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I:12 Chapter Property Transactions - Nontaxable Exchanges Discussion Questions I:12-1 The statement is not correct. For nontaxable exchanges, taxpayers maintain a continuing investment in comparable property. p. I:12-2. I:12-2 A taxpayer may want to recognize a loss on the exchange. The taxpayer's particular tax situation may make it advantageous to recognize a gain. For example, the taxpayer may be in a low tax bracket or have losses, which may be used to offset the gain. If the exchange is taxable, the basis of the property received may be higher. pp. I:12-2 and I:12-21. I:12-3 a. Debbie's basis for the equipment received in the exchange is $300,000, and the holding period starts on May 10, 2000. b. The exchange is not a like-kind exchange if either Debbie or Doug disposes of the property within two years following the date of the exchange. pp. I:12-7 through I:12-9. I:12-4 a. No. The maximum gain recognized is the realized gain which is the sum of the FMV of the equipment received and the FMV of the marketable securities less the adjusted basis of Kay's equipment. b. No. If the FMV of the marketable securities exceeds the realized gain, the recognized gain is equal to the realized gain. c. The basis of the marketable securities is their FMV. d. The holding period for the marketable securities begins on the day following the date of the exchange. pp. I:12-6, I:12-8, and I:12-9. I:12-5 a. No. To qualify as a like-kind exchange, a direct exchange of property must occur. b. The IRS indicates that a nontaxable exchange may exist when the taxpayer sells property to a dealer and then purchases like-kind property from the same dealer. p. I:12-5. I:12-6 No. The quality or grade of the property is not considered. p. I:12-3. I:12-7 Like class property is tangible personal properties within the same General Asset Class or within the same Product Class. p. I:12-3. I:12-8 The property must be identified within 45 days after the date on which the taxpayer transfers the property relinquished in the exchange and received within 180 days after the date on which the taxpayer transfers the property relinquished in the exchange (but not later than the due date for filing a return for the year in which the transfer of the relinquished property occurs). p. I:12-6. I:12-1 I:12-9 They might do a nonsimultaneous exchange. Burke may transfer the $800,000 to an escrow account and Kim should locate like-kind property that she wishes to own. p. I:12-6. I:12-10 If Jane identifies like-kind property that she would like to own, Lanny could purchase the property and then exchange the property for Janes farm. The exchange is a like-kind exchange for Jane and she does not recognize gain. p. I:12-5. I:12-11 No. The receipt of boot will not cause a realized loss to be recognized. p. I:12-6. I:12-12 A taxpayer who gives boot will recognize a gain if the fair market value of the boot is greater than the basis of the boot. A loss is recognized if the FMV of the boot (assuming the boot is not personal-use property) is less than the basis of the boot. p. I:12-9. I:12-13 An involuntary conversion is beyond the control of the taxpayer. Since the property is replaced, the taxpayer maintains a continuing investment and may lack the wherewithal to pay a tax on the gain. Section 1033 applies only to the nonrecognition of gain. p. I:12-10. I:12-14 No. The threat or eminence of requisition or condemnation of property may cause an involuntary conversion. p. I:12-11. I:12-15 If a portion of the taxpayer's property is condemned, the value of retained property may decline. Severance damages are amounts received because of the decline in value. Amounts received as severance damages reduce the basis of the retained property and any amount received in excess of basis is treated as gain. p. I:12-13. I:12-16 The replacement property must be functionally the same as the converted property. For example, a typewriter and a FAX machine do not perform the same functions and are not functionally related. pp. I:12-13 and I:12-14. I:12-17 If the real property is held for productive use in a trade or business or for investment and is condemned, a proper replacement may be made by acquiring like-kind property. p. I:12-14. I:12-18 With the current law, gain is always excluded, not deferred. The amount that may be excluded ($250,000 or $500,000) is higher. The exclusion may be used by a taxpayer more than once during his lifetime and regardless of age. To use the exclusion today, the property must be used and owned as a principal residence for at least two years, not three, of the five-year period before the sale. Instructors may want to mention problems associated with taxpayers losing their eligibility to use the $125,000 exclusion if they marry a person who has already used the exclusion. Today, the exclusion is determined on an individual basis. pp. I:12-16 and I:12-17. I:12-2 I:12-19 Maintaining an accurate adjusted basis is important if: 1. 2. 3. p. I:12-17. I:12-20 Since Steves house is his personal residence, he would want to capitalize the cost of wallpapering. There is no tax benefit to the homeowner of a personal residence if the cost of wallpapering is expensed. Martha's house is rental property and she wants to expense the cost of wallpapering against the rental income. p. I:12-17 and Chapter I6, pp. I6-17 and I6-18. I:12-21 $373,200 ($300,000 + $1,000 + $79,200 - $7,000). p. I:12-17. I:12-22 The property must be owned and used as a principal residence for at least two years during the five-year period ending on the date of sale. p. I:12-16. the gain realized exceeds $250,000 ($500,000 if married couple is eligible). the taxpayer does not qualify for the exclusion when residence is sold. property is used for rental and/or business and depreciation is allowable. Issue Identification Questions I:12-23 The principal tax issue is whether the exchange is taxable or qualifies as a tax-free exchange. If the exchange is taxable, John and Jane both need to consider the character (i.e., capital or ordinary) of the gain and determine the amount of the gain. Although not discussed in the text, it should be noted that Reg. Sec. 1.1031(a)-1 provides that partnership interests are not like-kind property and the exchange should, therefore, be taxable. p. I:12-4. I:12-24 a. What is the realized gain on the exchange? The realized gain is $350,000 [$1,000,000 - ($400,000 + $250,000)]. The FMV of the old rig must be $750,000. b. Will the new rig be used in Finland? If the new rig is to be used in Finland, the exchange is not a like-kind exchange and Chauvin must recognize the $350,000 gain. The basis of the new rig is $1,000,000. If the new rig is used in the United States, the exchange is a like-kind exchange, no gain is recognized, and the basis of the new rig is $650,000. p. I:12-3. I:12-3 c. What is the character of any gain recognized? Students should recognize that the gain is not capital gain, but are not likely to know that the gain is Sec. 1245 ordinary income discussed in Chapter P13. Instructors might use this problem as an opportunity to make students aware of Sec. 1245. I:12-25 Has Jaharta made a property replacement of property that will allow the corporation to elect to defer the gain resulting from the condemnation. In John L. Stevenson, [250 F. Supp. 647, 64-2 USTC 9821] the court ruled in favor of the taxpayer on facts identical to those in this case. The proceeds were reinvested in property similar or related in service or use to the property condemned. pp. I:12-13 and I:12-14. Problems I:12-26 The exchanges in b, c and f qualify as like-kind exchanges under Sec. 1031. pp. I:12-2 through I:12-4. I:12-27 Only the exchange in part d qualifies as a like-kind exchange. pp. I:12-2 through I:12-4. I:12-28 Realized Gain or (Loss) a. b. c. d. e. $65,000 $39,000 $30,000 $28,000 ($13,000) Recognized Gain or (Loss) -014,000 25,000 28,000 -0Basis of Equipment Received $20,000 $45,000 $60,000 $60,000 $68,000 pp. I:12-6 through I:12-8. I:12-29 Realized Gain or (Loss) a. b. c. $52,000 ($ 9,000) $27,000 Recognized Gain or (Loss) $16,000 -0$27,000* *Does not qualify as like-kind exchange. pp. I:12-6 through I:12-8. I:12-4 I:12-30 a. Realized gain Recognized gain Basis of new equipment Realized gain Recognized gain Basis of new equipment $ 7,000 ($21,000 - $14,000) 3,000 14,000 ($14,000 - $3,000 + $3,000) $13,000 ($27,000 - $14,000) 9,000 14,000 [$14,000 - ($3,000 + + $9,000] b. $6,000) pp. I:12-6 through I:12-8. I:12-31a. $120,000 [($444,000 + $26,000) - $350,000] b. $ 26,000 The gain is not solely like-kind. The barges are in asset-class 00.28 and the computer is an asset-class 00.12. The computer is not like-kind property. c. $350,000. d. $ 26,000. e. $ 8,840 ($26,000 x 34%). pp. I:12-6 through I:12-8. I:12-32a. Amount realized ($750,000 + $200,000) Minus: Basis of land exchanged Debt assumed by Paul Gain realized $950,000 $340,000 200,000 540,000 $410,000 b. No gain is recognized. c. Paul's basis for the building is $540,000 [($950,000 - $410,000) or ($340,000 + $200,000)]. When Paul assumes the debt, it is equivalent to the transfer of cash to David. pp. I:12-6 through I:12-8. I:12-33Value of farm received Plus: Liability that apartment complex is subject to Total consideration received Minus: Basis of apartment complex Liability to which farm is subject Gain realized $770,000 180,000 $950,000 $600,000 $100,000 (700,000) $250,000 The amount of boot received by Helmut is $80,000 ($180,000 - $100,000). If each party assumes a liability of the other party, Reg. Sec. 1.1031(d)-2 holds that only the net liability given or received is I:12-5 treated as boot. Since the amount of the boot received is less than the gain realized, Helmut recognizes a gain of $80,000. The basis of the farm is determined as follows: Basis of apartment complex Minus: Boot received ($180,000 - $100,000) Plus: Gain recognized Basis of farm received pp. I:12-6 through I:12-8. I:12-34 $50,000. Sheila is receiving $330,000 (land with FMV of $250,000 and Tony's assumption of her $80,000 debt). Sheila is giving up $380,000 of value (land with FMV of $230,000 and assumption of Tony's $150,000 liability). Thus, Tony must transfer $50,000 to Sheila to equalize the exchange. pp. I:12-6 through I:12-8. Note to Instructor: This problem allows one to illustrate a point not illustrated in the text. That is, how is the cash considered when each party assumes liabilities? Although liabilities are netted out as illustrated in problem I:12-32, the cash is not netted out against the liability. Thus Sheila will recognize a $50,000 gain despite the fact that she is assuming more liability than Tony is assuming, computed as follows: Amount realized: FMV of land received Sheilas liability assumed by Tony Cash received Adjusted basis of land exchanged Tonys liability assumed by Sheila $100,000 150,000 $250,000 80,000 50,000 380,000 250,000 $130,000 Lesser of realized gain or boot received* 50,000 $600,000 ( 80,000) 80,000 $600,000 Adjusted basis: Realized gain: Recognized gain: *In computing boot received, the liabilities may be offset with each other, but cash may not be offset against liabilities. Therefore, the boot received in this case is the cash received, or $50,000. (Reg. Sec. 1.1031(d)-2 Ex. 2). I:12-6 I:12-35 Total Amount realized Minus: Basis of land and marketable securities Gain realized Gain recognized $150,000 ( 60,000) $ 90,000 $ 15,000 Securities $25,000 ( 10,000) $15,000 $15,000 Land $125,000 ( 50,000) $ 75,000 $ -0- Gain recognized is $15,000. The FMV of the marketable securities exceeds the basis by $15,000 ($25,000 - $10,000). The basis for the apartment building is $75,000 ($50,000 + $10,000 + $15,000 recognized gain). pp. I:12-6 through I:12-9. I:12-36 a. Bob's realized and recognized gain is $214,000 ($300,000 - $86,000). The exchange is not a like-kind exchange since it was made with a related party who disposed of the property within two years after the exchange. b. Cindy's realized and recognized gain on the sale is $12,000 ($312,000 -$300,000). She must also recognize $21,000 ($300,000 - $279,000) gain on the exchange since it does not qualify as like kind. Therefore, the basis of the property sold is $300,000. pp. I:12-8 and I2-9. I:12-37 a. Amount realized Minus: Adjusted basis Gain realized $300,000 86,000 $214,000 None of the gain is recognized since neither related party transferred the property within two years of the exchange. b. Amount realized Minus: Adjusted basis Gain realized $300,000 ( 279,000) $ 21,000 None of the gain is recognized since neither related party transferred the property two within years of the exchange. Amount realized Minus: Adjusted basis Gain realized The $33,000 gain is recognized. pp. I:12-8 and I:12-9. c. $312,000 ( 279,000) $ 33,000 I:12-7 I:12-38Amount realized Minus: Basis of office building Gain realized Amount realized Minus: Cost of new office building Gain recognized Cost of new office building Minus: Gain deferred Basis of new office building * $350,000 - $68,000 = $282,000. Basis of machinery acquired pp. I:12-10 through I:12-12. I:12-39Amount realized Minus: Basis Gain realized Recognized Gain a. b. c. $ 2,500 -0$ 1,400 $25,000 ( 3,000) $22,000 $750,000 ( 400,000) $350,000 $750,000 ( 682,000) $ 68,000 $682,000 ( 282,000)* $400,000 $ 90,000 Basis of Land Purchased $3,000 $6,500 $3,000 Replacement period ends three years after the close of the first taxable year in which any part of the gain is realized due to condemnation of real property held for productive use in a trade or business or for investment. p. I:12-15. I:12-40a. Newark must pay at least $840,000 for the replacement property. b. The property must be replaced by December 31, 2009. c. None of the gain may be deferred as an office building and a storage tank are not functionally related. Therefore, Newark must recognize a gain of $240,000 ($840,000 $600,000). d. If real property used in a trade or business is condemned, the replacement period is three years from the end of the tax year in which the gain is realized. Newark must replace the properties by December 31, 2010. If real property used in a trade or business is condemned, the property may be replaced by obtaining like-kind property. Since the replacement property cost $810,000 and the amount realized is $840,000, only $30,000 of the gain is recognized. The remaining gain of $210,000 ($240,000 - $30,000) is deferred. pp. I:12-12 through I:12-15. I:12-8 I:12-41a. $30,000 of the gain must be recognized. b. Zero. All of the gain may be deferred. c. To qualify as a purchase of property, the basis of the property must be its cost within the meaning of Sec. 1012. Therefore, the recognized gain is $300,000. The contribution of capital is a nontaxable transfer and Federal's basis for the warehouse is $635,000. d. This is not a replacement of property, which is similar or related in service to the converted property. Therefore, the recognized gain is $300,000. e. The replacement period ends on December 31, 2009. Therefore, the recognized gain is $300,000. pp. I:12-13 through I:12-15. I:12-42a. The gain of $30,000 is recognized. Section 1033 does not apply since she does not plan to replace the property. b. She does not have to recognize a gain because of the severance damages. Severance damages reduce her basis, and a gain is recognized only if the severance damages received exceed the basis. c. $2,500 ($10,000 - $7,500). p. I:12-13. I:12-43 Selling price Minus: Selling expenses Amount realized Minus: Basis ($55,000 + $4,000) Gain realized $180,000 ( 8,000) $172,000 ( 59,000) $113,000 The realized gain is $113,000 and none of the gain is recognized. The basis of the new residence is its cost, $162,000. pp. I:12-16 and I:12-17. I:12-44The realized gain is $89,000 [($300,000 - $11,000) - $200,000] The recognized gain is zero because they own and use the house for at least two years of the five-year period before the sale. pp. I:12-16 and I:12-17. I:12-45a. $250,000. If Joe lives in the house for two years, they could exclude up to $500,000 of gain. b. $250,000. pp. I:12-18 and I:12-19. I:12-46a. $480,000. b. Yes, they may exclude the gain under Sec. 121. The basis of the residence is Yes, they may defer the gain under Sec. 1033 as an involuntary conversion. The basis of the residence is $370,000 ($480,000 - $110,000). The Mahans should exclude the gain under Sec. 121. p. I:12-20. I:12-47 Zero. Because the sale was due to a change in employment, a portion of the gain is excluded even if the two-year requirement is not satisfied. Because the $25,000 realized gain is less than $69,178 (101/730 of $500,000), all of the gain is excluded. p. I:12-19. I:12-9 I:12-48a. The recognized gain is $180,000. The realized gain is $680,000 ($880,000 $200,000), and they may exclude $500,000. The basis of the replacement residence is the $1,000,000 cost. b. None of the gain is recognized. All of the $680,000 gain is deferred because they purchased a residence that cost more than the $880,000 ($900,000 - $20,000) adjusted sales price. The basis of the replacement residence is $320,000 ($1,000,000 - the deferred gain of $680,000). Instructors may want to illustrate the deferral concept by asking students to answer question b assuming that the new residence cost $800,000 instead of $1,000,000. The recognized gain is $80,000 and deferred gain is $600,000. The basis of the replacement residence is $200,000 ($800,000 - $200,000). c. Beverley and George may prefer the old law since no gain is recognized in the current year. However, one disadvantage of the old law is the lower basis for the replacement residence, $200,000. A later sale may result in a large gain. pp. I:12-16 and I:12-17. I:12-49All of the $26,000 gain is recognized. Ken did not live in the house for the required twoyear period and does not qualify for the Sec. 121 exclusion p. I:12-18. I:12-50a. $204,000 ($300,000 - $96,000) b. $4,000 of the gain is recognized because it is attributable to depreciation after May 6, 1997. The gain is Sec. 1231 gain and is taxed at a maximum rate of 25% because it is unrecaptured Sec. 1250 gain. I:12-51a. $24,000. [($80,000 - $6,000) - $50,000] b. Zero. Sec. 121 applies. c. $51,000. [($148,000 - $7,000) - $90,000). d. $51,000. The two-year use and ownership tests are not met and no exceptions apply. pp. I:12-16 through I:12-19. I:12-52a. Realized gain is $122,000. [($200,000 - $8,000) - $70,000]. b. Recognized gain is zero. c. Realized gain is $240,000. [($520,000 - $30,000) - $250,000]. d. Recognized gain is $26,301. They may exclude up to $213,699 (312/730 x $500,000) although the two-year use and ownership tests are not satisfied. An exception applies when the move is due to a change in employment. A portion of the gain is excluded based on a ratio with a denominator of 730 days and the numerator being the shorter of: (1) the period which the ownership and use tests were met during the five-year period ending on the date of sale (312 days), or (2) the period of time after the date of the most recent sale or exchange for which the exclusion applied until the date of the current sale of exchange (496 days). pp. I:12-16 through I:12-19. I:12-10 Comprehensive Problem I:12-53 1. $61,000 ($36,000 + $16,000 + $9,000) 2. $15,000 [($329,000 - $14,000) - $50,000 = $265,000 - $250,000 exclusion] 3. $15,000 The loss on the sale of Dell stock is a wash sale. 4. $71,724 [$76,000 - moving expenses of $4,276 ($4,150 + $126)]. The $126 is 700 miles at $.18 per mile. 5. $8,000 Interest on home equity debt. 2,475 Interest on acquisition indebtedness of Iowa residence ($1,475 + $1,000). 66 2% Miscellaneous [($1,000 entertainment + $500) - 2% ($71,724)] 2,091 Real property taxes (212/365 x $3,600) 7,765 Charitable contributions ($6,000 + $1,765) 435 Personal property taxes $20,832 6. $47,492 [$71,724 - $20,832 - $3,400] 7. $150,933 [$150,000 + liability for property taxes assumed of $933 (227/365)($1,500)] 8. Yes, his AGI would be $171,724 and he would be subject to the phase-out rules for itemized deductions and the exemption deduction. Also, his miscellaneous itemized deductions subject to 2% of AGI would be zero. Education expenses are not deductible because they qualify him for a new trade or business. The loss on the sale of Dell stock is a wash sale. Medical expenses are not deductible as they are less than 7.5% of AGI. Prorated real property taxes on the Iowa residence are deductible in 2007. I:12-54a. It should not make a difference. If they sell their houses before marriage at FMV, Ray and Ellie each exclude the gain because the gain on each house is less than $250,000. If they sell their houses after marriage, they may still exclude the gain on each house. The exclusion is determined on an individual basis. b. There is probably no change. If they sell the houses before marriage at FMV, Ray will not recognize a gain, but Ellie will recognize a gain because the realized gain is greater than $250,000. If they sell after the marriage, Ellie will still have to recognize gain. Taxes might be lower or higher depending on their tax rate filing a joint return compared to filing as single. c. Ray could sell his house and exclude the gain, then live in Ellies house for two years before selling that house and exclude up to $500,000. p. I:12-17. Tax Form/Return Preparation Problems I:12-55 (See Instructors Guide) I:12-56 (See Instructors Guide) I:12-57 (See Instructors Guide) I:12-11 Case Study Problem I:12-58 Electric Corporation will recognize a taxable gain of $1,000,000 since the corporation receives boot as part of a like-kind exchange. The realized gain is $2,400,000 ($4,000,000 $1,600,000), which is more than the $1,000,000 of boot received. The tax basis of the land received is $1,600,000 and the tax basis of the marketable securities is $1,000,000. For financial statement purposes, the exchange is an exchange of similar productive assets. APB Opinion No. 29 stipulates that an exchange of similar productive assets is not recognized since the earnings process is not culminated. However, if boot is received, a gain is recognized. Computation of the gain for financial statement purposes differs from computation of the gain for tax purposes. For financial statement purposes, the exchange is viewed as a combination of an exchange and a sale with the basis of the land exchanged allocated based on relative FMV as shown below: FMV of Land Received Basis of Land Exchanged Gain Realized $3,000,000 ( 1,200,000) $1,800,000 FMV of Securities Received Basis of Land Sold Gain Realized $1,000,000 ( 400,000) $ 600,000 Gain realized on sale of the securities is $600,000. The financial accounting basis of the land received in the exchange is $1,200,000 and the basis of the marketable securities is $1,000,000 Since taxable income ($1,000,000) is greater than financial accounting income ($600,000), the deferred tax account will be debited by $136,000 ($400,000 x 34%). Tax Research Problems I:12-59 The Orchards should be able to exclude the entire gain realized from both sales. The sale or exchange of vacant land is a sale or exchange of a taxpayers principal residence if the vacant land is owned and used as part of the taxpayers principal residence and is adjacent to land containing the dwelling unit of the taxpayers principal residence. The sale or exchange of the dwelling unit must meet the requirements of Sec. 121 and the sale must be within two years before or two years after the date of sale or exchange of the vacant land. The requirements of Sec. 121 must be met with respect to the vacant land. For purposes of the maximum amount that may be excluded, the dwelling unit and the land are treated as one sale or exchange [Reg. 1.121-1(b)(3) Reg. 1.121-1(b)(4) Examples 3 and 4]. I:12-12 I:12-60 The exchange is not a like-kind exchange. George did not intend to hold the property received for productive use in a trade or business or for investment. He exchanged the property with the intent to make gifts of the property received [D.H. Click, 78 T.C. 225 (1982)]. After the exchange, George should rent the houses to the sons at a fair rental value. If he uses the property as rental property, the exchange is a like-kind exchange. George may later make gifts of the houses to the sons [F.S. Wagensen, 74 T.C. 653 (1980)]. I:12-61 $170,000. Occupancy is required, and a one-year sabbatical is not a temporary absence. [Reg. 1.121-1(c)(4) Example 4]. I:12-62 She should sell the house this year. The basis on half of the house is increased to $400,000 because the basis is FMV at time of death, thus the basis for the house is $450,000 ($400,000 for his half and $50,000 for her half). If she sells the house for $825,000 this year, the realized gain is $375,000, which may be excluded on their joint return. If she sells the house next year for $830,000, the realized gain is $380,000 but only $250,000 may be excluded. [Reg. 1.121-2(a)(4) Examples 5 and 6]. I:12-63 a. b. c. Yes. [Reg. 1.121-3(c)(1) & (4) Example 1] Yes. [Reg. 1.121-3(d)(1) & (3) Example 4]; the son is a qualified individual [Reg. 1.121-3(f)]. Probably No. The safe harbor test of (e)(2) is not satisfied. [Reg. 1.121-3(e)(1) & (4) Example 5]. I:12-13

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