Because pension funds don't pay traditional real estate taxes, they really can't capitalize on 1031s. But REITs do use them for two prime reasons, says Weller. The first is to preserve capital by recycling proceeds from property sales rather than being required to distribute them to shareholders. The second is to keep gains on property sales from being allocated to investors, who had originally contributed the sold properties to the REIT.

REITS also are finding ways to entice individual investors through a 1031-721 exchange, including Denver-based Dividend Capital Trust. Using 721, the REIT offers individual investors an opportunity to buy a replacement property and later exchange it for operating-partnership units in Dividend Capital. However, a downside is investors lose the ability to keep exchanging after the conversion.

In their zeal to make a tax-deferred exchange, some investors may enter into a property that's a bad fit with their investment goals. Stephen Owen, a Washington tax attorney who chairs the Tax Group of Piper Rudnick, warns that “the tax tail should not wag the dog in the exchange area.”

While there are obvious tax benefits from a 1031, “taxpayers must make sure the replacement property is a solid investment separate and apart from the tax benefits of the exchange.” In recent years, clients have been challenged to find attractively priced replacement properties, Owen says.

“But ‘swap until you drop’ is certainly where the industry is headed,” says Ponticiello. “The 1031 allows you to get into larger and larger assets and enables you to build wealth pretty quickly.”

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