Vol 01 chapter 15 2015

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Individual Income Taxes1

Chapter 15

Property Transactions:Nontaxable Exchanges

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The Big Picture (slide 1 of 3)

• Recall the situation introduced in ‘‘The Big Picture’’ in Chapter 14.

• Alice has changed her mind about selling the house to her nephew for $275,000. – Due to a recent groundbreaking for an upscale real

estate development nearby, the appraised value of the house has increased to $600,000.

• Alice has decided she needs to do something with the house other than let it remain vacant.

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• She is considering the following options: – Sell the house for approximately $600,000

• Sales commission will be 5%. – Convert the house to a vacation home

• It would be 100% personal use by Alice and her family.• Sell it in two years.

– Convert the house to a vacation home • Rent it 40% of the time and use it 60% of the time for personal use.• Sell it in two years.

– Sell her current home and move into the inherited house. • She has owned and lived in the current home for 15 years• Her gain on the sale would be about $200,000. • Since she is nearing retirement, she would live in the inherited

house for the required 2 year minimum period and then sell it.

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• Alice expects the inherited house to continue to appreciate in value by about 5% per year.

• She plans on retiring in two years and moving to a warmer climate. – Until then, she is neutral as to which house she lives in.

• What advice can you offer Alice? • Read the chapter and formulate your response.

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Nontaxable Transactions(slide 1 of 4)

• In a nontaxable transaction, realized gain or loss is not currently recognized– Recognition is postponed to a future date (via a

carryover basis) rather than eliminated

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• In a tax-free transaction, nonrecognition of realized gain is permanent

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• Holding period for new asset– The holding period of the asset surrendered in a

nontaxable transaction carries over to the new asset acquired

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• Depreciation recapture– Potential recapture from the asset surrendered

carries over to the new asset acquired in the transaction

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Like-Kind Exchanges(slide 1 of 11)

• §1031 requires nontaxable treatment for gains and losses when:– Form of transaction is an exchange– Assets involved are used in trade or business or

held for production of income• However, inventory, securities, and partnership

interests do not qualify– Asset exchanged must be like-kind in nature or

character as replacement property

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• Like-kind property defined– Interpreted very broadly

• Real estate for real estate– Improved for unimproved realty qualifies– U.S. realty for foreign realty does not qualify

• Tangible personalty for tangible personalty– Must be within the same general business asset or product

class– Personalty used mainly in the U.S. for personalty used mainly

outside the U.S. does not qualify – Livestock of different sexes does not qualify

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• When taxpayers involved in an exchange are related parties – To qualify for nontaxable exchange treatment,

related parties must not dispose of property exchanged within the 2 year period following exchange

– If such early disposition occurs, postponed gain is recognized as of date of early disposition

• Dispositions due to death, involuntary conversions, and certain non-tax avoidance transactions are not treated as early dispositions

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• Exchange requirement– The transaction must involve a direct exchange of

property to qualify as a like-kind exchange– If the exchange is a delayed (nonsimultaneous)

exchange, there are time limits on its completion• The new property must be identified within 45 days of

date old property was transferred• The new property must be received by the earlier of the

following:– Within 180 days of date old property was transferred– The due date (including extensions) for tax return covering

year of transfer

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• 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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• Boot– The transferor of boot property may recognize gain

or loss on that property• Gain or loss is recognized to the extent of the difference

between the adjusted basis and the fair market value of the boot

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• Basis in like-kind asset received: FMV of new asset– Gain not recognized+ Loss not recognized= Basis in new asset

• Basis in boot received is FMV of property

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• Basis in like-kind property using Code approach

Adjusted basis of like-kind asset given+ Adjusted basis of boot given+ Gain recognized– FMV of boot received– Loss recognized= Basis in new asset

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• Example of an exchange with boot:– Zak and Vira exchange equipment of same general

business asset class– Zak: Basis = $25,000; FMV = $40,000– Vira: Basis = $20,000; FMV = $30,000– Vira also gives securities: Basis = $7,000;

FMV = $10,000

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Example (Cont’d) Zak Vira

FMV Property Rec’d $30,000 $40,000+Securities 10,000 -0- Total FMV Rec’d $40,000 $40,000Less: Basis Property Given 25,000 30,000 *Realized Gain $15,000 $10,000Boot Rec’d $10,000 $ -0-

Gain Recognized $10,000 $ -0-

*$20,000 Equip. + $10,000 Securities = $30,000Securities: ($10,000 FMV - $7,000 basis) = $3,000 gain recognized by Vira

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Example (Cont’d) Zak Vira

FMV Property Rec’d $30,000 $40,000Postponed Gain -5,000 -10,000Basis Property Rec’d $25,000 $30,000

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Involuntary Conversions(slide 1 of 13)

• §1033 permits (i.e., not mandatory) nontaxable treatment of gains if the amount reinvested in replacement property ≥ the amount realized

• If the amount reinvested in replacement property is < amount realized, realized gain is recognized to the extent of the deficiency

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• Involuntary conversion – Results from the destruction, theft, seizure,

requisition, condemnation, or sale or exchange under threat of condemnation of property

• A voluntary act by taxpayer is not an involuntary conversion

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• §1033 requirements– Replacement property must be similar or related in

service or use as involuntarily converted property– Replacement property must be acquired within a

specified time period

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• Replacement property defined– Must be similar or related in service or use as the

converted property• Definition is interpreted very narrowly and differently

for owner-investor than for owner-user– For business or investment real estate that is

condemned, replacement property has same meaning as for like-kind exchanges

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• Taxpayer use test (owner-investor)– The properties must be used by the owner in

similar endeavors • Example: Rental apartment building can be replaced

with a rental office building because both have same use to owner (the production of rental income)

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• Functional use test (owner-user)– The property must have the same use to the owner

as the converted property• Example: A manufacturing plant is not replacement

property for a wholesale grocery warehouse because each has a different function to the owner-user

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• Time period for replacement– Taxpayer normally has a 2 year period after the

close of the taxable year in which gain is realized to replace the property

• Replacement time period starts when involuntary conversion or threat of condemnation occurs

• Replacement time period ends 2 years (3 years for condemnation of realty) after the close of the taxable year in which gain is realized

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• Example of time period for replacement– Taxpayer’s office building is destroyed by fire on

November 4, 2012– Taxpayer receives insurance proceeds on February

10, 2013– Taxpayer is a calendar-year taxpayer– Taxpayer’s replacement period is from November

4, 2012 to December 31, 2015

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• Nonrecognition of gain: Direct conversions– Involuntary conversion rules mandatory– Basis and holding period in replacement property

same as converted property

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• Nonrecognition of gain: Indirect conversions– Involuntary conversion rules elective– Gain recognized to extent amount realized (usually

insurance proceeds) exceeds investment in replacement property

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• Nonrecognition of gain: Indirect conversions– Basis in replacement property is its cost less

deferred gain– Holding period includes that of converted property

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• Involuntary conversion rules do not apply to losses– Losses related to business and production of

income properties are recognized– Personal casualty and theft losses are recognized

(subject to $100 floor and 10% AGI limit); personal use asset condemnation losses are not recognized or postponed

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• Involuntary conversion of personal residence– Gain from casualty, theft, or condemnation may be

deferred as involuntary conversion (§1033) or excluded as sale of residence (§121)

– Loss from casualty recognized (limited); loss from condemnation not recognized

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Example 18 - Involuntary Conversion (slide 1 of 3)

• Walt’s business building (adjusted basis $50,000) is destroyed by fire on October 5, 2014. – Walt is a calendar year taxpayer.

• On November 17, 2014, he receives an insurance reimbursement of $100,000 for the loss.– Walt invests $80,000 in a new building. – Walt uses the other $20,000 of insurance proceeds to pay

off credit card debt.

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• Walt has until December 31, 2016, to make the new investment and qualify for the nonrecognition election.

• Walt’s realized gain is $50,000 – $100,000 insurance proceeds received − $50,000

adjusted basis of old building• Assuming that the replacement property

qualifies, Walt’s recognized gain is $20,000. – $100,000 insurance proceeds − $80,000 reinvested

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• Walt’s basis in the new building is $50,000. – This is the building’s cost of $80,000 less postponed gain

of $30,000• $50,000 realized gain − $20,000 recognized gain

• The computation of realization, recognition, and basis would apply even if Walt was a real estate dealer and the building destroyed by fire was part of his inventory.– Unlike § 1031, § 1033 generally does not exclude

inventory.• For this $30,000 of realized gain to be postponed,

Walt must elect § 1033 deferral treatment.

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Example 19 - Involuntary Conversion

• Assume the same facts as in the previous example, except that Walt receives only $45,000 of insurance proceeds. – He has a realized and recognized loss of $5,000.– The basis of the new building is the building’s cost of $80,000.

• If the destroyed building had been held for personal use, the recognized loss would have been subject to the following additional limitations.– The loss of $5,000 would have been limited to the decline in fair

market value of the property, and – The amount of the loss would have been reduced first by $100 and

then by 10% of AGI (refer to Chapter 7).

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Sale of Residence(slide 1 of 7)

• Loss on sale– As with other personal use assets, a realized loss

on the sale of a personal residence is not recognized

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• Gain on sale– Realized gain on sale of principal residence is

subject to taxation– Realized gain may be partly or wholly excluded

under §121

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• §121 provides for exclusion of up to $250,000 of gain on the sale of a principal residence

• Taxpayer must own and use as principal residence for at least 2 years during the 5 year period ending on date of sale

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• Amount of Exclusion– $250,000 maximum– Realized gain is calculated in normal manner– Amount realized on sale is reduced by selling

expenses such as advertising, broker’s commissions, and legal fees

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• Amount of Exclusion (cont’d)– For a married couple filing jointly, the $250,000 max is

increased to $500,000 if the following requirements are met:

• Either spouse meets the 2 year ownership req’t,• Both spouses meet the 2 year use req’t,• Neither spouse is ineligible due to the sale of another principal

residence within the prior 2 years– Starting in 2008, a surviving spouse can continue to use the

$500,000 exclusion amount on the sale of a personal residence for the next two years following the year of the deceased spouse’s death

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• §121 cannot be used within 2 years of its last use except in special situations, such as:

• Change in place of employment,• Health,• Other unforeseen circumstances

• Under these circumstances, only a portion of the exclusion is available, calculated as follows:

Max Exclusion amount × number of qualifying months 24 months

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• The Housing Assistance Tax Act of 2008 reduces the gain eligible for the § 121 exclusion for a vacation home converted to a principal residence– § 121 exclusion is reduced by the proportion of the

periods of nonqualified use compared to the period the property was owned by the taxpayer

– Applies to sales and exchanges occurring after December 31, 2008

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The Big Picture - Example 26Sale Of A Residence - § 121 (slide 1 of 2)

• Return to the facts of The Big Picture on p. 15-1.

• Recall that one of Alice’s options is to sell her current house and move into the inherited house.

• Assume that Alice, who is single, sells her current personal residence (adjusted basis of $130,000) for $348,000. – She has owned and lived in the house for 15 years. – Her selling expenses are $18,000. – Prior to the sale, Alice pays $1,000 to make some

repairs and paint the two bathrooms.

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The Big Picture - Example 26Sale Of A Residence - § 121 (slide 2 of 2)

• Her recognized gain would be calculated as follows:

Amount realized ($348,000 - $18,000) $ 330,000Adjusted basis (130,000)Realized gain $ 200,000§ 121 exclusion (200,000)Recognized gain $ –0–

• Since the available § 121 exclusion of $250,000 would exceed Alice’s realized gain of $200,000, her recognized gain would be $0.

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The Big Picture - Example 27Sale Of A Residence - § 121

• Continue with The Big Picture and the facts of Example 26, except that the selling price is $490,000.

Amount realized ($490,000 - $18,000) $ 472,000Adjusted basis (130,000)Realized gain $ 342,000§ 121 exclusion (250,000)Recognized gain $ 92,000

• Since the realized gain of $342,000 > the § 121 exclusion of $250,000, Alice’s recognized gain would be $92,000

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Other Nonrecognition Provisions (slide 1 of 6)

• Several additional nonrecognition provisions are available:– Under §1032, a corporation does not recognize

gain or loss on the receipt of money or other property in exchange for its stock (including treasury stock)

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• Under §1035, no gain or loss is recognized from the exchange of certain insurance contracts or policies

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• Under §1036, a shareholder does not recognize gain or loss on the exchange of common stock for common stock or preferred stock for preferred stock in same corporation

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• Under §1038, no loss is recognized from the repossession of real property sold on an installment basis – Gain is recognized to a limited extent

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• Under §1041, transfers of property between spouses or former spouses incident to divorce are nontaxable

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• Under §1044, if the amount realized from the sale of publicly traded securities is reinvested in common stock or a partnership interest of a specialized small business investment company, realized gain is not recognized– Amounts not reinvested will trigger recognition of

gain to extent of deficiency– Statutory limits are imposed on the amount of gain

qualified for this treatment– Only individuals and C corporations qualify

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Refocus On The Big Picture (slide 1 of 5)

• Alice needs to be aware of the different tax consequences of her proposals.

• Sale of the inherited house. – This is by far the simplest transaction for Alice.– Based on the available data, her recognized gain would be:

Amount realized ($600,000 - $30,000) $ 570,000Adjusted basis (475,000)Recognized gain $ 95,000

• Because the sale of the house is not eligible for the § 121 exclusion, the tax liability is $14,250 ($95,000 X 15%).

• Alice’s net cash flow would be $555,750 – $570,000- $14,250.

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• Conversion into a vacation home.– Only personal use.

• With this alternative, the only tax benefit Alice would receive is the deduction for property taxes .

• She would continue to incur upkeep costs (e.g., repairs, utilities, insurance).

• At the end of the 2 year period, the sales results are similar to those of a current sale.

• The sale of the house would not be eligible for the § 121 exclusion.

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• Conversion into a vacation home – 60% personal use and 40% rental use.

• Alice would be able to deduct 40% of the costs – e.g., Property taxes, agent’s management fee, depreciation,

maintenance and repairs, utilities, and insurance.– However, this amount cannot exceed the rent income generated.

• The remaining 60% of the property taxes can be claimed as an itemized deduction.

• At the end of the 2 year period, the sales results would be similar to those of a current sale.

• In determining recognized gain, adjusted basis must be reduced by the amount of the depreciation claimed.

• The sale of the house would not be eligible for the § 121 exclusion.

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• Sale of present home now with sale of inherited home in 2 years.

• This option would enable Alice to qualify for the § 121 exclusion for each sale.

• She would satisfy the 2 year ownership and the 2 year use requirements, and the allowance of the § 121 exclusion only once every 2 years.

• Alice must be careful to occupy the inherited residence for at least 2 years. – Also, the period between the sales of the 1st and 2nd houses must be

greater than 2 years. • Qualifying for the § 121 exclusion of up to $250,000 would

allow Alice to avoid any Federal income tax liability.

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• With this information, Alice can make an informed choice.

• In all likelihood, she probably will select the strategy of selling her current house now and the inherited house in the future.

• A noneconomic benefit of this option is that she will have to sell only one house at the time of her retirement.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 58

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA [email protected]

SUNY Oneonta

Vol 01 chapter 15 2015

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