1031 Exchange FAQ

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Common 1031 Exchange Questions

Can i buy into an existing LLC to satisfy a 1031 Exchange?

Can I 1031 Exchange a property that I'm gifting to my daughter?

Do the 1031 Exchange rules apply to off-shore companies?

Can I 1031 Exchange a business?

Can a business do a 1031 Exchange?

What requirements must be met for property to qualify for like-kind 1031 Exchange?

Real Estate to be considered for 1031 Exchange must be of like-kind. According to the IRS, like-kind property is either real estate held for investment or real estate held for a business or trade. Real Estate held for investment is almost always land, either developed or undeveloped. Zoning of this land does not change the like-kind status. Developed land may have some additional issues, especially if there is a residence on it. Real Estate held for a business or trade can be a rental home, apartment complex or property such as a ranch with over 65 acres. In order for property to be considered held for a business or trade, the tax payer must be able to demonstrate that they have collected rents for at least 2 tax periods. More reading is available at

Related Info: like-kind, qualify, requirements, real, estate, land, business, trade


Do the 1031 Exchange rules apply to foreclosure transactions?

To the person losing the property, a foreclosure is treated by the IRS as a sale of the property. If the "sale" could be structured according the rules of Section 1031, the sale could be recognized as a 1031 exchange. But it sounds like a legal nightmare if the property is already in foreclosure. Also, you might have a forgiveness of debt problem. You should talk to your CPA or attorney regarding this before you take any steps.

Related Info: transactions, foreclosure, apply, rules, sale, debt, forgiveness, nightmare, problem


I have a note secured with real estate, can I 1031 Exchange this for another property?

Real Estate notes  are always excluded from 1031 Exchange treatment and will not qualify.

Sometimes you have property you want to sell yet some of the items do not qualify for 1031 treatment.

A transfer of that property in an exchange transaction will be treated as a sale of that property.

Section 1031 excludes these assets from nontaxable treatment:

Property you hold for personal use such as your primary residence.
Stock in trade and property held primarily for sale such as inventories and real estate held by dealers.
Stocks, bonds, notes, or other securities or evidences of indebtedness such as accounts receivable.
Partnership interests.
Notes
Choses in action.
Certificates of trust or beneficial interest


Related Info: estate, real, secured, notes, treatment, qualify, sale


What the heck is the 1031 exchange "napkin test?"

Old time 1031 Exchange gurus use the term "napkin test" to describe the basic rule that all cash proceeds from the sale of the Relinquished Property must be “reinvested” in the Replacement Property to avoid recognized taxable gain from the exchange. If you trade up, and all the cash is “reinvested”, no taxable boot. But if you trade down, and all the cash is not “reinvested”, the net cash back to you is treated as cash boot received and recognized as taxable gain.

However, there is an adjustment to cash boot received not realized by many when the exchange is originated and in the planning stages. Selling expenses paid in connection with a §1031 exchange are treated as cash boot paid and offsets any boot received. Selling expenses include brokerage commissions and other closing costs such as title policy fees, escrow fees, and recording fees. This means you can trade down by the amount of your selling expenses paid and still have no recognized gain. Here is an example of this vital tax-planning tool.

You sell your Relinquished Property and the cash proceeds total $135,000. Your selling expenses total $32,000 of which you paid $10,000 outside of escrow. The balance of the selling expenses or $22,000 was paid through escrow and the net proceeds of $113,000 are paid into your QI’s trust account. At this point, your net cash boot received is $103,000 and this is the amount you need to “reinvest” to avoid net boot received and taxable income.

Selling Expenses are all expenses directly related to the sale of the Relinquished Property and is the amount used by IRS to deduct from the Selling Price to figure the Adjusted Sales Price. Selling expenses do not include interest, points, taxes, fixing up expenses, repairs, insurance, operating expenses of the property, personal bills or impound account adjustments. Occasionally selling expenses are paid outside of escrow. For example, a consulting fee paid in connection with the transaction may qualify as a selling expense. Be sure to check with your tax professional if you have any questions regarding your particular selling expenses. See Chapter Four for more discussion of this important topic.

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My 1031 Exchange has an option contract with the buyer. How does this work?

In a 1031 Exchange,  gain or loss from of an option contract is considered gain or loss from the exchange of property. The option contract takes on the same classification as the property (to which it relates) would have if acquired by the optionee buyer.

Here's how it works for the 4 classifications of real estate:

Business Property —If the underlying property would have been business property in the hands of the optionee, the gain or loss is subject to §1231 treatment. To qualify, the option must have been held for more than one year. Under Section 1231, gain is treated as long-term capital gain. Loss is treated as ordinary loss. If the holding period of the option is one year or less, gain is treated as ordinary income. Loss is treated as ordinary loss.

Investment Property —If the underlying property would have been investment property in the hands of the optionee, capital gain or loss is realized. If the option was “held” for more than one year, the capital loss is long-term. If one year or less, short-term.

Personal Use Property—If the underlying property would have been real estate held for personal use in the hands of the optionee, gain is treated as capital gain. If a loss is suffered, it is personal and not deductible.

Dealer Property—If the underlying property would have been real estate held as property for sale to customers in the ordinary course of his trade or business by the optionee, any gain is treated as ordinary income. Any loss is treated as a deductible ordinary loss.

Related Info: work, buyer, contract, option, loss, gain, treated, ordinary, optionee


What type of property can I 1031 Exchange a Farm for?

Thanks for asking! If you farm qualifies for 1031 Exchange, the property will be considered as like-kind, according to the IRS. If the farm is considered like-kind, your qualify for 1031 Exchange with any other like-kind 1031 Exchange property. This includes other qualifying farms or ranches, raw or developed land (regardless of zoning), or rental properties such as duplexes or apartment complexes. The possibilities for 1031 Exchange Real Estate are nearly endless and depending on your needs a good 1031 Exchange Realtor can help you find just the right property.

Related Info: farm, type, like-kind, possibilities, complexes, apartment, duplexes


When can I have my 1031 Exchange Proceeds back?

It all depends on whether you have already identified your 1031 exchange replacement properties. If you already have, then you must wait until your 1031 Exchange Period is over before you should collect your money. If you have not yet identified your replacement properties, then you may have your proceeds back, though these would now be subject to Capital Gains tax.

Related Info: proceeds, replacement, properties, identified, capital, gains


How long can I own a 1031 Exchange Rental property before I can live there?

Remember, it's all about intent. For example, if, at the time of your 1031 exchange, you had no intention of converting your rental into your primary residence but an unforeseen event, not related to the exchange, takes place—perhaps the death of a spouse. Or the rental turns out to be an unbearable negative cash flow situation. You should be able to demonstrate to the IRS your original intent. In such cases, you should have no problem supporting your 1031 exchange.

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Ok, so I did a 1031 exchange this year. Now what do I do?

IMPORTANT LINKS TO IRS TAX FORMS AHEAD!

Unless you are a tax professional, you should have your return prepared by your tax person. The exchange of 1031 Exchange property is reported on Form 8824, Like-Kind Exchanges. The instructions for the form explain how to report the details of the exchange. The exchange must be reported even though no gain or loss is recognized. (Not to do so could extend your 3-year statute of limitations.) If you have any taxable gain, resulting from the transaction, because you had a partially deferred exchange or otherwise received money or unlike property, it is reported on Form 4797 - Sale of Business Property and Form 1040, Schedule D.Capital Gains and Losses.

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Can you split a 1031 Exchange?

IRS 1031 Exchange is a vehicle tax-payers have used for 20 years to defer their capital gains tax by selling qualified, like-kind  investment or business property. 1031 Exchange have been executed by single and married tax payers, businesses and partnerships, LLC's, Trusts, TIC's and Corporations. In order for there to be an exchange, the name on the title for the property you are selling, should remain the same for the properties you are purchasing. Changing Title or "splitting" the title out, will create issues with the IRS when it comes to determine who conducted the 1031 Exchange. Better to keep the title the same all the way through. If you hold property as a partnership or business, it is also possible to "split" up the partnership with a 1031 Exchange. Depending on how the properties are deeded, partner A can purchase one property as a replacement property, while another partner B can purchase 3 other properties separate from partner A. More information about splitting up a partnership with a 1031 Exchange can be read by clicking here.

Related Info: split, title, partnership, properties, partner, splitting, business


Can I 1031 Exchange a duplex for a motor home?

The quick answer to this question is NO. A 1031 Exchange requirement is that both properties must be of like-kind. Like kind real estate is ONLY property that is purchased for the purpose of investment, such as land, AND, property held for a business or trade, such as a rental property. Your duplex would certainly qualify for 1031 Exchange if you have been collecting rents from it for 2 or more tax periods. But a motorhome has a completely different tax classification and is not considered as like-kind. More information about Like-Kind 1031 Exchange properties, can be found here.

Related Info: home, motor, duplex, like-kind, properties, rents, periods, collecting, qualify


Some 1031 companies say “defer”, some say “don’t pay” capital gains tax with a 1031 Exchange. Which is correct?

Answer:  When you sell your property and purchase another property with a like-kind property you are conducting an IRS 1031 Exchange. "Defer" or "Don't Pay" is simply marketing language intended to get your to consider a 1031 Exchange if you have property to sell. With a 1031 Exchange the reality is that "some day" you will be paying the capital gains on your property but with a 1031 Exchange you are really "deferring" it to some other time. We have had customers defer their capital gains several times by buying and selling the same piece of land. Since land almost always qualifies, under the 1031 Exchange rules you can do this. The question is with a 1031 Exchange are you saying that you will "never" pay your capital gains tax. In our 20 plus year experience with the US Internal Revenue Service we learned to "never say never".

Related Info: correct, gains, capital, defer, companies, land, buying, selling


What is the difference between Capital Gains and Equity?

Answer:  Don't confuse them, they are not the same.

Equity is the money left over once you sell a  property and pay off all the liabilities including mortgages.

Capital gain on a property would be the difference between your basis and your adjusted sales price. If you bought property for $20k (your basis) and sold it for $100k, after paying off the liabilities you would have a capital gain of $80k.

If you sell instead of doing a §1031 Exchange, you would be obligated to pay a capital gains tax on the entire $80k.

Be extremely careful not to trap yourself with a regular sale.

Related Info: equity, gains, capital, difference, gain, basis, liabilities, $80k, paying


How do I do a 1031 Exchange in Texas?

1031 Exchange is a federal action involving the IRS and US Tax Payers. As Texas is one of the 50 states, completing a 1031 Exchange in that state should be no problem so long as the property you sell and the property you purchase are both considered of like-kind investment or business real estate. You do not have to use a Qualified Intermediary that resides in Texas, you may use any Qualified Intermediary that you wish, though we highly recommend Realty Exchangers, Inc, a 21 year company with an impeccable reputation for quick, easy and secure 1031 Exchanges.

Related Info: texas, realty, exchangers, recommend, resides, highly


1031 Exchange seems complicated. Is it?

Like a lot of things in life, it's only as complicated as you make it. In fact, the rules for 1031 exchange are actually quite simple. Owners of qualified 1031 Exchange properties, either investment real estate or business real estate, can defer the capital gains tax from a sale by exchanging their property for a like-kind property. The proceeds from the sale must be kept with a Qualified Intermediary.

What makes this difficult is the fact that some individuals try to circumvent the IRS's section 1031 Exchange rules by either trying to 1031 exchange a property that doesn't qualify or trying to tamper with their sale proceeds. The easiest and simplest way to conduct a 1031 Exchange is to understand the rules and keep your 1031 Exchange easy and simple.

Related Info: complicated, seems, rules, sale, estate, proceeds, real, circumvent


I sold a property last month, is it too late to 1031 Exchange it now?

 Hi, I am interested in determining if I can qualify for a 1031. I sold a property on Sept 22, 2011. I did deposit the cash into my bank account. I am now bidding on another property and could close before the end of the month. The properties are both investment properties. Can I still qualify? Can you assist me in the transaction? Thank you.

1031 Exchange must happen at the time of closing. Because your property has already closed, you now have access to the funds, this means you cannot 1031 Exchange. However, there are times when you have closed sale on a property but the money is still in escrow and out of your control. If that is the case, there may still be time to setup a 1031 Exchange. Check out http://www.realtyexchangers.com for more information.

Related Info: month, closed, properties, time, qualify, money, sale


How do I figure out real estate interest for 1031 exchange?

Here is a “nutshell” approach to figuring out how each kind of real estate interest (excepting your personal residence) is classified for tax purposes and how each is treated on the tax return.

There are three major classifications of interest on the Federal individual income tax return. Each classification is subject to different rules. Because of this, great care must be given to determine the correct classification of each interest item. It’s the only way to figure what is deductible and where to deduct it.

1. Business interest

(a) Interest on rental income real estate
(b) Interest on business indebtedness

2. Investment interest

3. Personal interest

(a) Consumer interest
(b) Qualified residence interest.

Borrower's Cost of Getting Loan
Borrowers may incur substantial fees and charges when a mortgage loan is funded. These costs include legal fees, "points", appraisal fees, escrow fees, service charges, surveys, real estate commissions and title costs. These financing costs must be analyzed and divided into two categories:

1. Costs that do not qualify as interest.
2. Costs that do qualify as interest.

Costs That Do Not Qualify As Interest
Costs that do not qualify as interest are treated as lending service costs. If the mortgage was obtained to acquire real estate used in business or held for profit, the costs are deductible by amortizing them over the life of the loan. If the mortgage was obtained to acquire real estate held for personal use, lending service costs are not deductible.

Amortization of loan costs is always taken using the straight-line method. Amortization is continued until all costs are written-off or the loan is paid off or assumed. If there is a balance in the unamortized loan costs account, and the loan is paid off or assumed, the tax treatment of the balance depends on the classification of the property. In cases of rental income and other business property, the balance is deductible as an operating expense of the property.

For example, 10 years ago you bought an apartment house and paid loan costs of $20,000 to acquire the 25-year mortgage loan. You now sell the property as part of a 1031 exchange. During the last ten years you deducted your loan costs by amortizing them at the rate of $800 per year ($20,000/25 years). Your deduction totaled $8,000 for the ten years ($800 per year times 10 years). The unamortized balance of $12,000 is deductible at the time of the sale as an operating expense of the property. Do not take it as a selling expense of the property - if you do, you could lose the entire deduction.

Costs That Do Qualify as Interest
Costs that qualify as interest are treated as prepaid interest - capitalized and amortized straight-line over the life of the loan.

The term "points" is used to describe the interest charges you pay as a borrower to a lender when you take out a mortgage. Lenders have different names for points: loan origination fees, premium charges, etc. But what they call them doesn't matter. If the payment for any of these charges or points is for the use of money, it is interest.

Charges or points paid for the use of money are deductible as mortgage interest. They are treated as prepaid interest and subject to the prepaid interest rules. Amortization of points is figured using the straight-line method and is continued until the points are all written-off or the loan is paid off or assumed. For example, if you are charged $2,000 interest points for a 20-year loan, the $2,000 is considered prepaid interest. Under the prepaid interest rules, you must spread your interest deduction over the tax years in which it belongs. In other words, you can only deduct in each year the interest expense for that year. $2,000 prepaid interest for a 20-year loan must be deducted over 20 years at the rate of $100 per year.

If there is a balance in the unamortized points account, and the loan is paid off or assumed, the tax treatment of the balance depends on the classification of the property. For rental income and other business, the balance is deductible as an operating expense of the property. For your personal residence, the balance is deductible as qualified residence interest, if otherwise qualified.

An easy to determine what kind of interest you are dealing with is this simple rule:
Interest deductions follow the money. Just ask this question for each interest amount - where did the money I'm paying interest on go? That's where the deduction goes. For example, you borrow money to buy a computer for your business. The interest is business interest - that's where the borrowed money went. Here’s another familiar example. You borrow a hard-money second nd on one of your rental properties and use the money to buy a new personal automobile.

Is the interest deductible? If yes, where do you deduct it? If not, why not?
Just ask the question -where did the money go? Since the money was used to buy a personal asset, the interest is not deductible. Wait a minute, you say. I borrowed the money on my rental property. Why can’t I deduct it against my rental property as an operating expense on Schedule E? The collateral has nothing to do with the use of the money you borrow so don't let it get in your way. The test is: Where did the money go?


Loan proceeds used to acquire:. ->Interest is deducted as:
Rental Property......................................->Rental Expense
Investment Property.............................->Investment Interest
Personal residence..................................->Itemized deduction (if qualified)
Farm property........................................>Farm expense
Dealer property......................................>Business Expense

Related Info: interest, estate, real, figure, loan, costs, money, deductible, expense


Can I 1031 Exchange a property that I'm gifting to my daughter?

You should be very careful here. The IRS is quite specific regarding gifting 1031 Exchange properties. They have stated that there MUST be an actual sale in order for there to be an exchange.

You will not get 1031 Exchange benefit merely if you intend to exchange—you must actually make an exchange of your property.

Related Info: daughter, gifting, benefit, order, intend, exchangeyou, actually, sale


How does my mortgage transfer in a 1031 Exchange?

You take on their mortgage and they take yours.

In a 1031 exchange, the assumption of a liability by the other party (or transfer of your property subject to a liability) is treated as boot received by you. It's called mortgage relief. In figuring your net mortgage relief, you may offset against it your assumption of a liability (or transfer of property subject to a liability).

The assumption of a liability or the transfer of a property subject to a liability is treated as boot.

If the other party assumes your liability—or your property transferred subject to the liability—you have received boot. You will be treated as if you received cash in the amount of the liability. The party assuming the liability, or acquiring the property subject to the liability, gives boot.

If you transfer unencumbered real estate in exchange for mortgaged real estate, you have paid boot equal to the amount of the mortgage. The payment of mortgage boot does not result in recognition of gain or loss to the person paying it.

Related Info: transfer, mortgage, liability, boot, treated, party


Why are the 1031 Exchange selling expenses deducted?

Many real estate agents and investors when working out the numbers for their 1031 exchange often overlook selling expenses as an offset against boot received. Factoring in this offset is critical when the exchange is originated and in the planning stages. Selling expenses paid in connection with a §1031 exchange are treated as cash boot paid and offsets any boot received. Selling expenses include brokerage commissions and other closing costs such as title policy fees, escrow fees, and recording fees.

Related Info: deducted, expenses, selling, boot, fees, offset, paid


What is a 1031 Exchange Disqualified person?

The exchanger or a disqualified person cannot qualify as qualified intermediaries for their own 1031 exchange. A person is a disqualified person if:

The person is an agent of the exchanger at the time of the transaction.
The person and the exchanger bear a relationship described in Section 267(b) or Section 707(b). However, you must substitute “10 percent” for “50 percent” each time it appears in those Sections.
The person and a person who is an agent of the Exchanger at the time of the transaction bear a relationship described in (2) above.

These people are treated as agents of the exchanger: A person who has acted as the exchanger’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period ending on the date of the transfer of the first of the relinquished properties. However, the regulation disregards certain services for purposes of determining if an agency relationship exists. Performance of services with respect to exchanges of real estate intended to qualify under §1031 is not taken into account.

Related Info: person, disqualified, exchanger, time, relationship, section, described


Will I have to pay capital gains tax if I don't 1031 Exchange my property?

For you individual case, best to discuss this with your tax advisor such as a CPA or attorney. We can help you figure out what your capital gains tax would be on your sale, just visit our Capital Gains Estimator located at http://www.realtyexchangers.com/estimatecapitalgains.php. This tool was created specifically for taxpayers wondering if they will even have a capital gain from their sale.

Related Info: gains, capital, sale, created, tool, specifically


Can I 1031 Exchange a rental property and purchase a primary residence with the proceeds?

No. 1031 Exchange rules require that the relinquished property and the replacement property be of like-kind. What this means is that they both must be either a business property such as a rental or an investment property, such as land. The sale you mention will incur the capital gains tax. If your goal is to defer those taxes, your 1031 Exchange replacement property must be of like-kind qualify for IRS 1031 Exchange.

Related Info: proceeds, residence, primary, purchase, rental, like-kind, replacement, gains, capital, incur, goal


1031 exchange, can money in escrow be transferred to another escrow account for property deposit?

We've had this question before where a customer is wondering if the 1031 Exchange Proceeds can be held in an escrow account with their title company rather than be transferred to Qualified Intermediary. This is an issue of Constructive Receipt. Constructive Receipt is where you have direct control over your 1031 Exchange funds. This is something you want to avoid at all costs because if the IRS discovers that you had Constructive Receipt of your 1031 Exchange proceeds, they will rule that your Exchange was actually a sale and you could be subject to capital gains tax. So, in order to defer your capital gains tax, should use the Safe Habor rule recommended by the IRS. Safe Harbor is a dis-interested 3rd party, while acting on your behalf and under your direction, has complete control over the proceeds. Safe Harbor is your Qualified Intermediary.

Having your 1031 Exchange proceeds held in an escrow account under the direction of your closing company is not using the Safe Harbor rule, which puts you in direct control over the money and puts you in Constructive Receipt of the funds. If you ever have Constructive Receipt, you have no 1031 Exchange.

If your funds are held in a Safe Harbor, then you cannot transfer them to another escrow account as an earnest money deposit. They can only be used for the direct purchase. Better to use your own funds for this purpose and get them back from the closing company after the sale closes.

Related Info: escrow, deposit, account, transferred, money, receipt, safe, constructive, funds, harbor, proceeds


How does the step up in basis work for my heirs if I die during my 1031 Exchange?

A related taxpayer exchange not disqualified if the disposition of property within the 2-year period following the original 1031 exchange takes place after the date of death of the taxpayer or the date of death of the related person.

A related taxpayer exchange is not disqualified if the disposition of property within the 2-year period following the original exchange if the disposition is made as the result of a compulsory or involuntary conversion of the property received in the original exchange. For this exception to apply, the original exchange had to occur before the threat or imminence of such conversion.

A related taxpayer exchange will not be disqualified if the disposition of property is made within the two year period following the original exchange if the IRS is satisfied that neither the original exchange or the later disposition has federal income tax avoidance as one of its principal purposes.

Related Info: heirs, work, basis, original, disposition, taxpayer, related, following, period


How safe in your money in an escrow account for a 1031 Exchange?

Qualified Escrow Accounts are about the safest type of account you can have when you are working with a Qualified Intermediary (Realty Exchangers), this is because you QI cannot access any of the money without your knowledge and signature. Also, insist that your QI apply FDIC insurance on all of your proceeds. Few QI's offer this service, though Realty Exchangers does. Read more about Fund Security here.

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Is the 1031 Exchange property I'm buying impacted by the depreciation of the property I'm selling?

Depreciation taken or method used on the relinquished property does not carry over to the replacement property in a 1031 Exchange. You figure the substituted basis of the replacement property, allocate the basis between land and depreciable assets and start over following current depreciation rules for the types of depreciable assets you acquire. Your CPA can explain this to you more fully.

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1031 Exchange Information Network

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How soon can I get my proceeds back after my 1031 Exchange closes?

Your 1031 Exchange Proceeds are available to you at any time. The fact that we are holding your money as your Qualified Intermediary does not mean you cannot have access to it. But in order to take advantage of deferring your Capital Gains tax, there are only a couple of times when you can access your proceeds without danger of collapsing your 1031 Exchange. When you close sale on your Relinquished Property (the property you are selling) you may take back proceeds known as "boot received". These funds may be used however you see fit, just know that they will be subject to Capital Gains Tax. The other time you may access your proceeds without putting your 1031 Exchange in danger is after the sale closes on your final identified replacement property. As with "boot receivable" your remaining unspent proceeds are also subject to the capital gains tax.

Related Info: closes, proceeds, capital, access, gains, sale, boot


Why is depreciation important to a 1031 exchange?

Depreciation is important in a 1031 Exchange because it is the amount of money you have taken off of your yearly taxes since you purchased the property. It is part of the formula for determining your basis when figuring out whether you will have capital gains on the sale or purchase of a property.

The depreciation recapture provisions of §1250 (real property) and §1245 (personal property) apply to 1031 Exchange as well as sales. These provisions require certain depreciation to be recaptured as ordinary income (instead of long-term capital gain) when the property is sold or exchanged and a gain is recognized.

If you exchange property subject to recapture, and no gain is recognized, the “recapture potential” of the Relinquished Property carries over to the Replacement Property.

If you exchange property subject to recapture, and gain is recognized because of boot taken, the ordinary income portion of the recognized gain is limited to the depreciation that would be recaptured as ordinary income if the property had been sold.

If you exchange property subject to depreciation recapture, and gain recognized because boot taken is less than depreciation that would be recaptured as ordinary income if the property had been sold, all the recognized gain will be taxed as ordinary income. The balance “recapture potential” carries over to the property acquired in the exchange.

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