Accounting for like-kind exchanges

National Public Accountant, The, August, 1991 by Alan D. Campbell

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.