Real Estate Exit Strategies: 1031 Exchanges and Other Tax-Efficient Options for Investors

Real estate investment strategies can change over time. You may find yourself asking, “Do I want to continue owning real estate, or should I sell and consider other investment alternatives?” There are many investment options an investor can pursue, but when selling real estate to invest the proceeds elsewhere, capital gain recognition is often triggered, resulting in less equity to reinvest. If a taxpayer has owned their property for many years, or has done several 1031 exchanges in a row, they may have significant tax liability when they finally decide they’d like to sell their investment property. With that in mind, you may want to think of ways to exit your real estate investment while potentially reducing, excluding, or deferring capital gain recognition. Many of the strategies are complex and their suitability is reliant on your particular facts and circumstances, so be sure to talk with your tax or legal advisor before pursuing any of these alternatives.

Option 1: The 1031 Exchange and Retirement - Swap Until you Drop

Internal Revenue Code Section 1031 applies to real property held for investment or productive use in a trade or business, and allows for the deferral of capital gain recognition if the property is exchanged for like-kind property. Section 1031 applies only to qualifying real property, not personal property. The broad definition of like-kind can help investors in many ways. For example, owners tired of the property management headaches of owning several properties can leverage their equity into one larger property. IRC Section 1031 also has broad geographic application, applying to real estate throughout the United States. An example of how this can benefit an investor if properly structured: a couple owning rental houses in California who have children attending college out of state may be able to exchange their California rentals for qualifying out of state investment properties their children or children’s classmates can rent from them while attending college, if the rental arrangement satisfies applicable requirements. Many investors continue to exchange real estate for many years and leverage their deferred tax dollars to purchase real estate that generates greater and greater returns. Some investors may have lower taxable income in retirement, which can affect applicable capital-gain rates. However, the actual tax result depends on the taxpayer’s full facts, including holding period, depreciation recapture, possible net investment income tax, and state tax.

One method of planning around capital gain recognition is “swapping until you drop,” i.e., never exiting a 1031 exchange property until death. If an investor continues to do exchange after exchange and ultimately dies while still owning their replacement property, the heirs inheriting the property may receive a basis adjustment at death, meaning the low basis that the investor carried over is stepped up to the fair market value of the property at the time of their death. If the inheriting party subsequently sells the property, they may recognize capital gain tax on any gains from the time of the investor’s death, not on the entirety of the gains that were rolled over during the investor’s exchanges. The actual result depends on the facts and applicable law. To that end, some taxpayers may plan to hold on to their investment property to derive income during their lives, never selling the property without doing an exchange, so that their heirs may inherit the property with reduced income tax consequences, depending on the facts and applicable law.

Option 2: An Installment Sale

An installment sale, also called a seller carryback note or seller financing, works best for real estate investors who want to sell their real estate but don’t need a lump sum payment. Instead of receiving a lump sum of money at the time of sale, buyers pay the seller monthly income at a rate and term decided upon by the seller. Taxes are not avoided with an installment sale. Under the installment method, a seller may report a portion of gain as installment payments are received, rather than recognizing all gain in the year of sale, subject to important exceptions and limitations. Interest, basis recovery, depreciation recapture, and other rules may affect the timing and character of income recognized. The tax benefit of installment reporting is that because taxes are not due in one lump sum at the time of sale, interest is earned on the deferred dollars over the years. Always discuss this type of transaction with your tax advisor, as installment sale reporting may be disallowed, limited, or affected by the structure of the transaction.

Option 3: The Charitable Remainder Trust (CRT)

A properly structured CRT may allow an investor to transfer appreciated property to a trust and receive required payments. With this option, the asset is transferred to a trust, the trust can sell the asset without immediate capital gain recognition at the donor level and makes required payments to one or more noncharitable beneficiaries, and the remaining trust assets pass to charity at the end of the trust term. The main advantage of a CRT is that in addition to required payments and the satisfaction of philanthropic objectives, the donor may qualify for a charitable income tax deduction, which is based on the present value of the charitable remainder interest, subject to applicable deduction limits and other requirements. If the deduction is not fully used in the year of contribution, it may also be carried forward for up to five additional years, subject to applicable limitations. CRTs are highly technical and should be structured by qualified tax and legal advisors.

Option 4: Joint Use of IRC Sections 121 and 1031

When a personal residence is sold, IRC section 121, the primary residence exclusion, allows for capital gain exclusion up to $250,000 if a taxpayer is single, and $500,000 if a taxpayer is married, if the residence has been the taxpayer’s primary residence for an aggregate two of the preceding five years. If a taxpayer has converted a property previously used for investment or business purposes into a primary residence, and then sells the property, they may be eligible, depending on the facts, for the primary residence exclusion. For taxpayers who can make use of this tool, their tax burden may be reduced, subject to depreciation recapture, nonqualified-use rules, and other limitations.

For example, Taxpayer X sells investment property A for $1M with $200,000 of gain and purchases investment property B for $1M in 2020. X holds property B for investment for three years, then converts the property to a principal residence in 2023, in which X resides for another 2 years. In 2025, X sells property B for $1.2M. At this point, the original gain plus the additional appreciation (totaling $400,000) may be taxable. However, X has resided in the property as a primary residence for two of the preceding five years, and thus may be able to exclude $250,000 of the total gain from taxation. X may be required to pay capitalngain tax on the remaining gain, subject to depreciation recapture, nonqualified-use rules, and the taxpayer’s specific facts (and less than they may have had to pay in taxes if they’d sold property A without doing an exchange).

Option 5: Gifting Real Estate Interests

If you want your children or other family members to own a portion of your real estate while you are still alive, you can gift portions of the real estate to them over time using the annual gift tax exclusion, which is adjusted periodically for inflation (as of 2026, it is $19,000). If a Family Limited Partnership (FLP) or other entity structure is used, interests in the entity may be gifted instead of direct interests in the real estate. Any potential valuation discounts and their availability should be reviewed carefully with qualified tax, legal, and valuation advisors.

One caveat: Unlike inherited real estate, where an heir may receive a basis adjustment at death of the donor, a donee generally receives the donor’s carryover basis in gifted property. Accordingly, recipients of gifted real estate should consult their tax advisor before selling to evaluate potential income tax consequences and available planning options, including whether a properly structured 1031 exchange may be an available strategy.

There are many other strategies that can be used in lieu of these options, and often the best results come from a combination of techniques. There are also potential risks and disadvantages associated with all of the above alternatives. For example, Charitable Remainder Trusts can be costly to structure, installment sales involve credit and collection risk, and exchanges require strict compliance with Section 1031 rules. In addition to consulting with a tax advisor, investors should seek the advice of a real estate attorney with tax and business experience, and may also want to consult a financial planner regarding broader investment alternatives before deciding what action to take with respect to their real estate holdings.