Simple Rules for Determining Replacement Property Basis in a 1031 Exchange
Taxpayers conducting tax-deferred 1031 exchanges take great care to ensure that they are following fundamental rules of the exchange – buying up in value and reinvesting all exchange proceeds in replacement property – in order to defer all capital gains from their relinquished property. However, once the exchange is over, the question often arises: what is the new cost basis in the replacement property (or properties)?
In a standard purchase transaction, the cost basis of a property will typically be the value at which it was acquired. However, in a 1031 exchange, a taxpayer is carrying over their basis from their relinquished property(ies) and thus, a different calculation is required to determine what the new basis in one or more replacement properties will be.
In very simple terms, the new basis in replacement property is the cost of its acquisition, less the total amount of capital gains deferred. If multiple replacement properties are acquired, the total amount of capital gains deferred in the transaction will be proportionately split amongst the replacement properties to reduce the basis of each replacement property acquired.
The following examples illustrate the above rule:
A taxpayer prepares to sell residential Property A, which they’ve owned for 10 years, and which has an adjusted basis of $225,000. The taxpayer sells the property for $400,000 and conducts a 1031 exchange. They have $175,000 of capital gains to defer ($400,000 sales price less $225,000 adjusted basis).
The taxpayer acquires residential Property B for $500,000 and fully defers all capital gains in their exchange. This purchase value, less the $175,000 of gains deferred, results in a new basis of $325,000.
- Note that residential property is depreciated over 27.5 years. The taxpayer took depreciation on Property A during the 10 years they owned the property. Thus, they can continue to depreciate the carried over portion of the basis of Property B ($225,000) for another 17.5 years. However, the “new” portion of the basis of Property B (basis of $325,000 less carried over basis of $225,000), or $100,000, can be depreciated over a new schedule of 27.5 years.
A taxpayer prepares to sell commercial property X, which they’ve owned for 10 years, and which has an adjusted basis of $500,000. The taxpayer sells the property for $1,000,000 and conducts a 1031 exchange. They have $500,000 of capital gains to defer.
The taxpayer acquires commercial property Y for $300,000 and commercial property Z for $900,000, and fully defers all capital gains in their exchange. The total gains deferred of $500,000 must be split proportionately between the two replacement properties Y and Z to determine what amount is taken from each property’s acquisition cost to come up with the new cost basis for each property.
Property Y: $300,000 / total replacement property value of $1,200,000 = 0.25
- 0.25 * total deferred gains of $500,000 = $125,000
- $300,000 acquisition cost less $125,000 deferred gains = new basis of $175,000
- Commercial property is depreciated over 39 years. The taxpayer took depreciation on Property X for the 10 years they owned the property. Thus, they can continue to depreciate the carried over portion of the basis of Property Y ($125,000) for another 29 years. They can depreciate the new portion of the basis of Property Y ($50,000) for 39 years.
Property Z: $900,000 / total replacement property value of $1,200,000 = 0.75
- 0.75 * total deferred gains of $500,000 = $375,000
- $900,000 acquisition cost less $375,000 deferred gains = new basis of $525,000
- The taxpayer can continue to depreciate the carried over portion of the basis of Property Z ($375,000) for another 29 years. They can depreciate the new portion of the basis of Property Z ($150,000) for 39 years.
A taxpayer prepares to sell two commercial Properties D and E, which they’ve owned for 10 years, and which have respective adjusted bases of $200,000 and $500,000. The taxpayer sells Property D for $700,000 and Property E for $1,000,000 and conducts a 1031 exchange. They have a total of $1,000,000 in capital gains to defer.
The taxpayer acquires residential Properties F and G for $1,000,000 each, and fully defers all capital gains in their exchange. The total gains deferred of $1,000,000 are split proportionately between the two properties to determine the amount taken from each property’s acquisition cost to come up with the new cost basis for each property. Because the properties are of equal value, the value of each is reduced by $500,000. In other words, the new cost basis for each Property F and G is $1,000,000 - $500,000, or $500,000.
- The taxpayer has exchanged commercial property for residential property, which has a different depreciation schedule. Because they took depreciation on Properties D and E for ten years, and because the new Properties F and G are residential, the taxpayer may depreciate the carried over portion of the basis for each (i.e. $500,000, which happens to be the entirety of the new basis for each property) for 17.5 more years, as opposed to the 29 years that were remaining on the depreciation schedules for Properties D and E. If a taxpayer exchanges residential for commercial property, however, they receive the benefit of a longer depreciation schedule.
Carry-Over of Basis for Future Exchanges
A taxpayer can continue to exchange replacement property acquired through previous 1031 exchanges. Each time, the adjusted basis of the property is carried over in the manner described above. If each sale is conducted as a 1031 exchange, with all proceeds reinvested and all gains deferred, capital gains continue to be deferred indefinitely. Once a taxpayer sells property acquired via an exchange (or via multiple exchanges) without doing another exchange, the carried over capital gains will be subject to taxation.
If a taxpayer continues to exchange investment property for new investment property in multiple exchanges, and continues to carry over their basis, once they pass away, their heirs will inherit the property at its stepped-up basis. In other words, under this scenario, the built-up capital gains carried over from exchange to exchange will never be taxed.
While the above examples and rules illustrate the very basics of calculating the basis in replacement property acquired through a 1031 exchange, they are not to be construed as tax advice. It is important for you to always review your adjusted basis, exchange figures, and replacement property acquisition figures with your tax advisor. They can provide you with concrete advice to help you make the best-informed choices when it comes to exchanging real property and determining your potential tax liability.
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