What Is the Downside of a 1031 Exchange?

Deferral is not forgiveness: the basis carryover

The rule that makes an exchange work is also its first cost. Under §1031(d), your basis in the replacement property is your basis in the property you gave up, adjusted for boot and for any additional cash you put in. Sell a building with a $400,000 adjusted basis for $1.5 million and buy a $1.5 million replacement, and your basis in the new building is $400,000, not $1.5 million. The $1.1 million of gain did not disappear; it is sitting inside the new property, and it will be recognized in full the day you sell that property for cash, along with whatever additional gain the new property earns. Exchange again and it rides along into the next property. The chain can run for decades, but at every link the deferred gain is a liability on your personal balance sheet that grows with each exchange and never shrinks, and tax rates at the end of the chain are not something anyone can promise you.

Most investors understand this in principle and underestimate it in practice, because the deferred gain is invisible on a settlement statement and the replacement property's price is not. The useful discipline is to carry the deferred tax as a line on your net worth statement, at today's rates, so that a $1.5 million building acquired in an exchange shows up as roughly $1.5 million of property and $280,000 of deferred tax rather than as $1.5 million of equity.

The depreciation you give up every year

The carried-over basis has a second, quieter cost. Depreciation is computed on basis, so a replacement property acquired in an exchange throws off far smaller deductions than the same property bought for cash. Using the figures above: a $1.5 million purchase with 80% allocated to the building produces about $43,600 of annual straight-line depreciation on a fresh basis. The same building acquired with a $400,000 carryover basis, under the exchanged-basis rules in Treas. Reg. §1.168(i)-6, continues depreciating the old basis on the old schedule and depreciates only the excess basis, if any, as new property. If there is no excess basis, the annual deduction stays at whatever the old building was producing, perhaps $11,000 a year on a basis that is mostly used up. The investor who exchanges forgoes roughly $32,000 of deductions a year, which at a 35% marginal rate is about $11,000 of tax every year for as long as the property is held. Over a ten-year hold that is $110,000 of additional tax, and it is rarely counted against the tax the exchange deferred. A cost segregation study on the replacement property helps only to the extent there is excess basis to segregate.

The clocks, and what they do to your judgment

Forty-five days to identify and 180 to close are not long in commercial real estate. A disciplined buyer with no tax motive might spend six months finding the right asset, walk away from three deals, and negotiate hard on the fourth because the alternative to buying is simply not buying. An exchanger's alternative to buying is a six-figure tax bill, and sellers, brokers, and sponsors know it. The result is a well-documented pattern: exchangers pay more than cash buyers for comparable property, accept less diligence, waive contingencies to make a date, and buy in markets they do not know because that is where inventory was available in week six. Industry commentary routinely observes that the money saved in tax is lost in the purchase, and while that is an overstatement for large gains, it is close to accurate for small ones.

The timeline also has no mercy for things outside your control. A lender who needs an extra two weeks, a title defect discovered on day 170, a seller who dies, a tenant estoppel that comes back wrong: any of these can turn a planned exchange into a taxable sale on day 181, after you have paid the intermediary and the attorneys and spent six months on the effort. Exchangers manage this risk by identifying backups, by using DST interests as a closable fallback, or by structuring a reverse exchange, each of which adds cost and complexity of its own.

What an exchange costs to run

The intermediary's fee is the visible cost and the smallest one: roughly $1,000 to $1,500 for a standard delayed exchange, several thousand for a reverse or improvement structure, plus the interest the intermediary earns on your funds while it holds them. The real costs are the ones an exchange forces that a hold would not. Two closings mean two sets of title, escrow, legal, and lender fees. In states and cities with transfer taxes, each conveyance is taxed: an exchange of a $4 million New York City commercial property pays roughly 3% in combined transfer taxes on the sale, and the replacement purchase in the same market carries its own. Acquisition financing on the replacement property brings origination fees, appraisal, and in New York a mortgage recording tax approaching 3%. Add the brokerage commission on the sale, which you would pay regardless, and a conventional exchange of a $1.5 million property can easily consume $25,000 to $60,000 in transaction costs that are not tax and are not recoverable. For a gain of $150,000, the tax on which might be $45,000, those costs are the whole argument.

Replacing debt you may not want

To defer all of the gain you must acquire replacement property of equal or greater value and take on at least as much debt as you paid off, or substitute cash for it. An investor who has spent twenty years paying down a mortgage and would like to own the next property free and clear cannot do so inside an exchange without writing a check for the difference; otherwise the debt relief is mortgage boot and is taxed. The exchange, in other words, can push you back into leverage at the point in life when you were trying to leave it. Investors who want a lower-leverage replacement sometimes accept a partial exchange and pay tax on the boot, which is a reasonable outcome but is not what the brochure promised. Those who exchange into a DST inherit the trust's leverage, chosen by the sponsor, with no ability to pay it down.

Frozen proceeds and the no-cash problem

From the moment your relinquished property closes until your replacement closes, the proceeds belong to the exchange. You cannot borrow against them, use them to bridge a purchase, or take a slice for a child's tuition without converting that slice to taxable boot. Afterward, your equity is in another illiquid building, and if the reason you were selling was to diversify out of real estate, reduce your workload, or fund something else, the exchange has defeated the purpose. A seller who needs $300,000 of the proceeds for a non-real-estate use and exchanges the rest has done a partial exchange, which is a legitimate plan; a seller who exchanges everything and then borrows against the new property to raise cash has taken on debt to avoid a tax, and should check whether the interest cost over time exceeds the tax that was deferred.

Suspended losses an exchange keeps frozen

This is the disadvantage the exchange industry least often mentions. Rental real estate is a passive activity for most investors, and losses it generates beyond passive income are suspended under §469 and carried forward. Many long-held properties have accumulated six figures of suspended losses, especially where a cost segregation study produced early deductions the owner could not use. Under §469(g), a fully taxable disposition of the activity to an unrelated party releases every suspended loss from that activity, to be used against the gain on the sale and then against any other income at all, including wages and portfolio income. A 1031 exchange is not a fully taxable disposition. The suspended losses stay attached to the activity, which now consists of the replacement property, and remain frozen until some future taxable sale. An investor with $150,000 of suspended losses who exchanges has given up a $150,000 ordinary deduction, worth perhaps $50,000 at a high marginal rate, in order to defer tax that the same deduction would have gone a long way toward absorbing. The arithmetic appears in the worked example below. Investors who qualify as real estate professionals and have been using their losses currently are unaffected; everyone else should know the number before deciding.

The low-income year you waste

Long-term capital gain is taxed at 0%, 15%, or 20% depending on your other income, unrecaptured §1250 gain at your ordinary rate up to 25%, and the 3.8% net investment income tax applies only above an income threshold. The year you retire, the year a business is sold at a loss, a year of large deductible medical expenses, or the first year after a spouse's death can put a seller in a bracket where a six-figure gain is taxed at a fraction of the usual rate. Deferring that gain into a future year, when income has recovered and rates may be higher, is backwards. The same logic applies to a seller who expects to move from a high-tax state to a no-tax state: waiting to sell until after the move avoids the state tax permanently, which an exchange from the high-tax state may not, as the next section explains.

State traps: clawbacks, withholding, transfer taxes

State law adds three disadvantages that depend on where the property sits. Clawback states, California with its annual Form 3840 along with Oregon, Montana, and Massachusetts, assert the right to tax deferred gain on their property when the replacement is eventually sold, wherever that replacement is and wherever you then live. An exchange out of California does not escape California; a taxable sale after establishing residency elsewhere does. Withholding and prepayment regimes in states such as Georgia, Colorado, and New York divert part of the proceeds to the state at closing unless the exchanger files the right affidavit in advance, and a missed form can turn exchange funds into boot. And transfer taxes, where they exist, apply to each leg of the exchange. Our state table flags which states carry which of these.

The disadvantage that is a myth: holding until death

Articles on this subject frequently list, among the downsides, that heirs inherit the deferred gain or that an investor near the end of life should skip the exchange because the step-up at death would have applied anyway. Both are wrong, and we have corrected our own earlier copy on this point. Under §1014, property owned at death takes a basis equal to its fair market value at that date. Exchanged property is owned at death like any other, so the heir's basis is the full value of the replacement property and the deferred gain, along with every earlier link in the chain, is never taxed by anyone. An investor who sells for cash shortly before death pays the full tax; an investor who exchanges and dies pays none. This is what practitioners mean by swap till you drop, and it is the single strongest argument for an exchange, not against one. The disadvantages above are real, but they are disadvantages for the living. If the realistic plan is to hold the replacement property until death, the basis carryover and the lost depreciation are costs that expire with you, and the exchange is usually right even for a modest gain. What a seller near the end of life should skip is the sale, not the exchange: holding the original property to death produces the same step-up with no fees at all.

A worked example: when paying the tax wins

An investor sells a rental duplex for $900,000. Adjusted basis is $560,000 after $120,000 of depreciation, so the gain is $340,000. The property has $150,000 of suspended passive losses from a cost segregation study taken in a year the owner's income was too high to use them. The owner is in a 32% ordinary bracket, lives in a state with a 5% income tax, and would, in an exchange, buy a $900,000 replacement under deadline pressure that we assume costs 3% more than a patient buyer would pay.

Illustrative; assumptions per our methodology. The exchange avoids $103,920 of tax this year but spends about $31,000 to do it, gives up a $48,000 deduction, and forgoes roughly $10,000 of depreciation a year. Over a decade the two paths are close, and the investor who paid has no deferred liability, full flexibility, and a clean basis. Change the facts to a $1.5 million gain with no suspended losses and the exchange wins easily. The point is that the answer depends on the facts, which is what the calculator is for.

What to do instead

If the disadvantages above describe your situation, the alternatives are not exotic. Pay the tax and invest the after-tax proceeds wherever you like; for gains under a few hundred thousand dollars this is the most common right answer. Hold the property if you do not actually need to sell, and let the step-up do the work. Sell on an installment basis under §453, recognizing gain as payments arrive and smoothing the bracket impact, though any §1245 recapture is recognized in the year of sale. Run a lazy 1031, buying any property you want on your own schedule and using cost segregation with bonus depreciation to generate deductions that offset the gain, accepting ordinary-rate recapture of those deductions later. Consider a qualified opportunity fund, a charitable remainder trust, or a deferred sales trust, each of which has a narrower use case and sharper edges than its marketing suggests. And if you do exchange, do it on purpose: identify backups, price the replacement as if there were no tax motive, keep a DST in reserve for the shortfall, and count the deferred tax as a liability from the day you close.