Like-Kind Exchange with Boot, Assumed Debt, and a Related-Party Twist
Trent exchanges a warehouse he held for productive use in his business for a smaller retail building also to be held for business use. The warehouse has an adjusted basis of $300,000 and a fair market value of $900,000. The retail building Trent receives is worth $700,000, and the buyer assumes Trent's $150,000 mortgage on the warehouse. Trent also receives $50,000 cash at closing. The transaction otherwise qualifies as a like-kind exchange under §1031 (real property for real property). Trent's accountant is computing gain recognized and basis, and also asks what would change if the buyer were Trent's brother-in-law.
1. Compute Trent's realized gain, recognized gain, and basis in the replacement property.
Read the worked answer
Realized gain = amount realized − adjusted basis. Amount realized = FMV of property received ($700,000) + cash received ($50,000) + debt relief ($150,000) = $900,000. Realized gain = $900,000 − $300,000 = $600,000.
Recognized gain (boot) = the lesser of realized gain or boot received. Boot = cash ($50,000) + net debt relief.
- Debt relief on the property given up: $150,000.
- Debt assumed on the property received: $0.
- Net debt relief = $150,000, which is boot. Total boot = $50,000 cash + $150,000 net debt relief = $200,000. Recognized gain = lesser of $600,000 or $200,000 = $200,000.
Basis in replacement property = FMV of replacement − deferred gain, or equivalently: Basis = adjusted basis of old ($300,000) + gain recognized ($200,000) − boot received ($200,000) + ... use the clean formula: New basis = FMV received ($700,000) − deferred gain ($400,000) = $300,000. Check: deferred gain = realized ($600,000) − recognized ($200,000) = $400,000; $700,000 − $400,000 = $300,000. Correct.
2. Trent's accountant suggests structuring the exchange so that Trent's brother-in-law buys the retail building and 'swaps' it to Trent, keeping the cash and debt relief out of the picture. Does the related-party rule under §1031(f) create a problem?
Read the worked answer
Yes - §1031(f) related-party exchanges carry a two-year holding requirement. If either party disposes of the property received within two years of the exchange, the nonrecognition is disregarded and gain is recognized as of the date of the original exchange (the original exchange is treated as taxable).
A brother-in-law is a related person under §1031(f)(3), which incorporates §267(b) - relationships include siblings, spouse, ancestors, and lineal descendants (note: brothers-in-law are generally not within §267(b) unless the statute's specific list is read narrowly; the exam often flags that the related-party list is specific, so confirm the exact relationship). The safer analysis: if the relationship does fall within §267(b), the two-year rule applies; if it does not, §1031(f) does not apply and the exchange is judged on its own terms.
More fundamentally, routing the transaction through a related intermediary to strip out boot does not eliminate the debt relief and cash - those are economic benefits to Trent and remain boot regardless of who holds legal title momentarily. The IRS can recharacterize a step transaction. The exam tests both the two-year related-party rule and the principle that boot is measured by net debt relief plus cash actually or constructively received.
3. Assume the exchange qualifies and Trent later sells the replacement retail building three years later for $850,000. What is his recognized gain, and how does the deferred gain interact?
Read the worked answer
Deferred gain carries over into the replacement property's basis. Trent's basis in the retail building is $300,000 (from prior task).
Sale three years later for $850,000:
- Amount realized = $850,000
- Adjusted basis = $300,000
- Recognized gain = $550,000
That $550,000 consists of:
- The $400,000 deferred gain from the original exchange, now recognized, plus
- $150,000 of post-exchange appreciation ($850,000 − $700,000 FMV at exchange).
Character depends on holding and use: the retail building was held for business use, so the gain is §1231 gain (potentially subject to §1231 look-back and, for the portion attributable to depreciation, §1250 recapture - here there is no depreciation mentioned, so treat as §1231 gain taxed at capital gain rates if net §1231 gain). The key exam point: deferred gain is not forgiven - it is embedded in the lower carryover basis and is taxed on eventual disposition.