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Accounting for like-kind exchanges.

Accounting for Like-Kind Exchanges

When one asset is exchanged for another asset of like kind, the accounting treatment differs from that if the asset were sold and another like-kind asset purchased. In a sale, the gain or loss that is realized would be recognized and the book value of any similar asset purchased would be its cost.

In a pure like-kind exchange, one asset is exchanged for another asset of like kind. No other form of consideration is given or received. Often like-kind exchanges are not pure exchanges because the fair market values of the assets to be exchanged differ. To make these exchanges, other assets of unlike-kind are given or received, or liabilities are relieved. These other assets or the relief of liabilities are known as "boot."

When a like-kind exchange takes place the gain or loss realized on the exchange must be determined. The gain or loss that is recognized depends upon whether a gain or loss was realized and whether any boot was received.

The financial accounting and tax accounting treatment given to like-kind exchanges often differs. These differences occur because of the different purposes of gain and loss recognition between financial accounting and tax accounting, different definitions of what constitutes like-kind assets and the different treatment given to boot received. This article will explain and illustrate these differences.

Definitions of Like-Kind

Properties

The financial accounting treatment given to like-kind exchanges is governed by APB Opinion No. 29, "Accounting for Nonmonetary Transactions." For financial accounting purposes, a like-kind exchange occurs when the exchange does not represent the culmination of the earnings process. Paragraph 21 of APB Opinion No. 29 states that an exchange of inventory for inventory to facilitate sales to third-party customers does not represent the culmination of the earnings process. Neither does the exchange of a productive asset for a similar productive asset constitute the culmination of the earnings process.

Paragraph 3 of APB Opinion No. 29 defines similar productive assets as those "of the same general type, that perform the same function or that are employed in the same line of business."

Internal Revenue Code Sec. 1031 governs the tax accounting treatment of like-kind exchanges. Sec. 1031(a)(1) requires that both the asset given up and the asset received must be held for investment or for productive use in a trade or business. The properties must also be of like kind. Regualtion Sec. 1.1031(a)-1(b) states that like kind has "reference to the nature or character of the property and not to its grade or quality." However, the properties must be of the same kind or class. Improved real estate may be exchanged for unimproved real estate.

Sec. 1031(a)(2) provides that inventory, corporate securities, notes, partnership interests, certificates of trust or beneficial interest, and choses in action are not eligible for like-kind exchange treatment. Thus, if any of these assets is exchanged for a similar asset, the gain or loss that is realized must be recognized in full under the general rule of Sec. 1001(c).

For tax purposes the gain or loss realized on the exchange of inventory for inventory to facilitate sales to third-party customers would be recognized in full. For financial accounting purposes, no gain would be recognized. However, a loss that is realized would be recognized.

The definition of like-kind properties is different for financial accounting than for tax purposes. For financial accounting purposes exchanges of inventory and investments in common stocks must be treated as nonmonetary transactions. Inventory and corporate securities are not eligible for like-kind exchange treatment for tax purposes. For financial accounting, if property, plant and equipment are exchanged the properties must have the functional use or be used in the same line of business. For tax purposes, any exchange of personal property for personal property or real property for real property is eligible for like-kind exchange treatment. The properties must be held for investment or used in a trade or business. They do not have to have the same functional use or be used in the same line of business.

Determination of Gain or

Loss Realized

For financial accounting, a pure like-kind exchange results in no gain being recognized. If the fair market value of the asset given in the exchange is less than its book value, a loss must be recorded for the impairment and the book value of the asset given in the exchange becomes the book value of the asset received in the exchange.

Example 1. Land with a cost of $10,000 and a fair market value of $8,000 is exchanged for land with a fair market value of $8,000. A loss of $2,000 must be recognized. The book value of the new land would be $8,000. The general journal entry would be as follows:

Land (New) 8,000

Loss on Exchange
 of Land 2,000
 Land (Old) 10,000


If boot is received in the exchange, the total consideration must be determined in order to determine how much gain is to be recognized. The total consideration is the sum of the boot received and the fair market value of the like-kind property received or, if more clearly determinable, the total consideration is the fair market value of the asset given in the exchange.

Example 2. Land with a cost of $6,000 and a fair market value of $10,000 is exchanged for land worth $9,000 and $1,000 in cash. The total consideration received is $10,000 which is equal to the $9,000 fair market value of the new land plus the $1,000 cash received. If the fair market value of the land received was not readily determinable, then the $10,000 fair market value of the land given in the exchange would be used as the total consideration received.

For tax purposes, Sec. 1001(a) states that the gain or loss realized is equal to the amount realized less the adjusted basis of the asset given in the exchange.

Sec. 1001(b) states that the amount realized is equal to the amount of money received plus the fair market value of property received in the exchange. Regulation Sec. 1001-2(a) further explains that the discharge of liabilities is included in the amount realized. However, according to Regulation Sec. 1001-2(c), the increase in liabilities on an exchange reduces the amount realized.

Example 3. Land that has an adjusted basis of $20,000 and a fair market value of $30,000 is exchanged for land with a fair market value of $22,000, $3,000 in cash and the other party's assumption of a $5,000 mortgage loan. The amount realized on the exchange is $30,000. The amount realized is equal to the sum of the $22,000 value of the land, the $3,000 cash received and the $5,000 liability discharged. The amount realized of $30,000 less the $20,000 adjusted basis of the land given equals the gain realized of $10,000.

Example 4. Land that cost $24,000 with a fair market value of $40,000 and subject to a mortgage of $8,000 is exchanged for land worth $36,000 which is subject to a mortgage of $4,000. The amount realized is $40,000 which is the $36,000 value of the land received, plus the $8,000 liability discharged, less the $4,000 liability incurred.

According to Sec. 1011, the adjusted basis of the asset given up is usually its cost adjusted for the items noted in Sec. 1016. Generally, the adjusted basis of an asset is its cost less its accumulated depreciation.

Loss Realized

If a loss is realized on a like-kind exchange, the loss must be recognized in full for financial accounting. This is in accordance with the principle of conservatism. For tax purposes Sec. 1031(a)(1) disallows the recognition of any loss on a like-kind exchange. Sec. 1031(c) makes it clear that no loss may be recognized on a like-kind exchange even when boot is received.

Example 5. A machine with a fair market value of $37,000 and an adjusted basis of $42,000 is exchanged for a machine worth $37,000 and an adjusted basis of $42,000 is exchanged for a machine worth $37,000. A $5,000 loss is realized on the exchange. The loss would be recognized for financial accounting, but no loss can be recognized for tax purposes.

Example 6. Land with a cost of $60,000 and a fair market value of $50,000 is exchanged for land worth $45,000 and $5,000 in cash. A $10,000 loss has been realized. The loss is recognized for financial accounting. No loss may be recognized for tax purposes even though $5,000 in boot was received.

Gain Realized

For financial accounting, APB Opinion No. 29, paragraph 21, requires the realized gain must not be recognized. Likewise, Sec. 1031(a)(1) specifies that no gain will be recognized for tax purposes in a pure like-kind exchange. The book value for financial accounting and the adjusted basis for tax purposes of the asset will seldom be the same because of the difference in depreciation methods between financial accounting and tax accounting. Thus, the amount of gain realized may be different, but no gain may be recognized for either financial accounting or tax accounting. For the sake of simplicity, the examples here assume that the book value for financial accounting is equal to the adjusted basis for tax purposes.

Example 7. A machine with a book value of $14,000 and a fair market value of $19,000 is exchanged for a similar machine worth $19,000. A $5,000 gain has been realized. No gain may be recognized for financial accounting or for tax purposes.

Paragraph 22 of APB Opinion No. 29 requires that when boot is received in a like-kind exchange a realized gain must be recognized to the extent that the boot received exceeds a proportionate amount of the book value of the asset given in the exchange.

To determine the portion of the asset given up that is deemed to have been sold for the boot received, the book value of the asset given in the exchange is multiplied by the fraction of the boot received divided by the sum of the boot received and the fair market value of the like-kind asset received. The gain realized is recognized to the extent that the boot received exceeds this portion of the book value of the asset given up.

For tax accounting Sec. 1031(b) states that if a gain is realized, the gain that is recognized will be limited to the boot received. The gain that is recognized can never exceed the gain that is realized. Thus, if the boot received exceeds the gain realized, the gain recognized will equal the gain realized. This is in accordance with the wherewithal-to-pay principle of taxation.

To the extent that the taxpayer has received boot, he is deemed to have the funds needed to pay taxes. Thus, the gain that is realized is recognized to the extent of the boot received.

Example 8. Land with a cost of $7,000 and a fair market value of $10,000 is exchanged for land with a fair market value of $9,000 and $1,000 in cash. The gain realized is $3,000. The boot received divided by the total consideration is equal to 10% ($1,000 / $1,000 + $9,000). Thus, $700 ($7,000 x 10%) of the land given in the exchange is deemed to have been sold for the $1,000 cash. The gain recognized for financial accounting is $300. For tax purposes the gain recognized would be $1,000.

Paragraph 22 of APB Opinion No. 29 makes it clear that the entity paying the boot in a like-kind exchange may not recognize any gain.

Example 9. A machine with a book value of $9,000 and a fair market value of $10,000 is exchanged for a similar machine worth $10,500. Cash of $500 is paid to complete the transaction. The gain realized is $1,000. However, no gain is recognized for financial accounting or for tax purposes because boot was paid, not received.

Paragraph 4 of APB Opinion No. 29 states that in nonmonetary transactions there is sometimes a small amount of monetary consideration in addition to the nonmonetary transaction. "Small" is not operationally defined. Perhaps if the amount of boot is not small the transaction would not be considered a nonmonetary transaction. In that case all of the gain that was realized would be recognized.

Example 10. Land with a cost of $30,000 and a fair market value of $50,000 is exchanged for land worth $8,000 and $42,000 in cash. The gain realized is $20,000. All of this gain might be recognized. The boot is not small, and the exchange is essentially a monetary transaction. For tax purposes the gain recognized would be all of the $20,000 gain realized because the boot received exceeds the gain realized.

For tax purposes Regulation Sec. 1031(b)-1(c) states that the relief of liabilities is to be considered boot for purposes of Sec. 1031(b). The increase in liabilities on the exchange will reduce the amount of boot received. APB Opinion No. 29 does not provide specific guidance as to the treatment of a decrease or increase in liabilities as a part of a nonmonetary transaction.

Example 11. Land with an adjusted basis of $12,000 and a fair market value of $20,000 and subject to a mortgage of $5,000 is exchanged for land worth $15,000. The amount realized is $20,000 - the $15,000 fair market value of the land received and the $5,000 liability discharged. The $20,000 amount realized less the $12,000 adjusted basis of the land given equals the gain realized of $8,000. The $5,000 liability discharged is considered boot. Therefore, the gain recognized is $5,000.

Example 12. Land with a adjusted basis of $36,000 and a fair market value of $41,000 is exchanged for land worth $40,000 subject to a mortgage of $6,000 and the other party's assumption of a mortgage loan of $7,000. The amount realized is $41,000-$40,000 fair market value of land received, plus the liability discharged of $7,000, less the $6,000 liability to which the land received is subject. The $41,000 amount realized less the $36,000 adjusted basis of the land given in the exchange leaves a gain realized of $5,000. The gain recognized is $1,000 - the $7,000 liability discharged less the $6,000 liability to which the land received is subject.

Generally, when boot is received in a like-kind exchange, the gain that is recognized for tax purposes will be greater than the gain that is recognized for financial accounting purposes.

Book Value or Basis

For financial accounting in a pure like-kind exchange, the book value of the asset given in the exchange (after being written down to fair market value if necessary) becomes the book value of the asset received in the exchange. If boot is paid in the like-kind exchange, the boot paid increases the book value of the asset received in the exchange.

For tax purposes, Sec. 1031(d) requires that in a pure like-kind exchange the adjusted basis of the asset given in the exchange becomes the basis of the asset received in the exchange. The asset given in the exchange may not be written down to fair market value as required by financial accounting standards. Losses are never recognized for tax purposes in like-kind exchanges.

If boot is paid, the basis of the asset received in the exchange is equal to the adjusted basis of the asset given in the exchange under Sec. 1031(d) increased by the boot given which represents an additional cost under Sec. 1012.

Example 13. Land with a book value of $6,000 and a fair market value of $9,000 plus $1,000 in cash is exchanged for land worth $10,000. No gain is recognized for financial accounting or for tax accounting. The book value of the new land acquired is $7,000. The general journal entry would be as follows:
 Land (New) 7,000
 Land (Old) 6,000
 Cash 1,000


Example 14. A machine with a book value of $15,000 (cost of $20,000 and accumulated depreciation of $5,000) and a fair market value of $12,000 is exchanged for a similar machine with a fair market value of $12,000. A $3,000 loss is realized. For financial accounting the $3,000 loss is recognized and the book value of the new machine is $12,000. The general journal entry would be as follows:

Machine (New) 12,000

Accumulated

Depreciation 5,000

Loss on Exchange
 of Machine 3,000
 Machine (Old) 20,000


For tax purposes none of the $3,000 loss that was realized may be recognized. The loss not recognized adds to the fair market value of the new machine acquired in determining its adjusted basis. The general journal entry for tax purposes would be as follows:

Machine (New) 15,000

Accumulated
 Depreciation 5,000
 Machine (Old) 20,000


If boot is received in a like-kind exchange, for financial accounting the book value of the like-kind asset received in the exchange is equal to the book value of the asset given in the exchange less the portion of the book value that is deemed to have been sold.

If boot is received in a like-kind exchange, for tax purposes Sec. 1031(d) provides that the basis of the asset received in the exchange is equal to the adjusted basis of the asset given in the exchange reduced by the boot received and increased by the gain recognized. Sec. 1031(d) further stipulates that the basis of the boot received is its fair market value on the date of the exchange.

Example 15. Land with a book value of $40,000 and a fair market value of $50,000 is exchanged for land worth $45,000 and $5,000 in cash. The total consideration or amount realized is $50,000, and the gain realized is $10,000. The portion of the book value that is deemed to have been sold is $4,000 [$40,000 x ($5,000 / $5,000)]. The gain recognized for financial accounting is $1,000 ($5,000 - $4,000). The book value of the new land acquired is $36,000 ($40,000 - $4,000). The general journal entry would be as follows:
 Land (New) 36,000
 Cash 5,000


Gain Recognized on
 Sale of Land 1,000
 Land (Old) 40,000


For tax purposes the gain recognized would be $5,000. The basis of the new land would be $40,000 which is the $40,000 adjusted basis of the old land, plus the $5,000 gain recognized, less the $5,000 boot received. The general journal entry would be as follows:
 Land (New) 40,000
 Cash 5,000


Gain Recognized on
 Sale of Land 5,000
 Land (Old) 40,000


Interperiod Income Tax

Allocation

The different treatments given to like-kind exchanges by financial accounting and by tax accounting give rise to timing differences. Accordingly, interperiod tax allocation is required under the provisions of Statement of Financial Accounting Standards No. 96.

Conclusion

The treatment given to like-kind exchanges by financial accounting and tax accounting is often different. For financial accounting, losses are always recognized. Gains are only recognized if boot is received. The gain to be recognized is equal to the boot received less the portion of the book value of the asset given in the exchange that bears the same ratio as the boot received to the total consideration received.

Losses are never to be recognized for tax purposes. Gains are recognized only to the extent of boot received.
COPYRIGHT 1991 National Society of Public Accountants
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Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Author:Campbell, Alan D.
Publication:The National Public Accountant
Date:Aug 1, 1991
Words:3345
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