The IRCS1031 Tax-Free Exchange - Calculating the Basis of Replacement Property

Introduction
This article provides a very brief introduction to two different methods and approaches for the computation of the basis of replacement property receive in an Internal Revenue Code Section 1031 (IRC1031) exchange. It should be noted that these methods are relatively simple, when compared to more complex IRC1031 exchanges. This is because some may involve more than one classification of like-kind properties (e.g., real property versus personal property). The Internal Revenue Service (IRS) provides some broad instructions on the IRC1031 exchange in its Publication 544 Sales and Other Dispositions of Assets. This publication is updated every year and is provided to the public, for free, by calling the IRS tax forms 1-800 telephone number or by downloading the publication from the Internet at www.irs.gov . IRC1031 exchanges are reported on Form 8824, Like-Kind Exchanges.

Basic Terminology
The below Table summarizes the two different methods and approaches for the computation of the basis of replacement property. However, before illustrating the methods for the IRC1031 exchange replacement property basis calculation, some basic terms must be defined, as follows:

Adjusted Basis Cost plus improvements less depreciation.

Relinquished That property sold in an IRC1031 like-kind exchange (e.g., relinquished property). Also known as phase I property, property given up, sale, exchange, or downleg.

Replacement That property purchased in an IRC1031 like-kind exchange (e.g., replacement property). Also known as phase II property, property received, purchase, target, or upleg.

Realized A classification of gain or loss that may or may not be realized or have any tax impact. A realized gain (or loss) may or may not be recognized.

Recognized A classification of gain or loss that always, by definition, has a tax impact. A recognized gain (or loss) must, first, have been realized.

Capital Gain Sales price less adjusted basis, when sold at a profit. The amount to which capital gains taxes and tax rates are applied. For the 2004 and 2005 tax years, long-term capital gains are taxed at 5% (for taxpayers in 5% or 10% ordinary income tax rates or brackets), 15% (for taxpayers in 25%, 28%, 33% or 35% ordinary income rates or brackets), and 25% (for taxpayers subject to IRC1250 recapture rules).

Capital Loss Sales price less adjusted basis, when sold at a loss.

Ordinary Income Those types, categories or classifications of income (e.g., dividends, interest and salary) to which ordinary income tax rates are applied. Ordinary income tax rates or brackets are higher than those applied to long-term capital gains to provide taxpayers with an economic incentive to invest, rather than speculate, long-term.

Tax-Deferred Tax savings are always the result of tax-planning strategies designed to achieve tax-deferral or tax-deferred treatment. This is the objective of the IRC1031 like-kind exchange. The tax is not eliminated, but is merely deferred or pushed into the future.

Deferred Gain A gain that is realized, but not recognized. This is the objective and/or motivation for the IRC1031 exchange.

Deferred Loss A loss that is realized, but not recognized. Though not the objective, the IRC1031 exchange is a double-edged sword. It results in partial or completely deferred gains, but also results in loss non-recognition. It is important for taxpayers to understand that the IRC1031 exchange is not an election, but is mandatory if all conditions are met. Therefore, it is not inconceivable that a taxpayer may accidentally defer a loss.

Boot Cash boot (i.e., cash that is constructively received), mortgage boot (i.e., debt relief or liabilities relieved of), or other boot consists of non-like-kind property received or given in an IRC1031 exchange, and is, therefore, potentially taxable.

The Table, below, uses the above terms to illustrate the two different methods and approaches for the computation of the Basis of REPLACEMENT Property received in an Internal Revenue Code Section 1031 (IRC1031) exchange.

Table

Method 1

Original Cost, Basis or Purchase Price of RELINQUISHED Property
+ Boot given (Adjusted Basis)
+ Gain recognized
+ Liability assumed by the transferor (seller)
- Boot received (Fair Market Value)
- Loss recognized
- Liability assumed by the transferee (buyer)
= Basis of REPLACEMENT Property

Method 2

Fair Market Value of REPLACEMENT Property
- Deferred (Realized less Recognized) Gain

+ Deferred Loss
= Basis of REPLACEMENT Property

Summary
This very brief article provides you with an introduction to a tabular representation of the two separate methods and approaches useful in calculating the basis of replacement property in an IRC1031 exchange. This represents the basics of replacement property basis calculations, as more complex IRC1031 exchanges may involve more than one classification of like-kind properties.

Feel free to publish or reproduce anywhere, as long as you provide a copy to and/or notify the author .

A.J. Cataldo, Ph.D., CPA, CMA

When is a Reverse 1031 Exchange the Right Choice?
Tax-deferred exchanges are great opportunities for real estate investors. In a typical property transaction, the seller is hit with the capital gains tax. Fortunately, section 1031 of IRS code stipulates that no gain or loss will be recognized in a qualifying exchange. A tax-deferred exchange is not as simple as swapping properties though. There ar...

1031 Exchange Rules
In a 1031 Exchange an investor sells his property, called Relinquished Property, to acquire a Replacement Property without attracting tax on capital gains.The whole exchange is overseen by a Qualified Intermediary (QI), a middle-man who provides services of paperwork, oversight, escrow and expertise to ensure that the transaction conforms to Rules ...

Understanding 1031 Tax Exchange
When you run your own business, paying taxes can really take up a lot of your earnings. However, there are ways in which you can save on tax and the 1031 tax exchange is one of them. The 1031 tax exchange is one of the most common types of tax deferral strategies used today. This allows you to sell either an investment property or a business and ...

1031 Exchange Info Guide 101
A smart tax saving tool that is gaining popularity among the real estate investors by enabling them to defer the entire capital gains tax is 1031 Exchange. Established in 1990 by the Internal Revenue Code Section 1.1031, it gives them an opportunity to defer their capital gain taxes on the sale of a property by re-investing the proceeds into like k...

The 1031 Tax Deferred Exchange: What Are the Requirements?
A 1031 tax deferred exchange is an excellent way to preserve equity in your properties. By allowing you to defer income taxes that would usually be charged when you sell a property, you will be in a better position to improve your economic standing. It will also give you added flexibility in managing and expanding your portfolio.1031 tax deferred e...

The Stand Of Internal Revenue Service On Reverse 1031 Tax Exchange
A number of people take advantage of the IRS 1031 tax exchange in the United States. It is however, only available after you have sold one property and buy the second in a defined period. Reverse 1031 tax exchange comes into picture when you want to purchase the new property first and then sell out the original property.The Internal Revenue Service...

The Skinny on 1031 Exchange: Maximizing Profits by Minimizing Your Tax Liability
A 1031 exchange refers to Section 1.1031 of the Internal Revenue Code which was passed in 1990. Normally, when you sell all real and personal property, the tax code requires the payment of the Capital Gains Tax. That is to say, when you sell your office for $100,000 more than you bought it for, you must pay the gains upon those earnings. However...