Can You Defer a Loss Using a 1031 Exchange? Understanding the Strategy and Its Implications

Many real estate investors are familiar with using a 1031 Exchange to defer capital gains taxes on the sale of investment property. But what happens when the property you’re selling has declined in value? Can a 1031 Exchange help defer—or even avoid—a loss?

In short: yes, it can. But whether it should is another matter entirely.

Here’s what investors need to understand about deferring losses using a 1031 Exchange, and how this fits into the bigger picture of long-term investment and tax planning.

1031 Exchanges as a Wealth-Building Tool

At its core, a 1031 Exchange allows an investor to defer capital gains taxes by reinvesting the proceeds of a sale into “like-kind” replacement property. Over time, this strategy can help build wealth by preserving more capital to reinvest and compound.

Rather than cashing out and taking a tax hit with each transaction, the 1031 Exchange allows investors to keep their money working in real estate. Eventually, some investors even hold properties until death, allowing heirs to benefit from a step-up in basis.

Can You Defer a Loss on the Sale of Investment Property?

Yes—but there’s a catch.

A properly structured 1031 Exchange defers both gains and losses. That means if you sell a property for less than your adjusted basis (i.e., at a loss), and exchange it for another like-kind property, you will not be able to deduct the loss at the time of the exchange.

Instead, the loss is essentially carried forward as part of the basis in the replacement property. In other words, the tax benefit of that loss is deferred until you sell the replacement property in a taxable transaction.

So while the IRS does allow loss deferral through a 1031 Exchange, it does not allow you to deduct a loss if you’re rolling into another investment.

Why Would You Defer a Loss?

On the surface, deferring a loss might seem counterintuitive—after all, wouldn’t you rather deduct the loss and potentially lower your tax bill now?

In some cases, yes. But there are a few reasons an investor might still choose to structure a 1031 Exchange even when the property is being sold at a loss:

• They want to stay invested in real estate and continue building their portfolio.

• They anticipate future appreciation in the new replacement property.

• They want to avoid triggering depreciation recapture and other unfavorable tax outcomes by exiting the real estate market entirely.

• They are planning for long-term estate benefits, such as a step-up in basis for heirs.

Structuring a 1031 Exchange Still Defers Gain or Loss

It’s important to remember that the deferral mechanism of a 1031 Exchange applies to both ends of the equation. Whether your relinquished property has appreciated or depreciated, a properly structured exchange will preserve your adjusted basis and carry it into the replacement property.

This makes the exchange a neutral vehicle in terms of immediate tax outcomes—but a powerful one for long-term planning.

Know the Tax Consequences Before Moving Forward

Before entering into a 1031 Exchange involving a loss, it’s crucial to understand the implications:

• You lose the immediate tax deduction that a sale at a loss would generate.

• The basis in your replacement property will reflect the carried-over loss, which may lower your depreciation deductions.

• If you eventually sell the replacement property without using another exchange, your tax position (and potentially, your loss deduction) will come back into play.

In some scenarios, investors may be better off not exchanging when a loss is involved—especially if they want to take advantage of a current-year deduction to offset other income.

Is Deferring a Loss Right for You?

Using a 1031 Exchange to defer a loss can make sense in the context of a long-term wealth-building strategy, but it’s not always the best move for everyone. The decision should be made carefully, with a full understanding of your basis, your income needs, and your investment goals.

Before proceeding, always consult with your CPA, tax advisor, and Qualified Intermediary to weigh your options. Tax deferral is a powerful tool—but it should be used intentionally, not automatically.