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 :
Here is the analysis for each part of the question:
A. Carlton’s Realized and Recognized Gain or Loss (Carlton sells land received from son)
- Adjusted basis in original land: \$200,000
- FMV of son’s land received: \$320,000
- Realized gain = FMV received – Adjusted basis
= \$320,000 – \$200,000 = \$120,000
Because this is a related-party exchange, §1031 (like-kind exchange) does not apply to related-party exchanges if either party disposes of the property within 2 years. Carlton sells the land on July 19, 2022, which is within 2 years, so the nonrecognition does not apply.
- Recognized gain on exchange: \$120,000
- On July 19, 2022, sale for \$375,000
- New basis: \$320,000 (the FMV of land received)
- Gain = \$375,000 – \$320,000 = \$55,000
✅ Final Answer A:
- Realized gain from exchange: \$120,000
- Recognized gain from exchange: \$120,000
- Recognized gain from sale: \$55,000
B. Carlton holds land; Son sells land received from Carlton
- Because the son sells the land within 2 years, §1031 nonrecognition is disallowed.
- Therefore, Carlton’s exchange triggers recognition:
- Realized gain = \$320,000 – \$200,000 = \$120,000
- Recognized gain = \$120,000
- Carlton’s basis in land received (Nov 1, 2021): FMV = \$320,000
- Carlton’s basis on July 19, 2022 (no sale by Carlton): still \$320,000
✅ Final Answer B:
- Realized and recognized gain: \$120,000
- Carlton’s basis: \$320,000 on both Nov 1, 2021, and July 19, 2022
C. How to avoid gain recognition in first exchange
Carlton could avoid gain recognition by ensuring neither he nor his son disposes of their respective properties within 2 years of the exchange. Under IRC §1031(f)(2)(C), a related-party like-kind exchange can qualify for nonrecognition if both parties retain their properties for at least 2 years.
Explanation (300 words):
Under Internal Revenue Code §1031, a like-kind exchange allows taxpayers to defer recognition of gain on exchanges of business or investment property for similar property. However, §1031(f) places restrictions on exchanges between related parties, including family members, to prevent abuse of the deferral provisions. Specifically, if either party disposes of the property within 2 years of the exchange, the deferred gain becomes taxable.
In Carlton’s situation, he exchanged investment land with his son. While this could qualify for nonrecognition under §1031, both parties must hold the properties for at least 2 years to preserve the deferral. If either party sells their newly acquired property before the 2-year mark—as happened when Carlton sold the land in July 2022—the entire gain from the exchange becomes recognized in the year of the sale.
To avoid recognizing the \$120,000 gain, Carlton should not have sold the land within 2 years of the exchange date. By holding the land until at least November 2, 2023, both parties would meet the 2-year holding requirement under §1031(f), allowing the gain to remain deferred. This strategy is commonly used by real estate investors to manage tax liabilities by deferring income until a more favorable time or potentially indefinitely through future exchanges.
In short, Carlton could have avoided recognizing gain by simply holding the land for at least two years post-exchange, thus complying with §1031 related-party rules.