What Is a Deferred Gain on a 1031 Exchange?

A Section 1031 exchange allows an investor to sell an investment or business property and reinvest the proceeds into a new, “like-kind” property. Governed by the Internal Revenue Code, the primary function of this transaction is to postpone the payment of capital gains taxes that would otherwise be due upon the sale of the first property.

The concept enabling this tax postponement is the “deferred gain.” When an exchange is executed correctly, the gain that would have been taxed is not forgiven but is instead carried forward. This deferred amount is preserved within the new investment property, rolling the potential tax liability into the future.

Calculating the Deferred Gain

Calculating the deferred gain involves three values: realized gain, recognized gain, and deferred gain. The realized gain is the total profit on the sale of the relinquished property, calculated by subtracting its adjusted basis from the sale price. The adjusted basis is the original purchase price, plus capital improvements, minus depreciation deductions taken over the years.

Any non-like-kind property received during the exchange is “boot,” which can be cash, a reduction in mortgage debt, or other non-real estate assets. The “recognized gain,” which is taxed in the year of the exchange, is the lesser of the total realized gain or the total boot received. If no boot is received, then no gain is recognized at the time of the exchange.

The deferred gain is the portion of the profit not taxed immediately and is calculated by subtracting the recognized gain from the realized gain. For example, an investor sells a property for $900,000 with an adjusted basis of $400,000, resulting in a realized gain of $500,000. If the investor receives $40,000 in cash boot, the recognized gain is $40,000, and the deferred gain is the remaining $460,000.

Determining the Basis of the Replacement Property

The deferred gain from a 1031 exchange directly impacts the tax basis of the newly acquired replacement property. The basis of an asset is its value for tax purposes, and in an exchange, the deferred gain reduces the basis of the new property. This adjustment ensures the gain is accounted for in the future.

The formula to determine the basis of the replacement property is its purchase price minus the deferred gain. This creates a lower basis than what the investor would have if they had purchased the property in a standard taxable transaction.

Continuing with the previous example, suppose the investor purchased a replacement property for $1,000,000. The deferred gain was $460,000. The basis of this new property would be its purchase price of $1,000,000 minus the $460,000 deferred gain, resulting in a new adjusted basis of $540,000.

This lower basis has long-term implications. Because depreciation is calculated on this reduced amount, the annual tax deductions for depreciation will be smaller. This lower basis also sets the stage for how gain will be calculated when the replacement property is eventually sold.

Tax Implications on the Subsequent Sale of Replacement Property

The deferred gain is accounted for when the replacement property is sold in a taxable transaction. The taxable gain is calculated using the reduced basis established after the exchange, which incorporates both the appreciation of the replacement property and the gain that was deferred.

Using the ongoing example, the replacement property has an adjusted basis of $540,000. If this property is later sold for $1,200,000, the total taxable gain would be $660,000. This amount includes the $460,000 of gain that was originally deferred, plus the $200,000 of appreciation the replacement property experienced.

When the property is sold, the total gain is subject to a multi-layered tax assessment. First, the portion of the gain attributable to depreciation deductions taken over the years is “recaptured” and is taxed at a maximum rate of 25%.

The rest of the gain, which reflects the property’s market appreciation, is taxed at the applicable long-term capital gains rate. Some investors may also be subject to the 3.8% Net Investment Income Tax (NIIT) if the taxpayer’s income exceeds certain thresholds.

Reporting the Exchange to the IRS

A 1031 exchange must be reported to the Internal Revenue Service on Form 8824, Like-Kind Exchanges. This form is filed with the taxpayer’s annual tax return for the year the exchange takes place.

To complete Form 8824, a taxpayer must provide detailed descriptions of the relinquished and replacement properties and the dates they were transferred. For a deferred exchange, the form requires the date the replacement property was identified in writing (within 45 days of the sale) and the date it was received (within 180 days of the sale).

The form also requires a complete financial breakdown of the transaction. This includes the fair market value of both properties, the adjusted basis of the property given up, and a detailed calculation of any boot received or paid. Part III of Form 8824 guides the taxpayer through the calculation of the deferred gain and the final basis of the new property.