Beware of recapture gain in like-kind exchanges.

• Author: Hamill, James R.

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...