The 1031 exchange: sell the building, buy the next one, defer the tax

The numbers

Picture an investor selling a commercial building for $2,000,000. They bought it for $1,400,000 and have taken $600,000 of depreciation, so their adjusted basis is $800,000 and the gain is $1,200,000. They don’t work in real estate full time, so the net investment income tax applies.

For illustration purposes. Tax law may change, which may change these calculations slightly.

Personal tax on the sale (federal)

With the exchange, all $2,000,000 goes into the next property instead of about $1,684,400. The deferred gain carries into the new property’s basis. Oklahoma tax is figured separately. Oklahoma may allow a deduction for qualifying gains on Oklahoma property held at least five years, which can change whether an exchange or a sale works better for state tax.

Deferral can become permanent. If you hold the last property until death, your heirs generally receive it at a stepped-up basis, and the deferred gain is never taxed under current law.

How it works

1. Plan before you list. Set up the exchange with a qualified intermediary before the sale closes. The exchange language goes into the sale contract.
2. Sell the old property. The sale money goes straight to the intermediary, not to you.
3. Identify the replacement within 45 days. In writing, usually up to three properties, or more under value-based rules.
4. Close within 180 days. Or by your tax return due date for that year, if earlier. File an extension if needed to keep the full 180 days.
5. Buy equal or greater. To defer all the tax, buy property worth at least as much as you sold, reinvest all the cash, and replace any debt that was paid off.

Who it fits

• Investors trading up to a bigger property, or trading several smaller rentals for one easier-to-manage building.
• Business owners selling the building their company used and buying another investment property.
• Farm and ranch owners exchanging land for other land or for commercial property.

When it doesn’t work

• Your home, vacation homes used mostly personally, and property bought to fix and flip.
• Equipment, vehicles, and other personal property, which no longer qualify.
• Interests in a partnership or LLC, as opposed to the real estate itself.
• When you need the cash from the sale.

The rules

• Like-kind is broad for real estate. Land, rentals, commercial buildings, and many other U.S. real property interests can be exchanged for each other. U.S. and foreign property aren’t like-kind.
• Boot is taxable. Cash you keep, or debt reduced without being replaced, is taxed to the extent of your gain.
• Same taxpayer. The taxpayer who sells must be the one who buys. Changing entities mid-exchange can break it.
• Related parties. Exchanges with family or related entities have a two-year holding rule.
• Reporting. Report the exchange on Form 8824 with your return.

Risks and costs to weigh

• Deadline pressure. Forty-five days goes fast. Overpaying for a replacement to save the exchange can cost more than the tax.
• Lower future depreciation. The new property carries over your old basis, so your depreciation going forward is smaller than if you’d bought it fresh.
• Intermediary risk. Use an established, bonded qualified intermediary.
• Rules can change. Section 1031 has been narrowed before and could be again.

How we handle it for clients

With a Cannon & Brown tax plan, we run the numbers on selling outright versus exchanging, including federal tax, Oklahoma tax, and the depreciation you give up, so you know what the exchange is really worth. We help you set it up with your intermediary and attorney, track the 45- and 180-day deadlines, and plan cost segregation on the replacement property. Because our technology keeps your numbers current, you get answers quickly while the clock is running. Your tax strategist reviews every recommendation.

Illustrative example. The investor and figures on this page are hypothetical, used to explain how the strategy works. They are not a client and not a promise of results. The example assumes a $2 million sale, $800,000 adjusted basis, $600,000 of depreciation taxed at up to 25%, the 20% capital gains rate, the 3.8% net investment income tax, and a replacement property of equal or greater value with all cash reinvested. Selling costs are ignored. This page is educational and is not tax or legal advice for your situation; tax rules and limits change.