Calculating Gain
Often the first step in determining whether a 1031 exchange is right for you is to calculate the amount of taxable gain generated by the sale of investment property.
Taxable gain on the sale of investment property is calculated in accordance with the following formula:
Sales Price less
Exchange Expenses less
Adjusted Basis equals
Taxable Gain
Exchange Expenses includes those transactional costs deductible in connection with the Exchange that should generally include costs that are:
- A direct cost of selling real property, which typically include:
- Real estate commissions
- Title insurance premiums
- Closing or escrow fees
- Legal fees
- Transfer taxes and Notary fees
- Recording fees
- or-
- Real estate commissions
- Costs specifically related to the fact the transaction is an exchange such as the Qualified Intermediary fees.
Costs related to obtaining the loan on the Replacement Property are not considered Exchange Expenses and should not be deducted from the Exchange Proceeds. Other non-exchange expenses include:
- Mortgage points and assumption fees
- Credit reports
- Lender's title insurance
- Prorated mortgage insurance
- Loan fees and loan application fees
- Property taxes
- Utility charges
- Association fees
- Hazard insurance
- Credits for lease deposits
- Prepaid rents and security deposits
- Mortgage points and assumption fees
In order to avoid "boot" on this non-exchange expenses, an Investor should consider paying for these items outside of closing or investing additional cash equity into the Replacement Property to offset these amounts.
The Adjusted Basis of the property is calculated by taking the acquisition cost of the property (less any deferred gain from prior 1031 exchanges), adding the cost of any capital improvements made to the property, and subjecting the amount of depreciation deductions taken.
Once Taxable Gain is determined, you can estimate your tax liability by multiplying the Taxable Gain by the applicable tax rate. Investment property held for a year or less will be taxed as ordinary income at the Investor’s individual tax rate. Investment property held for over one year is taxed at the long-term capital gains rate of 15% (lower if the Investor is in a lower federal tax bracket). Additionally, many states impose an additional state tax on top of the federal tax. Investors should check the tax rates in effect for the state in which the Relinquished Property is located.
The analysis set forth above provides an overly simplistic view of the complicated tax rules and regulations governing property taxation, basis determination, and gain calculation. Consultation with your CPA or personal tax advisor is strongly encouraged.
