Chapter 9 - Nontaxable Exchanges

Chapter9

QuestionsandProblemsforDiscussion

1. AlthoughCompanyPJmusthaveexpended$700,000forthe1,000acres,itdidnottakeacost
basisintheland.Instead,PJtookasubstitutedbasisofonly$475,000(basisofthepropertyPJ
surrenderedinthenontaxableexchange).Therefore,PJsrecognizedgainonsaleoftheland
willexceedthe$600,000appreciationby$225,000.

2. Becauseofthevalueforvaluepresumption,theamountsrealizedbyunrelatedpartiesonthe
exchangeofpropertyarealwaysequal.

3. Thetaxconsequencestounrelatedpartiesengaginginanontaxableexchangearecompletely
independent.Forinstance,onepartycouldhaveapartiallyrecognizedgainwhiletheotherparty
couldhaveanunrecognizedloss.

4. Thesubstitutedbasisofthequalifyingpropertyreceivedinanontaxableexchangecanbemore,
less,orequaltothecostoftheproperty,dependingonthegainorlossdeferredonthe
exchange.

5. a. IfFirmAistransactingwiththeKLSPartnershipitself,thecontributionofproperty(the2
percentinterestintheMGPartnership)fora10percentequityinterestinKLSisnontaxable
tobothFirmAandKLSPartnership.However,iftheotherpartyisapartnerinKLS(notthe
partnership),theexchangeistaxabletobothparties.
b. Mr.BsexchangeoflandforRVstockistaxabletoMr.BbutnontaxabletoRV.
c. CorporationCsexchangeofpersonaltyforrealtyistaxabletobothparties.
d. CompanyDsexchangeofinventoryforanewcomputersystemistaxabletoCompanyC.
Notenoughinformationisprovidedtodetermineiftheexchangeistaxabletotheother
party.

6. BecauseFirmQisexchanginginventoryforland,theexchangeistaxabletoFirmQ.Because
CompanyMisexchangingbusinessrealtyforinvestmentrealty,theexchangeisanontaxable,
likekindexchangetoCompanyM.

7. CompanyWexchangedmarketablesecuritiesfor$250,000ofthe$2millionFMVofBlackacre:
thisexchangedoesnotqualifyasalikekindexchange.Consequently,CompanyWrecognizes
a$220,000capitalgainontheexchange.

8. Ifthevalueofthedestroyedpropertyexceedstheinsurancereimbursementandtheinsurance
reimbursementexceedsthepropertysadjustedbasis,theownersuffersaneconomiclossbut
realizesagain.

9. Atransferofpropertytoacorporationinexchangeforthecorporationsstockisnontaxableonly
ifthetransferor(orgroupoftransferors)owns80percentormoreofthecorporationimmediately
aftertheexchange.Atransferofpropertytoapartnershipinexchangeforanequityinterestis
nontaxableregardlessoftheextentofthetransferorsownershipaftertheexchange.

10. Anassethasasubstitutedbasisifthecurrentownersbasisisdeterminedbyreferencetothe
basisofadifferentassetdisposedofbytheowner.Anassethasacarryoverbasisifthecurrent
ownersbasisisthesameasthebasisoftheassetinthehandsofapreviousowner.

91
 Chapter 9 - Nontaxable Exchanges
11. Forfinancialstatementpurposes,gainorlossrealizedontheexchangeofoneassetforanother
isusuallyincludedincurrentyearincome,evenifthegainorlossisnotrecognizedfortax
purposes.Thebook/taxdifferenceistemporarybecausetheunrecognizedgainorlossismerely
deferred,noteliminated.

12. Thetaxpayertakesasubstitutedbasisinthenewlyissuedstocksothatthedeferredgain(equal
totheunrealizedappreciationinthetransferredproperty)isembeddedinthestock.However,
thecorporationtakesacarryoverbasisinthepropertysothatthecorporationwillrecognizethe
unrealizedappreciationonsubsequentdispositionoftheproperty.Thus,boththeshareholder
andthecorporationhavedeferredgainwithrespecttotheirnewassets.

13. Congresshasnoquarrelwithtaxpayerswhosellsecuritiesatagain,thenimmediatelyreacquire
thesecurities.Thisstrategyacceleratestherecognitionofincomeandthepaymentoftaxon
thatincome.

14. FirmBshouldselltheblockofstockwiththelessvolatilemarketpricetominimizetheriskofa
significantpriceincreasebetweendateofsaleanddateofreacquisition.

15. Gainorlossrealizedonanontaxableexchangeisnoteliminatedbutmerelydeferreduntilthe
taxpayerdisposesofthepropertyreceivedintheexchangeinataxabletransaction.

ApplicationProblems

1. a. Realizedgain$6,700($16,000amountrealized$9,300taxbasis);recognizedgain
$6,700;taxbasisinnewequipment$16,000cost.
b. Realizedgain$6,700($16,000amountrealized$9,300taxbasis);recognizedgain0;tax
basisinnewequipment$9,300substitutedbasis.
c. Iftheexchangewastaxable,gainrecognizedonsaleofthenewequipmentis$850
($16,850amountrealized$16,000taxbasis).Iftheexchangewasnontaxable,gain
recognizedonsaleofthenewequipmentis$7,550($16,850amountrealized$9,300tax
basis).

2. a. Realizedloss$12,000($95,000amountrealized$107,000taxbasis);recognizedloss
$12,000;taxbasisinnewequipment$95,000cost.
b. Realizedloss$12,000($95,000amountrealized$107,000taxbasis);recognizedloss0;
taxbasisinnewequipment$107,000substitutedbasis.
c. Iftheexchangewastaxable,gainrecognizedonsaleofthenewequipmentis$5,000
($100,000amountrealized$95,000taxbasis).Iftheexchangewasnontaxable,loss
recognizedonsaleofthenewequipmentis$7,000($100,000amountrealized$107,000
taxbasis).

3. a. Rufusmustpay$12,500bootinadditiontotransferringpropertywitha$77,500FMV.The
totalamounttransferredtoHardymustbe$90,000,whichistheFMVofthepropertyHardy
transferstoRufus.
b. Rufusrealizesa$27,500gain($90,000amountrealized[$50,000taxbasisoftransferred
property+$12,500bootpaid]).Rufusrecognizesnogainbecauseitdidnotreceiveboot.Its
basisinthepropertyacquiredis$62,500($50,000substitutedbasisofpropertytransferred
+$12,500boot).

92
 Chapter 9 - Nontaxable Exchanges
c. Hardyrealizesa$30,000gain($90,000amountrealized[$77,500FMVofpropertyacquired
+$12,500bootreceived]$60,000taxbasisoftransferredproperty).Rufusrecognizes
$12,500gainequaltothebootreceived.Itsbasisinthepropertyacquiredis$60,000
(substitutedbasisofpropertytransferred).

93
 Chapter 9 - Nontaxable Exchanges
4. a. Realizedgain$12,000;recognizedgain$12,000;taxbasisinnewasset$32,000.
b. Realizedgain$12,000;recognizedgain0;taxbasisinnewasset$20,000.
c. Inthiscase,theoldassetmustbeworthonly$30,300.Realizedgain$10,300;recognized
gain$10,300;taxbasisinnewasset$32,000.
d. Realizedgain$10,300;recognizedgain$0;taxbasisinnewasset$21,700.
e. Inthiscase,theoldassetmustbeworth$36,500.Realizedgain$16,500;recognizedgain
$16,500;taxbasisinnewasset$32,000.
f. Realizedgain$16,500;recognizedgain$4,500;taxbasisinnewasset$20,000.

5. a. Realizedloss$15,000;recognizedloss$15,000;taxbasisinnewproperty$65,000.
b. Realizedloss$15,000;recognizedloss0;taxbasisinnewproperty$80,000.
c. Inthiscase,theoldpropertymustbeworthonly$63,000.Realizedloss$17,000;
recognizedloss$17,000;taxbasisinnewproperty$65,000.
d. Realizedloss$17,000;recognizedloss0;taxbasisinnewproperty$82,000.
e. Inthiscase,theoldpropertymustbeworth$73,000.Realizedloss$7,000;recognizedloss
$7,000;taxbasisinnewproperty$65,000.
f. Realizedloss$7,000;recognizedloss0;taxbasisinnewproperty$72,000.

6. a. Realizedgain$11,900;recognizedgain$2,500;taxbasisinnewasset$9,100.
b. Realizedgain$11,900;recognizedgain$11,900;taxbasisinnewasset$7,000.

7. a. Neilsbookgainis$327,400($932,000amountrealized$604,600bookbasis).Neilstax
gainis$359,000($932,000amountrealized$573,000taxbasis).
b. Neilsbookandtaxbasisintheinvestmentassetequalthe$932,000costoftheasset.
c. Neilsbookgainis$327,440($932,000amountrealized$604,600bookbasis).Itstaxgain
iszero.
d. Neilsbookbasisintheinvestmentassetisits$932,000cost.Neilstaxbasisinthe
investmentassetis$573,000,thesubstitutedbasisofthebusinessasset.

8. a. Neilsbookandtaxgainequal$68,000($1,000,000amountrealized$932,000book/tax
basis).
b. Neilsbookgainis$68,000($1,000,000amountrealized$932,000bookbasis).Neilstax
gainis$427,000($1,000,000amountrealized$573,000taxbasis).

9. a. CCsrecognizedgainontheexchangeoftheoldassetforthenewassetis$6,000($16,000
amountrealized$10,000adjustedbasis).Becausethisgainexceedsthe$7,000
depreciationthatCCdeductedwithrespecttotheoldasset,CCmustrecapturetheentire
gainasordinaryincome.CCscostbasisinthenewassetis$16,000.
b. Iftheoldassetandnewassetarelikekind,CCdoesnotrecognizeanyofthe$6,000gain
realizedontheexchange.CCssubstitutedbasisinthenewassetis$10,000.

10. a. XYZrealizeda$7,000gain($28,500amountrealized[$13,000basisinoldequipment+
$8,500]).Becausethisisalikekindexchange,XYZdoesnotrecognizeanygain.

94
 Chapter 9 - Nontaxable Exchanges
b. XYZtakesa$21,500basisinthenewequipment.

95
 Chapter 9 - Nontaxable Exchanges
11. a. OCDrealizeda$16,300gain($48,000amountrealized$31,700basisinoldfurniture).
Becausethisisalikekindexchange,OCDrecognizesonly$3,000gain(bootreceived).The
recognizedgainisrecapturedordinaryincome.
b. OCDtakesa$31,700basisinthenewfurniture.

12. a. Theresidentialrentalpropertymusthavea$185,000FMV.
b. FirmMLrealizesa$27,000gainbutrecognizesnogainonthislikekindexchange.
c. FirmMLsbasisinthe20acresis$173,000.

13. a. Theresidentialrentalpropertymusthavea$222,000FMV.
b. MLrealizesa$64,000gainandrecognizesa$22,000gainonthislikekindexchange.The
recognizedgainisSection1231gain.
c. MLsbasisinthe20acresis$158,000.

14. a. POsrealizedgainis$637,000($1,040,000amountrealized[$325,000FMVofBoardwalk+
$715,000debtrelief]$403,000adjustedbasis).POmustrecognizetheentire$637,000
gainbecausethe$715,000boot(debtrelief)exceedstherealizedgain.POstaxbasisin
Boardwalkis$325,000.
b. QRsrealizedgainis$247,000($1,040,000amountrealized$793,000adjustedbasis
[$78,000adjustedbasisinBoardwalk+$715,000debtassumption]).QRrecognizesnogain
andtakesa$78,000basisinMarvinGardens.

15. a. Bsrealizedgainis$160,000($525,000amountrealized$365,000adjustedbasis
[$240,000adjustedbasisinBlackacre+$125,000netdebtassumption]).Itrecognizesno
gainandtakesa$365,000basisinWhiteacre.
b. Wsrealizedgainis$425,000($525,000amountrealized[$400,000FMVofBlackacre+
$125,000netreliefofdebt]$100,000adjustedbasis).Itmustrecognize$125,000ofthe
gainbecauseofthereceiptof$125,000boot(netdebtrelief).ItstaxbasisinBlackacreis
$100,000.

16. a. FFrealizeda$35,300gain($250,000insurancereimbursement$214,700adjustedbasis)
ontheinvoluntaryconversionofitswarehouse.BecauseFFspentatleast$250,000onthe
constructionofareplacementbuildingandthereplacementoccurredwithinthetwotaxable
yearsfollowingtheyearoftheconversion,itdoesnotrecognizeanyoftherealizedgain.
FFsbasisinthereplacementbuildingis$264,700($300,000cost$35,300unrecognized
gain.
b. FFrealizeda$14,700loss($200,000insurancereimbursement$214,700adjustedbasis)
ontheinvoluntaryconversionofitswarehouse.Itcanrecognizetheentirelossasan
ordinarycasualtyloss.FFsbasisinthereplacementbuildingisthebuildings$300,000cost.

17. a. NPmustrecognizetheentire$120,000realizedgain($650,000insurancereimbursement
$530,000adjustedbasis)ontheinvoluntaryconversion.
b. NPdoesnotrecognizeanyofthe$120,000realizedgainbecauseitspentatleast$650,000
onreplacementpropertywithintwotaxableyearsfollowingtheyearinwhichthegainwas
realized.

96
 Chapter 9 - Nontaxable Exchanges
c. BecauseNPdidnotacquirethereplacementpropertywithintwotaxableyearsfollowingthe
yearinwhichthegainwasrealized,itmustrecognizetheentire$120,000gain.

97
 Chapter 9 - Nontaxable Exchanges
18. a. RPrealizeda$295,000gainontheinvoluntaryconversion.Becauseitreinvestedonly
$775,000ofthe$975,000amountrealizedinreplacementproperty,itmustrecognizea
$200,000gain.RPsbasisintheinventoryis$200,000,anditsbasisinthenewrealestate
is$680,000($775,000$95,000deferredgain).
b. Inthiscase,RPrealizeda$125,000gainontheinvoluntaryconversion.Becauseit
reinvestedonly$775,000ofthe$975,000amountrealizedinreplacementproperty,itmust
recognizetheentiregain.RPsbasisintheinventoryis$200,000,anditsbasisinthenew
realestateis$775,000.
c. Inthiscase,RPdoesnotrecognizeanyofthe$295,000realizedgainontheinvoluntary
conversion.RPsbasisinthenewrealestateis$780,000($1,075,000cost$295,000
deferredgain).

19. a. CompanyKrealizeda$64,000gain($480,000insurance$416,000adjustedbasis).It
recognized$30,000ofthegain($480,000insurance$450,000replacementcostofnew
equipment).
b. CompanyKstaxbasisinthenewequipmentis$416,000($450,000cost$34,000deferred
gain).
c. CompanyKwouldrecognizenogainandwouldtakea$428,000basisinthenew
equipment($492,000cost$64,000deferredgain).

20. a. Mr.Boydtransferscashandpropertywitha$30,000totalFMV.Ms.Tucktransfersproperty
witha$60,000FMV.Therefore,Mr.Boydshouldreceive400sharesworth$30,000,and
Ms.Tuckshouldreceive800sharesworth$60,000.
b. Mr.Boydrealizesa$16,800gain($30,000FMVstockreceived$13,200basisofcashand
propertytransferred).BecauseMr.BoydandMs.Tuckown100%ofBTsoutstandingstock
immediatelyaftertheirexchangesofpropertyforstock,theexchangesarenontaxable.Mr.
Boydrecognizesnogainandtakesa$13,200substitutedbasisinhis400BTshares.
c. Ms.Tuckrealizesan$18,500gain($60,000FMVstockreceived$41,500basisofproperty
transferred).BecauseMr.BoydandMs.Tuckown100%ofBTsoutstandingstock
immediatelyaftertheirexchangesofpropertyforstock,theexchangesarenontaxable.Ms.
Tuckrecognizesnogainandtakesa$41,500substitutedbasisinher800BTshares.
d. BTsbookbasisintheinventorytransferredbyMr.Boydis$20,000(FMV).Itstaxbasisin
theinventoryisa$3,200carryoverbasis.BTsbookbasisintheequipmenttransferredby
Ms.Tuckis$60,000(FMV).Itstaxbasisintheinventoryisa$41,500carryoverbasis.

21. a. Aprimaryreasonforaparentcorporationtousewhollyownedsubsidiariesistoisolatethe
riskassociatedwiththebusinessoperatedbythesubsidiary.Asecondreasonistoprovide
anindependentmanagementteamandorganizationalstructureforthesubsidiarys
business.Athirdreasonisthatemployeesofthesubsidiarycanbegivenanequitystakein
thesubsidiarywithoutgivingthemequityinthelargerparentcorporation.(Obviously,there
aremanyotherreasonsthatstudentsmayidentify.)
b. PVsrealizedgainis$6million,butitsrecognizedgainonthisnontaxablecorporate
formationiszero.PVsbasisinitsSVstockis$4million.

98
 Chapter 9 - Nontaxable Exchanges

22. a. BecauseMr.ZJdoesnotownatleast80percentofZJLsoutstandingstockimmediately
aftertheexchange,hemustrecognizetheentire$154,000realizedgain($400,000FMVof
stockreceived$246,000adjustedbasisofbusinessassetstransferred)ontheexchangeof
propertyforstock.
b. AlthoughMr.ZJownsa66.7percentmajorityinterestinZJLsoutstandingstock,hedoes
notmeetthe80percentcontrolrequirementandmustrecognizea$154,000gainonthe
exchangeofpropertyforstock.
c. BecauseMr.ZJwillown83percentofZJLsoutstandingstockimmediatelyafterthe
exchange,hedoesnotrecognizegainontheexchangeofpropertyforstock.

23. a. Mr.ZJandMrs.LarebothtransferringpropertytoZJLCorporationinexchangeforstock.
Immediatelyaftertheexchange,thetransferorswillown100percentofZJLsoutstanding
stock.Consequently,Mr.ZJsexchangeisnontaxable,andhedoesnotrecognizeanygain
ontheexchange.
b. Mr.ZJsbasisinhis1,000shareswillbea$246,000substitutedbasis.Mrs.Lsbasisinher
1,000shareswillbea$200,000costbasis.
c. ZJLstaxbasisintheassetstransferredfromMr.ZJwillbetheir$246,000carryoverbasis.

24. a. CorporationArealizeda$4,000loss,andCorporationZrealizeda$68,000gainonthe
contributionofbusinessequipmenttoAZPartnership.Neithercorporationrecognizesgain
orloss.
b. AsbasisinitsonehalfequityinterestinAZPartnershipis$134,000,whileZsbasisinits
onehalfequityinterestinAZPartnershipis$62,000.
c. AZPartnershipsbasisintheequipmentcontributedbyAis$34,000andintheequipment
contributedbyBis$12,000.

25. a. Ms.Deesrealizedlossonsaleis$16,000($46,000amountrealized[500shares$92
sellingpricepershare]$62,000basis[500shares$124costpershare]).Becauseshe
repurchasedtheshareswithin30daysofsale,noneofthelossisrecognizedunderthe
washsalerule.
b. BecauseMs.Deesrepurchaseoccurredmorethan30daysafterthesale,her$16,000
realizedlossisrecognized.
c. Herbasisinthe600sharesis$72,400($56,400cost(600shares$94costpershare)+
$16,000unrecognizedloss).
d. Herbasisinthe600sharesis$59,400(600shares$99costpershare).

26. a. SWcanrecognizethe$14,000lossrealizedonthesale.
b. BecauseSWpurchased1,000newsharesofDeltastockwithin30dayspriortothesale,
thewashsaleruleprohibitsSWfromrecognizinganylossonthesale.
c. BecauseSWpurchased1,000newsharesofDeltastockwithin30daysafterthesale,the
washsaleruleprohibitsSWfromrecognizinganylossonthesale.
d. Thewashsaleruledoesnotapplytorealizedgains.Thus,SWmustrecognizethe$11,000
gainrealizedonthesale.

99
 Chapter 9 - Nontaxable Exchanges

27. a. N/A
b. SWsbasisinthe1,200DeltasharespurchasedonMay1is$124,400($110,400cost+
$14,000unrecognizedloss).
c. SWsbasisinthe1,200DeltasharespurchasedonJune8is$124,400($110,400cost+
$14,000unrecognizedloss).
d. SWsbasisinthe1,200DeltasharespurchasedonJune8istheir$110,400cost.

28. KAIsnetincomeperbooksbeforetax $500,000

Bookgainonequipmenttheft $(18,000)
Taxgainonequipmenttheft 5,000
(13,000)
Bookgainonlikekindexchangeofrealty (350,000)
KAIstaxableincome $137,000

29. Alfixsnetincomeperbooksbeforetax $789,300

MACRSdepreciationinexcessofbookdepreciation (24,230)
BooklossonsaleofGreenacre:
$820,000$835,000book(cost)basis $15,000
TaxgainonsaleofGreenacre:
$820,000$500,000tax(substituted)basis 320,000
335,000
BookgainonsaleofDundeestock
$112,000$91,000bookbasis $(21,000)
TaxgainonsaleofDundeestock;
$112,000$68,200taxbasis 43,800
22,800
Alfixstaxableincome $1,122,870

IssueRecognitionProblems

1. CanSTreducethebootreceivedintheformof$450,000ofdebtreliefbythe$150,000cash
paidtoWX?DoesSTreceive$450,000or$300,000bootinthisexchange?CanWZoffsetthe
$150,000cashreceivedagainstitsassumptionofthe$450,000mortgageonitsnewoffice
building?DoesWZrecognizeanyofthe$1.2milliongainrealizedontheexchange?

2. Howisthe$5,000bootreceivedallocatedbetweenitem1anditem2?SinceJKrealizedan
$8,000gainontheexchangeofitem1anda$4,000lossontheexchangeofitem2,canJK
allocatethe$5,000cashreceipttoitem2(andavoidgainrecognitionwithrespecttoitem1)?

3. DoestheexchangeofrealestatelocatedintheUnitedStatesforrealestatelocatedinaforeign
countryqualifyasalikekindexchange?

4. Doesthedestructionofthecattlebecauseofthethreatofdiseasequalifyasaninvoluntary
conversion?DidFMusethe$150,000toreplacethecattle?

5. Isamovietheatercomplexsimilarorrelatedinserviceorusetoadriveinmoviecomplexthat
includesotheroutdoorentertainmentequipment?DoesthefactthatCompanyTwasnolonger
operatingthedriveinmovietheatermakeanydifferenceinapplyingtheinvoluntaryconversion
rules?

910
 Chapter 9 - Nontaxable Exchanges
6. DoesFirmFhaveanadditionaltwoyearsafter2007toinvestthe$25,000insurance
reimbursementinpropertysimilarorrelatedinserviceorusetotheofficebuildingthatwas
involuntarilyconvertedin2004?IfFirmFdoesnotinvestthe$25,000inanofficebuilding,how
doesitaccountforthepayment?

7. MustCompanyCrecognizethe$350,000realizedgainontheinvoluntaryconversionofthe
industrialplantbecauseitfailedtoplacethenewplantinserviceduringthetwotaxableyears
followingtheyearoftheinvoluntaryconversion?

8. CanABCamendits2006taxreturnandrecognizethe$295,000gain,therebyincreasingboth
thetaxableincomeandtheNOLcarrybackdeductiontothatyear?IfABCcanamendits2006
returntorevokethedeferralelection,isthereanytaxbenefitindoingso?

9. Whatportionofthe35percentpartnershipinterestispaymentforMr.Psprofessionalservices
andwhatportionisinexchangeforthecopyright?WhatistheFMVofMr.Psprofessional
servicesandmustherecognizecompensationincomeeventhoughPartnershipMpaidhimwith
equity?CanPartnershipMcapitalizethepaymentforMr.Psprofessionalservicestoitstax
basisinthethreebuildingshedesigned?

10. ArethesharesofXZYnonvotingpreferredstocksubstantiallythesameasXZYvotingcommon
stockforpurposesofthewashsalerule?

ResearchProblems

1. KileyCommunicationInc.canavoidrecognizingitsrealizedgainonlyifradiobroadcastlicenses
andtelevisionbroadcastlicensesqualifyaslikekindpropertyunderSection1031.InTAM
200035005,theIRSnotedthatthelikekindstatusofintangibleassetsdependsonthenatureof
therightsconferredbytheassetandthenatureoftheunderlyingpropertytowhichthe
intangibleassetrelates.BecauseanFCClicenseconfersarighttobroadcastonadesignated
channelandfrequencyrangeregardlessofwhetherthelicenserelatestoatelevisionstationor
aradiostation,theIRSconcludedthatthedifferencesbetweenradioandtelevisionlicensesare
merelydifferencesingradeorqualityanddonotchangethenatureoftherightconferred.
Therefore,FCCradioandtelevisionbroadcastlicensesarelikekindproperty,andKileycan
treattheexchangeasnontaxable,therebydeferringrecognitionofits$3.9milliongain.

2. Whenataxpayerelectstodefertherecognitionofgainrealizedonaninvoluntaryconversion,
thetaxpayermustacquirereplacementpropertythatissimilarorrelatedinserviceoruseto
theconvertedproperty.TheInternalRevenueCodeprovidesanalternativetoadirect
replacementofproperty:underSection1033(a)(2)(A):theacquisitionofcontrolofacorporation
thatownsreplacementpropertyisaqualifyingacquisitionforpurposesofthenonrecognition
rule.AccordingtoSection1033(a)(2)(E)(i),thetermcontrolmeanstheownershipofstock
representingatleast80percentofthetotalvotingpowerofallclassesofoutstandingstock
entitledtovoteplus80percentofthetotalnumberofallothershares.
SinceMr.BryanOlgivieisplanningtopurchase100percentoftheoutstandingstockof
IceMagic,hewillacquirecontrolofthecorporationwithinthemeaningofSection1033(a)(2)(A).
Therefore,ifthecorporationsindooriceskatingrinkqualifiesasreplacementproperty,Mr.
Olgiviecandeferrecognitionofthe$266,600gainrealizedontheinvoluntaryconversionofhis
indoorrollerskatingrink.Nodirectauthorityaddresseswhetheraniceskatingrinkandaroller
skatingrinkaresimilarorrelatedinserviceorusewithinthemeaningofSection1033.
Certainly,Mr.Olgiviecanmakeagoodargumentthatthetwoentertainmentfacilitiesmeetthe
statutoryrequirement.However,becausetheissueisbasedonfactsandcircumstances,the

911
 Chapter 9 - Nontaxable Exchanges
IRSwillnotissueanadvancedletterruling.Consequently,ifMr.OlgiviepurchasestheIceMagic
stock,hewillbeartheriskthattheIRSwillnotaccepthisargument.

912
 Chapter 9 - Nontaxable Exchanges

3. AccordingtoSection351(a)andSection368(c),Mr.Pomeroysexchangeofbusinessassetsfor
PomeroySkistockwasnontaxableifMr.Pomeroyownedatleast80percentofthe
corporationsoutstandingstockimmediatelyaftertheexchange.Accordingtocaselaw,Mr.
Pomeroymetthestatutorytimingrequirementaslongashiscontrolwasabsoluteand
unrestricted,evenifsuchcontrolwasmomentary.ThefactthatMr.Pomeroygaveawaya
controllingstockinterestaftertheexchangedoesnotviolateSection351(a)becausehewas
undernopreexistinglegalobligationtodoso.SeeWilgardRealtyCo.v.Commissioner,F.2d
514(CA2,1942).

4. BullenCompanysadjustedtaxbasisinthemachineryonJanuary1,2007,was$252,839
($413,000cost$160,161depreciationforthefirsttwoyearsinthesevenyearrecovery
period).Thedepreciationfor2007(thirdyearintherecoveryperiod)is$72,234($413,000
17.49%).Section168(i)(7)providesthatinthecaseofpropertytransferredinaSection351
exchange,thetransfereestepsintotheshoesofthetransferorwithrespecttodepreciationof
thecarryoverbasis.Prop.Reg.Sec.1.1685(b)(4)(i)clarifiesthatwhenthetransferorand
transfereehavethesametaxableyear,thedepreciationdeductionfortheyearoftransferis
proratedbetweenthemonamonthlybasis.BullenCompanytransferredtheequipmenttoEaton
Inc.onApril1.Consequently,Bullensshareofthe2007depreciationis$18,059(3months/12
months$72,234),andthecarryoverbasisofthepropertyonApril1is$234,780($252,839
$18,059depreciationfromJanuary1throughMarch31).Eatonsshareofthe2007depreciation
is$54,175(9months/12months$72,234).

TaxPlanningCases

1. a. BecauseNSwillbein80percentcontrolofCorporationTimmediatelyaftertheexchange,it
cannotrecognizeits$1.6millionrealizedlossontheexchangeofrealtyforstock.Theloss
willbedeferreduntilNSdisposesofthenewlyissuedTstock.
b. BecauseNSandCorporationTarerelatedparties,NSs$1.6millionrealizedlossonsale
wouldbedisallowed.
c. ByleasingtherealtytoCorporationT,NSavoidsthedeferralorlossdisallowancerulesand
retainstheopportunitytoselltherealtytoanunrelatedpurchaseratafuturedate.Thus,NS
keepsitsunrealizedloss,CorporationThasuseoftherealty,andthetaxcostofNSsrent
incomeandthetaxsavingsofCorporationTsrentdeductionnettozero.Thisseemstobe
thebestcourseofaction.

913
 Chapter 9 - Nontaxable Exchanges

2. PartyAsoffer:
FirmKsamountrealizedonsale(cash) $770,000
Basisoflandsold (600,000)
Capitalgainrecognizedonsale $170,000
.15
Tax $25,500
Cashreceived $770,000
Taxcost (25,500)
NPVofaftertaxcashflow $744,500

PartyBsoffer:
FirmKsamountrealized(FMVofland) $725,000
Basisoflandexchanged (600,000)
Deferredgainonlikekindexchange $125,000
EstimatedFMVofnewlandintwoyears
($725,000 1.21%growthfactorfortwoyears) $877,250
FirmKssubstitutedbasisofnewland (600,000)
Capitalgainrecognizedintwoyearsonsale $277,250
Taxrateoncapitalgain .15
Tax $41,588
Cashreceived $877,250
Taxcost (41,588)
Aftertaxcashflowfromsale $835,662
Discountfactorat7% .873
NPVofaftertaxcashflow $729,533
FirmKshouldacceptPartyAsoffertomaximizeNPV.

914
 Chapter 9 - Nontaxable Exchanges

3. UnderbothOption1andOption2,CorporationEFwillobtaintheuseofnewequipmentwitha
5yearMACRSrecoveryperiod.Theoptionshavedifferenttaxconsequencesandtransaction
costs,whichresultindifferentcashflowsovertherecoveryperiod.
Option1:
Amountrealizedonsaleofoldequipment $120,000
Adjustedbasis (50,000)
Gainrecognizedonsale $70,000
Taxrate .35
Tax $24,500
ThepresentvalueofEFstaxsavingsfromitsMACRSdeductionswithrespecttothe$120,000
costoftheequipmentiscomputedasfollows.
Cost Recovery TaxSavings PresentValue
Year Basis Deduction at35% at6%
0 $120,000 $24,000 $8,400 $8,400
1 38,400 13,440 12,674
2 23,040 8,064 7,177
3 13,824 4,838 4,064
4 13,824 4,838 3,832
5 6,912 2,420 1,808
$37,955
Cashreceivedonsale $120,000
Cashpaidfornewequipment (120,000)
TaxcostofsaleinYear0 (24,500)
AftertaxtransactioncostinYear0 0
TaxsavingsfromMACRSdeprecation 37,955
NPVofcashflows $13,455

Option2:
Becausetheexchangeoflikekindequipmentisnontaxable,EFstaxbasisinthenew
equipmentwouldbeonly$50,000(thebasisofitsoldequipment.ThepresentvalueofEFs
taxsavingsfromitsMACRSdeductionswithrespecttothissubstitutedbasisiscomputedas
follows.
Substituted Recovery TaxSavings PresentValue
Year Basis Deduction at35% at6%
0 $50,000 $10,000 $3,500 $3,500
1 16,000 5,600 5,281
2 9,600 3,360 2,990
3 5,760 2,016 1,693
4 5,760 2,016 1,597
5 2,880 1,008 753
$15,814

AftertaxtransactioncostinYear0:
($6,000$2,100taxsavingsfromdeduction) $(3,900)
TaxsavingsfromMACRSdeprecation 15,814
NPVofcashflows $11,914

EFshouldchooseOption1tomaximizeNPVofcashflows.

915
 Chapter 9 - Nontaxable Exchanges

4. DMrealizeda$30,000gainontheinvoluntaryconversion.Ifitelectstodeferthegain,itwillpay
notaxonthegainin2007.However,itsbasisinthereplacementassetswouldbeonly
$120,000.Ifthe$30,000gainisaSection1231gainandDMdoesnotelecttodeferrecognition,
itcandeductits$25,000capitallosscarryforward(whichexpiresafter2007).Consequently,DM
wouldpaytaxononly$5,000netgain.Inthiscase,itsbasisinthereplacementassetswouldbe
their$150,000cost,whichitwouldrecoverasMACRSdepreciationoverfouryears.By
recognizingthegainratherthanelectingtodeferit,DMgetsahigherbasisinitsnewassetsata
greatlyreducedtaxcost.

ComprehensiveProblemsforPartThree

1. Croydensrevenuesfromsalesofgoods $12,900,000
Costofgoodssold(includingUNICAPadjustment) (9,479,000)
Grossprofitfromsalesofgoods $3,421,000
Saleofofficefurnishings:
Amountrealized $45,000
Adjustedbasis (27,300)
Gainrecognized $17,700
Ordinaryincomerecapture 12,700
Section1231gain 5,000
Capitallosscarryforwardagainst1231gain (5,000)
Grossincome $3,433,700

Deductibleexpenses:
Baddebtexpense(actualwriteoffs) (31,200)
Administrativesalariesandwages(excluding$70,000
accruedbonusestocontrollingshareholdersand
$142,800wagescapitalizedtoinventory) (399,200)
Taxes (135,000)
Interest (33,900)
Advertising (67,000)
Propertyinsurancepremiums (19,800)
Repairs,maintenance,utilities (81,000)
MACRSonassetsplacedinserviceinprioryears (187,600)
Equipmentplacedinservicein2007:
Cost $275,000
Section179expense (112,000) (112,000)
Depreciablebasis $163,000
MACRSdepreciation($163,000 .1429) (23,293)
Croydenstaxableincome $2,343,707

Note:Croydensexchangeofthetransportationequipmentforapartnershipinterestwasnontaxable.
Croydensbasisinthepartnershipinterestis$71,100(adjustedbasisoftheequipment).

916
 Chapter 9 - Nontaxable Exchanges
2. LNConsultingsrevenuesfromservicecontracts $292,000
Saleofmutualfunds
Amountrealized $18,000
Adjustedbasis (16,600)
Gainrecognized 1,400
Exchangeofcomputerequipment
Amountrealized(FMVofofficefurniture) $6,000
Adjustedbasis (3,300)
Gainrecognized 2,700
Destructionofcompanycar
Amountrealized(insurancesettlement) $7,000
Adjustedbasis (9,100)
Lossrecognized (2,100)
Grossincome $294,000

Deductibleexpenses:
Administrativesalaries (32,000)
Professionalfees (800)
Mealsandentertainment(50%$1,090) (545)
Taxes (5,000)
Interest(notincluding$1,500prepaidinterest) (6,100)
Advertising (970)
Officeexpense (1,200)
Officerent (14,400)
MACRSandexpensingelection:
Assetsplacedinserviceinprioryears $4,600
Expensingelectionforassetsplaced
inservicethisyear:
Officefurniture($6,000cost) 6,000
Officeequipment($8,300cost) 8,300
(18,900)
LNConsultingstaxableincome $214,085

917