I completed a reverse 1031 exchange last year, with a bridge loan to buy replacement properties first. Does the loan interest go to cost basis, or as rental expense?

[Bubble]

Because it was a reverse 1031, the EAT needed fund to buy the replacement property first. Thus I got a personal loan. Then after the exchange closed, I paid off the loan, then rented out the replacement properties. I know normal mortgage interests would be rental expenses, but this bridge loan was only for the exchange process, not secured by the properties. So intuitively I would think it should be closing cost and add to the new cost basis?

[DianeW777]

It depends on exactly what the funds were used to pay. If it was actually a 'buy up'  in your exchange (your New Property cost more than you sold your Old for), the answer is easy – you treat the additional cash part as you would a new addition to an existing property. In other words, you treat the amount of the buy-up the same as you would the cost of a capital improvement. The date placed in service becomes the starting point for depreciation to begin on the buy up portion.

If none of the loan was considered a buy up then only the interest would be deductible as a rental expense in the 1031 exchange.

The basic concept of a 1031 exchange is that the basis of your Old Property rolls over to your New Property. In other words, if you sold your Old Property for $100,000, and bought your New Property for the same, your basis on the New Property would be the same. Your depreciation schedule would be exactly the same! In other words, you continue your depreciation calculations as if you still own the Old Property (your acquisition date, cost, previous depreciation taken, and remaining un-depreciated basis remain the same). You can re-name your property and keep good records for the tax free exchange because you will need them when you sell.

[Bubble]

Thank you, DianeW777. To be more precise, let me show a simple example similar to my actual case. It was a reverse 1031 exchange:

1. My exchange EAT purchased 2 replacement rental properties B & C at $2m total on 2/1/2024. To make this purchase happen, I borrowed $2m personally (the bridge loan) to fund it as a "loan" to the EAT, because in a reverse 1031, the EAT had no money yet so I had to finance it outside of the old property.
2. On 4/1, I sold/exchanged the old rental property A for $1.5m, with $500K cost basis.
3. On 4/3, the EAT transferred the 2 new property titles to me.
4. After the exchange closed, I paid off the $2m loan by 8/1/2024, with a $25K interests. This interest is NOT shown in any HUD statements because this loan was made outside of the closing transaction (e.g. say I borrowed from my siblings). 

I think my new cost basis is $500K (from old property) + $500K (buy-up)  + $25K (bridge loan interest) = $1,025k, since this interest was incurred BEFORE I acquired the new titles. I assume it cannot be rental expenses, but should be added to the cost basis. 

Is this all correct?

Thank you so much!

[DianeW777 · Accepted solution]

Yes, you should add the cost of the loan to the cost basis of all 'buy-up' for the new property. This 'buy-up' is listed as a new asset placed in service on the date of the exchange. The original asset should remain in tact, with a name change only. Some people handle it differently, but this makes the tax return entry easy and the results are the same.

Keep all of the exchange records for future use and you should be good to wrap up your return.

@Bubble