in which we get a lot of questions, is about the handling
of basis in a 1031 exchange. The questions go: “When
I sell my Old Property, what happens to that basis?”
“What about the depreciation I already took?”
“If I fully depreciated my Old Property, will
doing a 1031 exchange let me ‘freshen up’
my depreciation schedule?” “If I buy the
New Property for $100,000, can I depreciate the whole
$100,000?” Questions like these all relate back
to what happens to the basis of the property when you
do a 1031 exchange.
The first step in determining the basis
on your New Property is the basis of your Old Property.
Let’s take a simple example: Fred and Sue are
selling their purple duplex. They bought it in 1995
for $40,000, and they’ve taken $15,000 of depreciation
on the duplex since they bought it. Their tax basis
in the duplex is $25,000 ($40,000 minus $15,000). They
are selling it for $100,000 and have found a red condo
to buy as their replacement property for their 1031
exchange. What is the basis in their red condo? And
how is depreciation handled on the red condo?
Notice that they bought the red condo
for the same price that they sold the purple duplex.
This is an important fact because the purchase price
of the New Property is one of the primary facts that
affect the answer. The answer is because they “bought
equal,” the basis in the new red condo is $25,000
– the same as it was on the old purple duplex.
In a 1031 exchange, the basis rolls forward from the
Old Property (the purple duplex) to the New (the red
condo). What’s more, on their future depreciation
schedules, the purchase date for the red condo is 1995
(the date of the original purchase of the purple duplex),
and the depreciation schedule carries over as if they
were still depreciating the purple duplex.
The reason for this is because in the
eyes of the IRS, what happens in a 1031 exchange is
that you, in effect, still own the original property,
except that the address and legal description for the
property is now that of the red condo. In a 1031 exchange,
the purchase date, holding period and depreciation schedule
continue unaffected by the exchange; your basis in the
red condo is the same as it was for the purple duplex.
Now, let’s change the assumptions
and see what happens: instead of buying the red condo
for the same price they sold the purple duplex, they
buy a green office building for $150,000. In other words
they bought up by $50,000. Their basis in the office
building is now $75,000 which is the combination of
the “rollover basis” of $25,000 from the
purple duplex and the $50,000 buy up from the office
building. Their depreciation schedule shows the continued
depreciation of the purple duplex (as if they still
owned it) and the acquisition of the office building
portion as of the date they closed on the office building
What happens if they buy down? Instead
of the office building, let’s say Fred and Sue
buy a yellow, single-family rental house, for $90,000.
They sold the duplex for $100,000 and now they are buying
down to $90,000. Since the basis always rolls over,
their basis in the rental house is $25,000 – the
same as the duplex. Because they bought down, the amount
of the buy down ($10,000) is taxable. This is why I
always say that “the gain comes first in a 1031