Basics of Nontaxable Exchanges

BASICS OF NONTAXABLE EXCHANGES

A nontaxable exchange is a transaction in which the realized gain or loss is not currently recognized. If the exchange is completely nontaxable, all of the realized gain or loss is postponed. If the exchange is partially nontaxable, only part of the realized gain or loss is postponed. Potential forms of the transaction are sales, exchanges, and involuntary conversions (i.e., casualty, theft, or condemnation). The ability to postpone recognition of the realized gain or loss is either mandatory or elective, depending on the statutory language.

I. FOUR REQUIREMENTS FOR NONRECOGNITION **The property transferred in a like-kind exchange must be held for productive use in a trade or business or for investment. a. Property held for personal use does not qualify. b. The language of § 1031 provides that certain property is neither productive use nor investment property. Included are: inventory, partnership interests, stocks, bonds, and notes, other securities or evidence of indebtedness or interest. c. Note that it may be possible for the exchange of stock to qualify for nontaxable exchange treatment under § 1036.

**Like-kind Property. Property exchanged must be like-kind property. Under Reg. § 1.1031(a)-1(b), “the words ‘like-kind’ have reference to the nature or character of the property and not to its grade or quality. One kind or class of property may not be exchanged for property of a different kind or class.” The intent is that the term be interpreted broadly. However, there are three categories of exchanges which never qualify. These are: (1) The exchange of real property (realty) for personal property (personalty) and vice-versa. (2) The exchange of livestock of different sexes. (3) The exchange of real property located in the United States for foreign real property and vice-versa.

Even if the property exchanged qualifies as like-kind property, § 1031 postponement may not apply if the taxpayers involved in the exchange are related parties. (1) To qualify for postponement treatment, the taxpayer and the related party must not dispose of the like-kind property received in the exchange within the two-year period following the date of the exchange. (2) An early disposition results in the realized gain being recognized as of the date of such early disposition. (3) Certain events are not treated as early dispositions: transfers due to death, involuntary conversions, and certain non-tax avoidance transactions.

Examples of exchanges that are not like-kind are: (1) Exchange of numismatic-type coins (e.g., U.S. $20 gold coins) for bulliontype coins (e.g., South African Kruggerand gold coins). Rev. Rul. 79-143, 1979-1 C.B. 264. (2) Exchange of gold bullion held for investment for silver bullion held for investment. Rev. Rul. 82-166, 1982-2 C.B. 190. (3) Exchange of inventory for machinery used in the trade or business. (4) Exchange of land or building for machinery used in the trade or business. (5) Exchange of investment land in Vermont for investment land in France.

Regs. § 1.1031(a)-2 provide for greater specificity in determining whether depreciable tangible personal property is of a like kind or class. These Regulations make it more difficult to qualify for § 1031 like-kind exchange treatment for depreciable tangible personal property. Such property held for productive use in a business is of a like class only if the exchanged property is within the same general business asset class (as specified by the IRS in Rev. Proc. 87-57 or as subsequently modified) or the same product class (as specified by the Department of Commerce). Property included in both is evaluated under the general business asset class system rather than under the product class system. Examples of general business asset classes: (a) Office furniture, fixtures, and equipment. (b) Information systems (computers and peripheral equipment). (c) Airplanes. (d) Automobiles and taxis. (e) Buses. (f) Light general-purposes trucks. (g) Heavy general-purpose trucks.

**The property received must be held for productive use or for investment.

**The form of the transaction must be an exchange.

The § 1031 postponement of the recognition of the realized gain or loss is mandatory. Therefore, if the taxpayer wants to avoid nontaxable exchange treatment, it is necessary to structure the transaction so that the statutory requirements of §1031 are not satisfied. (e.g., the taxpayer may wish to avoid the § 1031 postponement in order to recognize a realized loss.

II. EFFECT OF BOOT Boot is property which is not like-kind property. a. Boot may be used to effect an exchange where the values of the like-kind property exchanged are not equal. b. Example: Khalid exchanges a building worth $50,000 for a building worth $45,000 plus $5,000 cash boot.

Receipt of Boot. The receipt of boot triggers recognition if there is realized gain. a. The amount of gain that is recognized is the lower of: (1) The amount of the realized gain. (2) The amount of boot received. b. If boot is received and loss is realized, no recognition occurs. Giving of Boot. The giving of boot normally does not trigger recognition. However, if the adjusted basis of the boot transferred is not equal to its fair market value, recognition of gain or loss occurs. In this situation, realization will not serve as the ceiling on recognition.

Giving and Receiving of Boot. Boot may be both given and received in a § 1031 transaction. The amounts of the boot involved normally should be netted to determine if the taxpayer is in a net giving or receiving position.

III. BASIS AND HOLDING PERIOD OF PROPERTY RECEIVED Basis of Boot Received. The basis of boot received is the fair market value of the property.

Basis of Like-Kind Property Received. Section 1031 provides the following basis calculation formula for the like-kind property received. Basis of like-kind property transferred + Basis of boot given + Gain recognized – Fair market value of boot received – Loss recognized

As a validity check, the basis of the like-kind property received also can be calculated using the following formula (If the basis has been properly calculated with each formula, the results will be the same).

Fair market value of like-kind property received – Postponed gain, or + Postponed loss

Holding Period. A separate holding period rule applies for the boot and the like-kind property received. The boot has a new holding period (i.e., from the date of the exchange). The like-kind property received generally has a carryover holding period (i.e., includes the holding period of the like-kind property transferred).

IV. INVOLUNTARY CONVERSIONS An involuntary conversion is the result of the destruction (complete or partial), theft, seizure, requisition or condemnation, or the sale or exchange under threat or imminence of requisition or condemnation of the taxpayer’s property. The form of the involuntary conversion may be either direct or indirect. a. In the direct form, the involuntarily converted property is converted directly into the replacement property (i.e., property into property). b. For the indirect form, the taxpayer receives money or other property (i.e., not qualifying property) which is then used to purchase the replacement property (i.e., property into money into property). Replacement Property Under the general rule, the replacement property must be “similar or related in service or use.” This requirement is more restrictive than the § 1031 test for like-kind property.

a. Functional use test. The functional use test is applicable for the owner-operator of involuntarily converted property. Under this restrictive test, the taxpayer’s use of the replacement property and the involuntarily converted property must be the same. Example: An office building that was used in a trade or business cannot be replaced with a factory building.

b. Taxpayer use test. The taxpayer use test is applicable for the owner-lessor of involuntarily converted property. Under this test, the properties must be used by the taxpayer in similar endeavors. Example: A warehouse leased to various tenants could be replaced with an office building that is leased to various tenants.

c. Direct versus indirect purchase of replacement property. The replacement property can be acquired directly by purchase of the property or indirectly by purchasing the stock of a corporation which owns such property if such stock purchase represents the acquisition of control (defined in the Code as at least 80 percent) of the corporation.

Exception for Certain Condemned Property. Section 1033(g) provides an exception to the requirement that the replacement property must be “similar or related in service or use.” This exception is applicable if the form of the involuntary conversion is the condemnation of real property which is used in the taxpayer’s trade or business or is held for investment. In this case, the “similar” requirement is replaced with the requirement that the replacement property be “like-kind.” The benefit of this exception is that the taxpayer is provided with much more flexibility in terms of the choice of replacement property. Example: Erika’s factory building is condemned to make way for an interstate highway. The proceeds received are reinvested in land to be held for investment. The acquisition of such land qualifies for postponement treatment under § 1033 because the replacement property need only be like-kind rather than “similar or related in service or use.” The exception under § 1033(g) will not apply if the method of acquiring the replacement property is the indirect method of stock purchase (i.e., purchasing the stock of a corporation which owns the replacement property and such stock purchase represents the acquisition of control of the corporation).

Replacement Time Period The earliest date for replacement depends on the form of the involuntary conversion. If the property is condemned, the earliest date for replacement is the date of the threat or imminence of requisition or condemnation of the property. If the form of the involuntary conversion is other than condemnation, the earliest date is the date the involuntary conversion occurs. Latest Date for Replacement. The starting point for determining the latest date for replacement is the date of the realization of gain. This is the date the taxpayer receives an asset inflow (cash or other property) associated with the involuntary conversion that is large enough to produce a realized gain. a. The general rule is that the taxpayer has two years from the end of the taxable year in which gain was first realized. b. Section 1033(g)(4) provides that the period shall be three years rather than two years if the form of the involuntary conversion is the condemnation of real property which is used in the taxpayer’s trade or business or held for investment. c. Reg. § 1.1033(a)-2(c)(3) provides that the IRS may grant an extension of the twoyear or three-year statutory period.

Nonrecognition Rules Realized Loss on the Involuntary Conversion. The rules for realized loss on the involuntary conversion of property are mandatory. a. A realized loss on the involuntary conversion of business or income producing property is recognized. b. A realized loss on the involuntary conversion of personal use property may or may not be recognized, depending on the factors mentioned below. (1) If the form of the involuntary conversion is a condemnation, the realized loss is not recognized. (2) If the form of the involuntary conversion is a casualty or theft, the realized loss is recognized subject to the $100 and 10% floor provisions for personal use casualty and theft loss property.

Realized Gain on the Involuntary Conversion. Separate rules are provided for direct conversions (i.e., conversion is directly into replacement property) and indirect conversions (i.e., conversion is into money and then into replacement property). a. A realized gain in a direct involuntary conversion is postponed. This provision is mandatory. b. A realized gain in an indirect involuntary conversion is recognized unless the taxpayer elects to postpone the gain. (1) The amount of the realized gain that is recognized if the taxpayer elects postponement is the lesser of the realized gain or the amount realized that is not reinvested in replacement property. If no election is made, the realized gain is recognized. (a) The realized gain. (b) The amount realized that is not reinvested in replacement property.

Basis and Holding Period of Proerty Received Basis of Boot Received. The basis of boot received is its fair market value. Basis of Qualifying Property Received. The basis of the qualifying property received is calculated as the fir market value of qualifying property received less the postponed gain Holding Period of Property Received. A separate holding period rule applies for the boot and the qualifying property received. a. The boot has a new holding period. b. The qualifying property received generally has a carryover holding period (i.e., includes the holding period of the qualifying property transferred). (1) The logic for this is to produce symmetrical treatment in that the qualifying property has a carryover basis. (2) However, in the case of involuntary conversions after March 1, 1954, the carryover holding period is not applicable unless the involuntarily converted property was either a capital asset or § 1231 property.

V. SALE OF A RESIDENCE: § 121 EXCLUSION

REQUIREMENTS FOR EXCLUSION TREATMENT Principal Residence. The property must have been the taxpayer’s principal residence (see the definition in 35.).

Ownership and Occupancy Requirements. At the date of sale, the residence must have been owned and used by the taxpayer as the principal residence for at least two years during the 5-year period ending on the date of the sale. The § 121 exclusion can be used only once every 2 years (i.e., not permitted for sales occurring within 2 years of its last use).

Exception to ownership and occupancy requirements and frequency of use requirement (i.e., relief provision). (1) Requirements are waived for each of the following: • Change in place of employment. • Health. • To the extent provided in the Regulations, other unforeseen circumstances. These Regulations were issued in December 2002. (2) Effect of waiver: Full amount of the § 121 exclusion may not be available. The amount of the exclusion provided by this relief provision is calculated as follows: No. of qualifying months X § 121 exclusion amount ($250,000 or $500,000) 24 months

CALCUATION OF THE AMOUNT OF THE EXCLUSION Maximum amount of § 121 exclusion for an unmarried individual is $250,000. If realized gain is not greater than $250,000, the recognized gain is $0. If realized gain is greater than $250,000, the recognized gain is the excess of the realized gain over $250,000. Amount realized in calculating the realized gain is the selling price less the selling expenses. (1) Examples of selling expenses: includes items such as cost of advertising the residence for sale, real estate broker commissions, legal fees in connection with the sale, and loan placement fees paid by the seller as a condition of arranging financing for the buyer. (2) Repairs and maintenance made by the seller to aid in selling the property are neither selling expenses nor adjustments to the seller’s basis for the residence.

Maximum amount of § 121 exclusion for a married couple. If a married couple files a joint return, the $250,000 § 121 exclusion amount is increased to $500,000 if the following requirements are satisfied. (1) Either spouse meets the at-least two years ownership requirement. (2) Both spouses meet the at-least two years use requirement. (3) Neither spouse is ineligible for the § 121 exclusion on the sale of the current principal residence because of the sale of another principal residence within the prior two years. If each spouse owns a qualified principal residence, each can qualify for the maximum $250,000 exclusion on the sale of their own residence regardless of whether a joint return or separate returns are filed.

BASIS OF A REPLACEMENT RESIDENCE Purchase of a replacement residence is not required. To be eligible for the § 121 exclusion, there is no need to acquire another residence. Basis of a new residence is its cost.

PRINCIPAL RESIDENCE Generally, the principal residence is the one in which the taxpayer resides most of the time. Effect of Renting on Principal Residence Requirement. The renting of the taxpayer’s principal residence prior to sale does not affect qualifying for the § 121 exclusion as long as the ownership and occupancy requirements in are satisfied. a. The residence thus does not have to be the principal residence on the date of sale. b. Negative effect of renting. Any realized gain that is attributable to depreciation is not eligible for the § 121 exclusion.

37. Part of a Residence May be Principal Residence. Part of the residence may be the taxpayer’s principal residence and part may not (e.g., part of the residence is used as a qualifying home office under § 280A). a. Not necessary to allocate the realized gain between the home office part and the principal residence part. b. Negative effect of home office. Any realized gain that is attributable to depreciation is not eligible for the § 121 exclusion.

ELECTION TO FORGO § 121 EXCLUSION Normal Result: The § 121 exclusion automatically applies if the taxpayer is eligible. Election to Forgo: An election can be made to forgo the § 121 exclusion. This could be desirable if realized gain on the sale of the residence is smaller than that on a subsequent sale of another residence during the two-year window.

Section 121 exclusion has no effect on realized losses.