What is Tax Basis?
The term “basis” is the cost of a property for tax purposes. When a property is initially purchased, its basis is the price paid for the property plus acquisition costs; often this is referred to as the “purchase money basis”. Over the time the property is owned, the basis of the property will change, resulting in an adjusted basis. Capital improvements to the property increase the basis. Items for which the owner receives a tax benefit, such as depreciation, decrease basis. If the property is sold (not exchanged) the difference, between the sales price and the basis in the property will determine the amount of capital gain which is taxable. It is very important to note that capital gain is determined by subtracting the adjusted basis from the sale price; loans are not relevant. Many people think that the loan balance or equity is relevant. It is not! To put it in equation form (ignoring closing costs): sales price - adjusted basis = capital gain; sales price - loan balance = equity. As a result, there are only two relevant figures to determine the capital gain: sales price and adjusted basis.
Items that Increase Basis in a 1031 Exchange
Purchasing a more expensive replacement property. When an exchanger purchases a replacement property that costs more than the relinquished property the basis increases (generally by the amount of the increase in value). For example, let’s assume an exchanger sells the relinquished property for $100x (with a basis of $50x) and buys a replacement property for $200x. The basis in the replacement property will increase by the additional investment of $100x (from $50x to $150x).
Liabilities/debts assumed on the replacement property. If an exchanger assumes a loan on the replacement property this will also increase their tax basis. In effect, assuming a loan on the replacement property is the same as if they paid more for the property and the seller paid off the loan.
Acquisition costs of the
replacement property. Closing costs such as
attorney’s fees, etc. which are incurred in connection with acquiring
the replacement property cannot be deducted but add to the basis of the
replacement property. In addition, the IRS considers fees paid to
Qualified Intermediaries to facilitate a 1031 exchange to be
acquisition costs. Accordingly, they are not an expense to be deducted
from the proceeds of the relinquished property but rather an expense
that is added to the basis of the replacement property.
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