1031 Exchange for an Apartment Building

A 20-unit building bought for $1.5 million and sold for $4 million: three federal layers totaling about $780,000

Hypothetical: a 1970s building purchased in 2004 for $1,500,000 with $1,200,000 allocated to the structure has taken roughly $800,000 of 27.5-year depreciation, leaving an adjusted basis of $700,000. A $4,000,000 sale with $200,000 of commissions and closing costs realizes $3,800,000 and a gain of $3,100,000.

The first $800,000 of gain is unrecaptured section 1250 gain taxed at up to 25%, or $200,000. The remaining $2,300,000 is long-term gain at 20% at this size ($460,000), and the 3.8% net investment income tax on the full $3,100,000 adds $117,800, for about $777,800 before state tax.

A complete exchange defers all of it and the $700,000 basis carries into the replacement, where the exchanged portion keeps depreciating on the old 27.5-year schedule under Pub. 946 and only the added value starts a new schedule.

Cost segregation moved part of your 25% gain into ordinary income, and §1245(b)(4) decides how much the exchange defers

A cost segregation study reclassifies carpet, appliances, cabinetry and similar items as 5-year property; those items are section 1245 property, so on a sale the gain up to the depreciation you took on them is ordinary income rather than 25% gain. With 100% bonus depreciation restored for property acquired after January 19, 2025, owners who front-load deductions this way build a larger ordinary-income layer.

Two rules then apply inside an exchange. Personal property has not been like-kind since 2018, so whatever price the contract allocates to furniture, appliances and equipment is taxed in the year of sale regardless of the exchange.

For §1245 items that remain real property under the exchange regulations (fixtures and components that state law treats as part of the building), section 1245(b)(4) limits ordinary recapture to the gain you recognize plus the fair market value of non-§1245 property you receive. That limit does little for a seller who receives a plain building in return, so have the study and the replacement allocation reviewed together before closing; the Journal of Accountancy analysis of this problem is the standard reference.

Security deposits, prepaid rent and prorations come out of your pocket, not the exchange account

Tenant deposits and rent collected for days after closing are credited to the buyer on the settlement statement. Those credits are not exchange expenses: Reg. 1.1031(k)-1(g)(7) disregards commissions, transfer taxes and title fees, but deposits and prepaid rent are amounts you owe the buyer, and paying them from exchange proceeds is treated as cash received by you.

On a 20-unit building holding $30,000 of deposits and $20,000 of rent for the rest of the month, netting those $50,000 against the price creates $50,000 of taxable boot even though no money reached you. The fix is mechanical: wire the deposits and prorated rent to the buyer from your operating account, or deposit them into escrow before closing so the full contract price flows to the intermediary.

• Treated the same way when paid from the exchange account: loan payoff fees and prepaid interest, property-tax prorations, repair credits and outstanding assessments.
• Safe to pay from proceeds: the brokerage commission, the intermediary's fee, the owner's title policy, escrow and recording charges, and transfer taxes.
• Replacement-reserve accounts the old lender held are your cash, not sale proceeds; their release at payoff sits outside the exchange.

Full deferral on a $4 million sale: buy at least $3.8 million and replace at least the $1.2 million loan

With a $1,200,000 loan payoff, the intermediary receives $2,600,000. The replacement must cost at least $3,800,000, absorb all $2,600,000 and carry at least $1,200,000 of debt or added cash; anything less is boot recognized up to the realized gain.

Form 8824 computes recognized gain as the smaller of realized gain or boot; the character of that gain (recapture versus capital gain) is then worked out on Form 4797 and Schedule D, so a partial exchange on a heavily depreciated building rarely produces cheap boot.

A DST that holds a mortgaged property allocates a share of that non-recourse loan to each investor, and that share counts toward the debt you must replace; a trust financed at 50% lets $2,600,000 of equity carry $2,600,000 of allocated debt, more than covering the payoff.

Four passive landing spots that keep you in apartments: a managed building, NNN, a multifamily DST, and the 721 door

Buying a newer, larger building and hiring a third-party manager keeps control and depreciation in your hands but leaves you the lender's guarantor and the decision-maker on every capital call. A triple-net property replaces tenants with one corporate lease, at the cost of single-tenant concentration.

A multifamily DST delivers fractional ownership of institutional apartment communities with sponsor management; Rev. Rul. 2004-86 treats the interest as real property because the trustee cannot renegotiate leases, borrow, reinvest or accept new capital. How the sponsor runs the trust is the diligence that matters.

If a DST you hold later contributes its property to a REIT operating partnership under section 721, the contribution itself is tax-free but it ends your 1031 options: partnership interests are not real property under Reg. 1.1031(a)-3, so operating partnership units cannot be exchanged again.

Three things the exchange does not fix: suspended losses, state tracking, and the old depreciation schedule

Check the cost-segregation, deposit and passive-loss treatment with your CPA or attorney before the purchase agreement is signed; each item below changes the sell-versus-exchange comparison.

• Suspended passive losses stay suspended: section 469(g) releases them only on a fully taxable disposition of your entire interest, so in a completed exchange they carry forward against the replacement's income, while a cash sale releases them against the gain.
• California-source gain follows you: if the building is in California and the replacement is not, FTB 3840 is due with the exchange-year return and every year until the deferred gain is recognized; see California.
• Depreciation restarts only on the new money: the carried-over basis continues on the relinquished building's remaining schedule, so a fully depreciated 1970s building brings little depreciation into the replacement unless you trade up.
• The 80% test still applies: a building is 27.5-year residential rental property only while at least 80% of gross rents come from dwelling units, so ground-floor retail can change the class without changing like-kind status.