Multi-Asset and Composite Exchanges

A separate regulation governs those transactions, and it closes Part VI. It is arithmetically dense and entirely mechanical, which makes it the rare provision that can be reduced to a procedure and followed.

32.1 The exchange-group methodology

As a general rule the application of section 1031 requires a property by property comparison for computing the gain recognized and the basis of property received. The multiple property regulation provides an exception.¹

The threshold definition is broader than the chapter title suggests, and it catches transactions practitioners do not think of as multi-asset. An exchange is an exchange of multiple properties if more than one exchange group is created. It is also an exchange of multiple properties if only one exchange group is created but there is more than one property being transferred or received within that group.²

A taxpayer relinquishing two apartment buildings and acquiring one shopping center is therefore governed by this regulation, even though every property on both sides is real property and there is only one exchange group. The second trigger is the one that matters after 2017.

A note on the regulation's vintage. The multiple property regulation was last amended in 2005 and was not amended by the real property regulations issued in 2020.³ Its text accordingly refers to General Asset Classes and Product Classes, and it recites the pre-2018 statutory exclusion list. A practitioner reading it today will find apparently operative language about asset classes for graders and railroad cars. That machinery is vestigial. Personal property is no longer eligible for nonrecognition in an exchange, as 13.1 develops, so for exchanges after 2017 the like class analysis has no field of operation and there is ordinarily one exchange group, consisting of the real property on both sides. The computational rules examined below are unaffected and remain fully operative.

The general approach proceeds in four steps.⁴

First, the properties transferred and the properties received are separated into exchange groups, matching up properties of a like kind or like class to the extent possible.

Second, all liabilities assumed by the taxpayer are offset against all liabilities of which the taxpayer is relieved, with any excess allocated as 32.2 describes.

Third, the rules of section 1031 are applied separately to each exchange group to determine the gain recognized.

Fourth, the rules of section 1031 are applied separately to each exchange group to determine the basis of the properties received.

The regulation assumes the exchange is made at arm's length, so that the aggregate fair market value of the property received equals the aggregate fair market value of the property transferred, and the amount realized with respect to the properties transferred in each exchange group is assumed to equal their aggregate fair market value.⁵

Composition of an exchange group. Each exchange group consists of the properties transferred and received in the exchange, all of which are of a like kind or like class. Where a property could be included in more than one exchange group, the taxpayer may include it in any of them. Property eligible for inclusion does not include money or property described in section 1031(a)(2). Each exchange group must consist of at least one property transferred and at least one property received.⁶

The last requirement is easy to overlook and disposes of a common structure. A group cannot be created from properties transferred alone. Where a taxpayer relinquishes something for which nothing of a like kind is received, that property is not in an exchange group at all, and its treatment follows 32.2.

The computation requires per-property figures. The fair market value must be determined for each property transferred and for each property received, and the adjusted basis must be determined for each property transferred.⁷ This is a real obligation and not a formality. A transaction documented with a single blended price cannot be run through this regulation, and the values will not be reconstructible three years later.

Surplus and deficiency. For each exchange group, an exchange group surplus or exchange group deficiency must be determined. A surplus is the excess of the aggregate fair market value of the properties received in the group, less any excess liabilities assumed by the taxpayer that are allocated to that group, over the aggregate fair market value of the properties transferred in the group. A deficiency is the reverse.⁸

Gain recognized. The gain or loss realized with respect to each exchange group is the difference between the aggregate fair market value of the properties transferred in that group and their aggregate adjusted basis. The gain realized is recognized to the extent of the lesser of the gain realized and the amount of the exchange group deficiency, if any. Losses realized with respect to an exchange group are not recognized. The total gain recognized under section 1031 is the sum of the amounts recognized for each group, and gain or loss with respect to the residual group is recognized under section 1001 or other applicable provisions.⁹

The intuition is worth stating because it converts an intimidating formula into a familiar idea. The exchange group deficiency is the multi-property analogue of trading down. A group that gives up more value than it receives has a deficiency, and the deficiency caps the gain recognized in exactly the way boot does in a single property exchange. A group that receives at least as much as it gives up has no deficiency and recognizes nothing.

32.2 Residual grouping and netting

Two mechanisms collect everything that does not fit neatly into an exchange group, and both differ from what a practitioner accustomed to single property exchanges would expect.

Liabilities net globally. All liabilities assumed by the taxpayer as part of the exchange are offset against all liabilities of which the taxpayer is relieved as part of the exchange, regardless of whether the liabilities are recourse or nonrecourse, and regardless of whether they are secured by or otherwise relate to specific property transferred or received.¹⁰

That sentence forecloses an argument that is made in nearly every portfolio transaction. A mortgage encumbering one relinquished parcel is not matched against the financing on its counterpart replacement parcel. All debt on both sides is thrown into a single netting computation, and only the net figure has consequences.

The net result is then handled in one of two ways.

Excess liabilities assumed by the taxpayer, meaning that assumed debt exceeds relieved debt, are allocated among the exchange groups, but not to the residual group, in proportion to the aggregate fair market value of the properties received in each group. The amount allocated to a group may not exceed the aggregate fair market value of the properties received in it.¹¹

Excess liabilities of which the taxpayer is relieved are treated as a Class I asset for purposes of the allocations to the residual group.¹² Class I assets are cash and general deposit accounts,¹³ so net debt relief is treated as cash received. This is the multiple property statement of the familiar rule taken up in Chapter 34.

The residual group. If the aggregate fair market value of the properties transferred in all of the exchange groups differs from the aggregate fair market value of the properties received in all of the exchange groups, taking liabilities into account, a residual group is created. It consists of an amount of money or other property having an aggregate fair market value equal to that difference. It consists of either money or other property transferred in the exchange, or money or other property received in the exchange, but not both.¹⁴

Other property for this purpose includes property described in section 1031(a)(2), property transferred that is not of a like kind or like class with any property received, and property received that is not of a like kind or like class with any property transferred.¹⁵

The residual group is filled in a prescribed order. The money and properties allocated to it are considered to come first from Class I assets, then Class II, then Class III, then Class IV, with the meanings those terms carry in the asset allocation regulations. Within each class, the taxpayer may choose which properties are allocated.¹⁶

Because Class I is cash and deposit accounts, cash is drawn into the residual group before anything else, and net debt relief is drawn in with it. The taxpayer's discretion operates only within a class, which is narrower latitude than it first appears.

Property outside every group. The amount of gain or loss realized and recognized with respect to properties transferred that are within neither an exchange group nor the residual group is determined under section 1001 and other applicable provisions, with proper adjustments for all liabilities not allocated to the groups.¹⁷

Basis. The aggregate basis of the properties received in each exchange group is the aggregate adjusted basis of the properties transferred within that group, increased by the gain recognized with respect to that group, increased by the exchange group surplus or decreased by the exchange group deficiency, and increased by any excess liabilities assumed allocated to that group. The resulting aggregate basis is allocated proportionately among the properties received in the group according to their fair market values. The basis of each property received within the residual group, other than money, is its fair market value.¹⁸

32.3 Portfolio and blended transactions

The regulation's own worked example is the clearest way to see the machinery operate, and it happens to include a liability, a surplus on one side and a deficiency on the other, and property that does not qualify. The example uses items of equipment, which no longer qualify at all after 2017. Read them as any non-qualifying property and the mechanics translate without change.¹⁹

A taxpayer transfers two parcels of real estate and a piece of equipment. Real estate A has an adjusted basis of $2,000 and a fair market value of $5,000. Real estate B has an adjusted basis of $8,000 and a fair market value of $13,500. The equipment has an adjusted basis of $500 and a fair market value of $2,000. In return the taxpayer receives one parcel of real estate with a fair market value of $26,500, subject to a $7,000 liability, and another item of equipment worth $1,000.

The analysis runs as follows.

The exchange group consists of the three parcels of real estate, two transferred and one received.

The taxpayer assumed $7,000 of liabilities and was relieved of none, so there are excess liabilities assumed of $7,000, allocated entirely to the single exchange group.

The exchange group has a surplus of $1,000, because the fair market value of the property received less the excess liabilities assumed allocated to the group, $26,500 less $7,000, exceeds the aggregate fair market value of the properties transferred in the group, $18,500, by that amount.

That $1,000 difference creates a residual group of $1,000, consisting of half of the equipment transferred. The remaining half of the equipment is treated as exchanged in a taxable transaction for the equipment received, since neither is of a like kind or like class to anything on the other side.

Gain is then computed group by group. Within the exchange group the gain realized is $8,500, the excess of $18,500 over the aggregate adjusted basis of $10,000, and the gain recognized is the lesser of that amount and the exchange group deficiency of zero, which is zero. The residual group produces $750, the excess of $1,000 over the $250 of basis allocable to half the equipment. The taxable exchange produces another $750. The total gain recognized is $1,500.

The basis of the real estate received is the $10,000 aggregate basis of the real estate transferred, increased by zero of recognized gain, increased by the $1,000 exchange group surplus, and increased by the $7,000 of excess liabilities assumed, or $18,000.

The other party's side of the same transaction demonstrates the deficiency rule. That party transferred the $26,500 parcel and received the two parcels worth $18,500, producing an exchange group deficiency of $8,000. Its gain realized within the group was $6,500, the excess of $26,500 over its $20,000 basis, and because $6,500 is less than the $8,000 deficiency, the entire $6,500 was recognized. Its $7,000 of debt relief was treated as cash received and went into its residual group.²⁰

Four points of practice close the chapter and connect it back to Part VI.

Identification does not scale with the portfolio. A taxpayer relinquishing six properties in one exchange still identifies three replacement properties under the three property rule, or must use the two hundred percent rule, as 25.2 and 25.3 develop. The regulation's allowance for multiple properties in an exchange group does not enlarge the identification limits.

The clocks run from the earliest closing. Where relinquished properties transfer on different dates as part of the same exchange, both periods are measured from the earliest transfer, so a portfolio disposed of over three months may find its identification period closing before its last sale, as 26.3 develops.

Non-qualifying property is not a marginal issue after 2017. Furniture, equipment, and other tangible personal property conveyed with real estate is non-qualifying property in every case. It lands in the residual group or in a separate taxable exchange, and the fifteen percent incidental property rule examined at 27.6 protects the safe harbor without changing that characterization.

Allocate values in the documents. The regulation requires a fair market value for every property on both sides and an adjusted basis for every property transferred. Contracts that allocate the price among the properties, prepared when the parties are still negotiating, produce those figures at no cost. Contracts that do not will require an allocation to be constructed after the fact, by someone with no contemporaneous evidence and an adverse examiner.

The quantification of gain, boot, and basis in the ordinary single property case, which the machinery of this chapter generalizes, is the subject of Part VII, beginning with Chapter 33.