Chapter 9 Property Acquisitions Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2013, Dr. Howard Godfrey Edited August 14, 2013

Preview of Coming Attractions Chapter 9 is the first of four chapters dealing with property – Acquisition (Chapter 9) – Depreciation (Chapter 10) – Disposition (Chapter 11) – Special Issues (Chapter 12 )

Tax Definition of Property The term property refers to long-lived assets owned by a taxpayer. The amount invested in an asset is the property’s basis. Under the capital recovery concept, a property’s basis may be recovered before any taxable income is realized from disposal of property.

Use of Property Property is classified by both its use and its type. Property is used for 1.Trade or business, 2.Production of income (investment), or 3.Personal purposes The same property may be used differently by different taxpayers

Types of Property All property may be classified by type as either tangible or intangible – Intangible property lacks physical substance and has only an economic existence – Tangible property has physical substance Tangible real property (realty) consists of land and structures permanently attached to land Tangible personal property (personalty) is all other tangible property

Property Investment Cycle Property Acquisition Property Disposition Period of Use Initial Basis Adjusted Basis plus additional capital minus capital recoveries

Basis of Property Basis is the taxpayer’s unrecovered investment in an asset that can be recovered without tax cost As the asset’s basis is recovered (through depreciation, depletion or amortization deductions), basis is reduced and is called adjusted basis

Acquisition in Taxable Exchange Basis of acquired asset equals the FMV of the property given up or FMV of the services performed Gain or loss is recognized as if cash had been exchanged for the property surrendered

Basis of Property The original basis of an asset includes – Cash plus fair market value of property given up by the buyer – Money borrowed and used to pay for the property – Liabilities of the seller assumed by the buyer – Expenses of the purchase such as attorney fees or brokerage commissions

Capital Expenditures The cost of a business asset with a useful life extending beyond the current year may be: – Deducted currently – Capitalized until disposal or – Capitalized with the cost allocated to the years the asset’s use benefits (cost recovery period)

Increases in Basis Two categories of increases Additional capital investments Capital expenditures Costs of defending ownership Special assessments Reinvestment of income from property Taxable income from conduit entities

Decreases in Basis Three broad categories of decreases Annual tax deductions for cost recovery Depreciation, depletion or amortization Losses from conduit entities Disposition of all or part of the property Capital recovery due to income exclusion

What costs to capitalize – Best Co. Best Co. purchased a new machine with an invoice cost of $100,000. A 2% discount was received for early payment. Delivery charges were $500 for moving the machine to the factory owned by Best. The company paid $300 in wages to employees while installing the machine. What is the cost of this machine? a. $98,000 b. $100,000 c. $98,500 d. $98,800 e. $99,000

Basis in Conduit Entities Basis in a conduit entity is adjusted yearly for items passed through to owners – Increased for additional capital invested, taxable and nontaxable income, and owner’s share of entity liabilities – Decreased for deductible or nondeductible expenses, cash or property distributed to the owner, and owner’s share of liability reductions

On 1-1-Yr-1, Ben invested $30,000 to become a 25% partner in a partnership that owns rental property. In Yr-1, the partnership had revenue of $90,000 and expenses of $60,000. No salary or guaranteed payment was made to any partner. Ben withdrew $4,000 from the partnership in Yr-1. What is Ben’s basis in his partnership interest at end of Yr-1?

Property Dispositions Amount Realized minus :Adjusted Basis Realized Gain Realized Loss Recognized Gain Recognized Loss

Initial Basis Amount invested = Cash paid, + FMV of property or services given + Increases in liabilities related to the purchase + Any cost incurred to get the asset ready for its intended use

Basis in Bargain Purchase-1 The all-inclusive income concept requires income recognition equal to the difference between an asset’s FMV and its sales price The asset’s basis = amount paid plus the amount of income recognized

Basis in Bargain Purchase-2 Your employer purchased land a few years ago for $30,000. Today it is worth $50,000. Your employer appreciates your fine work and sells the land to you for $45,000. How much income do you recognize? What is your basis in the land?

Basis in Bargain Purchase-3 How much income do you recognize? $5,000 What is your basis in the land? $50,000

Multiple Asset Purchase If more than one asset is acquired in a single transaction, the cost is apportioned to each using their relative fair market values (FMV) – If the purchase price exceeds the value of the assets, the excess is goodwill Alternatively, the buyer and seller can agree to a written allocation of the purchase price to individual assets

Purchase of Assets of a Business Purchase price is allocated to individual assets by their FMVs or through specific agreement Excess of purchase price over FMV of assets is considered Goodwill Purchase of corporate stock does not confer ownership of the business’ assets

Basis in Constructed Assets Basis includes Direct construction costs – Actual costs of physical construction Indirect construction costs – General costs of the business that support the construction For example: interest, taxes, equipment depreciation, general admin., etc.

Basis of Asset Acquired by Gift On the date of gift, compare FMV of property to the donor’s basis. If FMV > donor’s basis – Basis in the property is the donor’s basis plus any gift tax paid on net appreciation

Basis of Asset Acquired by Gift (continued) If Donor’s basis > FMV Basis is determined when property is eventually sold – If sold for more than donor’s basis, use donor’s basis (gain) – If sold for less than FMV, use FMV as basis (loss) – If sold for an amount between the two, use sales price as basis (no gain or loss)

Jan’s Basis in Gift Received Jan received a gift of stock valued at $10,000. The stock had an adjusted basis of $6,000 to the donor. No gift tax was paid on the transfer. Several months later, Jan sold the stock for $11,000. What is Jan's gain or (loss) on sale?

Dan’s Basis in Gift Received Dan received a gift of stock valued at $6,000. The stock had an adjusted basis of $10,000 to the donor. No gift tax was paid on the transfer. Several months later, Dan sold the stock for $5,000. What is Dan's gain or (loss) the sale?

Holding Period for Asset Acquired by Gift If donor’s basis is used, holding period carry’s over and begins on the donor’s acquisition date If FMV is used, holding period begins on the date of gift

Acquisition by Gift Donee’s basis is the donor’s basis + portion of gift taxes due to appreciation (but total cannot exceed FMV at date of gift) Fraction for portion of gift tax: FMV at gift date – Donor’s Basis FMV at gift date

Gift Basis – David -1 Ted bought stock for $18,000 five years ago. David received a gift of stock from Ted this year when the stock was worth $24,000. Ted paid $2,000 of gift taxes on the gift. What is David’s basis for the stock?

Gift Basis – David -2 $18,500. David uses Ted’s basis increased by a portion of the gift tax related to the appreciation on the gift determined as follows: $2,000 gift tax x [($24,000 -$18,000)/$24,000] = $500 gift tax related to appreciation. $18,000 carryover basis from donor + $500 gift tax = $18,500.

Gift Basis – Ellen -1 Ellen received a gift of stock from Gisela this year when the stock was worth $50,000. Gisela purchased the stock for $60,000 four years ago. Calculate Ellen’s basis for the stock if she sells it: a. for $65,000? b. for $45,000? c. for $55,000?

Gift Basis – Ellen -2 a. $60,000. The donor’s basis is always used to determine a gain. b. $50,000. Fair market value (when it is lower than the donor’s basis) is used to determine basis for loss. c. $55,000. When the selling price is between the donor’s basis and the lower fair market value, there is no gain or loss. Effectively, basis equals the selling price.

Acquisition by Inheritance Use date-of-death Fair Market Value as basis for inherited property (or alternate valuation date, if elected) Will

Basis of Property Acquired by Inheritance Three dates are important – Primary valuation date is the date of death – Alternate valuation date is six months after the date of death – Distribution date is the date a beneficiary receives the property

Basis of Property Acquired by Inheritance (continued) Basis is generally the FMV of the property on the primary valuation date If the estate is valued on the alternate valuation date – Basis is the FMV of the property on the earliest date received, either Date of distribution, or Alternate valuation date Holding period for inherited asset is long term

Basis in Property Converted From Personal to Business Use On the date of conversion, compare the asset’s personal-use basis to its FMV. If FMV > personal basis – Personal basis is used for depreciation and gain or loss calculations

Basis in Property Converted From Personal to Business Use If Personal basis > FMV – Use FMV for depreciation – Basis for sale is determined when the property is sold If sold for an amount > personal basis, use personal basis: (gain) If sold for amount < FMV, use FMV: (loss) If sold for an amount between the two, no gain or loss is recognized

Basis of Converted Property If the property is converted from personal use to business use, the basis for depreciation is the lesser of the property’s FMV or adjusted basis at the date of conversion – This prevents taxpayers from depreciating the portion of the property’s decline in value while it was used for personal purposes

Basis for Depreciation – Anne -1 Anne purchased a condo unit for $125,000 last year. She used condo as a personal residence. In the current year, when the condo unit appraises at $132,000, Anne moves out and converts condo to rental property. What basis can Anne use when computing her depreciation on the rental condo unit?

Basis for Depreciation – Anne -2 $125,000. Anne uses the lower of her basis or FMV at the date the condo is converted from personal to rental property.

Stock dividend – Common on Common Taxpayer bought 1,000 shares of common stock for a total cost of $66,000. Taxpayer received a 10% stock dividend, payable in common shares. What is basis of common stock?

Stock Div – Preferred on Common T/P bought 1,000 shares of Big Co. common stock at $100 per share. T/P received 100 shares of preferred stock as a dividend on the common stock. What is basis of common and preferred stock?

Basis in Securities- Wash Sales A wash sale occurs when a security sold at a loss is replaced with a substantially similar security +/- 30 days from the sale. Loss is not deductible under the substance-over-form doctrine Nondeductible loss amount is added to the basis of the replacement security

Wash Sale On 12-1-Yr-1, T/P buys 200 shares of BigCorp common stock, for $2, Yr-2, T/P buys 200 shares for $1, Yr-2, T/P sells the first 200 shares for $1, Yr-3, T/P sells the last 200 for $1,600. What is (are) the amount(s) and the year of recognition of losses that T/P can recognize?

Gift and Estate Planning Maude has asked you to give her advice on which asset to 1.Give away now, 2.Sell and give proceeds to charity 3.Leave in will See next slide

For preceding slide: 1.What do you know about basis of gift property vs. inherited property. 2.What do you know about “loss” basis of gift property with a value higher than basis at time of gift, and vice versa?

For preceding slide: 1.Would it be a good idea to give lot no. 1 to the son who will soon sell it? 2.Would it be a good idea to give lot no. 3 to the son who will soon sell it? 3.Would it be a good idea to give lot no. 3 to charity (not an option presented in the problem)? 4.Would it be a good idea to leave lot no. 3 to daughter in the will? 5.Would it be a good idea to leave lot no. 1 to daughter in the will?

The End