#8-1
Chapter 8
Nontaxable Exchanges
McGraw-Hill/Irwin
© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.
#8-2
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 involuntary
conversion
• Explain nonrecognition treatment for corporation or
partnership formation
• Describe tax effects of a wash sale
#8-3
Tax Neutrality
• A nontaxable exchange removes the government
as a party to the transaction; the tax law is neutral
• Example:
• Sandra owns stock in ABC with a FMV of $1,000 and a
tax basis of $200. She wants to rebalance her portfolio
and buy $1,000 of XYZ stock instead
• Unfortunately, if she sells ABC and buys XYZ, she must
pay tax on the $800 gain on ABC, and won’t have $1,000
to spend on XYZ
• IF the exchange of ABC for XYZ were nontaxable, she
could defer paying tax on $800, and could obtain a full
$1,000 value of XYZ stock
#8-4
Exchanges of Qualifying Property
• Common characteristics of a generic
nontaxable exchange include:
• Exchange of one qualifying property for another,
• Assumption of equal FMVs or the parties wouldn’t
swap (value-for-value presumption), and
• Realized gain or loss which
may not be recognized
#8-5
Substituted Basis
• Nonrecognition of gain or loss is not permanent, but
deferred until the property is disposed of in a
taxable sale or exchange
• The mechanism for ensuring deferral is to imbed
the deferred gain or loss in the new basis
• If no boot involved, basis in property received
= 1) basis of property surrendered
= 2) FMV of property received
- deferred gain + deferred loss
#8-6
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 swap properties
• Sally realizes, but does not recognize, the $40 gain
• Lisa realizes, but does not recognize, the ($10) loss
• Sally’s basis in her new property is $60 (FMV of $100
less $40 deferred gain)
• Lisa’s basis in her new property is $110 (FMV of $100
plus $10 deferred loss)
#8-7
The Effect of Boot
• Boot is any nonqualifying property in the
nontaxable 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
#8-8
Effect on Taxpayer Receiving Boot
• Any realized gain is recognized up to the FMV of
boot received
• Boot cannot increase the amount of the realized
gain
• Receiving boot does not cause loss recognition
• New basis in qualifying property received
= 1) basis of property surrendered + gain
recognized - FMV boot received
= 2) FMV of qualifying property received
- deferred gain + deferred loss
• New basis in boot = FMV of boot
#8-9
Example: Receiving Cash Boot
• Luke has qualifying property with a FMV of $1,000
(basis of $700). Robert has qualifying property with
a FMV of $900 (basis of $300) and cash of $100.
• If they swap, Luke receives property worth $1,000
in total. His realized gain is $300. He must
recognize $100 because he received boot of $100.
He defers $200 of gain.
• Luke has basis in qualifying property of $700 = 1)
$700 + $100 - $100 = 2) $900 - $200
#8-10
Taxpayer Giving Boot
• Giving boot does NOT trigger gain recognition on
the qualifying property given
• BUT all realized gains or losses ON the boot given
up must be recognized (if boot is not cash)
• The basis of the qualifying property received
= 1) basis of qualifying property surrendered
+ FMV of boot paid
= 2) FMV of qualifying property received
- deferred gain + deferred loss
#8-11
Example: Giving Cash Boot
• Recall that Robert swaps property with a FMV of
$900 (basis of $300) and $100 cash for property
with a FMV of $1,000
• Robert’s realized gain of $600 on the qualifying
property he gives up is NOT recognized. It is
deferred. Giving boot does not change this result
• Robert’s basis in the qualifying property he receives
is $400 =1) $300 original basis + $100 boot paid =
2) $1,000 FMV - $600 deferred gain
#8-12
Example: Relief of Debt = Cash Boot
• Ginger owns qualifying property with a
FMV of $200 (basis of $120), subject to a
mortgage of $50
• Susan owns qualifying property with a
FMV of $150 (basis of $110)
• When they swap properties, Susan
assumes the mortgage on Ginger’s
property. This is treated as $50 boot that
Susan pays Ginger
#8-13
Example: Relief of Debt = Cash Boot
• Ginger has a realized gain of $80 ($200 FMV $120 basis). She recognizes $50 because of boot
received and defers $30. Her new basis is $120
($200 FMV - $30 deferred gain)
• Susan has a realized gain of $40 which is
completely deferred. Her new basis is $160 ($150
FMV - $40 deferred gain)
#8-14
Example: Non-Cash Boot
• Dylan owns qualifying property with a FMV of $120
(basis of $70). Luke owns qualifying property with a
FMV of $100 (basis of $90). Luke also owns stock
(boot) with a FMV of $20 and a basis of $5.
• Dylan recognizes $20 of his $50 realized gain and
defers $30. His basis in the qualifying property
received is $70. His basis in the stock is $20.
• Luke recognizes none of the $10 realized gain and
defers $10. His basis in the qualifying property
received is $110.
#8-15
Four Types of Nontaxable Exchanges
• Like-Kind Exchanges
• Involuntary Conversions
• Formation of a Business Entity
• Wash Sales
#8-16
Like-Kind Exchanges
• Definition of like-kind property:
• Personalty within class (IRS classification system): car
for car, computer for computer, automobiles for taxis, but
not copying machines for computers
• Realty: ANY business or investment realty is like-kind
with other business or investment realty: land for
warehouse, factory for office
• Inventory, stocks, bonds, partnership interests are NOT
like-kind
#8-17
Like-Kind Exchanges
• No gain or loss recognized by a taxpayer who
exchanges business or investment property for
other business or investment property of a like-kind
except due to boot; nonrecognition is mandatory,
not elective
• For this reason, usually loss properties should be sold
rather than swapped
#8-18
Like-kind Exchange - Example
• Matt owns an office building with $70,000 adjusted
basis and $200,000 FMV
• Phil owns land held for investment with $180,000
adjusted basis and $170,000 FMV
• If Matt and Phil wish to exchange assets, how much
boot must be given, and by whom, in order for this
exchange to be economically rational?
• Phil must give Matt an additional $30,000 to make values
equal
#8-19
Like-kind Exchange – Example continued
• Assuming appropriate boot is given, how much gain or
loss is realized and recognized by Matt and Phil on the
exchange?
• Matt realizes $130,000 of gain ($200,000 value received $70,000 basis of asset given); Matt recognizes $30,000 of
gain (boot received)
• Phil realizes $(10,000) of loss ($200,000 value received $210,000 total basis of assets given, including cash boot);
Phil recognizes $0 loss
• Determine the adjusted basis of the assets received by
Matt and Phil
• Matt’s adjusted basis in the land received = $70,000;
adjusted basis in the cash boot = $30,000
• Phil’s adjusted basis in the building received = $210,000
#8-20
Involuntary Conversions
• Involuntary conversion includes:
• theft
• government claim of property or condemnation
• natural disasters: fire, hurricane, tornado, earthquake
• If insurance proceeds are more than the adjusted
basis, the disposition results in a realized gain
which the taxpayer may ELECT to defer
• Losses are fully recognized; this occurs if property
was not insured or the insurance proceeds are less
than adjusted basis
#8-21
Involuntary Conversion
• Requirements to defer gain:
• 1) Reinvest proceeds in property which is similar or
related in service or use (These rules are stricter than
like-kind for realty)
• 2) Replacement property must be purchased within TWO
taxable years following the year in which the conversion
took place
• IF taxpayer does not reinvest full proceeds, gain is
recognized UP TO the difference between the
amount realized and the amount reinvested;
unreinvested amount is like “boot”
#8-22
Involuntary Conversion - Example
• Amy’s factory has an adjusted basis of $500,000. The
factory is destroyed by a tornado and she receives $650,000
from the insurance company
• A) If Amy reinvests $700,000 in a new factory, she may defer
all the gain. Her new basis will be $550,000 = $700,000 $150,000 deferred gain
• B) If Amy reinvests $600,000 in a new factory, she must
recognize $50,000 of gain, but can defer $100,000. Her
new basis is $500,000
• C) If Amy reinvests $400,000 in a new factory,
she must recognize ALL $150,000 of gain. Her
new basis is $400,000
#8-23
Corporate Formations
• No gain or loss is recognized when property is
transferred to a corporation solely in exchange for
that corporation’s stock IF the transferors of
property are in control (own >=80% of outstanding
stock) of the corporation after the exchange
• Personal services are NOT property but must be
recognized as compensation income
• The shareholder’s basis in the stock = substituted
basis of property contributed
• The corporation’s basis in the property = carryover
basis of property from shareholder
#8-24
Corporate Formation - Example
• Phil and Lil form a corporation. Phil contributes
$10,000 cash. Lil contributes a building with a FMV
of $10,000 (adjusted basis of $6,000). Phil and Lil
each receive 50% of stock with a FMV of $10,000.
• Phil has no gain or loss. His basis in the stock is
$10,000 – the basis of the stock.
• Lil defers her gain of $4,000. Her basis
in the stock is $6,000 – the basis of the
building. The corp.’s basis in the
building is $6,000.
#8-25
Partnership Formation
• Similar to corporation rule but with no (80%) control
requirement
• No gain or loss recognized
• Partner and partnership keep old basis in property
contributed
#8-26
Wash Sales
• Special rule requires LOSS DEFERRAL, but not
gain deferral
• Loss deferral required if taxpayer sells a security at
a loss but repurchases substantially same
securities within 30 days after OR 30 days prior to
the sale
• New basis = new purchase price +
deferred loss
#8-27
Wash Sale - Example
• Dorothy owns Nike stock she bought 3 years ago
for $50 per share. She sells it on September 6 for
$40. She repurchases more Nike stock on
September 23 for $38
• She cannot recognize the loss of $10 per share on
the September 6 sale
• Her new basis in the stock bought September 23
will be $48 ($38 purchase price + $10 deferred
loss)
#8-28
Book/Tax Difference from Nontaxable Exchange
• For financial reporting purposes, realized gains and
losses are recognized; thus, book value of property
= FMV
• For tax purposes, realized gains and losses are not
recognized; thus adjusted basis = FMV – deferred
gains + deferred losses
• The book/tax difference is temporary
and will reverse as property is
depreciated or disposed of in a
taxable transaction
#8-29