As a Qualified Intermediary accommodating 1031 exchanges, I am often asked the question how to determine the capital gain when selling the replacement property when the property was originally acquired in a previous 1031 exchange. My first response is to gather your settlement statements before contacting your CPA who is familiar with your past federal tax returns. The goal is to determine the realized gain of the property to be sold that will ultimately be used to determine the recognized gain or tax due.
Adjusted Basis
The taxpayer may want to determine the tax consequences of selling the property to help decide whether another 1031 exchange makes sense. In a 1031 exchange, the replacement property tax basis is adjusted to reflect the basis of the relinquished or old property that was sold. Treasury Regulations Section 1031(d)-1(e) states that the basis of the replacement property acquired must be increased or decreased by the amount of the gain or loss recognized on the transfer of the relinquished property.
To start, the adjusted basis must be determined. Adjusted basis is defined as the net cost of an asset after increasing for improvements and decreasing by depreciation deductions. Once established, we look for the other variables needed to determine the replacement property basis. It is important in a 1031 exchange that the net equity and debt retired is equal or greater in the replacement property to defer all the capital gain.
Original purchase price + improvements – depreciation = Adjusted Basis
Selling price – adjusted basis – selling expenses = Realized Gain
Three Rules to Determine Capital Gain
There are three simple rules for determining amount of gain in an exchange and basis of replacement property.
- To defer 100 percent of the taxable gain in a 1031 exchange, the replacement property must be equal to or greater in value and equity than the relinquished property.
- Should the equity or mortgage in the replacement property be less , the taxpayer is taxed on the greater of the trade down in value or equity, but only to the extent of the realized gain from the exchange. Equity is the sales price less any mortgages less selling expenses.
- The basis in the replacement property equals the fair market value of the replacement property less the amount of the gain deferred by the taxpayer in the exchange.
Basis in the replacement property can be determined by:
- The total adjusted basis of the relinquished property and any other property conveyed in the exchange, plus
- Liabilities assumed by the taxpayer in the exchange, plus
- The amount of money paid by the taxpayer, plus
- The amount of gain recognized in the exchange, including gain recognized from other property, less
- The money or other property received by the taxpayer, less
- Liabilities of the taxpayer assumed by the other party and less
- Loss recognized on the other property in the exchange.
Example
Land was acquired for $60,000 and sold for $100,000 with a mortgage of $20,000 and a basis of $60,000. The replacement property is a single family residential investment acquired for $180,000 with a mortgage of $70,000 and the taxpayer pays additional cash of $30,000 along with the $80,000 from the land sale.
| Basis of relinquished property | $60,000 |
| Liabilities Assumed | $70,000 |
| Cash Paid | $30,000 |
| Liability Relief – | $20,000 |
| Basis in Replacement Property | $140,000 |
The replacement property basis equals the value of the replacement property ($180,000) less the amount of gain deferred on the exchange ($40,000) equals $140,000.
Allocation of basis between land and improvements is in proportion to their fair market values. Given the taxpayer exchanges land with a basis of $60,000 and a value of $100,000 for land and a building with fair market values of $70,000 and $110,000, respectively, 61.11 percent, or $61,111, of the $100,000 basis is allocated to the depreciable building ($110,000 divided by $180,000 = 61.11%).
Applying this to the single family residential investment, $85,554 is the basis associated with the improvements while the balance of $54,446 is the basis of the land. Land is not depreciated.
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