A 1031 exchange is a terrific tax tool for investors to plan around capital gains and depreciation recapture in real estate transactions. However, understanding the basis in a 1031 property exchange is not always straightforward.
A basis is the amount of money you pay for a piece of property, which includes the costs expended to acquire that property. A short example is buying a property for $100,000. In order to acquire that property, you had to pay $5,000 in closing costs to the bank and an attorney. Thus, your basis is $105,000.
This simple concept quickly gets complicated since the real estate basis changes over time. Hence, the concept of adjusted basis now rears its head. The reasons that your basis adjusts are mainly twofold:
- By improving the property in some way, e.g., a bathroom renovation, renovating a common area, or adding on to a property. These capital expenditures are added to your basis in a way that increases your basis in the property.
- Depreciation expenses of that property take your basis the other way. Depreciation expense allows the investor to lower their income by depreciating the property over a number of years. Depreciation also reduces your basis and can lead to tax liability when you sell the property outside of a 1031 exchange.
Calculating Cost Basis
1031 exchanges allow you to defer capital gains. In deferring those gains, your basis has to be recalculated. The general basis concept is that the new property purchased is the cost of that property minus any gain you deferred in the exchange. Below are the steps to explain how to calculate the cost basis of your new property.
- Figure out the adjusted basis in the property that you have just sold. This includes any mortgage you took to acquire the property.
- Add the value of any other property you transfer in the exchange, the mortgage amount on your new property, the amount of cash you are contributing to the new purchase, and any recognized gain on the sold property.
- Subtract any money or property you received in the exchange, the amount of the mortgage on the sold property, and any recognized loss on any property sold in the exchange.
These steps result in the basis of your newly acquired property in the 1031 exchange. Take note that the purchase price for the new property does not play a role in determining the cost basis. (Surprising to most investors, I know!)
When to Take the Capital Gain Tax Treatment
The takeaway from this new understanding is that 1031 exchanges are great tools. But sometimes it is worth taking the capital gain tax treatment if you are buying up. What does that really mean? The following example provides some insight.
Say that you buy a property in year 1 for $250,000. You sell the property in year 3 for $450,000. Over the course of the holding period of the property, you have depreciated the asset, resulting in an adjusted basis. You are also making approximately $200,000 in capital gains. Thus, you would owe capital gains tax and would have to recapture that depreciation taken.
But what if you took your $200,000 gain and bought an $800,000 property? Could you take advantage of new depreciation that would offset the depreciation recapture and offset your capital gains? The answer is yes.
In order to determine the correct dollar amounts you need to spend to hit this tipping point, I encourage you to speak with your CPA or accountant. 1031 exchanges are great, but don’t get so caught up in deferring capital gains that you miss an opportunity to buy into a property that may be a better fit for your plans.