When you eventually sell those replacement properties, you aren't just taxed on the "new" gain from the time you owned them. Instead, the tax liability from your original property follows you into the new ones.
Here is how the IRS views selling off your 1031 properties individually:
1. The "Carried Over" Basis
When you do a 1031 exchange, you don't "wipe out" your taxes; you defer them. The IRS tracks this by adjusting your Basis (your "investment" in the eyes of the tax man).
If you sell a property for $1M that you originally bought for $400k, you have a $600k deferred gain. If you use a 1031 exchange to buy two new properties for $500k each, that $600k gain is split between them.
- Each new property will have a "carry-over" basis of only $200k ($500k price minus $300k deferred gain).
- When you sell one of those properties later for $550k, the IRS sees a gain of $350k ($550k sale price - $200k basis), not just the $50k it grew while you owned it.
2. Selling Individually
Yes, you can sell them off one by one. Each sale is treated as an independent taxable event.
- Taxable Sale: If you sell one and just take the cash, you will owe capital gains tax (and depreciation recapture) on that specific property’s portion of the deferred gain.
- Partial 1031: You could also choose to do another 1031 exchange on just that one property, continuing to kick the tax can down the road while keeping the other properties in your portfolio.
3. The "Holding Period" Warning
There is no specific "clock" in the tax code that says how long you must hold a property before selling it, but the IRS looks for intent.
- To qualify for a 1031 exchange, you must have the intent to hold the property for investment or business use.
- If you buy three properties in an exchange and sell one of them 3 months later, the IRS might argue you didn't buy it for "investment" but rather as "inventory" (like a house flipper).
- The Rule of Thumb: Most CPAs recommend holding replacement properties for at least one to two years to prove investment intent before selling them off or converting them to personal use.
4. Depreciation Recapture
Don't forget that when you sell, you don't just owe capital gains tax (usually 15–20%); you also owe Depreciation Recapture (25%). Because you’ve likely been "writing off" the building's value over time, the IRS wants that money back when you finally cash out.
Summary Table: Selling One of Your 1031 Properties
| Scenario | Result |
|---|---|
| Sell and take the cash | You pay tax on the gain from this property + its share of the old deferred gain. |
| Sell and do another 1031 | Taxes continue to be deferred into a new replacement property. |
| Sell too quickly (< 1 year) | Risk of the IRS auditing the original exchange for lack of "investment intent." |