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Chapter 9

Nontaxable Exchanges

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Objectives

Explain the underlying tax concepts of a

nontaxable exchange
Compute the substituted basis of property received
in a nontaxable exchange
Compute gain when boot is received in a
nontaxable exchange
Explain book/tax differences related to nontaxable
exchanges
Identify properties that qualify for like-kind
exchange treatment
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Objectives (continued)

Describe the effect of the relief and assumption of

debt in a like-kind exchange
Compute gain recognized and the basis of
replacement property in an involuntary conversion
Explain the tax consequences of the exchange of
property for equity in a corporation or partnership
Describe the tax consequences of a wash sale
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Tax Neutrality

The government is not a party to a nontaxable

exchange, so the tax law is neutral
Example:
Sandra owns ABC stock with a FMV $1,000 and a $200
tax basis. She wants to rebalance her portfolio by selling
ABC and buying $1,000 worth of XYZ stock
If she sells ABC, she must pay tax on her $800 gain
realized and won’t have $1,000 to spend on XYZ
If an exchange of ABC for XYZ were nontaxable, she
could defer paying tax on $800 and could acquire $1,000
of XYZ stock
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Exchanges of Qualifying Property

Common characteristics of a generic

nontaxable exchange:
Exchange of one qualifying property for another
Equal FMVs of properties exchanged (value-for-
value presumption)
Realized gain or loss is not recognized
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Substituted Basis

Nonrecognized gain or loss is deferred until the

qualifying property received is disposed of in a
taxable transaction
Deferred gain or loss is embedded in the tax basis
of the qualifying property received
If no boot is involved, the tax basis equals:
Basis of property surrendered
FMV of property received - deferred gain/+ deferred loss
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Example of a Generic Nontaxable Exchange

Sally has property with FMV $100, basis $60

Lisa has property with FMV $100, basis $110
Sally and Lisa exchanges properties
Sally realizes but does not recognize $40 gain
Lisa realizes but does not recognize $10 loss
Sally’s basis in her new property is $60 (FMV $100 -
$40 deferred gain)
Lisa’s basis in her new property is $110 (FMV $100 +
$10 deferred loss)
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The Effect of Boot

Boot is any nonqualifying property in the

exchange
Includes cash and relief of debt
Debt relief is treated as boot received by the party
relieved of debt and boot paid by the party assuming debt
If both parties to the exchange are relieved of debt,
only the net amount is treated as boot
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Effect on Taxpayer Receiving Boot

Realized gain is recognized up to the FMV of boot

Boot cannot increase the amount of realized gain
Receiving boot does not cause loss recognition
Basis in qualifying property received equals:
Basis of property surrendered + gain recognized - FMV
boot received
FMV of qualifying property received - deferred gain/+
deferred loss
Basis in boot equals FMV
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Example: Receiving Cash Boot

Luke has qualifying property with a $1,000 FMV

and $700 basis. Robert has qualifying property with
a $900 FMV and $100 cash
If Luke and Robert enter into an exchange, Luke’s
realized gain is $300. He recognizes $100 gain and
defers $200 gain
Luke’s basis in the property received is $700
$700 substituted basis + $100 gain recognized - $100 boot received
$900 FMV - $200 deferred gain
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Taxpayer Paying Boot

Paying cash boot does not trigger gain recognition

Basis of qualifying property received equals:
Basis of qualifying property surrendered + FMV of boot
paid
FMV of qualifying property received - deferred gain/+
deferred loss
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Example: Paying Cash Boot

Robert exchanges qualifying property with a $900

FMV and $280 basis plus $100 cash for qualifying
property with a $1,000 FMV
Robert’s entire $620 realized gain on the exchange
of qualifying property is deferred
Robert’s basis in the qualifying property received is
$380
$280 substituted basis + $100 boot paid
$1,000 FMV - $620 deferred gain
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Example: Relief of Debt = Boot

Ginger owns qualifying property with a

$200 FMV and $120 basis subject to a $50
mortgage
Susan owns qualifying property with a
$150 FMV and $110 basis
When they exchange properties, Susan
assumes the $50 mortgage on Ginger’s
property.
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Example: Relief of Debt = Boot

Ginger’s amount realized is $200 ($150 FMV of

property received + $50 debt relief), and her
realized gain is $80.
Ginger recognizes $50 gain and defers $30 gain
Her basis in the property received is $120
$120 substituted basis + $50 gain recognized - $50 boot
received
$150 FMV - $30 deferred gain
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Example: Relief of Debt = Boot

Susan’s amount realized is $200 (FMV of property

received), and her realized gain is $40
Susan defers her entire $40 gain
Her basis in the property received is $160
$110 substituted basis + $50 boot paid
$200 FMV - $40 deferred gain
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Four Types of Nontaxable Exchanges

Like-kind exchanges
Involuntary conversions
Exchanges of property for equity in a
corporation or partnership
Wash sales
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Like-Kind Property

Definition of like-kind property:

Tangible business personalty within class (IRS
classification system)
Intangible business personalty of same legal nature or
character
All business or investment realty
Inventory, stocks, bonds, partnership interests, and
personal assets are not eligible for like-kind exchange
treatment
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Like-Kind Exchanges

No gain or loss recognized on the exchange of

like-kind properties
Receipt of boot triggers gain recognition
Nonrecognition is mandatory, not elective
Taxpayers usually prefer to sell loss properties in order
to recognize their realized loss
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Example: Like-kind Exchange

Matt owns an office building with $200,000 FMV

and $70,000 basis
Phil owns investment land with a $170,000 FMV
and $115,000 basis
If Matt and Phil decide to exchange realty, who
must pay boot to equalize the exchange?
Phil must pay Matt $30,000 boot
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Example continued

Compute gain realized and recognized by Matt and Phil

on the exchange
Matt realizes $130,000 gain ($170,000 FMV of land +
$30,000 cash - $70,000 basis of office building) and
recognizes $30,000 gain (boot received)
Phil realizes $55,000 gain ($200,000 FMV of office building
- $145,000 total basis of land and cash and recognizes no
gain
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Example continued

Determine the tax basis of the realty received by Matt

and Phil
Matt’s basis in the land received = $70,000
$70,000 substituted basis + $30,000 gain recognized -
$30,000 boot received
$170,000 FMV - $100,000 deferred gain
Phil’s basis in the building received = $145,000
$115,000 substituted basis + $30,000 boot paid
$200,000 FMV - $55,000 gain deferred
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Involuntary Conversions

Involuntary conversion includes:

Theft or vandalism
Government claim of property or condemnation
Natural disasters such as fire, hurricane, tornado,
earthquake, and flood
If insurance proceeds exceed basis of converted
property, the taxpayer may elect to defer gain
recognition
If basis of converted property exceeds insurance
proceeds, the taxpayer recognizes ordinary loss
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Involuntary Conversion

Requirements to defer gain:

Reinvest proceeds in property similar or related in service
or use to converted property
Replacement property must be purchased within two
taxable years following the year of the conversion
If taxpayer does not reinvest entire proceeds, gain
is recognized to the extent of the proceeds not
invested
Unreinvested amount is treated as boot
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Example: Involuntary Conversion

Amy’s factory had a $500,000 adjusted basis.The

factory was destroyed by a tornado, and Amy
received $650,000 from the insurance company
Amy realized a $150,000 gain on the involuntary
conversion
If Amy pays $700,000 to build a replacement
factory, she may elect to defer recognizing the gain
Her basis in the new factory is $550,000 ($700,000 cost -
$150,000 deferred gain)
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Example continued

If Amy pays $600,000 to build a replacement

factory, she must recognize $50,000 gain but can
elect to defer $100,000 gain
Her basis in the new factory is $500,000 ($600,000 cost -
$100,000 deferred gain)
If Amy pays $460,000 to build a replacement
factory, she must recognize her entire $150,000
gain
Her basis in the new factory is its $460,000 cost
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Corporate Formations

No gain or loss is recognized by a taxpayer who

transfers property to a corporation solely in
exchange for stock if the transferor is in control of
the corporation immediately after the exchange
Control is defined as ownership of 80% or more of the
corporation’s outstanding stock
If two or more taxpayers transfer property in the same
transaction, control is determined in the aggregate
A corporation never recognizes gain or loss on the
exchange of its stock for property
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Basis of Stock and Property

The basis of the stock received in the exchange

equals the basis of the transferred property
(substituted basis)

The basis of the transferred property to the

corporation equals its basis in the hands of the
transferor (carryover basis)
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Example: Corporate Formation

Phil and Lil form a corporation

Phil contributes $10,000 cash
Lil contributes a building with a $10,000 FMV and a
$3,200 adjusted basis

The corporation issues 500 shares of stock each to

Phil and Lil
Each share has a $20 FMV
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Example continued

Phil has no realized gain or loss

His basis in his 500 shares is their $10,000 cost
Lil realizes a $6,800 gain on the exchange of
property for stock
Because Lil and Phil have 100% control of the
corporation immediately after the exchange, Lil
recognizes no gain
Her basis in her 500 shares is $3,200
The corporation’s basis in the property contributed
by Lil is $3,200
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Partnership Formation

No gain or loss is recognized by the partner or the

partnership on the exchange of property for an
interest in the partnership
No control requirement

Partner’s basis in the interest equals the partner’s

basis in the transferred property (substituted basis)
Partnership’s basis in the transferred property
equals its basis in the hands of the partner
(carryover basis)
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Wash Sales

Special rule prohibits loss recognition

but not gain recognition on a wash sale
If a taxpayer sells a security at a loss but
repurchases substantially the same security within
30 days after or 30 days before the sale, the loss is
disallowed
The basis in the repurchased security equals cost
+ disallowed loss
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Example: Wash Sale

On September 13, Dorothy sold Nike stock with a

$4,000 basis for $3,750 cash
On October 4, Dorothy paid $3,810 to repurchase
the same Nike stock
Because the repurchase occurred within 30 days of the
sale, Dorothy cannot recognize her $250 loss on sale
Dorothy’s basis in her repurchased shares is $4,060
($3,810 cost + $250 deferred loss)
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Book/Tax Difference from Nontaxable Exchange

For financial reporting purposes, gains and losses

realized on property exchanges may be included in
book income
Book basis of property received equals FMV
If the exchange is nontaxable, the gain or loss
realized is a book/tax difference
The difference is temporary and will reverse as the
property is depreciated or amortized or when the property
is disposed of in a taxable transaction
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