Recording a 1031 exchange on your books takes a short sequence of journal entries: one to dispose of the relinquished property and park the proceeds with the Qualified Intermediary, one to reclassify any boot as recognized gain, one to record the replacement property at its full purchase price, and one to write that property down by the deferred gain so it lands at the correct carryover basis. The deferred gain doesn’t vanish. It rides inside the new asset as a lower depreciable basis and a larger taxable gain whenever you sell without another exchange.1Office of the Law Revision Counsel. 26 U.S. Code 1031 – Exchange of Real Property Held for Productive Use or Investment
Start With the Adjusted Basis of the Old Property
Every entry that follows depends on this number, so pull it before closing day. Take the original purchase price plus any capitalized closing costs, add capital improvements, and subtract accumulated depreciation. The result is your adjusted basis.2Internal Revenue Service. Topic No. 703, Basis of Assets
A running example makes the rest of this concrete. You bought a rental property for $500,000 and have claimed $150,000 in depreciation, leaving an adjusted basis of $350,000. The property sells for $900,000. A $200,000 mortgage is paid off at closing, and the Qualified Intermediary receives the remaining $700,000. Your realized gain is $550,000.
If the adjusted basis is wrong, every entry downstream is wrong too, so reconcile it against your depreciation schedules and capital expenditure records before you touch the ledger.
Record the Disposition and Park Proceeds With the QI
On the closing date, one compound entry handles the whole sale side. It removes the asset, clears accumulated depreciation, pays off the mortgage, sets up a holding account for the funds sitting with the intermediary, and books the realized gain as a temporary liability.
| Account | Debit | Credit |
|---|---|---|
| Accumulated Depreciation | $150,000 | |
| Mortgage Payable | $200,000 | |
| Exchange Proceeds Held by QI | $700,000 | |
| Land & Building – Relinquished Property | $500,000 | |
| Deferred Gain – 1031 Exchange | $550,000 |
Both sides total $1,050,000. The “Exchange Proceeds Held by QI” account is a short-lived asset that will zero out when you buy the replacement property. The “Deferred Gain – 1031 Exchange” account is a temporary liability that either reduces the new property’s basis or, if there’s boot, gets partially reclassified to recognized gain. Both should be cleared by the time the exchange closes.
Watch tenant security deposits and prorated rents. Those funds need to route through the QI rather than being credited directly to the buyer at closing. Money credited outside the exchange is treated as cash you received, which creates taxable boot. A prorations clause in the purchase contract handles this cleanly.
How Exchange Expenses Hit the Ledger
Costs paid from QI funds simply reduce the “Exchange Proceeds Held by QI” balance. Broker commissions on the sale of the relinquished property, QI fees, title insurance, escrow fees, and transfer taxes all qualify as exchange expenses and can be paid from exchange funds without triggering constructive receipt.3Internal Revenue Service. Instructions for Form 8824 If $45,000 in commissions and $5,000 in QI fees hit at closing, the holding account carries $650,000 instead of $700,000, and the deferred gain drops accordingly.
Loan costs are the exception. Points, loan origination fees, prorated mortgage insurance, and lender-required appraisals are costs of obtaining financing rather than costs of acquiring property. A quick test: if the expense would vanish in an all-cash purchase, it’s a loan cost. These don’t reduce your gain and don’t belong in the replacement property’s basis for exchange purposes. Coding them into the asset account inflates both the basis and every year of depreciation that follows.
Reclassify Boot as Recognized Gain
A fully deferred exchange only happens when you receive nothing but like-kind property. Cash returned by the QI, or net debt relief when the new mortgage is smaller than the old one, is boot, and it forces recognition of gain up to the amount of boot received. Recognized gain never exceeds realized gain, and losses aren’t recognized in a 1031 exchange regardless of boot.1Office of the Law Revision Counsel. 26 U.S. Code 1031 – Exchange of Real Property Held for Productive Use or Investment
Suppose the replacement property in the running example carries only a $100,000 mortgage. Your debt dropped by $100,000 ($200,000 old minus $100,000 new), so you have $100,000 of mortgage boot. That triggers a reclassification entry:
| Account | Debit | Credit |
|---|---|---|
| Deferred Gain – 1031 Exchange | $100,000 | |
| Recognized Gain – 1031 Exchange | $100,000 |
The $100,000 flows to the income statement and creates current-year tax. The remaining $450,000 stays deferred and will reduce the new property’s basis. If the exchange has no boot at all, skip this entry.
Mortgage boot can be offset by injecting your own cash into the exchange. Contributing $100,000 into the QI in this scenario nets the boot to zero, and the reclassification entry isn’t needed.
Record the Replacement Property and Write Down the Basis
The replacement property gets recorded in two steps. Assume a fully deferred exchange with no boot: you buy replacement property for $1,000,000, funded by $700,000 from the QI and a $300,000 new mortgage.
Step one puts the asset on the books at full cost:
| Account | Debit | Credit |
|---|---|---|
| Land & Building – Replacement Property | $1,000,000 | |
| Exchange Proceeds Held by QI | $700,000 | |
| Mortgage Payable | $300,000 |
The holding account is now empty and the new debt is booked. If you contributed extra cash beyond what the QI held, credit Cash for that amount as well.
Step two embeds the deferred gain and brings the asset to its carryover basis:
| Account | Debit | Credit |
|---|---|---|
| Deferred Gain – 1031 Exchange | $550,000 | |
| Land & Building – Replacement Property | $550,000 |
The replacement property now sits at $450,000, which equals the $350,000 adjusted basis of the old property plus the net new investment of $100,000 ($300,000 new mortgage minus $200,000 old mortgage). The deferred gain account is empty. The QI account is empty. Everything closes out.1Office of the Law Revision Counsel. 26 U.S. Code 1031 – Exchange of Real Property Held for Productive Use or Investment
Skipping this second entry is the single most common bookkeeping error in a 1031 exchange. The books look tidy in the exchange year, but depreciation runs too high every year afterward, and when the property is eventually sold the gain is wrong in both directions.
Split the Basis for Depreciation Going Forward
Fresh depreciation on the whole new basis is not the correct method. The IRS requires the replacement property’s basis to be split into two layers, each depreciated on its own schedule.4Internal Revenue Service. Notice 2000-4, Exchange of MACRS Property for MACRS Property
- Carryover basis, up to the adjusted basis of the relinquished property, continues on the old schedule. Same method, same convention, same remaining recovery period. In the example, $350,000 rides on the old property’s schedule with whatever years remain.
- Excess basis, the portion above the carryover, is treated as a new asset. Fresh recovery period (27.5 years residential, 39 years commercial) and its own method. In the example, the $100,000 excess starts a new schedule.
Before you calculate either layer, separate land from depreciable improvements. Land is never depreciable, and a 1031 exchange doesn’t change that. If $200,000 of a $1,000,000 replacement property is land, only the improvements go on the depreciation schedules, split between the two layers.
Some smaller operations run a single blended schedule over the entire new basis. That approach doesn’t technically comply with the rules, even if the arithmetic is close.
If the Exchange Fails, Reverse the Deferral
Two hard deadlines govern every deferred exchange. Miss either and the whole thing collapses into a taxable sale.1Office of the Law Revision Counsel. 26 U.S. Code 1031 – Exchange of Real Property Held for Productive Use or Investment You have 45 days from the transfer of the relinquished property to identify replacement property in writing, and 180 days from that transfer (or the due date of the return including extensions, whichever comes first) to close on the replacement.
When an exchange fails, the QI returns the money, and the deferred gain becomes recognized gain in the year of the original sale. On the books, reverse the deferred gain entry, move the balance from “Deferred Gain – 1031 Exchange” to recognized gain, and move the QI holding balance into Cash. Because those accounts are provisional until the replacement property closes, a memo note or sub-ledger flag on both is worth adding at the time of the original entry.
A related-party exchange adds a further contingency: if either side disposes of the exchanged property within two years, the deferred gain snaps back and becomes taxable in the year of the early sale. The initial entries look identical to any other 1031, but a contingent liability disclosure should sit on the books for the full two-year window.
Errors That Show Up Later
A few problems repeat across exchanges and are worth checking for before closing the books on the transaction.
Leaving the replacement property at full purchase price is the biggest one. It happens because the basis write-down doesn’t correspond to any cash movement, so it’s easy to forget. The fix is the second entry in the acquisition step above, and without it the asset is overstated and depreciation is inflated for the entire holding period.
Failing to separate land from improvements is the second. Land carries basis but no depreciation, and the exchange doesn’t override that.
Capitalizing loan costs into the replacement property’s basis is the third. Points and origination fees on the new mortgage are financing costs, not exchange expenses, and folding them into the asset account inflates depreciation.
Leaving the “Exchange Proceeds Held by QI” or “Deferred Gain – 1031 Exchange” accounts open after the transaction closes is the last. Both are temporary. Once the replacement property is on the books at its carryover basis, both balances should be zero. Stale accounts clutter the balance sheet and confuse anyone reviewing the file later.