Recently, I had a conversation with a good friend of mine about how his 1031 exchange transaction was going. During our discussion, he mentioned that he had been a bit overwhelmed when he tried to follow the calculation for the basis of his new property. I gave him a few pointers about how basis is computed in 1031 exchanges. It wasn’t long before he realized that the process isn’t as intimidating as he originally thought.
You’re likely aware that basis is an important concept in the context of real estate transactions. Your basis is a reflection of the investment you’ve placed into an asset reduced by depreciation and increased by capital improvements at the property, and as such, it is used to calculate the gain you realize when making a sale if you do not utilize a 1031 tax-deferred exchange.
Prior to engaging in any type of real estate transaction, it is imperative that you have an accurate calculation of the basis in your current property and also whatever basis you will acquire in the future. Even though calculating basis in 1031 exchanges isn’t something to be intimidated by, it still has a bit of complexity, so you are encouraged to consult with your tax advisor. In order to defer capital gains taxes on an investment property sale while replacing your relinquished property with a high-quality asset, you should consider partnering with a capable real estate investment management firm that can source properties for you and help you through the 1031 exchange process.
Let’s take a look at the various steps involved with making basis calculations in 1031 exchanges.
Determine the Basis in Your Original Property
The first step in the calculation of basis in 1031 exchanges is simply to determine the existing basis in your original property. To make this determination, think back to how you acquired your first property.
If you acquired your property in a traditional sale, your basis is the purchase price plus the costs incurred to obtain the property. Generally speaking, if your original property was given to you as a gift, then the donor’s net adjusted basis becomes your basis (if there is any gift tax due then all or part of it may increase your basis).
There are, however, some exceptions to this. For example, if the fair market value (FMV) of the gifted property is less than the donor’s net adjusted basis at the time of the gift, and the property is later sold for a price less than the FMV at the time of the gift, then the FMV at gifting is used as the basis to calculate a loss.
Another scenario would be where the FMV at time of gifting is also less than the donor’s net adjusted basis, but the property is eventually sold for more than the donor’s net adjusted basis at the time of gifting. Assuming there has not been any changes to the net adjusted basis between the time of the gift and the later sale, then the gain on the property would be the difference between the sales price and the net adjusted basis.
If the FMV at the time a donor gifts a property is equal to or greater than the donor’s net adjusted basis, then the recipient’s basis is the donor’s net adjusted basis at the time of gifting.
If you inherited the property, your basis is the property’s fair market value at the time of the original owner’s death.
When you calculate your net adjusted basis in your original property, be sure to take into account any changes that have occurred throughout the course of ownership. For instance, be sure you’ve accounted for any depreciation that has taken place, which reduces your basis or any capital improvements that have been made, which increase your basis.
Once you’ve determined the net adjusted basis of your original property, you’re ready to move forward with determining the new basis in your 1031 replacement property.
Calculating Basis in Your Replacement Property
When you complete your 1031 exchange, the net adjusted basis will reflect all of the liabilities, assets, gains, and losses that are involved in the transaction. Using the basis of your original property as your starting point, you calculate your new basis by adding the following:
- Any assets that were transferred (such as extra property or cash boot).
- Liabilities you assume.
- Any gain recognized from the exchange.
Then, subtract any assets you received, liabilities you transferred, and any loss realized from the other party.
This may seem complex at first, but when you mull over it for just a moment, it becomes pretty easy to understand. Let’s look at an example to break things down a bit.
Suppose your original property has a value of $2 million, and you have a net adjusted basis of $1 million and a mortgage of $1 million. You decide to sell your original property and then perform a tax-deferred 1031 exchange into a new property at a purchase price of $2.5 million and a mortgage of $1.3 million. To complete the deal, you give $200,000 cash to the other party as boot.
Using the steps outlined above, we can do a bit of math to reach the net adjusted basis:
$1 million (original net adjusted basis) $1.3 million (liability assumed by taxpayer) $200,000 (cash boot) – $1 million (liabilities assumed by other party) = $1.5 million (net adjusted basis).
The new basis of $1.5 million reflects all of the assets, liabilities, gains, and losses that took place throughout the exchange.
Here’s a good way to think about the basis of your replacement property: Your new basis represents the value of your replacement property minus whatever gain is deferred, or plus the total unrecognized loss should this be the case instead. This is a good way to quickly get a sense of your future basis.
In certain cases, calculating your new basis can be a bit trickier. For instance, when extra property is transferred, the calculation is more difficult because this property has to be independently appraised. Also, when large gains or losses are involved, the calculation is usually a bit more complicated. Please consult your tax advisor.
Any time you want to ensure your 1031 exchange is handled seamlessly, one of the best options is to partner with a trusted real estate investment management firm to avoid any hassle or headache. With decades of experience, the experts at CWS Capital Partners can find, evaluate, and acquire replacement properties for your 1031 exchange, manage the property, distribute cash flow to you from the asset, and provide you with reporting as an owner.
Please contact us to learn more about investing with CWS Capital Partners, or view our current offerings by completing our self-certification form for accredited or qualified investors.
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