Each Internal Revenue Code Section 1031 Exchange is a unique transaction(1). The focus of this article is with respect to exchanges involving real property for real property(2).
We begin by looking at the Form 8824 itself. This Form should be filed with the taxpayer’s federal income tax return(s) for the year in which the relinquished property has been sold. In reporting an exchange among related parties, it is necessary to complete the related-party section and file form 8824 for two years after the exchange was completed. If necessary (because of the 180-day exchange period rules), the taxpayer should consider extending their return from April 15th to August 15th. In fact, extending the return can prevent the acceleration of the 180-day deadline to April 15th of the year following the sale of the relinquished property. This can be a very significant issue for situations in which the relinquished property sale occurs between October 15th, and before January 1st.
The reader is encouraged to keep in mind two rules of thumb. First, if the market value of the replacement property is greater than that of the relinquished property, there is less likelihood of taxable income. Secondly, if mortgage debt is greater on the replacement property, there is less likelihood of taxable income, as well. The converse of these is also true. When the seller winds up with more cash than he/she had before the exchange, and/or less debt, there is a strong likelihood of taxable income. Since most 1031 exchanges are deferred exchanges, both the sale and the purchase through the intermediary must be accomplished in order for the taxpayer to be able to complete Form 8824. A deferred exchange is one in which the replacement property(s) being purchased is received after the property(s) being sold is relinquished.
The tax preparer is encouraged to have IRC Section 1031, IRS Regulations (particularly 1.1031(j)-1), Form 8824 (and instructions), Form 4797 (and instructions), and Schedule D (with instructions) at hand when completing Form 8824. This documentation, along with this article, and the specific information for the transactions involving all properties involved in the exchange, are the necessary ingredients to complete an accurate Federal Tax Return when the taxpayer is affected by a Section 1031 like-kind exchange. It is important to note that there can be multiple properties involved in one exchange but separate exchange transactions require separate Forms 8824. When multiple properties are either relinquished or received, the taxpayer should prepare a schedule to show the detail by property. This applies to all lines of Form 8824 and related Forms on which the word “property” appears. Regulation 1.1031(j)-1 can be relied upon to allocate basis among multiple assets involved in a single exchange.
Now we move to the completion of an actual Form 8824. On Lines 1 and 2, the taxpayer should put a description of the property(s) involved, together with their full address, including the country. Line 3 is used to report the date that the relinquished property(s) was originally acquired. Line 4 is used to report the date upon which the relinquished property(s) was sold through the intermediary. Line 5 is the date that you identify the replacement property(s) within the 45-day identification period. Line 6 is the date that you actually purchased the replacement property(s) through the intermediary (within the 180-day exchange period). Line 7 is used to indicate whether the exchange involved any related parties. Lines 8 through 11 deal with related-party exchanges, which are outside the scope of this article.
It is important to remember that the scope of this article focuses only upon real property Section 1031 exchanges when completing the remainder of the form.
Line 12 would generally not apply in a real-property exchange, but if assets other than real estate and/or legal tender were used to purchase the replacement property, the value of the assets given up would be placed on Line 12; the cost-basis of this property would be placed on Line 13; and Line 14 would be the gain or loss that would be the difference between the market value and the cost-basis. If such a gain or loss occurs, this would be reported in the same manner as any other non-like-kind exchange gain or loss would be reported. Typically, this gain or loss is transferred to Schedule D or Form 4797.
On Line 15, add the total cash received to the net reduction in debt (this is only necessary if the mortgage on the relinquished property exceeds the mortgage on the replacement property acquired) and subtract the transaction costs to accomplish the exchange. On Line 16, record the fair-market value (contract sales price) of the like-kind property that was received in the exchange. Line 17 is simply the total of Line 15 plus Line 16. Line 18 is the adjusted cost basis (original purchase price, plus improvements and less depreciation), plus any transaction costs to accomplish the exchange that were not included in Line 15. Line 19 is the realized (or economic) gain or loss. It is the difference between what was received, and what was relinquished.
On Line 20, record the smaller of Line 15 or Line 19. If the exchange resulted in a loss, this line would be 0(zero). Typically, this is the cash received in the exchange when the exchanger is not moving up in value of real property and mortgage debt. Line 21 refers to Form 4797. On this Line, the ordinary income recapture (accelerated depreciation) is reported. It is critical to obtain professional legal and/or tax advice if there is a potential for ordinary income recapture. Depreciation recapture rules can be very complex. In general, depreciation recapture occurs with Section 1245 property (usually pre-1987 purchases), and/or Section 1250 property (usually post-1986 purchases) are relinquished. This ordinary income is also reported on Line 16 of Form 4797. Line 22 of Form 8824 is the amount of the gain recognized that is not ordinary income under the recapture rules. It is, as the form states, the difference between Line 20 and Line 21. This Line should never be less than 0(zero). The insturctions for Form 8824, are not very user friendly with respect to what to do with this amount from here. Presuming that the amount on Line 22 is above 0(zero), it could go to one of three places. The first possibility is Schedule D (directly), but htis is unlikely in a 1031 exchange involving real property. The most likely possibility is Form 4797, Line 5. The third possibility is that this amount is transferred to Form 6252 (installment sales). An installment sales situation is most likely to arise where the exchanger took back a mortgage due from the purchaser of the relinquished property(s). Installment sales are, in and of themselves, fairly complicated and a subject not covered in this article there again, the taxpayer is encouraged to seek professional tax and/or legal advice.
Line 24 is the deferred gain, or the amount of the gain that will be postponed to the future. This, of course, is what every real estate investor is striving to maximize in a 1031 exchange. Finally, Line 25 is the basis of the property received in the like-kind exchange. If more than one property is received in the exchange, the taxpayer should refer to Regulation 1.1031(j)-1 for guidance in allocation of basis among the properties. A schedule showing the allocation of basis would be advisable.
- It is important for the reader to understand this article is not intended to be professional tax or legal advice, and that taxpayers involved in like-kind exchanges need to obtain professional tax and/or legal advice throughout the exchange process, including the preparation and filing of the Federal Income Tax Returns. The focus of this article is confined to exchanges involving real property for real property.
- This article is not intended for use in personal property like-kind exchanges. In addition, it does not deal with several other significant issues. Although Form 8824 is used to report 1031 exchanges, this article does not deal with IRC 1043, conflict-of-interest sales, which is also included on the form. Finally, the reader should be aware that the authors have excluded examples on purpose. With many professional tax preparation programs available, it makes more sense for the reader to enter the actual data of their exchange into a comprehensive tax program than for this author to produce numerous examples; none of which will emody all the facts of the reader’s exchange.