Principles of Taxation

1. Principles of Taxation Chapter 8 Nontaxable Exchanges

2. Objectives • Explain how nontaxable exchanges create tax neutrality. • Compute substituted basis of property received. • Compute gain when boot is received. • Identify qualifying like-kind property. • Describe the effect of relief of debt. • Compute recognized gain and basis in involuntary conversion. • Explain nonrecognition treatment for corporation or partnership formation. • Describe tax effects of a wash sale.

3. Tax Neutrality • A nontaxable exchange removes the government as a party to the transaction: the tax law is neutral. • Example: • Sandra owns stock in ABC with a FMV of $1000 and a tax basis of $200. • She wants to rebalance her portfolio and buy $1000 of XYZ stock instead. • Unfortunately, if she sells ABC and buys XYZ, she must pay tax on the $800 gain on ABC, and won’t have $1000 to spend on XYZ. • IF the exchange of ABC for XYZ were nontaxable, she could defer paying tax on $800, and could obtain a full $1000 value of XYZ stock.

4. Exchanges of Qualifying Property-Generic • One qualifying property for another. • Assume the FMVs are ________ or the parties wouldn’t swap. • Realized gain or loss may not be recognized. • Example: • Sam has property with FMV $100, basis $60. • Lisa has property with FMV $100, basis $110. • Sam and Lisa swap: Sam realizes, but does not recognize, the $40 gain. • Lisa realizes, but does not recognize, the ($10) loss.

5. Substituted Basis • Nonrecognition of gain or loss is not permanent, but deferred. • The mechanism for ensuring deferral is to imbed the deferred gain or loss in the new basis. • Basis in property received = • 1) basis of property surrendered = • 2) FMV of property received - deferred ______ + deferred ______. • What are Sam’s and Lisa’s new bases? Sam = $___, Lisa = $____.

6. The Effect of Boot • Define boot: • Does boot include cash? • Does book include relief of debt? • Examples will first show CASH boot, then other types of boot.

7. Effect on Taxpayer Receiving Boot • Any realized gain is recognized up to the ______ of boot received. • Boot cannot increase the amount of the ________ gain. • Receiving boot does not cause loss recognition. • New basis in qualifying property received = • 1) basis of property surrendered + ______ recognized - _____ boot received = • or 2) FMV of qualifying propertyreceived - deferred ______ + deferred ______. • New basis in boot = ______ of boot.

8. Example: Receiving Cash Boot • Luke has qualifying property with a FMV of $1000 and a basis of $700. • Robert has qualifying property with a FMV of $900 and a basis of $300. He also has cash of $100. • If they swap, Luke receives property worth $1000 in total. His realized gain is $_____. He must recognize $_____ because he received boot. He defers $____ of gain. • Luke has basis on qualifying property of $____ = 1) $700 + ____ - $____= 2) $900 - $_____.

9. Taxpayer Giving boot • Giving boot does not trigger gain recognition in qualifying property given. • BUT all realized gains or losses ON the boot given up must be recognized. • The FMV of the boot paid increases the basis of the qualifying property received = • 1) basis of qualifying property surrendered + FMV of boot paid = • 2) FMV of qualifying property received - deferred gain + deferred loss.

10. Example: Giving Cash Boot • Continue prior • Robert’s realized gain of $600 on the qualifying property he gives up is NOT recognized. It is deferred. Giving boot does not change this result. • Robert’s basis in the qualifying property he receives is $____ = • 1) $300 original basis + $____ boot paid = • 2) $1000 FMV - $____ deferred gain.

11. Example: Relief of Debt = Cash Boot • Ginger owns qualifying property with a FMV = $200 (basis = $120), subject to a mortgage of $50. • Susan owns qualifying property with a FMV = $150 (basis = $110). • When they swap properties, Susan assumes the mortgage on Ginger’s property. This is treated as $___ boot that Susan pays Ginger. • Ginger has a realized gain of $80. She recognizes $__ and defers $___. Her new basis is $___. • Susan has a realized gain of $___ which is completely deferred. Her new basis is $____.

12. Example: Non-Cash Boot • Dylan owns qualifying property with a FMV = $120 ( basis = $70). • Luke owns qualifying property with a FMV = $100 ( basis = $90). Luke also owns stock (boot) with a FMV = $20 (basis $5). • Dylan recognizes $20 of his $____ realized gain and defers $___. His basis in the qualifying property received is $____. His basis in the stock is $20. • Luke recognizes none of the $___ realized gain and defers $___. His basis in the qualifying property received is $____.

13. Like-Kind Exchanges • Personalty within class: Car for car, computer for computer, furniture for furniture. See regulations for details. • Realty: ANY business or investment realty is like-kind with other business realty: land for warehouse, factory for office. • Inventory, stocks, bonds, partnership interests are NOT like-kind. • Under like-kind rules, NO Gain OR Loss is recognized except due to boot. This is mandatory, not elective. For this reason, usually loss properties should be sold rather than swapped.

14. Involuntary Conversions • Involuntary conversion include: • Theft • Government claim of property or condemnation • Natural disasters: fire, hurricane, tornado, earthquake • Taxpayer may ELECT to defer gains. • What happens to losses?

15. Involuntary Conversion • Requirements to defer gain: • 1) Reinvest proceeds in property which is similar or related in service or use. (These rules are stricter than like-kind for realty.) • 2) Replacement property must be purchased within ______ taxable years following the year in which the conversion took place. • IF taxpayer does not reinvest full proceeds, gain is recognized UP TO the difference between the amount __________ and the amount__________.

16. Involuntary Conversion Example • Amy’s factory has an adjusted basis of $500,000. The factory is destroyed by a tornado and she receives $650,000 from the insurance company. • A) If Amy reinvests $700,000 in a new factory, she may defer all the gain. Her new basis will be $___,000 = $700,000 - $____,000 deferred gain. • B) If Amy reinvests $600,000 in a new factory, she must recognize $__,000 of gain, but can defer $___,000. Her new basis is $500,000. • C) If Amy reinvests $400,000 in a new factory, she must recognize ALL $150,000 of gain. Her new basis is $___,000.

17. Corporate Formations • No gain or loss is recognized when property is transferred to a corporation solely in exchange for that corporation’s stock IF the transferors of property are in control (>=____%) of the corporation after the exchange. • The shareholder’s basis in the stock = substituted basis of property contributed. • The corporation’s basis in the property = carryover basis of property from shareholder.

18. Corporate Formation Example • Phil and Lil form a corporation. Phil contributes $10,000 cash. Lil contributes a building with a FMV of $10,000 and an adjusted basis of $6,000. Phil and Lil each receive stock with a FMV of $10,000. After forming the corporation, Phil and Lil own 100% of the stock in aggregate. • Phil has no gain or loss. His basis in the stock is $_______. • Lil defers her gain of $________. Her basis in the stock is $_______. The corporation’s basis in the building is $6,000.

19. Partnership Formation • Similar to corporation rule but with no (80%) control requirement. • No gain or loss recognized. • Partner and partnership keep old basis in property contributed.

20. Wash Sales • Special rule requires LOSS DEFERRAL. • If taxpayer sells a security at a loss but repurchases substantially same securities within ____ days after OR____ days prior to the sale. • New basis = new purchase price + deferred loss.

21. Wash Sale Example • Dorothy owns Nike stock she bought 3 years ago for $50 per share. • She sells it on September 6 for $40. • She repurchases more Nike stock on September 23 for $38. • She cannot recognize the loss of $____ per share on the September 6 sale. • Her new basis in the stock bought September 23 will be $____.

22. Concept Review • Tax deferral produces carryover or substituted basis. • Taxable income recognition produces step-up/step-down to new fair market value basis.