Chap-11-1B-Property Disposition Howard Godfrey, Ph. D Chap-11-1B-Property Disposition Howard Godfrey, Ph.D., CPA Professor of Accounting ©Howard Godfrey-2015

Amount Realized Amount realized is gross sales price less selling expenses. Gross sales price is the amount received by the seller from the buyer and includes: Cash and FMV of property or services received Seller’s debt assumed by or paid by the buyer Gross sales price is decreased by amounts given to the buyer by the seller: Buyer’s expenses paid by or assumed by seller

Effect of Debt Assumption Assumption of debt is treated as a realization of income similar to paying or receiving cash Assumption of the seller’s debt increases sales price (as if buyer paid cash) Assumption of debt by the seller decreases the sales price (as if buyer received cash)

Types of Dispositions Sale – seller receives cash or cash equivalents in return for asset Exchange – taxpayer receives property other than cash or cash equivalents in return for property transferred to the other party Involuntary conversion – complete or partial destruction due to events not under control of taxpayer (condemnations, thefts, and casualties) Abandonment – property is permanently withdrawn from use (loss = basis of asset)

Recognized Gain or Loss Almost all realized gains are recognized (taxable) Losses are usually only recognized (deductible) if they are Incurred in a business Incurred in an investment activity Casualty or theft losses

Allan’s Gains and Losses-1 Allan received $5,000 cash and an auto worth $15,000 in exchange for a lot that was encumbered by a $13,000 liability that the buyer assumed. a. What is the amount realized on this sale? b. If Allan had a basis of $34,000 in the land, what is his gain or loss on the sale?

Allan’s Gains and Losses-2 c Allan’s Gains and Losses-2 c. If Allen has owned the land for five years as an investment, what is the character of the gain or loss? d. How would your answer to (c) change if the land had been used by Allan’s business as a parking lot?

Allan’s Gains and Losses-3 a Allan’s Gains and Losses-3 a. $5,000 + $15,000 + $13,000 = $33,000 amount realized. b. $33,000 - $34,000 = $1,000 loss c. Long-term capital loss. d. If the property had been used in a business, it would be Section 1231 property and it would be a Section 1231 loss.

Slides covering textbook pages 7-20 for Chapter 11 are in a separate file.

Concept Review Under all-inclusive income and realization concepts, gains should be recognized as taxable only if realized. A realized gain or loss on disposition of property may be deferred from recognition. Recognition is postponed, not forgiven.

Concept Review Substance-over-form doctrine accepts that a trade of assets between taxpayers is a continuation of the asset If taxpayers have a continuation of assets, they do not have the wherewithal-to-pay tax

All amounts realized must be reinvested Gains are deferred, not losses Similarities All amounts realized must be reinvested Gains are deferred, not losses Exception for like-kind exchanges Gain recognized is never more than gain realized

Similarities Deferral is accomplished through basis adjustment Basis of replacement property is decreased by deferred gains Basis of replacement property is “sometimes” increased by deferred losses Tax attributes carryover to replacement property

2. Like-Kind Exchanges and others

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 A Tax-free exchange defers gain or loss indefinitely

Like-Kind Exchanges Taxpayers must defer gain or loss realized on the exchange of like-kind property. Deferral is not elective. Like-kind property is property of the same nature, class, or character held for investment or used in a trade or business Some property (boot) is never considered like-kind Inventory, securities, currency, realty outside the U.S., partnership interests, intangibles, personal-use property, and livestock of different sex

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 the replacement asset is sold at a later date, the basis adjustment results in the deferred gain or loss being recognized (by changing amount of gain or loss)

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 basis of 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 Depreciation recapture potential carries over.

Qualifying 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

The receipt of boot can cause realized gain to be recognized Boot’s Effect on a Like-Kind Exchange The receipt of boot can cause realized gain to be recognized Boot is anything that is not eligible like-kind property and includes Cash Properties not of a like-kind Net liabilities discharged in the transaction

Determining Basis in 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

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 taxpayer’s property The taxpayer has a qualifying exchange The seller of the property and the third party have taxable transactions

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

Like-Kind Exchanges Effect of Boot If boot is included as part of an exchange When boot is received, a taxpayer has the wherewithal-to-pay and must recognize a gain up to the amount of boot When boot is given, no recognition is triggered Liabilities assumed are treated as cash given or received

Like-Kind Exchanges Between Related Parties Replacement property must by held for two years after exchange Disposal within the two years will trigger gain recognition

Like-Kind Exchange Planning Taxpayers with loss assets may 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 if there is a realized loss, as boot can be received without causing gain recognition

Exchanges-Not Like-Kind Ben paid $30,000 for land that is needed by IBM. Ben owes $8,000 on a mortgage on the land. IBM will trade IBM stock worth $100,000 for the land and will assume the mortgage of $8,000. How much is the gain to be recognized by Ben as a result of this exchange?

Exchanges – Not Like-Kind The Post and Rail Partnership traded farm land with an adjusted basis of $4,000 and a FMV of $9,000 for a farm tractor that has a FMV of $8,000 and cash of $1,000. What is the recognized gain or loss?

Like-Kind Exchanges Fred traded a tractor used solely in his construction business for another tractor for the same use. On the date of the trade, the old tractor had an adjusted basis of $3,000 and a FMV of $3,300. He received in exchange $200 in cash and a smaller tractor with a FMV of $3,100. Fred should report a gain on the exchange of: _____

Like-Kind Exchanges-Andee Andee Partnership traded its panel truck with an adjusted basis of $10,000 and MV of $12,000 for a pick-up truck with FMV of $7,000. Andee also received $5,000 cash on the trade. What is the gain, if any?

Like-Kind Property Which of the following examples of property may qualify for a like-kind exchange? a. Inventories b. Rental house c. Accounts receivable d. Raw materials IRS - 1995

Like-Kind Exchange Problem Tony traded a business truck with adjusted basis of $5,000 and a FMV of $9,000, for another truck having a FMV of $12,000. In addition, he paid cash of $3,000. What is Tony's basis in the truck?

Like-Kind Exchange Problem Mike exchanges business equipment with FMV of $100,000 and an adjusted basis of $90,000 for $4,000 cash and like-kind business equipment with a FMV of $96,000. What is M's recognized gain and basis of new asset?

Involuntary Conversions Taxpayers may “elect” to defer gain realized on involuntary conversions if the property Is replaced within two tax years At a cost at least equal to the amount realized from the conversion With prop. that is “similar or related in use” Gain occurs if insurance proceeds or payment from a government exceeds the property’s basis.

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 such as a fire, flood, tornado, hurricane or vandalism Condemnation – lawful taking of property for its fair market value by a government under the right of eminent domain

Casualty and Theft Losses For personal use property, the loss is 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 business property that is completely destroyed, the loss is always the property’s adjusted basis) This loss is then reduced by any insurance proceeds received

Casualty &Theft Loss Deductions Thefts are deductible in year of discovery For casualties in designated disaster areas, taxpayer 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

Gains on Involuntary Conversions If the insurance recovery on a casualty or theft is greater than the loss, the taxpayer has a gain Condemnations usually result in gain because proceeds received are often based on fair market value of property lost.

Gains on Involuntary Conversions If all proceeds are used to acquire qualified replacement property (or repair the property to its pre-casualty condition) within the required replacement period, the gain is deferred Gain may have to be recognized if all proceeds are not used to acquire replacement property (or make repairs to the damaged property) within the required time period

Replacement Period Extends 2 full tax years after the end of the taxable year in which the involuntary conversion occurs Extended to 3 years if the involuntary conversion involves the condemnation of business or investment realty

Involuntary Conversions Qualified Replacement Property Replacement property must meet a strict “functional-use” test Must perform the same function as the converted property Condemned real property must meet only the easier like-kind test Replacement property may be bought or built

Involuntary Conversions Recognition and Basis Gain recognized = amount realized - replacement cost Loss recognized = converted property’s basis - amount realized Replacement property’s basis = replacement cost - gain deferred

Involuntary Conversions Paul's business building is destroyed in a fire. Paul's adjusted basis was $50,000, and its FMV is $103,000. Paul receives insurance reimbursement of $100,000. In that same year, Paul invests $78,000 in another business building. If an election is made, what is Paul’s recognized gain & basis of new property.

Involuntary Conversion Pam's business building is destroyed in a fire. Pam's adjusted basis in the building is $50,000, and its FMV is $103,000. Pam files received an insurance reimbursement of $100,000. In that same year, Pam invests $101,000 of in another business building. If an election is made, what is Pam’s recognized gain and basis of new property?

Installment Method Gain is recognized proportionately as proceeds from sale are received Use severely restricted – generally available for casual sales only (excludes sales of inventory and securities. Limits for depreciable property) May not want to use if Marginal tax rate is expected to increase Unused losses are expiring

Installment Method Computing the gain recognized: Gain recognized each year is dependent on the payments received during the year Recognized Gain = (Total gain/contract price) X Payments Received Total gain = selling price less selling expenses less adjusted basis of property Contract price = Sales price less liabilities assumed by buyer Generally is equal to amount (other than interest) seller will receive from purchaser

Continue preceding slide Assume the taxpayer is a Mike Corporation and the tax rate is 40%. What is the balance in the deferred tax asset or liability account (related to this transaction) at year-end? Asset or liability?

Bold Co. Installment Sale [1] On 1-1-2015, Bold, Inc., sold for $800,000 a parcel of land which it owned for five years. The land had a basis of $700,000. Under the agreement $200,000 of the selling price plus appropriate interest will be received each year for four years, beginning on 12-31-2015. The amount of gain reported on the installment basis for 2015 is: a. $100,000 b. $75,000 c. $25,000 d. $15,000 e. none of these

Sale to Related Party Losses on sales to related parties are disallowed Related parties include brothers, sisters, spouse, ancestors and lineal descendents, as well as a more-than 50% owned corporation If related buyer later sells property at a gain, this gain can be reduced (not below zero) by the seller’s previously disallowed loss

Loss on Sale to Relative - 1 In April 2015, Pam sold stock with a cost basis of $17,000, to Lisa, her sister, for $10,000. In September 2015, Lisa sold the same shares of stock to her neighbor, Niki, for $20,000. What is Lisa's gain for 2015? a. $0 b. $3,000 c. $7,000 d. $10,000

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