Income Tax I
Bogdanski
Fall 2009

Sample Answers to Question 1

Exam No. 3256

Transaction 1: Purchase of the Rental home

First, Mark’s rental home has a fair market value (FMV) of $350,000. Mark’s basis in the home is $353,000 (his 35,000 out of pocket, $315,000 borrowed, and the attorney’s fees and transaction costs). The attorney’s fees and transaction costs are not deductible but must instead be included in the basis of the property pursuant to IRC §1001. At this time Mark receives no income (loans are not considered income since there is a duty to repay the loan).

Depreciation and Repairs:

The depreciation taken during 2005 through 2009 reduces Mark’s basis in the rental home to $293,000 ($353,000-60,000). The repairs and maintenance done on the house during this period, Mark may deduct (they are ordinary and necessary, and do not add substantial value to the property). Furthermore, Mark can deduct any state and local property taxes associated with the rental home (these will be above the line deductions).

Tina “like kind exchange:

The proposed exchange with Tina is most likely a “like kind exchange” governed by IRC §1031. Although Tina’s property is a lease and Mark’s is held in fee simple, the code allows for leaseholds of 30 years or longer to be treated as similar property. Also, the properties are used in business (commercial) and need only be similar in nature or character, not grade or condition. In this like kind exchange, Mark will realize a gain of $107,000 ((amount realized: $310K on the mortgage debt released + 90K FMV of Tina’s property) – (Mark’s adjusted basis $293K in the rental property)). Under IRC §1031(d), the mortgage on Mark’s house is treated like “boot” for all calculations. This has tremendous consequences on not only Mark’s realized gain, but also on his basis for the warehouse lease he will receive in exchange on the deal. In calculating his new basis Mark will take his old basis ($293K) and subtract any money received ($310K in boot), and add any recognized gain ($107K). This results in his new basis being $90K in a piece of property with a FMV of $90K.

Leila “gift”

If Mark were to make the property a gift to Leila, Mark would realize a gain of $17,000. His adjusted basis is $293,000, while he would be released of $310,000 of debt on the mortgage. Under IRC § 1250, the gains are capital, but only to the extent of the depreciation previously taken ($60,000) and the maximum rate is 25% rather than 15%.

Exam No. 3399

Property ownership

Mark acquired the home with a cost basis of the $350,000 he paid regardless of the method of obtaining the purchase money. The $315,000 given to him by the commercial lender is not income because it is loaned money he will have to pay back with his money later which will have already been subject to taxation. Similarly, the principal payments he makes on the loan will not be deductible as he already that received basis in the property.

Mortgage interest for the rental property is one of few forms of personal interest allowed as a deduction under §163(h). It appears Mark has some sort of rental business. Accordingly, the mortgage interest would be an ordinary and necessary expense. Under either, it would be deducted above the line. The property taxes paid on rental property are also be deductible above the line. The repairs and maintenance, assuming they were routine and not responsible for the increase in value of the property, were above the line deductible business expenses in the years they occurred. The $3000 transaction costs can be included in his cost basis, bringing it to $353,000. From that, he took $60,000 in depreciation leaving him with $293,000 in basis now.

Tina’s exchange

Non-recognition of gain or loss in exchange of like-kind property is not an election, but mandatory for all such transactions under §1031. Mark is giving up property held for business or investment, as it was used exclusively as a rental rather than for personal use. He is receiving property that will be held for business or investment as presumably he won’t personally use an out-of-state warehouse. It is a swap for a like-kind asset. Reg 1.1031(a)-1 says that all domestic real estate is like-kind, whether commercial or residential, developed or undeveloped, etc. The leasehold with 35 years remaining is considered like-kind with ownership.

In the exchange, he would receive $90,000 in FMV in the warehouse and as in Crane, $310,000 realized by Tina’s assumption of the mortgage. He’d realize $400,000 minus his $293,000 basis, regardless of his “equity.” Of this, he would recognize only the amount of gain up to boot, but here the assumption of the $310,000 mortgage is the boot, so he’d recognize all of his gain as a capital gain. His basis in the new property would be $293,000 – 310,000 boot + $107 gain recognized = $90,000.

Gift to Leila

Alternatively, he could “give” the property to Leila, but this would be a transaction that is treated as both a gift and a sale. He would be receiving the $310,000 assumption of the mortgage. He’d realize a capital gain of $17,000 on the $310,000 sale component and then give the remaining $90,000 worth of FMV property to Leila. He, as the donor, would then be subject to paying gift tax to the extent there is any depending on his other circumstances outside the scope of this class. Leila would get the $310,000 cost basis, but unlike Deidrich, Mark has no basis left to carryover into the gift component and as she hasn’t paid the gift tax, she would get basis for that either.

Exam No. 3572

Transaction one – the purchase of the rental property in 2005

When Mark bought the property for $350,000, his basis in the property became that amount. Basis includes both money you put down yourself and money you borrowed. Here, the transaction costs that were paid are part of the $350k basis, and are not subtracted. There is no amount realized at this point, no income at all from the facts we are given. The acquisition mortgage is currently $315,000.

Transaction 2 – rental 2005-2009

Since this is a rental property and not a personal residence, and therefore is used for business, Mark can property depreciate the property for wear and tear pursuant to the terms of the IRC. Here, the facts say he has properly done so. When he takes depreciation, the basis of the property is adjusted by the amount he depreciates. (Depreciation of a deduction of ordinary income). Therefore, by the end of 2009, his basis in the rental is now $350,000 minus $60,000, which equals $290,000. If Mark had made improvements to the rental, he would have had to capitalize such expenses by adding them to the basis. Here, there were no improvements, only repairs and maintenance. The repairs were properly deducted each year, as this is a business property and such a deduction is allowed. This has no effect on his basis.

The current balance of the mortgage principal is $310,000 because Mark has paid back $5000 of principal. Certainly most of Mark’s mortgage payments have consisted of interest payments, which he would have deducted from his tax return. If there were a personal residence, Mark would only be able to deduct the interest is he itemized his return. Mark may also deduct utility bills and insurance payments from his tax return that his incurred with this rental property, unlike a personal residence.

Even though the property has appreciated by $50,000 (current FMV of $400,000 minus sale price of $350,000), appreciation of year property is not a realizing event and there are no tax consequences.

Transaction 3 – proposed exchange

The kind of exchange contemplated by Mark is a 1031 exchange, where property held in a trade or business or for investment is exchanged for other like-kind property. While there is realization, there is no recognition of gain. Mark holds his rental in business, and he wishes to exchange for a leasehold on a warehouse which he would then hold for business (subleasing to a manufacturing company). The other side, Tina, is a dealer in real estate, and as such, she does not qualify for the 1031 non-recognition, but Mark still will if he trades with a dealer.

I believe that this is a like-kind exchange of real property interests. Doesn’t matter that it’s in a different state, as long as in US. (I think a lease interest will work – I have not taken property and do not know if this really is like-kind, which seems to be really broad for real property.) And no money will exchange hands. Therefore, the exchange should work for Mark.

In order to determine Mark’s basis in the new lease-hold, we have to apply three steps. First, what gain or loss is realized (1001). The amount realized by Mark is the fair market he receives, which is $90,000, the fair market value of the leasehold, plus the value of the mortgage (310,000), (per Crane) which Tina will assume, which equals 400,000. This is subtracted from his adjusted basis in the rental, $290,000. The gain by Mark is $110,000. The next step is to determine how much gain is recognized. He will recognized any “boot” received, which is non-like-kind property, up to the amount of gain realized. Boot here is the mortgage Tina will assume, which is $310,000, but the gain for Mark can only be up to the amount realized, $110,000. The third step is to figure out the new basis. You compute this by taking the old basis, $290,000, minus cash received (this includes the assumed mortgage) of $310,000, plus the gain recognized of $110,000, which equals $90,000.

With the recognized gain, there is a special provision for the amount of the gain which was due to his earlier depreciation. Per 1250, the gains are still capital, but for the $60,000 of depreciation, the rate will be 25% instead of 15%.

Because did not hold high FMV, low basis property, this might not be ideal for him, but it should work.

Transaction 4 – gift

If Mark gives the rental home to his daughter, it is a gift. A gift is given with detached, disinterested generosity, and is not a realizing event, and usually the recipient receives a carry-over basis from the donor. Since it’s a gift between family members for a wedding, it seems clear that the IRS would agree that this is a gift.

But here, Leila will not only receive the rental, but also assume the mortgage, which is an obligation of Mark. This is not discharge of indebtedness, because the debt will be paid to the lender, so that is not an issue. Doesn’t matter what kind of mortgage it is (recourse or non). However, this situation reminds me of Diedrich were the children were given stock by the parents and had to pay the gift tax on the stock. The basis there was also less than the amount of the obligation. There, the court found that the stock was only a partial gift, partial sale, which was a taxable event for the parents. Here, the amount of the mortgage is $310,000. Therefore, it is as if the daughter is paying $310,000 for real property with the carry-over basis of $290,000. Pursuant to Diedrich, the father would then have a taxable capital gain of $20,000 for the gift. As stated earlier, the gain would be subject to a rate of 25% rather than 15% since it is recapture of depreciation. I am not sure what the new basis for the daughter would be in the property, which currently has a FMV of $400,000. It would not be $400,000, and I don’t think it would be the carry-over basis $290,000, but instead would be the $310,000 value of the mortgage, which is what she had to pay to obtain the property. The $90,000 gain would still be in the property to be taxed at sale.

If the amount of the adjusted basis had been more than the mortgage debt, then this would not have been a realizing event at all, and the basis would have been the carry-over basis. No one would have taken the loss in that situation.

For Mark, the tax consequences of the gift is less severe. But he is losing all equity in the property that he got just by virtue of it being a good market.

Exam No. 3242

Dear Mark:

Below you will find a discussion of the income tax consequences of your 2005 purchase, the effects from the rental period of the property, as well as the proposed tax consequences of either exchanging the property with Tina or giving the property to your daughter.

When you purchased the house back in 2005, you had a basis of $353,000 in the property. This comes from the $35,000 amount of cash you put into the property, the $315,000 mortgage assumed on the property, as well as the $3,000 transactional costs incurred for this particular transaction.

During the period between 2005 and 2009, this property was rented out to others as part of your rental business. Since you were taking deductions from the depreciation of the home in an amount totaling $60,000, that amount will be taken out of your original basis of $353,000 to determine your § 1001 adjusted basis of $293,000. The rental income you received would also be taxable ordinary income to you during the rental period. However, the cost of the repairs that you have incurred could have also been taken as deductions and offset against your taxable rental income, as they sound like they were only repairs and maintenance, only to maintain the house and not make improvements. The mortgage principle payments totaling $5,000 do not affect your adjusted basis, but I will explain further down how that will have an impact on the possible transaction with Tina or your daughter.

Since you used this property productively in your rental business, you are eligible for § 1031 like-kind exchange if you were to go through the transaction with Tina. This would allow you to currently avoid recognizing the gain from the exchange of property held for business, trade or investment for “like kind” property held for business, trade or investment. In this case, Tina’s long-term leasehold qualifies as property from Tres. Regs § 1.1031(a), which explains that a 30 plus year leasehold can be exchanged for fee-simple property. While you would be exchanging a single-family home for a warehouse, it should still qualify as like kind, since the warehouse property would still be held for use for productive use in your rental business.

The exchange itself with Tina would bear tax consequences of a capital gain of $107,000. The amount realized from the exchange would be the FMV of her warehouse leasehold of $90,000 and the value of the mortgage she assumes from your property of $310,000 ($315,000-$5,000 of principle paid down) equaling a total of $400,000. Thus, the gain realized from this transaction would be the $400,000 amount realized less the adjusted basis of $293,000 as discussed above, netting to a gain realized of $107,000. The gain that would be recognized in this transaction would be the lesser of the gain realized or the mortgage boot received. In this case your gain recognized would be the $107,000 of gain realized. This gain would be a capital gain since although it was a sale of property used in trade or business, this is depreciable property, and so only the losses are considered ordinary, and long term gains are considered capital as expressed in § 1231. The new basis in the warehouse property would be the $90,000 FMV of the property derived from taking the adjusted basis in the single-family home, subtracting the $310,000 amount of mortgage boot, then adding the realized gain of $107,000.

As for your alternative transaction, giving the property to your daughter, even though you are giving her the property you are asking her to assume the mortgage. Thus, in this case, it would be a part sale part gift transaction. It would be treated as if you sold your property to your daughter for the amount of your outstanding mortgage of $310,000. Thus, you would have a realizing taxable event, and you would be taxed on the gain realized between the $310,000 mortgage and your $293,000 basis. Therefore, you would have a taxable capital gain of $17,000. However, if you had to pay gift tax on the $17,000, then your daughter could add that to her basis.

Given the two situations, if liquidity is a problem, then perhaps giving the property to your daughter might be the better choice, as you would only have to include $17,000 of taxable capital gain in your tax return.

Also, do note that your expenses incurred from my services are also deductable since § 212(3) allows for an itemized deduction of any tax advice received in connection with the determination, collection, or refund of any tax. However, it only applies to any amount that exceeds 2% of your AGI and will only be beneficial if you elected to not take the standard deduction and if you are not subject to the AMT. I will be sure to include an itemized bill so you may easily take advantage of these savings.