Like for Like Exchanges, Involuntary Conversions and Sale of Principal Residence
Like Kind Changes
Section 1031 defers recognizing gain or loss to the extent that property used in a trade or business or held for investment is exchanged for property of like-kind.
Let us explore the Definition of Like-Kind Property
For purposes of determining whether the like-kind requirement is met, property can be divided into three types:
I, Depreciable tangible personal property.
II. Other personal property which is intangible personal property, non- depreciable personal property and
personal property held for investment
III. Real Property
I. Depreciable Tangible Personal Property
There are two methods to satisfy the like-kind requirement for depreciable tangible personal property
First Method is the class method
This method consists of actual lists stating what is like for like property. These lists are the General Asset Class and the Product Class. Depreciable tangible personal property is of a like class if the property is either of the same General Asset Class or the same Product Class determined as of the date of the exchange.
General Asset Classes are:
1. Office furniture, fixtures and equipment.
2. Information systems (computers and peripheral equipment)
3. Data handling equipment, except computers
4. Airplanes (air frames and engines) except those used in commercial or contract carrying of passengers or freight, and all helicopters (airframes and engines.
5. Automobiles and taxis
6. Buses
7. Light general purpose trucks
8. Heavy general purpose trucks
9. Railroad cars and locomotives, except those owned by railroad transportation companies
10. Tractor units for use over the road
11. Trailers and trailer mounted containers
12. Vessels, barges, tugs and similar water transportation equipment, except those used in marine construction; and
13. industrial stream and electric generation and/or distribution systems
Product Class
A list of product class in the North American Classification System (NAICS). It is a manual that can be accessed on the internet.
Second Method for Personal Tangible Property
To determine whether property is of like-kind, all the facts and circumstances must be considered.
II. Other Personal Property
1. Intangible personal property patents and copyrights.
2. Nondepreciable personal property
3. Personal property held for investment-stamps, gems, antiques or coins
Other personal property must meet the like-kind property requirement in order to be like-kind property. There are no like classes provided for this type of property.
III. Real Property
The interest held in the property transferred and not just the property itself must be similar in character or nature. The following exchanges are considered exchanges of like-kind property:
1. timberland containing some virgin timber and substantial stands of second growth timber for timberland containing only virgin timber.
2. timberland for bare land
3. improved land for unimproved land
4. Real estate in a city for a farm or ranch
5. Underdeveloped ranch land for a commercial building.
6. A commercial building for commercial condominium offices
7. Cooperative housing corporation stock (with the stockholder's interest including a lease for more than 30 years) for a condominium interest in the same property when state law characterizes both the tenant-stockholders interest and the condominium interest as the ownership of real property
8. Apartment building for vacant land plus golf course improvements
9. fee interest for real subject to 99 years are condominium leases
10. rental property for farm property
11. A deep water terminal facility for in-land terminal sites along a pipeline.
12. timberland with reservation of timber cutting rights for state-owned timberland of lesser value.
Like for Like Exchange
1. The property exchanged and received must be held for business or investment purposes.
2. There must be an exchange of like-kind property.
3. One must recompute for Basis.
But before we can recompute for Basis:
One must first compute for recognized gain
We know that if we exchange a building for a building it is a like-kind exchange and there is no taxable event. However, we are going to compute for gain anyway so that we know what to do when items are exchanged that are not like-kind.
Formula for Recognized Gain
Recognized Gain is the Lesser of:
a. Realized Gain (Total FMV received minus Adjusted Basis of Property Surrendered)
OR
b. Boot
Example 1 of Exchange of Like-kind Property
__________________ exchanged a machine used in it's business with basis (cost) of $55,000 and fair market value of $75,000 for another machine basis from _____ of $65,000 and fair market value of $75,000. What is the recognized gain if any?
Machine 1 Machine 2
Basis FMV Basis FMV
$55,000 $75,000 $65,000 $75.000
Recognized Gains is the Lesser of:
a. Realized gain (total fair market value received minus basis of property surrendered).
In this case it is $75,000 FMV received - $55,000 basis of property surrendered = $20,000
OR
b. Boot which is -0-.
Answer: The lesser is zero. There is no recognized gain.
Now we can compute for Basis
The formula is:
a. adjusted basis of the property surrendered
b. increased by any boot given and any gain recognized
c. and decreased by any boot received
In our Example 1 Basis is computed as follows:
a. adjusted basis of property surrendered is $55,000
b. increased by any boot given and any gain recognized and both are -0-
c, and decreased by a Any boot received which is -0-
Answer is $55,000 +0 -0 = $55,000 basis
Like for Like and Non-Like Property
The non-like property in the exchange is called boot.
Boot
Boot is:
a. Cash
b. Non-like property
c. Relief of liability
Example 2 with Boot
__________________Traded a drilling press that he/she uses in his/her business with an adjusted basis of $2,000 and received a new one with a basis and FMV of $5,000 which is much larger and newer. ________had to pay $2,000 in cash and was promised a rebate of $500.00. What is ___________adjusted basis in the new drilling press?
Read the Question
What is the question asking for?
In this case the question is:
What is the basis of the new drilling press.
Drilling Press 1 Drilling Press 2
Basis FMV Cash Basis FMV Rebate
$2,000 $3,000 $2,000 $5,000 $5,000 We first compute for recognized gain because you cannot compute basis until you know what the recognized gain is as
follows:
Recognized gain is the Lesser of:
a. Realized (FMV received of $5,500 minus basis of property surrendered $2,000) = $3.500
OR
b. Boot of $500
Answer: Recognized gain is $500
Basis is:
a. adjusted basis of property surrendered of $2,000
b. increased by any boot given $2,000 and gain recognized of $500
c. and decreased by any boot received $500 rebate.
Answer: $2,000 + $2,000 +500 - $500 = $4,000 Basis
Example 3 with Boot
_________________owned an antique automobile that he/she used in his/her business with an adjusted basis of $7,000 and fair market value of $20,000. He/she exchanged the automobile with ____________ and received an automobile FMV of $10,000, cash $8,000 and a saw FMV $2,000. What is the recognized gain for the person with the antique automobile?
Automobile 1 Automobile 2
Basis FMV FMV
Auto $7,000 $20.000 Auto $10,000
Cash $ 8,000
Saw $ 2,000
20,000 Total
Recognized Gain is the lesser of:
a. Realized gain of (Total FMV of property received of $20,000 minus adjusted basis of property surrendered
$7,000) = $13,000
OR
b. Boot_________ received of $8,000 cash plus a saw FMV of $2,000 = $10,000
What is less $13,000 or $10,000?
Answer: Recognized gain is $10,000
Example 4
__________________exchanged a machine used in the business plus $26,000 cash for a newer machine. The old machine has an adjusted basis of $27,000 and a fair market value of $32,000 at the date of the exchange.
The new machine has a FMV of $58,000. What is the recognized gain on the older machine new machine exchanged?
Machine 1 Machine 2
Basis FMV Cash Basis FMV
$27,000 32,000 $26,000 $28,000 $58,000
Recognized gain is the lesser of:
a. Realized gain (FMV received $58,000 minus basis of property surrendered of $27,000) = $31,000
OR
b. Boot = 0
Answer is 0
Example 5
Like Kind Property with Liability
_____________________ exchanges his older building with a basis of $100,000, FMV of $200,000, and liability of $50,000 for a newer building with FMV of 130,000 and cash of $20,000.
Building 1 Building 2
Basis FMV Liability Cash FMV
$100,000 $200,000 $50,000 $20,000 $130,000
Recognized gain is the lesser of:
Total FMV received is: $150,000
Relief of liability +$50,000
$200,000
Minus adjusted basis of property surrendered ($100,000)
$100,000
OR
b. Boot
Cash $20,000
Liability Relieved +$50,000
$70,000
Lesser of $100,000 or $70,000
Answer: Recognized gain is $70,000
Characteristics of Like for Like Property
1. Deferral of gain
2. Deferral of unrecognized gains are accomplished by adjustments to the basis of the new and old property.
3. Like-kind exchange is a transfer of property for other than money or boot.
4. Gain is recognized in a like-kind exchange only to the extent non-like property is received.
5. Gain recognized is the lesser of the taxpayer's realized gain or amount of boot.
6 Gain is generally triggered when boot is received.
7. Must be used in a trade or business or investment.
8. The nature or character must be like for like.
9. The character of the property refer to the categories such as:
a. Depreciable tangible personal property
b. Other personal property
c. Real property
10. Like-kind exchanges do not apply to stocks, evidence of indebtedness or partnership interests.
11. An exchange of like-kind properties must be completed within the earlier of 180 days after the transfer of the exchanged
property or by the due date (including extensions) for the transferor's tax return for the taxable year in which the exchange
takes place.
12. There is a waiting period of 2 years after the date of the last transfer to dispose of the property if the like for like exchange is
between related parties.
13. Loss is not recognized in a like-kind exchange, even when cash is given in addition to the property.
14. A taxpayer who transfers mortgaged property as part of a tax free exchange is considered to have received cash in the amount of the mortgage to which the property is subject.
15. Report like for like exchanges on form 8824, Schedule D and form 4797. Form 8824 must be filed for two years if between
related parties.
Involuntary Conversions
WHAT IS AN INVOLUNTARY CONVERSION?
Property Destroyed by Fire
Property Destroyed by Earthquake
Property Destroyed by Hurricane
Condemnation
Embezzlement
An involuntary conversion occurs when property has been:
1. Destroyed
2. Stolen
3. Condemned for public use
4. Disposed under threat or imminence of condemnation.
What is the Taxability of Involuntary Conversion?
Involuntary conversion into similar property = no gain
Similar property is:
1. Property must have similar service
2. Property must have similar use
Involuntary conversion into money or property not similar = a portion may be taxable
Unless an election is made to replace with similar property
Involuntary Conversion
Replacement Period
PURPOSE:
To replace involuntary conversion into similar property when the recipient has received money (usually from an insurance company).
BEGINNING PERIOD:
Begins with the date of disposition or the earliest date of the threat or imminence of requisition or condemnation.
ENDING DATE:
Two years after the close of the first tax year in which any part of the gain is realized
OR
Later date if special permission is obtained.
Replacement Period Exceptions
1. Condemnation of business (other than inventory or investment real property) is 3 years.
2. Presidential declared disaster is 4 years.
3. Hurricanes may require additional years such Hurricane Katrina which was 4 years.
Gain on Involuntary Conversions
REIMBURSEMENT OF CASH IS NOT SIMILAR PROPERTY
If election is made to replace with similar property within the replacement period:
Example
Theater Building Insurance Company Taxpayer takes this money
Destroyed by Fire pays a cash reimbursement and purchased another
theater building
When is gain recognized in this situation?
1, The amount reimbursed exceeds the cost of the replacement property.
2. If the replacement property is the purchase of 80% or more of the stock of a corporation owning similar property, the gain is the amount reimbursed which exceeds the cost of the stock.
3. If the taxpayer invests in similar property in an amount equal to or greater than that of the reimbursement received for the involuntary conversion, there is no gain.
Sale of Personal Residence
No loss can be recognized on a sale of a residence.
Exclusion
The exclusion is available if the individual owned and occupied the residence for an aggregate of at least 2 out of the 5 years before the sale. The exclusion may be used only once every 2 years.
The amount of exclusion: $250,000 per individual and $500,000 for married filing jointly.
Married filing Joint
The $500,000 MFJ may be taken if:
1. Either spouse meets the ownership test.
2. Both spouses meet the use tests, and neither is ineligible for the exclusion because they sold or exchanged a personal residence.
3. A surviving spouse can qualify for the $500,000 exclusion if the residence is sold within 2 years of the other spouse's death.
Married Couples
Not entitled to $500,000
1. Married couples who do not live together but file joint returns, can take $250,000 for each spouse's personal principal residence.
2. If an individual marries and the other took the $250,000 exclusion within 2 years, the other is eligible for the $250,000 exclusion.
Divorce
Residence is transferred to the spouse and can add period of time the other spouse stayed in the residence.
Widowed Taxpayer
The widowed can receive the period during which the deceased spouse owned the residence. If the remaining spouse sells the residence within 2 years of the spouse's death, that spouse can deduct the $500,000 .
Physically or Mentally incapable
The period during which the taxpayer lives in a licensed care facility is taken into consideration to meet the two year period. But must have owned and used the residence for at least 1 year during the 5 years before sale.
Proration
One can prorate the 24 months if the taxpayer moves due to illness, job transfer or unusual circumstances..
Example of Proration
Taxpayer A lived in his residence 6 months and left due to relocation of his job.
Equation is 6/24= 25%X250,000 = $62,500 exclusion.
Sale of Residence Nonqualified Use
Gain from the sale or exchange of the main home is not excludable from income if it is allocable to nonqualified use. The period of time the residence was rented or business use.
Definition of nonqualified use: Nonqualified use means any person in 2009 or lateer where neither you or your spouse (or your former spouse) uses the property as a main home, with certain exceptions.
Exceptions:
1. Any portion of the 5 year period ending on the date of the sale or exchange after the last date you) or your spouse use the property as a main home.
2. Any period (not to exceed an aggregate period of 10 years during which you ( or your spouse) are serving on qualified official extended duty.
a. as a member of the Foreign service of the United States government or
b. as an employee of the intelligence community or
c. as a member of the uniformed services
3. Any other period of temporary service (not to exceed an aggregate period of 2 years) due to change of employment or health conditions.
4. Such other unforseen circumstances as may be specified by the IRS.
Calculation of Nonqualified Use
To figure the portion of gain allocated to the period of nonqualified use one must multiply the gain by the following fraction:
Total nonqualified use of ownership in 2009 or later
Total period of ownership
Example of Nonqualified Use
Mr. and Mrs. Enrolled agent purchased a personal residence on May 28, 2005. They lived in the house from May 28, 2005 to May 31, 2007. They rented the house from June 1, 2007 through March 31, 2009. They took depreciation of $10,000. They moved back into the house on April 1, 2009 and lived there until they sold the house on January 29, 2011 for a gain of $400,000.
They owned and lived in the house 2 out of the 5 year period from the date of sale which is January 31, 2006 through January 20, 2011.
Nonqualified use is January 11, 2009 through March 31, 2009 a total of 90 days.
Therefore:
Date of Ownerships is : 2032 days
Nonqualified days is: 90 days
Equation is: 90 X 400,000 gain = $17.716.53 gain
2032
Mr. and Mrs. Enrolled agents must report $17,716.53 as gain and the remainder of $382,283.47 ($17,716.53-$400,000) can be excluded on their joint return.
The End