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: 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. 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!)Adjusted Basis
Calculating Cost Basis
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.
About the Author: Brian T. Boyd, JD, LLM, www.BoydLegal.co
I am an expert in real estate transactions and tax planning, particularly in the realm of 1031 exchanges. My extensive knowledge is demonstrated through years of practical experience and a deep understanding of the intricate details involved in utilizing 1031 exchanges as a tax tool for investors. I have successfully guided numerous clients through the complexities of capital gains, depreciation recapture, and the calculation of property basis.
Now, let's delve into the concepts discussed in the article:
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1031 Exchange:
- A powerful tax tool for investors to plan around capital gains and depreciation recapture in real estate transactions.
- Allows the deferral of capital gains by reinvesting the proceeds from the sale of one property into another.
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Basis in a 1031 Property Exchange:
- Basis refers to the amount of money paid for a property, including acquisition costs.
- Example: Purchasing a property for $100,000, plus $5,000 in closing costs, results in a basis of $105,000.
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Adjusted Basis:
- The real estate basis changes over time due to capital improvements and depreciation.
- Capital expenditures (e.g., property improvements) increase the basis, while depreciation reduces it.
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Depreciation:
- Depreciation expense allows investors to lower their income over several years but also reduces the property basis.
- Can lead to tax liability when selling the property outside of a 1031 exchange.
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Calculating Cost Basis:
- Steps to calculate the cost basis of a newly acquired property in a 1031 exchange:
- Determine adjusted basis of the property sold.
- Add the value of transferred property, mortgage on the new property, cash contributions, and recognized gains.
- Subtract any money or property received, mortgage on the sold property, and recognized losses.
- Steps to calculate the cost basis of a newly acquired property in a 1031 exchange:
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Capital Gain Tax Treatment:
- 1031 exchanges defer capital gains, but it's crucial to assess whether taking the capital gain tax treatment is beneficial, especially when upgrading to a higher-value property.
- Example: Selling a property for a $200,000 gain and buying an $800,000 property to offset depreciation recapture and capital gains.
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Considerations:
- Emphasizes the importance of not getting overly fixated on deferring capital gains and missing opportunities to invest in properties better suited to one's plans.
The author, Brian T. Boyd, JD, LLM, provides valuable insights into the intricacies of 1031 exchanges, urging investors to carefully weigh their options and consult with professionals for optimal tax planning strategies.
