Question

(Part a.) I can't figure out what amount Mike would deduct for 12 years.

(Part b.) I can't figure out at all.

Mike and Melissa form the equal MM LLC. Mike contributes cash of $40,000 and land (fair market value of $100,000, adjusted basis of $136,000), and Melissa contributes the assets of her sole proprietorship (value of $140,000, adjusted basis of $115,000).

Mike purchased the land (value of $100,000; adjusted basis of $136,000) several years ago as an investment (capital) asset. Mike and MM LLC are trying to decide between two alternatives.

In Alternative 1, Mike will contribute the land to the LLC. MM will use the property as a § 1231 asset (a parking lot) and then sell it in six years at an estimated $100,000 price. (Disregard any potential improvements to the land.)

In Alternative 2, Mike will sell the land immediately to a third party and contribute to MM the $100,000 cash proceeds from the sale. MM will use that cash to purchase similar land for $100,000.

Use the following additional assumptions:

Neither Mike nor MM will realize other capital or § 1231 gains or losses now or in the future.

Mike's marginal tax rate is 35%.

A reasonable annual discount rate is 3%.

The tax treatment of capital and § 1231 gains and losses does not change in the foreseeable future.

a. For each alternative, when would the $36,000 loss be recognized, to whom would the loss be allocated, what is the character of the loss, and over what time period can the loss be deducted?

In Alternative 1,  the LLC would recognize the $36,000 loss in year 6 when the property is sold . Because the LLC will have held the property for more than five years, the LLC's use of the property determines the character of the loss. The loss is treated as a § 1231 loss and it is deducted by Mike .

In Alternative 2, the $36,000 loss would be recognized immediately by Mike as a long-term capital loss . As a result, Mike would be able to deduct $______ a year for the next 12 years.

b. In these two alternatives, calculate Mike's tax savings each year from deducting his share of any loss allocated to him that year. The present value factor at 3%, six years is 0.8375 and the present value factor of an annuity at 3% for six years is 5.417 and for 12 years is 9.954.

Alternative 1$_____

Alternative 2$_____

Answer 1

For Part A: Alternative 2: The answer what you have provided is sufficent because it is not asking to quantify the amount that is requried to deduct for the next 12 years. In fact the 12 years thing was not at all spoken in anywhere of the question. Since the $36,000 was the loss to be recognised immediately as the sale was made in the current year by mike and the loss to be treated as long term capital loss.

For Part B: In both alternatives Mike will be getting a long term capital profit of $36000/- for which he is required to pay tax in the same year at 35% but there is a Tax saving of $ 6300 ( Loss $36,000* 0.5 (mike share)*0.35 tax rate) in the Alternative 1 since MM LLC is going to sell the land which it has acquired from Mike at $ 1,36,000/- and sold at $ 1.00.000/- at the end of sixth year. The value of Tax saving at the end of the year one is $5276.25/- . If we divide it by the annuity factor for 6years at 3% i.e., 5.417. The annual tax savings will be $974.017. But in Alternative 2 there is no such type of tax saving because the MM LLC is not going to sell the land at the end of the sixth year.