Section 1031 Exchanges and Depreciation Recapture

Section 1031 allows an owner to defer tax on gain when exchanging real property held for business or investment for other real property of like kind, if requirements are met. Because accelerated depreciation from a study increases gain on a sale, many owners ask how exchanges fit. This page gives a general orientation and cautions that exchanges are technical and require professional guidance.

The deferral concept

In a qualifying exchange, gain that would otherwise be recognized is deferred. The replacement property takes a basis that reflects the deferred gain. Deferred gain is not eliminated. It is postponed until a later taxable disposition, if any. The deferral can extend across successive exchanges, but that depends on continuing to qualify.

Real property only

Under current law as generally understood, like-kind treatment applies to real property, not to personal property. That matters for a study because the study may classify part of a building as personal property. When a building is exchanged, the portion of value that is personal property may not qualify as like-kind. Gain attributable to that portion, which may include recapture as ordinary income, could be recognized. Exchange practitioners often deal with this by allocating value among components. See Depreciation Recapture on Sale: What Comes Back.

Boot

Cash or non-like-kind property received in an exchange is generally taxable to the extent of gain. Relief from debt can also be treated as boot in some circumstances. If personal property is part of the transaction, its allocation of value is relevant.

Basis after an exchange

The replacement property's basis is generally the basis of the relinquished property adjusted for boot and other items. For depreciation purposes, part of the replacement property's basis is treated as carried over from the old property and continues to be depreciated on the old schedule, and part is treated as new basis. A study on the replacement property may address both portions. Bonus treatment for exchanged property involves special rules. Ask your preparer. See Used Property and Bonus Depreciation Eligibility.

Suspended losses

An exchange is not generally a disposition that releases suspended passive losses. They remain suspended. See Suspended Losses and Carryforwards.

Timing requirements

Exchanges have strict deadlines for identifying and closing on replacement property and require a qualified intermediary in most cases. Missing a deadline can disqualify the exchange. See a qualified professional before you sell.

Planning implications for a study

• If you plan to exchange repeatedly, deferral may reduce concern about recapture, but it depends on future law and your plans.
• If you plan to sell and not reinvest, recapture applies.
• Personal property components require special attention in an exchange.

See Hold Period and the Decision.

Risks of relying on indefinite deferral

Law can change, exchanges can fail, and personal circumstances change. Build your decision so that it still makes sense if a taxable sale occurs.

Documentation

Keep the study and asset schedule for use by the intermediary and preparer. See Audit Defense and Documentation for Cost Segregation.

Related structures

Some owners consider other strategies for deferral or reduction, such as holding until death or using certain investments. Each has costs and legal requirements. Discuss with advisors.

Illustrative sequence in words

An owner sells a rental building and identifies replacement property within the required time, closes within the required time, and uses a qualified intermediary to hold proceeds. The replacement property is of like kind, and its value equals or exceeds the relinquished property's. Gain is deferred. The owner's basis in the replacement property is carried over in part. A study on the replacement property then analyzes both the carried-over portion and the additional basis, treating them per the applicable rules.

Points of caution

Personal property associated with the relinquished property, including items classified as such by a study, may not be eligible for deferral. The sale of a building to a buyer often includes fixtures and equipment. Ask your advisor how to allocate. Debt relief and cash received can create boot. Timing is strict, and missing deadlines can disqualify the exchange.

Planning horizon

If you expect to continue exchanging, deferral may last indefinitely, but tax laws change. If you plan to cash out eventually, the deferred gain becomes taxable at that time. A balanced plan considers both outcomes.

Professional help

Exchanges require specialized help. Consult a qualified intermediary, an attorney, and your tax preparer before you list the relinquished property.

Alternatives to discuss

Some owners consider other approaches to deferral or reduction, such as installment sales or long-term holding strategies. Each has its own rules and risks. This page does not evaluate them. Discuss with your advisors what fits your goals, and remember that any approach must be supported by facts and law.

Documentation

Keep intermediary agreements, identification notices, closing statements, and the study schedule. These support the exchange and later depreciation on the replacement property. Without them, reconstructing the basis of the replacement property is difficult.

What to ask before you list

Ask whether an exchange fits your goals, what replacement property you might target, how long you will have to identify and close, and what the study says about the allocation of value to personal property. Ask an intermediary about fees and process. Ask your preparer what the tax would be if the exchange failed.

Next steps

Read Hypothetical: Sale and Recapture After a Study for a numerical hypothetical.