A 1031 exchange — named for Section 1031 of the Internal Revenue Code — lets you sell one investment property and buy another without recognizing the gain in the year you sell. Follow the procedure and the tax bill that would have been due at closing is postponed, sometimes indefinitely.
That last word matters. The tax is deferred, not forgiven. It follows you into the next property through something called carryover basis, and it stays there until you sell without exchanging again. Understanding what you are actually buying with an exchange — and what you are giving up — starts with knowing what the alternative costs.
The one-paragraph version
Sell real property held for investment or business use, reinvest the entire proceeds into other real property held for investment or business use, use a Qualified Intermediary so the money never reaches you, name your replacement within 45 days, close within 180 — and the gain is not recognized this year. Break any one of those and you have an ordinary taxable sale.
Three limits worth knowing up front
- Investment or business property only. Not your primary residence, not a property you bought to flip and resell, not a second home you use personally. Held for productive use in a trade or business, or for investment.
- Real property only. Before 2018 you could exchange equipment, aircraft, artwork, and other personal property. The Tax Cuts and Jobs Act ended that. Real property for real property is all that remains.
- Deferral, not forgiveness. The gain rides along in the basis of whatever you buy. It is a postponement with real value — but it is a postponement.
What has to happen for it to work
Four requirements. All four, every time.
- A Qualified Intermediary, engaged before closing. The QI holds the proceeds. If the money touches your bank account — even for a day, even by escrow’s mistake — you have constructive receipt and there is no exchange left to save. This has to be set up before the sale closes. It cannot be fixed afterward.
- Identify by Day 45. In writing, signed by you, delivered to the QI before midnight of the 45th calendar day after your sale closes. Your attorney, CPA, agent, and relatives are disqualified parties — delivering it to them does not count.
- Close by Day 180. Or by your tax-return due date including extensions, whichever comes first. Both clocks start on the same day and run at the same time. Day 45 does not pause anything.
- Replace value and debt. Reinvest all your equity, and buy something of equal or greater value. If you pay off a loan and do not take on at least as much new debt (or add that much cash), the shortfall is taxable boot.
The identification step is where most exchanges are won or lost. If you are already in contract, read the step-by-step: how to fill out a 45-day identification form, including the three identification rules and a free fillable template.
“Like-kind” is far broader than most sellers think
The phrase misleads people into thinking they have to buy the same type of building. For real property, they do not. Like-kind refers to the nature of the property, not its grade, quality, or use:
- An apartment building can be exchanged for raw land.
- A single-family rental can be exchanged for an industrial or retail building.
- A duplex can be exchanged for farmland.
What matters is that both sides are real property held for investment or business use. The replacement does not have to be in the state you sold in, and it does not have to resemble what you sold. That is a wider decision than most sellers realize they are making — which is exactly why the 45-day clock is so tight.
A three-page briefing on the deadlines
The clocks, the identification rules, the debt requirement, and a deadline calendar you can check your own closing date against. Free.
Get the briefing →What a straight sale actually costs — four separate layers
This is the part sellers underestimate, and it is not one tax. It is four, stacked, and they are calculated on different bases. Most people picture the capital gains rate and stop there. The capital gains rate is layer two of four.
Depreciation recapture
Every year you owned the rental, you deducted depreciation. Each deduction lowered your adjusted basis. When you sell, that accumulated depreciation comes back as unrecaptured Section 1250 gain, taxed at a maximum federal rate of 25% — higher than the long-term capital gains rate most sellers are bracing for.
The trap inside the trap: basis is reduced by depreciation allowed or allowable. If you never claimed the deduction, the IRS still reduces your basis as if you had. Not taking it does not spare you the recapture.
Long-term capital gain
The remaining gain — appreciation above your original cost — is long-term capital gain if you held the property more than a year. The rate depends on your taxable income for the year, including the gain itself. A large sale routinely pushes an otherwise middle-bracket household into the top band for that one year.
| 2026 long-term capital gains rate | 0% | 15% | 20% |
|---|---|---|---|
| Single | up to $49,450 | $49,451–$545,500 | over $545,500 |
| Married filing jointly | up to $98,900 | $98,901–$613,700 | over $613,700 |
| Head of household | up to $66,200 | $66,201–$579,600 | over $579,600 |
| Married filing separately | up to $49,450 | $49,451–$306,850 | over $306,850 |
Thresholds are measured against taxable income — income after your standard or itemized deduction — not gross proceeds. Source: IRS Rev. Proc. 2025-32 §3.03. The 2026 standard deduction is $16,100 single, $32,200 married filing jointly, $24,150 head of household.
Net Investment Income Tax
Section 1411 adds a 3.8% surtax on net investment income — which includes gain on the sale of rental real estate — once modified adjusted gross income exceeds $200,000 single or $250,000 married filing jointly ($125,000 married filing separately). It sits on top of the capital gains rate, not instead of it. A gain taxed at 20% costs 23.8% once NIIT applies.
These thresholds were set by statute in 2013 and are not adjusted for inflation. They have not moved in thirteen years, and the sale itself is usually what pushes a seller over them.
State income tax
Every federal figure above excludes state tax. Nothing in the 0/15/20 brackets, the 25% recapture rate, or the 3.8% NIIT accounts for what your state takes — that is a separate bill calculated on the same gain.
Most states that levy an income tax treat capital gains as ordinary income, with no preferential rate. The spread is wide: Texas, Florida, Nevada, Tennessee, South Dakota, Wyoming, and Alaska impose no broad personal income tax; Washington applies a separate capital gains excise tax; California taxes gains as ordinary income at rates reaching 13.3%; New York reaches 10.9% before New York City residents add a city tax on top.
Two more state-level details that surprise sellers: several states require withholding at closing when the seller is a nonresident, so cash is taken before you file anything — and a handful require an annual information return after an exchange to track the deferred gain, with the tax clawed back if you later sell out of state.
Side by side: the same property, sold two ways
Numbers make this concrete in a way prose cannot. What follows is an illustration built on stated assumptions — not a projection, not a quote, and not a substitute for running your own figures with your CPA.
The assumptions
- A married couple bought a residential rental in 2011 for $500,000 ($400,000 building, $100,000 land).
- Fifteen years of straight-line depreciation on the building: $218,000 claimed.
- Adjusted basis today: $500,000 − $218,000 = $282,000.
- They sell in 2026 for $1,200,000 with $72,000 of selling costs.
- Their other income places the entire gain in the top long-term band and above the NIIT threshold.
- No installment sale, no suspended rental losses, no partial exchange, no state-specific adjustments.
| Same property, 2026 | Straight sale | Full 1031 exchange |
|---|---|---|
| Sale price | $1,200,000 | $1,200,000 |
| Less selling costs | −$72,000 | −$72,000 |
| Less adjusted basis | −$282,000 | −$282,000 |
| Total gain | $846,000 | $846,000 |
| Depreciation recapture25% × $218,000 | $54,500 | deferred |
| Long-term capital gain20% × $628,000 | $125,600 | deferred |
| Net Investment Income Tax3.8% × $846,000 | $32,148 | deferred |
| Federal tax due this year | $212,248 | $0 |
| State income tax0% to 13.3% of the gain | $0 – $112,518 | deferred |
| Total due this year | $212,248 – $324,766 | $0 |
| Basis going forward | n/a — settled | carries over |
Illustration only. Figures are arithmetic applied to the assumptions stated above, at 2026 federal rates. Real bracket stacking can place part of a gain in a lower band, and unrecaptured Section 1250 gain is taxed at the lesser of 25% or your marginal ordinary rate. Your result will differ. This is not a projection of any individual outcome and not tax advice.
The headline number is not the point. The point is the structure: on this illustration, federal tax alone runs about 25% of the gain, and in a high-tax state the combined bill approaches 38%. The exchange does not make that go away — it moves it. Which is worth doing only if the replacement property is one you actually want.
What deferral does not do
An honest account of a 1031 has to include the other side of the ledger.
- Your basis carries over. Buy a $1,200,000 replacement in a full exchange and your basis is not $1,200,000 — it is roughly your old basis plus any additional cash invested. That means less depreciation to deduct against rental income going forward, and a larger gain waiting when you eventually sell.
- Boot is taxable now. Cash you take off the table, or debt you shed without replacing, is recognized in the year of sale up to the amount of your gain. A partial exchange is a partial deferral, not an all-or-nothing failure — but the boot portion is taxed at the same stacked rates above.
- It can be deferred again. Nothing limits how many times you exchange. Each one rolls the accumulated gain forward into the next property.
- Death currently resets it. Under Section 1014, property included in an estate generally receives a basis step-up to fair market value at death, and the deferred gain is not taxed to the heirs. This is why the strategy is sometimes described as exchanging until the basis resets. It depends entirely on the law in force at the time, which is not something anyone can promise.
- The state may still be watching. California, Massachusetts, Montana, and Oregon are among the states that track deferred gain sourced to them and can recapture it if you later sell a replacement property located elsewhere.
When an exchange is the wrong answer
Deferral is not automatically worth having. An exchange is the wrong move when:
- The gain is small or your bracket is 0%. A retired couple with modest taxable income can have a meaningful long-term gain fall entirely in the 0% federal band. Recapture and state tax may still apply, but the deferral may not be worth the constraint.
- You need the proceeds. Exchange rules require reinvesting everything. If you need the cash for retirement, a straight sale and a known tax bill can be the cleaner answer.
- You cannot replace the debt. Replacement debt requires either qualifying for a new loan of at least the same size or bringing that much additional cash. A retired borrower with no employment income may find the first harder than it once was, and the second means writing a check on a sale meant to defer tax, not fund it.
- The deadline is driving the purchase. Buying a property you do not want in order to beat Day 45 is the tax tail wagging the dog. A bad asset bought to defer a good tax bill is a worse outcome than paying the tax.
- It was once your home. A former primary residence may qualify for the Section 121 exclusion on part of the gain, which has different and sometimes better mechanics. The two can interact, and the analysis is fact-specific.
Section 1031 or Section 1033: if the property was taken, not sold
Everything above assumes you chose to sell. If the property was condemned, seized under eminent domain, destroyed by fire or flood, or stolen, a different provision governs — Section 1033, the involuntary conversion rules. It is not a 1031 exchange, and treating it like one is how people lose a deferral they were entitled to. The mechanics differ in every respect that matters:
What changes under Section 1033
- No Qualified Intermediary. You can receive the condemnation award or the insurance proceeds yourself and reinvest them. Constructive receipt is not fatal here the way it is under 1031.
- Far more time, and no 45-day clock. The replacement period generally runs two years from the close of the first tax year in which any part of the gain is realized — extended to three years for real property held for business or investment that was condemned or taken under threat of condemnation, and four years for a principal residence lost in a federally declared disaster.
- A different replacement standard. The general test is property “similar or related in service or use,” which is narrower than like-kind. The exception runs the other way: for condemned real property held for business or investment, Section 1033(g) applies the broader like-kind standard instead.
- Deferral is elected, not automatic. You claim it on the return for the year the gain is realized. Do nothing and the gain is simply recognized.
Same underlying idea — reinvest and postpone the tax — but two separate sections of the code with separate deadlines and separate paperwork. If your property was taken or destroyed rather than sold, start here instead: eminent domain, fire, or flood — why your loss may be a taxable gain.
Frequently asked questions
Is a 1031 exchange tax-free?
No. It is tax-deferred. The gain is not recognized in the year of sale, but it carries into the basis of the replacement property and becomes taxable if you later sell without exchanging again. The words are not interchangeable, and treating deferral as forgiveness is the most common misunderstanding of the whole strategy.
What taxes do I pay if I don’t do a 1031 exchange?
Four, generally stacked in the same year: depreciation recapture on prior depreciation at a maximum federal rate of 25%; long-term capital gain at 0%, 15%, or 20% depending on taxable income; the 3.8% Net Investment Income Tax if modified adjusted gross income exceeds $200,000 single or $250,000 married filing jointly; and state income tax, which is charged on top of all the federal figures and reaches 13.3% in the highest state.
Does the federal capital gains rate include state tax?
No. The 0%, 15%, and 20% federal brackets, the 25% recapture ceiling, and the 3.8% NIIT are federal only. Your state calculates its own tax on the same gain, and most states with an income tax apply their ordinary rates with no preferential treatment for capital gains. Seven states impose no broad personal income tax at all; Washington applies a separate capital gains excise tax.
Can I do a 1031 exchange on my primary residence?
No. Section 1031 applies to property held for productive use in a trade or business or for investment. A primary residence does not qualify, though the Section 121 exclusion may apply to it instead. A property converted from personal use to rental use can qualify, subject to holding-period and intent considerations.
What is boot in a 1031 exchange?
Boot is any value you receive that is not like-kind property. Cash boot is proceeds you take rather than reinvest. Mortgage boot is debt you shed without replacing it with new financing or additional cash. Either is taxable in the year of sale, up to the amount of your realized gain.
How long do I have to hold the replacement property?
The statute sets no fixed holding period. What governs is intent to hold for investment or business use, judged on the facts. Practitioners often cite one to two years as a conservative benchmark, but that is convention rather than law, and a quick resale invites scrutiny.
What happens if I miss the 45-day or 180-day deadline?
The exchange fails and the sale is fully taxable in the year it closed — recapture, capital gain, NIIT, and state tax. There is no standard extension. The only relief is a federally declared disaster under Rev. Proc. 2018-58.
What is the difference between a 1031 exchange and a 1033 involuntary conversion?
Section 1031 covers a sale you choose to make. Section 1033 covers property you lost involuntarily — condemned, seized, destroyed, or stolen. Section 1033 is the more forgiving of the two: no Qualified Intermediary is required, you may receive the proceeds yourself, and there is no 45-day identification deadline. The replacement period generally runs two years from the close of the tax year in which the gain is realized, or three years for real property held for business or investment that was condemned. The replacement-property standard differs as well, and the deferral has to be elected on your return rather than happening by default.
Can I exchange into a property in a different state?
Yes. Like-kind real property is not restricted by location within the United States. Some states that tax the original gain require an annual filing afterward to track the deferred amount and can recapture it if the replacement is later sold, so the destination state is worth deciding deliberately rather than by default.
Your dates, your debt, your numbers.
Thirty minutes, no cost, phone or video. What we cover:
- Your closing date mapped against Day 45 and Day 180, and which tax year the sale lands in
- What replacing your debt would actually take, in your situation
- Whether an exchange is the right move at all — if a straight sale serves you better, I’ll say so
Sources
IRC §1031 (like-kind exchanges) · IRC §1(h) (capital gains rates and unrecaptured Section 1250 gain) · IRC §1411 (Net Investment Income Tax) · IRC §1016(a)(2) (basis reduced by depreciation allowed or allowable) · IRC §1014 (basis of property acquired from a decedent) · IRC §1033 and §1033(g) (involuntary conversions and replacement periods) · Treas. Reg. §1.1031(k)-1 (identification and exchange periods) · Rev. Proc. 2018-58 (disaster extensions) · IRS Rev. Proc. 2025-32 §3.03 (2026 inflation-adjusted capital gains thresholds) · IRS, Like-Kind Exchanges – Real Estate Tax Tips. State rates cited are top marginal rates as published by the respective state revenue agencies and change frequently — verify before relying on them. This article is educational and is not tax or legal advice. 1031 rules are strict and fact-specific; confirm every detail with a Qualified Intermediary and your own tax advisor.