CES Tax Implications & Benefits 1 — Questions and Answers
Question 1: What is the primary tax benefit of completing a successful 1031 exchange?
- Permanent elimination of capital gains tax
- Deferral of capital gains tax on the sale of investment property (Correct answer)
- Reduction of property tax on the replacement property
- Elimination of depreciation recapture on all future sales
Correct answer: Deferral of capital gains tax on the sale of investment property
A 1031 exchange defers — but does not eliminate — capital gains tax, allowing the taxpayer to reinvest the full proceeds.
Question 2: Under IRC Section 1031, what happens to the taxpayer's basis in the replacement property?
- It is set to the fair market value of the replacement property
- It carries over from the relinquished property (substituted basis) (Correct answer)
- It is reset to zero
- It is set to the replacement property's purchase price minus depreciation
Correct answer: It carries over from the relinquished property (substituted basis)
The taxpayer's basis in the replacement property is the substituted basis — generally the adjusted basis of the relinquished property carried forward.
Question 3: What is depreciation recapture, and how does it affect a 1031 exchange?
- Depreciation recapture is eliminated in a 1031 exchange
- Depreciation recapture is deferred along with the capital gain in a successful 1031 exchange (Correct answer)
- Depreciation recapture must be paid in full before the exchange can proceed
- Depreciation recapture only applies to residential rental properties
Correct answer: Depreciation recapture is deferred along with the capital gain in a successful 1031 exchange
In a successful 1031 exchange, depreciation recapture (taxed at 25%) is also deferred along with the capital gain.
Question 4: If a taxpayer continuously completes 1031 exchanges throughout their lifetime and holds the final property until death, what happens to the deferred gain?
- The gain is taxed at the heirs' ordinary income rate
- The gain is permanently eliminated through the step-up in basis at death (Correct answer)
- The gain must be paid within one year of death
- The gain transfers to the heirs as-is with no adjustment
Correct answer: The gain is permanently eliminated through the step-up in basis at death
Heirs receive a stepped-up basis to fair market value at the date of death, permanently eliminating all deferred gain from prior 1031 exchanges.
Question 5: Which tax rate applies to unrecaptured Section 1250 depreciation when it becomes taxable?
- 0%
- 15%
- 25% (Correct answer)
- 37%
Correct answer: 25%
Unrecaptured Section 1250 depreciation is taxed at a maximum rate of 25% when recognized.
Question 6: A taxpayer has a realized gain of $300,000 on the sale of investment property. They complete a 1031 exchange for a property of equal value. What is the recognized gain?
- $300,000
- $150,000
- $0 (Correct answer)
- $75,000
Correct answer: $0
In a fully qualifying 1031 exchange with no boot received, the recognized gain is zero — the entire $300,000 is deferred.
CES Tax Implications & Benefits 1
What is the primary tax benefit of completing a successful 1031 exchange?