Chapter 15 Property Transactions: Nontaxable Exchanges Individual Income Taxes © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1
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. 2
The Big Picture (slide 2 of 3) • 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. 3
The Big Picture (slide 3 of 3) • 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? • Alice also owns a building that is involuntarily converted. See the facts in Examples 19 and 20. – Alice’s objectives are to minimize recognition of any realized gain and to maximize the recognition of any realized loss. • Read the chapter and formulate your response. 4
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 5
Nontaxable Transactions (slide 2 of 4) • In a tax-free transaction, nonrecognition of realized gain is permanent 6
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 7
Nontaxable Transactions (slide 4 of 4) • Depreciation recapture – Potential recapture from the asset surrendered carries over to the new asset acquired in the transaction 8
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 9
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 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 10
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 11
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 12
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 13
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 14
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 15
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 16
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 17
Like-Kind Exchanges (slide 10 of 11) Example (Cont’d) FMV Property Rec’d +Securities Total FMV Rec’d Less: Basis Property Given Realized Gain Boot Rec’d Zak $30, 000 10, 000 $40, 000 25, 000 $10, 000 Vira $40, 000 -0$40, 000 30, 000 * $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 18
Like-Kind Exchanges (slide 11 of 11) Example (Cont’d) FMV Property Rec’d Postponed Gain Basis Property Rec’d Zak $30, 000 -5, 000 $25, 000 Vira $40, 000 -10, 000 $30, 000 19
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 20
Involuntary Conversions (slide 2 of 13) • 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 21
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 22
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 23
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) 24
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 25
Involuntary Conversions (slide 7 of 13) • 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 26
Involuntary Conversions (slide 8 of 13) • Example of time period for replacement – Taxpayer’s office building is destroyed by fire on November 4, 2010 – Taxpayer receives insurance proceeds on February 10, 2011 – Taxpayer is a calendar-year taxpayer – Taxpayer’s replacement period is from November 4, 2010 to December 31, 2013 27
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 28
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 29
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 30
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 31
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 32
The Big Picture - Example 19 Involuntary Conversion (slide 1 of 3) • Return to the facts of The Big Picture on p. 15 -1. • Alice’s business building (adjusted basis $50, 000) is destroyed by fire on October 5, 2012. – Alice is a calendar year taxpayer. • On November 17, 2012, she receives an insurance reimbursement of $100, 000 for the loss. – Alice invests $80, 000 in a new building. – Alice uses the other $20, 000 of insurance proceeds to pay off credit card debt. 33
The Big Picture - Example 19 Involuntary Conversion (slide 2 of 3) • Return to the facts of The Big Picture on p. 15 -1. • Alice has until December 31, 2014, to make the new investment and qualify for the nonrecognition election. • Alice’s realized gain is $50, 000 – $100, 000 insurance proceeds received − $50, 000 adjusted basis of old building • Assuming that the replacement property qualifies, Alice’s recognized gain is $20, 000. – $100, 000 insurance proceeds − $80, 000 reinvested 34
The Big Picture - Example 19 Involuntary Conversion (slide 3 of 3) • Return to the facts of The Big Picture on p. 15 -1. • Alice’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 Alice was a real estate dealer and the building destroyed by fire was part of her inventory. – Unlike § 1031, § 1033 generally does not exclude inventory. • For this $30, 000 of realized gain to be postponed, Alice must elect § 1033 deferral treatment. 35
The Big Picture - Example 20 Involuntary Conversion • Return to the facts of The Big Picture on p. 15 -1. • Assume the same facts as in the previous example, except that Alice receives only $45, 000 of insurance proceeds. – She 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). 36
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 37
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 38
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 39
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 40
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 41
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 42
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 43
The Big Picture - Example 26 Sale 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. 44
The Big Picture - Example 26 Sale Of A Residence - § 121 (slide 2 of 2) • Her recognized gain would be calculated as follows: Amount realized ($348, 000 - $18, 000) Adjusted basis Realized gain § 121 exclusion Recognized gain $ 330, 000 (130, 000) $ 200, 000 (200, 000) $ – 0– • Since the available § 121 exclusion of $250, 000 would exceed Alice’s realized gain of $200, 000, her recognized gain would be $0. 45
The Big Picture - Example 27 Sale 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) Adjusted basis Realized gain § 121 exclusion Recognized gain $ 472, 000 (130, 000) $ 342, 000 (250, 000) $ 92, 000 • Since the realized gain of $342, 000 > the § 121 exclusion of $250, 000, Alice’s recognized gain would be $92, 000 46
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) 47
Other Nonrecognition Provisions (slide 2 of 7) • Under § 1035, no gain or loss is recognized from the exchange of certain insurance contracts or policies 48
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 49
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 50
Other Nonrecognition Provisions (slide 5 of 7) • Under § 1041, transfers of property between spouses or former spouses incident to divorce are nontaxable 51
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 52
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 53
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, 000 Adjusted 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. 54
Refocus On The Big Picture (slide 2 of 5) • 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. 55
Refocus On The Big Picture (slide 3 of 5) • 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. 56
Refocus On The Big Picture (slide 4 of 5) • 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 1 st and 2 nd 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. 57
Refocus On The Big Picture (slide 5 of 5) • 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. • See Examples 19 and 20 for Alice’s tax consequences associated with the involuntary conversion. 58
If you have any comments or suggestions concerning this Power. Point Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta. edu SUNY Oneonta © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 59
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