How to Calculate Deferred Gain on a 1031 Exchange

A 1031 exchange provides a path for real estate investors to move from one investment property to another while postponing the payment of capital gains taxes. This tax deferral is authorized under Section 1031 of the Internal Revenue Code. The advantage is keeping capital invested in real estate that would otherwise be paid to the government in taxes. Understanding this deferral requires performing a specific calculation to determine how much of the gain is postponed.

This process allows an investor to sell a property, have the proceeds held by a third-party known as a qualified intermediary, and then use those funds to acquire a new, like-kind property. The rules are precise, requiring strict adherence to timelines for identifying and acquiring the replacement property. Calculating the deferred gain directly impacts the tax basis of the new investment and future tax liabilities.

Information Needed for the Calculation

Several key pieces of financial information must be gathered from the sale of the investment property being sold, known as the relinquished property. The first is the property’s adjusted basis. This figure starts with the original purchase price, is increased by the cost of any capital improvements made during ownership, and is reduced by any depreciation deductions that were claimed over the years.

Next, you must determine the final sale price and the total exchange expenses. The sale price is the gross amount the property sold for, while exchange expenses are the direct costs associated with the sale. These deductible costs include real estate broker commissions, title insurance fees, escrow fees, and legal fees related to the transaction.

From those figures, you can find the realized gain. This is the total on-paper profit from the sale, calculated by taking the sale price, subtracting the exchange expenses, and then subtracting the adjusted basis of the relinquished property. This realized gain represents the total potential gain from the transaction before considering the effects of the 1031 exchange.

A final piece of information to gather is the total “boot” received. Boot is any property or value received in the exchange that is not like-kind real estate and can trigger a tax liability. The most straightforward is cash boot, which is any cash the investor receives from the exchange proceeds. Another form is non-like-kind property boot, which is the fair market value of any other asset received, such as personal property included in the sale.

The third type is mortgage or debt boot, which arises from net debt relief. This occurs if the mortgage or debt paid off on the relinquished property is greater than the debt assumed on the new replacement property. For example, if an investor pays off a $300,000 mortgage on the old property but only takes on a $250,000 mortgage for the new one, the $50,000 difference is considered boot.

The Calculation Process

The calculation process uses the figures gathered previously to determine the taxable and deferred portions of the gain. For this example, assume a property sale resulted in a realized gain of $540,000.

The first step is to calculate the total boot received. This involves summing up all forms of boot that were part of the exchange. Continuing the example, if the investor received $20,000 in cash and had $30,000 in net debt relief, the total boot would be $50,000 ($20,000 + $30,000).

The second step determines the recognized gain, which is the portion of the realized gain that is currently taxable. The rule is that the recognized gain is the lesser of the realized gain or the total boot received. In our running example, the realized gain was $540,000 and the total boot was $50,000, making the recognized gain $50,000.

The final step is to calculate the deferred gain. This is the amount of profit that is not taxed in the current year and is instead rolled over into the new property. The formula is the realized gain minus the recognized gain. Using the example figures, the deferred gain would be $490,000 ($540,000 Realized Gain – $50,000 Recognized Gain).

Determining the Basis of the New Property

The gain that is deferred in a 1031 exchange directly impacts the tax basis of the newly acquired replacement property. This adjustment ensures the postponed gain will be accounted for upon a future taxable sale of the new property.

The calculation for the new property’s basis is the purchase price of the new property minus the deferred gain calculated in the exchange. For example, if an investor purchases a replacement property for $1,200,000 and has a deferred gain of $490,000 from the sale of the old property, the initial adjusted basis of the new property is $710,000 ($1,200,000 – $490,000).

This new, lower basis has long-term implications. First, it becomes the starting point for calculating annual depreciation deductions on the replacement property, which means smaller depreciation write-offs. This reduced basis will be used to calculate the capital gain when the replacement property is eventually sold in a taxable transaction.

Reporting the Exchange on Form 8824

After completing the exchange, the transaction must be reported to the Internal Revenue Service. The specific document required is IRS Form 8824, titled “Like-Kind Exchanges.” This form must be filed with the investor’s federal income tax return for the year in which the exchange took place.

Form 8824 is structured to walk a taxpayer through the necessary calculations to report the exchange correctly. It is divided into several parts, and Part I gathers descriptive information about the properties exchanged and the relevant dates, such as when the relinquished property was transferred and when the replacement property was identified and received.

Part III of Form 8824 is where the core calculations are formally reported. This section guides the filer through determining the realized gain, the recognized gain, and ultimately, the deferred gain. It also includes the calculation for the basis of the new like-kind property received.