This article is focused primarily on voluntary real estate exchanges performed in accordance with Internal Revenue Code (IRC) § 1031 but some basic concepts do carryover to other types of exchanges. There are a number of possibilities for a sale subsequent to an exchange. All of these build off of the basic concept that under an exchange the replacement property acquires the tax basis of the relinquished property and therefore in a subsequent sale of the replacement property the gain on the sale is the sale price minus the basis of the relinquished property. However there are many variations possible.
A. The Simple
Scenario
In 1995 you bought a vacant lot for investment for $50,000 cash in Delta, Colorado a block from your home. In 1998 you moved from Delta to Denver, Colorado, at that time the lot was now worth $60,000. You didn't want to keep driving to Delta to check on your vacant lot and found a party who owned a lot in Denver who wanted a lot in Delta. The two of you did a straight swap of properties with no additional cash going to either party. In 2005 you sold your lot in Denver for $75,000. What are the tax consequences?
Solution
Gain or loss from the sale or disposition of property is governed under IRC §1001. Under that code section, gain is calculated as the excess of the amount realized on the sale over the adjusted basis of the property as provided for in IRC §1011. Basis is determined under IRC §1011(a) by reference to IRC §1031. In pertinent part, basis under IRC §1031(d) is determined as the same as that of the property exchanged. Therefore, the gain would be:
Amount realized $75,000
Basis of original lot (property exchanged) $50,000
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Gain $25,000
B. The Simple Plus Received Cash in Original Exchange
Scenario
In 1995 you bought a vacant lot for investment for $50,000 cash in Delta, Colorado a block from your home. In 1998 you moved from Delta to Denver, Colorado, at that time the lot was now worth $60,000. You didn't want to keep driving to Delta to check on your vacant lot and found a party who owned a lot in Denver worth $57,000 who wanted a lot in Delta. The two of you did a straight swap of properties with the relinquishing property owner throwing in an additional $3,000 additional cash going to you. In 2005 you sold your lot in Denver for $75,000. What are the tax consequences?
Solution
Gain or loss from the sale or disposition of property is governed under IRC §1001. Under that code section, gain is calculated as the excess of the amount realized on the sale over the adjusted basis of the property as provided for in IRC §1011. Basis is determined under IRC §1011(a) by reference to IRC §1031. In pertinent part, basis under IRC §1031(d) is determined as the same as that of the property exchanged decreased in amount of any money received by the taxpayer and increased in the amount of gain or decreased in the amount of loss to the taxpayer that was recognized on such exchange. In pertinent part, IRC §1031(b) generally states that in an exchange including money received in addition to the replacement property, gain would be recognized at the time of the exchange not in excess of the cash received. Because there had been money received by you at the time of the original exchange in addition to the replacement property, gain was realized in that exchange as being $60,000 (the total value of money and property received) less your original basis of $50,000 for a total gain realized of $10,000. However according to §1031(b), the entire $10,000 gain was not recognized at that time but only to the extent of the cash received, $3,000. So at the time the exchange was completed in 1998 you had to pay tax on the recognized gain of $3,000. Therefore, the gain on the final sale of the Denver lot in 2005 would be:
Amount realized $75,000
Basis of original lot (property exchanged) $50,000
Money received by you in original exchange <3,000>
Gain previously recognized 3,000
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Basis for purposes of calculating gain on subsequent sale $50,000
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Gain $25,000
C. The Simple Plus Paid Cash in Original Exchange
Scenario
In 1995 you bought a vacant lot for investment for $50,000 cash in Delta, Colorado a block from your home. In 1998 you moved from Delta to Denver, Colorado, at that time the lot was now worth $56,000. You didn't want to keep driving to Delta to check on your vacant lot and found a party who owned a lot in Denver worth $59,000 who wanted a lot in Delta. The two of you did a straight swap of properties with the relinquishing property owner receiving from you an additional $2,000 cash. In 2005 you sold your lot in Denver for $75,000. What are the tax consequences?
Solution
Gain or loss from the sale or disposition of property is governed under IRC §1001. Under that code section, gain is calculated as the excess of the amount realized on the sale over the adjusted basis of the property as provided for in IRC §1011. Basis is determined under IRC §1011(a) by reference to IRC §1031. In pertinent part, basis under IRC §1031(d) is determined as the same as that of the property exchanged decreased in amount of any money received by the taxpayer and increased in theamount of gain or decreased in the amount of loss to the taxpayer that was recognized on such exchange. In pertinent part, IRC §1031(b) generally states that in an exchange including money received in addition to the replacement property, gain would be recognized at the time of the exchange not in excess of the cash received. Because there had been money received by you at the time of the original exchange in addition to the replacement property, gain was realized in that exchange as being $60,000 (the total value of money and property received) less your original basis of $50,000 for a total gain realized of $10,000. However according to §1031(b), the entire $10,000 gain was not recognized at that time but only to the extent of the cash received, $3,000. So at the time the exchange was completed in 1998 you had to pay tax on the recognized gain of $3,000. Therefore, the gain on the final sale of the Denver lot in 2005 would be:
Amount realized $75,000
Basis of original lot (property exchanged) $50,000
Money received by you in original exchange < 0 >
Gain previously recognized 0
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Basis for purposes of calculating gain on subsequent sale $50,000
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Gain $25,000
D. Inherited Property Acquired in Exchange
Scenario
In 1995 your dad bought a vacant lot for investment for $50,000 cash in Delta, Colorado a block from his home. In 1998 he moved from Delta to Denver, Colorado, at that time the lot was now worth $56,000. He didn't want to keep driving to Delta to check on his vacant lot and found a party who owned a lot in Denver worth $59,000 who wanted a lot in Delta. The two of them did a straight swap of properties with the relinquishing property owner receiving from your dad an additional $2,000 cash. Immediately after acquiring the property your dad started renting the acquired property and taking depreciation on it. In 2005 your dad died. He left the property to his estate to be sold and the money split equally between yourself and your younger sister. The lot sold for $75,000. What are the tax consequences?
Solution
Gain or loss from the sale or disposition of property is governed under IRC §1001. Under that code section, gain is calculated as the excess of the amount realized on the sale over the adjusted basis of the property as provided for in IRC §1011. Basis is determined under IRC §1011(a) by reference to IRC §1031. In pertinent part, basis under IRC §1031(d) is determined as the same as that of the property exchanged decreased in amount of any money received by the taxpayer and increased in the amount of gain or decreased in the amount of loss to the taxpayer that was recognized on such exchange. In pertinent part, IRC §1031(b) generally states that in an exchange including money received in addition to the replacement property, gain would be recognized at the time of the exchange not in excess of the cash received. Because there had been money received by you at the time of the original exchange in addition to the replacement property, gain was realized in that exchange as being $60,000 (the total value of money and property received) less your original basis of $50,000 for a total gain realized of $10,000. However according to §1031(b), the entire $10,000 gain was not recognized at that time but only to the extent of the cash received, $3,000. So at the time the exchange was completed in 1998 you had to pay tax on the recognized gain of $3,000. Therefore, the gain on the final sale of the Denver lot in 2005 would be:
Amount realized $75,000
Basis of original lot (property exchanged) $50,000
Money received by you in original exchange < 0 >
Gain previously recognized 0
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Basis for purposes of calculating gain on subsequent sale $50,000
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Gain $25,000