1031 Exchanges and Passive Real Estate

How to 1031 Exchange Into Passive Real Estate

Many real estate owners reach a point where they still want what real estate provides, the income and the long-term growth, but they no longer want the work that comes with managing it. Often they are also sitting on a property that has appreciated, which means selling would trigger a sizable tax bill. A 1031 exchange is what bridges those two facts. It lets you sell and move the gain into new real estate without paying tax today, so your capital keeps working instead of leaking out to taxes.

The question is how to do that when your goal is to step back from active management. Below is how a 1031 exchange works, the options for holding real estate passively in a way that still qualifies, and one limitation worth understanding before you start.

The basics

A 1031 exchange, named for Section 1031 of the tax code, lets you defer the capital gains tax and the depreciation recapture that would normally come due when you sell investment real estate, as long as you reinvest the proceeds into other investment real estate of like-kind. Nothing is forgiven. The tax is deferred, and it can be deferred again on the next exchange, which is how investors roll gains forward across decades and let their equity compound rather than shrinking with each sale.

As of 2026, the rule remains fully intact. Recent federal tax legislation left Section 1031 untouched, and while proposals to cap or limit the benefit surface from time to time, none has been enacted. The framework you plan around today is the same one that has been in place for years.

Your options for going passive

The like-kind requirement is broader than people expect. Almost any investment real estate is like-kind to almost any other, so a rental house can be exchanged for a warehouse, or raw land for an apartment building. The catch, when your goal is to go passive, is that you have to hold the replacement in a form the tax code treats as direct real property. Two structures do exactly that.

The first is a tenancy in common, or TIC. In a TIC, you take direct fractional title to a specific property, alongside other co-owners. Because you are a direct owner, your interest is eligible to exchange into and back out of later. The trade-off is complexity. A direct owner is also a borrower in the eyes of a lender, which means you typically get underwritten, including a credit and background review and disclosure of personal financials. Control among co-owners has to be arranged carefully so the sponsor can still run the deal, usually through the operating and co-ownership agreements. TICs work, but they carry real legal and lender mechanics behind them.

The second is a Delaware Statutory Trust, or DST. A DST holds title to real estate, and investors own beneficial interests in the trust that the tax code treats as direct interests in real property for 1031 purposes. The IRS confirmed this treatment in Revenue Ruling 2004-86, which is why DSTs have become a standard tool in exchange planning. The appeal is that a DST is fully passive. You do not take on management, voting, or lender underwriting the way TIC co-owners do, which is why DSTs have become a common landing spot for exchange dollars from owners who want out of active management entirely. DST interests are typically offered to accredited investors, and the structure can also set up a later move into a real estate investment trust through a 721 exchange, which keeps the deferral going while shifting into a more diversified position.

The constraint is the flip side of that passivity. DSTs operate under strict limits on what the trust can do once it is set up, often called the seven deadly sins, which cap things like raising new capital or renegotiating leases. That makes a DST a good fit for a stabilized, hold-and-collect asset and a poor fit for a value-add project. Minimums also tend to be lower than a whole-property TIC, which is part of why DSTs work well for splitting exchange proceeds across more than one replacement.

How it works

The mechanics are where exchanges succeed or fail, and the timelines are unforgiving. Once you sell, the clock starts. You have 45 days to formally identify your replacement property and 180 days to close on it. A qualified intermediary has to hold the sale proceeds in between, because taking the cash yourself, even briefly, breaks the exchange. The replacement generally needs to be of equal or greater value, with equal or greater debt, or the shortfall is treated as taxable boot. And the same taxpayer who sold has to be the one who buys.

Because those windows are short, the work happens before you sell, not after. Line up your qualified intermediary ahead of the closing, and have a clear picture of your replacement options before the 45-day clock starts. Since the details are specific to your situation, walk the plan through with a qualified intermediary and your own tax advisor early.

Where a fund interest falls short

This is the one that catches people off guard, so it is worth being clear about. When you invest in a typical real estate fund, you are not buying real property. You are buying a membership or partnership interest in an entity that owns the real estate. The tax code treats that interest as a security, not as real property, which means it does not qualify for 1031 treatment.

That cuts both ways. You generally cannot 1031 exchange the sale of your property into a fund interest, and an investor already in a fund generally cannot 1031 exchange out of their interest when the fund sells. Whether their gain stays deferred depends on whether the fund itself runs an exchange at the deal level, which is the sponsor's decision, not the individual investor's.

That deal-level versus investor-level distinction is the heart of it. A deal-level exchange is the fund selling a property and the whole partnership rolling into a replacement together, with every investor's deferral moving as a group. An investor-level exchange is one person rolling their own gain in or out independently, and that is the one a standard fund interest does not support. The lesson underneath all of this is simple: two investments can look almost identical on the economics yet have opposite outcomes for a 1031 exchange, depending entirely on how ownership and title are structured. When an exchange is part of your plan, the structure deserves as much attention as the projected return.

Talk it through before you sell

A 1031 exchange rewards planning, and the right structure depends on your situation, your timeline, and what you are trying to accomplish. If you are thinking about an exchange and want a clear-eyed read on your options, reach out before you sell. We work with investors on how an exchange can fit their goals, and where it makes sense, we can explore a structure built around it, whether that is a tenancy in common, a Delaware Statutory Trust for a fully passive exchange, or another path. The earlier we talk, the more room there is to do it right. [Get in touch].

Disclaimer: This article is educational and general in nature. It is not tax, legal, or investment advice. 1031 exchanges are complex and specific to your facts, so consult a qualified intermediary and your own tax advisor before acting. Nothing here is an offer to sell or a solicitation of an offer to buy any security.