Income Tax I
Bogdanski
Spring 2005

Sample Answers to Question 1

Exam No. 7002

The first transaction that takes place is the exchange of Blackacre and Whiteacre. On its face it appears to be a realizing event under §1001, because there is a sale or other disposition of property, here an exchange. However, for a taxable event there must be realization and recognition, and the present case presents a like-kind exchange under §1031 which is a non-recognition transaction.

Here, the four requirements of a like kind are met. First, Terry has the right kind of property going out. Particularly, Terry is giving up property held for investment purposes. Further, Terry is not subject to an exclusion of §1031 under this first requirement, because Blackacre is not a personal use asset, Terry is not a real estate dealer, the property is not a security. Clearly, the rental property qualifies for §1031. Second, Terry is receiving the right kind of property back since Whiteacre has been and will be used for investment purposes. Third, the properties are exchanged. The properties are not sold or purchased from one another. Finally, the Blackacre and Whiteacre are “like-kind.” Under Treasury Regulation §1.1031(a)(1), all real estate is “like-kind” and all real property is like other real property. The viewpoint is very liberal. It does not matter in this instance that Terry’s land is developed and being rented out to retail businesses and that Whiteacre is undeveloped, the real estate properties remain like-kind. Therefore, this exchange qualifies for §1031 because Terry held Blackacre for investment purposes and exchanged it for Darlene’s property, Whiteacre, which will also be held for Terry for investment purposes.

However, it is important to note that the fair market values of the two tracts of land are significantly different. Blackacre has a fair market value of $1,200,000 while Whiteacre has a fair market value of $800,000. This is important to note, because as part of the exchange Darlene receives not only Blackacre, but also takes Terry’s $400,000 mortgage. Terry is therefore, left with Whiteacre with a FMV of $800,000, but has relieved of the previous $400,000 mortgage. This difference of $400,000 has important tax consequences as it is becomes boot in this transaction. To determine whether Terry’s realized gain on this like-kind exchange you take his amount realized on the exchange and subtract the adjusted basis. The amount realized is the FMVof the property (Whiteacre) received, $800,000 plus the debt given up (from Blackacre), $400,000, for an amount realized of $1,200,000. The adjusted basis is the original cost, $1,000,000 minus the depreciation taken on Blackacre over the years, $100,000, for an adjusted basis of $900,000. Therefore the realized gain is equal to $300,000 (Amount realized minus adjusted basis). The recognized gain on the transaction is equal to the FMV of the not-like kind portion of the exchange. Here, under §1031(d) the mortgage given up is treated as boot and therefore since no other boot (cash or not-like kind property) was received, Terry appears to recognize a gain of $400,000. However, Terry gain not recognize the whole $400,000 since he cannot recognize more than is gain of $300,000. Therefore, Terry recognizes a gain of $300,000 on the exchange and will, at least some of it, be taxed on that gain as capital gain. The $300,000 is a capital gain because the land is held as an investment for more than one year, therefore qualifying as a capital asset and the gain is attributable to an exchange of property. However, only $200,000 will qualify as capital gain, because Terry had taken $100,000 of depreciable deduction on ordinary income on Blackacre, and therefore under §§1245, 1250, that portion of gain is subject to depreciation recapture and is therefore ordinary gain.

Finally, it is important to calculate Terry’s basis in Whiteacre. To do so you take the basis of the old property, $900,000, plus gain recognized, $300,000, minus the mortgage given up, $400,000, for a new basis for Terry in Whiteacre of $800,000.

However, the basis calculation is not quite complete.

Terry in the real estate transaction pays Andrea a fee of $25,000 for her services in connection with the transaction. As noted above, Terry gives up a capital asset in the exchange, and likewise, obtains a capital asset in return. The land received is being held for investment purposes, by a non-dealer, and was received as part of an exchange. This capital asset is also a capital expenditure. On a transaction of a capital expenditure all costs of buying, selling, or exchanging the property, including fees paid such as the one here, are also capitalized and associated to the capital expenditure, here being the acquisition of Whiteacre. Therefore, with the $25,000 fee being capitalized, this $25,000 is shoved into basis, giving Terry a basis in Whitacre of $825,000. The fee cannot be deducted as a current expense.

A few days later Terry receives the computer from Andrea with the note referencing the work that had been done and the hope of future business together. The argument can be made that the receipt of the computer is a gift, or a transfer of property in connection with service performed and therefore, income to Terry.

If the computer is received as a gift it is not gross income to Terry under §102. To analyze whether the computer is a gift, you look to the transferor’s subjective intent to determine whether it was given from detached and disinterested generosity. Such a determination is very factual and is a case by case determination. It is likely that given the fact that a transaction just took place that provided Andrea $25,000 and because of the note referencing the business relationship and the recognition and recompense of past and hopefully future business it seems unlikely that the computer would be a gift. If it did qualify as a gift, the basis would be a carryover basis of $600 to Terry, despite the fact that the FMV is $900.

If the transfer of the computer does not qualify as a gift it would appear to be gross income to Terry under §83. Gross income by definition from Glenshaw does not care about the source of funds, whether from labor, capital, or anything else, but looks to whether there is an accession to wealth, clearly realized, over which the taxpayer has complete dominion. Cleary, the computer with a FMV of $900 is an accession of wealth, and since the computer has been transferred to Terry in exchange for past business it appears to be clearly realized, and finally Terry has complete control over the computer. Therefore, it would appear that Terry has income from property received. Under §83 the income is determined by the excess of the FMV of property received subtracted by any amount paid by the taxpayer. Since Terry did not pay anything for the computer and the computer has a FMV of $900, it is apparent that Terry has recognized $900 of ordinary income on receipt of the computer since he is fully vested in the property at that time. Terry receives a $900 basis in the property under §1012.

Exam No. 7139

The taxpayer tax consequences depend on whether he incurred gross income which is defined as an undeniable accession to wealth, clearly realized and over which the taxpayer as complete control. § 61 provides a list for what IRS consider as income which is all income from whatever source derived

Blackacre’s status with T: rental property

T’s property is a rental property that is a capital asset used for commercial real estate retail businesses. Therefore in the selling or exchange of Blackacre or any transaction that triggers §1001, Terry will have a capital gain/loss taxed at a favorable rate unless he qualifies for an exception provided by the Code because he held on the property for more than 1 year.

T’s basis on Blackacre and depreciation:

Terry’s initial basis in the property is $1MM (his cost) and it’s reduced by the depreciation he took over the years. Therefore his adjusted basis in the property is $900,000 (1MM – 100,000 deductions). Blackacre depreciation will be taking place according to the straight line rule because it’s a real property and T can use the half-month convention which treat him as owning the real estate since the 15^th of the months of the year it was owned

Loan from Bank:

The loan T acquired from the bank is not taxable income to him, however he’ll be taxed on the income he produces to pay back the loan. Interests on the loan are deductible as per §212 as this is an above the line deduction that T does not have to itemize for. The interest might also qualify as an investment interest which is deductible as per §163(d) but only against the investment income (which could be the rents that T collects from Blackacre retial business rentals) otherwise he wont be allowed to deduct that interest against other ordinary income he’s receiving as this the business that T is doing is considered a passive activity in which he does not actually work himself. The same case applies any to any losses he incurs out of the Blackacre rental use that can not be deductible against any other ordinary or portfolio income he might be generating (note that he can carryover the interest and the losses to future years if there was not any capital income to offset them)

Exchange with Whitacre:

T’s exchange with D is a realizing event under §1001 and he will incur capital gain/loss on the transaction unless he qualifies for a non-recognition exception under the code. A realizing event under §1001(b) occurs when there’s a sale/disposition of property. The swap in the question qualifies as a realizing event. And therefore T incurs capital gain/loss. The mortgage on Blackacre is an assumable mortgage. To calculate the amount realized for T we need to subtract any money received + FMV of the property T got (whiteacre) + any mortgage Darlene assumed and subtract the adjusted basis of T’s blackacre (900,000) to yield the capital gain/loss of the exchange

The amount realized from the exchange – in regards to T is = $800,000 + 400,000 – 900,000 (his adjusted basis) = $300,000 capital gain realized

T’s may/maynot escape the taxable consequences of this exchange if he qualifies under Non-recognition exceptions to §1001 and his best bet is classifying this transaction as a like-kind exchange. T needs to satisfy requirement of §1031 that 1)he’s giving up property held for use in business or investment (Blackacre satisfies that b/c it was held for rental activities in retain business) 2) T is receiving property held for use in business or investment (whiteacre according to T’s plans are subject to future investment) 3) there must be an exchange (it’s not a sale or handling of money involved here) 4) properties given up/receive are of “like kind” and under Reg §1.1031(a)-1(b) all real estate is “like” all other real estate.

Under §1031(d) where one party to the like-kind exchange walks away from a mortgage b/c of the other party (Darlene) to the exchange assumed the mortgage, the mortgage = boot (and treated like cash received for tax purposes) and therefore the amount recognized to T would be any value of the realized gain up to the FMV of the boot (mortgage). Therefore T’s recognized gain = $300,000 because T can not recognize more than what he realizes. Therefore $300,000 is the amount that T put on his tax return for this transaction. His adjusted basis in the Whitacre would be = Basis in Blackacre (900,000) – any money received (mortgage “400,000) + any gain recognized (300,000) = $800,000 + fees paid (look down)

Fee paid to Darlene:

The fee paid to Andrea is a capital expenditure and therefore since it was a cost associated with buying a capital asset (whiteacre) and must be rolled into the basis of the Whiteacre. This is determined since T is spending money on whiteacre which is a profit orienting asset that will create a long-term benefit from him. Therefore Whiteacre adjusted basis will be $825,000

Laptop:

The laptop will not be taxable to T if it was found to be a gift b/c gifts are not a realizing events under 1001. Whether the laptop given to T from his real estate agent is a gift is determined by the motivation behind it (mind of the transferor) and whether it was out of detached and disinterested generosity. §102 govern this area. IRS can argue under the Olk case that a laptop is like a tip that was transferred in a commercial setting and shall be included as gross income however this argument may be reaching out too far b/c of the commercial relationship b/w T and his real estate agent had been discontinued. T might win this argument if A’s motivation was not for an expected return from T’s side. Assuming that T won his argument and it was determined that the laptop is a gift then terry get a carryover basis from A according to the general rule in §1051(a) when the Donor’s basis ($600) is equal or less than the FMV of the property ($900)

If IRS was able to extend the ruling of the Olk case to the laptop T received then he has to report that as a purchase under §1001 with an ordinary realized gain of 900 – his basis (cost = 0) = $900 unless T refused it

Exam No. 7464 – See .pdf file here.

Created by: <bojack@lclark.edu>
Update:  01 Jun 05
Expires:  31 Aug 06