This page describes a composite hypothetical. It is not a real client or a real result. All amounts and rates are assumptions for illustration.
The Scenario in Brief
An investor owns a small apartment building and is considering selling. The investor asks an advisor to compare a taxable sale with a like-kind exchange into another investment property, including what happens to depreciation recapture and to suspended passive losses.
Assumptions Used
- Sale price: 1,500,000 dollars, with 90,000 dollars in selling costs, for a net amount realized of 1,410,000 dollars.
- Adjusted basis: 700,000 dollars, after depreciation of 300,000 dollars, all straight-line.
- Suspended passive losses from prior years: 80,000 dollars.
- Assumed flat rates: 25 percent on unrecaptured Section 1250 gain, 20 percent on other long-term capital gain, and 3.8 percent net investment income tax. State tax is ignored.
- If an exchange is used, the investor would identify and close on a replacement property within the required deadlines with equal or greater value and debt.
Taxable Sale Arithmetic
| Item | Amount |
|---|---|
| Amount realized | 1,410,000 dollars |
| Adjusted basis | 700,000 dollars |
| Total gain | 710,000 dollars |
| Unrecaptured Section 1250 gain (depreciation taken) | 300,000 dollars |
| Remaining long-term capital gain | 410,000 dollars |
| Assumed tax on unrecaptured gain at 25 percent | 75,000 dollars |
| Assumed tax on remaining gain at 20 percent | 82,000 dollars |
| Assumed net investment income tax at 3.8 percent on 710,000 dollars | 26,980 dollars |
| Total assumed tax before suspended losses | 183,980 dollars |
In a fully taxable sale to an unrelated party, the 80,000 dollars of suspended losses would generally be released and could offset the gain, reducing taxable gain. Applying them against the remaining capital gain would reduce that tax by about 16,000 dollars at 20 percent, plus a reduction in the net investment income tax for that amount, in a simplified view. The ordering rules for suspended losses and the interaction with the surtax are technical and would be applied by a preparer.
Exchange Scenario
If the investor completes a qualifying like-kind exchange with equal or greater value and debt, the 710,000 dollars of gain, including the recapture, would generally be deferred. The replacement property would carry a lower basis, and future depreciation would be lower. Suspended passive losses would generally remain suspended and not be released. The investor would not pay tax now, but the deferred gain remains embedded in the new property, and the investor would need to decide whether to exchange again, hold, or sell later.
Comparison
| Consideration | Taxable sale | Exchange |
|---|---|---|
| Tax due now | assumed roughly 184,000 dollars before loss offsets | generally none if fully deferred |
| Suspended losses | generally released | generally remain suspended |
| Basis in new property | purchase price of new property | carryover basis |
| Flexibility | cash available for any use | proceeds must be reinvested in real property |
| Deadlines | none special | 45 and 180 day rules |
Factors the Advisor Would Weigh
The advisor would ask about the investor's goals. If the investor wants to leave real estate, an exchange may not fit. If the investor wants to continue investing, an exchange may let more capital keep working. The investor's health, estate plans, and age might matter, since a stepped-up basis at death can eliminate deferred gain for heirs under current law. The advisor would also consider whether there are better opportunities than the replacement property, since tax deferral should not lead to a poor investment.
Scenario Variations Worth Considering
If the investor had no suspended losses, the tax comparison would change. If part of the proceeds were needed for other purposes, the investor could take some cash, and that amount would be taxable as boot. If the investor sold in two tax years using an installment note, depreciation recapture would still be recognized in year one.
Risks and Limits
- Deadlines for exchanges are strict.
- Deferral is not elimination.
- Rates and rules can change.
- The arithmetic is simplified.
What This Scenario Teaches
An exit decision involves more than the headline gain. Recapture, suspended losses, surtaxes, and the investor's goals all matter, and the best approach may differ from investor to investor.
Questions to Bring to Your Advisor
- How much tax would a sale produce compared with an exchange?
- What happens to my suspended losses under each option?
- What deadlines must I meet for an exchange?
- How does my estate plan fit?
A Timeline for the Decision
If the investor is leaning toward an exchange, the timeline matters. The investor would engage an intermediary before the sale contract is signed, begin looking for replacement property early, prepare an identification letter before the 45th day, and confirm financing so that closing can occur within 180 days. If the investor is leaning toward a taxable sale, the advisor would estimate the tax, schedule an estimated payment, and confirm state withholding requirements at closing. In either case, the decision should be made before listing the property, since some options cannot be added after closing.
Estate Planning Interaction
Some investors consider holding property until death so that heirs receive a stepped-up basis under current law. That approach has trade-offs: it keeps capital tied up, and estate tax and other rules may apply. An advisor and an attorney would discuss it together.
Frequently Asked Questions
Is an exchange always better than a taxable sale?
No. It depends on the investor's goals, the replacement property, and the tax picture.
Are the figures in the scenario typical?
No. They are assumptions used for simple arithmetic.
Want to Talk Through Your Own Situation?
These scenarios are illustrations only. Book a discovery call with AE Tax Advisors to discuss the facts of your own business or portfolio.
Book a Discovery CallEducational purposes only. This page is an illustrative educational scenario, not tax, legal, or accounting advice, and it does not describe a real client or a real result. Tax laws change and outcomes depend on individual facts, so consult a qualified professional before acting. No result is guaranteed.