8 - 1

Tax-DeferredExchanges

Chapter 8

8 - 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

8 - 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

8 - 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 substitutes for basis of 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

8 - 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 by adjusting 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

8 - 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

8 - 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 - 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

8 - 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

8 - 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

8 - 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

8 - 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

8 - 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 taxedLoss 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

8 - 14

Involuntary Conversions

An involuntary conversion results fromTheft – 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

8 - 15

Casualties and Thefts

Gains and losses sustained on casualties and thefts are not under a taxpayer’s control so they receive special tax treatmentAllowable losses (including personal losses) are

immediately deductibleGains (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

8 - 16

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

8 - 17

Casualty and Theft Losses

Thefts deductible in year of discovery Casualty losses deducted in year loss

occursException: casualty losses in disaster areas

can be deducted electively in preceding year A net business loss is deducted from

ordinary income An investment loss is a miscellaneous

itemized deduction

8 - 18

Casualty and Theft Losses

Individuals have additional limits on losses from personal-use property$100 floor per casualty (per event) for 2010 ($500

for 2009)10% of AGI thresholdMust itemize to deduct loss

If the loss is in a presidentially declared disaster area in 200910% of AGI threshold does not applyTaxpayers who claim the standard deduction can

add this casualty loss to their standard deduction

8 - 19

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 Gain is deferred if reinvestment done within

replacement period

8 - 20

 Replacement Period

2 full tax years after the end of the taxable year in which gain is realized on the involuntary conversion

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 recognized is the lesser of realized gain or the proceeds not reinvested

8 - 21

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 needs to meet like-kind test

8 - 22

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, nonrecognition of gain is elective

8 - 23

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 all or part of the amount that is not reinvested

8 - 24

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

8 - 25

Transfers to Corporations

Gain or loss deferred when cash or property is contributed to corporation in exchange for stock Shareholders contributing qualified property

must own 80% of stock (services do not qualify)

Stock received for services results in taxable income to shareholder rendering services

Gain recognized when boot received Gain = lesser of realized gain or FMV boot

received

8 - 26

Transfers to Corporations

Stock basis = Basis of property given up

+ Gain recognized - Boot received - Liabilities assumed by the corporation

Basis carries over to corporation (increased by any gain recognized by shareholder)

Basis of boot received is its FMV

8 - 27

Transfers to Partnerships

No gain or loss is recognized by partners or the partnership (no minimum ownership required) Partners must recognize taxable income

attributable to services Basis of property carries over to the partnership 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 or her share of partnership liabilities)

8 - 28

Partner’s basis in partnership interest = Basis of property given up

+ liabilities assumed by the partnership- partner’s share of partnership

liabilities+ gain recognized

Transfers to Partnerships

8 - 29

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 reorganizationAcquisitive – one corporation acquires assets

or stock of another corporationDivisive – one corporation splits into 2 or

more corporationsRecapitalizationReincorporation

8 - 30

Corporate Reorganizations

Corporations and shareholders may exchange stock for property or 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

8 - 31

Reorganizations

Appendix 8A

8 - 32

Types of Reorganizations

Seven types of reorganizations referred to as Types A through GTypes A, B, and C are acquisitive reorganizationsTypes E and F involve only one corporation

making technical changesType D reorganization can be either divisive or

acquisitiveType G is similar to a D reorganization but applies

only in bankruptcy

8 - 33

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

8 - 34

Acquisitive Reorganizations

Asset acquisitionsType A – statutory merger or consolidationType C – stock for asset acquisitionType D – acquisitive

Stock for stock acquisitionType B

8 - 35

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 securitiesTarget recognizes no gain on receipt of other

property as long as it is distributed to its shareholders

8 - 36

Acquisitive Reorganizations

Gain is recognized by Acquirer only if it transfers appreciated property other than stock or securities to TargetTarget then uses FMV for its basisNo loss is recognized on depreciated

property

8 - 37

Acquisitive Reorganizations

Target’s shareholders usually recognize no gain or loss on receipt of stock in exchange for their stock in TargetThey 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 FMV of boot received

Basis of stock or securities received = basis surrendered – boot received + gain recognized

Basis of boot = FMV

8 - 38

Acquisitive Reorganization

Type B stock-for-stock reorganizationAcquiring 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

8 - 39

Type A Reorganization

Merger –acquisition of the assets of a targetTarget liquidates and the acquiring

corporation continues Consolidation – transfer of assets by two or

more corporations to a new corporationTransferring corporations liquidate and the

new corporation survives

8 - 40

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 become shareholders of Acquirer

Shareholder of both Acquirer and Target usually must approve the merger

Acquirer becomes liable for all liabilities of the Target

8 - 41

Type A Reorganization

Acquirer may transfer assets of Target to a subsidiary

Forward triangular mergersSubsidiary could be Acquirer with Target

shareholders becoming minority shareholders of Target

Subsidiary may acquire assets of Target using stock of Parent

8 - 42

Type A Reorganization

Reverse triangular mergerParent transfers assets of subsidiary (which

includes parent’s stock) to Target and subsidiary liquidates and Target becomes new subsidiary of parent

Additional requirements apply

8 - 43

Type B Reorganization

Acquisition of Target’s stock in exchange for voting stock of AcquirerShareholders of Target become

shareholders 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

8 - 44

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

8 - 45

Type C Reorganization

Similar to Type A, but specific requirements must be met

Acquirer must acquire substantially all the assets 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

8 - 46

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

8 - 47

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 receive sufficient stock to control Target (50%)

Acquirer may not transfer assets to a subsidiary nor use a subsidiary to acquire Target

Type D Acquisitive

8 - 48

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 corporationSpin-off – original shareholders receive 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

8 - 49

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 businessStock can be distributed to shareholders

tax-free

8 - 50

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 transferBusinesses 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

8 - 51

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

8 - 52

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 reorganized corporation

8 - 53

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

8 - 54

Other Considerations

Requesting an advance ruling on the tax consequences is advisable

Reorganization must have a sound business purpose

Must have continuity of ownership by shareholders of the participating corporations

Must have continuity of business enterprise Status of target’s NOLs and other attributes

must be considered

8 - 55

The End