Rev. Rul. 84-121

ISSUE

What are the federal income tax consequences to the seller and the purchaser of real property in the transaction described below?

FACTS

A , an individual, owned a parcel of unencumbered real property that is being used in A 's trade or business and that had an adjusted basis of 50 x dollars. For 5 x dollars, A granted to B an option to purchase A 's real property for a price of 100 x dollars. The option allowed B to pay the option price in cash or to transfer real property equal in value to the option price. At the time the option was granted, A 's real property had a fair market value of 100 x dollars. B exercised the option before the expiration of the option period, but instead of paying A 100 x dollars in cash, B purchased for 100x dollars another parcel of real property with a fair market value of 100 x dollars and immediately transferred that property to A . At the time B exercised the option, A 's real property had a fair market value of 150 x dollars. A used the property acquired from B in A 's trade or business. B is neither related to A nor employed by A .

LAW AND ANALYSIS

Under section 1001(a) of the Internal Revenue Code, the gain or loss on a sale or other disposition of property is the difference between the amount realized from the transaction over the adjusted basis provided in section 1011.

Under section 1031 of the Code, no gain or loss is recognized if property held for productive use in a trade or business or for investment (not including stock in trade or other property held primarily for sale, nor stocks, bonds, notes, choses in action, certificates of trust or beneficial interest, or other securities or evidences of indebtedness or interest) is exchanged solely for property of a like kind to be held either for productive use in a trade or business or for investment.

Under section 1031(b) of the Code, if an exchange would be within the provisions of subsection (a) if it were not for the fact that the property received in exchange consists not only of property permitted by such provision to be received without recognition of gain, but also other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property.

Under section 1031(d) of the Code, if property was acquired on an exchange described in section 1031, then the basis shall be the same as that of the property exchanged, decreased in the amount of any money received by the taxpayer and increased in the amount of gain or decreased in the amount of loss to the taxpayer that was recognized on such exchange.

In Rev. Rul. 75-291, 1975-2 C.B. 332, the Internal Revenue Service considered the income tax consequences of an exchange of land and a factory used by a manufacturing corporation for land and a factory owned by another corporation that acquired the land and constructed the factory solely for the purpose of making the exchange. The ruling holds that the exchange, as to the manufacturing corporation, qualified for nonrecognition of gain or loss under section 1031 of the Code because it used the property it transferred in its trade or business, but as to the other corporation, the exchange did not qualify under section 1031 because the property it transferred had not been used in its trade or business.

Similarly, the exchange of real property here qualifies under section 1031 with respect to A because both the real property A transferred to B and the real property A received were used in A 's trade or business. The exchange, however, does not qualify under section 1031 with respect to B because the property B acquired before the exchange was not used in B 's trade or business or held for investment.

In Helvering v. San Joaquin Fruit and Investment Co. 297 U.S. 496 (1936), XV 1 C.B. 196, the Supreme Court of the United States held that the exercise of an option to purchase real property is not treated as an exchange of the option and the option premium for the real property, but rather is treated as an acquisition of the property on the date the option is exercised. The Court indicated that the basis of real property acquired by the exercise of an option was the amount paid for the property under the option, not the property's fair market value on the date of exercise.

In Rev. Rul. 78-182, 1978-1 C.B. 265, 266 (Ruling 4A), dealing with "call" (purchase) options for stock, it was held that the basis of stock acquired on exercise of a "call" option is the option price of the stock, which is consistent with the holding of San Joaquin, plus the premium paid for the option. See also Rev. Rul. 67-96, 1967-1 C.B. 195.

Here, the basis of the property acquired by B upon exercise of the option is the cost of the property, plus the premium paid for the option. The disposition of property by B in payment of the option price is a taxable event.

HOLDING

Pursuant to section 1031(b) of the Code, A does not recognize gain or loss on the transfer of A 's real property in exchange for the real property received from B, except to the extent of the 5 x dollars premium paid by B to A for the option. Under section 1031(d), the adjusted basis to A in the property acquired from B is 50 x% i dollars, that is, the adjusted basis of A 's old property of 50 x dollars decreased by the 5 x dollars received by A and increased by the 5 x dollars of gain recognized by A on the exchange.

When B transfers to A the property that B had acquired in order to exercise the option, B has disposed of B 's property in a taxable transaction because B has not met the requirements of section 1031. On the present facts, B has no gain or loss because the amount considered realized by B (the option price of 100 x dollars) equals B 's basis in the property (100 x dollars). The adjusted basis to B in the property acquired from A is 105 x dollars, the option price for the property that B paid to A, plus the premium for the option paid by B to A.