8 - 1 ©2004 Prentice Hall, Inc. Tax-Deferred Exchanges Chapter 8

8 - 1©2004 Prentice Hall, Inc.

Tax-DeferredExchanges

Chapter 8


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


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


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


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


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


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


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


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


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


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


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


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


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


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


Casualty and Theft Losses

Loss limited to the lesser of:1. Decline in fair market value (or repair costs

to restore property to pre-casualty condition)

2. 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


Casualty and 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


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


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


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


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


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


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


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)


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


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)


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


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


Reorganizations

Appendix 8A


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


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



Asset acquisitions Type A – statutory merger or consolidation Type C – stock for asset acquisition Type D acquisitive

Stock for stock acquisition Type B



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



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



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


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


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



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



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



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


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


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


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


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


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


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


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


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


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


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


Type G Reorganization

Allows transfer of assets to a new corporation as part of bankruptcy proceedings

Stock or securities are distributed to the shareholders in a manner resembling a D reorganization


Other Considerations

Requesting an advance ruling on the tax consequences is advisable

Must have a sound business purpose Must be a continuity of ownership by

shareholders of the participating corporations Must be a continuity of business enterprise Status of target’s NOLs and other attributes

must be considered


The End

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8 - 1 ©2004 Prentice Hall, Inc. Tax-Deferred Exchanges Chapter 8