1031 Exchange: What Documents Should You Provide to Your CPA and How Is Partial Gain Calculated?

Many real estate investors believe that purchasing any replacement property automatically eliminates capital gains tax. Unfortunately, that is not how a Section 1031 Exchange works.

To properly calculate deferred gain and taxable gain, your CPA will need complete information regarding both the sale of the relinquished property and the purchase of the replacement property.

What Documents Should You Provide to Your CPA?

1. Sale Escrow Closing Statement (Relinquished Property)

Provide the final closing statement showing:

• Gross sales price
• Selling expenses
• Mortgage payoff
• Prorations and credits
• Net proceeds transferred to the Qualified Intermediary (QI)

2. Purchase Escrow Closing Statement (Replacement Property)

Provide the final closing statement showing:

• Purchase price
• Down payment
• New mortgage amount
• Exchange funds applied
• Closing costs

3. Prior Depreciation Schedule

Your CPA will need:

• Original purchase price
• Land allocation
• Building allocation
• Accumulated depreciation
• Prior 1031 exchange carryover basis (if applicable)

4. Qualified Intermediary (QI) Documents

Provide:

• Exchange agreement
• Assignment documents
• Identification letter
• Exchange accounting statement

5. Prior Year Tax Returns

Especially if:

• A previous 1031 exchange occurred
• The property has suspended passive losses
• The property has depreciation recapture issues

Important 1031 Exchange Deadlines

Identification Period – 45 Days

The taxpayer must identify potential replacement properties within 45 days after closing the sale of the relinquished property.

Failure to identify replacement property within this period generally disqualifies the exchange.

Exchange Completion Period – 180 Days

The replacement property must be acquired by whichever of the following occurs first:

• 180 days after the sale of the relinquished property, or
• The due date of the tax return (including extensions).

Many taxpayers refer to this as a "6-month rule," although the actual IRS rule is 180 days.

Requirements for Maximum Tax Deferral

To achieve full tax deferral, taxpayers generally must meet the following requirements.

Requirement #1 – Reinvest All Net Equity

All net exchange proceeds should be reinvested into replacement property.

Requirement #2 – Replace Debt

If the relinquished property mortgage is paid off, the taxpayer generally must do one of the following to avoid debt-relief boot:

• Obtain equal or greater replacement debt, or
• Contribute additional cash.

Requirement #3 – Purchase Equal or Greater Value Property

The replacement property value should generally be equal to or greater than the relinquished property value.

What Happens If You Do Not Fully Complete a 1031 Exchange?

Many taxpayers intentionally purchase a lower-value replacement property because they wish to reduce their real estate holdings or access cash.

In these situations, a portion of the gain may become taxable. The IRS refers to the taxable portion as boot.

Boot may include:

• Cash received
• Mortgage debt relief
• Other non-like-kind property received

Partial 1031 Exchange Gain Calculation

The basic rule is:

Recognized Gain = the lesser of Realized Gain or Total Boot Received

Formula

• Realized Gain = Sales Price − Selling Expenses − Adjusted Basis
• Boot = Cash Received + Debt Relief − Debt Replaced
• Recognized Gain = Lesser of: Realized Gain or Boot
• Deferred Gain = Realized Gain − Recognized Gain

Example

Relinquished Property:

• Sale price: $1,330,000
• Mortgage payoff: $604,114
• Realized gain: $451,688

Replacement Property:

• Purchase price: $891,100
• New mortgage: $600,000

Although most of the mortgage is replaced, the replacement property is still significantly lower in value than the relinquished property.

As a result:

• Some gain may be deferred.
• A significant portion of the gain may remain taxable.

This illustrates why taxpayers cannot simply estimate taxable gain by multiplying the replacement property's percentage of value or by dividing the gain proportionally.

Each exchange requires analysis of:

• Property value replacement
• Equity replacement
• Debt replacement
• Cash boot
• Prior depreciation and basis adjustments

Planning Tip

Before entering into a 1031 exchange, taxpayers should consult both their Qualified Intermediary and CPA to determine whether the proposed replacement property will actually achieve the intended tax deferral.

A transaction that appears to be a 1031 exchange may still result in substantial taxable gain if property value, equity, or debt replacement requirements are not satisfied.