To see the basics on how section 1031 works, check out this article.
Capital gains are calculated by subtracting your basis from the sale price. Your basis is equal to the amount you originally paid for the property, plus any improvements you made, minus depreciation deductions.
For example, say you have a rental house located at 589 Santa Sophia Ave. You bought the property for $80,000 and paid a total of $40,000 for foundation and roof work. These expenses had to be capitalized rather than deducted, so they increased your basis in the property. Say you sell the property for $200,000.
Your capital gain is calculated as follows:
Sales Price $200,000
Less: Cost of building, appliances, improvements, etc. $ 120,000
Less: Closing Costs $ 5,000
Capital Gain before depreciation is accounted for $ 75,000
Depreciation taken $ 38,000
Final Capital Gain $ 113,000
You pay capital gains tax of $22,600 if you’re in the 20% bracket for capital gains.
Now say you buy a new property at 1705 Nueva St for $200,000, including closing costs on the new property. If the land is worth 15% of the cost, your basis for depreciation will be $170,000. If this is residential real estate, you’ll deduct $6181 in deprecation each year.
Now assume that instead of paying the capital gains tax, you use section 1031 to exchange your old property for the new. You will have to adjust your basis in the new property down by the amount of the deferred capital gain. Your basis in the new property will now be $200,000 - $113,000, or $87,000. The land is worth 15% of the total basis, so your basis for depreciation will be $73,950. Your depreciation deductions will be $2689 per year. This is $3491 less than you would have been able to deduct if you had not used section 1031.
If you are in the 37% ordinary income tax bracket, the difference in your tax due to the decreased depreciation will be $1292. If you sell the property in, say, 5 years, for $250,000 your capital gain will be $163,000. You will have paid income tax of $6460 that you would not have had to pay if you had not used section 1031.
Whether this is a good deal for you depends on many factors, including:
- whether you had funds available to buy 1705 Nueva St and also to pay the $22,600 capital gains tax
- If you had funds available to do both, how you would have invested the $22,600 savings
- your income tax bracket for each of the 5 years between the acquisition of 1705 Nueva St and its sale