Taxpayers conducting tax-deferred 1031 exchanges must take great care to ensure that they are following the fundamental rules of the exchange, buying up in value and reinvesting all exchange proceeds in replacement property, in order to defer all capital gains from their relinquished property. However, once the exchange is over, the question often arises: what is the new cost basis in the replacement property/properties?
In a standard purchase transaction, the cost basis of a property will typically be the value at which it was acquired. However, in a 1031 exchange, a taxpayer is carrying over their basis from their relinquished property/properties, and thus, a different calculation is required to determine what the new basis in one or more replacement properties will be.
In very simple terms, the new basis replacement property is the cost of its acquisition, less the total amount of capital gains deferred. If multiple replacement properties are acquired, the total amount of capital gains deferred in the transaction will be proportionately split amongst the replacement properties to reduce the basis of each replacement property acquired.
The following examples illustrate the above rule:
A taxpayer prepares to sell residential Property A, which they’ve owned for 10 years, and which has an adjusted basis of $225,000. The taxpayer sells the property for $400,000 and conducts a 1031 exchange. They have $175,000 of capital gains to defer ($400,000 sales price less $225,000 adjusted basis).
The taxpayer acquires residential Property B for $500,000 and fully defers all capital gains in their exchange. This purchase value, less the $175,000 of gains deferred, results in a new basis of $325,000.
Note that residential property is depreciated over 27.5 years. The taxpayer took depreciation on Property A during the 10 years they owned the property. Thus, they can continue to depreciate the carried-over portion of the basis of Property B ($225,000) for another 17.5 years. However, the “new” portion of the basis of Property B (basis of $325,000 less carried over basis of $225,000), or $100,000, can be depreciated over a new schedule of 27.5 years.