Download Chapter 8: Tax-Deferred Exchanges

Chapter 8
Tax-Deferred
Exchanges
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Tax-Deferred Exchanges

A tax-deferred exchange postpones gain or
loss recognition to the future by adjusting
basis of the asset acquired
 The longer gain recognition can be
postponed the greater the tax savings
 The longer a loss is postponed the less
valuable the loss
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Basis Adjustments
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Gain is deferred by reducing the adjusted
basis of the replacement property by the
deferred gain
Loss is deferred by increasing the adjusted
basis of the replacement property by the
deferred loss
When the replacement asset is sold at a later
date, the basis adjustment results in the
deferred gain or loss being recognized
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Basis
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Carryover basis – the basis of the original
asset follows the asset to the new owner
Substituted basis – the basis of the original
asset is substituted for the basis of the asset
acquired
Holding period of the old asset is added to
the holding period of the new asset when
basis is determined by carryover, substitution
or basis adjustment
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Like-Kind Exchanges
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When eligible property is exchanged solely for
other eligible property of like-kind, no gain or
loss is recognized (Section 1031)
The gain or loss realized is deferred through
an adjustment to the basis of the replacement
property
Only property used in a trade or business or
held for investment is eligible property
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Like-Kind Exchanges

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Excluded properties include inventory, stock
in trade, securities, and partnership interests
If the requirements are met, like-kind
exchange treatment is mandatory (not
elective) and it applies to losses as well as
gains
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Qualifying Like-Kind Exchanges
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Realty must be exchanged for realty (can be land
or buildings)
Personalty must be exchanged for personalty in
same class
General asset classes for personalty include
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Office furniture, fixtures & equipment
Computers & info systems equipment
Automobiles & taxis
General-purpose light trucks
General-purpose heavy trucks
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Boot’s Effect on a
Like-Kind Exchange


The receipt of boot can cause realized gain to
be recognized
Boot is anything that is not eligible like-kind
property and includes
 Cash
 Properties not of a like-kind
 Net liabilities discharged in the transaction
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Boot’s Effect on a
Like-Kind Exchange

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Gain Recognized = lesser of gain realized
or boot received (giving boot does not affect
gain recognition)
If a loss is realized on a like-kind exchange,
boot has no effect on loss recognition
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Like-Kind Exchange Planning


Taxpayers with loss assets might want to sell
them so they can deduct their losses in the
current year, then buy replacement property
Alternatively, taxpayers can receive cash taxfree in an exchange if there is a realized
loss, as boot can be received without
causing gain recognition
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Determining Basis in
Like-Kind Exchanges

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Basis in replacement property = FMV of
property received less deferred gain plus
deferred loss
Alternatively, basis in replacement property =
basis of property surrendered plus boot given
plus gain recognized less boot received
 Holding period for new property includes
holding period of property surrendered

Basis of Boot = FMV
 Holding period begins on date received
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Indirect Exchange
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In an indirect exchange, the taxpayer hires a
third party to purchase the desired property
The third party then exchanges the justpurchased property for the taxpayer’s
property
The taxpayer has a qualifying exchange
The seller of the property and the third party
have taxable transactions
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Nonsimultaneous Exchange

A taxpayer can sell his property, but a third
party must hold all proceeds so that the
taxpayer has no access to any cash or other
property received in the sale
 The taxpayer has 45 days from the date the
property is transferred to identify like-kind
property to be exchanged
 The acquisition of the identified property
must be completed within 180 days
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Wash Sales

Wash sale - identical securities acquired
within 30 days before or after the sale date (a
61-day period)
 Wash sale losses are disallowed but gains are
taxed
 Loss is deferred by adding disallowed loss to
basis of new shares
 If more stock is sold than is purchased within
the 61-day period, only a portion of the loss
representing the repurchased stock is
deferred
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Involuntary Conversions

An involuntary conversion results from
Theft – embezzlement, larceny and robbery
(but not simply losing items)
Casualty – requires a sudden, unexpected,
and unusual event such as a fire, flood,
tornado, hurricane or vandalism
Condemnation – lawful taking of property for
its fair market value by a government under
the right of eminent domain
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Casualties and Thefts

Gains and losses sustained on casualties and
thefts are not under a taxpayer’s control so they
receive special tax treatment
Allowable losses (including personal losses) are
immediately deductible
Gains (due to receipt of insurance proceeds) may
be deferred if all insurance proceeds are used to
repair the damaged property or to acquire
qualifying replacement property
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Casualty and Theft Losses

Loss limited to the lesser of:
1.
2.

Decline in fair market value (or repair costs
to restore property to pre-casualty condition)
The adjusted basis of the property (for
business property that is completely
destroyed, the loss is always the property’s
adjusted basis)
This loss is then reduced by any insurance
proceeds received
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Casualty and Theft Loss
Deductions
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Thefts are deductible in year of discovery
For casualties in designated disaster areas,
taxpayer can elect to deduct loss in preceding
year
A net business loss is deducted from ordinary
income; an investment loss is a miscellaneous
itemized deduction
Individuals have additional limits on losses from
personal-use property:
$100 floor per casualty (per event)
10% of AGI threshold
Must itemize to deduct loss
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Gains on
Involuntary Conversions
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If the insurance recovery on a casualty or
theft is greater than the loss, the taxpayer has
a gain
Condemnations usually result in gain
because proceeds received are usually fair
market value
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Gains on Involuntary
Conversions
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If all proceeds are used to acquire qualified
replacement property (or repair the property
to its pre-casualty condition) within the
required replacement period, the gain is
deferred
Gain may have to be recognized if all
proceeds are not used to acquire
replacement property (or make repairs to the
damaged property) within the required time
period
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Replacement Period
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Extends 2 full tax years after the end of the
taxable year in which the involuntary conversion
occurs
Extended to 3 years if the involuntary
conversion involves the condemnation of
business or investment realty
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Replacement Property
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Functional-use test – replacement property
provides same function as converted property
Taxpayer-use test – only need to replace with
leased property (applies to investment real
estate rented and not used by owner)
Condemned business or investment realty
only need meet like-kind test
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Gain Recognition
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Gain Recognized = lesser of gain realized or
the amount not reinvested (amount realized
less amount reinvested)
This provision does not apply to losses
The basis in the replacement property is the
cost (amount reinvested) less any deferred
gain (gain realized less gain recognized)
Except in the case of direct conversion,
involuntary conversion treatment is elective
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Involuntarily Converted
Principal Residence
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If the taxpayer acquires a replacement
residence, using all the proceeds received,
all gain can be deferred
If taxpayer meets required ownership & use
tests, up to $250,000 ($500,000 if both
spouses qualify) of gain can be excluded
These two provisions can be combined to
exclude gain on the amount that is not
reinvested
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Transfers to Sole Proprietorships
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Gain or loss deferred on transferred assets
Basis of transferred asset to sole
proprietorship is lesser of adjusted basis or
fair market value at date of conversion to
business use
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Transfers to Corporations

Gain or loss deferred when cash or property
(services are not property) is transferred to
corporation in a qualifying exchange for stock
 Shareholders transferring property must own
80% of stock
 Service providers excluded from 80%
ownership unless property also transferred
 Stock received for services results in taxable
income to shareholder rendering services
 Gain recognized when boot (anything other
than stock) received; gain = the lesser of
realized gain or FMV boot received
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Transfers to Corporations (cont’d)
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Shareholder’s stock basis = basis of
property transferred plus gain recognized
less boot received less liabilities assumed
by the corporation
Basis of property transferred carries over
to corporation increased by any gain
recognized by shareholder
Basis of boot received is its FMV
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Transfers to Partnerships
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No gain or loss is recognized by partners
or the partnership (with no minimum
ownership required) on the transfer of
cash or property to the partnership in
exchange for a partnership interest
Partners must recognize taxable income
if partnership interest is received for
services rendered
Basis of property carries over to the
partnership
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Transfers to Partnerships
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Partner’s basis in partnership interest =
basis of property given up less liabilities
assumed by the partnership plus partner’s
share of partnership liabilities plus gain
recognized
Partner may be required to recognize gain
to avoid a negative basis
 If liabilities assumed by the partnership
exceed the partner’s initial basis
(including allocated share of partnership
liabilities)
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Corporate Reorganizations

Involve transfer of all or part of one or more
corporation’s assets or stock to a second
corporation over which it has control in a
transaction that qualifies as a reorganization
Acquisitive – one corporation acquires assets
or stock of another corporation
Divisive – one corporation splits into 2 or
more corporations
Recapitalization
Reincorporation
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Corporate Reorganizations
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Corporations and shareholders exchange
stock for property or stock for stock on a taxdeferred basis
The property or stock received will have a
carryover or substituted basis
Boot received will cause all or part of gain to
be recognized
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Reorganizations
Appendix 8A
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Types of Reorganizations
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Seven types of reorganizations referred to as
Types A through G
Types A, B, and C are acquisitive reorganizations
Types E and F involve only one corporation
making technical changes
Type D reorganization can be either divisive or
acquisitive
Type G is similar to a D reorganization but applies
only in bankruptcy
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Acquisitive Reorganizations
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Generally involves either
The acquisition of one corporation’s assets
(target) by a second corporation (acquirer)
after which the target ceases to operate
The acquisition of the target corporation’s
stock for stock of the acquirer, after which the
target becomes a subsidiary of the acquiring
corporation
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Acquisitive Reorganizations
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Asset acquisitions
Type A – statutory merger or consolidation
Type C – stock for asset acquisition
Type D – acquisitive
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Stock for stock acquisition
Type B
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Acquisitive Reorganizations
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Acquirer transfers stock and securities to
Target in exchange for Target’s assets
Neither Acquirer nor Target recognizes gain
or loss
Acquirer takes the same basis in the assets
as their basis in Target’s hands
Target recognizes no gain or loss on the
receipt of stock or securities
 Target recognizes no gain on receipt of other
property as long as this property is distributed to
its shareholders
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Acquisitive Reorganizations
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Gain is recognized by Acquirer only if it
transfers appreciated property other than
stock or securities to Target
No loss is recognized on depreciated property
that is transferred
Target uses FMV for the basis of all
transferred property
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Acquisitive Reorganizations

Target’s shareholders usually recognize no
gain or loss on receipt of stock in exchange
for their stock in Target
They may be required to recognize gain if
principle of securities received exceeds
securities surrendered
If shareholders receive boot, they recognize
gain equal to the lesser of realized gain or fair
market value of boot received
Basis of stock or securities received = basis
surrendered – boot received + gain
recognized
Basis of boot = fair market value
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Acquisitive Reorganizations
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Type B stock-for-stock reorganization
Acquiring corporation acquires Target’s stock
from its shareholders in exchange solely for
stock of Acquirer
Acquirer can use nothing but its own voting
stock to acquire Target’s stock
Neither Acquirer nor Target’s shareholders
recognize gain or loss
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Type A Reorganization

Merger – the acquisition of the assets of a
target
Target liquidates and the acquiring corporation
continues
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Consolidation – transfer of assets by two or
more corporations to a new corporation
Transferring corporations liquidate and the
new corporation survives
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Type A Reorganization
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Acquirer can use both its stock and securities
Must meet continuity of interest
At least 50% of the shareholders of Target
must becomes shareholders of Acquirer
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Shareholder of both Acquirer and Target
usually must approve the merger
Acquirer becomes liable for all liabilities of the
Target
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Type A Reorganization
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Acquirer may transfer assets of Target to a
subsidiary
Forward triangular mergers
Subsidiary could be Acquirer with Target
shareholders becoming minority shareholders
of Target
Subsidiary may acquire assets of Target using
stock of Parent
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Type A Reorganization
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Reverse triangular merger
Parent transfers assets of subsidiary (which
includes parent’s stock) to Target and
subsidiary liquidates
Target becomes new subsidiary of parent
Additional requirements apply
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Type B Reorganization
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Acquisition of Target’s stock in exchange for
voting stock of Acquirer
Shareholders of Target become shareholders
of Acquirer and Acquirer controls Target (owns
80% or more of stock)
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A subsidiary of Parent may also be the
Acquirer using solely Parent’s stock
Target’s stock may also be transferred to a
subsidiary of Parent
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Type B Reorganization
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Prior purchases of stock normally will not taint
the acquisition
Acquirer has up to one year to complete the
acquisition of control of Target
Once control requirement met, additional
acquisitions of Target’s stock for Parent’s
stock continue to qualify as a reorganization
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Type C Reorganization
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Similar to Type A but specific requirements must
be met
Acquirer must acquire substantially all the asset
of Target solely for voting stock of Acquirer
Must distribute any remaining assets and stock
of Acquirer to its shareholders and then liquidate
The assets acquired must permit Acquirer to
continue Target’s historical business
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Type C Reorganization
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Acquirer may assume an unlimited amount of
Target’s liabilities only if the Acquirer’s voting
stock is used in the acquisition
Otherwise, the combination of boot + liabilities
assumed cannot exceed 20% of consideration
Only Target’s shareholders must approve the
merger and liquidation of Target
Acquirer may transfer Target’s assets to a
subsidiary or a subsidiary may use parent stock
to acquire Target in a forward triangular merger
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Type D Acquisitive
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Acquirer transfers substantially all of its assets
to Target in exchange for stock of Target
Target holds its own assets as well as those of
Acquirer
Target stock is then distributed to Acquirer’s
shareholders and they received sufficient stock
(50%) to control Target
Acquirer may not transfer assets to a
subsidiary nor use a subsidiary to acquire
Target
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Type D Divisive
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Some (but not all) of original corporation's
assets are transferred to a subsidiary and
subsidiary’s stock is distributed to
shareholder of original corporation
Spin-off – original shareholders receive a pro
rata distribution of stock and do not surrender
stock of the original corporation
Split-off – stock of new corporation is
distributed to some of the shareholders in
exchange for their stock in the original
corporation
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Type D Divisive

Split-up – all assets of original corporation are
split between two or more new companies
and the stock of each company is distributed
to the shareholders in exchange for their
stock in the original corporation
Original corporation goes out of business
Stock can be distributed to shareholders
tax-free
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Type D Divisive
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The transfer of assets results in at least two
corporations, each of which must conduct an
active business immediately after the transfer
Businesses must have been conducted for at
least 5 years prior to separation


Sufficient stock and securities of new
corporation(s) must be distributed to
shareholders so they have at least 80% control
Any other property distributed to shareholders is
boot and causes gain to be recognized
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Type E Reorganization
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A recapitalization of an existing corporation
Allows tax-free exchange of common or
preferred stock for other common or preferred
stock, bonds for other bonds, and bonds for
stock
Stock may not be exchanged tax free for
bonds as that upgrades a shareholder to a
creditor
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Type F Reorganization
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A change in a corporation’s name, place of
incorporation, or its status from profit to
nonprofit or vice versa
Shareholders of the original corporation must
continue as shareholders of the
reorganization corporation
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Type G Reorganization
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Allows transfer of assets to a new
corporation as part of bankruptcy
proceedings
Stock or securities are distributed to the
shareholders in a manner resembling a D
reorganization
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Other Considerations
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Requesting an advance ruling on the tax
consequences is advisable
Must have a sound business purpose
Must maintain a continuity of ownership by
shareholders of the participating corporations
Must maintain a continuity of business
enterprise
Status of target’s NOLs and other attributes
must be considered
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The End
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