How Basis Works in Like-Kind Exchanges and Installment Sales

Your basis in property received through a like-kind exchange carries over from the property you gave up, adjusted for cash, debt relief, and any gain or loss recognized in the transaction. In an installment sale, you recover that basis a piece at a time: each principal payment is split between taxable gain and a tax-free return of basis using a fixed gross profit ratio. Basis in like-kind exchanges and installment sales works differently in mechanics but shares one consequence: an error at the start compounds through every future depreciation deduction and every eventual sale.

Basis in a 1031 Like-Kind Exchange

The replacement property’s basis starts with the adjusted basis of the property you gave up. From there, the statute layers on adjustments designed to keep the deferred gain locked inside the new asset.¹

Decrease the carried-over basis by:²

Cash you received in the exchange.
Liabilities on the relinquished property that the other party assumed, or that were paid off during a deferred exchange.
Any loss recognized on non-like-kind property you gave up.

Increase the basis by:

Additional cash you paid or costs you incurred to complete the exchange.
Liabilities you took on with the replacement property, including new debt.
Any gain you were required to recognize on the exchange.

The statute treats a liability the other party assumes as money received, so mortgage relief acts the same as a check in your pocket. The resulting number is what you use to depreciate the replacement property and to compute gain if you eventually sell it outright.

How Boot Changes the Math

Anything you receive in the exchange that is not like-kind real property counts as boot: cash, personal property, or net debt relief. Boot forces gain recognition, but the recognized gain is capped at the total boot received, so you never pay tax on more than the non-like-kind value you actually took out.³

Any gain recognized because of boot gets added back to the replacement property’s basis. That addition is what keeps you from being taxed twice on the same dollars when you later sell. The boot itself reduces basis on the other side of the ledger. In most exchanges these two adjustments partially offset, leaving a replacement basis somewhere between the old property’s adjusted basis and the new property’s fair market value.

Basis Recovery in an Installment Sale

An installment sale is any disposition where at least one payment arrives after the close of the tax year of the sale.⁴ Instead of paying tax on the full gain in year one, you spread it across the payment years using a gross profit ratio. That ratio is what divides each principal dollar into taxable gain and tax-free return of basis.

Gross Profit

Subtract your adjusted basis and all selling expenses (commissions, legal fees, transfer taxes) from the selling price. The selling price is the full amount the buyer agreed to pay, without reducing it for any existing mortgage the buyer assumes.⁵ The result is your gross profit, the total gain you will report over the life of the note.

Contract Price and the Gross Profit Ratio

Divide gross profit by the contract price to get your ratio. Contract price usually matches selling price, but when the buyer assumes an existing mortgage, contract price equals selling price minus the portion of the assumed mortgage that does not exceed your adjusted basis.⁶

Apply the ratio to the principal portion of every payment. A 40% ratio means 40 cents of each principal dollar is taxable gain and 60 cents is tax-free return of basis. Interest is taxed separately as ordinary income and stays out of this calculation.⁵ The ratio is fixed for the life of the note unless the contract price is renegotiated. Each year’s numbers go on Form 6252.⁷

When the Buyer’s Mortgage Exceeds Your Basis

The math shifts when the buyer takes over a mortgage larger than your adjusted basis. The excess above basis is treated as a payment received in the year of sale, taxable immediately whether or not the buyer has written you a check.⁵

Contract price also changes: subtract the mortgage from the selling price, then add back the amount by which the mortgage exceeds basis. Once the mortgage equals or exceeds basis, the gross profit ratio hits 100%. Every dollar of principal you collect after that is fully taxable, because the mortgage relief already returned your entire basis at the start. This scenario is common with heavily leveraged or heavily depreciated property, and it strips away most of the deferral you might have expected.

Depreciation Recapture Bites First

Recapture is the piece sellers most often miscalculate. Neither transaction lets you fully defer it.

Installment Sale Recapture

Depreciation recapture under Section 1245 or Section 1250 is fully taxable in the year of the sale, even if you receive no payments that year.⁸ Recapture cannot be spread across future payments the way capital gain can. You compute the recapture on Part III of Form 4797 and carry it to line 12 of Form 6252.⁹ That recapture also reduces the remaining gain that flows through the gross profit ratio, so you aren’t taxed twice on the same dollars. The upfront tax still catches sellers off guard when they built the deal around full deferral.

Recapture in a 1031 Exchange

A like-kind exchange does not switch off recapture. If the relinquished property carries Section 1245 or Section 1250 recapture, some of that gain may need to be recognized as ordinary income even while the balance is deferred. For real property with Section 1250 recapture, the amount recognized is capped at the greater of the gain otherwise recognized on the exchange or the recapture amount reduced by the fair market value of Section 1250 property received.¹⁰ Trade into replacement property valuable enough to absorb the recapture and most of it can be deferred; take significant boot and recapture exposure grows. Form 8824 has a specific line for this ordinary income recapture.¹¹

Imputed Interest on Seller-Financed Notes

An installment contract that charges little or no interest triggers Section 483. When payments come due more than a year after the sale and the stated rate falls below the applicable federal rate, the IRS treats the shortfall as unstated interest and recalculates the present value of the payments using the AFR as the discount rate. The gap between the face amount and that present value becomes imputed interest.¹²

That reclassification shrinks the amount treated as principal, which reduces the selling price for installment purposes, which changes your gross profit and your ratio. Sales totaling $3,000 or less are exempt. Everyone else avoids the problem by charging at least the AFR the IRS publishes each month.

Related Party Rules That Can Undo Your Basis Position

Both transactions have anti-abuse rules for deals between related parties, and both work by yanking your deferral if the property moves too soon.

Like-Kind Exchange Two-Year Rule

In a 1031 exchange with a related party, both sides must hold the exchanged properties for at least two years after the last transfer. An earlier disposition by either party retroactively disqualifies the exchange, and the deferred gain becomes taxable as of the date of that early disposition.¹³ Exceptions cover death, involuntary conversion, and cases where the IRS is satisfied tax avoidance was not a principal purpose. Structures designed to sidestep the two-year hold are disqualified outright.

Installment Sale Acceleration

Sell property to a related party on the installment method, and if that party resells within two years, the amount realized on the second sale is treated as if you received it when the resale happened.¹⁴ Your gain accelerates and your deferral collapses. The same exceptions apply. For marketable securities sold to a related party there is no time limit at all. The two-year clock also pauses during any period the related buyer has hedged away the risk of loss through a put, a short sale, or a similar position.

Related party covers a wide field: family (siblings, spouses, ancestors, lineal descendants), controlled entities, and the other relationships pulled in through the attribution rules of Sections 267(b) and 707(b)(1).

Reporting the Numbers

A like-kind exchange goes on Form 8824. The form captures fair market value and adjusted basis of both properties, identification and receipt dates, any non-like-kind property given or received, recognized gain or loss, and the replacement property’s resulting basis.¹¹ Deferred exchanges require identification of replacement property within 45 days and receipt within the earlier of 180 days or the return due date including extensions; miss either and the exchange fails and gain is fully taxable.¹⁵

An installment sale runs through Form 6252 each year until the note is paid off. Keep the qualified intermediary’s settlement statements, closing disclosures on both properties, your most recent depreciation schedule, and any appraisals. Those are the objective inputs the IRS asks for if the calculations are questioned, and they are what let you rebuild a basis figure years after the fact.

1
Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment – Section: (d) Basis
2
Internal Revenue Service. Publication 551 – Basis of Assets
3
Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment – Section: (b) Gain From Exchanges Not Solely in Kind
4
Office of the Law Revision Counsel. 26 USC 453 – Installment Method – Section: (b) Installment Sale Defined
5
Internal Revenue Service. Publication 537 – Installment Sales – Section: Figuring Installment Sale Income
6
eCFR. 26 CFR 15a.453-1 – Installment Method Reporting for Sales of Real Property and Casual Sales of Personal Property
7
Internal Revenue Service. About Form 6252, Installment Sale Income
8
Internal Revenue Service. Topic No. 705, Installment Sales
9
Internal Revenue Service. Form 6252 – Installment Sale Income
10
Internal Revenue Service. Publication 544 – Sales and Other Dispositions of Assets
11
Internal Revenue Service. Instructions for Form 8824
12
Office of the Law Revision Counsel. 26 USC 483 – Interest on Certain Deferred Payments
13
Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment – Section: (f) Special Rules for Exchanges Between Related Persons
14
Office of the Law Revision Counsel. 26 USC 453 – Installment Method – Section: (e) Second Dispositions by Related Persons
15
Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment – Section: (a)(3) Identification and Completion Requirements