Calculating Basis of New Property in a 1031 Exchange
You and your spouse can defer paying taxes on the sale of an investment property by exchanging it for another investment property. This smart investment move is called a like-kind exchange, or 1031 exchange, and allows you to delay your tax bill until you sell the new property.
But before you exchange your investment property, you need to know the adjusted basis of the relinquished property you give up in the exchange. By being able to calculate the basis of the old property, you can figure out your capital gain, depreciation, and the cost basis of the replacement property, which are taxable items taxpayers must report to the Internal Revenue Service.
In this article, we’ll show you how to calculate the basis of your new property when doing a 1031 exchange.
What is Cost Basis in Real Estate
Cost basis is essentially defined as the amount that your property is worth from the standpoint of taxation. Upon the sale of a piece of real estate (for example, your single-family home residence) profit or loss is calculated by taking the property’s sales price and subtracting it from your cost basis on the date of sale. In essence, the bigger your cost basis is? The less your ultimate gains (aka profits) will be, and the less you’ll owe come tax time.
Put simply: In real estate, the cost basis is the original value that a buyer pays for their property.
It’s an important figure to know because taxpayers who sell a residence or investment property must pay capital gains tax on any monies generated above and beyond what they initially paid for these assets. Think of cost basis as a measuring stick through which the Internal Revenue Service (IRS) will look to determine how much a taxpayer have made in terms of gains on the sale of an asset such as a house, apartment or condo – and, for that matter, what portion of any given real estate property sale that it might hope to collect tax monies on.
A short example is buying a property for $100,000. In order to acquire that property, you had to pay $5,000 in closing costs to the bank and an attorney. Thus, your tax basis is $105,000.
Calculating Cost Basis in 1031 Exchange?
1031 exchanges allow taxpayers to defer capital gains. In deferring those gains, your basis has to be recalculated. The general basis concept is that the new property purchased is the cost of that property minus any gain you deferred in the exchange. Below are the steps to explain how to calculate the cost basis of your new property.
- Figure out the adjusted basis in the property that you have just sold. This includes any mortgage you took to acquire the property.
- Add the value of any other property you transfer in the exchange, the mortgage amount on your new property, the amount of cash you are contributing to the new purchase, and any recognized gain on the sold property.
- Subtract any money or property you received in the exchange, the amount of the mortgage on the sold property, and any recognized loss on any property sold in the exchange.
These steps result in the basis of your newly acquired property in the 1031 exchange. Take note that the purchase price for the new property does not play a role in determining the cost basis.
Before we show you how to calculate the basis of your new property in a 1031 exchange, it is important that you learn how to decode your adjusted basis in your property as a taxpayer.
To calculate a rental property’s adjusted basis, you first have to know the original cost. This beginning basis is the purchasing price if you bought the property or the construction price if you built it. Alternatively, if you inherited the property, then its corresponding basis is the asset’s fair market value on the day you acquired it. This is otherwise known as the step-up basis.
Let’s work through an example scenario.
Say you purchase a real property for $400,000. You pay $11,000 in closing costs and make capital improvements to the property worth $13,000. At this point your adjusted basis is $424,000.
But now you want to sell the property. Selling costs also add on to the basis of the property, such as commissions fees and advertising costs. Your overall cost of sale is $9,000. That puts your adjusted basis at $433,000.
Certain factors will reduce that value, however. The property depreciated over the years, which you held for 8 years. Every year you held the property, it depreciated by $10,000. So, your overall depreciation is $80,000. The cumulative $80,000 reduces the adjusted basis down to $353,000. You would also include any additions or improvements that depreciated in value.
Finally, you sell the property for $500,000. That leaves you with a gain of $147,000 (after subtracting the adjusted basis of $353,000 from $500,000).
An Example Calculating the Basis in 1031 Exchange
For example, let’s say you perform a 1031 exchange by selling a property for $300,000. You have a mortgage of $150,000 on the property at the time of the sale, and your adjusted cost basis in the property is $170,000. This leaves you with $130,000 of capital gains to defer. You complete the exchange by purchasing a $500,000 property with a mortgage of $350,000.
In this case, you calculate your new basis by subtracting the capital gains deferred ($130,000) from the purchase price of the new property ($500,000), leaving you with a new cost basis of $370,000
Fortunately, you don’t need to memorize these calculations. Because you’ll probably be working with a qualified intermediary (QI), who’s highly familiar with the process. And if you don’t, your tax professional can always help out.