1. McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 9 Nontaxable Exchanges McGraw-Hill/IrwinCopyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 9-2 Objectives  Compute substituted basis of property received in a nontaxable exchange  Compute gain when boot is received  Identify qualifying like-kind property  Describe the effect of relief of debt  Compute recognized gain and basis in an involuntary conversion  Explain nonrecognition treatment for corporation or partnership formation  Describe tax effects of a wash sale

3. 9-3 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

4. 9-4 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

5. 9-5 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

6. 9-6 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)

7. 9-7 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

8. 9-8 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

9. 9-9 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

10. 9-10 Taxpayer Paying Boot  Paying 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

11. 9-11 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

12. 9-12 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.

13. 9-13 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

14. 9-14 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

15. 9-15 Four Types of Nontaxable Exchanges  Like-kind exchanges  Involuntary conversions  Exchanges of property for equity in a corporation or partnership  Wash sales

16. 9-16 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

17. 9-17 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

18. 9-18 Like-kind Exchange - Example  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

19. 9-19 Like-kind Exchange – 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

20. 9-20 Like-kind Exchange – 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

21. 9-21 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

22. 9-22 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

23. 9-23 Involuntary Conversion - Example  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)

24. 9-24 Involuntary Conversion - Example  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

25. 9-25 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

26. 9-26 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)

27. 9-27 Corporate Formation - Example  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

28. 9-28 Corporate Formation - Example  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

29. 9-29 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)

30. 9-30 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

31. 9-31 Wash Sale - Example  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)

32. 9-32 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

33. 9-33