|
One of the most frequent accounting questions we receive is about the handling of basis in a 1031 exchange. There is a lot of confusion about what happens to basis after a 1031 exchange has been completed.
A good starting point for this discussion is the definition of basis. I went to taxopedia.com and this is how they define adjusted basis:
"Your basis in property is the stepping-off point for determining taxable gain or loss when you sell it. The basis generally starts out as what you pay for the property, although special rules apply to assets you inherit or receive as a gift. Your basis can be adjusted while you own property. When you buy rental property, for example, the basis begins at what you pay for the place, including certain buying expenses and it is adjusted upward by the cost of permanent improvements. The basis is reduced by the amount of any depreciation you are allowed to deduct while you own the property. You use your adjusted basis to figure the gain or loss on the scale."
I thought this was a very good definition and thought it was important that the definition pointed out the negative affect depreciation has on basis. Depreciation reduces the basis. Many taxpayers don't seem to realize that, as they get the yearly tax benefit of depreciating real estate, they eventually will pay for that benefit if they sell at a gain by having a lower basis and by possibly paying a higher tax rate on their capital gain. As most of my tax lawyer colleagues will explain, many provisions of the tax code can be a double edged sword. The questions we receive center upon how basis is adjusted after a 1031 exchange and whether depreciation taken on the relinquished property is extinguished by performing a 1031 exchange.
Let's assume that our taxpayer, Tigger Woods, is selling his Palm Beach Investment Property for $1 million, which he bought several years ago for $500,000 and, over the years, had taken depreciation of $100,000. He made no improvements on the property during his ownership other than normal wear and tear. His basis is $400,000 ($500,000 minus $100,000 depreciated).
Tigger wants to buy a new investment property for $2 million in Naples, FL.
Upon completion of the purchase of the Naples property, Tigger will have performed a successful tax deferred exchange. His basis on the new property will be $1.4 million ($400,000 original basis plus the additional $1 million being paid for the new property).
As far as depreciation, he will have the same depreciation schedule as on the old property. If he started depreciating in 1999, his schedule on the new property will date back to 1999. Unfortunately, there is no "fresh start" when it comes to depreciation in a 1031 exchange. Although the taxpayer avoids paying depreciation recapture on the sale of the relinquished property, the depreciation taken on the relinquished property is carried over to the replacement property. |
