Normally, in a sale or exchange of property, either a taxable gain or a deductible loss is realized.  The gain or loss is normally determined as the difference between the total of the money, the fair market value of the property and services you receive, plus any liabilities assumed by the buyer or receiver, or that are attached to the property, and your adjusted basis in the property you sell or transfer. 

But there are certain cases in which property can be exchanged and no gain or loss is recognized for federal income tax purposes.  One of the most common types of non-taxable exchanges are like-kind exchanges, in which property is exchanged for other property that is similar in kind and use.

You must report trades of like-kind property on Form 8824, Like-Kind Exchanges.  If you have a recognized gain or loss on Form 8824, you should report it on either Schedule D or Form 4797, whichever applies.  Schedule D would normally be used for personal or investment assets, and Form 4797 would be used for business assets.

Nontaxable Like-Kind Exchanges

If the exchange involves only the like-kind property, and no money or other unlike property is involved, the exchange is nontaxable and the basis of the property received is generally the same as the basis of the property given.  Any gain or loss on the exchange would not be recognized until you sell or dispose of the property you receive.

If you pay money or give up other, different property in a like-kind exchange, no gain or loss is recognized on the exchange, but your basis in the new property is your basis in the like-kind property you give up plus the money you pay and the value of the other property you give.

In order for an exchange to be nontaxable, the properties given and received in the exchange have to meet two tests: they have to be qualifying property, and they have to be like-kind property.

Qualifying Property

Qualifying property is property used for productive use in a trade or business, or for investment purposes.  It could include land, buildings, machinery and vehicles.  But property that is held for sale in a trade or business, including stock in trade, inventory, merchandise, and real estate held by dealers, does not qualify for nontaxable exchanges.  Also, stocks, bonds or other securities held for investment do not qualify for like-kind nontaxable exchanges.

Personal property, such as your automobile and your home, do not normally qualify for nontaxable exchanges.

Like-Kind Property

Also, the property must be like-kind; that is, the property you give and receive in the exchange must be similar in nature or character, and generally used for the same purpose.  The fact that the properties are different in terms of their grade or quality does not disqualify them as like-kind property.

Real Property

The exchange of personal property for real property would not be a like-kind exchange.  But the exchange of different types of real property could be considered like-kind exchanges.  For example, the exchange of real property with one type of building or improvement for real property with another type of building or improvement would be considered a like-kind exchange.  And exchanges of urban property for rural property, or improved property for unimproved property could qualify as like-kind exchanges.

Like-kind exchanges could include the exchange of owned real estate for leased real estate under certain conditions.  For example, the exchange of owned property for property under a lease of more than 30 years could be considered a like-kind exchange.

For purposes of qualifying as nontaxable exchanges, a distinction is made between real property located in the United States and real property located outside the country.  An exchange of foreign and U.S. properties would not be considered a like-kind exchange.  But there is an exception for condemned property.  For purposes of postponing gain on a condemnation, foreign and U.S. real property could be considered like-kind property.

Personal Property

Personal property, for these purposes, is depreciable, tangible personal property for productive use in a trade or business, or for investment purposes, and does not include property used for personal purposes.  Depreciable, tangible personal property can qualify as like-kind property in a nontaxable exchange, based on different General Asset Classes and different Product Classes of property.

If the property given and the property received in an exchange fall into the same General Asset Class, or the same Product Class, they are considered like-kind property and would qualify for a nontaxable exchange.

The General Asset Classes include the following types of property:

• Office furniture, fixtures and equipment
• Computers and peripheral equipment
• Data handling equipment other than computers
• Aircraft
• Automobiles and taxis
• Buses
• Light general purpose trucks
• Heavy general purpose trucks
• Railroad cars and locomotives
• Tractors for over-the-road use
• Trailers and trailer-mounted containers
• Marine vessels
• Steam and electric generation and distribution systems

Product Classes are those defined in the North American Industry Classification System (NAICS).

Intangible Property

Intangible property can also be considered like-kind property and can qualify for a nontaxable exchange.  There are no like-classes defined for intangible property, and whether they are considered like-kind will depend on the nature of the underlying asset, and the rights involved in the intangible asset.  For example, an exchange of a copyright on a book for a patent on an invention may not be considered a like-kind exchange. 

Foreign and U.S. Property

Exchanges of personal property used predominately outside the United States for property used predominately inside the United States do not qualify as like-kind exchanges, even though the property may be similar in nature and use.  A gain or loss on an exchange would be recognized for U.S. income tax purposes.

Deferred Exchanges

If you give up property used for business or investment in return for replacement property of a like-kind that you will receive later, the exchange is a deferred exchange and can still qualify as a nontaxable exchange.  But if you receive money or other unlike property in full payment for the property you gave up, before you receive the replacement property, the transaction will be considered a sale rather than an exchange, and you would have to recognize any gain or loss on the transaction.  If you subsequently receive the replacement property, you would be considered to have bought it.

In order to be a qualified deferred exchange, eligible to be treated as nontaxable, you must identify the replacement property to be received within 45 days after transferring the property you give up in the exchange.  The property you expect to receive should be clearly identified in writing and this document should be delivered to the other party in the exchange.

Identifying Replacement Property

You can cancel an identification of the replacement property at any time during the 45-day identification period.  And, you can identify more than one replacement property. The limit is three separate properties, or any number of replacement properties provided that the total fair market value at the end of the 45-day identification period is not more than twice the fair market value of the property you are giving up in the exchange, as of the date you transfer it.

In a deferred exchange you can identify replacement property that has not yet been produced.  In this case, the property must be received by the later of 180 days after you transferred the property you gave up in the exchange, or the due date for filing your tax return for the year in which you gave up property in the exchange.

Partially Nontaxable Exchanges

A partially nontaxable exchange is one in which you receive like-kind property, and also receive money or unlike property, and you realize a gain on the exchange.  In this type of exchange, you are taxed on any gain you realize, but only up to the amount of the money or the fair market value of the unlike property you receive.  Any loss you incur on the exchange would not be deductible.

Maximum Amount of Gain

To figure the amount of your taxable gain on a partially nontaxable exchange, you would take the total of the money and the fair market value of the unlike property you receive and reduce this total by any exchange expenses, such as closing costs on the transaction.  The result is the maximum amount of taxable gain.  Then you would determine your gain on the overall exchange.  Your recognized gain for tax purposes is the lesser of these two results.

Your gain or loss on the overall exchange is the amount you realize on the exchange, less your adjusted basis in the property you give up.  The amount you realize includes money and the fair market value of the property you receive, plus any liabilities assumed by the other party, or that are attached to the property you transfer, such as real estate taxes or a mortgage.  Your adjusted basis in the property you give up in the exchange is its original basis, plus any improvements or additions, and less any depreciation, casualty losses, or other adjustments.  Your original basis in the property could be its cost or some other basis, depending on whether you acquired the property by purchase, gift, inheritance, or exchange.

Example

You exchange a tractor used in your business for another, similar tractor.  You originally paid $25,000 for your tractor and you have taken depreciation of $15,000.  You have a bank loan balance of  $1,000 outstanding on your tractor, which will be paid by the other party.  The tractor you are to receive has a fair market value of $12,000 and you will also receive other equipment with a fair market value of $500.  You have a partially taxable gain, as follows:

• Amount realized on the exchange = $13,500 ($12,000 for the tractor plus $500 for the other equipment plus $1,000 bank loan)
• Your adjusted basis = $10,000 ($25,000 original cost minus $15,000 depreciation)
• Realized gain = $3,500 ($13,500 amount realized less $10,000 adjusted basis)
• Taxable gain = $1,500 ($1,000 bank loan balance plus $500 fair market value of other equipment)

Unlike Property Given in Exchange

If you give up unlike property in what would otherwise be a nontaxable, like-kind exchange, you have to recognize gain or loss on the unlike property. The gain or loss that you would recognize, and report on your tax return, would be the difference between the fair market value of the unlike property and its adjusted basis.  For example:

You exchange  real estate you are holding for investment for other real estate.  The fair market value of the real estate you are receiving is $40,000 and the real estate you are giving up cost you $35,000 and presently has a fair market value of $38,000.  In addition, you are giving 100 shares of stock A that cost you $15 a share and have a present market value of $20 a share.

·        You would have a realized gain of $5,000 on the real estate ($40,000 fair market value of the property you are receiving minus $35,000 basis in the property you are giving up).  None of this gain would be taxable because the exchange qualifies as a nontaxable like-kind exchange.

·        You would have to recognize a gain of $500 for tax purposes for the difference between the fair market value of the stock ($20 a share times 100 shares = $2,000), and the basis of the stock ($15 a share times 100 shares = $1,500), since the stock is unlike property in the exchange.

Basis of Property Received in a Partially Taxable Exchange

When you receive different properties in a partially taxable exchange, you must first determine the total basis to be assigned to the properties received.  This is the total adjusted basis of the properties you give up plus any additional costs you incur on the exchange and any gain you recognize for tax purposes on the exchange, minus any money you receive and any loss you recognize on the exchange.

Once you determine the total basis of the property you receive, you allocate it first to the unlike property based on its fair market value, and the rest is allocated to the like-kind property received.

Example 1

You exchange a parcel of land with a building used for business purposes.  You originally bought the land for $58,000 and paid $25,000 to construct the building.  You have taken $20,000 depreciation on the building.  In the exchange, you receive land with a fair market value of $60,000, machinery with a fair market value of $7,000, and cash of $1,000.  You pay closing costs of $500 on the exchange.

• Your amount you realize on the exchange is $67,500 ($60,000 fair market value of the land, plus $7,000 fair market value of the machinery, plus cash of $1,000 you receive minus $500 of exchange expenses you pay).
• Your adjusted basis in the property you give up is $63,000 ($58,000 cost of the land plus $25,000 cost of the building, less $20,000 depreciation).
• Your realized gain on the exchange is $4,500 ($67,500 amount realized minus $63,000 adjusted basis).
• Your taxable gain on the exchange is $4,500 (which is the lesser of the overall gain realized on the exchange, and the amount of money and the fair market value of the unlike property you receive, which in this case would be a total of $7,500: cash of $1,000 received, less $500 in closing costs, plus $7,000 fair market value of machinery).
• Your basis in the property received would be a total of $67,000 as follows:
• Your total adjusted basis in the property you give up: $63,000
• Plus your additional cost of $500 for closing costs
• Plus the gain you recognized on the exchange: $4,500
• Minus the money you received: $1,000
• Of the total basis of $67,000, the amount allocated to the machinery you receive would be its fair market value of $7,000, and the balance of $60,000 would be allocated as the basis of the land you receive.

Example 2

You exchange a truck used for business purposes.  You originally bought the truck for $35,000 and have taken $20,000 depreciation on the truck.  In the exchange, you receive another truck with a fair market value of $16,000, machinery with a fair market value of $4,000, and cash of $750.  You pay closing costs of $400 on the exchange.

• Your amount you realize on the exchange is $20,350 ($16,000 fair market value of the truck, plus $4,000 fair market value of the machinery, plus cash of $750 minus $400 exchange expenses).
• Your adjusted basis in the property you give up is $15,000 ($35,000 cost of the truck less $20,000 depreciation).
• Your realized gain on the exchange is $5,350 ($20,350 amount realized minus $15,000 adjusted basis).
• Your taxable gain on the exchange is $4,350 (which is the lesser of the overall gain on the exchange of $5,350 and the amount of money and the fair market value of the unlike property you receive, which in this case would be a total of $4,350: cash of $750 received, less $400 in closing costs, plus $4,000 fair market value of machinery).
• Your basis in the property received would be a total of $19,000 as follows:
• Your total adjusted basis in the property you give up: $15,000
• Plus your additional cost of $400 for closing costs
• Plus the gain you recognized on the exchange: $4,350
• Minus the money you received: $750

Of the total basis of $19,000, the amount allocated to the machinery you receive would be its fair market value of $4,000, and the balance of $15,000 would be allocated as the basis of the truck you receive.

Like-Kind Exchanges Between Related Persons

Exchanges of like-kind property between related persons are subject to special rules.  Related persons include members of your family, corporations and partnerships in which you have more than 50% ownership.  If either party disposes of the property within 2 years after the exchange, the exchange does not qualify as a nontaxable exchange and any gain or loss on the original exchange would have to be recognized (reported for tax purposes) at the time of disposing of the property received in exchange.

Example

You and your brother both have rental properties that you use for the production of income.  You decide to exchange certain rental properties.  At the time of the exchange, the fair market value of your property was $80,000.  You originally paid $60,000 for it and have claimed depreciation of $40,000.  Your brother’s rental property has a fair market value of $82,000.  He paid $65,000 for it and has claimed $35,000 in depreciation.   You give your property plus $2,000 in cash in exchange for your bother’s property.  Less than 2 years after the exchange, you sell the property you received in the exchange to a third party for $85,000.

• You realized a gain of $64,000 on the exchange ($82,000 fair market value of the property you received plus $2,000 cash you paid, minus your adjusted basis of $20,000 in the property you gave up).
• Your brother realized a gain of $52,000 ($80,000 fair market value of the property he received, plus the $2,000 cash you paid, less his adjusted basis of $30,000 in the property he gave up).
• Since this was a nontaxable, like-kind exchange at the time, you did not recognize any gain for tax purposes, and your basis in the property you received is your basis in the property you gave up, $20,000, plus the $2,000 you paid in cash, for a total of $22,000.
• Your brother recognized gain on the exchange only for the $2,000 he received from you in cash.  His basis in the property he received is his adjusted basis in the property he gave up, $30,000, minus the $2,000 cash received, plus the gain of $2,000 that was recognized, for a total of $30,000.

When you sell your property within 2 years, the exchange is disqualified as a nontaxable exchange.

• You would have to recognize your gain of $64,000 on the exchange, and a gain of $63,000 on the sale of the property ($85,000 realized on the sale minus your adjusted basis of $22,000).
• Your brother would also have to recognize the rest of his gain from the exchange (total realized gain of $52,000 less $2,000 recognized gain), and his basis in his property would be increased to $80,000 ($30,000 basis from the exchange plus $50,000 additional gain recognized).

Exceptions to Related Persons Rule