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Retired or demolished property. The adjustments reflected in adjusted basis generally do not include deductions for depreciation on retired or demolished parts of section 1250 property unless these deductions are reflected in the basis of replacement property that is section 1250 property.

Example.

A wing of your building is totally destroyed by fire. The depreciation adjustments figured in the adjusted basis of the building after the wing is destroyed do not include any deductions for depreciation on the destroyed wing unless it is replaced and the adjustments for depreciation on it are reflected in the basis of the replacement property.

Figuring straight line depreciation. The useful life and salvage value you would have used to figure straight line depreciation are the same as those used under the depreciation method you actually used. If you did not use a useful life under the depreciation method actually used (such as with the units-of-production method) or if you did not take salvage value into account (such as with the declining balance method), the useful life or salvage value for figuring what would have been the straight line depreciation is the useful life and salvage value you would have used under the straight line method.

Salvage value and useful life are not used for the ACRS method of depreciation. Figure straight line depreciation for ACRS real property by using its 15-, 18-, or 19-year recovery period as the property's useful life.

The straight line method is applied without any basis reduction for the investment credit.

Property held by lessee. If a lessee makes a leasehold improvement, the lease period for figuring what would have been the straight line depreciation adjustments includes all renewal periods. This inclusion of the renewal periods cannot extend the lease period taken into account to a period that is longer than the remaining useful life of the improvement. The same rule applies to the cost of acquiring a lease.

The term renewal period means any period for which the lease may be renewed, extended, or continued under an option exercisable by the lessee. However, the inclusion of renewal periods cannot extend the lease by more than two-thirds of the period that was the basis on which the actual depreciation adjustments were allowed.

Rehabilitation expenses. A part of the special 60-month depreciation adjustment allowed for rehabilitation expenses incurred before 1987 in connection with low-income rental housing is additional depreciation. The additional depreciation is the special depreciation adjustments that are more than the adjustments that would have resulted if the straight line method, normal useful life, and salvage value had been used.

Example.

On January 7, 2001, Fred Plums, a calendar year taxpayer, sold real property in which the entire basis was from rehabilitation expenses of $40,000 incurred in 1985. The property was placed in service on January 3, 1986. Under the special depreciation provisions for rehabilitation expenses, the property was depreciated under the straight line method using a useful life of 60 months (5 years) and no salvage value. If Fred had used the regular straight line method, he would have used a salvage value of $4,000 and a useful life of 15 years, and would have had a depreciable basis of $36,000. Depreciation under the straight line method would have been $2,400 each year (1/15 x $36,000). On January 1, 2001, the additional depreciation for the property was $4,000, figured as follows.

	Depreciation	Straight Line	Additional
	Claimed	Depreciation	Depreciation
1986	8,000	2,400	5,600
1987	8,000	2,400	5,600
1988	8,000	2,400	5,600
1989	8,000	2,400	5,600
1990	8,000	2,400	5,600
1991		2,400	(2,400)
1992		2,400	(2,400)
1993		2,400	(2,400)
1994		2,400	(2,400)
1995		2,400	(2,400)
1996		2,400	(2,400)
1997		2,400	(2,400)
1998		2,400	(2,400)
1999		2,400	(2,400)
2000		2,400	(2,400)
Total	$40,000	$36,000	$4,000

Applicable Percentage

The applicable percentage used to figure the ordinary income because of additional depreciation depends on whether the real property you disposed of is nonresidential real property, residential rental property, or low-income housing. The percentages for these types of real property are as follows.

Nonresidential real property. For real property that is not residential rental property, the applicable percentage for periods after 1969 is 100%. For periods before 1970, the percentage is zero and no ordinary income because of additional depreciation before 1970 will result from its disposition.

Residential rental property. For residential rental property (80% or more of the gross income is from dwelling units) other than low-income housing, the applicable percentage for periods after 1975 is 100%. The percentage for periods before 1976 is zero. Therefore, no ordinary income because of additional depreciation before 1976 will result from a disposition of residential rental property.

Low-income housing. Low-income housing includes all the following types of residential rental property.

Federally assisted housing projects if the mortgage is insured under section 221(d)(3) or 236 of the National Housing Act or housing financed or assisted by direct loan or tax abatement under similar provisions of state or local laws.
Low-income rental housing for which a depreciation deduction for rehabilitation expenses was allowed.
Low-income rental housing held for occupancy by families or individuals eligible to receive subsidies under section 8 of the United States Housing Act of 1937, as amended, or under provisions of state or local laws that authorize similar subsidies for low-income families.
Housing financed or assisted by direct loan or insured under Title V of the Housing Act of 1949.

The applicable percentage for low-income housing is 100% minus 1% for each full month the property was held over 100 full months. If you have held low-income housing at least 16 years and 8 months, the percentage is zero and no ordinary income will result from its disposition.

Foreclosure. If low-income housing is disposed of because of foreclosure or similar proceedings, the monthly applicable percentage reduction is figured as if you disposed of the property on the starting date of the proceedings.

Example.

On June 1, 1992, you acquired low-income housing property. On April 3, 2003 (130 months after the property was acquired), foreclosure proceedings were started on the property and on December 3, 2004 (150 months after the property was acquired), the property was disposed of as a result of the foreclosure proceedings. The property qualifies for a reduced applicable percentage because it was held more than 100 full months. The applicable percentage reduction is 30% (130 months minus 100 months) rather than 50% (150 months minus 100 months) because it does not apply after April 3, 2003, the starting date of the foreclosure proceedings. Therefore, 70% of the additional depreciation is treated as ordinary income.

Holding period. The holding period used to figure the applicable percentage for low-income housing generally starts on the day after you acquired it. For example, if you bought low-income housing on January 1, 1988, the holding period starts on January 2, 1988. If you sold it on January 2, 2004, the holding period is exactly 192 full months. The applicable percentage for additional depreciation is 8%, or 100% minus 1% for each full month the property was held over 100 full months.

Holding period for constructed, reconstructed, or erected property. The holding period used to figure the applicable percentage for low-income housing you constructed, reconstructed, or erected starts on the first day of the month it is placed in service in a trade or business, in an activity for the production of income, or in a personal activity.

Property acquired by gift or received in a tax-free transfer. For low-income housing you acquired by gift or in a tax-free transfer the basis of which is figured by reference to the basis in the hands of the transferor, the holding period for the applicable percentage includes the holding period of the transferor.

If the adjusted basis of the property in your hands just after acquiring it is more than its adjusted basis to the transferor just before transferring it, the holding period of the difference is figured as if it were a separate improvement. See Low-Income Housing With Two or More Elements, next.

Low-Income Housing With Two or More Elements

If you dispose of low-income housing property that has two or more separate elements, the applicable percentage used to figure ordinary income because of additional depreciation may be different for each element. The gain to be reported as ordinary income is the sum of the ordinary income figured for each element.

The following are the types of separate elements.

A separate improvement (defined later).
The basic section 1250 property plus improvements not qualifying as separate improvements.
The units placed in service at different times before all the section 1250 property is finished. For example, this happens when a taxpayer builds an apartment building of 100 units and places 30 units in service (available for renting) on January 4, 2003, 50 on July 18, 2003, and the remaining 20 on January 18, 2004. As a result, the apartment house consists of three separate elements.

The 36-month test for separate improvements. A separate improvement is any improvement (qualifying under The 1-year test, below) added to the capital account of the property, but only if the total of the improvements during the 36-month period ending on the last day of any tax year is more than the greatest of the following amounts.

One-fourth of the adjusted basis of the property at the start of the first day of the 36-month period, or the first day of the holding period of the property, whichever is later.
One-tenth of the unadjusted basis (adjusted basis plus depreciation and amortization adjustments) of the property at the start of the period determined in (1).
$5,000.

The 1-year test. An addition to the capital account for any tax year (including a short tax year) is treated as an improvement only if the sum of all additions for the year is more than the greater of $2,000 or 1% of the unadjusted basis of the property. The unadjusted basis is figured as of the start of that tax year or the holding period of the property, whichever is later. In applying the 36-month test, improvements in any one of the 3 years are omitted entirely if the total improvements in that year do not qualify under the 1-year test.

Example.

The unadjusted basis of a calendar year taxpayer's property was $300,000 on January 1 of this year. During the year, the taxpayer made improvements A, B, and C, which cost $1,000, $600, and $700, respectively. The sum of the improvements, $2,300, is less than 1% of the unadjusted basis ($3,000), so the improvements do not satisfy the 1-year test and are not treated as improvements for the 36-month test. However, if improvement C had cost $1,500, the sum of these improvements would have been $3,100. Then, it would be necessary to apply the 36-month test to figure if the improvements must be treated as separate improvements.

Addition to the capital account. Any addition to the capital account made after the initial acquisition or completion of the property by you or any person who held the property during a period included in your holding period is to be considered when figuring the total amount of separate improvements.

The addition to the capital account of depreciable real property is the gross addition not reduced by amounts attributable to replaced property. For example, if a roof with an adjusted basis of $20,000 is replaced by a new roof costing $50,000, the improvement is the gross addition to the account, $50,000, and not the net addition of $30,000. The $20,000 adjusted basis of the old roof is no longer reflected in the basis of the property. The status of an addition to the capital account is not affected by whether it is treated as a separate property for determining depreciation deductions.

Whether an expense is treated as an addition to the capital account may depend on the final disposition of the entire property. If the expense item property and the basic property are sold in two separate transactions, the entire section 1250 property is treated as consisting of two distinct properties.

Unadjusted basis. In figuring the unadjusted basis as of a certain date, include the actual cost of all previous additions to the capital account plus those that did not qualify as separate improvements. However, the cost of components retired before that date is not included in the unadjusted basis.

Holding period. Use the following guidelines for figuring the applicable percentage for property with two or more elements.

The holding period of a separate element placed in service before the entire section 1250 property is finished starts on the first day of the month that the separate element is placed in service.
The holding period for each separate improvement qualifying as a separate element starts on the day after the improvement is acquired or, for improvements constructed, reconstructed, or erected, the first day of the month that the improvement is placed in service.
The holding period for each improvement not qualifying as a separate element takes the holding period of the basic property.

If an improvement by itself does not meet the 1-year test (greater of $2,000 or 1% of the unadjusted basis), but it does qualify as a separate improvement that is a separate element (when grouped with other improvements made during the tax year), determine the start of its holding period as follows. Use the first day of a calendar month that is closest to the middle of the tax year. If there are two first days of a month that are equally close to the middle of the year, use the earlier date.

Figuring ordinary income attributable to each separate element. Figure ordinary income attributable to each separate element as follows.

Step 1. Divide the element's additional depreciation after 1975 by the sum of all the elements' additional depreciation after 1975 to determine the percentage used in Step 2.

Step 2. Multiply the percentage figured in Step 1 by the lesser of the additional depreciation after 1975 for the entire property or the gain from disposition of the entire property (the difference between the fair market value or amount realized and the adjusted basis).

Step 3. Multiply the result in Step 2 by the applicable percentage for the element.

Example.

You sold at a gain of $25,000 low-income housing property subject to the ordinary income rules of section 1250. The property consisted of four elements (W, X, Y, and Z).

Step 1. The additional depreciation for each element is: W-$12,000; X-None; Y-$6,000; and Z-$6,000. The sum of the additional depreciation for all the elements is $24,000.

Step 2. The depreciation deducted on element X was $4,000 less than it would have been under the straight line method. Additional depreciation on the property as a whole is $20,000 ($24,000 - $4,000). $20,000 is lower than the $25,000 gain on the sale, so $20,000 is used in Step 2.

Step 3. The applicable percentages to be used in Step 3 for the elements are: W-68%; X-85%; Y-92%; and Z-100%.

From these facts, the sum of the ordinary income for each element is figured as follows.

	Step 1	Step 2	Step 3	Ordinary Income
W.....	.50	$10,000	68%	$ 6,800
X......	-0-	-0-	85%	-0-
Y......	.25	5,000	92%	4,600
Z......	.25	5,000	100%	5,000
Sum of ordinary income of separate elements				$16,400

Gain Treated as Ordinary Income

To find what part of the gain from the disposition of section 1250 property is treated as ordinary income, follow these steps.

In a sale, exchange, or involuntary conversion of the property, figure the amount realized that is more than the adjusted basis of the property. In any other disposition of the property, figure the fair market value that is more than the adjusted basis.
Figure the additional depreciation for the periods after 1975.
Multiply the lesser of (1) or (2) by the applicable percentage, discussed earlier. Stop here if this is residential rental property or if (2) is equal to or more than (1). This is the gain treated as ordinary income because of additional depreciation.
Subtract (2) from (1).
Figure the additional depreciation for periods after 1969 but before 1976.
Add the lesser of (4) or (5) to the result in (3). This is the gain treated as ordinary income because of additional depreciation.

A limit on the amount treated as ordinary income for gain on like-kind exchanges and involuntary conversions is explained later.

Use Part III, Form 4797, to figure the ordinary income part of the gain.

Corporations. Corporations, other than S corporations, have an additional amount to recognize as ordinary income on the sale or other disposition of section 1250 property. The additional amount treated as ordinary income is 20% of the excess of the amount that would have been ordinary income if the property were section 1245 property over the amount treated as ordinary income under section 1250. Report this additional ordinary income on Form 4797, Part III, line 26 (f).

Installment Sales

If you report the sale of property under the installment method, any depreciation recapture under section 1245 or 1250 is taxable as ordinary income in the year of sale. This applies even if no payments are received in that year. If the gain is more than the depreciation recapture income, report the rest of the gain using the rules of the installment method. For this purpose, include the recapture income in your installment sale basis to determine your gross profit on the installment sale.

If you dispose of more than one asset in a single transaction, you must figure the gain on each asset separately so that it may be properly reported. To do this, allocate the selling price and the payments you receive in the year of sale to each asset. Report any depreciation recapture income in the year of sale before using the installment method for any remaining gain.

For a detailed discussion of installment sales, see Publication 537.

Gifts

If you make a gift of depreciable personal property or real property, you do not have to report income on the transaction. However, if the person who receives it (donee) sells or otherwise disposes of the property in a disposition subject to recapture, the donee must take into account the depreciation you deducted in figuring the gain to be reported as ordinary income.

For low-income housing, the donee must take into account the donor's holding period to figure the applicable percentage. See Applicable Percentage and its discussion Holding period under Section 1250 Property, earlier.

Part gift and part sale or exchange. If you transfer depreciable personal property or real property for less than its fair market value in a transaction considered to be partly a gift and partly a sale or exchange and you have a gain because the amount realized is more than your adjusted basis, you must report ordinary income (up to the amount of gain) to recapture depreciation. If the depreciation (additional depreciation, if section 1250 property) is more than the gain, the balance is carried over to the transferee to be taken into account on any later disposition of the property. However, see Bargain sale to charity, later.

Example.

You transferred depreciable personal property to your son for $20,000. When transferred, the property had an adjusted basis to you of $10,000 and a fair market value of $40,000. You took depreciation of $30,000. You are considered to have made a gift of $20,000, the difference between the $40,000 fair market value and the $20,000 sale price to your son. You have a taxable gain on the transfer of $10,000 ($20,000 sale price minus $10,000 adjusted basis) that must be reported as ordinary income from depreciation. You report $10,000 of your $30,000 depreciation as ordinary income on the transfer of the property, so the remaining $20,000 depreciation is carried over to your son for him to take into account on any later disposition of the property.

Gift to charitable organization. If you give property to a charitable organization, you figure your deduction for your charitable contribution by reducing the fair market value of the property by the ordinary income and short-term capital gain that would have resulted had you sold the property at its fair market value at the time of the contribution. Thus, your deduction for depreciable real or personal property given to a charitable organization does not include the potential ordinary gain from depreciation.

You also may have to reduce the fair market value of the contributed property by the long-term capital gain (including any section 1231 gain) that would have resulted had the property been sold. For more information, see Giving Property That Has Increased in Value in Publication 526, Charitable Contributions.

Bargain sale to charity. If you transfer section 1245 or section 1250 property to a charitable organization for less than its fair market value and a deduction for the contribution part of the transfer is allowable, your ordinary income from depreciation is figured under different rules. First, figure the ordinary income as if you had sold the property at its fair market value. Then, allocate that amount between the sale and the contribution parts of the transfer in the same proportion that you allocated your adjusted basis in the property to figure your gain. See Bargain Sale under Gain or Loss From Sales and Exchanges in chapter 1. Report as ordinary income the lesser of the ordinary income allocated to the sale or your gain from the sale.

Example.

You sold section 1245 property in a bargain sale to a charitable organization and are allowed a deduction for your contribution. Your gain on the sale was $1,200, figured by allocating 20% of your adjusted basis in the property to the part sold. If you had sold the property at its fair market value, your ordinary income would have been $5,000. Your ordinary income is $1,000 ($5,000 x 20%) and your section 1231 gain is $200 ($1,200 - $1,000).

Transfers at Death

When a taxpayer dies, no gain is reported on depreciable personal property or real property transferred to his or her estate or beneficiary. For information on the tax liability of a decedent, see Publication 559, Survivors, Executors, and Administrators.

However, if the decedent disposed of the property while alive and, because of his or her method of accounting or for any other reason, the gain from the disposition is reportable by the estate or beneficiary, it must be reported in the same way the decedent would have had to report it if he or she were still alive.

Ordinary income due to depreciation must be reported on a transfer from an executor, administrator, or trustee to an heir, beneficiary, or other individual if the transfer is a sale or exchange on which gain is realized.

Example 1.

Janet Smith owned depreciable property that, upon her death, was inherited by her son. No ordinary income from depreciation is reportable on the transfer, even though the value used for estate tax purposes is more than the adjusted basis of the property to Janet when she died. However, if she sold the property before her death and realized a gain and if, because of her method of accounting, the proceeds from the sale are income in respect of a decedent reportable by her son, he must report ordinary income from depreciation.

Example 2.

The trustee of a trust created by a will transfers depreciable property to a beneficiary in satisfaction of a specific bequest of $10,000. If the property had a value of $9,000 at the date used for estate tax valuation purposes, the $1,000 increase in value to the date of distribution is a gain realized by the trust. Ordinary income from depreciation must be reported by the trust on the transfer.

Like-Kind Exchanges and Involuntary Conversions

A like-kind exchange of your depreciable property or an involuntary conversion of the property into similar or related property will not result in your having to report ordinary income from depreciation unless money or property other than like-kind, similar, or related property is also received in the transaction. For information on like-kind exchanges and involuntary conversions, see chapter 1.

Depreciable personal property. If you have a gain from either a like-kind exchange or an involuntary conversion of your depreciable personal property, the amount to be reported as ordinary income from depreciation is the amount figured under the rules explained earlier (see Section 1245 Property), limited to the sum of the following amounts.

The gain that must be included in income under the rules for like-kind exchanges or involuntary conversions.
The fair market value of the like-kind, similar, or related property other than depreciable personal property acquired in the transaction.

Example 1.

You bought a new machine for $4,300 cash plus your old machine for which you were allowed a $1,360 trade-in. The old machine cost you $5,000 two years ago. You took depreciation deductions of $3,950. Even though you deducted depreciation of $3,950, the $310 gain ($1,360 trade-in allowance minus $1,050 adjusted basis) is not reported because it is postponed under the rules for like-kind exchanges and you received only depreciable personal property in the exchange.

Example 2.

You bought office machinery for $1,500 two years ago and deducted $780 depreciation. This year a fire destroyed the machinery and you received $1,200 from your fire insurance, realizing a gain of $480 ($1,200 - $720 adjusted basis). You choose to postpone reporting gain, but replacement machinery cost you only $1,000. Your taxable gain under the rules for involuntary conversions is limited to the remaining $200 insurance payment. All your replacement property is depreciable personal property, so your ordinary income from depreciation is limited to $200.

Example 3.

A fire destroyed office machinery you bought for $116,000. The depreciation deductions were $91,640 and the machinery had an adjusted basis of $24,360. You received a $117,000 insurance payment, realizing a gain of $92,640.

You immediately spent $105,000 of the insurance payment for replacement machinery and $9,000 for stock that qualifies as replacement property and you choose to postpone reporting the gain. $114,000 of the $117,000 insurance payment was used to buy replacement property, so the gain that must be included in income under the rules for involuntary conversions is the part not spent, or $3,000. The part of the insurance payment ($9,000) used to buy the nondepreciable property (the stock) also must be included in figuring the gain from depreciation.

The amount you must report as ordinary income on the transaction is $12,000, figured as follows.

1)	Gain realized on the transaction ($92,640) limited to depreciation ($91,640)		$91,640
2)	Gain includible in income (amount not spent)	$3,000
	Plus: fair market value of property other than depreciable personal property (the stock)	9,000	12,000
Amount reportable as ordinary income (lesser of (1) or (2))			$12,000

If, instead of buying $9,000 in stock, you bought $9,000 worth of depreciable personal property similar or related in use to the destroyed property, you would only report $3,000 as ordinary income.

Depreciable real property. If you have a gain from either a like-kind exchange or involuntary conversion of your depreciable real property, ordinary income from additional depreciation is figured under the rules explained earlier (see Section 1250 Property), limited to the greater of the following amounts.

The gain that must be reported under the rules for like-kind exchanges or involuntary conversions plus the fair market value of stock bought as replacement property in acquiring control of a corporation.
The gain you would have had to report as ordinary income from additional depreciation had the transaction been a cash sale minus the cost (or fair market value in an exchange) of the depreciable real property acquired.

The ordinary income not reported for the year of the disposition is carried over to the depreciable real property acquired in the like-kind exchange or involuntary conversion as additional depreciation from the property disposed of. Further, to figure the applicable percentage of additional depreciation to be treated as ordinary income, the holding period starts over for the new property.

Example.

The state paid you $116,000 when it condemned your depreciable real property for public use. You bought other real property similar in use to the property condemned for $110,000 ($15,000 for depreciable real property and $95,000 for land). You also bought stock for $5,000 to get control of a corporation owning property similar in use to the property condemned. You choose to postpone reporting the gain. If the transaction had been a sale for cash only, under the rules described earlier, $20,000 would have been reportable as ordinary income because of additional depreciation.

The ordinary income to be reported is $6,000, which is the greater of the following amounts.

The gain that must be reported under the rules for involuntary conversions, $1,000 ($116,000 - $115,000) plus the fair market value of stock bought as qualified replacement property, $5,000, for a total of $6,000.
The gain you would have had to report as ordinary income from additional depreciation ($20,000) had this transaction been a cash sale minus the cost of the depreciable real property bought ($15,000), or $5,000.

The ordinary income not reported, $14,000 ($20,000 - $6,000), is carried over to the depreciable real property you bought as additional depreciation.

Basis of property acquired. If the ordinary income you have to report because of additional depreciation is limited, the total basis of the property you acquired is its fair market value (its cost, if bought to replace property involuntarily converted into money) minus the gain postponed.

If you acquired more than one item of property, allocate the total basis among the properties in proportion to their fair market value (their cost, in an involuntary conversion into money). However, if you acquired both depreciable real property and other property, allocate the total basis as follows.

Subtract the ordinary income because of additional depreciation that you do not have to report from the fair market value (or cost) of the depreciable real property acquired.
Add the fair market value (or cost) of the other property acquired to the result in (1).
Divide the result in (1) by the result in (2).
Multiply the total basis by the result in (3). This is the basis of the depreciable real property acquired. If you acquired more than one item of depreciable real property, allocate this basis amount among the properties in proportion to their fair market value (or cost).
Subtract the result in (4) from the total basis. This is the basis of the other property acquired. If you acquired more than one item of other property, allocate this basis amount among the properties in proportion to their fair market value (or cost).

Example 1.

In 1986, low-income housing property that you acquired and placed in service in 1981 was destroyed by fire and you received a $90,000 insurance payment. The property's adjusted basis was $38,400, with additional depreciation of $14,932. On December 1, 1986, you used the insurance payment to acquire and place in service replacement low-income housing property.

Your realized gain from the involuntary conversion was $51,600 ($90,000 - $38,400). You chose to postpone reporting the gain under the involuntary conversion rules. Under the rules for depreciation recapture on real property, the ordinary gain was $14,932, but you did not have to report any of it because of the limit for involuntary conversions.

The basis of the replacement low-income housing property was its $90,000 cost minus the $51,600 gain you postponed, or $38,400. The $14,932 ordinary gain you did not report is treated as additional depreciation on the replacement property. When you dispose of the property, your holding period for figuring the applicable percentage of additional depreciation to report as ordinary income will have begun December 2, 1986, the day after you acquired the property.

Example 2.

John Adams received a $90,000 fire insurance payment for depreciable real property (office building) with an adjusted basis of $30,000. He uses the whole payment to buy property similar in use, spending $42,000 for depreciable real property and $48,000 for land. He chooses to postpone reporting the $60,000 gain realized on the involuntary conversion. Of this gain, $10,000 is ordinary income from additional depreciation but is not reported because of the limit for involuntary conversions of depreciable real property. The basis of the property bought is $30,000 ($90,000 - $60,000), allocated as follows.

The $42,000 cost of depreciable real property minus $10,000 ordinary income not reported is $32,000.
The $48,000 cost of other property (land) plus the $32,000 figured in (1) is $80,000.
The $32,000 figured in (1) divided by the $80,000 figured in (2) is 0.4.
The basis of the depreciable real property is $12,000. This is the $30,000 total basis multiplied by the 0.4 figured in (3).
The basis of the other property (land) is $18,000. This is the $30,000 total basis minus the $12,000 figured in (4).

The ordinary income that is not reported ($10,000) is carried over as additional depreciation to the depreciable real property that was bought and may be taxed as ordinary income on a later disposition.

Multiple Properties

If you dispose of both depreciable property and other property in one transaction and realize a gain, you must allocate the amount realized between the two types of property in proportion to their respective fair market values to figure the part of your gain to be reported as ordinary income from depreciation. Different rules may apply to the allocation of the amount realized on the sale of a business that includes a group of assets. See chapter 2.

In general, if a buyer and seller have adverse interests as to the allocation of the amount realized between the depreciable property and other property, any arm's-length agreement between them will establish the allocation.

In the absence of an agreement, the allocation should be made by taking into account the appropriate facts and circumstances. These include, but are not limited to, a comparison between the depreciable property and all the other property being disposed of in the transaction. The comparison should take into account all the following facts and circumstances.

The original cost and reproduction cost of construction, erection, or production.
The remaining economic useful life.
The state of obsolescence.
The anticipated expenditures required to maintain, renovate, or modernize the properties.

Like-kind exchanges and involuntary conversions. If you dispose of and acquire both depreciable personal property and other property (other than depreciable real property) in a like-kind exchange or involuntary conversion, the amount realized is allocated in the following way. The amount allocated to the depreciable personal property disposed of is treated as consisting of, first, the fair market value of the depreciable personal property acquired and, second (to the extent of any remaining balance), the fair market value of the other property acquired. The amount allocated to the other property disposed of is treated as consisting of the fair market value of all property acquired that has not already been taken into account.

If you dispose of and acquire depreciable real property and other property in a like-kind exchange or involuntary conversion, the amount realized is allocated in the following way. The amount allocated to each of the three types of property (depreciable real property, depreciable personal property, or other property) disposed of is treated as consisting of, first, the fair market value of that type of property acquired and, second (to the extent of any remaining balance), any excess fair market value of the other types of property acquired. If the excess fair market value is more than the remaining balance of the amount realized and is from both of the other two types of property, you can apply the unallocated amount in any manner you choose.

Example.

A fire destroyed your property with a total fair market value of $50,000. It consisted of machinery worth $30,000 and nondepreciable property worth $20,000. You received an insurance payment of $40,000 and immediately used it with $10,000 of your own funds (for a total of $50,000) to buy machinery with a fair market value of $15,000 and nondepreciable property with a fair market value of $35,000. The adjusted basis of the destroyed machinery was $5,000 and your depreciation on it was $35,000. You choose to postpone reporting your gain from the involuntary conversion. You must report $9,000 as ordinary income from depreciation arising from this transaction, figured as follows.

The $40,000 insurance payment must be allocated between the machinery and the other property destroyed in proportion to the fair market value of each. The amount allocated to the machinery is 30,000/50,000 x $40,000, or $24,000. The amount allocated to the other property is 20,000/50,000 x $40,000, or $16,000. Your gain on the involuntary conversion of the machinery is $24,000 minus $5,000 adjusted basis, or $19,000.
The $24,000 allocated to the machinery disposed of is treated as consisting of the $15,000 fair market value of the replacement machinery bought and $9,000 of the fair market value of other property bought in the transaction. All $16,000 allocated to the other property disposed of is treated as consisting of the fair market value of the other property that was bought.
Your potential ordinary income from depreciation is $19,000, the gain on the machinery, because it is less than the $35,000 depreciation. However, the amount you must report as ordinary income is limited to the $9,000 included in the amount realized for the machinery that represents the fair market value of property other than the depreciable property you bought.

Leasehold replaced with fee simple property. Fee simple property you will use in your trade or business or for investment can qualify as replacement property that is similar or related in service or use to a condemned leasehold if you use it in the same business and for the identical purpose as the condemned leasehold.

A fee simple property interest generally is a property interest that entitles the owner to the entire property with unconditional power to dispose of it during his or her lifetime. A leasehold is property held under a lease, usually for a term of years.

Outdoor advertising display replaced with real property. You can choose to treat an outdoor advertising display as real property. If you make this choice and you replace the display with real property in which you hold a different kind of interest, your replacement property can qualify as like-kind property. For example, real property bought to replace a destroyed billboard and leased property on which the billboard was located qualifies as property of a like kind.

You can make this choice only if you did not claim a section 179 deduction for the display. You cannot cancel this choice unless you get the consent of the Internal Revenue Service.

An outdoor advertising display is a sign or device rigidly assembled and permanently attached to the ground, a building, or any other permanent structure used to display a commercial or other advertisement to the public.

Substituting replacement property. Once you designate certain property as replacement property on your tax return, you cannot substitute other qualified property. But, if your previously designated replacement property does not qualify, you can substitute qualified property if you acquire it within the replacement period.

Controlling interest in a corporation. You can replace property by acquiring a controlling interest in a corporation that owns property similar or related in service or use to your condemned property. You have controlling interest if you own stock having at least 80% of the combined voting power of all classes of voting stock and at least 80% of the total number of shares of all other classes of stock.

Basis adjustment to corporation's property. The basis of property held by the corporation at the time you acquired control must be reduced by your postponed gain, if any. You are not required to reduce the adjusted bases of the corporation's properties below your adjusted basis in the corporation's stock (determined after reduction by your postponed gain).

Allocate this reduction to the following classes of property in the order shown below.

Property that is similar or related in service or use to the condemned property.
Depreciable property not reduced in (1).
All other property.

If two or more properties fall in the same class, allocate the reduction to each property in proportion to the adjusted bases of all the properties in that class. The reduced basis of any single property cannot be less than zero.

Main home replaced. If your gain from a condemnation of your main home is more than you can exclude from your income (see Main home condemned under Gain or Loss From Condemnations, earlier), you can postpone reporting the rest of the gain by buying replacement property that is similar or related in service or use. To postpone reporting all the gain, the replacement property must cost at least as much as the amount realized from the condemnation minus the excluded gain.

You must reduce the basis of your replacement property by the postponed gain. Also, if you postpone reporting any part of your gain under these rules, you are treated as having owned and used the replacement property as your main home for the period you owned and used the condemned property as your main home.

Replacement period. To postpone reporting your gain from a condemnation, you must buy replacement property within a certain period of time. This is the replacement period.

The replacement period for a condemnation begins on the earlier of the following dates.

The date on which you disposed of the condemned property.
The date on which the threat of condemnation began.

The replacement period ends 2 years after the end of the first tax year in which any part of the gain on the condemnation is realized.

If real property held for use in a trade or business or for investment (not including property held primarily for sale) is condemned, the replacement period ends 3 years after the end of the first tax year in which any part of the gain on the condemnation is realized. However, this 3-year replacement period cannot be used if you replace the condemned property by acquiring control of a corporation owning property that is similar or related in service or use.

New York Liberty Zone property condemned. If property in the New York Liberty Zone was condemned as a result of the September 11, 2001, terrorist attacks, the replacement period ends 5 years after the end of the first tax year in which any part of the gain on the condemnation is realized. This 5-year replacement period applies only if substantially all of the use of the replacement property is in New York City.

Determining when gain is realized. If you are a cash basis taxpayer, you realize gain when you receive payments that are more than your basis in the property. If the condemning authority makes deposits with the court, you realize gain when you withdraw (or have the right to withdraw) amounts that are more than your basis.

This applies even if the amounts received are only partial or advance payments and the full award has not yet been determined. A replacement will be too late if you wait for a final determination that does not take place in the applicable replacement period after you first realize gain.

For accrual basis taxpayers, gain (if any) accrues in the earlier year when either of the following occurs.

All events have occurred that fix the right to the condemnation award and the amount can be determined with reasonable accuracy.
All or part of the award is actually or constructively received.

For example, if you have an absolute right to a part of a condemnation award when it is deposited with the court, the amount deposited accrues in the year the deposit is made even though the full amount of the award is still contested.

Replacement property bought before the condemnation. If you buy your replacement property after there is a threat of condemnation but before the actual condemnation and you still hold the replacement property at the time of the condemnation, you have bought your replacement property within the replacement period. Property you acquire before there is a threat of condemnation does not qualify as replacement property acquired within the replacement period.

Example.

On April 3, 2003, city authorities notified you that your property would be condemned. On June 5, 2003, you acquired property to replace the property to be condemned. You still had the new property when the city took possession of your old property on September 4, 2004. You have made a replacement within the replacement period.

Extension. You can get an extension of the replacement period if you apply to the IRS director for your area. You should apply before the end of the replacement period. Your application should contain all details of your need for an extension. You can file an application within a reasonable time after the replacement period ends if you can show reasonable cause for the delay. An extension of the replacement period will be granted if you can show reasonable cause for not making the replacement within the regular period.

Ordinarily, requests for extensions are granted near the end of the replacement period or the extended replacement period. Extensions are usually limited to a period of 1 year or less. The high market value or scarcity of replacement property is not a sufficient reason for granting an extension. If your replacement property is being built and you clearly show that the replacement or restoration cannot be made within the replacement period, you will be granted an extension of the period.

Choosing to postpone gain. Report your choice to postpone reporting your gain, along with all necessary details, on a statement attached to your return for the tax year in which you realize the gain.

If a partnership or a corporation owns the condemned property, only the partnership or corporation can choose to postpone reporting the gain.

Replacement property acquired after return filed. If you buy the replacement property after you file your return reporting your choice to postpone reporting the gain, attach a statement to your return for the year in which you buy the property. The statement should contain detailed information on the replacement property.

Amended return. If you choose to postpone reporting gain, you must file an amended return for the year of the gain (individuals file Form 1040X) in either of the following situations.

You do not buy replacement property within the replacement period. On your amended return, you must report the gain and pay any additional tax due.
The replacement property you buy costs less than the amount realized for the condemned property (minus the gain you excluded from income if the property was your main home). On your amended return, you must report the part of the gain you cannot postpone reporting and pay any additional tax due.

Time for assessing a deficiency. Any deficiency for any tax year in which part of the gain is realized may be assessed at any time before the expiration of 3 years from the date you notify the IRS director for your area that you have replaced, or intend not to replace, the condemned property within the replacement period.

Changing your mind. You can change your mind about reporting or postponing the gain at any time before the end of the replacement period.

Example.

Your property was condemned and you had a gain of $5,000. You reported the gain on your return for the year in which you realized it, and paid the tax due. You buy replacement property within the replacement period. You used all but $1,000 of the amount realized from the condemnation to buy the replacement property. You now change your mind and want to postpone reporting the $4,000 of gain equal to the amount you spent for the replacement property. You should file a claim for refund on Form 1040X. Explain on Form 1040X that you previously reported the entire gain from the condemnation, but you now want to report only the part of the gain equal to the condemnation proceeds not spent for replacement property ($1,000).

Reporting a Condemnation Gain or Loss

Generally, you report gain or loss from a condemnation on your return for the year you realize the gain or loss.

Personal-use property. Report gain from a condemnation of property you held for personal use (other than excluded gain from a condemnation of your main home or postponed gain) on Schedule D (Form 1040).

Do not report loss from a condemnation of personal-use property. But, if you received a Form 1099-S, Proceeds From Real Estate Transactions (for example, showing the proceeds of a sale of real estate under threat of condemnation), you must show the transaction on Schedule D even though the loss is not deductible. Complete columns (a) through (e), and enter -0- in column (f).

Business property. Report gain (other than postponed gain) or loss from a condemnation of property you held for business or profit on Form 4797. If you had a gain, you may have to report all or part of it as ordinary income. See Like-Kind Exchanges and Involuntary Conversions in chapter 3.

Nontaxable Exchanges

Certain exchanges of property are not taxable. This means any gain from the exchange is not recognized, and any loss cannot be deducted. Your gain or loss will not be recognized until you sell or otherwise dispose of the property you receive.

Like-Kind Exchanges

The exchange of property for the same kind of property is the most common type of nontaxable exchange. To be a like-kind exchange, the property traded and the property received must be both of the following.

Qualifying property.
Like-kind property.

These two requirements are discussed later.

Additional requirements apply to exchanges in which the property received is not received immediately upon the transfer of the property given up. See Deferred Exchange, later.

If the like-kind exchange involves the receipt of money or unlike property or the assumption of your liabilities, you may have to recognize gain. See Partially Nontaxable Exchanges, later.

Multiple-party transactions. The like-kind exchange rules also apply to property exchanges that involve three- and four-party transactions. Any part of these multiple-party transactions can qualify as a like-kind exchange if it meets all the requirements described in this section.

Receipt of title from third party. If you receive property in a like-kind exchange and the other party who transfers the property to you does not give you the title, but a third party does, you still can treat this transaction as a like-kind exchange if it meets all the requirements.

Basis of property received. If you acquire property in a like-kind exchange, the basis of that property is the same as the basis of the property you transferred.

For the basis of property received in an exchange that is only partially nontaxable, see Partially Nontaxable Exchanges, later.

Example.

You exchanged real estate held for investment with an adjusted basis of $25,000 for other real estate held for investment. The fair market value of both properties is $50,000. The basis of your new property is the same as the basis of the old ($25,000).

Money paid. If, in addition to giving up like-kind property, you pay money in a like-kind exchange, you still have no recognized gain or loss. The basis of the property received is the basis of the property given up, increased by the money paid.

Example.

Bill Smith trades an old cab for a new one. The new cab costs $30,000. He is allowed $8,000 for the old cab and pays $22,000 cash. He has no recognized gain or loss on the transaction regardless of the adjusted basis of his old cab. If Bill sold the old cab to a third party for $8,000 and bought a new one, he would have a recognized gain or loss on the sale of his old cab equal to the difference between the amount realized and the adjusted basis of the old cab.

Sale and purchase. If you sell property and buy similar property in two mutually dependent transactions, you may have to treat the sale and purchase as a single nontaxable exchange.

Example.

You used your car in your business for 2 years. Its adjusted basis is $3,500 and its trade-in value is $4,500. You are interested in a new car that costs $20,000. Ordinarily, you would trade your old car for the new one and pay the dealer $15,500. Your basis for depreciation of the new car would then be $19,000 ($15,500 plus $3,500 adjusted basis of the old car).

You want your new car to have a larger basis for depreciation, so you arrange to sell your old car to the dealer for $4,500. You then buy the new one for $20,000 from the same dealer. However, you are treated as having exchanged your old car for the new one because the sale and purchase are reciprocal and mutually dependent. Your basis for depreciation for the new car is $19,000, the same as if you traded the old car.

Reporting the exchange. Report the exchange of like-kind property, even though no gain or loss is recognized, on Form 8824. The instructions for the form explain how to report the details of the exchange.

If you have any recognized gain because you received money or unlike property, report it on Schedule D (Form 1040) or Form 4797, whichever applies. See chapter 4. You may have to report the recognized gain as ordinary income from depreciation recapture. See Like-Kind Exchanges and Involuntary Conversions in chapter 3.

Exchange expenses. Exchange expenses are generally the closing costs you pay. They include such items as brokerage commissions, attorney fees, and deed preparation fees. Subtract these expenses from the consideration received to figure the amount realized on the exchange. Also, add them to the basis of the like-kind property received. If you receive cash or unlike property in addition to the like-kind property and realize a gain on the exchange, subtract the expenses from the cash or fair market value of the unlike property. Then, use the net amount to figure the recognized gain. See Partially Nontaxable Exchanges, later.

Qualifying Property

In a like-kind exchange, both the property you give up and the property you receive must be held by you for investment or for productive use in your trade or business. Machinery, buildings, land, trucks, and rental houses are examples of property that may qualify.

The rules for like-kind exchanges do not apply to exchanges of the following property.

Property you use for personal purposes, such as your home and your family car.
Stock in trade or other property held primarily for sale, such as inventories, raw materials, and real estate held by dealers.
Stocks, bonds, notes, or other securities or evidences of indebtedness, such as accounts receivable.
Partnership interests.
Certificates of trust or beneficial interest.
Choses in action.

However, you may have a nontaxable exchange under other rules. See Other Nontaxable Exchanges, later.

An exchange of the assets of a business for the assets of a similar business cannot be treated as an exchange of one property for another property. Whether you engaged in a like-kind exchange depends on an analysis of each asset involved in the exchange. However, see Multiple Property Exchanges, later.

Like-Kind Property

There must be an exchange of like-kind property. Like-kind properties are properties of the same nature or character, even if they differ in grade or quality. The exchange of real estate for real estate and the exchange of personal property for similar personal property are exchanges of like-kind property. For example, the trade of land improved with an apartment house for land improved with a store building, or a panel truck for a pickup truck, is a like-kind exchange.

An exchange of personal property for real property does not qualify as a like-kind exchange. For example, an exchange of a piece of machinery for a store building does not qualify. Also, the exchange of livestock of different sexes does not qualify.

Real property. An exchange of city property for farm property, or improved property for unimproved property, is a like-kind exchange.

The exchange of real estate you own for a real estate lease that runs 30 years or longer is a like-kind exchange. However, not all exchanges of interests in real property qualify. The exchange of a life estate expected to last less than 30 years for a remainder interest is not a like-kind exchange.

An exchange of a remainder interest in real estate for a remainder interest in other real estate is a like-kind exchange if the nature or character of the two property interests is the same.

Foreign real property exchanges. Real property located in the United States and real property located outside the United States are not considered like-kind property under the like-kind exchange rules. If you exchange foreign real property for property located in the United States, your gain or loss on the exchange is recognized. Foreign real property is real property not located in a state or the District of Columbia.

This foreign real property exchange rule does not apply to the replacement of condemned real property. Foreign and U.S. real property can still be considered like-kind property under the rules for replacing condemned property to postpone reporting gain on the condemnation. See Postponement of Gain under Involuntary Conversions, earlier.

Personal property. Depreciable tangible personal property can be either like kind or like class to qualify for nonrecognition treatment. Like-class properties are depreciable tangible personal properties within the same General Asset Class or Product Class. Property classified in any General Asset Class may not be classified within a Product Class.

General Asset Classes. General Asset Classes describe the types of property frequently used in many businesses. They include the following property.

Office furniture, fixtures, and equipment (asset class 00.11).
Information systems, such as computers and peripheral equipment (asset class 00.12).
Data handling equipment except computers (asset class 00.13).
Airplanes (airframes and engines), except planes used in commercial or contract carrying of passengers or freight, and all helicopters (airframes and engines) (asset class 00.21).
Automobiles and taxis (asset class 00.22).
Buses (asset class 00.23).
Light general purpose trucks (asset class 00.241).
Heavy general purpose trucks (asset class 00.242).
Railroad cars and locomotives except those owned by railroad transportation companies (asset class 00.25).
Tractor units for use over the road (asset class 00.26).
Trailers and trailer-mounted containers (asset class 00.27).
Vessels, barges, tugs, and similar water-transportation equipment, except those used in marine construction (asset class 00.28).
Industrial steam and electric generation or distribution systems (asset class 00.4).

Product Classes. Product Classes include property listed in a 6-digit product class (except any ending in 9) in sectors 31 through 33 of the North American Industry Classification System (NAICS) of the Executive Office of the President, Office of Management and Budget, United States, 2002 (NAICS Manual). It can be accessed at . Copies of the manual may be obtained from the National Technical Information Service by calling 1-800- 553-NTIS (1-800-553-6847). The cost of the manual is $49 (plus shipping and handling) and the order number is PB2002101430.

Example 1.

You transfer a personal computer used in your business for a printer to be used in your business. The properties exchanged are within the same General Asset Class and are of a like class.

Example 2.

Trena transfers a grader to Ron in exchange for a scraper. Both are used in a business. Neither property is within any of the General Asset Classes. Both properties, however, are within the same Product Class and are of a like class.

Intangible personal property and nondepreciable personal property. If you exchange intangible personal property or nondepreciable personal property for like-kind property, no gain or loss is recognized on the exchange. (There are no like classes for these properties.) Whether intangible personal property, such as a patent or copyright, is of a like kind to other intangible personal property generally depends on the nature or character of the rights involved. It also depends on the nature or character of the underlying property to which those rights relate.

Example.

The exchange of a copyright on a novel for a copyright on a different novel can qualify as a like-kind exchange. However, the exchange of a copyright on a novel for a copyright on a song is not a like-kind exchange.

Goodwill and going concern. The exchange of the goodwill or going concern value of a business for the goodwill or going concern value of another business is not a like-kind exchange.

Foreign personal property exchanges. Personal property used predominantly in the United States and personal property used predominantly outside the United States are not like-kind property under the like-kind exchange rules. If you exchange property used predominantly in the United States for property used predominantly outside the United States, your gain or loss on the exchange is recognized.

Predominant use. You determine the predominant use of property you gave up based on where that property was used during the 2-year period ending on the date you gave it up. You determine the predominant use of the property you acquired based on where that property was used during the 2-year period beginning on the date you acquired it.

But if you held either property less than 2 years, determine its predominant use based on where that property was used only during the period of time you (or a related person) held it. This does not apply if the exchange is part of a transaction (or series of transactions) structured to avoid having to treat property as unlike property under this rule.

However, you must treat property as used predominantly in the United States if it is used outside the United States but, under section 168(g)(4) of the Internal Revenue Code, is eligible for accelerated depreciation as though used in the United States.

Deferred Exchange

A deferred exchange is one in which you transfer property you use in business or hold for investment and later you receive like-kind property you will use in business or hold for investment. (The property you receive is replacement property.) The transaction must be an exchange (that is, property for property) rather than a transfer of property for money used to buy replacement property.

If, before you receive the replacement property, you actually or constructively receive money or unlike property in full payment for the property you transfer, the transaction will be treated as a sale rather than a deferred exchange. In that case, you must recognize gain or loss on the transaction, even if you later receive the replacement property. (It would be treated as if you bought it.)

You constructively receive money or unlike property when the money or property is credited to your account or made available to you. You also constructively receive money or unlike property when any limits or restrictions on it expire or are waived.

Whether you actually or constructively receive money or unlike property, however, is determined without regard to certain arrangements you make to ensure that the other party carries out its obligation to transfer the replacement property to you. For example, if you have that obligation secured by a mortgage or by cash or its equivalent held in a qualified escrow account or qualified trust, that arrangement will be disregarded in determining whether you actually or constructively receive money or unlike property. For more information, see section 1.1031(k)-1(g) of the regulations. Also, see Like-Kind Exchanges Using Qualified Intermediaries, later.

Identification requirement. You must identify the property to be received within 45 days after the date you transfer the property given up in the exchange. This period of time is called the identification period. Any property received during the identification period is considered to have been identified.

If you transfer more than one property (as part of the same transaction) and the properties are transferred on different dates, the identification period and the receipt period begin on the date of the earliest transfer.

Identifying replacement property. You must identify the replacement property in a signed written document and deliver it to the other person involved in the exchange. You must clearly describe the replacement property in the written document. For example, use the legal description or street address for real property and the make, model, and year for a car. In the same manner, you can cancel an identification of replacement property at any time before the end of the identification period.

Identifying alternative and multiple properties. You can identify more than one replacement property. Regardless of the number of properties you give up, the maximum number of replacement properties you can identify is the larger of the following.

Three.
Any number of properties whose total fair market value (FMV) at the end of the identification period is not more than double the total fair market value, on the date of transfer, of all properties you give up.

If, as of the end of the identification period, you have identified more properties than permitted under this rule, the only property that will be considered identified is:

Any replacement property you received before the end of the identification period, and
Any replacement property identified before the end of the identification period and received before the end of the receipt period, but only if the fair market value of the property is at least 95% of the total fair market value of all identified replacement properties. (Do not include any you canceled.) Fair market value is determined on the earlier of the date you received the property or the last day of the receipt period.

Disregard incidental property. Do not treat property incidental to a larger item of property as separate from the larger item when you identify replacement property. Property is incidental if it meets both the following tests.

It is typically transferred with the larger item.
The total fair market value of all the incidental property is not more than 15% of the total fair market value of the larger item of property.

Replacement property to be produced. Gain or loss from a deferred exchange can qualify for nonrecognition even if the replacement property is not in existence or is being produced at the time you identify it as replacement property. If you need to know the fair market value of the replacement property to identify it, estimate its fair market value as of the date you expect to receive it.

Receipt requirement. The property must be received by the earlier of the following dates.

The 180th day after the date on which you transfer the property given up in the exchange.
The due date, including extensions, for your tax return for the tax year in which the transfer of the property given up occurs.

You must receive substantially the same property that met the identification requirement, discussed earlier.

Replacement property produced after identification. In some cases, the replacement property may have been produced after you identified it (as described earlier in Replacement property to be produced.) In that case, to determine whether the property you received was substantially the same property that met the identification requirement, do not take into account any variations due to usual production changes. Substantial changes in the property to be produced, however, will disqualify it.

If your replacement property is personal property that had to be produced, it must be completed by the date you receive it to qualify as substantially the same property you identified.

If your replacement property is real property that had to be produced and it is not completed by the date you receive it, it still may qualify as substantially the same property you identified. It will qualify only if, had it been completed on time, it would have been considered to be substantially the same property you identified. It is considered to be substantially the same only to the extent it is considered real property under local law. However, any additional production on the replacement property after you receive it does not qualify as like-kind property. (To this extent, the transaction is treated as a taxable exchange of property for services.)

Like-Kind Exchanges Using Qualified Intermediaries

If you transfer property through a qualified intermediary, the transfer of the property given up and receipt of like-kind property is treated as an exchange. This rule applies even if you receive money or other property directly from a party to the transaction other than the qualified intermediary.

A qualified intermediary is a person who enters into a written exchange agreement with you to acquire and transfer the property you give up and to acquire the replacement property and transfer it to you. This agreement must expressly limit your rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary.

Multiple-party transactions involving related persons. A taxpayer who transfers property given up to a qualified intermediary in exchange for replacement property formerly owned by a related person is not entitled to nonrecognition treatment if the related person receives cash or unlike property for the replacement property. (See Like-Kind Exchanges Between Related Persons, later.)

A qualified intermediary cannot be either of the following.

Your agent at the time of the transaction. This includes a person who has been your employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period before the transfer of property you give up.
A person who is related to you or your agent under the rules discussed in chapter 2 under Nondeductible Loss, substituting �10%� for �50%.�

An intermediary is treated as acquiring and transferring property if all the following requirements are met.

The intermediary acquires and transfers legal title to the property.
The intermediary enters into an agreement with a person other than you for the transfer to that person of the property you give up and that property is transferred to that person.
The intermediary enters into an agreement with the owner of the replacement property for the transfer of that property and the replacement property is transferred to you.

An intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment by the date of the relevant transfer of property.

Like-Kind Exchanges Using Qualified Exchange Accommodation Arrangements (QEAAs)

The like-kind exchange rules generally do not apply to an exchange in which you acquire replacement property (new property) before you transfer relinquished property (property you give up). However, if you use a qualified exchange accommodation arrangement (QEAA), the transfer may qualify as a like-kind exchange.

Under a QEAA, either the replacement property or the relinquished property is transferred to an exchange accommodation titleholder (EAT), discussed later, who is treated as the beneficial owner of the property. However, the replacement property held in a QEAA may not be treated as property received in an exchange if you previously owned it within 180 days of its transfer to the EAT. If the property is held in a QEAA, the IRS will accept the qualification of property as either replacement property or relinquished property and the treatment of an EAT as the beneficial owner of the property for federal income tax purposes.

Requirements for a QEAA. Property is held in a QEAA only if all the following requirements are met.

You have a written agreement.
The time limits for identifying and transferring the property are met.
The qualified indications of ownership of property are transferred to an EAT.

Written agreement. Under a QEAA, you and the EAT must enter into a written agreement no later than 5 business days after the qualified indications of ownership (discussed later) are transferred to the EAT. The agreement must provide all the following.

The EAT is holding the property for your benefit in order to facilitate an exchange under the like-kind exchange rules and Revenue Procedure 2000-37, as modified by Revenue Procedure 2004-51.
You and the EAT agree to report the acquisition, holding, and disposition of the property on your federal income tax returns in a manner consistent with the agreement.
The EAT will be treated as the beneficial owner of the property for all federal income tax purposes.

Property can be treated as being held in a QEAA even if the accounting, regulatory, or state, local, or foreign tax treatment of the arrangement between you and the EAT is different from the treatment required by the list above.

Bona fide intent. When the qualified indications of ownership of the property are transferred to the EAT, it must be your bona fide intent that the property held by the EAT represents either replacement property or relinquished property in an exchange intended to qualify for nonrecognition of gain (in whole or in part) or loss under the like-kind exchange rules.

Time limits for identifying and transferring property. Under a QEAA, the following time limits for identifying and transferring the property must be met.

No later than 45 days after the transfer of qualified indications of ownership of the replacement property to the EAT; you must identify the relinquished property in a manner consistent with the principles for deferred exchanges. See Identification requirement earlier under Deferred Exchange.
One of the following transfers must take place no later than 180 days after the transfer of qualified indications of ownership of the property to the EAT.
1. The replacement property is transferred to you (either directly or indirectly through a qualified intermediary, defined earlier under Like-Kind Exchanges Using Qualified Intermediaries).
2. The relinquished property is transferred to a person other than you or a disqualified person. A disqualified person is either of the following.
  1. Your agent at the time of the transaction. This includes a person who has been your employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period before the transfer of the relinquished property.
  2. A person who is related to you or your agent under the rules discussed in chapter 2 under Nondeductible Loss, substituting �10%� for �50%.�
The combined time period the relinquished property and replacement property are held in the QEAA cannot be longer than 180 days.

Exchange accommodation titleholder (EAT). The EAT must meet all the following requirements.

Hold qualified indications of ownership (defined next) at all times from the date of acquisition of the property until the property is transferred (as described in (2), earlier).
Be someone other than you or a disqualified person (as defined in 2(b), earlier).
Be subject to federal income tax. If the EAT is treated as a partnership or S corporation, more than 90% of its interests or stock must be owned by partners or shareholders who are subject to federal income tax.

Qualified indications of ownership. Qualified indications of ownership are any of the following.

Legal title to the property.
Other indications of ownership of the property that are treated as beneficial ownership of the property under principles of commercial law (for example, a contract for deed).
Interests in an entity that is disregarded as an entity separate from its owner for federal income tax purposes (for example, a single member limited liability company) and that holds either legal title to the property or other indications of ownership.

Other permissible arrangements. Property will not fail to be treated as being held in a QEAA as a result of certain legal or contractual arrangements, regardless of whether the arrangements contain terms that typically would result from arm's-length bargaining between unrelated parties for those arrangements. For a list of those arrangements, see Revenue Procedure 2000-37 in Internal Revenue Bulletin 2000-40.

Partially Nontaxable Exchanges

If, in addition to like-kind property, you receive money or unlike property in an exchange on which you realize a gain, you have a partially nontaxable exchange. You are taxed on the gain you realize, but only to the extent of the money and the fair market value of the unlike property you receive.

A loss is never deductible in a nontaxable exchange in which you receive unlike property or cash.

Figuring taxable gain. To figure the taxable gain, first determine the fair market value of any unlike property you receive and add it to any money you receive. Reduce that total by any exchange expenses (closing costs) you paid. The result is the maximum gain that can be taxed. Next, figure the gain on the whole exchange as discussed earlier under Gain or Loss From Sales and Exchanges. Your recognized (taxable) gain is the lesser of these two amounts.

Example.

You exchange real estate held for investment with an adjusted basis of $8,000 for other real estate you want to hold for investment. The fair market value of the real estate you receive is $10,000. You also receive $1,000 in cash. You paid $500 in exchange expenses. Although the total gain realized on the transaction is $2,500, only $500 ($1,000 cash received minus the $500 exchange expenses) is recognized (included in your income).

Assumption of liabilities. If the other party to a nontaxable exchange assumes any of your liabilities, you will be treated as if you received cash in the amount of the liability. For more information on the assumption of liabilities, see section 357(d) of the Internal Revenue Code.

Example.

The facts are the same as in the previous example, except the property you give up is subject to a $3,000 mortgage for which you were personally liable. The other party in the trade has agreed to pay off the mortgage. Figure the gain realized as follows.

FMV of like-kind property received	$10,000
Cash	1,000
Mortgage treated as assumed by other party	3,000
Total received	$14,000
Minus: Exchange expenses	(500)
Amount realized	$13,500
Minus: Adjusted basis of property you transferred	(8,000)
Realized gain	$5,500

The realized gain is taxed only up to $3,500, the sum of the cash received ($1,000 - $500 exchange expenses) and the mortgage ($3,000).

Unlike property given up. If, in addition to like-kind property, you give up unlike property, you must recognize gain or loss on the unlike property you give up. The gain or loss is equal to the difference between the fair market value of the unlike property and the adjusted basis of the unlike property.

Example.

You exchange stock and real estate you held for investment for real estate you also intend to hold for investment. The stock you transfer has a fair market value of $1,000 and an adjusted basis of $4,000. The real estate you exchange has a fair market value of $19,000 and an adjusted basis of $15,000. The real estate you receive has a fair market value of $20,000. You do not recognize gain on the exchange of the real estate because it qualifies as a nontaxable exchange. However, you must recognize (report on your return) a $3,000 loss on the stock because it is unlike property.

Basis of property received. The total basis for all properties (other than money) you receive in a partially nontaxable exchange is the total adjusted basis of the properties you give up, with the following adjustments.

Add both the following amounts.
1. Any additional costs you incur.
2. Any gain you recognize on the exchange.
Subtract both the following amounts.
1. Any money you receive.
2. Any loss you recognize on the exchange.

Allocate this basis first to the unlike property, other than money, up to its fair market value on the date of the exchange. The rest is the basis of the like-kind property.

Multiple Property Exchanges

Under the like-kind exchange rules, you generally must make a property-by-property comparison to figure your recognized gain and the basis of the property you receive in the exchange. However, for exchanges of multiple properties, you do not make a property-by-property comparison if you do either of the following.

Transfer and receive properties in two or more exchange groups.
Transfer or receive more than one property within a single exchange group.

In these situations, you figure your recognized gain and the basis of the property you receive by comparing the properties within each exchange group.

Exchange groups. Each exchange group consists of properties transferred and received in the exchange that are of like kind or like class. (See Like-Kind Property, earlier.) If property could be included in more than one exchange group, you can include it in any one of those groups. However, the following may not be included in an exchange group.

Money.
Stock in trade or other property held primarily for sale.
Stocks, bonds, notes, or other securities or evidences of debt or interest.
Interests in a partnership.
Certificates of trust or beneficial interests.
Choses in action.

Example.

Ben exchanges computer A (asset class 00.12), automobile A (asset class 00.22), and truck A (asset class 00.241) for computer R (asset class 00.12), automobile R (asset class 00.22), truck R (asset class 00.241), and $550. All properties transferred were used in Ben's business. Similarly, all properties received will be used in his business.

The first exchange group consists of computers A and R, the second exchange group consists of automobiles A and R, and the third exchange group consists of trucks A and R.

Treatment of liabilities. Offset all liabilities you assume as part of the exchange against all liabilities of which you are relieved. Offset these liabilities whether they are recourse or nonrecourse and regardless of whether they are secured by or otherwise relate to specific property transferred or received as part of the exchange.

If you assume more liabilities than you are relieved of, allocate the difference among the exchange groups in proportion to the total fair market value of the properties you received in the exchange groups. The difference allocated to each exchange group may not be more than the total fair market value of the properties you received in the exchange group.

The amount of the liabilities allocated to an exchange group reduces the total fair market value of the properties received in that exchange group. This reduction is made in determining whether the exchange group has a surplus or a deficiency. (See Exchange group surplus and deficiency, later.) This reduction is also made in determining whether a residual group is created. (See Residual group, later.)

If you are relieved of more liabilities than you assume, treat the difference as cash, general deposit accounts (other than certificates of deposit), and similar items when making allocations to the residual group, discussed later.

The treatment of liabilities and any differences between amounts you assume and amounts you are relieved of will be the same even if the like-kind exchange treatment applies to only part of a larger transaction. If so, determine the difference in liabilities based on all liabilities you assume or are relieved of as part of the larger transaction.

Example.

The facts are the same as in the preceding example. In addition, the fair market value of and liabilities secured by each property are as follows.

	Fair Market Value	Liability
Ben Transfers:
Computer A	$1,500	$ -0-
Automobile A	2,500	500
Truck A	2,000	-0-
Ben Receives:
Computer R	$1,600	$ -0-
Automobile R	3,100	750
Truck R	1,400	250
Cash	400

All liabilities assumed by Ben ($1,000) are offset by all liabilities of which he is relieved ($500), resulting in a difference of $500. The difference is allocated among Ben's exchange groups in proportion to the fair market value of the properties received in the exchange groups as follows.

$131 ($500 � $1,600 � $6,100) is allocated to the first exchange group (computers A and R). The fair market value of computer R is reduced to $1,469 ($1,600 - $131).
$254 ($500 � $3,100 � $6,100) is allocated to the second exchange group (automobiles A and R). The fair market value of automobile R is reduced to $2,846 ($3,100 - $254).
$115 ($500 � $1,400 � $6,100) is allocated to the third exchange group (trucks A and R). The fair market value of truck R is reduced to $1,285 ($1,400 - $115).

In each exchange group, Ben uses the reduced fair market value of the properties received to figure the exchange group's surplus or deficiency and to determine whether a residual group has been created.

Residual group. A residual group is created if the total fair market value of the properties transferred in all exchange groups differs from the total fair market value of the properties received in all exchange groups after taking into account the treatment of liabilities (discussed earlier). The residual group consists of money or other property that has a total fair market value equal to that difference. It consists of either money or other property transferred in the exchange or money or other property received in the exchange, but not both.

Other property includes the following items.

Stock in trade or other property held primarily for sale.
Stocks, bonds, notes, or other securities or evidences of debt or interest.
Interests in a partnership.
Certificates of trust or beneficial interests.
Choses in action.

Other property also includes property transferred that is not of a like kind or like class with any property received, and property received that is not of a like kind or like class with any property transferred.

For asset acquisitions occurring after March 15, 2001, money and properties allocated to the residual group are considered to come from the following assets in the following order.

Cash and general deposit accounts (including checking and savings accounts but excluding certificates of deposit). Also, include here excess liabilities of which you are relieved over the amount of liabilities you assume.
Certificates of deposit, U.S. Government securities, foreign currency, and actively traded personal property, including stock and securities.
Accounts receivable, other debt instruments, and assets that you mark to market at least annually for federal income tax purposes. However, see section 1.338-6(b)(2)(iii) of the regulations for exceptions that apply to debt instruments issued by persons related to a target corporation, contingent debt instruments, and debt instruments convertible into stock or other property.
Property of a kind that would properly be included in inventory if on hand at the end of the tax year or property held by the taxpayer primarily for sale to customers in the ordinary course of business.
Assets other than those listed in (1), (2), (3), (4), (6) and (7).
All section 197 intangibles except goodwill and going concern value.
Goodwill and going concern value.

Within each category, you can choose which properties to allocate to the residual group. If an asset described in any of the categories above, except (1), is includible in more than one category, include it in the lower number category. For example, if an asset is described in both (3) and (4), include it in (3).

Example.

Fran exchanges computer A (asset class 00.12) and automobile A (asset class 00.22) for printer B (asset class 00.12), automobile B (asset class 00.22), corporate stock, and $500. Fran used computer A and automobile A in her business and will use printer B and automobile B in her business.

This transaction results in two exchange groups: (1) computer A and printer B, and (2) automobile A and automobile B.

The fair market values of the properties are as follows.

	Fair Market Value
Fran Transfers:
Computer A	$1,000
Automobile A	4,000
Fran Receives:
Automobile B	$2,950
Printer B	800
Corporate Stock	750
Cash	500

The total fair market value of the properties transferred in the exchange groups ($5,000) is $1,250 more than the total fair market value of the properties received in the exchange groups ($3,750), so there is a residual group in that amount. It consists of the $500 cash and the $750 worth of corporate stock.

Exchange group surplus and deficiency. For each exchange group, you must determine whether there is an �exchange group surplus� or �exchange group deficiency.� An exchange group surplus is the total fair market value of the properties received in an exchange group (minus any excess liabilities you assume that are allocated to that exchange group) that is more than the total fair market value of the properties transferred in that exchange group. An exchange group deficiency is the total fair market value of the properties transferred in an exchange group that is more than the total fair market value of the properties received in that exchange group (minus any excess liabilities you assume that are allocated to that exchange group).

Example.

Karen exchanges computer A (asset class 00.12) and automobile A (asset class 00.22), both of which she used in her business, for printer B (asset class 00.12) and automobile B (asset class 00.22), both of which she will use in her business. Karen's adjusted basis and the fair market value of the exchanged properties are as follows.

	Adjusted Basis	Fair Market Value
Karen Transfers:
Automobile A	$1,500	$4,000
Computer A	375	1,000
Karen Receives:
Printer B		$2,050
Automobile B		2,950

The first exchange group consists of computer A and printer B. It has an exchange group surplus of $1,050 because the fair market value of printer B ($2,050) is more than the fair market value of computer A ($1,000) by that amount.

The second exchange group consists of automobile A and automobile B. It has an exchange group deficiency of $1,050 because the fair market value of automobile A ($4,000) is more than the fair market value of automobile B ($2,950) by that amount.

Recognized gain. Gain or loss realized for each exchange group and the residual group is the difference between the total fair market value of the transferred properties in that exchange group or residual group and the total adjusted basis of the properties. For each exchange group, recognized gain is the lesser of the gain realized or the exchange group deficiency (if any). Losses are not recognized for an exchange group. The total gain recognized on the exchange of like-kind or like-class properties is the sum of all the gain recognized for each exchange group.

For a residual group, you must recognize the entire gain or loss realized.

For properties you transfer that are not within any exchange group or the residual group, figure realized and recognized gain or loss as explained under Gain or Loss From Sales and Exchanges, earlier.

Example.

Based on the facts in the previous example, Karen recognizes gain on the exchange as follows.

For the first exchange group, the gain realized is the fair market value of computer A ($1,000) minus its adjusted basis ($375), or $625. The gain recognized is the lesser of the gain realized ($625) or the exchange group deficiency ($0), or $0.

For the second exchange group, the gain realized is the fair market value of automobile A ($4,000) minus its adjusted basis ($1,500), or $2,500. The gain recognized is the lesser of the gain realized ($2,500) or the exchange group deficiency ($1,050), or $1,050.

The total gain recognized by Karen in the exchange is the sum of the gains recognized with respect to both exchange groups ($0 + $1,050), or $1,050.

Basis of properties received. The total basis of properties received in each exchange group is the sum of the following amounts.

The total adjusted basis of the transferred properties within that exchange group.
Your recognized gain on the exchange group.
The excess liabilities you assume that are allocated to the group.
The exchange group surplus (or minus the exchange group deficiency).

You allocate the total basis of each exchange group proportionately to each property received in the exchange group according to the property's fair market value.

The basis of each property received within the residual group (other than money) is equal to its fair market value.

Example.

Based on the facts in the two previous examples, the bases of the properties received by Karen in the exchange, printer B and automobile B, are determined in the following manner.

The basis of the property received in the first exchange group is $1,425. This is the sum of the following amounts.

Adjusted basis of the property transferred within that exchange group ($375).
Gain recognized for that exchange group ($0).
Excess liabilities assumed allocated to that exchange group ($0).
Exchange group surplus ($1,050).

Printer B is the only property received within the first exchange group, so the entire basis of $1,425 is allocated to printer B.

The basis of the property received in the second exchange group is $1,500. This is figured as follows.

First, add the following amounts.

Adjusted basis of the property transferred within that exchange group ($1,500).
Gain recognized for that exchange group ($1,050).
Excess liabilities assumed allocated to that exchange group ($0).

Then subtract the exchange group deficiency ($1,050).

Automobile B is the only property received within the second exchange group, so the entire basis ($1,500) is allocated to automobile B.

Like-Kind Exchanges Between Related Persons

Special rules apply to like-kind exchanges between related persons. These rules affect both direct and indirect exchanges. Under these rules, if either person disposes of the property within 2 years after the exchange, the exchange is disqualified from nonrecognition treatment. The gain or loss on the original exchange must be recognized as of the date of the later disposition.

Related persons. Under these rules, related persons include, for example, you and a member of your family (spouse, brother, sister, parent, child, etc.), you and a corporation in which you have more than 50% ownership, you and a partnership in which you directly or indirectly own more than a 50% interest of the capital or profits, and two partnerships in which you directly or indirectly own more than 50% of the capital interests or profits.

An exchange structured to avoid the related party rules is not a like-kind exchange. See Like-Kind Exchanges Using Qualified Intermediaries , earlier.

For more information on related persons, see Nondeductible Loss under Sales and Exchanges Between Related Persons in chapter 2.

Example.

You used a panel truck in your house painting business. Your sister used a pickup truck in her landscaping business. In December 2003, you exchanged your panel truck plus $200 for your sister's pickup truck. At that time, the fair market value (FMV) of your panel truck was $7,000 and its adjusted basis was $6,000. The fair market value of your sister's pickup truck was $7,200 and its adjusted basis was $1,000. You realized a gain of $1,000 (the $7,200 fair market value of the pickup truck minus the $200 you paid minus the $6,000 adjusted basis of the panel truck). Your sister realized a gain of $6,200 (the $7,000 fair market value of your panel truck plus the $200 you paid minus the $1,000 adjusted basis of the pickup truck).

However, because this was a like-kind exchange, you recognized no gain. Your basis in the pickup truck was $6,200 (the $6,000 adjusted basis of the panel truck plus the $200 you paid). Your sister recognized gain only to the extent of the money she received, $200. Her basis in the panel truck was $1,000 (the $1,000 adjusted basis of the pickup truck minus the $200 received, plus the $200 gain recognized).

In 2004, you sold the pickup truck to a third party for $7,000. You sold it within 2 years after the exchange, so the exchange is disqualified from nonrecognition treatment. On your 2004 tax return, you must report your $1,000 gain on the 2003 exchange. You also report a loss on the sale of $200 (the adjusted basis of the pickup truck, $7,200 (its $6,200 basis plus the $1,000 gain recognized), minus the $7,000 realized from the sale).

In addition, your sister must report on her 2004 tax return the $6,000 balance of her gain on the 2003 exchange. Her adjusted basis in the panel truck is increased to $7,000 (its $1,000 basis plus the $6,000 gain recognized).

Two-year holding period. The 2-year holding period begins on the date of the last transfer of property that was part of the like-kind exchange. If the holder's risk of loss on the property is substantially diminished during any period, however, that period is not counted toward the 2-year holding period. The holder's risk of loss on the property is substantially diminished by any of the following events.

The holding of a put on the property.
The holding by another person of a right to acquire the property.
A short sale or other transaction.

A put is an option that entitles the holder to sell property at a specified price at any time before a specified future date.

A short sale involves property you generally do not own. You borrow the property to deliver to a buyer and, at a later date, buy substantially identical property and deliver it to the lender.

Exceptions to the rules for related persons. The following kinds of property dispositions are excluded from these rules.

Dispositions due to the death of either related person.
Involuntary conversions.
Dispositions if it is established to the satisfaction of the IRS that neither the exchange nor the disposition had as a main purpose the avoidance of federal income tax.

Other Nontaxable Exchanges

The following discussions describe other exchanges that may not be taxable.

Partnership Interests

Exchanges of partnership interests do not qualify as nontaxable exchanges of like-kind property. This applies regardless of whether they are general or limited partnership interests or are interests in the same partnership or different partnerships. However, under certain circumstances the exchange may be treated as a tax-free contribution of property to a partnership. See Contribution of Property in Publication 541, Partnerships.

An interest in a partnership that has a valid choice in effect under section 761(a) of the Internal Revenue Code to be excluded from all the rules of Subchapter K of the Code is treated as an interest in each of the partnership assets and not as a partnership interest. See Exclusion From Partnership Rules in Publication 541.

U.S. Treasury Notes or Bonds

Certain issues of U.S. Treasury obligations may be exchanged for certain other issues designated by the Secretary of the Treasury with no gain or loss recognized on the exchange. See U.S. Treasury Bills, Notes, and Bonds under Interest Income in Publication 550 for more information on the tax treatment of income from these investments.

For other information on these notes and bonds, call the Bureau of the Public Debt at 1-800-722-2678, or write to the following address.

Bureau of the Public Debt
Attn: Marketable Assistance Branch
P.O. Box 426
Parkersburg, WV 26102-0426

Insurance Policies and Annuities

No gain or loss is recognized if you make any of the following exchanges.

A life insurance contract for another or for an endowment or annuity contract.
An endowment contract for an annuity contract or for another endowment contract providing for regular payments beginning at a date not later than the beginning date under the old contract.
One annuity contract for another if the insured or annuitant remains the same.
A portion of an annuity contract for a new annuity contract if the insured or annuitant remains the same.

If you realize a gain on the exchange of an endowment contract or annuity contract for a life insurance contract or an exchange of an annuity contract for an endowment contract, you must recognize the gain.

For information on transfers and rollovers of employer-provided annuities, see Publication 575, Pension and Annuity Income, or Publication 571, Tax-Sheltered Annuity Plans (403(b) Plans).

Cash received. The nonrecognition and nontaxable transfer rules do not apply to a rollover in which you receive cash proceeds from the surrender of one policy and invest the cash in another policy. However, you can treat a cash distribution and reinvestment as meeting the nonrecognition or nontaxable transfer rules if all the following requirements are met.

When you receive the distribution, the insurance company that issued the policy or contract is subject to a rehabilitation, conservatorship, insolvency, or similar state proceeding.
You withdraw all amounts to which you are entitled or, if less, the maximum permitted under the state proceeding.
You reinvest the distribution within 60 days after receipt in a single policy or contract issued by another insurance company or in a single custodial account.
You assign all rights to future distributions to the new issuer for investment in the new policy or contract if the distribution was restricted by the state proceeding.
You would have qualified under the nonrecognition or nontaxable transfer rules if you had exchanged the affected policy or contract for the new one.

If you do not reinvest all of the cash distribution, the rules for partially nontaxable exchanges, discussed earlier, apply.

In addition to meeting these five requirements, you must do both the following.

Give to the issuer of the new policy or contract a statement that includes all the following information.
1. The gross amount of cash distributed.
2. The amount reinvested.
3. Your investment in the affected policy or contract on the date of the initial cash distribution.
Attach the following items to your timely filed tax return for the year of the initial distribution.
1. A statement titled �Election under Rev. Proc. 92-44� that includes the name of the issuer and the policy number (or similar identifying number) of the new policy or contract.
2. A copy of the statement given to the issuer of the new policy or contract.

Property Exchanged for Stock

If you transfer property to a corporation in exchange for stock in that corporation (other than nonqualified preferred stock, described later), and immediately afterward you are in control of the corporation, the exchange is usually not taxable. This rule applies both to individuals and to groups who transfer property to a corporation. It does not apply in the following situations.

The corporation is an investment company.
You transfer the property in a bankruptcy or similar proceeding in exchange for stock used to pay creditors.
The stock is received in exchange for the corporation's debt (other than a security) or for interest on the corporation's debt (including a security) that accrued while you held the debt.

Control of a corporation. To be in control of a corporation, you or your group of transferors must own, immediately after the exchange, at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the outstanding shares of each class of nonvoting stock.

The control requirement can be met even though there are successive transfers of property and stock. For more information, see Revenue Ruling 2003-51 in Internal Revenue Bulletin No. 2003-21.

Example 1.

You and Bill Jones buy property for $100,000. You both organize a corporation when the property has a fair market value of $300,000. You transfer the property to the corporation for all its authorized capital stock, which has a par value of $300,000. No gain is recognized by you, Bill, or the corporation.

Example 2.

You and Bill transfer the property with a basis of $100,000 to a corporation in exchange for stock with a fair market value of $300,000. This represents only 75% of each class of stock of the corporation. The other 25% was already issued to someone else. You and Bill recognize a taxable gain of $200,000 on the transaction.

Services rendered. The term property does not include services rendered or to be rendered to the issuing corporation. The value of stock received for services is income to the recipient.

Example.

You transfer property worth $35,000 and render services valued at $3,000 to a corporation in exchange for stock valued at $38,000. Right after the exchange, you own 85% of the outstanding stock. No gain is recognized on the exchange of property. However, you recognize ordinary income of $3,000 as payment for services you rendered to the corporation.

Property of relatively small value. The term property does not include property of a relatively small value when it is compared to the value of stock and securities already owned or to be received for services by the transferor if the main purpose of the transfer is to qualify for the nonrecognition of gain or loss by other transferors.

Property transferred will not be considered to be of relatively small value if its fair market value is at least 10% of the fair market value of the stock and securities already owned or to be received for services by the transferor.

Stock received in disproportion to property transferred. If a group of transferors exchange property for corporate stock, each transferor does not have to receive stock in proportion to his or her interest in the property transferred. If a disproportionate transfer takes place, it will be treated for tax purposes in accordance with its true nature. It may be treated as if the stock were first received in proportion and then some of it used to make gifts, pay compensation for services, or satisfy the transferor's obligations.

Money or other property received. If, in an otherwise nontaxable exchange of property for corporate stock, you also receive money or property other than stock, you may have to recognize gain. You must recognize gain only up to the amount of money plus the fair market value of the other property you receive. The rules for figuring the recognized gain in this situation generally follow those for a partially nontaxable exchange discussed earlier under Like-Kind Exchanges. If the property you give up includes depreciable property, the recognized gain may have to be reported as ordinary income from depreciation. See chapter 3. No loss is recognized.

Nonqualified preferred stock. Nonqualified preferred stock is treated as property other than stock. Generally, it is preferred stock with any of the following features.

The holder has the right to require the issuer or a related person to redeem or buy the stock.
The issuer or a related person is required to redeem or buy the stock.
The issuer or a related person has the right to redeem or buy the stock and, on the issue date, it is more likely than not that the right will be exercised.
The dividend rate on the stock varies with reference to interest rates, commodity prices, or similar indices.

For a detailed definition of nonqualified preferred stock, see section 351(g)(2) of the Internal Revenue Code.

Liabilities. If the corporation assumes your liabilities, the exchange generally is not treated as if you received money or other property. There are two exceptions to this treatment.

If the liabilities the corporation assumes are more than your adjusted basis in the property you transfer, gain is recognized up to the difference. However, if the liabilities assumed give rise to a deduction when paid, such as a trade account payable or interest, no gain is recognized.
If there is no good business reason for the corporation to assume your liabilities, or if your main purpose in the exchange is to avoid federal income tax, the assumption is treated as if you received money in the amount of the liabilities.

For more information on the assumption of liabilities, see section 357(d) of the Internal Revenue Code.

Example.

You transfer property to a corporation for stock. Immediately after the transfer, you control the corporation. You also receive $10,000 in the exchange. Your adjusted basis in the transferred property is $20,000. The stock you receive has a fair market value (FMV) of $16,000. The corporation also assumes a $5,000 mortgage on the property for which you are personally liable. Gain is realized as follows.

FMV of stock received	$16,000
Cash received	10,000
Liability assumed by corporation	5,000
Total received	$31,000
Minus: Adjusted basis of property transferred	20,000
Realized gain	$11,000

The liability assumed is not treated as money or other property. The recognized gain is limited to $10,000, the cash received.

Transfers to Spouse

No gain or loss is recognized on a transfer of property from an individual to (or in trust for the benefit of) a spouse, or a former spouse if incident to divorce. This rule does not apply to the following.

The recipient of the transfer is a nonresident alien.
A transfer in trust to the extent the liabilities assumed and the liabilities on the property are more than the property's adjusted basis.
A transfer of certain stock redemptions, as discussed in section 1.1041-2 of the regulations.

Any transfer of property to a spouse or former spouse on which gain or loss is not recognized is treated by the recipient as a gift and is not considered a sale or exchange. The recipient's basis in the property will be the same as the adjusted basis of the property to the giver immediately before the transfer. This carryover basis rule applies whether the adjusted basis of the transferred property is less than, equal to, or greater than either its fair market value at the time of transfer or any consideration paid by the recipient. This rule applies for determining loss as well as gain. Any gain recognized on a transfer in trust increases the basis.

For more information on transfers to a spouse, see Property Settlements in Publication 504, Divorced or Separated Individuals.

Rollover of Gain From Publicly Traded Securities

You can choose to roll over a capital gain from the sale of publicly traded securities (securities traded on an established securities market) into a specialized small business investment company (SSBIC). If you make this choice, the gain from the sale is recognized only to the extent the amount realized is more than the cost of the SSBIC common stock or partnership interest bought during the 60-day period beginning on the date of the sale. You must reduce your basis in the SSBIC stock or partnership interest by the gain not recognized.

The gain that can be rolled over during any tax year is limited. For individuals, the limit is the lesser of the following amounts.

$50,000 ($25,000 for married individuals filing separately).
$500,000 ($250,000 for married individuals filing separately) minus the gain rolled over in all earlier tax years.

For more information, see chapter 4 of Publication 550.

For C corporations, the limit is the lesser of the following amounts.

$250,000.
$1 million minus the gain rolled over in all earlier tax years.

Sales of Small Business Stock

If you sell qualified small business stock, you may be able to roll over your gain tax free or exclude part of the gain from your income. Qualified small business stock is stock originally issued by a qualified small business after August 10, 1993, that meets all 7 tests listed in chapter 4 of Publication 550.

Rollover of gain. You can choose to roll over a capital gain from the sale of qualified small business stock held longer than 6 months into other qualified small business stock. This choice is not allowed to C corporations. If you make this choice, the gain from the sale generally is recognized only to the extent the amount realized is more than the cost of the replacement qualified small business stock bought within 60 days of the date of sale. You must reduce your basis in the replacement qualified small business stock by the gain not recognized.

Exclusion of gain. You may be able to exclude from your gross income one-half your gain from the sale or exchange of qualified small business stock held by you longer than 5 years. This exclusion is not allowed to C corporations. Different rules apply when the stock is held by a partnership, S corporation, regulated investment company, or common trust fund.

Your gain that is eligible for the exclusion from the stock of any one issuer is limited to the greater of the following amounts.

Ten times your basis in all qualified stock of the issuer you sold or exchanged during the year.
$10 million ($5 million for married individuals filing separately) minus the gain from the stock of the same issuer you used to figure your exclusion in earlier years.

More information. For more information on sales of small business stock, see chapter 4 of Publication 550.

Rollover of Gain From Sale of Empowerment Zone Assets

You may qualify for a tax-free rollover of certain gains from the sale of qualified empowerment zone assets. This means that if you buy certain replacement property and make the choice described in this section, you postpone part or all of the recognition of your gain.

You can make this choice if you meet all the following tests.

You hold a qualified empowerment zone asset for more than 1 year and sell it at a gain.
Your gain from the sale is a capital gain.
During the 60-day period beginning on the date of the sale, you buy a replacement qualified empowerment zone asset in the same zone as the asset sold.

Any part of the gain that is ordinary income cannot be postponed and must be recognized.

Qualified empowerment zone asset. This means certain stock or partnership interests in an enterprise zone business. It also includes certain tangible property used in an enterprise zone business. You must have acquired the asset after December 21, 2000.

Amount of gain recognized. If you make the choice described in this section, you must recognize gain only up to the following amount:

The amount realized on the sale, minus
The cost of the qualified empowerment zone asset that you bought during the 60-day period beginning on the date of sale (and did not previously take into account in rolling over gain on an earlier sale of qualified empowerment zone assets).

If this amount is equal to or more than the amount of your gain, you must recognize the full amount of your gain. If this amount is less than the amount of your gain, you can postpone the rest of your gain by adjusting the basis of your replacement property as described next.

Basis of replacement property. You must subtract the amount of postponed gain from the basis of the qualified empowerment zone assets you bought as replacement property.

More information. For more information about empowerment zones, see Publication 954, Tax Incentives for Distressed Communities. For more information about this rollover of gain, see section 1397B of the Internal Revenue Code.

Exclusion of Gain From Sale of DC Zone Assets

If you sold or exchanged a District of Columbia Enterprise Zone (DC Zone) asset that you held for more than 5 years, you may be able to exclude the �qualified capital gain�. The qualified gain is, generally, any gain recognized in a trade or business that you would otherwise include on Form 4797, Part I. This exclusion also applies to an interest in, or property of, certain businesses operating in the District of Columbia.

DC Zone asset. A DC Zone asset is any of the following:

DC Zone business stock.
DC Zone partnership interest.
DC Zone business property.

Qualified capital gain. The qualified capital gain is any gain recognized on the sale or exchange of a DC Zone asset that is a capital asset or property used in a trade or business. It does not include any of the following gains.

Gain treated as ordinary income under section 1245;
Gain treated as unrecaptured section 1250 gain. The section 1250 gain must be figured as if it applied to all depreciation rather than the additional depreciation;
Gain attributable to real property, or an intangible asset, which is not an integral part of a DC Zone business; and
Gain from a related-party transaction. See Sales and Exchanges Between Related Persons in chapter 2.

See Publication 954, Tax Incentives for Distressed Communities, and section 1400B for more details on DC Zone assets and special rules.


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Virginia: 703-683-0600	Nationwide Toll-Free: 888-899-1031	Fax: 303-715-1012
© 2006 Castle Web Builder.com Building your business on the Web

Working Across the United States for 15 Years!
AZ(Phoenix): 480-551-7117	CA(Sacramento): 916-984-1751	CA(L.A.): 714-632-6697
Florida: 561-642-8666	Hawaii: 808-536-7060	New York: 718-850-4031
Virginia: 703-683-0600	Nationwide Toll-Free: 888-899-1031	Fax: 303-715-1012
© 2006 Castle Web Builder.com Building your business on the Web

Working Across the United States for 15 Years!
AZ(Phoenix): 480-551-7117	CA(Sacramento): 916-984-1751	CA(L.A.): 714-632-6697
Florida: 561-642-8666	Hawaii: 808-536-7060	New York: 718-850-4031
Virginia: 703-683-0600	Nationwide Toll-Free: 888-899-1031	Fax: 303-715-1012
© 2006 Castle Web Builder.com Building your business on the Web

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