What Happens If You Sell a 1031 Exchange Property At a Loss?

If you’ve been reading our blogs on a regular basis, you know that we publish a great deal of information about 1031 exchanges and potential tax benefits. Specifically, a well-executed like-kind exchange can defer capital gain taxes and depreciation recapture to a future date.  

But what happens if you consider selling a 1031 exchange property that might generate a loss rather than a gain?  

Here’s the simple answer. If that property is valued at a true capital loss, you likely wouldn’t need to swap it through a 1031 exchange. This is because no recognized capital gain would occur. Therefore, there likely wouldn’t be required capital gain taxes. 

But as with other issues dealing with taxes and exchanges, the actual answer is a little more complex. 

For one thing, a capital loss could mean that your property might sell below the basis, rather than what you actually paid for it. Basis represents the original price you paid for the property PLUS out-of-pocket expenses or closing costs connected with that property. 

Going further, the adjusted basis can also include accumulated depreciation deductions you took while you owned the property. Adjusted basis also includes capital improvements you might have made while you owned the property. 

Adding to the issue are depreciation recapture taxes. If you’ve owned your property for longer than one year, you might still have used property depreciation to offset your taxable income. So even if the price of your asset is lower than what you paid for it, you could still owe those depreciation recapture taxes to the IRS. You could defer that depreciation recapture through a 1031 exchange, even though (on paper), you’d be recording a loss, rather than a gain. 

Let’s look at the above, in numbers, through this hypothetical example. Let’s say you buy an investment duplex for $1 million. Over the time you own the property, depreciation brings the property’s adjusted basis down to $500,000. At some point, you sell the property for $800,000. 

Here’s the math: 

• You bought the property for $1 million and sold it for $800,000, meaning a loss (on paper) of $200,000. 
• However, due to depreciation, you actually owe capital gain taxes on $300,000. This is the difference between the sales price ($800,000) and the adjusted basis ($500,000). 
• The only way in which the above would represent a true capital loss is if sold the property for $400,000. That loss would be $100,000 – your $500,000 adjusted basis less the $400,000 sales price. Rather than exchanging that property, you could use that loss to reduce other capital gains. 

So can you exchange a 1031 exchange property at a loss? It depends. 

The above demonstrates that tax deferral strategies can be more complex than what’s on the surface. What you might consider a loss is something that the IRS would call a gain. As such, before embarking on any exchanges or reporting, be sure to consult a professional tax advisor.