Dear Tax Talk,
We are selling an investment property that was acquired in a 1031 exchange. We don’t want to do another 1031 exchange. How do we calculate what our tax will be, and how does the IRS know it’s a 1031 property rather than just property we purchased outright? Thank you.
— Kathy

Dear Kathy,
The calculation for the tax owed on the sale of investment property that was acquired in a 1031, or like-kind, exchange begins on Form 4797, Sales of Business Property.

Back when you acquired this property in the 1031 exchange transaction, it should have been reported on Form 8824, Like-Kind Exchanges. So the IRS should already know that this is how the property was acquired. Additionally, in Part III of this form, you would have calculated the basis of the new property you received. Going forward from when you acquired that new property, you would have used that basis to calculate any required depreciation on the property. Now that you are selling the property, you use Form 4797 to report the disposition.

So in summary, this is how a 1031 exchange, or like-kind exchange, progresses over the years:

Process of Like-kind, 1031 exchanges:

  1. Initial property is acquired. File Form 8824 along with Form 1040 for that tax year.
  2. During interim years, depreciation is claimed if applicable.
  3. Like-kind exchange occurs; new basis is calculated based on old property exchanged. File Form 8824 with Form 1040 for that tax year.
  4. During interim years, depreciation is claimed if applicable.
  5. Year of final sale: Use Form 4797 as a starting point.

Like-kind or 1031 exchanges are used by owners who would otherwise have a large gain on the sale of investment property they have held for years. Rather than pay tax and have less money to invest in new property, they “exchange” for another property. It gets complicated because there are all kinds of rules, but generally the basis carries forward, subject to adjustments.

Although there are a lot of calculations and requirements, exchanging qualifying like-kind property for another property is one of the most common types of nontaxable exchanges.

Thanks for the great question and best of luck to you.

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