Code) that allows an investor to sell a business or investment property and reinvest the proceeds into another like-kind property while deferring the capital gains tax that would otherwise be due on the sale. The gain isn’t eliminated, it’s rolled forward into the replacement property, as long as the investor follows IRS rules on timing, uses a qualified intermediary, and reinvests into a property of equal or greater value.

At a glance, a 1031 exchange requires: a like-kind investment or business property on both sides of the trade, a qualified intermediary who holds the sale proceeds, a 45-day window to identify replacement properties, a 180-day window to close on the replacement, and a replacement property equal to or greater in both price and loan amount to defer the full gain.

Financing the Replacement Property: Conventional vs. DSCR

Deferring the gain is only half the picture. The replacement property still has to be financed, and that decision matters just as much as the exchange itself. For the Fair Oaks-to-Folsom client discussed throughout this article, we looked closely at two paths: a conventional loan and a DSCR loan (short for Debt Service Coverage Ratio), which is a popular option for investors because it qualifies the loan using the property’s rental income rather than the borrower’s personal income, tax returns, and debt-to-income ratio.

In this case, our client easily qualified for a conventional loan based on his own income and credit profile, so that’s the route we took. The interest rate on the conventional loan came in slightly lower than the DSCR option available to him, and when a client qualifies comfortably either way, the lower rate usually wins.

How a DSCR Loan Is Actually Underwritten

DSCR loans are still a genuinely useful tool for a lot of investors, especially those who are self-employed, hold significant debt on other properties, or simply don’t want their personal income involved in the qualification. But the way they’re underwritten catches people off guard, so it’s worth spelling out clearly: 

• If the property is vacant, with no tenant in place, most DSCR programs require the property’s market rent to equal at least 100% of the total monthly mortgage payment (principal, interest, taxes, insurance, and HOA dues if applicable). That’s a ratio of 1.0.
• If there’s already a tenant in place with a signed lease, some DSCR programs only require the rent to cover about 75% of that monthly mortgage payment.

In higher-cost markets like Folsom, the rent-to-payment math doesn’t always work for a DSCR loan, unless the investor is putting down a substantial down payment.

If you’re new to investment properties, our Ultimate Guide to Real Estate Investing in 2026 explains the financing options, strategies, and loan programs available to today’s investors.

This is exactly where DSCR loans can get tricky in a market like Folsom. Home prices there run higher, and so do property taxes, since California property tax is largely tied to purchase price. Once insurance and, in some cases, HOA dues are added on top, the monthly mortgage payment on a home in the $600,000 range can be significant compared to typical market rents for a single-family rental in that area. Unless an investor is putting down a substantial down payment, one large enough to meaningfully shrink the loan amount and the resulting payment, the numbers often don’t pencil out for a DSCR loan in Folsom the way they might in a lower-cost market.

A Condo in Fair Oaks Becomes a Home in Folsom

One of my current clients is a great example of what smart, intentional real estate investing can look like. They recently sold a condo in Fair Oaks that had appreciated nicely over the years, leaving them with a $140,000 taxable gain on paper. Instead of writing a check to the IRS for capital gains tax, they’re doing what savvy investors have done for decades: a 1031 exchange.

They’re using the proceeds from the Fair Oaks sale to purchase a single-family rental home in Folsom for $600,000. Because they’re following the 1031 exchange rules correctly, that $140,000 gain isn’t taxed today. It’s deferred, rolled forward into the new property, where it will keep working for them instead of shrinking their investment.

For this client, the “why” goes beyond avoiding a tax bill this year. Their real strategy is longer-term. They intend to hold the Folsom property inside their family trust, and eventually pass it to their heirs. That single decision changes the entire tax picture, and it’s worth understanding exactly how and why.

The Correct Way to Do a 1031 Exchange

A 1031 exchange (named for Section 1031 of the Internal Revenue Code) lets an investor sell a business or investment property and reinvest the proceeds into a like-kind property while deferring the capital gains tax that would otherwise be due. It’s a deferral, not a forgiveness, and the IRS is strict about the mechanics. Here’s what has to happen for it to hold up:

• Like-kind property only. The property sold and the property purchased both have to be held for investment or business use. A primary residence doesn’t qualify, but a condo, a rental house, a duplex, or raw land generally does, as long as both sides of the trade are investment property.
• A qualified intermediary (QI) is required. The investor can never touch the sale proceeds. The money goes from escrow to a QI, who holds it and uses it to acquire the replacement property. Taking receipt of the funds, even briefly, disqualifies the exchange.
• The 45-day identification window. From the day the relinquished property closes, the investor has 45 calendar days to formally identify potential replacement properties in writing.
• The 180-day close window. The replacement property has to close within 180 calendar days of the original sale, not 180 days from identification.
• Equal or greater value and debt. To defer 100% of the gain, the replacement property should be equal to or greater in both purchase price and loan amount than the property sold. Buying “down” in price or taking on less debt than before can trigger partial taxable gain, known as “boot.”

In this client’s case, they sold their Fair Oaks condo and are reinvesting into a $600,000 Folsom property, which fully satisfies the value requirement and keeps the entire $140,000 gain deferred, so long as the identification and closing deadlines are met and a qualified intermediary handles the funds throughout.

Investors who want to review the IRS reporting requirements for like-kind exchanges can also refer to IRS Form 8824 (Like-Kind Exchanges).

What About a Reverse 1031 Exchange?

Most investors do what’s called a delayed exchange: sell first, then buy the replacement within the 45/180-day windows described above. But sometimes an investor finds the perfect replacement property before they’ve sold the relinquished one. That’s where a reverse 1031 exchange comes in.

In a reverse exchange, the order flips: the replacement property is acquired first, and the relinquished property is sold afterward, within the same 180-day framework. Because IRS rules don’t allow an investor to hold title to both properties at once and still call it an exchange, the replacement property (or sometimes the relinquished one) is temporarily held by a neutral third party called an Exchange Accommodation Titleholder, or EAT, under a structure the IRS outlined in Revenue Procedure 2000-37.

What Is an EAT? In Plain English

Think of an EAT like a friend who buys concert tickets for you because you can’t get to the box office in time, then holds onto them until you’re able to pay them back and take the tickets off their hands. The EAT is a separate legal entity, usually created just for this one transaction, that steps in and holds title to a property for you temporarily. It isn’t the real, lasting owner. It’s just parking the property so the paperwork works, until you’re ready to either sell your old property and take title yourself, or complete the full swap. Once that happens, the EAT signs the property over to you, and its job is done.

Here’s the practical catch, and the reason a reverse exchange really only works smoothly when financing isn’t needed: since the EAT, not the investor, holds title to the parked property, a conventional mortgage lender generally won’t lend directly to the investor against it. The property sits on the EAT’s books until the exchange is unwound. Investors who can pay cash for the replacement property, then sell the relinquished property and complete the exchange, have a straightforward path. Investors who need a loan to buy the replacement property have a much harder road: financing does exist for reverse exchanges, but it’s specialized, harder to find, and often more expensive, which is why most reverse exchanges in practice are cash transactions on the replacement side.

For our client, this wasn’t an issue. They sold Fair Oaks first and are now completing a standard delayed exchange into Folsom, which is the far more common and far more financeable path.

Some investors also use private financing to secure a replacement property quickly before arranging permanent financing.

Another Option: Exchanging Into a DST

A rental house isn’t the only kind of replacement property that qualifies for a 1031 exchange. There’s also the Delaware Statutory Trust, or DST, and it’s worth understanding because it solves a very different problem than the Fair Oaks-to-Folsom story above.

Investors evaluating different acquisition strategies may also want to compare traditional financing, DSCR loans, and private lending solutions.

What a DST Is

A DST is a legal trust that holds title to one or more investment properties, often something like a large apartment complex, a medical building, or a portfolio of self-storage facilities. Instead of buying a whole property yourself, you purchase a fractional, undivided beneficial interest in the trust. The IRS confirmed in Revenue Ruling 2004-86 that this kind of fractional interest counts as real property for 1031 purposes, so exchanging into a DST defers your capital gains tax exactly the way exchanging into a rental house does. A professional sponsor company handles everything: finding tenants, collecting rent, maintenance, refinancing, and eventually selling the asset.

Accredited Investors Only: What That Actually Means

DSTs are sold as securities, not as real estate listings, and by law they’re limited to accredited investors. An individual qualifies as an accredited investor if they meet any one of these:

• A net worth over $1 million, excluding the value of their primary residence, whether alone or combined with a spouse or partner.
• Individual income over $200,000 (or $300,000 combined with a spouse or partner) in each of the past two years, with a reasonable expectation of the same this year.
• Certain professional securities licenses, such as a FINRA Series 7, 65, or 82, held in good standing.

The requirement exists because DSTs are private placements, exempt from the same SEC registration and disclosure rules that apply to publicly traded investments, so the SEC limits them to investors considered financially able to absorb the risk. A licensed financial advisor or the DST sponsor confirms accredited status before an investor can purchase.

When a DST Makes Sense: Hanging Up the Landlord Hat

The DST’s real appeal shows up when an investor is done being a landlord. No more late-night maintenance calls, no more vacancy stress, no more finding a new property manager. The trade for that hands-off structure is real, though, and it shows up in two places: income and liquidity.

I had an investor client who owned a home in Stockton. She sold it a few years back for $350,000 and moved the proceeds into a DST through a 1031 exchange. As a landlord, she had been collecting roughly $2,000 a month in rent. In the DST, her distributions run closer to $1,200 a month.

That $800-a-month difference reflects sponsor fees, professional property management costs, and the fact that DST distributions are typically structured more conservatively than what an individual landlord might collect directly. It’s a real trade-off, and it’s one she made with her eyes open: preserving the asset, deferring the capital gains tax on the sale, reducing her personal liability as a property owner, and getting her time back. For her stage of life, that trade made sense.

The Liquidity Trade-Off

The other side of a DST is liquidity, or rather, the lack of it. Once money is invested in a DST, it’s generally locked in for the life of the trust’s business plan, which is commonly five to ten years. There’s no simple way to call a broker and cash out early the way you might sell a stock. Investors typically get their capital back only when the sponsor sells the underlying property and the trust dissolves, distributing proceeds to all investors at once. Some sponsors offer a limited secondary market for investors who need to exit early, but pricing on those secondary sales is often discounted, and there’s no guarantee a buyer will be available when you want one. Anyone considering a DST should go in assuming their money is committed for the full hold period.

The Legacy Piece: What Happens When Heirs Inherit the Property

This is where the client’s strategy gets really interesting, and where I want to be precise about the terminology, because “estate tax” and “inheritance tax” get used interchangeably and they aren’t the same thing.

Estate Tax vs. Inheritance Tax

• An estate tax is a tax on the total value of a person’s estate before it’s distributed, paid by the estate itself. The federal government has one. California does not.
• An inheritance tax is a tax owed by the person who receives the assets. California does not have one either. A small number of other states do.

For 2026, the federal estate tax exemption is $15 million per individual, or $30 million for a married couple, following the increase made permanent under the One Big Beautiful Bill Act. Estates below that threshold owe no federal estate tax at all, and amounts above it are taxed at 40%. For the overwhelming majority of families, including most real estate investors building a rental portfolio, this means the federal estate tax simply isn’t in play.

The Real Mechanism: Step-Up in Basis

The bigger benefit for this client’s heirs isn’t about dodging an estate tax bill. It’s about something called a step-up in basis under IRC Section 1014.

When an investor buys a property, holds it, and sells it during their lifetime, they pay capital gains tax on the difference between what they paid (their “basis”) and what they sold it for. That’s exactly what our client deferred with the 1031 exchange on their Folsom purchase.

But if, instead of selling, the property passes to heirs at the owner’s death, the heirs’ basis in the property resets, or “steps up,” to the property’s fair market value on the date of death. If the heirs then sell the property soon after inheriting it, there may be little to no capital gains tax owed at all, because the years of appreciation, including the $140,000 gain that was rolled forward from the Fair Oaks condo, effectively disappears for tax purposes.

This is sometimes nicknamed “swap till you drop.” The investor keeps exchanging into new properties over their lifetime, deferring tax each time, and never triggers the deferred gain themselves. When the property passes to heirs, the basis resets, and the deferred tax bill is never actually paid by anyone.

It’s worth being clear that placing a property in a revocable living trust does not, by itself, change how it’s taxed. What the trust accomplishes is a smooth, private transfer of the property to the named heirs without going through probate court. The tax benefit comes from the step-up in basis rule under IRC Section 1014, which generally applies to inherited property whether it passes through a trust, a will, or intestate succession.

What Leaving a Legacy Actually Means

For a lot of families, “leaving a legacy” gets reduced to a line item on a tax return. But talk to any client who has actually walked through this, and the conversation is rarely about tax code. It’s about a home in Folsom that grandchildren will visit. It’s about giving the next generation a foothold, an asset that can be sold, rented, or lived in, without a tax bill attached to decades of appreciation they didn’t create.

A legacy, in this sense, is really two things at once: an asset, and a set of decisions made early enough that the asset can actually do its job. A 1031 exchange, held long enough and structured correctly, turns one into the other.

Is This Really Just “What the Wealthy Do”?

There’s a common perception that strategies like this, deferring gains through exchanges, holding assets until death, passing them through trusts, are exclusively tools of the ultra-wealthy. It’s true that high-net-worth families use these tools aggressively, and it’s also true that the $15 million federal estate tax exemption means they’re the ones most likely to ever brush up against an actual estate tax bill.

But the 1031 exchange and the step-up in basis rule aren’t wealth-gated. They’re written into the tax code for any investor holding qualifying property, whether that’s one Folsom rental or a portfolio of twenty. Our client isn’t a family office. They’re a Sacramento-area investor who sold one condo and is buying one house. The tools are the same ones a much larger portfolio would use; they’re just applied at a smaller scale.

What separates investors who benefit from these strategies from those who don’t usually isn’t net worth. It’s whether someone on their team, a lender, a CPA, an estate attorney, walked them through the options before the sale closed instead of after.

An Important Reality Check: “Kicking the Can” Only Goes So Far

It’s worth being very direct about something people sometimes misunderstand: a 1031 exchange defers a tax bill. It does not make it disappear. If you exchange the Fair Oaks condo into the Folsom house, and then years from now you simply sell the Folsom house without doing another exchange, you will owe capital gains tax at that point, on the full deferred gain, not just on any appreciation since the purchase.

There is really only one way the deferred gain permanently goes away rather than eventually coming due: if the property is still owned, directly or through a properly funded trust, at the owner’s death, and passes to heirs. That’s the step-up in basis scenario covered earlier. Every other path, selling outright, cashing out of a DST at the end of its term without exchanging again, eventually settles the tax bill. A 1031 exchange is a deferral tool and a legacy tool. It is not an elimination tool on its own.

A Second Strategy: Timing the Sale to a Lower Tax Bracket

There’s another legitimate strategy worth knowing about, and it doesn’t involve a trust or an heir at all. It’s simply timing. Long-term capital gains (on any asset held more than a year) aren’t taxed at a flat rate. They’re taxed at 0%, 15%, or 20% at the federal level, and which bracket applies depends on your total taxable income in the year you sell, not on how much you originally paid for the property.

For 2026, as an example, a married couple filing jointly pays 0% federal capital gains tax on the portion of their income that falls under roughly $98,900 in taxable income, 15% on the portion between that and about $613,700, and 20% above that. A high earner in their peak working years, stacking a large capital gain on top of an already-high salary, is very likely to have that gain taxed at the top 20% rate, plus a possible additional 3.8% Net Investment Income Tax for higher earners.

That same investor, if they hold the property (through one exchange or several) until after they’ve retired and their W-2 income has stopped, may find their total taxable income in the year they finally sell falls into the 15% bracket instead of the 20% bracket, or even partially into the 0% bracket if their retirement income is modest enough. The gain itself doesn’t change. What changes is the tax rate applied to it, because that rate is driven by total income in the year of the sale, not by the investor’s income during the years they held the property.

This is a real and commonly used strategy: keep exchanging and deferring during your highest-earning years, then plan the eventual sale, if you do sell rather than pass the property to heirs, for a year when your overall income is lower. The right year, and the right structure, depends heavily on someone’s full financial picture, which is exactly the kind of planning worth doing with a CPA well before the sale, not after.

Bringing It Back to Mortgage Made Easy

This client’s Fair Oaks-to-Folsom exchange is a good example of what’s possible when a sale, a purchase, and a long-term family goal are all planned together instead of separately. A 1031 exchange defers the tax. A living trust smooths the transfer. And the step-up in basis rule is what actually lets a family pass on appreciation without passing on the tax bill.

If you’re weighing a 1031 exchange, whether delayed or reverse, and want to talk through financing on the replacement property, that’s exactly the kind of conversation I love having. Reach out any time, and let’s map out a path that works for your situation.

This article is for general educational purposes only and reflects tax law and SEC accredited investor thresholds understood to be current as of 2026. It is not tax, legal, financial, or investment advice, and it is not an offer to sell securities. 1031 exchange rules, DST structures, estate and inheritance tax law, capital gains brackets, and step-up in basis rules are complex, fact-specific, and change over time. DSTs are securities offered only by prospectus or private placement memorandum through licensed representatives. Please consult a qualified CPA, tax attorney, estate planning attorney, and licensed financial or securities professional before making decisions based on this information.

❓FAQs About 1031 Exchanges, DSTs, and Capital Gains Tax