Excess Principal Treated as “Other Property” (i.e., Boot)

Section 356 governs the receipt of "other property" (boot) in an exchange that otherwise qualifies as a reorganization. Under section 354(a)(2) and Treas. Reg. § 1.356-3, securities are permitted to 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, B — an individual — surrenders 100 shares of common stock together with a security in the principal amount of $1,000. In return, B receives 300 shares of common stock and a security with a principal amount of $1,500 and a fair market value of $1,575. Because a security in the principal amount of $1,000 was surrendered, only $1,000 of the principal amount received escapes boot treatment; the remaining $500 of principal is "excess" principal amount.

Under the regulation, the amount treated as other property is the fair market value of the excess principal amount, not its face amount. Applying the FMV-to-principal ratio of the security received ($1,575 / $1,500), the fair market value of the $500 excess principal is $525, which is treated as boot. The diagram's note reflects the mechanics of measuring the excess principal against the security surrendered.

• Securities Received Treated as Other Property (i.e., Boot)
• No Boot if No Excess Principal
• Stock Exchanged for Stock Plus Boot — Gain