Chapter 12

Special Property Transactions

Learning Objectives

LO 1. Explain how to defer gains using the like-kind exchange rules.

LO 2. Describe how to account for and report involuntary conversions.
LO 3. Apply the tax rules to report an installment sale.
LO 4. Explain how to exclude a gain on the sale of a personal residence.
LO 5. Apply the rules affecting related parties and wash sales.

Topics of Primary Importance

 Understanding the specifics of like-kind exchanges;

 Understanding the specifics of involuntary conversions;
 Understanding the specifics of installment sales;
 Understanding the gain exclusion on the sale of a personal residence.

Student Confusion Areas

 Determining the gain recognized (if any) with a like-kind exchange;

 Determining the basis of property received in a like-kind exchange;
 Determining the amount of gain excluded on the second sale of a personal
residence within two years.

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 Notes Outline

I. LO 1 - Like-Kind Exchanges

A. Requirements of nontaxable exchanges under §1031.

B. There are three criteria that must be met to qualify for a like-kind exchange:
1. There must be an exchange;
2. The real property transferred, and the real property received must be
held for productive use in a trade or business or for investment;
3. The property exchanged must be like-kind.

C. An important issue with a like-kind exchange is that it is not an elective

provision. In other words, when an exchange occurs that meets the three criteria,
the gain or loss must be deferred.
1. 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 in a trade or business or for investment.

D. Like-kind exchanges are only allowed for real property in post-2017 years.
Real property includes land and building used in a trade or business or held for
investment.

E. A dealer cannot participate in a like-kind exchange on a trade-in.

F. What is a “like-kind” asset?

1. The asset received does not have to be an exact duplicate of the
property exchanged. In order to qualify as “like-kind,” the property must
be of the same nature or character. The grade or quality of the exchanged
assets does not matter.
2. Business real property generally in the same depreciation class.

G. What is “boot” property?

1. “Boot” is defined as property given or received in a like-kind exchange
that is NOT like-kind property. Often, in an exchange, cash or another
non-like-kind asset is transferred from one party to the other to equalize
FMV. The cash or other asset would be called “boot.”
2. The receipt of boot property often triggers the recognition of gain.
3. When boot is received, the recognized gain is the lesser of the FMV of
the boot received or the realized gain on the exchange.
4. Giving boot does not trigger gain recognition.

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In-class example. Glenn exchanges land used in business with Ashton for another piece
of land. The basis of Glenn’s old land is $50,000, FMV is $66,000, and he gives cash of
$14,000. Ashton’s basis in his land is $70,000, FMV $80,000.

Glenn Ashton
New Land - FMV $80,000 Amt. Received $80,000
Basis of Old ($50,000) Basis of Old $70,000
Cash Given ($14,000) Gain – Recognized $10,000
Gain – Not Recognized $16,000

H. Tax basis of new property received

1. The basis of the new property received is calculated as follows:

Adjusted Basis of the Property Given Up

+ Adjusted Basis of the Boot Given
+ Gain Recognized
- FMV of Boot Received
- Loss Recognized
Adjusted Basis on New Asset

2. The adjusted basis can also be calculated by taking the FMV of the
property received (like-kind asset) less the gain postponed (or plus the loss
postponed).

In-class example. Assume the same facts as the previous example. What is the basis in
the new properties for Glenn and Ashton?
Glenn Ashton
Adjusted Basis of Property Given $50,000 $70,000
+ Adj. Basis of Boot Given $14,000 0
+ Gain Recognized 0 $10,000
- FMV of Boot Received 0 $14,000
- Loss Recognized 0 0
Basis of New Land $64,000 $66,000

Or FMV of Property Received – gain postponed + loss postponed = basis

Glenn $80,000 - $16,000 + $0 = $64,000
Ashton $66,000 - $0 + $0 = $66,000

I. The holding period used to determine any short-term or long-term treatment on

the sale of the new asset includes the holding period of the old asset exchanged.

J. Time period for finding exchange property

1. The property received in the exchange must be identified within 45
days after the transfer of the property relinquished in the exchange.

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 2. The replacement property must be received within the earlier of 180
days after the property was given up or the due date for filing a return
(including extensions) for the year of the transfer.

K. Liabilities assumed on the exchange

1. When a taxpayer is released of a liability in an exchange, the release of
a liability is considered boot received.
2. A release of a liability is treated as a money distribution.

L. Exchanges between related parties

1. Exchanges between related parties are not like-kind exchanges if either
party disposes of the property within two years of the exchange.
2. Any gain realized on the exchange is recognized in the year of the
subsequent sale.
3. A related party includes the taxpayer’s spouse, child, grandchild,
parent, brother, or sister; or a related corporation, S corporation,
partnership, or trust. Death or involuntary conversions within the two-
year period do not trigger the gain.

M. Deferred exchanges
1. A deferred exchange occurs when the title to the property to be
exchanged is placed in an escrow account with a custodian (usually an
attorney or CPA). The custodian then sells the property and the cash is
placed in an escrow account. The taxpayer then has 45 days to identify
like-kind property. Once the property is identified, the custodian
purchases the new asset and distributes the title to the taxpayer.
2. The main restriction is that the taxpayer cannot, at any time, have
actual or constructive receipt of the proceeds from the sale of old property.

II. LO 2 - Involuntary Conversions – IRC §1033

A. An involuntary conversion occurs when property is destroyed, stolen,

condemned, or disposed of under the threat of condemnation and the taxpayer
receives other property or payment such as insurance or condemnation award

B. If the taxpayer receives other property for the converted property of similar or
related use, no gain is recognized.

C. Any gain from an involuntary conversion must be recognized unless the

taxpayer elects the non-recognition provisions.

D. No gain will be recognized on an involuntary conversion if the taxpayer

replaces the converted property with similar property of equal or greater value
within a certain period of time.

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 E. To defer the entire gain, the replacement property must be purchased for an
amount equal to or greater than the proceeds from the conversion. The gain is
recognized to the lesser of the gain realized or the proceeds NOT used for
replacement.

F. Replacement property
1. If the property lost is anything other than real property, the replacement
property must be “similar or related in service or use.” This test is more
restrictive than the “like-kind” test.
2. If the property destroyed or condemned is real property, the similar use
restrictions are lessened. The replacement property for real property must
be only “like-kind.”

G. Replacement period
1. There is a time limit to purchase replacement property. The
replacement period ends 2 years after the close of the first taxable year in
which any part of the gain is realized.
2. If real property held for use in a trade or business or investment is
condemned, the replacement period is 3 years.

H. Basis and holding period of replacement property

1. The basis of the replacement property is calculated in a manner similar
to like-kind exchanges. When property is converted directly to similar
property, the new basis is calculated as follows:

Adjusted basis of converted (original) property

+ Money reinvested in excess of proceeds received
- Money received not used to replace the property
+ Amount of gain recognized by the taxpayer on the conversion
- Amount of loss recognized by the taxpayer on the conversion
= Adjusted basis of replacement property

I. The holding period for the replacement property includes the holding period of
the converted property.

In-class example
The city condemned land owned by Casey. Casey has a basis in the land of
$230,000 and he received $300,000 in condemnation proceeds. Casey invests
$292,000 in similar real estate. Assuming Casey elects to defer the gain under the
involuntary conversion rules, he would recognize a gain of $8,000 and the basis
of the new property would be $230,000.

III. LO 3 - Installment Sales

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 A. An installment sale is a disposition of property where at least one payment is
to be received after the year of the sale.

B. Typically, payments on installment sales consist of three components:

1. Interest Income.
2. Return of adjusted basis in the property sold.
3. Gain on the sale.

C. The return of basis and the gain portion of each payment are determined based
on the gross profit percentage of the asset sold. The gross profit percentage is
calculated as follows:

In-class example. Calculating the Gross Profit Percentage

Selling Price $250,000

Installment Sale Basis
Adj. Basis of the Property $50,000
Selling Expenses 6,000
Depreciation Recapture 0 (56,000)
Gross Profit 194,000

Contract Price $250,000

Gross Profit Percentage (Gross Profit divided by Contract Price) 77.6%

Most installment notes have interest attached as well. However, the interest
charges do not affect the gross profit calculation. If the taxpayer, in this example,
were to receive $50,000 cash down payment and $50,000 (plus interest) for the
next 4 years, income would be recognized as follows (interest income would be
“on top of” the numbers shown):

Cash Received Income Return of

Basis
Year of Sale $50,000 x 77.6% $38,800 $11,200
1st Payment $50,000 x 77.6% $38,800 $11,200
2nd Payment $50,000 x 77.6% $38,800 $11,200
3rd Payment $50,000 x 77.6% $38,800 $11,200
4th Payment $50,000 x 77.6% $38,800 $11,200
$250,000 $194,000
$56,000

D. The contract price is the lesser of the gross profit or the selling price reduced
by any debt assumed by the buyer.

E. Dealers, inventory, and depreciation recapture

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 1. An installment sale does not include any dispositions by a taxpayer
who is a dealer in the item sold (e.g., a car dealership cannot use the
installment method to account for the sale of a car).
2. The installment method cannot be used to report gain from the sale of
stock or securities that are traded on an established securities market.
3. Depreciation recapture must be recognized in the year of sale.

F. Taxpayers must use the installment method for deferred payments unless the
taxpayer elects not to use the installment method. To elect out of the installment
method the taxpayer simply reports the sale in its entirety on Form 4797 or
Schedule D, whichever applies.

IV. LO 4 - Sale of a Personal Residence – Exclusion of Gain

A. A taxpayer can exclude up to $500,000 ($250,000 for a single taxpayer) of

gain on the sale of his or her primary residence. This provision is an exclusion
and not a deferral of gain.

B. In order to qualify for the exclusion, the taxpayer must meet the ownership
test and the use test.
1. “The ownership test” - During the 5-year period ending on the date of
the sale, the taxpayer must have owned the home for at least 2 years.
2. “The use test” – During the 5-year period ending on the date of the
sale, the taxpayer must have lived in the home as his or her main home for
at least 2 years.
3. The ownership and use tests do not have to be continuous. The
taxpayer need only show that he or she owned and lived in the main home
for either 24 full months or 730 days during the 5-year period.

C. Reduced maximum exclusion

1. The exclusion applies to only one sale every two years.
2. When a second sale within two years is caused by health or
employment reasons or other unforeseen circumstances, a portion of the
gain can be excluded by taking a ratio of the number of days used divided
by 730 days.
3. Special Problems with Married Individuals
a. Married individuals can exclude up to $500,000 from the gain
on a personal residence.
b. Special Marriage Issues with Residence Exclusion:

Other Issues With Married Taxpayers

One spouse sells a home The other spouse is still allowed an exclusion of
gain up to $250,000
Death of spouse before The surviving spouse is deemed to have owned
sale and lived in the property for any period when the

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Home transferred from
spouse
Use of home after divorce
decedent spouse owned and lived in the home.
The transferee spouse is considered to have
owned the residence for any period of time when
the transferor spouse owned the residence.
The taxpayer is considered to have used the house
during any period when: (1) the taxpayer owned
it and (2) the spouse or former spouse is allowed
to live in it under a divorce or separation
agreement.

V. LO 5 - Related-Party Losses and Wash Sales

A. The related-party rules and wash sale rules are designed to limit losses (but
not gains) where the taxpayer still has control over the property that caused the
loss. These rules apply when a tax loss was created but substantial ownership of
the property did not change.

B. Related-party losses - No deduction is allowed with respect to any loss from

the sale or exchange of property, directly or indirectly, between related parties.
The following relationships are considered related parties:
1. Members of a family –include spouse, ancestors, lineal descendants,
brothers and sisters (whether whole or half-blood).
2. An individual and a corporation where more than 50 percent in value of
the outstanding stock is owned, directly or indirectly, by or for the
individual.
3. Two corporations that are members of the same controlled group;
4. A grantor and a fiduciary of any trust;
5. A fiduciary of a trust and a beneficiary of such trust;
6. Any corporation or partnership where there is more than 50%
ownership.
7. Constructive ownership rules also apply. With constructive ownership,
a taxpayer is deemed to also own the stock of anyone, or any entity he or
she controls.

C. Wash sales of stock - The purpose of the wash sale rules is to disallow a tax
loss where the ownership of a company is not reduced. A wash sale occurs when
a taxpayer sells stock or securities at a loss and, within a period of 30 days before
or 30 days after the sale, the taxpayer acquires substantially identical stock or
securities.

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