When you sell a 1031 exchange property in a normal cash sale, the capital gain you deferred in the original swap comes due, along with depreciation recapture on every dollar of depreciation you’ve claimed. Depending on how many exchanges you’ve stacked and how long you’ve owned the properties, the combined federal bill can include a 25% recapture rate, capital gains at 15% or 20%, and an additional 3.8% net investment income tax. You do have alternatives to writing that check, and the right choice depends on your basis, your holding period, and your longer-term plans for the money.
Why the Tax Bill Is Bigger Than You Think
The reason a 1031 sale hits harder than a regular sale comes down to basis. When you bought your first investment property outright, your basis started at what you paid. When you exchanged into a replacement property, the basis from the property you gave up carried over to the new one. That carryover basis sits well below what the replacement property actually cost, because it reflects the gain you never paid tax on.
The formula is the cost of the replacement property, minus the gain you deferred, plus any gain you recognized from boot received during the exchange.1Internal Revenue Service. Publication 551 (12/2025), Basis of Assets If you deferred $300,000 in gain and bought a $600,000 replacement, you started at a $300,000 basis. That $300,000 gap is untaxed profit sitting on your books.
Then depreciation eats into the basis every year. Residential rentals depreciate over 27.5 years, commercial over 39. After a decade, the adjusted basis on a property that already started low can be a small fraction of what the property is worth on the market. The gap between sale price and adjusted basis is your taxable gain, and it’s usually much larger than the appreciation you experienced during the years you owned this particular property.
What You’ll Owe on the Sale
Total gain equals the net sale price (after commissions and closing costs) minus your adjusted basis. That total splits into two pieces, each taxed differently.
Depreciation Recapture at 25%
Every dollar of depreciation you claimed, including depreciation on earlier properties in the exchange chain, is taxed at a federal rate of up to 25%. The IRS calls this unrecaptured Section 1250 gain, and the 25% ceiling comes from the capital gains rate structure of the tax code.2Office of the Law Revision Counsel. 26 USC 1 – Tax Imposed Recapture is calculated first. If your total gain is $500,000 and you claimed $150,000 in depreciation over the years, that $150,000 comes off the top at 25%.
Long-Term Capital Gain
Whatever remains after recapture is long-term capital gain, taxed at 0%, 15%, or 20% depending on your taxable income. For 2026, the 20% rate begins above $545,500 for single filers and $613,700 for married couples filing jointly.3Internal Revenue Service. Topic No. 409, Capital Gains and Losses Most investors land in the 15% bracket.
Net Investment Income Tax
On top of the rates above, higher-income investors owe an additional 3.8% on net investment income. The surtax applies to the lesser of your net investment income or the amount by which your modified adjusted gross income exceeds $200,000 (single), $250,000 (married filing jointly), or $125,000 (married filing separately).4Internal Revenue Service. Net Investment Income Tax Both the recapture and the capital gain count as investment income. So an investor in the 20% bracket effectively pays 23.8% on the capital gain portion and 28.8% on the recapture portion.
Suspended Passive Losses You Forgot You Had
Rental properties often generate paper losses that the passive activity rules block you from deducting in the year they occur. Those losses accumulate and carry forward. When you sell the property in a fully taxable transaction and dispose of your entire interest in the activity, those suspended losses are released and can offset the gain.5Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited
The key word is taxable. A 1031 exchange does not release suspended passive losses, except to the extent you recognize gain from boot. If you’ve been carrying substantial losses forward, a straight sale can be more tax-efficient than another exchange, because those losses are only useful against gain you actually report.
How Long You Should Hold Before Selling
The statute requires that replacement property be held for investment or productive use in a trade or business, but it doesn’t set a minimum holding period.6Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment Sell too quickly and you invite the IRS to ask whether you ever had investment intent.
Most tax advisors treat two years as a practical safe harbor, borrowing from the two-year holding rule that applies to related-party exchanges in the same section. If the IRS concludes you lacked investment intent, it can retroactively disallow the original exchange, making the deferred gain taxable in the earlier year, with interest and possibly penalties. Exceptions apply for circumstances outside your control, such as condemnation, casualty loss, or the investor’s death.
Deferring or Reducing the Tax
Roll Into Another 1031 Exchange
The most common approach is not to sell at all in the conventional sense. Use the current replacement property as the relinquished property in a new exchange and continue deferring. The same rules apply: identify replacement properties within 45 days, close within 180 days (or by your tax return due date, whichever comes first), use a qualified intermediary to hold the proceeds, and use the new property for investment or business.7Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031
Each successive exchange compounds the deferred gain. The new property inherits the carryover basis, adjusted for any new gain. After several exchanges, the basis can be a small fraction of market value, and the accumulated liability follows the investor as long as they hold real estate.
Sell on Installment
Carrying a note from the buyer instead of taking full cash at closing can qualify the sale for installment treatment. You report the capital gain proportionally as you receive payments, spreading the tax across years.8Internal Revenue Service. Topic No. 705, Installment Sales There’s a significant limitation: depreciation recapture cannot be spread out. The full 25% recapture bill is due in the year of sale regardless of how much cash you’ve actually collected. Only the long-term capital gain portion defers. You report installment income on Form 6252 each year payments come in.9Internal Revenue Service. About Form 6252, Installment Sale Income
Move In and Try for the Section 121 Exclusion
Section 121 shields up to $250,000 in gain ($500,000 for married couples filing jointly) on the sale of a principal residence.10Internal Revenue Service. Topic No. 701, Sale of Your Home The strategy works with a 1031 property, but with two big limitations.
Property acquired through a 1031 exchange cannot be sold under Section 121 during the five years following the acquisition date. That’s a flat lockout regardless of when you move in.11Office of the Law Revision Counsel. 26 USC 121 – Exclusion of Gain From Sale of Principal Residence You also still need to have lived in the home for at least two of the five years before sale.
Even after clearing both hurdles, you don’t exclude the whole gain. The gain is allocated between qualified use (residence) and nonqualified use (investment), and only the residence portion qualifies. If you rented the property six years and lived in it four, only four-tenths of the gain is eligible. Depreciation recapture is never eligible for Section 121 and remains taxable.
Hold Until Death for the Step-Up
Under current law, property included in a decedent’s estate receives a new basis equal to fair market value at the date of death.12Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent That wipes out the entire chain of deferred gain and all accumulated depreciation recapture. Heirs can sell shortly after inheritance with little or no capital gains tax.
For an investor who chained several exchanges over decades and deferred seven figures of gain, the step-up eliminates that liability entirely. It’s the reason many advisors structure their clients’ real estate around never making a final taxable sale. The step-up has been a recurring legislative target, though, so anyone banking on it should plan with some flexibility.
State Taxes Add Another Layer
Most states with an income tax also tax capital gains, and rates and rules vary. Some conform to federal 1031 treatment and defer at the state level; others impose their own requirements. Many states require withholding from real estate sale proceeds when the seller is a nonresident, typically ranging from about 2% to 9% of the sale price, though some calculate withholding on estimated gain instead. If you exchanged across state lines, you may owe tax in the state where the property sits, with a credit in your home state for tax paid elsewhere. A tax advisor who knows both state systems is worth the fee in these situations.
Reporting the Sale
The sale requires two main forms attached to your return. Form 4797 reports the transaction, with Part III separating the depreciation recapture taxed at 25%. The remaining long-term capital gain flows to Schedule D.13Internal Revenue Service. Instructions for Form 4797, Sales of Business Property The basis you report has to trace back to the carryover basis established on the Form 8824 you filed for the original exchange, adjusted for every year of depreciation since.
If you’ve done multiple exchanges, you’re unwinding years of deferred transactions in a single filing. Reconstructing exchange histories after the fact is expensive, and gaps in the record usually cost you money because you can’t document a higher basis. If you used the installment method, add Form 6252 for the year of sale and each year you receive payments. Everything attaches to your Form 1040.