Carlton holds undeveloped land for investment. His adjusted basis in the land is $200,000, and the FMV is $325,000. On November 1, 2021, he exchanges this land for land owned by his son, who is 31 years old. The appraised value of his son’s land is $320,000 with a basis of $310,000.
A. Calculate Carlton’s realized and recognized gain or loss from the exchange with his son and on Carlton’s subsequent sale of the land to a real estate agent on July 19, 2022, for $375,000.
B. Calculate Carlton’s realized and recognized gain or loss from the exchange with his son if Carlton does not sell the land received from his son, but his son sells the land received from Carlton on July 19, 2022. Calculate Carlton’s basis for the land on November 1, 2021, and July 19, 2022.
C. What could Carlton do to avoid any recognition of gain associated with the first exchange prior to his sale of the land?
The correct answer and explanation is :
A. Carlton’s Realized and Recognized Gain or Loss from the Exchange and Subsequent Sale
In an exchange of property where there is no immediate sale (like a like-kind exchange), gain or loss may be realized but not necessarily recognized, depending on the specifics of the exchange and the relationship between the parties involved.
Realized Gain from the Exchange:
- Adjusted Basis of Carlton’s Land: \$200,000
- FMV of the Land Carlton Receives (from his son): \$320,000
Realized Gain = FMV of the received property – Adjusted basis of the exchanged property
Realized Gain = \$320,000 – \$200,000 = \$120,000
Recognized Gain:
Under IRC Section 1031, if the exchange is a like-kind exchange, then Carlton may not recognize any gain at the time of the exchange, but he still realizes the gain.
However, an exchange between related parties (as here, since Carlton is exchanging property with his son) is subject to special rules. If the property is exchanged between family members (such as a parent and child), the IRS requires that any gain be recognized immediately (i.e., no deferral of gain).
Since the exchange is between a parent and a child, Carlton must recognize the \$120,000 gain at the time of the exchange, and this is taxable income in the year of the exchange, 2021.
Gain from the Subsequent Sale:
- Adjusted Basis of the New Land (after exchange): The basis of the land Carlton receives from his son is the same as his basis in the land he exchanged, \$200,000.
- Selling Price on July 19, 2022: \$375,000
Realized Gain from Sale = Selling price – Adjusted basis of the land received
Realized Gain from Sale = \$375,000 – \$200,000 = \$175,000
Carlton will recognize this gain when he sells the land.
Total Recognized Gain in 2021:
- Gain from exchange: \$120,000
- Gain from sale in 2022: \$175,000
Total Recognized Gain = \$120,000 + \$175,000 = \$295,000
B. Carlton’s Realized and Recognized Gain if He Does Not Sell the Land
Realized and Recognized Gain from Exchange:
- Realized Gain: \$120,000 (calculated the same way as above, the exchange between related parties requires gain recognition).
- Recognized Gain: Since it’s a related-party transaction, Carlton must recognize the gain at the time of exchange. Therefore, Carlton recognizes the \$120,000 gain immediately.
Basis of Land Received:
- Adjusted Basis of Land Received (on November 1, 2021): Carlton’s basis in the new land will be the same as his adjusted basis in the land he exchanged, which is \$200,000.
Basis of Land on July 19, 2022:
If Carlton doesn’t sell the land he received from his son by July 19, 2022, the basis remains the same at \$200,000.
C. Avoiding Recognition of Gain Prior to Sale of the Land
To avoid recognition of the gain on the exchange, Carlton would need to structure the exchange differently. The key to deferring recognition of gain in like-kind exchanges is ensuring that the exchange meets the requirements of IRC Section 1031.
For a valid like-kind exchange, Carlton should:
- Ensure the exchange qualifies under IRC Section 1031: The exchange must involve like-kind properties (real estate for real estate). The land exchanged must be held for investment or business purposes.
- Avoid exchanging property with a related party: The special rule for related-party transactions (which includes exchanges between parents and children) causes gain to be recognized immediately. If Carlton exchanges the property with an unrelated party, the gain could be deferred, meaning Carlton wouldn’t recognize the gain until he sold the new property.
In essence, to defer the gain, Carlton should not exchange property with his son. Instead, he could look for an exchange with an unrelated party. By doing so, he would meet the requirements for a like-kind exchange under IRC Section 1031, allowing him to defer the gain until the new property is sold.