Chapter 8 TaxDeferred Exchanges 2005 Prentice Hall Inc

Chapter 8 Tax-Deferred Exchanges © 2005 Prentice Hall, Inc. 8 - 1

Tax-Deferred Exchanges l A tax-deferred exchange postpones gain or loss recognition to the future by adjusting basis of the asset acquired Ø Ø © 2005 Prentice Hall, Inc. The longer gain recognition can be postponed the greater the tax savings The longer a loss is postponed the less valuable the loss 8 - 2

Basis Adjustments l l l 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 the replacement asset is sold at a later date, the basis adjustment results in the deferred gain or loss being recognized © 2005 Prentice Hall, Inc. 8 - 3

Basis l l l Carryover basis – the basis of the original asset follows the asset to the new owner Substituted basis – the basis of the original asset is substituted for the 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 © 2005 Prentice Hall, Inc. 8 - 4

Like-Kind Exchanges l l l When eligible property is exchanged solely for other eligible property of like-kind, no gain or loss is recognized (Section 1031) The gain or loss realized is deferred through an adjustment to the basis of the replacement property Only property used in a trade or business or held for investment is eligible property © 2005 Prentice Hall, Inc. 8 - 5

Like-Kind Exchanges l l Excluded properties include inventory, stock in trade, securities, and partnership interests If the requirements are met, like-kind exchange treatment is mandatory (not elective) and it applies to losses as well as gains © 2005 Prentice Hall, Inc. 8 - 6

Qualifying Like-Kind Exchanges l l l 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 Ø Ø Ø Office furniture, fixtures & equipment Computers & info systems equipment Automobiles & taxis General-purpose light trucks General-purpose heavy trucks © 2005 Prentice Hall, Inc. 8 - 7

Boot’s Effect on a Like-Kind Exchange l l The receipt of boot can cause realized gain to be recognized Boot is anything that is not eligible like-kind property and includes Ø Ø Ø Cash Properties not of a like-kind Net liabilities discharged in the transaction © 2005 Prentice Hall, Inc. 8 - 8

Boot’s Effect on a Like-Kind Exchange l l Gain Recognized = lesser of gain realized or boot received (giving boot does not affect gain recognition) If a loss is realized on a like-kind exchange, boot has no effect on loss recognition © 2005 Prentice Hall, Inc. 8 - 9

Like-Kind Exchange Planning l l 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 taxfree in an exchange if there is a realized loss, as boot can be received without causing gain recognition © 2005 Prentice Hall, Inc. 8 - 10

Determining Basis in Like-Kind Exchanges l l 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 Ø l Holding period for new property includes holding period of property surrendered Basis of Boot = FMV Ø Holding period begins on date received © 2005 Prentice Hall, Inc. 8 - 11

Indirect Exchange l l In an indirect exchange, the taxpayer hires a third party to purchase the desired property The third party then exchanges the justpurchased property for the taxpayer’s property The taxpayer has a qualifying exchange The seller of the property and the third party have taxable transactions © 2005 Prentice Hall, Inc. 8 - 12

Nonsimultaneous Exchange l 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 Ø Ø 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 © 2005 Prentice Hall, Inc. 8 - 13

Wash Sales l Wash sale - identical securities acquired within 30 days before or after the sale date (a 61 -day period) Ø Ø Ø Wash sale losses are disallowed but gains are taxed Loss 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 © 2005 Prentice Hall, Inc. 8 - 14

Involuntary Conversions l An involuntary conversion results from Ø Theft – embezzlement, larceny and robbery (but not simply losing items) Ø Casualty – requires a sudden, unexpected, and unusual event such as a fire, flood, tornado, hurricane or vandalism Ø Condemnation – lawful taking of property for its fair market value by a government under the right of eminent domain © 2005 Prentice Hall, Inc. 8 - 15

Casualties and Thefts l Gains and losses sustained on casualties and thefts are not under a taxpayer’s control so they receive special tax treatment Allowable losses (including personal losses) are immediately deductible Ø Gains (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 Ø © 2005 Prentice Hall, Inc. 8 - 16

Casualty and Theft Losses l Loss limited to the lesser of: 1. 2. l Decline in fair market value (or repair costs to restore property to pre-casualty condition) The adjusted basis of the property (for business property that is completely destroyed, the loss is always the property’s adjusted basis) This loss is then reduced by any insurance proceeds received © 2005 Prentice Hall, Inc. 8 - 17

Casualty and Theft Loss Deductions l l Thefts are deductible in year of discovery For casualties in designated disaster areas, taxpayer can elect to deduct loss in preceding year A net business loss is deducted from ordinary income; an investment loss is a miscellaneous itemized deduction Individuals have additional limits on losses from personal-use property: Ø $100 floor per casualty (per event) Ø 10% of AGI threshold Ø Must itemize to deduct loss © 2005 Prentice Hall, Inc. 8 - 18

Gains on Involuntary Conversions l l If the insurance recovery on a casualty or theft is greater than the loss, the taxpayer has a gain Condemnations usually result in gain because proceeds received are usually fair market value © 2005 Prentice Hall, Inc. 8 - 19

Gains on Involuntary Conversions l l If all proceeds are used to acquire qualified replacement property (or repair the property to its pre-casualty condition) within the required replacement period, the gain is deferred Gain may have to be recognized if all proceeds are not used to acquire replacement property (or make repairs to the damaged property) within the required time period © 2005 Prentice Hall, Inc. 8 - 20

Replacement Period l l Extends 2 full tax years after the end of the taxable year in which the involuntary conversion occurs Extended to 3 years if the involuntary conversion involves the condemnation of business or investment realty © 2005 Prentice Hall, Inc. 8 - 21

Replacement Property l l l 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 need meet like-kind test © 2005 Prentice Hall, Inc. 8 - 22

Gain Recognition l l 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, involuntary conversion treatment is elective © 2005 Prentice Hall, Inc. 8 - 23

Involuntarily Converted Principal Residence l l l If the taxpayer acquires a replacement residence, using all the proceeds received, all gain can be deferred If taxpayer meets required ownership & use tests, up to $250, 000 ($500, 000 if both spouses qualify) of gain can be excluded These two provisions can be combined to exclude gain on the amount that is not reinvested © 2005 Prentice Hall, Inc. 8 - 24

Transfers to Sole Proprietorships l l Gain or loss deferred on transferred assets Basis of transferred asset to sole proprietorship is lesser of adjusted basis or fair market value at date of conversion to business use © 2005 Prentice Hall, Inc. 8 - 25

Transfers to Corporations l Gain or loss deferred when cash or property (services are not property) is transferred to corporation in a qualifying exchange for stock Ø Ø Shareholders transferring property must own 80% of stock Service providers excluded from 80% ownership unless property also transferred Stock received for services results in taxable income to shareholder rendering services Gain recognized when boot (anything other than stock) received; gain = the lesser of realized gain or FMV boot received © 2005 Prentice Hall, Inc. 8 - 26

Transfers to Corporations (cont’d) l l l Shareholder’s stock basis = basis of property transferred plus gain recognized less boot received less liabilities assumed by the corporation Basis of property transferred carries over to corporation increased by any gain recognized by shareholder Basis of boot received is its FMV © 2005 Prentice Hall, Inc. 8 - 27

Transfers to Partnerships l l l No gain or loss is recognized by partners or the partnership (with no minimum ownership required) on the transfer of cash or property to the partnership in exchange for a partnership interest Partners must recognize taxable income if partnership interest is received for services rendered Basis of property carries over to the partnership © 2005 Prentice Hall, Inc. 8 - 28

Transfers to Partnerships l l Partner’s basis in partnership interest = basis of property given up less liabilities assumed by the partnership plus partner’s share of partnership liabilities plus gain recognized Partner may be required to recognize gain to avoid a negative basis Ø © 2005 Prentice Hall, Inc. If liabilities assumed by the partnership exceed the partner’s initial basis (including allocated share of partnership liabilities) 8 - 29

Corporate Reorganizations l Involve 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 reorganization Acquisitive – one corporation acquires assets or stock of another corporation Ø Divisive – one corporation splits into 2 or more corporations Ø Recapitalization Ø Reincorporation Ø © 2005 Prentice Hall, Inc. 8 - 30

Corporate Reorganizations l l l Corporations and shareholders exchange stock for property or stock for stock on a taxdeferred 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 © 2005 Prentice Hall, Inc. 8 - 31

Reorganizations Appendix 8 A © 2005 Prentice Hall, Inc. 8 - 32

Types of Reorganizations l Seven types of reorganizations referred to as Types A through G Types A, B, and C are acquisitive reorganizations Ø Types E and F involve only one corporation making technical changes Ø Type D reorganization can be either divisive or acquisitive Ø Type G is similar to a D reorganization but applies only in bankruptcy Ø © 2005 Prentice Hall, Inc. 8 - 33

Acquisitive Reorganizations l Generally involves either The acquisition of one corporation’s assets (target) by a second corporation (acquirer) after which the target ceases to operate Ø The acquisition of the target corporation’s stock for stock of the acquirer, after which the target becomes a subsidiary of the acquiring corporation Ø © 2005 Prentice Hall, Inc. 8 - 34

Acquisitive Reorganizations l Asset acquisitions Type A – statutory merger or consolidation Ø Type C – stock for asset acquisition Ø Type D – acquisitive Ø l Stock for stock acquisition Ø Type B © 2005 Prentice Hall, Inc. 8 - 35

Acquisitive Reorganizations l l 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 securities Ø Target recognizes no gain on receipt of other property as long as this property is distributed to its shareholders © 2005 Prentice Hall, Inc. 8 - 36

Acquisitive Reorganizations l Gain is recognized by Acquirer only if it transfers appreciated property other than stock or securities to Target No loss is recognized on depreciated property that is transferred Ø Target uses FMV for the basis of all transferred property Ø © 2005 Prentice Hall, Inc. 8 - 37

Acquisitive Reorganizations l Target’s shareholders usually recognize no gain or loss on receipt of stock in exchange for their stock in Target They may be required to recognize gain if principle of securities received exceeds securities surrendered Ø If shareholders receive boot, they recognize gain equal to the lesser of realized gain or fair market value of boot received Ø Basis of stock or securities received = basis surrendered – boot received + gain recognized Ø Basis of boot = fair market value Ø © 2005 Prentice Hall, Inc. 8 - 38

Acquisitive Reorganizations l Type B stock-for-stock reorganization Acquiring corporation acquires Target’s stock from its shareholders in exchange solely for stock of Acquirer Ø Acquirer can use nothing but its own voting stock to acquire Target’s stock Ø Neither Acquirer nor Target’s shareholders recognize gain or loss Ø © 2005 Prentice Hall, Inc. 8 - 39

Type A Reorganization l Merger – the acquisition of the assets of a target Ø l Target liquidates and the acquiring corporation continues Consolidation – transfer of assets by two or more corporations to a new corporation Ø Transferring corporations liquidate and the new corporation survives © 2005 Prentice Hall, Inc. 8 - 40

Type A Reorganization l l Acquirer can use both its stock and securities Must meet continuity of interest Ø l l At least 50% of the shareholders of Target must becomes shareholders of Acquirer Shareholder of both Acquirer and Target usually must approve the merger Acquirer becomes liable for all liabilities of the Target © 2005 Prentice Hall, Inc. 8 - 41

Type A Reorganization l l Acquirer may transfer assets of Target to a subsidiary Forward triangular mergers Ø Subsidiary could be Acquirer with Target shareholders becoming minority shareholders of Target Ø Subsidiary may acquire assets of Target using stock of Parent © 2005 Prentice Hall, Inc. 8 - 42

Type A Reorganization l Reverse triangular merger Ø Parent transfers assets of subsidiary (which includes parent’s stock) to Target and subsidiary liquidates Ø Target becomes new subsidiary of parent Ø Additional requirements apply © 2005 Prentice Hall, Inc. 8 - 43

Type B Reorganization l Acquisition of Target’s stock in exchange for voting stock of Acquirer Ø l l Shareholders of Target become shareholders of Acquirer and Acquirer controls Target (owns 80% or more of stock) A subsidiary of Parent may also be the Acquirer using solely Parent’s stock Target’s stock may also be transferred to a subsidiary of Parent © 2005 Prentice Hall, Inc. 8 - 44

Type B Reorganization l l l Prior purchases of stock normally will not taint the acquisition Acquirer has up to one year to complete the acquisition of control of Target Once control requirement met, additional acquisitions of Target’s stock for Parent’s stock continue to qualify as a reorganization © 2005 Prentice Hall, Inc. 8 - 45

Type C Reorganization l l Similar to Type A but specific requirements must be met Acquirer must acquire substantially all the asset 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 © 2005 Prentice Hall, Inc. 8 - 46

Type C Reorganization l l Acquirer may assume an unlimited amount of Target’s liabilities only if the Acquirer’s voting stock is used in the acquisition Otherwise, the combination of boot + liabilities assumed cannot exceed 20% of consideration Only Target’s shareholders must approve the merger and liquidation of Target Acquirer may transfer Target’s assets to a subsidiary or a subsidiary may use parent stock to acquire Target in a forward triangular merger © 2005 Prentice Hall, Inc. 8 - 47

Type D Acquisitive l l Acquirer transfers substantially all of its assets to Target in exchange for stock of Target holds its own assets as well as those of Acquirer Target stock is then distributed to Acquirer’s shareholders and they received sufficient stock (50%) to control Target Acquirer may not transfer assets to a subsidiary nor use a subsidiary to acquire Target © 2005 Prentice Hall, Inc. 8 - 48

Type D Divisive l Some (but not all) of original corporation's assets are transferred to a subsidiary and subsidiary’s stock is distributed to shareholder of original corporation Spin-off – original shareholders receive a pro rata distribution of stock and do not surrender stock of the original corporation Ø Split-off – stock of new corporation is distributed to some of the shareholders in exchange for their stock in the original corporation Ø © 2005 Prentice Hall, Inc. 8 - 49

Type D Divisive l 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 Ø Original corporation goes out of business Ø Stock can be distributed to shareholders tax-free © 2005 Prentice Hall, Inc. 8 - 50

Type D Divisive l The transfer of assets results in at least two corporations, each of which must conduct an active business immediately after the transfer Ø l l Businesses 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 © 2005 Prentice Hall, Inc. 8 - 51

Type E Reorganization l l l 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 © 2005 Prentice Hall, Inc. 8 - 52

Type F Reorganization l l A change in a corporation’s name, place of incorporation, or its status from profit to nonprofit or vice versa Shareholders of the original corporation must continue as shareholders of the reorganization corporation © 2005 Prentice Hall, Inc. 8 - 53

Type G Reorganization l l 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 © 2005 Prentice Hall, Inc. 8 - 54

Other Considerations l l l Requesting an advance ruling on the tax consequences is advisable Must have a sound business purpose Must maintain a continuity of ownership by shareholders of the participating corporations Must maintain a continuity of business enterprise Status of target’s NOLs and other attributes must be considered © 2005 Prentice Hall, Inc. 8 - 55

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