1031 Exchange: The Capital Gains Tax Loophole for Real Estate Investors
A 1031 exchange is the most practical capital gains tax loophole for active real estate investors. Unlike stepped-up basis or Opportunity Zones, it can potentially allow indefinite tax deferral without geographic restrictions.
Key Takeaway
The 1031 exchange is the most underutilized tax strategy for real estate investors. While stepped-up basis requires death and Opportunity Zones require specific locations, 1031 exchanges work for any like-kind real estate, anywhere in the country.
This article compares the five major capital gains tax loopholes and explains why 1031 exchanges potentially give active investors the greatest flexibility.
What Makes 1031 Exchanges a "Loophole"?
A tax loophole is a legal provision that allows taxpayers to reduce their tax liability. The 1031 exchange is one of the most powerful loopholes available to real estate investors, though calling it a "loophole" understates its legitimacy.
IRC Section 1031 has existed since 1921 and has been refined through decades of tax code updates. Congress designed this provision intentionally to encourage continued investment in real estate. When an investor sells property and reinvests the proceeds into like-kind replacement property, no capital gains tax is due at the time of sale. The tax is deferred, not evaded.
The distinction matters. Tax evasion is illegal. Tax deferral through a 1031 exchange is explicit tax policy, codified in federal law and supported by IRS guidance.
For investors unfamiliar with 1031 mechanics, see Anchor1031's guide to what is a 1031 exchange.
The 5 Major Capital Gains Tax Loopholes Compared
Tax policy experts identify five primary strategies that reduce or eliminate capital gains taxes on appreciated assets. Each has specific requirements, limitations, and ideal use cases.
1Stepped-Up Basis (The "Biggest" Loophole)
Under IRC Section 1014, stepped-up basis can potentially eliminate unrealized capital gains at death. When an investor dies, their heirs receive the assets at current fair market value, not the original purchase price. All appreciation during the decedent's lifetime may be permanently erased from the tax books.
Consider a property purchased for $100,000 that appreciates to $500,000. If the owner sells during their lifetime, they owe capital gains tax on $400,000 of gain. If they hold until death, their heirs inherit the property with a $500,000 basis. If the heirs sell immediately for $500,000, they owe zero capital gains tax.
Tax policy analysts often call stepped-up basis the "biggest" loophole because it applies to all appreciated assets, not just real estate.
Limitation: The investor must die to trigger the benefit. This is not a strategy for active investors who want to use their wealth during their lifetime.
21031 Like-Kind Exchange (The Active Investor's Loophole)
Under IRC Section 1031, a like-kind exchange can potentially allow real estate investors to defer capital gains taxes by reinvesting sale proceeds into like-kind replacement property. Unlike stepped-up basis, the investor does not need to die, and unlike Opportunity Zones, there are no geographic restrictions.
Consider the same $500,000 sale with $400,000 of gain. Using a 1031 exchange, the investor may defer the entire tax liability by purchasing replacement property of equal or greater value when structured properly. They can potentially repeat this process throughout their lifetime, building a larger portfolio with each exchange.
If the investor eventually holds the final property until death, their heirs may receive stepped-up basis on that property under IRC Section 1014. The entire chain of deferred gains could potentially be eliminated.
Potential advantages:
- Usable while alive and actively investing
- No geographic limitations
- Potentially repeatable across multiple properties
- May combine with stepped-up basis for potential permanent elimination
For step-by-step guidance, see Anchor1031's complete 1031 exchange guide.
3Opportunity Zones
Qualified Opportunity Zone investments allow investors to defer and potentially reduce capital gains by investing in designated economically distressed areas. Investors who hold for 10 or more years can exclude gains on the new investment from taxation.
Limitations: Geographic restrictions apply (designated census tracts only). The original benefit of reduced deferred gains has expired. New OZ investments now primarily receive only the 10-year exclusion on new gains.
4Installment Sales
An installment sale spreads gain recognition over the payment period rather than recognizing all gain at the time of sale. This is timing management, not true tax deferral.
Limitations: The tax is not eliminated or indefinitely deferred. It is simply spread across time. Interest income on the note adds to the tax burden.
5Charitable Remainder Trusts
A Charitable Remainder Trust (CRT) allows investors to donate appreciated property to a trust, avoid capital gains on the donation, and receive an income stream for life or a term of years. After the trust term ends, the remaining assets pass to charity.
Limitations: The investor ultimately gives up the asset. This strategy suits philanthropically-minded investors who prioritize charitable giving over wealth transfer to heirs.
Real Dollar Comparison: $1M Property Sale
The following table illustrates how a $1 million property sale with $400,000 of capital gains plays out under each strategy. Assumes a 23.8% federal rate (20% long-term capital gains plus 3.8% Net Investment Income Tax).
| Strategy | Tax at Sale | Tax Over Lifetime | Final Tax | Best For |
|---|---|---|---|---|
| No Strategy | $95,200 | $95,200 | $95,200 | N/A |
| 1031 Exchange | $0 | $0 (if held to death) | $0 | Active investors |
| Stepped-Up Basis | N/A (hold until death) | N/A | $0 | Estate planning |
| Opportunity Zone | $0 (deferred) | Varies | Partial exclusion after 10 years | Specific locations |
| Installment Sale | ~$9,520/year | $95,200+ (plus interest) | $95,200+ | Cash flow needs |
| Charitable Trust | $0 | $0 | $0 (assets to charity) | Philanthropic goals |
For investors who want to continue building wealth during their lifetime without geographic restrictions, the 1031 exchange provides the most practical path to zero or near-zero capital gains taxation.
Why 1031 Is the Most Practical Option for Active Investors
The 1031 exchange is the most underutilized tax strategy for real estate investors. While stepped-up basis requires death and Opportunity Zones require specific locations, 1031 exchanges work for any like-kind real estate, anywhere in the country, at any point in the investor's career.
Key practical advantages:
- Usable while living. Unlike stepped-up basis, investors benefit immediately rather than posthumously.
- No geographic restrictions. Unlike Opportunity Zones, investors choose properties based on investment merit, not census tract designation.
- Repeatable. Investors can chain multiple 1031 exchanges over decades, deferring gains across an entire portfolio.
- Combines with stepped-up basis. If the investor holds the final property until death, heirs receive stepped-up basis, permanently eliminating all previously deferred gains.
- Flexible property types. Any real estate held for investment qualifies. Apartments, retail, industrial, land, and even fractional interests in Delaware Statutory Trusts (DSTs) all work.
For investors exploring replacement options, Anchor1031's marketplace offers DST and syndication investments structured for 1031 exchange.
The "Buy, Borrow, Die" Strategy Explained
The "Buy, Borrow, Die" strategy combines 1031 exchanges with stepped-up basis to potentially eliminate capital gains taxes over an investor's lifetime and beyond, when structured properly.
Step 1: Buy
Acquire appreciating real estate. Hold for income and appreciation.
Step 2: Exchange
When ready to sell, use a 1031 exchange to defer capital gains. Reinvest into larger or more diversified property. Repeat throughout career.
Step 3: Borrow
Need cash? Refinance properties and extract equity through loans. Loan proceeds are not taxable income.
Step 4: Die
At death, heirs may receive all properties with stepped-up basis under IRC Section 1014. The entire chain of deferred gains could potentially be eliminated.
Example Lifetime Strategy:
- Age 40: Investor owns $500,000 property with $200,000 basis
- Age 50: 1031 exchange into $1.2 million property
- Age 60: 1031 exchange into $3 million portfolio
- Age 70: Portfolio worth $5 million with $200,000 original basis
- At death: Heirs receive $5 million portfolio with $5 million stepped-up basis
- Potential lifetime capital gains tax paid: $0
This strategy is legal and widely used. It illustrates how sophisticated real estate investors may potentially preserve and transfer generational wealth when properly structured.
1031 Exchange Rules You Must Follow
To successfully execute a 1031 exchange, investors must follow these IRS requirements precisely. Missing any deadline or requirement disqualifies the exchange.
45-day identification period
From the date of sale, you have exactly 45 days to identify potential replacement properties in writing. This deadline cannot be extended.
180-day closing deadline
You must close on replacement property within 180 days of selling the relinquished property, or by your tax return due date, whichever comes first.
Like-kind property
Real estate must be exchanged for real estate. However, "like-kind" is broadly interpreted. An apartment can be exchanged for land, retail, or DST interests.
Equal or greater value
To defer all gain, replacement property must be of equal or greater value than the relinquished property. Any difference (boot) is taxable.
Qualified Intermediary required
The investor cannot touch the sale proceeds. A Qualified Intermediary must hold the funds between sale and purchase.
For detailed guidance on selecting a QI, see Anchor1031's article on essential questions to ask your Qualified Intermediary.
Which Strategy Is Right for You?
The right capital gains strategy depends on your investment goals, timeline, and personal circumstances.
Choose 1031 exchange if:
- You plan to continue investing in real estate
- You want tax deferral while you are alive
- You prefer geographic flexibility
- You want to build a larger portfolio over time
Choose stepped-up basis planning if:
- Your primary goal is wealth transfer to heirs
- You do not need to access capital during your lifetime
- You are focused on estate planning rather than active investing
Choose Opportunity Zones if:
- You have identified a specific OZ investment with strong fundamentals
- You can commit to a 10+ year hold period
- The geographic limitation does not concern you
Choose installment sale or CRT if:
- You need steady income from the sale (installment)
- You have philanthropic goals (CRT)
- Passing assets to heirs is not a priority (CRT)
For personalized guidance, schedule a consultation with an Anchor1031 specialist.
Frequently Asked Questions
What is the biggest capital gains tax loophole?
Tax policy experts often call stepped-up basis under IRC Section 1014 the 'biggest' loophole because it applies to all appreciated assets at death. However, for living investors, the 1031 exchange under IRC Section 1031 is potentially the most practical loophole because it can be used repeatedly while actively investing, without geographic restrictions.
Is a 1031 exchange a loophole?
A 1031 exchange is a legal tax provision under IRC Section 1031, established in 1921. While some call it a 'loophole,' it is intentional tax policy designed to encourage continued investment in real estate. It is one of the most powerful, and legal, tax deferral strategies available when structured properly.
How do billionaires avoid capital gains tax?
Wealthy investors often use the 'Buy, Borrow, Die' strategy: they acquire real estate, use 1031 exchanges under IRC Section 1031 to potentially defer gains while alive, borrow against equity for cash flow (loans are not taxable income), and pass assets to heirs who may receive stepped-up basis under IRC Section 1014. This combination can potentially eliminate capital gains tax across generations when properly structured.
Can you avoid capital gains tax on real estate?
There are legal strategies that may reduce or defer capital gains taxes. These include 1031 exchanges under IRC Section 1031 (potentially defer indefinitely), holding until death for stepped-up basis under IRC Section 1014 (may eliminate permanently), Opportunity Zones (10-year exclusion on new gains), and Charitable Remainder Trusts (eliminate through charitable donation). The 1031 exchange is potentially the most practical option for active investors because it may allow repeated tax deferral without geographic or timeline restrictions.
What is the 1031 exchange loophole?
The 1031 exchange under IRC Section 1031 can potentially allow real estate investors to defer capital gains taxes by reinvesting sale proceeds into like-kind replacement property. If the investor holds the replacement property until death, their heirs may receive stepped-up basis under IRC Section 1014, potentially eliminating the deferred gains.
Bottom Line: The Most Practical Loophole
For real estate investors who want to continue building wealth during their lifetime, the 1031 exchange under IRC Section 1031 is potentially the most practical capital gains tax strategy available. It can be used while you are alive, may apply to any like-kind real estate anywhere, and can potentially be repeated throughout your investment career when structured properly.
Investors may chain multiple 1031 exchanges, then pass properties to heirs for potential stepped-up basis under IRC Section 1014. When properly executed, this approach can potentially result in minimal or zero lifetime capital gains tax.
About the Author
Trevor Sybertz, Partner
Trevor Sybertz is a Partner at Anchor 1031, where he specializes in educating clients about 1031 exchanges, private real estate offerings, and REITs. With over a decade of experience in commercial real estate and capital markets, Mr. Sybertz has helped clients invest more than $100M in equity across a wide range of real estate assets and markets. Previously, he served as a Director at RealtyMogul, and before that as Assistant Vice President of Institutional Equity Sales at Keefe, Bruyette & Woods where he covered commercial mortgage REITs and international equities.
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Disclosure
Tax Complexity and Investment Risk
Tax laws and regulations, including but not limited to Internal Revenue Code Section 1031, bonus depreciation rules, cost segregation studies, and other tax strategies, contain complex concepts that may vary depending on individual circumstances. Tax consequences related to real estate investments, depreciation benefits, and other tax strategies discussed herein may vary significantly based on each investor's specific situation and current tax legislation. Anchor1031, LLC and Great Point Capital, LLC make no representation or warranty of any kind with respect to the tax consequences of your investment or that the IRS will not challenge any such treatment. You should consult with and rely on your own tax advisor about all tax aspects with respect to your particular circumstances. Please note that Anchor1031 and Great Point Capital, LLC do not provide tax advice.
The information contained in this article is for general educational purposes only and does not constitute legal, tax, investment, or financial advice. This content is not a recommendation or offer to buy or sell securities. The content is provided as general information and should not be relied upon as a substitute for professional consultation with qualified legal, tax, or financial advisors.
Tax laws, regulations, and IRS guidance regarding 1031 exchanges are complex and subject to change. Information herein may include forward-looking statements, hypothetical information, calculations, or financial estimates that are inherently uncertain. Past performance is never indicative of future performance. The information presented may not reflect the most current legal developments, regulatory changes, or interpretations. Individual circumstances vary significantly, and strategies that may be appropriate for one investor may not be suitable for another.
All real estate investments, including 1031 exchanges, are speculative and involve substantial risk. There can be no assurance that any investor will not suffer significant losses, and a loss of part or all of the principal value may occur. Before making any investment decisions or implementing any 1031 exchange strategies, readers should consult with their own qualified legal, tax, and financial professionals who can provide advice tailored to their specific circumstances. Prospective investors should not proceed unless they can readily bear the consequences of potential losses.
While the author is a partner at Anchor1031, the views expressed are educational in nature and do not guarantee any particular outcome or create any obligations on behalf of the firm or author. Neither Anchor1031 nor the author assumes any liability for actions taken based on the information provided herein.