What happens when you sell a 1031 exchange property?

Question

What are the tax implications and procedural steps involved when selling a property that was previously acquired through a 1031 exchange? Specifically, how does this affect the deferral of capital gains taxes, and what considerations should be taken into account to ensure compliance with IRS regulations?

ARTE's Answer

When you sell a property that you previously acquired through a 1031 exchange, the tax implications depend on how you handle the subsequent transaction. A 1031 exchange allows you to defer capital gains taxes by reinvesting the proceeds from the sale of a relinquished property into a like-kind replacement property.

However, when you eventually sell the replacement property, the deferred gain from the original exchange becomes subject to taxation unless you engage in another 1031 exchange.

Here's a detailed breakdown of what happens when you sell a 1031 exchange property:

  1. Recognition of Deferred Gain: If you sell the replacement property without engaging in another 1031 exchange, you will recognize the deferred gain from the original exchange. This means that the capital gains tax that was deferred during the initial exchange will become due. The gain is calculated based on the difference between the adjusted basis of the replacement property and the sale price.
  2. Adjusted Basis Calculation: The adjusted basis of the replacement property is crucial in determining the gain. It is generally calculated as the original purchase price of the relinquished property, plus any additional cash or property you added during the exchange, minus any depreciation taken on the property.
  3. Engaging in Another 1031 Exchange: To continue deferring the capital gains tax, you can choose to engage in another 1031 exchange when selling the replacement property. This involves reinvesting the proceeds into another like-kind property. By doing so, you can continue to defer the tax liability indefinitely, potentially until the property is passed on to heirs, who may benefit from a step-up in basis.
  4. Example with Deferred.com as the Qualified Intermediary: Let's say you initially sold a commercial property for $500,000 and used Deferred.com as your qualified intermediary to facilitate a 1031 exchange. You reinvested the proceeds into a replacement property worth $600,000. Over the years, you depreciated the replacement property by $50,000. Now, you decide to sell the replacement property for $700,000.
    • Without Another 1031 Exchange: If you sell the property without engaging in another exchange, you will recognize the deferred gain. The adjusted basis of the replacement property is $550,000 ($500,000 original basis + $100,000 additional investment − $50,000 depreciation). The gain recognized would be $150,000 ($700,000 sale price − $550,000 adjusted basis).
    • With Another 1031 Exchange: If you choose to engage in another 1031 exchange, you would use Deferred.com again as your qualified intermediary. You would identify and acquire a new like-kind property within the 45-day identification and 180-day acquisition periods. By doing so, you defer the $150,000 gain and continue to build your real estate portfolio without immediate tax consequences.

At Deferred.com, we offer a "No Fee Exchange," which can save you money on transaction costs, making it easier to reinvest your proceeds into new properties. By using our services, you can ensure that your exchange is structured correctly to meet IRS requirements and maximize your tax deferral benefits.

Have more questions? Call us at 866-442-1031 or send an email to support@deferred.com to talk with an exchange officer at Deferred.

Deferred's AI Real Estate Tax Expert (ARTE) is a free research tool. Trained on 8,000+ pages of US tax law, regulations and rulings, ARTE outperforms human test takers on the CPA exam. This is page has ARTE's response to a common 1031 Exchange question and should not be considered personalized tax advice.

Sources

Learn More

See more frequently asked questions about 1031 exchanges

What can 1031 exchange funds be used for?
What are the permissible uses of funds held in a 1031 exchange, and how can they be applied to ensure compliance with IRS regulations and maximize the benefits of a tax-deferred exchange?
Does vacant land qualify for a 1031 exchange?
Can vacant land be considered like-kind property for the purposes of a 1031 exchange, allowing for the deferral of capital gains taxes when exchanged for other real property held for investment or productive use in a trade or business?
What happens to depreciation recapture in a 1031 exchange?
How is depreciation recapture handled in a 1031 exchange, and what are the implications for the taxpayer in terms of ordinary income recognition and deferral of gains?
When should you avoid a 1031 exchange?
Under what circumstances might it be more beneficial to avoid using a 1031 exchange for deferring capital gains taxes on the sale of investment property, and instead recognize the gain or loss immediately?
How long must a property be rented to qualify for a 1031 exchange?
What is the minimum rental period required for a property to be considered "held for investment" and thus qualify for a 1031 exchange under IRS guidelines? Please include any relevant safe harbor provisions or guidelines that might influence this determination.