1031 Exchange for a Rental House

A $500,000 house with $100,000 of depreciation owes about $100,000 of federal tax on a cash sale

Take a hypothetical house bought for $200,000, depreciated by $100,000 and sold for $500,000. Your adjusted basis is $100,000, so the realized gain is $400,000 before selling costs, and $100,000 of that gain is unrecaptured section 1250 gain because it equals the depreciation you deducted.

The IRS taxes that $100,000 at a maximum 25%, or $25,000. The remaining $300,000 is long-term capital gain; in the 20% bracket that is $60,000, and the 3.8% net investment income tax on the full $400,000 adds $15,200, for $100,200 of federal tax.

California taxes capital gains as ordinary income with no lower rate, and its top bracket is 12.3% for 2025, so a Californian could add about $49,200, bringing the total to roughly $149,400. A completed exchange defers every one of those figures; the gain carries into the replacement property's basis instead of your tax bill.

• For tax years beginning in 2026 the 20% rate starts above $545,500 of taxable income for single filers and $613,700 for joint filers; below that the 15% rate applies and the federal total in this example drops to $85,200.
• The 3.8% surtax starts at $200,000 of modified AGI for single filers and $250,000 for joint filers; those thresholds are not indexed, and a $400,000 gain pushes most sellers past them in the year of sale.
• Adjusted basis is cost plus capital improvements minus depreciation allowed or allowable, so depreciation you should have claimed but did not still reduces basis.

You roll forward the whole net sale price, not just the gain

Full deferral is a purchase-price test and a cash test, not a gain test. The replacement real estate must cost at least the net sale price of the house, all cash held by the qualified intermediary must go into it, and any mortgage you pay off must be replaced with new debt or fresh cash.

Continue the example with a $150,000 mortgage and $30,000 of commissions and closing costs. Net sale price is $470,000 and the intermediary receives $320,000, so a fully deferred exchange means buying at least $470,000 of property using all $320,000 plus at least $150,000 of financing or your own cash.

Anything short of that is boot. Cash you keep and net debt you shed are money received on Form 8824, and gain is recognized up to the smaller of that boot or your realized gain, with the balance still deferred.

Three situations where paying the tax beats exchanging a small rental

The exchange is not always the better answer, because it costs intermediary fees, forces a 45-day search and defers rather than erases the tax. Run these tests before you commit.

• Your gain is small: if taxable income including the gain stays under the 0% capital-gain ceiling ($49,450 single, $98,900 joint for 2026), much of the gain owes no federal rate at all, though the 25% recapture layer still applies.
• You have suspended passive losses: section 469(g) frees them only when you dispose of your entire interest in a fully taxable transaction, so a completed exchange keeps them suspended while a cash sale releases them against the gain.
• The house was your home within the last five years: section 121 may exclude up to $250,000 ($500,000 joint) of gain outright, and Rev. Proc. 2005-14 lets you apply the exclusion first and exchange only the remainder.
• You need a large slice of the proceeds anyway: a partial exchange taxes the cash you keep first, and once most of the gain is being recognized the fees rarely justify deferring the rest.

Where $320,000 of equity from a rental house can go: more doors, a net-lease building or DST slices

Like-kind for real estate turns on nature, not grade or quality, so a rental house can be exchanged for a duplex, a small apartment building, raw land, a single-tenant retail building or a beneficial interest in a Delaware Statutory Trust. The common disqualifiers are property held primarily for sale, your own residence and real estate outside the United States.

Consolidating into a duplex or fourplex keeps you a landlord with more rent per roof; a triple-net lease building shifts taxes, insurance and repairs to the tenant; a DST makes the income passive and lets one house become fractional interests in several institutional properties. Rev. Rul. 2004-86 is the IRS ruling that treats a properly restricted DST interest as real property for section 1031.

Spreading the proceeds across several replacements is allowed under the identification rules: name up to three properties of any value, or any number as long as their combined value stays within 200% of the house's value, which is $1,000,000 on a $500,000 sale. See DST asset classes for what those trusts typically hold.

Replacing a $150,000 mortgage when you trade up from one house

Debt relief counts as money received, so the loan you pay off at closing has to be matched on the replacement side. Form 8824 nets the liabilities: the excess of debt the buyer took over the debt you assume, the cash you pay and the other property you give up is added to your boot.

You are not required to borrow. If the $150,000 payoff is replaced by $150,000 of your own savings on the purchase, the equation balances; if you buy into a DST that carries a non-recourse loan, the share of that loan allocated to your interest counts as debt you assumed.

Trading up into a $700,000 fourplex with a $380,000 loan satisfies both tests with room to spare; buying a $400,000 replacement for cash falls $70,000 short on price and produces taxable boot even though no money hit your account.

First-exchange mistakes that show up on single-family sales

Most failed house exchanges are procedural, and each one below is avoidable with a call before the listing goes live. Confirm the math on your own basis and bracket with your CPA or attorney before you list.

• Closing before you hire a qualified intermediary: once the title company wires proceeds to you, the safe harbor in Reg. 1.1031(k)-1(g)(4) is unavailable and the sale is taxable; the exchange agreement must exist before you transfer the deed.
• Selling the house furnished: personal property is not like-kind, so washers, furniture and other contents are taxed separately even though the 15% incidental-property rule spares you from identifying them.
• Moving into the replacement too soon: Pub. 523 says you cannot convert the replacement to a main home immediately, and section 121(d)(10) blocks the home-sale exclusion for five years after a 1031 acquisition.
• Buying out of state from California: FTB 3840 is due with the exchange-year return and every year after until the California-source gain is recognized; see the California rules.
• Changing who holds title: the taxpayer that sells must be the taxpayer that buys, so a house held in your name should not land in a multi-member LLC without planning.
• Missing day 45 or day 180: the periods run from the day you transfer the house, end at midnight, and are not extended for weekends or a slow lender; the deadline guide covers the calendar.