My wife and I own two rental properties in Maryland with my brother and his wife who are New York residents. Each couple owns an undivided half share. Is there some way we could do an exchange without paying capital gains taxes so that we would take full ownership of one property and they would take the other? I guess if there was a difference in value, we could handle that between us as a side arrangement. Actually, the properties are probably pretty close to each other in value, so it would not have the appearance of an outlandish transaction. A second part to this question: If the exchange could be done, and as a result, each couple acquired the other half of the property, could each couple then begin to take depreciation on that half (since it is new to them), assuming of course these were still operated as rental properties? To handle the exchange transaction, if it can be done, do we need a good real estate agent or a tax attorney, or both?
An exchange of "like-kind" property, including real estate, is accorded special tax treatment under Section 1031 of the Internal Revenue Code. The property transferred and the property received by the taxpayer must be held for either use in a trade or business or for investment. The proposed exchange with your brother and his wife clearly qualifies as an exchange of like-kind property. The property interest transferred and received by each taxpayer is rental property, which qualifies as held for investment.
Your plan also qualifies as an exchange since there is a reciprocal transfer of property, rather than a transfer of property solely for money.
Section 1031 allows for non-recognition of gain to the extent that the market value of like-kind property received exceeds the tax basis of the property transferred. For example, assume the tax basis of the property you transfer is $20,000. The fair market value of the property interest you receive is $50,000. The gain of $30,000 on this exchange is not recognized for tax purposes.
If you receive cash or non-like-kind property as part of the exchange, gain will be recognized as to the cash received. Therefore, any cash one of you receives from the other will be treated as "boot" and should be recognized as capital gain on the recipients' income tax return.
You also may recognize gain if one or both parties to the exchange will take the property subject to an existing mortgage. The mortgage indebtedness is treated as cash received. Section 1031 provides relief where each party assumes a mortgage on the property received or takes subject to a mortgage. The amount of the mortgage on the property treated as cash is reduced by the amount of mortgage assumed or taken by the taxpayer.
There is a more restrictive test for like-kind property exchanges between related persons, including brothers. Non-recognition of gain will be lost if the related person disposes of the property received in exchange before the date two years after the date of the last transfer which was part of the exchange.
With respect to depreciation on the property received in a like-kind exchange, unique rules apply for determining the tax basis of the property. Essentially, the basis of the property transferred is carried over as the basis of the property received, adjusted for any cash paid or received, plus any gain recognized on the transaction. Your accountant can determine the new basis for property received.
Before exchanging property, the parties should review the entire transaction with their real estate attorney and tax adviser to fully understand the tax aspects and to make sure they comply with all the rules and regulations of the Internal Revenue Code.
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