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

• Both Section 357 (b) and (c) are applicable.
• Because the land is subject to two mortgages that are in excess of basis, under Section 357 (c), Rita would have a recognized gain of $375,000 on the transfer.
• But Section 357 (b) also is applicable because Rita borrowed the $125,000 shortly before incorporating and used the money for personal purposes.
• As Section 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).