Section 1031 allows you to put off the capital gains tax until later, but it does not eliminate the tax. The reasoning behind the original law was that if people exchange one asset, such as a building, for another, they’re not going to have ready cash to pay the tax. So instead of reporting the capital gain on your tax return at the time of the exchange, the gain is built into the new asset, and you pay the tax later when the second property is sold.
The way the gain is “built in” is by reducing the basis of the new asset you got in exchange for your old asset.
The benefit of using section 1031 is that you don’t have to pay a capital gains tax until you make a final sale of the property you received in the exchange. The immediate downside is that you end up with a low basis for depreciation. In other words, for putting off paying the capital gain until later, you’ve traded away the higher ordinary deductions you could get with an increased basis if you had paid the capital gains tax.
There are certain cases where section 1031 is clearly an advantage. For example, since your assets get a stepped-up basis to market value when you die, if you’re 88 years old and in poor health, section 1031 is a good deal. If you’re 43 and in good health, it’s not so clear-cut. You need to take into account you overall financial situation.
To see an example of how the basis in your new asset is calculated, click here.