As we’ve mentioned in previous blogs, 1031 exchanges can come with many challenges. There are the in-stone deadlines, cost considerations, and paperwork, to name a few.
There are also the calculations involved. Specifically, to know how much you can potentially defer through a like-kind exchange, you need to know about the gain from selling your relinquished property. Understanding that gain can help you pinpoint the right replacement property to defer capital gains and depreciation recapture taxes from the sale of your real estate.
Regarding your 1031 exchange activities, it’s essential to understand that there are two types of gains – realized and recognized. Here’s the difference:
A realized gain is the amount you earn from the sale of your real estate asset, In other words, the sales price, less transaction or closing costs, less your adjusted tax basis. The adjusted basis focuses on the original purchase price of your asset and includes affiliated acquisition costs and expenses dedicated to capital improvement.
A recognized gain is the taxable portion of your realized gain. Recognized gains can be less than realized gains due to certain tax offsets – like a 1031 exchange. When executed correctly, the 1031 exchange could defer taxes on those recognized gains.
The best way to potentially defer capital gains taxes in a 1031 exchange is to target a replacement property or properties of greater or equal value to the relinquished property/properties. This can help defer all capital gains and depreciation recapture taxes.
But this might not always be possible. In the real world, your realized gain (the profit) and your recognized gain (the taxable portion of that profit) could be different. Let’s take the following example.
Let’s say you acquired a rental property five years ago for $800,000. To complete that sale, you paid an extra $50,000 to cover due diligence and closing costs. The entire cost basis on the purchase of your property is $850,000.
Let’s also say that you have a clever accountant who helps you apply depreciation and other expenses of $100,000 during your ownership. This reduces the basis on that property to $750,000.
Five years later, an interested seller comes to you and offers $900,000 to buy the property. Your clever accountant tells you that your realized gain AND recognized gain from the sale will be $150,000 – or the difference between the sales price of $900,000 and the $750,000 cost basis. She also tells you you’ll owe capital gains and depreciation recapture taxes on that $150,000.
“How can we reduce that gain?” you might ask this accountant. The accountant could suggest you embark on a 1031 exchange and roll over at least part of that gain into a like-kind property. You target a replacement property and can roll over $100,000 of the $150,000 gain into it. This then leaves you with a recognized gain of $50,000. This is also known as “boot.” You’ll still owe taxes on that recognized gain. But you’ll still have deferred taxes on most of what you earned.
The above is a basic explanation. Calculating recognized and realized gains – especially through a 1031 exchange – can be much more complex. This requires the skill of a tax professional who is experienced in gain recognition and like-kind exchanges.