Tax-Deferred Exchanges

1. Tax-DeferredExchanges Chapter8

2. Tax-Deferred Exchanges • A tax-deferred exchange postpones gain or loss recognition to the future by adjusting basis of the asset acquired • The longer gain recognition can be postponed the greater the tax savings • The longer a loss is postponed the less valuable the loss

3. Basis Adjustments • Gain is deferred by reducing the adjusted basis of the replacement property by the deferred gain • Loss is deferred by increasing the adjusted basis of the replacement property by the deferred loss • When an asset is sold at a later date, the basis adjustment results in the deferred gain or loss being recognized

4. Basis • Carryover basis – the basis of the original asset follows the asset to the new owner • Substituted basis – the basis of the original asset is substituted for the asset acquired • Holding period of the old asset is added to the holding period of the new asset when basis is determined by carryover, substitution or basis adjustment

5. Like-Kind Exchanges • When eligible property is exchanged solely for other property of a like-kind no gain or loss is recognized (Section 1031) • The gain or loss realized is deferred through an adjustment to the basis of the replacement property • Qualifying property must be used in a business or for investment • Certain properties are excluded: inventory, stock, securities, and partnership interests

6. Like-Kind Exchanges • Realty must be exchanged for realty (can be land or buildings) • Personalty must be exchanged for personalty in same class • General asset classes for personalty include • Office furniture, fixtures & equipment • Computers & info systems equipment • Automobiles & taxis • General-purpose light trucks • General-purpose heavy trucks

7. Like-Kind Exchanges • The receipt of boot can cause realized gain to be recognized • Boot is anything that is not like-kind qualifying property and includes: • Cash • Properties not of a like-kind • Net liabilities discharged in the transaction

8. Like-Kind Exchanges • Gain Recognized = lesser of gain realized or boot received (giving boot does not affect gain recognition) • If the requirements are met, like-kind exchange treatment is mandatory (not elective) and it applies to losses as well as gains

9. Like-Kind Exchanges • Taxpayers with loss assets might want to sell them so they can deduct their losses in the current year, then buy replacement property • Alternatively, taxpayers can receive cash tax-free in an exchange because when there is a realized loss, boot can be received without causing gain recognition

10. Like-Kind Exchanges • Basis in replacement property = FMV of property received less deferred gain plus deferred loss • Alternatively, basis in replacement property = basis of property surrendered plus boot given plus gain recognized less boot received • Holding period for new property includes holding period of property surrendered • Basis of Boot = FMV • Holding period begins on date received

11. Indirect Exchange • In an indirect exchange, the taxpayer hires a third party to purchase the desired property • The third party then exchanges the just-purchased property for the taxpayer’s property • The taxpayer has a qualifying exchange • The seller of the property and the third party must treat the transaction as taxable

12. Nonsimultaneous Exchange • A taxpayer can sell his property, but a third party must hold all proceeds so that the taxpayer has no access to any cash or other property received in the sale • The taxpayer has 45 days from the date the property is transferred to identify like-kind property to be exchanged • The acquisition of the identified property must be completed within 180 days

13. Wash Sales • Wash sale - identical securities acquired within 30 days before or after sale (a 61-day period) • Wash sale losses are disallowed but gains are taxed • Loss is deferred by adding disallowed loss to basis of new shares • If more stock is sold than is purchased within the 61-day period, only a portion of the loss representing the repurchased stock is deferred

14. Involuntary Conversions • An involuntary conversion results from • Theft – embezzlement, larceny and robbery (but not simply losing items) • Casualty – requires a sudden, unexpected, and unusual event including a fire, flood, tornado, hurricane or vandalism • Condemnation – lawful taking of property for its fair market value by government under right of eminent domain

15. Casualties and Thefts • Gains and losses sustained on casualties and thefts are not under a taxpayer’s control so they receive special tax treatment • Allowable losses (including personal losses) are immediately deductible • Gains (due to receipt of insurance proceeds) may be deferred if all insurance proceeds are used to repair the damaged property or to acquire qualifying replacement property

16. Casualty and Theft Losses • Loss limited to the lesser of: • Decline in fair market value (or repair costs to restore property to pre-casualty condition) • The adjusted basis of the property (for completely destroyed business property the loss will always be adjusted basis) • This loss is then reduced by any insurance proceeds received

17. Casualtyand Theft Losses • Thefts deductible in year of discovery • For casualties in disaster areas can elect to deduct loss in preceding year • A net business loss is deducted from ordinary income; an investment loss is a miscellaneous itemized deduction • Individuals have additional limits on losses from personal-use property: • $100 floor per casualty (per event) • 10% of AGI threshold • Must itemize to deduct loss

18. Gains onInvoluntary Conversions • Casualty or theft gains result when insurance recovery is greater than basis • Condemnations usually result in gain because proceeds received are usually fair market value • If all of the proceeds are reinvested in qualified replacement property (or repairing the property to its pre-casualty condition) then the gain is deferred if reinvestment done within replacement period

19. Replacement Period • 2 full tax years after the end of the taxable year in which the involuntary conversion occurs • Extended to 3 years if it involves a condemnation of business or investment realty • If any of the proceeds are not reinvested (either through repairs of the damaged property or by acquiring replacement property within the time period), then gain is recognized on the amount not reinvested

20. Replacement Property • Functional-use test – replacement property provides same function as converted property • Taxpayer-use test – only need to replace with leased property (applies to investment real estate rented and not used by owner) • Condemned business or investment realty only need meet like-kind test

21. Gain Recognition • Gain Recognized = lesser of gain realized or the amount not reinvested (amount realized less amount reinvested) • This provision does not apply to losses • The basis in the replacement property is the cost (amount reinvested) less any deferred gain (gain realized less gain recognized) • Except in the case of direct conversion, involuntary conversion treatment is elective

22. Involuntarily ConvertedPrincipal Residence • If the taxpayer acquires a replacement residence using all the proceeds received, the gain can be deferred • If taxpayer meets 2 year ownership & use tests, can exclude up to $250,000 ($500,000 if both spouses qualify) of gain • These two provisions can be combined to exclude gain on the amount that is not reinvested

23. Transfers to Sole Proprietorships • Gain or loss deferred • Basis of transferred asset to sole proprietorship is lesser of adjusted basis or fair market value at date of conversion to business use

24. Transfers to Corporations • Gain or loss deferred when cash or property is contributed to corporation in exchange for stock • Shareholders contributing qualified property (services do not qualify) must own 80% of stock • Stock received for services results in taxable income to shareholder rendering services • Gain recognized when boot received (gain = the lesser of realized gain or FMV boot received)

25. Transfers to Corporations • Stock basis = basis of property given up + gain recognized less boot received less liabilities assumed by the corporation • Basis carries over to corporation (increased by any gain recognized by shareholder) • Basis of boot received is its FMV

26. Transfers to Partnerships • No gain or loss is recognized by partners or the partnership (with no minimum ownership required) but partners must recognize taxable income attributable to services • Basis of property carries over to the partnership • Partner’s basis in partnership interest = basis of property given up less liabilities assumed by the partnership plus partner’s share of partnership liabilities plus gain recognized • Partner may need to recognize gain to avoid a negative basis (if liabilities assumed by the partnership are greater than partner’s basis including his share of partnership liabilities)

27. Corporate Reorganizations • Involves transfer of all or part of one or more corporation’s assets or stock to a second corporation over which it has control in a transaction that qualifies as a reorganization • Acquisitive – one corporation acquires assets or stock of another corporation • Divisive – one corporation splits into 2 or more corporations • Recapitalization • Reincorporation

28. Corporate Reorganizations • Corporations and shareholders exchange stock for property and stock for stock on a tax-deferred basis • The property or stock received will have a carryover or substituted basis • Boot received will cause all or part of gain to be recognized

29. Reorganizations Appendix 8A

30. Types of Reorganizations • Seven types of reorganizations referred to as Types A through G • Types A, B, and C are acquisitive reorganizations • Types E and F involve only one corporation making technical changes • Types D reorganization can be either divisive or acquisitive • Type G is similar to a D reorganization but applies only in bankruptcy

31. Acquisitive Reorganizations • Generally involves either • The acquisition of one corporation’s assets (target) by a second corporation (acquirer) after which the target ceases to operate • The acquisition of the target corporation’s stock for stock of the acquirer, after which the target becomes a subsidiary of the acquiring corporation

32. Acquisitive Reorganizations • Asset acquisitions • Type A – statutory merger or consolidation • Type C – stock for asset acquisition • Type D acquisitive • Stock for stock acquisition • Type B

33. Acquisitive Reorganizations • Acquirer transfers stock and securities to Target in exchange for Target’s assets • Neither Acquirer nor Target recognizes gain or loss • Acquirer takes the same basis in the assets as their basis in Target’s hands • Target recognizes no gain or loss on the receipt of stock or securities • Target recognizes no gain on receipt of other property as long as it is distributed to its shareholders

34. Acquisitive Reorganizations • Gain is recognized by Acquirer only if it transfers appreciated property other than stock or securities to Target • Target then uses FMV for its basis • No loss is recognized on depreciated property

35. Acquisitive Reorganizations • Target’s shareholders usually recognize no gain or loss on receipt of stock in exchange for their stock in Target • They may be required to recognize gain if principle of securities received exceeds securities surrendered • If shareholders receive boot, they recognize gain equal to the lesser of realized gain or fair market value of boot received • Basis of stock or securities received = basis surrendered – boot received + gain recognized • Basis of boot = fair market value

36. Acquisitive Reorganization • Type B stock-for-stock reorganization • Acquiring corporation acquires Target’s stock from its shareholders in exchange solely for stock of Acquirer • Acquirer can use nothing but its own voting stock to acquire Target’s stock • Neither Acquirer nor Target’s shareholders recognize gain or loss

37. Type A Reorganization • Merger – the acquisition of the assets of a target • Target liquidates and the acquiring corporation continues • Consolidation – transfer of assets by two or more corporations to a new corporation • Transferring corporations liquidate and the new corporation survives

38. Type A Reorganization • Acquirer can use both its stock and securities • Must meet continuity of interest • At least 50% of the shareholders of Target must becomes shareholders of Acquirer • Shareholder of both Acquirer and Target usually must approve the merger • Acquirer becomes liable for all liabilities of the Target

39. Type A Reorganization • Acquirer may transfer assets of Target to a subsidiary • Forward triangular mergers • Subsidiary could be Acquirer with Target shareholders becoming minority shareholders of Target • Subsidiary may acquire assets of Target using stock of Parent

40. Type A Reorganization • Reverse triangular merger • Parent transfers assets of subsidiary (which includes parent’s stock) to Target and subsidiary liquidates and Target becomes new subsidiary of parent • Additional requirements apply

41. Type B Reorganization • Acquisition of Target’s stock in exchange for voting stock of Acquirer • Shareholders of Target become shareholder of Acquirer and Acquirer controls Target (owns 80% of stock) • Parent may also use a subsidiary as Acquirer using stock solely of the parent or it may drop the stock of Target into a subsidiary

42. Type B Reorganization • Prior purchases of stock will not taint the acquisition • Acquirer has up to one year to complete the acquisition of control of Target • Control does not have to be acquired as part of the reorganization

43. Type C Reorganization • Similar to Type A but specific requirements must be met • Acquirer must acquire substantially all the asset of Target solely for voting stock of Acquirer • Must distribute any remaining assets and stock of Acquirer to its shareholders and then liquidate • The assets acquired must permit Acquirer to continue Target’s historical business

44. Type C Reorganization • Acquirer may assume an unlimited amount of Target’s liabilities if only the Acquirer’s voting stock is used in the acquisition • Combination of boot + liabilities assumed cannot exceed 20% of consideration • Only Target’s shareholders must approve the merger and liquidation of Target • Acquirer may drop assets acquired from Target into a subsidiary or subsidiary may use parent stock to acquire Target in a forward triangular merger

45. Type D Acquisitive • Acquirer transfers substantially all of its assets to Target in exchange for stock of Target • Target holds its own assets as well as those of Acquirer • Target stock is then distributed to Acquirer’s shareholders and they received sufficient stock (50%) to control Target • Acquirer may not transfer assets to a subsidiary nor use a subsidiary to acquire Target

46. Type D Divisive • Some (but not all) of original corporation's assets are transferred to a subsidiary and subsidiary’s stock is distributed to shareholder of original corporation • Spin-off – original shareholders received a pro rata distribution of stock and do not surrender stock of the original corporation • Split-off – stock of new corporation is distributed to some of the shareholders in exchange for their stock in the original corporation

47. Type D Divisive • Split-up – all assets of original corporation are split between two or more new companies and the stock of each company is distributed to the shareholders in exchange for their stock in the original corporation • Original corporation goes out of business • Stock can be distributed to shareholders tax-free

48. Type D Divisive • The transfer of assets must result in at least two corporations each of which must conduct an active business immediately after the transfer • Businesses must have been conducted for at least 5 years prior to separation • Sufficient stock and securities of new corporation(s) must be distributed to shareholders so they have at least 80% control • Any other property distributed to shareholders is boot and causes gain to be recognized

49. Type E Reorganization • A recapitalization of an existing corporation • Allows tax-free exchange of common or preferred stock for other common or preferred stock, bonds for other bonds, and bonds for stock • Stock may not be exchanged tax free for bonds as that upgrades a shareholder to a creditor

50. Type F Reorganization • A corporation changes its name, its place of incorporation, or its status from profit to nonprofit or vice versa • Shareholders of the original corporation must continue as shareholders of the reorganization corporation