When discussing 1031 exchanges, the concept of 'basis' becomes crucial. But what does it mean in the context of a 1031 exchange? Essentially, the basis of the replacement property acquired in a 1031 exchange is the same as the basis of the relinquished property, subject to certain adjustments. This basis carries over from your old property to your new one, effectively preserving the deferred gain for potential recognition in the future. It's this ability to defer capital gains taxes through the transfer of basis that makes 1031 exchanges such a powerful tool for real estate investors.
What is basis?
Basis is the amount that a property is worth for tax purposes. The basis changes over time and can be adjusted, making the concept more confusing. When you buy a property, the price you pay is the starting basis. However, the cost basis also includes acquisition costs, such as title insurance, appraisal, and legal and escrow fees.
However, the cost or starting basis may increase or decrease over time. If you make capital improvements to the asset, the money spent on those improvements increases the basis. For example, suppose you bought a rental property for $400,000 and had acquisition costs of $40,000 for a cost basis of $440,000. Then you remodel the units and replace the roof at a total cost of $100,000. Now your adjusted basis is $540,000.
Your basis may also decrease. Typically, basis reductions are due to depreciation deductions but may also come from losses like casualty and theft. With the $400,000 value, you can deduct $14,545 annually for depreciation. If you held this rental property for three years, you reduce the basis by the claimed depreciation of $43,635 for an adjusted cost basis of $496,635*.
Is the realized amount different from the basis?
Yes. The realized amount for the relinquished property is the sales price minus any costs of the sale. If the property sells for $700,000 net, that is the realized amount. The realized amount minus the adjusted basis is $203,365.
What is the basis for the new property?
Calculating the basis for the new (replacement) property in a 1031 exchange is simpler--the purchase price plus the commission paid. The basis for the new asset must be equal to or greater than the relinquished asset for a successful 1031 exchange. If the purchase price of the replacement property is less than the adjusted basis of the relinquished property, the 1031 will have a boot that is subject to capital gains taxes.
How does a 1031 exchange affect the basis in the future?
The basis for the new property will include the taxes deferred in the exchange. Remember that the adjusted basis will decrease when depreciation deductions are taken, and the deferred taxes are also deductions from the cost basis. Suppose the investor continues to execute sequential 1031 exchanges until distributing the final asset to an heir. In that case, the heir receives the property at a stepped-up value, and the deferred taxes are eliminated.
*Note: The depreciation amount would change depending on when the improvements were made, as those improvements would change the adjusted basis. This is an illustration.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Hypothetical examples shown are for illustrative purposes only.