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)