1031 Exchange in Kentucky: 3.5% Flat Tax, Deed Tax, Basis Rules and DSTs

Kentucky's flat rate dropped to 3.5% for 2026, which is exactly the tax an exchange defers

For taxable years beginning on or after January 1, 2026, Kentucky taxes individual income at a flat 3.5%, down from 4% in 2025. House Bill 1 of the 2025 Regular Session, signed February 6, 2025 as Acts Chapter 1, made the cut under the state's revenue-trigger process and leaves room for further reductions if budget conditions are met in later years.

Kentucky gives capital gains no separate rate or exclusion, so the entire gain on a Lexington apartment building or a Bowling Green warehouse would be taxed at 3.5% if recognized. Because Kentucky adopts the Internal Revenue Code as of December 31, 2024 and Form 740 begins with federal adjusted gross income, gain deferred under §1031 simply never appears on the Kentucky return.

Nonresidents file Form 740-NP, where gains on sales of tangible assets located in Kentucky are Kentucky-source income; the exchange keeps that line at zero too. The federal mechanics, including the 45- and 180-day windows, are covered in the deadline guide.

The KRS 142.050 deed tax has no exchange exemption: the grantor pays $0.50 per $500

Kentucky imposes a real estate transfer tax on the grantor named in the deed at fifty cents for each $500 of value or fraction thereof, which works out to $1,000 on a $1 million sale. The county clerk computes and collects it before accepting the deed for recording and keeps 5% as a fee, and "value" includes any liens the buyer takes subject to.

The statute lists fifteen exempt transfers, among them deeds between spouses, between a limited liability company and its members, between parent and child for nominal consideration, and transfers under foreclosure. A like-kind exchange is not on the list, so a Kentucky seller in an exchange pays the deed tax exactly as any other grantor would, while a Kentucky buyer completing an exchange owes nothing at the clerk's counter beyond recording fees unless the contract shifts the cost.

Kentucky computes depreciation its own way, so your Kentucky basis rarely matches federal

Kentucky has never adopted the federal special depreciation allowance, and it caps the §179 deduction at $25,000 for property placed in service from September 10, 2001 through 2019 and at $100,000 for property placed in service from 2020 on, with no phase-out. The Department of Revenue's instructions tell taxpayers to build a "Kentucky Form 4562" by writing Kentucky across the top of a federal Form 4562 and striking the bonus-depreciation line.

The instructions are blunt about the consequence: the differences "will continue through the life of the assets," and there will be "recapture and basis differences for Kentucky and federal income tax purposes until the assets are sold or fully depreciated." On disposition, Kentucky wants a Kentucky version of Schedule D and Form 4797 showing the Kentucky gain.

For an exchanger this matters twice. If you claimed bonus depreciation after a cost-segregation study, your Kentucky adjusted basis in the relinquished property is higher than the federal figure, so the Kentucky gain being deferred is smaller, and the Kentucky basis that carries into the replacement property or DST interest is different from the federal one. Keep a separate Kentucky depreciation schedule and have your CPA carry both bases forward.

Louisville Metro's occupational license tax reaches rental profits and Form 4797 gains

Kentucky cities and counties levy occupational license taxes on net profits, and Louisville Metro's is the largest: 2.2% of net profit for residents and business entities, 1.45% for nonresident individuals, reported on Form OL-3. Rental income from warehouses, office buildings, apartment buildings with four or more units, land leases and short-term rentals "creates a business activity," so all of it is taxable; only individuals whose gross rental receipts come solely from residential property and total under $50,000 are excused, and an LLC never is.

Line 4 of the OL-3 picks up 100% of the capital gain carried from federal Form 4797 or Form 6252 on property used in a trade or business. Gain deferred under §1031 is not reported as recognized gain on Form 4797, so it generally does not land on the OL-3 either, but a seller with a Louisville rental should confirm that treatment with the Metro Revenue Commission, and sellers in Lexington, Northern Kentucky or other jurisdictions should check their own ordinance.

Kentucky farmland: agricultural value expires on conveyance, and a change of use brings deferred tax

Kentucky assesses qualifying farmland at its agricultural or horticultural value rather than fair cash value under KRS 132.450, with a ten-acre minimum for agricultural land (five acres for horticulture). The property valuation administrator records both values, and the lower one is taxed.

The classification "shall expire upon change of use by the owner or owners or upon conveyance of the property to a person other than a surviving spouse," so a buyer of exchanged farmland must re-establish it, and an owner who converts the land faces the deferred tax, which is the difference between what was paid at agricultural value and what would have been paid at fair cash value. Investors exchanging out of a farm should make sure the sale, not a prior change of use, is the first event the PVA sees.

Statewide, Kentucky's own real property rate is set each July under KRS 132.020 and has fallen for five consecutive years as HB 44 holds state revenue growth to 4%; the 2025 rate is 10.6 cents per $100 of assessed value. Local rates layered on top vary by county, city and school district.

No withholding at closing and no claw-back: Kentucky keeps the gain only if you recognize it

Kentucky has no statute requiring a buyer or closing attorney to hold back income tax from an out-of-state seller's proceeds, so there is no Kentucky counterpart to the exemption certificates that Maryland or Maine sellers must chase. A nonresident who recognizes gain on Kentucky property pays it with the 740-NP; a nonresident who defers it owes nothing on the sale.

Kentucky likewise has no rule tracking deferred gain into another state. If a Louisville investor exchanges into a DST that owns property in Georgia and Texas, Kentucky taxes the DST income as a resident, with credit for tax paid to other states, but never revisits the original Kentucky gain.