Form 8824 is the part of an investor’s tax return that contains 1031 exchange transaction information. Section III of the form determines the net results of the transaction (gain or loss). This section is the 1031 exchange transaction and how the IRS receives information about the transaction’s gain or loss for tax reasons.
Section III tends to trip people up because of its fair market value (FMV) and adjusted cost basis calculations. While Section III may be intimidating, over half of the lines are just simple adding and subtracting. For the rest, that’s where we need to get the FMV, cost basis, cash received, and net liabilities received by the other party. In this article, we’ll focus on two lines in particular — 15 and 16. By the end, you should hopefully have a much better grasp of Section III.
Lines 15 and 16
Lines 15 and 16 states the following:
15 Cash received, FMV of other property received, plus net liabilities assumed by other party, reduced (but not below zero) by any exchange expenses you incurred. See instructions . . .
16 FMV of like-kind property you received
The see instructions refer to Form 8824 instructions. Line 15 is a matter of adding and subtracting the above components. Let’s look at an example:
$400,000 – Relinquished property
$200,000 – Tax Basis
$20,000 – Closing Costs
$30,000 – Cash Received at Closing
$455,000 – Replacement property
$30,000 – Closing Costs
Total gain: = $190,000 = 400,0000 - 200,000 - 10,000
Because $15,000 was taken out of the 1031 transaction (cash back to investor), only $175,000 of gains can be deferred. The $15,000 is considered boot and goes on line 15. Line 15 is really the value of boot, which includes the components mentioned earlier.
Boot is taxable, which is why it is removed from the exchange transaction. Debt reduction can also create boot. This can happen when a property owner trades down in a 1031 exchange (i.e., trading to a lesser value property). Rent prorations can also generate boot if not handled carefully.
As another example:
$350 — Personal property
- $200 — prorated property taxes
= $150 — exchange expense total
The $150 goes on line 15.
Line 16 will contain the FMV of the like-kind property that the investor is acquiring. Generally, the FMV is the “purchase price” of this real estate.
Using earlier numbers, the purchase price of the replacement property is $455,000. That is the amount that goes on line 16.
Fair Market Value
Where do you find FMV? It can be found on the sales contract. Keep in mind that the sales contract doesn't factor in debt and other like-kind components.
Finding the FMV for direct property can be more difficult. The QI (qualified intermediary) should have the closing statement, but investors can’t always depend on the QI to extract the right FMV. For those reasons, investors should work with their real estate attorney and tax accountant.
Investors generally don’t have to worry about filling out tax forms. But understanding them provides insight into exactly how taxes impact gains. It’s the accountant’s job to ensure Form 8824 is filled in correctly, which is why it is worth working with a knowledgeable real estate accountant.