Beware of recapture gain in like-kind exchanges.

A like-kind exchange allows a taxpayer to trade investment or trade or business property for similar property without recognizing any realized gain. Under Regs. Secs. 1.1031(a)-1(b), real property exchanged for real property qualifies as like-kind, regardless of the property's state of improvement. However, it is also important to consider the application of Sec. 1245 and 1250 recapture to the exchange of real property.

Generally, both Secs. 1245(b)(4) and 1250(d)(4) allow the nonrecognition provisions of Sec. 1031 to override the recapture rules, although both sections require that any recapture potential be transferred to the replacement property received in the exchange. Sec. 1245(b)(4) limits the recapture gain attributable to relinquished Sec. 1245 property to the sum of the gain recognized from the exchange and the fair market value (FMV) of any property that is not Sec. 1245 property and that has not otherwise created gain from the exchange. Sec. 1250(d)(4) limits recapture gain to the sum of any gain recognized from the exchange and the excess of the potential recapture gain over the FMV of Sec. 1250 property received in die exchange.

The tax adviser must consider the recapture provisions when advising what type of replacement property should be acquired. The conventional wisdom that the state of improvement of real property is not relevant is not valid when the relinquished property is subject to recapture potential. If, for example, relinquished property has the potential for $100,000 of Sec. 1250 recapture, the taxpayer must acquire at least $100,000 of depreciable realty in the exchange to avoid recognizing recapture; the replacement property must have the potential for absorbing the recapture so that deferred gain retains its proper character.

Sec. 1250 recapture may occur in two general situations. First, if the real property was placed in service before 1987, and if the taxpayer did not elect to use straight-line depreciation, the excess of the depreciation claimed using an accelerated method (175% declining balance for post-1980 acquisitions) over what would have been claimed using the straight-line method is subject to recapture. Second, if die taxpayer takes advantage of the Sec. 108(a)(1)(D) exception from discharge of indebtedness income for qualified real property indebtedness, the resulting Sec. 108(c)(1) reduction in the basis of depreciable real property is treated, pursuant to Sec. 1017(d), as excess depreciation. When Sec. 1250 property is relinquished in an otherwise qualifying like-kind exchange, and excess depreciation creates recapture potential, the taxpayer should acquire depreciable replacement property with an FMV equal to or in excess of the potential recapture.

Example 1: Towns investment real property with an FMV of $1,000,000 and a tax basis of $300,000. The property has Sec. 1250 recapture potential of $100,000. If T exchanges the property for land valued at $900,000 and a depreciable structure valued at $100,000, md die exchange qualifies under Sec. 1031, the Sec. 1250 recapture income will be deferred. Under Sec. 1031(d), the total basis of the replacement property will be #300,000. Under Regs. Sec. 1.1250-3(d)(2)(iii), the basis of the Sec. 1250 property will be zero. This basis allocation ensures that the $100,000 recapture potential carries forward to the replacement property.

Example 1 illustrates that property with Sec. 1250 recapture potential cannot be exchanged for undeveloped land without recognizing the Sec. 1250 gain. However, a more subtle application of the recapture rules to otherwise qualifying like-kind exchanges occurs when the relinquished property is nonresidential realty placed in service before 1987 for which the straight-line method of cost recovery was not used. Prior to amendment by P.L. 99-514, Sec. 1245(a)(5) defined Sec. 1245 property to include nonresidential real property for which the straight-line method was not used. The Sec. 1245 recapture rules still apply to such property. The Sec. 1245 recapture must be recognized in the year of the exchange if none of the replacement property qualifies as Sec. 1245 property.

Example 2: J purchased nonresidential real property in january 1985 for $1,000,000. He properly allocated $800,000 to the depreciable structure and $200,000 to the land on which the structure was situated. By 1996, J claimed $568,000 of cost recovery deductions, which will be recaptured under the Sec. 1245 rules. If the property is now worth $2,000,000, and J wants to acquire like-kind replacement property to defer the $1,568,000 realized gain, he cannot simply acquire any depreciable real property. If J acquires $2,000,000 of residential realty, or nonresidential realty placed in service after 1986 (and therefore Sec. 1250 property), he will be required to recognize the $568,000 Sec. 1245 depreciation recapture.

The interaction of the depreciation recapture rules with Sec. 1031 complicates the role of the tax adviser in a likekind exchange. It not enough to simply state that real property may be exchanged for real property, without considering the state of improvement of such properties and the potential for either Sec. 1245 or Sec. 1250 recapture. In particular, recapture is difficult to avoid when the relinquished property is nonresidential real property that qualifies as Sec. 1245 property.