A 1031 exchange defers federal capital gains taxes and depreciation recapture taxes. However, state tax treatment varies significantly. Some states fully conform to federal 1031 exchange rules; others have their own requirements or do not recognize 1031 exchanges at all.
Federal Tax Deferral
A properly executed 1031 exchange defers: (1) federal long-term capital gains tax (currently 20% for most investors, plus a 3.8% Net Investment Income Tax for high earners); and (2) depreciation recapture tax (25% on the amount of depreciation previously taken).
- Long-term capital gains: 0%, 15%, or 20% depending on income
- Net Investment Income Tax: 3.8% for high earners
- Depreciation recapture: 25%
- All deferred — not eliminated — until the replacement property is sold
State Tax Considerations
Most states conform to federal 1031 exchange rules, but some states have additional requirements or clawback provisions. For example, some states require you to file a notice when exchanging out of state. Contact us to discuss the state-specific requirements for your exchange.
The Step-Up in Basis at Death
If you hold your replacement property until death, your heirs receive a stepped-up cost basis equal to the fair market value at the time of death. This effectively eliminates the deferred capital gains tax permanently — making 1031 exchanges a powerful estate planning tool.
Frequently Asked Questions
A properly executed 1031 exchange defers federal long-term capital gains tax (0%, 15%, or 20% depending on income), the 3.8% Net Investment Income Tax for high earners, and depreciation recapture tax at 25%. State capital gains taxes are also deferred in most states.