Tax Compliance and Planning for Property Transactions
Domain 3: Tax Compliance and Planning for Property Transactions
Property questions test three things at once: the basis you start from, the character of the gain, and whether a deferral or exclusion provision changes the timing. Almost every question turns on depreciation having reduced basis somewhere earlier in the holding period.
Basis and realization
- Amount realized = cash + FMV of property received + debt assumed by the buyer. Adjusted basis = cost (or carryover/step-up basis) + capital improvements − depreciation allowed or allowable.
- Inherited property takes a §1014 basis equal to FMV at death or the alternate valuation date; gifted property carries over the donor's §1015 basis, using FMV for loss purposes when FMV was lower on the gift date.
- A loss on a sale to a related party (§267) is disallowed; §1091 disallows a loss when substantially identical stock is bought within 30 days before or after the sale.
Character and recapture
- §1231 gains and losses are netted: a net gain is long-term capital gain, a net loss is ordinary.
- §1245 recaptures depreciation on personal property as ordinary income to the extent of gain.
- §1250 gain on real property is taxed at a maximum 25% rate as unrecaptured depreciation; the remainder is long-term capital gain.
The §121 exclusion
- $250,000 single / $500,000 married filing jointly, available if the taxpayer owned and used the home as a principal residence for two of the five years before sale and has not used the exclusion in the prior two years.
- A reduced exclusion applies for a change in employment, health, or unforeseen circumstances.
- Depreciation taken after May 6, 1997 is never excludable and is taxed at the 25% rate; nonqualified use after 2008 also reduces the excludable amount.
Deferral provisions
- §1031 requires real property held for productive use or investment: 45 days to identify, 180 days to close, boot taxed, basis carried over. Related-party exchanges require both sides to hold for two years.
- §453 applies automatically except for dealer dispositions, with depreciation recapture recognized in the year of sale.
- §1033 generally allows two years (three for business property) to replace involuntarily converted property.
Worked example
A single taxpayer bought a rental for $300,000, claimed $80,000 of depreciation, converted it to a residence, and sold it for $700,000 after five years of ownership and use. Adjusted basis is $220,000, so realized gain is $480,000. The $250,000 exclusion leaves $230,000: $80,000 of unrecaptured §1250 gain taxed at up to 25% and $150,000 of long-term gain. The $230,000 is also net investment income for the 3.8% tax.
Traps that cost marks
- Believing the home-sale exclusion shelters recapture as well as appreciation.
- Treating mortgage relief in a §1031 exchange as tax-free; debt relief is boot.
- Overlooking nonqualified use or a vacation-home second residence when applying §121.