### Similar presentations

9-2 Objectives  Compute substituted basis of property received in a nontaxable exchange  Compute gain when boot is received  Identify qualifying like-kind property  Describe the effect of relief of debt  Compute recognized gain and basis in an involuntary conversion  Explain nonrecognition treatment for corporation or partnership formation  Describe tax effects of a wash sale

9-3 Tax Neutrality  The government is not a party to a nontaxable exchange, so the tax law is neutral  Example:  Sandra owns ABC stock with a FMV \$1,000 and a \$200 tax basis. She wants to rebalance her portfolio by selling ABC and buying \$1,000 worth of XYZ stock  If she sells ABC, she must pay tax on her \$800 gain realized and won’t have \$1,000 to spend on XYZ  If an exchange of ABC for XYZ were nontaxable, she could defer paying tax on \$800 and could acquire \$1,000 of XYZ stock

9-4 Exchanges of Qualifying Property  Common characteristics of a generic nontaxable exchange:  Exchange of one qualifying property for another  Equal FMVs of properties exchanged (value-for- value presumption)  Realized gain or loss is not recognized

9-5 Substituted Basis  Nonrecognized gain or loss is deferred until the qualifying property received is disposed of in a taxable transaction  Deferred gain or loss is embedded in the tax basis of the qualifying property received  If no boot is involved, the tax basis equals:  Basis of property surrendered  FMV of property received - deferred gain/+ deferred loss

9-6 Example of a Generic Nontaxable Exchange  Sally has property with FMV \$100, basis \$60  Lisa has property with FMV \$100, basis \$110  Sally and Lisa exchanges properties  Sally realizes but does not recognize \$40 gain  Lisa realizes but does not recognize \$10 loss  Sally’s basis in her new property is \$60 (FMV \$100 - \$40 deferred gain)  Lisa’s basis in her new property is \$110 (FMV \$100 + \$10 deferred loss)

9-7 The Effect of Boot  Boot is any nonqualifying property in the exchange  Includes cash and relief of debt  Debt relief is treated as boot received by the party relieved of debt and boot paid by the party assuming debt  If both parties to the exchange are relieved of debt, only the net amount is treated as boot

9-8 Effect on Taxpayer Receiving Boot  Realized gain is recognized up to the FMV of boot  Boot cannot increase the amount of realized gain  Receiving boot does not cause loss recognition  Basis in qualifying property received equals:  Basis of property surrendered + gain recognized - FMV boot received  FMV of qualifying property received - deferred gain/+ deferred loss  Basis in boot equals FMV

9-9 Example: Receiving Cash Boot  Luke has qualifying property with a \$1,000 FMV and \$700 basis. Robert has qualifying property with a \$900 FMV and \$100 cash  If Luke and Robert enter into an exchange, Luke’s realized gain is \$300. He recognizes \$100 gain and defers \$200 gain  Luke’s basis in the property received is \$700  \$700 substituted basis + \$100 gain recognized - \$100 boot received  \$900 FMV - \$200 deferred gain

9-10 Taxpayer Paying Boot  Paying boot does not trigger gain recognition  Basis of qualifying property received equals:  Basis of qualifying property surrendered + FMV of boot paid  FMV of qualifying property received - deferred gain/+ deferred loss

9-11 Example: Paying Cash Boot  Robert exchanges qualifying property with a \$900 FMV and \$280 basis plus \$100 cash for qualifying property with a \$1,000 FMV  Robert’s entire \$620 realized gain on the exchange of qualifying property is deferred  Robert’s basis in the qualifying property received is \$380  \$280 substituted basis + \$100 boot paid  \$1,000 FMV - \$620 deferred gain

9-12 Example: Relief of Debt = Boot  Ginger owns qualifying property with a \$200 FMV and \$120 basis subject to a \$50 mortgage  Susan owns qualifying property with a \$150 FMV and \$110 basis  When they exchange properties, Susan assumes the \$50 mortgage on Ginger’s property.

9-13 Example: Relief of Debt = Boot  Ginger’s amount realized is \$200 (\$150 FMV of property received + \$50 debt relief), and her realized gain is \$80.  Ginger recognizes \$50 gain and defers \$30 gain  Her basis in the property received is \$120  \$120 substituted basis + \$50 gain recognized - \$50 boot received  \$150 FMV - \$30 deferred gain

9-14 Example: Relief of Debt = Boot  Susan’s amount realized is \$200 (FMV of property received), and her realized gain is \$40.  Susan defers her entire \$40 gain  Her basis in the property received is \$160  \$110 substituted basis + \$50 boot paid  \$200 FMV - \$40 deferred gain

9-15 Four Types of Nontaxable Exchanges  Like-kind exchanges  Involuntary conversions  Exchanges of property for equity in a corporation or partnership  Wash sales

9-16 Like-Kind Property  Definition of like-kind property:  Tangible business personalty within class (IRS classification system)  Intangible business personalty of same legal nature or character  All business or investment realty  Inventory, stocks, bonds, partnership interests, and personal assets are not eligible for like-kind exchange treatment

9-17 Like-Kind Exchanges  No gain or loss recognized on the exchange of like- kind properties  Receipt of boot triggers gain recognition  Nonrecognition is mandatory, not elective  Taxpayers usually prefer to sell loss properties in order to recognize their realized loss

9-18 Like-kind Exchange - Example  Matt owns an office building with \$200,000 FMV and \$70,000 basis  Phil owns investment land with a \$170,000 FMV and \$115,000 basis  If Matt and Phil decide to exchange realty, who must pay boot to equalize the exchange?  Phil must pay Matt \$30,000 boot

9-19 Like-kind Exchange – Example continued  Compute gain realized and recognized by Matt and Phil on the exchange  Matt realizes \$130,000 gain (\$170,000 FMV of land + \$30,000 cash - \$70,000 basis of office building) and recognizes \$30,000 gain (boot received)  Phil realizes \$55,000 gain (\$200,000 FMV of office building - \$145,000 total basis of land and cash and recognizes no gain

9-20 Like-kind Exchange – Example continued  Determine the tax basis of the realty received by Matt and Phil  Matt’s basis in the land received = \$70,000  \$70,000 substituted basis + \$30,000 gain recognized - \$30,000 boot received  \$170,000 FMV - \$100,000 deferred gain  Phil’s basis in the building received = \$145,000  \$115,000 substituted basis + \$30,000 boot paid  \$200,000 FMV - \$55,000 gain deferred

9-21 Involuntary Conversions  Involuntary conversion includes:  Theft or vandalism  Government claim of property or condemnation  Natural disasters such as fire, hurricane, tornado, earthquake, and flood  If insurance proceeds exceed basis of converted property, the taxpayer may elect to defer gain recognition  If basis of converted property exceeds insurance proceeds, the taxpayer recognizes ordinary loss

9-22 Involuntary Conversion  Requirements to defer gain:  Reinvest proceeds in property similar or related in service or use to converted property  Replacement property must be purchased within two taxable years following the year of the conversion  If taxpayer does not reinvest entire proceeds, gain is recognized to the extent of the proceeds not invested  Unreinvested amount is treated as boot

9-23 Involuntary Conversion - Example  Amy’s factory had a \$500,000 adjusted basis.The factory was destroyed by a tornado, and Amy received \$650,000 from the insurance company  Amy realized a \$150,000 gain on the involuntary conversion  If Amy pays \$700,000 to build a replacement factory, she may elect to defer recognizing the gain  Her basis in the new factory is \$550,000 (\$700,000 cost - \$150,000 deferred gain)

9-24 Involuntary Conversion - Example  If Amy pays \$600,000 to build a replacement factory, she must recognize \$50,000 gain but can elect to defer \$100,000 gain  Her basis in the new factory is \$500,000 (\$600,000 cost - \$100,000 deferred gain)  If Amy pays \$460,000 to build a replacement factory, she must recognize her entire \$150,000 gain  Her basis in the new factory is its \$460,000 cost

9-25 Corporate Formations  No gain or loss is recognized by a taxpayer who transfers property to a corporation solely in exchange for stock if the transferor is in control of the corporation immediately after the exchange  Control is defined as ownership of 80% or more of the corporation’s outstanding stock  If two or more taxpayers transfer property in the same transaction, control is determined in the aggregate  A corporation never recognizes gain or loss on the exchange of its stock for property

9-26 Basis of Stock and Property  The basis of the stock received in the exchange equals the basis of the transferred property (substituted basis)  The basis of the transferred property to the corporation equals its basis in the hands of the transferor (carryover basis)

9-27 Corporate Formation - Example  Phil and Lil form a corporation  Phil contributes \$10,000 cash  Lil contributes a building with a \$10,000 FMV and a \$3,200 adjusted basis  The corporation issues 500 shares of stock each to Phil and Lil  Each share has a \$20 FMV

9-28 Corporate Formation - Example  Phil has no realized gain or loss  His basis in his 500 shares is their \$10,000 cost  Lil realizes a \$6,800 gain on the exchange of property for stock  Because Lil and Phil have 100% control of the corporation immediately after the exchange, Lil recognizes no gain  Her basis in her 500 shares is \$3,200  The corporation’s basis in the property contributed by Lil is \$3,200

9-29 Partnership Formation  No gain or loss is recognized by the partner or the partnership on the exchange of property for an interest in the partnership  No control requirement  Partner’s basis in the interest equals the partner’s basis in the transferred property (substituted basis)  Partnership’s basis in the transferred property equals its basis in the hands of the partner (carryover basis)

9-30 Wash Sales  Special rule prohibits loss recognition but not gain recognition on a wash sale  If a taxpayer sells a security at a loss but repurchases substantially the same security within 30 days after or 30 days before the sale, the loss is disallowed  The basis in the repurchased security equals cost + disallowed loss

9-31 Wash Sale - Example  On September 13, Dorothy sold Nike stock with a \$4,000 basis for \$3,750 cash  On October 4, Dorothy paid \$3,810 to repurchase the same Nike stock  Because the repurchase occurred within 30 days of the sale, Dorothy cannot recognize her \$250 loss on sale  Dorothy’s basis in her repurchased shares is \$4,060 (\$3,810 cost + \$250 deferred loss)

9-32 Book/Tax Difference from Nontaxable Exchange  For financial reporting purposes, gains and losses realized on property exchanges may be included in book income  Book basis of property received equals FMV  If the exchange is nontaxable, the gain or loss realized is a book/tax difference  The difference is temporary and will reverse as the property is depreciated or amortized or when the property is disposed of in a taxable transaction

9-33