# A 1031 Exchange Example

## The Ron and Maggie Story

Let’s take an example couple, Ron and Maggie1, who purchased a small apartment building in California 10 years ago for \$1,500,000.  They invested \$500,000 of their own money and financed the rest with a \$1,000,000 mortgage.

### Purchase Price

 Cash Equity Paid by Investor \$500,000 Mortgage Financing \$1,000,000 Purchase Price \$1,500,000
Step
1

After several years, Ron and Maggie’s adjusted basis in the property may look like this:

 Purchase Price \$1,500,000 PLUS: Acquisition Costs (Example: Title Insurance) \$10,000 PLUS: Capital Improvements (Example: New Roof) \$65,000 LESS: Depreciation Taken During Ownership \$(400,000) LESS: Deferred Capital Gains \$- EQUALS: Adjusted Tax Basis at Sale \$1,175,000
Step
2

### Calculate Realized Gain

Ron and Maggie are contemplating selling their property.  They believe the property could be sold for \$2,850,000.  Assuming \$50,000 in closing costs, their “realized gain” may look like this:

Realized Gain

 Sales Price of Relinquished Property \$2,850,000 LESS: Closing Costs on Relinquished Property \$(50,000) EQUALS: Net Selling Price \$2,800,000 LESS: Adjusted Tax Basis (From Step 1) \$(1,175,000) EQUALS: Realized Gain \$1,625,000

Note that realized gain is different from cash received from the sale.  Assuming the mortgage has been paid down to \$800,000, net cash received may look like this:

 Sales Price \$2,850,000 LESS: Balance on Mortgage to Pay Off \$(800,000) LESS: Closing Costs on Relinquished Property \$(50,000) EQUALS: Net Cash Received on Sale \$2,000,000
Step
3

### Estimate Potential Tax Liability

Next, Ron and Maggie estimate their potential tax liability from the sale.  Assuming a Realized Gain of \$1,625,000 (see previous calculation), the sale would likely place the couple in the highest tax bracket, and their potential tax liabilities may look like this:

 Federal Capital Gains Tax1 20.0% \$245,000 Federal Tax on Depreciation Recapture2 25.0% \$100,000 Affordable Care Act Surtax 3.8% \$61,750 State Capital Gains Tax (CA)3 12.3% \$199,875 TAXES DUE (Effective Tax Rate)4 37.3% \$606,625

(1) Federal Capital Gains equal to Realized Gain less depreciation taken multiplied by the applicable rate.
(2) Based on amount of depreciation taken during ownership of the property. In this example,the amount is based on \$400,000 of depreciation taken.
(3) Rate varies by state. Example assumes California.
(4) Effective tax rate depicted as a percentage of Realized Gain of \$1,625,000 (from Step 2).

Step
4

By utilizing a 1031 exchange, Ron and Maggie may defer 37.3% in taxes and preserve all of the profit from the sale of their property.  This means they have more than \$600,000 in additional equity to reinvest!

 With 1031 Exchange Without 1031 Exchange Net Proceeds from Sale \$2,000,000 \$2,000,000 LESS: Taxes Paid \$- \$(606,625) EQUALS: Equity Available to Reinvest \$2,000,000 \$1,393,375

How Much Time do I Have?

There are two critical deadlines; If you miss either, you will owe taxes. The IRS does not grant extensions on these deadlines.  You have 45-days from the date you sell your property to identify potential Replacement Property(ies).  You have 180-days from the date you sell your property to purchase your Replacement Property(ies).

In order to defer ALL of your capital gains taxes, the Replacement Property must have a purchase price AND mortgage balance equal to or greater than the Relinquished Property being sold. Note that investors are not required to reinvest 100% of their sales proceeds in replacement property. This is known as a “Partial Exchange” and the portion the exchange proceeds that are not reinvested are referred to as “Boot” and are subject to taxes.

Ron and Maggie believe their property can be sold for \$2,850,000. Assuming the mortgage balance will be \$800,000, their evaluation of a suitable Replacement Property will look like this:

 Replacement Property Relinquished Property Purchase Price \$3,975,000 > OR = Sale Price: \$2,850,000 LESS: New Mortgage: 2,000,000 > OR = LESS: Mortgage Bal.: 800,000 ADD: Closing Costs** 25,000 LESS: Closing Costs: 50,000 EQUALS: Proceeds \$2,000,000 > OR = EQUALS: Proceeds: \$2,000,000

Closing Costs are considered part of your equity