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then the capital gain to be taxed here may be minimal, because it would consist only of the growth in
value since this purchase plus any amount depreciated after the acquisition. If, however, Morris
acquired the molding company through a purchase of stock, his basis will be the old company‟s
preacquisition basis, and the capital gain may be considerable. Either way, it would surely be desirable
to avoid taxation on this capital gain.
The tax code affords Morris the opportunity to avoid this taxation if, instead of selling his old
facility and buying a new one, he can arrange a trade of the old for the new so that no cash falls into
his hands. Under Section 1031 of the Internal Revenue Code, if properties of like kind used in a trade
or business are exchanged, no taxable event has occurred. The gain on the disposition of the older
facility is merely deferred until the eventual disposition of the newer facility. This is accomplished by
calculating the basis in the newer facility, starting with its fair market value on the date of acquisition,
and subtracting from that amount the gain not recognized upon the sale of the older facility. That
process builds the unrecognized gain into the basis of the newer building so that it will be recognized
(along with any future gain) upon its later sale. There has been considerable confusion and debate over
what constitutes like-kind property outside of real estate, but there is no doubt that a trade of real
estate used in business for other real estate to be used in business will qualify under Section 1031.
Although undoubtedly attracted by this possibility, Morris would quickly point out that such an
exchange would be extremely rare since it is highly unlikely that he would be able to find a new
facility that is worth exactly the same amount as his old facility, and thus any such exchange will have
to involve a payment of cash as well as an exchange of buildings. Fortunately, however, Section 1031
recognizes that reality by providing that the exchange is still nontaxable to Morris so long as he does
not receive any non-like-kind property (e.g., cash). Such non-like-kind property received is known as
boot, and will include, besides cash, any liability of Morris‟s (such as his mortgage debt) assumed by
the exchange partner. The facility he is purchasing is more expensive than the one he is selling, so
Morris will have to add some cash, not receive it. Thus, the transaction does not involve the receipt of
boot and still qualifies for tax deferral. Moreover, even if Morris did receive boot in the transaction, he
would recognize gain only to the extent of the boot received, so he might still be in a position to defer
a portion of the gain involved. Of course, if he received more boot than the gain in the transaction, he
would recognize only the amount of the gain, not the full amount of the boot.
But Morris has an even more compelling, practical objection to this plan. How often will the person
who wants to purchase your facility own the exact facility you wish to purchase? Not very often, he
would surmise. In fact, the proposed buyer of his old facility is totally unrelated to the current owner
of the facility Morris wishes to buy. How then can one structure this as an exchange of the two parcels
of real estate? It would seem, therefore, that a taxable sale of the one, followed by a purchase of the
other, will be necessary in almost every case.
Practitioners have, however, devised a technique to overcome this problem, known as the threecorner
exchange. In a nutshell, the transaction is structured by having the proposed buyer of Morris‟s
old facility use his purchase money (plus some additional money contributed by Morris) to acquire the
facility Morris wants to buy, instead of giving that money to Morris. Having thus acquired the new
facility, he then trades it to Morris for Morris‟s old facility. When the dust settles, everyone is in the
same position they would have occupied in the absence of an exchange. The former owner of the new
facility has his cash; the proposed buyer of Morris‟s old facility now owns that facility and has spent
only the amount he had proposed to spend; and Morris has traded the old facility plus some cash for
the new one. The only party adversely affected is the IRS, which now must wait to tax the gain in
Morris‟s old facility until he sells the new one.