Income
Tax I
Bogdanski
Fall 2011
Sample Answers to Question 1
Exam No. 9036
Property Settlement
Under § 1041 Willa will not recognize any gain on the transfer of Blackacre. This section applies so long as her marriage is recognized under federal law, is related to the cessation of marriage, and takes place within 1 year of the date when the marriage ceased. Willa's basis in the property is carry-over basis, so her basis will be $55,000, Henry's adjusted basis just before the divorce. Because the property is land, Willa may not depreciate the property and take corresponding deductions. Willa's payment of cash to Henry is also unlikely to be deductible for her because the cash is a property settlement, and not spousal support or alimony. A payment of cash is alimony when it is made in cash for the benefit of the ex-spouse if it is in a written document, the divorce instruments doesn't say that it isn't alimony, the payor/payee live apart, and the payor has no obligation to pay the payee when the payee dies. Unfortunately for Willa, the written document calls the cash payment a property settlement, so she is out of luck as far as a deduction goes. In addition, a single payment looks a lot more like property settlement than multiple payments over a number of years.
Like-Kind Exchange
This is a valid like-kind exchange under §1031(a). The property being Willa is exchanging is held for investment and it is exchanged for other real property. The fact that Willa also gets wine in the deal as boot does not ruin the exchange for tax purposes. Also, assuming Willa holds the new property either for use in a trade or business, or for investment purposes, the exchange meets all the requirements of a like kind exchange. The fact that Willa exchanges a vacant lot in a city for agricultural land also does not ruin the exchange for tax purposes because all domestic real estate is considered alike. Although the exchange was not contemporaneous, this does not ruin the exchange for tax purposes because §1031(a)(3) provides for a 180 day window, and the 5 weeks it took to complete the transaction is certainly within that window. In addition, Willa is an accountant and the problems states that the property was held for an investment, so it is unlikely that Willa would be considered a real estate dealer by the IRS (which would ruin the exchange for tax purposes). Vince's treatment of Blackacre after he receives, and his treatment/use of the agricultural property he exchanged with Willa has no bearing on whether Willa made a successful like-kind exchange under §1031.
Willa's realized gain on the transaction is $103,000 (the FMV of the property) +$12,0000 (the FMV of the wine, which is boot) -$55,000 (her basis in Blackacre) = $60,000. The recognized gain is the lesser of the realized gain or the boot. In this case the boot is lesser, thus Willa's recognized gain is $12,000. Willa's basis in the new property in total is $55,000 (her old basis) - $0 (cash received) + $12,000 (recognized gain) = $67,000. The basis in the agricultural land is $55,000 and her basis in the win is $12,000, essentially carryover basis for both.
The $12,000 recognized gain is taxable to Willa in the year she completed the exchange, and it will be a capital gain. The recognized gain meets the definition of capital gain because the property was exchanged (§1222) and the exchanged asset, the land held as an investment, was a capital asset because it is not listed under §1221 (all assets listed in §1221 are ordinary assets, not capital assets).
IRA withdrawal
The code sections governing traditional IRS are §§219 and 408. The contributions that Willa made to the IRA's were deductible in the years she made the deductions. Withdrawals are ordinary income to her in the year she makes the withdrawal. Because Willa is over the age of 60, she probably won't have a penalty for the withdrawal, so long as that meets the retirement age when she set up the account. This withdrawal will be $10,000 of ordinary income to Willa in the year she made the withdrawal.
Life Insurance withdrawal
The withdrawal from Willa's whole-life insurance policy she owns on her own life is also not subject to a penalty, and this withdrawal is unlikely to constitute income for Willa. The total premiums Willa invests in the policy, whether they go to the term premium or the investment portion of the policy, constitute her basis in the policy. Willa is allowed to withdraw from the investment portion of the policy and will incur no tax liability so long as the withdrawals do not exceed the total basis the has in the policy. Willa is also not taxed on the interest she earns on the investment portion or the growth that occurs on the investment portion.
New Business
Willa may take a number of deductions relating to starting her own business. Willa may carry-back the net operating losses in the first year of the business to the 2 years prior to the current year. Willa may deduct these losses against her income because the new business is not a passive activity and it is not subject to the anti-tax-shelter provisions in §469. Willa will also be able to deduct the first $5000 of start-up expenses under §195, and the remainder is a capital expenditure which must go into the basis of the business. The amount of the deduction should be the full $5000 unless she spends more than $50,000 starting the business, in which case the deduction phases out over time. Because this is a current business expense, it is an above-the-line deduction.
Willa will not be subject to Uni-Cap under § 263A even though she is a retailer(unless she makes the pools she is not a manufacturer, thus I assume she is a retailer) unless her gross receipts are over $10 million per year. If Willa pays herself for the hours that she spends working in her business then she can deduct that salary as a business expense from the business's income.
Exam No. 9202
Divorce
Property settlements in divorce are not realizing events. Therefore, Willa has no income and may take no deductions for anything she received or lost in the divorce.
Blackacre
Willa gets a cost basis in Blackacre of $55,000 (§1012). WHen Willa exchanges Blackacre, this exchange is a mandatory like-kind exchange under §1031, despite the fact that it is city real estate and she is receiving country real estate, because she is both giving and receiving property held primarily for investment. Her recognized gain is calculated to be the lesser of her amount realized in the exchange and the boot she received in the form of wine cases (§1031(b)). The fair market value of the boot is $12k. This means that her amount realized is $60k ($103k - $55k + $12k). Because the boot is less, then she recognizes $12k on the exchange, taxable at capital gain rates because she is exchanging investment property in the year of the exchange. The new basis of the wine is its fair market value at the time of transfer under §1031(d), $12k. THe new basis in the land is the old basis of Blackacre ($55k) reduced by the basis in the wine ($12k), or $43k (because the boot and amount recognized are the same). The fact that Vince transfers the land to Willa five weeks later does not render the like-kind transaction void under §1031(a)(3).
IRA & Life Insurance
Because the withdrawal is made from a traditional IRA, the withdrawal is taxed as ordinary income in the year she withdraws it. THe loan from the life insurance policy is not income because loans are not income. The interest accrued on the loan will be deductible above the line because the loan is used in the course of her business (§162).
New Business
The expense related to starting a business is not considered deductible under §162 because the startup costs are capital expenditures. A certain amount will be allowed, but any amount over that will not be deductible; however, the net operating loss will be deductible in any of the next 20 years (§172). She may also carry the NOL back 2 years to regain some of the taxes she might have paid then.
Exam No. 9321
Cash:
Because the cash that was previously W was transferred to H as part of a divorce settlemetn, 1041 applies. Under 1041, teh transfer is a realizing event, but not a recognizing event. to be taxable, a transfer has to be both realized and recognized. Under 1041, the transfer is basically treated as a gift between spouses. 1041(c) applies here because they are divorced -- all these transactions for up to a year will be presumed to be incident to the divorce. So no tax consequences for W.
Blackacre:
Again purusant to 1041, the transfer of the property from H to W will not be a recognizing event. So there will be no immediate tax consequences for W because she got the land in teh divorce agreement, although she will have a carryover basis in teh property equal to H's basis -- in this case $55k.
Exchange:
here the parties -- W and V -- are attempting to do a like kind exchange under 1031. IN this way, the exchange is a realizing event, but not a recognized event. Both parties will delay paying taxes. This is an election. Here, W holds blackacre for investment purposes and willb e getting wine land/ag land, which is also a business property, so both parcels of land qualify for 1031 treatment. According to 1.1031, it doesn't matter that the properties are very different -- vacant land for a vineyard. the code is very liberal with real property. tehrefore both are deemed to be a like kind wiht each other.
According to 1031(a) the exchange has to be completed iwth 180 days of the after the transfer of exchanged property. THerefore it is ok that they waited 5 weeks to actually exchange the properties. that will not kill the 1031 exchange.
A few years have elapsed since teh divorce, so blackacre may
have risen in value from teh FMV at the time of the
divorce -- which was $70,000. In the
There is boot in this exchange and under 1031, the boot will be both recognized and realized. First step is to determine teh realized gain for H using 1001. Here the amount realized is the total she will receive for her property -- 115k. 103 in cash and the FMV of the iwne, which is 12k. From that we subtract her carryover basis, which is 55 (H's basis in teh property) therefore her realized gain on this sale is 60. Under 1031, her recognized gain is the value of the boot, which is 12k. Her new basis in the property would be her old basis (55) minus any money received (0) plus the total recognized (12). So her new basis in exchange would be 67. However, 12 of that basis goes to the 50 cases of wine and the land has a basis of 55.
Here, W is recognizing a gain, and that gain is $12k. To determine if the gain is ordinary or capital, teh court will look at what she gave up in teh exchange, or the land. vacant land held for investment is a capital asset under 1221, so the gain will be a capital gain.
To W, teh land will be a capital asset. Anything NOT listed in 1221(a) is a capital asset except land that is used in a trade or business or held for investment. He appearsa to be holding the land as an investment b/c she is not operating the vineyard.. When she sell this land the gains will be captial gain.
Withdrawal from IRA
because the question says traditional, i will assume this is a qualified plan under 401k, and not a non-qualified plan. Here, W will be taxed when she withdraws. For either a qualified plan or a non-qualfied plan the EE is taxed when they withdraw the payments. Because she is still working and not yet at retirement age, the withdrawal for an non-qualified plan is subject to penalties for early withdraw. When she is withdrawing the money early, she will be withdrawing the income first and not the basis. THerefore she will be taxed on teh 10k. She will also be subject to penalities for early withdraw. th
withdrawals are treated as income. This woudl be ordinary income b/c a capital asset is not being sold or traded.
loan from her whole life policy.
Under a whole life policy 101, a loan from an account is not a withdraw. however, if she is taking money out of the account (and not using the account as collateral for a loan), she will not be taxed on her withdrawals up until the balance of ehr whole life policy and the total of her term life policy. HOwever, she can only withdraw that total if the interest from the whole life policy equaled the payment to the term and teh whole life portions combined. Here we will assume that she has paid more than $10k in term and whole life paymetns and that she is withdrawing only from the whole life portion. Her withdrawal will be treated as return of basis first, so no tax consequences.
if its a loan, there will also be no tax consequences because loans are not ascension to wealth under 61, and therefore at not taxed at the time they are taken out, but paid back with after tax dollars
New Business
Starting a business is a long term investment and therefore it is a capital expenditure under 263. That means she need to set up a basis in teh new business and then take loss deduction against it. The money that she put in to the business will not usually be immediately tax deductible as an ordinary and necessary cost. However, under 195, W can deduct $5000 of her start up fees immediately unless her total start up costs exceed 50,000. Here it does not seem like her costs exceed 50000 in the first year, so she will be able to deduct $5000 of her loss this year. The rest of the money will go into her basis for the business and can be deducted as the business makes money over a period of 15 years.
However, loss be an ordinary loss because a capital asset is not being sold or traded. futhermore, if she spend the money on inventory for her business or supplies it will be an ordinary loss. Ordinary losses are good because they can be deducted against all gains. Also if she used the money to buy supplies for her business, the loss would be oridinary. IF she used the money to buy depreciable property, it woudl be ordinary (but subject to 1231).
Hobby
Becaues W is an account, some may say that the hot tub biz is really just a hobby under 183. Becaues it operating at a loss this year, and hasn't been around for awhile, ti will not be presumed to be a business and not a hobby. TO determine if its a hobby, teh court will consider teh factors in 1.183. Here, because she runs it like a business, probably has a plan, puts a lot of time inot it, has experience as an accountant that coudl translate to owning a small business, and doesn't seem to be having much fun, the court will probably determine that its a business and not a hobby.
However, it is found to be a hobby, the losses are only deductible against the hobby gains