Property Transactions: Basis, Realized and Recognized Gain, and Nonrecognition
Realized and recognized gain
Under §1001, realized gain or loss is the difference between the amount realized and adjusted basis. Amount realized includes cash, fair market value of property received, and liabilities assumed or discharged. Adjusted basis is cost under §1012, increased by capital improvements and decreased by depreciation allowed or allowable under §1016. Recognized gain is realized gain minus nonrecognition under a specific Code section.
Basis rules
- Gift basis is carryover under §1015: donor’s basis plus gift tax paid on appreciation; for loss purposes, basis is the lower of carryover basis or fair market value at the gift date.
- Inherited property generally takes a stepped-up or stepped-down basis equal to fair market value at death under §1014.
- Property converted from personal to business use takes the lower of cost or fair market value at conversion for loss purposes.
- Stock splits and dividends adjust basis; improvements increase basis; depreciation reduces it.
Nonrecognition provisions
- §1031 exchanges real property held for productive use or investment for like-kind real property. Boot is taxable to the lesser of boot or realized gain; losses are not recognized.
- §1033 covers involuntary conversions; §351 covers transfers to controlled corporations; §721 covers contributions to partnerships; §1041 covers transfers incident to divorce.
- §121 excludes up to $250,000 ($500,000 married filing jointly) of gain on a principal residence if the taxpayer owned and used it as a principal residence for two of the five years before sale, generally once every two years.
Worked example
A taxpayer bought a rental building for $300,000, claimed $80,000 of depreciation, and exchanges it for like-kind real property worth $400,000 plus $50,000 cash. Adjusted basis is $220,000. Amount realized is $450,000, so realized gain is $230,000. Recognized gain is the lesser of boot ($50,000) or realized gain ($230,000), or $50,000. Deferred gain is $180,000. New basis is $400,000 minus $180,000, or $220,000.
Traps
- Forgetting that debt relief is boot.
- Recognizing loss in a §1031 exchange.
- Using §1031 for inventory or, after 2017, personal property.
- Calculating inherited basis from the decedent’s cost rather than date-of-death value.
- Overlooking the §121 two-of-five-year use test.