For many investors, 1031 exchanges are often used for tax deferral benefits. By exchanging like-kind properties, investors may defer recognition of capital gains, potentially allowing them to keep more capital invested. However, delayed tax payments aren’t the sole benefit of 1031 exchanges. Such transactions also offer real estate diversification. In this article, Realized 1031 explores how a 1031 exchange can be used as part of a broader diversification strategy.
In a traditional 1031 exchange, you swap two like-kind properties with similar values. The IRS also requires that both assets have been held for investment or business use (qualified use requirement). Because both assets must meet this criterion, they are generally expected to have the potential for appreciation or income generation.
The IRS does not require that both properties be in the same sector. As long as the exchange meets the like-kind standard, investors may use a 1031 exchange to shift into different sectors of real estate. For example, if an investor is seeking to reduce concentration in one area—such as commercial office space—they may consider exchanging into multifamily housing units. Diversifying in this way can potentially help manage exposure to specific market segments.
You are allowed to swap your relinquished property with multiple replacement assets, provided that the total value of all the replacement properties is within 200% of the relinquished property. This is called the 200% rule, and it offers additional flexibility in terms of the 1031 exchange real estate assets you can purchase.
If you sold a high-value property, the proceeds can be used to purchase smaller assets in other sectors. This level of diversification helps you to access new markets and manage risk more effectively if one sector experiences a downturn or reduced performance.
One more strategy for diversification using a 1031 exchange is finishing with a Delaware Statutory Trust (DST). This investment vehicle allows you to own a fractional interest in a trust that owns an underlying property. When the property generates income, the trust distributes it to investors.
As you enter a DST, you will pool your money along with other investors. This combined capital allows the DST to acquire assets that meet certain institutional standards—typically large-scale or professionally managed real estate. Gaining exposure to these types of assets can support broader portfolio diversification.
A few examples of assets commonly held in DSTs include:
Given the relatively low entry point for DSTs, proceeds from a single property sale can potentially be allocated across multiple trusts. This approach can further expand real estate diversification within a 1031 exchange.
Understanding the Risks
While 1031 exchanges can offer potential benefits such as tax deferral and portfolio diversification, they also involve certain risks that should be carefully considered. Real estate markets can be affected by economic conditions, interest rates, tenant performance, and regional factors. Investments made through a Delaware Statutory Trust (DST) are illiquid and may limit control over property management decisions, as trustees typically make those decisions on behalf of investors. In addition, failure to meet IRS requirements—such as timing rules or property qualification—can result in a failed exchange, which may trigger a taxable event. As with any investment strategy, it's important to evaluate whether a 1031 exchange aligns with your overall objectives, risk tolerance, and financial situation.
There are multiple ways a 1031 exchange can support portfolio diversification. Whether you’re entering a new sector, acquiring multiple properties, or accessing institutional-grade assets through a DST, these strategies may help spread exposure across different market segments. As always, consult with financial advisors and tax professionals to determine which strategies align with your overall investment objectives and risk tolerance.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://www.investopedia.com/financial-edge/0110/10-things-to-know-about-1031-exchanges.aspx
https://www.americanbar.org/groups/real_property_trust_estate/resources/real-estate/1031-exchange/
https://www.hellodata.ai/help-articles/what-does-institutional-grade-mean-in-real-estate
