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Welcome back. In the previous video we introduced the idea of nontaxable exchanges.

Meaning that there may be a realized gain or loss,

but the law affords taxpayers the ability to delay recognition until a future date.

One major example of nontaxable exchanges is a like-kind exchange.

Recall the section 1031 allows for nontaxable treatment,

under the like-kind exchange rules.

To qualify, first, the transaction must literally be an exchange and not a sale.

Second, the property must be used in a trade or

business or health for the production of income,

so no personal use assets qualify.

And finally, it must be an exchange of like-kind property,

meaning of the same nature or asset class.

Although the land in realty for land and realty rules are rather liberal,

as long as these are US domestic properties being exchanged.

In this video we'll look at a major wrinkle.

What if there is non-like-kind property also being exchanged in a like-kind exchange?

In particular, non-like-kind property is known as boot.

This can either be cash, or an assumption, or disposition of liabilities for example.

You can think of a situation where for example,

I will exchange my new business-use computer for your old business-use computer.

However, to make things somewhat more even,

in terms of the economic value that we're exchanging,

I might ask for you to pay me some cash too,

since I'm giving you a new computer and only getting your old computer.

A little bit of cash will make this deal more attractive to me,

and let's say you agree.

Well, we're trading a computer for a computer

which will qualify for like-kind exchange treatment,

but I'm also getting cash in this like-kind exchange.

What happens to that cash?

Can I delay recognition of that cash in terms of recognizing gains?

Well, when boot is received as part of a like-kind transaction,

the asset received must be recorded in two parts.

First, we record the property received in exchange for like-kind property.

So in our example, my new computer for your old computer.

Second, we record the property received in a quasi sale.

That is the value of the property that was essentially bought with the boot.

Or put another way,

the value of the property that was liquidated during the exchange.

In our example, if I'm giving you my new computer for your old computer and some cash,

I'm essentially liquidating or selling a part of the value

of my new computer to you for cash.

This is not an exchange.

This looks like a sale,

and a sale is a fully taxable event.

If I receive boot, it will trigger recognition to the extent there is a realized gain,

not a loss but only a gain.

Also to you, you're giving me boot.

To you giving of boot normally does not trigger recognition on your end.

It will just trigger recognition on the recipient's end when there is

a realized or economic gain on the exchange.

In particular, when boot is received and the like-kind exchange generates a realized gain,

that as the amount realized minus the adjusted basis is positive,

then the gain recognized is the lesser

of the realized gain or the amount of boot received.

Again, if boot is received but you have a realized loss,

then no recognition occurs.

And if boot is both given and received in a like-kind exchange,

then the amount of boot can be netted to determine if the taxpayer

is in a net giving or net receiving position.

Other issues related to basis,

that is, what is the basis of the boot that I received,

and what's the basis of the property that I received from you in the like-kind exchange,

knowing that there was also non-like-kind exchange property involved in the transaction.

First, the basis in the boot received is simply the fair market value of the boot.

So if you gave me $100 in cash during the like-kind exchange,

then my basis in the cash is the $100.

If you gave me a watch worth $100 during the like-kind exchange,

then my basis in the watch is $100 and so on.

Second, what is the basis in the like-kind property received?

In our example, what's my basis in the old computer that I received from you?

While here there is a formula involved.

We start with the basis of the like-kind property that I gave up,

that is I transferred to you.

I add in any basis of boot that I paid as well.

I also add any gain that I recognized.

Recall that if I recognized gain,

I should build that into my basis so that upon subsequent sale my basis is now higher,

and thus I won't be taxed on that amount twice.

Next, I subtract out the fair market value of the boot received from the basis

because as we just noted the boot has its own basis.

It is its own asset and should not be included in the like-kind properties basis.

Finally to the extent there is any loss recognized,

we'll subtract it from the basis of the like-kind property received.

Well, that's a mouthful.

Another way to figure out the basis in the like-kind property received is

to take the fair market value of the like-kind property received,

subtract any deferred gains,

and add in any deferred losses.

You'll get the same exact basis amount using either method.

The final major issue in like-kind exchanges is holding periods.

If there is boot exchanged then the holding period

of the boot begins when the taxpayer receives the boot.

That is, the holding period begins on the date of exchange.

For the like-kind property however,

we have a carryover holding period.

That is the sum of the holding period of the like-kind property given up,

plus the holding period of the like-kind property received.

It is as if you held the new property the entire time,

starting when you originally acquired the old property.

Let's do for example to illustrate the issue of realized gain,

recognized gain, and basis in the new machine in a like-kind exchange

when boot is also being exchanged.

Let's say Boise Corp. exchanges machine with a $14,000 basis

for a new machine with an $18,000 fair market value and $3,000 in cash.

The machines are used in Boise's business and are in the same general asset class.

Let's determine Boise's realized gain,

recognized gain, and basis in the new machine.

To figure out realized gain,

recall that we simply compare the amount realized,

that is all the value that the seller is getting whether it's cash or non-cash property,

and compare it to the adjusted basis of the property being given up.

Here the total amount realized is the $18,000 new machine fair market value,

plus the $3,000 in cash, for a total of $21,000.

We compare it to the adjusted basis of the machine given up of $14,000,

to yield a realized gain of $7,000.

Now, how much of this gain is recognized that is includable in this year's gross income?

Because boot is being exchanged and we have a realized gain,

then the recognized gain is calculated as the lesser of the realized gain or $7,000,

or the boot received, or $3,000 representing the cashier.

Here the lesser is the cash of $3,000.

Therefore, although the realized economic gain was $7,000,

Boise Corp. only needs to report $3,000 as gain on this year's tax return.

So, how does all of this affect the basis in the new machine received by Boise?

Well, the basis in the new machine is calculated as follows:

the basis in a like-kind property given up of $14,000,

plus the adjusted basis of any boot given up,

in this case it's zero,

there was no boot given up by Boise.

Then we add in any gain recognized or $3,000,

and subtract out the fair market value of the boot received of $3,000,

because the boot has its own basis,

we shouldn't be including it in the basis of the new machine.

Finally, we subtract out any recognized losses but there were none.

So at the end of the day Boise's basis in the new machine is $14,000.

Now, let's change the facts just a little.

Let's say that in addition to receiving $3,000 in cash,

Boise gets rid of a $6,000 liability that was related to the machine given up,

and the liability was assumed by the other party.

In other words, Boise here is getting something of value by getting rid of a liability.

Now, what is Boise's realized gain,

recognized gain and the basis in the new machine?

To figure out realized gain,

again we simply compare the amount realized,

that is all the value that the sellers getting whether it's cash or non-cash property,

including getting rid of debt and comparing it

to the adjusted basis of the property being given up.

Here, the total amount realized is the $18,000 new machine fair market value,

plus the $3,000 in cash received,

plus the $6,000 in debt relief,

in that the other party is assuming Boise's debt.

The total here is $27,000.

We compare that to the adjusted basis of the machine giving up of

$14,000 to yield a realized gain of $13,000.

Now, how much of this gain is recognized that is included in this year's gross income?

Because boot is being exchange and we have a realized gain,

then the recognized gain is calculated as the lesser of

the realized gain of $13,000 or the boot received of $9,000,

representing both the cash and the debt relief.

Here, the lesser is the boot of $9,000.

Therefore, although the realized economic gain was $13,000,

Boise Corp only needs to report $9,000 as gain on this year's tax return.

So how does all this affect the basis in the new machine received by Boise?

Well, the basis in the new machine against trusts with a basis

in the like-kind property given up of $14,000,

plus the adjusted basis of any boot given up,

in this case it's zero, there was no boot given out by Boise.

Then we add in any gain recognized or $9,000,

and subtract out the fair market value of the boot received also $9,000.

Finally, we subtract out any recognized losses but there were none.

So at the end of the day, Boise's basis in the new machine is $14,000.

So we've been dealing with all this boot,

what actually happens when there's no boot?

So let's change the facts a little again in our third example.

Let's say we still have an exchange of machines,

but that no boot is being exchanged as well.

What is Boise's realized gain,

recognized gain and basis in the new machine?

To figure out realized gain,

again we simply compare the amount realized, that is,

all the value that the seller is getting whether cash or

non-cash property and compared to the adjusted basis of the property being given up.

Here, the total amount realized is just the $18,000 new machine fair market value.

We compare to the adjusted basis of the machine given up of $14,000,

to yield a realized gain of $4,000.

Now, how much of this gain is recognized in this year's gross income?

Although no boot is being exchanged,

we can still use our handy formula,

where the recognized gain is the lesser of

the realized gain of $4,000 or the boot received, zero.

Here, the lesser is the boot of zero.

Therefore, although the realized economic gain was $4,000,

Boise corp does not need to report any gain on this year's tax return.

This, of course, should make perfect sense because

this is indeed a pure like-kind exchange.

If only like-kind property is being exchanged,

then there is mandatory non-taxable treatment of any realized gains or losses.

In this case, the realized gain of $4,000 cannot be recognized in the current period.

It would just be recognized at some later date.

Perhaps, when Boise sells the new machine.

So, how should all of this affect the basis in the new machine received by Boise?

Again, because this is a pure like-kind of exchange there is no change in basis.

The basis carries over from the old machine to the new machine.

It's pretty straightforward here.

Now, in our last example,

let's say that we bring back the boot of $3,000,

but the fair market value of the new machine is only

$13,000 not $18,000 like we had before.

What now is the realized and recognize gain to Boise on this exchange,

plus the basis in the new machine?

Same approach as before.

The realized gain is the difference between the amount realized,

here $13,000 a fair market value of the new machine,

plus the $3,000 boot received of cash,

minus the adjusted basis of the old machine given up of $14,000,

yielding a realized gain of $2,000.

Now, how much of this $2,000 is recognized on Boise's tax return?

Because boot is being exchanged and we have a realized gain,

then the recognized gain is calculated as the lesser of the realized gain or

$2,000 or the boot received of $3,000 representing the cash.

Here, the lesser is the realized gain of $2,000.

Therefore, here the realized economic gain of $2,000 is all being recognized

as gain on this year's tax return even though they actually got $3,000 in cash.

So how does all of this affect basis in the new machine received by Boise?

Well, the basis in the new machine again starts with a basis

in the like-kind property given up of $14,000,

plus the adjusted basis of any boot given up in this case it's zero.

There was no boot given up by Boise.

Then we add in any gain recognized or $2,000 and

subtract out the fair market value of the boot received or $3,000.

Finally, we subtract out any recognized losses,

but here there were none.

So at the end of the day,

Boise's basis in the new machine is $13,000.

Notice that this ending basis is $1,000 lower than the basis in the old machine.

Why is that? Why did the basis go down?

Well, recall that the realized and recognized gain was $2,000,

but the boot received was $3,000.

So there was this extra $1,000 that Boise got in cash,

but then did not recognize in this year's income.

So what the calculation does,

is it reduces the basis in the machine so that in the future when the machine is sold

the realized gain will be calculated based on this lower adjusted basis, lower by $1,000.

This postponed gain is built into

the lower basis that is keeping the sales price constant or more broadly,

the amount realized constant.

The lower the basis,

the higher will be the gain.

So that $1,000 difference between the $2,000

recognized gain and the $3,000 boot received,

is evident in this downward adjustment to

the new machine's basis and will be

recognized at a future date if the machine were to be sold.

In all, this video examined like-kind

exchange issues related to boot basis and holding periods.

Importantly, when there is a realized gain on

a like-kind exchange where a boot is also exchanged,

then the recognized gain is the lesser of the realized gain or boot received.