1031 Exchanges: Understanding Taxable Boot and Deferred Gain

Most experienced real estate investors know about the 1031 exchange. But if this is your first time hearing about it, in short, a 1031 exchange allows you to roll the gain from your rental property into the next property.

Think back to when you would play Monopoly as a kid (or yesterday if you’re like me)… remember how you could trade four green houses for one red hotel?

That’s a 1031 exchange. I’m trading smaller property for a larger property.

Many of our clients at The Real Estate CPA engage in 1031 exchanges as it’s a highly effective wealth-building strategy. There’s a term called “swap until you drop” which basically means you can 1031 exchange until the day you die, at which point your heirs receive the property at a stepped-up basis effectively wiping out all of the gains you’ve deferred over the years.

In today’s article, we’re going to break down the basics and also talk about a couple of strategies you should be aware of.

Note: this could all change in the coming months with the Biden admin’s tax proposal.

The Basics of a 1031 Exchange

A 1031 exchange gets its name from IRC Section 1031 which allows you to avoid paying taxes on any gains when you sell an investment property and reinvest the proceeds into a new investment property.

All 1031 exchanges must use a Qualified Intermediary (QI) to hold the exchange funds.

This is EXTREMELY important: if you try to 1031 a property, but you receive the funds personally, you will not qualify for a 1031 exchange.

The proceeds received from the property you are selling must be held by a QI.

You can generally engage a QI two to four weeks prior to closing on the property you are selling. That will give them enough time to advise you on the transaction and set up escrow accounts to hold your funds.

Who is a QI? Check out the definition in Treas. Regs. Sec. 1.1031(k)-1(g)(4).

In order for a 1031 exchange to remain 100% tax-free, you must receive more value than you relinquish. We’ll talk about that shortly.

When Should You Use a 1031 Exchange?

You should consider using a 1031 exchange any time you are looking to sell property that has appreciated in value and/or you have taken depreciation against the property for several years.

Our rule of thumb at our CPA firm is that you should save at least $10,000 in taxes for a 1031 exchange to be worth your time and money (it can be stressful).

Assuming you have not claimed any depreciation, you need a gain of at least $50,000 to make a 1031 exchange worthwhile ($50,000 x 20% long-term cap gain rate = $10,000).

Depreciation recapture is a different type of gain that may make a 1031 worthwhile.

If you claimed depreciation on a property you are selling, you will have to recapture that depreciation when you sell.

“Recapture” simply means that you’ll pay a tax on the amount of depreciation you’ve claimed.

A simple example to illustrate: you buy a $100,000 rental and claim depreciation of $20,000 overtime. You then sell for $100,000.

Most novice investors think that because you bought for $100,000 and sold for $100,000, you don’t have any taxable gain.

But because you claimed $20,000 of depreciation, your adjusted basis is actually $80,000. So when you sell for $100,000, you have $20,000 of taxable gain, all of which is depreciation recapture.

There are three types of depreciation recapture:

• 1245 Gain (depreciation on 5 and 7 year property recaptured at ordinary tax rates)
• 1250 Gain (depreciation on 15 property, in excess of straight-line depreciation, recaptured at ordinary tax rates)
• Unrecaptured 1250 Gain (depreciation on 27.5-year and 39-year property (the “building”) taxed at a maxmium 25% rate)

We’ll write a separate article on depreciation recapture in the future that fully explains this. Point is, it can be very expensive and is often not something investors consider when selling their rentals.

Before you decide on a 1031, make sure you don’t have a large amount of suspended passive losses. To confirm this, look at Form 8582, line 4.

Suspended passive losses can offset any gain on sale from a passive activity. So it’s a good idea to understand what amount of suspended passive losses you have prior to deciding on a 1031… you may have enough losses to completely offset your gain!

Do You “Restart” Depreciation On the Replacement Property?

A common mistake that we see in previously prepared tax returns is a tax preparer “restarting” depreciation on the new property.

Assume that you sell a property with an original cost basis of $80,000 and an adjusted basis of $60,000 (meaning you’ve claimed $20,000 of depreciation) for $100,000 and you exchange it for a property worth $120,000.

The mistake is to restart depreciation at $120,000 less the cost of land rather than carrying over the old basis and continuing the depreciation schedule.

The correct method is to continue reporting the original $80,000 of basis with $20,000 of accumulated depreciation over the remaining useful life of the property sold.

This is detailed in IRC Sec. 168(k) and the corresponding regulations.

You can however run a cost segregation study on the old cost basis and any new cost basis (i.e. new cash that you put into the deal or the increase in debt). Doing so will allow you to shift some of the cost to a fast useful life.

Here’s how it works.

For the $120,000 property that was purchased, assuming the land was worth 10%. First, we apply that ratio to the cost basis of the property given up ($80,000) to get land of $8,000 and the remaining basis of $72,000. A cost segregation study on the new property may find that 20% should be allocated to 5-year property and 10% allocated to 15-year property.

This means that we’d allocate $14,400 ($72,000 x 20%) to 5-year property and $7,200 ($72,000 x 10%) to 15-year property. The remaining would be allocated to 27.5 year property.

We’d then apply the land % and cost segregation results to the new basis of $20,000 (because we sold the property for $100,000 and bought the new property for $120,000, meaning we had to add $20,000 of cash or debt which is considered “new basis”).

Here’s what it looks like on your federal depreciation schedule that should be attached to your tax returns:

Property Description	Date in Service	Cost Basis	Accumulated Depreciation
8824 – Building – 123 Main Street	06/30/2017	$50,400	$20,000
Land	07/15/2021	$10,000	$0
5-Year Property	07/15/2021	$18,000	$0
15-Year Property	07/15/2021	$9,000	$0
Building – 755 Latimer Rd	07/15/2021	$12,600	$0

If you add the cost basis column, you’ll get $100,000. This makes sense because:

• We sold a property for $100,000 that had an adjusted basis of $60,000… meaning we are deferring a $40,000 gain.
• We added $20,000 of basis in order to buy our $120,000 new property

Said in another way, if we immediately sold our $120,000 property for $120,000, because the cost basis column only reports $100,000 of basis, we’d have $20,000 of gain. And because we have $20,000 of accumulated depreciation, we’d also have $20,000 of depreciation recapture gain. The total gain adds up to $40,000 (which is the gain we rolled forward).

The first row “8824 – Building” is meant to indicate that is the basis that is rolling forward and continuing on the 27.5 year depreciation schedule. Form 8824 is where you report like-kind exchanges to the IRS, so we add that to the asset description in our software to keep tabs on it. And because we carry forward the accumulated depreciation, and use the original placed-in-service date of the sold property, we will retain our original depreciation schedule for the carryover basis.

The 168(k) regulations allow you to use a cost segregation study to “restart” MACRS property that has a useful life less than the original useful life of the carryover basis. If we didn’t perform a cost segregation study, all of the $80,000 original basis, minus the cost of land, would be reported as “8824 – Building – Main Street” in order to carry forward the original depreciation schedule. The new basis of $20,000, minus the cost of land, would be reported on “Building – 755 Latimer.”

If this was overwhelming (as it was for me the first time I learned how to walk through this), simply share this with your CPA come tax time if you’ve performed a 1031 exchange.

Timing and the Three Tests

When you undergo a 1031 exchange, you must adhere to strict guidelines.

The first relates to timing requirements.

You must identify replacement properties within 45 days of the sale and conclude the exchange within 180 days of sale. Note that these timelines are concurrent, meaning the 180 days start at the closing table, not after your 45 day identification period is complete.

You must meet one of the identification requirements in order for your 1031 exchange to qualify:

• Three property rule: identify three properties regardless of market value and close on one of them
• 200% rule: identify an unlimited number of replacement properties as long as their aggregate value does not exceed 200% of the value of the sold property
• 95% rule: identify as many properties as you like as long as you acquire 95% of the total value identified.

With each of these rules, you can close on as many properties as needed to replace the full value of your sold property.

If you don’t replace the full value, you’ll likely have cash or mortgage boot which is taxable.

An easy way to think through what value of replacement property you need to acquire in order to avoid boot is:

• Does my net equity, plus any additional cash or debt that I add, exceed the original cost of the property that I’m acquiring.

For example, if you bought a property for $100,000 and had a $60,000 mortgage, your net equity is $40,000.

If you then bought a property for $90,000, you’d need to add $50,000 of cash or debt to acquire the property (since your $40,000 of net equity is rolling into it).

But this is $10,000 less than the original cost of the property, so you’ll have $10,000 of “boot” that you’d pay taxes on.

So if I have $40,000 of net equity, I need to find a deal where I can add at least $60,000 of cash or debt to in order to avoid boot.

Pairing a 1031 with Sec. 121

IRS Revenue Procedure 2005-14 allows you to convert your primary residence into an investment property by moving out and renting it. The Rev. Proc. does not address timeline, though it is believed that if you rent for at least 12 months your property will be considered “held for investment” which is important for the 1031 rules.

The Sec. 121 exclusion allows you to avoid paying tax on up to $250,000 of gain ($500,000 if married filing joint) as long as you meet the ownership and use tests. To meet these tests, you must have owned and used, personally, the property for two of the past five years.

You cannot exclude depreciation recapture via Sec. 121.

So let’s assume you bought a primary residence in June 2020. Due to the two-year use requirement, you need to live in the property until June 2022. At that point, you decide to rent it out.

As long as you sell the property by June 2025, you will have met the “two of the past five years” test because you owned and used the property for two of the past five years.

This means the gain will qualify for the 121 exclusion.

Let’s assume you are single, have $40,000 of depreciation recapture and $310,000 of gain from appreciation.

The 121 exclusion will allow you to exclude $250,000 of the $310,000 of gain from taxes.

This leaves you with $40,000 of depreciation recapture and $60,000 of remaining gain from appreciation.

That’s where the 1031 exchange comes in. Because you rented the property for a long period of time, you have an investment property meaning you can 1031 to defer your depreciation recapture and the remaining gain.

Takeaways

A 1031 exchange is a powerful strategy for real estate investors to use to build wealth over time.

You must always use a QI and its important to familiarize yourself with the time and value tests that qualify you for a 1031 exchange.

Many advisors incorrectly report a 1031 exchange on tax returns in that they don’t carry forward the old basis of the property relinquished. Make sure yours doesn’t!

Consider pairing a 1031 with the Sec. 121 exclusion for massive tax savings.