Study Unit 6: Basis and Property Transactions PDF

1 STUDY UNIT SIX BASIS AND PROPERTY TRANSACTIONS 6.1 Basis................................................................ 1 6.2 Adjustments to Basis...........................................

1 STUDY UNIT SIX BASIS AND PROPERTY TRANSACTIONS 6.1 Basis................................................................ 1 6.2 Adjustments to Basis................................................... 9 6.3 Like-Kind Exchanges................................................... 11 6.4 Involuntary Conversions................................................. 13 The concept of basis is important in federal income taxation. The assigned value of property at any particular time is the property’s basis. Multiple factors may require a taxpayer to adjust the basis of his or her property during the time (s)he owns it. Uniform capitalization rules determine if a cost is allocated to the basis of the property or expensed in the current year. 6.1 BASIS Overview When a taxpayer acquires property, his or her basis in the property is initially cost, substituted, transferred, exchanged, or converted basis. 1. Cost basis is the sum of capitalized acquisition costs. a. Cost basis includes the FMV of property given up. If it is not determinable with reasonable certainty, use the FMV of property received. b. A rebate to the purchaser is treated as a reduction of the purchase price. It is not included in basis or in gross income. 2. Substituted basis is computed by reference to basis in other property. 3. Transferred basis is computed by reference to basis in the same property in the hands of another. 4. Exchanged basis is computed by reference to basis in other property previously held by the person. 5. Converted basis is when personal-use property is converted to business use; the basis of the property is the lower of its basis or the FMV on the date of conversion. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 2 SU 6: Basis and Property Transactions Unit of Property 6. Whether tangible (real or personal) property costs are deducted or capitalized is determined by examining the unit of property. The unit of property is a group of functionally interdependent components and can either be an asset, group of assets, or a defined portion of an asset. In the case of personal or real property other than a building, all the components that are functionally interdependent comprise a single unit of property. The identified units of property must be further divided into major components and substantial structural parts. Absent an available exception, costs to replace a major component or substantial structural part must be capitalized. Capitalized Acquisition Costs 7. Initial basis in purchased property is the cost of acquiring it. Only capital costs are included, i.e., those for acquisition, title acquisition, and major improvements. a. Capital acquisition expenditures may be made by cash, by cash equivalent, in property, with liability, or by services. b. An improvement expenditure must be capitalized if it (1) results in a betterment to the unit of property, (2) adapts the unit of property to a new or different use, or (3) results in a restoration of the unit of property. 1) An expenditure is a betterment if it ameliorates a condition or defect that existed before acquisition of the property or arose during the production of the property; is for a material addition to the property; or increases the property’s productivity, efficiency, strength, etc. 2) An expenditure is an adaptation to a new or different use if it adapts the unit of property to a use inconsistent with the taxpayer’s intended ordinary use at the time the taxpayer originally placed the property into service. 3) An expenditure is a restoration if it a) Restores a basis that has been taken into account, b) Returns the unit of property to working order from a nonfunctional state, c) Results in a rebuilding of the unit of property to a like-new condition after the end of the property’s alternative depreciation system class life, or d) Replaces a major component or substantial structural part of the unit of property. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 6: Basis and Property Transactions 3 Common Capitalized Costs (for Sec. 1012) Purchase Price (Stated) Miscellaneous Costs Liability to which property is subject Appraisal fees NOTE: Not unstated interest Freight Installation Testing Closing Costs Major Improvements Brokerage commissions New roof Pre-purchase taxes New gutters Sales tax on purchase Extending water line to property Title transfer taxes Demolition costs and losses Title insurance New electrical wiring Recording fees Attorney fees Document review, preparation EXAMPLE 6-1 Tax Basis -- Building with a Mortgage If an individual buys a building for $20,000 cash and assumes a mortgage of $80,000 on it, his or her basis is $100,000. 4) In the case of repainting a building’s exterior, the basic rules are a) If painting is the only thing being done, the painting costs are expensed or b) If painting is part of a larger project that includes capital improvements to the building’s structure, the painting costs are capitalized. c. A taxpayer must capitalize amounts paid to facilitate the acquisition of real or personal property. This treatment applies when the amount is paid in the process of investigating or otherwise pursuing the acquisition. 1) Facilitative (i.e., capitalized) costs do not include amounts paid to determine whether to acquire real property or which real property to acquire. Such amounts are current deductions. 2) Amounts paid for employee compensation and overhead are treated as amounts that do not facilitate the acquisition of real or personal property. EXAMPLE 6-2 Facilitative Cost Dolores is a manager of a family-owned grocery store and is assigned to determine where to open a second location. The compensation for Dolores’ time is deducted, not capitalized, by the grocery store as a facilitative cost. If the work had been performed by a real estate professional and paid as commission, the amount would have to be capitalized because it was paid to facilitate the acquisition of real property. d. Expenses not properly chargeable to a capital account. Costs of maintaining and operating property are not added to basis, e.g., interest on credit related to the property, insurance (e.g., casualty), ordinary maintenance or repairs (e.g., painting), etc. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 4 SU 6: Basis and Property Transactions Basis in a Rental House – How to Calculate and Treat Improvements that Happen Later Figure 6-1 Visual Memory Aid: For candidates who are visual learners, the figure above and the description below can aid in recalling how to capitalize certain capital acquisition costs. Basis in a rental house includes purchase price plus closing costs. Add to the basis and capitalize long-term improvements. In Figure 6-1 above, the right side of the house shows capitalized improvements that must be depreciated over periods of up to 27 1/2 years. These include improvements to land (e.g., sidewalks, landscaping, sprinkler systems), swimming pools, new roofs, extensions of or additions to the structure, air conditioning units, central vacuum systems, security systems, and septic tanks. Improvements that are added later in the life of the rental unit must be separately capitalized and depreciated. The left side of the house shows short-term repairs. Short-term repairs are expensed in the year in which they are made. Short-term repairs include repairing broken windows, faucets, and air conditioning units; patching leaking roofs; painting; etc. The image above is © Dugger Corcoran Illustrations, LLC. Reprinted with permission. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 6: Basis and Property Transactions 5 Uniform Capitalization Rules 8. Costs of constructing real or tangible personal property to be used in trade or business and costs of producing or acquiring property for sale to customers are capitalized. a. Costs (both direct and most allocable indirect costs) necessary to prepare the property for its intended use must be capitalized, e.g., for permits, materials, equipment rental, compensation for services (minus any work opportunity credit), and architect fees. 1) Costs and losses associated with demolishing a structure are allocated to the land. The costs include the adjusted basis (not FMV) of the structure and demolition costs. b. Construction period interest and taxes must be capitalized as part of building cost. c. Indirect costs not capitalized include, among other things, marketing, selling, advertising, distribution, research, experimental, Sec. 179, strike, warranty, unsuccessful bid, and deductible service costs. d. Uniform capitalization rules do not apply to producers and resellers if the company’s average annual gross receipts for the past 3 years do not exceed $29 million. e. Uniform capitalization rules do not apply to the following: 1) Property produced by the taxpayer for personal purposes 2) Qualified creative expenses incurred by an individual as a freelance writer, photographer, or artist 3) Property produced under a long-term contract 4) Research and development expenses allowable as a deduction 5) Intangible drilling and development costs 6) Timber and certain ornamental trees (more than 6 years old) 7) Animals, dependent on taxpayer ownership 8) Selling, marketing, advertising and distribution costs De Minimis Expense 9. Taxpayers can make an election to deduct a de minimis amount for each transaction relating to tangible property with an economic useful life of at least 12 months. a. A de minimis amount is a cost that is so small that it is not worth tracking. Taxpayers may expense any purchased assets with a cost of less than $2,500 provided they also use this policy for financial accounting purposes. The determination of the value of an asset includes all capitalized costs but the limit is applied on a per unit basis. 1) The limit is raised to $5,000 for taxpayers with an applicable financial statement (e.g., a certified, audited financial statement that is accompanied by the report of an independent certified public accountant). EXAMPLE 6-3 De Minimis Expense Henry, a business owner, purchases 2 computers for $3,000 and pays $500 to have them installed. The cost per computer is $1,750 [($3,000 + $500) ÷ 2], which allows the computers to be expensed as a de minimis expense. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 6 SU 6: Basis and Property Transactions Liabilities 10. Acquisition basis is a. Increased for notes to the seller (minus unstated interest) b. Increased for liabilities to which the acquired property is subject Property for Services 11. The FMV of property received in exchange for services is income (compensation) to the provider when it is not subject to a substantial risk of forfeiture and not restricted as to transfer. The property acquired has a tax cost basis equal to the FMV of the property. EXAMPLE 6-4 Tax Basis -- Property Received for Services Jim’s neighbor needs his fence painted and offers to give Jim a rare baseball card if Jim paints his fence. The baseball card has a fair market value of $500. If Jim paints the fence, he has a $500 basis in the baseball card. Lump Sum 12. When more than one asset is purchased for a lump sum, the basis of each is computed by apportioning the total cost based on the relative FMV of each asset. Gifts 13. The donee’s basis in property acquired by gift is the donor’s basis, increased for any gift tax paid attributable to appreciation. The donor’s basis is increased by a. If the FMV on the date of the gift is less than the donor’s basis, the donee has a dual basis for the property. 1) Loss basis. The FMV at the date of the gift is used if the property is later transferred at a loss. 2) Gain basis. The donor’s basis is used if the property is later transferred at a gain. 3) If the property is later transferred for more than FMV at the date of the gift but for less than the donor’s basis at the date of the gift, no gain (loss) is recognized. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 6: Basis and Property Transactions 7 Figure 6-2 Visual Memory Aid: For candidates who are visual learners, the figure above and the description below can aid in recalling how to calculate gains and losses of gifts with a FMV less than AB. In the illustration above, Uncle Donor gifts his niece a vehicle. The big question: What basis should she use if she decides to sell the vehicle and how can she determine a gain or loss on her tax return? Imagine on the day of the gift the FMV is only $10,000 (according to Internet research), but the uncle paid $40,000 (his AB) for it years ago. If the niece is only able to sell it for $9,500, she can claim a loss of $500. Note in her hand the small stack of bills. It may help to remember that if she sells it for “pennies” her basis is the Fair Market Value, because it was a Fair Loss. Now, imagine the same FMV ($10,000) and AB ($40,000), but the niece was able to sell it for $41,000 and claim a gain of only $1,000. Notice the large stack of bills in her other hand. Her basis for determining a gain is the donor’s adjusted basis. The memory device is GAIN a DONOR. Alternatively, imagine the same FMV ($10,000) and AB ($40,000), but the sale price falls between the FMV and the AB, leaving the niece with neither a gain nor a loss. Without a net gain or loss, the sale is a WASH, represented in the illustration by a washing machine. The image above is © Dugger Corcoran Illustrations, LLC. Reprinted with permission. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 8 SU 6: Basis and Property Transactions b. Depreciable basis is transferred basis adjusted for gift taxes paid. If converted from personal to business use, it is FMV on the date of conversion if less than adjusted basis. EXAMPLE 6-5 Sale of Gift Property Bobby received a house as a gift from his father. At the time of the gift, the house had a FMV of $80,000 and the father’s adjusted basis was $100,000. If no events occurred that changed the basis and Bobby sells the house for $120,000, Bobby will have a $20,000 gain because he must use the father’s adjusted basis ($100,000) at the time of the gift to figure his gain. If he sells the house for $70,000, he will have a $10,000 loss because he must use the FMV ($80,000) at the time of the gift to figure his loss. If the sale was between $80,000 and $100,000, Bobby would not recognize a gain or a loss. c. When property other than money is contributed by a nonshareholder (e.g., government), the transferred basis is zero. Inherited Property 14. Basis is the FMV on the date of death or 6 months thereafter if the executor qualifies for and elects the alternate valuation date for the estate tax return. Property Converted into Business Use 15. Basis for depreciation is the lesser of the FMV of the property at the conversion date or the adjusted basis at conversion. Land Improvements 16. Depreciable land improvements generally have a recovery period of 15 years under MACRS. The 150% declining balance method applies. An issue that often arises is whether all or any portion of a land improvement is depreciable. In general, to be depreciable, a land improvement must be subject to wear and tear. Sidewalks, concrete driveways, asphalt streets and concrete curbs, playground equipment, fencing, and landscaping have been classified as land improvements. Sewer lines are not land improvements. Leasehold Improvements 17. Improvements made by the lessee are not income to the lessor either at the time the improvements are made or upon termination of the lease. Thus, the basis of the improvements is zero. Gain or loss will be recognized only at the time the property is sold. a. However, where the lessee makes repairs that are the responsibility of the lessor or makes improvements in lieu of rent, the lessor has rental income to the extent of the market value of the improvements and the basis of the improvements is market value. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 6: Basis and Property Transactions 9 6.2 ADJUSTMENTS TO BASIS Initial basis is adjusted consistent with tax-relevant events. Adjustments include the following: 1. Certain expenditures subsequent to acquisition are property costs, and they increase basis, e.g., legal fees to defend title or title insurance premiums. 2. Basis must be increased for expenditures that prolong the life of the property by at least 1 year or materially increase its value. a. Assessments that increase the value of property should be capitalized. b. If the assessments do not add value to the property, they may be deductible. 1) Examples include major improvements (e.g., new roof, addition to building) and zoning changes. EXAMPLE 6-6 Adjusted Basis In order to save money on their utility bills, Mr. and Mrs. Thrifty paid to replace their old roof with a new one with better insulation. The new roof materially increased the value of the house, so the cost of the roof should be added to the basis of the house. 2) Generally, repairs and maintenance expenses are considered a current-period deduction. However, certain repairs may be classified as an improvement, which must be capitalized. There are multiple safe harbors that allow repairs and maintenance to always be classified as a current-period expense instead of capitalized. a) Taxpayers who have elected to use the de minimis expense treatment must expense all repairs up to the de minimis amount (i.e., $2,500). b) The costs of performing certain routine maintenance activities for property may result in an improvement to the unit of property, i.e., capitalized costs. i) However, a safe harbor allows routine repairs and maintenance to be expensed. This safe harbor applies to actions that maintain the asset and are reasonably expected to be performed more than once for the asset’s class life under the alternative depreciation system. 3. Increase to basis may result from liability to the extent it is secured by real property and applied to extend its life. 4. Basis must be reduced by the larger of the amount of depreciation allowed or allowable (even if not claimed). Unimproved land is not depreciated. a. Section 179 expense is treated as a depreciation deduction. 1) The Sec. 179 amount is $1,160,000 for 2023. 2) The limitation is reduced (but not below zero) by the amount by which the cost of Sec. 179 property placed in service during the 2023 taxable year exceeds $2,890,000. 5. A shareholder does not recognize gain on the voluntary contribution of capital to a corporation. a. The shareholder’s stock basis is increased by the basis in the contributed property. b. The corporation has a transferred basis in the property. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 10 SU 6: Basis and Property Transactions 6. The basis of stock acquired in a nontaxable distribution (e.g., stock rights) is allocated a portion of the basis of the stock upon which the distribution was made. a. If the new and old shares are not identical, basis is allocated in proportion to the FMV of the original stock and the distribution as of the date of distribution. b. If the new and old shares are identical (e.g., stock splits), the old basis is simply divided among the new total of shares. c. If the FMV of the stock rights is less than 15% of the FMV of the stock upon which it was issued, the rights have a zero basis (unless an election is made to allocate basis). EXAMPLE 6-7 Basis of Rights to Purchase Stock A taxpayer exercises (sells) rights to purchase stock at $50 per share when the rights are worth $6 per share. Since the rights are worth less than 15% of the FMV of the stock, the taxpayer is not required to allocate a portion of old basis of the stock to the stock rights. Tax Benefit Adjustments 7. Basis adjustment is required for certain specific items that represent a tax benefit. Four examples follow: Casualty Losses a. Basis is reduced by the amount of the loss, by any amounts recovered by insurance, and by any amounts for which no tax benefit was received. Debt Discharge b. Specific exclusion from gross income is allowed to certain insolvent persons for debt discharged. Reduction in basis is required for certain amounts excluded. Credits for Building Rehabilitation c. Sometimes, the full amount of the credit must be deducted from the basis; other times, only one-half of the credit must be deducted. In the case of low-income housing, no reduction is required. d. Exclusions from income of subsidies for energy conservation measures decrease the basis of property. Partial Disposition of Property 8. The basis of the whole property must be equitably apportioned among the parts; relative FMV is generally used. Common Examples of Decreases to Basis Exclusion from income of subsidies for energy conservation measures Casualty or theft loss deductions and insurance reimbursements Certain vehicle credits Section 179 deduction Deductions previously allowed (or allowable) for amortization, depreciation, and depletion Depreciation Nontaxable corporate distributions Rebates treated as adjustments to the sales price Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 6: Basis and Property Transactions 11 6.3 LIKE-KIND EXCHANGES Section 1031 defers recognizing gain or loss to the extent that real property productively used in a trade or business or held for the production of income (investment) is exchanged (commonly referred to as relinquished) for property of like-kind. Realized gain (loss) is the gain (loss) from the sale or exchange. Recognized gain (loss) is the amount reported on the tax return. Like-Kind Property 1. Only real property qualifies for like-kind treatment for transfers after 2017. Like-kind real property is alike in nature or character but not necessarily in grade or quality. a. Properties are of like kind if each is within a class of like nature or character, without regard to differences in use (e.g., business or investment), improvements (e.g., bare land or house), location (e.g., city or rural), or proximity. 1) A real estate lease that runs 30 years or more is treated as real property, and the exchange of it for other real estate qualifies under Sec. 1031 as long as the parties to the exchange are not dealers in real estate. b. Real property located within the United States is like-kind with all other real property in the U.S. Foreign real estate is like-kind with other foreign real estate. But, U.S. real estate and foreign real estate are not like-kind. This is different from the rule for involuntary conversions by condemnation discussed in Subunit 6.4. Boot 2. Boot is all nonqualified property transferred in an exchange transaction. a. Gain is recognized equal to the lesser of gain realized or boot received. b. Boot received includes cash, net liability relief, and other nonqualified property (its FMV). EXAMPLE 6-8 Like-Kind Exchange with Boot Scott owned a parcel of real estate that he was holding for investment. It had an adjusted basis of $50,000. Scott exchanged the real estate for a piece of land with a fair market value of $60,000, a boat for personal use that had a fair market value of $3,000, and $2,000 cash. Scott’s basis in the land received is equal to the adjusted basis of the real estate transferred ($50,000), less the boot received of the boat ($3,000) and the cash ($2,000), plus the gain recognized on the transaction. Gain is recognized to the extent of boot received. Here, the boat and the cash are boot; therefore, a gain of $5,000 must be recognized. This recognized gain increases basis of the land to $50,000. EXAMPLE 6-9 Like-Kind Exchange Real property with an adjusted basis of $50,000 is exchanged for $20,000 cash and like-kind property with a FMV of $40,000. The recognized gain is $10,000 ($40,000 + $20,000 – $50,000), the lesser of the gain realized ($10,000) and the boot received ($20,000). EXAMPLE 6-10 Like-Kind Qualified Property Alan exchanged real property with a basis of $60,000 plus $5,000 cash for like-kind property with a FMV of $63,000. Alan’s $2,000 loss [$63,000 – ($60,000 + $5,000)] is not deductible. Liabilities 3. Liabilities are treated as money paid or received. a. If each party assumes a liability of the other, only the net liability given or received is treated as boot. b. Liabilities include mortgages on property. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 12 SU 6: Basis and Property Transactions Basis 4. Qualified property received in a like-kind exchange has an exchanged basis adjusted for boot and gain recognized. AB of property given + Gain recognized + Boot given (cash, liability incurred, other property) – Boot received (cash, liability relief, other property) + Exchange fees incurred – Loss recognized (boot given) = Basis in acquired property NOTE: The IRS has ruled that exchange expenses can be deducted to compute gain or loss realized, offset against cash payments received in determining recognized gain, or included in the basis of the property received. Realized Gain 5. Under Sec. 1031, realized gain is usually recognized only to the extent of boot received (Cash + FMV of other property + Net liability relief). Deferred Like-Kind Exchanges 6. If a taxpayer sells property and buys similar property in two mutually dependent transactions, the taxpayer may have to treat the sale and purchase as a single nontaxable exchange. Deadlines 7. An exchange of like-kind real properties must be completed within the earlier of a. 180 days after the transfer of the exchanged property or b. The due date (including extensions) for the transferor’s tax return for the taxable year in which the exchange took place. c. The taxpayer has 45 days from the date of the transfer to identify the like-kind real property received in the exchange. 1) The replacement property must be clearly described in a signed, written document. The document then must be delivered to the other person involved in the exchange. a) The identification of multiple replacement real properties is permitted. Exchange Expenses 8. Any exchange expenses are subtracted from the total of the following (but not below zero): a. Any cash paid to the taxpayer by the other party; b. The FMV of other (not like-kind) property received by the taxpayer, if any; and c. Net liabilities assumed by the other party–the excess, if any, of liabilities (including mortgages) assumed by the other party over the total of (1) any liabilities assumed, (2) cash paid by the taxpayer to the other party, and (3) the FMV of the other (not like- kind) property given up by the taxpayer. If the exchange expenses exceed (1), (2), and (3), the excess is added to the basis of the like-kind property. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 6: Basis and Property Transactions 13 6.4 INVOLUNTARY CONVERSIONS A taxpayer defers recognition of gain if property is involuntarily converted directly into similar or related property. Also, a taxpayer may elect to defer recognition of gain if property is involuntarily converted indirectly into money (i.e., nonqualified proceeds) or property that is not similar or related in use under Sec. 1033 (i.e., nonqualified property). Nonrecognition of gain is contingent on the involuntarily converted property being reinvested in qualified replacement property within the replacement period. The source of the funds for reinvestment (i.e., insurance proceeds or loan) is immaterial. Losses on involuntary conversions are not deferred. 1. An involuntary conversion of property results from destruction, theft, seizure, requisition, condemnation, or the threat of imminent requisition or condemnation. 2. Section 1033 does not apply to any realized losses. a. Loss from condemnation or requisition of a personal-use asset is not deductible. But certain casualty losses are deductible. b. When loss is realized, basis is determined independently of Sec. 1033. Direct Conversion 3. When property is first converted into other property that is similar or related in service or use to the converted property, the realized gain is deferred. a. Nonrecognition is mandatory, not elective, on direct conversion to the extent of any amount realized in the form of qualified replacement property. b. Basis in the proceeds (property) is exchanged, i.e., equal to the basis in the converted property. Indirect Conversion 4. When property is first converted involuntarily into nonqualified proceeds or property and qualified property is later purchased within the replacement period, an election may be made to defer realized gain. a. The deferral is limited to the extent that the amount realized is invested in qualified replacement property. b. Basis in the qualified replacement property is decreased by the amount of any unrecognized gain. 5. The replacement period begins on the earlier of the date of disposition or the threat of condemnation and ends 2 years after the close of the first tax year in which any part of the gain is realized. a. Regarding real property used in business or held for investment (not inventory, dealer property, or personal-use property), if conversion is by condemnation or requisition, or threat thereof, 3 years is allowed. b. Construction of qualified property must be complete before the end of the replacement period for its cost to be included. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 14 SU 6: Basis and Property Transactions 6. “Similar or related in service or use” means the following: Owner-User a. For an owner-user, that the property has functional similarity, i.e., meets a functional use test that requires the property to 1) Have similar physical characteristics 2) Be used for the same purpose Owner-Investor b. For an owner-investor, that the service or use of the property has a close relationship to the service or use the previous property had to the investor, such that the owner- investor’s risks, management activities, services performed, etc., continue without substantial change. Owner-General c. For owners (in general), that, if property held for investment or for productive use in a trade or business is involuntarily converted due to a federally declared disaster, any tangible replacement property will be deemed similar or related in service or use. 7. For real property used in business or held for investment (not inventory, dealer property, personal-use property, etc.), if conversion is by condemnation or threat thereof, like-kind property qualifies as replacement. This standard (i.e., like-kind) is less stringent than the similar or related standard. For condemnations, foreign and U.S. real property are considered like-kind property and subject to the less stringent standard. This is different from the rule for Sec. 1031 like-kind exchanges discussed in Subunit 6.3. a. Conversion must be direct. 8. To recap, on a Sec. 1033 involuntary conversion, realized gain is generally recognized only to the extent that any amount realized exceeds the cost of the similar or related-in-service property. Gain recognized is subject to classification as ordinary income under Sec. 1245 or Sec. 1250. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].