The deferral mechanism
When you sell a property and reinvest the proceeds into a like-kind replacement property under IRC Section 1031, you do not recognize the gain in the year of sale. Instead, your adjusted basis in the replacement property is reduced by the deferred gain — effectively carrying the tax liability forward into the new investment.
The gain doesn't disappear; it is preserved in the replacement property's low basis. When you eventually sell the replacement without exchanging, the deferred gain (plus any new gain) becomes taxable. You've kept 100% of your equity working in real estate in the meantime.
What gets deferred
A complete 1031 exchange defers both the capital gains portion and the depreciation recapture portion of the gain. You defer unrecaptured Section 1250 gain (up to 25% rate), Section 1245 recapture (ordinary rates), and long-term capital gains (0/15/20% rates). The only taxable amount is 'boot' — cash or net debt relief you receive without reinvesting.
Chaining exchanges and step-up at death
Many investors use a series of 1031 exchanges — selling and exchanging repeatedly over decades — while the deferred gain accumulates in progressively larger properties. When the investor dies, the heirs receive a step-up in basis to the property's fair market value at death, eliminating all accumulated deferred gain and recapture. This 'swap till you drop' strategy means the deferred tax may never be paid.
Frequently asked questions
Does a 1031 exchange eliminate capital gains tax?
No — it defers it. The gain is embedded in the replacement property's lower basis and becomes taxable when you sell without exchanging, unless you hold until death and your heirs receive a step-up in basis.
Does 1031 defer depreciation recapture as well?
Yes. Both the capital gains and all depreciation recapture are deferred in a complete exchange. Only boot creates immediate tax.
How many times can I do a 1031 exchange?
As many times as you like, as long as you follow the rules each time. There is no limit on the number of exchanges or the total gain deferred.
Sources
- IRS Topic No. 409 — Capital Gains and Losses
- IRS Publication 544 — Sales and Other Dispositions of Assets
- IRS — Like-Kind Exchanges (Real Estate Tax Tips)
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.