How does a 1031 exchange change the tax basis in your replacement property?
And, for starters, what is tax basis?
Let’s go over the basics and provide you a few examples.
What is tax basis?
Tax basis is what the IRS uses to keep track of the gain you make on taxable investments (And, therefore, how the IRS calculates the tax you owe). For real estate, the IRS calculates tax basis as “purchase price + commissions.”
However, the story doesn’t end there. Tax basis changes over time. Your property accrues more basis as you make major improvements; it loses basis through depreciation.
Below, we’ll discuss how tax basis interacts with your sale of real estate. Then we’ll add a 1031 exchange to the transaction and describe its effects.
Depreciation, tax basis and capital gain
Depreciation is what’s known as a non-cash cost of operating improved real estate. You are required to depreciate your real estate; it is mandatory even when the market suggests that your real estate is going up in value.
Moreover, from a seller’s perspective, lower basis through depreciation will increase capital gain and, by extension, taxes due on that gain.
Alternatively, a higher basis achieved through additional investment into the property will lower capital gain.
The IRS only allows depreciation on improvements to real estate and not on the land itself. You can only depreciate real property through two methods:
- Straight-line – where you depreciate the value of the real estate improvements over the IRS defined life of the improvements. With straight-line depreciation, you must use the IRS defined life of 39 years for commercial improvements and 27.5 years for investment residential improvements.
- Cost segregation – where each item of real estate improvement is valued separately and each item has a separate useful life. Cost segregation depreciation accelerates the allowed depreciation. Therefore, this increases your non-cash operating expenses.
Recognized gain vs. realized gain
- You recognize (i.e. pay) income taxes on appreciated real estate based on the gain after you can realize (i.e. calculate) the gain.
- Income tax on your gain is due the year in which you sell.
- Before you sell, the real value of your property is unknown. You can neither recognize nor realize gain without a sale price.
- Upon sale, the marketplace sets the value of your asset. Your gain is equal to the difference between the asset’s sale price and its basis.
Deferring your tax liability with a 1031 exchange
Suppose you sell real estate and perform a 1031 exchange. Instead of recognizing the gain, your gain carries forward from the relinquished property to the replacement property. Therefore, the result is a complete deferral of tax liability* — no matter how low the tax basis or how high the capital gain.
Furthermore, a successful 1031 exchange allows you to defer all income taxes. This includes capital gains, recaptured depreciation, state income taxes (in most states), and the Obamacare (ACA) surcharge on excess income.
Deferred liability also means deferred tax basis. Your basis in the prior is not wiped away; it merely transfers into the new asset.
- You purchased a Basic Box condo in 2000 for $100,000
- After capital improvements and depreciation, your Basic Box condo has a tax basis of $80,000 in 2005.
- Basic Box condo sells for $150,000 in 2005.
- After a 1031 exchange, you swap Basic Box condo for Starter Home for $200,000.
- Now, the tax basis in your Starter Home includes $80,000 of tax basis carried forward, plus additional basis based on how much the replacement property exceeds the sale price of the relinquished property (in our case $50K).
- Tax basis in Stater Home is $130K, NOT $200K.
This example shows that you can defer income tax liability, but not avoid it altogether.
To defer all potential taxes using IRC section 1031, you must trade equal or greater in net sales price AND net equity. Explore our website or contact one of our coordinators for help completing a successful
1031 exchanges and the time value of money
By delaying payment of taxes, you hold onto more capital with which to buy more or larger investments, lower your mortgage payment, or increase your leverage. A 1031 exchange allows you to build investment wealth faster and/or in a style more suited to your lifestyle.
We think of a 1031 exchange as an “interest-free loan from the government.” Therefore, the longer you can delay, the more options you have and the wealthier you become.
Income taxes are often your biggest cost when transacting in real estate. With the right planning, thankfully, they do not have to be.