Bryant - Course 4. Tax Planning. 8. Like-Kind Exchanges and Involuntary Conversions

Question 1

Real property exchanged for personal property is not a like-kind exchange.
* False
* True

Answer 1

True.

Real property and personal property are not considered like-kind property, therefore, they cannot be characterized as a like-kind exchange.

Question 2

Each of the following is a permitted exchange for which no gain or loss is recognized under Section 1036 EXCEPT:
* BIF common stock for BIF preferred stock
* Voting ABC common stock for non-voting ABC common stock
* Class-A YYZ common stock for Class-B YYZ common stock
* CYP preferred stock for CYP preferred stock

Answer 2

BIF common stock for BIF preferred stock

IRC Section 1036 provides that no gain or loss is recognized on the exchange of common stock for common stock, or preferred stock for preferred stock in the same corporation. Section 1036 applies even if voting common stock is exchanged for non-voting common stock of the same corporation.

Question 3

A sale of property and subsequent purchase of like-kind property may be treated as a like-kind exchange if the two transactions are interdependent.
* False
* True

Answer 3

True.

A sale of property and subsequent purchase of like-kind property may be treated as a like-kind exchange if the two transactions are interdependent.

Question 4

In a qualifying like-kind exchange, Lauryn realized a gain of $25,000 and received $30,000 of net boot. Select Lauryn’s recognized gain on the transaction.
* $5,000
* $0
* $25,000
* $30,000

Answer 4

$25,000

In a like-kind exchange the recognized gain is the lesser of:
* realized gain, or
* net boot received

For Lauryn, the realized gain was $25,000 and the net boot received was $40,000 (? $30k). As a result, Lauryn recognizes $25,000 on the transaction (i.e., the lesser of realized gain or net boot received).

Question 5

What are Like-Kind Exchanges?

Answer 5

IRC Section 1031(a) states that “[n]o gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”

Section 1031 is not an elective provision. If the exchange qualifies as a like-kind exchange, non-recognition of gain or loss is mandatory. To qualify for like-kind exchange treatment, a direct exchange must occur and the property exchanged must be like-kind. A taxpayer who prefers to recognize a loss on an exchange must structure the transaction to avoid having the exchange qualify as a like-kind exchange.

Question 6

What is important about Location of the Property in 1031 exchanges?

Answer 6

Transfers of real property located in the U.S. and real property located outside the U.S. after July 9, 1989, are not like-kind exchanges. In general, Section 1031 does not allow exchanges between a U.S. property and a foreign-based property. The IRC specifically states that property held in the U.S. is not of a like-kind with foreign-held property.

Question 7

Exchange with Different Classes Example:

Gail exchanges an office building with a $400,000 adjusted basis for an airplane with a $580,000 FMV to be used in business.
* Is this a like-kind exchange?
* Does Gail recognize a gain or loss?

Answer 7

This is not a like-kind exchange because the office building is real property and the airplane is personal property.

Gail must recognize an $180,000 ($580,000 - $400,000) gain.

Question 8

How does like-kind exchanges relate to Exchanges of Securities?

Answer 8

The like-kind exchange rules do not apply to stocks, bonds, or notes. However, IRC Section 1036 provides that no gain or loss is recognized on the exchange of common stock for common stock, or preferred stock for preferred stock in the same corporation. Section 1036 applies even if voting common stock is exchanged for non-voting common stock of the same corporation. The non-taxable exchange of stock of the same corporation may be between two stockholders or a stockholder and the corporation.

Section 1036 does not apply to exchanges of common stock for preferred stock, stock for bonds of the same corporation, or any kind of stock in different corporations.

Question 9

What are the rules for a Non-Simultaneous Exchange?

Answer 9

The most common like-kind exchange of real estate is a non-simultaneous exchange. The rules for these exchanges have been clarified as a result of the Tax Reform Act of 1984. A non-simultaneous exchange is a like-kind exchange if the exchange is completed within a specified time period.

The property to be received in the exchange must be identified within 45 days after the date of the transfer of the property relinquished in the exchange.

The replacement property must be received within the earlier of 180 days, after the date the taxpayer transfers the property relinquished in the exchange or the due date for filing a return (including extensions) for the year in which the transfer of the relinquished property occurs.

Most importantly, the person claiming the like-kind exchange may not control the proceeds of the first exchange during the time between the non-simultaneous exchanges.

Question 10

When can the 180-day period be shortened?

Answer 10

This 180-day period may be shortened if it extends beyond the due date for the exchanger’s tax return in which he or she must report the exchange (usually April 15 of the year following the date the relinquished property closes) and the exchanger does not file for and is not granted an extension for the filing of that tax return.

Question 11

Once Relinquish Property Closes, how many days to identify replacement?

Answer 11

The exchanger has 45 days from the closing date of the relinquished property to identify the replacement property.

Question 12

Once Relinquish Property Closes, how many days to close on replacement?

Answer 12

The exchanger has 180 days from the closing date of the relinquished property to close on the replacement property.

Question 13

How many properties are you able to identify?

Answer 13

IRS rules for deferred exchanges provide for identification of only a limited number of properties. You may identify three properties and close on one or more of them, or you may identify any number of properties as long as you meet certain specific IRS guidelines.

Question 14

Explain Constructive Receipt Issues

Answer 14

It is important in a deferred exchange that the taxpayer not be in constructive receipt of the proceeds of the sale during the process (i.e., after the sale but before the subsequent purchase). A taxpayer is in constructive receipt of money or other property at the time that the taxpayer receives economic benefit from it, such as when it is credited to the taxpayer’s account, set apart for the taxpayer, or otherwise made available so that the taxpayer may draw upon it at any time or may draw upon it at any time if notice of intention to draw is given. The taxpayer avoids the constructive receipt rules as long as substantial restrictions must be placed on the taxpayer’s control of the receipt of the funds or property and continue to not be in constructive receipt unless and until the restrictions lapse, expire, or are waived.

Question 15

What type of account must be established to ensure that the taxpayer avoids constructive receipt of the proceeds of the relinquished property?

Answer 15

A “qualified escrow account” must be established to ensure that the taxpayer avoids constructive receipt of the proceeds of the relinquished property. Key details on the concept of constructive receipt and “qualified escrow accounts” are discussed in this audio guide.

Question 16

Define boot

Answer 16

Like-kind exchanges rarely involve only property of a like-kind. The values of the exchanged properties will most likely not be identical, causing one party to “make up” the difference by paying some cash, assuming some liabilities, or providing some other form of non-qualifying property (i.e., property that is not of a like-kind). To complete the exchange, non-like-kind property or money may be given or received. Cash and non-like-kind property are considered boot.

Question 17

How much is recognized gain in a like-kind exchange?

Answer 17

Gain is recognized to the extent of the boot received. However, the amount of recognized gain is limited to the amount of the taxpayer’s realized gain. In effect, the realized gain serves as a ceiling for the amount of the recognized gain. The receipt of boot as part of a non-taxable exchange does not cause a realized loss to be recognized.

Simply, in a like-kind exchange the recognized gain is the lesser of:
* realized gain, or
* net boot received

Question 18

If non-like-kind property other than cash is received as boot, what determines the amount of the boot?

Answer 18

If non-like-kind property other than cash is received as boot, the amount of the boot is the property’s FMV.

Question 19

Taxation of Boot Received Example #1:

Mario exchanges business real estate with a $50,000 adjusted basis for $10,000 cash and business real estate with a $65,000 FMV.
* What is the realized gain?
* What is the recognized gain?

Answer 19

The realized gain is $25,000 ($75,000 - $50,000).

Because the $10,000 of boot received is less than the $25,000 of realized gain, the recognized gain is $10,000.

Question 20

Taxation of Boot Received Example #2:

Mary exchanges undeveloped land with a $70,000 adjusted basis for $20,000 cash and farmland with a $65,000 FMV.
* What is the realized gain?
* What is the recognized gain?

Answer 20

Her realized gain is $15,000 ($85,000 - $70,000).

Because the $20,000 of boot received is more than the $15,000 of realized gain, only $15,000 of gain is recognized.

Question 21

Describe the effects of Property Transfers Involving Liabilities

Answer 21

When liability is assumed (or property is taken subject to liability) in an exchange, the liability is treated as boot received by the original debtor. This is because, in the IRS view, the assumption of the original debtor’s liability is equivalent to the new owner providing the original owner cash in the exchange to pay off the loan while simultaneously financing this cash by establishing a loan against the property received. This “implied cash transfer” is treated as boot received by the original debtor/owner.

Question 22

Exchange Involving the Assumption of Debt Example #1:

Mary exchanges land with a $550,000 fair market value (FMV) that is used in her business for Doug’s building, which has a $450,000 FMV. Mary’s basis in the land is $400,000, and the land is subject to a liability of $100,000, which Doug assumes.
* What is Mary’s realized gain?
* What is Mary’s recognized gain?

Answer 22

Mary’s realized gain is $150,000 [($450,000 + $100,000) - $400,000].

Because the assumption of the $100,000 liability is treated as boot, Mary recognizes a $100,000 gain.

Question 23

Exchange Involving the Assumption of Debt Example #2:

Longpoint Apartments owns a building with an adjusted basis of $500,000 that is valued at $1,700,000. The property currently has a mortgage of $1,000,000, leaving the owner with net equity of $700,000. Longpoint exchanges the property with Shortfall Apartments, which owns an unencumbered building with a value of $700,000.
* What is the amount realized by Longpoint?
* What is the gain realized by Longpoint?
* How much is the boot?
* How much is recognized?

Answer 23

The amount realized by Longpoint in the exchange is $1,700,000 ($700,000 value of property received plus $1,000,000 of liabilities assumed by Shortfall).

The gain realized by Longpoint is $1,200,000 ($1,700,000 amount realized less $500,000 adjusted basis), of which the boot of $1,000,000 must be recognized as a gain in the year of the transfer.

Question 24

How do you calculate the Basis of Property Received?

Answer 24

Basis of Property Exchanged – Boot Received + Gain Recognized – Loss Recognized = Basis of Property Received

The basis of property received in a nontaxable exchange is equal to the adjusted basis of the property exchanged increased by gain recognized and reduced by any boot received or loss recognized on the exchange.

Question 25

Basis of Property Received Calculation #1:

Question 26

Basis of Property Received Calculation #2:

Chuck, who is in the business of racing horses, exchanges a silo with a $30,000 basis for $10,000 cash and a barn with an $80,000 fair market value (FMV).
* What is Chuck’s realized gain?
* How much of the gain is recognized?
* What is Chuck’s basis for the replacement property?

Answer 26

Chuck’s realized gain is $60,000 [($80,000 + $10,000) - $30,000], and $10,000 of the gain is recognized because the boot received is less than the realized gain.

Chuck’s basis for the replacement property (i.e., the barn) is $30,000 ($30,000 basis of property exchanged - $10,000 of boot received + $10,000 of gain recognized).

Question 27

Basis of Property Received Calculation #3:

Pam, who operates a winery, exchanges a plot of land & vines with a $15,000 basis for $3,000 cash and an undeveloped tract of farmland with a $10,000 FMV.
* What is the realized loss?
* What is the recognized loss?
* What is Pam’s basis for the replacement property?

Answer 27

The $2,000 realized loss [($10,000 + $3,000) - $15,000] is not recognized.

The receipt of boot does not cause a realized loss to be recognized.

Pam’s basis for the replacement property (i.e., the undeveloped farmland) is $12,000 ($15,000 basis of property exchanged - $3,000 boot received).

Question 28

Saul, who operates a luxury camping business, exchanges a tent with a $3,000 basis for a cabin with a $4,000 FMV and a treehouse with a $6,000 FMV.
* What is the realized loss?
* What is the recognized loss?
* What is Saul’s basis for the cabin?
* What is Saul’s basis for the treehouse?

Answer 28

If more than one item of like-kind property is received, the basis is allocated among the properties in proportion to their relative FMVs on the date of the exchange.

The $7,000 realized gain [($4,000 + $6,000) - $3,000] is not recognized.

The total base of the properties received is $3,000. This amount is allocated to the properties (i.e., the cabin and the treehouse) based on their relative FMVs.
Saul’s basis for the cabin is $1,200 [($4,000 / $10,000) X $3,000], and
the basis for the treehouse is $1,800 [($6,000 / $10,000) X $3,000].

Question 29

How is basis calculated for Non-Like-Kind Property Received?

Answer 29

The basis of non-like-kind property received is “an amount equivalent to its fair market value (FMV) at the date of the exchange.”

Question 30

Non-Like-Kind Property Received Example:

Sundai exchanges a storage shed used in his business with a $20,000 adjusted basis for a different storage shed with a $50,000 FMV and $5,000 of marketable securities.
* What is the realized gain?
* What is the boot?
* What is basis for the marketable securities
* What is the basis for the storage shed?

Answer 30

Sundai’s realized gain is $35,000 [($50,000 + $5,000) - $20,000], and $5,000 of the realized gain is recognized due to the receipt of boot.

Sundai’s basis for the marketable securities is $5,000, and

the basis for the storage shed is $20,000 [$20,000 (basis of property exchanged) - $5,000 (boot received) + $5,000 (gain recognized)].

Question 31

What happens in Exchanges Between Related Parties?

Answer 31

Exchanges of property between related parties are not like-kind exchanges under the current law if either party disposes of the property within two years of the exchange. Any gain resulting from the original exchange is recognized in the year of the subsequent disposition. Dispositions due to death or involuntary conversion, or for non–tax avoidance purposes, are disregarded.

Question 32

When are gains/losses recognized when there’s a transfer of non-like-kind property?

Answer 32

If the taxpayer transfers non-like-kind property, gain or loss equal to the difference between the FMV and the adjusted basis of the non-like-kind property surrendered must be recognized. But, if the non-like-kind property is a personal use asset, the loss is not recognized.

Question 33

Non-Like-Kind Property Exchange Example #1:

Paul exchanges timberland held as an investment for undeveloped land with a $200,000 FMV. Paul’s basis for the timberland is $125,000. His tractor with a $6,000 basis and a $4,000 FMV is also transferred.
* What is Paul’s recognized gain/loss?
* What is Paul’s basis for the land received?
* How many exchanges is Paul actually making?
* Which is a like-kind exchange?
* Which is a taxable exchange?

Answer 33

Because the non-like-kind property (that is, the tractor) that Paul transfers have a FMV less than its basis, he recognizes a $2,000 ($4,000 - $6,000) loss.

Paul’s basis for the undeveloped land is $129,000 ($125,000 + $6,000 - $2,000).

Paul recognizes a loss on the non-like-kind property he surrenders, despite receiving property in the aggregate with a FMV greater than the total adjusted basis of the transferred assets. Paul is actually making two exchanges.

His exchange of timberland with a basis of $125,000 for undeveloped land with a $196,000 FMV is a like-kind exchange, but his exchange of the tractor with a basis of $6,000 for undeveloped land with a $4,000 FMV is a taxable exchange.

Question 34

Non-Like-Kind Property Exchange Example #2:

Shirley exchanges land with a $30,000 basis and marketable securities with a $10,000 basis to David for land with a $60,000 FMV in a transaction that otherwise qualifies as a like-kind exchange. The FMV of the marketable securities and the land surrendered by Shirley is $14,000 and $46,000 respectively.
* What is Shirley’s recognized gain?
* What is Shirley’s basis for the land received?

Answer 34

Because the non-like-kind property that Shirley transfers has a FMV greater than its basis, she recognizes $4,000 ($14,000 - $10,000) of gain.

Shirley’s basis for the land received is $44,000 ($30,000 + $10,000 + $4,000), which is the basis of both the assets exchanged plus the gain recognized on the exchange.

Question 35

How is Holding Period for Property Received determined?

Answer 35

The holding period of like-kind property received in a nontaxable exchange includes the holding period of the property exchanged if the like-kind property surrendered is a capital asset or an asset that is Section 1231 property. In essence, the holding period of the property exchanged carries over to the holding period of the like-kind property received. The rule regarding the holding period carryover is consistent with the notion of continuing investment in the underlying property that has been transferred. The holding period for the boot property received begins the day after the date of the exchange.

Question 36

Holding Period for Property Received Example:

Mario owns an art studio he acquired on May 1, 2016, as an investment. He exchanges the art studio on April 10, 2023, for a sculpture garden and marketable securities to be held as investments.
* What is the holding period for the sculpture?
* What is the holding period for the marketable securities?

Answer 36

The holding period for the sculpture garden begins on May 1, 2016.

The holding period for the marketable securities starts on April 11, 2023.

Question 37

Donald owns a warehouse that is used in business while Gayle owns land. Donald exchanges the warehouse for the land, which will be held for investment. The FMV of the warehouse is $240,000 (basis $100,000) and the warehouse is subject to a mortgage of $50,000, which is assumed by Gayle. Donald receives $40,000 cash and the land, which has a FMV of $150,000 (basis of $130,000 to Gayle). What gain must Gayle recognize?
* $0
* $20,000
* $50,000
* $70,000

Answer 37

$0

Gayle has no gain to recognize. She did not receive any boot and like-kind property was exchanged.

Question 38

The holding period for the boot property received includes the holding period of the property given in exchange for boot.
* False
* True

Answer 38

False

Holding period for boot property received begins on the day after the date of the exchange.

Question 39

Mary exchanges business real estate with a $70,000 adjusted basis for $20,000 cash and land with a $65,000 FMV. What would be her realized gain and recognized gain?
* $20,000 and $15,000
* $65,000 and $20,000
* $70,000 and $15,000
* $15,000 and $15,000

Answer 39

$15,000 and $15,000

Mary’s realized gain is $15,000 ($85,000 - $70,000). As the $20,000 of boot received is more than the $15,000 of realized gain, only $15,000 of gain is recognized.

Question 40

What are Involuntary Conversions?

Answer 40

Property must be compulsorily or involuntarily converted into money or other property for Section 1033 to apply. An involuntary conversion may be due to theft, seizure, requisition, condemnation, or destruction of the property. The destruction of the property may be complete or partial. For purposes of Section 1033, destruction of property does not have to meet the “suddenness” test if the cause of destruction otherwise falls within the general concept of a casualty.

An involuntary conversion occurs when a governmental unit exercises its power of eminent domain to acquire the taxpayer’s property without the taxpayer’s consent. The threat or imminence of requisition or condemnation of property may permit a taxpayer to defer recognition of gain from the sale or exchange of property under the involuntary conversion rules. Taxpayers who transfer property due to the potential governmental acquisition must be careful to confirm that a decision to obtain their property for public use has been made. Written confirmation of potential condemnation is particularly helpful.

Question 41

Property must be condemned for the conversion of property to be classified as an involuntary conversion.
* False
* True

Answer 41

False.

The threat or eminence of requisition or condemnation of property may cause an involuntary conversion.

Question 42

Does Section 1033 apply when there is a Threat of Condemnation?

Answer 42

If a threat of condemnation exists and the taxpayer has reasonable grounds to believe that the property will be condemned, Section 1033 applies even if the taxpayer sells the property to an entity other than the governmental unit that is threatening to condemn the property.

Threat of Condemnation Example:
On Tuesday night, the city commission authorized the city attorney to start the process of condemning two lots owned by Beth for use as a public park. On Wednesday afternoon, Beth sells the two lots to Marty at a gain. The sale of property to Marty is an involuntary conversion, and Beth may elect to defer recognition of the gain if she satisfies the Section 1033 requirements.

Question 43

Is the destruction or sale of livestock because of disease an involuntary conversion?

Answer 43

Although the typical involuntary conversion generally results from a casualty or condemnation, Section 1033 provides that certain transactions involving livestock are to be treated as involuntary conversions (e.g., the destruction or sale of livestock because of disease is an involuntary conversion).

Question 44

How do you calculate Realized Gain on an Involuntary Conversion?

Answer 44

The taxpayer’s realized gain is the excess of the amount received due to the involuntary conversion over the adjusted basis of the property converted. The total award or proceeds received are reduced by expenses incurred, such as attorney’s fees in connection with determining the settlement to be received from a condemnation. If the payment of the award or proceeds is delayed, any amount paid as interest is not included in determining the amount realized.
Amounts received as interest on an award for property condemned are taxed as ordinary income even if the interest is paid by a state or political subdivision.

Question 45

Realized Gain on an Involuntary Conversion Example:

Richard’s property, which has a $100,000 basis, is condemned by the city of Phoenix. Richard receives a $190,000 award and pays $1,000 in legal expenses for representation at the condemnation proceedings and $800 for an appraisal of the property.
* What is the amount realized?
* What is the gain realized?

Answer 45

The amount realized is $188,200 [$190,000 - ($1,000 + $800)].

The gain realized is $88,200 ($188,200 - $100,000).

Part or all of the realized gain may be deferred if the requirements of Section 1033 are satisfied and an election is made to defer the gain.

Question 46

How do you calculate Recognized Gain on an Involuntary Conversion?

Answer 46

To defer the entire gain, the taxpayer must purchase replacement property with a cost equal to or greater than the amount realized from the involuntary conversion. If the replacement property is purchased for an amount less than the amount realized, that portion of the realized gain that is equal to the excess of the amount realized from the conversion over the cost of the replacement property must be recognized.

Question 47

Recognized Gain on an Involuntary Conversion Example #1:

Bob owns a restaurant with a $200,000 basis. The restaurant is destroyed by fire and he receives $300,000 from the insurance company. Bob’s realized gain is $100,000 ($300,000 - $200,000). He purchases another restaurant for $275,000.
* How much may Bob elect to defer under Sec. 1033?
* How much of Bob’s gain must be recognized?

Answer 47

Bob may elect to defer $75,000 of the gain under Sec. 1033.

$25,000 ($300,000 - $275,000) of Bob’s gain must be recognized because he failed to reinvest all of the $300,000 insurance proceeds in a suitable replacement property.

Question 48

Recognized Gain on an Involuntary Conversion Example #2:

Stacey owns a racehorse with a $450,000 basis used for breeding purposes. The racehorse is killed by lightning and she collects $800,000 from the insurance company. Stacey’s realized gain is $350,000 ($800,000 - $450,000). She purchases another racehorse for $430,000.
* What is Stacey’s recognized gain?

Answer 48

The entire $350,000 of gain is recognized because the cost of the replacement property is $370,000 ($800,000 - $430,000) less than the amount realized from the involuntary conversion.

Question 49

How do you calculate the basis of the replacement property?

What is the holding period of the replacement property?

Answer 49

If replacement property is purchased, the basis of the replacement property is its cost minus any deferred gain.

If the taxpayer elects to defer the gain, the holding period of the replacement property includes the holding period of the converted property.

Question 50

If the taxpayer elects to defer gain, the holding period of the replacement property __ ____??____ __ the holding period of the converted property.
* includes
* does not include

Answer 50

includes

If the taxpayer elects to defer the gain, the holding period of the replacement property includes the holding period of the converted property.

Question 51

How long must related parties hold on to like-kind property after an exchange in order for it to be considered a like-kind exchange?
* Two years
* One year
* Six months
* Two months

Answer 51

Two years

Exchanges of property between related parties are not like-kind exchanges under current law if either party disposes of the property within two years of the exchange.

Question 51

How does severance compensation affect basis?

Answer 51

If a portion of the taxpayer’s property is condemned, the taxpayer may receive severance damages as compensation for a decline in the value of the retained property. For example, if access to the retained property becomes difficult or if the property is exposed to greater damage from flooding or erosion, its value may decline.

The IRS considers severance damages to be “analogous to the proceeds of property insurance; they represent compensation for damages to the property.”

Amounts received as severance damages reduce the basis of the retained property and any amount received in excess of the property’s basis is treated as gain.

Question 52

If severance damages are used to restore the retained property, does it reduce the basis of the retained property?

Answer 52

The Section 1033 provisions concerning non-recognition of gain may apply to severance damages. For instance, if severance damages are used to restore the retained property, only that portion of severance damages not spent for restoration reduces the basis of the retained property.

A taxpayer who uses severance damages to purchase adjacent farmland to replace the portion of the farm condemned may use Section 1033 to defer a gain due to the receipt of the severance damages.

Question 53

Severance Damages Basis Calculation Example:

Cindy owns a 500-acre farm with a $200 basis per acre ($100,000 basis). The state condemns ten acres across the northwest corner of her farm to build a major highway. Cindy receives a condemnation award of $500 per acre for the ten acres. The highway separates the farm into a 25-acre tract and a 465-acre tract. Because her ability to efficiently use the 25-acre tract for farming is reduced, the state pays additional severance damages of $90 per acre for the 25 acres.
* What is Cindy’s realized gain from condemnation of the ten acres?
* How does severance compensation affect the basis of the 25-acre tract?

Answer 53

Cindy’s gain realized from condemnation of the ten acres is $3,000 [$5,000 - ($200 X 10 acres)].

The $2,250 ($90 X 25 acres) of severance damages reduces the basis of the 25-acre tract from $5,000 ($200 X 25 acres) to $2,750 [($200 X 25) - $2,250]. The reduction in basis is applied solely to the 25 acres because of its decline in value as farmland.

Question 54

What is the basis and holding period of the replacement property if involuntary conversion of property converts directly into similar property?

Answer 54

If involuntary conversion of property converts directly into similar property rather than money, non-recognition of gain is mandatory. The basis of the replacement property is the same as the basis of the converted property and the holding period for the converted property carries over to the replacement property. Direct conversions are rarely encountered because the usual payment procedure for insurance companies and governmental agencies involves payment of cash.

Question 55

Ed’s farm with a $200,000 basis is condemned by the state. The state transfers other farmland with a $280,000 FMV to Ed.
* What is the realized gain?
* What is the recognized gain?
* What is the the basis of the farmland?.

Answer 55

The $80,000 ($280,000 - $200,000) of realized gain is not recognized.

The basis of the farmland received is $200,000.

Question 56

What test do Taxpayers need to pass to qualify for non-recognition of gain due to an involuntary conversion?

Answer 56

To qualify for non-recognition of gain due to an involuntary conversion, the taxpayer must acquire a qualified replacement property. With some exceptions, the replacement property must be “similar or related in service or use to the property so converted.” Taxpayers who own and use the property must pass the functional-use test although replacement may be made with like-kind property in certain cases. A taxpayer who owns and leases the property that is involuntarily converted may use the taxpayer-use test.

Question 57

What exception is made for livestock reinvestment of replacement property?

Answer 57

According to Section 1033(a)(2)(A) and 1033(f), the replacement of property requirement is modified when proceeds from the involuntary conversion of livestock may not be reinvested in property similar or related in use to the converted livestock because of soil contamination or other environmental contamination. Section 1033(f) permits the livestock to be replaced with other property, used for farming purposes.

Question 58

Ted owns a farm that has livestock. His livestock was destroyed due to a soil contamination caused by a chemical spill. Ted used the replacement money for other needs on the farm instead of purchasing more livestock. This is an allowable replacement of property.
* False
* True

Answer 58

True.

The replacement property is modified when the proceeds from the involuntary conversion of livestock may not be reinvested in property similar or related in use to the converted livestock because of soil contamination or other environment contamination.

Question 59

Describe the functional-use test

Answer 59

The functional-use test is more restrictive than the like-kind test. To be considered similar or related in service or use, the replacement property must be functionally the same as the converted property (e.g., the exchange of a business building for land used in business qualifies as a like-kind exchange). Replacing a building with land does not qualify as replacement property under the involuntary conversion rules. The building must be replaced with a building that is functionally the same as the converted building.

Question 60

Functional-Use Example:

Julie owns a movie theater that is destroyed by fire. She uses the insurance proceeds to purchase a skating rink. The converted property has not been replaced with property that is similar or related in service or uses under the functional-use test.
* Is she able to defer the gain under Section 1033?

Answer 60

The election to defer the gain under Section 1033 is not available.

Question 61

If real property held for productive use in a trade or business or for investment is condemned, a proper replacement has to pass what test?

Answer 61

If real property held for productive use in a trade or business or for investment is condemned, a proper replacement may be made by acquiring like-kind property. This exception to the functional-use test applies only to real property used in a trade or business or held for investment but not to real property held as inventory.

Question 62

Like-Kind Exchange Rule Example:

Ken owns a building used in his business that is condemned by the state to widen a highway. He uses the proceeds to purchase land to be held for investment.
* Is the land is a qualified replacement property?

Suppose the building is destroyed by a violent windstorm.
* Is the land is a qualified replacement property?

Answer 62

The land is a qualified replacement property because the condemned building is real property used in a trade or business, and the like-kind exchange rule may be applied to the condemnation.

Ken’s purchase of the investment land is not qualified replacement property because the more flexible like-kind exchange rules apply only to condemnations. He must purchase property with the same functional use as the business building.

Question 63

When is the taxpayer-use test used?

Answer 63

The taxpayer-use test applies to the involuntary conversion of rental property owned by an investor. This test permits greater flexibility than the functional-use test. The principal requirement is that the owner-investor must lease out the replacement property that is acquired. However, the lessee is not required to use the leased property for the same functional use.

Question 64

Taxpayer-Use Test Example:

Sally owns an apartment complex that is rented to college students. The apartment complex is destroyed by fire. She uses the insurance proceeds to purchase a medical building that is leased to physicians.
* Is this a qualified replacement property?

Answer 64

This is a qualified replacement property by Sally under the taxpayer-use test, and the gain, if any, may be deferred if an election is made under Section 1033.

Question 65

Instead of purchasing replacement property, what else may taxpayers purchase that qualifies?

Answer 65

The general rule with involuntary conversions is that the taxpayer must purchase the replacement property. Taxpayers may purchase replacement property indirectly by purchasing control (i.e., 80% or more of the stock) of a corporation that owns the replacement property.

However, this exception is not applicable to the purchase of like-kind property to replace condemned real property used in a trade or business or held for investment.

Question 66

Replacement Property Example #1:

Hank’s airplane, used in business, is hijacked and taken to a foreign country. He uses the insurance proceeds to purchase 80% of the Fast Corporation stock. Fast Corporation owns an airplane that is qualified replacement property.
* Are the involuntary conversion requirements are satisfied if Hank elects to defer any gain realized?

Answer 66

The involuntary conversion requirements are satisfied if Hank elects to defer any gain realized.

Question 67

Replacement Property Example #2:

Lynn’s farm is condemned by the state for public use. She uses the proceeds to purchase 80% of Vermont Corporation stock. Vermont Corporation owns eight parking lots.
* Is this a qualified replacement property?

Answer 67

Qualified replacement property has not been obtained through the stock purchase because the parking lots are not functionally the same as the farm.

The like-kind rules do not apply because this exception for the purchase of control does not apply.

Question 68

What are the Time Requirements for Replacement?

Answer 68

The general rule is that the period begins with the date of disposition of the converted property and ends “two years after the close of the first taxable year in which any part of the gain upon the conversion is realized.” Suppose the involuntary conversion is due to condemnation or requisition or the threat of such. In that case, the replacement period begins on the date of the threat or imminence of the requisition or condemnation. The replacement period can be extended with special permission from the IRS.

The replacement period is longer if the involuntary conversion is due to the condemnation of real property (excluding inventory) held for productive use in a trade or business or for investment. The replacement period ends three years after the close of the first tax year in which any part of the gain is realized. This provision for a longer replacement period applies to the same type of real property that may be replaced with like-kind property.

Question 69

Involuntary Conversion Replacement Property Example:

On December 8, 2020, Craig’s business property was destroyed by fire. Craig receives insurance proceeds in 2021 and elects to defer recognition of the gain.
* When must Craig replace the property?

Answer 69

He must replace the property between December 8, 2020, and December 31, 2023.

The two-year time period includes 2023 because the gain is realized when the insurance proceeds are received in 2021.

Question 70

The replacement period for involuntary conversions due to the condemnation of real property held for productive use in a trade or business or for investment is __ ____??____ __.
* three years
* two years
* five years
* four years

Answer 70

three years

The replacement period ends three years after the close of the first tax year in which any part of the gain is realized.

Question 71

Each of the following is true of the deferred gains attributed to the involuntary conversion of personal property EXCEPT:
* Qualifying replacement property must be acquired within a specific time period.
* Gain deferral is elective, except for direct conversions.
* Replacement property must be similar or related in service or use to the converted property.
* The replacement property may be acquired by gift, inheritance, or purchase.

Answer 71

The replacement property may be acquired by gift, inheritance, or purchase.

The general rule is that the taxpayer must purchase the replacement property.

Question 72

A taxpayer owned land and a warehouse held for rental purposes. Upon condemnation of this property, the taxpayer invested the proceeds in a gas station on land they owned that was also held for rental purposes.
Which of the following statements is CORRECT?
* Functional-use test can be applied and gain can be deferred
* Taxpayer-use test can be applied and gain can be deferred
* Replacement with like-kind property can be applied and gain can be deferred
* Gain is realized

Answer 72

Taxpayer-use test can be applied and gain can be deferred

Since the taxpayer owned land and a warehouse held for rental purposes and invested the proceeds in a gas station on land they owned that was also held for rental purposes, the taxpayer-use test is applied. The taxpayer-use test applies to the involuntary conversion of rental property owned by an investor. The owner-investor has leased out the replacement property that is acquired.

Question 73

Belton Inc. is a calendar-year taxpayer. On December 1, 2023, one of Beltron’s warehouses is destroyed by fire. The property had an adjusted basis of $400,000. On January 15, 2023, the insurance company paid Beltron $500,000.
When does Beltron’s replacement period end for replacing the asset and avoiding recognition of a gain?
* January 15, 2024
* December 31, 2024
* January 15, 2025
* December 31, 2025

Answer 73

December 31, 2025

The replacement period for an involuntary conversion ends two full tax years after the year when the taxpayer receives any of the proceeds. In this case, the replacement period includes 2025 since the gain is realized when the proceeds are received in 2023.

Question 74

Avoiding the Like-Kind Exchange Provisions - why and how

Answer 74

In some cases, a taxpayer may prefer a taxable exchange to a non-taxable like-kind exchange. For instance, if the gain is taxed as a capital gain and the taxpayer has capital losses to offset the gain, the taxpayer may prefer to recognize the gain during the current year. If the gain on the exchange is recognized instead of deferred, the basis of the property received in the exchange is higher.

If an exchange qualifies as a like-kind exchange, no loss on the exchange is recognized. A taxpayer who prefers to recognize a loss should avoid making a like-kind exchange. It may be advantageous to sell the property to recognize the loss and then purchase the replacement asset in two independent transactions. If the sale and purchase transactions are with the same party, the IRS may maintain that the like-kind exchange rules apply because the two transactions are in substance a like-kind exchange (i.e., the judicial doctrine of substance over form might be applied).

Question 75

Like-Kind Exchange Considerations Example:

Connie owns land with a $20,000 basis. The land is held as an investment. Connie exchanges the land for a duplex with a $100,000 FMV. Because the exchange qualifies as a like-kind exchange, no gain is recognized and Connie’s basis for the duplex is $20,000. If the exchange does not qualify as a like-kind exchange (e.g., the land is a personal-use asset), Connie recognizes an $80,000 capital gain. Connie’s basis for the duplex is $100,000. The basis of the duplex, except for the portion allocable to land, is eligible for depreciation.

Question 76

Select the reason(s) that a taxpayer may want to avoid like-kind exchange provisions.
* Sale of the property at a gain may produce a capital gain.
* A loss on a non-taxable exchange is not recognized.
* If gain on the exchange is recognized instead of deferred, the basis of the property received in the exchange is higher.

Answer 76

Sale of the property at a gain may produce a capital gain.
A loss on a non-taxable exchange is not recognized.
If gain on the exchange is recognized instead of deferred, the basis of the property received in the exchange is higher.
All of these are viable reasons for a taxpayer to avoid a like-kind exchange.

Question 77

Reporting Involuntary Conversions Considerations

Answer 77

The election to defer recognition of the gain from an involuntary conversion is made by not reporting the gain as income for the first year in which the gain is realized. All details pertaining to the involuntary conversion (including those relating to the replacement of the converted property) should be reported for the taxable year or years in which any of the gain is realized.

A taxpayer who elects to defer recognition of the gain but does not make a proper replacement of the property within the required period of time must file an amended return for the year or years for which the election was made. An amended return may be needed if the cost of the replacement property is less than expected at the time of the election. All details pertaining to the replacement of converted property must be reported in the year in which the replacement occurs.

A taxpayer who is either ineligible or does not want to defer the gain must report the gain in the usual manner. If a taxpayer does not elect to defer the gain in the year the gain is realized and the replacement period has not expired, a subsequent election may be made. In that case, a refund claim should be filed for the tax year in which the gain was realized and previously recognized.

Taxpayers who do not initially elect to defer the gain from an involuntary conversion may make the election at a later date, but the election may not subsequently be revoked. The Tax Court has ruled that the Treasury Regulations allow the filing of an amended return for a year in which the election is made only if:
* a proper replacement is not made within the specified time period or
* the replacement is made at a cost lower than anticipated at the time of the election.

The IRS takes the position that the taxpayers who designate qualifying property as replacement property may not later designate other qualifying property as the replacement property.

Question 78

Involuntary Conversion Reporting Example:

Marcus has a property with a $40,000 adjusted basis, which was destroyed by a storm in 2022. Marcus received $45,000 in insurance proceeds in 2022 and planned to purchase property similar to the converted property in 2023 at a cost of $47,000. He elected to defer recognition of the gain in 2022. In 2023, the replacement property is purchased for $44,500.
* What must Marcus do for 2021 tax return?
* What does the return recognize?

Answer 78

Marcus must file an amended return for 2021 and recognize a $500 ($45,000 - $44,500) gain.

Question 79

To defer the entire gain in an involuntary conversion, the taxpayer must purchase replacement property with a cost ________________ the amount realized from the involuntary conversion.
* equal to or less than
* at least 80% of
* equal to or greater than
* greater than

Answer 79

equal to or greater than

If the replacement property is purchased for an amount less than the amount realized, that portion of the realized gain that is equal to the excess of the amount realized from the conversion over the cost of the replacement property must be recognized.

Question 80

In an involuntary conversion, the principal requirement of the __ ____??____ __ test is that the owner-investor must lease out the replacement property that is acquired.
* functional-use
* related service
* taxpayer-use
* like-kind

Answer 80

taxpayer-use

The taxpayer-use test applies to the involuntary conversion of rental property owned by an investor. The principal requirement is that the owner-investor must lease out the replacement property that is acquired.

Question 81

Property received will NOT be treated as property of a like-kind if:
* the replacement property is not identified on or before the day that is 90 days after the date on which the taxpayer transfers the property relinquished in the trade.
* the replacement property is not received on or before the day that is 45 days after the date on which the taxpayer transfers the property relinquished in the trade.
* the replacement property is not identified on or before the day that is 30 days after the date on which the taxpayer transfers the property relinquished in the trade.
* the replacement property is not received on or before the day that is 180 days after the date on which the taxpayer transfers the property relinquished in the trade.

Answer 81

before the day that is 180 days after the date on which the taxpayer transfers the property relinquished in the trade.

Relinquish Property Close
* The exchanger has 45 days from the closing date of the relinquished property to identify the replacement property.

Replacement Property Close
* The exchanger has 180 days from the closing date of the relinquished property to close on the replacement property.

Question 82

In a qualifying like-kind exchange, Josef realized a gain of $55,000 and received $40,000 of net boot. Select Josef’s recognized gain on the transaction.
* $15,000
* $55,000
* $40,000
* $0

Answer 82

$40,000

In a like-kind exchange the recognized gain is the lesser of:
* realized gain, or
* net boot received

For Josef, the realized gain was $55,000 and the net boot received was $40,000. As a result, Josef recognizes $40,000 on the transaction (i.e., the lesser of realized gain or net boot received).

Question 83

Blanche owns an acre of land in the Naples, Florida suburbs that she has held for investment purposes. She originally purchased the land in 1978 for $60,000 and it is now worth $250,000. Bill owns an investment in five acres of land in rural Pennsylvania. He paid $225,000 for the land that now is worth $180,000. Both parties come to terms and agree to exchange their holdings.
Bill will receive the Naples, Florida property with a basis of __ ____??____ __.
* $60,000
* $45,000
* $225,000
* $180,000

Answer 83

$225,000

The basis of property received in a nontaxable exchange is equal to the adjusted basis of the property exchanged increased by the gain recognized and reduced by any boot received or loss recognized on the exchange.

Bill’s adjusted basis in the Pennsylvania property (i.e., the property exchanged) was $225,000 and there are no additional adjustments to the basis. Thus, Bill will have a $225,000 basis in the Naples, Florida property.

Question 84

The original gain or loss deferred on a qualifying like-kind exchange between related parties must be recognized if the taxpayer or the related party dispose of the property acquired in the exchange within:
* 2 years of the date of the exchange
* 5 years of the date of the exchange
* 1 year of the date of the exchange
* 3 years of the date of the exchange

Answer 84

2 years of the date of the exchange

Exchanges of property between related parties are not like-kind exchanges under the current law if either party disposes of the property within two years of the exchange. Any gain resulting from the original exchange is recognized in the year of the subsequent disposition.

Question 85

To qualify for non-recognition of gain treatment in an involuntary conversion, the converted property generally must be replaced within __ ____??____ __ after the close of the first taxable year in which any part of the gain upon the conversion is realized.
* five years
* one year
* two years
* three years

Answer 85

two years

The general rule is that the period begins with the date of disposition of the converted property and ends “two years after the close of the first taxable year in which any part of the gain upon the conversion is realized.”

Question 86

The property to be received in the exchange must be identified within __ ____??____ __ days after the date of the transfer of the property relinquished in the exchange.
* 60
* 30
* 45
* 180

Answer 86

45

The property to be received in the exchange must be identified within 45 days after the date of the transfer of the property relinquished in the exchange.

Question 87

Blanche owns an acre of land in the Naples, Florida suburbs that she has held for investment purposes. She originally purchased the land in 1978 for $60,000 and it is now worth $250,000. Bill owns an investment in five acres of land in rural Pennsylvania. He paid $225,000 for the land that now is worth $180,000. Both parties come to terms and agree to exchange their holdings.
Identify the amount of realized gain that is deferred for Blanche in this exchange.
* $190,000
* $70,000
* $180,000
* $120,000

Answer 87

$120,000

Realized gains and losses resulting from non-taxable exchanges (i.e., Section 1031 exchanges) are deferred. Unrecognized gain might be recognized when the property is sold or exchanged in a taxable transaction because the basis of the replacement property is less than its FMV by the amount of the deferred gain.

In Blanche’s case, her original basis is $60,000, and the current FMV of the exchanged land she received is $180,000. Therefore, the realized gain is $120,000 ($180,000 - $60,000).

Question 88

Company A transfers property subject to a $400,000 mortgage in a qualifying like-kind exchange for property subject to a $300,000 mortgage and $25,000 in cash.
What is the result of this transaction?
* Company A is in receipt of boot equal to $75,000.
* Company A is in receipt of boot equal to $100,000.
* Company A is in receipt of boot equal to $25,000.
* No gain is recognized because it is a qualifying like-kind exchange.

Answer 88

Company A is in receipt of boot equal to $75,000.

When liability is assumed (or property is taken subject to liability) in an exchange, the liability is treated as boot received by the original debtor.

In this case, the net boot received by Company A is $75,000 [$400,000 (liability assumed by B) – [$300,000 (liability assumed by A) + $25,000 (boot given)].

Question 89

Identify the qualifying like-kind exchange.
* Real property in the U.S. for real property in the U.S.
* Personal-use property in the U.S. for personal-use property in the U.S.
* Real property in the U.S. for personal-use property in the U.S.
* Real property in the U.S. for real property in Canada.

Answer 89

Real property in the U.S. for real property in the U.S.

In general, IRC Section 1031 does not allow exchanges between a U.S. property and a foreign-based property. The IRC specifically states that property held in the U.S. is not of a like-kind with foreign-held property.

Under the Tax Cuts and Jobs Act (TCJA), Section 1031 now applies only to exchanges of real property and not to exchanges of personal or intangible property.