How Can A Loss Be A Gain....?!

What happens when you sell exchange property at a loss? Let’s say you sell a property for $175,000 that you bought in an exchange for $200,000 – most of you would think that you have a loss of $25,000, but in fact you probably have a gain.

--Gary Gorman

What Happens When You Sell An Exchange Property At A Loss?
by Gary Gorman founding partner, 1031 Exchange Experts, LLC

In today’s real estate market, this is a great question that commonly arises: "What does happen if you sell a property bought in a 1031 exchange at a loss?" Let’s say, for example, you have a buyer with cash in hand offering you $175,000 for a rental property you paid $200,000 for as part of a 1031 exchange you did three years ago.

“Do I have a capital loss of $25,000? And if so, how will that impact my tax return?” I’m currently getting a lot of calls from people with questions similar to this. Most of them are annoyed, and a few are just down right mad, to discover that instead of the loss they think they have, they actually have a gain on the sale.

“How can that be?” they ask. The answer is that when you do a 1031 exchange your basis from the Old Property rolls over to the New. The Old basis is modified slightly if you buy-up, but not if you buy-down. For example, if the Old Property you just sold for $200,000 has a tax basis of $125,000, and you buy a replacement property for $200,000, your tax basis in the New Property is exactly the same as the Old ($125,000) and you deferred paying tax on the $75,000 gain.

On the other hand, if you buy the New Property for $190,000, you’ve bought-down (which is a taxable event, even with a 1031 exchange) and you’ll pay tax on the $10,000 buy-down. Your basis on the New Property is still $125,000, your deferred gain is $65,000, and you paid tax on the other $10,000.

The result is slightly different if you buy-up in an exchange. Assume, for example, that you paid $225,000 for the New Property; its basis would be $125,000 plus the buy-up of $25,000 for a new basis of $150,000, and your deferred gain remains unchanged at $75,000. This is how the IRS views it, although you arrive at exactly the same basis amount if you take the purchase price of $225,000 and back off the deferred gain of $75,000.

So, coming back to the purpose of this article, what does happen if you sell the New Property at a loss? If you sell the property for $175,000, and your basis is $125,000, you have a gain of $50,000, and it matters not that you paid $200,000 for the property. The net effect of the transaction is that you had a deferred gain of $75,000 when you did the exchange, but then lost $25,000 of value resulting in a taxable gain of $50,000 when you sold it.

A couple of final thoughts about this whole issue: first, depending on the amount of your loan on the property, you may realize barely enough cash on the sale to pay the tax. Also, to point out the obvious, you can still do another exchange on this property and avoid paying the tax on the $50,000 gain.