Tax 4-1 Analyze a situation to identify an exchange of assets that qualifies for like-kind treatment.

Question 1

Like Kind Exchange of Assets

Revenue Code Section 1031 provides that no gain or loss is recognized where investment property or business property is exchanged solely for property of a like-kind. Thus, a like-kind exchange is a potentially nontaxable transaction involving the exchange of qualifying, like-kind property. Taxpayers involved in such transactions often have no recognized (taxable) gain at the time of the exchange. There are, however, certain situations in which the like-kind exchange may be taxable:

(4-1, 8)

Answer 1

If the taxpayer receives “boot,” i.e., any property that is not qualified or like-kind, then gain may be recognized (subject to tax) in the exchange.

Question 2

Like Kind Exchange of Assets

Generally, the transaction must be an actual exchange of properties. The sale of one asset and the subsequent purchase of another asset does not qualify for like-kind exchange treatment. As we will discuss, most exchanges of real estate are handled through a qualified _____.

(4-1, 8)

Answer 2

qualified intermediary (QI)

It is possible to have a delayed (nonsimultaneous) exchange that qualifies for like-kind exchange treatment. In a so-called “Starker exchange,” there are time limits for the taxpayer to identify the replacement property and also to actually receive the new property. If these strict time limits are not met, the transaction will not qualify for preferential treatment under the like-kind exchange rules.

Question 3

Like Kind Exchange of Assets

In a delayed exchange, the following 2 requirements must be met:

(4-1, 8)

Answer 3

1. The property to be received must be identified within 45 days after the date on which the old property is transferred.
2. The new property must be received within 180 days after the date on which the old property is transferred, but not later than the due date of the tax return (including extensions) for the year that the old property is transferred.

Because it is extremely rare for two individuals to desire a direct exchange of properties, most transactions involving real estate require the use of a qualified intermediary, also known as an accommodator, or facilitator.

Question 4

Like Kind Exchange of Assets

A qualified _____ is a person who is not the taxpayer or a disqualified person (the taxpayer’s agent, for example), and enters into a written agreement with the taxpayer (the exchange agreement) under which the he: acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property for the taxpayer, and transfers the replacement property to the taxpayer.

(4-1, 9)

Answer 4

intermediary (QI)

In addition, the exchange agreement must expressly limit the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain benefits of money or other property held by the QI.

Question 5

Like Kind Exchange of Assets

The like-kind exchange treatment is available only for _____ property. That is, property held for productive use in a trade or business or held for investment purposes. In order to avoid the recognition of income from an exchange, the property must be used in a trade or business or held for investment purposes.

(4-1, 9)

Answer 5

qualifying

For example, a taxpayer who wants to exchange a personal residence for rental property would not be entitled to the nontaxable treatment of a like kind
exchange. The exchange may qualify, however, if the taxpayer first converts the personal residence into rental property. Additionally, a taxpayer may exchange property used in a trade or business or held for investment purposes for property not currently used in that manner. As long as the taxpayer utilizes the acquired property in a trade or business or for investment, then the exchange may be nontaxable to that taxpayer.

Question 6

Qualifying Property Example

John owns a vacant lot for investment purposes and Bill owns a home that he uses as a residence. John and Bill could exchange properties and the exchange would qualify as a like-kind exchange for John, as long as John uses the home as an _____ _____.

(4-1, 9)

Answer 6

uses the home as an investment property.

If John used the home as a personal residence, the exchange would not qualify. In no instance would the exchange be a like-kind exchange for Bill, as he did not transfer property used for investment or trade or business purposes.

Question 7

Qualifying Property Example

Certain assets are never treated as qualifying property. Qualifying property does not include inventory or other property held primarily for sale. Neither general nor limited partnership interests qualify for like-kind exchange treatment. In addition, securities, stocks, bonds, notes, or other forms of indebtedness or
indications of ownership do not qualify. This latter rule prevents…

(4-1, 10)

Answer 7

investors from diversifying their securities holdings without recognizing taxable income when a particular security has appreciated in value.

Question 8

Qualifying as Like-Kind Property

The next consideration is whether the property qualifies as like-kind. The like kind requirement limits tax-free exchanges to the exchange of _____ for _____ or _____ for _____. While a light truck may be exchanged for a van, the same light truck would not qualify as like-kind property if exchanged for a tract of land.

(4-1, 10)

Answer 8

realty for realty and personalty for personalty

A leasehold interest in real estate of 30 years or more has been treated as an ownership interest by the IRS, and may be treated as an ownership interest in the realty for purposes of a like-kind exchange.

Question 9

Qualifying as Like-Kind Property

The like-kind requirement does not mean that the property transferred must be _____ to the property received. The term refers to the nature or character of the property, and not to its grade or quality.

(4-1, 10)

Answer 9

identical

For instance, an exchange of an apartment building for vacant farmland may be like-kind.

Question 10

Qualifying as Like-Kind Property

Three types of exchanges are specifically prohibited:

(4-1, 10)

Answer 10

1. Realty may not be exchanged for personalty, or vice versa.
2. An exchange of U.S. realty for foreign realty is not considered like-kind. Also, personalty used predominantly within the United States and personalty
   used predominantly outside the United States are not like-kind.
3. An exchange of livestock of different sexes is not considered like-kind.

Question 11

Qualifying as Like-kind exchange

This type of exchange occurs when three taxpayers are involved in the exchange. Such exchanges require careful planning and must be structured properly to avoid the recognition of income.

(4-1, 11)

Answer 11

three-cornered like-kind exchanges

Like-kind exchanges often are used to dispose of real estate that has passed the crossover point and acquire other real estate. The crossover point refers to the point in time when the deductions from a real estate investment are equal to or less than the income the real estate is generating.

Question 12

Boot

When “boot” is received in a like-kind exchange, a portion of the exchange may become taxable. Boot is anything that is not qualified, like-kind property. If a
taxpayer is relieved of debt due to the like-kind exchange, such debt relief is treated as a receipt of cash by the taxpayer and, as such, is treated as boot.
However, if the taxpayer also assumes a mortgage liability due to the exchange, only the _____ debt relief is considered to be boot

(4-1, 12)

Answer 12

net

For example, assume Brenda is involved in a like-kind exchange. In the exchange, she assumes a mortgage of $25,000, and is relieved of a mortgage of $40,000. Brenda has received $15,000 boot, the amount of the net debt relief.

Question 13

Like-Kind Exchange Rules

The following are rules that can be applied in calculating the gain realized, the gain recognized, and the adjusted basis of the acquired property.

1. Losses are _____ recognized (deducted) by either taxpayer in a like-kind exchange.

never or always

(4-1, 12)

Answer 13

never

Question 14

Like-Kind Exchange Rules

The following are rules that can be applied in calculating the gain realized, the gain recognized, and the adjusted basis of the acquired property.

2. The like-kind exchange provision is _____.

(4-1, 12)

Answer 14

mandatory

Thus, if a taxpayer is contemplating a transaction in which there would be a loss recognized, the taxpayer should sell that property, and purchase the new property in an unrelated transaction in order to allow recognition (deductibility) of the loss.

Question 15

Like-Kind Exchange Rules

The following are rules that can be applied in calculating the gain realized, the gain recognized, and the adjusted basis of the acquired property.

3. There will be [gain or no gain] recognized unless the taxpayer receives boot (cash, net debt relief, or other non=qualifying property).

(4-1, 12)

Answer 15

no gain

Question 16

Like-Kind Exchange Rules

The following are rules that can be applied in calculating the gain realized, the gain recognized, and the adjusted basis of the acquired property.

4. Gain generally is recognized by the taxpayer who _____ boot (cash, net debt relief, or other non-qualifying property).

(4-1, 12)

Answer 16

receives

Question 17

Like-Kind Exchange Rules

The following are rules that can be applied in calculating the gain realized, the gain recognized, and the adjusted basis of the acquired property.

5. The gain recognized is always the [lesser or greater] of the gain realized or the boot received. If the taxpayer received no boot, there will be no recognized (taxable) gain.

(4-1, 12)

Answer 17

lesser

Question 18

Like-Kind Exchange Rules

Holding Period Requirement: In a like-kind exchange between related parties, any gain or loss must be recognized (on an amended return) if either the property transferred or the property received is disposed of within _____ years after the exchange.

one

two

three

(4-1, 12)

Answer 18

two

However, dispositions due to involuntary conversion, death, or non-tax-avoidance purposes are not subject to this rule.

Question 19

Like-Kind Exchange Rules

If a taxpayer receives boot in a like-kind exchange, then the gain recognized is equal to the [greater of or lesser of] the gain realized or the boot received. Thus, if there is no boot received, there is no gain that is subject to tax.

(4-1, 13)

Answer 19

lesser of

Question 20

Like-Kind Exchange Rules

If there is a recognized gain, it is necessary to determine the character of that gain. If the property is Section 1245 property (personalty), then the gain is considered _____ income, up to the amount of gain that is subject to the recapture provisions. After that, any remaining gain on personalty is Section 1231 gain.

(4-1, 13)

Answer 20

ordinary

For real estate, any gain up to the amount of straight-line depreciation is considered 25% long-term capital gain (unrecaptured Section 1250 gain). Any gain in excess of the unrecaptured Section 1250 gain is “regular” long-term capital gain, eligible for the preferential capital gains rates. If there is no gain recognized on the exchange, the potential recapture carries over to the qualifying property received (the replacement property).

Question 21

Module Check

8. Which one of the following exchanges may qualify as a like-kind exchange?
   a. a heifer exchanged for a bull
   b. an apartment building located in Miami exchanged for an apartment building located in Mexico City
   c. farming equipment exchanged for farmland
   d. a shopping center exchanged for farmland

(LO 4-1)

Answer 21

d. a shopping center exchanged for farmland

The like-kind requirement does not mean that the property transferred must be identical to the property received. It merely requires that realty be exchanged for realty.

a. was incorrect because “An exchange of livestock of different sexes is not considered like-kind.”
b. was incorrect because “An exchange of U.S. realty for foreign realty is not considered like-kind.”
c. was incorrect because “The like-kind requirement limits exchanges to realty for realty and personalty for personalty.”

Question 22

Module Check

16. Jimmy West owns an apartment building in Cleveland. He would like to exchange his apartment building for another asset in a like-kind exchange. Which of the following assets could Jimmy receive to qualify for like-kind exchange treatment?
    a. commercial rental property in Detroit
    b. residential rental property in Mexico
    c. a residence in which he will live
    d. a piece of manufacturing equipment for his business

(LO 4-1)

Answer 22

a. commercial rental property in Detroit

An exchange of an apartment building for commercial rental property may be a like-kind exchange. As long as qualifying real property (property used in a trade or business or held for investment purposes) is exchanged for qualifying real property, the exchange is like-kind.

b. is incorrect because “An exchange of U.S. realty for foreign realty does not qualify as a like-kind exchange.”
c. is incorrect because “While realty for realty is often a like-kind exchange, the receipt of realty that will be a personal-use asset does not qualify for like-kind exchange treatment.”
d. is incorrect because “To qualify for like-kind exchange treatment, realty must be exchanged for realty (or personalty for personalty). An exchange of realty for personalty does not qualify for like-kind exchange treatment.”

Question 23

Like-kind exchange of property

Identify what requirements must be met so that income will not be recognized when a like-kind exchange of property is utilized.

(4-1, pg 55 of text)

Answer 23

1. The property to be exchanged must be qualifying property— property held for productive use in a trade or business or held for investment purposes.
2. The property to be exchanged must be like-kind property (real estate for real estate or personal property for personal
   property) .

Question 24

Like-kind exchange of property

Identify the situation in which a like-kind exchange will result in the recognition of taxable income.

(4-1, pg 55 of text)

Answer 24

1. The taxpayer receives boot.
2. Boot includes cash, non-like-kind property, or net debt relief
3. Net debt relief occurs when the taxpayer is relieved of a mortgage and assumes a mortgage that is less than the previous mortgage.
4. Nonqualified (non-like-kind) property is any property that is not qualified, like-kind property.

Question 25

28. John Torrence has an apartment building that he would like to trade. Which of the following assets could John receive in a like-kind exchange?

I. a shopping center
II. an interest in a real estate limited partnership
III. a vacant lot
IV. land-grading equipment

I and III only

II and III only

III and IV only

I, II, III, and IV

(LO 4–1)

Answer 25

I and III only

In a like-kind exchange for real estate, only other real estate may be received as qualifying property. Thus, the shopping center and the vacant lot are the only assets that would be qualifying property in a like-kind exchange of realty. The land-grading equipment is personalty and thus would not be considered like-kind property. The interest in a limited partnership is specifically not allowed as qualifying property.