In some senses, structuring a 1031 Exchange is a trade off. If a taxpayer sells their existing property and pays the tax, he or she will have more depreciation in the new property that they subsequently purchase because the basis from the existing property did not shift over and reduce the basis in the new property as it would if a 1031 Exchange was executed. If the same taxpayer structures a 1031 Exchange from the sale of a existing property into the purchase of a new property, the tax basis from the existing property shifts over to the new property and is increased by the difference in their values.
For Example:
Existing Property Sales Price …………………………. $550,000
Existing Property Tax Basis ……………………………. $230,000
Capital Gain + Depreciation Recapture …………. $320,000
New Property Purchase Price ………………………… $750,000
A 1031 Exchange results in the new property having an adjusted tax basis of $430,000 ($750,000 less $320,000). The taxpayer will begin depreciating the property from $430,000 over the applicable depreciation period.
If a taxpayer does not do a 1031 Exchange, the new property will have a $750,000 tax basis. The taxpayer will begin depreciating the new property from $750,000 over the applicable depreciation period. The taxpayer will have higher depreciation deductions over time, but at the significant cost of having paid all the tax up front.
In the case where a 1031 Exchange is properly structured, the taxpayer has use of money that would otherwise be paid in tax to the Government to apply toward the purchase of like-kind new property. This tax deferral will stay in effect until the property is sold, and tax will be due even then only if the taxpayer does not exchange that property for other like-kind replacement property through another 1031 Exchange. Furthermore, if an individual taxpayer retains the new property until death, his or her heirs will receive a step up in basis thus eliminating the deferred tax on the gain altogether.