LIKE KIND EXCHANGES

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Chapter 39

Nonrecognition Transactions §10312

No gain or loss recognized when property is exchanged solely for property of “like-kind” Defer recognition of gain or loss until property is

disposed of in a taxable transaction Replacement property receives substituted basis

Exceptions to §1031 3

Stock in trade or other property held primarily for sale

Stocks, bonds or notesOther securities or evidence of indebtedness or

interestInterests in a partnershipCertificates of trust or beneficial interestsChoses in action

Continuity of Interest4

§1031 assumes property received in an exchange is simply a continuation of that investment in a modified form Inappropriate time to levy a tax or permit a

deduction– there is no wherewithal to pay Administrative difficulty in valuing like-kind

exchange property

“Like Kind” Property5

Transferred property must be exchanged solely for “property of a like kind” to be held either for productive use in a trade or business or for investment §1031(a)(1)

Remember, inventory, stocks, bonds, notes, securities, partnership interests, and similar intangibles are EXCLUDED §1061(a)(2)

“Like Kind” Property (continued)6

“like kind” refers to nature or character of the property and not its grade or quality Property exchanged must be exchanged for

property in the same class Real estate – building for land; improved real

estate for unimproved real estate Personalty property – same “general business

asset class”; auto for auto, equipment for equipment

“Like Kind” Property (continued)7

Additional considerations Personal property treated with narrower approach Transfer of multiple assets

No “business for business” exchange, need to look at underlying assets

Holding Requirements8

Property given up in the exchange must be held for “productive use in a trade or business or for investment”

Property received in the exchange is to be held for “productive use in a trade or business or for investment” No personal-use property allowed Property use of one party does not necessarily

disqualify the other party 2 year holding period on exchanges between

related parties

Example9

In-class exercise

Receipt of Nonqualified Property (“Boot”)10

Does not disqualify nonrecognition treatment

Boot = receipt of money or nonqualified property

Requires recognition of gain to the extent of boot received (money or FMV of nonqualified property)

Does NOT permit recognition of loss

Example 111

Taxpayer exchanged Blackacre (Adjusted Basis=$50,000) for Whiteacre (FMV=75,000) and cash ($10,000)

Amount Realized $85,000 (75 for Whiteacre +10 for cash/

boot)Less: Adjusted Basis 50,000 (Blackacre)Gain $35,000

Gain recognized $10,000 (boot received)Gain deferred $25,000 (35-10)

Example 212

Taxpayer exchanged Blackacre (Adjusted Basis =$100,000) for Whiteacre (FMV=75,000) and cash ($10,000)

Amount Realized $85,000 (75 for Whiteacre +10 for cash/ boot)Less: Adjusted Basis 100,000 (Blackacre)Loss $(15,000)

Loss recognized -0-Loss deferred $15,000

Liabilities Transferred13

If mortgaged property is exchanged for unencumbered property, then debt (relief) is boot

If mortgaged property is exchanged for mortgaged property, then liabilities are netted Debt received by transferee is boot to transferor to

extent debt assumed by transferee is greater than debt assumed by transferor

If transferor transfers debt and other boot, can use other boot to reduce amount of debt transferred

Example 114

Taxpayer exchanged Blackacre (Adjusted Basis=$50,000) subject to a mortgage of $10,000 for Whiteacre (FMV=75,000)

Amount Realized $85,000 (75 for Whiteacre +10 for mortgage)Less: Adjusted Basis 50,000 (Blackacre)Gain $35,000

Gain recognized $10,000 (boot received-debt relief)Gain deferred $25,000 (35-10)

Example 215

Taxpayer exchanged Blackacre (Adjusted Basis=$50,000) subject to a mortgage of $10,000 for Whiteacre (FMV=75,000) subject to a mortgage of $8,000

Amount Realized $77,000 (75 for Whiteacre +10 Blackacre mortgage -8 Whiteacre mortgage)Less: Adjusted Basis 50,000Gain $27,000

Gain recognized $2,000 (boot - net debt relief) B>WGain deferred $25,000 (27-2)

Example 316

Taxpayer exchanged Blackacre (Adjusted Basis=$50,000) subject to a mortgage of $15,000 AND cash of $5,000 for Whiteacre (FMV=75,000)

Amount Realized $85,000 (75 for Whiteacre +15 Blackacre mtg. -5 cash)Less: Adjusted Basis 50,000Gain $35,000

Gain recognized $10,000 (boot received) *Cash reduces mtg.Gain deferred $25,000 (35-10)

Basis of Property Received17

Basis of like-kind property surrendered+ Basis of Boot surrendered+ Gain recognized on Boot– Basis of Boot received (FMV)– Loss recognized on Boot Basis of like-kind property receivedOr FMV of like-kind property received+ Unrecognized loss– Unrecognized gain Basis of like-kind property received

Example 118

Taxpayer exchanges Blackacre with adjusted basis of $500,000 and FMV of $800,000 subject to a mortgage of $150,000 for Whiteacre with a FMV $600,000 and $30,000 cash and oil painting with FMV $20,000{gain realized=[(600+30+20+150)-500]=300,000}

Basis of like-kind property surrendered $500,000 (Blackacre)

+ Basis of Boot surrendered+ Gain recognized on Boot 200,000 (Mtg.

+cash+painting)– Basis of Boot received (FMV) -200,000– Loss recognized on Boot Basis of like-kind property received $500,000

Or, (600,000 – 100,000 = 500,000)

Depreciation and Amortization19

Like-kind property received in like-kind exchange is recovered over the remaining recovery period of the surrendered property

Related Parties §1031(f)20

Nonrecognition is denied to both parties to a like-kind exchange between related persons if either of them disposes of the property received within 2 years

Example21

In-class exercise

Qualifying Exchanges

Reciprocal transfer of properties (most common)

Multiparty Exchanges (Round-robin exchange) A transfers Blackacre to

B, B transfers Whiteacre to C, C transfers Greenacre to A

D purchases Whiteacre from T, D transfers Whiteacre to F in exchange for Blackacre (only F qualifies for nonrecognition)

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Qualifying Exchanges (continued)23

Deferred Exchanges §1031(a)(3) Property must be identified within 45 days after

the taxpayer’s transfer Property must be received within the earlier of

180 days after the taxpayer’s transfer or the due date (including extensions) of the taxpayer’s tax return

Safe harbor for qualified intermediaryReverse Exchanges Rev. Proc. 2000-37

Receipt of replacement property before transferring relinquished property

Involuntary Conversions §103324

Gain on “involuntary conversion” (destruction in whole or in part, casualty, theft, condemnation) of property is not recognized if property is replaced with property “similar or related in service or use”

Mandatory if property is converted directly into qualified replacement property (direct conversion)

Elective if taxpayer receives cash or other dissimilar property and then acquires qualified replacement property (indirect conversion)

“involuntary conversion”25

Process by which the taxpayer loses or relinquishes property in exchange for money or other property Destruction in whole or in part – encompasses casualties,

however, does not need to be sudden Theft Seizure – confiscation of property by a public agency

without compensation Requisition or Condemnation – confiscation of property

for public use with just compensation Threat or Imminence of Requisition or Condemnation Miscellaneous Events

“similar or related in service or use”26

Substantially similar business propertyReasonably similar business continuationMore stringent than like-kind property rules

Exception: §1033(h)(2) – tangible property held in trade or business or for investment converted in a presidentially declared disaster replaced with ANY tangible trade or business property (but not for investment) qualifies

Exception: §1033(g) – real property converted by seizure, requisition, or condemnation or threat of imminence need only meet “like-kind” requirement similar to §1031

Remodeling or improving property satisfies requirement that replacement property to be “purchased”

Elective nonrecognition of gain27

Replacement property cost ≥ amount realized on conversion

Purchase of property occurs within 2 years after close of tax year in which gain on conversion was realized

Cost of replacement property includes cash paid and liabilities assumed

Amount realized includes cash received and liabilities discharged less expenses incurred

Gain recognized to the extent amount realized on conversion ≥ cost of replacement property

Amounts received for compensation for lost profits are included in income

Example28

Taxpayer received $10,000 condemnation award for Blackacre (adjusted basis=$10,000). Condemning authority paid $15,000 to discharge mortgage. Taxpayer paid $2,000-legal fees in proceedings. Taxpayer paid $5,000 cash, $15,000 mortgage, and $1,000 commissions for replacement property.

Amount realized $23,000 (10 award +15 mtg

discharge -2 legal

fees)Less: Adjusted basis (10,000)Gain realized $13,000

Gain recognizedAmount realized $23,000Less: repl. property (21,000) (5 cash+15 mtg + 1 comm.)Gain recognized $ 2,000

Basis of Replacement Property29

Cost of Replacement PropertyLess: Unrecognized GainBasis of Replacement Property

Depreciation30

Basis of replacement property is recovered over the remaining recovery period of the converted property