I.A Introductory Concepts, Purchases and Sales, Taxable Exchanges

Simple Sale

Taxable Exchanges When properties are exchanged, a realization event happens if property is exchanged for property that is materially different, which means it carries different legal entitlements. This means the parties are entitled to take a loss at this point. Different security, different obligors, etc. (Cottage Savings). A mere loan modification will suffice (1.1001-3)

Calculating Basis in Arms Length Taxable Exchange with Mismatched FMVs (Assuming there can be no Like-Kind Exchange; such as if stock is involved)

If You Dont Know What the FMV of Your Property Received Its whatever you give up

Using Property as Payment If someone transfers property in lieu of cash to pay off a debt, he will recognize any appreciation in the property in excess of its basis. Treat the debt discharge as amount realized in the simple sale equation.

Improvement Made By Lessee on Lessors Land During Lease Term If the lessee builds something on the lessors land that increases its value, the lessor does not recognize this until he sells the property at gain. (109)

I.B Gifts, Spouses

General Gifts: (Detached and disinterested generosity is the test; Duberstein) Donor Recognizes no gain upon transfer of the gift. Donee His basis in the gifted property depends on whether it is sold at a gain or at a loss. If the gift is sold for more than the donors basis, the donees basis is the donors basis. If the gift is sold for less than the donors basis, the donees basis is FMV at time of gift. So, if the gift is sold for less than the donors basis but more than the FMV at time of gift, the donee will neither have a gain nor a loss.

Gifts Between Spouses If one spouse gives a gift to the other spouse, the basis remains the same. (1041) This is true for gifts (transfers) that are incident to divorce as well. (within 1 year after the marriage ceases, or related to its cessation) Part Sale, Part Gift (Non-Arms Length) If someone sells property to someone else for less than FMV in a non-arms length exchange, the deal is bifurcated into a sales element and a gift element. The difference between FMV and the sale price is the gift. Donor/Seller His basis is allocated to the sale portion only. Donee/Buyer His basis is the greater of the donors basis, or amount donee paid for the property.

I.C Transfers at Death

Bequests Decedent Recognizes no gain upon transfer Donee His basis is the FMV of the property at time of decedents death. Planning Tips: If property is appreciated, the decedent should hold onto it and pass it along at death. If property is depreciated, the decedent should give it to the donee while he is still alive.

Automatic Long-Term Holding Period If a donee gets property through a bequest, and the donee sells the property within 1 year, it is treated as being held for more than one year. (1223(9)) Allows for a long-term capital gain.

Prospective Payee Dies Before Receiving Income If someone is due money, and he dies before receiving it, and the money is not properly includible in the tax year when he died (or in a prior year): The money is taxed to the recipient, whether estate, beneficiary or heir, when collected. (look at the will) (691) The money is treated as if in the hands of the decedent, and is income to the person who receives it.

II.A Theory and Stakes, Property Qualifying for Cost Recovery

Depreciation of Capital Expenditures If something is a business expenditure that will generate income for the taxpayers business, and it has an estimable useful life beyond one year, then it is a capital expenditure that must be depreciated rather than deducted.

Value of a Deduction The value of a deduction today: How much does the taxpayer need to put in the bank today, in order to get the deduction amount at the end of the depreciation period? Land The cost of raw land is not depreciable. But, if the costs of land preparation relate more to depreciable assets (like a golf green drainage system) than to the land itself, you might be able to depreciate. (RR 2001-60)

Artworks Artworks are not depreciable, even when used in a trade or business. (No determinable useful life; not subject to wear and tear)

Expenditures Incurred in Organizing a Corporation Organizational expenditures (like costs paid to lawyers for drafting documents; does not include cost of transferring capital to the corporation) are deductible up to $5000 in the year when business commences, reduced by the extent that organizational expenditures exceed $50,000. (248) The remainder that cant be deducted up front (that exceeds $5000 or the reduced limit) is deducted straight-line over 15 years, beginning in the year when the original $5000 is deducted. Example: $35,000 of organizational expenses. Corp. may deduct $5000 up front; remaining $30,000 is deducted ratably ($2000 a year for 15 years). Total deduction in year 1 would be $7000.

A Building Sitting on Land, that has been Leased to a Third Party at FMV The land is not depreciable The lease has no separate value (assuming its at FMV), so it is ignored (167(c)(2) Allocate the purchase price between the land and the building according to FMV. If a portion of the price was for the value of the lease, then to acquire the property, the new owner would have to pay a premium: 167(c)(2)- The new owner allocate to the lease. The basis goes to the underlying property; land and/or building.

Land, Leased Away, and Lessee Built Building On It You need ownership and a basis to depreciate land. Lessor The lessor has no basis in the building and is not entitled to depreciate it. When the lease is over, the lessor will have a basis of $0 in the building, so he may not depreciate it then, either. Lessee The lessee is entitled to depreciate the costs of the building because he built it and has a basis in it. He will depreciate according to the usual depreciation period (27.5 or 39 years), despite having a shorter lease. If the lease ends before the lessee has finished depreciating it, he may take a loss for the remaining basis. (Geneva Drive-In)

A Building on Land, Leased to a Third Party, Reversionary Interest in Building Reflected in Sales Price The purchaser must allocate the purchase price between the land and the reversionary interest in the building. He may not depreciate the building until after the lease is over and it starts generating income. (Matching Principle) (Geneva Drive-In)

Land, Leased to a Third Party for Rent Higher than FMV, Sold Subject to Lease The taxpayer may not allocate any of the purchase price to the value of the lease, even if it is for more than rental value and is therefore valuable. (167(c)(2)). He must allocate that cost to the property subject to the lease. Here, the underlying property is just land, which is not depreciable, so he will have to wait until he sells the property to recover his basis.

II.B Intangibles

Basic Strategy First, see if the intangible may be depreciated under 197 All items covered by 197 have the same depreciation period of 15 years 197(c) says an amortizable section 197 intangible must be 1. Acquired by the TP, and 2. Held for income-producing purposes. The intangible cannot be self-created, and must be listed in (d)(1)(D/E/F). If its self-created, you cant amortize it, and you must wait to recover it when you sell the business.

If the intangible is not covered by 197, see if it can be depreciated under 167 You can get a depreciation deduction over the useful life of the asset acquired as long as it has a finite useful life. If it does not have finite useful life that is determinable, then it is not depreciable. (167(a)-3) You can use either straight-line over useful life, or the Income Forecast Method Goodwill or Going Concern Value Is depreciable (amortizable) under 197(d)(1)(A); 15 years ratably, if acquired.

Noncompete Covenant Acquired as part of the Purchase of a Business Covenants not to compete are depreciable under 197(d)(1); 15 years ratably. It doesnt matter how long the covenant runs. If it ends before the 15 year period, you cant claim a loss on the covenant unless you actually sell the entire business. (197(f)(1)(b)).

Noncompete Covenant Signed in Connection with Existing Business This is not a section 197 intangible because it wasnt acquired in connection with the acquisition of an interest in a trade or business. But, it has an determinable useful life. Amortize ratably over its useful life under 167. (RR 68-636)

Customer List or Subscriber List Is amortizable under 197; 15 years ratably.

U.S. Rights to a Motion Picture Acquired in Acquisition of Trade or Business Is amortizable under 197; 15 years ratably.

U.S. Rights to a Motion Picture Acquired Separately This is not a 197 intangible because it was acquired separately. This is not a tangible under 168. 167 allows you to amortize it either using the: Straight-Line Method, or if you elect, Income Forecast Method (RR 60-358)

Income Forecast Method Only available for movies, films, sound recordings, patents, copyrights, books. 197(g)(6) Maximum recovery period is 11 years. How it works: If the estimates were either too high or too low, interest will be paid by either the taxpayer or the government. The IFM is good because you are likely to make more money in earlier years, so you recover more up front. Also its recovery period is shorter than 197. You would only elect straight-line if you think you will make more money in the future, and wont be able to use a large write-off in the earlier years.

Nonresidential 39Residential 27.5 Computer - 5Leasehold on Real Property A leasehold interest is not a section 197 intangible. Amortize ratably over the remaining term of the lease. But, the recovery period will include renewal options if less than 75% of the cost is attributable to the lease remaining at the time of acquisition. Example: if $2000 is attributable to the 10 years remaining, and the remaining $8000 is attributable to the renewal period.

Patent Acquired in Connection with Acquisition of Trade or Business Such a patent is a Section 197 intangible. Amortize over 15 years, regardless of the remaining useful life of the patent.

Patent Created By Taxpayer May be deducted immediately upon the taxpayers election with respect to research and development. (174)

Patent Acquired Separately You may use either the: Straight-line method, or the Income Forecast Method. Special alternative ways if the patent is fixed per use, etc. (1.167(a)-14)

If a Section 197 Intangible becomes worthless before the 15 Year period is Up, or if the Section 187 intangible is Sold If taxpayer has other 197 intangibles that were acquired in the acquisition of the trade or business: He cannot recognize a loss unless he disposes of all assets acquired in the acquisition of the trade or business. Instead: Add this to the basis of each retained Section 197 intangible: (1.197-2(g)(1))

If an Intangible is Depreciated using Straight-Line or Income Forecast Method, and it Becomes Worthless or is Sold The taxpayer may take a loss on the unrecovered basis.

If a Section 197 Intangible Has a Contingent Purchase Price (Like $40,000 down and 40% of annual net profits derived from the intangible) The initial payment is amortized ratably over 15 years. Any additional payment is amortized ratably over the remaining months of the original 15-year period. (1.197-2(f))

If a Non-197 Intangible Has a Contingent Purchase Price The fixed portion is amortized straight-line over the life of the patent, or using the income forecast method. The contingent portion: If payable at least annually as a fixed amount per use or fixed percentage of revenue, then current deduction in amount paid (Associated Patentees) Otherwise, straight line or income forecast method. (1.167(a)-14

II.C Tangible Personal Property and Real Property

Basic Strategy First, see if 179 applies (the full deduction, with $500k limit that is reducible). Take any excess basis and then: Second, see if 168(k) applies. (50% reduction in basis for new property with recovery period of 20 years or less, placed into service 12/31/07 1/1/14). Then, Go to 168 and depreciate the remainder of basis.

Section 179 Applies to Section 179 Property, which is: (179(d)(1)) Tangible property to which 168 applies (depreciable property), or computer software, that is also Section 1245 property (not real estate), and was PURCHASED for use in trade or business (not investment property). Cant be from related party (siblings dont count; 179(d)(2)) May be New or Old property. Doesnt matter if you borrow to buy. It allows you to deduct the entire cost of the property in the year it was placed into service, up to $500,000 in 2013. But, only taxable Trade or Business Income may be offset. Also, there is a phase-out to the $500,000 limit: The limit is reduced by the amount that the total section 179 property placed into service exceeds $2,000,000. So, if this applies, you deduct the entire cost of the property and you get a 0 basis.

Section 168(k) Applies only to NEW property, acquired after 12/31/07 and placed into service before 1/1/14, with a recovery period of 20 years or less (no real estate). (qualified property). 168(k) is elective. Allows the taxpayer to deduct 50% right off the basis.

Sections 167/168 If you have tangible property that is depreciable under 167 (held for use in trade/business), you depreciate the way 168 tells you to do it. 168 says you must determine the applicable depreciation method, recovery period, and convention. Doesnt matter if its used or new. Ignore salvage value.

First, find the recovery period. (168((i)). Some things are explicitly given recovery periods in 168(e) and 168(c) Like computers, which is qualified tech. equipment with 5 year r.p. If its not in 168(e), check Rev. Proc. 87-56 If its not there, then its 7 year property. (168(e)(3)(C)) 168(i) class life 168(e) year property 168(c) recovery period

Second, determine the depreciation method. (168(b)) The default is the 200 percent declining balance method, which applies to the declining adjusted basis. You then switch to straight-line in the first taxable year in which doing so would yield a larger allowance. There is the 150 percent declining balance method, which is mandatory for some properties and is optional for others. A taxpayer might choose it to make it easier to calculate the AMT. Theres also straight line. Finally, theres also the Alternative Depreciation System in 168(g), which is even slower and might be used in computing earnings and profits.

Third, determine the applicable convention. (applies to year of acq. + disposition) The default is half year; property is treated as placed into service at the mid-point of the year in which it was placed into service. For real property, its mid-month. If more than 40 % of the basis of section 168 non-real estate property is placed in service during the last 3 months of the year, its mid quarter. (If its mid-quarter, 4th quarter, you get 1.5 months of depreciation in year 1 and 10.5 months of depreciation in the last year).

Illustration of applying the 5-year recovery period, 200-balance method, and mid-month convention to non-179 property with a $100,000 basis: (remember there will actually be 6 years)1. Apply 168(k) and subtract 50% (50,000 remains)2. Determine the straight-line applicable percentage:a. (here, 20%)3. Double the applicable percentage to get the 200-balance percentage (here, 40%)4. Year 1: Take into account the convention. Here, were using the midmonth convention, so our year 1 deduction will be half of 40% of 50,000, or 20%, or $10,000 (40,000 remains)5. Year 2: Subtract 40% of 40,000, or 16,000 (24,000 remains)6. Year 3: Subtract 40% of 24,000, or 9600 (14,400 remains)7. Year 4: Subtract 40% of 14,400, or 5760 (8640 remains)8. Year 5: The 200-balance method would yield a deduction of 3456. a. To figure what the straight-line amount would be: divide the remaining balance by the remaining years: which is more, so use that. (2880 remains)9. Year 6: Recover the remainder, 2880.

If you sell the property in the middle of the depreciation process: Use the applicable convention in the year of sale. So, if its sold in year 3, and youre using the 5 year/200-balance/mid-month method as above, you subtract 20% of year 2s balance to get your final year 3 balance, which the basis you use to calculate gain.

Real Property (Land and Building) 179 is inapplicable because it is not Section 1245 property 168(k) is inapplicable because its limited to property with a recovery period of 20 years or less Allocate the price between the land (which is not depreciable) and the building (which is). Only depreciate the buildings portion. If its nonresidential real property (like a hotel), you will use the 39-year recovery period and the mid-month convention.

III.A Effect of Debt on Basis

Recourse Debt Always creates basis. This includes buying property by assuming a mortgage; its paying with recourse debt issued by the sellers old lender. This includes buying property by giving the seller a purchase money mortgage (if buyer is personally liable) The seller is the lender in this case.

Nonrecourse Debt (really about having the right to take depreciation deductions) If the nonrecourse debt approximates the FMV of the property, it will be taken into account and added to basis. (presumption is that the taxpayer would rather pay off the debt than lose his equity in the property in foreclosure) If the nonrecourse debt far exceeds the current FMV of the property, the debt will not be taken into account and will not be added to basis (cash will be, though, unless its a total sham.) (presumption is there is no equity to protect and he will walk from the deal) It doesnt matter if the property actually went up in value; we decide on day 1. (All of this is from Franklin)

Contingent Purchase Price (Like, $100 down and 50% of profits derived from property for next 5 years) Contingent liabilities are not included in basis. Only the cash down would be included. (Albany Car Wheel) (RR 77-110) Proposed regs say that payments should be added to basis when made. (1.168-2(d)(3)).

Nonrecourse Debt, Option to Satisfy Note with Principal Payment at a Discount (Like, $250 with p.m.m., option to settle in full with payment of $200 in year 3) The taxpayer will have a full basis as long as the nonrecourse debt approximates the FMV of the property. If the buyer does exercise the option and pays off the debt at a discount: 108(e)(5) says he gets a price adjustment and basis reduction. This only applies where the debtor was the buyer of property and the seller is the lender and releases the buyer from part of the debt. Proposed regs say that you should use this new basis to calculate depreciation going forward.

III.B Dispositions of Encumbered Property; Cancellation of Indebtedness

Second Mortgages Second mortgages are not added to the basis of the property they are taken against. Its not income to the borrower, and nothing happens when its paid off, either. However, if a subsequent buyer relieves the taxpayer of a second mortgage (even if nonrecourse), that is included in amount realized with respect to the property.

Gift, in which Debt is Shed (Part Sale Part Gift). If someone transfers property to someone else that has debt attached to it, it is considered a part sale part gift. It is a taxable disposition to the donor. To calculate the donees basis in the property:

Foreclosure Sale, with Non-Recourse Mortgage (No COD) The taxpayers amount realized is whatever debt he has been relieved of, that is connected with the property subject to the foreclosure. This includes nonrecourse debt that is included in his basis, and second mortgages. It does not include nonrecourse debt far exceeding the FMV. FMV of the property is irrelevant, as is the sale price of the foreclosure. A deed in lieu of foreclosure is treated exactly the same (if the property is simply transferred to the mortgagees with no foreclosure sale, in exchange for debt relief)

Foreclosure Sale, with Recourse Mortgage (Possible COD) The taxpayers amount realized is whatever was actually recovered from the foreclosure sale, because he hasnt been relieved of any debt. Its recourse. AR AB = gain or loss. If its a loss, it can be recognized, if the land was held for trade/biz. (can have both COD and loss; its bifurcated). Bad debt is possible to the forgiver. If the debt is actually cancelled, that will be COD income to the taxpayer. He might get relief through a 108 provision. If appreciated property is used to settle a debt, the taxpayer must recognize a gain on the appreciation.

Availability of 108 If the taxpayer is insolvent, he may use 108(a)(1)(B), which says the taxpayer may exclude debt that is cancelled and lower his basis in the property by that amount. To the extent he is rendered solvent, there is cancellation of debt income. The taxpayer must reduce certain tax attributes, and he gets smaller depreciation deductions going forward. But, he may elect to first reduce the basis of his depreciable assets. Solvency is determined by looking at assets and liabilities before and after the cancellation of debt. Insolvent if liabilities exceed assets. COD reduces liabilities.

If the taxpayer is not insolvent, hey may still use 108 if this is qualified real property indebtedness. (108(a)(1)(D)) QRPI: The taxpayer may not be a C corporation, The debt was incurred or assumed by the taxpayer in connection with real property used in a trade or business and is secured by such real property, The debt was incurred to construct, acquire, or improve the property, And the taxpayer elects to have it be treated as QRPI. There are two limits: If debt exceeds FMV in property: Amount you can exclude from COD cannot exceed the amount of the principal debt before the discharge, less the FMV of the real property securing the debt. Amount you can exclude from COD cannot exceed the aggregate adjusted bases of depreciable real property held by the taxpayer immediately before the discharge. So if the property is leased, and its his only property, then he has no depreciable real property and he cant exclude any COD.

Alternatively, if the taxpayer is not insolvent, try qualified principal residence indebtedness (108(a)(1)(E): Any COD income can be excluded, up to $2,000,000. The cancellation must occur because of a decline in the value of the residence, or be based on the taxpayers financial condition. The taxpayer would normally reduce his basis in the house by the excluded COD income, but if there has been a foreclosure and there is no longer any house left, he cant, but he still gets the COD exclusion. If he is allowed to keep the house, then the basis is reduced.

Alternatively, if the property (any type of property) is seller financed, 108(e)(5) can apply: The buyer/debtor gets a price reduction and basis reduction in the amount of the COD. This only applies where the debtor was the buyer of property and the seller is the lender and releases the buyer from part of the debt. Proposed regs say that you should use this new basis to calculate depreciation going forward.

IV.A Capital Gains and Losses, Net Investment Income Tax

Capital Assets 1221(a): capital assets do not include: stock in trade, or inventory, held primarily for sale to customers real and depreciable property used in business, like land, buildings, machinery, and equipment (subject to special treatment under 1231) copyright, literary, musical, or artistic composition, letter or memo, or similar, held by the person who created it (for letter or memo, to whom it was intended) accounts or notes receivable acquired in ordinary course of business a publication of the US government any commodities derivative financial instrument held by such a dealer any hedging transaction clearly identified as such supplies of a type regularly used or consumed by taxpayer in the ordinary course of a trade or business

Capital Gains and Losses First, divide into 4 categories: Long term gains; long term losses; short term gains; short term losses. Second, net the long-term gains/losses, and then net the short-term gains/losses. Youll have an overall long term gain/loss, and an overall short term gain/loss. Third: If gains in both categories: shorts taxed at normal rates; longs at 20% If losses in both categories: combine both, and offset against $3000 of ordinary income with unlimited carryforward. If excess of short term gain over long term loss, the excess is short term gain which is taxed at the normal rate. If excess of long term gain over short term loss, the excess is long ter gain which is taxed at 20%. If the net loss in either category exceeds the net gain in the other, the exess loss is offset against $3000 of ordinary income, with unlimited carryforward

Collectibles (artworks, etc.) May be either long-term or short-term capital gain/loss, depending on holding period Taxed at 28% for investors; taxed at ordinary rates for dealers.

Qualified Dividends Taxed at 20% if: Held for 60 days during the 121 day period beginning 60 days before the ex-dividend date. Otherwise, taxed at 39.6%. Dividends cannot be offset by capital losses.

1231 Property Real or depreciable property used in a trade or business, held for more than one year, which is not inventory. Net all the 1231 gains and losses in a year If more 1231 gains than losses: gains and losses are all treated as long-term capital gains and losses If more 1231 losses than gains: gains and loss are all treated as ordinary gains and losses If you sell one more item at a gain in a loss year, it will be taxed at the ordinary rate If you sell one more item at a loss in a gain year, it is a capital loss If, in a given year, you recognize a net 1231 gain but have taken an ordinary deduction for a 1231 loss within the last 5 years, the prior ordinary loss deduction is recaptured by recharacterizing that portion of the later 1231 gain in the current year as ordinary.

Application of 1245 A taxpayers gain on the sale of his 1231 property (except for real estate) is taxed as ordinary income to the full extent of his prior depreciation deductions. The excess gets ordinary 1231 gain treatment. 1245 covers depreciable intangibles as well.

Application of 1250 Applies to real estate (buildings, etc.) Historical: Recaptures the excess of depreciation actually taken over the depreciation that would have been allowed under the straight-line method. So, it recaptures the excess of accelerated over straight-line depreciation, whereas 1245 recaptures all depreciation previously allowed But, this doesnt matter because you can only use the straight-line method for real estate today. Today: The gain allocable to previous depreciation is deemed to be Unrecaptured 1250 Gain, and is taxed at 25% The excess is treated under 1231, normally Also, if your basis has been reduced under 108 (COD), and you sell the property at a gain, the amount of basis previously reduced is Unrecaptured 1250 Gain taxed at the ordinary rate.

Net Investment Income Tax Extra 3.8% tax is added to Net Investment Income (interest, rent, dividends, royalties) over the threshold amount, which is $200,000 for a single taxpayer according to 1411(b) The 3.8 tax is applied to the lesser of: The total amount of net investment income, or The excess of modified adjusted gross income over the threshold amount ($200,000) So, if it applies, 23.8% tax on long term; 43.4% on short. Distinguishing Capital Assets from Inventory If property is held primarily for the sale to customers in the ordinary course of the taxpayers business, it is like inventory and is not a capital asset. Stocks If the taxpayer is a trader, gains and losses associated with the sale of stock is capital, because these are not for sale to customers. A trader buys and sells in the same market, and his profits are from fluctuations in the marketplace, not from services. A trader may elect to use the mark-to-market approach. He might do this because his gains will mostly be short-term anyway, and this way he could get the ordinary losses as well. If the taxpayer is a dealer, then they will be ordinary gains/losses. A dealer can identify certain securities as made for investment purposes on the date of acquisition in order to avoid ordinary treatment. A dealer is required to follow 475, the mark to market section. It requires him to report gain or loss accruing as of year end without realization events. It is ordinary gain/loss, rather than capital.

Whether Land is a Capital Asset As a preliminary matter, is it 1231 property? If it is not used in the taxpayers trade or business, then its not. 1231 does not apply to dealer property. Regarding whether its a capital asset, its a fact-specific inquiry: Was it held for sale to customers in the ordinary course of trade/business? Winthrop Factors:1. The nature and purpose of the acquisition of the property, and the duration of the ownership2. The extent and nature of the taxpayers efforts to sell the property3. The number, extent, continuity, and substantiality of the sales (most important)4. Extent of subdividing, developing, and advertising to increase sales5. The use of a business office for the sale of property6. The character and degree of supervision or control exercised by the taxpayer over any representative selling the property7. The time and effort the taxpayer habitually devoted to the sales A single sale can be a trade/business. You can be in two trades/businesses at once. If the profit result from a sale of a parcel is due entirely to the taxpayers own efforts in improving the property, rather than from market appreciation, he will probably be held to have been in the business of improving and selling property to customers.

1237 Safe Harbor For taxpayer who want to get capital gain from the sale of their real property Applies when all the taxpayer did is subdivide the property and engage in some promotional activities with respect to a single tract of land. Three elements must be satisfied:1. Land must not have been substantially improved (value increased by 10%)2. Land must not have been previously held for sale to customers3. Land must have been held by the taxpayer for 5 years before the sale. Consequences: For the first 5 subdivided parcels, the taxpayer will get capital gain. When he sells the sixth parcel, it will be ordinary income up to 5% of the sales price of each parcel sold within the year when the sixth parcel is sold and thereafter. Remainder is capital gain. Even if you fail 1237, you can still get capital treatment if you make the argument that youre not a dealer.

IV.B Options, Hedges, and Other Contract Rights

Options (1234) If a buyer buys an option to purchase something at a certain price Its called a call The buyers basis is the call price, plus the remainder paid The seller has an open transaction upon receipt of the call price When the call is exercised, the seller has an amount realized of the call price, plus the remainder paid The character of the gain depends on how he held the land, for how long, and whether it was investment or dealer property If a buyer buys a call, and then sells it to a third party for less than he paid for it The buyer can claim a loss The character of the loss will be the same as the underlying property would have been in the buyers hands had he held the land; holding period is the length of time he held the option. If the third party uses the call, he will have a basis in the property of the price he paid for the call, plus the remainder paid. The seller has income in the amount of the buyers original call price.

Character and Holding Period: The character (capital v. ordinary) is determined by the underlying property. The holding period (whether long-term or short-term) is determined by the amount of time the option was held. But, if the underlying property was stock or securities, then it is always short term gain.

If a seller pays for an option to sell a piece of property to someone for a certain price during a time window: It is called a put. Seller When he exercises the put, his amount realized will be: Sale price, minus the price of the put Assuming investment, he will have a capital gain or loss depending on the purpose for which he bought the property. Buyer When the put is exercised, his basis in the property he was forced to buy will be: Sale price, minus the price of the put If a buyer buys a call, and then lets it expire. Buyer Will have a loss (character determined by the underlying property) (holding period is how long he held the call) Seller Has income in the amount of the call price, and it will be treated as a sale/exchange.

Hedging A hedging transaction is any transaction entered into in the taxpayers normal trade or business primarily to manage risk of price changes with respect to ordinary property that is held or is to be held by the taxpayer. Property is ordinary if it could never be a capital asset. Hedging transactions are ordinary assets. (1221(b)(2)). The precise identity of the commodities involved should not matter (like ash for pine) Loss arising from sale of stock is capital loss, regardless of the taxpayers motive in buying the stock. (Arkansas Best) Business purpose only matters if youre talking about one of the explicit statutory exemptions. Issues A hedge must be identified as such by the close of the day on which the taxpayer enters into the hedging transaction. (1221(a)(7)) But, the regs say you have 35 days to identify the hedging transaction. (substantially contemporaneously, but not longer than 35 days). If the taxpayer doesnt properly identify the hedge, then its not a hedging transaction, with exception for inadvertent error. So, if you have a loss and dont identify its not a hedge, unless you can show inadvertent error. (1.1221-2(g)(1)) Anti-Abuse Provision If you have a loss and you dont identify it, unless youve got inadvertent error, the loss will be capital and the gain will be ordinary. Speculating is not a hedge. It must be entered into PRIMARILY to manage risk. (so, buying way more futures than you need to manage risk of inventory will probably be speculating.

Short Sales Sale of something you dont own. You sell today with borrowed property, and then when you close the transaction, you have to acquire property to pay back the lender of those assets. You win if the price of the asset sold goes down, because you cover it with a cheaper asset. Its a bet. Short sales can count as hedging transactions, when used to manage interest rate changes. (1221(b)(2)(A)(ii)). You win if the interest rates increase, and lose if they go down. It is irrelevant what the proceeds will be used for, as long as it is within the ordinary course of trade or business. Any potential loss that can be taken will be tied to the debt term, and spread around it. Say there was a $50m loss on a hedging transaction. 15-year debt term (using 15-year notes) The regs say you treat the $50 loss as OID, and spread it around the 15 year period.. Point: Any benefit you get from the decrease in interest will be offset by the loss youve taken, and spread it around the 15 year period. Loss is deferred.

Payments to Cancel Leases Substitute Theory A payment made to cancel a lease is ordinary income of the continued rent would have been ordinary income. (Hort) Look at the nature of the asset, whether the transfer involves a right to transfer income that will be earned in the future, or if it involves income that was previously earned Selling rights to receive income from a lottery ticket would be ordinary income to the seller; its income that was previously earned. Carve out Theory If you have a horizontal carve out, whereby you only temporally transfer part of what you own, then you havent transferred property and you cannot have capital gain. (giving away the fruit) If you give away a percentage of the whole property you own for the entire time you own it, its a vertical carve out, and it can be capital. (giving away the tree)

Lessor pays Lessee to cancel the unexpired portion of the lease, or for a severable economic unit Would be a capital sale/exchange Buying out someones entire interest is a vertical carve out, and should be a capital sale/exchange

V.A General Limitations on Losses

Losses, Generally An individual has allowed loss if its a: Trade/Business Loss Investment Loss

Losses Regarding Stock Mere fluctuations in stock value are not a realization event, unless the stock becomes worthless. (165(g)) Also, abandoned securities. Its worthless if it has no recognizable value. Its relevant whether the taxpayer would receive anything upon liquidation of the corp. if the corps liabilities exceed its assets, and theres no reasonable expectation that the corp will become solvent in the future, then it becomes worthless. If a capital asset becomes worthless during the year, the loss that results is treated as if it arose from the sale or exchange of a capital asset on the last day of the year.

Related Parties 1041 trumps 267, so a transfer from husband to wife will also transfer the husbands basis (no loss), and the wife uses that basis when she sells the property to a third party.

267: No loss recognized upon sale to related person. (indirect sales, too, via stock exchange if close in time; 20 days is enough not to be. McWilliams) Treats siblings as members of a family. (And many other relationships. brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants) If a sister sells stock to her brother at a loss, she may not recognize the loss. The sister will get a cost basis in the stock (whatever she paid for it. When she sells, she only has to recognize gain to the extent that it exceeds the previously disallowed loss. Sister should have sold to her brothers wife instead. If a sale is conducted through a public stock exchange; like sister sells to A and stock exchange and A sells to brother on stock exchange; the loss is allowed because its hard to maintain that a transaction between related parties took place.

Provisions If an individual owns MORE than 50% of a corporation, he and the corporation are related parties. An individual is deemed to own all of the stock that his family members do. An individual is not deemed to own a family members family members stock. (267(c)(5))

Wash Sale Rule (1091) If a taxpayer disposes of stock or securities at a loss and, within a period beginning 30 days prior to the sale and ending 30 days after the sale (61 days), the TP purchases substantially identical stock from anyone, the TP cant deduct the loss sustained because he has not sufficiently closed out his investment. (must modify basis instead) Does not apply to dealers. Modify basis like this:

If the taxpayer sells old shares in a corporation and buys new ones in the same corporation within the 30-day window, he cant take a loss. His basis in the old stock is transferred to the new stock.

Old and Cold Stock Suppose that W owns the stock. She paid $500 several years ago, and now its only worth $100. Today, W purchases another $100 of the stock. 20 days later, she sells the old and cold stock for $100. She retains the $100 shares she bought today. Can she claim a $400 deduction? The regs say NO< SHE HASN'T CLOSED OUT HER INVESTMENT, because she still retains the 100 shares she just bought and 1091 will apply. (1.1091-1(h), ex. 1) Contracts to Wash Stock 1091 covers contracts to wash stock (to resell substantially identical shares to the seller) if the time of the contract is within the prohibited time period, regardless when the sale takes place Non-Bona Fide Sale If the original sale was not bona fide, and there is no agreement but in fact the taxpayer repurchases the stock (doesnt matter when), then the loss may be disallowed. control; sympathetic buyer are elements If the stock was publicly traded and bought through a stock exchange, its probably bona fide. Miscellaneous No attribution rules apply

Selling Notes Normally, if a lender lends money to a borrower and accepts a note, the note is worth what its face value is (and it will have annual interest, too). If the lender then sells the note to a third party at a loss, he will get a capital loss. But, If the lender sells the note to a party Related to the Borrower: 108(e)(4) treats the acquisition of outstanding debt by related party to the debtor as if such acquisition had been made by the debtor itself. (A Kirby Lumber Situation) The borrower will have immediate COD Income in the amount of the difference between the face value of the note and the price at which it was sold to the party related to the borrower.

Bad Debts: 166 (Relief to a creditor whose note has become worthless) (trumps 165) You need a bona fide debt, arising from a debtor/creditor relationship based on an enforceable agreement to pay. Also, the debt must become worthless, which is a factual question. It must be uncollectible. Includes partial worthlessness, which can happen if the debtor is only able to pay part of the debt and the creditor accepts less payment in full satisfaction. If it is a business bad debt: (created in the taxpayers business, or acquired by the taxpayer and connected with his business) A deduction is permitted (166(a)) If it is a nonbusiness bad debt: (loans to friends; etc.) The loss incurred is a short-term capital loss. If its a mixed motive, use the dominant motive. TIES IN WITH MORTGAGE FOREGIVENESS AND COD INCOME.

V.B At Risk and Passive Loss Limitations

Basic Strategy First, apply 465 (applies to losses generated by non-recourse debt). If the losses survive, then: Second, apply 469 (portfolio and passive baskets)

465 Applies to individuals and closely held corporations A taxpayer may deduct losses with regard to a particular activity to the extent that he is at risk in that particular activity, or to the extent that it generates income. Excess deductions may not be currently used against any other income, but may be carried forward indefinitely.

How to do it:1. Determine the activitys loss in the current yeara. Compare the income derived from it with expenses (including depreciation deductions) attributable to itb. 465 only applies if the activity has a loss2. Determine how much the taxpayer is at risk with respect to that activitya. Add up:i. Money,a. Check for negative cash flow. Add up cash received from the activity (income plus loans taken out against it) and subtract cash expenditures (real expenses, not including depreciation deductions). If this is negative, assume that much can from his pocket and is at risk.ii. Adjusted bases of properties contributed to the activity, andiii. Certain borrowed amounts:1. Recourse debt2. Nonrecourse debt with pledged property not used in that activity as security, up to the extent of the securitys FMV. (from seller is OK)3. Qualified Nonrecourse Financing borrower must hold real property and receive financing with respect to this real estate holding, and must borrow the nonrecourse financing from any federal, state, or local government or instrumentality, or from a Qualified Person.a. A qualified person is an unrelated lender who did not sell the taxpayer the property or obtain a fee. Apply attribution rules: if it is received from a related party, the financing from the related person must be commercially reasonable and on substantially the same terms as loans involving unrelated persons.3. The activitys current year loss may possibly be taken in the current year, up to the at risk amount calculated in the previous step, if it passes 469.4. The excess that cant be used now is carried forward and can be used against the same activity in the next taxable year. a. Amount at Risk carry forward:i. If the loss is greater than the amount at risk, the amount at risk is all used up. It starts at zero the next year.ii. If the loss is smaller than the amount at risk, it gets carried forward.5. Take the allowable loss (up to the at-risk amount) and run it through 469 (start looking there now):6. Determine if the allowable loss is passive.7. Determine if the taxpayer has any other income that year.8. If the taxpayer has other passive income, he may use the passive loss determined above against that income (or if he disposed of his entire interest in that passive activity). If not, he must carry it forward, along with the loss disallowed under 465 for not being at risk.

469 If the taxpayer is an individual, closely held c-corp., estate, or trust, and the loss calculated in 465, above, is a passive loss (determined below), then the taxpayer cant take the loss in the current year unless he has other passive income against which he can take it:

Sets up Three Baskets of Income: Active Trade or Business income in which the taxpayer materially participates. Portfolio Interest, dividends, annuities, gain/loss from investment property, etc. Passive basket: Income from business activities in which the taxpayer does not materially participate. (like running an apartment building, or selling a building held for rental, if not a real estate professional). Material participation: continuous, regular, substantial participation. Rental activities are per se passive, unless: 1. More than half of the personal services performed in trades or businesses by the taxpayer are performed in real property trades or businesses in which the taxpayer materially participates, and 2. Such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates. (hotels and motels do not count as rental properties) If the taxpayer has passive income in the current year, he may offset by all passive losses available in that year, whether from other activities, from the current year, or if they have been carried forward. You aggregate them. And remember, If an excess passive loss is associated with an activity, and the taxpayer has disposed of his entire interest in the passive activity, he may take the loss in the current year by offsetting against any other income.

VI Like Kind Exchanges

1031 Like-Kind Exchanges A shareholder may only get 1031 treatment if he holds his property for business or investment. (cant sell property for too soon after the swap, because then the IRS might conclude that it wasnt held for business use or investment). They may not be inventory, stocks, bonds, etc. They must be like kind in nature, not in grade or quality. Properties are like kind if the properties are like kind or if they fall within the same ASSET CLASS (which is a safe harbor). RR 87-46: same asset classes as for depreciation. No negative inference if they do not meet the safe harbor.

Consequences of the Like-Kind Exchange (with Boot) If a party furnishes boot, he recognizes gain if the boot was appreciated, or loss if the boot was depreciated. Gain on the boot is gain in the underlying property that the taxpayer has given up. (if the loss in built into the like kind property, its not recognized, even if there is boot). His basis in his new property: If a party receives boot: (does not get to recognize a loss) Pay attention to the character of the gain; if its 1245 property, you might have to recapture depreciation. Basis in new property: You allocate the basis to the non-like-kind property up to its FMV, and the remainder goes to the like-kind property.

Related Parties (1031(f)) If a taxpayer exchanges properties with a related party, there is no recognition of gain/loss according to 1031. But, if either party sells his property within 2 years of the exchange, then there is no nonrecognition of gain/loss, and they will have to recognize their gain/loss at the point of sale. (dont amend returns) Both parties will recognize his gain, and their bases will be adjusted to the cost basis they would have had, had the original swap been taxed.

If one of the parties would have had a loss under the original swap, it might not have be able to be recognized because of 267. (see Losses). He cant take advantage of this later on because its his own loss. Upon the later sale and recognition to both parties, the OTHER party (the one who didnt have the loss) can take advantage of this disallowed loss and reduce his gain by the disallowed loss amount (267(d)).

One-Sided 1031 Treatment If one party starts building a house on his property (and its not business/investment obviously), the other party can still get 1031 treatment.

1031 is Not Elective If 2 cash sales between the same parties are mutually dependent, (each contingent on the other), they will be collapsed together and it will be treated as a 1031 exchange. Involving a third party, and the cash goes full circle: If the taxpayer does not know the other two parties are related (no reason to know of the relationship,) or are partners, and they were not really mutually dependent, and theres a good business purpose, its closer to Bell Lines and it will not be collapsed. Otherwise, its similar to Red Wing Carriers and will be collapsed.

Intangibles Whether intangible personal property is of a like kind to other intangible property generally depends on the nature and character of the rights involved and underlying property to which the intangibles relate. Radio and TV licenses are like kind

Multi-Party Exchanges (remember: must have trade/biz purpose before and after the exchange) The cash may never pass through the taxpayers hands for him to get 1031 treatment. Three party exchange T wants Ys property; Y wants cash; X wants Ts property for cash. Y can sell his property to X for cash. Then, X and T can swap. Four party exchange Need a qualified intermediary, who may not be the taxpayers agent for tax purposes. He also may not be related to the taxpayer, or someone who was related to him in the prior 2 years (like in the capacity of an attorney, accountant, broker, etc.) There must also be an agreement, which expressly limits the taxpayer right to obtain the money held by the QI. T wants Ys property; Y wants cash; X wants Ts property for cash. T can hire a QI. T will transfer the property to the QI, who will sell the farm to X for cash. Then, the QI will use that cash to buy Ys property, and will transfer it to T.

Non-Simultaneous Swaps 2 timing requirements The property to be ultimately received must be identified by the 45th day after the taxpayer transfers his property. Must be in writing, and communicated unambiguously to someone else involved in the transaction. Taxpayer can identify up to 3 replacement properties without regard to FMV; this means he can replace 1 property with more than 1, or have alternatives. The replacement property must be received within 180 days after the taxpayer transfer his property.

The regs provide safe harbors that allow the taxpayer security in various forms without losing 1031 treatment (after he transfers his property away). 1.1031(k)-1(g)(2)(A):a)Mortgageb)Stand by letter of credit from a bank or other financial institutionc)Guarantee from 3rd partyd)Deposit of cash into a Qualified Escrow AccountNot a disqualified person 1.1031(k)-1(g)(3)(ii)(A)TP cant get the cash 1.1031(k)-1(g)(3)(ii)(B)

He can also get interest at the end of the deal.

Can also do it the other way (parking transaction): Taxpayer knows what property he wants; but hasn't found someone to take his yet. An Accommodation party is used to buy the replacement party; he keeps it until taxpayer is ready to get rid of his own property, at which point the AP swaps them and sells the old asset for cash.

Safe Harbor: if the property is held in a Qualified Exchange Accommodation Arrangement. Theres an AP, who cannot be the taxpayer or a disqualified person. The taxpayer and the AP must enter into an agreement. The replacement property must be identified no later than 45 days after the old property is relinquished. Timing Requirements: ID of the old property within 45 days New must be transferred and old must be sold no later than 180 days after AP becomes the owner of each asset. Total time period that any property can be held by AP cant exceed 180 days.

With Mortgages

To find basis in the new property:

GAIN REALIZED:(FMV of Prop. Received) + (Cash/Debt Relief Received) (AB of Prop. Given) (Cash Given) (Debt Assumed)

GAIN RECOGNIZED:Gain Realized, but only up to amount of Cash/Net Debt Relief Received, less amount of Cash Given

BASIS IN NEW PROPERTY:(AB of Prop. Given) + (Cash Given) + (Debt Assumed) (Cash/Debt Relief Received) + (Gain Recognized)

Sale Leaseback (problem 7) 2 ways a sale leaseback can be characterized: a cash sale (respect the transaction) Will happen if the valuation of the property is fair, and the valuation of the lease is fair. Or if the building were built with a sale leaseback in mind, because then it wouldn't be held for business or investment. like-kind exchange: a swap of a fee interest in the property for a long-term lease in the property, plus cash boot Will happen if the rent charged is less than fair rental value, because it looks like the seller is getting a good lease deal as part of the consideration for the transfer of the building. The sellers basis in the lease would be the difference between FMV and what was paid for it. It would be amortized over the term of the lease.

VII Installment Sales

Installment Sale (453) An installment sale is when the seller will not get paid at all, or only in part, in the year of the sale. Applies to just about any real or personal property, but not publicly traded stock. It only works for gains, not losses. Losses are recognized all at once, up front. Payment does not include receipt of the buyers own evidence of indebtedness, unless readily tradable. (as good as cash) Pay does include another persons debt, though. But if its all received in the same year, then its not an installment sale. If you have an installment sale, you must use the Installment Method, unless you elect out (which youd only do in rare circumstances).

The Installment Method1. Determine the Gross Profita. 2. Determine the Total Contract Pricea. b. 3. Determine the Gross Profit Ratio:a. 4. Multiply the gross profit ratio by every one of the payments (including any down payments). That portion of the payment is taxable gain, and the rest of each payment is a return of basis.a. The character of the gain depends on the underlying gain of the asset sold.

Notes There must be adequate stated interest; otherwise OID is involved. The form of the debt doesn't matter (separate promissory note, etc). Property (like cash) can be a down payment as well. Treat it the same

Sales of Publicly Traded Stock A sale of stock thats traded on an established market is not eligible for installment method treatment. (453(k)(2)). All of the gain is recognized in the year of sale.

Losses Losses are not eligible for installment treatment. You recognize any loss in the year of sale.

When More than One Asset is Sold You must allocate the amount realized among the assets sold. The down payment must also be allocated. The parties are free to allocate the down payment how they like, up to the assets FMV. You should allocate as much of the loss property, if any, as possible to the down payment so that you can take a loss. But, absent a special allocation, the down payment is allocated based on relative FMV (selling price).

How to Do It1. Allocate the properties among the down payment as much as you want. Its wise to allocate the loss property to the down payment so you can take a loss and defer gain.a. Otherwise, the down payment will be proportional to all the assets FMVs.2. Calculate a separate gross profit ratio for each of the assets being sold (unless its a loss property)3. The remainder of the installment payments will be divisible among the FMVs of the properties, adjusted for however the down payment was allocated.4. Multiply each assets gross profit ratio by the portion of each payment that is allocable to that asset.

Handling Unrecaptured 1250 Gain (25%) If the seller must recover previous Unrecaptured 1250 gain on real property, then the first dollars of gain he gets with respect to that property is subject to recapture and is taxed at 25%.

Installment Sales of Depreciated property (1245; applies to 1231 property) When depreciable property is sold under the installment method, all of the resulting recapture from the sale must be reported in the year of the sale. (ordinary rate) Only the balance of the gain (total gain, less gain associated with depreciation recapture) is reported under the installment method. How to calculate the gross profit ratio: Do it the normal way, but add the recognized depreciated recapture amount to the basis, when you go to calculate the gross profit. (numerator of the fraction.) Then proceed like normal

Buyers Own Debt Is not payment unless it is a cash equivalent. Being guaranteed is not good enough. A stand by letter of credit is not good enough. A certificate of deposit or treasury note is good enough, and it will turn it into a payment.

Qualifying Indebtedness Is viewed as returning basis, only up to amount of basis. The amount that exceeds basis will be viewed as payment.

If debt relief is QI, you dont treat the assumption of debt as payment. But, if QI Debt Relief exceeds the basis in the property, that excess is also treated as payment in the year of sale.

If debt relief is NOT QI, you do treat the assumption of debt as payment in the first year of the sale, and the gross profit ratio is applied to it.

Debt relief is generally QI unless: The debt is related to selling expenses, The debt is unrelated to the property (like medical bills), The debt is incurred after the sellers acquisition of the property, in anticipation of the sale (eve of the transaction borrowing).

Calculating gross profit ratio: Determine the Gross Profit Determine the Total Contract Price Determine the Gross Profit Ratio:

Related Parties and Depreciable Property If theres a sale of depreciable property to a related party, then the installment method is not available., unless the principal purpose of the sale was not tax avoidance. (453(g)(2)). Related persons are defined in 1239(b): Includes corporations owned more then 50% by the taxpayer. Constructive ownership rules of 267(c) apply, so one spouse is deemed to own what the other spouse owns.

If the Seller Sells the Installment Obligation to a Third party Upon sale of an installment obligation, gain or loss is recognized to the extent of the difference between the basis of the obligation and the amount realized (the amount paid by the third party to the seller for the note). To calculate the sellers basis in the note:

Accepting a smaller amount from the buyer in full satisfaction is treated as selling the note back to the buyer for the reduced price. Treat it as above. The buyer, though, has COD income in the amount of the discount that might be eligible for a purchase price adjustment under 108.

Gifting the installment obligation is treated as a SALE. Do as above. (unless between spouses, then basis is simply transferred under 1041). Amount realized is the FMV of the note at time of gift. Calculate the basis as above. Donees basis in the gifted note: Donors basis (as calculated above) + gain recognized by the donor upon the gift

453A If you have sales that are big enough, the government will charge you interest that you must pay on the privilege of deferring your tax liability through an installment sale plan. This does not apply to sales of personal use property. Thresholds for 453A to matter: The Sales price must be more than $150,000. The aggregate of all of the outstanding installment obligations must be more than $5,000,000. open the statute and make sure it applies to this seller. If it applies:1. Determine the applicable percentagea. (face amount of the installment obligations that arose during year 1 and were outstanding at the end of year 1, minus 5,000,000) divided by (face amount of the installment obligations that arose during year 1 and were outstanding at the end of year 1)2. Determine the deferred tax liabilitya. i. Unrecognized gain is the GRP x outstanding installment paymentsii. make sure the tax rate is right 28% for art, etc.3. Determine the interest rate:a. The normal underpayment rate under 6691.4. Calculate the interest charge the taxpayer must pay in year 1:a. 5. In year 2, do it again, except modify the applicable percentage by modifying step 2 only. Calculate a new deferred tax liability by reducing the unrecognized gain by the amounts that were recognized in the previous year. Everything else stays the same, including the applicable percentage.6. Keep going until the gain is all recognized.

Borrowing Against an Installment Obligation (453A(d)) You can monetize an installment obligation before the money is received by borrowing against the note, thereby getting cash value.

If the seller obtains cash or other property indirectly as a consequence of the installment sale, 453A(d) applies: Threshold: The total sales price must exceed $150,000, and it doesnt apply to personal use property.

To the extent a debt is secured by an installment obligation, the proceeds of that debt are considered payments received on the installment obligation. To the extent you have constructive payments, subsequent actual payments will not be viewed as installment payments. To do it: Multiply the gross profit ratio by the loan proceeds received, that were secured by the installment obligation. This amount is taxed as gain. Cant be asked to include as payment more than what the portion of the contract price that has yet to be reported as payment is. Then, the amount of the loan proceeds will not be taxed again when the actual installment payments are received

VIII Leasing

Maybe the lessee is not really the lessee, but rather the owner of the property. So the rent payments will not be treated as such. Talking about substance over form. If the lease is respected as a lease, then the lessor is treated as the owner of the property and is entitled to depreciation deductions on it. If the lease is not respected, then the lessee is treated as the owner of the property, and is entitled to the depreciation, and there are no rental payments. Usually, the deductions have different value to different taxpayers.

Alstores The Steinway Co. owned a warehouse and wanted to sell it; but they need to continue to use it over the next 2 years. Warehouse worth 1m and the fair rental value for a 2.5 year period was 250,000 Steinway sold it to Alstores for 750,000 cash + the right to continue to use the property over the next 2.5 years without rent payments (worth 250,000). Did Alstores have rental income as a result of its bargain purchase? Alstores argued the despite the form of the transaction (sale and leaseback), what really happened is that they only bought a future interest in the property that would pass to them in 2.5 years for 750,000. They became the owner only after the 2.5 years was up. In that case, if accepted, then there would be no lease in the transaction b/c Steinway was the owner during the 2.5 period. If no lease, no rental income and takes a 750,000 cost basis that they could begin to depreciate after the 2.5 years are up and the property reverts back to them. G takes the position that Alstores owned the property from the beginning and leased it back for 2.5 years. Alstores would have rental income from the lease = to the value of the warehouse (1m) less the 750,000 cash paid. Alstores would take a basis in the beginning = to 1 million and they could depreciate it under 168. Alstores won; government respected the transaction Factors: Under the terms of the lease, it was a sale. If Steinway wasnt able to stay for the full 2.5 years, or something happened to the property, then Alstores had to reimburse Steinway for the rental value of the property during the period it couldn't be used. Why would Alstores pay Steinway for nonoccupancy if Steinway really owned the property? It looks like a payment to a lessee when the lessee cannot enjoy the property. Looks like burden of ownership falls on Alstores. (Most important factor) Steinway only had rights pursuant to a standard lease, so it couldn't encumber the property, etc., (Steinway and the government were on one side, and Alstores was on the other, saying theres no lease)

Frank Lyon Supreme court endorses the notion that we look at benefits and burdens to determine who is the owner. Supreme court, instead of looking at the benefits Frank Lyon could get from the transaction, it focused on the RISKS. Focused on 3 Looked at the mortgage. Whose was it? Said it was with recourse, so the exposure that Frank Lyon had was much greater than 500k, and that sort of exposure was inconsistent with being a lender. Looked at the 500k, and said it could lose that money, because Worthen had no obligation to pay that amount because it wasn't a traditional loan. We might say it was likely to be repaid because there were economic incentives to exercise one or the other option, which would then pay back 500k + 6%. Worthen could choose not to exercise any option. The building could be worthless at the end of 25 years, leaving 25 with no way to recover, but would still be liable for the ground lease payments. Supreme Court 5 part test for testing a sale leaseback There must be a genuine multiparty transaction The transaction must have economic substance It must be compelled or encouraged by business or regulatory realties Transaction must be imbued with tax indifference considerations (?) Not shaped by solely tax avoidance features with meaningless labels

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