Tax-Free Exchanges Under IRC §1032, §1035, §1036, §1038, §1041
Other sections of the tax code, besides §1031 for like-kind property exchanges and §1033 for involuntary conversions, provide tax-free exchanges for certain types of property. Under IRC §1032, a corporation can issue stock in exchange for money or other property tax-free. Under §1036, common stock or preferred stock of the same corporation can be exchanged tax-free for stock of the same type, whether it is exchanged between the corporation and the stockholder or between stockholders. However, preferred stock with special redemption rights or a variable dividend rate does not qualify for tax-free treatment. Losses on the qualifying exchange are not deductible. Also, exchanging common stock for preferred stock or vice versa is not tax-free unless the exchanges were the result of a tax-free recapitalization of the corporation.
Conversion of a tenancy in common to a joint tenancy is tax-free, as is as a partition of the property among tenants in common.
Under §1035, certain insurance policies can also be exchanged tax-free:
- the exchange of a life insurance policy for an endowment or annuity policy
- an exchange of endowment contracts where the regular payments for the replacement contract begins on a date no later than under the relinquished contract
- the exchange of an endowment contract for an annuity, and
- the exchange of annuity contracts.
However, an annuity contract cannot be exchanged for a life insurance or endowment policy. Any tax-free exchange of annuity contracts must have the same annuitants.
If an insurance company is in financial trouble, then the policyholder can surrender the policy and reinvest the proceeds tax-free for a new policy with a different company, if the transfer is completed within 60 days. If a government agency disallows any withdrawal of money, then the taxpayer must assign all rights to any future distributions to the issuer of the new policy. Revenue Procedure 92-44
For transfers between annuities that occur before October 24, 2011, Revenue Procedure 2008-24 allows a tax-free exchange only if there is no withdrawal of money received within 12 months after the transfer, or if a taxpayer satisfies a penalty exception for annuity distributions before age 59½, such as being disabled. Revenue Procedure 2011-38 also allows tax-free exchanges between annuities if the amount received in the acquired annuity is no more than the previous amount, other than the amount received as an annuity for 10 or more years, or for one or more lives, that is received within the 180 day period after the transfer or the date of a new contract, either under the old or the new contract. Otherwise, the IRS may treat the distribution as taxable annuity earnings or as boot.
Under §1038, losses on realty that has been sold as an installment sale that was subsequently repossessed is not recognized, but some gains may be recognized.
§1041 permits tax-free transfers between spouses, or between former spouses, if the exchange was part of a divorce settlement. If property is transferred to a former spouse, then is it is tax-free if the transfer was the result of a divorce. However, transfers to a former spouse must occur within 1 year after the marriage or must be because of the divorce. However, transfers to spouses or former spouses who are nonresident aliens are taxable, since the federal government may not be able to collect the tax later when the property is ultimately disposed of.
Exchanges of coins and bullion can be tax-free if they are of like kind. Bullion-type coins depend on the amount of metal that they contain for their worth, whereas numismatic coins depend more on the numismatics of the coin, such as the coin's age, condition, and rarity. Generally, bullion coins cannot be exchanged tax-free for numismatic coins.
Property Transferred to Closely Held Corporations
Property transferred to a closely held corporation will be tax-free if the taxpayer owns at least 80% of the combined voting power of the corporation and 80% of all stock immediately after the transfer. Any securities received in addition to the stock are treated as taxable boot. The corporation receives a carryover basis of the property from the transfer. If there are partners forming a partnership, then the partners must own at least 80% of the voting stock and 80% of all other stock after the transfer. However, property subject to debt is not treated as a boot to the corporation. Instead, the taxpayer's basis is reduced by the amount of the debt. However, these rules will not apply if the transfer was part of a tax avoidance scheme or if the liabilities exceed the basis of the transferred property.
Example: Tax Basis of Stock Received in Exchange for Property Transferred to a Closely Held Corporation
- You exchange real estate with a fair market value of $100,000 to your new corporation in exchange for all the stock.
- Your tax basis in the real estate is $40,000.
- The tax basis of the real estate to the corporation is $100,000, its fair market value when transferred.
- The tax basis of the stock you acquired = the tax basis of the property you gave = $40,000.
- Later, you sell the stock for $120,000.
- Your gain = $120,000 − $40,000 = $80,000 is recognized in the year of the sale.