Worked Computations

1. Amount realized, being the gross consideration for the relinquished property reduced by exchange expenses.
2. Realized gain, being the amount realized less the adjusted basis.
3. Boot, being cash received plus the fair market value of other property received plus net debt relief.
4. Recognized gain, being the lesser of realized gain and boot.
5. Character of the recognized gain and the resulting rate.
6. Basis of the replacement property, being its cost less the deferred gain.
7. Allocation of that basis, and its division into exchanged and excess basis for depreciation.

A caution about the return form before beginning. Form 8824 is drafted for a two party swap, and mapping a three party deferred exchange onto it requires care. Line 15 directs the taxpayer to reduce boot by exchange expenses, and line 18 directs that expenses not used on line 15 be added to the adjusted basis of the property given up. Both instructions assume the expenses have not already been netted out of the figures being entered.

In an ordinary deferred exchange the commission, the intermediary's fee, and the settlement charges are paid at the relinquished closing out of the gross price, so the cash the intermediary receives is already net of them. Subtracting them again on line 15 or adding them again on line 18 counts them twice, understates the realized gain, and understates the recognized gain. The computations below are performed under sections 1001 and 1031 directly, and the return position should be reconciled to them so that no item is counted twice.

39.1 Fully deferred exchange

Facts. A taxpayer owns a retail building held for twenty years. It is sold for $2,400,000. Exchange expenses, comprising the brokerage commission, the intermediary's fee, title and settlement charges, and transfer and recordation taxes, total $160,000. A mortgage of $900,000 is paid at closing. The adjusted basis is $650,000, consisting of land of $300,000 and a building with an original depreciable basis of $900,000 against which $550,000 of straight line depreciation has been taken. The intermediary receives $1,340,000.

The taxpayer acquires an apartment building for $2,600,000, funded with the $1,340,000 of exchange proceeds and a new loan of $1,260,000. The replacement property is appraised at twenty five percent land and seventy five percent improvements.

Computation. The figures below are computed under sections 1001 and 1031 directly rather than by tracing the return form's lines, for the reason given above.¹

Boot is zero. No cash was received. The $900,000 of debt relief is fully offset by the $1,260,000 of debt assumed on the replacement property.²

Recognized gain is zero. Deferred gain is $1,590,000.

Basis of the replacement property is its cost of $2,600,000 less the deferred gain of $1,590,000, or $1,010,000. The section 1031(d) computation confirms it: the $650,000 relinquished basis, plus the $1,260,000 of liabilities assumed, less the $900,000 of debt relief treated as money received, plus zero of recognized gain.³

Allocated by relative fair market value, the land takes $252,500 and the improvements take $757,500.

Depreciation. The exchanged basis is the lesser of the basis in the replacement depreciable property, $757,500, and the adjusted depreciable basis of the relinquished building, $350,000. It is therefore $350,000, and the excess basis is $407,500.⁴

The relinquished building was nonresidential real property on a thirty nine year recovery period with nineteen years remaining. The replacement property is residential rental property on twenty seven and a half years, which is shorter, so the exchanged basis continues on the relinquished property's thirty nine year period over its remaining nineteen years. The excess basis is new property and is depreciated over twenty seven and a half years.

What this teaches. The taxpayer bought up in value and up in debt and deferred everything, including $550,000 of unrecaptured section 1250 gain that would have been taxed at twenty five percent on a sale. The election out of the depreciation continuation rules would be a mistake here: the default recovers $350,000 over nineteen years, and electing would spread the entire $757,500 over a fresh twenty seven and a half.

39.2 Partial exchange with cash boot

Facts. The relinquished property and its sale are identical to 39.1. The taxpayer instead acquires a smaller building for $2,000,000, funded with $1,100,000 of exchange proceeds and a new loan of $900,000. The intermediary returns the remaining $240,000 to the taxpayer at the end of the exchange period.

Computation.

Realized gain is unchanged at $1,590,000.

Boot is the $240,000 of cash received. The $900,000 of debt relief is exactly offset by the $900,000 of new debt, so there is no mortgage boot.

Recognized gain is the lesser of $1,590,000 and $240,000, or $240,000.

Character. The relinquished building carried $550,000 of accumulated straight line depreciation. Because the depreciation was straight line, there is no section 1250 recapture.⁵ The entire $240,000 falls within the unrecaptured section 1250 gain layer and is taxed at twenty five percent rather than at the long term capital gain rate.⁶ With the net investment income tax where it applies, the federal rate is 28.8 percent, and Maryland State and local income tax applies on top of that.

The client who asked for $240,000 and was told to expect capital gain treatment will pay roughly $69,000 of federal tax on it before State tax, not the $48,000 that a twenty percent rate would suggest.

Deferred gain is $1,350,000.

Basis of the replacement property is $2,000,000 less $1,350,000, or $650,000.

That figure is worth pausing on. It is exactly the adjusted basis of the relinquished property. The reason is structural: the taxpayer replaced the debt dollar for dollar and recognized the entire amount of cash taken out, so the two adjustments in the section 1031(d) formula cancelled. Where debt is replaced exactly and all boot is recognized, basis carries over unchanged.

What this teaches. The value test and the proceeds test are separate. The taxpayer here satisfied the debt requirement perfectly and still recognized gain, because $240,000 of proceeds was not reinvested. Buying down in value by $400,000 while replacing debt exactly produced $240,000 of boot, being the cash left over after the smaller purchase.

39.3 Mortgage boot with offsetting cash

Facts. The same building is sold for $2,400,000 with $160,000 of exchange expenses, but the mortgage is $1,500,000 rather than $900,000. The intermediary therefore receives only $740,000. The adjusted basis remains $650,000.

The taxpayer acquires a replacement property for $2,240,000, funded with the $740,000 of exchange proceeds, a new loan of $1,200,000, and $300,000 of the taxpayer's own cash contributed at the replacement closing.

Computation.

Realized gain is $1,590,000, as in 39.1.

Boot requires the netting rule. The taxpayer was relieved of $1,500,000 of debt. Against that, the taxpayer assumed $1,200,000 of new debt and paid $300,000 of cash, a total of $1,500,000. Consideration given in the form of cash is offset against consideration received in the form of debt relief.⁷

Net debt relief is zero. No cash was received. Boot is zero and recognized gain is zero.

Basis of the replacement property is $2,240,000 less the $1,590,000 of deferred gain, or $650,000. The section 1031(d) computation agrees: $650,000, plus $300,000 of cash paid, plus $1,200,000 of liabilities assumed, less $1,500,000 of debt relief.

What this teaches. This is the asymmetry of 33.3 in a single fact pattern, and it is worth stating the counterfactual explicitly.

The taxpayer traded down in debt by $300,000 and cured the resulting mortgage boot with $300,000 of outside cash, dollar for dollar. Now reverse the transaction. Suppose the taxpayer had instead borrowed $1,500,000 on the replacement property and taken $300,000 home. The debt relief would have been fully offset, but the $300,000 of cash received would be boot in its entirety, and the additional borrowing would do nothing to shelter it, because consideration received in the form of cash is not offset by consideration given in the form of an assumption of liabilities.⁸

The same $300,000, moving in opposite directions, is worth nothing in one case and produces $300,000 of taxable boot in the other. This is the single most valuable planning point in Part VII.

39.4 Multi-property allocation

Facts. A taxpayer relinquishes two properties in a single exchange.

Scroll sideways to see all columns.

Exchange expenses total $150,000, and the intermediary receives $1,350,000. The taxpayer acquires a single replacement building worth $2,390,000 and, as part of the same closing, receives equipment worth $60,000. The acquisition is funded with the $1,350,000 of exchange proceeds and a new loan of $1,100,000. The aggregate adjusted depreciable basis of the two relinquished buildings is $380,000.

Computation.

The properties transferred and received are separated into exchange groups.⁹ After 2017 there is one exchange group, consisting of properties A and B and the replacement building, because personal property is no longer eligible and the equipment cannot be in an exchange group.

Boot is the $60,000 fair market value of the equipment received. No cash was received, and the $900,000 of debt relief is more than offset by the $1,100,000 of new debt.

Recognized gain is $60,000, taxed as unrecaptured section 1250 gain to the extent of the accumulated straight line depreciation on the relinquished buildings.

Deferred gain is $1,540,000.

Basis. The total cost of the properties received is $2,450,000, and the basis of everything received is that amount less the deferred gain, or $910,000. The section 1031(d) computation confirms it: $650,000, plus $1,100,000 of liabilities assumed, less $900,000 of debt relief treated as money received, plus $60,000 of recognized gain.

The basis is then allocated. Property other than like-kind property is assigned an amount equivalent to its fair market value, and the like-kind property takes the remainder.¹⁰ The equipment therefore takes $60,000 and the replacement building takes $850,000.

If the building is appraised at twenty percent land and eighty percent improvements, the land takes $170,000 and the improvements $680,000. The exchanged basis is the lesser of $680,000 and the $380,000 aggregate adjusted depreciable basis of the relinquished buildings, or $380,000, and the excess basis is $300,000.

What this teaches. Three points that recur in portfolio transactions.

The identification limits did not expand because two properties were relinquished. The taxpayer was still confined to three replacement properties, or to the two hundred percent rule.¹¹

Both the identification and the exchange periods ran from the earlier of the two closing dates, not from each.¹² Where the two closings were separated by two months, the identification period may have expired before the second closing occurred.

The equipment is not a marginal item. It is boot at its full fair market value, it takes a fair market value basis, and no amount of care in the real property analysis makes it disappear. The fifteen percent incidental property rule examined at 27.6 protects the intermediary arrangement and does not change this result.

39.5 Failed exchange with straddle reporting

Facts. The taxpayer closes on the relinquished property on November 12 for $2,400,000, with $160,000 of exchange expenses and a $900,000 mortgage paid at closing. The adjusted basis is $650,000 and the intermediary receives $1,340,000.

The taxpayer's board authorized a like-kind exchange before the closing, and the authorization and its reasons are recorded in the minutes. The exchange agreement contains the ordinary limitation on the taxpayer's rights and permits release of the funds after the end of the identification period if no replacement property has been identified. In December the board concludes that the intended expansion is not feasible and instructs the intermediary to stop searching. That decision is also recorded in the minutes. No replacement property is identified, and the intermediary delivers the $1,340,000 on the forty sixth day, which falls in January of the following year.

Computation.

The exchange failed, so the transaction is a sale. Amount realized is $2,400,000 less the $160,000 of expenses, or $2,240,000, and realized gain is $1,590,000, all of it recognized.

The question is when. The answer comes from a coordination rule that most practitioners never reach.

In the case of a transfer of relinquished property involving a qualified intermediary, the determination of whether the taxpayer has received a payment for purposes of section 453 is made as if the intermediary is not the agent of the taxpayer. A person who otherwise satisfies the definition of a qualified intermediary is treated as one even though that person ultimately fails to acquire identified replacement property and transfer it to the taxpayer.¹³ The rule ceases to apply at the earlier of the time the taxpayer obtains an immediate ability or unrestricted right to the funds or the end of the exchange period.¹⁴

Two limitations qualify it.

The rule does not apply unless the taxpayer had a bona fide intent to enter into a deferred exchange at the beginning of the exchange period. A taxpayer is treated as having that intent only if it is reasonable to believe, based on all the facts and circumstances as of the beginning of the exchange period, that like-kind replacement property will be acquired before the end of the exchange period.¹⁵

The rule does not apply if the relinquished property is disqualified property, meaning property not held for productive use in a trade or business or for investment, or property described in section 1031(a)(2).¹⁶

Result. The taxpayer is not treated as having received payment when the intermediary received the sale proceeds in November. Payment is received in January, on release of the funds, and subject to the other requirements of sections 453 and 453A the entire $1,590,000 gain may be reported in the following year under the installment method.¹⁷

The regulation's own example confirms both the outcome and the evidence that supports it. On facts materially identical to these, the directors' authorization of a like-kind exchange, the terms of the exchange agreement, and the absence of other relevant facts established the bona fide intent, and the taxpayer was permitted to report the gain in the following year notwithstanding that the exchange failed for ordinary business reasons.¹⁸

What this teaches. Four points, and the first is the reason to attempt an exchange even when it may fail.

A failed exchange can still buy a year. A fourth quarter relinquishment that fails at day forty six moves the entire gain into the following taxable year, which defers the tax by twelve months and may allow it to be planned around. That result depends on the intermediary structure being in place at the closing, and it is unavailable to a taxpayer who simply sold.

The day forty six release is only available to a taxpayer who identified nothing. A taxpayer who identifies and then cannot close is locked until the end of the exchange period.¹⁹ In a fourth quarter transaction that period ends the following year in any event, so the timing result is similar; in a first quarter transaction it means the funds are held for months.

Bona fide intent is established at the beginning of the exchange period and proved with contemporaneous documents. Minutes, an engagement letter reciting the exchange objective, correspondence with brokers about replacement property, and the exchange agreement itself are the evidence. Assembled after the fact, in the year the position is examined, they are worth much less.

The installment method is not automatic and may not be wanted. Sections 453 and 453A impose their own requirements, including an interest charge on larger deferred obligations, and a taxpayer may elect out of installment treatment where reporting the gain in the earlier year is preferable. Where the exchange was partly successful, section 453(f)(6) supplies special rules for computing the total contract price and gross profit.²⁰

The related party and anti-abuse regimes, which constrain both successful exchanges and the planning around failed ones, are the subject of Part VIII.