Copyright
© 1986-2008 by John A. Bogdanski. All rights reserved.
Here are my suggested answers to the practice problems from the Syllabus and Supplement. Use them to check your own solutions to the problems; feel free to print them out for your own use, if you think that would be helpful.
Please don't consult these answers until you have tried to solve the problems on your own (or with the help of other students). Just putting the questions and the answers side-by-side and treating them as additional reading defeats the purpose of the problem approach. You have enough reading to do in this course already!
These suggested answers have been checked carefully for accuracy, but there is always a possibility that an error may have gone unnoticed. If something in these answers doesn't seem correct to you, and additional study doesn't clear the problem up, please come and see me to discuss it.
Here's hoping that the problems help you excel in the class!
Jack Bogdanski
A. Gifts
1. This is a gift; B has no gross income. A gets no deduction.
2. B has $100 of gross income. See I.R.C. § 61. Assuming that A is engaged in a business in which B is working, A gets a salary deduction of $100. See I.R.C. § 162(a); cf. I.R.C. § 83(h).
3. The transfer categorically cannot be a gift, regardless of intent or motive. See I.R.C. § 102(c). Therefore, B clearly has $100 of gross income. A's deduction is not limited by I.R.C. § 274(b), because this transfer simply cannot be a gift. However, A must prove a sufficient business connection for this transfer in order to deduct the $100; given A's motivation, this seems unlikely.
4. As to B, same results as in Question 2. See I.R.C. § 102(c). A's deduction is a tough question; the deduction would probably depend on A's primary purpose in making the transfer. If A is engaged in a business in which B is working, then assuming that the compensatory purpose is the primary one, A would be entitled to deduct the $100.
5. Despite the employment relationship, this is virtually certain to be a gift; B has no gross income. See Prop. Reg. § 1.102-1(f)(2). A gets no deduction.
6. This one is not as clear as Question 5; despite the close family relationship, the transfer on payday may make the IRS suspicious about this being a gift. See Prop. Reg. § 1.102-1(f)(2) (burden on employee to "show that the transfer was not made in recognition of the employee's employment"). To the extent that the transfer is somehow held not be a gift, B has gross income, and (assuming that A is engaged in a business in which B is working) A is entitled to a salary deduction in the same amount. If the transfer is held to be entirely a gift, the results are the same as in Question 5.
7. This is a gift; B has no gross income. See Duberstein. If A is entitled to any business deduction in this circumstance -- and because of A's motivation, A may not be entitled to any deduction at all -- it is limited to $25. See I.R.C. § 274(b).
8. This is not a gift. See Duberstein. B has $100 of gross income. A gets a $100 business deduction. See I.R.C. § 162(a).
9. This requires application of the Duberstein test. The answer depends on what A's primary motivation is. If it is detached and disinterested generosity, the results are the same as in Question 7. On the other hand, if A's primary motivation is to reward B for past business, the results are the same as in Question 8. (In resolving the factual issue of motivation, feel free to apply your experience with the mainsprings of human conduct.)
10. B clearly has $5 of gross income, regardless of A's motives. See Olk. Depending on whether there is some business connection to the meal, A may be entitled to a business deduction; however, in some circumstances the deduction for a $5 tip is limited to a $2.50 maximum. See I.R.C. § 274(n).
B. Gain, loss and basis
1. Although Jay receives new stock with a total fair market value of $600 (1,000 shares times $0.60), he realizes no gain under Eisner v. Macomber. His original basis in the first 1,000 shares (50 cents per share, or $500 total) must be apportioned among the old and new shares. Following the stock dividend, each share, old or new, has a basis of 25 cents ($500 total basis / 2,000 total shares). Treas. Reg. § 1.307-1.
2. Terri's realized gain is $100 -- the difference between her amount realized on the sale ($600 cash) and her adjusted basis ($500). I.R.C. §§ 1001, 1012. Sarah's basis is her cost, $600. I.R.C. § 1012.
3. Terri's realized loss is $75 -- the difference between her amount realized on the sale ($425 cash) and her adjusted basis ($500). I.R.C. §§ 1001, 1012. Note that the loss may or may not be deductible for Terri, under I.R.C. § 165(c), and if deductible, the loss may be a capital loss with limited deductibility under I.R.C. § 1211(b). Sarah's basis is her cost, $425. I.R.C. § 1012.
4. Gifts are not usually realizing events; thus, neither Dan nor Curtis realizes any gain or loss at the time of the gift. Assuming that no gift tax was paid at the time of the gift, Curtis's basis is a carryover basis from Dan, $30,000. I.R.C. § 1015. Thus, when Curtis sells Blackacre, his gain is $25,000 ($55,000 amount realized minus $30,000 adjusted basis).
5. Once again, no gain or loss is realized at the time of the gift. Since the fair market value of the property at the time of the gift is less than Dan's basis, Curtis gets a different basis for gain purposes than for loss purposes under I.R.C. § 1015. The basis for purposes of determining gain is the usual carryover basis from Dan, or $30,000; however, for purposes of determining loss, Curtis's basis is the fair market value of Blackacre at the time of the gift, or $20,000. When Curtis sells for $55,000, he has a gain; thus, he gets to use $30,000 (not $20,000) as his basis. As a result, he realizes a gain of $25,000 ($55,000 amount realized minus $30,000 adjusted basis).
6. Once again, no gain or loss is realized at the time of the gift. Since the fair market value of the property at the time of the gift is less than Dan's basis, Curtis gets a different basis for gain purposes than for loss purposes under I.R.C. § 1015. The basis for purposes of determining gain is a carryover basis from Dan, or $30,000; however, for purposes of determining loss, Curtis's basis is the fair market value of Blackacre at the time of the gift, or $20,000. When Curtis sells for $15,000, he sustains a loss; thus, he must use $20,000 (not $30,000) as his basis. As a result, he realizes a loss of $5,000 ($15,000 amount realized minus $20,000 adjusted basis). Note that the loss may or may not be deductible for Curtis, under I.R.C. § 165(c), and if deductible, the loss may be a capital loss with limited deductibility under I.R.C. § 1211(b).
7. Once again, no gain or loss is realized at the time of the gift. Since the fair market value of the property at the time of the gift is less than Dan's basis, Curtis gets a different basis for gain purposes than for loss purposes under I.R.C. § 1015. The basis for purposes of determining gain is a carryover basis from Dan, or $30,000; for purposes of determining loss, Curtis's basis is the fair market value of Blackacre at the time of the gift, or $20,000. When Curtis sells for $25,000, it is not initially clear whether he realizes a gain or a loss. Using the basis for determining gain -- $30,000 carryover from Dan -- he realizes a loss. Using the basis for determining loss -- $20,000 fair market value at the time of the gift -- he realizes a gain. In this situation, Curtis is assigned a basis of $25,000 -- exactly the same as his amount realized. Therefore, he realizes no gain or loss.
8. Death and the passing of property at death are not realizing events; thus, neither Janice nor Kay realizes any gain or loss when Janice dies. When Kay sells the shares for $85 each, her amount realized is $85,000. Her basis in the shares is equal to their fair market value on the date of Janice's death, or $80,000. Thus, Kay's realized gain is $5,000. (If Janice's estate had properly elected to use an alternate valuation date for estate tax purposes, Kay's basis would be the fair market value on the alternate date.) On these facts, Janice's basis ($20,000) is not relevant.
9. Eddie realizes no gain or loss. Under
10. Eddie's outright sale of part of Greenacre requires him to allocate his basis in the parcel under Treas. Reg. § 1.61-6(a) and realize gain or loss. One way to "equitably apportion" the $100,000 overall basis among the 20 acres might be to assign equal value to each acre. Assuming that such an allocation is "equitable," each acre's basis would be $5,000 ($100,000/20); the basis in the 2½ acres that Eddie sold would be $12,500 ($5,000 x 2½). Subtracting this amount from Eddie's amount realized of $25,000, his realized gain on the sale would be $12,500. His basis in Greenacre after the sale (the remaining 17½ acres, that is) would be $87,500 -- the original basis of $100,000, adjusted downward by the $12,500 of basis that Eddie "used up" on the sale of the 2½ acres. Again, that would work out to $5,000 an acre ($5,000 x 17½ = $87,500).
11. Upon collection of the $2,500 from the trust, Denise realizes $2,500 of gross income. She is not permitted to use any basis to offset that amount, under Irwin v. Gavit and I.R.C. § 273. When Denise sells her life estate to Zeke for $18,000, with Gilbert keeping his remainder, Denise realizes $18,000 of gain under I.R.C. § 1001. She is not allowed to use any of the basis of the property to offset her gain. I.R.C. § 1001(e)(1), (2). If, however, Gilbert and Denise sold their interests to Zeke in a single transaction, part of the overall basis in the property ($30,000, the date-of-death value in Yolanda's estate under I.R.C. § 1014) would be allocated to Denise, and the rest of the basis would be allocated to Gilbert. Under the allocation, Denise would get to use some basis (the precise amount of which is beyond the scope of this course). Thus, any gain she realized would be something less than $18,000, and she could conceivably even realize a loss.
12. Neither Doris nor her estate has income when
C. Debt
1. Zero. Borrowed funds are not income to the borrower. Ben has no increase in his wealth, since he incurs an obligation to repay the $5,000.
2. Wally has zero income when he borrows the money. If he spends just the $18,000 he borrows on the new car, his cost basis in the car immediately after he buys it is $18,000. I.R.C. § 1012. If he adds $4,000 of his own funds to the borrowed funds -- for a total purchase price of $22,000 -- his basis in the car is $22,000, its cost.
3. (a) The making of the loan produces no tax consequences for Stuart.
(b) Later, Stuart came up with $500 to repay part of the loan. Presumably, those were dollars on which Stuart had already paid income tax. (If he borrowed the $500 from someone else, he eventually would still have to find after-tax funds to repay that $500 debt.)
(c) The cancellation of the indebtedness is not income to Stuart, since it is a gift from Frank. I.R.C. § 102(a).
4. When Connie first buys the equipment, its basis to her is $5,000 -- the principal amount she agrees to pay the dealer. This is her cost under I.R.C. § 1012. The reduction of the purchase price to $4,200, although arguably a discharge of indebtedness, is excluded from gross income as a renegotiation of the purchase price of the computer. See I.R.C. § 108(e)(5). Connie's basis is adjusted downward, from $5,000 to $4,200, as a result of the renegotiation of the price.
5. Leonora is able to obtain a release from her debt, which has an outstanding balance of $450,000, by paying only $420,000. The $30,000 difference is discharge of indebtedness income (also known as cancellation of indebtedness income); it must be included in Leonora's gross income for the year of the discharge, under Kirby Lumber.
6. Since Leonora's discharge of debt takes place in a federal bankruptcy proceeding, it is excluded from her gross income, under I.R.C. § 108(a)(1)(A). As a result, however, Leonora will lose certain future tax benefits (such as net operating loss carryforwards and even basis), under I.R.C. § 108(b).
7. Immediately before the discharge of the debt, Leonora is insolvent by $10,000; that is, the fair market values of all of her assets total $10,000 less than the amount of her total liabilities (including the debt to the bank). See I.R.C. § 108(d)(3), defining the term "insolvent." Since she is insolvent by only $10,000, only $10,000 of her discharge of indebtedness income is excluded from her gross income under I.R.C. § 108(a)(1)(B); the other $20,000 must be included in her gross income for the year in which the debt is cancelled.
8. The transfer of the widget in satisfaction of her debt is a realizing event for Edna under I.R.C. § 1001. Her amount realized is the $100 debt that she satisfies by transferring the property; subtracting her basis of $55, she has $45 of gain on the transfer of the widget to Hank. She gets no deduction, since housekeeping expenses are nondeductible personal expenses under I.R.C. § 262.
Hank has bartered his services for property. Under I.R.C. § 83, he has income of $100 (the fair market value of the widget) on the receipt of the widget. His basis in the widget immediately thereafter is his "tax cost," also $100.
9. Melissa recognizes $5,000 of gain on the transfer. Under Diedrich, a donee's assumption of the donor's liability (in excess of basis) causes the transaction to be characterized as part sale, part gift. As the outstanding amount of the debt exceeds Melissa's basis by $5,000, she has $5,000 of gain upon making the gift. Sean's basis in the land is a $25,000 cost basis under I.R.C. § 1012, since that is the amount he had to pay to obtain the property.
10. The results are the same as in Question 9. This is not a situation in which debt is being discharged (cancelled). The debt is to be satisfied in full by the transferee of the property, Sean. Therefore, I.R.C. § 108 is inapplicable, and Melissa's insolvency has no bearing on the tax consequences.
11. If Melissa has a basis of $28,000, she realizes no gain or loss upon making the gift. Gifts generally are not realizing events, and the rule illustrated by Diedrich applies only if the liability being assumed exceeds the donor's basis in the donated property. Sean gets a carryover basis of $28,000. I.R.C. § 1015.
12. Whitney pays Randy $15,000 cash and assumes a mortgage with an outstanding balance of $195,000. Under Crane, Randy's amount realized is both the $15,000 and the $195,000 mortgage assumption, for a total amount realized of $210,000. Subtracting Randy's adjusted basis of $185,000, Randy recognizes a $25,000 gain.
Whitney's basis in the duplex immediately after purchasing it is its total cost to Whitney, or $210,000. I.R.C. § 1012. Both the $15,000 cash payment and the assumed mortgage of $195,000 are included in this cost basis, pursuant to Crane.
13. On these facts, the result is the same regardless of whether the mortgage is recourse or nonrecourse. Crane applies in either case.
14. Randy's bankruptcy would have no effect, as none of the debt is being discharged (cancelled). Whitney is agreeing to pay it in full. Therefore, I.R.C. § 108 is inapplicable.
15. Under Tufts, Teresa's amount realized is the full balance of the mortgage, or $570,000. Subtracting her adjusted basis of $540,000, Teresa's gain on the abandonment of the property to the lender is $30,000. This makes sense because, while Teresa invested $20,000 of her own funds in the property originally and has paid another $10,000 in after-tax funds to the lender as repayments of principal, she deducted a total of $60,000 of depreciation. The difference between her $30,000 total after-tax investment and the $60,000 of depreciation deductions she took should be (and is) treated as gain when she "walks away from" the real estate.
While the realization of this $30,000 of gain definitely occurs, however, there is no discharge of indebtedness income here since the loan was nonrecourse. The lender received exactly what it originally bargained for -- the possibility that Teresa could abandon the property to the lender with no personal liability. (In other words, on these facts, the Wayne Barnett Theory does not prevail.) See generally Treas. Reg. § 1.1001-2(e) Example (7). So there is simply a $30,000 gain, and no discharge of indebtedness income.
16. If the loan had been recourse, and somehow Teresa was able to satisfy $570,000 of recourse indebtedness by transferring property worth only $545,000 to the lender, the analysis would be somewhat different than in Question 15. Teresa's amount realized on the sale would be only $545,000 -- the fair market value of the property at the time of the abandonment. Subtracting her basis of $540,000, she would have only $5,000 of gain.
However, the lender now has an actual or potential judgment against her for the $25,000 difference between the value of the property as abandoned and the amount Teresa owed. That $25,000 deficiency is Teresa's personal liability. And if for some reason the lender does not collect anything on that personal liability, Teresa has discharge of indebtedness income equal to that $25,000, in addition to her $5,000 gain. See Treas. Reg. §§ 1.1001-2(a)(2), 1.1001-2(c) Example (8).
Here, the lender did not receive what it bargained for, which was complete repayment "come hell or high water." Thus, in this situation, we follow an approach similar to the one Wayne Barnett advocated in Tufts. Teresa has $5,000 of gain, and $25,000 of discharge of indebtedness income.
17. If Teresa had been in bankruptcy, she would get a strikingly different tax result in Question 16 from the tax result in Question 15. In Question 15, with a nonrecourse loan, since none of the income is discharge of indebtedness income, the bankruptcy is irrelevant; all $30,000 of gain under Tufts would be included in gross income. In Question 16, however, since $25,000 of debt was discharge of indebtedness income, it would be excluded under I.R.C. § 108(a)(1)(A); only the $5,000 of gain would be included in gross income.
In addition, gain on the sale of property may qualify as capital gain. In contrast, income from discharge of indebtedness is never capital gain -- it is always ordinary income.
18. Howard realizes a gain of $90,000. His amount realized from Barb is $185,000 -- $115,000 cash plus $70,000 in assumed liabilities. His adjusted basis is $95,000. The difference between the two ($185,000 minus $95,000) is his gain, $90,000. Howard is eligible to exclude the gain under I.R.C. § 121 even if he does not reinvest in a new home. Barb's basis is $185,000 -- the $115,000 cash she paid plus the total liabilities she assumed, $70,000. Crane.
19. Irv also realizes a gain of $90,000. His amount realized from Paula is $160,000 -- $90,000 cash plus $70,000 in assumed liabilities. His adjusted basis is $70,000. The difference between the two ($160,000 minus $70,000) is his gain, $90,000. Irv is eligible to exclude the gain under I.R.C. § 121 even if he does not reinvest in a new home. Paula's basis is $160,000 -- the $90,000 cash she paid plus the total liabilities she assumed, $70,000. Crane.
D. Chapter 2 -- general essay question
"Model" answers to examination questions can be unfairly intimidating; no one can write them under true exam conditions. Therefore, rather than attempt to provide a model, here is a brief discussion of the issues presented in the problem:
The key question is whether the $10 million is includible in
There are five possible ways to characterize this $10 million award:
1. A bequest from Jane.
2. Deferred compensation for services rendered to Jane.
3. Compensatory damages for libel by Dweezil (actually, slander, since the defamation was oral).
4. Compensatory damages for assault by Dweezil.
5. Punitive damages.
A good answer to this question would ask not only in which of the five categories of receipts this award could be classified, but also what the tax consequences would be of each of the characterizations. A summary of such a discussion follows.
If the amount is a bequest from Jane, it is a gift under section 102(a)
of the Code. Amounts received in will contests can be treated as gifts, because
they can proceed from the detached and disinterested generosity of the donor.
However, if the amounts represent compensation for services rendered to Jane,
they must be included in
Is the award a bequest from Jane? Arguably yes, because of the intimate
personal nature of the relationship between the two. On the other hand,
Further, he might seek to circumvent section 102(c) by arguing that he was not Jane's employee at all (rather, an independent contractor) or that the employment relationship ended with Jane's death. He might also seek to fit into the exception in the proposed regulations under section 102(c) for transfers to employees who are close relatives of the transferor-employer; since he and Jane were not related or married, query whether such an argument could be sustained. But even if section 102(c) is inapplicable, the propriety of characterizing the award as a bequest is a difficult question of fact.
Another possible characterization of the award is as damages for
defamation. To the extent that it does represent such damages, it is included
in gross income, since only damages paid on account of personal physical
injury are excludible under section 104(a)(2). To the extent that
Assault is a different story. To the extent that the damages were on account of the assault, they are for physical injury and therefore excludible under section 104(a)(2). If the award represents damages properly attributable to the assault, any amounts paid on account of the emotional distress arising out of the physical injury are also excludible.
Any amount attributable to
Does any part of the award represent a bequest, or damages? If it is
damages, which tort did they arise from? And are the damages compensatory or
punitive? On questions such as this, the law is not entirely clear, but the Tax
Court has indicated in several cases that the test is not the validity of the
claims so much as the intent of the payor. One must
ask, these cases suggest, which claims the defendant intended to settle by
reason of the payment. Under this analysis the question would be what Jane's
estate (essentially, Dweezil) was intending to settle
when it paid
As for allocating between any compensatory and any punitive damages,
there is little guidance in precedent, but the IRS has indicated that it will
look to the relative amounts contained in the plaintiff's complaint. Under any
such analysis,
To sum up, which is it -- taxable or nontaxable? As with many essay questions, there's no clear answer, but an awful lot to write about.
E. Nonrecognition provisions
1. A tricky question! Since A is a dealer in real estate, section 1031(a)(1) of the Code may not apply at all. Section 1031(a)(2)(A) renders it inapplicable to "property held primarily for sale." Assuming A held Blackacre primarily for sale, the entire $80 of realized gain ($100 amount realized minus $20 basis) must be recognized; A's basis in Whiteacre is $100.
2. Here, section 1031(a)(1) definitely does not apply. See I.R.C. § 1031(a)(2)(B). B must recognize the entire $30 of gain realized ($70 amount realized minus $40 basis) on the exchange. B's basis in the new stock is $70.
3. Section 1031(a)(1) applies, as each truck is used in a business. Although $50 of gain is realized ($80 amount realized minus $30 basis), none of it is recognized. C's basis in the new truck is the same as that of the old, $30. I.R.C. § 1031(d).
4. To compute the recognized gain, first compute the realized gain under I.R.C. § 1001: the amount realized is $80 ($20 cash plus $60 fair market value of property received), C's basis in the old truck was $30, and thus the gain realized is $50. Next, under section 1031(b), compute the "boot," i.e., the sum of money and fair market value of nonlike-kind property received -- here, the $20 cash. The gain recognized is the lesser of the gain realized or the amount of the "boot" -- here, $20.
C's basis in the new truck is that of the old, $30, decreased by the $20 in cash received and increased in the amount of gain recognized ($20) -- in other words, a $30 basis in the new truck. I.R.C. § 1031(d).
5. Here, the gain realized is $50. The amount of "boot" (here, cash) is $60. The gain recognized is the lesser of the two, i.e., $50.
C's basis in the new truck is that of the old, $30, decreased by the $60 in cash received and increased in the amount of gain recognized ($50) -- in other words, a $20 basis in the new truck. I.R.C. § 1031(d).
6. To compute the recognized gain, first compute the realized gain under I.R.C. § 1001: the amount realized is $85 (zero cash and $85 fair market value of property received), D's basis in Greenacre was $15, and thus the gain realized is $70. Next, under section 1031(b), compute the "boot," i.e., the sum of money and fair market value of nonlike-kind property received. A truck is not of a like kind with real estate. Thus, the fair market value of nonlike-kind property received is $20. The gain recognized is the lesser of the gain realized or the amount of the "boot" -- here, $20.
D's basis in Redacre and the truck is $35, computed as follows: the basis in Greenacre, $15, decreased by any cash received (zero) and increased in the amount of gain recognized ($20), for a total new basis of $35. I.R.C. § 1031(d) (first sentence). This total must be allocated between Redacre and the new truck; the prevailing rule, under the second sentence of I.R.C. § 1031(d), is that the nonlike-kind property is assigned all the basis up to its fair market value. Here, this means that the truck gets a basis of $20, its fair market value; the other $15 is allocated to Redacre.
7. The gain realized is still $70. D's amount realized is $85 ($15 fair market value of the truck, $65 fair market value of Redacre, plus $5 realized under Crane and Tufts on account of the $5 mortgage to which Greenacre is subject). As D's basis in Greenacre was $15, the gain realized is $70. Next, under section 1031(b), compute the "boot": $15 fair market value of the truck plus the $5 mortgage on Greenacre, which is treated as cash received by D. See I.R.C. § 1031(d) (last sentence). The gain recognized is the lesser of the gain realized or the amount of the "boot" -- here, $20.
D's basis in Redacre and the truck is computed as follows: the basis in Greenacre, $15, decreased by the cash received (the $5 mortgage on Greenacre) and increased in the amount of gain recognized ($20), for a total new basis of $30. This is allocated $15 to the truck (its fair market value) and the remaining $15 to Redacre.
8. The realized gain is $60. D's amount realized is $75 ($20 fair market value of the truck and the $65 value of Redacre, minus the $10 mortgage to which Redacre is subject). As D's basis in Greenacre was $15, the gain realized is $60. Under section 1031(b), the only "boot" D receives is the truck, worth $20. Since D is taking on a new mortgage rather than giving up an old one, there is no additional "boot." The gain recognized is the lesser of the gain realized or the amount of the "boot" -- here, $20.
D's basis in Redacre and the truck is computed as follows: the basis of Greenacre, $15, decreased by any cash received (zero), increased in the amount of gain recognized ($20), plus an additional $10 "cost" basis for the mortgage on Redacre, under Crane. See Treas. Reg. § 1.1031(d)-1(a) (second sentence). Thus, the total new basis is $45, which is allocated $20 to the truck (its fair market value) and the remaining $25 to Redacre.
[Note: The material illustrated by Question 9 immediately below – mortgages both given up and assumed by the taxpayer in the same exchange – will not be included on the Fall 2008 final exam. -- J.B.]
9. The gain realized is $70, computed as follows:
|
Value of Redacre |
$ 65 |
|
Value of truck |
40 |
|
Liability to which Greenacre is subject |
5 |
|
Amount realized |
110 |
Less:
|
Basis of Greenacre |
$15 |
|
|
Redacre mortgage assumed |
25 |
|
|
Basis |
40 |
|
|
Gain realized |
|
$70 |
See Treas. Reg. § 1.1031(d)-2, Example (2). The gain recognized is the lesser of the $70 gain realized or the "boot." See I.R.C. § 1031(b). Here, the "boot" is the $40 fair market value of the truck. As to the $5 mortgage on Greenacre, it is not boot because D assumed more of a mortgage on Redacre than the $5 mortgage on Greenacre. See Treas. Reg. § 1.1031(b)-1(c). Therefore, the amount of "boot" on the transaction is $40, and $40 gain is recognized.
The total basis of Redacre and the truck are computed as follows:
|
|
Basis of Greenacre |
$15 |
|
Plus: |
Assumed mortgage on Redacre |
25 |
|
|
|
40 |
|
Less: |
Greenacre mortgage (treated as money received) |
5 |
|
|
|
35 |
|
Plus: |
Gain recognized |
40 |
|
|
Total basis |
$75 |
See I.R.C. § 1031(d) (first and third sentences); Treas. Reg. § 1.1031(d)-2, Example (2). This $75 total basis must be allocated between Redacre and the truck. Since the truck has a $40 fair market value, it receives a $40 basis; the other $35 of basis is allocated to Redacre. See I.R.C. § 1031(d) (second sentence).
10. Here, Y realizes a loss, but is not permitted to recognize it because of section 1031(a). The loss on the exchange of the old computer is $10 -- the amount realized ($35 of trade-in value) less the old computer's basis ($45). The loss is not recognized, however -- nonrecognition under section 1031 is mandatory.
Y's basis in the new computer is $85, computed as follows: $45 basis in the old computer (I.R.C. § 1031(d)), plus $40 cash contributed (I.R.C. § 1012).
11. This is a like-kind exchange, even though the parcel surrendered by Z was held for investment and the property to be received was to be held for productive use in a trade or business. See Treas. Reg. § 1.1031(a)-1(a). The gain realized is $120; the amount realized is $200 ($350 fair market value of the new property less $150 mortgage to which it is subject), and the basis of the property surrendered is $80. There is no gain recognized, and the basis of the new property is $230 -- $80 basis in the old property (I.R.C. § 1031(d)) plus $150 mortgage assumed (Crane).
12. This is an involuntary conversion as described in section 1033(a)(2). E realizes $40 gain -- the $100 cash received from the condemning authority (or insurance company) less his $60 basis. If E wishes, he may recognize the entire $40 of gain. Alternatively, E may elect nonrecognition under I.R.C. § 1033(a)(2)(A), in which case his gain is recognized only to the extent the amount realized ($100) exceeds the cost of the similar property purchased ($70). Thus, under a proper section 1033 election, E recognizes $30 of gain.
If section 1033 is not elected, E's basis in the new property is its cost, $70. I.R.C. § 1012. If section 1033 is elected, basis is governed by section 1033(b). The basis of the new property is its cost ($70), decreased by the gain not recognized on the transaction ($10), for a new basis of $60. See I.R.C. § 1033(b) (last sentence).
Unlike section 1031, section 1033 applies to property held primarily for sale; thus, on these facts, the fact of E's being a real estate dealer would appear to have no bearing on the outcome.
13. The gain realized is $30,000. The amount realized is $80,000 -- $70,000 cash plus $10,000 debt assumed (per Crane); the basis is $50,000. However, the gain is not recognized under I.R.C. § 121. The basis of the new home is its cost, $75,000.
14. The results are the same as in Question 13.
15. On the sale of Newacre, F realizes a gain of $8,000. F's amount realized is $83,000 -- the $65,000 cash and the $18,000 note. F's adjusted basis in Newacre is presumably still $75,000.
Can F escape recognition of the $8,000 gain under I.R.C. § 121? Only if he meets the two-year rule of I.R.C. § 121(b)(3) or qualifies for the exception to the two-year rule, in I.R.C. § 121(c)(2). The tax treatment of the sale of Oldacre would not be affected in any event.
F. Installment sales
1. Since Stan is a real estate dealer, it is very likely that the parcel of real estate sold to Betty was held by Stan for sale to customers in the ordinary course of his trade or business; if so, the sale is not an "installment sale" within the meaning of section 453(b) of the Code, and the installment method of reporting is unavailable. See I.R.C. §§ 453(b)(2)(A), 453(l)(1)(B). Thus, Stan computes his gain in the year of the sale by computing his amount realized -- assuming Stan is a cash method taxpayer, his amount realized is the $40 cash and $58 fair market value of the note, for a total amount realized on the sale of $98 -- and subtracting his basis of $60. His gain in the year of sale is therefore $38.
Having taken into account $58 amount realized on receipt of the note, Stan gets a basis in the note of $58. As the $60 of principal is paid on the note over the next six years, Stan has additional income totaling $2.
2. Assuming that Chrysler Corp. stock is traded on an established securities market, section 453(k)(2)(A) applies. Under that provision, the installment method is unavailable and "all payments to be received shall be treated as received in the year of disposition." Therefore, Susan's gain in the year of the sale is $750 -- the $1,000 of total payments to be received minus her $250 basis. The fair market value of Bob's note is irrelevant. Susan's basis in the note after the gain is realized on the sale is its full face amount, $200. Thus, when Bob pays the $200 the following year, no further gain is realized.
3. This is an installment sale within the meaning of section 453(b). The guarantee by Barbara's wealthy mother does not cause receipt of the note by Steve to be treated as payment in the year of sale. I.R.C. § 453(f)(3). Nor does the mortgage taken by Steve to secure Barbara's obligation.
Since the installment method applies, the gain in any year is the payment
received, multiplied by the "gross profit ratio." I.R.C. § 453(c);
Temp. Treas. Reg. § 15a.453-1(b)(2). This ratio is the gross profit to be
derived from the transaction, divided by the total contract price.
4. If Steve makes an election under section 453(d), he elects out of the installment method. In such a case, the normal realization rules of section 1001 apply. Assuming that Steve is a cash method taxpayer, his gain in the year of sale would be $85,000. His amount realized is $95,000 -- $20,000 cash down payment and $75,000 fair market value of Barbara's note -- and his basis in the property sold is $10,000.
After taking into account a $75,000 amount realized on receipt of Barbara's note, Steve gets a basis in that note of $75,000. Thus, as Barbara makes the $80,000 of additional payments over the following four years, Steve has an additional $5,000 of income.
[Note: The material illustrated by Questions 5 through 9 immediately below will not be included on the Fall 2008 final exam. -- J.B.]
5. We are back to the installment method here. As noted earlier, on the closing of the sale to Barbara, Steve has an immediate gain of $18,000. If immediately thereafter, Steve gives the note to Manny, he has disposed of an installment note, triggering gain under section 453B. Since the transaction is a gift rather than a sale or exchange, section 453B(a)(2) applies. Steve must take into account as additional gain immediately upon the gift the difference between the fair market value of the installment obligation at the time of the gift and Steve's basis in the obligation at that time.
The fair market value of the note at the time of the gift is $75,000. To compute the gain accelerated by the gift, one needs to subtract Steve's basis in the note from that figure. Steve's basis in the note is, roughly speaking, the basis he had in the sold property that he did not get to "use" at the closing. Steve's original basis in the property was $10,000. At the closing, he received a $20,000 cash down payment but was taxed on only $18,000 of gain, so he "used up" $2,000 of his basis at that time. Therefore, his basis in the note at the time of the gift must be $8,000, and his gain on the gift must be $67,000 ($75,000 fair market value minus $8,000 basis in the note).
To follow the Code language more closely, section 453B(b) describes Steve's basis in the installment obligation as the excess of the face value of the obligation ($80,000) over "an amount equal to the income which would be returnable [i.e., reportable] were the obligation satisfied in full." If the obligation were satisfied in full -- that is, if Barbara paid it off at the time at which Steve is disposing of it -- Steve's gain would be $72,000 -- a payment of the full $80,000 due, multiplied by the "gross profit ratio" of 9/10. Subtracting that hypothetical gain of $72,000 from the $80,000 face value of the installment obligation, section 453B(b) gets to the same result we did applying pure logic -- an $8,000 basis in the note.
To sum up, Steve's gain on the gift of the note to Manny would be $67,000. Manny's basis in the note would carry over from Steve under section 1015, but it would include not only Steve's $8,000 basis in the note, but also the $67,000 of gain recognized at the time of the gift, for a basis to Manny of $75,000.
6. When Steve collects each of the $20,000 down payment and first two deferred payments, he realizes $18,000 of gain. Thereafter, the face amount of the note is reduced to $40,000. When Steve sells the note to the bank for $37,500, section 453B comes into play. Since the obligation is being sold, under section 453B(a)(1), one simply subtracts from the amount realized, $37,500, Steve's basis in the installment obligation.
Since on these facts, the note has a face amount of $40,000 at the time it is sold, Steve's basis in the obligation is $4,000, computed under section 453B(b) as follows: $40,000 face amount less the amount that would have been income if the $40,000 were paid off ($40,000 x 9/10 = $36,000). Thus, the basis in the installment obligation at the time the obligation is sold (i.e., "factored") is $4,000.
Since the amount realized on the sale of the note is $37,500, and Steve's basis in the note is $4,000, his gain on the sale is $33,500. This makes sense because Steve's original basis in the property was $10,000, and he ultimately got $97,500 for it -- $60,000 from Barbara and $37,500 from the bank. He paid tax on $54,000 of gain on receipt of the payments from Barbara, and $33,500 on the sale of the note to the bank, for a total gain of $87,500 -- the correct result.
7. Normally, use of property to secure a loan is not treated as a realizing event; it is not treated as a sale or other disposition of the property. However, in certain cases, a pledge of an installment obligation being taxed under section 453 is treated as a disposition of the installment obligation, and thus a realizing event, under section 453A(d). An important question to ask, therefore, is whether section 453A(d) applies. If it doesn't, the loan is like any other loan -- not a realizing event -- and Steve can wait until he receives actual payment from Barbara to report his deferred gain. But if section 453A(d) is applicable, the loan proceeds are treated as "payment" on the note. (A $37,500 payment multiplied by the gross profit ratio of 9/10 would result in $33,750 of gain at the time of the loan.)
Section 453A(d) applies only if the sale price of the property exceeds $150,000; here the sale price is only $100,000, and so section 453A(d) is clearly inapplicable. See I.R.C. § 453A(a)(2). Steve has no gain upon taking out the loan; he will continue to enjoy installment treatment.
8. Assuming no election out of the installment method, Samantha's gain on the sale is computed under that method. The $10,000 mortgage assumed by Brian is "qualifying indebtedness" under Temp. Treas. Reg. § 15a.453-1(b)(2)(iv), and thus increases the gross profit ratio by decreasing the denominator of that fraction. The gross profit ratio here is the gross profit of $60,000 ($100,000 total contract price minus $40,000 basis), divided by $90,000 -- the total contract price of $100,000 minus the $10,000 qualifying indebtedness. See Temp. Treas. Reg. § 15a.453-1(b)(2)(iii). Therefore, the gross profit ratio is $60,000/$90,000, or 2/3 (66.67% or 0.6667).
When Samantha receives the $50,000 down payment, she has gain of $33,333.33, or $50,000 x 0.6667. As she receives each of Brian's four deferred payments of $10,000, she realizes additional gain of $6,666.67. Thus, her total gain is $60,000.
Note that when Brian pays off the mortgage he assumed from Samantha, there are no tax effects to Samantha.
9. Assuming again no election out of the installment method, the analysis is somewhat similar to that in Question 8. However, if the mortgage is greater than the seller's basis, as it is here, only part of the mortgage affects the gross profit ratio. Under Temp. Treas. Reg. § 15a.453-1(b)(2)(iii), there is subtracted from the total contract price in the denominator (here, a total contract price of $100,000) so much of the qualifying indebtedness ($30,000) as does not exceed Samantha's basis in the property (here, $20,000). As a result, the gross profit ratio is $80,000/$80,000, computed as follows: gross profit of $80,000 ($100,000 contract price minus $20,000 basis) divided by $80,000 ($100,000 contract price minus so much of the qualifying indebtedness as does not exceed basis). Hence, the gross profit ratio is 1/1.
The $10,000 of qualifying indebtedness that exceeds Samantha's basis in the property is added to her payment received in the year of sale. See Temp. Treas. Reg. § 15a.453-1(b)(3)(i) (seventh sentence, beginning "For purposes of determining the amount of payment..."). Therefore, in the year of sale, Samantha has gain of $60,000 -- the $50,000 down payment, plus the $10,000 deemed payment (mortgage in excess of basis), multiplied by the gross profit ratio of 1/1. Note that this occurs even though the payment she actually received from Brian was only $50,000.
As each of the four $5,000 of additional payments is made by Brian to her, Samantha has additional gain of $5,000, for a total gain of $80,000 overall. Once again, since Brian assumed the mortgage, his repayment of mortgage principal and interest to the lender is no longer relevant to the computation of Samantha's gain once the sale is closed.
Suggested
answers to practice examination
Multiple choice questions
1. D. This is a tough question under section 125 of the Code, relating to cafeteria plans. Because the employees have the right to choose cash in lieu of other benefits, K is in constructive receipt of $600 cash, and thus has $600 of gross income, unless section 125(a) excludes the income. Section 125(a) excludes benefits received under a "cafeteria plan" from gross income, but "cafeteria plan" is defined in section 125(d)(2) to include only plans which are limited to cash and "qualified benefits," as defined in section 125(f). Section 125(f) states that "qualified benefits" are those excluded by the Code, but not those excluded by section 106(b), 117, 127, or 132. Here the plan offers tuition reimbursement, which is excludible, if at all, only under section 127. Therefore, the tuition reimbursement is not a "qualified benefit." Therefore, the plan is not a "cafeteria plan." Therefore, K has constructive receipt of $600 cash, and it is all includible in gross income.
2. D. To answer this question, you must know both sections 1014 and 1015 well. S's gain or loss depends upon his basis; that basis is determined under section 1015. His basis for determining gain is $3,000, his mother's basis. But since the fair market value at the time of the gift ($2,000) was less than M's basis, S's basis for determining loss is $2,000. When he sells for $2,500, he has no gain or loss. This is because his carryover basis of $3,000 results in a loss, and as just explained, his basis for determining loss is $2,000; since $2,000 basis results in a $500 gain, and $2,000 is only the basis for determining loss, no gain or loss is realized.
Knowing the correct treatment of S narrows the possibilities for the correct answer down to choices B and D. B is wrong because D's gain is only $200, not $5,900. D received the heirloom upon the death of M; thus, D's basis is the fair market value for estate tax purposes, or $5,800. When D sells for $6,000, her gain is only $200.
3. D again. Under section 102(c)(1), transfers from employers to employees cannot be gifts, no matter what the motivation of the employer; thus, A is wrong. As the car wasn't transferred to charity, there is no hope for an exclusion under section 74; therefore, choice B is incorrect. Since there appears to be no exclusion for the expensive automobile under any other Code provision, D is the best answer.
4. The correct answer is C. A is incorrect since, under cases such as Smith, child care expenses are nondeductible personal, family or living expenses, disallowed under section 262. D is incorrect since school age has nothing to do with the child care credit; the age limitation is 13 years old under section 21(b)(1)(A). This narrows the choices down to B and C. C is correct because under section 21(c), the cap on employment-related expenses eligible to be taken into account is $3,000 for a household with one "qualifying individual" (here, the child). Applying the applicable percentage, 20 percent, to the maximum $3,000 of expenses, the limit on the credit here is $600. Thus, B, which allows too much credit, is incorrect.
5. A is the best answer. This is a casualty loss under section 165(c)(3), deductible subject to the 10 percent annual A.G.I. floor and the $100-per-occurrence "deductible" amount. First compute the amount of the economic loss -- the difference between the pre-fire value ($80,000) and the post-fire value ($50,000) -- or $30,000. Next, compare this to the taxpayer's basis, $40,000, and take the lesser of the two, $30,000. Subtracting the insurance proceeds ($20,000), one arrives at the figure $10,000. From this, $100 is deducted under section 165(h)(1), leaving $9,900; then, the 10 percent A.G.I. floor must be applied. H's A.G.I. is $50,000; 10 percent of that figure is $5,000. Subtracting the $5,000 from the $9,900 just calculated, the casualty loss deduction is $4,900. Thus, A is the best answer of the lot.
6. C is the best answer. This is the problem presented by Tufts, the tax treatment of dispositions of nonrecourse-mortgaged property where the fair market value of the property is less than the outstanding balance of the mortgage loan. B is wrong because it reflects the suggestion of the obsolete Crane footnote that was rejected by Tufts. D is wrong because it taxes I as if all $100,000 of the mortgage were discharged in the abandonment, whereas I paid off $15,000 of the mortgage with his own after-tax dollars, leaving only $85,000 for an amount realized. A is a somewhat appealing answer, since I is bankrupt and section 108 allows exclusion of income that results from the discharge of indebtedness in such situations -- but as the discussion (and rejection) of Professor Barnett's theory makes clear, gain from a disposition of property subject to a nonrecourse mortgage, even in the Tufts situation, does not qualify for section 108 treatment. Thus, C is correct -- an $85,000 amount realized less an adjusted basis of $80,000, with no opportunity for exclusion under section 108.
7. C. A is incorrect because it ignores Section 172. B is incorrect because T is permitted to carry the net operating loss back to past years as well as forward to future years. D is incorrect, because under current law the loss may be carried back only two years, rather than five.
8. D. All of these statements are true. A is true because the couple is above the "breakpoint" between the 25 percent bracket and the 28 percent bracket. That dividing line is $131,450 for 2008. B is also true. The couple's marginal rate is 28 percent; this is higher than 10 percent, and their overall effective rate of tax is clearly lower than 28 percent. C is also true, since for 2008 the "phaseout" of personal exemptions begins at an adjusted gross income of $239,950, and theirs is only $185,000.
Essay question
"Model" answers to essay questions are often unfairly intimidating; no one can write them under true exam conditions. Moreover, a question writer never knows all of the issues lurking in his or her handiwork. Surprises virtually always crop up in the course of grading! Therefore, I used for purposes of this practice exam an adaptation of an actual one-hour question from my summer 1987 examination (changing the dates as appropriate). Rather than tell how I would approach the problem, here are slightly adapted versions of two satisfactory answers I received on that actual exam (again, with the dates changed). They are not elegant, to be sure, but they covered the salient points to the extent necessary for a good grade in that class:
First sample answer
1.A. Under the installment method, Sid would apply the gross profit ratio to his payments received.
50K × [100K-20K (basis) / 100K] = 40K taxable gain for 2005
Barbara's original escrow account of $200,000 could be construed as constructive receipt or as evidence that Sid is using the installment method only to save taxes. Since the deal was not finalized until later, Sid will probably get away with it. The $50,000 could also be constructive receipt, but Sid's contract does not give him the right to go and get the $50,000 and the $50,000 is subject to B's other creditors, so the deal is probably good. The accounts are for sale of property, not personal services, so they are not covered by Rev. Ruling 60-31, and securing the transaction with the mortgage is not constructive receipt.
B. Barbara's basis in Redacre is $100,000 -- the purchase price. Barbara is, in effect, borrowing $50,000 from Sid and securing it with the mortgage. Borrowed money can buy basis.
C. The parties appear to have screwed up the 3-way exchange. Sid received money from Barbara, and then used the money to purchase O's property. If Barbara had given the money to O, it would have worked. Sid's receipt of the $100,000 is a recognized gain of $80,000 on Whiteacre. His basis in the leasehold is his cost -- $100,000. Sid should have given Whiteacre to O in return for the leasehold. Then Barbara can buy the Whiteacre property from O for $. The lawyer may owe Sid some tax $. O was not trading his inventory, so the deal would work.(1)
Second sample answer
1. The Initial Discussion and Offer
Sid did not constructively receive the $200,000 that Barbara put in the escrow account. Although the check was payable to Sid, he had no legal right to the money and he did not "turn his back" on it. Barbara's clear willingness to sell [sic] does not create income for Sid.
Redacre
Redacre was sold by Sid to Barbara under an installment sale contract since at least one payment will be received after the close of the current taxable year. § 453(b)(1). Sid may make an election under 453(d) to decline to use the installment method for allocating basis to each payment, and instead use § 1001 and try to use the Burnet v. Logan approach of getting all your basis out first. This will probably not be successful. Thus, under § 453 Sid may allocate a portion of his basis to each payment he receives, including the down payment. The portion is:
gross profit realized / total contract price
Sid's 2005 down payment is taxable to the following extent:
$50,000 × [$100,000 - $20,000 / $100,000] = $40,000
Subsequent payments (of principal) will use the same fraction. Interest is always ordinary income.
The mortgage secured Barbara's promise to Sid to pay $50,000 & interest. So long as the payments are made it is insignificant to Sid.
Barbara's bank account to pay the interest will provide her with interest income. It has no tax significance to Sid.
Barbara's basis in Redacre immediately after the purchase is $100,000, her cost. The mortgage & note are equivalent to a loan, the proceeds are not income and they are included in her basis.
Whiteacre
The three way transaction is unnecessarily complex and results in a higher taxable income for Sid. In sum, Sid received $100,000 from Barbara, paid $100,000 to Oscar, transferred Whiteacre to Oscar and received the lease in return.
To get the lease Sid transferred Whiteacre. Since the lease had a FMV of $100,000, Sid is taxed on $80,000 because he can subtract his basis. The $100,000 of cash because it is subtracted from the $100,000 Sid paid results in no tax implications on the deal. Sid's basis equals his cost or $100,000 in the lease.
The proper, and certainly clearer, way to handle this problem is with a three way, like kind exchange under § 1031. Barbara would pay Oscar the $100,000. Oscar, a dealer in real estate, does not qualify for non-recognition. Neither would Barbara as she's paying cash. Sid would as he's receiving property to be used in a trade or business in exchange for investment property, Whiteacre. The leasehold due to its length should be treated as a fee. Sid would transfer Whiteacre to Barbara through an exchange for the lease with Oscar. Oscar would transfer Whiteacre to Barbara. Sid would have no recognized income, although he would have realized income. Sid's basis would remain at $20,000. This differs from the previous result and is accomplished basically by keeping the cash out of Sid's hands.
1.
Note: This last sentence in the first
sample answer is incorrect. Oscar's status as a dealer of inventory would not
affect Sid.
Created by: bojack@lclark.edu
Update: 15 Nov 08
Expires: 31 Aug 09