1038 Tax Exchange: Rules for Real Property Reacquisition

When a seller finances the sale of real estate and the buyer defaults, Internal Revenue Code (IRC) Section 1038 provides specific rules for the reacquisition. This provision is a nonrecognition rule, not an exchange, that governs the tax consequences for the seller. Instead of treating the reacquisition as a new purchase, it provides a framework for unwinding the original sale. This limits the immediate gain a seller must recognize and dictates how to calculate that gain and the property’s new basis.

Qualifying for Section 1038 Treatment

Application of Section 1038 is mandatory, not elective, if certain conditions are met. The primary requirement is that the transaction must involve the reacquisition of real property, such as land and buildings. This provision does not extend to personal property that might have been included in the original sale.

The taxpayer reacquiring the property must be the original seller. The reacquisition must also occur because the seller is enforcing their security rights in the property. This means the seller must have carried back a note or other debt from the buyer that was secured by the real property itself. Finally, the seller must take back the property in partial or full satisfaction of that debt, regardless of whether it is through foreclosure or a voluntary conveyance.

Calculating the Recognized Gain on Reacquisition

When a seller reacquires property under Section 1038, they may have to recognize a limited amount of gain, but the law prevents the recognition of any loss. The recognized gain is calculated as the lesser of two specific amounts. The first is the total cash and the fair market value of any other property the seller received from the buyer, less any gain from the original sale that the seller has already reported as income.

The second calculation acts as a ceiling on the recognized gain. This amount is the total gain the seller realized on the original sale, reduced by both the amount of gain already reported as income and any costs the seller paid to reacquire the property. These reacquisition costs can include legal fees, court costs, or other expenses directly related to taking back the property.

To illustrate, assume a seller sold property with a basis of $150,000 for $250,000, realizing a total potential gain of $100,000. The buyer paid $70,000 before defaulting, and of that amount, the seller had already reported $28,000 as gain. The first calculation is $70,000 (cash received) minus $28,000 (gain reported), which equals $42,000.

If the seller paid $5,000 in legal fees to reacquire the property, the second calculation is $100,000 (original gain) minus $28,000 (gain reported) and $5,000 (reacquisition costs), which equals $67,000. In this case, the seller would recognize a gain of $42,000, the lesser of the two amounts.

Determining the Basis of the Reacquired Property

After reacquiring the property, the seller must establish a new tax basis. This new basis is used for calculating depreciation if the property is held for rent or for determining the gain or loss on a future sale. The calculation for the new basis ensures the tax treatment remains consistent with the original sale and reacquisition events.

The formula for the new basis begins with the seller’s adjusted basis in the buyer’s debt at the time of reacquisition. To this amount, the seller adds two other figures: the gain recognized on the reacquisition and any money or property the seller paid as part of the reacquisition process, such as legal fees.

Using the previous example, the seller’s basis in the remaining $180,000 of debt must be calculated. With an original profit percentage of 40% ($100,000 gain / $250,000 price), the basis in the debt is $108,000 ($180,000 (1 – 0.40)). The new basis of the reacquired property is the sum of this $108,000 basis in debt, the $42,000 of recognized gain, and the $5,000 in reacquisition costs, for a total of $155,000.

Related Tax Implications

Several other tax consequences arise from a Section 1038 reacquisition. A seller is prohibited from claiming a bad debt deduction for the buyer’s note at the time of reacquisition, as the nonrecognition provisions supersede the normal rules for worthless debts. If the seller had previously taken a deduction for a partially worthless debt, that amount must be included in income in the year the property is taken back.

The holding period for the reacquired property is also subject to a special rule. The seller’s new holding period includes the period they owned the property before the original sale, plus the holding period after the reacquisition. However, the time that the buyer owned the property is excluded.

A specific provision applies to the reacquisition of a principal residence if the original sale qualified for the Section 121 exclusion. If the seller reacquires the residence and then resells it within one year of the reacquisition date, the resale is treated as part of the original sale transaction. This allows the seller to use the Section 121 exclusion against the gain from the combined transaction, and no gain or loss from the reacquisition itself is recognized.