Non-Recognition Transactions: Section 1031 Like-Kind Exchanges

We would have two taxable transactions if - I buy stock for $200,000 in cash and it appreciates in value to $300,000 You buy a house for $100,000 in cash and it appreciates in value to $300,000. We swap.

But section 1031 permits nonrecognition – deferral of realization – at least in part, if we swap like-kind property held for permitted purposes.

The “price” for nonrecognition and the method for deferring gain recognition is carryover or substituted basis.

You must swap; you cannot satisfy the statute if you receive cash and later buy like-kind property with the cash.

Certain kinds of triangular and escrow arrangements are permitted and important out in practice as ways to comply with the statute without a direct trade.

Sec is not elective, but is easy to avoid.

The statute begins by seeming to require only a swap of qualifying property, but we will see that “boot” is permitted.

Property exchanged and that acquired must be like-kind. What is that?

For personal property, the regulations and rulings are narrow. Double eagle gold coins and Swiss currency NOT like kind Double eagle gold coins and South African Krugerrands are NOT like-kind.

For real property, the rulings are generous. Urban real estate and ranch are like-kind. Improved and unimproved land are like-kind. Fractional interest in minerals on rural land and fractional interest in city hotel lot are like- kind.

In addition to being like-kind, both the property given up and that acquired must be Either held for productive use in a trade or business OR held for investment.

Inventory property or other property held for sale in the ordinary course of business is NOT eligible for section 1031 treatment.

For a shoe manufacturer, shoes are inventory; the shoe- making machine is held for productive use in a trade or business.

It is okay under sec for the taxpayer to exchange property held for productive use for investment property or vice versa. The two properties do not both have to be held for the same permitted purpose.

That is, the taxpayer doing the exchange can mix and match, trading property held for one of the permitted uses for property held for the other.

Be careful about gifts. Okay to swap ranch for another ranch and give ranch to children 9 months later. Not okay to swap farm for residential properties chosen by kids and in which kids life for free until gift.

Test each party to an exchange separately. Ask how that person held the property given and that acquired. Consider the farmer and the dealer when farmer exchanges old tractor plus cash for new tractor.

Not only inventory, but also stocks, bonds and notes are excluded from sec Purpose of sec is to permit nonrecognition for illiquid investments, when taxpayer has not “cashed in.” Thus, recognition is required when assets are liquid.

Let’s look at handout entitled “Summary of Section 1031.”

Let’s stop and consider again realization versus recognition.

A has land with AB of $50k and FMV of $150k. B has $150k in cash. They swap. What is A’s gain realized? Gain recognized? Basis in acquired property? What is B’s gain realized? Gain recognized? Basis in acquired property?

A has land with AB of $50k and FMV of $150k. B has stock with AB of $75k and FMV of $150k. They swap. What is A’s gain realized? Gain recognized? Basis in acquired property? What is B’s gain realized? Gain recognized? Basis in acquired property?

A has land with AB of $50k and FMV of $150k. B has land with AB of $75k and FMV of $150k. They swap. What is A’s gain realized? Gain recognized? Basis in acquired property? What is B’s gain realized? Gain recognized? Basis in acquired property?

Let’s stop and consider again the section 1031 basis rules. First calculate the “pot” of basis: Basis of all property given up, plus Gain recognized because of boot received, plus Basis of boot paid (includes face value of cash), plus Gain or loss (as a negative number) recognized because of boot paid

You can use a special rule for boot paid. Treat boot paid as a side transaction. Calculate gain or loss. Include the FMV of boot paid in your total basis number for the pot of basis.

Assign any U.S. cash received its face vaue and reduce the pot of basis by that amount.

Assign any non-cash boot received FMV as basis and reduce the pot of basis further by that amount.

What remains in the pot is the basis for qualifying property. If there is more than one piece of qualifying property, allocate basis between or among them per relative fair market value of the properties.

Let’s do the problems from the textbook.

Let’s do handout “More on Like-Kind Exchanges” with exchange between farmer and retiree. Farmer - farm with an AB of $50k and FMV of $75k along with a diamond ring just inherited from his mother, worth $25k. Retiree – office building with AB of $75k and FMV of $90k.

Let’s go over 2004 Optional Quiz with Grandmother Moneybags and Grandson Sam.