When the Property You Want Does Not Use All of Your 1031 Exchange Proceeds
A common 1031 exchange problem occurs when an investor finds a direct replacement property they like, but the purchase does not use all of the exchange value or equity.
The remaining cash or a reduction in qualifying replacement liabilities may create taxable exposure depending on the full exchange structure. Rather than abandon the preferred direct property, an investor may be able to combine that purchase with one or more DST interests.
Investor Snapshot
- Investor profile
- Michael R., a business owner selling a long-held building that qualified for a 1031 exchange.
- Preferred replacement
- Smaller direct investment property.
- Problem
- The direct property alone would not use all available exchange proceeds.
- Goal
- Purchase the desired property while reinvesting additional exchange funds into qualifying replacement real estate.
The Challenge: The Best Direct Property Was Too Small for the Exchange
The investor identified a direct property that fit his long-term plan, but its purchase price was below the amount needed to fully reinvest the exchange proceeds. Simply taking the remaining funds out of the exchange could cause gain to be recognized to the extent required under the tax rules.
Walking away from the direct property and buying a larger building solely for tax reasons was not an attractive solution. The better question was whether the exchange could be completed using more than one replacement asset.
The Strategy: Combine Direct Real Estate With DST Replacement Property
A 1031 exchange can involve multiple replacement properties. In this scenario, the investor acquired the direct property he wanted and allocated remaining exchange proceeds to one or more DST interests selected as additional replacement real estate.
This type of structure can be useful when DSTs are serving a specific portfolio function: filling a value or equity gap, diversifying the exchange, adding passive income, or reducing the amount of cash that would otherwise leave the exchange.
Why This Strategy Could Fit
- Allows the investor to keep the direct property that best fits the operating or investment plan.
- Provides an additional replacement-property option for exchange proceeds not used by the direct acquisition.
- Can reduce concentration by pairing a directly owned asset with professionally managed fractional real estate.
- May help reduce or avoid taxable boot when the full transaction satisfies 1031 requirements.
- Gives the investor flexibility to match DST allocations more precisely to remaining exchange equity and, where appropriate, debt-replacement needs.
The Outcome
The investor completes the direct acquisition and uses DST interests for the remaining portion of the exchange. The result is a blended portfolio rather than an all-or-nothing decision between direct real estate and DSTs.
Whether the structure fully defers gain depends on the facts of the exchange, including the value of replacement property acquired, cash received, liabilities paid off or assumed, and other tax considerations. The investor’s CPA and qualified intermediary should confirm the exchange mechanics.
Investor Takeaway
DSTs do not have to replace 100% of a 1031 exchange. They can also be used as a precision tool alongside direct real estate when an investor needs additional replacement value, wants to diversify, or is approaching the end of the identification period with funds that still need a home.
This is a hypothetical case study — the investor described is not an actual client.
Case Study Disclosure
Illustrative example only. This case study does not represent an actual client and is not a guarantee of future results. It is a hypothetical composite informed by situations commonly encountered by real estate investors; the individuals described are not actual clients and the scenario is not an account of an actual transaction. Charts and diagrams are schematic illustrations of structure and do not depict actual amounts, offerings, or results. Photographs are stock imagery and do not depict actual clients, advisors, or properties. The appropriate 1031 exchange or DST strategy depends on an investor’s individual facts, objectives, tax situation, liquidity needs, and risk tolerance. DST and other private placement investments involve material risks, including illiquidity and the potential loss of principal. Nothing on this page is tax or legal advice. Investors should review the applicable offering documents and consult their tax and legal professionals before making an investment decision.