Unit 8 - Nonrecognition Property Transactions

Question 1

The 3 most common examples of non-recognition transactions are

Answer 1

1. Selling a primary residence – excluded gain under section 121
2. Like kind exchanges – non-taxable/deferred exchange under section 1031
3. Involuntary conversions – exchange under section 1033

Question 2

Section 121 exclusion

Answer 2

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

Question 3

Requirements for reporting profit on the sale of a home

And where reported?

Answer 3

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

Question 4

Keycriteria for a property to be classified as a home?

Answer 4

Includes having sleeping quarters, a kitchen, and bathroom facilities

Question 5

Eligibility requirements for section 121

Answer 5

To be eligible for the section 121 exclusion, taxpayer must

1. Have sold their main home.
2. Meet “ownership and use” tests
3. 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

Question 6

Ownership test

Answer 6

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

Question 7

Use test

Answer 7

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

Question 8

Eligibility requirements for section 121 – married homeowners

Answer 8

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)

Question 9

Home sale - special rule for the holding. For a divorce.

Answer 9

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

Question 10

Section 121 exclusion – unrelated individuals

Answer 10

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

Question 11

Section 121 exclusion – deceased spouses

Answer 11

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

Question 12

Section 121 exclusion – military personnel exception

Answer 12

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

Question 13

Section 121 exclusion – disability exception

Answer 13

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

Question 14

Home sale section 121– rules for reduced exclusions

Answer 14

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

1. Work related move.
2. Health related move.
3. Unforeseeable events.

Question 15

Rules for reduced exclusions – work related move

Answer 15

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

Question 16

Rules of reduced exclusions – health related move

Answer 16

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

Question 17

Rules of reduced exclusions – unforeseeable events

Answer 17

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

Question 18

Calculating the section 121 – reduced exclusion amount

Answer 18

The reduced exclusion amount equals the full $250,000 or $500,000 multiplied by a fraction

The numerator is the shorter of

1. The period the taxpayer owned and used the home as a principal residence during the five-year period ending on the sale date.
2. 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

Question 19

Land sales

Answer 19

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

Question 20

Land sale exclusion

Answer 20

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

Question 21

Section 121 exclusion – homes used partially for business

Answer 21

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

Question 22

Homes used partially for business – calculating the exclusion amount

Answer 22

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

Question 23

Uncaptured section 1250 gain

Answer 23

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

Question 24

What is a “like-kind exchange” - section 1031 exchange

Answer 24

An exchange that takes place when a taxpayer trades, one qualifying real property for another

Any gain is considered postponed

Two types

1. Simultaneous swap – a swap of two properties
2. Deferred exchange – allows a taxpayer to sell their property and then acquire one or more replacement properties at a later date.

Question 25

The following types of property may qualify for like kind treatment…

Answer 25

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

1. Land and improvements to land such as buildings, concrete parking lots and foundations.
2. Uncovered, natural products, such as natural mineral deposits, mines, and Wells.
3. Water and airspace superjacent to land.
4. Certain intangible interest in real property – such as leaseholds and options.
5. Property that is real property under state or local law

Question 26

Most common type of section 1031 exchange

Answer 26

Is a swap of one rental property for another

Taxpayers may exchange different types of real property – including buildings, farmland, Timberland, even undeveloped land

Question 27

To qualify for non-recognition treatment – like kind exchanges must meet all the following conditions

Answer 27

1. The property must be held for investment or business use
2. The property must not be held primarily for sale – such as real estate held as inventory by a real estate dealer
3. 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
4. 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
5. 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

Question 28

Section 1031 exchange – deadline

Answer 28

The replacement property in a section 1031 exchange must be received by the earlier of

1. The 180th day after the date on which the property was given up was transferred.

Or

2. 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

Question 29

Qualified intermediary not needed…

Answer 29

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

Question 30

Reporting like kind exchanges – section 1031 exchange

Answer 30

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.

Question 31

Like kind exchange changes (section 1031 exchange) - nonqualified exchanges

Answer 31

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)

Question 32

Like kind exchanges – taxable exchanges

Answer 32

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

Question 33

Cash boot

Answer 33

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)

Question 34

Mortgage boot

Answer 34

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

Question 35

Calculating the basis of property received in a like kind exchange

Answer 35

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

Question 36

Like kind exchanges between related parties

Answer 36

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

1. If one of the parties involved in the exchange dies.
2. If the part is subsequently converted an involuntary exchange such as a fire.
3. 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

Question 37

Involuntary conversions – section 1033 exchanges

Answer 37

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

Question 38

Involuntary conversions – taxable gain

Answer 38

Happens when a taxpayers insurance reimbursement exceeds the basis in the property

Question 39

Calculating the taxable gain on the involuntary conversion payment

Answer 39

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

Question 40

Involuntary conversions – section 1033 exchanges – replacement period

Answer 40

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

Question 41

Involuntary conversions – section 1033 exchanges – calculating the basis of the replacement property

Answer 41

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

Question 42

Condemnations

Answer 42

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.

Question 43

Eminent domain

Answer 43

Gives the government the power to take private property in exchange for compensation

Same replacement period Rules apply.

Question 44

Condemnation or destruction of a main home

Answer 44

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