Chapter9NontaxableExchanges

Chapter 9
Questions and Problems for Discussion
1.

Although Company PJ must have expended $700,000 for the 1,000 acres, it did not take a cost
basis in the land. Instead, PJ took a substituted basis of only $475,000 (basis of the property PJ
surrendered in the nontaxable exchange). Therefore, PJs recognized gain on sale of the land
will exceed the $600,000 appreciation by $225,000.

2.

Because of the value-for-value presumption, the amounts realized by unrelated parties on the
exchange of property are always equal.

3.

The tax consequences to unrelated parties engaging in a nontaxable exchange are completely
independent. For instance, one party could have a partially recognized gain while the other party
could have an unrecognized loss.

4.

The substituted basis of the qualifying property received in a nontaxable exchange can be more,
less, or equal to the cost of the property, depending on the gain or loss deferred on the
exchange.

5.

a. If Firm A is transacting with the KLS Partnership itself, the contribution of property (the 2
percent interest in the MG Partnership) for a 10 percent equity interest in KLS is nontaxable
to both Firm A and KLS Partnership. However, if the other party is a partner in KLS (not the
partnership), the exchange is taxable to both parties.
b. Mr. Bs exchange of land for RV stock is taxable to Mr. B but nontaxable to RV.
c.

Corporation Cs exchange of personalty for realty is taxable to both parties.

d. Company Ds exchange of inventory for a new computer system is taxable to Company C.

Not enough information is provided to determine if the exchange is taxable to the other party.
6.

Because Firm Q is exchanging inventory for land, the exchange is taxable to Firm Q. Because
Company M is exchanging business realty for investment realty, the exchange is a nontaxable,
like-kind exchange to Company M.

7.

Company W exchanged marketable securities for $250,000 of the $2 million FMV of Blackacre:
this exchange does not qualify as a like-kind exchange. Consequently, Company W recognizes
a $220,000 capital gain on the exchange.

8.

If the value of the destroyed property exceeds the insurance reimbursement and the insurance
reimbursement exceeds the propertys adjusted basis, the owner suffers an economic loss but
realizes a gain.

9.

A transfer of property to a corporation in exchange for the corporations stock is nontaxable only
if the transferor (or group of transferors) owns 80 percent or more of the corporation immediately
after the exchange. A transfer of property to a partnership in exchange for an equity interest is
nontaxable regardless of the extent of the transferors ownership after the exchange.

10. An asset has a substituted basis if the current owners basis is determined by reference to the
basis of a different asset disposed of by the owner. An asset has a carryover basis if the current
owners basis is the same as the basis of the asset in the hands of a previous owner.

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Chapter9NontaxableExchanges
11. For financial statement purposes, gain or loss realized on the exchange of one asset for another
is usually included in current year income, even if the gain or loss is not recognized for tax
purposes. The book/tax difference is temporary because the unrecognized gain or loss is merely
deferred, not eliminated.
12. The taxpayer takes a substituted basis in the newly issued stock so that the deferred gain (equal
to the unrealized appreciation in the transferred property) is embedded in the stock. However,
the corporation takes a carryover basis in the property so that the corporation will recognize the
unrealized appreciation on subsequent disposition of the property. Thus, both the shareholder
and the corporation have deferred gain with respect to their new assets.
13. Congress has no quarrel with taxpayers who sell securities at a gain, then immediately reacquire
the securities. This strategy accelerates the recognition of income and the payment of tax on
that income.
14. Firm B should sell the block of stock with the less volatile market price to minimize the risk of a
significant price increase between date of sale and date of reacquisition.
15. Gain or loss realized on a nontaxable exchange is not eliminated but merely deferred until the
taxpayer disposes of the property received in the exchange in a taxable transaction.
Application Problems
1.

a. Realized gain $6,700 ($16,000 amount realized $9,300 tax basis); recognized gain
$6,700; tax basis in new equipment $16,000 cost.
b. Realized gain $6,700 ($16,000 amount realized $9,300 tax basis); recognized gain -0-; tax
basis in new equipment $9,300 substituted basis.
c.

2.

If the exchange was taxable, gain recognized on sale of the new equipment is $850
($16,850 amount realized $16,000 tax basis). If the exchange was nontaxable, gain
recognized on sale of the new equipment is $7,550 ($16,850 amount realized $9,300 tax
basis).

a. Realized loss $12,000 ($95,000 amount realized $107,000 tax basis); recognized loss
$12,000; tax basis in new equipment $95,000 cost.
b. Realized loss $12,000 ($95,000 amount realized $107,000 tax basis); recognized loss -0-;
tax basis in new equipment $107,000 substituted basis.
c.

3.

If the exchange was taxable, gain recognized on sale of the new equipment is $5,000
($100,000 amount realized $95,000 tax basis). If the exchange was nontaxable, loss
recognized on sale of the new equipment is $7,000 ($100,000 amount realized $107,000
tax basis).

a. Rufus must pay $12,500 boot in addition to transferring property with a $77,500 FMV. The
total amount transferred to Hardy must be $90,000, which is the FMV of the property Hardy
transfers to Rufus.
b. Rufus realizes a $27,500 gain ($90,000 amount realized [$50,000 tax basis of transferred
property + $12,500 boot paid]). Rufus recognizes no gain because it did not receive boot. Its
basis in the property acquired is $62,500 ($50,000 substituted basis of property transferred
+ $12,500 boot).
c.

Hardy realizes a $30,000 gain ($90,000 amount realized [$77,500 FMV of property acquired
+ $12,500 boot received] $60,000 tax basis of transferred property). Rufus recognizes
$12,500 gain equal to the boot received. Its basis in the property acquired is $60,000
(substituted basis of property transferred).

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Chapter9NontaxableExchanges
4.

a. Realized gain $12,000; recognized gain $12,000; tax basis in new asset $32,000.
b. Realized gain $12,000; recognized gain -0-; tax basis in new asset $20,000.
c.

In this case, the old asset must be worth only $30,300. Realized gain $10,300; recognized
gain $10,300; tax basis in new asset $32,000.

d. Realized gain $10,300; recognized gain $-0-; tax basis in new asset $21,700.
e. In this case, the old asset must be worth $36,500. Realized gain $16,500; recognized gain
$16,500; tax basis in new asset $32,000.
f.
5.

Realized gain $16,500; recognized gain $4,500; tax basis in new asset $20,000.

a. Realized loss $15,000; recognized loss $15,000; tax basis in new property $65,000.
b. Realized loss $15,000; recognized loss -0-; tax basis in new property $80,000.
c.

In this case, the old property must be worth only $63,000. Realized loss $17,000;
recognized loss $17,000; tax basis in new property $65,000.

d. Realized loss $17,000; recognized loss -0-; tax basis in new property $82,000.
e. In this case, the old property must be worth $73,000. Realized loss $7,000; recognized loss
$7,000; tax basis in new property $65,000.
f.
6.

Realized loss $7,000; recognized loss -0-; tax basis in new property $72,000.

a. Realized gain $11,900; recognized gain $2,500; tax basis in new asset $9,100.
b. Realized gain $11,900; recognized gain $11,900; tax basis in new asset $7,000.

7.

a. Neils book gain is $327,400 ($932,000 amount realized $604,600 book basis). Neils tax
gain is $359,000 ($932,000 amount realized $573,000 tax basis).
b. Neils book and tax basis in the investment asset equal the $932,000 cost of the asset.
c.

Neils book gain is $327,440 ($932,000 amount realized $604,600 book basis). Its tax gain
is zero.

d. Neils book basis in the investment asset is its $932,000 cost. Neils tax basis in the
investment asset is $573,000, the substituted basis of the business asset.
8.

a. Neils book and tax gain equal $68,000 ($1,000,000 amount realized $932,000 book/tax
basis).
b. Neils book gain is $68,000 ($1,000,000 amount realized $932,000 book basis). Neils tax
gain is $427,000 ($1,000,000 amount realized $573,000 tax basis).

9.

a. CCs recognized gain on the exchange of the old asset for the new asset is $6,000 ($16,000
amount realized $10,000 adjusted basis). Because this gain exceeds the $7,000
depreciation that CC deducted with respect to the old asset, CC must recapture the entire
gain as ordinary income. CCs cost basis in the new asset is $16,000.
b. If the old asset and new asset are like-kind, CC does not recognize any of the $6,000 gain
realized on the exchange. CCs substituted basis in the new asset is $10,000.

10. a. XYZ realized a $7,000 gain ($28,500 amount realized [$13,000 basis in old equipment +
$8,500]). Because this is a like-kind exchange, XYZ does not recognize any gain.
b. XYZ takes a $21,500 basis in the new equipment.

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Chapter9NontaxableExchanges
11. a. OCD realized a $16,300 gain ($48,000 amount realized $31,700 basis in old furniture).
Because this is a like-kind exchange, OCD recognizes only $3,000 gain (boot received). The
recognized gain is recaptured ordinary income.
b. OCD takes a $31,700 basis in the new furniture.
12. a. The residential rental property must have a $185,000 FMV.
b. Firm ML realizes a $27,000 gain but recognizes no gain on this like-kind exchange.
c.

Firm MLs basis in the 20 acres is $173,000.

13. a. The residential rental property must have a $222,000 FMV.

b. ML realizes a $64,000 gain and recognizes a $22,000 gain on this like-kind exchange. The
recognized gain is Section 1231 gain.
c.

MLs basis in the 20 acres is $158,000.

14. a. POs realized gain is $637,000 ($1,040,000 amount realized [$325,000 FMV of Boardwalk +
$715,000 debt relief] $403,000 adjusted basis). PO must recognize the entire $637,000
gain because the $715,000 boot (debt relief) exceeds the realized gain. POs tax basis in
Boardwalk is $325,000.
b. QRs realized gain is $247,000 ($1,040,000 amount realized $793,000 adjusted basis
[$78,000 adjusted basis in Boardwalk + $715,000 debt assumption]). QR recognizes no gain
and takes a $78,000 basis in Marvin Gardens.
15. a. Bs realized gain is $160,000 ($525,000 amount realized $365,000 adjusted basis
[$240,000 adjusted basis in Blackacre + $125,000 net debt assumption]). It recognizes no
gain and takes a $365,000 basis in Whiteacre.
b. Ws realized gain is $425,000 ($525,000 amount realized [$400,000 FMV of Blackacre +
$125,000 net relief of debt] $100,000 adjusted basis). It must recognize $125,000 of the
gain because of the receipt of $125,000 boot (net debt relief). Its tax basis in Blackacre is
$100,000.
16. a. FF realized a $35,300 gain ($250,000 insurance reimbursement $214,700 adjusted basis)
on the involuntary conversion of its warehouse. Because FF spent at least $250,000 on the
construction of a replacement building and the replacement occurred within the two taxable
years following the year of the conversion, it does not recognize any of the realized gain.
FFs basis in the replacement building is $264,700 ($300,000 cost $35,300 unrecognized
gain.
b. FF realized a $14,700 loss ($200,000 insurance reimbursement $214,700 adjusted basis)
on the involuntary conversion of its warehouse. It can recognize the entire loss as an
ordinary casualty loss. FFs basis in the replacement building is the buildings $300,000 cost.
17. a. NP must recognize the entire $120,000 realized gain ($650,000 insurance reimbursement
$530,000 adjusted basis) on the involuntary conversion.
b. NP does not recognize any of the $120,000 realized gain because it spent at least $650,000
on replacement property within two taxable years following the year in which the gain was
realized.
c.

Because NP did not acquire the replacement property within two taxable years following the
year in which the gain was realized, it must recognize the entire $120,000 gain.

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Chapter9NontaxableExchanges
18. a. RP realized a $295,000 gain on the involuntary conversion. Because it reinvested only
$775,000 of the $975,000 amount realized in replacement property, it must recognize a
$200,000 gain. RPs basis in the inventory is $200,000, and its basis in the new real estate
is $680,000 ($775,000 $95,000 deferred gain).
b. In this case, RP realized a $125,000 gain on the involuntary conversion. Because it
reinvested only $775,000 of the $975,000 amount realized in replacement property, it must
recognize the entire gain. RPs basis in the inventory is $200,000, and its basis in the new
real estate is $775,000.
c.

In this case, RP does not recognize any of the $295,000 realized gain on the involuntary
conversion. RPs basis in the new real estate is $780,000 ($1,075,000 cost $295,000
deferred gain).

19. a. Company K realized a $64,000 gain ($480,000 insurance - $416,000 adjusted basis). It
recognized $30,000 of the gain ($480,000 insurance - $450,000 replacement cost of new
equipment).
b. Company Ks tax basis in the new equipment is $416,000 ($450,000 cost - $34,000 deferred
gain).
c.

Company K would recognize no gain and would take a $428,000 basis in the new
equipment ($492,000 cost - $64,000 deferred gain).

20. a. Mr. Boyd transfers cash and property with a $30,000 total FMV. Ms. Tuck transfers property
with a $60,000 FMV. Therefore, Mr. Boyd should receive 400 shares worth $30,000, and Ms.
Tuck should receive 800 shares worth $60,000.
b. Mr. Boyd realizes a $16,800 gain ($30,000 FMV stock received $13,200 basis of cash and
property transferred). Because Mr. Boyd and Ms. Tuck own 100% of BTs outstanding stock
immediately after their exchanges of property for stock, the exchanges are nontaxable. Mr.
Boyd recognizes no gain and takes a $13,200 substituted basis in his 400 BT shares.
c.

Ms. Tuck realizes an $18,500 gain ($60,000 FMV stock received $41,500 basis of property
transferred). Because Mr. Boyd and Ms. Tuck own 100% of BTs outstanding stock
immediately after their exchanges of property for stock, the exchanges are nontaxable. Ms.
Tuck recognizes no gain and takes a $41,500 substituted basis in her 800 BT shares.

d. BTs book basis in the inventory transferred by Mr. Boyd is $20,000 (FMV). Its tax basis in
the inventory is a $3,200 carryover basis. BTs book basis in the equipment transferred by
Ms. Tuck is $60,000 (FMV). Its tax basis in the inventory is a $41,500 carryover basis.
21. a. A primary reason for a parent corporation to use wholly owned subsidiaries is to isolate the
risk associated with the business operated by the subsidiary. A second reason is to provide
an independent management team and organizational structure for the subsidiarys
business. A third reason is that employees of the subsidiary can be given an equity stake in
the subsidiary without giving them equity in the larger parent corporation. (Obviously, there
are many other reasons that students may identify.)
b. PVs realized gain is $6 million, but its recognized gain on this nontaxable corporate
formation is zero. PVs basis in its SV stock is $4 million.

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Chapter9NontaxableExchanges
22. a. Because Mr. ZJ does not own at least 80 percent of ZJLs outstanding stock immediately
after the exchange, he must recognize the entire $154,000 realized gain ($400,000 FMV of
stock received $246,000 adjusted basis of business assets transferred) on the exchange
of property for stock.
b. Although Mr. ZJ owns a 66.7 percent majority interest in ZJLs outstanding stock, he does
not meet the 80 percent control requirement and must recognize a $154,000 gain on the
exchange of property for stock.
c.

Because Mr. ZJ will own 83 percent of ZJLs outstanding stock immediately after the
exchange, he does not recognize gain on the exchange of property for stock.

23. a. Mr. ZJ and Mrs. L are both transferring property to ZJL Corporation in exchange for stock.
Immediately after the exchange, the transferors will own 100 percent of ZJLs outstanding
stock. Consequently, Mr. ZJs exchange is nontaxable, and he does not recognize any gain
on the exchange.
b. Mr. ZJs basis in his 1,000 shares will be a $246,000 substituted basis. Mrs. Ls basis in her
1,000 shares will be a $200,000 cost basis.
c.

ZJLs tax basis in the assets transferred from Mr. ZJ will be their $246,000 carryover basis.

24. a. Corporation A realized a $4,000 loss, and Corporation Z realized a $68,000 gain on the
contribution of business equipment to AZ Partnership. Neither corporation recognizes gain
or loss.
b. As basis in its one-half equity interest in AZ Partnership is $134,000, while Zs basis in its
one-half equity interest in AZ Partnership is $62,000.
c.

AZ Partnerships basis in the equipment contributed by A is $34,000 and in the equipment

contributed by B is $12,000.

25. a. Ms. Dees realized loss on sale is $16,000 ($46,000 amount realized [500 shares $92
selling price per share] $62,000 basis [500 shares $124 cost per share]). Because she
repurchased the shares within 30 days of sale, none of the loss is recognized under the
wash sale rule.
b. Because Ms. Dees repurchase occurred more than 30 days after the sale, her $16,000
realized loss is recognized.
c. Her basis in the 600 shares is $72,400 ($56,400 cost (600 shares $94 cost per share) +
$16,000 unrecognized loss).
d. Her basis in the 600 shares is $59,400 (600 shares $99 cost per share).
26. a. SW can recognize the $14,000 loss realized on the sale.
b. Because SW purchased 1,000 new shares of Delta stock within 30 days prior to the sale, the
wash sale rule prohibits SW from recognizing any loss on the sale.
c.

Because SW purchased 1,000 new shares of Delta stock within 30 days after the sale, the
wash sale rule prohibits SW from recognizing any loss on the sale.

d. The wash sale rule does not apply to realized gains. Thus, SW must recognize the $11,000
gain realized on the sale.

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Chapter9NontaxableExchanges
27. a. N/A
b. SWs basis in the 1,200 Delta shares purchased on May 1 is $124,400 ($110,400 cost +
$14,000 unrecognized loss).
c.

SWs basis in the 1,200 Delta shares purchased on June 8 is $124,400 ($110,400 cost +
$14,000 unrecognized loss).

d. SWs basis in the 1,200 Delta shares purchased on June 8 is their $110,400 cost.
28. KAIs net income per books before tax
Book gain on equipment theft
Tax gain on equipment theft

$500,000
$(18,000)
5,000

Book gain on like-kind exchange of realty

KAIs taxable income

(13,000)
(350,000)
$137,000

29. Alfixs net income per books before tax

MACRS depreciation in excess of book depreciation
Book loss on sale of Greenacre:
$820,000 $835,000 book (cost) basis
$15,000
Tax gain on sale of Greenacre:
$820,000 $500,000 tax (substituted) basis 320,000

$789,300
(24,230)

335,000
Book gain on sale of Dundee stock
$112,000 $91,000 book basis
Tax gain on sale of Dundee stock;
$112,000 $68,200 tax basis

$(21,000)
43,800
22,800
$1,122,870

Alfixs taxable income

Issue Recognition Problems
1.

Can ST reduce the boot received in the form of $450,000 of debt relief by the $150,000 cash
paid to WX? Does ST receive $450,000 or $300,000 boot in this exchange? Can WZ offset the
$150,000 cash received against its assumption of the $450,000 mortgage on its new office
building? Does WZ recognize any of the $1.2 million gain realized on the exchange?

2.

How is the $5,000 boot received allocated between item 1 and item 2? Since JK realized an
$8,000 gain on the exchange of item 1 and a $4,000 loss on the exchange of item 2, can JK
allocate the $5,000 cash receipt to item 2 (and avoid gain recognition with respect to item 1)?

3.

Does the exchange of real estate located in the United States for real estate located in a foreign
country qualify as a like-kind exchange?

4.

Does the destruction of the cattle because of the threat of disease qualify as an involuntary
conversion? Did FM use the $150,000 to replace the cattle?

5.

Is a movie theater complex similar or related in service or use to a drive-in movie complex that
includes other outdoor entertainment equipment? Does the fact that Company T was no longer
operating the drive-in movie theater make any difference in applying the involuntary conversion
rules?

6.

Does Firm F have an additional two years after 2007 to invest the $25,000 insurance
reimbursement in property similar or related in service or use to the office building that was
involuntarily converted in 2004? If Firm F does not invest the $25,000 in an office building, how
does it account for the payment?

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Chapter9NontaxableExchanges
7.

Must Company C recognize the $350,000 realized gain on the involuntary conversion of the
industrial plant because it failed to place the new plant in service during the two taxable years
following the year of the involuntary conversion?

8.

Can ABC amend its 2006 tax return and recognize the $295,000 gain, thereby increasing both
the taxable income and the NOL carryback deduction to that year? If ABC can amend its 2006
return to revoke the deferral election, is there any tax benefit in doing so?

9.

What portion of the 35 percent partnership interest is payment for Mr. Ps professional services
and what portion is in exchange for the copyright? What is the FMV of Mr. Ps professional
services and must he recognize compensation income even though Partnership M paid him with
equity? Can Partnership M capitalize the payment for Mr. Ps professional services to its tax
basis in the three buildings he designed?

10. Are the shares of XZY nonvoting preferred stock substantially the same as XZY voting common
stock for purposes of the wash sale rule?
Research Problems
1.

Kiley Communication Inc. can avoid recognizing its realized gain only if radio broadcast licenses
and television broadcast licenses qualify as like-kind property under Section 1031. In TAM
200035005, the IRS noted that the like-kind status of intangible assets depends on the nature of
the rights conferred by the asset and the nature of the underlying property to which the
intangible asset relates. Because an FCC license confers a right to broadcast on a designated
channel and frequency range regardless of whether the license relates to a television station or
a radio station, the IRS concluded that the differences between radio and television licenses are
merely differences in grade or quality and do not change the nature of the right conferred.
Therefore, FCC radio and television broadcast licenses are like-kind property, and Kiley can
treat the exchange as nontaxable, thereby deferring recognition of its $3.9 million gain.

2.

When a taxpayer elects to defer the recognition of gain realized on an involuntary conversion,
the taxpayer must acquire replacement property that is similar or related in service or use to
the converted property. The Internal Revenue Code provides an alternative to a direct
replacement of property: under Section 1033(a)(2)(A): the acquisition of control of a corporation
that owns replacement property is a qualifying acquisition for purposes of the nonrecognition
rule. According to Section 1033(a)(2)(E)(i), the term control means the ownership of stock
representing at least 80 percent of the total voting power of all classes of outstanding stock
entitled to vote plus 80 percent of the total number of all other shares.
Since Mr. Bryan Olgivie is planning to purchase 100 percent of the outstanding stock of
IceMagic, he will acquire control of the corporation within the meaning of Section 1033(a)(2)(A).
Therefore, if the corporations indoor ice-skating rink qualifies as replacement property, Mr.
Olgivie can defer recognition of the $266,600 gain realized on the involuntary conversion of his
indoor roller skating rink. No direct authority addresses whether an ice skating rink and a roller
skating rink are similar or related in service or use within the meaning of Section 1033.
Certainly, Mr. Olgivie can make a good argument that the two entertainment facilities meet the
statutory requirement. However, because the issue is based on facts and circumstances, the
IRS will not issue an advanced letter ruling. Consequently, if Mr. Olgivie purchases the IceMagic
stock, he will bear the risk that the IRS will not accept his argument.

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Chapter9NontaxableExchanges
3.

According to Section 351(a) and Section 368(c), Mr. Pomeroys exchange of business assets for
Pomeroy Ski stock was nontaxable if Mr. Pomeroy owned at least 80 percent of the corporations
outstanding stock immediately after the exchange. According to case law, Mr. Pomeroy met the
statutory timing requirement as long as his control was absolute and unrestricted, even if such
control was momentary. The fact that Mr. Pomeroy gave away a controlling stock interest after
the exchange does not violate Section 351(a) because he was under no preexisting legal
obligation to do so. See Wilgard Realty Co. v. Commissioner, F.2d 514 (CA-2, 1942).

4.

Bullen Companys adjusted tax basis in the machinery on January 1, 2007, was $252,839
($413,000 cost $160,161 depreciation for the first two years in the seven-year recovery
period). The depreciation for 2007 (third year in the recovery period) is $72,234 ($413,000
17.49%). Section 168(i)(7) provides that in the case of property transferred in a Section 351
exchange, the transferee steps into the shoes of the transferor with respect to depreciation of
the carryover basis. Prop. Reg. Sec. 1.168-5(b)(4)(i) clarifies that when the transferor and
transferee have the same taxable year, the depreciation deduction for the year of transfer is
prorated between them on a monthly basis. Bullen Company transferred the equipment to Eaton
Inc. on April 1. Consequently, Bullens share of the 2007 depreciation is $18,059 (3 months/12
months $72,234), and the carryover basis of the property on April 1 is $234,780 ($252,839
$18,059 depreciation from January 1 through March 31). Eatons share of the 2007 depreciation
is $54,175 (9 months/12 months $72,234).

Tax Planning Cases

1.

a. Because NS will be in 80 percent control of Corporation T immediately after the exchange, it

cannot recognize its $1.6 million realized loss on the exchange of realty for stock. The loss
will be deferred until NS disposes of the newly issued T stock.
b. Because NS and Corporation T are related parties, NSs $1.6 million realized loss on sale
would be disallowed.
c.

By leasing the realty to Corporation T, NS avoids the deferral or loss disallowance rules and
retains the opportunity to sell the realty to an unrelated purchaser at a future date. Thus, NS
keeps its unrealized loss, Corporation T has use of the realty, and the tax cost of NSs rent
income and the tax savings of Corporation Ts rent deduction net to zero. This seems to be
the best course of action.

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Chapter9NontaxableExchanges
2.

Party As offer:
Firm Ks amount realized on sale (cash)
Basis of land sold
Capital gain recognized on sale
Tax

$770,000
(600,000)
$170,000
.15
$25,500

Cash received
Tax cost
NPV of after-tax cash flow

$770,000
(25,500)
$744,500

Party Bs offer:
Firm Ks amount realized (FMV of land)
Basis of land exchanged
Deferred gain on like-kind exchange

$725,000
(600,000)
$125,000

Estimated FMV of new land in two years

($725,000 1.21% growth factor for two years)
Firm Ks substituted basis of new land
Capital gain recognized in two years on sale
Tax rate on capital gain
Tax

$877,250
(600,000)
$277,250
.15
$41,588

Cash received
Tax cost
After-tax cash flow from sale
Discount factor at 7%
NPV of after-tax cash flow

$877,250
(41,588)
$835,662
.873
$729,533

Firm K should accept Party As offer to maximize NPV.

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3.

Under both Option 1 and Option 2, Corporation EF will obtain the use of new equipment with a
5-year MACRS recovery period. The options have different tax consequences and transaction
costs, which result in different cash flows over the recovery period.
Option 1:
Amount realized on sale of old equipment
$120,000
Adjusted basis
(50,000)
Gain recognized on sale
$70,000
Tax rate
.35
Tax
$24,500
The present value of EFs tax savings from its MACRS deductions with respect to the $120,000
cost of the equipment is computed as follows.
Year
0
1
2
3
4
5

Cost
Basis
$120,000

Recovery
Deduction

Tax Savings
at 35%

Present Value
at 6%

$8,400
13,440
8,064
4,838
4,838
2,420

$8,400
12,674
7,177
4,064
3,832
1,808
$37,955

$24,000
38,400
23,040
13,824
13,824
6,912

Cash received on sale

Cash paid for new equipment
Tax cost of sale in Year 0
After-tax transaction cost in Year 0
Tax savings from MACRS deprecation
NPV of cash flows

$120,000
(120,000)
(24,500)
-037,955
$13,455

Option 2:
Because the exchange of like-kind equipment is nontaxable, EFs tax basis in the new
equipment would be only $50,000 (the basis of its old equipment. The present value of EFs
tax savings from its MACRS deductions with respect to this substituted basis is computed as
follows.
Year
0
1
2
3
4
5

Substituted
Basis
$50,000

Recovery
Deduction
$10,000
16,000
9,600
5,760
5,760
2,880

After-tax transaction cost in Year 0:

($6,000 $2,100 tax savings from deduction)
Tax savings from MACRS deprecation
NPV of cash flows

Tax Savings
at 35%

Present Value
at 6%

$3,500
5,600
3,360
2,016
2,016
1,008

$3,500
5,281
2,990
1,693
1,597
753
$15,814

$(3,900)
15,814
$11,914

EF should choose Option 1 to maximize NPV of cash flows.

9-11

Chapter9NontaxableExchanges
4.

DM realized a $30,000 gain on the involuntary conversion. If it elects to defer the gain, it will pay
no tax on the gain in 2007. However, its basis in the replacement assets would be only
$120,000. If the $30,000 gain is a Section 1231 gain and DM does not elect to defer recognition,
it can deduct its $25,000 capital loss carryforward (which expires after 2007). Consequently, DM
would pay tax on only $5,000 net gain. In this case, its basis in the replacement assets would be
their $150,000 cost, which it would recover as MACRS depreciation over four years. By
recognizing the gain rather than electing to defer it, DM gets a higher basis in its new assets at a
greatly reduced tax cost.

Comprehensive Problems for Part Three

1.

Croydens revenues from sales of goods

Cost of goods sold (including UNICAP adjustment)
Gross profit from sales of goods
Sale of office furnishings:
Amount realized
$45,000
Adjusted basis
(27,300)
Gain recognized
$17,700
Ordinary income recapture
Section 1231 gain
Capital loss carryforward against 1231 gain
Gross income

$12,900,000
(9,479,000)
$3,421,000

12,700
5,000
(5,000)
$3,433,700

Deductible expenses:
Bad-debt expense (actual write-offs)
Administrative salaries and wages (excluding $70,000
accrued bonuses to controlling shareholders and
$142,800 wages capitalized to inventory)
Taxes
Interest
Advertising
Property insurance premiums
Repairs, maintenance, utilities
MACRS on assets placed in service in prior years
Equipment placed in service in 2007:
Cost
$275,000
Section 179 expense
(112,000)
Depreciable basis
$163,000
MACRS depreciation ($163,000 .1429)
Croydens taxable income

(31,200)
(399,200)
(135,000)
(33,900)
(67,000)
(19,800)
(81,000)
(187,600)
(112,000)
(23,293)
$2,343,707

Note: Croydens exchange of the transportation equipment for a partnership interest was nontaxable.
Croydens basis in the partnership interest is $71,100 (adjusted basis of the equipment).

9-12

Chapter9NontaxableExchanges
2.

LN Consultings revenues from service contracts

Sale of mutual funds
Amount realized
Adjusted basis
Gain recognized
Exchange of computer equipment
Amount realized (FMV of office furniture)
Adjusted basis
Gain recognized
Destruction of company car
Amount realized (insurance settlement)
Adjusted basis
Loss recognized
Gross income
Deductible expenses:
Administrative salaries
Professional fees
Meals and entertainment (50% $1,090)
Taxes
Interest (not including $1,500 prepaid interest)
Advertising
Office expense
Office rent
MACRS and expensing election:
Assets placed in service in prior years
Expensing election for assets placed
in service this year:
Office furniture ($6,000 cost)
Office equipment ($8,300 cost)

$292,000
$18,000
(16,600)
1,400
$6,000
(3,300)
2,700
$7,000
(9,100)
(2,100)
$294,000
(32,000)
(800)
(545)
(5,000)
(6,100)
(970)
(1,200)
(14,400)
$4,600
6,000
8,300
(18,900)
$214,085

LN Consultings taxable income

9-13