Selling vs. Exchanging a Business Asset

Business assets are property, personal or real, that the taxpayer holds for production of income (such as a duplex or a retail business site) or holds for investment purposes (such as vacant land or nonproductive farmland). They do not include property held for personal use by the taxpayer, such as a residence or second home. If the taxpayer purchased the property, the basis of the property is its cost to the taxpayer. The adjusted basis of the property is determined by adding the value of any improvements made to the property and subtracting any depreciation deductions taken by the taxpayer.

Jeff bought his duplex in 1987 for $75,000 in cash. Since then he has added a garage for $10,000 and has taken $20,000 in depreciation deductions. His adjusted basis at the present time is $65,000. ($75,000 + $10,000 - $20,000). If Jeff sells the duplex for $125,000, he will have a $60,000 capital gain ($125,000 minus $65,000). Jeff is in the 28% income tax bracket. Under the Taxpayer Relief Act of 1997, Jeff's capital gains tax is:

Instead of selling it, Jeff decides to exchange his duplex for a newer rental property. As long as Jeff acquires a replacement property costing at least as much as the sales price of the duplex and re-invests all his cash proceeds in the new property, the taxes on the $60,000 capital gain will be deferred. For example, Jeff can acquire a new duplex as replacement property which costs $150,000, with a $25,000 mortgage. This gives Jeff an additional $13,000 (the capital gains taxes on a sale) to invest in the new property.

Jeff's replacement property will have a transferred basis: the adjusted basis of the old duplex plus any additional funds Jeff invests in the new property. For example, Jeff's new duplex with a fair market value (cost) of $150,000 will have a basis of $90,000 ($65,000 + $25,000). In the future, if Jeff sells the new property in a taxable sale, the gain that he previously deferred will be taxed, as well as any future gain. But keep in mind that capital gains tax rates were reduced in Year 2001 under the Taxpayer Relief Act of 1997, and in the meantime, Jeff gets to use Uncle Sam's money without interest! And he'll be paying any future tax bill with tomorrow's dollars!

If Jeff keeps the new property until he dies or replaces it in the future in another exchange his heirs will inherit the property at a stepped-up basis, which means their basis will be the fair market value of the property at the time of Jeff's death. The heirs can immediately resell the property for zero gain or in the future be taxed only on the gain which accumulates after Jeff's death. The gain that Jeff has deferred is eliminated. That's a tax-free exchange!