A 1031 Exchange Example With Real Numbers

The relinquished property

Original purchase: $250,000 (land $50,000, building $200,000). Capital improvements: $25,000. Depreciation claimed over 15 years: $200,000 / 27.5 = $7,273/year x 15 years = $109,090. Adjusted basis: $250,000 + $25,000 - $109,090 = $165,910. Net sale price: $550,000. Total deferred gain: $550,000 - $165,910 = $384,090 (recapture: $109,090; capital gain: $275,000).

The replacement property and new basis

You acquire a replacement property for $700,000 (land $140,000, building $560,000). Your carryover basis in the replacement = $700,000 - $384,090 (deferred gain) = $315,910. Depreciable basis = $315,910 - $140,000 (land) = $175,910. Annual depreciation going forward: $175,910 / 27.5 = $6,397/year — significantly lower than the $20,364/year you would get on full purchase-price basis ($560,000 / 27.5).

The tax deferred and the trade-off

By exchanging, you deferred approximately $27,273 in recapture tax (at 25%) and $41,250 in capital gains tax (at 15%) — roughly $68,523 in federal tax kept working in your portfolio. The cost: lower annual depreciation on the replacement property. Whether the compounded investment return on $68,523 over the hold period exceeds the foregone depreciation deductions is the key calculation — in most scenarios with long holds, the exchange wins significantly.

The timeline that makes it work: 45 and 180 days

The numbers above only hold if you follow the strict statutory clock. From the day you close on the relinquished property, you have 45 calendar days to identify replacement property in writing and 180 calendar days to close on it (or the due date of your tax return including extensions, if earlier). These deadlines are absolute — there is no good-cause extension short of a federally declared disaster. In our example, the day the $550,000 sale closes, the 45- and 180-day clocks start together. Miss either one and the entire $384,090 gain becomes taxable in the year of sale. Line up candidate replacements before you sell.

Why you need a qualified intermediary

To defer the gain, you cannot touch the sale proceeds. A qualified intermediary (QI) — an independent third party who is not your agent, attorney, or relative — holds the $550,000 from the sale and uses it to acquire the replacement property on your behalf. If the cash hits your bank account or you have the right to control it, the exchange fails and the gain is fully taxable ('actual or constructive receipt'). Engage the QI and sign the exchange agreement before closing on the sale; you cannot retroactively convert a completed sale into an exchange. QI fees are modest (often several hundred to a couple thousand dollars) relative to the ~$68,523 deferred here.

The 'napkin test': three rules to defer 100%

To defer the entire gain, follow three rules of thumb: (1) buy replacement property of equal or greater value than what you sold; (2) reinvest all of your net equity; and (3) obtain equal or greater debt on the replacement (or add cash to make up any shortfall). In our example you sold for $550,000 and bought for $700,000 — trading up in value — and reinvested all proceeds, so all three boxes are checked and the full $384,090 defers. Fall short on any of the three and the shortfall becomes boot, which is taxable.

What partial deferral (boot) would look like

Suppose instead of buying up, you bought a $450,000 replacement and pocketed $100,000 of the proceeds. That $100,000 is cash boot and is taxable now — and boot is taxed recapture-first, so your first $100,000 of boot is taxed at up to 25% recapture rates, roughly $25,000 of federal tax, rather than the lower capital-gains rate. Reducing your debt without replacing it creates mortgage (debt-relief) boot with the same effect. The lesson: any value, equity, or debt you strip out of the deal is exactly the slice that loses its deferral. Trading up avoids boot entirely.

Depreciating the replacement: the two-schedule rule

Our example simplified the replacement depreciation to $175,910 / 27.5. The precise default rule (Reg. 1.168(i)-6) is a two-part calculation. The carryover (exchanged) basis continues on the relinquished property's remaining recovery schedule — same method, same remaining years — as if nothing happened. Only the excess basis (the extra $150,000 you paid above the old property's value, here funding new building) is treated as newly placed-in-service property starting a fresh 27.5-year clock (and potentially eligible for bonus depreciation on qualifying components). You can elect out and depreciate the entire basis as new, but the default split is what most software applies. Either way, total depreciable basis is lower than a straight purchase, which is the deferral's trade-off.

Swap till you drop: the exit that erases the tax

The deferred $68,523 is not forgiven — it rides along in the reduced carryover basis and comes due whenever you finally sell for cash. Two exits change that. Keep exchanging into ever-larger properties ('swap till you drop') and hold until death: your heirs receive a stepped-up basis equal to fair market value at your death, which eliminates the entire built-in gain and all the accumulated deferred recapture. Alternatively, convert a former exchange property into a primary residence and later claim a partial Section 121 exclusion (subject to nonqualified-use proration and no relief for recapture). The step-up is why disciplined investors treat 1031 as a lifetime deferral, not just a one-time trick.

Watch for state clawback and common mistakes

A few traps recur. Some states — California most prominently — apply a clawback: if you exchange out of an in-state property into an out-of-state one, the state tracks the deferred in-state gain and taxes it when you eventually cash out, requiring annual information filings in the meantime. Other frequent errors: taking constructive receipt of funds, blowing the 45-day identification, identifying more property than the identification rules (three-property or 200% rules) allow, trying to exchange a primary residence or flip inventory (only property held for investment or productive use in a trade or business qualifies), and forgetting that since 2018 only real property is like-kind — the furniture and appliances in a rental no longer qualify and can generate a small taxable component. Run your specific numbers through the calculator and confirm the plan with a QI and CPA before you list.

The identification rules in the 45-day window

Within the 45-day window, your written identification must satisfy one of three rules. Under the three-property rule, you may identify up to three properties of any value. Under the 200% rule, you may identify any number of properties as long as their combined fair market value does not exceed 200% of the value of what you sold. And under the 95% rule (a fallback if you blow the first two), you must actually acquire at least 95% of the total value you identified. In our example, selling for $550,000, you could name three candidate replacements outright, or a longer list as long as the total stayed under $1.1 million (200% of $550,000). Identify in a signed writing delivered to your QI — a mental shortlist does not count.

Reverse and improvement exchanges

Two variations solve common timing problems. In a reverse exchange, you (through an 'exchange accommodation titleholder') acquire the replacement property before selling the relinquished one — useful in a hot market where you must move fast to secure the replacement. In an improvement (or 'construction') exchange, exchange funds are used to build or renovate the replacement property during the 180-day window so that its finished value is high enough to fully absorb your proceeds and avoid boot. Both are legitimate under IRS safe-harbor guidance but are more complex and costly than a standard 'forward' exchange, and both still run on the 45-/180-day clock. Engage a QI experienced in the specific structure before starting.

Reporting the exchange on Form 8824

A 1031 exchange is reported to the IRS on Form 8824 in the year the relinquished property is transferred, even though no tax is due on the deferred gain. The form walks through the like-kind property description, the key dates (to prove you met the 45- and 180-day deadlines), the realized gain, any recognized gain from boot, and the resulting basis in the replacement property. Any recognized boot flows to Form 4797 and Schedule D. Keeping the closing statements from both the sale and the purchase, the QI's exchange agreement and accounting, and your basis worksheet makes completing Form 8824 straightforward — and gives you the documentation to support the deferral if it is ever questioned.

Is the deferral worth the lower depreciation?

The core trade-off in our example was clear: about $68,523 of federal tax kept invested, in exchange for annual depreciation dropping from roughly $20,364 (on a fresh $560,000 building basis) to about $6,397 on the carryover basis. Whether the exchange wins comes down to time and rate. Keeping $68,523 compounding for a long hold — and ultimately erasing the deferred tax through a step-up at death — almost always beats the modest extra depreciation you forgo, especially for a high-bracket investor. The exchange looks weakest for someone who expects to cash out for good in just a few years, since the deferred tax then comes due while the depreciation shortfall accumulated the whole time. Run both paths through the calculator with your actual hold period and rates before deciding.

Frequently asked questions

Does a 1031 exchange reset my depreciation deduction?

No. Your depreciable basis is reduced by the deferred gain, producing lower annual deductions than buying without an exchange. However, you also kept the deferred tax working for you.

What is carryover basis in a 1031 exchange?

The replacement property's purchase price reduced by the deferred gain from the exchange. It becomes your tax basis going forward.

What are the 45-day and 180-day deadlines?

From the sale closing, you have 45 calendar days to identify replacement property in writing and 180 calendar days to close on it. Both are strict, with no ordinary extensions.

What is boot and how is it taxed?

Boot is any value you take out of the exchange — cash pocketed or debt reduced without replacement. It is taxable now, and it is taxed recapture-first, meaning up to 25% on the depreciation portion before capital-gains rates apply.

Do I have to buy a more expensive property?

To defer 100% of the gain, buy equal or greater value, reinvest all equity, and carry equal or greater debt (or add cash). Any shortfall becomes taxable boot.

How is the replacement property depreciated?

By default, the carryover basis continues on the old property's remaining schedule, and only the excess basis you paid above the old value starts a fresh 27.5-year schedule (and may qualify for bonus depreciation).

Sources

Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.