IRS Section 1031 Tax Deferral Rules
Under IRS Section 1031, real estate investors can defer paying capital gains taxes and depreciation recapture when selling an investment property, provided they reinvest the proceeds in a "like-kind" property.
To defer 100% of the taxes, the investor must follow two primary rules:
1. Reinvest all cash proceeds: All net cash proceeds from the sale must be handled by a Qualified Intermediary (QI) and reinvested.
2. Equal or greater value & debt: The purchase price of the replacement property must be equal to or greater than the net sales price of the original property, and the new mortgage balance must equal or exceed the old one.
The math is formulated as follows:
$$\text{Adjusted Basis} = \text{Original Price} + \text{Improvements} - \text{Depreciation}$$
$$\text{Realized Gain} = \text{Net Sales Price} - \text{Adjusted Basis}$$
$$\text{Depreciation Recapture Gain} = \min(\text{Realized Gain}, \text{Depreciation})$$
$$\text{Capital Gains Portion} = \text{Realized Gain} - \text{Depreciation Recapture Gain}$$
If the replacement property costs less than the original property's net sales price, the difference is boot. Boot is taxable up to the total realized gain of the transaction.