RE Tax Lecture

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					Federal Taxation of Property Transactions Scott Racine 310-229-1059 (Work) 818-501-8160 (Home) If you have a tax problem, first go to the code, then to the regulations, then go to revenue rulings (these are not the law, but they are the view of the IRS), Cases (tax court, federal district court, claims court). There are two types of regulations. In order to have capital gains, you need a sale or exchange of a capital asset that has been held for at least 12 months. PROBLEM SET 1 Problem 1 I. (a) – Gross Income = $229,000; AGI = $229,000; ST = $4,000 (b) – Gross Income = $225,000; AGI = $224,000; ST = $4,000 (c) – Gross Income = $225,000; AGI = $224,000; ST = $0 (d) – Gross Income = $225,000; AGI = $223,000; ST = $2,000 (e) – Gross Income = $225,000; AGI = $223,000; ST = $3,000 (f) – Gross Income = $221,000; AGI = $217,000; ST = $0,000 (Carry over $5,000 of LTCL) (g) – (i) – Gross Income = $221,000; AGI = $217,000; ST = $0 (Carry $4,000 LTCL & $5,000 STCL) (ii) – Gross Income = $225,000; AGI = $217,000; ST = $0 (Carry $3,000 LTCL & $2000 STCL) II.

1/18/06 Lecture Two types of income, normal and capital gains. Highest tax rate is 35%, Capital Gains tax is 15%. Why is there a discount for capital gains? It promotes investment in certain types of property. What is income – Any accretion to wealth that is clearly realized over which you have dominion and control. § 61 – Is the basis for collecting taxes. Gross income is all income from whatever source derived.

Basically all income is taxable unless you can specifically point to an exclusion. Deductions are a matter of legislative grace, and nothing is deductible unless specifically provided for in the code. In this class we are going to study § 61(a)(3) – Gains derived from dealings in property. Problem I. (a) – Salary + Gains from dealings in property give us Gross Income. Then we go to adjusted gross income, this is under § 62(a)(3) – Losses from sale or exchange of property (to the extent deductible under § 161 and following). Losses from dealings in property go into calculating your adjusted gross income. What is net capital gain? § 1222(11) – Long term capital gain – Gains from a 1) sale or exchange of a 2) capital asset 3) held for more than one year. Net Capital Gain is Net Long Term Capital Gain minus Net Short Term Capital Loss. The heart of the code is § 1001. Gain is the excess of the amount realized minus adjusted basis. Net Capital Gain gets taxed at 15%. 1/25/06 Take your short term capital losses first. Carry over all the rest. An individual can carry forward forever. § 1091 – If you sell a stock or something, and you buy it back with 30 days (something substantially identical) then there is no loss, the loss carries over. There is no converse rule for gains. § 1 Taxes on individuals §11 Taxes on corporations Collectibles are taxable at 28% rate Un-recaptured § 1250 gain is taxed at 25%. This is when you take too much depreciation on your property. Problem I number II. (a) (i) § 11 – This is where the tax on corporation is. Tax is 15% on first $50,000 (7,500), 25% on the amount between 50 and 75K (6,250), 34% on 75K up to 10 million. The tax on this problem is $28,500. No preference for capital gains tax. Only good for netting losses with gains. (ii) Same as above

(b) Taxable income is 5000 business income, and he gets to net his losses and gains so no capital income. Then there is a $10,000 carry over. No $3000 deduction. You carry it back 3 years, then carry forward 5 years. If you carry it back you can offset capital gains in previous years (short or long term all treated the same, basically all treated as short term because no difference in tax), you basically get a refund. Commish v. Glenshaw Glass – Court says that Congress wants to tax all income that is not exempted. Income is accession to wealth, clearly realized, over which the taxpayers have complete dominion and control. If something is unsolicited, it is not taxable income. 2/1/06 Formula for figuring out the tax upon tax. After tax amount/(1-tax rate) If salary is $50,000 and company is going to pay tax amount on your behalf, then they need to give you $50,000/(1-tax rate). So assuming tax rate is 35% then take 50,000/.65. That is the amount the company must give you total. The amount above 50,000 is the tax that you give to the govt. Problem book, page 5. In an arms length transaction with unrelated parties, every thing is considered equal. When you make a bargained for exchange we consider it a fair deal. If the property goes up in value then it is an unrealized gain. If you find a diamond in your piano, that is a windfall because you did not bargain for that. Unsolicited books from publishers are not income. This is because the benefit is more for the publisher. There is no such thing as a gift to an employee. What is a gain? FMV is what a willing purchaser would buy for and willing seller would sell for, each having all the facts, and neither being under compulsion.

We tax gains from the sale or other disposition of property. The excess of the amount realized over the adjusted basis shall be treated as realized gains, or the excess of the adjusted basis over the amount realized will be treated as realized losses. If you convert property to cash or other property materially different from that property, then you have disposition. It is not income if a tenant defaults and leaves an improvement on the property, unless it was intended as rent. 1. Is there a disposition that results in a taxable event? 2. What is the amount realized? 3. What is the basis? Materially different if the respective possessors enjoy legal entitlements that are different in kind or in extent. Really just means different rights and different obligations. Changing mortgages counts even if they are the same value, this is because different borrowers. This is enough to be materially different. 2/8/06 If one company swaps a bushel of wheat with another company’s bushel of wheat then that is not a disposition because a bushel of wheat is not materially different. You also need to know when you include it in income. § 446 You can compute your income in a variety of ways. If you have an inventory then you are required to use the accrual method of accounting. Regs under § 451. Cash Basis – This is the method that every individual taxpayers for his personal books, is on. This method reports income in the year a taxpayer actively or constructively receives cash or its equivalent. If something is credited to your account, set apart for you, or otherwise made available so you can draw upon it at any time or draw upon it during the taxable year. This is read as “and.” So basically you can not turn your back on income. If your employer wants to give you a check you can’t say, no not now, mail it to me. It is also when you receive something in the mail, not when dropped in the mail. Check counts because it is a cash equivalent. If you transfer property and get a note from a bankrupt dude, then that is not considered income until you collect enough on the note to cover your basis.

Problem II AFR – is the applicable federal rate. You have to charge that rate, otherwise there is imputed interest. For purpose of this class, do not discuss imputed interest. AR = Sum of any money received plus the FMV of any property received. In this case we have $2000 cash plus 4 notes each with a face value of $1500. Total AR = $8000. The basis is $4,000 so the total realized gain is $4000. Now, on each note you eventually get paid off 2000 on each note, at that time you have a 500 gain because the basis in your note is now 1500, it is the tax cost. Remember that only in rare situations will property not have a FMV. But if the notes had no ascertainable value then in the first year only AR would be the 2000 cash and gain would be 0. The next year a note gets paid off and then in that year AR would be 2000 and gain 0 again. Then in the following year another note pays off and AR is 2000, all would be gain because you used up your 4000 basis. So on into the future as the notes get paid off. The Regs say that if the note is paying interest at or more than the applicable federal rate, then the FMV is the face value. So under the regs the AR would be $10,000. Basis is 4000 and gain is 6000. (b) The accrual method of accounting: § 451-1 – All events test: when all events occur that fix the right to income and the amount of income can be ascertained with accuracy. Paul Horning would have income then because all the events occurred that fixed his right to it, he did not get it yet though. T has an AB of 4000 and an AR of 10000. The events that occurred that fixed his right to income was the sale of the house. But if he given a 30 year lease instead then he did not get the face value of the lease up front because all events have not occurred, the landlord has to provide access to the house on an ongoing basis. In this case the 6000 gain occurs in the first year and then when each note is paid then there is nothing because you have already recognized it. So if we use the regs for the cash method then there is no difference between cash and accrual method. The problem is that you only get 2000 cash but have to pay taxes on a 6000 gain. The installment method. Installment sale is any kind of sale where one payment is received after the taxable year in which the sale occurred. On this transaction there are 8000 of payments to be received after the first year. So can use the installment method. Gross Profit Ratio is Gross Profit / Total Contract Price Find your gain to total cash ratio. Here it is 60%, 6000/10000. Then report 60% of each installment as gain, so each 2000 receipt will result in 1200 gain. 5 of those give you a total of 6000 gain.

Part (b) – 2/15/06 Note with face of $8,000 and FMV of $6,000. Warren Jones says use the FMV so the amount realized is $6,000. But the regulations (7701-1(g)) say if the note provides for adequate interest then the FMV is the face. Doctrine of open transaction cash equivalent – If the note is not the equivalent of cash you don’t have the take the note in. In order for a note to be a cash equivalent it has to be saleable. Has to not trade at a significant discount. You really have 3 options when you have a note (fixed payment obligation) 1) The treasury option (include the face value) 2) Include something less than face if you can show that it has a value less than face (Warren Jones closed transaction) 3) Open Transaction (argue that you don’t include anything until you get paid if the note is really crappy) For a contingent payment obligation Open – “rare and extraordinary circumstances” Closed – Cash FMV Accrual – “all events” reasonable certainty Installment Method Basis 40 – Cash 10 + 90 note payable 10 for 9 years. 100-40= 60 60/100 = 60% Take the gross profit ratio and apply it to each payment received. 60% of $10 is $6 of gain each time. Recapture – If you depreciate too much, then all the recapture comes in on the year of sale. You can’t bring it in on the installment method. It is recaptured at rates of ordinary income. Problem 2 Cash - $10, Note $90 and recapture $25 Take the $25 at ordinary income in the year of sale and add that to you basis. So then the gross profit ration is based on a gain of $35 over $100. So 35%. Problem 3 Cash 10, Note 70, Mortgage 20

So now it is 60/80 = 75% Problem 4 Qualifying indebtedness can only be up until the basis. Here there is a mortgage of $60. Cash of 10 and note of 30. The gross profit ratio is 100%. Gain is 60 and sale price minus qualifying debt is 100 – 40 (because the basis was 40 so that is the max of the mortgage that qualifies). 60/60 = 100%. In this case the $20 of mortgage is considered liability in excess of basis an is considered income in the year of sale. OTHER PROPERTY – Money or monies worth. Can be services, debt, relief of debt, contractual right to be paid. ADJUSTED BASIS The basis of the property shall be the cost Problem II A swaps his stock with B. A’s stock is worth 25 but B’s is 26. A’s amount realized is 26 and B’s is 25. The new basis of the property received is the FMV of what was received. 2/22/06 FMV of property received is basis. That way there is symmetry between basis and amount realized. When people make an arms-length transaction then it is assumed to be an equal transaction. If it is unequal then it is simply gains or losses unrealized. If cash is on one side of the transaction then that will obviously drive the value of the transaction. If there is a transaction between a father and son, or when you sell to a charity, those are not arms length so they are looked at more closely. If you transfer stock in small corporations, that is a taxable transaction. If the company you work for gives you stock then it is taxable to the person who gets the stock at the FMV. The basis is what was required to be included as income. If taxpayer pays $1000 for an option to purchase property at $10,000. Then the property goes up to $15,000 so he exercises the option and buys the property. Here the basis is $11,000. There is no income though until he sells it. Holding period for a stock starts the day you exercise it, do not get to tack the option period on. Instead of buying the option, what if you were granted the option. You don’t get taxed on the day of grant, but if your employer granted you the option, when you exercise it and pay $10,000 for $15,000 worth of property then you are considered to have a gain of $5,000. That $5,000 is

considered compensation for your services, because they gave you the option for your services and you made $5,000 on it. If you buy property and give someone $50 cash and a $50 note, even if the note is non-recourse, the basis is $100. PROBLEM II C. (a) (b) A liability is not included in basis. Here the basis in the property is still $100. No income in the $120 either. (c) His basis started at 100. He took 25 of depreciation. So his basis is now 75. (d) AR is 25 in cash plus the 150 in mortgages he got rid of. The FMV of the property is more than the mortgages so the new owner will pay the mortgages. The basis was 75 so the gain is 100. (e) Now we are dealing with a new taxpayer, B. He has a basis of 175. He took 60 in depreciation, so his basis is 115. The property is worth 120, but the mortgages on the property are 140. Since you were not taxed at the time you got the loan, we tax you when you are relieved of that loan. 3/1/06 (e) Basis 175 minus the 60 in depreciation is 115. He got 140 in loans on the property. So his AB is 115 but what is the AR. The FMV is 120 but he got 140 in loans against it. This guy has a cash investment in this property of 35. He took 60 of depreciation deductions. He had a 25 non-cash tax benefit. When you have a non-recourse mortgage the FMV of the property includes the full purchase price unreduced by the mortgages. When you dispose of the property you include the full value of the non-recourse notes. So in this case the AR is 140. On a recourse loan the AR is the FMV of the property. Here it would be 120 and then he would still owe 20 to the bank. If the bank discharges it then it is income from discharge of indebtedness. The income from discharge of debt is not a capital gain because to get a capital gain you need gain from sale or exchange of capital asset. Here there is no sale or exchange. Just discharge of debt. p. 7 in the thin book. #1 – Bought box for 50 and finds out it is worth 5000. No income yet because not realized. 2) If sells it or if trades for meals, that is a realization. 3)

If you have all scattered lots and you want to find the basis in all of them. Find the total value of all the lots and then find the value of one particular lot. Get the percentage proportion, and then use that percentage against the total basis. The allocation is supposed to be at the time of purchase. ON THE FINAL, YOU CAN BRING IN ANYTHING YOU WANT 3/8/06 Tufts says you take the full amount of a non-recourse loan Problem III (a) Section 102 says there is not tax on receipt of gifts. § 1015 - General Rule – Donee’s basis is the donor’s basis. Unless the FMV is less than the donor’s basis, then for purposes of determining a loss use the FMV as the donee’s basis. § 1223 – If donee sells the property and uses for a basis the donor’s basis, then he gets to tack on donor’s holding period for purposes of capital gains. (b) Basis is 55. Use 50 for the amount of the gift because the value was 100 but paid 50. The value of the gift part was 50. Problem III C. Transfer to tax exempt organization. § 1011(b) – Donor transfers the property to charity. His basis was $40 and his amount realized $50 (the amount of the loan). The total value of the property is $200. Here what they do is they say you are not actually selling the whole property for $50, you are only selling ¼ of the property. So your basis on that ¼ of the property is $10, you sold it for $50, so the gain is $40. Still get to take a deduction of $150 but that is neither here nor there. D. Basis of donee when gets property by death is FMV at time of death. Also get automatic long term treatment, no matter how long it is held by either party. Under § 1223 any property sold within 12 months of getting it by devise is treated as long term. 3/22/06 Page 26 in the small book. Chapter 7 Problems Problem III – D. E. Step up basis for the portion got by death, so total basis is $55. F. Double step up in basis. Capital Assets –

What is a sale or exchange? This is a lot smaller than sale or disposition. You have to have a complete disposition of the property. You can not retain any rights in the property. Problem IV – (a) C bought the right to income for $100. He got $200 of income. His gain is $100. Is that a capital gain? Here what is happening is the contract gets cancelled and he gets the money. Under common law that is not the sale or exchange of his contract rights so it is just ordinary income. § 1234 – Gain or loss attributable to the cancellation, lapse, expiration or other termination of a contract right that is linked to property that is considered a capital asset, will be treated as a capital gain or loss. The normal customary meaning of a sale is transfer of property at a fixed price for money or its equivalent. 3/29/06 To have a capital gain you need a complete disposition. You must cash out of the investment. You can retain the burden but none of the benefits. Also, it must be a sale or exchange, so termination or cancellation does not count. It must exist before and after. Also, loss from worthlessness of stock or security is considered to be a sale or exchange. Also a non-business bad debt is treated as a short term capital loss. § 1274 and § 1271 Problem IV A. (b) Capital Gain. It is a sale or exchange. If it took place on Dec. 15 then it would also be a capital gain. (c) (i) This is a sale or exchange – This is a complete disposition, he has no rights, and the property still exists. (ii) No sale or exchange because he still owns the property. (iii) Here there is no consideration paid so it is not a sale or exchange. (iv) (1) and (2) are the same thing. It is a sale or exchange, capital loss of 40. And then also 20 in income from discharge of debt, and that 20 is ordinary income. (v) If the mortgage is non-recourse then it is a capital loss of 20 (d) It seems like this is an ordinary loss because he didn’t sell anything in 1986. But if it is one single integrated transaction (Aerosmith) then the character is the same as in the first one, so this is a capital loss. WHAT IS A CAPITAL ASSET? A capital asset is all property that is not excluded. What is excluded?

1. Stock in trade, aka inventory or property held primarily for sale to customers in the ordinary course of a trade or business is excluded. 2. Real or personal property that is used in a trade or business that can be depreciated is excluded. 3. Copyrightable property that is made by the taxpayer is not a capital asset. 4. Accounts and notes receivable. 5. Supplies that are consumed by the business. 4/5/06 What is a capital asset? Biggest exceptions are 1221(a)1 – Inventory and dealer property is not a capital asset, and 1221(a)2 – Property held in a trade of business that is depreciable or any kind of real property held in a trade or business. Also excluded is copyrightable or other similar property that is made by the taxpayer. This does not apply to the employer because the employer did not make the property. So it is a capital asset. Also excluded are notes and accounts receivable. Government publications are excluded. Supplies that are regularly consumed by the taxpayer are excluded. § 1231 property – General Rule: § 1231 gain > § 1231 loss = all items LTC General Rule: § 1231 gain < or = § 1231 loss = all items are ordinary § 1231 gain or loss is a gain from the sale or exchange of property used in a trade or business. Also any gain from a compulsory or involuntary conversion (condemnation, destruction, theft, etc.). Also any gain or loss from condemnation from an otherwise garden variety capital asset. What is property used in trade or business? Any depreciable property or any real property that is used in trade or business that is held for more than 1 year. When he says 1231(b) property he means depreciable business property or business land that has been held for more than a year. Casualty of § 1231(b) property or casualty of a capital asset held for more that 1 year and held for profit. If the casualty losses exceed casualty gains then § 1231 does not apply. If § 1231 does not apply then it will be an ordinary loss. This section does not cover casualty of a personal asset. For personal casualty losses, you take off $100 and then deduct excess of 10% of AGI.

Special rule when casualty gains exceed casualty losses. All gains are treated from gains from capital assets. PROBLEM SET IV B. (a) (i) 10K gain from sale of capital asset = 10K LTCG (ii) 10K gain from the sale of real property used in T’s trade or business – 1231 b asset = 10K tier 1 = LTCG (iii) 5K loss from the sale of depreciable personal property used in T’s trade or business – 1231 b asset = 5K tier 1 = LTCL (b) (i) 10K gain form the condemnation of T’s personal residence = condemnation is considered a sale or exchange, this is not a casualty because the sovereign doesn’t steel, this is just the sale of your personal residence, it is a long term capital gain. (ii) 10K loss from casualty of non-depreciable personal property used in trade or business = this is a capital asset. (iii) $5K casualty gain of Car = If this was used in a trade or business then it will be 1231 b asset, if not then go to 165 h, and it would be a capital gain. (iv) 5K casualty loss of inventory So Net ii and iii, you get a overall loss, so they are ordinary. If they would have been net gain then they are capital and you move them up to net with other capital gains and losses. The first thing you do is you look for casualties. This is capital assets and 1231 b assets, but you do not have personal use assets. Then you look at these and ask if losses exceed gains. If so then stop here and you have ordinary assets. If gains exceed losses then you move them up and net with gains and losses from 1231 b assets. (c) (i) 5K casualty loss of personal use property = 165 h (ii) 5K loss from abandonment of 1231 property = This is a ordinary loss (iii) 10K casualty gain of 1231 b property, tier 2 (iv) 3K loss from sale of 1231 b property, tier 1 First net we do is 165 h. Just one and gains do not exceed losses so this is just an ordinary loss. Then look at tier 2, here gains exceed losses and then bring those gains up to tier 1 and net again. Gains exceed losses so that is a LTCG. Remember for property to be qualified as 1231 property, it has to be held for more than one year. (d) (i) 10K gain from sale of depreciable real property, if this is trade or business property then it is 1231 b property in tier 1. (ii) 10K loss from 1231 b property, tier 1.

(iii) 10K gain from personal use capital asset = 10K LTCG (iv) 5K loss on condemnation of personal residence = sale of personal capital asset. It is a 5K Capital Loss. This is not a casualty loss so you can not even deduct it. Can’t jump through the hoop. Can only deduct casualty loss or trade or business asset. Now net tier 1 and it is 0. Here gains don’t exceed losses so they are both ordinary. 4/12/06 § 1231 Nature of Prop Disposition § 1231 (b) assets § 1221 capital assets Nature of Prop Disposition § 1231 (b) assets Sale or exchange § 1221 capital asset, condemnation used in trade or business Person Casualty Abandonment LT ST

Long Term

Short Term

Condemnation is treated the same as sale or exchange. Abandonment is real easy, we are not in 1231 and it is not a sale or exchange so it is all going to be ordinary income or ordinary losses. LONG TERM – Sale or exchange or condemnation 1231 (b) assets, if gains exceed losses then capital, and if losses exceed gains then ordinary. For personal, the gains and losses are capital but you can not deduct the losses. LONG TERM – Casualty For personal, if gains exceed losses then all gains are capital, if losses exceed gains then they are ordinary and get to take them under 165(h) (subject to 10% of AGI floor). It is Dec 16, 2006 and someone comes to you and says I have two 1231 (b) assets one with $10,000 gain and one with $20,000 loss. Sell one this year and one the next, that way the loss does not net out the gain. The loss is ordinary and the gain is capital. §1231(c) – If you have $20,000 loss in year one it will be considered un-recaptured 1231 loss. It carries forward for the next five years. If you have a $10,000 1231 capital gain the next year it will be considered ordinary rather than capital gain to the extent you have un-recaptured 1231 losses.

So in the example we just had, you want to sell the gain first, take the capital gain, and then sell the loss next year.

§ 1221 1) Primarily for sale 2) to customers 3) in ordinary course of trade or business Inventory is easy What about someone who inherited land and held it for 30 years? If he got it at 100 and now it is worth 1 million, if he sells it then it would be capital gain taxed at 15%. If he subdivides it and turns into a dealer then it is ordinary income. A dealer is someone who holds property primarily for sale to customers in the ordinary course of trade or business. An investor buys for investment. A stock trader buys and sells more frequently but has no customers, and is not in business. Definition of primarily: it is your prime motive, your first importance. Problem IV C. (a) If subdivide it then may be considered to be a dealer and may have to pay ordinary income, not capital. Not sure. Can sell the property to your own corp and take the capital gains on that, and then have the corp subdivide it and they will be a dealer and get ordinary gains from there. (b) If he is in the business then all he can deduct all losses, but does get long term gains on stocks held over a year. This is because does not meet § 1221, he does not have customers. (c) The corn products case said that the buying and selling of futures was an integrally related part of their business, so no capital gain. (d) If predominant motive of purchasing the stock was for business, then the losses are ordinary losses. Because of section 1223 (1233?) it is a capital loss. If he can show that it was a hedge then ordinary loss. p. 1164. If the transaction is not a hedging transaction, you get capital gains and losses no matter what. There is not exception for motivation or for doing it in trade or business. There is an exception for hedging transactions but . . . If you are selling a lot, then generally you are a dealer. If you are managing stock and bonds for your own account you can never have ordinary income because you don’t have customers. In a hedging transaction, unless you clearly identify it as a hedge, they will be treated as capital assets. (e) If they are selling on a semi-regular basis then it is not a liquidation. The company has a dual purpose, to lease and to sell. They would try to argue that they hold the property primarily

for lease and the sale is incidental, just a way to dispose of it, so the gains are capital. Is this a capital asset or a 1231 asset? A 1231 asset is just depreciable property in a trade or business. If you are in the business of leasing and you sell the equipment at the end of its useful life (by useful life they mean the useful life to the company), then you are liquidating and you are not in a separate business of sale. But if you are selling the property before the end of its useful life then you are in the business of selling. If you are in the business then ordinary income, if not then capital gains. D.     

 

Inventory is 10K gain of ordinary income. The accounts receivable are 3K of ordinary loss. The stock will be 3K of long term capital gain. The real property is not a capital asset under 1221 but it is a 1231(b) asset. We don’t know if it will get long term capital gain treatment or just ordinary income treatment. It is tier 1. Personal property that is depreciated will be re-captured when it is sold. The unrecaptured depreciation is taxed at ordinary income rates. Any excess gain over that will be 1231 gain, any excess loss under that will be 1231 loss. This is 5K of tier 1 gain. And 5K of ordinary income gain. Patent – capital gains treatment of 5K, long term. It is not a 1231 asset. § 1235 tells us how to deal with patents. It depends if he was a holder. If he was a holder it would be long term capital gain. Goodwill – goodwill is a capital asset.

Now net your 1231 and there is a 10K tier 1 gain and a 5K tier 1 gain so those are treated as LTCG. 1245 property – The lower of either your [recomputed basis or (AR if sale, or FMV if other disposion)] / AB will be taxed at ordinary income. What is 1245 property – Personal property that is or was subject to depreciation. 4/22/06 Rental property – Tier 2 – Casualty of 1231(b) property and casualties of capital assets held for more than one year and held in a trade or business or for profit. It does not apply to property that has been held for one year or less or to any personal (not in trade or business) property. Net these first. If a loss then these are ordinary loss and done with these, move to tier 1. If these are a net gain, then move them up to tier 1 and continue. Tier 1 is the hodgepot. This consists of anything moved up from tier 2, and sales or exchanges of 1231(b) property and condemnation of 1231(b) property or condemnation of capital assets held for more than one year.

Casualty of personal use property – If a casualty loss of personal asset then ordinary loss. If personal casualty gains exceed losses then all gains and losses get treated as capital. So then you take each casualty gain or loss and treat it as if it were a sale or exchange of a capital asset, so figure out whether each one is a long term or short term gain or loss. Hypo: Car casualty loss held more than a year of 10K Box of pens casualty gains held less than one year of 20K All we need to know about depreciation. When you take depreciation you must lower the basis. So if you buy a property for 80 and then take 20 in depreciation and sell for 100. The basis is 60 and the profit is 40. But 20 is recapture so that is ordinary income from the start and if you are using the installment method use 80 as the basis and 100 as the total contract price for a gross profit of 20 because you already accounted for the depreciation and that can not be factored into installment method. 4/26/06 § 1031 1) Exchange 2) Held in a trade or business or for investment or for profit 3) For like kind also held in trade or business or for investment or for profit Boot is anything other than property that is not like kind (usually money). You recognize gain, but not in excess of boot. So recognize the lesser of gain or boot. Like Kind – This is in reference to the nature and character of the property. Farmland for a commercial building is ok. Land for Land is ok. A truck for a truck is ok. Machinery for machinery is ok. But gold bullion for a $20 silver coin is not ok. A fee simple for a leasehold is ok as long as the leasehold is over 30 years. The section does not apply to stocks or bonds or anything that is held primarily for sale. Inventory obviously does not count. Interest in a partnership can not be exchanged. Neither gain nor loss is recognized. In § 1031 form always prevails over substance. PROBLEM VI A. Does not count under 1031 because they were held primarily for sale. $20 ordinary income. B. (a) This qualifies as 1031 exchange. T has gain of 25. Did he get any boot? No. So there is 25 realized gain but none is recognized. His new basis is 50. X has a loss of 5 realized but none recognized. His new basis is 80. § 1031(d) tells us how to compute the basis –

OLD AB + Amounts Paid other than exchange property (liabilities assumed, cash, FMV of nonlike kind property given up) – Amounts Received other than exchange property (liabilities relieved, cash, FMV of non-like kind property received) + Gain Recognized – Loss Recognized = New AB (b) Here, as to X 1031 does not apply. He would recognize a loss of 5 due to the sale or exchange. (c) No exchange, 1031 does not apply (d) T has not held the second property in trade or business or for investment so 1031 does not apply. (e) That is a sham exchange because they each wrote check for $75 to each other. This is an exchange. C. You have X with money, T with a farm, and Y with a building. Two ways to do it as a Three Corner Exchange Y X T

Y gives building to X and X gives money to Y Now, X and T exchange the building and the farm OR X Y T First Y exchanges the building and the farm with T. Now, X gives 100 to Y and Y gives farm to X. Four Corner Exchange X has money, T has farm, and Y has building, and you have a 3 rd party accommodator. 3d party takes everything and gives back out to the right people. So for T, his is giving farm to 3rd party and getting the building from him. That is the exchange. D. (a) For T his AR is 110. His AB is 50 + 40 (assumed liability) is 90. His gain is 20. He received property of a like kind and he also received cash in that someone has assumed his mortgage. The regs say that if you get boot from liability relinquished you can net that boot against any cash given up or liability taken on. Go through the formula to find his new AB. 50 + 40 – 40 = 50. The new AB is 50. For X, he has an AR of 110, his AB is 70 so gain realized is 40.

(b) For T his AR is 70 + 50 = 120. His AB is 50 + 40 = 90. Gain = 30 realized. How much is recognized. He is getting 70 in property and then actually netting 10 in boot (50 boot received and 40 boot given). We know is gain is 30 and he has to recognize 10. To figure out his new AB go through the formula. 50 + 40 – 50 + 10 = 50. So he has a property worth 70 with a basis of 50 when all is said and done. And he must recognize 10 in gain. For X his AR is 80 + 40 = 120. His AB is 30 + 50 = 80. Gain = 40 realized. How much is recognized. He has a gain of 40 but a net negative of boot so complete exchange, no gain is recognized. What is his new AB. Use the formula. 30 + 50 – 40 + 0 = 40. (c) For T his AR is 70 + 30 + 10 = 110. His AB is 50 + 40 = 90. Gain of 20 realized. How much is recognized. In mortgage boot he is losing 10. But in cash he picked up 10. But, he can not offset cash boot against liability boot no matter what. In any case where cash is taken out there will be gain recognized. Here he recognized 10 in gain. If there was recapture of depreciation then it would be deferred except to the extent you recognize gain. So if there was more than 10 in recapture then it will be recaptured and the rest will be deferred. What is T’s new AB. 50 + 40 – 40 + 10 = 60. For X his AR is 70 + 40 = 110. His AB is 30 + 10 + 30 = 70. Gain = 40 realized. How much recognized. None, because he was short 10 on the boot, but made it up in cash. You can net cash given with liability received. What is his new AB. 30 + 40 – 40 + 0 = 30


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