Relinquished Property: The property(ies) sold by an exchanger and the proceeds for which are held by the Qualified Intermediary.
Replacement Property: The property(ies) purchased with the proceeds from the sale of the relinquished property.
Qualified Intermediary (QI): An unrelated third-party (person or entity) who, pursuant to an exchange agreement, acquires the relinquished property from the Taxpayer and sells it to the Buyer; holds the proceeds from the sale of the relinquished property on behalf of the Taxpayer; and acquires and sells the replacement property to the Taxpayer in order to complete the exchange.
Safe Harbors: The guidelines, or procedures, created by the IRS in order to ensure that an exchange satisfies IRS scrutiny and survives an audit.
The safe harbors for a standard exchange include:
Proceeds held by an intermediary not related to, or an agent of, the taxpayer
An identification of replacement property, submitted in writing to the QI by the end of the 45th day after closing on the relinquished property.
Closing on all replacement properties by the end of 180 days after the first closing on relinquished property, and disbursement by the QI of all proceeds held.
Boot: Any property, cash, cash equivalent, or non-like-kind gain that the exchanger receives in an exchange. "Cash boot" is recognized to the extent of cash or other thing of value received; "mortgage boot" exists to the extent of any liabilities assumed or forgiven in the exchange. Capital gains taxes must be paid on boot, to the extent that it exceeds realized gain.
Proceeds: The net funds resulting from the sale of property held by the QI for the benefit of the exchanger pursuant to the exchange agreement.
Taxpayer/Exchanger: The person or entity conducting the exchange and responsible for filing the appropriate tax return and forms.
Buyer: The person or entity who purchases from the Taxpayer the relinquished property.
Seller: The person or entity who sells to the Taxpayer the replacement property.
Basis: A Taxpayer's basis in property is normally the purchase price of the property; in other words, the basis in the relinquished property is considered to be what the Taxpayer paid for the property when it was purchased. Determining basis correctly is the first step in evaluating the financial benefit of entering into an exchange. In order to have an exchange that fully defers all capital gains, the basis in the replacement property should be equal to or greater than the basis in the relinquished property.
Basis in the replacement property must be calculated in addition to calculating basis in the relinquished property. The adjusted basis in the relinquished property is carried over and to that figure is added additional debt (if any) in the replacement property.
Adjusted Basis: the figure calculated when the cost of capital improvements is added to, and depreciation eligible to be claimed subtracted from, the original basis in the relinquished property. Determining Adjusted Basis in the relinquished property is the second step to calculating the value of an exchange.
Gain Realized: the difference between the purchase price the Buyer pays for the Relinquished Property and the Taxpayer's adjusted basis in the property. Any transactional costs to the Taxpayer (real estate commissions, attorney's fees, etc.) are subtracted from realized gain.
Gain Recognized: that portion of realized gain that is taxable. Realized gain is taxable only when it is recognized, generally in the same calendar year it was realized. In an exchange, gain is recognized in the amount of boot received (if any) or gain realized, whichever is less. The only way to fully defer proceeds, and recognize no gain, is to purchase replacement property that has a fair market value equal to or greater than that of the relinquished property; have as much or more equity in the replacement property as in the relinquished property; and receive no boot. To avoid recognizing gain in an exchange, Taxpayers should always trade up in equity and value.
Here is an example of these figures:
Taxpayer purchases Property A in 1990 for $300,000, $150,000 of which was paid in cash and the remainder (also $150,000) was a mortgage. Taxpayer spent $50,000 making structural repairs to the property, and claimed $30,000 in depreciation on tax returns.
Basis in Property A = $300,000
Adjusted Basis in Property A:
+ Capital improvements + 50,000
Depreciation - 30,000
ADJUSTED BASIS $320,000
Taxpayer is selling Property A to Buyer for $500,000 and wants to purchase Property B for $750,000 as replacement property. Taxpayer does not have sufficient cash on hand to purchase Property B and will take out a lone for $350,000 to make up the difference.
Gain Realized in sale of Property A:
Consideration received $500,000
basis - 320,000
GAIN REALIZED $180,000
Basis in Property B:
Adj. basis in A $320,000
+ Add. debt on
BASIS in B $670,000
Taxpayer had a $150,000 mortgage on Property A, which is now considered "boot received" because that debt no longer exists. Offset against that is "boot given," or the new mortgage in the amount of $350,000, so Taxpayer does not need to declare any boot as gain recognized.