What it actually does
Selling a rental normally triggers capital gains tax on the appreciation plus recapture on the depreciation you claimed along the way. A 1031 exchange lets you postpone both by reinvesting into another property held for investment or business use. Like-kind is broad for real estate: a duplex can be exchanged for raw land, a small retail building, or a package of single-family rentals. The deferred gain rides along in the new property’s basis, so the bill follows you until you eventually sell without exchanging. That deferral is the entire point — it keeps equity compounding instead of leaking to tax every time you trade up.
What full deferral requires
The rule of thumb is trade up, or at least trade even, in both price and debt. Buy a replacement that costs less than what you sold, or replace less debt than you retired, and the shortfall is generally treated as boot and taxed now even though the rest of the exchange stands. Cash pulled out at closing is boot too, which is why investors who want liquidity usually refinance after the exchange rather than skimming proceeds during it. Run the arithmetic before you sign the listing agreement, because the structure is far harder to fix once the relinquished property has closed.
Taxable boot = cash received + mortgage debt relieved but not replaced. Full deferral generally requires the replacement property to cost at least as much as the relinquished one sold for, with all net equity reinvested.
The two clocks
From the day the relinquished property closes, you have 45 calendar days to identify replacement candidates in writing and 180 calendar days to close on one. The clocks run at the same time, they include weekends and holidays, and they are unforgiving. Identification usually follows the three-property rule — name up to three candidates regardless of value — or the 200% rule, which allows more properties as long as their combined value stays inside twice what you sold. You never touch the sale proceeds; a qualified intermediary holds them and wires them into the replacement closing. Taking receipt of even part of the money can unwind the exchange.
Where investors get burned
The most common failure is a thin replacement market. Investors sell into a hot market, spend 45 days discovering that everything available is overpriced, and buy a weaker asset purely to save tax — a deferred tax bill is not worth a bad deal. The second is a title mismatch, since the entity that sold generally has to be the entity that buys. The third is underwriting the replacement on optimism because the clock is loud. Line candidates up before you list, and run each one on rent, taxes, insurance, a real capex reserve, and coverage at today’s rates. Because the mechanics turn on federal rules and state conformity varies, coordinate this with your CPA and attorney rather than improvising.
Put it to work
Related terms
- Depreciation — An annual paper deduction that writes off the cost of a rental building — never the land — over a fixed recovery period, currently 27.5 years for residential and 39 for most commercial property.
- Depreciation recapture — When you sell, the depreciation you claimed — or were entitled to claim — gets taxed back.
- Cash-out refinance — Replacing an existing mortgage with a larger new loan and taking the difference in cash, tapping built-up equity without selling.
- Cap rate — Capitalization rate — net operating income divided by purchase price, shown as a percent.