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Understanding Nontaxable Property Exchanges for Smart Real Estate Decisions

Dive into strategies for Alice's property, includes tax-free options vs. selling, like-kind exchanges, and personalized advice.

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Understanding Nontaxable Property Exchanges for Smart Real Estate Decisions

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  1. Chapter 15 Property Transactions: Nontaxable Exchanges

  2. 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

  3. 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

  4. 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 from her job 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? Read the chapter and formulate your response. 4

  5. 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

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

  7. 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

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

  9. 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

  10. 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

  11. 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

  12. 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

  13. 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

  14. 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

  15. 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 Like-Kind Exchanges(slide 7 of 11)

  16. 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 Like-Kind Exchanges(slide 8 of 11)

  17. 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

  18. Like-Kind Exchanges(slide 10 of 11) Example (cont’d) ZakVira FMV Property Rec’d $30,000 $40,000 +Securities 10,000 -0- Total FMV Rec’d $40,000 $40,000 Less: Basis Property Given 25,00030,000 * Realized Gain $15,000 $10,000 Boot Rec’d $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

  19. Like-Kind Exchanges(slide 11 of 11) Example (Cont’d) ZakVira FMV Property Rec’d $30,000 $40,000 Postponed Gain -5,000 -10,000 Basis Property Rec’d $25,000 $30,000 19

  20. 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

  21. 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

  22. 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

  23. 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

  24. 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)

  25. 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

  26. Involuntary Conversions(slide 7 of 13) • Time period for replacement • 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

  27. Involuntary Conversions(slide 8 of 13) • Example of time period for replacement • Taxpayer’s office building is destroyed by fire on November 4, 2009 • Taxpayer receives insurance proceeds on February 10, 2010 • Taxpayer is a calendar-year taxpayer • Taxpayer’s replacement period is from November 4, 2009 to December 31, 2012

  28. 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

  29. 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

  30. 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

  31. 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

  32. 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

  33. 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

  34. 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

  35. 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

  36. 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

  37. 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

  38. §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 Sale of Residence(slide 6 of 7)

  39. 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

  40. The Big Picture - Example 26Sale Of A Residence - § 121 (slide 1 of 2) Return to the facts of The Big Picture on p. 15-2. 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. 40

  41. The Big Picture - Example 26Sale Of A Residence - § 121 (slide 2 of 2) Her recognized gain would be calculated as follows: Amount realized ($348,000 - $18,000) $ 330,000 Adjusted basis (130,000) Realized gain $ 200,000 § 121 exclusion (200,000) Recognized gain $ –0– Since the available § 121 exclusion of $250,000 would exceed Alice’s realized gain of $200,000, her recognized gain would be $0. 41

  42. The Big Picture - Example 27Sale 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) $ 472,000 Adjusted basis (130,000) Realized gain $ 342,000 § 121 exclusion (250,000) Recognized gain $ 92,000 Since the realized gain of $342,000 > the § 121 exclusion of $250,000, Alice’s recognized gain would be $92,000($342,000 - $250,000) 42

  43. 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)

  44. Other Nonrecognition Provisions (slide 2 of 7) • Under §1035, no gain or loss is recognized from the exchange of certain insurance contracts or policies

  45. 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

  46. 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

  47. Other Nonrecognition Provisions (slide 5 of 7) • Under §1041, transfers of property between spouses or former spouses incident to divorce are nontaxable

  48. 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

  49. 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

  50. 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). 50

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