A 1031 exchange lets you trade one investment property for another and defer the capital gains and depreciation recapture, as long as a qualified intermediary holds the sale proceeds in between. You have 45 days from closing to identify the replacement and 180 days to close on it. The gain isn't forgiven. Your old basis carries into the new property, and the tax follows it.
Most investors know the headline: sell one property, buy another, defer the tax. But the details underneath, the deadlines, the intermediary, the identification rules, the carryover basis, are what determine whether a 1031 actually works in practice. And they’re also what determine where cost segregation fits into the picture.
Here’s how a 1031 actually works, and where cost segregation can add value on both sides of the transaction.
What Is a 1031 Exchange?
Section 1031 of the Internal Revenue Code lets you sell real property held for investment or business use and roll the proceeds into other like-kind real property without recognizing the gain in the year of sale. That includes the capital gain and, in most cases, the depreciation recapture. The gain isn't forgiven.
The adjusted basis of the property you sell (the relinquished property) carries into the property you buy (the replacement property), and the deferred tax moves with it.
For exchanges completed after December 31, 2017, the Tax Cuts and Jobs Act limited §1031 to real property. Equipment, vehicles, furniture, and other personal property no longer qualify.
Many investors exchange repeatedly to trade up their portfolios and keep deferring. Under current law, if you hold the final replacement property until death, your heirs generally receive a step-up in basis and the deferred tax goes away entirely.
The 45-Day and 180-Day 1031 Exchange Rules
Two deadlines run the show. You have 45 days from the sale of the relinquished property to identify potential replacement properties in writing. You have 180 days from that sale to close on one of them (or by your tax return due date for that year, whichever comes first). These are calendar days. They don’t pause for weekends or holidays.
The identification has to be signed by you, delivered to your qualified intermediary or another party to the exchange who isn't a disqualified person, and describe each property unambiguously, by street address or legal description. A property you actually close on within the 45 days counts as identified.
Within that 45-day identification window, you pick one of three identification methods:
- 3-property rule: identify up to three properties, no value limit.
- 200% rule: identify more than three, but their combined fair market value can’t exceed 200% of the relinquished property’s value.
- 95% rule: identify any number, but you have to actually acquire 95% of the total identified value.
Miss the 45-day identification deadline or the 180-day closing deadline, and the exchange collapses into a taxable sale. There’s no extension or hardship exception.
The Qualified Intermediary and Cost Segregation Planning
You can’t touch the proceeds. The moment you take actual or constructive receipt of the funds from the sale, the exchange is blown. That’s where the qualified intermediary (QI) comes in.
The QI is a neutral third party that holds the sale proceeds between closings, handles the exchange documents, and keeps you inside the safe harbor in Treasury Regulation §1.1031(k)-1(g)(4). The exchange agreement with the QI has to be signed before the relinquished property closes. Investors who close first and look for an intermediary afterward have usually already taken constructive receipt, and the exchange is gone.
What Qualifies as Like-Kind
Like-kind is broader for real estate than most people realize. A small multifamily can be exchanged for a shopping center. Raw land can be exchanged for an office building. Nearly any real property held for investment or business use qualifies, as long as the replacement is also held for investment or business use. The one geographic limit: U.S. real property and foreign real property aren't like-kind to each other.
What doesn’t qualify: primary residences, property held for resale (like fix-and-flips or dealer inventory), and personal property of any kind.
Boot is anything you receive in the exchange that isn't like-kind real property, and it's taxable in the year of sale up to the amount of your gain. Cash you take out at closing is boot. So is debt relief: if the mortgage on the replacement property is smaller than the one you paid off, the difference counts as boot unless you offset it by adding cash of your own. To defer the full gain, buy replacement property of equal or greater value and reinvest all of your net equity.
Cost Segregation Before the Sale
If you’re planning a 1031 and haven’t run a cost seg study on the property you’re selling, there’s still time to do one, and it can be worth it.
If you've owned the property for years without a study, a look-back study filed with Form 3115 lets you claim the depreciation you missed as a single catch-up adjustment under §481(a), without amending prior returns. In a planned exchange, that adjustment can land in the year of the sale.
Whether and how much bonus depreciation that catch-up can include depends on when you originally acquired and placed the property in service, not on today's rate. As of 2026, 100% bonus depreciation applies to property acquired after January 19, 2025 and placed in service after that date. A building bought in 2019 is measured against the rules for 2019; one bought in 2023 or 2024 is measured against the phase-down rates of those years.
The extra depreciation lowers the adjusted basis you carry into the replacement property, so it's a timing benefit as there's a larger deduction now in exchange for less depreciation later. Whether the recapture on it is deferred depends on what you're trading into.
Components that are real property for §1031 purposes generally roll into the exchange. Components that aren't, such as appliances and furniture, are treated as sold for their share of the price, and that part of the gain is taxable. And under §1245(b)(4), even components that qualify as real property for the exchange can trigger ordinary-income recapture if the replacement property doesn't contain enough §1245 property to absorb it. That's the reason to model the relinquished property's component mix against the replacement's with your CPA before you list.
Cost Segregation After the 1031 Exchange
Once you close on the replacement property, you can run a cost seg study on it too. This is where the basis math matters. In a 1031, the replacement property’s depreciable basis splits into two parts:
- Carryover basis: the adjusted basis from the relinquished property, which continues its existing depreciation schedule.
- Excess basis: any additional investment above the relinquished property’s basis, typically from cash added or new debt. Cost seg on the excess basis works like a study on a regular acquisition. You identify short-life components, accelerate the depreciation, and potentially apply bonus depreciation.
On the carryover basis, the treatment is more nuanced and depends on how the study is structured and how your CPA handles it on the return.
There are two practical takeaways here:
- The bigger the step-up in value between the old and new property, the more excess basis you have to work with, and the more a cost seg study is worth running on the replacement.
- The projected deductions need to be modeled correctly. Applying cost segregation to the full purchase price of the replacement, as if it were a fresh acquisition, will overstate the benefit.
The Lazy 1031: Offsetting Passive Gain Without an Exchange
Another approach, sometimes called a lazy 1031 or 1031 lite, skips the exchange.
You sell, recognize the gain, and in the same tax year buy a different rental and run a cost seg study on it. Gain from selling a passive rental is passive income under IRC §469, and depreciation on a new rental is generally a passive loss, so the two can offset each other with no QI and no 45-day clock. If you qualify as a real estate professional or materially participate in a short-term rental, those losses aren't passive, and they can offset more than the sale.
It works because gain from the sale of a passive rental is passive income under IRS §469. Depreciation from a new rental property is a passive loss. The two can offset each other without a formal exchange, a QI, or a 45-day clock.
The tradeoffs compared to a formal 1031:
- You get a full fresh basis on the new property, which means more depreciation going forward versus the constrained carryover basis in a 1031.
- There’s no 45-day or 180-day deadline. You can buy when the right deal actually shows up.
- But the sale itself is still a taxable event. You need enough passive loss in the same year to absorb the gain. This approach tends to work well for investors rotating into syndications, making partial portfolio exits, or situations where the gain is modest enough that the friction of a formal 1031 isn’t worth it.
1031 Exchange vs. Lazy 1031
The 1031 is a strong tool when you want full deferral of a sizable gain, you’re staying in direct real estate, and you have a clear replacement property in mind. The lazy 1031 is a better fit when flexibility and timing matter more. Either way, cost segregation has a role to play. Before the sale, after the exchange, or on a new acquisition that offsets the gain.
The common thread is timing the deduction to the year you actually need it. If you’re planning a sale in the next 12 months, it’s worth modeling both paths before you commit. Get a free quote with Maven Cost Segregation.