TaxDeferred Exchanges

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Tax-DeferredExchanges

• Chapter 8

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Tax-Deferred Exchanges

• A tax-deferred exchange postpones gain or loss
  recognition to the future by adjusting basis of
  the asset acquired
• The longer gain recognition can be postponed, the
  greater the tax savings
• The longer a loss is postponed, the less valuable
  the loss

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Basis Adjustments

• Gain is deferred by reducing the adjusted basis
  of the replacement property by the deferred gain
• Loss is deferred by increasing the adjusted basis
  of the replacement property by the deferred loss
• When an asset is sold at a later date, the basis
  adjustment results in the deferred gain or loss
  being recognized

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Basis

• Carryover basis the basis of the original asset
  follows the asset to the new owner
• Substituted basis the basis of the original
  asset is substituted for the asset acquired
• Holding period of the old asset is added to the
  holding period of the new asset when basis is
  determined by carryover, substitution or basis
  adjustment

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Like-Kind Exchanges

• When eligible property is exchanged solely for
  other property of a like-kind, no gain or loss is
  recognized (Section 1031)
• The gain or loss realized is deferred by
  adjusting the basis of the replacement property
• Qualifying property must be used in a business
  or for investment
• Certain properties are excluded
• inventory, stock, securities, and partnership
  interests

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Like-Kind Exchanges

• Realty must be exchanged for realty (can be land
  or buildings)
• Personalty must be exchanged for personalty in
  same class
• General asset classes for personalty include
• Office furniture, fixtures equipment
• Computers info systems equipment
• Automobiles taxis
• General-purpose light trucks
• General-purpose heavy trucks

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Like-Kind Exchanges

• The receipt of boot can cause realized gain to be
  recognized
• Boot is anything that is not like-kind qualifying
  property and includes
• Cash
• Properties not of a like-kind
• Net liabilities discharged
• in the transaction

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Like-Kind Exchanges

• Gain Recognized lesser of gain realized or boot
  received (giving boot does not affect gain
  recognition)
• If the requirements are met, like-kind exchange
  treatment is mandatory (not elective) and it
  applies to losses as well as gains

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Like-Kind Exchanges

• Boot
• Any property involved in the exchange that is not
  like-kind property is boot
• The receipt of boot causes gain recognition equal
  to the lesser of boot received (FMV) or gain
  realized
• No loss is recognized even when boot is received

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Like-Kind Exchanges

• Boot
• The transferor of boot property may recognize
  gain or loss on that property
• Treat as if boot property sold for its FMV

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Problem, part I

• In a like-kind exchange, TP1 received real estate
  with FMV 100,000.
• TP1 gave in exchange
• Real estate FMV 80,000 AB 50,000
• Machinery FMV 20,000 AB 15,000
• Will TP1 recognize any gain or loss?

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Problem, part II

• TP2 exchanged real estate with AB 70,000 and FMV
  100,000
• For real estate FMV 80,000
  
  AB 50,000 and
  machinery FMV 20,000 AB
  15,000
• Will TP2 recognize any gain nor loss?

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Like-Kind Exchanges

• Taxpayers with loss assets might want to sell
  them so they can deduct their losses in the
  current year, then buy replacement property
• Alternatively, taxpayers can receive cash
  tax-free in an exchange because when there is a
  realized loss, boot can be received without
  causing gain recognition

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Like-Kind Exchanges

• Basis in replacement property FMV of property
  received less deferred gain plus deferred loss
• Alternatively, basis in replacement property
  basis of property surrendered plus boot given
  plus gain recognized less boot received
• Holding period for new property includes holding
  period of property surrendered
• Basis of Boot FMV
• Holding period begins on date received

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• TP exchanged factory with FMV 100,000, AB
  80,000, for a warehouse with FMV 100,000.
• What is TPs realized gain, recognized gain,
  deferred gain, and basis in the warehouse?

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Indirect Exchange

• In an indirect exchange, the taxpayer hires a
  third party to purchase the desired property
• The third party then exchanges the just-purchased
  property for the taxpayers property
• The taxpayer has a qualifying exchange
• The seller of the property and the third party
  must treat the transaction as taxable

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Nonsimultaneous Exchange

• A taxpayer can sell his property, but a third
  party must hold all proceeds so that the taxpayer
  has no access to any cash or other property
  received in the sale
• The taxpayer has 45 days from the date the
  property is transferred to identify like-kind
  property to be exchanged
• The acquisition of the identified property must
  be completed within 180 days

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Wash Sales

• Wash sale - identical securities acquired within
  30 days before or after sale (a 61-day period)
• Wash sale losses are disallowed but gains are
  taxed
• Loss is deferred by adding disallowed loss to
  basis of new shares
• If more stock is sold than is purchased within
  the 61-day period, only a portion of the loss
  representing the repurchased stock is deferred

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Involuntary Conversions

• An involuntary conversion results from
• Theft embezzlement, larceny and robbery (but
  not simply losing items)
• Casualty requires a sudden, unexpected, and
  unusual event including a fire, flood, tornado,
  hurricane or vandalism
• Condemnation lawful taking of property for its
  fair market value by government under right of
  eminent domain

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Casualties and Thefts

• Gains and losses sustained on casualties and
  thefts are not under a taxpayers control so they
  receive special tax treatment
• Allowable losses (including personal losses) are
  immediately deductible
• Gains (due to receipt of insurance proceeds) may
  be deferred if all insurance proceeds are used to
  repair the damaged property or to acquire
  qualifying replacement property

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Definition of Casualty Theft (C T)

• Losses or damages to the taxpayers property that
  arise from fire, storm, shipwreck, or other
  casualty or theft
• Loss is from event that is identifiable, damaging
  to taxpayers property, and sudden, unexpected,
  and unusual in nature
• Events not treated as casualties include losses
  from disease and insect damage

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Definition of Theft

• Theft includes robbery, burglary, embezzlement,
  etc.
• Does not include misplaced items

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When Casualty Theft Is Deductible

• Casualties year in which loss is sustained
• Exception If declared disaster area by
  President, can elect to deduct loss in year prior
  to year of occurrence
• Thefts year in which loss is discovered

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Effect of Claim for Reimbursement

• If reasonable prospect of full recovery
• No casualty loss is permitted
• Deduct in year of settlement any amount not
  reimbursed
• If only partial recovery is expected, deduct in
  year of loss any amount not covered
• Remainder is deducted in year claim is settled

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Amount of CT Deduction

• Amount of loss and its deductibility depends on
  whether
• Loss is from nonpersonal (business or production
  of income) or personal property
• Loss is partial or complete

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Amount of Nonpersonal CT Losses

• Theft or complete casualty
  (FMV after 0)
• Adjusted basis in property less insurance
  proceeds
• Partial casualty
• Lesser of decline in value or adjusted basis in
  property, less insurance proceeds

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CT Examples

• Business and production of income losses (no
  insurance proceeds received)
• Adjusted FMV FMV
• Item Basis Before After Loss
• A 6,000 8,000 5,000
  3,000
• B 6,000 8,000 1,000
  6,000
• C 6,000 4,000 0
  6,000

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Nonpersonal CT Losses

• Business, rental, and royalty properties
• Deduction will be FOR AGI
• Investment properties
• Deduction will be FROM AGI
• Misc. itemized deduction not subject to 2 of AGI
  limitation

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Nonpersonal CT Gains

• Depending on the property, gain can be ordinary
  or capital
• Amount of nonpersonal gains
• Insurance proceeds less adjusted basis in property

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Personal CT Gains

• Net personal casualty gains and losses
• If gains exceed losses, treat as gains and losses
  from the sale of capital assets (and added to
  them.)
• Short term or long term, depending on holding
  period
• Personal casualty and theft gains and losses are
  not netted with the gains and losses on business
  and income-producing property

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Personal CT Losses

• Net personal casualty gains and losses
• If losses exceed gains, CT deduction will be
  FROM AGI (an itemized deduction)
• Amount of personal CT losses
• Lesser of decline in value or adjusted basis in
  property, less insurance proceeds
• CT Limitation
• Each CT occurrence is deductible to extent gt
  100, and aggregate of CT losses for year must
  be gt 10 AGI

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Example of CT Limitation (slide 1 of 2)

• Karen (AGI 40,000) has the following CT
  (amounts are lesser of decline in value or
  adjusted basis)
• 1. Car stolen (6,000) with camera inside (500)
• Earthquake damage house (2,000), furniture
• (1,000)

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Example of CT Limitation (slide 2 of 2)

• Example of CT limitation (contd)
• Karen has no insurance coverage for either
  loss
• 1. 6,000 500 6,500 100 6,400
• 2. 2,000 1,000 3,000 100 2,900
• Karens deductible CT loss is 5,300 6,400
  2,900 (10 40,000)

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PROBLEMS

• ABC Computer Co. incurred the following casualty
  and theft losses during the current year.
  Compute the casualty and theft loss deduction for
  each.
• Adj. FMV FMV Ins.
  Basis Before After Reimburse
• Robbery 10,000 9,000
  0 9,000 (Computer)
• Fire 65,000 100,000
  55,000 55,000
• (Store)
• Fire 3,000 4,000
  0 2,000
• (Truck)

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PROBLEMS

• Tom was involved in an accident while driving his
  automobile. The car cost him 10,000 originally,
  and was used only for personal use. FMV before
  the accident was 5,000. After the accident, FMV
  was 1,000. His insurance company reimbursed him
  3,000. His AGI was 50,000. He had no other
  thefts or casualties. What amount can he deduct
  as a net casualty loss for the year?

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Gains onInvoluntary Conversions

• Casualty or theft gains result when insurance
  recovery is greater than basis
• Condemnations usually result in gain because
  proceeds received are usually fair market value
• If all of the proceeds are reinvested in
  qualified replacement property (or repairing the
  property to its pre-casualty condition) then
• Gain is deferred if reinvestment done within
  replacement period

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 Replacement Period

• 2 full tax years after the end of the taxable
  year in which the involuntary conversion occurs
• Extended to 3 years if it involves a condemnation
  of business or investment realty
• If any of the proceeds are not reinvested (either
  through repairs of the damaged property or by
  acquiring replacement property within the time
  period), then gain is recognized on the amount
  not reinvested

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Replacement Property

• Functional-use test replacement property
  provides same function as converted property
• Taxpayer-use test only need to replace with
  leased property (applies to investment real
  estate rented and not used by owner)
• Condemned business or investment realty only
  needs to meet like-kind test

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Gain Recognition

• Gain Recognized lesser of gain realized or the
  amount not reinvested (amount realized less
  amount reinvested)
• This provision does not apply to losses
• The basis in the replacement property is the cost
  (amount reinvested) less any deferred gain (gain
  realized less gain recognized)
• Except in the case of direct conversion,
  involuntary conversion treatment is elective

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Simple example

• Involuntary conversion with
• Cash received 200
• Basis of old property 180
• Cost of replacement property 192

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Involuntarily ConvertedPrincipal Residence

• If the taxpayer acquires a replacement residence
  using all the proceeds received, the gain can be
  deferred
• If taxpayer meets 2 year ownership use tests,
  can exclude up to 250,000 (500,000 if both
  spouses qualify) of gain
• These two provisions can be combined to exclude
  gain on the amount that is not reinvested

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Transfers to Sole Proprietorships

• Gain or loss deferred
• Basis of transferred asset to sole proprietorship
  is lesser of
• Adjusted basis or
• Fair market value at date of
• conversion to business use

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Transfers to Corporations (351 Rule)

• Gain or loss deferred when cash or property is
  contributed to corporation in exchange for stock
• Shareholders contributing qualified property must
  own 80 of stock (services do not qualify)
• Stock received for services results in taxable
  income to shareholder rendering services
• Gain recognized when boot (other than stock)
  received (loss is never recognized)
• Gain lesser of realized gain or FMV boot
  received

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Transfers to Corporations

• Stock basis
• Basis of property given up
• Gain recognized
• - Boot received
• - Liabilities assumed by the corporation
• Basis carries over to corporation (increased by
  any gain recognized by shareholder)
• Basis of boot received is its FMV

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TP transfers property to Corp X for gt80 its
stock 10,000 cash

• TPs AB in property is 60,000
• FMV of property is 100,000
• FMV of 80 of stock is 90,000
• What is TPs realized gain, recognized gain, and
  deferred gain?
• What is TPs basis in the stock?
• What is Corp Xs basis in the property?

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Transfers to Partnerships

• No gain or loss is recognized by partners or the
  partnership (no minimum ownership required)
• Partners must recognize taxable income
  attributable to services
• Basis of property carries over to the partnership
• Partner may need to recognize gain to avoid a
  negative basis (if liabilities assumed by the
  partnership are greater than partners basis
  including his share of partnership liabilities)

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Transfers to Partnerships

• Partners basis in partnership interest
• Basis of property given up
• liabilities assumed by the partnership
• - partners share of partnership liabilities
• gain recognized

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• TP contributes equipment from his sole
  proprietorship to partnership.
• Equipment had FMV 50,000. It was purchased last
  year for 70,000. 10,000 of depreciation had
  been taken.
• TP received 1/3 interest in partnership.

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The End