When you trade rental houses or other investment properties, the Internal Revenue Service gives you the option of using a mechanism called a like-kind exchange. In this scenario, the money from the sale of the first investment property automatically goes into a replacement property.
This allows you to defer paying capital gains taxes and depreciation recapture taxes on the sale and lets you keep all of your equity working for you. The drawback is that you carry your lower basis forward into the newer property, so when you sell, you'll pay all of the taxes that are due.
Determining Your Cost Basis
Sum the purchase price of the property that you're selling with the closing costs that you paid when you first bought it; loan-related costs are excluded. For instance, if your rental house cost $87,000 and you paid $1,750 in closing costs and $870 in loan costs, your cost basis would be $88,750.
Adding the Cost of Improvements
Add all of the costs of the improvements that you've made to your property over the years. Improvements are projects that you complete that either make the property last longer, make it worth more or change the way in which you can use it. A $3,500 bathroom renovation and a $6,700 new roof would be improvements, but replacing one broken window for $450 wouldn't be. Adding those two renovations to the $88,750 cost basis gives you an adjusted basis of $98,950.
Calculating the Depreciated Basis
Subtract all of the depreciation that you claimed or could have claimed, whichever is greater, from the adjusted basis to find your depreciated basis. If you claimed the entire $27,325 of depreciation to which you were entitled, it would reduce your $98,950 adjusted basis to $71,625. This depreciated basis is the value that comes from the property that you sell in the exchange -- called your relinquished property.
Determining the Amount Realized
Subtract the commissions and closing costs from your relinquished property's selling price to find the amount realized. If you sell it for $162,000, pay $3,200 in closing costs, and pay $9,720 in commissions, your amount realized is $149,080.
Figuring in the Replacement Property
Total the replacement property's purchase price with its closing costs. If you buy a $192,000 threeplex and pay $5,150 in closing costs, its cost basis, leaving the exchange aside for the moment, would be $197,150.
Finding the New Cost Basis
Subtract the amount realized from the cost basis of the new property and add the depreciated basis back in. In this example, you'd subtract $149,080 from $197,150 to find out that you put $48,070 of new value in, then add back the old property's depreciated value of $71,625 to find a new basis of $119,695.
Deferred Tax Liability
You can continually do like-kind exchanges between properties, deferring your tax liability for decades. If you do this until you die, your heirs can inherit the property with a stepped-up basis, potentially eliminating the capital gains and recapture tax liability that you've built up over the years. In other words, death beats taxes!
Seeking Professional Advice
Calculating basis in section 1031 like-kind exchanges can be extremely complicated, so it's wise to have the help of an accountant. This is especially true if you've done chains of multiple 1031 exchanges, taken money out or used creative depreciation strategies like cost segregation.
