Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / How Wealthy Families Use 1031 Exchanges to Defer Capital Gains
Transcript
- Lucas: So, there is a section of the tax code that has quietly enabled massive real estate wealth accumulation for over a century, and it's called the 1031 exchange. Luna: Right, the like-kind exchange. It's not exactly a secret, but the way families use it strategically is often misunderstood. Lucas: Exactly. The core idea is straightforward: if you sell a business or investment property and reinvest the proceeds into another similar property, you can defer all capital gains taxes. No tax bill at the time of sale. Luna: And because real estate tends to appreciate, the gain just keeps growing—potentially deferred for decades. Lucas: Precisely. One concrete example I like: a family bought a shopping center in the early 2000s for about five million dollars. Fast forward to 2025, it's worth twenty million. They want to sell and move into a multi-tenant office building. Luna: So they have a fifteen million dollar capital gain. That could be around three million in federal capital gains tax, plus state taxes in some places. Lucas: Exactly. But if they use a 1031, they can sell the shopping center, park the proceeds with a qualified intermediary, and within 45 days identify up to three potential replacement properties. They have 180 days total to close on one. Luna: And the intermediary is key. You cannot touch the money yourself, or the IRS treats it as a sale and tax is due immediately. Lucas: Correct. The qualified intermediary holds the cash, then transfers it directly to the seller of the new property. In our example, they find an office building for twenty-two million, put the twenty million from the sale plus two million additional cash, and they now have a new asset with no tax paid. Luna: Plus, they get to depreciate the new property all over again, which is another tax advantage. Lucas: Right. And here's where the generational strategy gets interesting. If they hold that office building until death, their heirs receive it with a step-up in basis to its fair market value. The entire deferred capital gain disappears. Luna: So the tax is permanently avoided, not just deferred. That's a massive wealth transfer mechanism. Lucas: Exactly. It's worth noting that the Tax Cuts and Jobs Act in 2017 narrowed 1031 to only real estate. Before that, you could exchange aircraft, art, even racehorses. Now it's just real property held for business or investment. Luna: But real estate is where most of the wealth is, so it's still a huge tool. Lucas: And the definition of 'like-kind' is surprisingly broad. You can exchange a strip mall for an apartment building, or raw land for a net-leased property. It doesn't have to be the same type of real estate. Luna: Right, as long as both are within the US. Foreign real estate doesn't qualify. Lucas: Correct. Another nuance: some states, like California and New York, don't fully conform to the federal 1031 rules. You may still owe state-level capital gains even if you defer federal. Luna: So it's not a silver bullet. You need good tax advice. Lucas: Absolutely. And there's a trap with mortgage debt. If you reduce your debt in the exchange—say you sell a property with a ten million mortgage and buy one with seven million—the difference of three million is treated as 'boot' and taxed. Luna: So you need to reinvest all the equity and at least as much debt to fully defer. Lucas: Right. Now, many family offices use a 'continuous exchange' strategy. They keep trading up into larger properties, never paying tax, and eventually pass the portfolio to the next generation with a step-up. Luna: That can span multiple lifetimes effectively. But eventually, if someone sells without doing another exchange, the tax is due. Lucas: True, but there's also the option to donate the property to a charitable remainder trust, which can avoid the gain and generate an income stream. But that's a different episode. Luna: We should do that one. But first, I know our listeners find these deep dives really helpful. It takes time to research and produce episodes like this. Lucas: It does. And if you've gotten value from these conversations, a few dollars a month genuinely makes a difference. It's what keeps the show ad-free and independent. You can find it at buy me a coffee dot com slash fexingo. Luna: Yeah, it's a small way to support the work we do, and we really appreciate it. Lucas: Anyway, back to 1031 exchanges. One final point I want to make: the 45-day identification period is incredibly strict. You cannot change your mind after the deadline, even if a deal falls through. That's why many families identify the maximum three properties, or more under certain rules. Luna: Can you identify more than three? I thought the rule was three properties, but if you want more, you have to meet a 200% value test. Lucas: Exactly. You can identify any number of properties as long as their total value doesn't exceed 200% of the sale price. Or you can use the 95% exception—if you close on 95% of the total value identified, you can identify more. But most people stick to three to keep it simple. Luna: And the 180-day closing period can't be extended, even if the intermediary delays. Lucas: Right. So planning is critical. Many family offices work with a dedicated exchange team to ensure every deadline is met. Failure to close on time means the gain is recognized and tax is due. Luna: And that can be a painful surprise if you're not careful. Lucas: Absolutely. So the bottom line: a 1031 exchange is one of the most powerful tools for building and transferring real estate wealth, but it requires discipline and good advisors. When done right, it's a legal way to defer capital gains indefinitely—or even eliminate them through the step-up at death. Luna: And it's something every real estate investor should have in their toolkit. Lucas: I think so too. That's our take for today.