When Exchanges of Property Are Not Taxable
Nontaxable Like-Kind Exchanges
If the exchange involves only the like-kind property, and no money or other unlike property is involved, the exchange is nontaxable and the basis of the property received is generally the same as the basis of the property given. Any gain or loss on the exchange would not be recognized until you sell or dispose of the property you receive.
If you pay money or give up other, different property in a like-kind exchange, no gain or loss is recognized on the exchange, but your basis in the new property is your basis in the like-kind property you give up plus the money you pay and the value of the other property you give.
In order for an exchange to be nontaxable, the properties given and received in the exchange have to meet two tests: they have to be qualifying property, and they have to be like-kind property.
Qualifying property is property used for productive use in a trade or business, or for investment purposes. It could include land, buildings, machinery and vehicles. But property that is held for sale in a trade or business, including stock in trade, inventory, merchandise, and real estate held by dealers, does not qualify for nontaxable exchanges. Also, stocks, bonds or other securities held for investment do not qualify for like-kind nontaxable exchanges.
Personal property, such as your automobile and your home, do not normally qualify for nontaxable exchanges
Also, the property must be like-kind; that is, the property you give and receive in the exchange must be similar in nature or character, and generally used for the same purpose. The fact that the properties are different in terms of their grade or quality does not disqualify them as like-kind property.
If you give up property used for business or investment in return for replacement property of a like-kind that you will receive later, the exchange is a deferred exchange and can still qualify as a nontaxable exchange. But if you receive money or other unlike property in full payment for the property you gave up, before you receive the replacement property, the transaction will be considered a sale rather than an exchange, and you would have to recognize any gain or loss on the transaction. If you subsequently receive the replacement property, you would be considered to have bought it.
In order to be a qualified deferred exchange, eligible to be treated as nontaxable, you must identify the replacement property to be received within 45 days after transferring the property you give up in the exchange. The property you expect to receive should be clearly identified in writing and this document should be delivered to the other party in the exchange.
Identifying Replacement Property
You can cancel an identification of the replacement property at any time during the 45-day identification period. And, you can identify more than one replacement property. The limit is three separate properties, or any number of replacement properties provided that the total fair market value at the end of the 45-day identification period is not more than twice the fair market value of the property you are giving up in the exchange, as of the date you transfer it.
In a deferred exchange you can identify replacement property that has not yet been produced. In this case, the property must be received by the later of 180 days after you transferred the property you gave up in the exchange, or the due date for filing your tax return for the year in which you gave up property in the exchange.
Partially Nontaxable Exchanges
A partially nontaxable exchange is one in which you receive like-kind property, and also receive money or unlike property, and you realize a gain on the exchange. In this type of exchange, you are taxed on any gain you realize, but only up to the amount of the money or the fair market value of the unlike property you receive. Any loss you incur on the exchange would not be deductible.
Maximum Amount of Gain
To figure the amount of your taxable gain on a partially nontaxable exchange, you would take the total of the money and the fair market value of the unlike property you receive and reduce this total by any exchange expenses, such as closing costs on the transaction. The result is the maximum amount of taxable gain. Then you would determine your gain on the overall exchange. Your recognized gain for tax purposes is the lesser of these two results.
Your gain or loss on the overall exchange is the amount you realize on the exchange, less your adjusted basis in the property you give up. The amount you realize includes money and the fair market value of the property you receive, plus any liabilities assumed by the other party, or that are attached to the property you transfer, such as real estate taxes or a mortgage. Your adjusted basis in the property you give up in the exchange is its original basis, plus any improvements or additions, and less any depreciation, casualty losses, or other adjustments. Your original basis in the property could be its cost or some other basis, depending on whether you acquired the property by purchase, gift, inheritance, or exchange
Unlike Property Given in Exchange
If you give up unlike property in what would otherwise be a nontaxable, like-kind exchange, you have to recognize gain or loss on the unlike property. The gain or loss that you would recognize, and report on your tax return, would be the difference between the fair market value of the unlike property and its adjusted basis. For example:
You exchange real estate you are holding for investment for other real estate. The fair market value of the real estate you are receiving is $40,000 and the real estate you are giving up cost you $35,000 and presently has a fair market value of $38,000. In addition, you are giving 100 shares of stock A that cost you $15 a share and have a present market value of $20 a share.
•You would have a realized gain of $5,000 on the real estate ($40,000 fair market value of the property you are receiving minus $35,000 basis in the property you are giving up). None of this gain would be taxable because the exchange qualifies as a nontaxable like-kind exchange.
• You would have to recognize a gain of $500 for tax purposes for the difference between the fair market value of the stock ($20 a share times 100 shares = $2,000), and the basis of the stock ($15 a share times 100 shares = $1,500), since the stock is unlike property in the exchange.
Basis of Property Received in a Partially Taxable Exchange
When you receive different properties in a partially taxable exchange, you must first determine the total basis to be assigned to the properties received. This is the total adjusted basis of the properties you give up plus any additional costs you incur on the exchange and any gain you recognize for tax purposes on the exchange, minus any money you receive and any loss you recognize on the exchange
Once you determine the total basis of the property you receive, you allocate it first to the unlike property based on its fair market value, and the rest is allocated to the like-kind property received.
Like-Kind Exchanges Between Related Persons
Exchanges of like-kind property between related persons are subject to special rules. Related persons include members of your family, corporations and partnerships in which you have more than 50% ownership. If either party disposes of the property within 2 years after the exchange, the exchange does not qualify as a nontaxable exchange and any gain or loss on the original exchange would have to be recognized (reported for tax purposes) at the time of disposing of the property received in exchange.
Exceptions to Related Persons Rule
This rule disqualifying exchanges between related parties from their nontaxable status does not apply when dispositions of the property are due to the death of either of the related persons, in cases of involuntary conversions, or in cases where the main purpose of the exchange and the subsequent disposition was not to avoid federal income taxes and this fact can be satisfactorily established with the Internal Revenue Service.