Calculating Tax Benefits in a 1031 Exchange

If you’re looking to sell a business or investment property, a 1031 Exchange is a tax deferral strategy worth considering. Through 1031 Exchanges, you can defer taxes such as capital gains, depreciation recapture, state, and net investment income tax. Understanding key financial figures such as sales prices, property values, adjusted basis, and capital gains are crucial for ensuring a successful transaction.

What You Need to Know for a 1031 Exchange  

There are many things to consider when choosing whether to do a 1031 Exchange. Knowing these figures associated with your real estate transaction will help you navigate the exchange process with confidence. Let’s break down the essentials. 

Key Financial Figures  

Accumulated Depreciation: Accumulated depreciation is the total amount of depreciation that has been recorded on a real estate property since it was placed in service. It represents the reduction in the property's value over time due to wear and tear, obsolescence, or physical deterioration. Accumulated depreciation is subtracted from the property's original cost to calculate its book value or net carrying value. For example, if a building was purchased for $1,000,000 and has accumulated depreciation of $200,000, its book value is $800,000. Accumulated depreciation is also used to determine the taxable gain or loss when the property is sold or exchanged.  

Adjusted Basis: The adjusted basis is the original cost of a property modified by certain factors like capital improvements, depreciation, and other adjustments. It reflects the current value of the asset for tax purposes and is used to calculate capital gains or losses when the asset is sold. Adjusted basis is calculated by taking the cost basis, adding the value of improvements or other additions, and subtracting the accumulated depreciation.  

Capital Gain: This represents the profit you make from selling your property and is calculated by subtracting your adjusted basis from the sale price. The capital gain is the amount of money that would be taxed if a 1031 Exchange were not utilized. A 1031 Exchange allows those taxes to be deferred by reinvesting in like-kind property.  

Capital Improvements: Capital improvements are additions or upgrades to property that enhance its value, extend usage, or adapt it for new use. Capital improvements could include building an extension, installing central air conditioning, or adding a new roof. These improvements are considered long-term investments and can be capitalized, meaning the cost is added to the property’s basis and depreciates over time.  

Original Purchase Price: The original purchase price is what was initially paid for the Relinquished Property. Original purchase price is also known as cost basis.  

Replacement Property Value: To fully defer taxes under a 1031 Exchange, the Replacement Properties purchased must have a value equal to or greater than the sale price of the Relinquished Property. If the value of the Replacement Property is less than the sale price, the difference, known as "boot,” may be taxable.  

Sale Price of the Relinquished Property: This is the price at which you sell your current property, which serves as the foundation for the entire 1031 Exchange. The sale price, along with other factors, determines how much you’ll need to reinvest into a new property to defer taxes fully. If you don’t reinvest an amount equal to or greater than this amount, you might face a taxable event. 

Calculations to Determine Your Tax Deferral with a 1031 Exchange  

Make use of the following calculations to help you determine the financial implications of your 1031 Exchange. 

Adjusted Basis: 

Adjusted basis is an important figure that helps determine the gain or loss that may be deferred when exchanging like-kind properties. 

There’s a specific formula that you can use: 

Original purchase price of Relinquished Property + Capital Improvements + Other additions in value - Depreciation = Adjusted Basis

Capital Gains:  

This calculation gives you the profit from the sale of your property, which would typically be subject to capital gains tax. In a 1031 Exchange, the goal is to defer this tax. 

There’s a specific formula that you can use: 

Today’s Gross Sales Price  - Cost of Sale (including commissions, fees, etc.) - Adjusted Basis  = Total Capital Gains

Taxes Due: 

This calculation sums the total tax liability you would face if you chose not to utilize a 1031 Exchange. 

There’s a specific formula that you can use: 

Depreciation Recapture (Accumulated Depreciation x 25%) + Federal Capital Gain Rate (Capital Gains x 15% or 20%, depending on your tax bracket) + State Tax (varies by state, up to 13.3%) + Net Investment Income Tax SF/HE (Net Investment Income x 3.8%) = Total Tax Due

Using these formulas, can help you see the potential savings to be gained in your 1031 Exchange. Testing formulas can help gauge if preliminary estimates of tax liability, additional equity, etc., make a 1031 Exchange a strategy worth pursuing for your investment goals.

1031 Asset Solutions has dedicated specialist to help with your inquiries about 1031 Exchange tax benefits. Give us a call today at 844-401-1031.