Chapter 13 Property Transactions: Determination of Gain or Loss, Basis Considerations, and Nontaxable Exchanges

The Big Picture (slide 1 of 3) Alice owns a house that she inherited from her mother 7 months ago. The fair market value of the house at the date of her grandmother’s death was $475,000. Her grandmother’s basis for the house was $275,000 The house currently is worth $600,000. 2

The Big Picture (slide 2 of 3) Alice is considering two options. The first is to give the house to her son, Michael. Michael, his wife Sandra, and their daughter Peggy would live in the house. The second option is to sell the house. Projected selling expenses would be about 7% of the selling price. 3

The Big Picture (slide 3 of 3) Alice would also like to know the tax consequences of selling her car She paid $22,000 for the car 4 months ago and has used it exclusively for personal use. Based on the ‘‘Blue Book’’ value, she anticipates that she can sell it for $20,000 to $23,000. In addition, earlier this year Alice sold some stock at a realized loss and subsequently repurchased some shares of the same stock. She has also asked you about the tax consequences of these transactions. Read the chapter and formulate your response. 4

Determination of Gain or Loss (slide 1 of 7) Realized gain or loss Difference between amount realized from sale or other disposition of the asset and its adjusted basis Sale or other disposition Includes trade-ins, casualties, condemnations, thefts, bond retirements 5

Determination of Gain or Loss (slide 2 of 7) Amount realized from disposition Total consideration received, including cash, FMV of property received, mortgages/loans transferred to buyer Fair market value (FMV): Value of asset determined by arms-length transaction, i.e., amount set by transaction between willing buyer and seller with neither obligated to enter into transaction Reduced by any selling expenses

Determination of Gain or Loss (slide 3 of 7) Adjusted basis Original cost (or other adjusted basis) plus capital additions less capital recoveries

Determination of Gain or Loss (slide 4 of 7) Capital additions Cost of improvements and betterments to the property that are capital in nature and not currently deductible

Determination of Gain or Loss (slide 5 of 7) Capital recoveries Amount of basis recovered through: Depreciation or cost recovery allowances Casualty and theft losses (and insurance proceeds) Certain corporate distributions Amortizable bond premium Easements

Determination of Gain or Loss (slide 6 of 7) Recognized gain or loss Amount of realized gain (loss) that is included in (deducted from) gross income

Determination of Gain or Loss (slide 7 of 7) Realized gains and losses are not always recognized Realized gains may be deferred or excluded Realized losses may be deferred or disallowed Realized losses from the sale, exchange, or condemnation of personal use assets (e.g., a personal residence) is not recognized for tax purposes Exception - casualty or theft losses from personal use assets In contrast, any gain realized from the sale or other disposition of personal use assets is, generally, fully taxable

The Big Picture - Example 8 Gain On Sale of Personal Use Assets Return to the facts of The Big Picture on p. 13-2. Assume Alice sells the car, which she has held exclusively for personal use, for $23,000. Recall that her adjusted basis of the car is $22,000. Alice has a realized and recognized gain of $1,000. 12

The Big Picture - Example 9 Loss On Sale of Personal Use Assets Return to the facts of The Big Picture on p. 13-2. Assume Alice sells the car in Example 8 for $20,000. She has a realized loss of $2,000, but the loss is not recognized. 13

Capital Recovery Doctrine Taxpayer is entitled to recover cost or other original basis of property acquired and is not taxed on that amount To extent receive only investment back upon disposition of an asset, taxpayer has no gain

Basis Considerations (slide 1 of 6) Original basis of an asset is generally its cost Bargain purchase assets have a basis equal to their FMV Bargain amount may be income to purchaser (e.g., employee = compensation; shareholder = dividend)

Basis Considerations (slide 2 of 6) Identification problems Security sales where specific identification not possible, use FIFO to compute basis

Basis Considerations (slide 3 of 6) Allocation problems: lump-sum purchase Must allocate basis to each asset obtained Allocation usually based on relative FMV of assets

Basis Considerations (slide 4 of 6) Allocation problems: Going concern purchase Assign purchase price to assets (excluding goodwill) to extent of their total FMV Then allocate among assets based on FMV Residual amount is goodwill Goodwill is an amortizable § 197 asset Allocation applies to both purchaser and seller

Basis Considerations (slide 5 of 6) Allocation problems: Nontaxable stock dividends Basis of original shares is allocated over the original and new shares Based on number of shares (common on common), or Based on relative FMV (preferred on common) Holding period includes the holding period of the original shares

Basis Considerations (slide 6 of 6) Allocation problems: Nontaxable stock rights Basis in rights is zero unless taxpayer is required or elects to allocate basis from stock Required to allocate if FMV of rights is at least 15% of the FMV of the stock Allocation is based on relative FMV of rights and stock Holding period includes holding period of the stock on which the rights were distributed However, if the rights are exercised, holding period of newly acquired stock begins with date the rights are exercised

Gift Basis (slide 1 of 10) Gift property may have a dual basis, i.e., basis for gain and loss may differ Basis is dependent on relationship between FMV at date of gift and donor’s adjusted basis

Gift Basis (slide 2 of 10) Gift basis for cost recovery The donee's basis for cost recovery is the donor’s basis (donee's gain basis)

Gift Basis (slide 3 of 10) Gift basis for subsequent gain When a gifted asset is disposed of by the donee, the basis for calculating any gain is the donor’s adjusted basis (carryover basis) This basis is called the “gain basis” Gain basis may be increased if donor incurred gift tax on gift Holding period for donee includes that of donor

Gift Basis (slide 4 of 10) Gift basis for subsequent loss When a gifted asset is disposed of by a donee, the basis for calculating any loss is the lesser of FMV at the date of gift or the donor’s adjusted basis This basis is called the “loss basis”

Gift Basis (slide 5 of 10) Gift basis for subsequent loss If FMV < donor’s basis on the date of the gift, a dual basis will exist for the asset Gain basis = donor’s basis Loss basis = FMV on date of gift If dual basis and sold for loss, holding period for donee starts on date of gift

Gift Basis (slide 6 of 10) Gift basis when no gain or loss If a dual basis exists and the amount realized from the disposition of a gifted asset falls between the gain basis and the loss basis No gain or loss is realized Holding period for donee is not needed since there is no gain or loss

Gift Basis (slide 7 of 10) Example of gift basis determination Alex received a gift from Beth on June 15 this year FMV of asset on June 15 was $8,000 Beth bought the asset on May 5, 1985 for $10,000

Gift Basis (slide 8 of 10) Example of gift basis determination (cont’d) If Alex sells the asset for $11,000, there is a $1,000 gain ($11,000 – $10,000) If Alex sells the asset for $7,000, there is a $1,000 loss ($7,000 – $8,000) If Alex sells the asset for $9,000, there is no gain or loss ($9,000 – $9,000)

Gift Basis (slide 9 of 10) Adjustment for gift taxes The proportion of gift tax paid (on gifts after 1976) by the donor on appreciation of asset can be added to basis of donee The donee's basis is equal to: Donor’s basis + [(unrealized appreciation/taxable gift) × gift tax]

Gift Basis (slide 10 of 10) Example of gift tax: Cathy received a gift from Darren on June 15 of this year FMV on June 15 was $33,000 Darren had a basis in the asset of $28,000 Darren paid gift tax of $800 Cathy’s basis in the gifted property is $28,200 [$28,000 + ($5,000/($33,000 – $13,000) × $800)]

Property Acquired from a Decedent (slide 1 of 7) Generally, beneficiary’s basis in inherited assets will be the FMV of the asset at decedent’s date of death Exception: If the executor/administrator of estate elects alternate valuation date, basis is FMV on such date Inherited property is always treated as long-term property

Property Acquired from a Decedent (slide 2 of 7) Inherited property valuation date Date assets valued for estate tax is either: Date of decedent’s death, which is called the primary valuation date (PVD), or 6 months after date of decedent’s death, which is called the alternate valuation date (AVD) Can only be elected if both the value of gross estate and the estate tax liability are lower than if PVD was used

Property Acquired from a Decedent (slide 3 of 7) Inherited property valuation date When PVD is used, beneficiary’s basis will be the FMV at date of decedent’s death When AVD is used, beneficiary’s basis will be the FMV at the earliest of: Date asset is distributed from estate, or 6 months after date of decedent’s death

Property Acquired from a Decedent (slide 4 of 7) Example of inherited property valuation: At Rex’s date of death, April 30 of this year, his assets had an adjusted basis of $200,000, and a FMV of $700,000 PVD selected and assets distributed June 30; beneficiary’s basis is $700,000

Property Acquired from a Decedent (slide 5 of 7) Example of inherited property valuation (cont’d) October 30 this year (six months after date of Rex’s death), the assets had a FMV of $650,000 AVD selected and assets distributed November 10; beneficiary’s basis is $650,000 AVD selected and assets distributed June 30 when FMV of assets is $670,000; beneficiary’s basis is $670,000

Property Acquired from a Decedent (slide 6 of 7) Deathbed gifts Property inherited by taxpayer (or spouse) which was both appreciated and gifted by same taxpayer to decedent within 1 year of decedent's death Beneficiary’s basis in property is carryover of decedent’s basis (not date of death FMV) Generally the same basis taxpayer had on date of gift

Property Acquired from a Decedent (slide 7 of 7) Survivor’s share of community property Both decedent’s share and surviving spouse’s share of community property receives basis of FMV on date of death Surviving spouse’s share deemed to be acquired from decedent Survivor’s share in common law state Only 1/2 of jointly held property of spouses is included in the estate In such a case, no adjustment of the basis is permitted for the excluded property interest (the surviving spouse’s share)

The Big Picture - Example 25 Property Acquired From A Decedent Return to the facts of The Big Picture on p. 13-2. In 2011, Alice inherited her mother’s house. At the date of death, the mother’s adjusted basis for the house was $275,000. The house’s fair market value at the date of death was $475,000. The alternate valuation date was not elected. Alice’s basis for income tax purposes is $475,000. This is commonly referred to as a stepped-up basis. 38

The Big Picture - Example 26 Property Acquired From A Decedent Return to the facts of The Big Picture on p. 13-2. Assume the same facts as in Example 25, except the house’s fair market value at the date of the mother’s death was $260,000. Alice’s basis for income tax purposes is $260,000. This is commonly referred to as a stepped-down basis. 39

Disallowed Losses (slide 1 of 5) Related parties (§ 267) Losses on sale of assets between related parties are disallowed For income-producing or business property, any loss disallowed can be used to reduce gain recognition on subsequent disposition of asset to unrelated party Only available to original transferee Not available for sales of personal use assets

Disallowed Losses (slide 2 of 5) Related parties include: Family members, Corporation and a shareholder who owns greater than 50% (directly or indirectly) of the corporation, and Partnership and a partner who owns greater than 50% (directly or indirectly) of the partnership

Disallowed Losses (slide 3 of 5) Wash sales Losses from wash sales are disallowed Wash sale occurs when taxpayer disposes of stock or securities at loss and acquires substantially identical stock or securities within 30 days before or after the date of the loss sale

Disallowed Losses (slide 4 of 5) Wash sales Disallowed loss is added to the basis of the substantially identical stock or securities that caused the disallowance Does not apply to gains realized on disposition of securities

Disallowed Losses (slide 5 of 5) Personal use assets Loss on the disposition of personal use assets is disallowed Personal use asset loss cannot be converted into a business (or production of income) use deductible loss Original loss basis for an asset converted is the lower of personal use basis or FMV at date of conversion Cost recovery basis similarly limited

The Big Picture - Example 34 Wash Sale Return to the facts of The Big Picture on p. 13-2. Alice owned 100 shares of Green Corporation stock (adjusted basis of $20,000). She sold 50 shares for $8,000. Ten days later, she purchased 50 shares of the same stock for $7,000. Alice’s realized loss of $2,000 ($8,000 amount realized -$10,000 adjusted basis) is not recognized because it resulted from a wash sale. Alice’s basis in the newly acquired stock is $9,000 ($7,000 purchase price + $2,000 unrecognized loss from the wash sale). 45

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 46

Nontaxable Transactions (slide 2 of 4) In a tax-free transaction, nonrecognition of realized gain is permanent 47

Nontaxable Transactions (slide 3 of 4) Holding period for new asset The holding period of the asset surrendered in a nontaxable transaction carries over to the new asset acquired 48

Nontaxable Transactions (slide 4 of 4) Depreciation recapture Potential recapture from the asset surrendered carries over to the new asset acquired in the transaction 49

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 50

Like-Kind Exchanges (slide 2 of 11) 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 51

Like-Kind Exchanges (slide 3 of 11) 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 52

Like-Kind Exchanges (slide 4 of 11) 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 53

Like-Kind Exchanges (slide 5 of 11) 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 54

Like-Kind Exchanges (slide 6 of 11) 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 55

Like-Kind Exchanges (slide 7 of 11) 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 56

Like-Kind Exchanges (slide 8 of 11) 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 57

Like-Kind Exchanges (slide 9 of 11) 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 58

Like-Kind Exchanges (slide 10 of 11) Example (Cont’d) Zak Vira FMV Property Rec’d $30,000 $40,000 +Securities 10,000 -0- Total FMV Rec’d $40,000 $40,000 Less: Basis Property Given 25,000 30,000 * Realized Gain $15,000 $10,000 Boot Rec’d $10,000 $ -0- Gain Recognized $10,000 $ -0- *$20,000 Equip. + $10,000 Securities = $30,000 Securities: ($10,000 FMV - $7,000 basis) = $3,000 gain recognized by Vira 59

Like-Kind Exchanges (slide 11 of 11) Example (Cont’d) Zak Vira FMV Property Rec’d $30,000 $40,000 Postponed Gain -5,000 -10,000 Basis Property Rec’d $25,000 $30,000 60

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 61

Involuntary Conversions (slide 2 of 13) 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 62

Involuntary Conversions (slide 3 of 13) §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 63

Involuntary Conversions (slide 4 of 13) 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 64

Involuntary Conversions (slide 5 of 13) 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) 65

Involuntary Conversions (slide 6 of 13) 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 66

Involuntary Conversions (slide 7 of 13) Time period for replacement 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 67

Involuntary Conversions (slide 8 of 13) Example of time period for replacement Taxpayer’s office building is destroyed by fire on November 4, 2009 Taxpayer receives insurance proceeds on February 10, 2010 Taxpayer is a calendar-year taxpayer Taxpayer’s replacement period is from November 4, 2009 to December 31, 2012 68

Involuntary Conversions (slide 9 of 13) Nonrecognition of gain: Direct conversions Involuntary conversion rules mandatory Basis and holding period in replacement property same as converted property 69

Involuntary Conversions (slide 10 of 13) Nonrecognition of gain: Indirect conversions Involuntary conversion rules elective Gain recognized to extent amount realized (usually insurance proceeds) exceeds investment in replacement property 70

Involuntary Conversions (slide 11 of 13) Nonrecognition of gain: Indirect conversions Basis in replacement property is its cost less deferred gain Holding period includes that of converted property 71

Involuntary Conversions (slide 12 of 13) 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 72

Involuntary Conversions (slide 13 of 13) 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 73

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 74

Sale of Residence (slide 2 of 7) Gain on sale Realized gain on sale of principal residence is subject to taxation Realized gain may be partly or wholly excluded under §121 75

Sale of Residence (slide 3 of 7) §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 76

Sale of Residence (slide 4 of 7) 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 77

Sale of Residence (slide 5 of 7) 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 78

Sale of Residence (slide 6 of 7) §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 79

Sale of Residence (slide 7 of 7) 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 80

Other Nonrecognition Provisions (slide 1 of 7) 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) 81

Other Nonrecognition Provisions (slide 2 of 7) Under §1035, no gain or loss is recognized from the exchange of certain insurance contracts or policies 82

Other Nonrecognition Provisions (slide 3 of 7) 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 83

Other Nonrecognition Provisions (slide 4 of 7) Under §1038, no loss is recognized from the repossession of real property sold on an installment basis Gain is recognized to a limited extent 84

Other Nonrecognition Provisions (slide 5 of 7) Under §1041, transfers of property between spouses or former spouses incident to divorce are nontaxable 85

Other Nonrecognition Provisions (slide 6 of 7) 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 86

Other Nonrecognition Provisions (slide 7 of 7) Under §1045, realized gain from sale of qualified small business stock held > 6 months may be postponed if other qualified small business stock is acquired within 60 days Qualified small business stock is stock acquired at its original issue for money, other property, or services from a domestic corp with assets that do not exceed $50 million before or after the issuance of small business stock 87

Refocus On The Big Picture (slide 1 of 4) Gift of Inherited House Alice says that this is the only gift that she would make to Michael this year. She has made no prior gifts to any individual that exceeded the annual per donee exclusion amount (i.e., currently $13,000). With this information, you inform Alice that no gift tax would be due on the gift of the house to Michael. However, she would use up $587,000 ($600,000 - $13,000) of her lifetime gift tax exclusion. Michael’s basis for the house would be a carryover of Alice’s basis of $475,000. The fair market value at the date of the decedent’s death. 88

Refocus On The Big Picture (slide 2 of 4) Sale of Inherited House Alice’s adjusted basis for the house is $475,000 The fair market value on the date of her grandmother’s death. If Alice sells the house for $600,000, her projected selling expenses would be $42,000 ($600,000 X 7%). 89

Refocus On The Big Picture (slide 3 of 4) She would have a recognized gain of $83,000 as calculated below. Amount realized ($600,000 - $42,000) $ 558,000 Less: Adjusted basis (475,000) Realized and recognized gain $ 83,000 The house is a capital asset, and Alice’s holding period is long term since she inherited the house. Thus, the gain would be classified as a long-term capital gain (i.e., eligible for a 15% tax rate). The Federal income tax due would be $12,450 ($83,000 X 15%). 90

Refocus On The Big Picture (slide 4 of 4) What If? Alice is leaning toward selling the house. However, she knows that her grandmother would not want her to have to pay income taxes on the sale. Alice inquires as to whether there is any way that she could reduce the Federal income tax on the sale to $0. You inform Alice of the exclusion provision under § 121 of the Code. She can qualify for this exclusion of realized gain provision if she satisfies the at least two-out-of-five-years ownership and use requirements. This would necessitate her moving into the house for 2 years and occupying it as her principal residence. 91

Dr. Donald R. Trippeer, CPA If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta