Concepts in Federal Taxation Chapter 12: nonrecognition transactions & Final review

Concepts in Federal TaxationChapter 12:nonrecognitiontransactions & Final review November 30, 2012

administrative • Attendance • Midterm 2Statistics • Average: 95 • SD: 20 • Total 145 • Final • Thursday, December 13th 11:30-2:30PM • Chapters 5, 6, 8, 11, 12, 13 (p. 3-18) • Tips

Homework Problems HW Problems: Assignment #13 Chapter 12 P#32, 45, 49, 73 Extra problems: #51

#32 Shirley has an old tractor that has an adjusted basis of $9,000 and a fair market value of $5,000. She wants to trade it in on a new tractor that costs $25,000. Write a memorandum to Shirley advising her about how to structure the transaction to optimize her tax situation.

#32 • Shirley should structure the transaction as a sale of the old tractor and a separate purchase of the new tractor • This will allow her to recognize the $4,000 ($5,000 - $9,000) loss on the tractor right away • If Shirley structures the transaction as an exchange, she will not be able to deduct the loss on the exchange • The loss is deferred and added to the basis of the new tractor • A sale and purchase with the same dealer in property is usually collapsed by the IRS as an like-kind exchange • She will have to defer the $4,000 loss • She should not buy the new tractor from the same dealer to which she sells the old tractor to avoid this classification

#45 Grant Industries’ warehouse is condemned by the city on August 18, 2012. Because of widespread publicity leading up to the condemnation, Grant anticipates it and purchases a replacement warehouse on April 15, 2012, for $670,000. The city pays Grant $430,000 for the condemned property, which has an adjusted basis to Grant of $220,000. Write a letter to Grant Industries explaining why it might want to recognize the entire gain on the condemnation.

#45 • Grant will elect to recognize the gain if it doesn’t have to pay tax on the gain • If Grant has either a NOL or a capital loss that it could use to offset the gain, it should recognize the entire gain • The gain will go untaxed by offsetting against the losses • Grant will have a basis in the replacement warehouse of the full $670,000 purchase price (no deferral) • The larger basis will result in larger cost recovery deductions in the future

#49 Alley’s automobile dealership, which has an adjusted basis of $400,000, is destroyed by a hurricane in the current year. Alley’s receives $600,000 from its insurance company to cover the loss. Alley’s has begun to rebuild the dealership at an estimated cost of $750,000. Assume that the rebuilding costs at least $750,000.

#49 a. What is the minimum gain Alley’s must recognize on the hurricane damage? • Alley’s has two years to complete the replacement of the dealership (in order to defer any gains) • Assuming that the replacement period requirement is met and Alley’s rebuilding costs are $750,000, Alley’s will not have to recognize any gain on the hurricane damage currently • Alley’s will have fully reinvested the $600,000 of insurance proceeds in the dealership ($600,000 < $750,000) • The basis of the new dealership will be reduced by the deferred gain

#49 Amount realized (insurance proceeds)$ 600,000 Adjusted basis (400,000) Realized gain $ 200,000 Recognized gain -0- Deferred gain $ 200,000 Basis of new dealership ($750,000 - $200,000) = $550,000

#49 b. Alley’s is organized as a corporation. Because of a slump in the automobile industry, Alley’s has net operating losses totaling $400,000 that it is carrying forward from the previous 5 years. Alley’s expects to have another operating loss in the current year. Write a letter to Alley’s explaining how to account for the involuntary conversion results and why you advise taking those measures. • Since Alley’s has a NOL carryover, Alley’s can recognize the entire $200,000 gain on the involuntary conversion and pay no tax on the gain • The current year loss and the NOL carryover will offset the $200,000 gain • By electing to recognize the gain in the current year, Alley’s will have a basis in the new dealership equal to its cost • No reduction in cost since no deferred gain • By recognizing the gain, Alley’s uses up some of its NOL carryforward • Some of the NOL carryforward may be lost if Alley’s does not return to profitability in the future (20 years)

#73 During the current year, the Harlow Corporation, which specializes in commercial construction had the following property transactions. Determine the realized and recognized gain or loss on each of Harlow’s property transactions and the basis of any property acquired in each transaction.

#73 a. In April, a tornado damages a crane and a dump truck at one of its construction sites. The crane was acquired in 2009 for $120,000 and has an adjusted basis $39,650. The dump truck was acquired in 2007 for $70,000 and has an adjusted basis of $33,880. The insurance company reimburses Harlow $35,000 for the crane and $42,000 for the dump truck. The company decides not to replace the dump truck and uses the insurance proceeds to purchase a new crane for $110,000. • Involuntary conversion • The purchase of the new crane is a qualified replacement • The reinvestment of the dump truck proceeds into a new crane does not qualify • Fails functional use test

#73 Dump truck: Amount realized (insurance proceeds)$ 42,000 Adjusted basis (33,880) Realized gain $ 8,120 Recognized gain (8,120) Deferred gain $ -0- • Harlow must recognize a gain of $8,120 on the dump truck since no qualified replacement

#73 Crane: Amount realized (insurance proceeds)$ 35,000 Adjusted basis (39,650) Realized loss $ (4,650) Recognized loss 4,650 Deferred loss $ -0- Basis of new crane (purchase price) = $110,000 • Harlow must recognize the $4,650 loss on the crane • Losses on an involuntary conversion must be recognized

#73 b. The company trades a road grader with a fair market value of $72,000 for a bulldozer worth $60,000. Harlow receives $12,000 in the exchange. The road grader originally cost $90,000 and has an adjusted basis of $50,000. The bulldozer cost $85,000, and its adjusted basis is $37,000. • The exchange qualifies as a like-kind exchange • Since neither a road grader nor a bulldozer are classified in any general asset class, to qualify as a like-kind exchange both the road grader and bulldozer must be in the same product class • Both are in NAICS product class 333120, so the exchange is like-kind (exhibit 12-1)

#73 Amount realized (bulldozer + cash) $ 72,000 Adjusted basis (50,000) Realized gain $ 22,000 Recognized gain (cash boot received) (12,000) Deferred gain $ 10,000 Basis of bulldozer = $50,000 ($60,000 - $10,000) • Harlow realizes a gain of $22,000 on the exchange • The $12,000 of cash boot received must be recognized • Wherewithal to pay • Harlow’s recognized gain is $12,000 and its deferred gain is $10,000

#73 c. A fire destroys the company’s supply warehouse. The warehouse originally cost $300,000 and has an adjusted basis of $200,000. Its fair market value before the fire is $250,000. The insurance company pays Harlow $230,000, which it uses to acquire a warehouse costing $280,000. • Harlow has realized a gain of $30,000 from the fire • $230,000 insurance proceeds - $200,000 adjusted basis • Harlow acquired a replacement warehouse that costs more than the insurance proceeds, so it can defer the $30,000 gain • $280,000 > $230,000 • The basis of the new warehouse is $250,000 • $280,000 - $30,000

#73 Amount realized (Insurance proceeds) $ 230,000 Adjusted basis (200,000) Realized gain $ 30,000 Recognized gain $ -0- Deferred gain $ 30,000 Basis of warehouse = $250,000 ($280,000 - $30,000)

#73 d. The city of PeaceDale condemns land that Harlow had acquired in 1978 for $22,000 and held as an investment. The city pays Harlow the $195,000 fair market value of the land. Harlow uses the proceeds to acquire a commercial office park for $350,000. • Qualified replacement property on an involuntary conversion must have the same functionaluse as the property converted • An exception is granted for condemned business or investment real property, which only requires the property acquired be like kind property • The replacement of the land with the commercial office park qualifies as like-kind property (realty for realty) • Harlow may elect to defer the gain it realizes on the condemnation

#73 Amount realized (condemnation proceeds) $ 195,000 Adjusted basis (22,000) Realized gain $ 173,000 Recognized gain $ -0- Deferred gain $ 173,000 • Harlow has realized a gain of $173,000 on the condemnation • Harlow does not have to recognize any gain because the entire $195,000 of condemnation proceeds are reinvested in the purchase of the office park • Basis of office park = $177,000 ($350,000 - $173,000)

#73 e. Harlow sells an automobile used by its president for business purposes for $10,000 to a local car dealership. The car originally cost $32,000, and its adjusted basis is $15,000. The company had an agreement to replace the automobile with a customized four-wheel-drive vehicle from a company that specializes in custom cars. However, the day the company sells the automobile, it is informed that the custom car company will not be able to deliver the vehicle for at least 10 weeks. Harlow terminates its contract with the custom car company and buys a new automobile from the local car dealership for $55,000. • This transaction is structured as a sale and a purchase • The IRS will collapse sales and purchases involving the same parties into one like kind exchange • Since the car dealership is involved in both the sale and purchase, it is likely that the IRS would be successful in treating the transaction as an exchange

#73 Amount realized $ 10,000 Adjusted basis (15,000) Realized loss $ (5,000) Recognized loss $ -0- Deferred loss $ (5,000) • As an exchange, Harlow will not be able to immediately recognize a loss on the old automobile • The $5,000 loss is deferred until Harlow sells the new automobile

#73 Fair market value of new automobile $55,000 Add: Deferred loss 5,000 Basis in new automobile $60,000

Extra problems—#51 Aretha sells her house on June 9, 2011, for $220,000 and pays commissions of $10,000 on the sale. She had purchased the house for $60,000 and made capital improvements costing $15,000. What are Aretha’s realized and recognized gain in each of the following cases? a. Aretha is single and acquired the house on September 15, 2004. • Aretha has a realized gain • She can exclude the entire amount of the gain ($250,000 max) if she meets both the ownership test and the use test: • The ownership test requires that she own the house for at least two of the five years preceding the sale • The use test requires that the house was her principal residence for two of the preceding five years

Extra problems—#51 • Because Aretha meets both of these tests, she can exclude the $135,000 gain Amount realized ($220,000 - $10,000) $ 210,000 Adjusted basis ($60,000 + $15,000) (75,000) Realized gain $ 135,000 Exclusion amount (135,000) Recognized gain $ -0-

Extra problems—#51 b. Assume the same facts as in part a, except that Aretha sold the house for $375,000 and pays commissions of $30,000 on the sale. • Aretha has a realized gain of $270,000 and a recognized gain of $20,000 Amount realized ($375,000 - $30,000) $ 345,000 Adjusted basis ($60,000 + $15,000) (75,000) Realized gain $ 270,000 Exclusion amount (250,000) Recognized gain $ 20,000

Extra problems—#51 c. Aretha is single and acquired the house on September 1, 2010. She sold the house because her company transferred her to Phoenix. • Aretha fails to meet the ownership and use tests • She can still qualify for a pro rata portion of the exclusion since her failure to meet these tests is due to a change in employment, health, or unforeseen circumstances • The amount she can exclude is the ratio of the number of months she met the ownership and use tests (9 months—September to June) to the total number of months in the exclusion period (24 months) multiplied by the exclusion amount of $250,000

Extra problems—#51 • The amount Aretha can exclude is $93,750: $93,750 = 9 months x $250,000 24 months Amount realized ($220,000 - $10,000) $ 210,000 Adjusted basis ($60,000 + $15,000) (75,000) Realized gain $ 135,000 Exclusion amount ( 93,750) Recognized gain $ 41,250

Extra problems—#51 d. Assume the same facts as in part c, except that she moved to Phoenix to enter medical school. • Aretha fails to meet the ownership and use tests • Since her reason for failing these tests is not due to a change in employment, health, or unforeseen circumstances, she does not qualify for a pro rata share of the $250,000 exclusion • Aretha has a recognized and realized gain of $135,000: Amount realized ($220,000 - $10,000) $ 210,000 Adjusted basis ($60,000 + $15,000) (75,000) Realized gain $ 135,000 Exclusion amount -0- Recognized gain $ 135,000

Practice final—SA #2 Bradley has the following transactions related to his investments and his business during 2010:

Practice final—SA #2 a. Determine the amount and character of each gain or loss LTCG of $2,000. STCL of $7,000. 1231 loss of $6,000. Section 1245 recapture of $9,000 and Section 1231 gain of $3,000. Section 1231 business casualty loss of $5,000.

Practice final—SA #2 What is capital gain income? • Capital gain income (loss) results from the sale or other disposition of a capital asset. • Capital assets consist of stocks, bonds, other investment assets, and personal use property. • Examples include land, buildings, machinery, etc. Generally, these are assets that cannot quickly be turned into cash and are often only liquidated in a worst-case scenario. • Any asset that is NOT: • An inventory item • A receivable • Real or depreciable property used in a trade or business • Intellectual property • Certain US Government publications

Practice final—SA #2 What is Section 1231 property? • A Section 1231 property is an asset that is held for more than 1 year and which is: • Depreciable or real property used in a trade or business, • Timber, coal, and domestic iron ore, • Livestock; horses must be held more than 2 years, or • Unharvested crops.

Practice final—SA #2 What is the tax advantage of selling a Section 1231 property at a gain? • Netting • Within this procedure, there are two possible benefits. • First, if the capital gain and loss procedure results in a net long-term capital gain, the tax rate applicable to the gain for an individual taxpayer is 15%. • Second, if the taxpayer has a net capital loss, the Section 1231 long-term capital gain effectively allows deduction of a loss which may have otherwise been limited.

Practice final—SA #2 How are the recapture provisions for Section 1245 and Section 1250 property different? Section 1245 Section 1250 • Section 1245 recaptures all gain which is due to the depreciation deduction as ordinary income. • For there to be either a capital gain or a Section 1231 gain on a Section 1245 asset, the asset must be sold for more than its original cost. • That is, only the true appreciation in the price of a Section 1245 gain is accorded capital gain or Section 1231 gain status. • Section 1250 recaptures excess depreciation as ordinary income. • Excess depreciation is defined as the depreciation deducted less the allowable straight-line depreciation. • Therefore, straight-line depreciation on Section 1245 assets can create capital gain or Section 1231 gain. • As long as a straight-line depreciation is taken on a Section 1250 asset, no recapture occurs.

Practice final—SA #2 b. Determine the effect of the gains and losses on Bradley's 2010 adjusted gross income. You must present the calculations in proper form to receive full credit. Section 1231 Netting: Capital Gain and Loss Netting:

Practice final—SA #2 Summary of effect on taxable income:

Practice Final—sa #3 Hank and Lois sell their home for $775,000, incurring selling expenses of $40,000. They had purchased the residence in 1975 for $185,000 and made capital improvements totaling $45,000. They buy a new residence for $310,000. What is their realized gain and recognized gain on the sale? What is their basis in the new house? Issues; • Realized gain/recognized gain • Ownership and Use • They can exclude $500,000 of the gain if either of them meets the ownership test and both of them meet the use test. • The ownership test requires that either of them own the house for at least two of the five years preceding the sale. • The use test requires that the house was the principal residence for both of them in two of the preceding five years. • Because they meet both of these tests, they can exclude $500,000 of the gain.

Practice Final—sa #3 Amount realized ($775,000 - $40,000) = $735,000 Adjusted basis ($185,000 + $45,000) = (230,000) Realized gain $505,000 Exclusion amount (500,000) Recognized gain $ 5,000

Practice Final—sa #3 Basis in new home $310,000 (purchase price ) The exclusion has no impact on the basis of the new home

Practice final—SA #4 James and Mark exchange equipment each use in their business. In the trade, James receives Mark's equipment that is worth $20,000. Mark also assumes the $10,000 loan James had on the equipment. James purchased his equipment for $25,000 and had taken $12,000 of depreciation on the equipment up to the date of the exchange. Mark's adjusted basis in his equipment is $16,000 on the date of the exchange.

Practice final—SA #4 James Mark $20,000 FMV $16,000 AB $25,000 purchase $12,000 depreciation $10,000 loan Before trade $25,000 purchase $12,000 depreciation $10,000 loan $20,000 FMV $16,000 AB After trade

Practice final—SA #4 Realized gain ($20,000 + $10,000) - ($25,000 - $12,000) = $17,000 Mark’s Equipment + Loan James’s Basis – Depreciation • His amount realized is the FMV of the property received plus the $10,000 loan assumption • His adjusted basis is reduced by the depreciation taken on the equipment

Practice final—SA #4 Boot $10,000 Loan • James must recognize ordinary income of $10,000 on the exchange • Gain must be recognized to the extent that boot is received in a like-kind exchange • The assumption of the loan on the equipment is considered to be boot and must be recognized • Because the equipment is Section 1245 property, any gain recognized on the equipment must be recaptured to the extent of the depreciation taken ($12,000) on the equipment

Practice final—SA #4 Basis in new equipment • $20,000 • $7,000 • = $13,000 Mark’s FMV Realized gain - Boot • James's basis in the new equipment is $13,000 ($20,000 - $7,000) • Any gain that is not recognized on a like-kind exchange is deferred into the basis of the new property received in the exchange • James realizes a gain of $17,000, recognizes $10,000 of the gain and defers the remaining $7,000 of gain

Important concepts • Commonalities of nonrecognition transactions • Substance over form (continuation of investment) • Wherewithal to pay is lacking • All amounts realized are reinvested • Like kind exchanges (deferral mandatory) • Involuntary conversions (deferral elective) • Gain deferral, not losses • Except like like exchanges, losses are mandatory • Realized gains are maximum gain recognized • Deferral accomplished through basis adjustment • Basis = FMV of replacement less gain deferred • Basis = FMV of replacement plus loss deferred • Carryover of tax attributes • Holding period • Depreciation recapture potential

Important concepts • Like kind exchanges • Direct exchange requirement—a sale followed by a purchase doesn’t qualify • Interdependent sale and purchase will be collapsed by IRS • Deferred exchanges allowed (3rd party exchanges) • Max 180 days after 1st exchange to complete 2nd exchange • Max 45 days after 1st exchange to identify property for 2nd exchange • Like kind property requirements • Business or investment property only • Realty for realty is sufficient • Like kind classes for tangible personalty (same asset class used for depreciation) • Use NAICS code if both properties don’t fall into general asset classes • Exchanges that never qualify (look at page 12-11)

Important concepts • Effect of boot • Receipt of boot • Has wherewithal to pay • Liabilities assumed = boot • If both parties assume liabilities, net the liabilities, and the party with a positive net liability has received boot • Giving boot doesn’t trigger recognition • Losses on like kind exchanges are never recognized, even when boot is received • Related party exchanges • Must hold for 2 years after exchange

Important concepts • Involuntary conversions • Casualties, theft, condemnations, seizures • Sales due to threats • Sales of livestock due to weather related conditions • Treatment of involuntary conversion gains and losses • Losses fully recognized • Gains on direct conversions are treated the same as like kind exchanges (mandatory deferral of gains) • Gain deferral on other involuntary conversions is elective • Know when it is beneficial to defer and when not to defer • Qualified replacement property • Functional use test • Same usage or function • Except condemned realty (use like-kind test) • 2 year window to replace; 3 for condemned real estate

Concepts in Federal Taxation Chapter 12: nonrecognition transactions & Final review