Equity and capital gain are both important to a 1031 exchange. Let’s take a cursory look at how you determine both equity and gain.
In order to determine gain, we need to know your cost basis. Your cost basis is going to be informed by calculations starting with the purchase price you paid when you bought the property.
1. CALCULATE ADJUSTED BASIS
Your purchase price is the starting amount of your cost basis, which actually changed over time. For instance, if you made any improvements to the property, that amount should be added. Likewise, if you deducted any depreciation while you owned that property, that should be subtracted. Therefore, to find your final cost basis, or what we call the adjusted basis, take the original purchase price plus any improvements and less any depreciation.
Original Purchase Price + Improvements – Depreciation = Net Adjusted Basis
2. CALCULATE EQUITY
Equity represents the hard-earned value that is in any property you own. To determine your equity, take your gross selling price and subtract your closing expenses, or closing costs, and then further subtract the amount of any remaining debt. The remaining number leftover will be your equity in that property.
Selling Price – Cost of Sale – Debt = Equity
3. CALCULATE CAPITAL GAIN
Now, to find your capital gain amount, take the net selling price from your sale and deduct the final adjusted basis.
Sales Price – Adjusted Basis – Cost of Sale = Capital Gain
Lastly, here is a very simple rule that works in exchanges: If you want a totally tax free transaction, do these two things:
1. Buy a replacement property that is equal to or greater in value than the net selling price of your relinquished, or exchange, property.
2. Move all your equity from your old property into the new one.
If you do these two steps, you will have a tax free transaction.