1031 base calculation

1 Reply

I believe I understand the base calculation for the replacement property in general. However, I am not clear on whether paying broker fees outside of closing could make a difference or be (tax) advantageous in certain situations.

Assume a sale price of 200k on the relinquished property. The adjusted base is 100k (includes the depreciation taken in years prior). The loan balance is 50k. The replacement property is bought for 150k (assume it is a DST for simplicity and say there is a 150k minimum for 1031 exchange investors). Assume that the LTV on the new property is 50% (way above what is it for old property). Assume that transaction fees are 10k (it will be more in real life, but this is an example). I can think of this being structured two ways:

A. Transaction fees are paid from sale proceeds and QI receives 140k. Need to wire extra 10k to QI to reach 150k. New property FMV is 300k. Capital gains to be deferred: 200k - 50k - 10k - 100k = 40k. Base in new property is computed as: 300k - 40k = 260k.

B. Transaction cost is paid outside of closing, that is 10k is paid directly to broker etc. QI receives 150k since closing shows no expense. Capital gains to be deferred: 200k - 50k - 100k = 50k. Base in new property is computed as 300k - 50k = 250k. However, there is a 10k expense in this year that counts against profits.

So basically, the choice is between taking an immediate 10k expense versus taking depreciation on 10k larger base. It seems the immediate option is better. What am I missing? This would imply to try to pay all costs outside of closing if possible. Am I correct?

@Matyas Sustik .  I see where you're trying to get to - I think.  The lure of current expenses saves you more than depreciation over time.  But that's not good accounting practice.  And it could really blow up in your face.  At the least that would be seen by the IRS as taking boot.  So the best you're going to get is that the 10K is taxable before you offset with the current expense.  Unless you're simply going to use your own proceeds to pay the expense.  And if you do that your net sale price rises which means more gain to defer, a higher reinvestment target.  And the worst case would be that by trying to do it that way you may nullify the entire exchange.

Closing costs are a cost of the sale and should be paid from the closing proceeds . They reduce your gain by reducing the net sale.  Yep not as good maybe as turning it into current expenses but a much better paper trail. So in your case I'd never advocate closing transaction costs be paid outside of closing.  Although sometimes a realtor who is also the exchanger will forgo taking a commission so they to not show current income on the sale.  and instead all proceeds go into the 1031 exchange.

Even if you did though you would never have to advance any money to your QI to make up a difference.   Hopefully there's nt a QI telling you this.  Simply let all of your costs of closing flow through the settlement statement.  That's the appropriate way.  And it's what the IRS will be looking for if you're ever audited.  But in order to defer all tax you must do two things and replace debt isn't one of them.

1.  You must purchase at least as much as your net sale (this is defined as your contract price less closing costs and expenses (in your case that would be $200K - $10K = $190K)

2. You must use all of your net proceeds in the purchase or purchases.  Net proceeds are defined as your net sale less any mortgage that was paid off. (again in your case that would be $190K - $50K = $140K)

You do not have to replace debt. You can bring in money of your own (but it doesn't have to flow through your QI). Most people don't have outside money so they end up taking new debt. But you don't have to. In your example, as long as you purchase at least $190K in real estate using all $140K to do so you would defer all tax and depreciation recapture. In your example though of the DST it works out fine.

BTW I'm not sure your capital gain is being calculated right.  If the basis is $100K and you sell for $200K then your gain is $100K.  The debt doesn't factor into gain calculation at all.  If you leave the transaction costs in then your basis is still $100K but your net sale is $190K so your gain is only $90K.

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