Income Tax I
Bogdanski
Fall 2015

Sample Answers to Question 1

Exam No. 3778

Rental business.

Tiana operates a rental business as a second job. Rentals are per se passive activities, under § 469, and passive activity losses may only be deductible against passive activity profits (except for a "mom and pop" rental income of $25,000, which phases out for larger operations). Tiana owns a rental "tower" so is unlikely to qualify as a mom and pop.

As the owner of the residential rental property, she may depreciate the property over a recovery period of 27.5 years. The facts do not provide information about how much depreciation Tiana may have taken on the property, nor how much profit or loss she claims.

From the facts, it seems safe to infer that Tiana has owned the tower for at least a few years; her adjusted basis is only half the current market value. With slow depreciation rates (which adjust the basis downward) and reasonable increases in real estate values (at 7 percent inflation in real estate values, it would take 10 years to double the value), it seems she's owned the property for several years.

Real Estate Exchange: 1031 analysis

Tiana has a basis of $300,000 in the tower, which has a market value of $600,000. She would like to transfer the property without having to recognize the gains.

Under § 1031, she may transfer property held for business or investment use for other property to be held for business or investment use. (All real estate is considered "like-kind" for the purposes of § 1031.) The rental tower qualifies as used for business, but does Blueacre? All the facts say is that she plans to build a horse stable and paddock. Is that for her personal, recreational use? Or does she intend to build a stable out in horse country to board others' horses and offer riding lessons to spoiled suburban children? Or, is her plan to hold the land for investment, and she believes the a stable and paddock will increase the resale value of the investment? We do not have the facts, but it seems suspicious. (Especially if she spends a lot of time riding herself.)

(The fact that Uri is a real estate dealer -- and thus from his end ineligible for 1031 transactions -- is irrelevant to Tiana's tax treatment. Further the fact that he seems to have held the property for personal, not investment or business use, is irrelevant to Tiana.)

If Tiana's intent is to use Blueacre for investment or trade, 1031 applies. She would recognize the gain in her property to the extent that she receives boot. In this case, Uri transfers Blueacre and also assumes the $150,000 mortgage on the tower. Assuming the mortgage is the equivalent of providing $150,000 in cash boot. Tiana's amount realized is $600,000 ($450,000 FMV of Blue plus $150,000 assumption of mortgage). The gain realized is $300,000 ($600,000 minus the $300,000 basis). The gain recognized is $150,000 (the lesser of the gain realized or the boot). That gain is treated as capital gain, with preferential rates, because she has held the property for more than one year -- but only to the extent it does not represent recaptured depreciation that she took on the tower in past years. The recaptured depreciation is treated as ordinary income.

If 1031 applies, her basis in Blue is $300,000 (basis in the tower) -- $150,000 (money received) + $150,000 (gain recognized) = $300,000.

If 1031 doesn't apply, this is straight up property transaction treated as two sales, with gain recognized. In the transaction, she receives Blueacre, FMV $450,000 and the assumption of mortgage, worth $150,000 (per Crane) for a total amount realized of $600,000. The gain realized is the amount realized minus the basis, or $600,000 minus $300,000. With no non-recognition provisions in play, she would recognize $300,000 in gain from the sale of the tower (treated as ordinary income up to the amount of depreciation recapture, with the rest as capital gains). Her basis in Blueacre would be the FMV she paid for it (by transferring the tower), or $450,000.

Blueacre expenses.

Finally, tax treatment of her expenses in clearing the land for a stable/paddock depend on whether the property is seen as a personal property, a hobby asset or a business asset.

If personal, capital improvements add to basis of her property. They are not deductible against ordinary income.

If "business" expenses under 162, they would be deductible. They are not repairs or immediately deductible business expenses -- but rather the first phase of a planned capital improvement (creating an asset with useful life more than a year) that could be depreciated. She could deduct the entire $5,000 as a start-up costs under § 179, or add the $5,000 to the basis of the stable and paddock, to be depreciated over the life of that asset. NOTE: This deduction applies only if she intends to use the property for a business (which is questionable -- see above). A further challenge to taking these depreciation deductions is that this may well be seen as either a passive activity (how involved will she be in running the stable?) or a hobby (likely). The factors for determining whether hobby use is her intent include, among others: her income (high), how much work there is involved (so far, little), her expertise, and the recreational value of the use (high). If, as is probable, the land is treated as a hobby business (if business at all), she will only be able to deduct her hobby losses against any hobby income. (Although the Nickersons got away with it.) The depreciation expenses would be carried over to be deductible only against her future income -- should there be any.

Stock sale.

Tiana bought the stock "several years ago" all at once -- so the basis is the sales price, $20,000, evenly distributed among all the shares. The basis is thus $20 a share. She sells 100 shares of the stock to her friend Val. The adjusted basis of that stock is $20 times 100, or $2,000. The amount realized is the sales price of $5,000. The gain recognized under § 1001 is the amount realized, $5,000 minus the adjusted basis, $2,000 = $3,000.

The question then turns to the timing and characterization of that gain. Tiana has structured the sale as an installment sale -- a disposition of property where at least 1 payment is to be received after the close of the taxable year in which the disposition occurs. § 453 (b)(1). That section generally allows distribution of the basis and gain over the series of installment payments, under a set formula.

However, there is an exception: Sales of publicly traded stock, by individuals or dealers, do not qualify for installment sales treatment. Instead, all taxpayers must use the closed accrual accounting method. Under an accrual accounting, income must be recognized when all events have occurred to fix your rights to the income, and the amount can be determined with reasonable accuracy. In this case, Tiana would have to report the full proceeds of the sale -- $3,000 -- in the year of the sale.

The additional interest to be paid in the second year (but not the $2,500 payment) would be included in Tiana's gross income the second year, as ordinary income.

Mae.

Tiana will likely be eligible to include her aged mother as a dependent on T's tax return. Under § 152, a dependent may be a qualifying relative, who does not have to live with the taxpayer -- as long as the dependent's income is under $4,000 (all figures cited for 2015), the taxpayer provides more than half the individual's support, and she is not someone else's qualifying child. Parents are "qualifying relatives" (§ 152(d)(2)(C)), Mae earns less than $4,000, and is certainly nobody's qualifying child. Tiana sends a check to "help" pay Mae's support. Does her check cover more than half of Mae's support? Or is her sister Sally paying the larger share? If so, whichever sibling provides more than half of Mae's support can claim her as a dependent -- but only one may make that claim.

Claiming her as a dependent would mean Tiana would receive a $4,000 personal exemption for Mae on her income taxes, below the line. This is phased out only for the very highest earners; it is unclear whether Tiana makes more than $309,000. If Tiana were taking the standard deduction, she would take an additional $1050 standard deduction (or Mae's earned income plus $350) if Mae were her dependent. There is an additional standard deduction for the aged and blind of $1250 §63f. (However, I assume Tiana's property taxes, and other state and local property taxes make it well worth itemizing, so the standard deduction is not Tiana's concern.)

Mae's medical expenses would only be deductible by the TP claiming her as a dependent to the extent they are over 10% of AGI. Tiana's AGI is likely quite high and unless Mae's medical expenses are truly extraordinary, that will not be a factor.

Exam No. 3453

Consequences for Tiana in each transaction/event:

Tower for Blueacre:

The deal - In this transaction, Tiana has a realized gain of $300k ((value of Blueacre, plus mortgage assumed by Uri) - (her basis in Tower)). This amount would be a captial gain should it be recognized - given that the property was one held by her for investment (sounds like it can be assume for over a year). It was also used in a "sale or exchange" as required under §1222. Uri's dealer status has no impact on Tiana for purposes of the transaction, only her use/status matters for gains or nonrecognition purposes. Her new basis in Blueacre will depend on whether or not the transaction qualifies as a §1031 exchange, but should it qualify, it will be measured by calculating: (old basis - ($ recv'd) + (any gain recognized)). [gain realized under §1001; then calculate gain or loss recognized; then new basis]

LKE (§1031(a))? - Here, it looks like the transaction will qualify as a like-kind exchange under §1031(a), because the property she is giving up meets the business/investment requirement; the property being acquired is an investment property (this is somewhat of a question, give that she made the horse improvements - it would come down to her intent, though with respect to proving that she intended to derive a profit, and that it wasn't just for hobby purposes); finally, the properties would qualify as like-kind, regardless of the difference in grade/quality, since both are real estate. It is important to note that giving away her mortgage will count as boot in the §1031 calculation. Because the new property is work $150k less than the amount of her old property, however, she will be required to recognized that amount of gain. (($600k) - ($300k) + ($150k - since she didn't acquire property with = or greater FMV)). Her basis in the new property will be $300k following the transaction, with $5k added to her cost basis after improvements to the land (assuming that's what the horse prep. is).

Finally, any transaction costs not mentioned will be considered capital expenditures and go into cost basis or be counted against gain (none mentioned, however).

Stock sale to Val:

Installment sale? - Since this transaction is the sale of a stock traded on a major exchange, it must be treated in the closed (accrual) method, rather than using an installment method, under § 453(k). Using that method, Tiana must calculate her recognized gain by using the full value (not FMV) of the note (no basis used first) and cash received. Tiana's fractional basis in the shares sold to Val is $2,000, assuming even allocation of Tiana's basis across the shares. Her gain on the sale will be recognized at $3,000. That is why you always want to sell your stock with a high basis first, less gain to recognize earlier.

The gains Tiana realizes on the immediate transaction will be capital gains, as they are in capital assets held for more than a year, and produced as a result of a sale. She is also not a dealer. Any interest she earns on the note will be characterized as ordinary income.

Elections - There is no election available under § 453, since the code already mandates closed accrual application in this situation. It is distinct from a situation where there might have been the availability to pursue the open method instead of an installment method.

Checks sent to Mae:

It appears that Tiana's checks to her mother are not out of detached and disinterested generosity. If they were, they would probably be a gift, given the familial relationship (question however, the regular intervals...)). Gift would be a tax nothing - non realizing event.

That brings up whether or not the payments entitle Tiana to a deduction or credit. Is Mae a dependent? She lives in another city, so that may complicate her status for this purpose. §21(b)(1)(B)'s credit would not be appropriate, because her mom does not sound like she is not at Tiana's abode for half of the year. Additionally, there is no deduction for food and clothing expenses in the code, so it would likely just come down to whether the medical expenses qualified for deduction... Under §213, they would be subject to a 10% AGI floor (itemized deduction if she qualified) (for the taxpayer, so Tiana). It looks as though she meets the familial requirements under §152, though as a qualifying relative; it does not appear that her mom makes over the exemption amount, and there is no residency requirement here. There is a % of support requirement, and it might be met depending on how much she sends each month in relation to Mae's costs. Any itemized deductions would also be subject to phasedown under §68 if Tiana's income is too high (it may be since she is an executive).

Exam No. 3125

First, Tiana (T) rents units to tenants. That income, whatever it is, would be ordinary income and subject to taxation at the relevant rate. Assumedly, T also collects an income from her job at the insurance company, which would also be taxable as ordinary income.

Second, T has no income from the loan because the assumption is that she will be paying that money back. Further, T would be able to deduct the interest on the loan incurred to purchase rental property as an above the line deduction under sections 163 and 62. And her property tax on the rental property would be deductible as an above the line deduction.

Third, T enters into a real estate exchange agreement with Uri (U). This appears to be an exchange of like-kind property that would fall under 1031 if and only if T is exchanging the apartment building for Blueacre with the intention of holding Blueacre for trade/business or investment. If she, like U, intends to use it only for personal use, then this would effectively be a sale with T realizing a gain as follows:

+FMV of Blueacre ($450k) + debt assumption ($150k) - basis ($300k) = $300k recognized and thus taxable income. That would also make her purchase price of Blueacre the FMV which would mean she would have a basis of $450k in Blueacre.

If, however, T plans to use Blueacre for business, which is likely given that nothing in the facts say she has horses and we know she has had rental property before which means she might be angling to rent space in the stables to people who own horses, then she can treat the sale as a like kind exchange which would prevent her from realizing the entire gain shown above as follows:

+FMV of Blueacre ($450k) + debt assumption ($150k) = $600k amount realized - $300k basis = $300k recognized but the actual recognition is the lesser of the gain realized and the boot. Here, the boot is the $150k debt assumption (treated like cash for this case), which means the actual recognized gain is $150k.

Her basis, then, is the basis of the old $300k - the $150k cash received (debt assumption) + the $150k gain recognized = $300k basis in Blueacre after the exchange.

Further, we know we T can use 1031 because she's exchanging real estate for real estate which is always like kind and there is an exchange rather than a sale. And, T is not in the real estate business which means she can use 1031 unlike U who would be excluded from 1031 because he's a real estate professional.

Regardless which method the courts decide, once T owns the property then she starts to improve it by spending $5k to help begin construction. It's debatable whether that would actually increase her basis, however, because there's no indication that this is a permanent improvement that actually materially affects the value of the land I would err on the side of caution and conclude that there is not an adjustment of basis resulting from the land clearing.

Also, T would be able to deduct the property tax of the vacant investment real estate, if she is using it as an investment, as an itemized deduction under section 164.

Next, T decides to sell some stock to Val (V). T owns 1000 shares with a basis of $20,000 which means the basis in each share is $20. T goes to sell 100 shares, with a basis of $2000, to V for $5000 with $2500 up front and another $2500 plus interest a year after the sale closes.

As a result of this transaction, T is left with 900 shares of stock with a basis of $18,000.

T's income from this sale can only go one way because while this is an installment sale, this is an installment sale of publically traded stock which means she has to use the closed accrual method regardless.

Under the closed accrual method, T pays the whole gain during the first year which means $5000 + interest - $2000 (basis) = $3000 + interest as capital gain (because stocks are held for over a year in expectation of a long term investment) in year one. The interest is easy enough to find that T cannot argue that it should be put off because it's impossible to quantify. The FMV of the promissory note has no real relevance unless T decides to go sell it, which would be dumb.

Finally, T sends money to help support her mother. While this is certainly a good deed, it's unlikely to have any beneficial tax consequence for T because a dependency exemption for a qualifying relative requires that the taxpayer provides more than half of the support necessary for a relative or a member of the taxpayer's household. Here, the mother lives with the sister which supports the assertion that the sister provides more than one half of the support. If, however, T does pay for more than half of the mother's care, because the mother makes less than $4000 a year, T could claim the mother for a dependency exemption. If T doesn't get to claim her mother, she can still claim herself for a personal exemption depending upon her total income for the year, which may be high enough to phase out the exemption, or at least reduce it.