What constitutes disposition?
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The most common form of property disposition is by sale. Other events that are also considered dispositions of property are thefts, condemnations, and casualtys. For a disposition to take place, an “identifiable event” must occur. The property cannot merely fluctuate in value due to market conditions.
Basis in new property received:
In a normal purchase and sale transaction, a taxpayer’s basis in the new property is the
Fair Market Value of the property received. In a simple 1031
Tax Exchange transaction that only involves the exchange of property, the basis of the property given up is transferred over to the new property received |
Example: Mark 1031 Exchanges his rental house in Phoenix that has a
Fair Market Value of $275,000, adjusted basis of $230,000, straight up for Luke’s duplex in Montana. In this situation, Marks basis in his new duplex
after the 1031 Exchange transaction is complete would be $230,000.
The process for calculating the new basis in property received
in a 1031 Tax Exchange transaction becomes a bit more complicated when more than
Like Kind Property is involved in the
1031 Exchange. In general, the calculation begins with the basis of the property being transferred
in the 1031 Exchange, plus any other money given to the other party, plus the amount of gain recognized, less any money received from the other party, less any loss recognized in the
1031 Exchange transaction.
Example: Mark 1031 Exchanges his $275,000 rental house and $15,000 cash for Luke’s duplex. Mark’s new basis in the duplex is his old basis of $230,000 plus the $15,000 cash. His new basis is $245,000.
Basis recovery and depreciation stem
from the underlying fundamental concept of income tax.
Income tax, by definition, is a tax on income. In a basic
transaction where property is purchased and then resold, the
difference between the purchase and sales price is income.
This income is what gets taxed. (Of course in real life it
is never that simple)
In general, taxpayers are entitled to
recover the cost of property acquired when determining the
amount of income that they must pay taxes on (or gain on
sale). This process is done by annual depreciation
deductions. As time passes on, the basis of the property
gets decreased with these depreciation deductions until the
property is sold. At the time of sale, the property’s
depreciated basis is used when computing taxable income (or
gain on sale).
The purchase of property at a “bargain
price” is an exception to these rules. If property is
received at a price that is significantly lower than fair
market value due to a “off market” transaction, the new
basis in the property must still be reported at its fair
market value (higher than bargain price). The purchaser must
report the difference between the bargain price and the
property’s fair market value as income. An example of a
bargain purchase could be a corporation selling property to
a stockholder at below market value. The difference between
the bargain price and the fair market value of the property
is actually a dividend to the stockholder
Holding period treatment for 1031 Exchanges & related party
1031 Exchanges:
If a taxpayer participates in a
1031 Like-Kind
Exchange with a related party, the taxpayer must hold the new asset for at least 2 years in order to qualify for the
1031 Tax Exchange deferral. The exchange will not qualify as
a 1031 Tax Exchange if the new asset is disposed of within 2 years of the transfer. Related parties are family members, partners in a partnership, grantors and fiduciaries of trusts, and certain members of closely held C or S corporations. Exceptions to this rule include dispositions due to deaths, involuntary conversions, or transfers for non tax avoidance purposes.
Generally, the holding period for property received in a 1031 Exchange is the same as the holding period for the property transferred
in a 1031 Exchange.
For Example: Marks’ house was long term capital gain property and he
1031 Exchanged it with Susan for her Condominium. After the
1031 Tax exchange, Mark could turn around and sell the condo and the gain recognized with the sale would be treated as a long term capital gain.
1031 Exchange- Guidelines for a successful 1031 tax exchange transaction:
There are certain precautionary measures recommended by the IRS that should be taken when structuring a
1031 Like-Kind Exchange. These guidelines ensure the IRS that the taxpayer was not actually in receipt of money or other property prior to receiving the
1031 Exchange replacement property. These guidelines ensure that the
1031 Exchange transaction was indeed an exchange, not a purchase and sale.
 When you transfer your property
in a 1031 Tax Exchange use a mortgage, deed of trust, or
letter of credit as collateral to secure the other
party’s obligation to transfer their assets rather than
a cash deposit in a 1031 Exchange.
If cash is used in the
1031 Tax Exchange transaction, require that it be placed
into a qualified escrow account. The escrow agreement
will prevent you from “receiving” the cash before the
replacement property is transferred in the 1031
Exchange.
Use a
qualified accommodator to facilitate the
1031 Tax Exchange transaction.
All of these three recommendations ensure to an outside party that you were not in receipt of the cash or
other property prior to the receipt of the subject property
being transferred in the 1031 Tax Exchange.
Disadvantages of the 1031 Tax Exchange:
In certain circumstances however, it may be beneficial for a taxpayer to structure the transaction as a purchase and sale and forego the preferential tax treatment of the 1031
Exchange. One advantage could be that recognizing gain would give the taxpayer a higher basis in the new property, and thus more room for depreciation. It also could be beneficial for the taxpayer to realize a loss on a transaction that could be used to offset other income. Also, a taxpayer may not want another property.
For more information on tax strategies and
the potential benefits of a 1031 Tax Exchange, please consult a professional.
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