Basis

This chapter computes it. The rule is one sentence long and its application is arithmetic.

35.1 The substituted-basis computation

If property was acquired on an exchange described in section 1031, the basis shall be the same as that of the property exchanged, decreased in the amount of any money received by the taxpayer, and increased in the amount of gain or decreased in the amount of loss to the taxpayer that was recognized on the exchange.¹

Two additions complete the formula and appear in the regulation rather than the statute. Where additional consideration is given by the taxpayer, the basis of the property acquired is increased by the amount of that consideration.² And money received includes debt relief, because liabilities of the taxpayer assumed by the other party, or to which the transferred property is subject, are treated as money received.³

Assembled, the computation reads:

Adjusted basis of the relinquished property
plus cash paid by the taxpayer
plus liabilities assumed by the taxpayer on the replacement property
less cash and other property received
less liabilities of the taxpayer assumed by the other party
plus gain recognized
equals the basis of the replacement property.

The regulation works it twice on a single transaction, using the same facts examined at 33.3.⁴

D, with a $100,000 basis and an $80,000 mortgage, received property worth $250,000 subject to a $150,000 mortgage, plus $40,000 of cash, and recognized $40,000 of gain. D's basis is $100,000, plus the $150,000 of liabilities assumed, less the $40,000 of cash and the $80,000 of debt relief, plus the $40,000 of gain recognized, or $170,000.

E, with a $175,000 basis and a $150,000 mortgage, received property worth $220,000 subject to an $80,000 mortgage, paid $40,000 of cash, and recognized $30,000 of gain. E's basis is $175,000, plus the $40,000 of cash paid and the $80,000 of liabilities assumed, less the $150,000 of debt relief, plus the $30,000 of gain recognized, or $175,000.

A check worth knowing. The same answer is produced by a shorter route: the basis of the replacement property equals its fair market value less the gain deferred. D received property worth $250,000 and deferred $80,000 of a $120,000 realized gain, giving $170,000. E received property worth $220,000 and deferred $45,000 of a $75,000 realized gain, giving $175,000. The taxpayer in the earlier example who received a $600,000 apartment house and deferred $100,000 of a $300,000 gain has a $500,000 basis.⁵

This is not an independent rule. It is a consequence of the statutory formula, and it is the fastest way to verify a computation performed the long way. It also states the economic point in one line: the replacement property carries a basis reduced by exactly the gain the taxpayer did not pay tax on.

35.2 Allocation among multiple replacement properties

Where the property acquired consists in part of like-kind property and in part of other property, the basis computed under 35.1 is allocated between the properties received other than money, and for the purpose of the allocation there is assigned to the other property an amount equivalent to its fair market value at the date of the exchange.⁶

The ordering is what matters. Non-like-kind property takes its fair market value off the top. The like-kind property takes whatever remains.

The regulation's illustration is compact.⁷ A taxpayer with a $10,000 basis transferred investment real estate and received real estate worth $9,000, an automobile worth $2,000, and $1,500 in cash. The realized gain was $2,500 and all of it was recognized. The basis of the property received is $10,000, less the $1,500 of money received, plus the $2,500 of gain recognized, or $11,000. The automobile takes $2,000, being its fair market value, and the real estate takes the remaining $9,000.

Among multiple like-kind properties, allocation is by relative fair market value. The multiple property regulation states it for exchanges within its scope: the aggregate basis of the properties received in an exchange group is allocated proportionately to each property received according to its fair market value.⁸ The return instructions state the same requirement for the categories the form separates, directing that the allocated amounts be proportionate to their fair market values.⁹

The allocation that actually matters in practice is not on the form. Once the basis of a replacement building is fixed, it must be divided between land, which is not depreciable, and improvements, which are. That division governs depreciation for the next twenty seven and a half or thirty nine years and is worth more than most of the elections a client will be asked about.

Three points of discipline follow.

The allocation should be supported at acquisition rather than reconstructed. An appraisal that separately values land is the strongest evidence; the assessor's ratio is the common fallback and is generally accepted where nothing better exists.

The allocation on the relinquished property does not carry over. The taxpayer is allocating the basis of a different building on different land, and the ratio that applied to the old property has no bearing.

Where the replacement property includes components that are not real property, the allocation interacts with Chapter 32 and with the recapture rules of Chapter 37. A cost segregation study performed on the replacement property is a separate decision, taken after the basis is fixed, and it does not change the total.

35.3 Basis where boot is recognized

The formula in 35.1 contains an offsetting pair that is easy to read past and important to understand. Money received decreases basis. Gain recognized increases it.

The consequence is that recognizing gain is not a pure loss to the taxpayer. Tax is paid, and basis is purchased with it. A taxpayer who recognizes $40,000 of gain has $40,000 more basis in the replacement property than a taxpayer who did not, which will be recovered through depreciation or on the eventual disposition.

The regulation's simplest case makes the arithmetic visible. Where all of the realized gain is recognized, the two adjustments net out and the taxpayer ends with a cost basis. In the allocation example just examined, the taxpayer's $10,000 basis less $1,500 of money plus $2,500 of gain produced $11,000, which is exactly the aggregate fair market value of the real estate and the automobile received.¹⁰ A fully taxable exchange leaves the taxpayer where a purchase would have.

The loss case runs in one direction only and is a trap. No loss is recognized on an exchange within section 1031 even where the taxpayer receives boot.¹¹ The basis of the property received is the basis of the property transferred, decreased by the money received, with no increase for the disallowed loss, allocated among the properties received with fair market value assigned to the other property.¹²

The disallowed loss is therefore preserved in a basis higher than the value of what was received. It is not lost, but it is deferred, and the taxpayer has given up a current deduction to get a future one.

The planning consequence should be stated to any client whose property has declined in value. Section 1031 is not elective in the sense that a qualifying exchange can be reported as a sale; if the transaction is structured as an exchange and meets the requirements, nonrecognition applies. A taxpayer holding a loss property who wants the deduction must structure a sale, and the decision has to be made before the transaction rather than on the return.

35.4 Effect of exchange expenses

Section 33.5 established the rule and this section states its basis consequence, which is the reason the rule matters.

Exchange expenses reduce boot, but not below zero. To the extent they are not used for that purpose, they are added to the adjusted basis of the property given up in computing the realized gain.¹³

Both applications increase the basis of the replacement property, by different routes.

Where an expense reduces boot, it reduces the gain recognized, which under 35.1 reduces the increase to basis. But it also reduces the money treated as received, which increases basis by the same amount. The two move together and the taxpayer ends with more basis and less current tax.

Where an expense reduces realized gain, it increases the gain deferred as a proportion of a smaller total, and under the check at 35.1 the basis of the replacement property rises accordingly.

Either way the expense is capitalized rather than deducted, which is the ordinary treatment of a cost of disposing of or acquiring property, and which is the answer to the client who asks whether the intermediary's fee and the commission are deductible. They are not. They are recovered through depreciation over decades or on the eventual sale.

Two closing points connect this chapter to the next.

The basis figure is an input, not an output. Everything in Chapter 36 depends on the number computed here, and specifically on how much of it is exchanged basis carried over from the relinquished property and how much is new.

Compute it at closing, not at filing. The allocation between land and improvements, the split examined in Chapter 36, and any cost segregation decision all depend on facts that are easiest to establish while the appraisal, the settlement statement, and the contract allocations are current.