How does a partial 1031 exchange affect the recognition of gain and depreciation recapture when a property when a partially depreciated building is sold?
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A partial 1031 exchange occurs when a taxpayer sells a property and reinvests only part of the proceeds into like-kind replacement property, while retaining some cash or receiving non-like-kind property (collectively referred to as "boot"). This situation has specific consequences for the recognition of gain and the recapture of depreciation, especially when the relinquished property is a partially depreciated building.
1. Recognition of Gain in a Partial 1031 Exchange
General Rule:Under IRC §1031(a), no gain or loss is recognized on the exchange of real property held for productive use in a trade or business or for investment if exchanged solely for like-kind property to be held for similar purposes. However, if the taxpayer receives money or non-like-kind property (boot) in addition to like-kind property, gain is recognized to the extent of the sum of the money and the fair market value of the non-like-kind property received.
Application to Partial Exchanges:- The portion of the proceeds not reinvested in like-kind property (i.e., the boot) is immediately taxable.- The recognized gain is the lesser of the realized gain or the amount of boot received.- Boot can be in the form of cash, non-like-kind property, or debt relief (if the mortgage on the relinquished property exceeds that on the replacement property).
Example:If a building is sold for $500,000, and only $400,000 is reinvested in like-kind property, the $100,000 retained is boot and is subject to immediate taxation. If the realized gain on the transaction is $120,000, only $100,000 is recognized (the amount of boot), and the remaining $20,000 is deferred.
2. Depreciation Recapture in a Partial 1031 Exchange
Depreciation Recapture Rules:- For depreciable real property, depreciation recapture is governed by IRC §§1245 and 1250.- Section 1250 applies to most buildings (real property), and recaptures "additional depreciation" (i.e., depreciation in excess of straight-line) as ordinary income. For property depreciated only using straight-line, there is generally no ordinary income recapture, but "unrecaptured section 1250 gain" may be taxed at a maximum 25% rate.
Partial Exchange and Recapture:- In a partial 1031 exchange, the amount of gain that must be recaptured as ordinary income under §1250 is limited to the recognized gain (i.e., the boot), not the total realized gain.- The recapture amount is the lesser of (a) the total depreciation taken on the relinquished property, or (b) the recognized gain (boot).- Any remaining unrecaptured depreciation is carried over to the replacement property and may be subject to recapture upon its subsequent disposition.
Example:Suppose a building was purchased for $400,000, $100,000 of which has been depreciated. The building is sold for $500,000, and only $400,000 is reinvested in like-kind property, with $100,000 received as boot. The realized gain is $200,000 ($500,000 - [$400,000 - $100,000 depreciation]). The recognized gain is $100,000 (the boot). The depreciation recapture is the lesser of the depreciation taken ($100,000) or the recognized gain ($100,000), so the entire $100,000 of recognized gain is subject to recapture as unrecaptured section 1250 gain (taxed at up to 25%).
3. Debt Relief as Boot
If the mortgage on the relinquished property exceeds that on the replacement property, the difference is treated as boot and is taxable, even if no cash is received. This is because the IRS treats debt relief as an economic benefit.
4. Reporting and Documentation
- The transaction must be reported on IRS Form 8824, which details the properties exchanged, the amount of boot received, and the calculation of recognized gain and depreciation recapture.
- Proper documentation, including closing statements and exchange agreements, is essential to substantiate the transaction.
5. Summary of Key Points
- In a partial 1031 exchange, only the portion of the gain attributable to boot is recognized and subject to tax.
- Depreciation recapture is limited to the recognized gain (boot) and is taxed as ordinary income (or at the unrecaptured section 1250 gain rate, as applicable).
- Any unrecaptured depreciation not recognized due to the deferral is carried over to the replacement property.
- Debt relief can also constitute boot and trigger recognition of gain and recapture.
- The remainder of the gain (not recognized) and associated depreciation recapture is deferred until the replacement property is disposed of in a taxable transaction.
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