A 1031 Exchange Only Defers: Your Zero Basis Follows You Into the New Property

A 1031 exchange only defers: your old basis follows you

A like-kind exchange under IRC 1031 does not erase gain. It postpones it. The tax law keeps the deferred gain alive by giving the replacement property the old property's basis: the replacement's basis is what you paid for it, minus the gain you deferred (IRC 1031(d)).

When you trade into a property worth the same as the one you gave up, with no cash taken out and no new debt, that works out to your old adjusted basis, carried over dollar for dollar.

For an owner who has depreciated a rental for decades, that old basis is small. The building has been written down to nothing, so what remains is mostly the land. The new property can be worth $900,000 and carry a basis of $80,000. You hold a $900,000 asset with the tax profile of an $80,000 one.

The illustration: one rental, one exchange, one later sale

Everything below is a round-number illustration, not a client case and not a prediction. It leaves out selling costs, improvements, closing costs and the mid-month convention so the arithmetic is easy to check. The tax figures come from this site's engine on 2026 law for a married couple filing jointly in a state with no income tax and $150,000 of other income.

The sale price was below what you paid, and the sale still produces a $770,000 taxable gain. The reason is in the formula. Taxable gain is the amount realized minus your adjusted basis (IRC 1001, 1011). It is not the amount realized minus what you paid. The price you paid for the replacement ($900,000) never enters the formula; the basis ($80,000) does.

In fairness, most of that gain was earned long before the sale. The property rose from $400,000 to about $900,000 and the exchange kept that $820,000 of deferred gain open instead of closing it. The sale at $850,000 simply cashes the bill in.

Why the new property gives you little or no depreciation

Depreciation is the shelter that makes rent less taxable each year. A buyer who pays $900,000 of fresh money for the same property, with 80% of the value in the building ($720,000), deducts $720,000 / 27.5, or about $26,182, every year (IRC 168(c)). Land is never depreciable, so the other $180,000 produces nothing.

The exchange buyer starts from a different place. Treasury Regulation 1.168(i)-6 splits the replacement's basis in two. Exchanged basis, the carryover part, is the lesser of the replacement's basis under IRC 1031(d) or the old property's adjusted depreciable basis, and it keeps depreciating on the old property's schedule (Reg. 1.168(i)-6(b)(7), (c)).

Here the old building was fully written off, so there is nothing left on that schedule and the exchanged basis is zero. Whatever basis is left over is excess basis and is treated as newly placed in service (Reg. 1.168(i)-6(b)(8), (d)).

That leaves the $80,000 of carried-over basis, and it has to be shared between the replacement's land and its building. If the building is 80% of the value, at most about $64,000 of it, roughly $2,327 a year over 27.5 years, is depreciable.

That is about one-eleventh of the $26,182 the fresh-money buyer takes. Less shelter means more of each year's rent is taxed. How your preparer allocates the basis is a facts and circumstances call; the point is that the ceiling is the carried-over basis, not the price.

The 25% bill follows the depreciation into the new property

When the replacement is sold in a taxable sale, the depreciation taken on the old building comes back as unrecaptured Section 1250 gain, taxed at a maximum federal rate of 25% (IRC 1(h)(6), 2026). The depreciation history follows the property through an exchange (IRC 1250(d)(4); Treas. Reg. 1.1250-3(d)).

In the illustration that slice is the full $320,000, and the engine puts federal income tax at $154,763 plus $25,460 of 3.8% net investment income tax (IRC 1411, 2026), for $180,223 in all.

The 25% is a ceiling, not a flat rate (IRC 1(h)(6)). Unrecaptured 1250 gain stacks on top of your other income and is taxed at your ordinary rate when that rate is lower. If the same $770,000 had all been taxed as ordinary long-term gain, the engine shows $154,665; the 25% layer is responsible for the $25,558 difference. Add state tax where your state has one.

Allowed or allowable: depreciation you never took still counts

Basis is reduced by the depreciation allowed, and not less than the depreciation allowable (IRC 1016(a)(2)). If a rental was available for rent and you skipped the deduction, forgot an improvement, or the property sat empty between tenants while still held out for rent, the basis drops anyway. You pay tax on deductions you never received.

The 25% slice is measured the same way, from the depreciation the law allowed. If you still own the property, an automatic accounting method change on Form 3115 can catch up the missed depreciation in one year; see missed depreciation before a sale. A property that was never held for rent is a different question: land and a home you only lived in carry no depreciation to recapture.

What softens this, stated honestly

• You can keep exchanging. There is no limit on the number of 1031 exchanges (IRC 1031). The deferred gain stays deferred as long as each trade qualifies.
• Heirs get a step-up. At death the basis resets to fair market value (IRC 1014), which wipes out the deferred gain and the depreciation recapture. Estate tax can still apply above the exemption; see holding for the step-up.
• New cash or new debt adds depreciable basis. Money you put in, or debt you take on beyond the old loan, becomes excess basis that depreciates as new property (Reg. 1.168(i)-6(d)). Trading up is the usual way to rebuild the shelter; see cost segregation after a 1031 with boot.
• Land never depreciates. The land share of any property has no depreciation to recapture and none to take.
• Primary residences are different. Gain on a home you owned and used for two of the last five years can be excluded up to $250,000, or $500,000 for many joint filers (IRC 121, 2026), but depreciation taken after May 6, 1997 is not excluded (IRC 121(d)(6)). See Section 121 and 1031 together.
• Only real property qualifies today. Since 2018 a 1031 exchange is limited to real property (IRC 1031(a)(1)).

How to see your own numbers before you trade or sell

1. Pull the last depreciation schedule (Form 4562) and your last Form 8824 if you exchanged before. Total all depreciation, including years you skipped.
2. Subtract it from what you paid plus improvements, then add back the land. That is your adjusted basis.
3. Compare it with the replacement price. The gap is the deferred gain you are carrying, and it is the number that decides the tax if you ever sell.
4. Ask what you want to own at the end: another exchange, a sale with the tax planned, or a hold for the step-up. Related: adjusted basis explained and 1031 exchange vs taxable sale.

If you want these numbers run on your own property before you decide, get the Big Sale Tax Analysis.

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