Section 1031 of the Internal Revenue Code deals with the tax-free treatment of exchanges of "like-kind" property in the context of real estate. This post deals with the various requirements for nonrecognition of gain under Section 1031.
Why is a 1031 Exchange Not Recognized?
In general, any sale of real property causes gain or loss to be realized for accounting purposes, and the Internal Revenue Code follows this principle as well. Under Internal Revenue Code Section 1001, the sale or other disposition of property produces taxable gain or loss on the difference between the adjusted basis of the property and the amount realized for it. Property that has an adjusted basis of $10 is sold for $20, taxable gain of $10 is realized. Despite the fact that taxable gain or loss is realized in a given year, the Code may provide for the nonrecognition of the gain or loss. This is the case under Section 1031 when investment property is exchanged for investment property of like-kind.
If realized gain or loss is subject to nonrecognition treatment under a Code provision, the gain is not included in gross income nor is the loss deductible in determining gross income. Nonrecognition provisions are numerous in the Internal Revenue Code. Generally, these provisions are similar in the sense that after the transaction, the taxpayer has remained invested in the property that can be viewed as a continuation of his or her investment in the property disposed of. Nonrecognition of gain or loss is predicated on the notion that taxation of gain or loss is not yet appropriate, despite the fact that a technical realization of gain or loss has occurred. For example, if appreciated property is contributed to a partnership or corporation, taxable gain is generally not recognized. The technical sale of the property in exchange for a partnership interest or stock is ignored for tax purposes because the taxpayer has, in effect, continued his or her investment in the property.
What Does Like-Kind Exchange Mean?
The IRC Section 1031 provides for the nonrecognition of gain or loss if property held for productive use in a trade or business or for investment is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment. Thus the taxpayer disposing of real property in exchange for other property must ask three questions:
- Was the property relinquished by the taxpayer held for investment or for productive use in a trade or business (qualifying property)?
- Is the property received by the taxpayer to be held for investment or for productive use in a trade or business (qualifying property)?
- Are the properties exchanged of "like kind"?
What if the Exchange is Not Solely in Kind?
The nonrecognition rule of Section 1031 would be of limited utility if it applied only to exchanges solely of the like kind qualifying property. Because it is highly unusual for two pieces of real property to be exactly equal in value, an exchange of real property is likely to involve some cash or other nonqualifying property to equalize the transaction. For example, A may trade a parcel worth $100 for a parcel worth $90, plus $10 in cash to equalize the transaction. If nonrecognition treatment applied only to exchanges solely of like kind qualifying property, A would be denied nonrecognition treatment due to the receipt of a small amount of nonqualifying property.
What is Boot in a 1031 Exchange?
What is Boot in a 1031 Exchange?
However, Internal Revenue Code Section 1031 provides that if cash or other nonqualifying property is received by the taxpayer in addition to qualifying like kind property, gain is recognized only to the extent of the amount of money received and the fair market value of any other nonqualifying property received. Cash or nonqualifying property received in an exchange is referred to as "boot," presumably because it is thrown in "to boot."
If we assume in our example that A had a basis of $60 in the $100 parcel he relinquished, his realized gain on the exchange is $40, the difference between his basis ($60), and the amount realized on the exchange ($90 + $10 = $100). Under Internal Revenue Code Section 1031(b), however (assuming all the other requirements for nonrecognition treatment are met), A will recognize only $10 of the $40 realized gain because he received only $10 of boot.
If we assume in our example that A had a basis of $60 in the $100 parcel he relinquished, his realized gain on the exchange is $40, the difference between his basis ($60), and the amount realized on the exchange ($90 + $10 = $100). Under Internal Revenue Code Section 1031(b), however (assuming all the other requirements for nonrecognition treatment are met), A will recognize only $10 of the $40 realized gain because he received only $10 of boot.
