How to Calculate the Basis for a 1031 Exchange

A 1031 exchange allows real estate investors to defer capital gains taxes on a property’s sale by reinvesting the proceeds into a like-kind asset. This deferral is achieved by adjusting the tax basis of the new property. A property’s basis is its value for tax purposes, and the tax-deferred gain from the original property reduces the basis of the replacement property. This lower basis means a larger taxable gain may be realized upon its future sale, unless another exchange is performed.

Information Needed for the Calculation

To begin, you must gather several pieces of information, starting with the adjusted basis of the property being sold (the relinquished property). This figure is calculated by taking the original purchase price, adding the cost of any capital improvements, and then subtracting the accumulated depreciation. Depreciation is the annual tax deduction allowed to recover the cost of an income-producing property over its useful life. Capital improvements are investments that add to the property’s value or prolong its life, such as a new roof, and are distinct from simple repairs.

You also need the fair market value (FMV) for both the relinquished and replacement properties, which is their price on the open market. This is established by their sale and purchase prices. A detailed accounting of all exchange expenses is also required, which are costs like real estate commissions, qualified intermediary fees, legal fees, and title insurance.

Finally, you must identify any “boot” received in the exchange. Boot is any non-like-kind property that can trigger an immediate tax liability. It comes in two forms: cash boot, which is any sale proceeds the investor keeps, and mortgage boot, which occurs if the debt on the new property is less than the debt paid off on the old one.

Calculating the Recognized Gain

The “realized gain” is the total economic profit from the transaction, whether it is taxed now or later. It is calculated by taking the fair market value of the property received, adding any boot, and then subtracting the adjusted basis of the property given up and any exchange expenses paid. This figure represents the overall financial gain on the sale.

The “recognized gain” is the portion of the realized gain that is immediately subject to tax. To determine the recognized gain, you take the lesser of the total boot received or the total realized gain. If no boot is received in the exchange, there is no recognized gain, and the entire capital gain is deferred.

For example, an investor with a realized gain of $200,000 who receives $15,000 in cash boot has a recognized gain of $15,000. This amount is subject to capital gains tax in the current year. The remaining $185,000 of the gain is deferred and will be used to adjust the basis of the new property.

The New Basis Calculation Formula

After determining the recognized gain, you can calculate the basis of the replacement property. This new basis is what will be used for future depreciation and to determine the gain or loss upon its eventual sale. The most direct formula is to subtract the deferred gain from the fair market value of the replacement property. The deferred gain is the realized gain minus the recognized gain.

An alternative way to calculate the new basis is to start with the adjusted basis of the relinquished property. To this figure, you add the purchase price of the new property and subtract the sale price of the old property, then adjust the result by adding any recognized gain. Both formulas should yield the same result, providing a way to check your work.

To use a comprehensive example, an investor sells a property with an adjusted basis of $300,000 for $500,000, creating a $200,000 realized gain. They purchase a new property for $485,000 and receive $15,000 in cash boot. The recognized gain is $15,000, making the deferred gain $185,000. Using the primary formula, the new basis is the purchase price of $485,000 minus the deferred gain of $185,000, which equals $300,000.

Reporting the Exchange on Form 8824

The details of a 1031 exchange must be reported to the IRS using Form 8824, Like-Kind Exchanges. This form is filed with your federal income tax return for the year the exchange took place and systematically guides you through the required calculations.

Part III of the form is where the realized and recognized gains are calculated using the figures for the properties, boot, and expenses. This section confirms the amount of gain, if any, that must be reported as taxable income for the year. The final calculation for the new property’s basis is completed in Part IV, establishing the figure that will be used for future depreciation and tax purposes.