1.   Gain or Loss

Topics - This chapter discusses:

  • Sales and exchanges

  • Abandonments

  • Foreclosures and repossessions

  • Involuntary conversions

  • Nontaxable exchanges

  • Transfers to spouse

  • Rollovers and exclusions for certain capital gains

Useful Items - You may want to see:

Publication

  • 523 Selling Your Home

  • 537 Installment Sales

  • 547 Casualties, Disasters, and Thefts

  • 550 Investment Income and Expenses

  • 551 Basis of Assets

  • 908 Bankruptcy Tax Guide

  • 4681 Canceled Debts, Foreclosures, Repossessions, and Abandonments

Form (and Instructions)

  • Schedule D (Form 1040) Capital Gains and Losses

  • 1040 U.S. Individual Income Tax Return

  • 1040X Amended U.S. Individual Income Tax Return

  • 1099-A Acquisition or Abandonment of Secured Property

  • 1099-C Cancellation of Debt

  • 4797 Sales of Business Property

  • 8824 Like-Kind Exchanges

  • 8949 Sales and Other Dispositions of Capital Assets

Although the discussions in this chapter may at times refer mainly to individuals, many of the rules discussed also apply to taxpayers other than individuals. However, the rules for property held for personal use usually will not apply to taxpayers other than individuals. See chapter 5 for information about getting publications and forms.

Sales and Exchanges

A sale is a transfer of property for money or a mortgage, note, or other promise to pay money. An exchange is a transfer of property for other property or services. The following discussions describe the kinds of transactions that are treated as sales or exchanges and explain how to figure gain or loss.

Sale or lease.    Some agreements that seem to be leases may really be conditional sales contracts. The intention of the parties to the agreement can help you distinguish between a sale and a lease.

  There is no test or group of tests to prove what the parties intended when they made the agreement. You should consider each agreement based on its own facts and circumstances. For more information, see chapter 3 in Publication 535, Business Expenses.

Cancellation of a lease.    Payments received by a tenant for the cancellation of a lease are treated as an amount realized from the sale of property. Payments received by a landlord (lessor) for the cancellation of a lease are essentially a substitute for rental payments and are taxed as ordinary income in the year in which they are received.

Copyright.    Payments you receive for granting the exclusive use of (or right to exploit) a copyright throughout its life in a particular medium are treated as received from the sale of property. It does not matter if the payments are a fixed amount or a percentage of receipts from the sale, performance, exhibition, or publication of the copyrighted work, or an amount based on the number of copies sold, performances given, or exhibitions made. Nor does it matter if the payments are made over the same period as that covering the grantee's use of the copyrighted work.

  If the copyright was used in your trade or business and you held it longer than a year, the gain or loss may be a section 1231 gain or loss. For more information, see Section 1231 Gains and Losses in chapter 3.

Easement.   The amount received for granting an easement is subtracted from the basis of the property. If only a specific part of the entire tract of property is affected by the easement, only the basis of that part is reduced by the amount received. If it is impossible or impractical to separate the basis of the part of the property on which the easement is granted, the basis of the whole property is reduced by the amount received.

  Any amount received that is more than the basis to be reduced is a taxable gain. The transaction is reported as a sale of property.

  If you transfer a perpetual easement for consideration and do not keep any beneficial interest in the part of the property affected by the easement, the transaction will be treated as a sale of property. However, if you make a qualified conservation contribution of a restriction or easement granted in perpetuity, it is treated as a charitable contribution and not a sale or exchange, even though you keep a beneficial interest in the property affected by the easement.

  If you grant an easement on your property (for example, a right-of-way over it) under condemnation or threat of condemnation, you are considered to have made a forced sale, even though you keep the legal title. Although you figure gain or loss on the easement in the same way as a sale of property, the gain or loss is treated as a gain or loss from a condemnation. See Gain or Loss From Condemnations, later.

Property transferred to satisfy debt.   A transfer of property to satisfy a debt is an exchange.

Note's maturity date extended.   The extension of a note's maturity date is not treated as an exchange of an outstanding note for a new and different note. Also, it is not considered a closed and completed transaction that would result in a gain or loss. However, an extension will be treated as a taxable exchange of the outstanding note for a new and materially different note if the changes in the terms of the note are significant. Each case must be determined by its own facts. For more information, see Regulations section 1.1001-3.

Transfer on death.   The transfer of property of a decedent to an executor or administrator of the estate, or to the heirs or beneficiaries, is not a sale or exchange or other disposition. No taxable gain or deductible loss results from the transfer.

Bankruptcy.   Generally, a transfer (other than by sale or exchange) of property from a debtor to a bankruptcy estate is not treated as a disposition. Consequently, the transfer generally does not result in gain or loss. For more information, see Publication 908, Bankruptcy Tax Guide.

Gain or Loss From Sales and Exchanges

You usually realize gain or loss when property is sold or exchanged. A gain is the amount you realize from a sale or exchange of property that is more than its adjusted basis. A loss is the adjusted basis of the property that is more than the amount you realize. 

Table 1-1. How To Figure Whether You Have a Gain or Loss

IF your... THEN you have a...
Adjusted basis is more than the amount realized, Loss.
Amount realized is more than the adjusted basis, Gain.

Basis.   You must know the basis of your property to determine whether you have a gain or loss from its sale or other disposition. The basis of property you buy is usually its cost. However, if you acquired the property by gift, inheritance, or in some way other than buying it, you must use a basis other than its cost. See Basis Other Than Cost in Publication 551, Basis of Assets. Special rules apply to property acquired from a decedent who died in 2010 and the executor made the election to file Form 8939, Allocation of Increase in Basis for Property Received From a Decedent. See Publication 4895, Tax Treatment of Property Acquired From a Decedent Dying in 2010, for details.

Adjusted basis.   The adjusted basis of property is your original cost or other basis plus (increased by) certain additions and minus (decreased by) certain deductions. Increases include costs of any improvements having a useful life of more than 1 year. Decreases include depreciation and casualty losses. For more details and additional examples, see Adjusted Basis in Publication 551.

Amount realized.   The amount you realize from a sale or exchange is the total of all money you receive plus the fair market value (defined below) of all property or services you receive. The amount you realize also includes any of your liabilities that were assumed by the buyer and any liabilities to which the property you transferred is subject, such as real estate taxes or a mortgage.

Fair market value.   Fair market value (FMV) is the price at which the property would change hands between a buyer and a seller when both have reasonable knowledge of all the necessary facts and neither is being forced to buy or sell. If parties with adverse interests place a value on property in an arm's-length transaction, that is strong evidence of FMV. If there is a stated price for services, this price is treated as the FMV unless there is evidence to the contrary.

Example.

You used a building in your business that cost you $70,000. You made certain permanent improvements at a cost of $20,000 and deducted depreciation totaling $10,000. You sold the building for $100,000 plus property having an FMV of $20,000. The buyer assumed your real estate taxes of $3,000 and a mortgage of $17,000 on the building. The selling expenses were $4,000. Your gain on the sale is figured as follows.

Amount realized:    
Cash $100,000  
FMV of property received 20,000  
Real estate taxes assumed by buyer 3,000  
Mortgage assumed by  
buyer
17,000  
Total 140,000  
Minus: Selling expenses 4,000 $136,000
Adjusted basis:    
Cost of building $70,000  
Improvements 20,000  
Total $90,000  
Minus: Depreciation 10,000  
Adjusted basis   $80,000
Gain on sale $56,000

Amount recognized.   Your gain or loss realized from a sale or exchange of property is usually a recognized gain or loss for tax purposes. Recognized gains must be included in gross income. Recognized losses are deductible from gross income. However, your gain or loss realized from certain exchanges of property is not recognized for tax purposes. See Nontaxable Exchanges, later. Also, a loss from the sale or other disposition of property held for personal use is not deductible, except in the case of a casualty or theft.

Interest in property.   The amount you realize from the disposition of a life interest in property, an interest in property for a set number of years, or an income interest in a trust is a recognized gain under certain circumstances. If you received the interest as a gift, inheritance, or in a transfer from a spouse or former spouse incident to a divorce, the amount realized is a recognized gain. Your basis in the property is disregarded. This rule does not apply if all interests in the property are disposed of at the same time.

Example 1.

Your father dies and leaves his farm to you for life with a remainder interest to your younger brother. You decide to sell your life interest in the farm. The entire amount you receive is a recognized gain. Your basis in the farm is disregarded.

Example 2.

The facts are the same as in Example 1, except that your brother joins you in selling the farm. The entire interest in the property is sold, so your basis in the farm is not disregarded. Your gain or loss is the difference between your share of the sales price and your adjusted basis in the farm.

Canceling a sale of real property.   If you sell real property under a sales contract that allows the buyer to return the property for a full refund and the buyer does so, you may not have to recognize gain or loss on the sale. If the buyer returns the property in the year of sale, no gain or loss is recognized. This cancellation of the sale in the same year it occurred places both you and the buyer in the same positions you were in before the sale. If the buyer returns the property in a later tax year, you must recognize gain (or loss, if allowed) in the year of the sale. When the property is returned in a later year, you acquire a new basis in the property. That basis is equal to the amount you pay to the buyer.

Bargain Sale

If you sell or exchange property for less than fair market value with the intent of making a gift, the transaction is partly a sale or exchange and partly a gift. You have a gain if the amount realized is more than your adjusted basis in the property. However, you do not have a loss if the amount realized is less than the adjusted basis of the property.

Bargain sales to charity.   A bargain sale of property to a charitable organization is partly a sale or exchange and partly a charitable contribution. If a charitable deduction for the contribution is allowable, you must allocate your adjusted basis in the property between the part sold and the part contributed based on the fair market value of each. The adjusted basis of the part sold is figured as follows.
Adjusted basis of 
entire property ×
Amount realized 
(fair market value of part sold)
  Fair market value of entire 
property

  Based on this allocation rule, you will have a gain even if the amount realized is not more than your adjusted basis in the property. This allocation rule does not apply if a charitable contribution deduction is not allowable.

  See Publication 526, Charitable Contributions, for information on figuring your charitable contribution.

Example.

You sold property with a fair market value of $10,000 to a charitable organization for $2,000 and are allowed a deduction for your contribution. Your adjusted basis in the property is $4,000. Your gain on the sale is $1,200, figured as follows.

Sales price $2,000
Minus: Adjusted basis of part sold ($4,000 × ($2,000 ÷ $10,000)) 800
Gain on the sale $1,200

Property Used Partly for Business or Rental

Generally, if you sell or exchange property you used partly for business or rental purposes and partly for personal purposes, you must figure the gain or loss on the sale or exchange as though you had sold two separate pieces of property. You must subtract depreciation you took or could have taken from the basis of the business or rental part. However, see the special rule below for a home used partly for business or rental. You must allocate the selling price, selling expenses, and the basis of the property between the business or rental part and the personal part.

Gain or loss on the business or rental part of the property may be a capital gain or loss or an ordinary gain or loss, as discussed in chapter 3 under Section 1231 Gains and Losses. Any gain on the personal part of the property is a capital gain. You cannot deduct a loss on the personal part.

Home used partly for business or rental.    If you use property partly as a home and partly for business or to produce rental income, the computation and treatment of any gain on the sale depends partly on whether the business or rental part of the property is part of your home or separate from it. See Property Used Partly for Business or Rental, in Publication 523.

Property Changed to Business or Rental Use

You cannot deduct a loss on the sale of property you purchased or constructed for use as your home and used as your home until the time of sale.

You can deduct a loss on the sale of property you acquired for use as your home but changed to business or rental property and used as business or rental property at the time of sale. However, if the adjusted basis of the property at the time of the change was more than its fair market value, the loss you can deduct is limited.

Figure the loss you can deduct as follows.

  1. Use the lesser of the property's adjusted basis or fair market value at the time of the change.

  2. Add to (1) the cost of any improvements and other increases to basis since the change.

  3. Subtract from (2) depreciation and any other decreases to basis since the change.

  4. Subtract the amount you realized on the sale from the result in (3). If the amount you realized is more than the result in (3), treat this result as zero.

The result in (4) is the loss you can deduct.

Example.

You changed your main home to rental property 5 years ago. At the time of the change, the adjusted basis of your home was $75,000 and the fair market value was $70,000. This year, you sold the property for $55,000. You made no improvements to the property but you have depreciation expense of $12,620 over the 5 prior years. Although your loss on the sale is $7,380 [($75,000 − $12,620) − $55,000], the amount you can deduct as a loss is limited to $2,380, figured as follows.

Lesser of adjusted basis or fair market value at time of the change $70,000
Plus: Cost of any improvements and any other additions to basis after the change -0-
  70,000
Minus: Depreciation and any other decreases to basis after the change 12,620
  57,380
Minus: Amount you realized from the sale 55,000
Deductible loss $2,380

Gain.   If you have a gain on the sale, you generally must recognize the full amount of the gain. You figure the gain by subtracting your adjusted basis from your amount realized, as described earlier.

  You may be able to exclude all or part of the gain if you owned and lived in the property as your main home for at least 2 years during the 5-year period ending on the date of sale. However, you may not be able to exclude the part of the gain allocated to any period of nonqualified use.

  For more information, see Business Use or Rental of Home in Publication 523. In addition, special rules apply if the home sold was acquired in a like-kind exchange. See Special Situations in Publication 523. Also see Like-Kind Exchanges, later.

Abandonments

The abandonment of property is a disposition of property. You abandon property when you voluntarily and permanently give up possession and use of the property with the intention of ending your ownership but without passing it on to anyone else. Generally, abandonment is not treated as a sale or exchange of the property. If the amount you realize (if any) is more than your adjusted basis, then you have a gain. If your adjusted basis is more than the amount you realize (if any), then you have a loss.

Loss from abandonment of business or investment property is deductible as a loss. A loss from an abandonment of business or investment property that is not treated as a sale or exchange generally is an ordinary loss. This rule also applies to leasehold improvements the lessor made for the lessee that were abandoned.

If the property is foreclosed on or repossessed in lieu of abandonment, gain or loss is figured as discussed later under Foreclosure and Repossessions. The abandonment loss is deducted in the tax year in which the loss is sustained.

If the abandoned property is secured by debt, special rules apply. The tax consequences of abandonment of property that is secured by debt depend on whether you are personally liable for the debt (recourse debt) or you are not personally liable for the debt (nonrecourse debt). For more information, including examples, see chapter 3 of Publication 4681.

You cannot deduct any loss from abandonment of your home or other property held for personal use only.

Cancellation of debt.   If the abandoned property secures a debt for which you are personally liable and the debt is canceled, you may realize ordinary income equal to the canceled debt. This income is separate from any loss realized from abandonment of the property.

  You must report this income on your tax return unless one of the following applies.
  • The cancellation is intended as a gift.

  • The debt is qualified farm debt.

  • The debt is qualified real property business debt.

  • You are insolvent or bankrupt.

  • The debt is qualified principal residence indebtedness.

File Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), to report the income exclusion. For more information, including other exceptions and exclusion, see Publication 4681.

Forms 1099-A and 1099-C.   If you abandon property that secures a loan and the lender knows the property has been abandoned, the lender should send you Form 1099-A showing information you need to figure your loss from the abandonment. However, if your debt is canceled and the lender must file Form 1099-C, the lender may include the information about the abandonment on that form instead of on Form 1099-A, and send you Form 1099-C only. The lender must file Form 1099-C and send you a copy if the amount of debt canceled is $600 or more and the lender is a financial institution, credit union, federal government agency, or any organization that has a significant trade or business of lending money. For abandonments of property and debt cancellations occurring in 2013, these forms should be sent to you by January 31, 2014.

Foreclosures and Repossessions

If you do not make payments you owe on a loan secured by property, the lender may foreclose on the loan or repossess the property. The foreclosure or repossession is treated as a sale or exchange from which you may realize gain or loss. This is true even if you voluntarily return the property to the lender. You also may realize ordinary income from cancellation of debt if the loan balance is more than the fair market value of the property.

Buyer's (borrower's) gain or loss.   You figure and report gain or loss from a foreclosure or repossession in the same way as gain or loss from a sale or exchange. The gain or loss is the difference between your adjusted basis in the transferred property and the amount realized. See Gain or Loss From Sales and Exchanges, earlier.

You can use Table 1-2 to figure your gain or loss from a foreclosure or repossession.

Amount realized on a nonrecourse debt.   If you are not personally liable for repaying the debt (nonrecourse debt) secured by the transferred property, the amount you realize includes the full debt canceled by the transfer. The full canceled debt is included even if the fair market value of the property is less than the canceled debt.

Example 1.

Chris bought a new car for $15,000. He paid $2,000 down and borrowed the remaining $13,000 from the dealer's credit company. Chris is not personally liable for the loan (nonrecourse debt), but pledges the new car as security. The credit company repossessed the car because he stopped making loan payments. The balance due after taking into account the payments Chris made was $10,000. The fair market value of the car when repossessed was $9,000. The amount Chris realized on the repossession is $10,000. That is the outstanding amount of the debt canceled by the repossession, even though the car's fair market value is less than $10,000. Chris figures his gain or loss on the repossession by comparing the amount realized ($10,000) with his adjusted basis ($15,000). He has a $5,000 nondeductible loss.

Example 2.

Abena paid $200,000 for her home. She paid $15,000 down and borrowed the remaining $185,000 from a bank. Abena is not personally liable for the loan (nonrecourse debt), but pledges the house as security. The bank foreclosed on the loan because Abena stopped making payments. When the bank foreclosed on the loan, the balance due was $180,000, the fair market value of the house was $170,000, and Abena's adjusted basis was $175,000 due to a casualty loss she had deducted. The amount Abena realized on the foreclosure is $180,000, the balance due and debt canceled by the foreclosure. She figures her gain or loss by comparing the amount realized ($180,000) with her adjusted basis ($175,000). She has a $5,000 realized gain.

Amount realized on a recourse debt.   If you are personally liable for the debt (recourse debt), the amount realized on the foreclosure or repossession includes the lesser of:
  • The outstanding debt immediately before the transfer reduced by any amount for which you remain personally liable immediately after the transfer, or

  • The fair market value of the transferred property.

You are treated as receiving ordinary income from the canceled debt for the part of the debt that is more than the fair market value. The amount realized does not include the canceled debt that is your income from cancellation of debt. See Cancellation of debt, below.

Seller's (lender's) gain or loss on repossession.   If you finance a buyer's purchase of property and later acquire an interest in it through foreclosure or repossession, you may have a gain or loss on the acquisition. For more information, see Repossession in Publication 537.

  

Table 1-2. Worksheet for Foreclosures and Repossessions

Part 1. Use Part 1 to figure your ordinary income from the cancellation of debt 
upon foreclosure or repossession. Complete this part only  
if you were personally liable for the debt. Otherwise,  
go to Part 2.
 
1. Enter the amount of outstanding debt immediately before the transfer of  
 property reduced by any amount for which you remain personally liable after  
 the transfer of property
 
2. Enter the fair market value of the transferred property  
3. Ordinary income from cancellation of debt upon foreclosure or  
  repossession.*
Subtract line 2 from line 1.  
 If less than zero, enter zero
 
Part 2. Figure your gain or loss from foreclosure or repossession.  
4. If you completed Part 1, enter the smaller of line 1 or line 2.  
 If you did not complete Part 1, enter the outstanding debt immediately before  
 the transfer of property
 
5. Enter any proceeds you received from the foreclosure sale  
6. Add lines 4 and 5  
7. Enter the adjusted basis of the transferred property  
8. Gain or loss from foreclosure or repossession. Subtract line 7 
 from line 6
 
* The income may not be taxable. See Cancellation of debt.

Cancellation of debt.   If property that is repossessed or foreclosed on secures a debt for which you are personally liable (recourse debt), you generally must report as ordinary income the amount by which the canceled debt is more than the fair market value of the property. This income is separate from any gain or loss realized from the foreclosure or repossession. Report the income from cancellation of a debt related to a business or rental activity as business or rental income.

  
You can use Table 1-2 to figure your income from cancellation of debt.

  You must report this income on your tax return unless one of the following applies.
  • The cancellation is intended as a gift.

  • The debt is qualified farm debt.

  • The debt is qualified real property business debt.

  • You are insolvent or bankrupt.

  • The debt is qualified principal residence indebtedness.

File Form 982 to report the income exclusion.

Example 1.

Assume the same facts as in Example 1 under Amount realized on a nonrecourse debt, earlier, except Chris is personally liable for the car loan (recourse debt). In this case, the amount he realizes is $9,000. This is the lesser of the canceled debt ($10,000) or the car's fair market value ($9,000). Chris figures his gain or loss on the repossession by comparing the amount realized ($9,000) with his adjusted basis ($15,000). He has a $6,000 nondeductible loss. He also is treated as receiving ordinary income from cancellation of debt. That income is $1,000 ($10,000 − $9,000). This is the part of the canceled debt not included in the amount realized.

Example 2.

Assume the same facts as in Example 2 under Amount realized on a nonrecourse debt, earlier, except Abena is personally liable for the loan (recourse debt). In this case, the amount she realizes is $170,000. This is the lesser of the canceled debt ($180,000) or the fair market value of the house ($170,000). Abena figures her gain or loss on the foreclosure by comparing the amount realized ($170,000) with her adjusted basis ($175,000). She has a $5,000 nondeductible loss. She also is treated as receiving ordinary income from cancellation of debt. (The debt is not exempt from tax as discussed under Cancellation of debt, above.) That income is $10,000 ($180,000 − $170,000). This is the part of the canceled debt not included in the amount realized.

Forms 1099-A and 1099-C.   A lender who acquires an interest in your property in a foreclosure or repossession should send you Form 1099-A showing the information you need to figure your gain or loss. However, if the lender also cancels part of your debt and must file Form 1099-C, the lender may include the information about the foreclosure or repossession on that form instead of on Form 1099-A and send you Form 1099-C only. The lender must file Form 1099-C and send you a copy if the amount of debt canceled is $600 or more and the lender is a financial institution, credit union, federal government agency, or any organization that has a significant trade or business of lending money. For foreclosures or repossessions occurring in 2013, these forms should be sent to you by January 31, 2014.

Involuntary Conversions

An involuntary conversion occurs when your property is destroyed, stolen, condemned, or disposed of under the threat of condemnation and you receive other property or money in payment, such as insurance or a condemnation award. Involuntary conversions are also called involuntary exchanges.

Gain or loss from an involuntary conversion of your property is usually recognized for tax purposes unless the property is your main home. You report the gain or deduct the loss on your tax return for the year you realize it. You cannot deduct a loss from an involuntary conversion of property you held for personal use unless the loss resulted from a casualty or theft.

However, depending on the type of property you receive, you may not have to report a gain on an involuntary conversion. Generally, you do not report the gain if you receive property that is similar or related in service or use to the converted property. Your basis for the new property is the same as your basis for the converted property. This means that the gain is deferred until a taxable sale or exchange occurs.

If you receive money or property that is not similar or related in service or use to the involuntarily converted property and you buy qualifying replacement property within a certain period of time, you can elect to postpone reporting the gain on the property purchased.

This publication explains the treatment of a gain or loss from a condemnation or disposition under the threat of condemnation. If you have a gain or loss from the destruction or theft of property, see Publication 547.

Condemnations

A condemnation is the process by which private property is legally taken for public use without the owner's consent. The property may be taken by the federal government, a state government, a political subdivision, or a private organization that has the power to legally take it. The owner receives a condemnation award (money or property) in exchange for the property taken. A condemnation is like a forced sale, the owner being the seller and the condemning authority being the buyer.

Example.

A local government authorized to acquire land for public parks informed you that it wished to acquire your property. After the local government took action to condemn your property, you went to court to keep it. But, the court decided in favor of the local government, which took your property and paid you an amount fixed by the court. This is a condemnation of private property for public use.

Threat of condemnation.   A threat of condemnation exists if a representative of a government body or a public official authorized to acquire property for public use informs you that the government body or official has decided to acquire your property. You must have reasonable grounds to believe that, if you do not sell voluntarily, your property will be condemned.

  The sale of your property to someone other than the condemning authority will also qualify as an involuntary conversion, provided you have reasonable grounds to believe that your property will be condemned. If the buyer of this property knows at the time of purchase that it will be condemned and sells it to the condemning authority, this sale also qualifies as an involuntary conversion.

Reports of condemnation.   A threat of condemnation exists if you learn of a decision to acquire your property for public use through a report in a newspaper or other news medium, and this report is confirmed by a representative of the government body or public official involved. You must have reasonable grounds to believe that they will take necessary steps to condemn your property if you do not sell voluntarily. If you relied on oral statements made by a government representative or public official, the Internal Revenue Service (IRS) may ask you to get written confirmation of the statements.

Example.

Your property lies along public utility lines. The utility company has the authority to condemn your property. The company informs you that it intends to acquire your property by negotiation or condemnation. A threat of condemnation exists when you receive the notice.

Related property voluntarily sold.   A voluntary sale of your property may be treated as a forced sale that qualifies as an involuntary conversion if the property had a substantial economic relationship to property of yours that was condemned. A substantial economic relationship exists if together the properties were one economic unit. You also must show that the condemned property could not reasonably or adequately be replaced. You can elect to postpone reporting the gain by buying replacement property. See Postponement of Gain, later.

Gain or Loss From Condemnations

If your property was condemned or disposed of under the threat of condemnation, figure your gain or loss by comparing the adjusted basis of your condemned property with your net condemnation award.

If your net condemnation award is more than the adjusted basis of the condemned property, you have a gain. You can postpone reporting gain from a condemnation if you buy replacement property. If only part of your property is condemned, you can treat the cost of restoring the remaining part to its former usefulness as the cost of replacement property. See Postponement of Gain, later.

If your net condemnation award is less than your adjusted basis, you have a loss. If your loss is from property you held for personal use, you cannot deduct it. You must report any deductible loss in the tax year it happened.

You can use Part 2 of Table 1-3 to figure your gain or loss from a condemnation award.

Main home condemned.   If you have a gain because your main home is condemned, you generally can exclude the gain from your income as if you had sold or exchanged your home. You may be able to exclude up to $250,000 of the gain (up to $500,000 if married filing jointly). For information on this exclusion, see Publication 523. If your gain is more than you can exclude but you buy replacement property, you may be able to postpone reporting the rest of the gain. See Postponement of Gain, later.

Table 1-3. Worksheet for Condemnations

Part 1. Gain from severance damages. 
If you did not receive severance damages, skip Part 1 and go to Part 2.
 
1. Enter gross severance damages received  
2. Enter your expenses in getting severance damages  
3. Subtract line 2 from line 1. If less than zero, enter -0-  
4. Enter any special assessment on remaining property taken out of your award  
5. Net severance damages. Subtract line 4 from line 3. If less than zero, enter -0-  
6. Enter the adjusted basis of the remaining property  
7. Gain from severance damages. Subtract line 6 from line 5. If less than zero, enter -0-  
8. Refigured adjusted basis of the remaining property. Subtract line 5 from line 6. If less than zero, enter -0-  
Part 2. Gain or loss from condemnation award.  
9. Enter the gross condemnation award received  
10. Enter your expenses in getting the condemnation award  
11. If you completed Part 1, and line 4 is more than line 3, subtract line 3 from line 4. If you did not complete Part 1, but a special assessment was taken out of your award, enter that amount. Otherwise, enter -0-  
12. Add lines 10 and 11  
13. Net condemnation award. Subtract line 12 from line 9  
14. Enter the adjusted basis of the condemned property  
15. Gain from condemnation award. If line 14 is more than line 13, enter -0-. Otherwise, subtract line 14 from  
line 13 and skip line 16
 
16. Loss from condemnation award. Subtract line 13 from line 14  
  (Note: You cannot deduct the amount on line 16 if the condemned property was held for personal use.)  
Part 3. Postponed gain from condemnation.  
(Complete only if line 7 or line 15 is more than zero and you bought qualifying replacement property or made expenditures to restore the usefulness of your remaining property.)
 
17. If you completed Part 1, and line 7 is more than zero, enter the amount from line 5. Otherwise, enter -0-  
18. If line 15 is more than zero, enter the amount from line 13. Otherwise, enter -0-  
19. Add lines 17 and 18. If the condemned property was your main home, subtract from this total the gain you excluded from your income and enter the result  
20. Enter the total cost of replacement property and any expenses to restore the usefulness of your remaining property  
21. Subtract line 20 from line 19. If less than zero, enter -0-  
22. If you completed Part 1, add lines 7 and 15. Otherwise, enter the amount from line 15. If the condemned property was your main home, subtract from this total the gain you excluded from your income and enter the result  
23. Recognized gain. Enter the smaller of line 21 or line 22.  
24. Postponed gain. Subtract line 23 from line 22. If less than zero, enter -0-  

Condemnation award.   A condemnation award is the money you are paid or the value of other property you receive for your condemned property. The award is also the amount you are paid for the sale of your property under threat of condemnation.

Payment of your debts.   Amounts taken out of the award to pay your debts are considered paid to you. Amounts the government pays directly to the holder of a mortgage or lien against your property are part of your award, even if the debt attaches to the property and is not your personal liability.

Example.

The state condemned your property for public use. The award was set at $200,000. The state paid you only $148,000 because it paid $50,000 to your mortgage holder and $2,000 accrued real estate taxes. You are considered to have received the entire $200,000 as a condemnation award.

Interest on award.   If the condemning authority pays you interest for its delay in paying your award, it is not part of the condemnation award. You must report the interest separately as ordinary income.

Payments to relocate.   Payments you receive to relocate and replace housing because you have been displaced from your home, business, or farm as a result of federal or federally assisted programs are not part of the condemnation award. Do not include them in your income. Replacement housing payments used to buy new property are included in the property's basis as part of your cost.

Net condemnation award.   A net condemnation award is the total award you received, or are considered to have received, for the condemned property minus your expenses of obtaining the award. If only a part of your property was condemned, you also must reduce the award by any special assessment levied against the part of the property you retain. This is discussed later under Special assessment taken out of award.

Severance damages.    Severance damages are not part of the award paid for the property condemned. They are paid to you if part of your property is condemned and the value of the part you keep is decreased because of the condemnation.

  For example, you may receive severance damages if your property is subject to flooding because you sell flowage easement rights (the condemned property) under threat of condemnation. Severance damages also may be given to you if, because part of your property is condemned for a highway, you must replace fences, dig new wells or ditches, or plant trees to restore your remaining property to the same usefulness it had before the condemnation.

  The contracting parties should agree on the specific amount of severance damages in writing. If this is not done, all proceeds from the condemning authority are considered awarded for your condemned property.

  You cannot make a completely new allocation of the total award after the transaction is completed. However, you can show how much of the award both parties intended for severance damages. The severance damages part of the award is determined from all the facts and circumstances.

Example.

You sold part of your property to the state under threat of condemnation. The contract you and the condemning authority signed showed only the total purchase price. It did not specify a fixed sum for severance damages. However, at settlement, the condemning authority gave you closing papers showing clearly the part of the purchase price that was for severance damages. You may treat this part as severance damages.

Treatment of severance damages.   Your net severance damages are treated as the amount realized from an involuntary conversion of the remaining part of your property. Use them to reduce the basis of the remaining property. If the amount of severance damages is based on damage to a specific part of the property you kept, reduce the basis of only that part by the net severance damages.

  If your net severance damages are more than the basis of your retained property, you have a gain. You may be able to postpone reporting the gain. See Postponement of Gain, later.

  
You can use Part 1 of Table 1-3 to figure any gain from severance damages and to refigure the adjusted basis of the remaining part of your property.

Net severance damages.   To figure your net severance damages, you first must reduce your severance damages by your expenses in obtaining the damages. You then reduce them by any special assessment (described later) levied against the remaining part of the property and retained out of the award by the condemning authority. The balance is your net severance damages.

Expenses of obtaining a condemnation award and severance damages.   Subtract the expenses of obtaining a condemnation award, such as legal, engineering, and appraisal fees, from the total award. Also, subtract the expenses of obtaining severance damages, which may include similar expenses, from the severance damages paid to you. If you cannot determine which part of your expenses is for each part of the condemnation proceeds, you must make a proportionate allocation.

Example.

You receive a condemnation award and severance damages. One-fourth of the total was designated as severance damages in your agreement with the condemning authority. You had legal expenses for the entire condemnation proceeding. You cannot determine how much of your legal expenses is for each part of the condemnation proceeds. You must allocate one-fourth of your legal expenses to the severance damages and the other three-fourths to the condemnation award.

Special assessment retained out of award.   When only part of your property is condemned, a special assessment levied against the remaining property may be retained by the governing body out of your condemnation award. An assessment may be levied if the remaining part of your property benefited by the improvement resulting from the condemnation. Examples of improvements that may cause a special assessment are widening a street and installing a sewer.

  To figure your net condemnation award, you must reduce the amount of the award by the assessment retained out of the award.

Example.

To widen the street in front of your home, the city condemned a 25-foot deep strip of your land. You were awarded $5,000 for this and spent $300 to get the award. Before paying the award, the city levied a special assessment of $700 for the street improvement against your remaining property. The city then paid you only $4,300. Your net award is $4,000 ($5,000 total award minus $300 expenses in obtaining the award and $700 for the special assessment retained).

If the $700 special assessment was not retained out of the award and you were paid $5,000, your net award would be $4,700 ($5,000 − $300). The net award would not change, even if you later paid the assessment from the amount you received.

Severance damages received.   If severance damages are included in the condemnation proceeds, the special assessment retained out of the severance damages is first used to reduce the severance damages. Any balance of the special assessment is used to reduce the condemnation award.

Example.

You were awarded $4,000 for the condemnation of your property and $1,000 for severance damages. You spent $300 to obtain the severance damages. A special assessment of $800 was retained out of the award. The $1,000 severance damages are reduced to zero by first subtracting the $300 expenses and then $700 of the special assessment. Your $4,000 condemnation award is reduced by the $100 balance of the special assessment, leaving a $3,900 net condemnation award.

Part business or rental.   If you used part of your condemned property as your home and part as business or rental property, treat each part as a separate property. Figure your gain or loss separately because gain or loss on each part may be treated differently.

  Some examples of this type of property are a building in which you live and operate a grocery, and a building in which you live on the first floor and rent out the second floor.

Example.

You sold your building for $24,000 under threat of condemnation to a public utility company that had the authority to condemn. You rented half the building and lived in the other half. You paid $25,000 for the building and spent an additional $1,000 for a new roof. You claimed allowable depreciation of $4,600 on the rental half. You spent $200 in legal expenses to obtain the condemnation award. Figure your gain or loss as follows.

    Resi- 
dential 
Part
Busi- 
ness 
Part
1) Condemnation award received $12,000 $12,000
2) Minus: Legal expenses, $200 100 100
3) Net condemnation award $11,900 $11,900
4) Adjusted basis:    
  ½ of original cost, $25,000 $12,500 $12,500
  Plus: ½ of cost of roof, $1,000 500 500
  Total $13,000 $13,000
5) Minus: Depreciation   4,600
6) Adjusted basis, business part   $8,400
7) (Loss) on residential property ($1,100)  
8) Gain on business property $3,500
The loss on the residential part of the property is not deductible.

Postponement of Gain

Do not report the gain on condemned property if you receive only property that is similar or related in service or use to the condemned property. Your basis for the new property is the same as your basis for the old.

Money or unlike property received.   You ordinarily must report the gain if you receive money or unlike property. You can elect to postpone reporting the gain if you buy property that is similar or related in service or use to the condemned property within the replacement period, discussed later. You also can elect to postpone reporting the gain if you buy a controlling interest (at least 80%) in a corporation owning property that is similar or related in service or use to the condemned property. See Controlling interest in a corporation, later.

  To postpone reporting all the gain, you must buy replacement property costing at least as much as the amount realized for the condemned property. If the cost of the replacement property is less than the amount realized, you must report the gain up to the unspent part of the amount realized.

  The basis of the replacement property is its cost, reduced by the postponed gain. Also, if your replacement property is stock in a corporation that owns property similar or related in service or use, the corporation generally will reduce its basis in its assets by the amount by which you reduce your basis in the stock. See Controlling interest in a corporation, later.

You can use Part 3 of Table 1-3 to figure the gain you must report and your postponed gain.

Postponing gain on severance damages.   If you received severance damages for part of your property because another part was condemned and you buy replacement property, you can elect to postpone reporting gain. See Treatment of severance damages, earlier. You can postpone reporting all your gain if the replacement property costs at least as much as your net severance damages plus your net condemnation award (if resulting in gain).

  You also can make this election if you spend the severance damages, together with other money you received for the condemned property (if resulting in gain), to acquire nearby property that will allow you to continue your business. If suitable nearby property is not available and you are forced to sell the remaining property and relocate in order to continue your business, see Postponing gain on the sale of related property, next.

  If you restore the remaining property to its former usefulness, you can treat the cost of restoring it as the cost of replacement property.

Postponing gain on the sale of related property.   If you sell property that is related to the condemned property and then buy replacement property, you can elect to postpone reporting gain on the sale. You must meet the requirements explained earlier under Related property voluntarily sold. You can postpone reporting all your gain if the replacement property costs at least as much as the amount realized from the sale plus your net condemnation award (if resulting in gain) plus your net severance damages, if any (if resulting in gain).

Buying replacement property from a related person.   Certain taxpayers cannot postpone reporting gain from a condemnation if they buy the replacement property from a related person. For information on related persons, see Nondeductible Loss under Sales and Exchanges Between Related Persons in chapter 2.

  This rule applies to the following taxpayers.
  1. C corporations.

  2. Partnerships in which more than 50% of the capital or profits interest is owned by  
    C corporations.

  3. All others (including individuals, partnerships (other than those in (2)), and S corporations) if the total realized gain for the tax year on all involuntarily converted properties on which there is realized gain of more than $100,000.

  For taxpayers described in (3) above, gains cannot be offset with any losses when determining whether the total gain is more than $100,000. If the property is owned by a partnership, the $100,000 limit applies to the partnership and each partner. If the property is owned by an S corporation, the $100,000 limit applies to the S corporation and each shareholder.

Exception.   This rule does not apply if the related person acquired the property from an unrelated person within the replacement period.

Advance payment.   If you pay a contractor in advance to build your replacement property, you have not bought replacement property unless it is finished before the end of the replacement period (discussed later).

Replacement property.   To postpone reporting gain, you must buy replacement property for the specific purpose of replacing your condemned property. You do not have to use the actual funds from the condemnation award to acquire the replacement property. Property you acquire by gift or inheritance does not qualify as replacement property.

Similar or related in service or use.   Your replacement property must be similar or related in service or use to the property it replaces.

  If the condemned property is real property you held for productive use in your trade or business or for investment (other than property held mainly for sale), like-kind property to be held either for productive use in trade or business or for investment will be treated as property similar or related in service or use. For a discussion of like-kind property, see Like-Kind Property under Like-Kind Exchanges, later.

Owner-user.   If you are an owner-user, similar or related in service or use means that replacement property must function in the same way as the property it replaces.

Example.

Your home was condemned and you invested the proceeds from the condemnation in a grocery store. Your replacement property is not similar or related in service or use to the condemned property. To be similar or related in service or use, your replacement property must also be used by you as your home.

Owner-investor.   If you are an owner-investor, similar or related in service or use means that any replacement property must have the same relationship of services or uses to you as the property it replaces. You decide this by determining all the following information.
  • Whether the properties are of similar service to you.

  • The nature of the business risks connected with the properties.

  • What the properties demand of you in the way of management, service, and relations to your tenants.

Example.

You owned land and a building you rented to a manufacturing company. The building was condemned. During the replacement period, you had a new building built on other land you already owned. You rented out the new building for use as a wholesale grocery warehouse. The replacement property is also rental property, so the two properties are considered similar or related in service or use if there is a similarity in all the following areas.

  • Your management activities.

  • The amount and kind of services you provide to your tenants.

  • The nature of your business risks connected with the properties.

Leasehold replaced with fee simple property.   Fee simple property you will use in your trade or business or for investment can qualify as replacement property that is similar or related in service or use to a condemned leasehold if you use it in the same business and for the identical purpose as the condemned leasehold.

  A fee simple property interest generally is a property interest that entitles the owner to the entire property with unconditional power to dispose of it during his or her lifetime. A leasehold is property held under a lease, usually for a term of years.

Outdoor advertising display replaced with real property.   You can elect to treat an outdoor advertising display as real property. If you make this election and you replace the display with real property in which you hold a different kind of interest, your replacement property can qualify as like-kind property. For example, real property bought to replace a destroyed billboard and leased property on which the billboard was located qualify as property of a like-kind.

  You can make this election only if you did not claim a section 179 deduction for the display. You cannot cancel this election unless you get the consent of the IRS.

  An outdoor advertising display is a sign or device rigidly assembled and permanently attached to the ground, a building, or any other permanent structure used to display a commercial or other advertisement to the public.

Substituting replacement property.   Once you designate certain property as replacement property on your tax return, you cannot substitute other qualified property. But, if your previously designated replacement property does not qualify, you can substitute qualified property if you acquire it within the replacement period.

Controlling interest in a corporation.   You can replace property by acquiring a controlling interest in a corporation that owns property similar or related in service or use to your condemned property. You have controlling interest if you own stock having at least 80% of the combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation.

Basis adjustment to corporation's property.   The basis of property held by the corporation at the time you acquired control must be reduced by your postponed gain, if any. You are not required to reduce the adjusted basis of the corporation's properties below your adjusted basis in the corporation's stock (determined after reduction by your postponed gain).

  Allocate this reduction to the following classes of property in the order shown below.
  1. Property that is similar or related in service or use to the condemned property.

  2. Depreciable property not reduced in (1).

  3. All other property.

If two or more properties fall in the same class, allocate the reduction to each property in proportion to the adjusted basis of all the properties in that class. The reduced basis of any single property cannot be less than zero.

Main home replaced.   If your gain from a condemnation of your main home is more than you can exclude from your income (see Main home condemned under Gain or Loss From Condemnations, earlier), you can postpone reporting the rest of the gain by buying replacement property that is similar or related in service or use. The replacement property must cost at least as much as the amount realized from the condemnation minus the excluded gain.

  You must reduce the basis of your replacement property by the postponed gain. Also, if you postpone reporting any part of your gain under these rules, you are treated as having owned and used the replacement property as your main home for the period you owned and used the condemned property as your main home.

Example.

City authorities condemned your home that you had used as a personal residence for 5 years prior to the condemnation. The city paid you a condemnation award of $400,000. Your adjusted basis in the property was $80,000. You realize a gain of $320,000 ($400,000 − $80,000). You purchased a new home for $100,000. You can exclude $250,000 of the realized gain from your gross income. The amount realized is then treated as being $150,000 ($400,000 − $250,000) and the gain realized is $70,000 ($150,000 amount realized − $80,000 adjusted basis). You must recognize $50,000 of the gain ($150,000 amount realized − $100,000 cost of new home). The remaining $20,000 of realized gain is postponed. Your basis in the new home is $80,000 ($100,000 cost − $20,000 gain postponed).

Replacement period.   To postpone reporting your gain from a condemnation, you must buy replacement property within a certain period of time. This is the replacement period.

  The replacement period for a condemnation begins on the earlier of the following dates.
  • The date on which you disposed of the condemned property.

  • The date on which the threat of condemnation began.

  The replacement period generally ends 2 years after the end of the first tax year in which any part of the gain on the condemnation is realized. However, see the exceptions below.

Three-year replacement period for certain property.   If real property held for use in a trade or business or for investment (not including property held primarily for sale) is condemned, the replacement period ends 3 years after the end of the first tax year in which any part of the gain on the condemnation is realized. However, this 3-year replacement period cannot be used if you replace the condemned property by acquiring control of a corporation owning property that is similar or related in service or use.

Five-year replacement period for certain property.   The replacement period ends 5 years after the end of the first tax year in which any part of the gain is realized on the compulsory or involuntary conversion of the following qualified property.
  • Property in any Midwestern disaster area compulsorily or involuntarily converted on or after the applicable disaster date as a result of severe storms, tornadoes, or flooding, but only if substantially all of the use of the replacement property is in a Midwestern disaster area.

  • Property in the Kansas disaster area compulsorily or involuntarily converted after May 3, 2007, but only if substantially all of the use of the replacement property is in the Kansas disaster area.

  • Property in the Hurricane Katrina disaster area compulsorily or involuntarily converted after August 24, 2005, as a result of Hurricane Katrina, but only if substantially all of the use of the replacement property is in the Hurricane Katrina disaster area.

Extended replacement period for taxpayers affected by other federally declared disasters.    If you are affected by a federally declared disaster, the IRS may grant disaster relief by extending the periods to perform certain tax-related acts for 2013, including the replacement period, by up to one year. For more information visit www.irs.gov/uac/Tax-Relief-in-Disaster-Situations.

Weather-related sales of livestock in an area eligible for federal assistance.   Generally, if the sale or exchange of livestock is due to drought, flood, or other weather-related conditions in an area eligible for federal assistance, the replacement period ends 4 years after the close of the first tax year in which you realize any part of your gain from the sale or exchange.

   If the weather-related conditions continue for longer than 3 years, the replacement period may be extended on a regional basis until the end of your first drought-free year for the applicable region. See Notice 2006-82. You can find Notice 2006-82 on page 529 of Internal Revenue Bulletin 2006-39 at www.irs.gov/irb/2006-39_IRB/ar13.html.

   Each year, the IRS publishes a list of counties, districts, cities, or parishes for which exceptional, extreme, or severe drought was reported during the preceding 12 months. If you qualified for a 4-year replacement period for livestock sold or exchanged on account of drought and your replacement period is scheduled to expire at the end of 2013 (or at the end of the tax year that includes August 31, 2013), see Notice 2013-62. You can find Notice 2013-62 on page 466 of Internal Revenue Bulletin 2013-45 at www.irs.gov/irb/2013-45_IRB/ar04.html. The replacement period will be extended under Notice 2006-82 if the applicable region is on the list included in Notice 2013-62.

Determining when gain is realized.   If you are a cash basis taxpayer, you realize gain when you receive payments that are more than your basis in the property. If the condemning authority makes deposits with the court, you realize gain when you withdraw (or have the right to withdraw) amounts that are more than your basis.

  This applies even if the amounts received are only partial or advance payments and the full award has not yet been determined. A replacement will be too late if you wait for a final determination that does not take place in the applicable replacement period after you first realize gain.

  For accrual basis taxpayers, gain (if any) accrues in the earlier year when either of the following occurs.
  • All events have occurred that fix the right to the condemnation award and the amount can be determined with reasonable accuracy.

  • All or part of the award is actually or constructively received.

For example, if you have an absolute right to a part of a condemnation award when it is deposited with the court, the amount deposited accrues in the year the deposit is made even though the full amount of the award is still contested.

Replacement property bought before the condemnation.   If you buy your replacement property after there is a threat of condemnation but before the actual condemnation and you still hold the replacement property at the time of the condemnation, you have bought your replacement property within the replacement period. Property you acquire before there is a threat of condemnation does not qualify as replacement property acquired within the replacement period.

Example.

On April 3, 2012, city authorities notified you that your property would be condemned. On June 5, 2012, you acquired property to replace the property to be condemned. You still had the new property when the city took possession of your old property on September 4, 2013. You have made a replacement within the replacement period.

Extension.   You can request an extension of the replacement period from the IRS director for your area. You should apply before the end of the replacement period. Your request should explain in detail why you need an extension. The IRS will consider a request filed within a reasonable time after the replacement period if you can show reasonable cause for the delay. An extension of the replacement period will be granted if you can show reasonable cause for not making the replacement within the regular period.

  Ordinarily, requests for extensions are granted near the end of the replacement period or the extended replacement period. Extensions are usually limited to a period of 1 year or less. The high market value or scarcity of replacement property is not a sufficient reason for granting an extension. If your replacement property is being built and you clearly show that the replacement or restoration cannot be made within the replacement period, you will be granted an extension of the period.

  Send your request to the address where you filed your return, addressed as follows:

Extension Request for Replacement Period of Involuntarily Converted Property 
Area Director 
Attention: Area Technical Services, Compliance Function

Election to postpone gain.   Report your election to postpone reporting your gain, along with all necessary details, on a statement attached to your return for the tax year in which you realize the gain.

  If a partnership or a corporation owns the condemned property, only the partnership or corporation can elect to postpone reporting the gain.

Replacement property acquired after return filed.   If you buy the replacement property after you file your return reporting your election to postpone reporting the gain, attach a statement to your return for the year in which you buy the property. The statement should contain detailed information on the replacement property.

Amended return.   If you elect to postpone reporting gain, you must file an amended return for the year of the gain (individuals file Form 1040X) in either of the following situations.
  • You do not buy replacement property within the replacement period. On your amended return, you must report the gain and pay any additional tax due.

  • The replacement property you buy costs less than the amount realized for the condemned property (minus the gain you excluded from income if the property was your main home). On your amended return, you must report the part of the gain you cannot postpone reporting and pay any additional tax due.

Time for assessing a deficiency.   Any deficiency for any tax year in which part of the gain is realized may be assessed at any time before the expiration of 3 years from the date you notify the IRS director for your area that you have replaced, or intend not to replace, the condemned property within the replacement period.

Changing your mind.   You can change your mind about reporting or postponing the gain at any time before the end of the replacement period. If you decide to make an election after filing the tax return and after making the payment of the tax due for the year or years in which any of the gain on the involuntary conversion is realized, and before the expiration of the period with which the converted property must be replaced, file a claim for refund for such year or years.

Example.

Your property was condemned and you had a gain of $5,000. You reported the gain on your return for the year in which you realized it, and paid the tax due. You buy replacement property within the replacement period. You used all but $1,000 of the amount realized from the condemnation to buy the replacement property. You now change your mind and want to postpone reporting the $4,000 of gain equal to the amount you spent for the replacement property. You should file a claim for refund on Form 1040X (or other applicable amended return). Include a statement explaining that you previously reported the entire gain from the condemnation, but you now want to report only the part of the gain equal to the condemnation proceeds not spent for replacement property ($1,000).

Reporting a Condemnation Gain or Loss

Generally, you report gain or loss from a condemnation on your return for the year you realize the gain or loss.

Personal-use property.   Report gain from a condemnation of property you held for personal use (other than excluded gain from a condemnation of your main home or postponed gain) on Form 8949 or Schedule D (Form 1040), as applicable. See the Instructions for Form 8949 and the Instructions for Schedule D (Form1040).

  Do not report loss from a condemnation of personal-use property. But, if you received a Form 1099-S, Proceeds From Real Estate Transactions, (for example, showing the proceeds of a sale of real estate under threat of condemnation), you must show the transaction on Form 8949 and Schedule D (Form 1040), even though the loss is not deductible. See the Instructions for Schedule D (Form 1040) and the Instructions for Form 8949.

Business property.   Report gain (other than postponed gain) or loss from a condemnation of property you held for business or profit on Form 4797. If you had a gain, you may have to report all or part of it as ordinary income. See Like-Kind Exchanges and Involuntary Conversions in chapter 3.

Nontaxable Exchanges

Certain exchanges of property are not taxable. This means any gain from the exchange is not recognized, and any loss cannot be deducted. Your gain or loss will not be recognized until you sell or otherwise dispose of the property you receive.

Like-Kind Exchanges

The exchange of property for the same kind of property is the most common type of nontaxable exchange. To be a like-kind exchange, the property traded and the property received must be both of the following.

  • Qualifying property.

  • Like-kind property.

These two requirements are discussed later.

Additional requirements apply to exchanges in which the property received is not received immediately upon the transfer of the property given up. See Deferred Exchange, later.

If the like-kind exchange involves the receipt of money or unlike property or the assumption of your liabilities, you may have to recognize gain. See Partially Nontaxable Exchanges, later.

Multiple-party transactions.   The like-kind exchange rules also apply to property exchanges that involve three- and four-party transactions. Any part of these multiple-party transactions can qualify as a like-kind exchange if it meets all the requirements described in this section.

Receipt of title from third party.   If you receive property in a like-kind exchange and the other party who transfers the property to you does not give you the title, but a third party does, you still can treat this transaction as a like-kind exchange if it meets all the requirements.

Basis of property received.   If you acquire property in a like-kind exchange, the basis of that property is generally the same as the basis of the property you transferred.

Example.

You exchanged real estate held for investment with an adjusted basis of $25,000 for other real estate held for investment. The basis of your new property is the same as the basis of the old ($25,000).

  For the basis of property received in an exchange that is only partially nontaxable, see Partially Nontaxable Exchanges, later.

Money paid.   If, in addition to giving up like-kind property, you pay money in a like-kind exchange, you still have no recognized gain or loss. The basis of the property received is the basis of the property given up, increased by the money paid.

Example.

Bill Smith trades an old cab for a new one. The new cab costs $30,000. He is allowed $8,000 for the old cab and pays $22,000 cash. He has no recognized gain or loss on the transaction regardless of the adjusted basis of his old cab. If Bill sold the old cab to a third-party for $8,000 and bought a new one, he would have a recognized gain or loss on the sale of his old cab equal to the difference between the amount realized and the adjusted basis of the old cab.

Sale and purchase.   If you sell property and buy similar property in two mutually dependent transactions, you may have to treat the sale and purchase as a single nontaxable exchange.

Example.

You used your car in your business for 2 years. Its adjusted basis is $3,500 and its trade-in value is $4,500. You are interested in a new car that costs $20,000. Ordinarily, you would trade your old car for the new one and pay the dealer $15,500. Your basis for depreciation of the new car would then be $19,000 ($15,500 plus $3,500 adjusted basis of the old car).

You want your new car to have a larger basis for depreciation, so you arrange to sell your old car to the dealer for $4,500. You then buy the new one for $20,000 from the same dealer. However, you are treated as having exchanged your old car for the new one because the sale and purchase are reciprocal and mutually dependent. Your basis for depreciation for the new car is $19,000, the same as if you traded the old car.

Reporting the exchange.   Report the exchange of like-kind property, even though no gain or loss is recognized, on Form 8824, Like-Kind Exchanges. The instructions for Form 8824 explain how to report the details of the exchange.

  If you have any recognized gain because you received money or unlike property, report it on Form 8949, Schedule D (Form 1040) or Form 4797, as applicable. See chapter 4. You may have to report the recognized gain as ordinary income from depreciation recapture. See Like-Kind Exchanges and Involuntary Conversions in chapter 3.

Exchange expenses.   Exchange expenses are generally the closing costs you pay. They include such items as brokerage commissions, attorney fees, and deed preparation fees. Subtract these expenses from the consideration received to figure the amount realized on the exchange. If you receive cash or unlike property in addition to the like-kind property and realize a gain on the exchange, subtract the expenses from the cash or fair market value of the unlike property. Then, use the net amount to figure the recognized gain. See Partially Nontaxable Exchanges, later.

Qualifying Property

In a like-kind exchange, both the property you give up and the property you receive must be held by you for investment or for productive use in your trade or business. Machinery, buildings, land, trucks, and rental houses are examples of property that may qualify.

The rules for like-kind exchanges do not apply to exchanges of the following property.

  • Property you use for personal purposes, such as your home and your family car. However, see below.

  • Stock in trade or other property held primarily for sale, such as inventories, raw materials, and real estate held by dealers.

  • Stocks, bonds, notes, or other securities or evidences of indebtedness, such as accounts receivable.

  • Partnership interests.

  • Certificates of trust or beneficial interest.

  • Choses in action, such as a lawsuit in which you are the plaintiff.

  • Certain tax-exempt use property subject to a lease. For more information, see section 470(e) of the Internal Revenue Code.

However, you may have a nontaxable exchange under other rules. See Other Nontaxable Exchanges, later.

A dwelling unit (home, apartment, condominium, or similar property) may, for purposes of a like-kind exchange, qualify as property held for productive use in a trade or business or for investment purposes if certain requirements are met. See Rev. Proc. 2008-16, 2008-10 I.R.B. 547, available at http://www.irs.gov/irb/2008-10_IRB/ar12.html.

An exchange of the assets of a business for the assets of a similar business cannot be treated as an exchange of one property for another property. Whether you engaged in a like-kind exchange depends on an analysis of each asset involved in the exchange. However, see Multiple Property Exchanges, later.

Like-Kind Property

There must be an exchange of like-kind property. Like-kind properties are properties of the same nature or character, even if they differ in grade or quality. The exchange of real estate for real estate and the exchange of personal property for similar personal property are exchanges of like-kind property. For example, the trade of land improved with an apartment house for land improved with a store building, or a panel truck for a pickup truck, is a like-kind exchange.

An exchange of personal property for real property does not qualify as a like-kind exchange. For example, an exchange of a piece of machinery for a store building does not qualify. Also, the exchange of livestock of different sexes does not qualify.

Real property.   An exchange of city property for farm property, or improved property for unimproved property, is a like-kind exchange.

  The exchange of real estate you own for a real estate lease that runs 30 years or longer is a like-kind exchange. However, not all exchanges of interests in real property qualify. The exchange of a life estate expected to last less than 30 years for a remainder interest is not a like-kind exchange.

  An exchange of a remainder interest in real estate for a remainder interest in other real estate is a like-kind exchange if the nature or character of the two property interests is the same.

Foreign real property exchanges.   Real property located in the United States and real property located outside the United States are not considered like-kind property under the like-kind exchange rules. If you exchange foreign real property for property located in the United States, your gain or loss on the exchange is recognized. Foreign real property is real property not located in a state or the District of Columbia.

  This foreign real property exchange rule does not apply to the replacement of condemned real property. Foreign and U.S. real property can still be considered like-kind property under the rules for replacing condemned property to postpone reporting gain on the condemnation. See Postponement of Gain under Involuntary Conversions, earlier.

Personal property.   Depreciable tangible personal property can be either like-kind or like-class to qualify for nonrecognition treatment. Like-class properties are depreciable tangible personal properties within the same General Asset Class or Product Class. Property classified in any General Asset Class may not be classified within a Product Class.

General Asset Classes.   General Asset Classes describe the types of property frequently used in many businesses. They include the following property.
  1. Office furniture, fixtures, and equipment (asset class 00.11).

  2. Information systems, such as computers and peripheral equipment (asset class 00.12).

  3. Data handling equipment except computers (asset class 00.13).

  4. Airplanes (airframes and engines), except planes used in commercial or contract carrying of passengers or freight, and all helicopters (airframes and engines) (asset class 00.21).

  5. Automobiles and taxis (asset class 00.22).

  6. Buses (asset class 00.23).

  7. Light general purpose trucks (asset class 00.241).

  8. Heavy general purpose trucks (asset class 00.242).

  9. Railroad cars and locomotives except those owned by railroad transportation companies (asset class 00.25).

  10. Tractor units for use over the road (asset class 00.26).

  11. Trailers and trailer-mounted containers (asset class 00.27).

  12. Vessels, barges, tugs, and similar water-transportation equipment, except those used in marine construction (asset class 00.28).

  13. Industrial steam and electric generation or distribution systems (asset class 00.4).

Product Classes.   Product Classes include property listed in a 6-digit product class (except any ending in 9) in sectors 31 through 33 of the North American Industry Classification System (NAICS) of the Executive Office of the President, Office of Management and Budget, United States, 2012 NAICS Manual. It can be accessed at http://www.census.gov/naics. Copies of the hard cover manual may be obtained from the National Technical Information Service (NTIS) at http://www.ntis.gov or by calling 1-800-553-NTIS (1-800-553-6847) or (703) 605-6000.

Example 1.

You transfer a personal computer used in your business for a printer to be used in your business. The properties exchanged are within the same General Asset Class and are of a like-class.

Example 2.

Trena transfers a grader to Ron in exchange for a scraper. Both are used in a business. Neither property is within any of the General Asset Classes. Both properties, however, are within the same Product Class and are of a like-class.

Intangible personal property and nondepreciable personal property.    Whether intangible personal property, such as a patent or copyright, is of a like-kind to other intangible personal property generally depends on the nature or character of the rights involved. It also depends on the nature or character of the underlying property to which those rights relate.

Example.

The exchange of a copyright on a novel for a copyright on a different novel can qualify as a like-kind exchange. However, the exchange of a copyright on a novel for a copyright on a song is not a like-kind exchange.

Goodwill and going concern.   The exchange of the goodwill or going concern value of a business for the goodwill or going concern value of another business is not a like-kind exchange.

Foreign personal property exchanges.   Personal property used predominantly in the United States and personal property used predominantly outside the United States are not like-kind property under the like-kind exchange rules. If you exchange property used predominantly in the United States for property used predominantly outside the United States, your gain or loss on the exchange is recognized.

Predominant use.   You determine the predominant use of property you gave up based on where that property was used during the 2-year period ending on the date you gave it up. You determine the predominant use of the property you acquired based on where that property was used during the 2-year period beginning on the date you acquired it.

  But if you held either property less than 2 years, determine its predominant use based on where that property was used only during the period of time you (or a related person) held it. This does not apply if the exchange is part of a transaction (or series of transactions) structured to avoid having to treat property as unlike property under this rule.

  However, you must treat property as used predominantly in the United States if it is used outside the United States, but under section 168(g)(4) of the Internal Revenue Code, is eligible for accelerated depreciation as though used in the United States.

Deferred Exchange

A deferred exchange is an exchange in which you transfer property you use in business or hold for investment and later receive like-kind property you will use in business or hold for investment. (The property you receive is replacement property.) The transaction must be an exchange (that is, property for property) rather than a transfer of property for money used to buy replacement property. In addition, the replacement property will not be treated as like-kind property unless the identification and the receipt requirements (discussed later) are met.

If, before you receive the replacement property, you actually or constructively receive money or unlike property in full consideration for the property you transfer, the transaction will be treated as a sale rather than a deferred exchange. In that case, you must recognize gain or loss on the transaction, even if you later receive the replacement property. (It would be treated as if you bought the replacement property.)

If, before you receive the replacement property, you actually or constructively receive money or unlike property in less than full consideration for the property you transfer, the transaction will be treated as a partially taxable exchange. See Partially Nontaxable Exchanges, later.

Actual and constructive receipt.   For purposes of a deferred exchange, you actually receive money or unlike property when you receive the money or unlike property or receive the economic benefit of the money or unlike property. You constructively receive money or unlike property when the money or unlike property is credited to your account, set apart for you, or otherwise made available for you so that you can draw upon it at any time or so that you can draw upon it if you give notice of intention to do so. You do not constructively receive money or unlike property if your control of receiving it is subject to substantial limitations or restrictions. However, you constructively receive money or unlike property when the limitations or restrictions lapse, expire, or are waived.

  The following rules also apply.
  • Whether you actually or constructively receive money or unlike property is determined without regard to your method of accounting.

  • Actual or constructive receipt of money or unlike property by your agent is actual or constructive receipt by you.

  • Whether you actually or constructively receive money or unlike property is determined without regard to certain arrangements you make to ensure the other party carries out its obligations to transfer the replacement property to you. See Safe Harbors Against Actual and Constructive Receipt in Deferred Exchanges, later.

Identification requirement.   You must identify the property to be received within 45 days after the date you transfer the property given up in the exchange. This period of time is called the identification period. Any property received during the identification period is considered to have been identified.

  If you transfer more than one property (as part of the same transaction) and the properties are transferred on different dates, the identification period and the exchange period begin on the date of the earliest transfer.

Identifying replacement property.   You must identify the replacement property in a signed written document and deliver it to the person obligated to transfer the replacement property or any other person involved in the exchange other than you or a disqualified person. See Disqualified persons, later. You must clearly describe the replacement property in the written document. For example, use the legal description or street address for real property and the make, model, and year for a car. In the same manner, you can cancel an identification of replacement property at any time before the end of the identification period.

Identifying alternative and multiple properties.   You can identify more than one replacement property. However, regardless of the number of properties you give up, the maximum number of replacement properties you can identify is:
  • Three properties regardless of their fair market value; or

  • Any number of properties whose total fair market value at the end of the identification period is not more than double the total fair market value, on the date of transfer, of all properties you give up.

  If, as of the end of the identification period, you have identified more properties than permitted under this rule, the only property that will be considered identified is:
  • Any replacement property you received before the end of the identification period, and

  • Any replacement property identified before the end of the identification period and received before the end of the exchange period, but only if the fair market value of the property is at least 95% of the total fair market value of all identified replacement properties. Fair market value is determined on the earlier of the date you received the property or the last day of the exchange period. See Receipt requirement, later.

Disregard incidental property.   Do not treat property incidental to a larger item of property as separate from the larger item when you identify replacement property. Property is incidental if it meets both the following tests.
  • It is typically transferred with the larger item.

  • The total fair market value of all the incidental property is not more than 15% of the total fair market value of the larger item of property.

  For example, furniture, laundry machines, and other miscellaneous items of personal property will not be treated as separate property from an apartment building with a fair market value of $ 1,000,000, if the total fair market value of the furniture, laundry machines, and other personal property does not exceed $ 150,000.

Replacement property to be produced.   Gain or loss from a deferred exchange can qualify for nonrecognition even if the replacement property is not in existence or is being produced at the time you identify it as replacement property. If you need to know the fair market value of the replacement property to identify it, estimate its fair market value as of the date you expect to receive it.

Receipt requirement.   The property must be received by the earlier of the following dates.
  • The 180th day after the date on which you transfer the property given up in the exchange.

  • The due date, including extensions, for your tax return for the tax year in which the transfer of the property given up occurs.

This period of time is called the exchange period. You must receive substantially the same property that met the identification requirement, discussed earlier.

Replacement property produced after identification.   In some cases, the replacement property may have been produced after you identified it (as described earlier in Replacement property to be produced.) In that case, to determine whether the property you received was substantially the same property that met the identification requirement, do not take into account any variations due to usual production changes. Substantial changes in the property to be produced, however, will disqualify it.

  If your replacement property is personal property that had to be produced, it must be completed by the date you receive it to qualify as substantially the same property you identified.

  If your replacement property is real property that had to be produced and it is not completed by the date you receive it, it still may qualify as substantially the same property you identified. It will qualify only if, had it been completed on time, it would have been considered to be substantially the same property you identified. It is considered to be substantially the same only to the extent it is considered real property under local law. However, any additional production on the replacement property after you receive it does not qualify as like-kind property. To this extent, the transaction is treated as a taxable exchange of property for services.

Interest income.    Generally, in a deferred exchange, if the amount of money or property you are entitled to receive depends upon the length of time between when you transfer the property given up and when you receive the replacement property, you are treated as being entitled to receive interest or a growth factor. The interest or growth factor will be treated as interest, regardless of whether it is paid in like-kind property, money, or unlike property. Include this interest in your gross income according to your method of accounting.

  If you transferred property in a deferred exchange and an exchange facilitator holds exchange funds for you and pays you all the earnings on the exchange funds according to an escrow agreement, trust agreement, or exchange agreement, you must take into account all items of income, deduction, and credit attributable to the exchange funds.

  If, in accordance with an escrow agreement, trust agreement, or exchange agreement, an exchange facilitator holds exchange funds for you and keeps some or all the earnings on the exchange funds in accordance with the escrow agreement, trust agreement, or exchange agreement, you will be treated as if you had loaned the exchange funds to the exchange facilitator. You must include in income any interest that you receive and, if the loan is a below-market loan, you must include in income any imputed interest.

  Exchange funds include relinquished property, cash, or cash equivalent that secures an obligation of a transferee to transfer replacement property, or proceeds from a transfer of relinquished property, held in a qualified escrow account, qualified trust, or other escrow account, trust, or fund in a deferred exchange.

  An exchange facilitator is a qualified intermediary, transferee, escrow holder, trustee, or other person that holds exchange funds for you in a deferred exchange under the terms of an escrow agreement, trust agreement, or exchange agreement.

For more information relating to the current taxation of qualified escrow accounts, qualified trusts, and other escrow accounts, trusts, and funds used during deferred exchanges of like-kind property, see Regulations sections 1.468B-6 and 1.7872-16. If the exchange facilitator is a qualified intermediary, see Safe Harbors Against Actual and Constructive Receipt in Deferred Exchanges, below.

Disqualified persons.   A disqualified person is a person who is any of the following.
  1. Your agent at the time of the transaction.

  2. A person who is related to you under the rules discussed in chapter 2 under Nondeductible loss, substituting “10%” for “50%.

  3. A person who is related to a person who is your agent at the time of the transaction under the rules discussed in chapter 2 under Nondeductible loss, substituting “10%” for “50%.

  For purposes of (1) above, a person who has acted as your employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period ending on the date of the transfer of the first of the relinquished properties is your agent at the time of the transaction. However, solely for purposes of whether a person is a disqualified person as your agent, the following services for you are not taken into account.
  • Services with respect to exchanges of property intended to qualify for nonrecognition of gain or loss as like-kind exchanges.

  • Routine financial, title insurance, escrow, or trust services by a financial institution, title insurance company, or escrow company.

  The rule in (3) above does not apply to a bank or a bank affiliate if it would otherwise be a disqualified person under the rule in (3) solely because it is a member of the same controlled group (as determined under section 267(f) of the Internal Revenue Code, substituting “10%” for “50%” ) as a person that has provided investment banking or brokerage services to the taxpayer within the 2-year period ending on the date of the transfer of the first of the relinquished properties. For this purpose a bank affiliate is a corporation whose principal activity is rendering services to facilitate exchanges of property intended to qualify for nonrecognition of gain under section 1031 and all of whose stock is owned by either a bank or a bank holding company.

Safe Harbors Against Actual and Constructive Receipt in Deferred Exchanges

The following arrangements will not result in actual or constructive receipt of money or unlike property in a deferred exchange.

  • Security or guarantee arrangements.

  • Qualified escrow accounts or qualified trusts.

  • Qualified intermediaries.

  • Interest or growth factors.

Security or guarantee arrangements.   You will not actually or constructively receive money or unlike property before you actually receive the like-kind replacement property just because your transferee's obligation to transfer the replacement property to you is secured or guaranteed by one or more of the following.
  1. A mortgage, deed of trust, or other security interest in property (other than in cash or a cash equivalent).

  2. A standby letter of credit that satisfies all the following requirements:

    1. Not negotiable, whether by the terms of the letter of credit or under applicable local law,

    2. Not transferable (except together with the evidence of indebtedness which it secures), whether by the terms of the letter of credit or under applicable local law,

    3. Issued by a bank or other financial institution,

    4. Serves as a guarantee of the evidence of indebtedness which is secured by the letter of credit, and

    5. May not be drawn on in the absence of a default in the transferee's obligation to transfer the replacement property to you.

  3. A guarantee by a third person.

  The protection against actual and constructive receipt ends when you have an immediate ability or unrestricted right to receive money or unlike property under the security or guarantee arrangement.

Qualified escrow account or qualified trust.   You will not actually or constructively receive money or unlike property before you actually receive the like-kind replacement property just because your transferee's obligation is secured by cash or cash equivalent if the cash or cash equivalent is held in a qualified escrow account or qualified trust. This rule applies for the amounts held in the qualified escrow account or qualified trust even if you do receive money or unlike property directly from a party to the exchange.

  An escrow account is a qualified escrow account if both of the following two conditions are met.

  
  • The escrow holder is neither you nor a disqualified person. See Disqualified persons, earlier.

  • The escrow agreement expressly limits your rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the escrow account. For more information on how to satisfy this condition, see Additional restrictions on safe harbors, later.

  A trust is a qualified trust if both of the following conditions are met.
  • The trustee is neither you nor a disqualified person. See Disqualified persons, earlier. For purposes of whether the trustee of a trust is a disqualified person, the relationship between you and the trustee created by the qualified trust will not be considered a relationship between you and a related person.

  • The trust agreement expressly limits your rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held by the trustee. For more information on how to satisfy this condition, see Additional restrictions on safe harbors, later.

  The protection against actual and constructive receipt ends when you have an immediate ability or unrestricted right to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the qualified escrow account or qualified trust.

Qualified intermediary.   If you transfer property through a qualified intermediary, the transfer of the property given up and receipt of like-kind property is treated as an exchange. This rule applies even if you receive money or unlike property directly from a party to the transaction other than the qualified intermediary.

  A qualified intermediary is a person who is not a disqualified person (discussed earlier) and who enters into a written exchange agreement with you and, as required by that agreement:
  • Acquires the property you give up,

  • Transfers the property you give up,

  • Acquires the replacement property, and

  • Transfers the replacement property to you.

  For determining whether an intermediary acquires and transfers property, the following rules apply.
  • An intermediary is treated as acquiring and transferring property if the intermediary acquires and transfers legal title to that property.

  • An intermediary is treated as acquiring and transferring the property you give up if the intermediary (either on its own behalf or as the agent of any party to the transaction) enters into an agreement with a person other than you for the transfer of that property to that person, and, pursuant to that agreement, that property is transferred to that person (i.e., by direct deed from you).

  • An intermediary is treated as acquiring and transferring replacement property if the intermediary (either on its own behalf or as the agent of any party to the transaction) enters into an agreement with the owner of the replacement property for the transfer of that property and, pursuant to that agreement, the replacement property is transferred to you (i.e., by direct deed to you).

  An intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment by the date of the relevant transfer of property.

  The written exchange agreement must expressly limit your rights to receive, pledge, borrow, or otherwise obtain the benefits of money or unlike property held by the qualified intermediary.

Safe harbor method for reporting gain or loss when qualified intermediary defaults.   Generally, if a qualified intermediary is unable to meet its contractual obligations to you or otherwise causes you not to meet the deadlines for identifying or receiving replacement property in a deferred or reverse exchange, your transaction may not qualify as a tax-free deferred exchange. In that case, any gain may be taxable in the current year.

  However, if a qualified intermediary defaults on its obligation to acquire and transfer replacement property because of bankruptcy or receivership proceedings, and you meet the requirements of Revenue Procedure 2010-14, you may be treated as not having actual or constructive receipt of the proceeds of the exchange in the year of sale of the property you gave up. If you meet the requirements, you can report the gain in the year or years payments (or debt relief treated as payments) are received, using the safe harbor gross profit ratio method. See Revenue Procedure 2010-14, 2010-12 I.R.B. 456, available at www.irs.gov/irb/2010-12_IRB/ar07.html.

Multiple-party transactions involving related persons.   If you transfer property given up to a qualified intermediary in exchange for replacement property formerly owned by a related person, you may not be entitled to nonrecognition treatment if the related person receives cash or unlike property for the replacement property. (See Like-Kind Exchanges Between Related Persons, later.)

Interest or growth factors.   You will not be in actual or constructive receipt of money or unlike property before you actually receive the like-kind replacement property just because you are or may be entitled to receive any interest or growth factor in the deferred exchange. This rule applies only if the agreement under which you are or may be entitled to the interest or growth factor expressly limits your rights to receive the interest or growth factor during the exchange period. See Additional restrictions on safe harbors, below.

Additional restrictions on safe harbors.   In order to come within the protection of the safe harbors against actual and constructive receipt of money and unlike property discussed above, the agreement must provide that you have no rights to receive, pledge, borrow, or otherwise obtain the benefits of money or unlike property before the end of the exchange period. However, the agreement can provide you with the following limited sets of rights.
  • If you have not identified replacement property by the end of the identification period, you can have rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent after the end of the identification period.

  • If you have identified replacement property, you can have rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent when or after you receive all the replacement property you are entitled to receive under the exchange agreement.

  • If you have identified replacement property, you can have rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent on the occurrence of a contingency that is related to the exchange, provided for in writing, and beyond your control or the control of any disqualified person other than the person obligated to transfer the replacement property.

Like-Kind Exchanges Using Qualified Exchange Accommodation Arrangements (QEAAs)

The like-kind exchange rules generally do not apply to an exchange in which you acquire replacement property (new property) before you transfer relinquished property (property you give up). However, if you use a qualified exchange accommodation arrangement (QEAA), the transfer may qualify as a like-kind exchange. For details, see Revenue Procedure 2000-37, 2000-40 I.R.B. 308 as modified by Revenue Procedure 2004-51, 2004-33 I.R.B. 294, available at www.irs.gov/irb/2004-33_IRB/ar13.html.

Under a QEAA, either the replacement property or the relinquished property is transferred to an exchange accommodation titleholder (EAT), discussed later, who is treated as the beneficial owner of the property. However, for transfers of qualified indications of ownership (defined later), the replacement property held in a QEAA may not be treated as property received in an exchange if you previously owned it within 180 days of its transfer to the EAT. If the property is held in a QEAA, the IRS will accept the qualification of property as either replacement property or relinquished property and the treatment of an EAT as the beneficial owner of the property for federal income tax purposes.

Requirements for a QEAA.   Property is held in a QEAA only if all the following requirements are met.
  • You have a written agreement.

  • The time limits for identifying and transferring the property are met.

  • The qualified indications of ownership of property are transferred to an EAT.

Written agreement.   Under a QEAA, you and the EAT must enter into a written agreement no later than 5 business days after the qualified indications of ownership (discussed later) are transferred to the EAT. The agreement must provide all the following.
  • The EAT is holding the property for your benefit in order to facilitate an exchange under the like-kind exchange rules and Revenue Procedure 2000-37, as modified by Revenue Procedure 2004-51.

  • You and the EAT agree to report the acquisition, holding, and disposition of the property on your federal income tax returns in a manner consistent with the agreement.

  • The EAT will be treated as the beneficial owner of the property for all federal income tax purposes.

  Property can be treated as being held in a QEAA even if the accounting, regulatory, or state, local, or foreign tax treatment of the arrangement between you and the EAT is different from the treatment required by the written agreement as discussed above.

Bona fide intent.   When the qualified indications of ownership of the property are transferred to the EAT, it must be your bona fide intent that the property held by the EAT represents either replacement property or relinquished property in an exchange intended to qualify for nonrecognition of gain (in whole or in part) or loss under the like-kind exchange rules.

Time limits for identifying and transferring property.   Under a QEAA, the following time limits for identifying and transferring the property must be met.
  1. No later than 45 days after the transfer of qualified indications of ownership of the replacement property to the EAT, you must identify the relinquished property in a manner consistent with the principles for deferred exchanges. See Identification requirement earlier under Deferred Exchange.

  2. One of the following transfers must take place no later than 180 days after the transfer of qualified indications of ownership of the property to the EAT.

    1. The replacement property is transferred to you (either directly or indirectly through a qualified intermediary, defined earlier under Qualified intermediary).

    2. The relinquished property is transferred to a person other than you or a disqualified person. A disqualified person is either of the following.

      1. Your agent at the time of the transaction. This includes a person who has been your employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period before the transfer of the relinquished property.

      2. A person who is related to you or your agent under the rules discussed in chapter 2 under Nondeductible Loss, substituting “10%” for “50%.

  3. The combined time period the relinquished property and replacement property are held in the QEAA cannot be longer than 180 days.

Exchange accommodation titleholder (EAT).   The EAT must meet all the following requirements.
  • Hold qualified indications of ownership (defined next) at all times from the date of acquisition of the property until the property is transferred (as described in (2), above).

  • Be someone other than you or a disqualified person (as defined in 2(b), above).

  • Be subject to federal income tax. If the EAT is treated as a partnership or S corporation, more than 90% of its interests or stock must be owned by partners or shareholders who are subject to federal income tax.

Qualified indications of ownership.   Qualified indications of ownership are any of the following.
  • Legal title to the property.

  • Other indications of ownership of the property that are treated as beneficial ownership of the property under principles of commercial law (for example, a contract for deed).

  • Interests in an entity that is disregarded as an entity separate from its owner for federal income tax purposes (for example, a single member limited liability company) and that holds either legal title to the property or other indications of ownership.

Other permissible arrangements.   Property will not fail to be treated as being held in a QEAA as a result of certain legal or contractual arrangements, regardless of whether the arrangements contain terms that typically would result from arm's-length bargaining between unrelated parties for those arrangements. For a list of those arrangements, see Revenue Procedure 2000-37.

Partially Nontaxable Exchanges

If, in addition to like-kind property, you receive money or unlike property in an exchange of like-kind property on which you realize a gain, you may have a partially nontaxable exchange. If you realize a gain on the exchange, you must recognize the gain you realize (see Amount recognized, earlier) but only to the extent of the money and the fair market value of the unlike property you receive. If you realize a loss on the exchange, no loss is recognized. However, see Unlike property given up, below.

The recognized (taxable) gain on the disposition of the like-kind property you give up is the smaller of two amounts. The first is the amount of gain realized. See Gain or Loss From Sales and Exchanges, earlier. The second is the limit of recognized gain. To figure the limit on recognized gain, add the money you received and the fair market value of any unlike property you received. Reduce this amount (but not below zero) by any exchange expenses (closing costs) you paid. Compare that amount to your gain realized. Your recognized (taxable) gain is the smaller of the two.

Example.

You exchange real estate held for investment with an adjusted basis of $8,000 for other real estate you now hold for investment. The fair market value (FMV) of the real estate you received was $10,000. You also received $1,000 in cash. You paid $500 in exchange expenses.

FMV of like-kind property received $10,000
Cash 1,000
Total received $11,000
Minus: Exchange expenses paid (500)
Amount realized $10,500
Minus: Adjusted basis of property you transferred (8,000)
Realized gain $2,500

 
Although the total gain realized on the transaction is $2,500, the recognized (taxable) gain is only $500, figured as follows.

Money received (cash) $1,000
Minus: Exchange expenses paid (500)
Recognized gain $500

Assumption of liabilities.   For purposes of figuring your realized gain, add any liabilities assumed by the other party to your amount realized. Subtract any liabilities of the other party that you assume from your amount realized.

  For purposes of figuring the limit of recognized gain, if the other party to a nontaxable exchange assumes any of your liabilities, you will be treated as if you received money in the amount of the liability. You can decrease (but not below zero) the amount of money you are treated as receiving by the amount of the other party's liabilities that you assume and by any cash you pay, or unlike property you give up. For more information on the assumption of liabilities, see section 357(d) of the Internal Revenue Code. For more information on the treatment of the assumption of liabilities in a sale or exchange, see Regulations section 1.1031(d)-2.

Example.

The facts are the same as in the previous example, except the property you gave up was subject to a $3,000 mortgage for which you were personally liable. The other party in the trade agreed to pay off the mortgage. Figure the gain realized as follows.

FMV of like-kind property received $10,000
Cash 1,000
Mortgage assumed by other party 3,000
Total received $14,000
Minus: Exchange expenses (500)
Amount realized $13,500
Minus: Adjusted basis of property you transferred (8,000)
Realized gain $5,500

 
The realized gain is recognized (taxable) gain only up to $3,500, figured as follows.

Money received (cash) $1,000
Money received (liability assumed by other party) 3,000
Total money and unlike property received $4,000
Minus: Exchange expenses paid (500)
Recognized gain $3,500

Example.

The facts are the same as in the previous example, except the property you received had a fair market value (FMV) of $14,000 and was subject to a $4,000 mortgage that you assumed. Figure the gain realized as follows.

FMV of like-kind property received $14,000
Cash 1,000
Mortgage assumed by other party 3,000
Total received $18,000
Minus: Exchange expenses (500)
Amount realized $17,500
Minus: Adjusted basis of property you transferred (8,000)
Minus: Mortgage you assumed (4,000)
Realized gain $5,500

 
The realized gain is recognized (taxable) gain only up to $500, figured as follows.

Money received (cash) $1,000
Money received (net liabilities assumed by other party):  
Mortgage assumed by other party $3,000
Minus: Mortgage you assumed (4,000)
Total (not below zero) $0
Total money and unlike property received $1,000
Minus: Exchange expenses paid (500)
Recognized gain $500

Unlike property given up.   If, in addition to like-kind property, you give up unlike property, you must recognize gain or loss on the unlike property you give up. The gain or loss is equal to the difference between the fair market value of the unlike property and the adjusted basis of the unlike property.

Example.

You exchange stock and real estate you held for investment for real estate you also intend to hold for investment. The stock you transfer has a fair market value of $1,000 and an adjusted basis of $4,000. The real estate you exchange has a fair market value of $19,000 and an adjusted basis of $15,000. The real estate you receive has a fair market value of $20,000. You do not recognize gain on the exchange of the real estate because it qualifies as a nontaxable exchange. However, you must recognize (report on your return) a $3,000 loss on the stock because it is unlike property.

Basis of property received.   The total basis for all properties (other than money) you receive in a partially nontaxable exchange is the total adjusted basis of the properties you give up, with the following adjustments.
  1. Add both the following amounts.

    1. Any additional costs you incur.

    2. Any gain you recognize on the exchange.

  2. Subtract both the following amounts.

    1. Any money you receive.

    2. Any loss you recognize on the exchange.

Allocate this basis first to the unlike property, other than money, up to its fair market value on the date of the exchange. The rest is the basis of the like-kind property.

Multiple Property Exchanges

Under the like-kind exchange rules, you generally must make a property-by-property comparison to figure your recognized gain and the basis of the property you receive in the exchange. However, for exchanges of multiple properties, you do not make a property-by-property comparison if you do either of the following.

  • Transfer and receive properties in two or more exchange groups.

  • Transfer or receive more than one property within a single exchange group.

In these situations, you figure your recognized gain and the basis of the property you receive by comparing the properties within each exchange group.

Exchange groups.   Each exchange group consists of properties transferred and received in the exchange that are of like-kind or like-class. (See Like-Kind Property, earlier.) If property could be included in more than one exchange group, you can include it in any one of those groups. However, the following may not be included in an exchange group.
  • Money.

  • Stock in trade or other property held primarily for sale.

  • Stocks, bonds, notes, or other securities or evidences of debt or interest.

  • Interests in a partnership.

  • Certificates of trust or beneficial interests.

  • Choses in action.

Example.

Ben exchanges computer A (asset class 00.12), automobile A (asset class 00.22), and truck A (asset class 00.241) for computer R (asset class 00.12), automobile R (asset class 00.22), truck R (asset class 00.241), and $400. All properties transferred were used in Ben's business. Similarly, all properties received will be used in his business.

The first exchange group consists of computers A and R, the second exchange group consists of automobiles A and R, and the third exchange group consists of trucks A and R.

Treatment of liabilities.   Offset all liabilities you assume as part of the exchange against all liabilities of which you are relieved. Offset these liabilities whether they are recourse or nonrecourse and regardless of whether they are secured by or otherwise relate to specific property transferred or received as part of the exchange.

  If you assume more liabilities than you are relieved of, allocate the difference among the exchange groups in proportion to the total fair market value of the properties you received in the exchange groups. The difference allocated to each exchange group may not be more than the total fair market value of the properties you received in the exchange group.

  The amount of the liabilities allocated to an exchange group reduces the total fair market value of the properties received in that exchange group. This reduction is made in determining whether the exchange group has a surplus or a deficiency. (See Exchange group surplus and deficiency, later.) This reduction is also made in determining whether a residual group is created. (See Residual group, later.)

  If you are relieved of more liabilities than you assume, treat the difference as cash, general deposit accounts (other than certificates of deposit), and similar items when making allocations to the residual group, discussed later.

  The treatment of liabilities and any differences between amounts you assume and amounts you are relieved of will be the same even if the like-kind exchange treatment applies to only part of a larger transaction. If so, determine the difference in liabilities based on all liabilities you assume or are relieved of as part of the larger transaction.

Example.

The facts are the same as in the preceding example. In addition, the fair market value of and liabilities secured by each property are as follows.

  Fair 
Market 
Value
 
 
Liability
Ben Transfers:    
Computer A $1,500 $ -0-
Automobile A 2,500 500
Truck A 2,000 -0-
Ben Receives:    
Computer R $1,600 $ -0-
Automobile R 3,100 750
Truck R 1,400 250
Cash 400  

All liabilities assumed by Ben ($1,000) are offset by all liabilities of which he is relieved ($500), resulting in a difference of $500. The difference is allocated among Ben's exchange groups in proportion to the fair market value of the properties received in the exchange groups as follows.

  • $131 ($500 × $1,600 ÷ $6,100) is allocated to the first exchange group (computers A and R). The fair market value of computer R is reduced to $1,469 ($1,600 − $131).

  • $254 ($500 × $3,100 ÷ $6,100) is allocated to the second exchange group (automobiles A and R). The fair market value of automobile R is reduced to $2,846 ($3,100 − $254).

  • $115 ($500 × $1,400 ÷ $6,100) is allocated to the third exchange group (trucks A and R). The fair market value of truck R is reduced to $1,285 ($1,400 − $115).

In each exchange group, Ben uses the reduced fair market value of the properties received to figure the exchange group's surplus or deficiency and to determine whether a residual group has been created.

Residual group.   A residual group is created if the total fair market value of the properties transferred in all exchange groups differs from the total fair market value of the properties received in all exchange groups after taking into account the treatment of liabilities (discussed earlier). The residual group consists of money or other property that has a total fair market value equal to that difference. It consists of either money or other property transferred in the exchange or money or other property received in the exchange, but not both.

  Other property includes the following items.
  • Stock in trade or other property held primarily for sale.

  • Stocks, bonds, notes, or other securities or evidences of debt or interest.

  • Interests in a partnership.

  • Certificates of trust or beneficial interests.

  • Choses in action.

Other property also includes property transferred that is not of a like-kind or like-class with any property received, and property received that is not of a like-kind or like-class with any property transferred.

  Money and properties allocated to the residual group are considered to come from the following assets in the following order.
  1. Cash and general deposit accounts (including checking and savings accounts but excluding certificates of deposit). Also, include here excess liabilities of which you are relieved over the amount of liabilities you assume.

  2. Certificates of deposit, U.S. Government securities, foreign currency, and actively traded personal property, including stock and securities.

  3. Accounts receivable, other debt instruments, and assets that you mark to market at least annually for federal income tax purposes. However, see Regulations section 1.338-6(b)(2)(iii) for exceptions that apply to debt instruments issued by persons related to a target corporation, contingent debt instruments, and debt instruments convertible into stock or other property.

  4. Property of a kind that would properly be included in inventory if on hand at the end of the tax year or property held by the taxpayer primarily for sale to customers in the ordinary course of business.

  5. Assets other than those listed in (1), (2), (3), (4), (6), and (7).

  6. All section 197 intangibles except goodwill and going concern value.

  7. Goodwill and going concern value.

Within each category, you can choose which properties to allocate to the residual group. If an asset described in any of the categories above, except (1), is includible in more than one category, include it in the lower number category. For example, if an asset is described in both (3) and (4), include it in (3).

Example.

Fran exchanges computer A (asset class 00.12) and automobile A (asset class 00.22) for printer B (asset class 00.12), automobile B (asset class 00.22), corporate stock, and $500. Fran used computer A and automobile A in her business and will use printer B and automobile B in her business.

This transaction results in two exchange groups: (1) computer A and printer B, and (2) automobile A and automobile B.

The fair market values of the properties are as follows.

  Fair 
Market 
Value
Fran Transfers:  
Computer A $1,000
Automobile A 4,000
Fran Receives:  
Automobile B $2,950
Printer B 800
Corporate Stock 750
Cash 500

The total fair market value of the properties transferred in the exchange groups ($5,000) is $1,250 more than the total fair market value of the properties received in the exchange groups ($3,750), so there is a residual group in that amount. It consists of the $500 cash and the $750 worth of corporate stock.

Exchange group surplus and deficiency.   For each exchange group, you must determine whether there is an “exchange group surplus” or “exchange group deficiency.” An exchange group surplus is the total fair market value of the properties received in an exchange group (minus any excess liabilities you assume that are allocated to that exchange group) that is more than the total fair market value of the properties transferred in that exchange group. An exchange group deficiency is the total fair market value of the properties transferred in an exchange group that is more than the total fair market value of the properties received in that exchange group (minus any excess liabilities you assume that are allocated to that exchange group).

Example.

Karen exchanges computer A (asset class 00.12) and automobile A (asset class 00.22), both of which she used in her business, for printer B (asset class 00.12) and automobile B (asset class 00.22), both of which she will use in her business. Karen's adjusted basis and the fair market value of the exchanged properties are as follows.

   
Adjusted 
Basis
Fair 
Market 
Value
Karen Transfers:    
Automobile A $1,500 $4,000
Computer A 375 1,000
Karen Receives:    
Printer B $2,050
Automobile B 2,950

The first exchange group consists of computer A and printer B. It has an exchange group surplus of $1,050 because the fair market value of printer B ($2,050) is more than the fair market value of computer A ($1,000) by that amount.

The second exchange group consists of automobile A and automobile B. It has an exchange group deficiency of $1,050 because the fair market value of automobile A ($4,000) is more than the fair market value of automobile B ($2,950) by that amount.

Recognized gain.   Gain or loss realized for each exchange group and the residual group is the difference between the total fair market value of the transferred properties in that exchange group or residual group and the total adjusted basis of the properties. For each exchange group, recognized gain is the lesser of the gain realized or the exchange group deficiency (if any). Losses are not recognized for an exchange group. The total gain recognized on the exchange of like-kind or like-class properties is the sum of all the gain recognized for each exchange group.

  For a residual group, you must recognize the entire gain or loss realized.

  For properties you transfer that are not within any exchange group or the residual group, figure realized and recognized gain or loss as explained under Gain or Loss From Sales and Exchanges, earlier.

Example.

Based on the facts in the previous example, Karen recognizes gain on the exchange as follows.

For the first exchange group, the gain realized is the fair market value of computer A ($1,000) minus its adjusted basis ($375), or $625. The gain recognized is the lesser of the gain realized, $625, or the exchange group deficiency, $-0-.

For the second exchange group, the gain realized is the fair market value of automobile A ($4,000) minus its adjusted basis ($1,500), or $2,500. The gain recognized is the lesser of the gain realized, $2,500, or the exchange group deficiency, $1,050.

The total gain recognized by Karen in the exchange is the sum of the gains recognized with respect to both exchange groups ($-0- + $1,050), or $1,050.

Basis of properties received.   The total basis of properties received in each exchange group is the sum of the following amounts.
  1. The total adjusted basis of the transferred properties within that exchange group.

  2. Your recognized gain on the exchange group.

  3. The excess liabilities you assume that are allocated to the group.

  4. The exchange group surplus (or minus the exchange group deficiency).

You allocate the total basis of each exchange group proportionately to each property received in the exchange group according to the property's fair market value.

  The basis of each property received within the residual group (other than money) is equal to its fair market value.

Example.

Based on the facts in the two previous examples, the bases of the properties received by Karen in the exchange, printer B and automobile B, are determined in the following manner.

The basis of the property received in the first exchange group is $1,425. This is the sum of the following amounts.

  1. Adjusted basis of the property transferred within that exchange group ($375).

  2. Gain recognized for that exchange group ($-0-).

  3. Excess liabilities assumed allocated to that exchange group ($-0-).

  4. Exchange group surplus ($1,050).

Printer B is the only property received within the first exchange group, so the entire basis of $1,425 is allocated to printer B.

The basis of the property received in the second exchange group is $1,500. This is figured as follows.

First, add the following amounts.

  1. Adjusted basis of the property transferred within that exchange group ($1,500).

  2. Gain recognized for that exchange group ($1,050).

  3. Excess liabilities assumed allocated to that exchange group ($-0-).

Then subtract the exchange group deficiency ($1,050).

Automobile B is the only property received within the second exchange group, so the entire basis ($1,500) is allocated to automobile B.

Like-Kind Exchanges Between Related Persons

Special rules apply to like-kind exchanges between related persons. These rules affect both direct and indirect exchanges. Under these rules, if either person disposes of the property within 2 years after the exchange, the exchange is disqualified from nonrecognition treatment. The gain or loss on the original exchange must be recognized as of the date of the later disposition.

Related persons.   Under these rules, related persons include, for example, you and a member of your family (spouse, brother, sister, parent, child, etc.), you and a corporation in which you have more than 50% ownership, you and a partnership in which you directly or indirectly own more than a 50% interest of the capital or profits, and two partnerships in which you directly or indirectly own more than 50% of the capital interests or profits.

  
An exchange structured to avoid the related party rules is not a like-kind exchange. See Like-Kind Exchanges Between Related Persons, earlier.

  For more information on related persons, see Nondeductible Loss under Sales and Exchanges Between Related Persons in chapter 2.

Example.

You used a panel truck in your house painting business. Your sister used a pickup truck in her landscaping business. In December 2012, you exchanged your panel truck plus $200 for your sister's pickup truck. At that time, the fair market value of your panel truck was $7,000 and its adjusted basis was $6,000. The fair market value of your sister's pickup truck was $7,200 and its adjusted basis was $1,000. You realized a gain of $1,000 (the $7,200 fair market value of the pickup truck minus the $200 you paid minus the $6,000 adjusted basis of the panel truck). Your sister realized a gain of $6,200 (the $7,000 fair market value of your panel truck plus the $200 you paid minus the $1,000 adjusted basis of the pickup truck).

However, because this was a like-kind exchange, you recognized no gain. Your basis in the pickup truck was $6,200 (the $6,000 adjusted basis of the panel truck plus the $200 you paid). Your sister recognized gain only to the extent of the money she received, $200. Her basis in the panel truck was $1,000 (the $1,000 adjusted basis of the pickup truck minus the $200 received, plus the $200 gain recognized).

In 2013, you sold the pickup truck to a third party for $7,000. You sold it within 2 years after the exchange, so the exchange is disqualified from nonrecognition treatment. On your 2013 tax return, you must report your $1,000 gain on the 2012 exchange. You also report a loss on the sale of $200 (the adjusted basis of the pickup truck, $7,200 (its $6,200 basis plus the $1,000 gain recognized), minus the $7,000 realized from the sale).

In addition, your sister must report on her 2013 tax return the $6,000 balance of her gain on the 2012 exchange. Her adjusted basis in the panel truck is increased to $7,000 (its $1,000 basis plus the $6,000 gain recognized).

Two-year holding period.   The 2-year holding period begins on the date of the last transfer of property that was part of the like-kind exchange. If the holder's risk of loss on the property is substantially diminished during any period, however, that period is not counted toward the 2-year holding period. The holder's risk of loss on the property is substantially diminished by any of the following events.
  • The holding of a put on the property.

  • The holding by another person of a right to acquire the property.

  • A short sale or other transaction.

  A put is an option that entitles the holder to sell property at a specified price at any time before a specified future date.

  A short sale involves property you generally do not own. You borrow the property to deliver to a buyer and, at a later date, buy substantially identical property and deliver it to the lender.

Exceptions to the rules for related persons.   The following kinds of property dispositions are excluded from these rules.
  • Dispositions due to the death of either related person.

  • Involuntary conversions.

  • Dispositions if it is established to the satisfaction of the IRS that neither the exchange nor the disposition had as a main purpose the avoidance of federal income tax.

Other Nontaxable Exchanges

The following discussions describe other exchanges that may not be taxable.

Partnership Interests

Exchanges of partnership interests do not qualify as nontaxable exchanges of like-kind property. This applies regardless of whether they are general or limited partnership interests or are interests in the same partnership or different partnerships. However, under certain circumstances the exchange may be treated as a tax-free contribution of property to a partnership. See Publication 541, Partnerships.

An interest in a partnership that has a valid election to be excluded from being treated as a partnership for federal tax purposes is treated as an interest in each of the partnership assets and not as a partnership interest. See Publication 541.

U.S. Treasury Notes or Bonds

Certain issues of U.S. Treasury obligations may be exchanged for certain other issues designated by the Secretary of the Treasury with no gain or loss recognized on the exchange. See U.S. Treasury Bills, Notes, and Bonds under Interest Income in Publication 550 for more information on the tax treatment of income from these investments.  

Insurance Policies and Annuities

No gain or loss is recognized if you make any of the following exchanges, and if the insured or the annuitant is the same under both contracts.

  • A life insurance contract for another life insurance contract, or for an endowment or annuity contract, or for a qualified long-term care insurance contract.

  • An endowment contract for an annuity contract or for another endowment contract providing for regular payments beginning at a date not later than the beginning date under the old contract, or for a qualified long-term insurance contract.

  • One annuity contract for another annuity contract.

  • An annuity contract for a qualified long-term care insurance contract.

  • A qualified long-term care insurance contract for another qualified long-term insurance contract.

In addition, if certain conditions are met, no gain or loss is recognized on the direct transfer of a portion of the cash surrender value of an existing annuity contract for a second contract, regardless of whether the contracts are issued by the same or different companies. For more information on the applicable contracts, see Revenue Procedure 2011-38, 2011-30 I.R.B. 66. You can find Revenue Procedure 2011-38 at www.irs.gov/irb/2011-30_IRB/ar09.html.

If you realize a gain on the exchange of an endowment contract or annuity contract for a life insurance contract or an exchange of an annuity contract for an endowment contract, you must recognize the gain.

For information on transfers and rollovers of employer-provided annuities, see Publication 575, Pension and Annuity Income, or Publication 571, Tax-Sheltered Annuity Plans (403(b) Plans) For Employees of Public Schools and Certain Tax-Exempt Organizations.

Cash received.   The nonrecognition and nontaxable transfer rules do not apply to a rollover in which you receive cash proceeds from the surrender of one policy and invest the cash in another policy. However, you can treat a cash distribution and reinvestment as meeting the nonrecognition or nontaxable transfer rules if all the following requirements are met.
  1. When you receive the distribution, the insurance company that issued the policy or contract is subject to a rehabilitation, conservatorship, insolvency, or similar state proceeding.

  2. You withdraw all amounts to which you are entitled or, if less, the maximum permitted under the state proceeding.

  3. You reinvest the distribution within 60 days after receipt in a single policy or contract issued by another insurance company or in a single custodial account.

  4. You assign all rights to future distributions to the new issuer for investment in the new policy or contract if the distribution was restricted by the state proceeding.

  5. You would have qualified under the nonrecognition or nontaxable transfer rules if you had exchanged the affected policy or contract for the new one.

If you do not reinvest all of the cash distribution, the rules for partially nontaxable exchanges, discussed earlier, apply.

  In addition to meeting these five requirements, you must do both the following.
  1. Give to the issuer of the new policy or contract a statement that includes all the following information.

    1. The gross amount of cash distributed.

    2. The amount reinvested.

    3. Your investment in the affected policy or contract on the date of the initial cash distribution.

  2. Attach the following items to your timely filed tax return for the year of the initial distribution.

    1. A statement titled “Election under Revenue Procedure 92-44” that includes the name of the issuer and the policy number (or similar identifying number) of the new policy or contract.

    2. A copy of the statement given to the issuer of the new policy or contract.

Property Exchanged for Stock

If you transfer property to a corporation in exchange for stock in that corporation (other than nonqualified preferred stock, described later), and immediately afterward you are in control of the corporation, the exchange is usually not taxable. This rule applies to transfers by one person and to transfers by a group. It does not apply in the following situations.

  • The corporation is an investment company.

  • You transfer the property in a bankruptcy or similar proceeding in exchange for stock used to pay creditors.

  • The stock is received in exchange for the corporation's debt (other than a security) or for interest on the corporation's debt (including a security) that accrued while you held the debt.

Control of a corporation.   To be in control of a corporation, you or your group of transferors must own, immediately after the exchange, at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation.

  
The control requirement can be met even though there are successive transfers of property and stock. For more information, see Revenue Ruling 2003-51, 2003-21 I.R.B. 938.

Example 1.

You and Bill Jones buy property for $100,000. You both organize a corporation when the property has a fair market value of $300,000. You transfer the property to the corporation for all its authorized capital stock, which has a par value of $300,000. No gain is recognized by you, Bill, or the corporation.

Example 2.

You and Bill transfer the property with a basis of $100,000 to a corporation in exchange for stock with a fair market value of $300,000. This represents only 75% of each class of stock of the corporation. The other 25% was already issued to someone else. You and Bill recognize a taxable gain of $200,000 on the transaction.

Services rendered.   The term property does not include services rendered or to be rendered to the issuing corporation. The value of stock received for services is income to the recipient.

Example.

You transfer property worth $35,000 and render services valued at $3,000 to a corporation in exchange for stock valued at $38,000. Right after the exchange, you own 85% of the outstanding stock. No gain is recognized on the exchange of property. However, you recognize ordinary income of $3,000 as payment for services you rendered to the corporation.

Property of relatively small value.   The term property does not include property of a relatively small value when it is compared to the value of stock and securities already owned or to be received for services by the transferor if the main purpose of the transfer is to qualify for the nonrecognition of gain or loss by other transferors.

  Property transferred will not be considered to be of relatively small value if its fair market value is at least 10% of the fair market value of the stock and securities already owned or to be received for services by the transferor.

Stock received in disproportion to property transferred.   If a group of transferors exchange property for corporate stock, each transferor does not have to receive stock in proportion to his or her interest in the property transferred. If a disproportionate transfer takes place, it will be treated for tax purposes in accordance with its true nature. It may be treated as if the stock were first received in proportion and then some of it used to make gifts, pay compensation for services, or satisfy the transferor's obligations.

Money or other property received.   If, in an otherwise nontaxable exchange of property for corporate stock, you also receive money or property other than stock, you may have to recognize gain. You must recognize gain only up to the amount of money plus the fair market value of the other property you receive. The rules for figuring the recognized gain in this situation generally follow those for a partially nontaxable exchange discussed earlier under Like-Kind Exchanges. If the property you give up includes depreciable property, the recognized gain may have to be reported as ordinary income from depreciation. See chapter 3.

   Note. You cannot recognize or deduct a loss.

Nonqualified preferred stock.   Nonqualified preferred stock is treated as property other than stock. Generally, it is preferred stock with any of the following features.
  • The holder has the right to require the issuer or a related person to redeem or buy the stock.

  • The issuer or a related person is required to redeem or buy the stock.

  • The issuer or a related person has the right to redeem or buy the stock and, on the issue date, it is more likely than not that the right will be exercised.

  • The dividend rate on the stock varies with reference to interest rates, commodity prices, or similar indices.

For a detailed definition of nonqualified preferred stock, see section 351(g)(2) of the Internal Revenue Code.

Liabilities.   If the corporation assumes your liabilities, the exchange generally is not treated as if you received money or other property. There are two exceptions to this treatment.
  • If the liabilities the corporation assumes are more than your adjusted basis in the property you transfer, gain is recognized up to the difference. However, for this purpose, exclude liabilities assumed that give rise to a deduction when paid, such as a trade account payable or interest.

  • If there is no good business reason for the corporation to assume your liabilities, or if your main purpose in the exchange is to avoid federal income tax, the assumption is treated as if you received money in the amount of the liabilities.

For more information on the assumption of liabilities, see section 357(d) of the Internal Revenue Code.

Example.

You transfer property to a corporation for stock. Immediately after the transfer, you control the corporation. You also receive $10,000 in the exchange. Your adjusted basis in the transferred property is $20,000. The stock you receive has a fair market value (FMV) of $16,000. The corporation also assumes a $5,000 mortgage on the property for which you are personally liable. Gain is realized as follows.

FMV of stock received $16,000
Cash received 10,000
Liability assumed by corporation 5,000
Total received $31,000
Minus: Adjusted basis of property transferred 20,000
Realized gain $11,000

  The liability assumed is not treated as money or other property. The recognized gain is limited to $10,000, the cash received.

Transfers to Spouse

No gain or loss is recognized on a transfer of property from an individual to (or in trust for the benefit of) a spouse, or a former spouse if incident to divorce. This rule does not apply to the following.

  • The recipient of the transfer is a nonresident alien.

  • A transfer in trust to the extent the liabilities assumed and the liabilities on the property are more than the property's adjusted basis.

  • A transfer of certain stock redemptions, as discussed in section 1.1041-2 of the regulations.

Any transfer of property to a spouse or former spouse on which gain or loss is not recognized is treated by the recipient as a gift and is not considered a sale or exchange. The recipient's basis in the property will be the same as the adjusted basis of the property to the giver immediately before the transfer. This carryover basis rule applies whether the adjusted basis of the transferred property is less than, equal to, or greater than either its fair market value at the time of transfer or any consideration paid by the recipient. This rule applies for determining loss as well as gain. Any gain recognized on a transfer in trust increases the basis.

For more information on transfers to a spouse, see Property Settlements in Publication 504, Divorced or Separated Individuals.

Rollover of Gain From Publicly Traded Securities

You can elect to roll over a capital gain from the sale of publicly traded securities (securities traded on an established securities market) into a specialized small business investment company (SSBIC). If you make this election, the gain from the sale is recognized only to the extent the amount realized is more than the cost of the SSBIC common stock or partnership interest bought during the 60-day period beginning on the date of the sale (and did not previously take into account on an earlier sale of publicly traded securities). You must reduce your basis in the SSBIC stock or partnership interest by the gain not recognized.

The gain that can be rolled over during any tax year is limited. For individuals, the limit is the lesser of the following amounts.

  • $50,000 ($25,000 for married individuals filing separately).

  • $500,000 ($250,000 for married individuals filing separately) minus the gain rolled over in all earlier tax years.

For C corporations, the limit is the lesser of the following amounts.

  • $250,000.

  • $1 million minus the gain rolled over in all earlier tax years.

An estate, trust, partnership, or S corporation cannot make the election.

For more information, including information on how to make the election and how to report and postpone the gain, see chapter 4 of Publication 550.

Gains on Sales of Qualified Small Business Stock

If you sell qualified small business stock, you may be able to roll over your gain tax free or exclude part of the gain from your income. Qualified small business stock is stock originally issued by a qualified small business after August 10, 1993, that meets all seven tests listed in chapter 4 of Publication 550.

The election to roll over gain or to exclude part of the gain from income is not allowed to C corporations.

Rollover of gain.   You can elect to roll over a capital gain from the sale of qualified small business stock held longer than 6 months into other qualified small business stock. If you make this election, the gain from the sale generally is recognized only to the extent the amount realized is more than the cost of the replacement qualified small business stock bought within 60 days of the date of sale. You must reduce your basis in the replacement qualified small business stock by the gain not recognized.

Exclusion of gain.   You may be able to exclude from your gross income 50% of your gain from the sale or exchange of qualified small business stock you held more than 5 years. The exclusion can be up to 75% for stock acquired after February 17, 2009, and up to 100% for stock acquired after September 27, 2010, and before January 1, 2014. The exclusion can be up to 60% for certain empowerment zone business stock.

  Your gain from the stock of any one issuer that is eligible for the exclusion is limited to the greater of the following amounts.
  • Ten times your basis in all qualified stock of the issuer you sold or exchanged during the year.

  • $10 million ($5 million for married individuals filing separately) minus the gain from the stock of the same issuer you used to figure your exclusion in earlier years.

More information.   For more information on sales of small business stock, including stock held by a partnership, S corporation, regulated investment company, or common trust fund, see section 1202 of the Internal Revenue Code, and chapter 4 of Publication 550. See the Instructions for Schedule D (Form 1040) and the Instructions for Form 8949 for information on how to report the gain.

Exclusion of Gain From Sale of DC Zone Assets

If you sold or exchanged a District of Columbia Enterprise Zone (DC Zone) asset acquired after 1997 and before 2012, held for more than 5 years, you may be able to exclude the qualified capital gain.

DC Zone asset.   A DC Zone asset is any of the following.
  • DC Zone business stock.

  • DC Zone partnership interest.

  • DC Zone business property.

Qualified capital gain.   The qualified capital gain is any gain recognized on the sale or exchange of a DC Zone asset that is a capital asset or property used in a trade or business. It does not include any of the following gains.
  • Gain treated as ordinary income under section 1245.

  • Gain treated as unrecaptured section 1250 gain. The section 1250 gain must be figured as if it applied to all depreciation rather than the additional depreciation.

  • Gain attributable to real property, or an intangible asset, which is not an integral part of a DC Zone business.

  • Gain from a related-party transaction. See Sales and Exchanges Between Related Persons in chapter 2.

  See section 1400B of the Internal Revenue Code for more details on DC Zone assets and special rules.


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