Exam 1 Chapter 9 Review

Involuntary Conversions Defer Condition 1

A taxpayer who realizes a gain on the involuntary conversion of property can elect to defer the gain if two conditions are met. First, the taxpayer must reinvest the amount realized on the conversion (the insurance or condemnation proceeds) in property similar or related in service or use. This condition requires taxpayers to replace their original property to avoid paying tax on the realized gain. Both the IRS and the courts have been strict in their interpretation of the concept of similar or related property. For instance, the IRS ruled that a taxpayer who owned a land-based seafood processing plant that was destroyed by fire and who used the insurance proceeds to purchase a floating seafood processing vessel was ineligible for nonrecognition treatment because the properties were not similar in function.

Compute gain recognized when boot is received in a nontaxable exchange cont

Because Firm A must recognize an $8,000 gain, it can increase its basis in its new assets by this amount. In other words, Firm A's investment in the new assets has increased to $148,000 ($140,000 basis in the surrendered property plus $8,000 gain recognized). Firm A must allocate this $148,000 basis between the two assets acquired: $8,000 cash and the qualifying property. Cash always takes a basis equal to monetary value. Consequently, only $140,000 of basis is allocated to the qualifying property. This $140,000 basis can also be derived by subtracting Firm A's $52,000 deferred gain from the $192,000 FMV of the qualifying property. The modification to the substituted basis rule when boot is received in a nontaxable exchange is summarized as follows: Basis of qualifying property surrendered +Gain recognized -(FMV of boot received) =Basis of qualifying property acquired

Exchanges of qualifying property

Every nontaxable exchange transforms one property interest into another. The type of property that can be swapped tax free depends on the unique qualification requirements of the relevant IRC section. But only the disposition and receipt of qualifying property can be a nontaxable exchange. Given that the exchange involves only qualifying property, it is nontaxable to both firms. What else do we know about this exchange? Assuming that Firms A and B are unrelated parties dealing at arm's length, they must have agreed that the properties are of equal value. To quantify the respective tax consequences of the exchange to each firm, we must know the FMV of the property received and the page tax basis in the property surrendered. This information is presented in Exhibit 9.2. Because Firm A disposed of property with a $140,000 basis in return for property worth $200,000, it realized a $60,000 gain. Because the exchange involved qualifying property, Firm A does not recognize any gain in the current year. Similarly, Firm B's disposition of qualifying property with a basis in return for qualifying property worth resulted in a $185,000 basis in return for qualifying property worth $200,000 resulted in a $15,000 recognized but unrealized gain.

Compute gain recognized when boot is received in a nontaxable exchange.

Firm A: FMV: $200,000 Basis $140,000 Firm B: FMV: $192,000 Basis: $185,000 In tax terminology, any cash or nonqualifying property included in a nontaxable exchange is called boot. The presence of boot does not disqualify the entire exchange. Instead, the party receiving the boot must recognize a portion of realized gain equal to the FMV of the boot. Refer to Exhibit 9-3 in which the FMV of the property surrendered by Firm B was only $192,000. For Firm A to agree to the exchange, Firm B had to pay $8,000 cash so that Firm A received $200,000 total value in exchange for its asset worth $200,000. In this case, Firm A received $8,000 boot and must recognize $8,000 of its $60,000 realized gain.

Neutrality of Nontaxable Exchange

Firm T, which has a 21 percent marginal tax rate, owns an investment asset with a $50,000 basis and a $110,000 fair market value (FMV). The asset generates $6,600 annual income, which represents a 6 percent return on FMV. Firm T is considering selling this asset and reinvesting the proceeds in a new venture that promises a 6.7 percent return on capital. If the sale of the investment asset is taxable, Firm T will have only $97,400 after-tax proceeds to reinvest. Amount realized on sale $110,000 Basis in investment asset $(50,000) Gain realized and recognized =$60,000 .21 Tax Cost =$12,600 After-tax cash ($110,000 - 12,600)=$97,400 The annual income from a $97,400 investment at a 6.7 percent rate of return is only $6,526. Therefore, Firm T should not undertake the sale/reinvestment because of the front-end tax cost. On the other hand, if the conversion of the investment to an equity interest in the new venture can be accomplished with no front-end tax cost, the new investment is superior to the old, and Firm T should undertake the sale/reinvestment.

Involuntary Conversions

Firms generally control the circumstances in which they dispose of property. Occasionally, a disposition is involuntary; property may be stolen or destroyed by a natural disaster such as a flood or a fire. If the property is not insured or if the insurance proceeds are less than the property's adjusted basis, the owner can deduct the unrecovered basis as an ordinary casualty loss. However, if the property is insured and the insurance proceeds are more than the adjusted basis, the disposition actually results in a realized gain. Another example of an involuntary conversion is a condemnation of private property by a government agency that takes the property for public use. If a government has the right of eminent domain, it can compel an owner to sell property to the agency for its FMV. If the condemnation proceeds exceed the basis of the condemned property, the owner realizes a gain.

Explain book/tax differences related to nontaxable exchanges.

For financial reporting purposes, gains and losses realized on property exchanges often are included in income. In such cases, nontaxable exchanges cause a difference between book income and taxable income. The book basis of the property received in the exchange (the property's FMV) is different from the property's tax basis. Consequently, the book/tax difference caused by the exchange is temporary and will reverse as the newly acquired property is depreciated or when it is disposed of in a taxable transaction.

Book/ Tax Difference from Nontaxable Exchange

Hogan Inc. exchanged old property ($138,200 book and tax basis) for new property ($210,000 FMV). Hogan's $71,800 realized gain was included in book income but was not recognized as taxable income because the old and new properties qualified for nontaxable exchange treatment. Hogan's depreciable book basis in the new property is $210,000, and its depreciable tax basis is only $138,200. Therefore, the $71,800 excess of book income over taxable income resulting from the exchange will reverse as future excesses of book depreciation over MACRS depreciation.

9-6

Read these in the textbook

Summary

The Internal Revenue Code contains an assortment of nontaxable exchange provisions with different definitional and operational rules. Nonetheless, these provisions share the following generic characteristics: -The exchange must involve qualifying property, as defined in the provision. -The gain or loss realized on the exchange is deferred. -The basis of the qualifying property received equals the basis of the qualifying property surrendered (substituted basis rule). -The receipt of boot gains recognition to the extent of the boot's FMV.

Compute gain recognized when boot is received in a nontaxable exchange cont 2

The fact that Firm B paid boot in the exchange did not cause it to recognize gain. Firm B surrendered property with an aggregate basis of $193,000 ($8,000 cash + $185,000 basis of surrendered property) to acquire property worth $200,000. As a result, Firm B realized a $7,000 gain, none of which is recognized. Firm B's basis in the new property is $193,000, the aggregate basis of the cash and property surrendered. This $193,000 basis equals the $200,000 FMV of the new property less $7,000 deferred gain. The substituted basis rule when boot is paid in a nontaxable exchange is summarized as follows: Basis of qualifying property surrendered +FMV of boot paid =Basis of qualifying property acquired

Explain the underlying tax concepts of a nontaxable exchange transaction.

The nontaxable exchange provisions are extremely useful because they allow taxpayers to convert property from one form to another without a tax cost. In other words, a nontaxable exchange provision makes the tax law neutral with respect to certain business and investment decisions.

Involuntary Conversions Defer Condition 2

The second condition is that replacement of the involuntarily converted property must occur within the two taxable years following the year in which the conversion place. Thus, taxpayers making the deferral election usually have ample time to locate and acquire replacement property. If the cost of replacement property equals or exceeds the amount realized on an involuntary conversion, none of the taxpayer's realized gain is recognized. If the taxpayer does not reinvest the entire amount realized in replacement property (i.e., the taxpayer uses some of the insurance or condemnation proceeds for other purposes), the amount not reinvested is treated as boot, and the taxpayer must recognize gain accordingly. In either case, the basis of the replacement property is its cost less unrecognized gain. As a result, unrecognized gain is deferred until the taxpayer disposes of the replacement property in a future taxable transaction. The involuntary conversion rule provides relief to taxpayers deprived of property through circumstances beyond their control and who want nothing more than to return to the status quo by replacing that property. The rule applies to the involuntary conversion of any type of asset. Moreover, the rule is elective; taxpayers who would benefit by recognizing the entire gain realized on an involuntary conversion may do so.

More on boot

Two more facts concerning boot should be mentioned. First, the receipt of boot can never trigger recognition of more gain than the recipient realized on the exchange. For example, if Firm A received $70,000 cash and qualifying property worth $ 130,000, the receipt of $70,000 boot would trigger recognition of the entire $60,000 gain realized. (After all, Firm A would recognize only $60,000 gain if it sold the property for cash!) In this case, Firm A's basis in the qualifying property would be $130,000 ($140,000 basis of qualifying property surrendered + $60,000 gain recognized - $70,000 boot received). Second, the receipt of boot does not trigger loss recognition. Consider the new set of facts in Exhibit 9-4 in which Firm A surrendered qualifying property with a $230,000 basis in exchange for $8,000 cash and qualifying property worth $ 192,000. As a result, it realized a loss, none of which is recognized. Firm A's $230,000 basis in the surrendered property must be allocated between the $8,000 cash received and the new property. Because the cash absorbed $8,000 of the substituted basis, Firm A's basis in the qualifying property is ($230,000 basis of qualifying property surrendered — $8,000 boot received). This basis can also be derived by adding Firm A's $30,000 deferred loss to the S 192,000 FMV of the property.

Neutrality of Nontaxable Exchange cont.

Unfortunately for taxpayers in the same strategic position as Firm T, tax neutrality for asset exchanges is the exception rather than the rule. An asset exchange is taxable unless it meets the requirements of one of the nontaxable exchange provisions scattered throughout the Internal Revenue Code. These requirements vary substantially across provisions. Some nontaxable exchange provisions are mandatory, while others are elective on the part of the taxpayer. Some apply only to realized gains, yet others apply to both realized gains and losses. Certain provisions require a direct exchange of noncash assets, while others allow the taxpayer to be in a temporary cash position. Nevertheless, all the nontaxable exchanges share several characteristics. We begin the chapter by analyzing these common characteristics in the context of a generic exchange. By doing so, we can focus on the structure of nontaxable exchanges before considering the details of any particular exchange.