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Study Notes on Exchanges
I. Section 1031 Exchange (Introduction)
High tax rates
Large build-in gain
15%.
0% since 2008 for individuals in 10% and 15% income tax brackets.
20% for individuals in the 35% income tax brackets.
1.Ordinary income rate as high as 37% (2020) for assets held one year or less.
2. 28% rate gain on Collectible and Section 1202 stocks.
3. 25% on un-recaptured section 1250 gain, not otherwise recaptured as ordinary income, attributed to prior depreciation of real property and held for more than one year.
4. 15%(20% for high-income taxpayers) rate on the gain on assets held more than 12 months.
Investors are taking the 15% (20% for high-income taxpayers) capital gains rather than going through like-kind exchanges.
Installment sale under Section 453.
Tax deferral device.
Recognized gain on the sale of personal and real properties is generally deferred until the actual receipt of the purchase price.
A portion of the dollar received in payment of the purchase price is treated as taxable gain.
The remainder of the dollar received is treated as a return on the basis as nontaxable.
Tax Reform Act of 1986.
- Temporarily adoption of the proportionate disallowance rules.
- A seller was considered to have received a constructive payment in an amount determined under a formula geared to the seller’s outstanding borrowings and the year’s installment sales.
Revenue Act of 1987.
- Repealed proportionate disallowance rules but added restrictions.
- Installment sales are completely denied to dealers in real and personal property.
Deposition of Installment notes.
- On later disposition of an installment sale note, gain or loss must be recognized equal to the difference between the basis of the note and the amount realized.
- A sale that generated the note was between related parties, the amount realized is deemed to be the face amount of the note (§453B(f)).
- Gifts of installment obligations received from third parties result in gain or loss.
The stepped-up basis on Death.
- No stepped-up basis on death.
- A decedent would have reported on the installment basis had they lived, are taxed to the heir as “income in respect of a decedent” to the extent the obligation’s face value exceeds its basis in decedent’s hands.
- Heirs report the same portion of payments as income as the decedent would have (§691(a)(4); Reg. §1.691(a)(5)).
Related parties.
- Installment sale method not allowed if depreciable assets were sold to related parties.
- All the gains must be reported on the year of the sale (no deferral).
- A resale by a related purchaser will trigger recognition of gain by the initial seller.
- Gain will be recognized, based on the initial seller’s gross profit ratio, to the extent the amount realized on the resale exceeds actual payments made under the installment sale (§453(e)).
- Creative methods for marketing properties.
- Exchange is tax-free.
- Can avoid mortgage in excess of basis.
- Can delay or limit recapture.
- Increase leveraging.
- Improve depreciable base.
Test your knowledge
II. Section 1031 Exchange (Function)
Adding partnership interest to the list of assets for ineligible for nonrecognition treatment.
Providing time restrictions for delaying exchange.
Elimination of tax-deferred exchange treatment for the taxpayer that is expatriate to the US.
Granting a full 45 days to designate property to complete the exchange.
Stock in trade or other property held primarily for sale,
Stocks, bonds or notes,
Other securities or evidences of indebtedness or interest,
Interests in a partnership,
Certificates of trust or beneficial interests, and
Choses in action.
Equivalent to receive a tax-free loan from the government in exchange.
Under 202(c) of the Revenue Act of 1921.
Continuity of investment and administrative convenience for the government.
Yes, once the requirements are met, intentionally or accidentally, the taxpayer does not have the election to report or defer the gain or loss otherwise incurred in the transaction.