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

2. 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.

3. 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.

4. 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.

5. 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.

6. 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.

7. 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.

8. 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.

9. 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.

10. 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

11. 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.

12. 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

13. 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.

14. 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.

15. 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.

16. 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.

17. 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

18. 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.

19. 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.

20. 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.

21. 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.

22. 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.