What happens when you sell an exchange property at a loss? In today's real estate market, this is a great, and common, question. What does happen if you sell a property, that you bought in a 1031 exchange, at a loss? Let's say, for example, that you have a buyer with cash in hand offering you $175,000 for a rental property you paid $200,000 for as part of a 1031 exchange you did three years ago?

"Do I have a capital loss of $25,000, and if so, how will that impact my tax return?" I'm currently getting a lot of calls from people with questions similar to this. Most of them are annoyed, and a few just down right mad, to discover that instead of the loss they think they have, they have a gain on the sale.

"How can that be," you ask? The answer is that when you do a 1031 exchange your basis from the Old Property rolls over to the New. The Old basis is modified slightly if you buy-up, but not if you buy-down. For example, if your Old Property that you just sold for $200,000 has a tax basis of $125,000, and you buy a replacement property for $200,000, your tax basis in the New Property is exactly the same as the Old ($125,000) and you've deferred paying tax on the $75,000 gain.

On the other hand, if you buy the New Property for $190,000, you've bought-down (which is a taxable event in a 1031 exchange), and you'll pay tax on the $10,000 buy-down. Your basis on the New Property is still $125,000, your deferred gain is $65,000, and you paid tax on the other $10,000.

The result is slightly different if you buy-up in an exchange. Assume, for example, that you paid $225,000 for the New Property; its basis would be $125,000 plus the buy-up of $25,000 for a new basis of $150,000, and your deferred gain remains unchanged at $75,000. This is how the IRS views it, although you arrive at exactly the same basis amount if you take the purchase price of $225,000 and back off the deferred gain of $75,000.

So, coming back to the purpose of this article, what does happen if you sell the New Property at a loss? If you sell the property for $175,000, and your basis is $125,000, you have a gain of $50,000, and it matter not that you paid $200,000 for the property. The net effect of the transaction is that you had a deferred gain of $75,000 when you did the exchange, but then lost $25,000 of value resulting in a taxable gain of $50,000 when you sold it.

A couple of final thoughts about this whole issue: first, depending upon the amount of your loan on the property, you may realize barely enough cash on the sale to pay the tax. Also, to point out the obvious, you can still do another exchange on this property and avoid paying tax on the gain.

Published: March 5, 2009

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Gary Gorman is a retired CPA who has taught national tax classes for both Arthur Andersen & Co. and for Price Waterhouse & Co. and numerous undergraduate tax classes at Oregon State University. Since 1994 he has educated realtors, investors, CPAs and attorneys throughout the United States and Mexico on the intricacies of 1031 Exchanges. As the author of the best selling 1031 book Exchanging Up! and a co-author with Rich Dad/Poor Dad and Donald Trump, Gary is considered one of the Nation's leading 1031 Experts. Gary is the owner and managing partner of the national firm, 1031 Exchange Experts, LLC, which headquarters is located in Denver, Colorado, and offices in Arizona, Connecticut, Florida, Hawaii, and Texas. His firm is commited to securely holding client funds in separate, segregated accounts which clients can monitor through our affiliate banks' website. As a Qualified Intermediary, Gary has been involved in more than 30,000 1031 Exchange transactions since 1994. Contact him at , visit his website at expert1031.com, or call 866-694-0204.