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Showing posts with label Basis. Show all posts
Showing posts with label Basis. Show all posts

Sunday, February 18, 2024

The Consistent Basis Rule

 

I was talking to two brothers last week who are in a partnership with their two sisters. The partnership in turn owns undeveloped land, which it sold last year. The topic of the call was the partnership’s basis in the land, considering that land ownership had been divided in two and the partnership sold the property after the death of the two original owners. Oh, and there was a trust in there, just to add flavor to the stew.

Let’s talk about an issue concerning the basis of property inherited from an estate.

Normally basis means the same as cost, but not always. Say for example that you purchased a cabin in western North Carolina 25 years ago. You paid $250 grand for it. You have made no significant improvements to the cabin. At this moment your basis is your cost, which is $250 grand.

Let’s add something: you die. The cabin is worth $750 grand.

The basis in the cabin resets to $750 grand. That means – if your beneficiaries sell it right away – there should be no – or minimal – gain or loss from the sale. This is a case where basis does not equal cost, and practitioners refer to it as the “mark to market,” or just “mark” rule, for inherited assets.

There are, by the way, some assets that do not mark. A key one is retirement assets, such as 401(k)s and IRAs.

A possible first mark for the siblings’ land was in the 1980s.

A possible second mark was in the aughts.

And since the property was divided in half, a given half might not gone through both marks.

There is something in estate tax called the estate tax exemption. This is a threshold, and only decedents’ estates above that threshold are subject to tax. The threshold for 2024 is $13.6 million per person and is twice that if one is married.

That amount is scheduled to come down in 2026 unless Congress changes the law. I figure that the new amount will be about $7 million. And twice that, of course, if one is married.

COMMENT: I am a tax CPA, but I am not losing sleep over personal estate taxes.

However, the exemption thresholds have not always been so high. Here are selected thresholds early in my career: 

Estate Tax

Year

Exclusion

1986

500,000

1987- 1997

600,000

1998

625,000

I would argue that those levels were ridiculously low, as just about anyone who was savings-minded could have been exposed to the estate tax. That is – to me, at least – absurd on its face.

One of our possible marks was in the 1980s, meaning that we could be dealing with that $500,000 or $600,000 estate threshold.

So what?

Look at the following gibberish from the tax Code. It is a bit obscure, even for tax practitioners.

Prop Reg 1.1014-10(c):

               (3) After-discovered or omitted property.

(i)  Return under section 6018 filed. In the event property described in paragraph (b)(1) of this section is discovered after the estate tax return under section 6018 has been filed or otherwise is omitted from that return (after-discovered or omitted property), the final value of that property is determined under section (c)(3)(i)(A) or (B) of this section.

(A) Reporting prior to expiration of period of limitation on assessment. The final value of the after-discovered or omitted property is determined in accordance with paragraph (c)(1) or (2) of this section if the executor, prior to the expiration of the period of limitation on assessment of the tax imposed on the estate by chapter 11, files with the IRS an initial or supplemental estate tax return under section 6018 reporting the property.

(B) No reporting prior to expiration of period of limitation on assessment. If the executor does not report the after-discovered or omitted property on an initial or supplemental Federal estate tax return filed prior to the expiration of the period of limitation on assessment of the tax imposed on the estate by chapter 11, the final value of that unreported property is zero. See Example 3 of paragraph (e) of this section.

(ii) No return under section 6018 filed. If no return described in section 6018 has been filed, and if the inclusion in the decedent's gross estate of the after-discovered or omitted property would have generated or increased the estate's tax liability under chapter 11, the final value, for purposes of section 1014(f), of all property described in paragraph (b) of this section is zero until the final value is determined under paragraph (c)(1) or (2) of this section. Specifically, if the executor files a return pursuant to section 6018(a) or (b) that includes this property or the IRS determines a value for the property, the final value of all property described in paragraph (b) of this section includible in the gross estate then is determined under paragraph (c)(1) or (2) of this section.

This word spill is referred to as the consistent basis rule.

An easy example is leaving an asset (intentionally or not) off the estate tax return.

Now there is a binary question:

Would have including the asset in the estate have caused – or increased – the estate tax?

If No, then no harm, no foul.

If Yes, then the rule starts to hurt.

Let’s remain with an easy example: you were already above the estate exemption threshold, so every additional dollar would have been subject to estate tax.

What is your basis as a beneficiary in that inherited property?

Zero. It would be zero. There is no mark as the asset was not reported on an estate tax return otherwise required to be filed.

If you are in an estate tax situation, the consistent basis rule makes clear the importance of identifying and reporting all assets of your estate. This becomes even more important when your estate is not yet at – but is approaching – the level where a return is required.

At $13.6 million per person, that situation is not going to affect many CPAs.

When the law changes again in a couple of years, it may affect some, but again not too many, CPAs.

But what if Congress returns the estate exemption to something ridiculous – perhaps levels like we saw in the 80s and 90s?

Well, the consistent basis rule could start to bite.

What are the odds?

Well, this past week I was discussing the basis of real estate inherited in the 1980s.

What are the odds?

Sunday, January 28, 2024

Using A Fancy Trust Without An Advisor

 

I am a fan of charitable remainder trusts. These are (sometimes) also referred to as split interest trusts.

What is an interest in a trust and how can you split it?

In a generic situation, an interest in a trust is straightforward:

(1) Someone may have a right to or is otherwise permitted to receive an income distribution from a trust. This is what it sounds like: if the trust has income, then someone might receive all, some or none of it – depending on what the trust is designed to do. This person is referred to as an “income” beneficiary.

(2) When there are no more income beneficiaries, the trust will likely terminate. Any assets remaining in the trust will go to the remaining beneficiaries. This person(s) is referred to as a “remainder” beneficiary.

Sounds complicated, but it does not have to be. Let me give you an example.

(1)  I set up a trust.

(2)  My wife has exclusive rights to the income for the rest of her life. My wife is the income beneficiary.

(3)  Upon my wife’s death, the assets remaining in the trust go to our kids. Our kids are the remainder beneficiaries.

(4)  BTW the above set-up is referred to as a “family trust” in the literature.

Back to it: what is a split interest trust?

Easy. Make one of those interests a 501(c)(3) charity.

If the charity is the income beneficiary, we are likely talking a charitable lead trust.

If the charity is the remainder beneficiary, then we are likely talking a charitable remainder trust.

Let’s focus solely on a charity as a remainder interest.

You want to donate to your alma mater – Michigan, let’s say. You are not made of money, so you want to donate when you pass away, just in case you need the money in life. One way is to include the University of Michigan in your will.

Another way would be to form a split interest trust, with Michigan as the charity. You retain all the income for life, and whatever is left over goes to Michigan when you pass away. In truth, I would bet a box of donuts that Michigan would even help you with setting up the trust, as they have a personal stake in the matter.

That’s it. You have a CRT.

Oh, one more thing.

You also have a charitable donation.

Of course, you say. You have a donation when you die, as that is when the remaining trust assets go to Michigan.

No, no. You have a donation when the trust is formed, even though Michigan will not see the money (hopefully) for (many) years.

Why? Because that is the way the tax law is written. Mind you, there is crazy math involved in calculating the charitable deduction.

Let’s look at the Furrer case.

The Furrers were farmers. They formed two CRATs, one in 2015 and another in 2016.

COMMENT: A CRAT is a flavor of CRT. Let’s leave it alone for this discussion.

In 2015 they transferred 100,000 bushels of corn and 10,000 bushels of soybeans to the CRAT. The CRAT bought an annuity from a life insurance company, the distributions from which were in turn used to pay the Fullers their annuity from the CRT.

They did the same thing with the 2016 CRT, but we’ll look only at the 2015 CRT. The tax issue is the same in both trusts.

The CRT is an oddball trust, as it delays - but does not eliminate – taxable income and paying taxes. Instead, the income beneficiary pays taxes as distributions are received.

EXAMPLE: Say the trust is funded with stock, which it then sells at a $500,000 gain. The annual distribution to the income beneficiary is $100,000. The taxes on the $500,000 gain will be spread over 5 years, as the income beneficiary receives $100,000 annually.

Think of a CRT as an installment sale and you get the idea.

OK, we know that the Furrers had income coming their way.

Next question: what was the amount of the charitable contribution?

Look at this tangle of words:

§ 170 Charitable, etc., contributions and gifts.

           (e)  Certain contributions of ordinary income and capital gain property.

(1)  General rule.

The amount of any charitable contribution of property otherwise taken into account under this section shall be reduced by the sum of-

(A)  the amount of gain which would not have been long-term capital gain (determined without regard to section 1221(b)(3)) if the property contributed had been sold by the taxpayer at its fair market value (determined at the time of such contribution),

This incoherence is sometimes referred to as the “reduce to basis” rule.

The Code will generally allow a charitable contribution for the fair market value of donated property. Say you bought Apple stock in 1997. Your cost (that is, your “basis”) in the stock is minimal, whereas the stock is now worth a fortune. Will the Code allow you to deduct what Apple stock is worth, even though your actual cost in the stock is (maybe) a dime on the dollar?

Yep, with some exceptions.

Exceptions like what?

Like the above “amount of gain which would not have been long-term capital gain.”

Not a problem with Apple stock, as that thing is capital gain all day long.

How about crops to a farmer?

Not so much. Crops to a farmer are like yoga pants to Lululemon. That is inventory - ordinary income in nerdspeak - as what a farmer ordinarily does is raise and sell crops. No capital gain there.

Meaning?

The Furrers must reduce their charitable deduction by the amount of income that would not be capital gain.

Well, we just said that none of the crop income would be capital gain.

I see income minus (the same) income = zero.

There is no charitable deduction.

Worst … case … scenario.

I found myself wondering how the tax planning blew up.

In July 2015, after seeing an advertisement in a farming magazine, petitioners formed the Donald & Rita Furrer Charitable Remainder Annuity Trust of 2015 (CRAT I), of which their son was named trustee. The trust instrument designated petitioners as life beneficiaries and three eligible section 501(c)(3) charities as remaindermen.”

The Furrers should have used a tax advisor. A pro may not be necessary for routine circumstances: a couple of W-2s, a little interest income, interest expense and taxes on a mortgage, for example.

This was not that. This was a charitable remainder trust, something that many accountants might not see throughout a career.

Yep, don’t do this.

Our case this time is Furrer v Commissioner, T.C. Memo 2022-100.

Sunday, June 4, 2023

The Gallenstein Rule

 

It is a tax rule that will eventually go extinct.

It came to my attention recently that it can – however – still apply.

Let’s set it up.

(1)  You have a married couple.

(2)  The couple purchased real estate (say a residence) prior to 1977.

(3)  One spouse passes away.

(4)  The surviving spouse is now selling the residence.

Yeah, that 1977 date is going to eliminate most people.

We are talking Section 2040(b).

(b)  Certain joint interests of husband and wife.

(1)  Interests of spouse excluded from gross estate.

Notwithstanding subsection (a), in the case of any qualified joint interest, the value included in the gross estate with respect to such interest by reason of this section is one-half of the value of such qualified joint interest.

(2)  Qualified joint interest defined.

For purposes of paragraph (1), the term "qualified joint interest" means any interest in property held by the decedent and the decedent's spouse as-

(A)  tenants by the entirety, or

(B)  joint tenants with right of survivorship, but only if the decedent and the spouse of the decedent are the only joint tenants.

In 1955 Mr. and Mrs. G purchased land in Kentucky. Mr. G provided all the funds for the purchase. They owned the property as joint tenants with right of survivorship.

In 1987 Mr. G died.  

In 1988 Mrs. G sold 73 acres for $3.6 million. She calculated her basis in the land to be $103,000, meaning that she paid tax on gain of $3.5 million.

Someone pointed out to her that the $103,000 basis seemed low. There should have been a step-up in the land basis when her husband died. Since he owned one-half, one-half of the land should have received a step-up.

COMMENT: You may have heard that one’s “basis” is reset at death. Basis normally means purchase cost, but not always. This is one of those “not always.” The reset (with some exceptions, primarily retirement accounts) is whatever the asset was worth at the date of death or – if one elects – six months later.  Mind you, one does not have to file an estate tax return to trigger the reset; rather, it happens automatically. That is a good thing, as the lifetime estate tax exemption is approaching $13 million these days. Very few of us are punching in that weight class.

Someone looked into Mrs. G’s situation and agreed. In May 1989 Mrs. G filed an amended tax return showing basis in the land as $1.8 million. Since the basis went up, the taxable gain went down. She was entitled to a refund.

Three months later she filed a second amended return showing basis in the land as $3.6 million. She wanted another refund.

This time she caught the attention of the IRS. They could understand the first amended but not the second. Where were these numbers parachuting from?

I am going to spare us both a technical walkthrough through the history of Code section 2040.

There was a time when joint owners had to track their separate contributions to the purchase of property, meaning that each owner would have his/her own basis. I suppose there are some tax metaphysics at play here, but the rule did not work well in real life. Sales transactions often occur decades after the purchase, and people do not magically know that they need to start precise accounting as soon as they buy property together. Realistically, these numbers sometimes cannot be recreated decades after the fact. In 1976 Congress changed the rule, saying: forget tracking for joint interests created after 1976. From now on the Code will assume that each tenant contributed one-half.

That is how we get to today’s rule that one-half of a couple’s property is included in the estate of the first-to-die. By being included in an estate, the property is entitled to a step-up in basis. The surviving spouse gets a step-up in the inherited half of the property. The surviving spouse also keeps his/her “old” basis in his/her original one-half. The surviving spouse’s total basis is therefore the sum of the “old” basis plus the step-up basis.

Mr. G died before 1977.

Meaning that Mrs. G was not subject to the new rule.

She was subject to the old rule. Since Mr. G had put up all the money, all the property (yes, 100%) was subject to a step-up in basis when Mr. G died.

That was the reason for the second amended return.

The Court agreed with Mrs. G.

It was a quirk in tax law.

The IRS initially disagreed with the decision, but it finally capitulated in 2001 after losing in court numerous times.

Mind you, the quirk still exists. However, the population it might affect is dwindling, as this law change was 47 years ago. We only live for so long.

However, if you come across someone who owned property with a spouse before 1977, you might have something.

BTW this tax treatment has come to be known by the widow who litigated against the IRS: the tax-nerds sometimes call it “the Gallenstein rule.”

Saturday, April 30, 2022

Basis Basics

I am looking at a case involving a basis limitation.

Earlier today I accepted a meeting invite with a new (at least to me) client who may be the poster child for poor tax planning when it comes to basis.

Let’s talk about basis – more specifically, basis in a passthrough entity.

The classic passthrough entities are partnerships and S corporations. The “passthrough” modifier means that the entity (generally) does not pay its own tax. Rather it slices and dices its income, deductions and credits among its owners, and the owners include their slice in their own respective tax returns.

Make money and basis is an afterthought.

Lose money and basis becomes important.

Why?

Because you can deduct your share of passthrough losses only to the extent that you have basis in the passthrough.

How in the world can a passthrough have losses that you do not have basis in?

Easy: it borrows money.

The tax issue then becomes: can you count your share of the debt as additional basis?

And we have gotten to one of the mind-blowing areas of passthrough taxation.  Tax planners and advisors bent the rules so hard back in the days of old-fashioned tax shelters that we are still reeling from the effect.

Let’s start easy.

You and I form a partnership. We both put in $10 grand.

What is our basis?

                                     Me             You

         Cash                  10,000       10,000                  

 

The partnership buys an office condo for $500 grand. We put $20 grand down and take a mortgage for the rest.

What is our basis?

                                     Me             You

         Cash                  10,000       10,000                  

         Mortgage        240,000       240,000

                                250,000       250,000

So we can each have enough basis to deduct $250,000 of losses from this office condo. Hopefully that won’t be necessary. I would prefer to make a profit and just pay my tax, thank you.

Let’s change one thing.

Let’s make it an S corporation rather than partnership.

What is our basis?

                                     Me             You

         Cash               10,000        10,000                   

         Mortgage             -0-              -0-

                                10,000        10,000

Huh?

Welcome to tax law.

A partner in a general partnership gets to increase his/her basis by his/her allocable share of partnership debt. The rule can be different for LLC’s taxed as a partnership, but let’s not get out over our skis right now.       

When you and I are partners in a partnership, we get to add our share of the mortgage - $480,000 – to our basis.

S corporations tighten up that rule a lot. You and I get basis only for our direct loans to the S corporation. That mortgage is not a direct loan from us, so we do not get basis.

What does a tax planner do?

For one thing, he/she does not put an office condo in an S corporation if one expects it to throw off tax losses.

What if it has already happened?

I suppose you and I can throw cash into the S. I assure you my wife will not be happy with that sparkling tax planning gem.

I suppose we could refinance the mortgage in our own names rather than the corporate name.

That would be odd if you think about. We would have personal debt on a building we do not own personally.

Yeah, it is better not to go there.

The client meeting I mentioned earlier?

They took a partnership interest holding debt-laden real estate and put it inside an S corporation.

Problem: that debt doesn’t create basis to them in the S corporation. We have debt and no tax pop. Who advised this? Someone who should not work tax, I would say.

I am going to leverage our example to discuss what the Kohouts (our tax case this time) did that drew the Tax Court’s disapproval.               

Let’s go back to our S corporation. Let’s add a new fact: we owe someone $480,000. Mind you, you and I owe – not the S corporation. Whatever the transaction was, it has nothing to do with the S corporation.

We hatch the following plan.

We put in $240,000 each.

You: OK.

We then have the corporation pay the someone $480,000.

You: Hold up, won’t that reduce our basis when we cut the check?

Ahh, but we have the corporation call it a “loan” The corporation still has a $480,000 asset. Mind you, the asset is no longer cash. It is now a “loan.”  Wells Fargo and Fifth Third do it all the time.

You: Why would the corporation lend someone $480,000? Wells Fargo and Fifth Third are at least … well, banks.

You have to learn when to stop asking questions.

You: Are we going to have a delay between putting in the cash and paying - excuse me - “loaning” someone $480,000?

Nope. Same day, same time. Get it over with. Rip the band-aid.

You: Wouldn’t a Court have an issue with this if we get caught … errr … have the bad luck to get audited?

Segue to our court case.

In Kohout the Court considered a situation similar enough to our example. They dryly commented:

Courts evaluating a transaction for economic substance should exercise common sense …”

The Court said that all the money sloshing around could be construed as one economic transaction. As the money did not take even a breather in the S corporation, the Court refused to spot the Kohouts any increase in basis.

Our case this time was Kohout v Commissioner, T.C. Memo 2022-37.


Sunday, July 18, 2021

A Day Trader and Wash Losses

 

We have had a difficult time with the tax return of someone who dove into the deep end of the day-trading pool last year. The year-end Fidelity statement reported the trades, but the calculation of gain and losses was way off. The draft return landed on my desk showing a wash loss of about $2.5 million. Problem: the client was trading approximately $250 grand in capital. She would have known if she lost $2.5 million as either she (1) would have had a capital call, (2) used margin, or (3) done a bit of both.

Let’s talk about wash sales.

The rule was created in 1921 because of a too-favorable tax strategy.

Let’s say that you own a stock. You really believe in it and have no intention of parting with it. You get near the end of the year and you are reviewing your to-date capital gains and losses with your advisor. You have $5 thousand in capital gains so far. That stock you like, however, took a dip and would show a $4 thousand loss … if you sold it. The broker hatches a plan.

“This is what we will do” says the broker. We will sell the stock on December 30 and buy it back on January 2. You will be out of the stock for a few days, but it should not move too much. What it will do is allow us to use that $4 thousand loss to offset the $5 thousand gain.”

It is a great plan.

Too great, in fact. Congress caught wind and changed the rules. If you sell a stock at a loss AND buy the same or substantially identical stock either

·      30 days before or

·      30 days after …

… the sale creating the loss, you will have a wash sale. What the tax law does is grab the loss ($4 thousand in our example) and add it to the basis of the stock that you bought during the 30 day before-and-after period. The loss is not permanently lost, but it is delayed.

Mind you, it only kicks-in if you sell at a loss. Sell at a gain and the government will always take your money.

Let’s go through an example:

·      On June 8 you sell 100 shares at a loss of $600.

·      On July 3 you buy 100 shares of the same stock.

You sold at a loss. You replaced the stock within the 61-day period. You have a wash loss. The tax Code will disallow the $600 loss on the June 8 trade and increase your basis in the July 3 trade by $600. The $600 loss did not disappear, but it is waiting until you sell that July 3 position.

Problem: you day trade. You cannot go 48 hours without trading in-and-out of your preferred group of stocks.

You will probably have a lot of wash sales. If you didn’t, you might want to consider quitting your day job and launching a hedge fund.

Problem: do this and you can blow-up the year-end tax statement Fidelity sends you. That is how I have a return on my desk showing $2.5 million of losses when the client had “only” $250 grand in the game.

I want to point something out.

Let’s return to our example and change the dates.

·      You already own 100 shares of a stock

·      On June 8 you buy another 100 shares

·      On July 3 you sell 100 shares at a loss

This too is a wash. Remember: 30 days BEFORE and after. It is a common mistake.

The “substantially identical” stock requirement can be difficult to address in practice. Much of the available guidance comes from Revenue Rulings and case law, leaving room for interpretation. Let’s go through a few examples.

·      You sell and buy 100 shares of Apple. That is easy: wash sale.

·      You sell 100 shares of Apple and buy 100 shares of Microsoft. That is not a wash as the stocks are not the same.

·      You sell 30-year Apple bonds and buy 10-year Apple bonds. This is not a wash, as bonds of different maturities are not considered substantially identical, even if issued by the same company.

·      You sell Goldman Sachs common stock and buy Goldman Sachs preferred. This is not a wash, as a company’s common and preferred stock are not considered substantially identical.

·      You sell 100 shares of American Funds Growth Fund and buy 100 shares of Fidelity Growth Company. The tax law gets murky here. There are all kinds of articles about portfolio overlap and whatnot trying to interpret the “substantially identical” language in the area of mutual funds.  Fortunately, the IRS has not beat the drums over the years when dealing with funds. I, for example, would consider the management team to be a significant factor when buying an actively-managed mutual fund. I would hesitate to consider two actively-managed funds as substantially identical when they are run by different teams. I would consider two passively-managed index funds, by contrast, as substantially identical if they tracked the same index.  

·      You sell 100 shares of iShares S&P 500 ETF and buy the Vanguard S&P 500 ETF.  I view this the same as two index mutual funds tracking the same index: the ETFs are substantially identical.

·      Let’s talk options. Say that you sell 100 shares of a stock and buy a call on the same stock (a call is the option to buy a stock at a set price within a set period of time). The tax Code considers a stock sale followed by the purchase of a call to be substantially identical.

·      Let’s continue with the stock/call combo. What if you reverse the order: sell the call for a loss and then buy the stock? You have a different answer: the IRS does not consider this a wash.

·      Staying with options, let’s say that you sell 100 shares of stock and sell a put on the same stock (a put is the option to sell a stock at a set price within a set period of time). The tax consequence of a put option is not as bright-line as a call option. The IRS looks at whether the put is “likely to be exercised,” generally interpreted as being “in the money.”

Puts can be confusing, so let’s walk through an example. Selling means that somebody pays me money. Somebody does that for the option of requiring me to buy their stock at a set price for a set period. Say they pay me $4 a share for the option of selling to me at $55 a share. Say the stock goes to $49 a share. Their breakeven is $51 a share ($55 minus $4). They can sell to me at net $51 or sell at the market for $49.  Folks, they are selling the stock to me. That put is “in-the-money.”  

Therefore, if I sell a put when it is in-the-money, I very likely have something substantially identical.

There are other rules out there concerning wash sales.

·      You sell the stock and your spouse buys the stock. That will be a wash.

·      You sell a stock in your Fidelity account and buy it in your Vanguard account. That will be a wash.

·      You sell a stock and your IRA buys the stock. All right, that one is not as obvious, but the IRS considers that a wash. I get it: one is taxable and the other is tax-deferred. But the IRS says it is a wash. I am not the one making the rules here.

·      There is a proportional rule. If you sell 100 shares at a loss and buy only 40 shares during the relevant 61-day period, then 40% (40/100) of the total loss will be disallowed as a wash.

Let’s circle back to our day trader. The term “trader” has a specific meaning in the tax Code. You might consider someone a trader because they buy and sell like a madman. Even so, the tax Code has a bias to NOT consider one a trader. There are numerous cases where someone trades on a regular, continuous and substantial basis – maybe keeping an office and perhaps even staff - but the IRS does not consider them a trader. Maybe there is a magic number that will persuade the IRS - 200 trading days a year, $10 million dollars in annual trades, a bazillion individual trades – but no one knows.

There is however one sure way to have the IRS recognize someone as a trader. It is the mark-to-market election. The wash loss rule will not apply, but one will pay tax on all open positions at year-end. Tax nerds refer to this as a “mark,” hence the name of the election.

The mark pretends that you sold everything at the end of the year, whether you actually did or did not. It plays pretend but with your wallet. This tax treatment is different from the general rule, the one where you actually have to sell (or constructively sell) something before the IRS can tax you.

Also, the election is permanent; one can only get out of it with IRS permission.

A word of caution: read up and possibly seek professional advice if you are considering a mark election. This is nonroutine stuff – even for a tax pro. I have been in practice for over 35 years, and I doubt I have seen a mark election a half-dozen times.

Saturday, June 22, 2019

Like-Kind Exchange? Bulk Up Your Files


I met with a client a couple of weeks ago. He owns undeveloped land that someone has taken an interest in. He initially dismissed their overtures, saying that the land was not for sale or – if it were – it would require a higher price than the potential buyer would be interested in paying.

Turns out they are interested.

The client and I met. We cranked a few numbers to see what the projected taxes would be. Then we talked about like-kind exchanges.

It used to be that one could do a like-kind exchange with both real property and personal property. The tax law changed recently and personal property no longer qualifies. This doesn’t sound like much, but consider that the trade-in of a car is technically a like-kind exchange. The tax change defused that issue by allowing 100% depreciation (hopefully) on a business vehicle in the year of purchase. Eventually Congress will again change the depreciation rules, and trade-ins of business vehicles will present a tax issue.

There are big-picture issues with a like-kind exchange:

(1)  Trade-down, for example, and you will have income.
(2)  Walk away with cash and you will have income.
(3)  Reduce the size of the loan and (without additional planning) you will have income.

I was looking at a case that presented another potential trap.

The Brelands owned a shopping center in Alabama.

In 2003 they sold the shopping center. They rolled-over the proceeds in a like-kind exchange involving 3 replacement properties. One of those properties was in Pensacola and becomes important to our story.

In 2004 they sold Pensacola. Again using a like-kind, they rolled-over the proceeds into 2 properties in Alabama. One of those properties was on Dauphin Island.

They must have liked Dauphin Island, as they bought a second property there.


Then they refinanced the two Dauphin Island properties together.

Fast forward to 2009 and they defaulted on the Dauphin Island loan. The bank foreclosed. The two properties were sold to repay the bank

This can create a tax issue, depending on whether one is personally liable for the loan. Our taxpayers were. When this happens, the tax Code sees two related but separate transactions:

(1) One sells the property. There could be gain, calculated as:

Sales price – cost (that is, basis) in the property

(2) There is cancellation of indebtedness income, calculated as:

Loan amount – sales price

There are tax breaks for transaction (2) – such as bankruptcy or insolvency – but there is no break for transaction (1). However, if one is being foreclosed, how often will the fair market value (that is, sales price) be greater than cost? If that were the case, wouldn’t one just sell the property oneself and repay the bank, skipping the foreclosure?

Now think about the effect of a like-kind exchange and one’s cost or basis in the property. If you keep exchanging and the properties keep appreciating, there will come a point where the relationship between the price and the cost/basis will become laughingly dated. You are going to have something priced in 2019 dollars but having basis from …. well, whenever you did the like-kind exchange.

Heck, that could be decades ago.

For the Brelands, there was a 2009 sales price and cost or basis from … whenever they acquired the shopping center that started their string of like-kind exchanges.

The IRS challenged their basis.

Let’s talk about it.

The Brelands would have basis in Dauphin Island as follows:

(1)  Whatever they paid in cash
(2)  Plus whatever they paid via a mortgage
(3)  Plus whatever basis they rolled over from the shopping center back in 2003
(4)  Less whatever depreciation they took over the years

The IRS challenged (3).  Show us proof of the rolled-over basis, they demanded.

The taxpayers provided a depreciation schedule from 2003. They had nothing else.

That was a problem. You see, a depreciation schedule is a taxpayer-created (truthfully, more like a taxpayer’s-accountant-created) document. It is considered self-serving and would not constitute documentation for this purpose.

The Tax Court bounced item (3) for that reason.

What would have constituted documentation?

How about the closing statement from the sale of the shopping center?

As well as the closing statement when they bought the shopping center.

And maybe the depreciation schedules for the years in between, as depreciation reduces one’s basis in the property.

You are keeping a lot of paperwork for Dauphin Island.

You should also do the same for any and all other properties you acquired using a like-kind exchange.

And there is your trap. Do enough of these exchanges and you are going to have to rent a self-storage place just to house your paperwork.

Our case this time was Breland v Commissioner, T.C. Memo 2019-59.