Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Principles of Taxation Chapter 8 Nontaxable exchanges

Slide 8-2 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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.

Slide 8-3 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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 portolio 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.

Slide 8-4 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Exchanges of qualifying property-generic  One qualifying property for another.  Assume the FMVs are equal 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.

Slide 8-5 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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 gain + deferred loss  What are Sam’s and Lisa’s new bases? Sam = $60, Lisa = $110.

Slide 8-6 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 The effect of boot  Boot is any nonqualifying property in the nontaxable exchange - includes cash and relief of debt.  Examples will first show CASH boot, then other types of boot.

Slide 8-7 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Effect on taxpayer receiving boot  Any realized gain is recognized up to the FMV of boot received.  Boot cannot increase the amount of the realized gain.  Receiving boot does not cause loss recognition.  New basis in qualifying property =  1) basis of property surrendered + gain recognized - FMV boot received =  2) FMV of qualifying property received - deferred gain + deferred loss  New basis in boot = FMV of boot.

Slide 8-8 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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 $300. He must recognize $100 because he received boot. He defers $200 of gain.  Luke has basis on qualifying property of $700 = 1) $700 + $100 - $100 = 2) $900 - $200.

Slide 8-9 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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.

Slide 8-10 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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 $400 =  1) $300 original basis + $100 boot paid =  2) $1000 FMV - $600 deferred gain  See AP1, AP6

Slide 8-11 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Example: relief of debt = cash boot.  Ginger owns qualifying property with a FMV of $200 and a basis of $120, subject to a mortgage of $50.  Susan owns qualifying property with a FMV of $150 and a basis of $110.  When they swap properties, Susan assumes the mortgage on Ginger’s property. This is treated as $50 boot that Susan pays Ginger.

Slide 8-12 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Example: relief of debt = cash boot.  Ginger has a realized gain of $80. She recognizes $50 and defers $30. Her new basis is $120.  Susan has a realized gain or $40 which is completely deferred. Her new basis is $160.  See AP9

Slide 8-13 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Example: non-cash boot.  Dylan owns qualifying property with a FMV of $120 and a basis of $70.  Luke owns qualifying property with a FMV of $100 and a basis of $90. Luke also owns stock (boot) with a FMV of $20 and a basis of $5.  Dylan recognizes $20 of his $50 realized gain and defers $30. His basis in the qualifying property received is $70. His basis in the stock is $20.  Luke recognizes none of the $10 realized gain and defers $10. His basis in the qualifying property received is $110.

Slide 8-14 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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.

Slide 8-15 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Involuntary conversions  Involuntary conversion includes:  theft  government claim of property or condemnation  natural disasters: fire, hurricane, tornado, earthquake  Taxpayer may ELECT to defer gains.  Losses are fully recognized.

Slide 8-16 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Involutary 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 TWO 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 realized and the amount reinvested.

Slide 8-17 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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 $550,000 = $700,000 - $150,000 deferred gain.  B) If Amy reinvests $600,000 in a new factory, she must recognize $50,000 of gain, but can defer $100,000. 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 $400,000.  See AP13

Slide 8-18 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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 (>=80%) 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.

Slide 8-19 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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 $10,000.  Lil defers her gain of $4,000. Her basis in the stock is $6,000. The corporation’s basis in the building is $6,000.

Slide 8-20 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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.

Slide 8-21 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Wash sales  Special rule requires LOSS DEFERRAL.  If taxpayer sells a security at a loss but repurchases substantially same securities within 30 days after OR 30 days prior to the sale.  New basis = new purchase price + deferred loss.  See AP19.

Slide 8-22 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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 $10 per share on the September 6 sale.  Her new basis in the stock bought September 23 will be $48.