Question

Rita forms Finch Corporation by transferring land (basis of $125,000; fair market value of $750,000) which is subject to a mortgage of $375,000. Two weeks prior to incorporating Finch, Rita borrows $125,000 for personal purposes and gives the lender a second mortgage on the land. Finch Corporation issues stock worth $250,000 to Rita and assumes the two mortgages on the land. What are the tax consequences to Rita and to Finch Corporation?

Answer 1

ANSWER:Both §§ 357(b) and (c) are applicable. Because the land is subject to two mortgages that are in excess of basis, under § 357(c) Rita would have a recognized gain of $375,000 on the transfer. But§ 357(b) also is applicable because Rita borrowed the $125,000 shortly before incorporating and used the money for personal purposes. As § 357(b) causes all the liabilities to be tainted, Rita has boot of $500,000. Of Rita’s realized gain of $625,000 [$750,000 (value of the stock received and release of mortgages) –$125,000 (basis in the land)], $500,000 gain (the amount of boot) is recognized.

When§§ 357(b) and (c) both apply to the same transfer, § 357(b) predominates. Finch Corporation has a basis of $625,000 in the land, computed as follows: $125,000 (carryover basis from Rita) +$500,000 (gain recognized by Rita). Rita has a basis of $125,000 in her stock, computed as follows: $125,000 (basis in the land) +$500,000 (gain recognized) –$500,000 (liabilities assumed by Finch Corporation).