1031 Property Exchanges

TCJA Still Allows Section 1031 Exchanges of Real Property

Taxpayers who are serious real estate investors periodically adjust their portfolios by getting rid of properties and acquiring new ones. However, selling appreciated properties results in a current tax hit which real estate investors hate-especially when they intend to roll over their sales proceeds by purchasing new properties. The good news is that IRC Sec. 1031 allows taxes to be deferred if so-called like-kind exchanges can be arranged. In fact, deferral is mandatory, rather than elective when Section 1031 applies.

Tax Cuts and Jobs Act IRS Information

TCJA Eliminated Section 1031 Treatment for Personal Property Swaps

Tax-deferred Section 1031 treatment is now only allowed for qualifying exchanges of real estate, for exchanges completed after 12/31/17 (no more Section 1031 treatment for exchanges of personal property). This is a permanent change. [See IRC Sec. 1031(a)(l).]

More information regarding TCJA

Section 1031 Treatment Still Allowed for Real Estate Swaps

The TCJA did not make any changes to the Section 1031 rules for real estate swaps.  Under Section 1031, taxable gains are deferred when buyers and sellers swap real estate properties, except to the extent cash or dissimilar property (boot) is received in the transaction. If a party to the transaction receives boot, gain is currently recognized in an amount equal to the lesser of the total gain or the boot’s FMV [IRC Sec. 103l(b)].

Even deferred real property exchanges can qualify for tax-deferred Section 1031 treatment [IRC Sec. 1031(a)(3)]. This is very important, because it is usually difficult for a seller who wants to make a like-kind exchange to locate another party who has suitable replacement property and who also wants to make an exchange rather than a cash sale. Under the deferred exchange rules (which are beyond the scope of this analysis), the seller need not make a direct and immediate exchange of one property for another.

The seller can, in effect, sell for cash and then locate the replacement property a bit later. And the owner of the replacement property can sell for cash without spoiling the first party’s ability to defer his or her taxable gain.

Real Property Section 1031 Exchange Basics

Under Section 1031, mandatory nonrecognition of gains (and losses) applies when properties are exchanged in what would otherwise be taxable sale transactions.

To qualify for Section 1031 nonrecognition treatment, both the property given up by the seller and the property received must be investment property or business property in the seller’s hands. Note that investment property can be swapped for other investment property or for business property, and vice versa. From the perspective of either party to the exchange, it does not matter whether or not the other party qualifies for Section 1031 treatment (Rev. Rul. 75-292).

The regulations give a very liberal interpretation to the like-kind requirement for real estate swaps. Reg. 1.1031(a)-1 says improved real estate can be swapped for unimproved real estate, a strip shopping center can be traded for an apartment building, a marina can be swapped for a golf course, etc. However, real property cannot be swapped for personal property. Finally, property held for personal use (such as a home or a boat), inventory, partnership interests, and investment securities do not qualify for Section 1031 treatment. Historically, most Section 1031 exchanges have involved real estate, and after the TCJA Section 1031 exchanges are limited to real estate.

Realized versus Recognized Gain or Loss and Receipt of Boot

When two parties wish to make a Section 1031 exchange of properties with differing FMVs, the party with the less valuable property must add additional consideration to equalize the values. This is called boot.

Boot can be cash or dissimilar property or a mixture of both.

In analyzing a Section 1031 transaction, the first step is determining the amount of realized gain (or loss) for each party. Realized gain equals:

1. FMV of property (including any non-cash boot) plus any cash boot received, minus
2. The tax basis of the property given up (including any non-cash boot) plus any cash boot given.

In contrast to the realized gain, the recognized gain is the amount that must be currently reported under the federal income tax rules (not to exceed the realized gain). As explained earlier, a party to a Section 1031 exchange generally has no recognized gain unless boot is received. If boot is received, the recognized gain is the lesser of the realized gain or the FMV of the boot.

Example 1  Chuck and Rocky trade undeveloped agricultural acreage in a Section 1031 like-kind exchange.  Chuck’s land has FMV of $500,000 and tax basis of $300,000. Rocky’s land is worth only $430,000, and his basis is $80,000. To equalize the trade, Rocky gives Chuck a used tractor, some other farming equipment, and a big load of manure worth a total of $70,000.

Chuck’s realized gain is $200,000 ($430,000 + $70,000 – $300,000); however, he currently recognizes only $70,000 (lesser of the $200,000 realized gain or the $70,000 worth of boot received).  Rocky’s realized gain is $350,000 ($500,000 – $80,000 – $70,000), but he has no recognized gain on the swap, because he receives no boot (he pays boot).

Basis and Holding Period for Like-Kind Property Received

In effect, the tax basis of the like-kind property received is adjusted down or up for any unrecognized gain or loss attributable to the like-kind property given up [IRC Sec. 103l(d)]. Therefore, the tax basis of the like -kind property received equals:

1. The tax basis of the like-kind property given up, PLUS
2. Gain recognized (if any) on like-kind property given up, PLUS
3. FMV of boot given up (if any), MINUS
4. FMV of boot received (if any)

The holding period for the like-kind property received includes the holding period of the old like-kind property given up [IRC Sec. 1223(1)].

As for any noncash boot received, its tax basis will always be equal to FMV, because it is received in a fully taxable transaction. Therefore, as of the transaction date, a new holding period begins for the noncash boot.

Example 2  Assume the same facts as in Example 1.

Chuck’s basis in the like-kind property received is $300,000 ($300,000 + $70,000 + zero – $70,000). In effect, the $130,000 unrecognized gain from the old property has become a $130,000 built-in gain in the new property (FMV of $430,000 minus tax basis of $300,000).

Rocky’s basis in his new like-kind property is $150,000 ($80,000 +zero+ $70,000 – zero). Rocky’s $350,000 unrecognized gain from the old property has become a $350,000 built-in gain in the new property (FMV of $500,000 less tax basis of $150,000).

Effect of Liabilities

In real life, most 1031 real estate transactions involve properties burdened by mortgages. The impact of liabilities on realized and recognized gains and losses is explained below.

Effect on Realized Gain Computation. Under Reg. 1.1031(d)-2, the transferor’s realized gain equals

1. Gross amount of debt shifted to the transferee, PLUS
2. FMV of boot received in form of cash and/or dissimilar property (if any), PLUS
3. FMV of like-kind property received, MINUS
4. Tax basis of like-kind property given plus any boot given, MINUS
5. Gross amount of liabilities taken on by transferor

Effect on Recognized Gain Computation. The transferor’s recognized gain equals the lesser of the realized gain (from above) or the boot received. When the transferee assumes a liability or takes property subject to a liability, this counts as boot received for purposes of computing the recognized gain. When both parties assume liabilities or take property subject to liabilities, amounts are netted. For example, if the transferor takes on liabilities in excess of the amount shifted to the transferee, the transferor has given boot equal to the net amount, and the transferee has received boot in the same amount.

However, deemed net boot given from liabilities (excess of the line 5 amount over the line 1 amount) cannot be used to offset actual boot received in the form of cash and/or dissimilar property (the line 2 amount) [Reg. 1.1031(d)-2, Example 2). Put another way, the transferor must recognize gain equal to the lesser of the realized gain or the actual boot received (the line 2 amount), even when the transferor has given net boot attributable to liabilities.

When the transferor gives actual boot in the form of cash or dissimilar property (included in the line 4 amount), the actual boot given offsets any net boot received from liabilities (excess of line 1 amount over line 5 amount) [Reg. 1.1031(d)-(2), Example 2). Thus, if actual boot given exceeds the net boot received from liabilities transferred to the other party, there is no recognized gain.

Example 3  Reilly owns Happy Hill (FMV of $4,000,000, mortgage of $3,400,000, and tax basis of $3,000,000).  She swaps the property for Grumpy Acres (FMV of $3,600,000, mortgage of $3,500,000, and tax basis of $3,200,000), which is owned by Rick. Because Rick’s equity in Grumpy Acres is only $100,000 versus Reilly’s $600,000 equity in Happy Hill, Rick tosses in $500,000 of cash to square the deal.

Reilly’s realized gain is $1,000,000 calculated as follows:

1. $3,400,000 Happy Hill debt shifted to Rick
2. 500,000 FMV of boot received
3. 3,600,000 FMV of like-kind property received
4. (3,000,000) Tax basis of property given up
5. (3,500,000) Grumpy Acres debt assumed by Reilly

Reilly’s recognized gain is limited to $500,000, which equals the amount of actual boot received. She gets no “credit” for the $100,000 of net boot given from liabilities (excess of $3.5 million she assumed over $3.4 million she shifted to Rick). However, as will be seen below, the net boot given from liabilities increases Reilly’s tax basis in Grumpy Acres.

Reilly’s tax basis in Grumpy Acres is $3.1 million calculated as follows:

1. $3,000,000 tax basis of Happy Hill
2. 100,000 boot given from liabilities
3. 500,000 gain recognized on swap of Happy Hills
4. (500,000) cash boot received

Reilly has a built-in gain of $500,000 in Grumpy Acres (FMV of $3,600,000 less basis of $3,100,000).  This equals her realized gain of $1,000,000 less the $500,000 that was deferred by making the like-kind exchange.

Rick’s realized gain on the disposition of Grumpy Acres is $400,000 calculated as follows:

1. $3,500,000 Grumpy Acres debt shifted to Rhonda
2. 0 FMV of boot received
3. 4,000,000 FMV of like-kind property received
4. (3,700,000) Tax basis of property and boot given
5. (3,400,000) Happy Hills debt assumed by Rick

Rick’s recognized gain is zero, because he offsets the $100,000 of net boot received from liabilities with the $500,000 of actual boot given to Reilly.  Rick’s basis in Happy Hills is $3,600,000 calculated as follows:

1. $3,200,000 Tax basis of Grumpy Acres
2. 500,000 Boot given
3. 0 Gain recognized from Grumpy Acres
4. (100,000) Boot received (from liabilities)

Rick has a built-in gain of $400,000 in Happy Hills (FMV of $4,000,000 minus basis of $3,600,000). This equals his realized gain of $400,000 from Grumpy Acres, all of which was deferred by making the Section 1031 like-kind exchange.

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