Does a 1031 exchange work for commercial real estate?

Yes. Any U.S. real property held for investment or productive use in a trade or business qualifies for a 1031 exchange under IRC §1031, regardless of property type. Office buildings, industrial warehouses, retail centers, multifamily apartment complexes (5+ units), and mixed-use properties all qualify. The like-kind standard for real estate is very broad — any investment real property is like-kind to any other investment real property, so you can exchange an office building for a residential rental, a DST interest, or raw land.

What is the depreciation recapture tax on commercial real estate?

Commercial (nonresidential) real property depreciates over 39 years under MACRS, versus 27.5 years for residential rental property. Despite the slower schedule, all accumulated §1250 unrecaptured depreciation is still taxed at 25% federal in a taxable sale. A commercial building held 15 years accumulates roughly 38% of the depreciable building value (15 ÷ 39 years), and that full amount faces the 25% recapture rate — all deferred in a compliant 1031 exchange.

What are defeasance costs in a commercial property sale?

Defeasance is a prepayment mechanism for CMBS and conduit commercial loans: instead of paying off the loan, the borrower substitutes a Treasury security portfolio that replicates the remaining payment stream. The cost is the difference between what those Treasuries cost and the outstanding loan balance, which varies with the interest rate environment. In a low-rate origination / rising-rate payoff scenario, defeasance cost can be near zero or even negative (the Treasuries cost less than the loan balance). In the reverse scenario, defeasance can cost 1–4% of the outstanding balance. These costs reduce net proceeds available for reinvestment and should be factored into exchange planning math.

Can I exchange my commercial property into a Delaware Statutory Trust?

Yes. Delaware Statutory Trusts qualify as like-kind replacement property for commercial real estate owners under Revenue Ruling 2004-86. DST options for commercial 1031 exchanges include industrial and logistics facilities, medical office buildings, NNN-leased retail, and large multifamily portfolios. DST investors must be SEC-accredited (net worth over $1M excluding primary residence, or income over $200K single/$300K MFJ). DSTs carry 7–12% front-end loads and the Seven Deadly Sins restrictions — no new debt, no capital calls, no renegotiation of existing debt.

Can I exchange commercial property for residential rental property?

Yes. The like-kind standard for real estate is extremely broad. An office building can exchange into a single-family rental, a multifamily apartment complex, raw land, or any other investment real property. Property type is irrelevant — what matters is that both the relinquished and replacement properties are U.S. real estate held for investment or business use.

How does debt replacement work for a commercial real estate 1031 exchange?

To fully defer all gain you must reinvest all net equity proceeds and replace all debt paid off at closing. Commercial properties commonly carry 55–70% LTV loans. If your commercial property had a $2M mortgage paid off at sale, the replacement property must carry at least $2M in new debt — or you must contribute additional equity to cover the shortfall. Taking less debt without compensating with additional cash creates mortgage boot, which is taxed at the same rates as cash boot: 25% recapture first, then 20% LTCG, then 3.8% NIIT.

What happens to suspended passive losses in a commercial real estate 1031 exchange?

Under IRC §469(g), suspended passive activity losses do not release in a 1031 exchange — they carry over to the replacement property and remain suspended. If you have substantial suspended PALs, a taxable sale would release all of them in the sale year, potentially absorbing a large share of the capital gains tax. A financial advisor should compare the after-tax outcome of exchange versus taxable sale when significant PALs are involved, because the PAL release can sometimes make the taxable sale less costly than it first appears.

When is a taxable sale better than a 1031 exchange for a commercial property?

A taxable sale may beat the exchange when: the property has large suspended PALs that offset most of the gain; defeasance or yield maintenance costs substantially reduce net proceeds, making exchange economics marginal; the investor needs liquidity for retirement income and cannot replace it with suitable replacement property; the property is being sold in a distressed situation with limited equity to reinvest; or the investor's health suggests holding until death for the §1014 step-up is a better strategy than an exchange that adds another decade of real estate complexity.

Commercial Real Estate 1031 Exchange: Office, Industrial, Retail, and Multifamily

Commercial real estate owners selling office buildings, industrial warehouses, retail centers, or large multifamily properties face the same 1031 exchange rules as residential investors — with a few important differences. The 39-year commercial depreciation schedule, CMBS loan prepayment costs, and the 2026 office market all affect whether the exchange pencils out. This guide covers the tax math, the mechanics, and the planning decisions that matter specifically for commercial sellers.

Which Commercial Properties Qualify

Under IRC §1031, any U.S. real property held for investment or productive use in a trade or business qualifies — and the like-kind standard is extremely broad. "Like-kind" for real estate means any investment real property to any other investment real property, regardless of property type. All of the following qualify as both relinquished and replacement property.¹

Property type	Qualifies?	Notes
Office buildings (Class A, B, or C)	Yes	Must be held for investment or business use; owner-occupied with no investment intent is a closer question
Industrial / warehouse / logistics	Yes	One of the strongest-performing commercial sectors; DST options widely available
Retail strip centers, anchored centers	Yes	Anchor tenant lease quality drives replacement-property economics
Single-tenant NNN retail	Yes	Strong DST and direct-ownership replacement options; see NNN guide
Multifamily 5+ units (apartment buildings)	Yes	Same rules as smaller residential rentals; 27.5-year depreciation applies to residential components
Mixed-use (commercial + residential)	Yes for investment portion	Allocate basis between qualifying investment use and any owner-occupied commercial space
Medical office / healthcare facilities	Yes	Sought-after as both direct replacement and DST option
Self-storage, manufactured housing community	Yes	Less CMBS exposure; often easier loan prepayment terms
Owner-occupied business real estate (IRC §1231)	Yes, if sold separate from business	Real estate held in a trade or business qualifies; not a pure investment requirement
REIT shares / partnership interests	No	Securities, not real property. UPREIT (§721 contribution) is a separate path — see UPREIT guide

The 39-Year Depreciation Schedule — How It Differs from Residential

The most important mechanical difference between commercial and residential 1031 exchanges is the depreciation schedule. Nonresidential real property (any building where 80% or more of the gross rental income comes from non-dwelling uses) depreciates over 39 years under MACRS, not the 27.5 years that applies to residential rental property.²

In practical terms:

A $2M depreciable commercial building generates $51,282/year in straight-line depreciation (vs $72,727/year for a residential building of the same cost)
After 15 years, a commercial building has accumulated ~38% of its depreciable basis in deductions ($769,231 on a $2M building) vs ~55% for a residential property of the same age
Despite the slower accumulation, the §1250 unrecaptured gain is still taxed at 25% on a taxable sale — the rate is identical to residential

The depreciation leverage math still works for commercial: The investor who deducted $51,282/year at a 37% marginal rate saved $18,974/year in taxes. At sale, recapture is taxed at 25%. The spread (deductions at 37%, recapture at 25%) is favorable — the 1031 exchange defers the recapture while the investor has already captured the annual tax benefit at the higher rate.

Qualified Improvement Property and Bonus Depreciation

Not all improvements to commercial buildings follow the 39-year schedule. Qualified Improvement Property (QIP) — interior non-structural improvements to nonresidential real property made after the building was first placed in service — is classified as 15-year property and is eligible for 100% bonus depreciation under OBBBA for property placed in service after January 19, 2025.³

In a 1031 exchange involving a replacement commercial property, a cost segregation study can identify QIP and shorter-life personal property components (5-year, 7-year, 15-year) that qualify for immediate expensing — partially offsetting the lower depreciation available from the carryover basis on the exchange.

Commercial Loan Prepayment Costs: Defeasance and Yield Maintenance

The most common financial surprise in commercial real estate sales — exchange or otherwise — is the prepayment cost built into CMBS (commercial mortgage-backed securities) and conduit loans. Unlike residential mortgages, most CMBS debt cannot be simply paid off before maturity without triggering a significant prepayment penalty.

Defeasance

Defeasance is the dominant prepayment mechanism for conduit CMBS loans. Instead of paying off the outstanding principal, the borrower substitutes a portfolio of U.S. Treasury securities whose payments precisely match the remaining loan payment schedule. The cost to the borrower is the difference between what those Treasuries cost today and the outstanding loan balance.

The defeasance cost depends entirely on the interest rate environment:

Low-rate origination, higher-rate environment at payoff (2024–2026): Treasuries yield more than the loan coupon, so the required Treasury portfolio costs less than the loan balance — defeasance cost can be zero or produce a small credit to the borrower
High-rate origination, lower-rate environment at payoff: Treasuries yield less than the loan coupon, so the required portfolio costs more than the loan balance — defeasance can cost 1–5% of the outstanding balance

Commercial properties financed in 2021–2022 at historic low rates (3–4%) that are now being sold into the 2025–2026 rate environment typically face near-zero or very low defeasance costs — because current Treasury yields are comparable to or above the original loan rate. Properties financed at higher rates in 2018–2019 and sold into a lower-rate environment face larger costs.

Yield Maintenance

An alternative prepayment structure, yield maintenance calculates the prepayment premium as the present value of the remaining interest payments above what the lender could earn by reinvesting at current Treasury rates. The practical outcome is similar to defeasance — the cost depends on the spread between the original loan rate and current Treasury yields.

Step-Down Prepayment Penalties

Smaller commercial and balance-sheet loans more commonly use step-down prepayment schedules — for example, 5-4-3-2-1% of outstanding balance, declining by 1% per year of the loan. These are simpler and less expensive than defeasance on large CMBS loans, but still reduce net proceeds available for the exchange.

Practical implication for exchange planning: Before calculating how much equity is available to reinvest, get the defeasance or yield maintenance cost quoted from the lender or a defeasance specialist. These costs reduce net sale proceeds and therefore reduce the amount that must be reinvested to avoid boot — but they also reduce the equity available to place into the replacement property. Model this alongside the boot calculator.

Worked Example: $3.5M Office Building, 12-Year Hold

Consider an investor who purchased a suburban office building in 2014:

Purchase price: $2,000,000 (land $400,000, depreciable building $1,600,000)
Original mortgage: $1,400,000 at 4.5%. Current balance at sale: $1,210,000
Defeasance cost estimate (current rate environment): $0 (near-zero — current Treasury yields comparable to original rate)
Sale price in 2026: $3,500,000
Selling costs: $175,000 (5%)
Net sale proceeds: $3,325,000
Net equity after loan payoff: $3,325,000 − $1,210,000 = $2,115,000

Depreciation calculation: $1,600,000 ÷ 39 years = $41,026/year straight-line. 12 years of depreciation = $492,308.

Step	Calculation	Amount
Adjusted basis	$2,000,000 − $492,308 depreciation	$1,507,692
Amount realized	$3,500,000 − $175,000 selling costs	$3,325,000
Total realized gain	$3,325,000 − $1,507,692	$1,817,308
§1250 unrecaptured depreciation (25%)	$492,308 × 25%	$123,077
Long-term capital gain (20%)	($1,817,308 − $492,308) × 20%	$265,000
Net investment income tax (3.8%)	$1,817,308 × 3.8%	$69,058
Total federal tax — taxable sale		$457,135
Tax deferred via 1031 exchange	All of the above	$457,135

State tax is additional: California would add $1,817,308 × 13.3% = ~$241,700 in state tax, for a combined federal + state bill exceeding $698,000. All of it deferred in a compliant exchange.

Reinvestment Requirements for Full Deferral

To fully defer the $457,135 in federal tax, the investor must:

Reinvest all net equity: $2,115,000 (the proceeds after paying off the $1,210,000 loan) must go into the replacement property. Any amount kept is cash boot and is taxed first.
Replace all debt: The $1,210,000 mortgage paid off at closing must be replaced with at least $1,210,000 in new debt on the replacement property — or the investor must put in additional equity to make up the difference.
Minimum replacement property value: Net proceeds ($3,325,000) + no boot = replacement property must cost at least $3,325,000. Use the replacement property calculator to model exact numbers.

Commercial Property Types: Selling Dynamics in 2026

The commercial real estate market in 2026 is not uniform. The property type being sold significantly affects deal pricing, buyer pool, and the replacement property options that make economic sense.

Property type	2026 market dynamic	1031 exchange notes
Office (suburban)	Elevated vacancy in most markets; prices down 20–40% from 2021 peak in many submarkets; flight to quality ongoing	Strong case for exchange to preserve equity and defer gain on older purchases; distressed office may have limited exchange equity
Office (Class A urban)	Better occupancy than Class B/C; lease-up activity returning in primary markets	Still liquid market for exchanges; DST industrial/NNN replacement often chosen to reduce office concentration
Industrial / logistics	Vacancy rising modestly but still historically low; rent growth moderating; strong long-term demand	Excellent DST supply; often the preferred replacement for investors exiting office or retail; cap rates 4.5–6.5%
Retail (anchored centers)	Grocery-anchored centers performing well; value-add strip centers more challenging; essential retail strong	NNN single-tenant retail (pharmacy, fast food, dollar store) widely available as DST or direct replacement
Multifamily 5+ units	Apartment fundamentals solid in most markets; rent growth slowing; new supply elevated in 2024–2026 in some markets	Most DST sponsors offer multifamily options; 27.5-year depreciation applies to residential portion of mixed-use
Medical office / healthcare	Resilient demand; long leases; healthcare tenant credit strong; cap rates 5–6.5%	Popular DST option; tenants tend to be on long-term leases with rate bumps

Replacement Property Options for Commercial Sellers

Commercial sellers have a wider range of replacement property types than residential investors in some respects — and a more constrained financing market in others. Here is how the main paths compare.

Direct Commercial Property Replacement

Buying another commercial property provides the most flexibility for investors who want to continue active ownership. The challenge is matching debt: commercial loan LTV requirements typically run 55–70%, compared to 75–80% for residential. An investor selling a heavily leveraged commercial property may need to invest additional equity to replace the debt on a comparable replacement property.

Moving from one commercial type to another (office to industrial, retail to multifamily) is entirely valid under the like-kind standard and is a common strategic shift — particularly as investors exit office-heavy exposure and into logistics or essential-service properties.

Delaware Statutory Trusts (DSTs)

DSTs have become the default passive-replacement option for commercial sellers who want to exit active management while deferring tax. The DST market offers commercial-flavored options that align with the property types many commercial sellers already understand:

Industrial DSTs: Logistics and fulfillment facilities leased to Amazon, FedEx, UPS, and third-party logistics operators. Long leases (7–15 years), investment-grade tenants, monthly distributions typically 4–6% annualized. Strong demand from investors exiting office.
Medical office DSTs: Healthcare campuses and outpatient facilities leased to hospital systems and specialty practices. Recession-resistant; long leases; tenant improvement obligations on the sponsor side.
NNN retail DSTs: Single-tenant dollar stores, pharmacies, quick-service restaurants. Passive landlord; tenant handles maintenance, insurance, and taxes. See the NNN guide for detail on individual NNN vs DST.
Multifamily DSTs: Large apartment complexes operated by institutional management platforms. Monthly income, potential appreciation, and professional management built in.

DST caution for commercial sellers: DST sponsors typically earn 7–12% front-end loads on capital invested. On a $2M DST investment, that represents $140,000–$240,000 in load that reduces net capital deployed. A fee-only financial advisor who earns no commission regardless of recommendation is better positioned to evaluate whether the DST economics justify the cost relative to direct replacement property.

UPREIT via §721 Contribution

Commercial property owners with larger portfolios or investors seeking eventual liquidity in publicly traded REIT shares can contribute the replacement property (or a DST interest after its 2-year conversion window) to a REIT's operating partnership under IRC §721 in exchange for OP units. The §721 contribution defers gain recognition at contribution. See the UPREIT vs DST guide for the full comparison.

Multi-Property Exchange: Diversification Strategy

Commercial sellers with a single large asset — particularly office or retail — can use the multiple properties guide to exchange into several smaller replacement properties across different asset classes or geographies. Selling a $5M suburban office building and exchanging into two NNN properties plus a DST position, for example, diversifies sector and geographic risk while deferring the full tax.

Carryover Basis and Depreciation on the Replacement Commercial Property

A 1031 exchange does not give the replacement property a fresh cost basis. Under IRC §1031(d), the replacement property inherits the relinquished property's adjusted basis — not its purchase price.⁴

In the worked example above: the investor's adjusted basis in the office building at sale was $1,507,692. After the exchange, the replacement property's adjusted basis starts at $1,507,692 (plus any additional equity invested), regardless of how much the replacement property cost to acquire.

The practical impact on commercial property:

The exchanged-in basis portion continues on whatever remains of the original 39-year (or 27.5-year, if the old property was residential) depreciation schedule — not a fresh 39-year clock
Additional cash invested in the exchange starts a new depreciation schedule from the acquisition date
A cost segregation study on the replacement property can identify 5-, 7-, and 15-year components eligible for 100% bonus depreciation under OBBBA — generating significant first-year deductions even with the reduced carryover basis

For a detailed analysis of how cost segregation interacts with the carryover basis, see the cost segregation guide.

The Step-Up at Death: Permanent Elimination of Deferred Gain

Every dollar of deferred gain accumulated through 1031 exchanges — including the full §1250 recapture and capital gain on a large commercial property — can be permanently eliminated under IRC §1014 if the property is held until death. Heirs inherit the property at its fair market value on the date of death; all deferred gain disappears.

Under OBBBA (enacted July 2025), the estate tax exemption is permanently set at $15 million per person ($30 million MFJ). Commercial real estate portfolios of this size or below can pass to heirs with no federal estate tax, and the accumulated 1031 exchange deferral is eliminated entirely at the same time.⁵

The one trap: suspended passive activity losses carry over to the replacement property but are permanently forfeited at death under IRC §469(g)(2) — they are not released and not deducted. For commercial investors with large suspended PALs, the choice between holding until death (losing the PALs forever) versus a strategic taxable sale before death (releasing PALs to offset gain) is a genuine planning question worth modeling with a financial advisor.

When a Taxable Sale Beats the 1031 Exchange for Commercial Property

The 1031 exchange defers tax — it does not eliminate it absent a step-up at death. There are commercial-specific situations where the taxable sale is the better choice.

Situation	Why taxable sale may win
Large suspended passive activity losses	A taxable sale releases all suspended PALs from the property in the year of sale — they directly offset the capital gain. If PALs are large enough relative to the gain, the effective tax bill on a taxable sale can be substantially lower than it first appears
Property value is near or below the loan balance	Little or no equity to reinvest means little or no gain to defer; exchange overhead may exceed the tax benefit
Defeasance or yield maintenance cost is very high	A 3–5% prepayment penalty on a $3M loan balance ($90K–$150K) reduces exchange economics; factor into the exchange vs taxable sale comparison
Investor needs liquidity and cannot match it with replacement income	A commercial property generating strong lease income may not have a DST or NNN replacement with equivalent cash flow — taking proceeds and investing in a diversified portfolio may produce better retirement income
Portfolio already 90%+ in real estate	Exchanging into more commercial real estate to defer tax while already heavily concentrated increases risk beyond the value of the deferral
Declining health; step-up strategy is near-term	If the investor is elderly and the estate plan captures the §1014 step-up, an exchange that adds another decade of real estate complexity may not change the long-run tax outcome
Low income year (retirement transition, NOL carryforward)	In an unusually low income year, LTCG may land fully or partially in the 15% or even 0% bracket — making deferral less valuable. The 0% LTCG bracket applies for 2026 up to $96,700 taxable income for single filers, $193,350 MFJ (20% bracket threshold).⁶

The Financial Advisor's Role in Commercial Exchanges

Commercial real estate exchanges are typically larger, more complex, and more consequential than residential exchanges. The advisory team — qualified intermediary, CPA, real estate attorney, and financial advisor — is the same, but the financial planning decisions are more intricate.

A fee-only financial advisor who works with commercial real estate investors can:

Model the full exchange vs taxable sale comparison, including state tax, defeasance costs, suspended PALs, and post-exchange cash flow — over a 10–20 year horizon
Evaluate DST options against direct replacement property, including the load-adjusted return comparison and the Seven Deadly Sins liquidity restrictions
Size the debt replacement requirement against available financing — commercial lending markets differ significantly from residential in LTV, prepayment terms, and lender appetite by property type
Coordinate with the estate plan: commercial properties often require trust or entity restructuring before the exchange to align with estate planning goals
Advise on the PAL release vs exchange tradeoff when significant suspended losses are on the books
Model the carryover basis depreciation schedule and cost segregation opportunity on the replacement property

When to engage: Commercial exchanges benefit most from financial planning that starts before the property goes under contract — ideally 3–6 months before. Once the 45-day identification clock starts, the advisor is helping you evaluate replacement properties under time pressure rather than building the full comparison from scratch.

Get matched with a fee-only advisor

Tell us about your commercial real estate situation. We will match you with a fee-only financial advisor who has experience coordinating commercial property 1031 exchanges — including exchange vs taxable sale analysis, debt replacement structuring, DST evaluation, and post-exchange financial planning.

Sources

IRC §1031 — Like-kind exchanges of property held for productive use or investment: law.cornell.edu/uscode/text/26/1031
IRS Publication 946 (How to Depreciate Property), Table B-1 — Nonresidential real property, 39-year GDS straight-line mid-month: irs.gov/publications/p946
OBBBA §70201 (Permanent 100% bonus depreciation, property placed in service after January 19, 2025); IRS Notice 2026-11 — OBBBA bonus depreciation guidance: irs.gov
IRC §1031(d) — Basis of property acquired in like-kind exchange; IRS Publication 544 (Sales and Other Dispositions of Assets): irs.gov/publications/p544
IRC §1014 — Basis of property acquired from a decedent; OBBBA §60001 — $15M estate and gift tax exemption (permanent): law.cornell.edu/uscode/text/26/1014
IRS Revenue Procedure 2025-67 — 2026 tax year inflation adjustments including LTCG bracket thresholds: irs.gov

Tax values verified as of August 2026. The 39-year depreciation schedule, §1250 recapture rate (25%), LTCG rate (20%), and NIIT (3.8%) are confirmed against IRS Publication 946, IRS Publication 544, and IRC §1411. LTCG 0% bracket threshold ($96,700 single / $193,350 MFJ for 2026) is sourced from IRS Rev. Proc. 2025-67. OBBBA permanent bonus depreciation confirmed per IRS Notice 2026-11. Confirm all values with a qualified tax professional before relying on any amount.