McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2001 Principles of Taxation Chapter 8 Nontaxable Exchanges

Slide 8-2 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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 portfolio 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 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Exchanges of Qualifying Property-Generic  One qualifying property for another.  Assume the FMVs are ________ 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 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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 ______ + deferred ______.  What are Sam’s and Lisa’s new bases? Sam = $___, Lisa = $____.

Slide 8-6 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 The Effect of Boot  Define boot:  Does boot include cash?  Does book include relief of debt?  Examples will first show CASH boot, then other types of boot.

Slide 8-7 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Effect on Taxpayer Receiving Boot  Any realized gain is recognized up to the ______ of boot received.  Boot cannot increase the amount of the ________ gain.  Receiving boot does not cause loss recognition.  New basis in qualifying property received =  1) basis of property surrendered + ______ recognized - _____ boot received =  or 2) FMV of qualifying property received - deferred ______ + deferred ______.  New basis in boot = ______ of boot.

Slide 8-8 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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 $_____. He must recognize $_____ because he received boot. He defers $____ of gain.  Luke has basis on qualifying property of $____ = 1) $700 + ____ - $____= 2) $900 - $_____.

Slide 8-9 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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 $____ =  1) $300 original basis + $____ boot paid =  2) $1000 FMV - $____ deferred gain.

Slide 8-11 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Example: Relief of Debt = Cash Boot  Ginger owns qualifying property with a FMV = $200 (basis = $120), subject to a mortgage of $50.  Susan owns qualifying property with a FMV = $150 (basis = $110).  When they swap properties, Susan assumes the mortgage on Ginger’s property. This is treated as $___ boot that Susan pays Ginger.  Ginger has a realized gain of $80. She recognizes $__ and defers $___. Her new basis is $___.  Susan has a realized gain of $___ which is completely deferred. Her new basis is $____.

Slide 8-12 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Example: Non-Cash Boot  Dylan owns qualifying property with a FMV = $120 ( basis = $70).  Luke owns qualifying property with a FMV = $100 ( basis = $90). Luke also owns stock (boot) with a FMV = $20 (basis $5).  Dylan recognizes $20 of his $____ realized gain and defers $___. His basis in the qualifying property received is $____. His basis in the stock is $20.  Luke recognizes none of the $___ realized gain and defers $___. His basis in the qualifying property received is $____.

Slide 8-13 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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 8-14 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Involuntary Conversions  Involuntary conversion include:  Theft  Government claim of property or condemnation  Natural disasters: fire, hurricane, tornado, earthquake  Taxpayer may ELECT to defer gains.  What happens to losses?

Slide 8-15 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Involuntary 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 ______ 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 __________ and the amount__________.

Slide 8-16 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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 $___,000 = $700,000 - $____,000 deferred gain.  B) If Amy reinvests $600,000 in a new factory, she must recognize $__,000 of gain, but can defer $___,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 $___,000.

Slide 8-17 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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 (>=____%) 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 8-18 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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 $_______.  Lil defers her gain of $________. Her basis in the stock is $_______. The corporation’s basis in the building is $6,000.

Slide 8-19 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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 8-20 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Wash Sales  Special rule requires LOSS DEFERRAL.  If taxpayer sells a security at a loss but repurchases substantially same securities within ____ days after OR____ days prior to the sale.  New basis = new purchase price + deferred loss.

Slide 8-21 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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 $____ per share on the September 6 sale.  Her new basis in the stock bought September 23 will be $____.

Slide 8-22 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Concept Review  Tax deferral produces carryover or substituted basis.  Taxable income recognition produces step- up/step-down to new fair market value basis.