These lectures cover adjusted basis for non taxable exchange section 1031 including realized gain , realized loss, recognized gain, recognized loss, and section 1021 gain exclusion.
Non-Taxable Exchange section 1031
Basis for Non-taxable Exchanges Section 1031
Section 121 Exclusion
Example: Section 121 Exclusion Relief Provision
Example: Section 121 Gain Exclusion
Form 8949 Section 121 Exclusion
Example: Section 121 Exclusions
Computation of Realized Gains and Losses
Realized gain or loss is the difference between the amount realized from the sale or other disposition of property and the property’s adjusted basis on the disposition date. If the amount realized exceeds the property’s adjusted basis, the result is a . On the other hand, if the property’s adjusted basis exceeds the amount realized, the result is a realized loss.
The from a sale or other disposition of property is a measure of the economic value received for property given up. In general, it is the sum of any money received (which includes any debt relief) plus the fair market value of other property received.4 Debt relief includes any liability (like a mortgage) assumed by the buyer when the property is sold. Debt relief also occurs if property is sold subject to the mort- gage. In addition, debt relief is not limited by the fair market value of the property.
In a property transaction, the of property received is the price determined by a willing seller and a willing buyer when neither is compelled to sell or buy.6 All of the relevant factors must be considered, and if the fair market value of the property received cannot be determined, the value of the property given up by the tax- payer may be used.
In calculating the amount realized, selling expenses (such as advertising, commis- sions, and legal fees) relating to the sale are deducted. As a result, the amount realized is the net amount the taxpayer received directly or indirectly, in the form of cash or any- thing else of value, from the disposition of the property.
The calculation of the amount realized may appear to be one of the least complex areas associated with property transactions. However, because numerous positive and negative adjustments may be required, this calculation can be complex and confusing. In addition, determining the fair market value of the items received by the taxpayer can be difficult. The following example provides insight into various items that can affect the amount realized.
The of property disposed of is the property’s original basis adjusted to the date of disposition.9 Original basis is the cost or other basis of the property on the date acquired by the taxpayer. Many assets are acquired without purchasing them (e.g., via gift or inheritance). We’ll discuss how to determine basis for these acquisitions later in the chapter. Capital additions increase and capital recoveries decrease the original basis As a result, adjusted basis is determined as follows:
Cost (or other adjusted basis) on date of acquisition + Capital additions – Capital recoveries = Adjusted basis on date of disposition
Capital additions include the cost of capital improvements and betterments made to the property by the taxpayer. These costs are different from repair and maintenance expenses, which are neither capitalized nor added to the original basis (refer to Chapter 6). As a result, repair and maintenance expenses are deductible in the current taxable year if they are related to business or income-producing property. Any liability on property that is assumed by the buyer is also included in the buyer’s original basis of the property. The same rule applies if property is acquired subject to a liability. Amortization of the discount on bonds increases the adjusted basis of the bonds.
Capital recoveries decrease the adjusted basis of property. The prominent types of capital recoveries are discussed below.
Depreciation and Cost Recovery: The original basis of depreciable property is reduced by any cost recovery or depreciation allowed while the property is held by the taxpayer. The amount subtracted annually from the original basis is the greater of the allowed or allowable cost recovery or depreciation.
Casualties and Thefts: A casualty or theft may result in the reduction of the adjusted basis of property.13 The adjusted basis is reduced by the amount of the deductible loss. In addition, the adjusted basis is reduced by the amount of insurance proceeds received. However, the receipt of insurance proceeds may result in a recognized gain rather than a deductible loss. The gain increases the adjusted basis of the property.
Certain Corporate Distributions A nontaxable corporate distribution is treated as a return of capital, and it reduces the shareholder’s stock basis.15 Corporations normally disclose this information to shareholders. Once the basis of the stock is reduced to zero, the amount of any subsequent distributions is a capital gain if the stock is a capital asset.
Amortizable Bond Premium The basis in a bond purchased at a premium is reduced by the amortizable portion of the bond premium.16 Investors in taxable bonds may elect to amortize the bond premium, with an interest deduction allowed for the amount of the amortized premium.17 So the election enables the taxpayer to take an annual interest deduction to offset ordinary income in exchange for a larger capital gain or smaller capital loss on the disposition of the bond. The amortization deduction is allowed for taxable bonds because the premium is viewed as a cost of earning the taxable interest from the bonds.
Unlike taxable bonds, the premium on tax-exempt bonds must be amortized (and the basis is reduced even though the amortization is not allowed as a deduction). No amortization deduction is permitted on tax-exempt bonds because the interest income is exempt from tax and the amortization of the bond premium merely represents an adjustment of the tax-exempt income earned on the bond.
Recognized Gain or Loss is the amount of the realized gain that is included in the taxpayer’s
gross income. A , on the other hand, is the amount of a realized loss that is deductible for tax purposes.20 As a general rule, the entire amount of a realized gain or loss is recognized.
Nonrecognition of Gain or Loss
In certain cases, a realized gain or loss on a property disposition is not recognized. Non- taxable exchanges, which are covered later in this chapter, are examples. Others include losses realized on the sale, exchange, or condemnation of personal use assets (as opposed to business or income-producing property) and gains realized on the sale of a residence. In addition, realized losses from the sale or exchange of business or income-producing property between certain related parties are not recognized.
Sale, Exchange, or Condemnation of Personal Use Assets
A realized loss from the sale, exchange, or condemnation of personal use assets (e.g., a personal residence or an automobile used only for personal purposes) is not recognized for tax purposes. An exception exists for casualty or theft losses from personal use assets . On the other hand, any gain realized from the sale or other disposition of personal use assets is, generally, fully taxable.
Determination of Cost Basis
As noted earlier, the basis of property is generally the property’s cost. Cost is the amount paid for the property in cash or other property.23
A bargain purchase of property is an exception to the general rule for determining basis. A bargain purchase results when an employer transfers property to an employee at less than the property’s fair market value (as compensation) or when a corporation transfers property to a shareholder at less than the property’s fair market value (a dividend). The amount included in income as either compensation for ser- vices or dividend income is the difference between the bargain purchase price and the property’s fair market value. The basis of property acquired in a bargain purchase is the property’s fair market value.24 If the basis of the property were not increased by the bargain amount, the taxpayer would be taxed on this amount again at disposition.
GENERAL CONCEPT OF A NONTAXABLE EXCHANGE
A taxpayer who is going to replace a business asset (e.g., machinery) may decide to sell the old asset and purchase a new asset. In this case, any realized gain or loss on the asset sold is recognized, and the basis of the new asset is its cost. Alternatively, the taxpayer may be able to trade the old asset for the new asset. This exchange of assets might qualify for nontaxable exchange treatment.
The tax law recognizes that nontaxable exchanges result in a change in the form but not in the substance of the taxpayer’s relative economic position. Effectively, the replacement property received in the exchange is viewed as a continuation of the old investment.60 In addition, a nontaxable exchange often does not provide the taxpayer with the wherewithal to pay the tax on any realized gain that would be recognized (i.e., the taxpayer does not have the cash that would have been received in a sale).
In a , realized gains or losses are not recognized. Instead, the recognition of gain or loss is postponed (deferred) until the property received in the nontaxable exchange is subsequently sold in a taxable transaction. This “deferral” is accomplished by assigning a carryover basis to the replacement property.
In some nontaxable exchanges, only part of the property involved in the transac- tion qualifies for nonrecognition treatment. If the taxpayer receives cash or other nonqualifying property, part or all of the realized gain from the exchange is recog- nized, since the taxpayer has the wherewithal to pay tax. Here, the basis of the replacement property is adjusted to reflect any deferred gain (gain realized but not recognized).
It is important to distinguish between a nontaxable disposition, as the term is used in the statute, and a tax-free transaction. The term nontaxable refers to postponement of recognition via a carryover basis. In a tax-free transaction, the nonrecognition is permanent. Here, the basis of any property acquired does not depend on the basis of the property sold by the taxpayer. In this chapter, we discuss two nontaxable trans- actions (like-kind exchanges and involuntary conversions) and one tax-free transaction (sale of a personal residence).
LIKE-KIND EXCHANGES—§ 1031
Section 1031 requires nontaxable exchange treatment if the following requirements are satisfied:
• Both the property given up and the property received are either “used in a trade or business” or “held for investment.”
only apply to business and investment property. Property held for personal use, inventory, domestic property exchanged for foreign property, and partnership interests (both limited and general) do not qualify under the like-kind exchange provisions. The same is true for financial instruments (like stock, bonds, or a
note), even though they are held for investment. If a taxpayer exchanges like-kind property solely for like-kind property, gain or loss
realized is not recognized (it is deferred) and the basis and holding period from the old property attaches (or carries over) to the new property.
Subject to certain exceptions, related parties can engage in tax-free like-kind exchanges, but a two-year holding period applies to both the relinquished property and the replacement property.
The nonrecognition provision for like-kind exchanges is mandatory rather than elective. A taxpayer who wants to recognize a realized gain or loss will have to structure the transaction in a way that fails the like-kind exchange requirements. For example, a tax- payer may want to avoid like-kind treatment so that a realized loss can be recognized. Or a taxpayer might want to recognize a gain so that capital loss carryovers can be used.
One final point: the like-kind exchange rules are applied independently to each taxpayer in the exchange; one taxpayer may qualify for like-kind treatment, and the other may not.
“The words ‘like-kind’ refer to the nature or character of the property and not to its grade or quality. One kind or class of property may not … be exchanged for property of a different kind or class.”
According to the Regulations, the term like-kind is intended to be interpreted very broadly. The key phrase, however, is “kind or class of property.” For the like-kind exchange rules to apply, real estate can be exchanged only for other real estate, and personalty can be exchanged only for other personalty.64 For example, the exchange of a machine (personalty) for an office building (realty) is not a like-kind exchange.
Real property (or realty) includes principally rental buildings, office and store buildings, manufacturing plants, warehouses, and land. It is immaterial whether realty is improved or unimproved. Thus, unimproved land can be exchanged for an apartment house. Personalty includes principally machines, equipment, trucks, automobiles, furniture, and fixtures.
It is unusual to find like-kind transactions where the value of the property given up is equal to the value of the property received. In most situations, one party normally pro- vides some other property (e.g., cash) to “even out” the exchange. When a taxpayer in a like-kind exchange gives or receives some property that is not like-kind property, gain or loss recognition may occur. Property that is not like-kind property, including cash, is referred to as . Although the term boot does not appear in the Code, tax practitioners commonly use it rather than saying “property that is not like-kind property.”
The receipt of boot will trigger recognition of gain if there is realized gain. The amount of the recognized gain is the lesser of the boot received or the realized gain (realized gain serves as the ceiling on recognition). If a taxpayer recognizes gain in a like-kind exchange, the character of the gain depends on the character of the asset given up.
Basis and Holding Period of Property Received
If an exchange qualifies as nontaxable under § 1031, the basis of property received must be adjusted to reflect any postponed (deferred) gain or loss. The basis of like-kind property received in the exchange is the property’s fair market value less postponed gain or plus postponed loss. The basis of any boot received is the boot’s fair market value.
The Code provides an alternative approach for determining the basis of like-kind property received:
Adjusted basis of like-kind property surrendered þ
+Adjusted basis of boot given þ
-Fair market value of boot received
=Basis of like-kind property received