Mixing a 1031 exchange and a short sale can be done, but often times cannot. Timing can have alot to do with it. A 1031 exchange allows the taxpayer to defer the federal and state capital gains and recaptured depreciation taxes when selling real estate held in the productive use of a business or for investment. After aggregating the taxes triggered upon sale, the tax can be as high as 40 percent of the sales price. If the taxpayer, who can be an individual, husband and wife, trust, corporation, or domestic or foreign follows the 1031 rules, those taxable dollars can be used towards purchasing replacement property and the taxpayer effectively receives an indefinite interest free loan. The tax is ultimately due when the replacement property is sold, unless deferred again in another 1031 exchange.