Question

Mark transfers all of the property of his sole proprietorship to a newly formed Baxter Corporation in exchange for all of the Baxter stock. Mark has claimed depreciation on some of the property. Under what circumstances is Mark required to recapture previously claimed depreciation deductions? How is the depreciation deduction for the year of transfer calculated? What are the tax consequences if Baxter sells the depreciation property? Give examples and explain fully.

Answer 1

Chapter lOis concerned with the realization and recognition of gain or loss and with the determination of basis under varying circumstances indud. ing: an ordinary purchase, a bargain purchase, acquisition through gift, acquisition through inheritance conversion of property from personal use to business use, nontaxable and taxable stock dividends and 0: ~10,001 srock rights. and wash sales. EXAMPLE 10.1 ~10,01S EXAMPLE 10.2 �------------------Property Transactions: Determination 10-3 of Basis and Gains and Losses Factors in Determining Gain or loss ~10,001 DEFINITION OF REALIZED GAIN OR LOSS Realized gain or loss is the difference between the amount realized (see 1110,015) from the sale or orher disposition of property and the adjusted basis (see 11 10,025) at the time of sale or disposition. If the amount realized exceeds the adjusted basis, there is a realized gain. On the other hand, if the adjusted basis exceeds the amount realized, there is a realized loss. Code Sec. 1001(a); Reg. §J.lOOI-I(a). The term "other disposition" is interpreted broadly and includes transactions such as trade-ins, casualties, thefts, and condemnations. The term does not include a fluctuation in market value of an asset because me possibiliry for the taxpayer to gain or lose value of an asset still exists and no identifiable event has occurred EXAMPLE 10.1 to "fix" the gain or loss realized. Reg. §1.I001-1(c)(I). Adam Acres sells property with an adjusted basis of $20,000 for $30,000 and has a realized gain of $10,000. If he had sold the property for $15,000, he would have had a $5,000 realized loss. IfAdam exchanged Beach Corporation stock with an adjusted basis of $4,000 for Clark Corporation stock with a fair market value of $7,000, he has a realized gain of $3,000. If, however, Adam had Danville Corporation stock with an adjusted basis of S5,000 that has appreciated in value to S8,000, there is no realized gain because there is no sale or other disposition of the property. The recovery of cost doctrine allows the taxpayer to recover the cost of property before being taxed on rhc !'>.tkproceeds. While owning the asset, the taxpayer may recover the cost through depreciation deductions, providing it is depreciable property. Basis is reduced for the depreciation deductions and at rhe time of sale or other disposition the remaining amount of cost is recovered through a comparison of the amount realized with the adjusted basis to determine whether there is a realized gain or loss. ~10,01S AMOUNT REALIZED The amount realized from the sale or other disposition of property is the sum of any money received plus the fair marker value of other property received. It does not include any amount received from the purchaser ns reimbursement for real property taxes which are treated as imposed on the purchaser, bur it docs include amounts representing real property taxes which are treated as imposed on the seller, if they arc paid by rhe purchaser. ode Sec. 100 I(b). The amount realized from a sale or other disposition of property also includes the amount of liabilities from which the transferor is relieved as a result of the sale or disposition. 1"\C amount realized is reduced by selling expenses, Dariene Brown owns land worth $40,000 which is subject to a $16,000 mortgage. She sells it to Edward EXAMPLE 10.2 Greene who pays S24,OOOcash and also assumes the mortgage. She incurs $2,000 selling expenses. Darlene's amount realized is $3B,000 ($24,000 + $16,000 - $2,000). The "fair market value" of the property is the price a willing buyer and a willing seller would reach after bargaining where neither parry is acting under compulsion. Vano,us sources can provide evidence of value. Stock exchange quotations genetally provide evidence of the fau market value of stock except for unusually large blocks of stock. Sales of similar property on the open market are also evidence of value, and the opinion of appraisers or experts is generally given SIgnIficant weight. To summarize: Cash Received + Fair Market Value of Property and Services Received + liabilities of Seller Assumed by Buyer Selling Expenses Amount Realiled 1110,015 10-4 CCH Federal Taxation-Comprehensive ~10,02S ADJUSTED BASIS Topics ~10,030 . The concept of basis is important in federal income tax~[ion. In effect, It measur~s the amount of the taxpayer's investment in the property, which the taxpayer IS able to have ret~rned wlrI:0ur .tax c?osequences. The taxpayer's original basis of property purchased ~sgenerall! cost, b~t. In some srruanons l~~ay befair market value, or a substituted basis. To figure the adjusted basis, the ongInal cost or other basis IS adjusted in various ways to reflect additions and reductions in jnves[~enr. . The basis of property must be increased by capital expenditures a.od decreased ~~ ~pltal returns. These adjustments are made to all types of proferry for ~Il events occurring after acquisitIOn whe:her o.riginal basis is cosr, fair market value, or a substituted basts.Code Sees. 1011 and 1016. Increases 10 baSIShave the effect of reducing the amount of gain realized or increasing the amount of realized loss as wellasdepreciation or cost recovery.Decreases in basis have the effect of increasing the amount of realized gainor decreasing the amount of loss and depreciation or cost recovery. To summarize: ~10,035 Original Basis + Capital Expenditures Capital Returns Adjusted Basis Capital expenditures are costs chargeable to the capital account. Routine repair and maintenance expenses are not capital expenditures. However, improvements, betterments, acquisition COStS,purchase commissions, and legal costS for defending title are all capital expenditures. Capital returns include depreciation, depletion, amortization, tax-freedividends, compensation or awards for involuntary conversions, deductible casualty losses, insurance reimbursements, and cash rebates received by a purchaser. Code Sec. I016(a). The basis reduction for ACRS or MACRS cost recovery,depreciation, amortization, or depletion isno less than that allowable under the law. If the taxpayet claimed a higher deduction than was allowable and that deduction was allowed for tax purposes (i.e., actually deducted on the taxpayer's rerum), the basis reduction is mat higher allowed amount. If a taxpayer takes no depreciation, then the amount allowable is the amount allowable under the straight-line method. Code Sec. 1016; Reg. §1.1 0 16-3(a)(2)(I). (Basis, of course, is not reduced for depreciation on assets where it is not allowable, such as on personal useassets as a residence or personal auromobile.) EXAMPLE 10.3 JudyJergens purchased a business building inJanuary 2001 for 5390,000 to be depreciated straight-line over 39 years. She took depreciation of $10,000 a year from 2001 through 2011 and none for 2012 and 2013. She sofd the asset on January 2, 2014, for $450,000 and reported a $170,000 gain ($450,000 - ($390,000 - $110,000)). She was incorrect, however, because she should have reduced the basis by the greater of the allowed or allowable depreciation, and $10,000 depreciation was also allowable for 2012 and 2013. Thus,her gain should have been $190,000 ($450,000 - ($390,000 - $130,000)). Basis may .also.be.reducedby the amortization of a premium on taxable bonds at the raxpayere election, and a re~u.ctIon m Interest income in computing taxable income is then allowed. The basis is reduced because It IS a reco~ery of the cost. If no election to amortize premium on taxable bonds is made, chen the ta:'payer recoglllzes a smaller capital gain or a larger capital loss upon ultimate sale or disposi[io~.~e ~reml~s on ta.~-exempt ~onds must. be amortized for purposes of reducing basis, but no reduction~n Interest .