Is a 1031 exchange tax-free, or does the deferred tax come due later?

The IRS answers this question in its own fact sheet, twice

There is no ambiguity to resolve here, which is unusual in this area. FS-2008-18 opens with the statement that section 1031 "allows you to postpone paying tax on the gain" and that the deferred gain "is tax-deferred, but it is not tax-free."

It then repeats the point under a warning heading, noting that promoters of improper exchanges "typically ... are not tax professionals" and that "many promoters of like-kind exchanges refer to them as 'tax-free' exchanges not 'tax-deferred' exchanges."

If someone selling you a replacement property uses the phrase tax-free, that is a reason to look harder at everything else they have told you. How to judge whoever is advising you on the exchange is set out here.

Carryover basis is the machinery, and it means you paid something for the deferral

The deferral is not an exemption. Section 1031(d) hands the replacement property the relinquished property's basis, adjusted down for money you received and up for any gain you recognized, so the untaxed gain is simply re-parked in a low number.

That low basis is the deferred tax in physical form: it sits on your depreciation schedule and on the gain calculation for the next sale. The IRS fact sheet spells out the cost: "A collateral affect is that the resulting depreciable basis is generally lower than what would otherwise be available if the replacement property were acquired in a taxable transaction."

So the honest description is a swap. You keep the tax dollars working in real estate now and accept smaller depreciation deductions, and a larger eventual gain, in return. How the replacement is depreciated from that basis is covered here.

The bill arrives on the first cash exit, and it carries everything you deferred

The fact sheet is equally direct about when: "When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax."

Partial exits count in proportion. Cash or net debt relief you take at any point along the chain is recognized then, not at the end.

A broken exchange accelerates the whole thing rather than part of it. The fact sheet warns that taking control of cash or other proceeds before the exchange is complete "may disqualify the entire transaction from like-kind exchange treatment and make ALL gain immediately taxable."

What that final sale actually costs, layer by layer, is worked through here.

A hypothetical $500,000 deferral, priced three ways

Round hypothetical numbers make the choice concrete. You exchange out of a rental carrying $500,000 of deferred gain, of which $200,000 is the depreciation layer, and hold DST interests.

• Sell the DST interests for cash in five years and the $500,000 returns, $200,000 of it at the 25% maximum rate and $300,000 at long-term capital gain rates, plus the 3.8% surtax and state tax.
• Exchange again into new DST interests and nothing is due; the basis simply carries forward again.
• Hold until death and §1014 resets basis to the date-of-death value, so the $500,000 is never taxed as income at all.
• The 2026 estate side is separate: Rev. Proc. 2025-32 sets the basic exclusion amount at $15,000,000 per person for calendar year 2026, indexed from 2027.

Three ways the deferral becomes permanent, and what each one costs

Deferral turns into forgiveness only through the estate, but two intermediate routes keep the deferral alive while changing what you own.

Exchanging repeatedly is unlimited; each closing simply restarts the deadlines. How many times you can do it is answered here.

A section 721 contribution of DST-held real estate into an operating partnership converts your interest into units and ends the ability to do another 1031 with it, with tax triggered when units are redeemed. The mechanics are here and the one-way nature of it here. Estate and gift consequences differ by family and state, so confirm the plan with your CPA or attorney.

Deferred gain is reported, but it is not income on any line of your 1040

People often expect the deferral to show up as a phantom number somewhere. It does not.

Form 8824 is filed with the return for the year of the sale, and line 24 carries the deferred gain after subtracting any recapture and recognized gain. Nothing on line 24 flows to Schedule D or Form 4797.

What does flow is line 21 for recapture recognized now and line 22 for other recognized gain, and line 25 fixes your basis in the replacement. Line-by-line help for a simple exchange sits here, and the records to keep afterwards are listed here.

What the deferral is worth, and when it stops being worth it

The benefit is arithmetic rather than magic. Money that would have gone to the IRS this year stays invested in real estate instead, and keeps working there until the deferral ends or is stepped up away.

Three costs sit on the other side of that. The smaller depreciation deductions the IRS fact sheet warns about, the intermediary and acquisition costs of doing the exchange, and the loss of flexibility during the identification and exchange periods. What an exchange costs is set out here.

There is a behavioural cost too. Deferral only pays if the replacement is something you would have wanted regardless, which is why buying a property purely to finish an exchange so often converts a tax saving into a worse asset.

It stops paying altogether in a few recognisable cases: a small gain, a low bracket, a low-tax state, and fees that eat the saving. The same is true where the gain is mostly recent appreciation rather than depreciation, since there is no 25% layer to protect.

The side-by-side with simply paying the tax is here, and the low-bracket version of the question here.