Ppt ch 15

Chapter 15
Property Transactions:
Nontaxable Exchanges

Individual Income Taxes
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1

The Big Picture (slide 1 of 3)
• Recall the situation introduced in ‘‘The Big
Picture’’ in Chapter 14.
• Alice has changed her mind about selling the
house to her nephew for $275,000.
– Due to a recent groundbreaking for an upscale real
estate development nearby, the appraised value of
the house has increased to $600,000.
• Alice has decided she needs to do something
with the house other than let it remain vacant.
2

• She is considering the following options:
– Sell the house for approximately $600,000
• Sales commission will be 5%.
– Convert the house to a vacation home
• It would be 100% personal use by Alice and her family.
• Sell it in two years.
– Convert the house to a vacation home
• Rent it 40% of the time and use it 60% of the time for personal use.
• Sell it in two years.
– Sell her current home and move into the inherited house.
• She has owned and lived in the current home for 15 years
• Her gain on the sale would be about $200,000.
• Since she is nearing retirement, she would live in the inherited
house for the required 2 year minimum period and then sell it.

3

• Alice expects the inherited house to continue to
appreciate in value by about 5% per year.
• She plans on retiring in two years and moving to a
warmer climate.
– Until then, she is neutral as to which house she lives in.
• What advice can you offer Alice?
• Alice also owns a building that is involuntarily
converted. See the facts in Examples 19 and 20.
– Alice’s objectives are to minimize recognition of any
realized gain and to maximize the recognition of any
realized loss.
• Read the chapter and formulate your response.

4

Nontaxable Transactions
(slide 1 of 4)

• In a nontaxable transaction, realized gain or
loss is not currently recognized
– Recognition is postponed to a future date (via a
carryover basis) rather than eliminated

5

(slide 2 of 4)

• In a tax-free transaction, nonrecognition of
realized gain is permanent

6

(slide 3 of 4)

• Holding period for new asset
– The holding period of the asset surrendered in a
nontaxable transaction carries over to the new
asset acquired

7

(slide 4 of 4)

• Depreciation recapture
– Potential recapture from the asset surrendered
carries over to the new asset acquired in the
transaction

8

Like-Kind Exchanges
(slide 1 of 11)

• §1031 requires nontaxable treatment for gains
and losses when:
– Form of transaction is an exchange
– Assets involved are used in trade or business or
held for production of income
• However, inventory, securities, and partnership
interests do not qualify
– Asset exchanged must be like-kind in nature or
character as replacement property

9

Like-Kind Exchanges
(slide 2 of 11)

• Like-kind property defined
– Interpreted very broadly
• Real estate for real estate
– Improved for unimproved realty qualifies
– U.S. realty for foreign realty does not qualify
• Tangible personalty for tangible personalty
– Must be within the same general business asset or product
class
– Personalty used mainly in the U.S. for personalty used mainly
outside the U.S. does not qualify
– Livestock of different sexes does not qualify

10

Like-Kind Exchanges
(slide 3 of 11)

• When taxpayers involved in an exchange are
related parties
– To qualify for nontaxable exchange treatment,
related parties must not dispose of property
exchanged within the 2 year period following
exchange
– If such early disposition occurs, postponed gain is
recognized as of date of early disposition
• Dispositions due to death, involuntary conversions, and
certain non-tax avoidance transactions are not treated as
early dispositions

11

Like-Kind Exchanges
(slide 4 of 11)

• Exchange requirement
– The transaction must involve a direct exchange of
property to qualify as a like-kind exchange
– If the exchange is a delayed (nonsimultaneous)
exchange, there are time limits on its completion
• The new property must be identified within 45 days of
date old property was transferred
• The new property must be received by the earlier of the
following:
– Within 180 days of date old property was transferred
– The due date (including extensions) for tax return covering
year of transfer

12

Like-Kind Exchanges
(slide 5 of 11)

• Boot
– Any property involved in the exchange that is not
like-kind property is “boot”
– The receipt of boot causes gain recognition equal
to the lesser of boot received (FMV) or gain
realized
• No loss is recognized even when boot is received

13

Like-Kind Exchanges
(slide 6 of 11)

• Boot
– The transferor of boot property may recognize gain
or loss on that property
• Gain or loss is recognized to the extent of the difference
between the adjusted basis and the fair market value of
the boot

14

Like-Kind Exchanges
(slide 7 of 11)

• Basis in like-kind asset received:
FMV of new asset
– Gain not recognized
+ Loss not recognized
= Basis in new asset
• Basis in boot received is FMV of property

15

Like-Kind Exchanges
(slide 8 of 11)

• Basis in like-kind property using Code
approach
Adjusted basis of like-kind asset given
+ Adjusted basis of boot given
+ Gain recognized
– FMV of boot received
– Loss recognized
= Basis in new asset

16

Like-Kind Exchanges
(slide 9 of 11)

• Example of an exchange with boot:
– Zak and Vira exchange equipment of same general
business asset class
– Zak: Basis = $25,000; FMV = $40,000
– Vira: Basis = $20,000; FMV = $30,000
– Vira also gives securities: Basis = $7,000;
FMV = $10,000

17

Like-Kind Exchanges
(slide 10 of 11)

Example (Cont’d)
Zak Vira
FMV Property Rec’d $30,000 $40,000
+Securities 10,000 -0-
Total FMV Rec’d $40,000 $40,000
Less: Basis Property Given 25,000 30,000 *
Realized Gain $15,000 $10,000
Boot Rec’d $10,000 $ -0-

Gain Recognized $10,000 $ -0-

*$20,000 Equip. + $10,000 Securities = $30,000
Securities: ($10,000 FMV - $7,000 basis) = $3,000 gain
recognized by Vira
18

Like-Kind Exchanges
(slide 11 of 11)

Example (Cont’d)
Zak Vira
FMV Property Rec’d $30,000 $40,000
Postponed Gain -5,000 -10,000
Basis Property Rec’d $25,000 $30,000

19

Involuntary Conversions
(slide 1 of 13)

• §1033 permits (i.e., not mandatory) nontaxable
treatment of gains if the amount reinvested in
replacement property ≥ the amount realized
• If the amount reinvested in replacement
property is < amount realized, realized gain is
recognized to the extent of the deficiency

20

(slide 2 of 13)

• Involuntary conversion
– Results from the destruction, theft, seizure,
requisition, condemnation, or sale or exchange
under threat of condemnation of property
• A voluntary act by taxpayer is not an involuntary
conversion

21

(slide 3 of 13)

• §1033 requirements
– Replacement property must be similar or related in
service or use as involuntarily converted property
– Replacement property must be acquired within a
specified time period

22

(slide 4 of 13)

• Replacement property defined
– Must be similar or related in service or use as the
converted property
• Definition is interpreted very narrowly and differently
for owner-investor than for owner-user
– For business or investment real estate that is
condemned, replacement property has same
meaning as for like-kind exchanges

23

(slide 5 of 13)

• Taxpayer use test (owner-investor)
– The properties must be used by the owner in
similar endeavors
• Example: Rental apartment building can be replaced
with a rental office building because both have same use
to owner (the production of rental income)

24

(slide 6 of 13)

• Functional use test (owner-user)
– The property must have the same use to the owner
as the converted property
• Example: A manufacturing plant is not replacement
property for a wholesale grocery warehouse because
each has a different function to the owner-user

25

(slide 7 of 13)

• Time period for replacement
– Taxpayer normally has a 2 year period after the
close of the taxable year in which gain is realized
to replace the property
• Replacement time period starts when involuntary
conversion or threat of condemnation occurs
• Replacement time period ends 2 years (3 years for
condemnation of realty) after the close of the taxable
year in which gain is realized

26

(slide 8 of 13)

• Example of time period for replacement
– Taxpayer’s office building is destroyed by fire on
November 4, 2010
– Taxpayer receives insurance proceeds on February
10, 2011
– Taxpayer is a calendar-year taxpayer
– Taxpayer’s replacement period is from November
4, 2010 to December 31, 2013

27

(slide 9 of 13)

• Nonrecognition of gain: Direct conversions
– Involuntary conversion rules mandatory
– Basis and holding period in replacement property
same as converted property

28

(slide 10 of 13)

• Nonrecognition of gain: Indirect conversions
– Involuntary conversion rules elective
– Gain recognized to extent amount realized (usually
insurance proceeds) exceeds investment in
replacement property

29

(slide 11 of 13)

• Nonrecognition of gain: Indirect conversions
– Basis in replacement property is its cost less
deferred gain
– Holding period includes that of converted property

30

(slide 12 of 13)

• Involuntary conversion rules do not apply to
losses
– Losses related to business and production of
income properties are recognized
– Personal casualty and theft losses are recognized
(subject to $100 floor and 10% AGI limit);
personal use asset condemnation losses are not
recognized or postponed

31

(slide 13 of 13)

• Involuntary conversion of personal residence
– Gain from casualty, theft, or condemnation may be
deferred as involuntary conversion (§1033) or
excluded as sale of residence (§121)
– Loss from casualty recognized (limited); loss from
condemnation not recognized

32

The Big Picture - Example 19
Involuntary Conversion (slide 1 of 3)
• Return to the facts of The Big Picture on p. 15-1.
• Alice’s business building (adjusted basis $50,000) is
destroyed by fire on October 5, 2012.
– Alice is a calendar year taxpayer.
• On November 17, 2012, she receives an insurance
reimbursement of $100,000 for the loss.
– Alice invests $80,000 in a new building.
– Alice uses the other $20,000 of insurance proceeds to pay
off credit card debt.

33

• Alice has until December 31, 2014, to make
the new investment and qualify for the
nonrecognition election.
• Alice’s realized gain is $50,000
– $100,000 insurance proceeds received − $50,000
adjusted basis of old building
• Assuming that the replacement property
qualifies, Alice’s recognized gain is $20,000.
– $100,000 insurance proceeds − $80,000 reinvested
34

• Alice’s basis in the new building is $50,000.
– This is the building’s cost of $80,000 less postponed gain
of $30,000
• $50,000 realized gain − $20,000 recognized gain
• The computation of realization, recognition, and basis
would apply even if Alice was a real estate dealer and
the building destroyed by fire was part of her
inventory.
– Unlike § 1031, § 1033 generally does not exclude
inventory.
• For this $30,000 of realized gain to be postponed,
Alice must elect § 1033 deferral treatment.
35

Involuntary Conversion
• Assume the same facts as in the previous example, except that
Alice receives only $45,000 of insurance proceeds.
– She has a realized and recognized loss of $5,000.
– The basis of the new building is the building’s cost of $80,000.
• If the destroyed building had been held for personal use, the
recognized loss would have been subject to the following
additional limitations.
– The loss of $5,000 would have been limited to the decline in fair
market value of the property, and
– The amount of the loss would have been reduced first by $100 and
then by 10% of AGI (refer to Chapter 7).

36

Sale of Residence
(slide 1 of 7)

• Loss on sale
– As with other personal use assets, a realized loss
on the sale of a personal residence is not
recognized

37

Sale of Residence
(slide 2 of 7)

• Gain on sale
– Realized gain on sale of principal residence is
subject to taxation
– Realized gain may be partly or wholly excluded
under §121

38

Sale of Residence
(slide 3 of 7)

• §121 provides for exclusion of up to $250,000
of gain on the sale of a principal residence
• Taxpayer must own and use as principal residence for at
least 2 years during the 5 year period ending on date of
sale

39

Sale of Residence
(slide 4 of 7)

• Amount of Exclusion
– $250,000 maximum
– Realized gain is calculated in normal manner
– Amount realized on sale is reduced by selling
expenses such as advertising, broker’s
commissions, and legal fees

40

Sale of Residence
(slide 5 of 7)

• Amount of Exclusion (cont’d)
– For a married couple filing jointly, the $250,000 max is
increased to $500,000 if the following requirements are
met:
• Either spouse meets the 2 year ownership req’t,
• Both spouses meet the 2 year use req’t,
• Neither spouse is ineligible due to the sale of another principal
residence within the prior 2 years
– Starting in 2008, a surviving spouse can continue to use the
$500,000 exclusion amount on the sale of a personal
residence for the next two years following the year of the
deceased spouse’s death

41

Sale of Residence
(slide 6 of 7)

• §121 cannot be used within 2 years of its last use
except in special situations, such as:
• Change in place of employment,
• Health,
• Other unforeseen circumstances
• Under these circumstances, only a portion of the
exclusion is available, calculated as follows:

Max Exclusion amount × number of qualifying months
24 months

42

Sale of Residence
(slide 7 of 7)

• The Housing Assistance Tax Act of 2008
reduces the gain eligible for the § 121
exclusion for a vacation home converted to a
principal residence
– § 121 exclusion is reduced by the proportion of the
periods of nonqualified use compared to the period
the property was owned by the taxpayer
– Applies to sales and exchanges occurring after
December 31, 2008

43

Sale Of A Residence - § 121 (slide 1 of 2)
• Recall that one of Alice’s options is to sell her current
house and move into the inherited house.
• Assume that Alice, who is single, sells her current
personal residence (adjusted basis of $130,000) for
$348,000.
– She has owned and lived in the house for 15 years.
– Her selling expenses are $18,000.
– Prior to the sale, Alice pays $1,000 to make some
repairs and paint the two bathrooms.
44

Sale Of A Residence - § 121 (slide 2 of 2)
• Her recognized gain would be calculated as follows:

Amount realized ($348,000 - $18,000) $ 330,000
Adjusted basis (130,000)
Realized gain $ 200,000
§ 121 exclusion (200,000)
Recognized gain $ –0–

• Since the available § 121 exclusion of $250,000
would exceed Alice’s realized gain of $200,000, her
recognized gain would be $0.
45

Sale Of A Residence - § 121
• Continue with The Big Picture and the facts of
Example 26, except that the selling price is $490,000.

Amount realized ($490,000 - $18,000) $ 472,000
Realized gain $ 342,000
§ 121 exclusion (250,000)
Recognized gain $ 92,000

• Since the realized gain of $342,000 > the § 121
exclusion of $250,000, Alice’s recognized gain would
be $92,000
46

Other Nonrecognition Provisions
(slide 1 of 7)

• Several additional nonrecognition provisions
are available:
– Under §1032, a corporation does not recognize
gain or loss on the receipt of money or other
property in exchange for its stock (including
treasury stock)

47

(slide 2 of 7)

• Under §1035, no gain or loss is recognized
from the exchange of certain insurance
contracts or policies

48

(slide 3 of 7)

• Under §1036, a shareholder does not recognize
gain or loss on the exchange of common stock
for common stock or preferred stock for
preferred stock in same corporation

49

(slide 4 of 7)

• Under §1038, no loss is recognized from the
repossession of real property sold on an
installment basis
– Gain is recognized to a limited extent

50

(slide 5 of 7)

• Under §1041, transfers of property between
spouses or former spouses incident to divorce
are nontaxable

51

(slide 6 of 7)

• Under §1044, if the amount realized from the
sale of publicly traded securities is reinvested
in common stock or a partnership interest of a
specialized small business investment
company, realized gain is not recognized
– Amounts not reinvested will trigger recognition of
gain to extent of deficiency
– Statutory limits are imposed on the amount of gain
qualified for this treatment
– Only individuals and C corporations qualify

52

(slide 7 of 7)

• Under §1045, realized gain from sale of qualified
small business stock held > 6 months may be
postponed if other qualified small business stock is
acquired within 60 days
• Qualified small business stock is stock acquired at its
original issue for money, other property, or services
from a domestic corp with assets that do not exceed
$50 million before or after the issuance of small
business stock

53

Refocus On The Big Picture (slide 1 of 5)
• Alice needs to be aware of the different tax consequences of
her proposals.
• Sale of the inherited house.
– This is by far the simplest transaction for Alice.
– Based on the available data, her recognized gain would be:
Amount realized ($600,000 - $30,000) $ 570,000
Recognized gain $ 95,000

• Because the sale of the house is not eligible for the § 121
exclusion, the tax liability is $14,250 ($95,000 X 15%).
• Alice’s net cash flow would be $555,750
– $570,000- $14,250.

54

• Conversion into a vacation home.
– Only personal use.
• With this alternative, the only tax benefit Alice would
receive is the deduction for property taxes .
• She would continue to incur upkeep costs (e.g.,
repairs, utilities, insurance).
• At the end of the 2 year period, the sales results are
similar to those of a current sale.
• The sale of the house would not be eligible for the §
121 exclusion.
55

• Conversion into a vacation home
– 60% personal use and 40% rental use.
• Alice would be able to deduct 40% of the costs
– e.g., Property taxes, agent’s management fee, depreciation,
maintenance and repairs, utilities, and insurance.
– However, this amount cannot exceed the rent income generated.
• The remaining 60% of the property taxes can be claimed as an
itemized deduction.
• At the end of the 2 year period, the sales results would be
similar to those of a current sale.
• In determining recognized gain, adjusted basis must be
reduced by the amount of the depreciation claimed.
• The sale of the house would not be eligible for the § 121
exclusion.

56

• Sale of present home now with sale of inherited home in 2
years.
• This option would enable Alice to qualify for the § 121
exclusion for each sale.
• She would satisfy the 2 year ownership and the 2 year use
requirements, and the allowance of the § 121 exclusion only
once every 2 years.
• Alice must be careful to occupy the inherited residence for at
least 2 years.
– Also, the period between the sales of the 1st and 2nd houses must be
greater than 2 years.
• Qualifying for the § 121 exclusion of up to $250,000 would
allow Alice to avoid any Federal income tax liability.
57

• With this information, Alice can make an informed
choice.
• In all likelihood, she probably will select the strategy
of selling her current house now and the inherited
house in the future.
• A noneconomic benefit of this option is that she will
have to sell only one house at the time of her
retirement.
• See Examples 19 and 20 for Alice’s tax consequences
associated with the involuntary conversion.

58

If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:

Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta

© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
59

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