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Property Transactions: Basis, Gain, Loss, and Nontaxable Exchanges

Learn about the basis, gain, loss, and nontaxable exchanges in property transactions. Understand how to minimize realized gain, maximize realized loss, and consider basis considerations.

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Property Transactions: Basis, Gain, Loss, and Nontaxable Exchanges

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  1. Chapter 7 Property Transactions: Basis, Gain and Loss, and Nontaxable Exchanges

  2. The Big Picture (slide 1 of 5) Alice owns land that she received from her father 10 years ago as a gift. The land was purchased by her father in 1992 for $2,000 and was worth $10,000 at the time of the gift. Alice’s father did not owe gift taxes upon making the transfer. The property is currently worth about $50,000. Alice is considering selling the land and purchasing a piece of undeveloped property in the mountains. 2

  3. The Big Picture (slide 2 of 5) Alice also owns 500 shares of AppleCo stock. 300 of which were acquired as an inheritance when her grandfather died in 1996. Alice’s grandfather paid $12,000 for the shares, and The shares were worth $30,000 at the time of his death. The other 200 shares of AppleCo were purchased by Alice two months ago for $28,000. The stock is currently worth $120 per share, and Alice is considering selling the shares. 3

  4. The Big Picture (slide 3 of 5) Alice owns a house that she inherited from her grandmother 2 years ago. A developer has recently offered Alice $600,000 for the property. 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. Alice is considering selling the house. She expects any selling expenses to be minimal, 4

  5. The Big Picture (slide 4 of 5) The building Alice used in her business, adjusted basis of $50,000, was destroyed by a fire on October 5, 2015. On November 17, 2015 she receives an insurance reimbursement of $100,000 for the loss. Alice intends to invest $80,000 of the insurance proceeds in a new building and use the other $20,000 to pay off credit card debt. 5

  6. The Big Picture (slide 5 of 5) Alice has come to you for tax advice with respect to the property she owns. What is the recognized gain or loss for the land, stock, and house if they are sold? Can Alice avoid paying taxes on any of the sales? Alice’s objectives are to minimize the recognition of any realized gain and to maximize the recognition of any realized loss. Read the chapter and formulate your response. 6

  7. 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 7

  8. 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

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

  10. 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

  11. 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

  12. 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

  13. 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

  14. 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

  15. Basis Considerations(slide 1 of 5) • 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)

  16. Basis Considerations (slide 2 of 5) • Identification problems • Security sales where specific identification not possible, use FIFO to compute basis

  17. Basis Considerations (slide 3 of 5) • Allocation problems: lump-sum purchase • Must allocate basis to each asset obtained • Allocation usually based on relative FMV of assets

  18. Basis Considerations (slide 4 of 5) • 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

  19. Basis Considerations (slide 5 of 5) • 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

  20. Gift Basis(slide 1 of 6) • 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

  21. Gift Basis(slide 2 of 6) • Gift basis for cost recovery • The donee's basis for cost recovery is the donor’s basis (donee's gain basis)

  22. Gift Basis(slide 3 of 6) • 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

  23. The Big Picture - Example 15Gift – Carryover Basis Return to the facts of The Big Picture on p. 7-1. Alice’s father purchased the land in 1992 for $2,000. He gave the land to Alice 10 years ago, when the fair market value was $10,000. No gift tax was paid on the transfer. Alice is considering selling the land, which is currently worth $50,000. If she sells the property for $50,000, Alice will have a realized gain of $48,000 ($50,000 amount realized - $2,000 basis in the land). 23

  24. Gift Basis(slide 4 of 6) • 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”

  25. Gift Basis(slide 5 of 6) • 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

  26. The Big Picture - Example 16Gift – Loss Basis Return to the facts of The Big Picture on p. 7-1. Instead, assume Alice’s father had purchased the land in 1992 for $12,000. He gave the land to Alice 10 years ago, when the fair market value was $10,000 and paid no gift tax on the transfer. If Alice sells the property for $50,000, she has a realized gain of $38,000. $50,000 amount realized - $12,000 basis in the land. However, if the property has declined in value and Alice sells the land for only $8,000, she will realize a loss of $2,000. $8,000 amount realized - $10,000 basis in the land. 26

  27. Gift Basis(slide 6 of 6) • 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

  28. The Big Picture - Example 17Gift – No Gain Or Loss Return to the facts of The Big Picture on p. 7-1. Assume Alice’s father had purchased the land for $12,000. He gave the land to Alice 10 years ago when it was worth $10,000. No gift tax was paid on the transfer. Now, Alice plans to sell the property for $11,000. To calculate gain, she would use a basis of $12,000, her father’s basis. But when a $12,000 basis is compared to the $11,000 sales proceeds, a loss is produced. To calculate loss, Alice must use the property’s fair market value at the date of gift—namely, $10,000. When a $10,000 basis is compared to sales proceeds of $11,000, a gain is produced. Accordingly, no gain or loss is recognized on this transaction. 28

  29. Gift Basis- Adjustment For Gift Taxes(slide 1 of 2) • 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]

  30. Gift Basis- Adjustment For Gift Taxes(slide 2 of 2) • Example of gift tax: • Cathy received a gift from Darren on June 15 of this year • FMV on June 15 was $34,000 • Darren had a basis in the asset of $29,000 • Darren paid gift tax of $800 • Cathy’s basis in the gifted property is $29,200 [$29,000 + ($5,000/($34,000 – $14,000) × $800)]

  31. Property Acquiredfrom a Decedent (slide 1 of 6) • 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

  32. The Big Picture - Example 20Property Acquired From A Decedent Return to the facts of The Big Picture on p. 7-1. Alice owns 500 shares of AppleCo stock, 300 of which were inherited from her grandfather. Her grandfather’s cost basis in the stock was $12,000. The shares were worth $30,000 at the time of his death. Alice purchased the other 200 shares for $28,000. Her basis in the 500 AppleCo shares is $58,000. The 300 shares received as an inheritance take a stepped up basis of $30,000, and The 200 shares purchased take a cost basis of $28,000. 32

  33. Property Acquiredfrom a Decedent (slide 2 of 6) • 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

  34. Property Acquiredfrom a Decedent (slide 3 of 6) • 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

  35. Property Acquiredfrom a Decedent (slide 4 of 6) • 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

  36. Property Acquiredfrom a Decedent (slide 5 of 6) • 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

  37. Property Acquiredfrom a Decedent (slide 6 of 6) • 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

  38. 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

  39. 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

  40. 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

  41. 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

  42. 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

  43. 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 43

  44. Nontaxable Transactions(slide 2 of 4) In a tax-free transaction, nonrecognition of realized gain is permanent 44

  45. 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 45

  46. Nontaxable Transactions(slide 4 of 4) Depreciation recapture Potential recapture from the asset surrendered carries over to the new asset acquired in the transaction 46

  47. 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 47

  48. 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 48

  49. 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 49

  50. 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 50

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