Possible 1031 trap/backfire?

[Matt W.]

Hi BP, 

I've heard different answers about 1031s so I'd love some clarification: (using simple numbers and assuming I hold for 2 years, leaving out depreciation and selling costs, and making the differences in purchase prices extreme to illustrate the different ideas).

Say I buy house A for 100k cash, and sell 2 years later for 200k (100k gain), then do a 1031 exchange of all 200k as 10% down on a $2,000,000 house B (I know this isn't realistic, but using it for the sake of illustration). Now, after another 2 years, I sell the $2 million house B for $2,100,000 ($100k gain again) but this time just cash out and don't do a 1031.  So as I understand it, I'd owe taxes on the house A $100k gain and the house B 100k gain, so 200k total taxable gain. 

A friend (who seems smart about real estate) tells me that in the example I used, the taxable gain would be the difference between the sale price of house B and the original purchase price of house A ($2,100,000-100,000=2,000,000 taxable "gain"). So at 20% LTCG tax rate, you would owe $400k, completely negating the actual $200k gain and owing an additional $200k!

So to me this seems crazy and not how it should work, but maybe I am missing something? If his version is true, you could 1031 so many times or to such high values that you would owe many times more in taxes than you ever made in gains, which seems completely backwards to the core concept that you only pay taxes when you profit. 

Thanks in advance!

(Edit: changed the value of house B from $1MM to $2MM to illustrate the extreme problem more clearly.)

@Dave Foster

[Ash Hegde]

Your understanding is correct. In your example, you are going to defer 100k of gain on the sale of house A, so you have 100k less in tax basis on house B, which would be 900k. When you sell house B for 1.1m, your gain will be 200k.