The short answer
The deferred gain never sits in a separate account; it is built into the low basis your replacement carried over, so a fall in value simply shrinks it. Sell below what you paid and you usually still have a taxable gain, just a smaller one: every dollar of price decline cancels a dollar of the gain you deferred. You have a tax loss only if the sale price falls below your adjusted carried basis, and then a rental's loss is generally a section 1231 loss that can be ordinary. The depreciation reflected in that basis, including depreciation on the property you exchanged away, is still taxed at up to 25% to the extent there is gain.
At a glance
| Where the deferral lives | In the replacement's carried-over basis, under section 1031(d) |
|---|---|
| Price below purchase | Usually still a gain, reduced by the amount of the decline |
| Real tax loss | Only when the amount realized is below your adjusted carried basis |
| Character of a rental loss | Section 1231; ordinary if your section 1231 losses exceed gains for the year |
| Five-year lookback | A net section 1231 loss turns later section 1231 gains ordinary to that extent |
| 25% layer | Depreciation on this and earlier properties in the chain, to the extent of gain |
| Exchanging again | Section 1031 defers losses too, so a loss property is usually sold, not exchanged |
The deferred gain is embedded in a basis that is lower than your purchase price
Section 1031(d) gives the replacement 'the same' basis as the property you gave up, adjusted for money and recognized gain. The difference between what you paid and that carried basis is the gain you deferred; how the number is built is on basis in the replacement property.
When you later sell for cash, there is no line that brings the old gain back. You compute gain the ordinary way, amount realized minus adjusted basis, and the deferred gain is inside the result because the basis was never stepped up. That is why the general case is on the tax when you finally sell; this page covers the case where value has fallen.
A price decline cancels deferred gain dollar for dollar before it creates any loss
Because the basis is low, a sale below your purchase price normally still shows a gain. The decline does not disappear, though: it reduces that gain one-for-one. Part of the gain you deferred is never taxed, because the value that produced it no longer exists.
Only once the price falls below the adjusted carried basis does a loss appear. For many long-held chains that floor is far below today's prices, so a true tax loss is rare unless the property was bought with a high basis, such as a trade-up funded by a large amount of new cash or debt.
Worked example: a $200,000 price drop removes $200,000 of deferred gain
Hypothetical, round numbers, costs ignored; run your own numbers with your CPA. You sold a rental for $900,000 with an adjusted basis of $300,000 after $150,000 of depreciation, deferring $600,000. You bought a $900,000 replacement with that $300,000 basis and claimed $50,000 of depreciation on it, so its adjusted basis is now $250,000.
The market falls and you sell for $700,000, $200,000 below what you paid. Gain is $700,000 minus $250,000, or $450,000. Had the value held at $900,000, the gain would have been $650,000, so the decline erased $200,000 of gain.
The character still follows the depreciation. Section 1250(b)(3) counts depreciation 'whether in respect of the same or other property' reflected in the adjusted basis, so the $150,000 claimed before the exchange and the $50,000 since make $200,000 of unrecaptured section 1250 gain, taxed at a maximum of 25% under Topic 409. The other $250,000 is long-term capital gain, plus the 3.8% net investment income tax above $250,000 joint or $200,000 single modified AGI.
Now suppose the sale is $200,000. Amount realized is $50,000 below the $250,000 basis, so you have a $50,000 loss and all $600,000 of deferred gain is gone.
A true loss on a rental is usually a section 1231 loss, which can offset ordinary income
Rental real estate used in a trade or business is section 1231 property. Under section 1231(a)(2), when your section 1231 gains for the year do not exceed your section 1231 losses, they are not treated as capital, so a net loss is ordinary rather than limited the way capital losses are.
The cost comes later. Section 1231(c) treats net section 1231 gain as ordinary income to the extent of 'non-recaptured net section 1231 losses' from the five most recent preceding years. Plan any other property sales in that window with your CPA.
A fully taxable sale of your entire interest also releases suspended passive losses under section 469(g); see suspended passive losses and the 1031. Land held purely for investment is different: a loss on it is generally a capital loss, deductible against ordinary income only up to $3,000 a year ($1,500 married filing separately) under section 1211(b).
Do not exchange a property that would sell at a real loss, and check the gain case before you decide
Section 1031(a)(1) says 'no gain or loss shall be recognized', so an exchange buries a real loss in the next property's basis. If the sale would produce a loss, a taxable sale is usually the better route; see selling at a loss with a 1031.
If the sale still shows a gain, the usual choices apply: pay the reduced tax, or exchange again and keep deferring. A replacement can be a direct property or a Delaware Statutory Trust interest, described on traditional DSTs, which carries its own risks and no assurance that values recover.
Related questions
Do I have to pay tax on the original deferred gain if I sell at a loss?
Not as a separate amount. The deferred gain is taxed only to the extent the sale price exceeds your adjusted carried basis, so a fall in value permanently removes that much of it.
Is the loss measured from what I paid for the replacement?
No. It is measured from your adjusted basis, which carried over from the property you exchanged and is reduced by depreciation since.
Does depreciation from my old property still count at 25%?
Yes, to the extent there is gain. Section 1250(b)(3) counts depreciation reflected in the basis whether it was taken on the same or other property.
Can a 1231 loss offset my salary?
A net section 1231 loss for the year is not treated as capital, so it is generally ordinary, subject to the passive activity rules. It can also make section 1231 gains in the next five years ordinary.
Should I exchange into something cheaper instead of selling?
If the sale would show a loss, an exchange would defer that loss rather than let you use it. If it shows a gain, an exchange still defers it.
Sources
Checked against these publications on September 30, 2026. Rules and figures change; confirm the current version with your CPA or attorney before you act. This page is general information, not tax or legal advice.