The replacement property's tax basis is not its purchase price. It is the carryover basis from the relinquished property, adjusted for boot paid, boot received, gain recognized, and exchange expenses. Because that carryover basis sits below market value, it shrinks future depreciation deductions and leaves an embedded gain that is taxed if the property is later sold outside a 1031 exchange.
Why the replacement basis is not the purchase price
A client buys an $800,000 building and assumes their tax basis is $800,000. After a 1031 exchange, it can be less than half that.
That gap matters, because the replacement property's basis is the foundation for three separate calculations:
- Depreciation deductions in future years
- Gain or loss if the property is ever sold outside a 1031 exchange
- The deferred gain that travels with the property
Get it wrong and the client is caught out - either by depreciation deductions that come in below what they penciled, or by a far larger gain than they expected when they sell.
Many practitioners treat the replacement property as a new purchase with a basis equal to its price. That is how basis works for property bought outside a 1031 exchange. Inside one, the price is not the basis. The basis carries over from the relinquished property, adjusted for a few specific items.
The carryover basis formula
New Basis = Adjusted Basis of Relinquished Property - Boot Received + Boot Paid + Gain Recognized + Exchange Expenses
Each piece:
Adjusted basis of the relinquished property. The original cost of the property sold, reduced by depreciation already taken and increased by capital improvements.
Boot received. Any non-like-kind value the client took out of the deal - cash, net debt reduction, personal property. It is subtracted because it is economic gain the client pocketed rather than reinvested.
Boot paid. Cash or debt the client added at the replacement closing beyond what the exchange proceeds and any new mortgage covered. It raises basis because it is fresh capital going in.
Gain recognized. If the client received boot and recognized gain on Form 8824, Part III, that recognized gain is added back. This is what prevents double taxation: the recognized gain is taxed now, and the rest of the gain stays deferred inside the basis.
Exchange expenses. The direct costs of running the exchange - qualified intermediary (QI) fees, 1031 advisor fees, documentation. These are capitalized into the investment, not deducted in the current year.
Worked example: from sale to new basis
Client B sells a rental held for 20 years, with two decades of depreciation behind it.
Relinquished property
- Original purchase price, 20 years ago: $450,000
- Accumulated depreciation: $140,000
- Adjusted basis: $450,000 - $140,000 = $310,000
- Sale price: $750,000
- Mortgage assumed by the buyer: $200,000
- Selling expenses (6% commission, attorney, title): $45,000
Replacement property
- Purchase price: $800,000
- New mortgage: $750,000
- Cash the client adds from savings: $50,000
- QI fees, paid separately by the client: $1,500
Step 1: Amount realized and realized gain
Amount realized = sale price + debt assumed by the buyer - selling expenses = $750,000 + $200,000 - $45,000 = $905,000
Realized gain = $905,000 - $310,000 = $595,000
Step 2: Boot
Mortgage boot arises only when the debt relieved on the old property exceeds the debt taken on the new one. Here the client replaced a $200,000 mortgage with a $750,000 mortgage, so debt went up: no mortgage boot.
The client kept none of the sale proceeds, so there is no cash boot. The $50,000 of personal savings added at closing is boot paid, which raises basis rather than triggering tax.
Total boot received: $0.
Step 3: Gain recognized
Recognized gain is the lesser of realized gain ($595,000) or boot received ($0), so $0. The entire gain is deferred.
Step 4: New basis
New basis = adjusted basis ($310,000) - boot received ($0) + boot paid ($50,000) + gain recognized ($0) + exchange expenses ($1,500) = $361,500
Step 5: Split basis between land and building
Depreciation runs on the building, not the land, so the $361,500 has to be allocated. Using the appraisal or the property tax assessment - say 30% land, 70% building:
- Land (non-depreciable): $361,500 × 30% = $108,450
- Building (depreciable): $361,500 × 70% = $253,050
Step 6: Annual depreciation
The $253,050 building basis is recovered over 27.5 years for residential rental or 39 years for non-residential commercial property.
- Residential: $253,050 / 27.5 = $9,201 per year
- Commercial: $253,050 / 39 = $6,489 per year
Now compare that to what the client assumes if they think basis equals the $800,000 price. At 70% building, that would be $560,000 of depreciable basis and $560,000 / 27.5 = $20,364 a year. The real figure, $9,201, is less than half.
The reason is the whole point of the exchange. Only $361,500 of the $800,000 is basis the client can depreciate. The rest is gain rolled forward from the old property, and deferred gain does not generate depreciation. The deferral is the benefit; lower depreciation is the price.
The embedded gain that comes with the property
After the exchange, the replacement property carries an embedded gain - the difference between what it is worth and its tax basis.
Market value: $800,000 Tax basis: $361,500 Embedded gain: $438,500
Sell the next day at $800,000 with no appreciation, and that $438,500 is taxable. And it only grows, because every year of depreciation lowers the basis further.
Say Client B holds for 10 years and takes $9,201 a year in depreciation, or $92,010 in total:
Adjusted basis after 10 years: $361,500 - $92,010 = $269,490 Market value, now up $50,000: $850,000 Gain if sold: $850,000 - $269,490 = $580,510
That figure is the original deferred gain plus a decade of appreciation, minus the basis the depreciation deductions consumed. The gain is taxed only if the property is sold outside a 1031 exchange during the client's life. At death the basis generally steps up to market value and the deferred gain is forgiven; the cases where it does not are rare.
Serial exchanges compound the gap
Each new exchange starts from the current adjusted basis, so the distance between market value and basis widens with every roll.
Pick up Client B 10 years later: adjusted basis $269,490, market value $850,000, ready to exchange again.
Sale price: $850,000 Adjusted basis: $269,490 Realized gain: $580,510
The client buys a second replacement for $900,000, this time with a smaller $300,000 mortgage, adds $50,000 of personal cash (boot paid), and pays $1,500 in exchange fees.
Because the old $750,000 mortgage is far larger than the new $300,000 one, debt drops by $450,000 - and that debt relief is mortgage boot:
Mortgage boot: $750,000 - $300,000 = $450,000 Cash boot: $0 Total boot: $450,000
Recognized gain: the lesser of $580,510 or $450,000, so $450,000 is taxed this year.
New basis = $269,490 - $450,000 + $50,000 + $450,000 + $1,500 = $320,990
Market value: $900,000 Embedded gain: $900,000 - $320,990 = $579,010
The basis is now about 36% of market value. More of the client's wealth sits in deferred gain, and less in capital they actually put in.
This is how investors who exchange for decades end up holding multimillion-dollar properties on low-six-figure bases. It is not an error; it is deferral doing exactly what it does. It is also why the step-up in basis at death matters so much to them: the accumulated gain is wiped out for their heirs.
Recordkeeping: what to keep, and for how long
Documents to keep
- Exchange agreement. The signed agreement among client, QI, and the other parties. It fixes the identification and receipt dates, property descriptions, and any special terms.
- Both closing statements. The HUD-1 or Closing Disclosure for the sale and for the purchase. These show the exact proceeds, debt payoff, costs, and where the money went.
- QI accounting statement. The intermediary's record of how funds flowed from sale to purchase - the paper trail behind every basis and boot number.
- Identification letter. The written identification of the replacement property, made within 45 days of the sale. It proves the client identified correctly and on time.
- Depreciation schedules. For the relinquished property (accumulated depreciation) and the replacement (starting basis and annual deductions). These should tie to Form 8824 and later returns.
- Form 8824, every copy. The form filed for the exchange year, plus any later ones for basis adjustments or related-party dispositions.
- Appraisal or property assessment. Support for the land-versus-building allocation.
- Title commitment and deed. Confirmation of ownership and property description for the replacement.
- Prior exchange documentation. For a serial exchanger, the carryover chain depends on records from every earlier exchange.
- Correspondence. Emails and letters with the QI, client, title company, lender, and CPA about the exchange, the basis math, and any changes.
How long to keep it
Keep records for as long as the client holds the replacement property, plus 3 to 7 years after they dispose of it.
The reasoning is the statute of limitations. An income tax return is generally open for 3 years. A substantial understatement of income - more than 25% - extends that to 6 years. Fraud carries no limit at all. Seven years is a safe target.
For serial exchangers, the clock does not start until the final property is sold outside a 1031 exchange or passed to heirs. Keep every prior exchange record until then.
Related-party exchanges. If Part II of Form 8824 was filed, keep the records at least 2 years from the exchange date to document the 2-year holding requirement. If a disposition triggered another Form 8824, keep those records too.
Basis worksheet for client files
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EXCHANGE BASIS CALCULATION WORKSHEET
Client: [name]
Relinquished Property: [description]
Replacement Property: [description]
Exchange Date: [date]
RELINQUISHED PROPERTY:
Original Cost Basis: $ [___]
Less: Accumulated Depreciation: $ [___]
Adjusted Basis at Sale: $ [___]
REALIZED GAIN:
Sale Price (gross): $ [___]
Add: Debt Assumed by Buyer: $ [___]
Less: Selling Expenses: $ [___]
Amount Realized: $ [___]
Less: Adjusted Basis: $ [___]
REALIZED GAIN: $ [___]
BOOT CALCULATION:
Mortgage Boot (Old Debt - New Debt): $ [___]
Cash Boot (cash kept, not reinvested): $ [___]
Proration Boot (if any): $ [___]
Closing Cost Boot (if any): $ [___]
TOTAL BOOT RECEIVED: $ [___]
RECOGNIZED GAIN:
Lesser of Realized Gain or Boot Received: $ [___]
DEFERRED GAIN: $ [___]
NEW BASIS CALCULATION:
Adjusted Basis of Relinquished Property: $ [___]
Less: Boot Received: $ [___]
Plus: Boot Paid (client's cash added): $ [___]
Plus: Gain Recognized: $ [___]
Plus: Exchange Expenses (QI fees, etc.): $ [___]
NEW TOTAL BASIS: $ [___]
ALLOCATION OF BASIS (if depreciable):
Land Percentage: [___]%
Building Percentage: [___]%
Land Basis (non-depreciable): $ [___]
Building Basis (depreciable): $ [___]
DEPRECIATION SCHEDULE:
Depreciable Basis: $ [___]
Recovery Period (27.5 yr or 39 yr): [___]
Annual Depreciation Deduction: $ [___]
EMBEDDED GAIN:
Market Value of Replacement: $ [___]
Tax Basis of Replacement: $ [___]
Embedded Deferred Gain: $ [___]
NOTES:
[space for any special items, prior exchanges, etc.]
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Related resources
- The basis figures as they land on the form: Form 8824 Advisor Walkthrough.
- How boot drives the calculation: Boot for Advisors: Cash Boot, Mortgage Boot, and Hidden Boot.
- The future tax cost of a low basis: Depreciation and 1031: Recapture, Section 1250, and Planning Notes.
- Model different scenarios with the Basis Tracking Calculator.
New basis is the old adjusted basis, minus boot received, plus boot paid, gain recognized, and exchange expenses. Document it with both closing statements, the QI accounting, the exchange agreement, depreciation schedules, and prior Forms 8824. For serial exchangers, basis carries forward through every exchange, widening the gap between market value and tax basis.
Frequently asked questions
Why does basis often surprise clients after exchanging?
Because the replacement property's basis is not its purchase price. A client who pays $800,000 expects a basis of $800,000, but in a 1031 exchange the basis is the carryover from the relinquished property (say $300,000), adjusted for boot. Add $50,000 of boot paid and the basis is $350,000, not $800,000. That means smaller depreciation deductions going forward. The tradeoff is deliberate: the client defers tax on the sale gain and accepts a lower basis and lower deductions in return.
How does boot paid or received affect basis?
Boot paid (cash or debt added at closing that is not borrowed against the replacement property) increases basis; boot received (net debt reduction or cash kept) decreases it. If a client adds $30,000 of personal cash at the replacement closing, basis rises $30,000; if the client receives $20,000 of mortgage boot (old debt minus new debt), basis falls $20,000. The formula tracks both: New Basis = Old Basis + Boot Paid - Boot Received + Gain Recognized +/- adjustments.
What documents should we keep for the workpapers?
Keep the exchange agreement, both closing statements (sale and purchase), the QI accounting statement, the identification letter, depreciation schedules for both the relinquished and replacement properties, Form 8824 for every year, any prior exchange documentation if this is a serial exchange, the title commitment, an appraisal or property inspection report for the land/building allocation, and correspondence with the QI, CPA, and client. Hold them for as long as the client owns the replacement property, plus 3 to 7 years after disposal, depending on statute-of-limitations exposure. For serial exchangers, keep every prior record until the final property is sold outside a 1031 exchange.
How does basis carry through serial exchanges?
On a second exchange (selling the first replacement and buying another), the basis carries forward again, with the current adjusted basis as the new starting point. The gap between market value and tax basis keeps widening. After three exchanges a client might own a $1 million property with a $300,000 basis and a $700,000 embedded gain. That is why the step-up in basis at death matters so much to serial exchangers: the accumulated gain is forgiven and heirs take a basis equal to fair market value.
What happens to basis at death (step-up)?
When the owner dies, the beneficiary's basis is stepped up to fair market value on the date of death, which erases the embedded deferred gain. If a property has a $300,000 basis and a $1 million market value, the heir inherits a $1 million basis, and a later sale at $1 million produces no reportable gain. The pattern for many very-high-net-worth investors is to defer gains through serial exchanges during life and let the embedded gain disappear at death.