What Happens When You Sell a 1031 Exchange Property?

A 1031 exchange provides a path for real estate investors to defer capital gains taxes by reinvesting the proceeds from a sold property into a new, like-kind property. This tax-deferral mechanism, authorized by Section 1031 of the Internal Revenue Code, is a postponement of tax, not a permanent forgiveness. The tax obligation crystallizes when the investor decides to sell the replacement property in a taxable sale. At this point, the deferred gain from the original exchange, plus any additional appreciation from the new property, becomes subject to taxation.

Determining the Adjusted Basis of Your Replacement Property

The first step in understanding the future tax consequences of selling a replacement property is to determine its adjusted basis. The basis of the new property is not simply its purchase price. Instead, the basis from the original property, known as the relinquished property, is carried over to the replacement property. This carryover basis is the mechanism that preserves the deferred gain.

The calculation begins with the purchase price of the replacement property, from which you subtract the gain that was deferred from the sale of the original property. The resulting figure represents the new property’s basis, which is then adjusted for factors like additional cash paid or new mortgage debt assumed.

For example, assume an investor sells a property for $1 million that had an adjusted basis of $400,000, resulting in a $600,000 realized gain. The investor uses a 1031 exchange to acquire a new property for $1.2 million. The basis of this new property is calculated by taking the $1.2 million purchase price and subtracting the $600,000 deferred gain, which results in a new adjusted basis of $600,000.

This lower basis means that when the replacement property is eventually sold, the taxable gain will be higher. Any capital improvements made to the replacement property will increase its adjusted basis, while any depreciation deductions taken during the ownership period will decrease it.

Calculating the Taxable Gain Upon Sale

When the replacement property is sold in a taxable transaction, the total gain is the difference between the final sale price and the property’s adjusted basis. This total gain is not taxed uniformly; it is separated into two components with different tax treatments: depreciation recapture and capital gain.

The first portion of the gain is depreciation recapture. Over the years of owning the properties, an investor likely claimed depreciation deductions to lower their taxable income. Upon sale, the IRS “recaptures” the benefit of these deductions, and this amount is taxed at a maximum rate of 25 percent for real estate.

After accounting for depreciation recapture, the remaining portion of the gain is treated as a long-term capital gain. This includes the gain deferred from the initial 1031 exchange and any additional appreciation in the replacement property’s value. Depending on the investor’s total taxable income, this gain is taxed at federal rates of 0%, 15%, or 20%. Some high-income investors may also be subject to an additional 3.8% Net Investment Income Tax.

To illustrate, let’s build on the previous example. The replacement property with an adjusted basis of $600,000 was held for several years, during which $100,000 in depreciation was claimed, reducing the basis to $500,000. The property is then sold for $1.5 million. The total gain is $1 million ($1.5 million sale price – $500,000 adjusted basis). The first $100,000 of this gain is depreciation recapture, taxed at up to 25%, while the remaining $900,000 is long-term capital gain.

Reporting the Sale to the IRS

Once the taxable gain and its components have been calculated, the transaction must be reported to the IRS using specific forms that separate the gain.

The depreciation recapture component of the gain is reported on Form 4797, Sales of Business Property. This form is designed for reporting the sale of property used in a trade or business, including investment real estate. Part III of Form 4797 is used to calculate the gain attributable to depreciation, which is taxed up to the 25% maximum for real estate.

The remaining capital gain is reported on Form 8949, Sales and Other Dispositions of Capital Assets, which then flows to Schedule D, Capital Gains and Losses. Form 8949 lists each asset sale, including the sale price, adjusted basis, and the resulting gain. The information from both forms is ultimately carried to the investor’s main tax return, Form 1040.

Strategic Alternatives to a Taxable Sale

An investor holding a replacement property from a 1031 exchange is not limited to a taxable sale. Strategic alternatives exist that can further postpone or even eliminate the tax liability associated with the accumulated gains.

One common strategy is to initiate another 1031 exchange. The replacement property from the first exchange becomes the relinquished property in a new exchange. This allows the investor to roll the entire deferred gain into another like-kind investment property, deferring capital gains and depreciation recapture taxes indefinitely.

Another strategy involves holding the property until death. Under current tax law, heirs receive the property with a “stepped-up basis,” meaning the property’s basis is adjusted to its fair market value at the date of the owner’s death. This step-up in basis eliminates the income tax liability on all the deferred capital gains and depreciation recapture. The heirs can then sell the property at its new, higher basis and owe little to no capital gains tax.