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The IRCS1031 Tax-Free Exchange – Calculating the Basis of Replacement Property

Introduction

This article provides a very brief introduction to two different methods and approaches for the computation of the basis of replacement property receive in an Internal Revenue Code Section 1031 (IRC§1031) exchange. It should be noted that these methods are relatively “simple,” when compared to more complex IRC§1031 exchanges. This is because some may involve more than one classification of like-kind properties (e.g., real property versus personal property).

The Internal Revenue Service (IRS) provides some broad instructions on the IRC§1031 exchange in its Publication 544 – Sales and Other Dispositions of Assets. This publication is updated every year and is provided to the public, for free, by calling the IRS tax forms 1-800 telephone number or by downloading the publication from the Internet at http://www.irs.gov . IRC§1031 exchanges are reported on Form 8824, Like-Kind Exchanges.

Basic Terminology

The below Table summarizes the two different methods and approaches for the computation of the basis of replacement property. However, before illustrating the methods for the IRC§1031 exchange replacement property basis calculation, some basic terms must be defined, as follows:

Adjusted Basis Cost plus improvements less depreciation.

Relinquished That property “sold” in an IRC§1031 like-kind exchange (e.g., relinquished property).

Also known as “phase I property,” property “given up,” “sale,” “exchange,” or “downleg.”

Replacement That property “purchased” in an IRC§1031 like-kind exchange (e.g., replacement property). Also known as “phase II property,” property “received,” “purchase,” “target,” or “upleg.”

Realized A classification of gain or loss that may or may not be “realized” or have any tax impact. A realized gain (or loss) may or may not be recognized.

Recognized A classification of gain or loss that always, by definition, has a tax impact. A recognized gain (or loss) must, first, have been realized.

Capital Gain Sales price less adjusted basis, when sold at a profit. The amount to which capital gains taxes and tax rates are applied. For the 2004 and 2005 tax years, long-term capital gains are taxed at 5% (for taxpayers in 5% or 10% ordinary income tax rates or brackets), 15% (for taxpayers in 25%, 28%, 33% or 35% ordinary income rates or brackets), and 25% (for taxpayers subject to IRC§1250 recapture rules).

Capital Loss Sales price less adjusted basis, when sold at a loss.

Ordinary Income Those types, categories or classifications of income (e.g., dividends, interest and salary) to which ordinary income tax rates are applied. Ordinary income tax rates or brackets are higher than those applied to long-term capital gains to provide taxpayers with an economic incentive to invest, rather than speculate, long-term.

Tax-Deferred Tax “savings” are always the result of tax-planning strategies designed to achieve tax-deferral or tax-deferred treatment. This is the objective of the IRC§1031 like-kind exchange. The tax is not eliminated, but is merely deferred or pushed into the future.

Deferred Gain A gain that is realized, but not recognized. This is the objective and/or motivation for the IRC§1031 exchange.

Deferred Loss A loss that is realized, but not recognized. Though not the objective, the IRC§1031 exchange is a double-edged sword. It results in partial or completely deferred gains, but also results in loss non-recognition. It is important for taxpayers to understand that the IRC§1031 exchange is not an election, but is “mandatory” if all conditions are met. Therefore, it is not inconceivable that a taxpayer may “accidentally” defer a loss.

Boot Cash boot (i.e., cash that is constructively received), mortgage boot (i.e., debt relief or liabilities relieved of), or other boot consists of non-like-kind property received or given in an IRC§1031 exchange, and is, therefore, potentially taxable.

The Table, below, uses the above terms to illustrate the two different methods and approaches for the computation of the Basis of REPLACEMENT Property received in an Internal Revenue Code Section 1031 (IRC§1031) exchange.

Table

Method 1

Original Cost, Basis or Purchase Price of RELINQUISHED Property

+ Boot given (Adjusted Basis)

+ Gain recognized

+ Liability assumed by the transferor (seller)

– Boot received (Fair Market Value)

– Loss recognized

– Liability assumed by the transferee (buyer)

= Basis of REPLACEMENT Property

Method 2

Fair Market Value of REPLACEMENT Property

– Deferred (Realized less Recognized) Gain

+ Deferred Loss

= Basis of REPLACEMENT Property

Summary

This very brief article provides you with an introduction to a tabular representation of the two separate methods and approaches useful in calculating the basis of replacement property in an IRC§1031 exchange. This represents the “basics” of replacement property basis calculations, as more complex IRC§1031 exchanges may involve more than one classification of like-kind properties.

Feel free to publish or reproduce anywhere, as long as you provide a copy to and/or notify the author .

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