1031 Exchange Guide for CPAs: Reporting, Basis Tracking and the DST Questions Clients Ask

Form 8824 belongs to the year of the sale, and a related-party exchange keeps it on the return for two more years

The Instructions for Form 8824 say the form is filed with the return for the tax year in which the client transferred property in a like-kind exchange, and again for the two years following the year of a related-party exchange. Line 7 defines related parties to include a spouse, child, grandchild, parent, grandparent, brother or sister and related entities, and treats an exchange through an intermediary or a disregarded entity as an indirect exchange with that party.

Part III computes the recognized gain and the basis of what was received. Lines 25a through 25c then allocate that basis among section 1250 property, section 1245 property and intangibles, in proportion to fair market value. When a client used several replacements, or a building plus DST interests, Form 8824 with multiple properties or DSTs covers the summary-form and attachment rules.

A sale in the last months of the year with a replacement in the next creates a reporting question if the exchange fails or leaves cash; 1031 exchanges that straddle two tax years covers the installment treatment and the return-due-date limit on the exchange period.

The replacement basis runs on two depreciation schedules unless the client elects out

Reg. section 1.168(i)-6 splits the replacement's basis into exchanged basis, which carries over from the relinquished property, and excess basis, defined as any basis under section 1031(d) above the exchanged basis. The depreciable exchanged basis 'is depreciated over the remaining recovery period' of the relinquished property, and if the replacement's own recovery period is shorter, the old period still governs. The regulation's office-building example treats the depreciable excess basis 'as being placed in service' in the year of replacement, under the method, recovery period and convention for the new property.

Hypothetical: a client's old rental building has $200,000 of adjusted depreciable basis with 17.5 years left on its 27.5-year schedule. After the exchange, $200,000 of the replacement building's basis keeps running over those 17.5 years and the other $400,000, funded with new debt and cash, starts a fresh 27.5-year schedule. That is two lines on Form 4562 and in the fixed-asset ledger for one property; the figures are hypothetical, so run the client's own numbers.

Paragraph (i)(1) lets the taxpayer elect not to apply the section and treat the whole basis as newly placed in service. The election applies to both the relinquished and the replacement property and only for the electing taxpayer, so decide it with the return for the replacement year. If cost segregation is planned for the excess basis, cost segregation and the 1031 covers the interaction.

Keep the old property's records until the new property's statute closes, because the basis chain depends on them

The IRS records guidance says that when property is received in a nontaxable exchange, the taxpayer must keep 'the records on the old property, as well as on the new property, until the period of limitations expires for the year in which you dispose of the new property.' For a client on a third or fourth exchange, that can mean purchase documents from decades ago.

Build a one-page basis roll-forward for each exchange: adjusted basis of the property given up, money and debt relief received, money paid and new debt, gain recognized, and the resulting section 1031(d) basis. Basis in replacement property after a 1031 has the formula and the Form 8824 line references.

State conformity is where clients get surprised: some states follow the deferred gain out of state

California is the clearest case. The Form FTB 3840 instructions require the form for exchanges of California property for out-of-state like-kind property, filed 'for the taxable year of the exchange and for each subsequent taxable year, generally until the California sourced deferred gain or loss is recognized.' If the taxpayer neither files the form nor a return, the FTB may estimate income and assess tax, penalties and interest.

A DST portfolio can also spread the client's rental income across several states, each with its own nonresident filing threshold. Does a 1031 defer state capital gains tax summarizes state treatment, and DST multi-state tax issues covers the filings that follow a trust's properties.

DST questions: no K-1, taxable income is not the cash received, and the trustee's statement drives Schedule E

Rev. Rul. 2004-86 treats each DST owner as a grantor who 'is considered to own the trust assets attributable to that undivided fractional interest,' so income, deductions and credits flow to the owner under section 671. Under Reg. section 1.671-4, a grantor trust's items are shown on a statement rather than reported by the trust, and the trustee must furnish the owner a statement showing all items of income, deduction and credit for the year.

Two follow-ups are worth asking the sponsor each year. First, whether the depreciation on the statement is computed on the trust's cost, because the client's own deduction runs from the client's exchanged and excess basis. Second, for a zero-cash-flow trust, what the projected taxable income is, since loan principal paid from rent is not deductible even when no cash reaches the owner. DST tax forms and reporting goes further.

When a client asks you whether a DST suits them, the investment recommendation has to come from a registered representative or adviser. Send them to us with the deferred gain, the debt to replace and the deadline, and we will return a written proposal you can review.