Section 356 governs the receipt of "other property" (boot) in an exchange that otherwise qualifies for nonrecognition. Under section 354(a)(2) and Treas. Reg. § 1.356-3, a security may be received tax-free only to the extent the principal amount of securities received does not exceed the principal amount of securities surrendered. The fair market value of any excess principal amount is treated as other property received in the exchange.
Here, E — an individual — surrenders a security in the principal amount of $1,000 and receives a security with a principal amount of $1,200 and a fair market value of $1,080. Because a $1,000 security was surrendered, $1,000 of the principal amount received is not excess; the remaining $200 of principal is the "excess" principal amount that must be tested under section 356.
The regulation treats the fair market value of the excess principal amount — not its face amount — as boot. Applying the FMV-to-principal ratio of the security received ($1,080 / $1,200 = 0.90), the fair market value of the $200 excess principal is $180. As the diagram's table shows, the total security ($1,200 principal / $1,080 FMV) splits into a no-excess portion ($1,000 / $900) and an excess portion ($200 / $180), and the $180 is the amount treated as other property.
Securities are not treated as stock for section 354/356 purposes; principal amount received in excess of principal amount surrendered is treated as other property.
E surrendered a $1,000 security, so $1,000 of the $1,200 principal received is not excess; only the remaining $200 of principal is subject to boot analysis.
The regulation treats the fair market value of the excess principal amount — $180, not the $200 face amount — as the boot received in the exchange.
Because the security is worth $1,080 against $1,200 of principal, the excess $200 of principal carries $180 of fair market value, which is the boot.
