Property Transactions

Sources of Basis: Buy it, Die it, Gift it or Trade it.

Cost basis: Sec. 1012

Include sales tax paid, installation costs, etc.

Cost can include debt-financing "leverage"

Is a limit for seller finance debt, due to concern about economic reality of nonrecourse prices: the million dollar watch

Taxable income items "buy" basis

Basis is "bought" when income goes thru tax system. After paying tax, what's left has a "tax cost" -- it's previously taxed income, not to be taxed again. Eg most executive stock options

Basis of Inherited property: Sec. 1014

AB = FMV at date of death. so a "step up" (or down) for inherited property. Creates an incentive to hold appreciated property til death

Note community property double step-up: Sec. 1014(b)(6)

This is a problem w/ proposed repeal of estate tax

Gift basis: Sec. 1015

A "Carryover", where recipient takes donor's AB

Exception if donor pays gift tax:

Per Sec. 1015(d)(6): (donor's potential gain)/FMV x tax paid is added to recipient's basis

Exception if FMV less than donor's basis

Recipient uses has donor's AB for gain; FMV for loss

There is a similar split basis rule for conversion of personal use property to business use

Trade basis

In tax-deferred transactions, gain/loss isn't recognized. But the basis of the item given up is substituted in as the basis of the property received in order to preserve potential gain for tax on a later sale.

Applies to RE trades, incorporations, mergers. Many p'ship rules involve basis tracking

The "Conservation of Basis" Principles

A dollar is a dollar is a dollar.

For money, Face = Cost = FMV, if it's Tp's functional currency and lacks collector value

Tax-free exchanges usually preserve Basis

If gain isn't taxed now, set basis so gain may be taxed later. Eg. mergers and stock splits.

Stock dividends are like splits, unless there's an option to get cash (so proportionate interest could change)

Negative basis isn't allowed

If a transaction would produce negative basis, set basis to 0 and book a gain

Example: distribution of refinance money by Corp to Sh

The "No double recovery" principle

Depreciation charges adjust basis, so less is left to offset any sale proceeds

Exchanges and Basis Tracking

Basic Concepts

"Realized" and "recognized"

When property is sold or exchanged, Tp "realizes" gain or loss, measured as: money received plus the fair value of other property received less the basis of the property given up.

Note that debt relief is treated as "other property received"

Realized gains are "recognized" (i.e. included in income) unless an exception applies. Losses are "recognized" (i.e. deducted) only if a specific code section so provides, but Sec. 165 generally allows losses from a trade or business, a transaction for profit, or due to casualty or theft.

Note that a loss on sale of one's own home isn't deductible.

Some realized gains/losses are not recognized, as when property is "exchanged" (i.e. no cash-out thru sale) and when the property received has some degree of similarity to that given up.

Main types of non-recognition transactions

Sec 1031 "like kind" exchanges (primarily real estate)

Sec 1033 casualty gain replacement

Sec 351 transfers to controlled corporations

Secs. 354 and 361 corporate reorganizations

Sec. 721 transfers to partnerships

Sec. 731 partnership distributions

Sec. 267 related party loss sales

Secs. 1091 and 1092 wash sales and straddles

Sec. 1041 divorce

Former Sec. 1034 home sales (repealed in 1997, but still affects basis of existing homes)

Basis tracking

In order to prevent gain/loss from escaping tax if the acquired property is later sold, the tax basis (measure of Tp's investment) in the property given up is transferred into the acquired property. Basis is further adjusted if money or non-exchange property is given/received, and if gain/loss is *partly* recognized. Basis tracking is the key to the nonrecognition rules.

The Basis Formula:

Adj. Basis exchange property given up

+ cash given

+ FMV of non-exchange property ("boot") given

+ gain recognized on receipt of cash/boot

- cash rec'd

- FMV of non-exchange prop rec'd

- loss recognized (if any)

equals adj. basis of exchange property received

The Checksum

FMV of exchange property received
- Gain realized
+ Gain recognized
equals adj basis of exchange property received

(i.e AB = FMV - unrecognized gain. If a loss, AB = FMV + unrecognized loss)

Sec 1031 "like kind" exchanges

Applies to both gains and losses, property used in business or held for investment, and technically not elective (tho Tp may structure transaction to avoid it)

What is "like kind"

For equipment trade-ins look to IRS industrial census categories, but all real estate is like kind with all other real estate

How are exchanges structured?

Tp can't hold non-like kind cash. Result: the 3-corner exchange and the "deferred exchange" via qualified intermediaries ("dummies"). IRS regulations re 45 days to id and 180 to close

How are gains, losses and basis calculated?

An exchange table for the properties, showing basis, FMV, debt, FMV equity and boot

Relief of debt is treated as unlike kind "boot", but can net debt relief against cash paid and against debt incurred

Note that the lower basis in an exchange means lower depreciation allowances for the acquired property

Sec. 1033 involuntary conversions

Applies only to gains on casualties (usually from insurance > basis) or gov't condemnation, can be business, investment or personal use property, and is elective

Similar or related in service or use

Tp must acquire replacement property that is "similar or related in service or use" by end of 2nd tax year after gain is realized.

Any shortfall (failure to reinvest full insurance proceeds) triggers gain recognition. Basis of replacement property = cost - unrecognized gain

If real estate condemned by government, TP has 3 years and can look for "like kind" property