What are the Basics for Calculating Your Basis

When an investor sells an invest­ment prop­er­ty there is the abil­i­ty to defer pay­ing cap­i­tal gains tax­es (taxed at 0%, 15%, or 20%) as well as the recap­ture of depre­ci­a­tion (taxed at 25%) for pay­ment at anoth­er time. The IRC §1031 enables you to exchange the prop­er­ty you are sell­ing for anoth­er prop­er­ty.

By Al DiNi­co­la, AIF®, CEPA™
April 20, 2023
Adinicola@namcoa.com
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD

This may be referred to as a like kind exchange. For the pur­pos­es of this writ­ing, we will address invest­ment prop­er­ty and not pri­ma­ry res­i­den­tial prop­er­ty. We are not pro­vid­ing tax advice and investors are encour­aged to con­sult their own CPA.

Under­stand­ing  basis in a 1031 exchange.

 There are sev­er­al types of basis, includ­ing:

• Orig­i­nal Cost basis;
• Adjust­ed Cost Basis;
• Depre­ci­at­ed Basis;
• Tax Basis;
• Car­ried For­ward Basis; and
• Step up in Basis.

The con­fu­sion may begin with an investor won­der­ing what hap­pens to their basis when the prop­er­ty is sold. When the top­ic of depre­ci­a­tion aris­es there are a vari­ety of ques­tions. What hap­pens to depre­ci­a­tion while I own the prop­er­ty? How long does it take to use up all the depre­ci­a­tion? How can I start depre­ci­a­tion over again with a new prop­er­ty? If I use up all the depre­ci­a­tion and I still want tax advan­taged real estate, what do I do? Does the entire prop­er­ty get depre­ci­at­ed?  All of these ques­tions and more may be traced back to the orig­i­nal prop­er­ty to estab­lish your basis. There may be a long paper trail need­ed if you do mul­ti­ple exchanges.

Hypo­thet­i­cal exam­ple

Jack & Diane are sell­ing a rental house in New Jer­sey. They paid $175,000 for the prop­er­ty in Jan­u­ary 2002. They also paid 15,000 in clos­ing costs.  They invest­ed anoth­er  $25,000 to add a garage. They accept an offer for $400,000 on the prop­er­ty (Decem­ber clos­ing 2022). They have owned the prop­er­ty for ten years. They have locat­ed a prop­er­ty in Day­tona Beach for $400,000.

Orig­i­nal Cost Basis

The orig­i­nal cost basis is the orig­i­nal pur­chase price, asso­ci­at­ed clos­ing cost at the time of acqui­si­tion of the relin­quished prop­er­ty. The orig­i­nal cost basis in the home would be $190,000 ($175,000 orig­i­nal pur­chase price, $15,000 in clos­ing cost).

Adjust­ed Basis

The adjust­ed basis would be the orig­i­nal cost basis plus the $25,000 for the garage. If there were any oth­er major ren­o­va­tion or cost that adds to the val­ue of the home those cost or invest­ment would be added.   For this exam­ple, the total adjust­ed cost basis would be $215,000. 

Depre­ci­at­ed Basis

Depre­ci­a­tion is an inter­est­ing sit­u­a­tion. The IRS assumes you have tak­en the depre­ci­a­tion whether you uti­lized that depre­ci­a­tion or not. The prop­er­ty was depre­ci­at­ed each year. The depre­ci­a­tion sched­ule is 27.5 years for res­i­den­tial prop­er­ty (com­mer­cial prop­er­ty is 39 years). How­ev­er, the entire pur­chase price of $175,000 is not depre­ci­at­ed. Only the struc­ture can be depre­ci­at­ed and not the land. For this exam­ple, we will assign a land val­ue of $25,000 to the prop­er­ty and $150,000 for the struc­ture plus the clos­ing cost of $15,000 and addi­tion of the garage $25,000 for a total of $190,000. The depre­ci­a­tion tak­en was $6,900 each year for a total of $138,000. In this case  the prop­er­ty has a depre­ci­at­ed basis  of $77,000.  In some cas­es, the depre­ci­at­ed  basis may be zero if the prop­er­ty was held for the entire depre­ci­a­tion peri­od. 

Tax Basis

One of the first  items an investor may want to know is  the tax basis in order to deter­mine if the investor wish­es to enter into a 1031 tax deferred exchange. The tax basis would be used to estab­lish the cap­i­tal gains on the prop­er­ty as well as the recap­ture of the depre­ci­a­tion over the years. The New Jer­sey home has an adjust­ed cost basis of $215,000 and sold for $400,000. The cost of sell­ing the New Jer­sey home was $20,000 and that is sub­tract­ed from the sell­ing price to arrive at the net sell­ing price used to deter­mine the cap­i­tal gains. This would be $380,000. The net sell­ing price on the prop­er­ty would be $380,000 minus the $77,000 depre­ci­at­ed basis tak­en for a Tax Basis of $303,000. For fed­er­al tax pur­pos­es this amount is divid­ed into recap­ture and cap­i­tal gains. There will be recap­ture of the $138,000 depre­ci­a­tion tak­en is taxed at a rate of 25%. The remain­ing $165,000 would be taxed at the cap­i­tal gains rate. This would depend on the indi­vid­ual tax pay­er (0%, 15%, 20%). Indi­vid­ual states such as New Jer­sey have tax­es that are also due upon the sale and would use the entire $303,000 for cal­cu­la­tions. There may also be (depend­ing on tax pay­er income lev­el) a 3.8% NIC tax on gain. These tax­es would be deferred if uti­liz­ing a 1031 tax deferred exchange.

Car­ry For­ward Basis

The  $77,000 depre­ci­at­ed basis is the  car­ried for­ward basis.  The prop­er­ty in Day­tona Beach is the same price as the New Jer­sey home being sold. This is a very impor­tant fact because the price of the new prop­er­ty is a big fac­tor that affects many items. Actu­al­ly, they are buy­ing equal. Because they bought equal the basis in the new prop­er­ty is the same as the remain­ing basis in the New Jer­sey home. The basis rolls for­ward to the new Day­tona Beach prop­er­ty.

The orig­i­nal date (2002) of the New Jer­sey home is what appears on the future depre­ci­a­tion sched­ules.  The depre­ci­a­tion sched­ule car­ries over as if they were still depre­ci­at­ing the New Jer­sey home. In this case there is no addi­tion­al depre­ci­a­tion time oth­er than what is remain­ing on the $77,000. That would be sev­en- and one-half years remain­ing.  

 If you had a mort­gage on the relin­quished prop­er­ty this will be not­ed.

The depre­ci­at­ed  basis on an invest­ment prop­er­ty can appear to be allu­sive to deter­mine. One of the most impor­tant fac­tors is the pur­chase price of the replace­ment prop­er­ty. This dic­tates many items that will affect you.

How to increase basis in replace­ment prop­er­ty.

The ques­tion many investors ask is how do you change the dynam­ics on the exchange and poten­tial­ly increase tax favored write offs?  One strat­e­gy would be to pur­chase up, mean­ing  a more expen­sive replace­ment prop­er­ty. Rather than buy­ing a $400,000 prop­er­ty in Day­tona Beach hypo­thet­i­cal­ly they pur­chase a $500,000 prop­er­ty. Their basis in the prop­er­ty would be increased by $100,000.  This is a com­bi­na­tion of the rollover $77,000 plus the $100,000 for a total of $177,000. There would be 7½ years remain­ing on the $77,000 and the $100,000 would start on a 27 ½ year depre­ci­a­tion sched­ule. The updat­ed depre­ci­a­tion sched­ule shows the con­tin­ued depre­ci­a­tion of the New Jer­sey homes (as if they still owned it) and the acqui­si­tion of the Day­tona Beach prop­er­ty por­tion as of the date they closed on the Day­tona Beach prop­er­ty.

Bring more cash or acquire more debt!

In order to increase the pur­chase price, the investor would need to bring addi­tion­al cash or arrange for a mort­gage or loan for the $100,000. This may involve apply­ing for a loan.  In most cas­es the investor would need to sign for and be liable for the loan.  To avoid per­son­al lia­bil­i­ty for a loan, some investors uti­lize Delaware Statu­to­ry Trust (DST) as a replace­ment prop­er­ty espe­cial­ly when lever­age is present.  DST have non-recourse debt. This elim­i­nates the need for Jack & Diane to apply for or be liable for any of the assigned debt on the new acqui­si­tion. We have guid­ed investors who have ful­ly depre­ci­at­ed their invest­ment prop­er­ties who acquired a DST with 50% Loan to Val­ue. This would increase the basis by an addi­tion­al the amount of the debt assign­ment ($400,000 for exam­ple). Acquir­ing addi­tion­al debt is not for all investors.  If the investor uti­lized a future 1031 exchange the acquired debt (or bal­ance paid off) needs to be replaced. The oth­er con­sid­er­a­tion would be the over­all goals of the investor when acquir­ing a prop­er­ty and in this exam­ple the Day­tona Beach prop­er­ty may have oth­er uses in the future.

Step Up in Basis

The final basis would be ref­er­enced as the step-up basis.  This strat­e­gy ben­e­fits the heirs of the investor.  When the investor pass­es away there is an adjust­ment from the orig­i­nal basis to the cur­rent mar­ket val­ue. If the orig­i­nal prop­er­ty was pur­chased for $175,000 ful­ly depre­ci­at­ed (over 27.5 years) and now worth $750,000 that is the new basis. The basis has been stepped up to cur­rent val­ue.  If the prop­er­ty is sold there would be no cap­i­tal gains tax­es due and there would be no recap­ture of depre­ci­a­tion tak­en.  This strat­e­gy may be uti­lized to build gen­er­a­tional wealth.

As pre­vi­ous­ly stat­ed, we are not CPA. We have guid­ed many investors with a list of ques­tions for their CPAs and assist­ed in count­less 1031 exchange con­sul­ta­tions.  We have also assist­ed in the acqui­si­tion of DST uti­liz­ing the 1031 process.  Call with any ques­tions you may have. DSTs are not for all investors. The acqui­si­tion of a DST is for accred­it­ed investors only. Con­tact your invest­ment advis­er for addi­tion­al details on how a DST may be a solu­tion to your 1031 Exchange and suit­ed for your invest­ment future. For more infor­ma­tion on how to prop­er­ly set up an IRC 1031Tax Deferred Exchange or if you are an accred­it­ed investor and would like addi­tion­al infor­ma­tion on a DST con­tact Al DiNi­co­la at 239–691-8098 or email adinicola@namcoa.com.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus. Invest­ing in secu­ri­ties, real estate, or any invest­ment, whether pub­lic or pri­vate, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor. NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion). Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 8215 SW Tualatin ‑Sher­wood Rd, Suite 200 Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

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