How Stepped-Up Basis Affects a 1031 Exchange
It may make the case for replacing a property far less compelling.
Provided by Terri Fassi, CPA, MBA, CDFA
Have you inherited a home or income property? If so, you may be weighing your options: you could hang onto it, you could sell it, or you could replace it through a 1031 exchange. One major factor affecting your choice will be the property’s tax basis – the value of that real estate in the eyes of the tax collector.1
The tax basis of a property changes over time, and it can change dramatically when a property is inherited or gifted. Usually, the basis is “stepped up.” Let’s explain what that phrase means.3
When you buy real estate, your starting tax basis is known as the cost basis. The cost basis is defined as the full purchase price for the property. If you buy a home for $300,000 (with or without financing), your initial tax basis is the cost basis of $300,000.1
When you inherit real estate, your basis is not the original owner’s cost basis. Instead, it is the fair market value of the property at the time of the owner’s death. This adjustment is known as a “step-up,” and it provides many heirs with a nice tax break.1,2
As an example, say someone inherits a 12-unit apartment building. The full purchase price of the building was $300,000 in 1990, but the fair market value of the building was $600,000 at the owner’s death. The heir sells the building for $620,000. Her tax basis is $600,000, which means her total taxable profit on the sale will be only $20,000 instead of $320,000. Correspondingly, she faces capital gains tax on $20,000 of profit rather than $320,000 of profit.1
When basis is stepped up, there may be much less incentive to replace a property (and defer tax on the gain) through a 1031 exchange. Selling the property may be the better option.
A 1031 exchange – an alternative to a conventional sale – offers you a legal way to replace an unwanted property with a more desirable one, without triggering capital gains taxes in the year of the swap. These like-kind exchanges are facilitated with the assistance of a third party – a qualified intermediary who can help you complete the exchange within 180 days of the initial property transfer (and before you file your 1040 for the tax year involved).3
If you want to quickly sell inherited real estate, the case for a 1031 exchange weakens. If your goal is to unload the property within a few months, it may not appreciate much (or at all) in that time. The taxable profit above the stepped-up basis may be small or nonexistent, so capital gains tax may not be much of a concern. If you decide to hang onto the property for a couple of years, then the case for initiating a like-kind exchange grows stronger.3
What variables factor into the decision to sell or exchange? First, the fair market value of the property has to be determined. Take the original total purchase price of the property, add the value of any improvements, and subtract any depreciation taken. That is your adjusted basis.1,2
Once you have that number, plug it into the middle of another equation: Projected Sale Price – (Adjusted Basis + Projected Agent Commission + Projected Title Fees + Any Other Probable Closing Costs) = Realized Taxable Gain.2
Now onto determining the tax due. As a simple rule of thumb, multiply the depreciation that will be taken from the realized taxable gain by 25% to estimate recaptured depreciation. Then apply federal capital gains tax, state capital gains tax, and (in some circumstances) county capital gains tax to the remaining balance to arrive at the recognized gain, or the total capital gains tax you are projected to owe. If that total capital gains tax is not burdensome to you, you may opt to just sell the property rather than exchange it.2
Before making any move, be sure you confer with a tax professional or a real estate professional to evaluate these options.
Terri Fassi may be reached at 970-416-0088 or firstname.lastname@example.org
This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.
1 – nolo.com/legal-encyclopedia/determining-your-homes-tax-basis.html [9/13/16]
2 – atlas1031.com/blog/1031-exchange/bid/82182/1031-Exchange-and-Stepped-Up-Basis [2/19/13
3 – cincinnati.com/story/money/2016/05/05/property-exchange-can-defer-avoid-tax/83982782/ [5/5/16]