Non-recognized property transfers – 351(a) and 1031 exchanges
Most exchanges of property are taxable events. Sometimes the US Congress legislates federal tax code that encourages economic growth. For example, Internal Revenue Code (IRC) Section 351(a) encourages the formation of a corporation; the exchanges of business property for corporate ownership (shares) under some circumstances do not have recognized immediate taxable gains. Any taxable consequences of the transaction are deferred to a future time. The social intent of this code section encourages incorporation of businesses. In a similar way, Congress ruled that like-kind IRC Section 1031 exchanges defer immediate taxable gains on a sale of real estate investment property. You might consider using a “1031 exchange” to defer paying taxes on a highly appreciated farm or ranch by “exchanging” proceeds for some other “like-kind” real estate and thus, postponing capital gains tax. Both these IRC sections thus describe non-recognition transactions.
You need to answer three questions in a nonrecognition transactions; (1) what is the gain realized in the exchange, (2) what would the gain recognized, and finally, (3) what is the basis in property received.
1) Gain realized in property given up is:
Fair Market Value (FMV) of assets and cash received
Amount of debt assumed by “other” party
Less any exchange (“selling”) expense
Less the adjusted basis of the property given up
2) Gain immediately recognized in the exchange is:
Total cash received (unlike property called Boot)
Net liability, if any, assumed by “other” party. Any assumed liability by the “other” party is considered “money” received
Less any exchange (“selling”) expenses paid
3) Basis of property received is:
Adjusted basis of transferred property
Net liabilities, if any, assumed by taxpayer
Plus “selling expense” (considered boot paid)
Plus gain recognized (from Step 2)
Less any Boot (cash, unlike-property) received
There are two requirements for a IRC Section 351(a) treatment; namely, (1) the exchange involves only the receipt of stock for transferred property, and, (2) immediately following the exchange of property for corporate stock, you have “control” (at least 80%) of the corporation as defined in IRC Section 368(c). The adjusted basis in property transferred to the corporation will ordinarily have the same value as the amount preceding the non-recognized exchange. The key requirement in a Section 1031 exchange is that the property has a productive use either in trade, business, or investment. A taxpayer not only defers capital gains taxes on their on their original investment property, they transfer taxes to the replacement property. There are no limits on the number of exchanges that can be transacted and thus, no restrictions on how far into the future the tax liability can be deferred.
Finally, before applying these “tax-free” exchange techniques, carefully research special situations involving related parties, if say, there is a disposition of exchanged like-kind property within 2 years, and issues when the amount of boot or assumed debt/liability is in excess of the transferred property’s adjusted basis.