Modeling the 1031: Boot, Basis Carryover, and Deferred Gain

Key Takeaways

Why the Math Matters

Every 1031 exchange produces a specific numerical result: how much gain was deferred, how much was recognized (taxed), what the new property's depreciable basis is, and how that basis gets depreciated going forward. These aren't academic questions. They determine the after-tax IRR of the replacement property, the depreciation deductions available to offset operating income, and the embedded tax liability that will eventually come due, whether at the next disposition, a partnership dissolution, or death.

The concepts of boot (the taxable portion) and basis carryover (the reduced depreciable basis) are familiar. Modeling them correctly in a pro forma is harder. The errors compound: an incorrect basis flows into an incorrect depreciation schedule, which produces an incorrect after-tax cash flow, which generates an incorrect IRR. A fund that ignores the embedded deferred gain overstates the after-tax return its LPs will actually realize.

This article covers the formulas, the bifurcation mechanics, and how to wire them into a disposition waterfall. The worked examples use illustrative numbers, and each one ties out from its own inputs.

Boot Calculation

Boot is the non-like-kind consideration received in an exchange: anything the exchanger gets that isn't qualifying real property, as defined in IRC Section 1031(b). Boot is taxable to the extent of the realized gain. There are two components:

Cash boot

Cash boot is exchange cash not reinvested in the replacement property. Compare cash to cash. If you sell for $40M, net $38.5M after closing costs, and pay off a $20M mortgage, the QI holds $18.5M. If you buy a $35M replacement with a new $20M mortgage, you need only $15M of that cash. The $3.5M left over is cash boot.

Formula: Cash Boot = max(0, Cash Held by QI – Cash Invested in Replacement Property)

Mortgage boot

Mortgage boot arises when the debt on the relinquished property exceeds the debt on the replacement property. Debt relief is treated as boot received. If you pay off a $20M mortgage on the relinquished property and take on only a $15M mortgage on the replacement, the $5M difference is mortgage boot.

Formula: Mortgage Boot = max(0, Debt Relieved – Debt Assumed – Additional Cash Paid), where Additional Cash Paid is new cash invested beyond the QI balance

Critically, mortgage boot can be offset by adding cash. If you owe $20M on the relinquished property and assume only $15M on the replacement, you can add $5M of additional cash to eliminate the mortgage boot. The IRS nets cash contributed against debt relief, but only in one direction. Liabilities assumed offset liabilities relieved under Treasury Regulation 1.1031(b)-1(c). Cash paid also offsets liabilities relieved, but liabilities assumed do not offset cash received, under Treasury Regulation 1.1031(d)-2 (Example 2(c)). You cannot use excess debt assumption to offset cash boot.

Total taxable boot

Formula: Total Boot = Cash Boot + Mortgage Boot (additional cash paid reduces mortgage boot; excess debt assumed never reduces cash boot)

Exchange expenses also reduce boot. The Instructions for Form 8824 (line 15) reduce the sum of cash received, other property received, and net liabilities assumed by the other party (but not below zero) by any exchange expenses incurred. In the example above, the $1.5M of closing costs (treated here as exchange expenses) is already netted out of the $18.5M.

Boot is taxable to the extent of the realized gain. If your realized gain is $21.5M and your total boot is $3.5M, you recognize $3.5M of gain. If your boot exceeds your gain (unusual but possible in low-gain scenarios), you recognize gain only up to the gain amount. Boot cannot create a loss.

Basis Carryover and Excess Basis

The replacement property's tax basis is not its purchase price. Under IRC Section 1031(d) and Treasury Regulation 1.1031(d)-1, the basis carries over from the relinquished property, adjusted for money received, gain recognized, and additional consideration paid. This produces a basis that is lower than the amount paid, sometimes substantially lower after serial exchanges.

The formula

Statutory form: Replacement Basis = Adjusted Basis of Relinquished Property – Money Received (including liabilities relieved) + Gain Recognized + Additional Consideration Paid (new cash and liabilities assumed)

Shortcut: Replacement Basis = Purchase Price – Deferred Gain

The two forms give the same answer. Use one or the other. The shortcut already reflects boot, so subtracting boot again double counts it. The statutory form is the better audit check because every input comes straight from the closing statements.

For depreciation, Treasury Regulation 1.168(i)-6 splits the replacement basis into two components:

• Carryover (exchanged) basis: The lesser of the basis in the replacement building (the depreciable MACRS property, after land is allocated out) or the relinquished building's adjusted depreciable basis at the time of exchange. This represents the "old" investment that carries forward.
• Excess basis: Any replacement building basis above the exchanged basis. It generally tracks the new investment above the relinquished property's equity (added cash, or new debt above the debt relieved), after land is allocated out.

Total Replacement Basis = Carryover Basis + Excess Basis

Worked example

Relinquished property: purchased for $25M, accumulated depreciation $8M, adjusted basis $17M, sold for $40M less $1.5M closing costs = $38.5M amount realized (which includes the $20M of mortgage relief). Realized gain = $38.5M – $17M = $21.5M.

Replacement property: purchased for $35M with $15M of QI cash and a new $20M mortgage. Boot received: $3.5M of cash (from the prior example). Gain recognized: $3.5M (boot is taxable to the extent of gain, and gain exceeds boot).

Deferred gain: $21.5M – $3.5M = $18M.

Replacement basis, statutory form: $17M old basis – $3.5M cash received – $20M liabilities relieved + $3.5M gain recognized + $20M new mortgage = $17M. Shortcut: $35M – $18M = $17M.

The replacement basis equals the old adjusted basis. That's not a coincidence. The gain recognized exactly offsets the cash boot, and the new mortgage exactly replaces the debt relieved. None of the $17M is new investment. For depreciation, the exchanged/excess split is made at the building level: after land is allocated out of the $17M, the replacement building's basis is compared with the relinquished building's adjusted depreciable basis (Treas. Reg. 1.168(i)-6(b)(7) and (b)(8)).

Now change one input. Suppose the exchanger reinvests all $18.5M of QI cash, adds $1.5M of new cash, and keeps the same $20M mortgage to buy a $40M replacement. There is no boot. Statutory form: $17M – $20M + $0 + $20M + $1.5M = $18.5M. Shortcut: $40M – $21.5M = $18.5M. The $1.5M of added cash is new investment. At the building level, whatever part of the replacement building's basis exceeds the relinquished building's adjusted depreciable basis is excess basis that gets its own depreciation schedule (see the Post-Exchange Depreciation example below).

Deferred Gain Tracking

Institutional portfolios can contain properties that have been through two, three, or more sequential 1031 exchanges. Each exchange compounds the deferred gain and reduces the basis further. Tracking this is essential for three reasons:

1. The deferred gain is an embedded liability. It comes due when the property is eventually sold in a taxable transaction. Section 1031 defers recognition; it does not eliminate it, as IRS Publication 544 (Sales and Other Dispositions of Assets) makes explicit. A property with $30M of cumulative deferred gain carries an embedded federal tax liability of about $7.1M to $8.6M: 23.8% (20% plus 3.8% NIIT) if none of the gain is unrecaptured section 1250 gain, up to 28.8% (the 25% maximum rate plus NIIT) if all of it is. State tax is extra. That liability must be factored into any disposition analysis.
2. LPs bear it. In a partnership, a taxable sale passes the recognized gain through to the partners, so limited partners need the deferred gain figure for their own tax planning.
3. Exit strategy depends on it. A property with $40M of deferred gain may never be sold in a taxable transaction. The fund will exchange it again or contribute it to an UPREIT via Section 721. For property held directly by an individual (or a disregarded entity), holding until death gives the heirs a basis equal to fair market value under IRC Section 1014. For property held in a partnership, a partner's death does not adjust the partnership's basis in the property unless a section 754 election is in effect (or the partnership has a substantial built-in loss), under IRC Section 743. The size of the deferred gain drives the exit strategy.

Serial exchange example

Exchange 1: Buy Property A for $10M. Sell for $20M (adjusted basis $7M, gain $13M). Exchange into Property B for $20M. Property B basis: $20M – $13M = $7M.

Exchange 2: Sell Property B for $35M (adjusted basis after depreciation: $5M, gain $30M). Exchange into Property C for $35M. Property C basis: $35M – $30M = $5M.

Property C was purchased for $35M but has a tax basis of $5M and an embedded deferred gain of $30M. Assuming a 20% land allocation, the depreciable basis is about $4M, on a property that a market buyer would depreciate at $28M. Over the building's life, the exchange owner deducts $24M less. Spread evenly over 39 years, that is about $615K a year of lost deductions. For illustration, at an assumed 37% marginal federal rate, it costs about $228K a year of after-tax cash flow. The actual year-by-year timing depends on the carryover basis's remaining recovery period.

The embedded tax: Property A lost $3M of basis to depreciation and Property B lost $2M, so $5M of the $30M is depreciation-driven. Assuming that depreciation was straight-line and Property C is sold at its $35M cost before further depreciation, a taxable sale owes $5M × 25% (maximum rate on unrecaptured section 1250 gain) + $25M × 20% + $30M × 3.8% NIIT = $7.39M, or about $7.4M of federal tax, before state tax.

Post-Exchange Depreciation

The replacement property's depreciable basis is not a single number on a single schedule. After a 1031 exchange, depreciation is bifurcated into two components that follow different rules:

Carryover basis depreciation

The carryover basis (the building basis up to the relinquished building's adjusted depreciable basis) continues depreciating on the relinquished building's remaining recovery period, using the same method and convention, when the old and new buildings share the same recovery period and method (Treas. Reg. 1.168(i)-6(c)(3)(ii)). If the relinquished property was a 39-year commercial building placed in service 12 years ago, the carryover basis has 27 years of remaining life. The depreciation schedule doesn't reset. Different rules apply when the recovery periods differ, for example a 27.5-year residential building exchanged for a 39-year commercial one (Treas. Reg. 1.168(i)-6(c)(4)).

A market buyer would start a fresh 39-year schedule on the full purchase price (less land). The exchange buyer continues the old schedule on the lower carryover basis. Over the full recovery period, the exchange buyer deducts less, because the total basis is lower. In any single year the gap can be smaller, because the carryover basis is recovered over a shorter remaining period.

Excess basis depreciation

If the exchanger invested more than the relinquished property's equity (additional cash, or new debt above the debt relieved), the excess creates new basis that starts a fresh depreciation schedule. The excess basis is depreciated as if the replacement property were newly placed in service: 39 years for commercial real property, 27.5 years for residential rental property, using the applicable method and convention.

Example

Relinquished property: commercial office, 39-year straight-line life, placed in service 15 years ago. Building cost: $19.5M, or $500,000/year. Accumulated depreciation: $7.5M. Building adjusted basis: $12M. Remaining life: 24 years. Land basis: $3M. Total adjusted basis: $15M. Mortgage: $12M. Net sale price: $27M, so the QI holds $15M and the realized gain is $12M.

Replacement property: purchased for $35M with all $15M of QI cash and a new $20M mortgage. Land allocation: 20% ($7M). Building: $28M. No boot, so the full $12M gain is deferred. The new mortgage is $8M larger than the debt relieved, and that $8M of added debt is the only new investment. Replacement basis: $15M – $12M + $20M = $23M (shortcut: $35M – $12M = $23M).

The basis allocated to land is set under section 1031(d) and its regulations, and the land is not depreciated (Treas. Reg. 1.168(i)-6(d)(2)(i)). As a modeling convention, this example splits the $23M by relative value, using the same 20% land share as the purchase price. Land: 20% × $23M = $4.6M, which is never depreciated. Building: $18.4M. Exchanged basis is the lesser of the $18.4M building basis and the relinquished building's $12M adjusted depreciable basis, so $12M. Excess basis is the remaining $6.4M (80% of the $8M of added debt, with the other 20%, or $1.6M, going to land). The annual figures below are straight-line approximations that ignore the mid-month convention and the partial year of replacement.

Carryover basis (building): $12M, depreciated over the remaining 24 years = $500,000/year.

Excess basis (building): $6.4M, depreciated over a fresh 39 years = $164,103/year.

Total annual depreciation, years 1–24: $664,103. Years 25–39: $164,103.

Compare to a market buyer: $28M ÷ 39 years = $717,949/year. For the first 24 years the exchange buyer is about $54K a year behind ($717,949 – $664,103), because the carryover basis recovers faster (24 remaining years vs. 39) but the total depreciable base is smaller. Most of the $9.6M basis gap ($28M vs. $18.4M) shows up later: in years 25 through 39, when the carryover schedule has run out, and in a larger gain at sale. A model that lumps the $18.4M onto one 39-year schedule without electing out shows $471,795/year and understates early deductions by about $192K a year. The result depends on the specific numbers, not a rule of thumb.

Boot as a Decision Variable

Boot is usually framed as something to avoid. That framing is incomplete. Boot is a decision variable. Sometimes taking boot is the right economic answer.

Return to the first example: a fund sells for $40M, pays off a $20M mortgage, and the QI holds $18.5M. Realized gain is $21.5M. The acquisitions team identifies a $35M replacement that meets all investment criteria, which leaves $3.5M of cash boot. Avoiding boot entirely means spending all $18.5M of QI cash with at least $20M of new debt, so the fund needs a replacement of at least $38.5M. The only one available is marginally acceptable and trades at a 5.2% cap rate versus the target's 5.8%.

For illustration, assume the relinquished property's depreciation was all straight-line on real property, with no cost-segregated section 1245 components (recapture on those would be ordinary income). Then take the worst case on the boot: all $3.5M is taxed as unrecaptured section 1250 gain (the relinquished property carried $8M of depreciation). At the 25% maximum rate plus 3.8% NIIT, federal tax is about $1.0M. Now price the alternative. The $38.5M property's NOI is $2.0M (5.2% of $38.5M). Valued at the 5.8% cap rate the fund underwrites to, that NOI is worth about $34.5M, so paying $38.5M overpays by about $4.0M. Overpaying $4.0M to avoid $1.0M of tax destroys about $3.0M of value. The tax-efficient answer is to take the boot.

The framework: compare the tax cost of boot against the economic cost of avoiding it. If avoiding boot requires overpaying for a replacement property, accepting a lower-quality asset, or rushing into a deal before the 45-day deadline, the boot may be cheaper than the alternative.

Common Mistakes

• Using purchase price as depreciable basis. A frequent error in post-exchange pro formas. The replacement property's depreciable basis is the carryover basis plus excess basis, not the purchase price. Over the building's life, a $35M acquisition with a $17M basis generates roughly half the depreciation that a $35M taxable purchase would. If your model shows full depreciation on the purchase price, every after-tax metric is wrong.
• Netting cash boot against mortgage boot. The netting runs one way only. Excess debt assumption does not offset cash boot. You can offset mortgage boot by contributing additional cash, but you cannot offset cash boot by assuming more debt. This asymmetry is easy to get backwards.
• Ignoring depreciation bifurcation. Unless the taxpayer elects out under Treas. Reg. 1.168(i)-6(i), the carryover basis and excess basis must be depreciated on separate schedules with different remaining lives. Lumping them together on a single 39-year schedule understates depreciation in the years the carryover schedule is still running.
• Forgetting that exchange expenses reduce boot. IRS Publication 544 treats closing costs paid on the disposition (such as brokerage commissions, attorney fees, and deed preparation fees) and closing costs paid on the acquisition of the replacement property as exchange expenses, and Form 8824 (line 15) reduces boot by them. Property taxes, rent prorations, security deposits, and repairs on the closing statement are not exchange expenses. Leaving exchange expenses out overstates taxable boot and the tax liability.
• Not tracking cumulative deferred gain across serial exchanges. Each exchange adds to the deferred gain. A property that has been through three exchanges may carry $40M+ of deferred gain that will come due at the next taxable event. If the portfolio manager doesn't track this, exit strategy analysis is based on incomplete information.
• Treating the exchange as tax elimination rather than tax deferral. Section 1031 defers gain. It doesn't eliminate it. The deferred gain is embedded in the replacement property's basis and will be recognized at the next taxable disposition (unless the property is exchanged again, contributed under Section 721, or, for property held directly by an individual (or a disregarded entity), held until death for a basis step-up under Section 1014; for property held in a partnership, the inside-basis step-up requires a section 754 election under Section 743(b)). Modeling an exchange as a permanent tax benefit overstates the after-tax return.
• Neglecting cost segregation on excess basis. The excess basis component of a replacement property is eligible for a cost segregation study, which can accelerate depreciation by reclassifying components to shorter recovery periods (5, 7, or 15 years). The carryover basis retains its original classification. Bonus depreciation follows the same split: OBBBA restored 100% bonus depreciation for qualified property acquired after January 19, 2025 (IRS Notice 2026-11), but when the replacement property is used property, only the excess basis is eligible, not the exchanged basis (Treas. Reg. 1.168(k)-2(g)(5)(iii)(A)). Missing this opportunity leaves depreciation deductions on the table.

How to Model It

A 1031 exchange model needs to flow from the disposition through the exchange and into the replacement property's operating pro forma. Here's what each section requires:

Disposition tab

Sale price, closing costs (brokerage, transfer tax, legal), net proceeds to QI, adjusted basis of relinquished property (original cost less accumulated depreciation), realized gain, unrecaptured section 1250 gain (gain up to accumulated straight-line depreciation, taxed at a maximum 25% under IRC Section 1(h)(1)(E) and 1(h)(6)), and remaining capital gain (taxed at a maximum 20%). Both pieces also carry the 3.8% Net Investment Income Tax under IRC Section 1411 for applicable taxpayers. State tax is separate. The exchange must be reported on IRS Form 8824 (Like-Kind Exchanges) attached to the taxpayer's return for the year of the relinquished property transfer.

Exchange tab

Net proceeds from QI, debt relieved on relinquished property, cash boot calculation, mortgage boot calculation (with offset logic), total boot, gain recognized (lesser of total boot and realized gain), deferred gain, replacement property basis calculation (purchase price minus deferred gain, checked against the Section 1031(d) build-up), and basis bifurcation (carryover vs. excess).

Replacement property depreciation tab

Two depreciation schedules running in parallel: carryover basis on the relinquished property's remaining life, excess basis on a fresh recovery period. Land allocation applied to total basis (not purchase price). The tab should show annual depreciation from each component and the combined total, year by year, for the projected hold period.

After-tax cash flow tab

NOI, debt service, before-tax cash flow, depreciation (from the bifurcated schedule), taxable income, tax liability, after-tax cash flow. The embedded deferred gain should be modeled as a contingent liability in the disposition year, either as a future tax at the expected exit or as a present-value adjustment to current-period returns.

The test of a good 1031 model: change the relinquished property's accumulated depreciation and watch the replacement property's after-tax IRR recalculate. If it doesn't (if the depreciation schedule and basis don't update), the formulas aren't properly linked.

Related Articles

This article is part of the 1031 exchange series. Each article covers a specific aspect of exchange structuring for institutional CRE portfolios:

• 1031 Exchange Mechanics: The 45-day and 180-day deadlines, three identification rules, and like-kind requirements post-TCJA.
• Reverse Exchanges: EAT/QEAA structures, Rev. Proc. 2000-37 safe harbor, and improvement exchanges at institutional scale.
• DST Replacement Property: When and how to use DST interests as identification backstops and passive replacement vehicles.
• 721 Exchange / UPREIT: Contributing exchanged property into a REIT operating partnership for liquidity and diversification.