Unit 8 - Nonrecognition Property Transactions Flashcards
The 3 most common examples of non-recognition transactions are
- Selling a primary residence – excluded gain under section 121
- Like kind exchanges – non-taxable/deferred exchange under section 1031
- Involuntary conversions – exchange under section 1033
Section 121 exclusion
Only pertains to a taxpayers primary residence does not apply to rental properties, vacation, homes, or secondary residences
Taxpayers can often exclude the gain from selling their primary residence
Unmarried and MFS – up to $250,000 of gain can be excluded
MFJ – up to $500,000 of gain can be excluded
Requirements for reporting profit on the sale of a home
And where reported?
If the entire profit is excluded, it is not necessary to report the sale unless…
A form 1099 – S is received for the proceeds
If a portion of the gain is taxable – the sale must be reported on schedule D and form 8949
Any profit earned from selling a home that is not considered the primary residence – must be reported as taxable income
Keycriteria for a property to be classified as a home?
Includes having sleeping quarters, a kitchen, and bathroom facilities
Eligibility requirements for section 121
To be eligible for the section 121 exclusion, taxpayer must
- Have sold their main home.
- Meet “ownership and use” tests
- Not have excluded gain in the two years prior to the current sale of a home.
But some exceptions when the primary reason for selling the home residence was a change of employment, health, or unforeseen circumstances
Ownership test
During the five-year period ending on the date of the sale – the taxpayer must have owned the home for at least two years
Does not have to be continuous
Figured separately from the test
24 months or 730 days
Use test
During the five-year period ending on the date of the sale – the taxpayer must have lived in the home as their main home for at least two years
Does not have to be continuous
Separately from the ownership test
24 full months or 730 days
Taxpayer must physically occupy the home, except for temporary brief absences, such as short vacations and seasonal trips
Eligibility requirements for section 121 – married homeowners
Married homeowners must meet all the following conditions to meet the ownership and use test
They file a joint return
Either spouse meets the ownership test – only one is required to own the home
Both spouses meet the use test
Neither spouse has excluded gain in the two years before the current sale of the home
If only one spouse qualifies – that spouse may still be eligible for a separate exclusion of up to $250,000 – instead of claiming the full $500,000 exclusion (regardless if filing MFJ or MFS)
Home sale - special rule for the holding. For a divorce.
Ownership transfers from one spouse to the other during a divorce
But the individual must still have used, lived in, the house for the two years
Section 121 exclusion – unrelated individuals
Unmarried and unrelated individuals that cohabitate together
Both parties meet the use and ownership test
Both individuals can exclude up to $250,000 of gain on their separate returns
Section 121 exclusion – deceased spouses
Surviving spouse is treated as if they owned and lived in the home during any period that the deceased spouse did
May exclude up to $500,000 of gain from the sale if it occurs within two years after the death of the deceased spouse
As long as the surviving spouse did not remarry before the sale
Section 121 exclusion – military personnel exception
The five year period can be suspended for up to 10 years for US military, as well as for foreign service personnel, US peace corpse, workers, and intelligence officers that are on official extended duty
Offers taxpayers a greater chance to fulfill the two-year residency requirement
Section 121 exclusion – disability exception
Exception to the use test, if during the five year period before the sale of the home a taxpayer becomes physically or mentally disabled
Must have owned and lived in the home for at least one year
Considered to have lived in the home during any time that they are forced to live in a licensed facility, including a nursing home
Must still meet the two-year ownership test
Home sale section 121– rules for reduced exclusions
If taxpayer owned and used a home for less than two years or who has used the homes sale exclusion within the prior to your period…
May still be eligible for a reduced exclusion if they meet one of the following three exceptions
- Work related move.
- Health related move.
- Unforeseeable events.
Rules for reduced exclusions – work related move
Safe Harbor applies if the new job is at least 50 miles farther from the old home then was the former place of employment
If no former employment – the distance between the new place of employment and the old home must be at least 50 miles
Rules of reduced exclusions – health related move
Safe Harbor applies if a doctor recommends a change of residence for reasons of health of the taxpayer, a spouse, a child, or certain other related persons
Rules of reduced exclusions – unforeseeable events
Safe harbors include the following
Death, divorce, or legal separation
Unemployment
Multiple births, resulting from the same pregnancy
Damage to the residence, resulting from a disaster, an active war, or terrorism
Involuntary conversion of the property or condemnation
Calculating the section 121 – reduced exclusion amount
The reduced exclusion amount equals the full $250,000 or $500,000 multiplied by a fraction
The numerator is the shorter of
- The period the taxpayer owned and used the home as a principal residence during the five-year period ending on the sale date.
- The period between the last sale for which the taxpayer claimed the exclusion and the sale date for the home currently being sold.
The denominator is two years or the equivalent in months or days (730 days or 24 months)
It’s possible for the reduced exclusion amount to be more than the gain on the sale – resulting in a non-taxable gain on the full amount
Land sales
The sale of a vacant plot of land with no house on it does not qualify for the section 121 exclusion
If land is sold on which the main home is located, but not the house itself – the gain is not excludable
Land sale exclusion
Taxpayer may be able to exclude the gain from selling a vacant lot that is connected to their primary residence
Can only be applied if the vacant land was used in connection with the main home and the sale occurs within two years before or after selling the home
Must be directly adjacent to the home and must have been owned and used as part of the home – not for any business purposes
Section 121 exclusion – homes used partially for business
If a taxpayers home was used partially for business purposes or as a rental property
The gain is reported on form 4797 – sales of business property
If a taxpayer claimed depreciation deductions – they cannot exclude the portion of the gain equivalent to the amount of depreciation deducted
Section 121 only applies to the portion of a home
Homes used partially for business – calculating the exclusion amount
Rules apply for properties that are converted from a non-qualifying use such as a rental to a qualifying use such as a personal residence
Equals a fraction
Numerator is the amount of time used for business use
Denominator is the total amount of time owed
Multiplied by the total gain equals the amount, not excluded
I need depreciation would be subtracted from the excludable portion of the gain
Uncaptured section 1250 gain
The amount of depreciation claimed in prior years up to the amount of recognized gain
Technically, long-term gain with a special maximum rate of 25%
Only applies to the sale of depreciable real estate and not other types of business assets, like machinery or equipment
What is a “like-kind exchange” - section 1031 exchange
An exchange that takes place when a taxpayer trades, one qualifying real property for another
Any gain is considered postponed
Two types
- Simultaneous swap – a swap of two properties
- Deferred exchange – allows a taxpayer to sell their property and then acquire one or more replacement properties at a later date.
The following types of property may qualify for like kind treatment…
Like kind exchanges only apply to real estate exchanges
Any exchange of personal property will be treated as a non-cash sale and will not qualify for non-recognition treatment
The following types of property may qualify for like kind treatment
- Land and improvements to land such as buildings, concrete parking lots and foundations.
- Uncovered, natural products, such as natural mineral deposits, mines, and Wells.
- Water and airspace superjacent to land.
- Certain intangible interest in real property – such as leaseholds and options.
- Property that is real property under state or local law
Most common type of section 1031 exchange
Is a swap of one rental property for another
Taxpayers may exchange different types of real property – including buildings, farmland, Timberland, even undeveloped land
To qualify for non-recognition treatment – like kind exchanges must meet all the following conditions
- The property must be held for investment or business use
- The property must not be held primarily for sale – such as real estate held as inventory by a real estate dealer
- There must be an actual exchange of two or more assets or properties. - the exchange of property for cash is always treated as a sale not an exchange
- When a property is transferred in exchange for light property to be received later -(deferred exchange) - the property to be received must be identified in writing within 45 days after the date of transfer of the property given up
- For most exchanges, a qualified intermediary QI MUST BE PROCURED TO FACILITATE THE EXCHANGE USING ESCROW ACCOUNTS - this type of QI promises to return the proceeds of the exchange to the transfer of the property
Section 1031 exchange – deadline
The replacement property in a section 1031 exchange must be received by the earlier of
- The 180th day after the date on which the property was given up was transferred.
Or
- The due date, including extensions, of the tax return for the year in which the transfer of that property occurs.
The IRS is very strict about these deadlines
Qualified intermediary not needed…
Only in a simultaneous 1031 exchange – a two-party swap – is a qualified intermediary not needed
That occurs only when the exchange is processed on the same day and there is no delayed exchange
Reporting like kind exchanges – section 1031 exchange
Taxpayers report like kind exchanges on form 8824, like kind exchanges
Taxpayer must calculate and keep track of their basis in the new property. They acquired in an exchange.
Like kind exchange changes (section 1031 exchange) - nonqualified exchanges
Personal use Realty is not eligible for a like kind exchange
The exchange of a personal residence for another personal residence or an apartment building does not qualify
The prohibition would also apply to a vacation home
The exchange of property within the US for similar property outside the US also would not be a qualifying exchange
Foreign real estate is not eligible for nonrecognition treatment
Inventory is never eligible for like treatment (house, flippers or lot developers)
Like kind exchanges – taxable exchanges
If a taxpayer receives property in exchange for other property that does not meet the like kind exchange rules
May need to recognize gain, if the fair market value of the property is greater than the adjusted basis of the property given
Property received is generally FMV at the time of the exchange
Cash boot
Boot is frequently used to describe cash or other other property added to an exchange to compensate for a difference in the values of properties traded
A taxpayer must generally not receive boot, or cash, in an exchange in order for the exchange to be completely tax-free
Received – the boot is a taxable gain (after subtracting any exchange expenses, or closing costs)
Mortgage boot
When an exchange involves property that is subject to a liability – such as an existing mortgage
The assumption of the liability is treated as if it was a transfer of cash and less considered boot by the party who is relieved of the liability
On the other hand, if a party assumes a mortgage from the other party, it is treated as cash boot given to the other party
If both parties transfer a liability – taxpayer is treated as having received boot only if they are relieved of a greater liability than the liability they assume
When there is mortgage boot and cash bill in the same transaction – the mortgage boot paid does not offset any cash boot received
Calculating the basis of property received in a like kind exchange
The basis of property received in a section 1031 exchange is the basis of the property given up with some adjustments
Gain is only deferred, not forgiven, and a kind exchange
If there is no boot transfer, the basis remains the same
If cash is also given – the original properties basis, plus the cash value equals the new basis
Like kind exchanges between related parties
Are permitted
But if either party disposes of the property within two years after the exchange – the exchange is disqualified from nonrecognition treatment
Any gain or loss that was deferred in the original transaction must be recognized in the year. The disposition occurs.
The mandatory holding period rule does not apply
- If one of the parties involved in the exchange dies.
- If the part is subsequently converted an involuntary exchange such as a fire.
- If it can be established to the satisfaction of the IRS exchange and subsequent disposition were not done mainly for tax avoidance purposes.
Taxpayers must file form 8824 for the following related exchange
Involuntary conversions – section 1033 exchanges
Refers to a situation where a taxpayers property is lost, damaged, or destroyed, and the taxpayer receives a payment as a result
Examples include …
Casualty
Disaster
Theft
Condemnation
Involuntary conversions – taxable gain
Happens when a taxpayers insurance reimbursement exceeds the basis in the property
Calculating the taxable gain on the involuntary conversion payment
Taxpayer reports the gain or deduct the loss in the year, the gain or losses realized
Taxpayer can elect to defer reporting the gain from an involuntary conversion if they reinvest the proceeds in similar property
Any remaining amounts would be taxable gain
Involuntary conversions – section 1033 exchanges – replacement period
Generally ends two years after the end of the first tax year in which any part of the gain is realized
No requirement for a qualified intermediary to be employed to hold the escrow funds
Real property (real estate) that is held for investment or business use such as residential rentals and Office buildings – three year replacement period
Sale of livestock due to weather related conditions – four year replacement period
Main home in a federally declared disaster area – 4 to 5 years depending on IRS guidance
Involuntary conversions – section 1033 exchanges – calculating the basis of the replacement property
The replacement properties basis is the same as the converted properties basis on the date of the conversion subject to certain adjustments
The basis is decreased by any loss taxpayer recognizes on the involuntary conversion or any money a taxpayer receives that they do not spend on similar property
The basis is increased by any gain, taxpayer recognizes on the involuntary conversion and any additional cost of acquiring the replacement property
New basis and property equals cost of the new property minus the deferred gain
Condemnations
A specific type of involuntary conversion that involves the legal process of taking private property for public use
If a building poses a threat to public safety or health, it may be condemned by the government
It is considered a for sale – the owner is essentially selling their property to the government or another party
Same replacement period Rules applied.
Eminent domain
Gives the government the power to take private property in exchange for compensation
Same replacement period Rules apply.
Condemnation or destruction of a main home
If a taxpayers main home is condemned or destroyed – the taxpayer can exclude the gain as if they had sold the home under the section 121 exclusion
Single files can exclude up to $250,000
Joint filer can exclude up to $500,000
