1. Like-Kind Exchanges. 2. Involuntary Conversions. 3. Sale of Principal Residence. 4. Tax Planning Considerations

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1 Outline 1 Unit10. Property Transactions - Nontaxable Exchanges (PAK Chap. 12) The transactions examined in this chapter overrides the normal rule that provides for the recognition of realized gains and realized losses on property. The three exceptions are: 1. Like kind exchange, 2. Involuntary conversion, and 3. Sale of personal residence Compliance and Procedural Considerations 3 (Ex. 12-1,12-2) 4 1) Like-Kind Property Defined (Ex through 12-12) Section 1031(a): No gain or loss shall be recognized on like-kind exchanges. Property qualifying for a like-kind exchange must be held for investment or for use in a trade or business. The like-kind exchange treatment is mandatory if the transaction meets the statutory requirements. Character: Like-kind property refers to the nature and character of the property and not its grade or quality. Example: House for land is ok if both are used either in business or for investment. Location of the property: Within the U.S. Same class: Exchanged property must be of the same class (i.e. personal property for personal and real property for real).. Example: office building (real property) for business airplane (personal property) is not a like-kind exchange. Recent regulations require that personal property be within the same General Business Asset Class or within the same Product Class to qualify for like-kind exchange. Example: business computer for business printer ok. An exchange of inventory or securities does not qualify. An exchange of stocks, bonds, and notes does not quality, unless it s within the same corporation for the same type of security (common stock for common stock or preferred stock for preferred stock). 5 2) A Direct Exchange Must Occur (Ex ) 6 3) Three-Party Exchanges (Ex , 12-15) A direct exchange must generally occur, not a conversion into proceeds with a subsequent purchase. Certain interdependent transactions may receive exchange treatment even though there is no direct exchange (i.e. sale to dealer immediately followed by purchase from dealer). A three-corner exchange (where one party buys property to exchange) is respected under the likekind exchange rules. Three parties may be involved in a simultaneous or nonsimultaneous like-kind exchange and still qualify for gain deferral. This format is most effective when there is a cash buyer and a seller who does not want to recognize gain currently. Finding a suitable exchange property may be difficult. 1

2 7 4) Receipt of Boot (Ex , 12-19, 12-22) Gain is recognized to the extent of boot received, limited by the realized No loss is ever recognized on like-kind property. However, a loss will be recognized on any boot given which has an adjusted basis exceeding its fair market value. Boot is any kind of non-qualifying property (i.e. cash and relief of mortgage liability). If both properties are encumbered with debt, the mortgages are offset to determine if there is net boot. 8 5) Basis of Property Received (Ex , 12-25, 12-26) The basis of qualifying property received in a likekind exchange is the basis of property given up less boot received plus gain recognized. For properties with a deferred gain, the new property's basis will be its FMV less the deferred For properties with a deferred loss, the new property's basis will be the FMV plus deferred loss. The basis of non-qualifying property (boot) received in a like-kind exchange is the property's fair market value. 9 6) Exchanges Between Related Parties (Example I12-27) Like-kind treatment between related parties is disallowed if either party disposes of the property within two years of the exchange. The gain(s) will be recognized in the year of subsequent disposition. Exceptions exist for dispositions due to death, involuntary conversion, or for non-tax avoidance purposes. 10 7) Transfer of Non-Like-Kind Property (Ex , 12-30) Gain or loss on non-qualifying property transferred pursuant to the like-kind exchange is recognized by the transferor. 8) Holding Period for Property Received (Ex ; Topic Review 12-1) (Ex , 12-33) 11 The holding period of like-kind property received includes the holding period of the like-kind property given up. The holding period for non-qualifying property (boot) begins with the date of the exchange. 12 Gains from involuntary conversions may be fully deferred if the full amount of the proceeds is invested in qualifying replacement property within a certain period and an election is made to defer the Losses on involuntary conversions are fully recognized. 2

3 13 1) Involuntary Conversion Defined (Ex. 2-35) Involuntary conversions include theft, seizure, requisition, condemnation, or destruction of property. The conversion may be total or partial. Disposition of property under actual threat of condemnation also qualifies. Gains arise from insurance proceeds exceeding the property's adjusted basis for casualties and thefts. Gains also arise from governmental proceeds exceeding the property's adjusted basis for condemnations. 2) Treatment of Gain Due to Involuntary Conversion into Boot (Ex ; 12-37, 12-38) 14 Gain is recognized on involuntary conversions to the extent proceeds exceed replacement cost of qualifying property, limited to realized EXAMPLE: A taxpayer realizes $50,000 of gain on an involuntary conversion where she received $160,000 of insurance proceeds. If she makes a qualifying replacement for $140,000, the taxpayer must recognize $20,000 of gain ($160,000 proceeds less $140,000 replacement cost). Adjusted basis of replacement property is cost less unrecognized EXAMPLE: In the above example the taxpayer would have a basis in the replacement property of $110,000 ($140,000 cost less $30,000 unrecognized gain). Severance Damages (paid by government on condemnation for a decline in value of the retained property) reduce adjusted basis of remaining property. If severance damages exceed the remaining adjusted basis, gain is recognized. 2) Treatment of Gain Due to Involuntary Conversion into Boot (Ex ; 12-37, 12-38) 15 Gain is recognized on involuntary conversions to the extent proceeds exceed replacement cost of qualifying property, limited to realized EXAMPLE: A taxpayer realizes $50,000 of gain on an involuntary conversion where she received $160,000 of insurance proceeds. If she makes a qualifying replacement for $140,000, the taxpayer must recognize $20,000 of gain ($160,000 proceeds less $140,000 replacement cost). Adjusted basis of replacement property is cost less unrecognized EXAMPLE: In the above example the taxpayer would have a basis in the replacement property of $110,000 ($140,000 cost less $30,000 unrecognized gain). Severance Damages (paid by government on condemnation for a decline in value of the retained property) reduce adjusted basis of remaining property. If severance damages exceed the remaining adjusted basis, gain is recognized. 3) Replacement Property (Ex , 12-42, 12-43) 16 Generally, replacement property is required to be similar or related in service or use to the converted property. EXAMPLE: A stolen delivery truck used in the taxpayer's trade or business would need to be replaced with some type of delivery vehicle to qualify for gain deferral. If real property used in a trade or business or held for investment is condemned, it may be replaced under the less restrictive like-kind standard. Rental property may be replaced under the taxpayer-use test where the only requirement is that the owner lease the replacement property also. Business or investment property involuntarily converted as a result of a presidentially-declared disaster can be replaced with any tangible business property. 4) Obtaining Replacement Property (Ex ) 17 Generally the taxpayer must purchase the replacement property. Indirect purchase may be allowed by purchasing 80% control of a corporation owning qualifying replacement property. 5) Time Requirements for Replacement (Ex , 12-48; Topic Review 12-2) 18 The normal replacement period is two years after the end of the tax year in which the involuntary conversion gain is realized. Condemned real property held for use in a trade or business or for investment can be replaced within three years after the end of the tax year in which the involuntary conversion gain is realized. 3

4 (Ex , I2-51) 20 Individuals may exclude up to $250,000 of realized gain on the sale of a principal residence, assuming that certain conditions are met. Married taxpayers filing jointly may exclude up to $500,000 on a similar transaction. Taxpayers are required to have owned and occupied the principal residence in at least two of the last five years. This IRC Sec. 121 exclusion is available at any age, and no replacement residence is required. Any realized gain in excess of the exclusion is recognized as capital No loss is recognized on the sale of a personal residence ) Determining the Realized Gain (Ex ) 22 2) Adjusted Basis of Residence (Ex ) Realized gain is the amount by which the amount realized exceeds the adjusted basis of the principal residence. The adjusted basis of the residence at the time of sale is the original basis (i.e., cost, gift, inheritance) plus capital improvements less any allowable depreciation or casualty loss. 23 3) Multiple Use of Exclusion (Ex ) 24 4) Principal Residence Defined (Ex ) The IRC Section 121 exclusion is now generally available once every two years. A taxpayer has only one principal residence, but it can be a condominium, houseboat, or house trailer. If a taxpayer owns multiple residences, facts and circumstances are analyzed on a case-by-case basis to determine which residence is the taxpayer s principal residence. 4

5 25 5) Sale of More Than One Principal Residence Within a Two-Year Period (Ex , 12-58) 26 6) Nonqualified Use After 2008 (Ex ) A prorata exclusion may be available for sales which do not meet the two year rules if the multiple sales are due to a change in employment, health, or unforeseen circumstances. In situations where the taxpayer converts rental real estate into the taxpayer s personal residence, the gain allocable to periods of post-2008 nonqualified use is subject to taxation, rather than being excluded. 27 7) Involuntary Conversion of a Principal Residence (Ex. I12-64) Gains on the involuntary conversion of a principal residence may be treated under the involuntary conversion rules, the gain exclusion rules, or a combination of both. 28 1) Avoiding the Like-Kind Exchange Provisions (Ex ) Taxpayers in certain situations (i.e., potential losses) may want to avoid likekind exchange treatment. EXAMPLE: Taxpayer owns a delivery truck with an adjusted basis of $12,000 and a fair market value of $5,000. If the taxpayer trades the old delivery truck in on a new truck, no loss can be recognized under the like-kind exchange rules. The taxpayer may be better off by selling the old truck outright so that the loss can be deducted. 29 2) Sale of a Principal Residence (Ex ) Careful planning should be done to take full advantage of the principal residence gain exclusion. EXAMPLE: If a taxpayer owns multiple residences, the taxpayer should occupy the residence that is most likely to be sold at a gain as his/her principal residence. 5