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.