Tax Implications When a 1031 Exchange Fails

A 1031 exchange allows real estate investors to defer capital gains taxes when swapping one investment property for another. But what happens when an exchange doesn’t go as planned — and fails to meet IRS requirements?

When a 1031 exchange fails, the sale is treated as a taxable event. That means the entire gain from the sale becomes immediately subject to capital gains tax — and potentially depreciation recapture — as if no exchange had been attempted.

Common Reasons for a Failed Exchange

• Missed deadlines: Not identifying a replacement property within 45 days or not closing within 180 days.

• Receiving cash (“boot”): Taking possession of sale proceeds before completing the exchange.

• Improper property type: Acquiring property that doesn’t qualify as “like-kind.”

• Using unqualified intermediaries: Working with an entity that doesn’t meet IRS safe harbor rules.

What You Can Do

If your exchange fails, your qualified intermediary will release your sale proceeds — but they’ll be taxable in the year of the sale. However, you may still offset part of the gain with deductions or losses from other investments.

To avoid this, plan ahead. Engage a qualified intermediary early, verify your replacement properties quickly, and always adhere to IRS timelines.

The Bottom Line
A failed 1031 exchange can lead to a hefty and unexpected tax bill. Proper preparation, professional guidance, and strict compliance with IRS rules are your best defense.

Thinking of selling an investment property? Learn how a 1031 exchange can help you preserve more of your profits — and reduce your tax exposure.