Handling Tax Basis in a 1031 Exchange

One area in which we get a lot of questions, is about the handling of basis in a 1031 exchange. The questions go: “When I sell my Old Property, what happens to that basis?” “What about the depreciation I already took?” “If I fully depreciated my Old Property, will doing a 1031 exchange let me ‘freshen up’ my depreciation schedule?” “If I buy the New Property for $100,000, can I depreciate the whole $100,000?” Questions like these all relate back to what happens to the basis of the property when you do a 1031 exchange.

The first step in determining the basis on your New Property is the basis of your Old Property. Let’s take a simple example: Fred and Sue are selling their purple duplex. They bought it in 1995 for $40,000, and they’ve taken $15,000 of depreciation on the duplex since they bought it. Their tax basis in the duplex is $25,000 ($40,000 minus $15,000). They are selling it for $100,000 and have found a red condo to buy as their replacement property for their 1031 exchange. What is the basis in their red condo? And how is depreciation handled on the red condo?

Notice that they bought the red condo for the same price that they sold the purple duplex. This is an important fact because the purchase price of the New Property is one of the primary facts that affect the answer. The answer is because they “bought equal,” the basis in the new red condo is $25,000 – the same as it was on the old purple duplex. In a 1031 exchange, the basis rolls forward from the Old Property (the purple duplex) to the New (the red condo). What’s more, on their future depreciation schedules, the purchase date for the red condo is 1995 (the date of the original purchase of the purple duplex), and the depreciation schedule carries over as if they were still depreciating the purple duplex.

The reason for this is because in the eyes of the IRS, what happens in a 1031 exchange is that you, in effect, still own the original property, except that the address and legal description for the property is now that of the red condo. In a 1031 exchange, the purchase date, holding period and depreciation schedule continue unaffected by the exchange; your basis in the red condo is the same as it was for the purple duplex.

...This is important because the purchase price is one of the primary facts that affect the answer...

Now, let’s change the assumptions and see what happens: instead of buying the red condo for the same price they sold the purple duplex, they buy a green office building for $150,000. In other words they bought up by $50,000. Their basis in the office building is now $75,000 which is the combination of the “rollover basis” of $25,000 from the purple duplex and the $50,000 buy up from the office building. Their depreciation schedule shows the continued depreciation of the purple duplex (as if they still owned it) and the acquisition of the office building portion as of the date they closed on the office building purchase.

What happens if they buy down? Instead of the office building, let’s say Fred and Sue buy a yellow, single-family rental house, for $90,000. They sold the duplex for $100,000 and now they are buying down to $90,000. Since the basis always rolls over, their basis in the rental house is $25,000 – the same as the duplex. Because they bought down, the amount of the buy down ($10,000) is taxable. This is why I always say that “the gain comes first in a 1031 exchange."