Chapter 8: Tax-Deferred Exchanges

Report
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 an 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 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 property of a like-kind, no gain or loss is
recognized (Section 1031)
The gain or loss realized is deferred by
adjusting the basis of the replacement property
Qualifying property must be used in a
business or for investment
Certain properties are excluded:
 inventory, stock, securities, and partnership
interests
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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:
 Office furniture, fixtures & equipment
 Computers & info systems equipment
 Automobiles & taxis
 General-purpose light trucks
 General-purpose heavy trucks
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Like-Kind Exchanges
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The receipt of boot can cause realized gain to
be recognized
Boot is anything that is not like-kind qualifying
property and includes:
 Cash
 Properties not of a like-kind
 Net liabilities discharged
in the transaction
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Like-Kind Exchanges

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Gain Recognized = lesser of gain realized
or boot received (giving boot does not affect
gain recognition)
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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Like-Kind Exchanges

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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 because when there is a
realized loss, boot can be received without
causing gain recognition
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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
must treat the transaction as taxable
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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 likekind 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 sale (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 including a fire, flood,
tornado, hurricane or vandalism
Condemnation – lawful taking of property for
its fair market value by government under
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
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Loss limited to the lesser of:
1) Decline in fair market value (or repair costs
to restore property to pre-casualty
condition)
2) The adjusted basis of the property (for
completely destroyed business property,
the loss will always be adjusted basis)
This loss is then reduced by any insurance
proceeds received
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Casualty and Theft Losses
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Thefts deductible in year of discovery
Casualties in disaster areas 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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Casualty or theft gains result when insurance
recovery is greater than basis
Condemnations usually result in gain
because proceeds received are usually fair
market value
If all of the proceeds are reinvested in
qualified replacement property (or repairing
the property to its pre-casualty condition) then
 Gain is deferred if reinvestment done within
replacement period
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Replacement Period
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2 full tax years after the end of the taxable year
in which the involuntary conversion occurs
Extended to 3 years if it involves a
condemnation of business or investment realty
If any of the proceeds are not reinvested (either
through repairs of the damaged property or by
acquiring replacement property within the time
period), then gain is recognized on the amount
not reinvested
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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 needs to 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,
the gain can be deferred
If taxpayer meets 2 year ownership & use
tests, can exclude up to $250,000 ($500,000
if both spouses qualify) of gain
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
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
is contributed to corporation in exchange for
stock
 Shareholders contributing qualified
property must own 80% of stock (services
do not qualify)
 Stock received for services results in
taxable income to shareholder rendering
services
 Gain recognized when boot received

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Gain = lesser of realized gain or FMV boot
received
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Transfers to Corporations

Stock basis =
Basis of property given up
+ Gain recognized
- Boot received
- Liabilities assumed by the corporation
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Basis 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 (no minimum ownership required)
 Partners must recognize taxable income attributable
to services
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Basis of property carries over to the partnership
Partner may need to recognize gain to avoid a
negative basis (if liabilities assumed by the
partnership are greater than partner’s basis
including his share of partnership liabilities)
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Transfers to Partnerships
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Partner’s basis in partnership interest =
Basis of property given up
+ liabilities assumed by the partnership
- partner’s share of partnership liabilities
+ gain recognized
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Corporate Reorganizations

Involves 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 may
exchange stock for property or stock for stock
on a tax-deferred 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 it 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
Target then uses FMV for its basis
No loss is recognized on depreciated
property
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Acquisitive Reorganizations
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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
FMV of boot received
Basis of stock or securities received = basis
surrendered – boot received + gain
recognized
Basis of boot = FMV
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Acquisitive Reorganization
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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
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Merger –acquisition of the assets of a target
Target liquidates and the acquiring
corporation continues
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
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 and 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% of stock)
Parent may also use a subsidiary as Acquirer
using stock solely of the parent or it may drop
the stock of Target into a subsidiary
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Type B Reorganization
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Prior purchases of stock will not taint the
acquisition
Acquirer has up to one year to complete the
acquisition of control of Target
Control does not have to be acquired as part
of the 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
assets 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 if only the Acquirer’s voting
stock is used in the acquisition
Combination of boot + liabilities assumed cannot
exceed 20% of consideration
Only Target’s shareholders must approve the
merger and liquidation of Target
Acquirer may drop assets acquired from Target
into a subsidiary or 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 receive sufficient stock
to control Target (50%)
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
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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 must result 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 corporation changes its name, its 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
Reorganization must have a sound business
purpose
Must be a continuity of ownership by
shareholders of the participating corporations
Must be 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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