CONCEPTS IN
FEDERAL TAXATION
November 30,
2012
CHAPTER 12:
NONRECOGNITION
TRANSACTIONS & FINAL
REVIEW
ADMINISTRATIVE
 Attendance
 Midterm 2 Statistics
Average: 95
SD: 20
Total 145
 Final
Thursday, December 13 th 11:30-2:30PM
Chapters 5, 6, 8, 11, 12, 13 (p. 3-18)
Tips
HOMEWORK PROBLEMS
HW Problems:
Assignment #13
Chapter 12
P#32, 45, 49, 73
Extra problems: #51
#32
Shirley has an old tractor that has an adjusted basis of $9,000
and a fair market value of $5,000. She wants to trade it in on a
new tractor that costs $25,000. Write a memorandum to
Shirley advising her about how to structure the transaction to
optimize her tax situation.
#32
 Shirley should structure the transaction as a sale of the old
tractor and a separate purchase of the new tractor
 This will allow her to recognize the $4,000 ($5,000 - $9,000)
loss on the tractor right away
 If Shirley structures the transaction as an exchange, she will
not be able to deduct the loss on the exchange
The loss is deferred and added to the basis of the new tractor
 A sale and purchase with the same dealer in property is
usually collapsed by the IRS as an like-kind exchange
She will have to defer the $4,000 loss
 She should not buy the new tractor from the same dealer to
which she sells the old tractor to avoid this classification
#45
Grant Industries’ warehouse is condemned by the city on August
18, 2012. Because of widespread publicity leading up to the
condemnation, Grant anticipates it and purchases a
replacement warehouse on April 15, 2012, for $670,000. The
city pays Grant $430,000 for the condemned property, which
has an adjusted basis to Grant of $220,000. Write a letter to
Grant Industries explaining why it might want to recognize the
entire gain on the condemnation.
#45
 Grant will elect to recognize the gain if it doesn’t have to pay
tax on the gain
 If Grant has either a NOL or a capital loss that it could use to
of fset the gain, it should recognize the entire gain
The gain will go untaxed by offsetting against the losses
Grant will have a basis in the replacement warehouse of the full
$670,000 purchase price (no deferral)
 The larger basis will result in larger cost recovery deductions
in the future
#49
Alley’s automobile dealership, which has an adjusted basis of
$400,000, is destroyed by a hurricane in the current year.
Alley’s receives $600,000 from its insurance company to cover
the loss. Alley’s has begun to rebuild the dealership at an
estimated cost of $750,000. Assume that the rebuilding costs
at least $750,000.
#49
a. What is the minimum gain Alley’s must recognize on the
hurricane damage?
 Alley’s has two years to complete the replacement of the
dealership (in order to defer any gains)
 Assuming that the replacement period requirement is met and
Alley’s rebuilding costs are $750,000, Alley’s will not have to
recognize any gain on the hurricane damage currently
 Alley’s will have fully reinvested the $600,000 of insurance proceeds
in the dealership ($600,000 < $750,000)
 The basis of the new dealership will be reduced by the
deferred gain
#49
Amount realized (insurance proceeds)
Adjusted basis
Realized gain
Recognized gain
Deferred gain
$ 600,000
(400,000)
$ 200,000
-0$ 200,000
Basis of new dealership ($750,000 - $200,000) = $550,000
#49
b. Alley’s is organized as a corporation. Because of a slump in the
automobile industr y, Alley’s has net operating losses totaling $400,000
that it is carr ying for ward from the previous 5 year s. Alley’s expects to
have another operating loss in the current year. Write a letter to Alley’s
explaining how to account for the involuntar y conversion results and why
you advise taking those measures.
 Since Alley’s has a NOL carr yover, Alley’s can recognize the entire
$200,000 g ain on t he involuntar y conversion and pay no tax on the
g ain
 The current year loss and the NOL carryover will offset the $200,000 gain
 By electing to recognize t he g ain in t he current year, Alley’s will have a
basis in t he new dealership equal to it s cost
 No reduction in cost since no deferred gain
 By recognizing t he g ain, A lley’s u ses u p some of it s NOL carr yfor ward
 Some of the NOL carryforward may be lost if Alley’s does not return to
profitability in the future (20 years)
#73
During the current year, the Harlow Corporation, which
specializes in commercial construction had the following
property transactions. Determine the realized and recognized
gain or loss on each of Harlow’s property transactions and the
basis of any property acquired in each transaction .
#73
a. In April, a tornado damages a crane and a dump truck at one
of its construction sites. The crane was acquired in 2009 for
$120,000 and has an adjusted basis $39,650. The dump truck
was acquired in 2007 for $70,000 and has an adjusted basis of
$33,880. The insurance company reimburses Harlow $35,000
for the crane and $42,000 for the dump truck. The company
decides not to replace the dump truck and uses the insurance
proceeds to purchase a new crane for $110,000.
 Involuntary conversion
 The purchase of the new crane is a qualified replacement
 The reinvestment of the dump truck proceeds into a new
crane does not qualify
Fails functional use test
#73
Dump truck:
Amount realized (insurance proceeds)
Adjusted basis
Realized gain
Recognized gain
Deferred gain
$ 42,000
(33,880)
$ 8,120
(8,120)
$
-0-
 Harlow must recognize a gain of $8,120 on the dump truck
since no qualified replacement
#73
Crane:
Amount realized (insurance proceeds)
Adjusted basis
Realized loss
Recognized loss
Deferred loss
$ 35,000
(39,650)
$ (4,650)
4,650
$
-0-
Basis of new crane (purchase price) = $110,000
 Harlow must recognize the $4,650 loss on the crane
Losses on an involuntary conversion must be recognized
#73
b. The company trades a road grader with a fair market value of
$72,000 for a bulldozer worth $60,000. Harlow receives
$12,000 in the exchange. The road grader originally cost
$90,000 and has an adjusted basis of $50,000. The bulldozer
cost $85,000, and its adjusted basis is $37,000.
 The exchange qualifies as a like -kind exchange
 Since neither a road grader nor a bulldozer are classified in
any general asset class, to qualify as a like -kind exchange
both the road grader and bulldozer must be in the same
product class
 Both are in NAICS product class 333120, so the exchange is
like-kind (exhibit 12-1)
#73
Amount realized (bulldozer + cash)
Adjusted basis
Realized gain
Recognized gain (cash boot received)
Deferred gain
$ 72,000
(50,000)
$ 22,000
(12,000)
$ 10,000
Basis of bulldozer = $50,000 ($60,000 - $10,000)
 Harlow realizes a gain of $22,000 on the exchange
 The $12,000 of cash boot received must be recognized
Wherewithal to pay
 Harlow’s recognized gain is $12,000 and its deferred gain is
$10,000
#73
c. A fire destroys the company’s supply warehouse. The
warehouse originally cost $300,000 and has an adjusted basis
of $200,000. Its fair market value before the fire is $250,000.
The insurance company pays Harlow $230,000, which it uses to
acquire a warehouse costing $280,000 .
 Harlow has realized a gain of $30,000 from the fire
$230,000 insurance proceeds - $200,000 adjusted basis
 Harlow acquired a replacement warehouse that costs more
than the insurance proceeds, so it can defer the $30,000 gain
$280,000 > $230,000
 The basis of the new warehouse is $ 250,000
$280,000 - $30,000
#73
Amount realized (Insurance proceeds)
Adjusted basis
Realized gain
Recognized gain
Deferred gain
$ 230,000
(200,000)
$ 30,000
$
-0$ 30,000
Basis of warehouse = $250,000 ($280,000 - $30,000)
#73
d. The city of PeaceDale condemns land that Harlow had acquired
in 1978 for $22,000 and held as an investment. The city pays
Harlow the $195,000 fair market value of the land. Harlow uses
the proceeds to acquire a commercial office park for $350,000 .
 Qualified replacement property on an involuntary conversion
must have the same functional use as the property converted
 An exception is granted for condemned business or investment
real property, which only requires the property acquired be like
kind property
The replacement of the land with the commercial office park qualifies as
like-kind property (realty for realty)
 Harlow may elect to defer the gain it realizes on the
condemnation
#73
Amount realized (condemnation proceeds)
Adjusted basis
Realized gain
Recognized gain
Deferred gain
$ 195,000
(22,000)
$ 173,000
$
-0$ 173,000
 Harlow has realized a gain of $173,000 on the condemnation
 Harlow does not have to recognize any gain because the
entire $195,000 of condemnation proceeds are reinvested in
the purchase of the of fice park
 Basis of of fice park = $177,000 ($350,000 - $173,000)
#73
e. Harlow sells an automobile used by its president for business
purposes for $10,000 to a local car dealership. The car originally
cost $32,000, and its adjusted basis is $15,000. The company
had an agreement to replace the automobile with a customized
four-wheel-drive vehicle from a company that specializes in custom
cars. However, the day the company sells the automobile, it is
informed that the custom car company will not be able to deliver
the vehicle for at least 10 weeks. Harlow terminates its contract
with the custom car company and buys a new automobile from the
local car dealership for $55,000.
 This transaction is structured as a sale and a purchase
 The IRS will collapse sales and purchases involving the same
parties into one like kind exchange
Since the car dealership is involved in both the sale and purchase, it is
likely that the IRS would be successful in treating the transaction as an
exchange
#73
Amount realized
Adjusted basis
Realized loss
Recognized loss
Deferred loss
$ 10,000
(15,000)
$ (5,000)
$
-0$ (5,000)
 As an exchange, Harlow will not be able to immediately
recognize a loss on the old automobile
 The $5,000 loss is deferred until Harlow sells the new
automobile
#73
Fair market value of new automobile
Add: Deferred loss
Basis in new automobile
$55,000
5,000
$60,000
EXTRA PROBLEMS—#51
Aretha sells her house on June 9, 2011 , for $220,000 and pays
commissions of $10,000 on the sale. She had purchased the
house for $60,000 and made capital improvements costing
$15,000. What are Aretha’s realized and recognized gain in each
of the following cases?
a. Aretha is single and acquired the house on September 15, 2004.
 Aretha has a realized gain
 She can exclude the entire amount of the gain ($ 250,000 max) if
she meets both the ownership test and the use test:
1. The ownership test requires that she own the house for at least
two of the five years preceding the sale
2. The use test requires that the house was her principal
residence for two of the preceding five years
EXTRA PROBLEMS—#51
 Because Aretha meets both of these tests, she can exclude
the $135,000 gain
Amount realized ($220,000 - $10,000)
Adjusted basis ($60,000 + $15,000)
Realized gain
Exclusion amount
Recognized gain
$ 210,000
(75,000)
$ 135,000
(135,000)
$
-0-
EXTRA PROBLEMS—#51
b. Assume the same facts as in part a, except that Aretha sold
the house for $375,000 and pays commissions of $30,000 on
the sale.
 Aretha has a realized gain of $270,000 and a recognized gain
of $20,000
Amount realized ($375,000 - $30,000)
Adjusted basis ($60,000 + $15,000)
Realized gain
Exclusion amount
Recognized gain
$ 345,000
(75,000)
$ 270,000
(250,000)
$ 20,000
EXTRA PROBLEMS—#51
c. Aretha is single and acquired the house on September 1 ,
2010. She sold the house because her company transferred her
to Phoenix.
 Aretha fails to meet the ownership and use tests
 She can still qualify for a pro rata portion of the exclusion
since her failure to meet these tests is due to a change in
employment, health, or unforeseen circumstances
 The amount she can exclude is the ratio of the number of
months she met the ownership and use tests (9 months—
September to June) to the total number of months in the
exclusion period (24 months) multiplied by the exclusion
amount of $250,000
EXTRA PROBLEMS—#51
 The amount Aretha can exclude is $93,750:
$93,750 = 9 months
24 months
x $250,000
Amount realized ($220,000 - $10,000)
Adjusted basis ($60,000 + $15,000)
Realized gain
Exclusion amount
Recognized gain
$ 210,000
(75,000)
$ 135,000
( 93,750)
$ 41 ,250
EXTRA PROBLEMS—#51
d. Assume the same facts as in part c, except that she moved to
Phoenix to enter medical school.
 Aretha fails to meet the ownership and use tests
 Since her reason for failing these tests is not due to a change in
employment, health, or unforeseen circumstances, she does not
qualify for a pro rata share of the $250,000 exclusion
 Aretha has a recognized and realized gain of $ 135,000:
Amount realized ($220,000 - $10,000)
Adjusted basis ($60,000 + $15,000)
Realized gain
Exclusion amount
Recognized gain
$ 210,000
(75,000)
$ 135,000
-0$ 135,000
PRACTICE FINAL—SA #2
Bradley has the following transactions related to his investments and his business during
2010:
(1)
Stock purchased in 2002 is sold at a gain of $2,000.
(2)
Bonds purchased in 2010 are sold at a loss of $7,000.
(3)
A building used in his business is sold at a loss of $6,000. The
building had been purchased in 1996 and $18,000 of
depreciation had been taken on the building.
(4)
Equipment purchased in 2006 is sold at a gain of $12,000.
Depreciation of $9,000 had been taken before the sale.
(5)
A delivery van is destroyed in an accident. Bradley realizes a
loss of $5,000 on the van. He uses the $13,000 of insurance
proceeds as a down payment on a new van costing $28,000.
a. Determine the amount and character of each gain or loss.
b. Determine the effect of the gains and losses on Bradley's 2010
adjusted gross income. You must present the calculations in
proper form to receive full credit.
PRACTICE FINAL—SA #2
a. Determine the amount and character of each gain or loss
(1)
Stock purchased in 2002 is sold at a gain of $2,000.
LTCG of $2,000.
(2)
Bonds purchased in 2010 are sold at a loss of $7,000.
STCL of $7,000.
(3)
A building used in his business is sold at a loss of $6,000. The
building had been purchased in 1996 and $18,000 of
depreciation had been taken on the building.
1231 loss of $6,000.
(4)
Equipment purchased in 2006 is sold at a gain of $12,000.
Depreciation of $9,000 had been taken before the sale.
Section 1245 recapture of $9,000
and Section 1231 gain of $3,000.
(5)
A delivery van is destroyed in an accident. Bradley realizes a
loss of $5,000 on the van. He uses the $13,000 of insurance
proceeds as a down payment on a new van costing $28,000.
Section 1231 business casualty loss
of $5,000.
PRACTICE FINAL—SA #2
What is capital gain income ?
 C a p it al g a in i n c o me ( l o s s) r e s ult s f ro m t h e s a le o r o t h e r d i s p o s it io n o f a
c a pit al a s s et .
 C a p it al a s s et s c o n s is t o f s to c ks , b o n ds , o t h e r i nves t ment a s s et s , a n d p e r s o na l
u s e p ro pe r t y.
 E xa mples i n c lude l a n d, b u i ldings , m a c hiner y, e t c . G e n erally, t h e s e a re a s s et s
t h a t c a n not q u ic kly b e t u r n ed i n to c a s h a n d a re o f te n o n ly l iq uida ted i n a
w o r s t - ca se s c e na rio .
 A ny a s s et t h a t i s N OT:
•
An inventory item
•
A receivable
•
Real or depreciable property used in a trade or business
•
Intellectual property
•
Certain US Government publications
PRACTICE FINAL—SA #2
What is Section 1231 property?
 A Section 1231 property is an asset that is held for more than
1 year and which is:
1. Depreciable or real property used in a trade or business,
2. Timber, coal, and domestic iron ore,
3. Livestock; horses must be held more than 2 years, or
4. Unharvested crops.
PRACTICE FINAL—SA #2
What is the tax advantage of selling a Section 1231 property at
a gain?
 Netting
 Within this procedure, there are two possible benefits.
① First, if the capital gain and loss procedure results in a net
long-term capital gain, the tax rate applicable to the gain
for an individual taxpayer is 15%.
② Second, if the taxpayer has a net capital loss, the Section
1231 long-term capital gain ef fectively allows deduction of
a loss which may have otherwise been limited .
PRACTICE FINAL—SA #2
How are the recapture provisions for Section 1245 and Section
1250 property dif ferent?
Section 1245
 Section 1245 recaptures all gain which is
due to the depreciation deduction as
ordinary income.
 For there to be either a capital gain or a
Section 1231 gain on a Section 1245 asset,
the asset must be sold for more than its
original cost.
 That is, only the true appreciation in the
price of a Section 1245 gain is accorded
capital gain or Section 1231 gain status.
Section 1250
 Section 1250 recaptures excess
depreciation as ordinary income.
 Excess depreciation is defined as the
depreciation deducted less the allowable
straight-line depreciation.
 Therefore, straight-line depreciation on
Section 1245 assets can create capital gain
or Section 1231 gain.
 As long as a straight-line depreciation is
taken on a Section 1250 asset, no
recapture occurs.
PRACTICE FINAL—SA #2
b. Determine the ef fect of the gains and losses on Bradley's
2010 adjusted gross income. You must present the calculations
in proper form to receive full credit .
Section 1231 Netting:
Business casualty loss
$ 5,000
Ordinary loss
1231 gain on equipment
1231 loss on building
Net Section 1231 loss
$ 3,000
(6,000)
$(3,000)
Ordinary loss
Capital Gain and Loss Netting:
Long-term gain on stock
Short-term loss on bonds
Net short-term capital loss
$ 2,000
(7,000)
$(5,000)
PRACTICE FINAL—SA #2
Summary of effect on taxable income:
Ordinary income from sale
of equipment
Business casualty loss
Section 1231 loss
Capital loss deduction
Decrease in taxable
income, all ordinary
$ 9,000
(5,000)
(3,000)
(3,000)
$(2,000)
PRACTICE FINAL—SA #3
Hank and Lois sell their home for $775,000, incurring selling expenses of
$40,000. They had purchased the residence in 1975 for $1 85,000 and made
capital improvements totaling $45,000. They buy a new residence for
$310,000. What is their realized gain and recognized gain on the sale? What
is their basis in the new house?
Issues;
•
Realized gain/recognized gain
•
Owner ship and Use
 They can exclude $500,000 of the gain if either of them meets the
owner ship test and both of them meet the use test.
 The owner ship test requires that either of them own the house for at least
two of the five year s preceding the sale.
 The use test requires that the house was the principal residence for both of
them in two of the preceding five year s .
 Because they meet both of these tests, they can exclude $500,000 of the
gain.
PRACTICE FINAL—SA #3
Amount realized
($775,000 - $40,000) = $735,000
Adjusted basis
($185,000 + $45,000) = (230,000)
Realized gain
$505,000
Exclusion amount
(500,000)
Recognized gain
$ 5,000
PRACTICE FINAL—SA #3
Basis in new home
$310,000 (purchase price )
The exclusion has no impact on the basis of the new home
PRACTICE FINAL—SA #4
James and Mark exchange equipment each use in their business. In the trade, James
receives Mark's equipment that is worth $20,000. Mark also assumes the $10,000 loan
James had on the equipment. James purchased his equipment for $25,000 and had
taken $12,000 of depreciation on the equipment up to the date of the exchange. Mark's
adjusted basis in his equipment is $16,000 on the date of the exchange.
a.
What is James's realized gain on the exchange?
b.
What are the amount and the character of the gain James must recognize on the exchange?
c.
What is James's basis in the equipment acquired in the exchange?
PRACTICE FINAL—SA #4
James
Mark
Before trade
$25,000 purchase
$12,000 depreciation
$10,000 loan
$20,000 FMV
$16,000 AB
After trade
$20,000 FMV
$16,000 AB
$25,000 purchase
$12,000 depreciation
$10,000 loan
PRACTICE FINAL—SA #4
a.
What is James's realized gain on the exchange?
Realized gain
($20,000 + $10,000)
- ($25,000 - $12,000)
= $17,000
Mark’s Equipment + Loan
James’s Basis –
Depreciation
• His amount realized is the FMV of the property received plus the $10,000
loan assumption
• His adjusted basis is reduced by the depreciation taken on the equipment
PRACTICE FINAL—SA #4
b.
What are the amount and the character of the gain James must recognize on the exchange?
Boot
$10,000
Loan
• James must recognize ordinary income of $10,000 on the exchange
 Gain must be recognized to the extent that boot is received in a like-kind
exchange
 The assumption of the loan on the equipment is considered to be boot
and must be recognized
• Because the equipment is Section 1245 property, any gain recognized on the
equipment must be recaptured to the extent of the depreciation taken
($12,000) on the equipment
PRACTICE FINAL—SA #4
c.
What is James's basis in the equipment acquired in the exchange?
Basis in new
equipment
$20,000
- $7,000
= $13,000
Mark’s FMV
Realized gain - Boot
 James's basis in the new equipment is $13,000 ($20,000 - $7,000)
 Any gain that is not recognized on a like-kind exchange is deferred into the
basis of the new property received in the exchange
 James realizes a gain of $17,000, recognizes $10,000 of the gain and defers
the remaining $7,000 of gain
IMPORTANT CONCEPTS
I.
Commonalities of nonrecognition transactions
A.
B.
C.
Substance over form (continuation of investment)
Wherewithal to pay is lacking
All amounts realized are reinvested
1.
2.
D.
Gain deferral, not losses
1.
2.
E.
Like kind exchanges (deferral mandatory)
Involuntary conversions (deferral elective)
Except like like exchanges, losses are mandatory
Realized gains are maximum gain recognized
Deferral accomplished through basis adjustment
1. Basis = FMV of replacement less gain deferred
2. Basis = FMV of replacement plus loss deferred
F. Carryover of tax attributes
1. Holding period
2. Depreciation recapture potential
IMPORTANT CONCEPTS
II. Like kind exchanges
A. Direct exchange requirement—a sale followed by a purchase doesn’t
qualify
1.
2.
Interdependent sale and purchase will be collapsed by IRS
Deferred exchanges allowed (3 rd party exchanges)
a.
b.
Max 180 days after 1st exchange to complete 2nd exchange
Max 45 days after 1st exchange to identify property for 2nd exchange
III. Like kind property requirements
A. Business or investment property only
B. Realty for realty is sufficient
C. Like kind classes for tangible personalty (same asset class used for
depreciation)
D. Use NAICS code if both properties don’t fall into general asset
classes
E. Exchanges that never qualify (look at page 12 -11)
IMPORTANT CONCEPTS
IV. Ef fect of boot
A.
Receipt of boot
1.
2.
3.
4.
5.
B.
Has wherewithal to pay
Liabilities assumed = boot
If both parties assume liabilities, net the liabilities, and the party with
a positive net liability has received boot
Giving boot doesn’t trigger recognition
Losses on like kind exchanges are never recognized, even when boot is
received
Related party exchanges
1.
Must hold for 2 years after exchange
IMPORTANT CONCEPTS
V.
Involuntary conversions
A.
Casualties, theft, condemnations, seizures
1.
2.
B.
Sales due to threats
Sales of livestock due to weather related conditions
Treatment of involuntary conversion gains and losses
1.
2.
Losses fully recognized
Gains on direct conversions are treated the same as like kind
exchanges (mandatory deferral of gains)
Gain deferral on other involuntary conversions is elective
3.
a.
Know when it is beneficial to defer and when not to defer
VI. Qualified replacement property
A.
Functional use test
1.
2.
B.
Same usage or function
Except condemned realty (use like-kind test)
2 year window to replace; 3 for condemned real estate
IMPORTANT CONCEPTS
VII. Sale of principal residence
A.
B.
Loss not deductible
May elect to exclude gain
1. Up to $250,000 (or $500,000 if MFJ)
2. No adjustment to basis of any new residence
C. Requirements for exclusion
1. Must be principal residence
2. Must meet 3 tests:
a.
b.
c.
Ownership test
Use test
Exclude only once every 2 years
3. If fail any of the 3 tests, can take pro rata amount of the exclusion