What is A 1031 TAX EXCHANGE?
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Section 1031 of the tax code allows a
taxpayer to defer the recognition of a gain or loss
on the exchange of Like-Kind Property, and thus
postpone the payment of tax. Before getting into
details about the implications of a 1031
Tax Exchange, lets discuss the taxes that are due on a typical sale of real estate.
Example: Mark owns a house in Phoenix that he rents out for rental income. He decides to sell the house and purchase a condo in Sacramento. Mark purchased the house 3 years ago for $245,000, and has since replaced the roof (cost $10,000) and taken depreciation deductions of $25,000. Mark sells his house at its fair market value for $275,000. Step 1 in finding out how much Mark owes in taxes is to calculate his adjusted basis in the property
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Adjusted Basis:
A property’s adjusted basis is the original basis of the property (what you originally paid for it), plus any capital improvements made, less any capital recoveries taken.
Original Basis (cost at acquisition)
+ Capital Improvements
- Capital Recoveries
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= Adjusted Basis at Disposition
The original basis of the property is the total amount paid for the property at acquisition. This includes escrow fees, title insurance fees, and any other fees that were incurred that were necessary in the purchase of the property.
Capital improvements made to the property are major expenditures for the improvement, restoration, or adaptation of the property. They are not repairs and maintenance expenses incurred in the ordinary operation of the property.
Capital recoveries include the total amount of depreciation taken on the property since acquisition, and any casualty or theft that has resulted in the reduction of the property’s value.
Marks basis is calculated as follows:
| Purchase Price |
$245,000 |
| + Capital Improvements |
$10,000 |
| - Capital Recoveries |
$25,000 |
| Adjusted Basis |
$230,000 |
Now that we have calculated Marks adjusted basis, we can calculate Marks capital gain on sale. Since Mark has held the property for longer than a year, the property is classified as long term capital gain property and is taxed at a lower rate than short term capital gain (holding period under 1 year). We can calculate Marks’ long term capital gain on sale by subtracting his adjusted basis from the price that Mark sold the property for.
| Sales Price |
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$275,000 |
| - Less Adjusted Basis |
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$230,000 |
| Long term capital gain on sale |
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$45,000 |
| Tax due on sale |
| Depreciation Recapture |
$25,000 x 25% |
$6,250 |
| Long term capital gain |
$20,000 x 20% |
$4,000 |
| Estimated Tax due on sale |
$10,250 |
This results in Mark paying $10,250 in unnecessary taxes. Instead, Mark could
"1031 Tax Exchange” his house in Phoenix for another property and save this money. Since most real estate transactions are structured with a 20% equity down payment and an 80% mortgage, this savings could enable Mark to acquire $51,250 more in real estate ($10,250 /.20).
Now that we have a better understanding of the potential benefits associated with a 1031
Tax Exchange, lets explore the process in greater detail. First off, in order for a transaction to qualify for a 1031
Exchange it must:
 Take the form of an “exchange” rather than a purchase and sale
The property disposed of and the property received must be held for investment purposes, or
for the productive use in a trade or a business.
The property disposed of and the property received must be of like-kind in nature Example: Mark owns a house in Phoenix that he rents out for rental income. Mark
1031 Exchanges this rental property with Susan for her condominium in Sacramento that she also rents out for rental income. The
1031 Tax Exchange is of like-kind in nature and thus neither Mark nor Susan must recognize a gain or loss on the transaction. Neither are subject to tax on the
1031 Exchange transaction.
This is a very simple example of a 1031 Exchange. Most transactions, however, are more complicated, and involve multiple parties. |
