2024 Tax Planning Series: Basis of Property Under 1031 Like-Kind Exchanges and 1033 Involuntary Conversions

Tax planning and preparation are unique to each client and should be tailored to an individual and company's needs. Building wealth by acquiring property is a strategy that suits many clients for tax reasons.

Code Section 1031, like-kind exchanges, and Code Section 1033, involuntary conversions, can impact the value or "basis of the property." The "basis of property" refers to the value used to determine gain or loss for tax purposes when the property is sold. Your CPA will need to calculate the basis of the replacement property for future reporting and treatment as a gain or loss.

Basis of Property Acquired Under Code Section 1031 (Like-Kind Exchanges)

A like-kind exchange involves swapping one property for another of the same nature or character. The properties do not have to be identical but must be similar in use. For example, you can exchange:

• An apartment building for a commercial office space
• Raw land for a rental property

When you acquire property through a like-kind exchange, the basis of the new property is generally the same as the basis of the property you exchanged, with some adjustments.

Here's how it works:

• Adjusted Basis of Old Property: Start with the adjusted basis of your exchanged property. The adjusted basis is the original purchase price plus improvements minus depreciation.
• Additions and Subtractions: Your CPA will adjust this basis by:
  • Adding any additional money paid in the exchange
  • Adding any gain recognized on the exchange.
  • Subtracting any cash received in the exchange.
  • Subtracting any loss recognized on the exchange.
• Basis of New Property: The result is the new property's basis.
  • This means the deferred gain or loss is embedded in the new property's basis, and you won't recognize it until you sell the new property in a taxable transaction.

Example:

Suppose you exchange a property with an adjusted basis of $100,000 for another property and receive $10,000 in cash. In that case, the basis of the new property will generally be $90,000 (the adjusted basis of the old property minus the cash received).

Basis of Property Acquired Under Code Section 1033 (Involuntary Conversions)

When you replace property that has been involuntarily converted (such as through theft, destruction, or condemnation), the basis of the new property depends on the treatment of any gain or loss and whether you choose to defer the gain under Section 1033:

• Recognized Gain or Loss: If you recognize gain or loss on the conversion (meaning you do not defer it), the basis of the new property is its cost.
• Deferred Gain: If you choose to defer the gain (which is allowed if you reinvest the proceeds in similar property within a specified time frame), the basis of the new property is generally the same as the basis of the converted property, with adjustments for any money received or additional costs incurred. If multiple properties are acquired, an allocation is required on the basis.

Example:

Suppose your property with an adjusted basis of $100,000 is destroyed. You receive $150,000 in insurance proceeds and reinvest $140,000 of the $150,000 payout you received in a new property. In that case, the basis of the new property will generally be $90,000 ($100,000 adjusted basis of the old property minus the $50,000 gain not reinvested).

Reporting On Taxes

When you acquire property under Sections 1031 or 1033, you must report these exchanges in the year of the transaction. You will need to report the sale dates on the property, identify the relinquished and replacement properties, and include if any cash was received to your CPA so they can correctly calculate and report the basis of the new property to ensure correct tax treatment in the future. Your CPA will use this information to complete the relevant tax forms.

Acquiring property under Code Sections 1031 and 1033 can be a solid investment opportunity. Contact the Cambalia McGee LLP team to ensure compliance with all IRS regulations and maximize the benefits of these tax provisions.