Like-Kind Exchange and Boot
Marta exchanges a rental building (adjusted basis $300,000; fair market value $520,000) for another rental building (FMV $430,000) plus $90,000 cash. Both properties are held for productive use in a trade or business and qualify under IRC §1031. Marta had claimed $120,000 of accumulated depreciation on the relinquished property. She is in the 24% marginal ordinary bracket and 20% long-term capital gains bracket (plus 3.8% net investment income tax). Marta's accountant proposes treating the entire $220,000 realized gain as deferred and reporting no gain. Marta asks whether that is correct and what her basis in the replacement property will be.
1. Compute Marta's recognized gain and the character of the boot.
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Realized gain. Amount realized ($430,000 FMV replacement + $90,000 cash) − adjusted basis $300,000 = $220,000 realized gain.
Recognized gain (IRC §1031(b)). Gain is recognized to the extent of boot received. Cash of $90,000 is boot. Therefore recognized gain = $90,000, limited to realized gain of $220,000.
Character of the $90,000. Because the relinquished property was §1231 property with $120,000 of accumulated depreciation, the recognized gain is subject to §1250 recapture to the extent of additional depreciation (post-1986). Under current law, §1250 recapture is generally limited, and the gain is typically taxed as unrecaptured §1250 gain at a maximum 25% rate to the extent of depreciation taken ($120,000). Since recognized gain ($90,000) is less than accumulated depreciation ($120,000), the entire $90,000 is unrecaptured §1250 gain taxed at 25%, plus the 3.8% NIIT where applicable.
Conclusion. The accountant is incorrect - $90,000 must be recognized. The remaining $130,000 of realized gain is deferred.
2. Compute Marta's basis in the replacement property and explain the deferral.
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Substituted basis (IRC §1031(d)).
Basis of replacement property = FMV of replacement − deferred gain = $430,000 − $130,000 = $300,000.
Alternative formula: Adjusted basis of relinquished property ($300,000)
- gain recognized ($90,000) − boot received ($90,000)
- (nothing else) = $300,000.
Check. Deferred gain = realized gain $220,000 − recognized $90,000 = $130,000. Basis $300,000 + deferred gain $130,000 = $430,000 FMV. ✓
Explanation. The $130,000 of gain is deferred because Marta reinvested in qualifying replacement property and received only $90,000 of boot. The deferred gain is embedded in the lower basis of the replacement property and will be recognized on a future disposition.
Tax impact of recognized gain. $90,000 × 25% = $22,500 federal (plus 3.8% NIIT = $3,420 if applicable).
Planning note. Marta could have avoided recognition by reinvesting all proceeds and receiving no boot; the $90,000 cash is the sole trigger.