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Figuring Substituted Basis of Replacement Property - Topic 10

A well-known fact about real estate exchanges that’s not true is depreciation on the Replacement Property is based on the fair market value (market purchase price) at the time of the exchange. Many an exchanger and uninformed tax professionals have fallen into this trap.

Before you make the final decision to go ahead with your exchange, you need to figure the basis of your Replacement Property. This topic addresses  how to calculate the substituted basis of the Replacement Property and make allocations for new depreciation deductions.

Before you enter into any exchange of real estate, you must figure the basis of the Replacement Property you are acquiring and see how it fits in with your financial and tax plans.

 Much depends on this basis. For example, if the Replacement Property is an apartment complex (§1231 property), an allocation must be made of your ‘new’ basis to figure the amount qualifying for depreciation. You need this to figure the amount of your depreciation deduction. If your unrecognized gain on the Relinquished Property is large, the basis of your Replacement Property will be very low compared to market values. This can have unexpected results if not anticipated.

Your operations statement for the apartment complex will reflect rental income based on today’s market values. But your depreciation deduction will be based on “yesterday’s cost.” You need to recognize this difference and accept it as part of your planning before going ahead with the exchange.

Nonrecognition of gain in a §1031 exchange is linked with the “substituted basis” rule. This rule is designed to expose the unreported gain to tax if the Replacement Property you acquire in the exchange is ever disposed of later in a taxable transaction.

The basis of the property you acquire in a §1031 exchange is the same as the adjusted basis of your Relinquished Property increased by any additional consideration you give for the Replacement Property.

Here's a good rule to help you remember:

â The basis of what you get is the basis of everything you give to get it.

Substituted Basis

The rules for figuring basis for property acquired in a tax-free exchange take into account the gain is not forgiven, but “postponed” This is accomplished by providing a “substituted basis” for the property received. The basis of your Relinquished Property exchanged without recognition of gain becomes the basis of your new property. Your old basis is “substituted” into the new property. Someday, if you dispose of the new property, the previously unrecognized gain (or loss) might be subject to tax.

Parallel Point 10-1

You exchange real estate worth $150,000 for other real estate also worth $150,000. The basis of your Relinquished Property is $60,000. Under the rules of §1031, your gain of $90,000 is not recognized and the basis of your Relinquished Property—$60,000—substitutes into your Replacement Property. The basis of your Replacement Property is now $60,000.

Later, if you sell the real estate acquired in this exchange for $175,000, your gain will be $115,000—$175,000 sales price less your basis of $60,000. $25,000 of the gain was from appreciation over its $150,000 market value at the time of the exchange. The balance of the gain is $90,000; the amount of gain not recognized at the time of exchange.

Figuring Basis When Boot is Paid

If you pay additional consideration (boot) in your exchange, the amount of boot paid is added to the substituted basis of the Replacement Property. Selling expenses paid by you in connection with the exchange counts as cash boot paid and is also added to the basis of the Replacement Property.

Parallel Point 10-2

You exchange real estate worth $150,000 for other real estate worth $185,000. The basis of your Relinquished Property is $60,000. To balance the equities, you give the other party a note for $35,000. You pay your real estate broker a commission of $12,000 for handling the deal. Your basis in the Replacement Property is $107,000.

Substituted basis from Relinquished Property $ 60,000

Plus additional consideration paid 35,000

Plus commission paid 12,000

Equals total basis of Replacement Property $107,0 00

Figuring Basis When Boot is Received

Figuring the basis is more complicated when boot is received.

Substituted basis is increased by:

1.Cash and other boot given by you.

2.Gain recognized by you.

Substituted basis is decreased by:

1.Cash and other boot received by you.

2.Other boot includes mortgage boot given and received.

Property Subject to Mortgage

If the property you give up in the exchange is mortgaged, the mortgage is counted as money received and reduces your substituted basis. This rule applies whether or not the other party assumes the mortgage. Also, the rule applies whether or not the assumption results in recognition of gain to you in the year you make the exchange.

In exchanges where the properties of both parties are mortgaged, the differences in the mortgages must be taken into account. If the mortgage you assume is larger than the mortgage transferred with the property given up, the difference is added to the basis of your new property. If the mortgage you assume is smaller than the mortgage transferred with the property given up, the difference is deducted from the basis of your new property.

More Than One Property Received

If more than one like-kind property is received in the exchange, the substituted basis is allocated to the properties acquired in proportion to their relative values on the date of the exchange. [xix]

If you receive unlike property in an exchange, the property must be allocated a basis equal to its fair market value on the date of the exchange.

All exchangers know that no matter how smooth the transaction is going, there are always pesky little problems popping up. Some are just annoying but others can present troublesome problems. Since every taxpayer and exchange is as different as fingerprints, here are some of the special issues you must be able to deal with.



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