Example of a Partially Taxable Exchange

A Qualified Section 351(b) Exchange

  • You transfer property with an adjusted basis of $20,000 to a corporation for stock.
  • Immediately after the transfer you control the corporation.
  • In exchange, you receive stock with a fair market value of $20,000
  • You also receive $10,000 in cash
  • The property you transferred was subject to a mortgage of $6,000.
  • The total amount you receive from the corporation is $36,000:
    • $20,000 in stock plus
    • $10,000 cash plus
    • $6,000 mortgage assumed by the corporation.

After the Exchange

,After the exchange, the following items are addressed:

  1. Gain recognition.
  2. Basis in stock you received from the corporation.
  3. Corporation's basis in property it received from you.

1. Gain Recognition

You must recognize gain up to the amount of boot received. Boot is money and the fair market value of other property you receive in addition to the stock you receive in an exchange for your property.

In the example, you received $10,000 in cash (boot). Although your realized gain was $16,000 ($36,000 in stock and cash you received minus $20,000 in property you transferred), only the $10,000 cash payment must be recognized (reported) for tax purposes.

Liabilities Assumed by the Corporation

For gain recognition purposes, liabilities assumed by the corporation in an exchange are not treated as if you (the transferor) received money or other property from the corporation. Therefore, liabilities assumed by a corporation are generally ignored for gain recognition purposes.

However, if the liabilities assumed by the corporation exceed the adjusted basis of the property transferred to it, the amount by which such liabilities exceed the adjusted basis of the property is taxable gain.

2. Basis in Stock You Received From the Corporation

In an exchange, certain items may increase or decrease your stock basis.

Recognized gain:

A shareholder must increase his stock basis by the amount of his recognized gain on an exchange. Therefore, in the above example, you must increase your stock basis by the recognized gain of $10,000.

Liabilities Assumed by the Corporation:

For basis reduction purposes, in an exchange, liabilities assumed by the corporation are generally treated as if you received money. Therefore, liabilities assumed by the corporation generally reduce your stock basis.

For example, if you transfer property to a corporation and the property is subject to a mortgage, if the corporation assumes the mortgage your stock basis is reduced by the amount of the mortgage it assumed.

However, if the liability being assumed is of the type that would give rise to a DEDUCTION by the corporation, then, your basis would not be reduced by this type of liability.

Accounts payable assumed by a corporation from a cash basis taxpayer is a type of liability that could give rise to a deductible expense on the corporation's books after an exchange took place.

For example, if a taxpayer on a calendar year using the cash method of accounting purchases $100 worth of office supplies in December with payment due in January of the following tax year.

As of December, a cash method taxpayer would not have recorded the transaction on books of the business since expenses are only recorded when actually paid.

If an exchange took place in December and the cash method taxpayer transferred the $100 liability for the office supplies to the corporation and the corporation assumed the liability and paid the $100 in January of the following year, the corporation would record the $100 expense on its books in January for the office supplies.

Therefore, this is a liability that would give rise to an expense, and it would not reduce your stock basis.

Boot Received from the Corporation:

Tax rules also require you to reduce your stock basis up to the amount of boot you receive in an exchange. In the above example, you must reduce your stock basis by $10,000, the mount of cash (boot) you received.

Figuring Your Stock Basis After the Exchange

Your basis in the stock you received after the exchange is $14,000.

Determined as follows:

  • Adjusted basis of the property you transferred to the corporation: $20,000 plus
  • Your recognized gain: $10,000, minus
  • Cash (boot) you received: $10,000, minus
  • The mortgage assumed by the corporation: $6,000, equals
  • Your basis in the stock: $14,000

3. Corporation's Basis in Property it Received From You

The corporation's basis in the property it received is $30,000.

Determined as follows:

  • The corporation takes your adjusted basis in the property you transferred to it as its basis, which is $20,000, and
  • Increases it by your recognized gain of $10,000.

Tax rules say, the corporation must increase its basis in the property it receives by the gain recognized by the shareholder. Don't confuse recognized gain with realized gain.

Realized gain is the total gain and may not necessarily be recognized for tax reporting purposes. In the above example, $16,000 was the realized gain.

Recognized gain is the portion of the realized gain that must be reported on your income tax return. In the above example, recognized gain (taxable gain) was $10,000 and is the amount of gain you must report for tax purposes.

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