When an investment property is sold for more than its original cost, the seller receives a financial gain that the IRS taxes at the capital gains tax rate. The amount of capital gain is calculated by taking the selling price of the asset minus its “adjusted basis” (i.e., the original cost of the property, plus money used for capital improvements, minus depreciation, minus selling expenses).
It is important to understand that an asset may be sold at little or no profit, but with a capital gain. Capital gains are taxed at either 20% or 23.5%. The 20% rate applies to those in the 25% or higher income tax brackets. State capital gains tax also applies, and any gain attributable to depreciation is taxed at a hefty 25%.
Section 1031 allows taxpayers to defer paying capital gains tax if — instead of selling an asset and pocketing the cash — they reinvest the cash into “like kind” replacement property. Many investors exchange property using tax deferred dollars to diversify their assets and add to their property portfolios. A common mistake, however, is the failure to “balance the equities” in a 1031 exchange.
WHAT DOES BALANCING THE EQUITIES MEAN?
Balancing the equities is essential to deferring all capital gains taxes. It means that the debt acquired on the replacement property must be equal or greater than the debt on the relinquished property. Additionally, the cash invested on the replacement property must be equal or greater to the cash from the sale of the relinquished property.
WHAT HAPPENS IF EQUITIES ARE NOT BALANCED?
If equities don’t balance, any cash from the sale of the relinquished property that isn’t reinvested in replacement property will be taxed. Likewise, if the debt on the replacement property is less than the debt on the relinquished property, the difference will be taxed unless the taxpayer adds cash to the transaction to make up the difference. When conducting a property exchange, taxpayers should bear in mind the following rules:
- Buy replacement property with value equal or greater to the value of the relinquished property
- Invest all cash proceeds from the sale of the relinquished property into the replacement property.
- Acquire debt on the replacement property that is equal to or greater than the debt on the relinquished property, or add cash in place of debt.
These rules are illustrated by the following example:
Thomas plans on selling a commercial real estate property for $2 million that he originally purchased for $800,000. When he owned the building, he spent $200,000 on improvements and took $250,000 in depreciation. His adjusted basis is $750,000 (i.e., original purchase price, plus improvements, less depreciation). His gain will be $1.19 million (i.e., sales price, minus adjusted basis, minus estimated closing costs). With his current mortgage at $1 million and estimated closing costs of $60,000, the buyer, Smith, will net proceeds of approximately $940,000.
Thomas plans on acquiring an office building for $3,000,000 and would like to defer all his capital gains taxes by completing a property exchange under Section 1031. Smith can determine whether his equities are in balance by using the following worksheet:
Relinquished property | Replacement property |
Sale price – $2 million | Purchase price – $3 million |
− $1 million existing debt | − $2.06 million new debt |
− $60,000 closing costs | = $940,000 cash down |
= $940,000 cash proceeds |
Thomas’s down payment on the replacement property must be $940,000 to avoid receiving taxable cash. Thomas has balanced his equities by investing all of his cash and acquiring equal or greater debt on the replacement property. Thomas can pay the additional cost of the replacement property with either a larger loan or an increased cash down payment.
