Question

How does the transfer of mortgage property to a controlled corporation affect the transferor-shareholder’s basis in stock received? Assume that no gain is recognize on the transfer.

Answer 1

Without a provision to the contrary, the transfer of mortgaged property to a controlled corporation could trigger gain to the property transferor if the corporation took over the mortgage. This would be consistent with the rule dealing with like-kind exchanges under § 1031. Generally, when liabilities are assumed by another party, the party no longer responsible for the debt is treated as having received cash or boot. Section 357(a) provides, however, that when the acquiring corporation assumes a liability in a § 351 transaction, the transfer does not result in boot to the transferor-shareholder for gain recognition purposes. Nevertheless, liabilities assumed by the transferee corporation are treated as boot in determining the basis of the stock received by the shareholder. As a result, the basis of the stock received is reduced by the amount of the liabilities assumed by the corporation. See the more complete discussion of basis computations later.

The basis of property received by a corporation from a shareholder as a capital contribution is equal to the basis of the property in the hands of the shareholder. The basis of property transferred to a corporation by a nonshareholder as a contribution to capital is zero.
If stocks and bonds are capital assets in their owner’s hands, losses from their worthlessness are governed by § 165(g)(1). Under this provision, a capital loss materializes as of the last day of the taxable year in which the stocks or bonds become worthless. No deduction is allowed for a mere decline in value. The burden of proving complete worthlessness is on the taxpayer claiming the loss. One way to recognize partial worthlessness is to dispose of the stocks or bonds in a taxable sale or exchange.34 But even then, the investor loss is disallowed if the sale or exchange is to a related party.
Thus, any corporate debt or securities (e.g., long-term debt such as bonds) received are treated as boot because they are not an equity interest or stock. Therefore, the receipt of debt in exchange for the transfer of appreciated property to a controlled corporation causes recognition of gain