A 1031 exchange lets you exchange your investment real estate (relinquished property) for another of equal or greater value (replacement property). The main benefit of the exchange is that you could defer payment on capital gains taxes and depreciation recapture.
An important metric in working with a like-kind exchange is the cost basis, specifically, the new basis of the replacement property. Understanding the basis is essential because it impacts what taxes you might pay when you eventually sell the replacement property.
Defining Basis
Sometimes known as “cost basis,” basis is defined as the value of a property when it’s purchased minus expenses.
Basis crops up twice in the 1031 exchange:
- The adjusted basis of the relinquished property is modified for depreciation and capital improvements. The replacement property must be of equal or greater value to fully defer taxes.
- The basis of the replacement property is achieved by calculating the final purchase price minus deferred capital gains and other allowable deductions. This is used as the base value for future depreciation calculations and eventual tax liability when the replacement property is sold.
Calculating the basis becomes more complex for multiple exchanges.
1031 Exchange Formula for the New Basis
Below is the formula used for a 1031 exchange involving a single relinquished property and a single replacement property:
New Basis = (Adjusted Cost Basis of Relinquished Property + Additional Cash Paid) – (Boot Received + Transaction Costs + Gains Deferred)
In which:
- The adjusted cost basis of the relinquished property represents that property’s original cost.
- Additional cash paid is the added value paid for the replacement property as long as it is of greater value than your relinquished one.
- Boot represents cash, or non-like-kind property received.
- Transaction costs include allowable deductions such as brokerage commission and other professional fees.
- Gaines deferred represents capital gains that won’t be taxed after the exchange.
1031 Exchange Basis Examples
The following are examples to explain better how basis operates through a like-kind exchange.
#1–One Property to One Property Exchange
In this scenario, your relinquished property has an adjusted basis of $200,000. You sell the property through a 1031 exchange for $500,000, generating capital gains of $300,000.
With the proceeds held by your Qualified Intermediary (QI), you acquire a replacement property for $600,000. This fits with the “greater or equal value” capital gains reinvestment requirement of a like-kind exchange.
Plugging these into the formula, here’s what you get for the new basis:
$500,000 (from the relinquished property sale) plus
$100,000 (the extra paid for the replacement property) minus
$300,000 (the capital gains generated from the relinquished property sale)
The new basis is $300,000.
The above is complicated by the depreciation schedule of the relinquished property, which depends on how long you held it and received depreciation benefits. For residential real estate, the depreciation schedule is 27.5 years, while for commercial property, it is 39 years.
So, if you held the above-mentioned relinquished asset for 10 years, there are 17.5 years remaining if it is a residential property. That depreciation schedule is assigned to your replacement property. However, this would apply only to the value of the relinquished property ($500,000). The extra paid for the replacement property ($100,000) has a new schedule of 27.5 years.
#2–One Property to Multiple Property Exchange
Things become more complex when you acquire more than one replacement property.
Let’s say that your relinquished property has an adjusted basis of $1 million, and you sell it for $1.5 million, resulting in $500,000 of capital gains. Meanwhile, you acquire two replacement properties valued at $800,000 (Property A) and $900,000 (Property B). You would need to determine the proportion of deferred gains for each property with this formula:
Property purchase value/Total Replacement Property purchase value = Deferred Gains Proportion
Plugging the above into the formula, we’d have:
- Property A: $800,000 / $1,700,000 = 0.47 or 47%. Multiply this by the deferred gains, which equals $235,000, which is subtracted from the purchase price. The cost basis is $565,000.
- Property B: $900,000 / $1,700,000 = 0.53 or 53%. Multiply this by the deferred gains, which equals $265,000, which is subtracted from the purchase price. The cost basis is $635,000.
#3–Multiple Property to Multiple Property Exchange
In this case, you have two relinquished properties:
- Property C is valued at $800,000 and sold for $1.3 million.
- Property D is valued at $700,000 and sold for $1.2 million.
- The capital gains total $1 million.
Meanwhile, you acquire two replacement properties, Property E and F, costing $1.5 million. Because they have the same value, the deferred gain proportion is 50% for either property. This means you could reduce $500,000 from each asset’s purchase value to obtain a new cost basis of $1 million.
Basis and Allowable Expenses
When calculating basis in a 1031 exchange, certain costs can reduce taxable gain or increase the basis of the replacement property:
- Brokerage commissions, professional fees, and escrow fees reduce taxable gain but do not always increase basis unless capitalized.
- Capital improvements: Costs for major renovations, structural upgrades, or new additions can be added to the replacement property’s basis.
- Routine repair and maintenance costs: These cannot be added to basis.
Knowing the Basis for Successful Exchanges
Understanding the 1031 exchange basis of replacement property acquisitions is critical for tax management and investment strategies. The basis helps determine depreciation amounts while allowing you to determine the future value of the replacement property if you plan to exchange it down the road.
However, due to the complexities of basis, it’s always a good idea to work with professionals who understand the concept and can calculate correct figures. Doing so can help you avoid tax or other costly surprises.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
