Tax-Deferred 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 through an
  adjustment to 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

• 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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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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Casualty and Theft Losses

• Loss limited to the lesser of
• Decline in fair market value (or repair costs to
  restore property to pre-casualty condition)
• The adjusted basis of the property (for
  completely destroyed business property the loss
  will always be adjusted basis)
• This loss is then reduced by any insurance
  proceeds received

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Casualty and Theft Losses

• Thefts deductible in year of discovery
• For casualties in disaster areas can elect to
  deduct loss in preceding year
• A net business loss is deducted from ordinary
  income an investment loss is a miscellaneous
  itemized deduction
• Individuals have additional limits on losses from
  personal-use property
• 100 floor per casualty (per event)
• 10 of AGI threshold
• Must itemize to deduct loss

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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 the
  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 need
  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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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

• Gain or loss deferred when cash or property is
  contributed to corporation in exchange for stock
• Shareholders contributing qualified property
  (services do not qualify) must own 80 of stock
• Stock received for services results in taxable
  income to shareholder rendering services
• Gain recognized when boot received (gain the
  lesser of realized gain or FMV boot received)

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Transfers to Corporations

• Stock basis basis of property given up gain
  recognized less boot received less 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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Transfers to Partnerships

• No gain or loss is recognized by partners or the
  partnership (with no minimum ownership required)
  but partners must recognize taxable income
  attributable to services
• Basis of property carries over to the partnership
• Partners basis in partnership interest basis
  of property given up less liabilities assumed by
  the partnership plus partners share of
  partnership liabilities plus gain recognized
• 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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Corporate Reorganizations

• Involves transfer of all or part of one or more
  corporations assets or stock to a second
  corporation over which it has control in a
  transaction that qualifies as a reorganization
• Acquisitive one corporation acquires assets or
  stock of another corporation
• Divisive one corporation splits into 2 or more
  corporations
• Recapitalization
• Reincorporation

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Corporate Reorganizations

• Corporations and shareholders exchange stock for
  property and stock for stock on a tax-deferred
  basis
• The property or stock received will have a
  carryover or substituted basis
• Boot received will cause all or part of gain to
  be recognized

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Reorganizations

• Appendix 8A

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Types of Reorganizations

• Seven types of reorganizations referred to as
  Types A through G
• Types A, B, and C are acquisitive reorganizations
• Types E and F involve only one corporation making
  technical changes
• Types D reorganization can be either divisive or
  acquisitive
• Type G is similar to a D reorganization but
  applies only in bankruptcy

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Acquisitive Reorganizations

• Generally involves either
• The acquisition of one corporations assets
  (target) by a second corporation (acquirer) after
  which the target ceases to operate
• The acquisition of the target corporations stock
  for stock of the acquirer, after which the target
  becomes a subsidiary of the acquiring corporation

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Acquisitive Reorganizations

• Asset acquisitions
• Type A statutory merger or consolidation
• Type C stock for asset acquisition
• Type D acquisitive
• Stock for stock acquisition
• Type B

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Acquisitive Reorganizations

• Acquirer transfers stock and securities to Target
  in exchange for Targets assets
• Neither Acquirer nor Target recognizes gain or
  loss
• Acquirer takes the same basis in the assets as
  their basis in Targets hands
• Target recognizes no gain or loss on the receipt
  of stock or securities
• Target recognizes no gain on receipt of other
  property as long as it is distributed to its
  shareholders

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Acquisitive Reorganizations

• Gain is recognized by Acquirer only if it
  transfers appreciated property other than stock
  or securities to Target
• Target then uses FMV for its basis
• No loss is recognized on depreciated property

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Acquisitive Reorganizations

• Targets shareholders usually recognize no gain
  or loss on receipt of stock in exchange for their
  stock in Target
• They may be required to recognize gain if
  principle of securities received exceeds
  securities surrendered
• If shareholders receive boot, they recognize gain
  equal to the lesser of realized gain or fair
  market value of boot received
• Basis of stock or securities received basis
  surrendered boot received gain recognized
• Basis of boot fair market value

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Acquisitive Reorganization

• Type B stock-for-stock reorganization
• Acquiring corporation acquires Targets stock
  from its shareholders in exchange solely for
  stock of Acquirer
• Acquirer can use nothing but its own voting stock
  to acquire Targets stock
• Neither Acquirer nor Targets shareholders
  recognize gain or loss

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Type A Reorganization

• Merger the acquisition of the assets of a
  target
• Target liquidates and the acquiring corporation
  continues
• Consolidation transfer of assets by two or more
  corporations to a new corporation
• Transferring corporations liquidate and the new
  corporation survives

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Type A Reorganization

• Acquirer can use both its stock and securities
• Must meet continuity of interest
• At least 50 of the shareholders of Target must
  becomes shareholders of Acquirer
• Shareholder of both Acquirer and Target usually
  must approve the merger
• Acquirer becomes liable for all liabilities of
  the Target

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Type A Reorganization

• Acquirer may transfer assets of Target to a
  subsidiary
• Forward triangular mergers
• Subsidiary could be Acquirer with Target
  shareholders becoming minority shareholders of
  Target
• Subsidiary may acquire assets of Target using
  stock of Parent

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Type A Reorganization

• Reverse triangular merger
• Parent transfers assets of subsidiary (which
  includes parents stock) to Target and subsidiary
  liquidates and Target becomes new subsidiary of
  parent
• Additional requirements apply

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Type B Reorganization

• Acquisition of Targets stock in exchange for
  voting stock of Acquirer
• Shareholders of Target become shareholder of
  Acquirer and Acquirer controls Target (owns 80
  of stock)
• Parent may also use a subsidiary as Acquirer
  using stock solely of the parent or it may drop
  the stock of Target into a subsidiary

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Type B Reorganization

• Prior purchases of stock will not taint the
  acquisition
• Acquirer has up to one year to complete the
  acquisition of control of Target
• Control does not have to be acquired as part of
  the reorganization

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Type C Reorganization

• Similar to Type A but specific requirements must
  be met
• Acquirer must acquire substantially all the asset
  of Target solely for voting stock of Acquirer
• Must distribute any remaining assets and stock of
  Acquirer to its shareholders and then liquidate
• The assets acquired must permit Acquirer to
  continue Targets historical business

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Type C Reorganization

• Acquirer may assume an unlimited amount of
  Targets liabilities if only the Acquirers
  voting stock is used in the acquisition
• Combination of boot liabilities assumed cannot
  exceed 20 of consideration
• Only Targets shareholders must approve the
  merger and liquidation of Target
• Acquirer may drop assets acquired from Target
  into a subsidiary or subsidiary may use parent
  stock to acquire Target in a forward triangular
  merger

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Type D Acquisitive

• Acquirer transfers substantially all of its
  assets to Target in exchange for stock of Target
• Target holds its own assets as well as those of
  Acquirer
• Target stock is then distributed to Acquirers
  shareholders and they received sufficient stock
  (50) to control Target
• Acquirer may not transfer assets to a subsidiary
  nor use a subsidiary to acquire Target

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Type D Divisive

• Some (but not all) of original corporation's
  assets are transferred to a subsidiary and
  subsidiarys stock is distributed to shareholder
  of original corporation
• Spin-off original shareholders received a pro
  rata distribution of stock and do not surrender
  stock of the original corporation
• Split-off stock of new corporation is
  distributed to some of the shareholders in
  exchange for their stock in the original
  corporation

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Type D Divisive

• Split-up all assets of original corporation are
  split between two or more new companies and the
  stock of each company is distributed to the
  shareholders in exchange for their stock in the
  original corporation
• Original corporation goes out of business
• Stock can be distributed to shareholders tax-free

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Type D Divisive

• The transfer of assets must result in at least
  two corporations each of which must conduct an
  active business immediately after the transfer
• Businesses must have been conducted for at least
  5 years prior to separation
• Sufficient stock and securities of new
  corporation(s) must be distributed to
  shareholders so they have at least 80 control
• Any other property distributed to shareholders is
  boot and causes gain to be recognized

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Type E Reorganization

• A recapitalization of an existing corporation
• Allows tax-free exchange of common or preferred
  stock for other common or preferred stock, bonds
  for other bonds, and bonds for stock
• Stock may not be exchanged tax free for bonds as
  that upgrades a shareholder to a creditor

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Type F Reorganization

• A corporation changes its name, its place of
  incorporation, or its status from profit to
  nonprofit or vice versa
• Shareholders of the original corporation must
  continue as shareholders of the reorganization
  corporation

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Type G Reorganization

• Allows transfer of assets to a new corporation as
  part of bankruptcy proceedings
• Stock or securities are distributed to the
  shareholders in a manner resembling a D
  reorganization

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Other Considerations

• Requesting an advance ruling on the tax
  consequences is advisable
• Must have a sound business purpose
• Must be a continuity of ownership by shareholders
  of the participating corporations
• Must be a continuity of business enterprise
• Status of targets NOLs and other attributes must
  be considered

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The End