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
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.
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).
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.
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.
|Original Cost Basis||$190,000|
|Adjusted Cost Basis||$215,000|
|Depreciation taken (rounded)||$138,000|
|Depreciated Basis (rounded)||$77,000|
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 firstname.lastname@example.org.
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