Advanced Individual Income Tax

Accounting 811: Spring, 1998

Week 8: Basis and Cost Recovery

 Outline (c) 1997-98 Robert H. Daniels

 Control Panel

1. Income as "gains from dealing in property"

 One of largest, most complex code areas

A subset of this is "capital gains"
  (gains from dealing in property other than ordinary course of business)
Even tho its not big part of individual income:
  10% or less of taxable income

Concept of "basis"

tax equivalent of "book value"
As adjusted for a variety of items

COST RECOVERY of "Adjusted Basis" on sale

Needed to measure the gain element: not gross receipts
idea is that T recovers investment w/o that being taxable income

2. Measuring gain and loss on property dealings

G/L = Amt Realized ($ and FMV property) - Adj Basis

Code Sec 1001

Weakly drafted: cases center on meaning of "property"

What is the "amount realized" in the payment of debts?

Case: International Freighting

use of appreciated property to pay corporate obligation (employee bonuses) is a realization event, causing tax on difference between cost and market value

IF didn't actually get $ or property -- but it did get "money's worth" in employee services

Is example of court curing the weak language of Sec. 1001. More examples later in context of disposition of debt financed property

Adjusted Basis

basis is the measure of remaining embedded tax cost:

can think of it as previously taxed income, which is not income again when received

Sec. 1016(a) list of plus adjustment factors

realized and recognized defined: Sec. 1001(c)

unless specific exception: typically deferral
realized losses offset income only w/ specific rule

3. Sources of basis

Cost:  Sec. 1012

Cost can be debt-financed cost

limit for seller finance debt
the $1 mm nonrecourse watch tax shelter

basis "bought" when income goes thru tax system
when income is taxed, what's left has a "tax cost"

"fresh start" basis as of 3/1/13: per case law

Dying basis: Sec. 1014

if inherit property, AB = FMV at date of death: Sec. 1014

so a "step up" (or down) of inherited prop
incentive to hold appreciated property til death

Note community property rule: Sec. 1014(b)(6)

Gift basis

"Carryover" recip takes donor's AB Sec. 1015

Case: Taft v. Bowers

Facts: father gives Dtr appreciated stock in 1921, 1922
  Dtr sells in 1923

Issue: is dtr taxable on increase in value only while she held
  or while father held as well

Holding: the latter

Reasoning: issue is construction of statute

 (w/ some constitutional background)
 Gift tax was new in 1920

If father had sold, his gain would be income to him
Donee not treated as tho purchased at market: would allow father's gain to completely avoid tax

 Exception if gift tax paid: 1015(d)(6)

gt on donor's appreciation added to donee's AB

Exception if FMV less than donor's AB

rule: recip has donor's AB for gain; FMV for loss

Trade basis

Tax deferred transactions: g/l not recognized

substitute AB of prop given in as AB of prop rec'd
effect is to preserve taxable gain potential

RE trades, incorporation, much of p'ship involves basis tracking

"Boot": taxable unlike kind prop

used to equalize exchange
AB new = AB old + gain recog - $ rec'd - FMV boot rec'd

if convert prop from personal to business use:

AB is lesser of personal AB, or FMV at time of conversion

 

4. Debt financing and "amount realized":

The Crane, Woodsam, Tufts trilogy

Problem: the weak definition of amount realized

Crane v. Commissioner

 Facts:(case not assigned: background)

Mrs Crane inherited bldg worth $262K w/ $262K debt
  was during great depression.
no recourse as to her, the heir: "mortgagee in possession"

She used estate tax value for depreciation
Seven years later sold for $2,500 net, subject to mortgage

Issue: did amt realized include the amount of the debt? Held: yes

note: Mrs. C is being inconsistent: limitations

Reasoning:

Would be absurd and inconsistent to include only equity in amount realized, if debt is is property basis and depreciation

Construe the act as a whole:
  not need actual receipt of "money or other property"
  "in their narrowest sense"

Mrs. C got a benefit in the amount of the mortgage relief, since she had equity above the mortgage

Comment: Crane made tax shelters possible

Deductions based on walkaway debt
and Other People's Money

Woodsam

Facts: (not assigned) (background)

Mrs. W borrows $ and pledges property.
Debt now exceeds her basis.
Later transfers to Woodsam Co -- basis carryover

Woodsam sells, and argues that basis should have been increased by the excess of debt over AB
i.e. that Mrs. W should have realized gain when she remortgaged

Again, note Tp's inconsistency

Holding: Refinance was not a taxable transaction, regardless of basis

Comment: made tax-free cash possible

 Tufts v. Commissioner

(To be discussed in class)

5: Cost recovery: Taxation of Annuities

repeated tack-ons take it up to (w)

Types of purchased payments

Single or many premiums, fixed rate, guaranteed or variable (or inflation-linked)

One or two lives

Immediate or deferred, Wasting or refund feature,

Sec. 72 also applies to government pensions and to many retirement accounts

Divide receipts between income and return of investment

Key is Sec. 72(b): exclusion ratio

investment in contract/expected return

investment: 72(c)(1): cost less prior exclusions

expected return 72(c)(3): life expectancy or "aggregate of amounts receivable as annuity"

 (1 - Exclusion Ratio) * current payment = current income

Special rules

If overrecovered, exclusion stops

If underrecovered, deduct on last return, treat as operating loss!

lump sum refunds

allocated to income to extent of cash value buildup Sec. 72(e)(3)

10% penalty tax for premature w/drawal. Sec. 72(q)

done to equalize annuities and retirement plans 72(t)

6. Relief of Debt Creating Income

Kirby Lumber case: repurchase of bonds at a discount

Sec. 108: not income if Title 11, insolvent, (farm debt)

108(b) reduction of tax attributes: NOL, credits, basis

 Zarin