Section 1031 Exchange With Boot, Depreciation Recapture, and a Related Party
Elena Ruiz exchanges a downtown office building for a warehouse in a qualifying §1031 exchange. The office building has a fair market value of $1,200,000, an adjusted basis of $300,000, and $500,000 of accumulated depreciation. It is subject to a $200,000 mortgage that the buyer assumes. The warehouse has a fair market value of $900,000 and is subject to a $100,000 mortgage that Elena assumes. Elena also receives $300,000 cash at closing. Both properties are held for investment. The buyer of the office building is Elena’s brother, who plans to hold it as a rental. Elena has no other exchanges during the year and does not elect out of §1031. She wants to know the tax she cannot defer, the basis of the warehouse, and the risk from the related-party rule.
1. Compute Elena’s realized gain, recognized gain, and character of the recognized gain.
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Amount realized:
- Cash received: $300,000
- Fair market value of warehouse received: $900,000
- Mortgage on office assumed by buyer: $200,000
- Less mortgage on warehouse assumed by Elena: ($100,000)
- Amount realized: $1,300,000
Realized gain: $1,300,000 − $300,000 adjusted basis = $1,000,000.
Boot:
- Cash: $300,000
- Net debt relief: $200,000 − $100,000 = $100,000
- Total boot: $400,000
Recognized gain: lesser of realized gain ($1,000,000) or boot ($400,000) = $400,000.
Character: Elena has $500,000 of accumulated depreciation, which exceeds the $400,000 recognized gain. Therefore, the entire $400,000 is unrecaptured §1250 gain, taxed at a maximum rate of 25%. None is deferred §1231 gain in 2024.
2. Compute Elena’s basis in the warehouse.
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The substitute basis is the fair market value of the replacement property minus the deferred gain:
- Fair market value of warehouse: $900,000
- Realized gain: $1,000,000
- Recognized gain: $400,000
- Deferred gain: $600,000
- Basis: $900,000 − $600,000 = $300,000
Cross-check using the formula: old basis $300,000 + recognized gain $400,000 − boot received $400,000 = $300,000. The $300,000 basis preserves the $600,000 deferred gain for future disposition.
3. Explain the related-party risk and what happens if Elena’s brother sells the office building within two years.
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Under §1031(f), a like-kind exchange between related parties is subject to a two-year holding rule. If either party disposes of the exchanged property within two years, the deferred gain is generally recognized. The purpose is to prevent basis-shifting among family members.
If Elena’s brother sells the office building within two years:
- Elena’s $600,000 deferred gain is triggered and recognized.
- The gain is in addition to the $400,000 boot already recognized in 2024.
- The character of the deferred gain depends on the depreciation and §1231 rules at the time of the triggering sale.
Exceptions exist for dispositions caused by death, certain involuntary conversions, and transactions where the gain is otherwise recognized. Because the brother is a related party, Elena should obtain a written holding commitment and monitor the two-year period.