LEARNING OBJECTIVES After studying this chapter, you should be able to J> Understand the tax consequences arising from a lke-kind exchange B> Determine the basis of property received in alike-kind exchange > Determine whether gain from an involuntary conversion may be deferred D> Determine the basis of replacement property in an involuntary conversion B> Determine when a gain resulting from the sale of a principal residence is excluded PROPERTY TRANSACTIONS: NONTAXABLE EXCHANGES = \ 7 aT12-2 Individual CHAPTER OUTLINE. Uke Kind Exchanges.122 Involuntary Conversions.1210 Sale of Principal Residence..12-16 KEY POINT ‘The transactions examined inthis chapter override the normal rule ‘that provides for the recognition of realized gains and realized losses on property used in a busi- ness or held for investment ¥ Chapter 12 ‘Taxpayers who sell or exchange property for an amount greater or less than their basis in that property have a realized gain or loss on the sale or exchange. Almost any transfer of property is treated asa sale or other disposition (see Chapter I:5). The realized gain or loss must be recognized unless a specific Code section provides for nonrecognition treatment. If the realized gain or loss is not recognized at the time of the transaction, the nonrecog- nized gain or loss may be deferred in some cases and excluded in others, The general rules related to the computation of realized and recognized gains or losses are covered in Chapter I:5. This chapter discusses three of the most common transactions that may result in nonrecognition of a realized gain or loss: > Like-kind exchanges under Sec. 1031 (deferred gain or loss) > Involuntary conversions under Sec. 1033 (deferred gain) > Sales of a personal residence under Sec. 121 (excluded gain) Nonrecognition of gain treatment for like-kind exchanges, involuntary conversions, and the sale of a residence may be partially justified by the fact that taxpayers may lack the wherewithal to pay the tax despite the existence of a realized gain. For example, a tax- payer who realizes a gain due to an involuntary conversion of property (damage from fire, storm, etc.) may have to use the amount received to replace the converted property. A typical requirement in a nontaxable exchange is that the taxpayer is required to maintain a continuing investment in comparable property (e.g.,a building is exchanged for another building). In essence, a change in form rather than a change in substance occurs. ‘A transaction generally considered to be nontaxable may be taxable in part. In like- kind exchange, for example, the taxpayer may also receive money or property that is not like-kind property. If non-like-kind property or money is received, the realized gain is tax- able to the extent of the sum of the money and the fair market value (FMV) of the non-like-kind property received.! (TA xe-Kinv EXCHANGES foyer eneay 1 Understand the tax ‘consequences arising from a like-kind exchange EXAMPLE 1:12-1 > EXAMPLE 1:12-2 > REAL-WORLD EXAMPLE ‘An exchange or trade of profes- ‘sional football player contracts ‘qualifies asa ike-ind exchange Rev. Rul. 71137, 1971-1 CB. 108 ADDITIONAL ‘COMMENT ‘The mandatory nonrecognition of loss Under Sec 1031 can be avoided by sling the old prop: ‘erty in one transaction and. buying the new property in a separate, unrelated transaction "See, 10310). Section 1031(a) provides that “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use im a trade or business or for investment.”* In a like-kind exchange, both the property transferred and the property received must be held either for productive use in the trade or business or for investment. ‘Tom owns land used in his trade or business. He exchanges the land for other land, which is to be held for investment. No gain or loss is recognized by Tom because he has exchanged prop- erty used in a trade or business for like-kind property to be held for investment. < Dawn's automobile is held for personal use. She exchanges the automobile, with a $10,000 basis, for stock of AT&T with a $12,000 FMV. The stock is held for investment. A $2,000 gain is, recognized because the automobile is not used in Dawn's trade or business or held for invest- ment. The exchange is not a like-kind exchange because neither personal-use assets nor stock qualify as like-kind property. < Section 1031 is not an elective provision. If the exchange qualifies as a like-kind exchange, nonrecognition of gain or loss is mandatory. To qualify for like-kind exchange treatment, a direct exchange must occur and the property exchanged must be like-kind. A taxpayer who prefers to recognize a loss on an exchange must structure the transaction to avoid having the exchange qualify as a like-kind exchange. LIKE-KIND PROPERTY DEFINED CHARACTER OF THE PROPERTY. To be a nontaxable exchange under Sec. 1031, the property exchanged must be like-kind. The Treasury Regulations specify that “the words 2 Se, 10313.EXAMPLE 1:12-3. EXAMPLE L:12-4 > ADDITIONAL COMMENT Real property soften referred to atreal estate EXAMPLE I: 25 EXAMPLE 1:12-6 > ADDITIONAL COMMENT The rules in the Regulations dea: ing with exchanges of personal property are nat interpreted as Fiberally a the rules relating to teal property. $ Reg. Sec. 1.103131). “ad. 5 hid Real property includes land and prope permanent manner: Pesonal property that Property Transactions: Nontaxable Exchanges ¥ Individuals 12-3 like-kind’ have reference to the nature or character of the property and not to its grade or quality.”} Thus, exchanges of real property qualify even if the properties are dissimiliar. Eric owns an apartment building held for investment. Eric exchanges the building for farmland, ‘to be used in his trade or business. The exchange is a like-kind exchange because both the building and the farmland are classified as real property and both properties are used either in business or held for investment. < ‘Tail Corporation exchanges improved real estate for unimproved real estate, both of which are held for investment. The exchange is alike-kind exchange-* < LOCATION OF THE PROPERTY. Transfers of real property located in the U.S. and real property located outside the U.S. after July 9, 1989, are not like-kind exchanges. Exchanges of personal property predominantly used in the United States and personal property used outside of the United States that occur after June 8, 1997, are not like-kind exchanges. To determine where the property is predominantly used, the two-year period ending on the date the property is exchanged is analyzed. For property received, the loca- tion of predominant use is determined by analyzing the use during the two-year property after the property is received. PROPERTY MUST BE THE SAME CLASS. An exchange is not a like-kind exchange when property of one class is exchanged for property of a different kind or class.* For example, if real property is exchanged for personal property (or vice versa), no like-kind exchange occurs.§ Gail exchanges an office building with a $400,000 adjusted basis for an airplane with a {$580,000 FMV to be used in business. This is not a like-kind exchange because the office build- ing is real property and the airplane is personal property. Gail must recognize a $180,000, ($580,000 ~ $400,000) gain. < Gary exchanges a business truck for another truck to use in his business. Tiss an exchange of like-kind property. < PROPERTY OF ALIKE CLASS. The Treasury Regulations provide that personal prop- erty of a like class meets the definition of like-kind.” Like class property is defined as depreciable tangible personal properties within the same General Asset Class or within the same Product Class. Property within a General Asset Class consists of depreciable tangible personal property described in one of the asset classes provided in Rev. Proc. 87- 56 for depreciation.” Some of the General Asset Classes are as follows: > Office furniture, fixtures, and equipment (Asset Class 00.11) Information systems such as computers and peripheral equipment (Asset Class 00.12) Automobiles and taxis (Asset Class 00.22) Buses (Asset Class 00.23) Light general purpose trucks (Asset Class 00.241) Heavy general purpose trucks (Asset Class 00.242) Vessels, barges, tugs, and similar water-transportation equipment except those used in marine construction (Asset Class 00.28) For purposes of the like-kind exchange provisions, a single property may not be classified in more than one General Asset Class or more than one Product Class. Furthermore, property in any General Asset Class may not be classified in a Product Class. A property's General Asset Class or Product Class is determined as of the exchange date. vryvyvyy atively permanent manner i fistare and is considered part ofthe el prop ty. Personal propery ill property that is not eal property ora fixture. F Reg See: 10310) attached t land ina elatvely —§ Reg See. 11031a) 20). ified o real property inarel:—° 1987-2 CB. 674