When in the course of the 1031 tax exchange, it becomes necessary for one party (that of the exchanger) to notify the federal government of its activities, IRS Form 8824 is required. Its purpose is two fold: 1). Ensure the IRS is notified of the exchange in the tax year “in which the first relinquished property is transferred” and 2.) Ensure a “substituted” rather than a “transferred (or carry over)” basis is recorded by the IRS. This second point is of extreme importance as it redefines the taxable basis of the replacement property.
There are two types of basis encountered in the common tax terminology, “substituted basis” and “carryover (or transferred basis)”. In a carryover basis, the basis the property will hold is based on the previously transferred property and cannot be affected by any new capital investment. So if Thomas exchanges a property with a $100K basis, $400K in capital gains and $100K in new capital for one of $600K, the IRS will see the new property has having a basis of $100K.
This perception is incorrect. Section 1031 only embraces a “substituted basis”.
In a “substituted basis” any extra capital invested is added to the previous basis. So in the above example, Thomas would end up with a basis of $200K (the original $100K basis plus the $100K of new capital). This can drastically affect depreciation schedules, altering investment planning and potentially allowing clients to put more money in their pockets.
It is unfortunate that the misconception of a “carryover” basis has become widespread in the 1031 tax exchange community because it hinders further investment. If one was given the choice of investing in two properties both with the same basis but one which required an extra $100K of capital investment, the cheaper alternative would almost invariably be chosen. However, if one knew that $100K in extra capital would create a $100K in depreciable basis, they may be more likely to choose the larger investment. The substituted basis is a rare tool provided by the IRS to encourage investment but in order to function one must know about it.
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There are two types of basis encountered in the common tax terminology, “substituted basis” and “carryover (or transferred basis)”. In a carryover basis, the basis the property will hold is based on the previously transferred property and cannot be affected by any new capital investment. So if Thomas exchanges a property with a $100K basis, $400K in capital gains and $100K in new capital for one of $600K, the IRS will see the new property has having a basis of $100K.
This perception is incorrect. Section 1031 only embraces a “substituted basis”.
In a “substituted basis” any extra capital invested is added to the previous basis. So in the above example, Thomas would end up with a basis of $200K (the original $100K basis plus the $100K of new capital). This can drastically affect depreciation schedules, altering investment planning and potentially allowing clients to put more money in their pockets.
It is unfortunate that the misconception of a “carryover” basis has become widespread in the 1031 tax exchange community because it hinders further investment. If one was given the choice of investing in two properties both with the same basis but one which required an extra $100K of capital investment, the cheaper alternative would almost invariably be chosen. However, if one knew that $100K in extra capital would create a $100K in depreciable basis, they may be more likely to choose the larger investment. The substituted basis is a rare tool provided by the IRS to encourage investment but in order to function one must know about it.
