Property Transactions: Nonrecognition of Gains Or Losses

Chapter 11

Property Transactions: Nonrecognition of Gains or Losses

(Rev 01-11-2017)

Taxable income generally includes gain from the sale or exchange of property. To deduct losses you must rely on statutory permission.

Gains - Gains are taxed on any disposition of property, generally, whether by sale, exchange, or other means of disposition.

Recognition - Recognition refers to when/if you include the gain in your taxable income.

Sometimes Gain on sale may be

·  Deferred:

o  Temporarily not recognized.

o  Examples include exchanges of business property for like kind business property, involuntary conversions and certain stock swaps.

·  Excluded

o  Permanently not recognized.

o  Examples include sales of personal residences and appreciation up to date of death on inherited property.

Sale of Personal Residence (Code Section 121)

·  Rules effective for home sales after May 6, 1997.

Taxpayers may exclude gain from the sale of their principal residence:

·  $250,000 of gain if single, or

·  $500,000of gain if married filing jointly.

To qualify, taxpayers must:

·  Have owned the house two of the last five years,

·  Have occupied the home as their principal residence two of the last five years.

Other Rules

·  This exclusion may be only used once every two years.

·  The basis of the new house is not reduced by the gain excluded.

·  You may elect out of this provision and pay tax on the gain if you wish.

·  Gains over excluded amount are taxable and may not be “rolled over” like in prior law.

·  You may not use the exclusion within five years of acquiring the property through a ‘like kind’ (Section 1031) exchange.

Special Rules for married taxpayers

The exclusion is allowed if:

·  Both meet the USE test, but

·  Only one meets the OWNERSHIP test.

BUT, neither has used their principal residence exclusion in a prior sale within the last two years.

What is a ‘Principal Residence”?

The main home in which the taxpayer lives. Time spent, religious & group affiliations, licensing, insurance, voting are all factors considered.

·  May only have one principal residence at a time.

Proration of Exclusion

·  If the 2 year rule cannot be met because of health, job loss, transfer, or other ‘unforeseen circumstances’, may exclude a portion of the maximum gain ($250k/$500k) based on (number of months of residency over 24 months).

Widowed Taxpayers

·  May exclude the full exclusion of up to $500,000 if home is sold within two years of spouses’ death.

·  Spouse will get ‘stepped up basis’ as well on deceased spouse’s share, if applicable.

Divorced Taxpayers

If a taxpayer receives the home from an ex-spouse as a property settlement, the time the ex-spouse owned the home is added to the taxpayer’s time of ownership.

If the ex- spouse keeps their name on the title but allows the other spouse to live in the house, he/she will still be allowed to consider it their principal residence, if stated under the terms of the divorce decree or separation instrument.

Co-Ops

Ownership of ‘shares’ in a co-op is treated as ownership of (principal) residence.

Taxpayers in Nursing homes

If a taxpayer becomes incapacitated, and needs to go into a nursing home or similar facility, he/she only needs to have owned and lived in the principal residence one out of five years to qualify for exclusion.

Terms

Gain/Loss

·  Amount Realized minus Adjusted Basis.

Amount realized

·  Selling price less selling expenses.

Selling Expenses

·  Advertising, broker costs, legal fees, closing cost credits, etc. paid by the seller. The HUD-1 Statement reports all expenses, etc.

Adjusted basis

·  Cost plus improvements minus depreciation claimed, less any gain excluded under prior (pre-1997) law.

Like Kind Exchange

·  No gain or loss is recognized where property held as a trade/business is exchanged solely for property of a like-kind also used in a trade or business. IRC section 1031.

·  Like-kind means of same nature, class or character:

o  IRS is somewhat liberal; any real property can be exchanged for any other real property.

o  Does not apply to inventory, stocks & bonds, debt securities, partnership interests, etc.

Gains from exchanges not solely in kind (‘Boot’)

·  If the transferor in a Sec 1031 exchange receives Boot, no loss is deductible and realized gain is recognized to the extent of the boot received.

·  Transferor of the property subject to a mortgage (or any liability) is deemed to have received cash in the amount of the mortgage.

·  Basis of the property acquired is the same as the adjusted basis of the property transferred, plus any gain recognized, minus the sum of boot received, e.g.

Transferor gives a car with an adjusted basis of $10,000

Receives a car with a FMV of 15,000

and cash of 2,000

Total amount realized is $17,000

Gain realized is ($17,000-$10,000) $7,000

Gain recognized (extent of boot received) $2,000

Basis of new car: Transferred basis $10,000

Plus gain recognized 2,000

Less the boot received ( 2,000)

Basis of new vehicle $10,000

Same Data, but No Boot:

Gain realized $5,000

Gain recognized -0-

Basis of new vehicle $10,000

Same data but no boot and FMV of new vehicle is only $8,000

FMV of property received $ 8,000

Basis of property given 10,000

Loss realized (2,000)

Loss recognized - 0 -

Basis of new vehicle $10,000

v  Thus, losses on 1031 exchanges are never recognized; unless on boot given which will be the adjusted basis of boot less the FMV of the of the boot

Basis of 1031 Property

Basis of like kind property given

Minus Boot received

Plus gain recognized

Equals Basis of new property

Three-Cornered ("Starker”) Exchanges

·  Often, you can’t find another person with whom to do a direct swap.

·  You can use a third person, a “qualified intermediary” to facilitate the exchange.

·  The sales do not have to be simultaneous, but must be completed w/in 180 days.

·  Property to be acquired must be ‘identified’ within 45 days.

·  This is also called three way or three-cornered exchanges.

·  The taxpayer can have no access to cash or the /proceeds during the period of the exchange.

·  Any cash the taxpayer receives will be considered boot received and is taxable.

Involuntary conversions

·  Include amounts received in a condemnation, or on the sale under threat of condemnation, etc.

·  If the taxpayer receives similar property in an involuntary conversion, gain is not recognized, but deferred until the subsequent sale of the new property.

·  If the taxpayer receives dissimilar property (e.g. cash) and replaces it with similar property within two years following close of tax year in which gain is realized, the taxpayer may elect to defer any gain to the extent proceeds do not exceed replacement cost.

·  Similar property means similar use (not functionally similar, which the IRS likes), so rental property should be replaced with rental property.

·  Losses from involuntary conversions may not be deferred unless 1031 property.

Basis of Property

·  In a direct exchange, no gain is recognized and the basis of the new property becomes the basis of the old property (a “substituted basis”).

·  In a non-direct exchange, and gain was deferred, the basis of new property is the cost of the new property less any gain deferred.

Severance Damages

·  Sometimes government may condemn only part of a property and leave the rest. They then may pay you “severance damages” for the reduction in value of the portion you have left.

·  Severance damages reduce the basis of the property damaged (what is left), and if damages exceed the basis, the excess is taxable gain.

Qualifying Replacement Property

·  The rules are more strict than for a like-kind exchange property.

·  The replacement property must meet a “similar in related service or use” test.

·  New property must be used in the same way as the old property was used.

Condemnation of Real Property

·  Slightly more liberal than other involuntary conversion rules.

·  May use like kind rules for replacement property.

Time Limit for Acquiring Replacement Property

·  Generally, the condemned property must be replaced within two years from close of the first taxable year in which the gain is realized.

·  Real property must be replaced within three years.

·  In a Presidentially Declared Disaster area, the property may be replaced within four years.

Reporting in the year of deferral

·  Taxpayers should include a schedule of supporting details showing the transaction and the gain or loss calculation.

·  If the taxpayer fails to acquire replacement property, or doesn’t spend all the proceeds, they must amend the original return, paying any tax and interest due.

Depreciation rules for property acquired in a like-kind exchange or Involuntary conversion:

·  The basis carried over from the old asset continues to be depreciated using its old depreciation system.

·  Treat the excess basis of new property acquired as a separate asset that was newly acquired.

·  Taxpayer may elect to treat the entire property as a newly acquired property and only depreciate one thing.

Other Non-Recognition Provisions

·  Contributing property to a partnership or corporation.

·  Stock for stock exchanges in same corporation.

·  Insurance Contract Exchanges.

·  Qualified Corporate re-organizations.

Reacquisition (Repossession) of Real Property:

·  Losses on repossessions are not recognized.

·  Gain on repossession is recognized only to extent of cash received less gain already included in income. Gain is limited to gain on original sale less repossession costs and gain already recognized.

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