How does a like-kind exchange defer capital gains taxes for real estate investors?

< Back to Q&A

Here’s an example. Suppose an investor bought a rental property for $300,000 and later sells it for $500,000. Without a section 1031 exchange, the investor may owe tax on the $200,000 gain, plus potential depreciation recapture. Instead, if the investor follows the 1031 exchange rules and reinvests the proceeds into qualifying replacement property, the gain is carried forward into the new property rather than taxed immediately. That means more equity remains available for the next acquisition.

For some investors, the strategy extends beyond a single transaction. By completing successive 1031 exchanges over many years, an investor may continue deferring gain while growing a real estate portfolio. Under current law, property included in a decedent’s estate generally receives a step-up in basis at death. As a result, deferred gain associated with the property may not be recognized by heirs, making estate planning one of the reasons long-term investors often consider a 1031 exchange strategy.

Strict compliance with the rules is essential. The investor cannot take possession of the sale proceeds. A qualified intermediary typically holds the funds between the sale of the relinquished property and the purchase of the replacement property. The investor must identify potential replacement property within 45 days and generally close within 180 days, making the 1031 exchange timeline one of the most unforgiving parts of the process. The IRS instructions also state that Form 8824 is used to figure deferred gain, recognized gain when non-like-kind property or cash is involved, and the basis of the replacement property.

The replacement property does not have to be identical. For real estate, “like-kind” is broad. A rental home may be exchanged for commercial property, raw land may be exchanged for multifamily property, and one investment property may be exchanged for another investment property, assuming the properties are held for investment or business use. Personal residences and property held primarily for resale generally do not fit the rule.

Delaware Statutory Trust structures may be relevant for investors who want a more passive replacement property option, though they come with liquidity, control, and qualification considerations that should be reviewed carefully.

One area that often surprises investors is depreciation. A properly structured exchange may defer both capital gain and depreciation recapture, but the taxpayer’s basis in the replacement property is reduced by the deferred gain. That lower basis can create a larger taxable gain later if the investor eventually sells without another exchange. Unrecaptured Section 1250 gain is one reason investors should model the tax impact before assuming the exchange solves every tax issue.

Boot is another trap. “Boot” generally means value received that does not qualify for deferral, such as cash retained from the sale or debt that is not replaced. If an investor sells property with debt and buys replacement property with less debt, the shortfall may create taxable gain. In other words, the exchange can still work, but not all of the gain may be deferred.

The Impact of Rising and Falling Interest Rates can also affect whether an exchange is practical. Higher rates may make replacement debt more expensive and reduce buying power, while lower rates may make it easier to trade into larger or better-positioned property. Either way, the tax strategy should not outrun the investment strategy.

Used well, a 1031 exchange can help real estate investors preserve cash flow, reposition portfolios, and build wealth over time. To maximize the benefits and avoid costly mistakes such as receiving taxable boot or missing key requirements, investors should work closely with a qualified intermediary and experienced tax advisor before moving forward with an exchange.

How BT Can Help

For more than four decades, Bennett Thrasher has provided businesses and individuals with strategic business guidance and solutions through professional tax, audit, advisory, and business process outsourcing services. Contact Trey Webb, partner in charge of Bennett Thrasher’s Real Estate and Hospitality Tax Group, or call us at 770.396.2200.

Back to Q&A