Income Taxation:Chapter 13

1. Income Taxation:Chapter 13 Property Transactions: Basis Determination & Recognition of Gain or Loss

2. Introduction to Property Transactions Recovery of Cost Doctrine Realization Concept: “Realization” requires An external transaction Plus a change in basic property right

3. Introduction to Property Transactions General Rule Recognize income as soon as it is realized.

4. DefinitionsAmount Realized; Gain or Loss Realized Amount realized on sale or disposition of an asset: Cash Received

5. DefinitionsAmount Realized; Gain or Loss Realized Amount Realized Less: Adjusted Basis Equals: Gain or Loss Realized

6. Amount Realized Example 1

7. Amount Realized Example 2

8. General Basis of Property ADD: Purchase Cost: Cash paid FMV of property given up Unpaid mortgage of property received, if the purchaser assumes the mortgage Debt (notes payable) given to seller Other acquisition costs (legal, appraisals, etc.) Taxes relating to acquisition Interest and taxes on construction Most interest related to acquisition may be capitalized or deducted (TP’s option) Capital additions (betterments & improvements)

9. General Basis of Property LESS: Depreciation allowed or taken Liquidating distributions by corporations Casualties and certain other losses Amortized bond premiums EQUALS: Adjusted Basis

10. Basis of Property Converted fromPersonal to Business Use Property converted from personal use to business use: Basis = lower of adj. basis or FMV at date of conversion. But, for sale at gain, basis = original basis - accum. depr. NOTE: Sometimes this means no gain or loss on sale. Example: house: $40,000 COST, $30,000 FMV at conversion, $35,000 SP

11. Basis of Inherited Property General Rule: Basis* FMV at date of death or Alternative valuation date: FMV at date of death plus 6 mos. if estate tax is due and estate has declined in value Holding Period = Deemed Long-term EXAMPLE P bought property at $100. FMV at death = $250. W inherits property, sells at $310. Gain (long-term) = ($310 - 250) = $60 *The “step-up” in basis rules are scheduled to be repealed with respect to deaths occurring after the year 2009

12. Basis of Inherited Property Exception #1 Income in Respect of a Decedent Or, “IRD” Items (Section 691)

13. Basis of Inherited Property Exception #2

14. Basis of Property Acquired by Gift General Rule: Carryover Basis Adjust basis for gift tax paid on the appreciation of the property up to the date of the gift. The adjustment is called the “gift tax adjustment.” Add the gift tax adjustment to the carryover basis

15. Basis of Property Acquired by Gift FMV at date of gift < donor’s basis: an exception Basis for gain/loss depends on whether asset is later sold for more or less than donor’s basis

16. “Nontaxable” Exchanges: Summary

17. Section 1031Like-Kind Exchanges Mandatory deferred gain or loss on exchange of business/investment property To qualify, property must be like-kind Real estate can be exchanged for real estate For personalty, property exchanged must be in same General Asset Class or Product Class for safe-harbor Traditionally, personalty-for-personalty qualifies Section 1031 excludes: inventories, stocks, bonds, notes, non-U.S. property, interest in Partnerships

18. Like-Kind Exchange Between Related Parties Deferral of Gain permitted if exchange between related persons remains intact for at least two years after the exchange. Any gain that is deferred on exchange between related persons is recognized if exchanged property is sold within two years of the exchange. Transferor will be treated as if the property was sold on the exchange date…recognizing “deferred” gain as of the date the transferee sold the property (transferee pays tax on post-exchange appreciation).

19. Section 1031Like-Kind Exchanges with Boot When boot is received in a like-kind exchange: Recognize as income lesser of boot received or gain realized No loss is recognized when boot is received The receipt of boot may cause recognition of Gain (boot does not disqualify Section 1031) Treat liabilities forfeited as boot received, liabilities assumed as boot given…net liability relief is treated as boot received

20. Like-Kind Exchange of Mortgaged Property X-chg. of mortgaged property treat as x-chg involving boot -- TP who is relieved of mortgage treated as having received cash in amount of mortgage if both properties x-chg’d are mortgaged, treat difference in mortgages as boot Realized losses on Sec. 1031 exchanges are not recognized (but loss on boot property given up is recognized) Basis of property received is adjusted by: subtracting deferred gains adding deferred losses

21. Like-Kind Exchanges - Timing Timing “simultaneous” exchange required simultaneous IF Prop. to be rec’d in the exchange is identified w/in 45 days after TP gives up his/her property and Incoming property is actually rec’d w/in 180 days after TP transfers property out, or by the date of the tax return (including extensions), whichever is earlier.

22. Basis of Property Rec’d inSec. 1031 Exchange Plus: Gain recognized Boot paid (cash or property) Liabilities assumed by TP Liabilities encumbering property rec’d Less: Boot rec’d (not including mortgages out) Liabilities assumed by transferee (notes receivable to transferor) Liabilities encumbering property transferred out

23. Section 121 Exclusion of $250,000 ($500,000 MFJ) of Gain on Sale of Personal Residence Purpose of Sec. 121 To exclude $250,000 ($500,000 MFJ) of gains on sale of a personal residence Eligibility TP must own and occupy home as principal residence for at least 2 of 5 prior years. The full exclusion is available only if TP has not utilized exclusion in previous two years.

24. Section 121 Example S (Single TP) sells her home and realizes a $125,000 gain. S, who is moving to a new state to take a new job, has owned the home for only 9 months.

25. Section 121Special Rule for Depreciation If depreciation was recognized on home (home office or rental for example) gains must be recaptured up to amount of depreciation taken before the Sec. 121 exclusions, as per depreciation recapture rules. (effective May 7, 1997)

26. Mortgage Forgiveness Debt Relief Act of 2007 : Personal Residence Mortgage Forgiveness Debt Relief Act of 2007 applies to years 2007-2009 ((H.R. 3648/extended thru 2012 with H.R. 1424) and excludes from gross income up to $2 million ($1 million for married, filing separately) forgiven on debt used to buy, build or substantially improve a principal residence during 2007-2009. The excluded amount will reduce the residence’s basis, but not below zero. The exclusion applies if the discharge is directly related to a decline in the value of the residence or to the taxpayer’s financial condition (The Act does not apply to vacation homes).

27. Mortgage Forgiveness Debt Relief Act of 2007 : Personal Residence The basis reduction could result in a recognized gain when the home is sold. However, such gain would qualify for the general rules for excluding gain (i.e., $250,000 and $500,000). The Act also permits surviving spouses to qualify for the $500,000 joint-filing home-sale exclusion if (1) the residence is sold not later than two years after the first spouse's death; and (2) the exclusion requirements were met immediately before the spouse's death.

28. Housing and Economic Recovery Act of 2008: Personal Residence Creates new First-time Homebuyer Credit for an individual who is a first-time homebuyer of a personal residence in U.S. The first-time homebuyer credit is equal to the lesser of $7,500 or $3,750 for married filing separately or 10 percent of the purchase price of the home (between April 8, 2008 and January 1, 2009 as adjusted under American Recovery and Reinvestment Act of 2009 – previously July 1, 2009).  Credit phases out at AGI over $150,000 (MFJ), $75,000 (Single); full phase out at $170,000 (MFJ) and $95,000 (Single)

29. Housing and Economic Recovery Act of 2008: Personal Residence Although a home purchased in 2009 may be deemed purchased as of December 31, 2008 for purposes of claiming this “credit”, the American Recovery and Reinvestment Act of 2009 provides a more generous credit opportunity.  However, this credit must be recaptured over fifteen years with no interest. The recapture (6.67% of the total credit) begins in the second taxable year after the taxable year in which the home is purchased.

30. American Recovery and Reinvestment Act of 2009: Personal Residence Creates new $8,000 First-time Homebuyer Credit for an individual who is a first-time homebuyer of a personal residence in U.S. The first-time homebuyer credit is equal to the lesser of $8,000 or $4,000 for married filing separately or 10 percent of the purchase price of the home (after December 31, 2008 through November 30, 2009). New “No Pay-Back” provision (i.e., required repayments) after 36 months in the home.  Credit phases out at AGI over $150,000 (MFJ), $75,000 (Single); full phase out at $170,000 (MFJ) and $95,000 (Single)

31. Housing and Economic Recovery Act of 2008: Personal Residence An additional standard deduction is provided for real estate taxes for non-itemizers. ----Maximum additional standard deduction is lesser of the real estate taxes or $1,000 (MFJ) and $500 (Single) --Provision extended thru December 31, 2009 by Tax Extenders and AMT Relief Act of 2008 These provisions (e.g., the first-time homebuyer credit and the additional standard deduction for real property taxes for non-itemizers) are retroactive and will impact the 2009 filing season.

32. Housing and Economic Recovery Act of 2008: Personal Residence For sales and exchanges after December 31, 2008, Section 121 is amended to limit exclusion of gain to ONE sale or exchange every 2 years and provides a special rule for certain sales by surviving spouses. 

33. Housing and Economic Recovery Act of 2008: Personal Residence Under Sec. 121(b)(5)(A), Sec. 121(a) shall not apply to the gain from the sale of a principal residence allocated to “nonqualified use” (i.e., vacation home or rental). “Nonqualified use” does not include periods when the homeowner vacated their property for military service, a change of employment, health conditions, or other unforeseen circumstances.  Sec. 121(b)(5)(B) - gain shall be allocated to periods of nonqualified use based on the ratio which property owned by the taxpayer relates to property owned. 

34. Housing and Economic Recovery Act of 2008: Personal Residence Exclusion Calculation: Gain Exclusion Reduced by Ratio of Months of Nonqualified Use Over Total Months of Ownership Determine Months of Nonqualified Use All nonqualified use before 1/1/09 is ignored Period of ownership after last use as a principal residence is not treated as nonqualified use Any period of 2 years or less for change of employment, health conditions, military service (10 years or less), or other unforeseen circumstance is not counted as nonqualified

35. Housing and Economic Recovery Act of 2008: Example Example of Pre/Post 2009 Purchase: Home purchased in Jan of 2000. Used as Second Residence through Dec 2009. Converted to Personal Residence in Jan 2010 and sold in Jan of 2014. Allocating nonqualified use: 14 years total ownership or 168 months 12 months of post-2008 nonqualified use 12/168 or 7.14% of gain would be taxed. What if converted to Personal Residence on Jan 1, 2009? No nonqualified use. Full exclusion. What if same months of ownership but original purchase was in Jan 2009? 120 months of nonqualified use or 71.43%

36. Housing and Economic Recovery Act of 2008: Example Good Taxpayer: Client buys principal residence in 2009 for $650,000, $150,000 cash and $500,000 mortgage. Uses it as principal residence for 2 years. Client refinances mortgage and property appraised at $650,000. Client uses as second home for 3 years. Spends $100,000 “modernizing house.” Sells it for $1,000,000. Total Cost Basis = $750,000 Gain = $1,000,000 - $750,000 = $250,000 Nonqualified Use = 0/60 = 0% $0 capital gain is taxed ($250,000 excluded)

37. Housing and Economic Recovery Act of 2008: Example Evil Taxpayer: Client buys second home in 2009 for $650,000 with $150,000 cash and $500,000 mortgage. Uses it as second home for 3 years. Client refinances mortgage and property appraised at $650,000. Client uses as principal residence for 2 years. Spends $100,000 “modernizing house.” Sells it for $1,000,000. Total Cost Basis = $750,000 Gain = $1,000,000 - $750,000 = $250,000 Nonqualified Use = 36/60 = 60% $150,000 capital gain is taxed ($100,000 excluded)

38. Does the Outcome Make Sense? Use: Both had 2 years of residence, 3 years of non-residence Exclusion: One taxpayer received full exclusion; the other received 40%. Conclusion: TP w/Appreciation While Second Home: No Tax TP w/Appreciation While Residence: Taxed Taxpayers who convert their second or rental homes to a principal residence to qualify for the home sale exclusion are penalized!

39. Disallowed Losses Add unrecognized loss to the basis of the replacement stock/securities to enable later recovery of basis Holding period of old stock/securities carries over

40. Disallowed Losses No loss deductions are allowed for the following: Loss on sale or disposition of personal use assets Losses on property acquired by gift are limited to the loss subsequent to the gift Losses on property converted from personal use to business use are limited to the loss happening after conversion Losses on sales between related parties are disallowed, but: if the asset is later sold to an outside party at a gain, the gain may be reduced by the previously disallowed loss

41. Disallowed Losses Brothers, sisters, spouses, lineal antecedents and descendants Corporation owned more than 50% (directly or indirectly) by TP