What Taxes Are Deferred Through a 1031 Exchange?
A 1031 exchange lets real estate investors defer certain taxes. To qualify, they must sell an investment property and reinvest the proceeds into another like-kind property, meaning a property held for business or for investment. Understanding which taxes are deferred and how to calculate your potential tax liability is crucial for anyone considering this investment strategy.
The Four Levels of Taxes Deferred in a 1031 Exchange
- Depreciation Recapture Tax: Depreciation is the reduction in a property’s value over time due to wear and tear. When you sell a property, the IRS “recaptures” the accumulated depreciation you claimed at a 25% rate. This tax applies solely to improvements made to real estate, not to land itself, since land does not depreciate.
- Federal Capital Gains Tax: Capital gains are the profits you make when you sell a property for more than you paid for it. Short-term gains apply to property held for one year or less. These gains are taxed at ordinary federal income tax rates (up to 37%). Long-term gains apply to property held for more than one year and receive preferential tax rates of either 15% or 20%, depending on income and filing status. As of 2026, single filers with a taxable income greater than $545,500 and married couples filing jointly with over $613,700 in taxable income are subject to the 20% tax rate, while taxpayers below these thresholds are taxed at 15%.
- State Income Tax: State income tax rates vary from 0% to 13.3%, depending on where your property is located. Since state laws differ, always check with a qualified tax advisor to determine the state-specific tax requirements that will affect your transaction.
- Net Investment Income Tax: The Net Investment Income Tax (NIIT) is a 3.8% federal tax on net investment income, such as capital gains and rental income. It applies only if your modified adjusted gross income is above $200,000 for single filers or $250,000 for married taxpayers filing jointly. The NIIT applies only to the portion of income that exceeds these income thresholds.
Tax Liability Formulas
Use the following formulas to estimate the taxes from your property sale that could be deferred with a 1031 exchange.
First, calculate your adjusted cost basis.
Adjusted Cost Basis = Original Purchase Price
+ Capital Improvements
– Depreciation
Next, use the previously calculated adjusted cost basis to determine your capital gains.
Capital Gains = Sales Price
– Closing Costs (commissions, fees, etc.)
– Adjusted Cost Basis
Tax due is the total tax liability you would owe if you do not utilize a 1031 exchange.
Total Tax Due = Depreciation Recapture (Accumulated Depreciation x 25%)
+ Federal Capital Gain Tax (Capital Gains x 15% or 20%)
+ State Tax (up to 13.3%)
+ Net Investment Income Tax (Net Investment Income x 3.8%)
Calculating your exact tax liability can be complex and depends on your unique situation. For a quick estimate of the taxes you could defer with a 1031 exchange, use Land 1031’s online calculator. Always consult a qualified tax advisor to understand the precise tax implications for your specific real estate transaction.
If you have questions about whether a 1031 exchange is right for you and your property, email our 1031 team at info@land1031.net or click here for more information!
