The exchange postpones the tax rather than cancelling it, and the replacement property inherits the low basis. Both belong in the sum.
A 1031 exchange defers the whole federal tax on the sale, but it does not cancel it, so what it is worth is the time value of that tax. On an illustrative commercial property bought for 6,000,000 and sold ten years later for 9,000,000, the gain is 3,960,769 and the tax deferred is 1,004,202. If the replacement is sold, and the tax paid, ten years later, the deferral is worth 493,716 today at a 7 per cent discount rate, and about 385,833 once the depreciation lost on the replacement's lower basis is counted.
Worked in full in Commercial Real Estate Investing by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Section 1031 of the US tax code lets an investor sell real property held for investment or for use in a business (since the 2017 tax reform, only real property qualifies) and reinvest the proceeds in like-kind property without recognising the gain, provided a qualified intermediary holds the cash, the replacement is identified within 45 days and bought within 180. Brokers quote the tax saved. The investor should price the tax deferred, and that is a different number.
| Input | Value |
|---|---|
| Purchase price ten years ago | 6,000,000 |
| Of which building, depreciated over 39 years | 4,800,000 |
| Of which land, not depreciated | 1,200,000 |
| Sale price today; selling costs | 9,000,000; 3% |
| Mortgage repaid at sale | 4,000,000 |
| Rate on recaptured depreciation (unrecaptured section 1250 gain) | 25% |
| Long-term capital gains rate; net investment income tax | 20%; 3.8% |
| Loan to value on the replacement | 60% |
| Investor's discount rate | 7% |
Step 1 is the gain the exchange defers. Depreciation has reduced the tax basis, so the gain is larger than the rise in price.
Depreciation = 4,800,000 ÷ 39 = 123,077 a year × 10 = 1,230,769
Adjusted basis = 6,000,000 − 1,230,769 = 4,769,231
Amount realised = 9,000,000 − 270,000 of costs = 8,730,000
Gain = 8,730,000 − 4,769,231 = 3,960,769
Step 2 is the tax a straight sale would trigger. The part of the gain that reverses the depreciation is taxed at up to 25 per cent; the rest is a long-term capital gain; the 3.8 per cent applies to the whole.
Recaptured depreciation: 1,230,769 × 25% = 307,692
Capital gain: 2,730,000 × 20% = 546,000
Net investment income tax: 3,960,769 × 3.8% = 150,509
Federal tax deferred = 1,004,202, an effective 25.4% of the gain
Step 3 is what the deferral is worth. The tax comes back when the replacement is sold in a taxable sale, so its value is the tax minus the present value of paying it later.
Present value of paying 1,004,202 in ten years = 1,004,202 ÷ 1.0710 = 510,485
Value of the deferral = 1,004,202 − 510,485 = 493,716, 49.2% of the tax
In Excel: =Tax-Tax/(1+r)^n
The tax is 21.2 per cent of the 4,730,000 of equity released by the sale. Kept inside the exchange, the whole 4,730,000 buys 11,825,000 of property at 60 per cent loan to value. Paid to the tax authority first, the remaining 3,725,798 buys 9,314,496. The exchange therefore keeps 2,510,504 more property earning rent, which is where the deferral shows up in the investor's IRR rather than as a line in the sale statement.
| Line | Taxable sale | 1031 exchange |
|---|---|---|
| Equity after repaying the loan | 4,730,000 | 4,730,000 |
| Federal tax paid now | 1,004,202 | 0 |
| Equity reinvested | 3,725,798 | 4,730,000 |
| Replacement property at 60% LTV | 9,314,496 | 11,825,000 |
| Tax basis of the replacement | 9,314,496 | 7,864,231 |
| Years until the tax is paid | Discount rate 5% | 7% | 9% |
|---|---|---|---|
| 5 | 217,383 | 288,220 | 351,539 |
| 10 | 387,709 | 493,716 | 580,016 |
| 20 | 625,729 | 744,697 | 825,021 |
The longer the chain of exchanges, the closer the deferral comes to the whole tax: 74.2 per cent of it after twenty years at 7 per cent. The limiting case is the reason exchanges are often chained for life: under current US rules heirs generally take the property at a basis stepped up to market value, and the deferred tax is then never paid.
Counting 1,004,202 as money saved, and forgetting the basis. The replacement costs 11,825,000 but its tax basis is only 7,864,231, so it depreciates as if the deferred gain had never been reinvested. Roughly, on the same 80 per cent building share and 39-year life, that is 81,247 a year of depreciation the investor no longer gets, worth 30,061 a year at a 37 per cent ordinary rate. Over ten years that lost shield has a present value of 211,137, partly offset by the 103,254 present value of the smaller recapture it leaves at the next sale. Net, the deferral is worth about 385,833, 38.4 per cent of the tax, not 100 per cent.
The second mistake is taking cash or reducing debt on the way through. Any cash the investor keeps, and any fall in mortgage debt not replaced with new cash, is boot and is taxed in the year of the exchange. Full deferral needs a replacement at least as valuable as the property sold, with all the equity reinvested. The levered return on the larger replacement is worked as in levered versus unlevered IRR in real estate.
Size the tax first: depreciation recaptured at 25 per cent, the rest of the gain at 20 per cent, 3.8 per cent on the whole. Then value the deferral as the tax minus the present value of paying it later, and subtract the depreciation the carryover basis takes away. On the illustrative sale, 1,004,202 deferred for ten years is worth about 493,716, and about 385,833 net. What makes it large is the extra 2,510,504 of property it keeps at work. How purchase costs and the hold period interact on the replacement is in how long to hold a property to recover the purchase costs, and the book's own sale, yield and attribution workings are in the free workbook for this case.
No, it defers it. The gain rolls into a lower basis in the replacement property and is taxed when that property is sold in a taxable sale. In the illustrative case 1,004,202 is deferred; if paid ten years later its present value at 7 per cent is 510,485, so the deferral is worth 493,716. Under current US rules, heirs generally receive a stepped-up basis, which is why exchanges held until death can avoid the tax entirely.
After the sale closes, the investor has 45 days to identify replacement property in writing and 180 days to complete the purchase, with the proceeds held by a qualified intermediary meanwhile. Missing either deadline makes the sale taxable. In the illustrative case that means 1,004,202 of federal tax and 2,510,504 less purchasing power at 60 per cent loan to value.
The tax not paid stays in the equity and is levered by the new loan. In the illustrative case 4,730,000 of equity buys 11,825,000 of property at 60 per cent loan to value, against 9,314,496 if 1,004,202 of tax is paid first, a difference of 2,510,504, or 27.0 per cent more property for the same investor.
This article is one calculation from Commercial Real Estate Investing. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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