August 18, 2023
Generally, taxpayers must recognize capital gain when they sell a real property and pay capital gain tax. However, there are opportunities for taxpayers to defer their gain on the exchange of property, including like-kind exchanges (code 1031) and involuntary conversions (code 1033). Like-kind exchanges offer tax planning opportunities to defer gain on the exchange of real property held for business use or for investment in exchange for similar replacement property. An involuntary conversion is the receipt of replacement property because of a casualty, theft, destruction, or condemnation.
In both transaction types, the gain can be deferred until a taxable sale or exchange occurs. Taxpayers will need to calculate the basis of the replacement property for the future reporting and treatment as a gain or loss. To figure your gain or loss on a sale, exchange, or disposition of property, taxpayers must make certain adjustments to the basis of property.
Basis in like-kind exchanges
The basis of the property you receive is the same as the basis of the property you gave up. If you receive money in addition to property, the basis of the property received is the same as the basis of the property you gave up and includes adjustments for: cash paid, cash received, exchange expenses, and any gain recognized.
Basis in involuntary conversions
The basis of replacement property similar or related in service or use to the converted property received is the old property’s basis on the date of conversion and includes adjustments. Adjustments are made for the following: money received and not spent on similar replacement property, gain or loss on conversion, and expenses for acquiring the replacement property. If multiple replacement properties are acquired an allocation is required for the basis.
Deferred exchange and additional regulations
As a rule of thumb, if the exchange of properties is not simultaneous, the property to be received must be identified within 45 days after the date the relinquished property is transferred. In addition, the identified property must be received within 180 days after the date of transfer or the extended due date for the return for the tax year in which the transfer occurred, whichever date is earlier.
Further, in a deferred exchange, the "seller" cannot actually or constructively receive money or other property for the relinquished property before the replacement property is received. To protect a seller who has given up his property but has received nothing in return except a promise to acquire replacement property in the future, several safe harbors in particular have been utilized by practitioners to prevent the transaction from being treated as a sale. The "buyer" can deposit cash into an escrow account or provide a letter of credit or third-party guarantee. Alternatively, the seller can transfer his property to a qualified intermediary (defined in Treasury regulations). A qualified intermediary will acquire the replacement property with funds furnished by the buyer and then transfer the relinquished property to the buyer and the replacement property to the seller.
Reporting
Reporting is required in the year of the like-kind exchange in Form 8824 to calculate the amount of gain deferred as well as the basis of the like-kind property received in the year of the transaction. Additionally, report the dates of sale and identification of the relinquished and replacement properties and if any cash is received, report the amount of gain recognized for the cash or property received. For involuntary conversions, report the gain or loss on your return in the year you realize the gain or loss. Limitations may apply to losses from both transaction types.
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