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 with His Son and Subsequent Sale of the Land to a Real Estate Agent:
To calculate Carlton’s realized gain or loss on the exchange, we first need to establish the realized gain from the exchange and then calculate the recognized gain on that exchange.
- Realized Gain:
The realized gain is the difference between the fair market value (FMV) of the land received and Carlton’s adjusted basis in the land given up. $$
\text{Realized Gain} = \text{FMV of Land Received} – \text{Adjusted Basis of Land Given}
$$ The FMV of Carlton’s son’s land is \$320,000, and his adjusted basis in the land he gave up is \$200,000. $$
\text{Realized Gain} = 320,000 – 200,000 = 120,000
$$ - Recognized Gain:
Since Carlton is exchanging land with his son, this is likely a like-kind exchange under Section 1031 of the Internal Revenue Code (IRC). For like-kind exchanges, gain is generally not recognized immediately. However, the gain will be deferred, and the recognition of gain occurs only when the new property is eventually sold. For this transaction, Carlton will not recognize the gain immediately and will instead defer it. - Subsequent Sale of the Land to the Real Estate Agent:
On July 19, 2022, Carlton sells the land for \$375,000. Since the gain from the exchange with his son was deferred, the gain is recognized at the time of the sale. $$
\text{Recognized Gain} = \text{Sale Price} – \text{Basis of New Land}
$$ The basis of the land Carlton received from his son is determined by his original basis in the land exchanged, which is \$200,000, adjusted for any deferred gain. Carlton’s recognized gain from the sale is: $$
\text{Recognized Gain} = 375,000 – 200,000 = 175,000
$$
B. Realized and Recognized Gain or Loss if Carlton Does Not Sell the Land and His Son Sells the Land:
In this case, Carlton does not sell the land he received from his son, but his son sells the land Carlton gave him. The gain Carlton realized on the exchange is deferred, and he does not recognize any gain until he sells the land.
- Carlton’s Realized Gain on the Exchange:
As calculated in Part A, Carlton’s realized gain on the exchange is \$120,000. Since Carlton has not sold the land, this gain is deferred. - Carlton’s Basis for the Land on November 1, 2021:
Carlton’s basis in the land received from his son is equal to the adjusted basis of the land he gave up, which is \$200,000. However, since the exchange is a like-kind exchange, the gain of \$120,000 is deferred and added to the basis. Therefore, Carlton’s basis in the land received on November 1, 2021, is: $$
\text{Basis in Land Received} = 200,000 + 120,000 = 320,000
$$ - Carlton’s Basis for the Land on July 19, 2022:
The basis will remain \$320,000 on July 19, 2022, unless there are further changes (e.g., improvements or depreciation). Therefore, Carlton’s basis does not change unless he sells the land or makes adjustments like improvements.
C. How Carlton Could Avoid Any Recognition of Gain Prior to His Sale of the Land:
To avoid recognition of gain prior to the sale of the land, Carlton could ensure that the transaction qualifies as a “like-kind exchange” under IRC Section 1031. Under the like-kind exchange provisions, if Carlton exchanges property for property of a similar kind, the gain is deferred until he disposes of the property received in the exchange.
However, the exchange must meet certain requirements:
- The properties exchanged must be of like-kind (which they are, as both properties are real estate).
- The transaction must not involve the exchange of property with a related party unless it falls under exceptions (such as a business exchange).
- If the transaction is between related parties, like Carlton and his son, the like-kind exchange rules prevent gain deferral unless the property is not sold for at least two years after the exchange.
To avoid recognition of gain, Carlton could:
- Ensure that the exchange qualifies as a tax-deferred like-kind exchange.
- Delay the sale of the land received until the two-year holding period requirement is met.
By following these steps, Carlton would be able to defer recognition of any gain until he sells the land at a later time, thus postponing any tax liability.