There May Still Be Capital Gain Even If they Are Selling for Less than What They Paid to Purchase It!!!
You ask, "How can that possibly be?"
Well, remember that when a taxpayer engages in a 1031 Tax Deferred Exchange (selling investment property and exchanging into a new investment property) they are DEFERRING the capital gain tax that would normally be recognized on the sale.
What does Deferral mean?
It means that the basis of the Replacement Property is reduced by the amount of Capital Gain that was deferred on the sale of the Relinquished Property resulting in a much lower (than the purchase price) basis.
If you need a refresher regarding calculating the Net Adjusted Basis for a property click here for my blog post on the topic.
If you need a refresher regarding calculating a rough estimate of Capital Gain on the sale of property click here for my blog post on the topic.
If you would like to see a Comparison Between a Sale and an Exchange Click Here.
EXAMPLE:
Say you sold an investment property (Property I) that you originally purchased (not as an exchange) for $200,000. You owned it for two years and then decided to sell it because it had appreciated substantially (it's now worth $400,000). You and your tax advisor decide that a 1031 exchange makes sense in this situation. So, you hire a Qualified Intermediary prior to closing escrow on Property I (so you don't have actual or constructive receipt of the proceeds). You comply with the 45 day Identification Period and you close escrow on the Property II ($420,000) within 180 days of closing escrow on Property I. Exchange Completed and you successfully deferred $200,000 in capital gain. ($400,000 (sale price) - $200,000* (basis) = $200,000)
Now it's two years later (2008) and you need to sell Property II, which is now only worth $320,000. You think that you don't have a capital gain issue because the property is worth $100,000 less than what you paid for it. What you have forgotten though, is that the basis in Property II is not $420,000 it is $220,000. The $200,000 capital gain on Property I that was deferred by 1031 exchanging into Property II reduces Property II's basis by $200,000, so the basis is calculated ($420,000 - $200,000 (deferred capital gain) = $220,000.
Therefore a rough estimate of the capital gain on the sale of Property II is ($320,000 (sale price) - $220,000 (basis*) = $100,000.
*This is simple basis (to simplify the example) not Net Adjusted Basis which gives a more accurate estimate of capital gain. See the above refresher links for discussions of Net Adjusted Basis and Calculating Capital Gain.
THIS EXAMPLE ILLUSTRATES WHY IT IS SO IMPORTANT FOR PEOPLE TO CONSULT THEIR TAX ADVISORS PRIOR TO SELLING REAL PROPERTY. YOU MAY MAKE A LOGICAL ASSUMPTION THAT CREATES A SIGNIFICANT TAXABLE EVENT THAT COULD BE PREVENTED WITH A SIMPLE CONSULTATION.
Lisa A. Lambert, Esq. 877.646.1031 or LisaL@apiexchange.com
Asset Preservation, Inc. 800.282.1031 or info@apiexchange.com or www.apiexchange.com
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Lisa, thank you! This is such a great resource of information for our investors. I appreciate the links too!
May I reproduce this and a couple of other related blogs of yours on our company's website? I will, of course plug you and your website as the author and expert here and provide a link to your site.
It may garner you clients and I would love to have some of them start using you for their 1031 exchanges. We used to work with another company out of California called North American Exchange Co., but they sold to Wamu. We then started using Wamu, but then they fired our rep, Tony. We loved Tony! Not too happy with Wamu because of that right now.