Federal Income Taxation

Professor Colon

Spring 2000

Answers to Chapter 16 (Home Equity Indebtedness) and Chapter 28 (Realization)

Chapter 16

Problem 1(a)

Mortgages is acquisition indebtedness ("AI") (163(h)(3)(B)(i)). All interest is deductible.

Problem 1(b)

Assume no principal payments on 1^st mortgage. 40% of second mortgage used to pay for substantial improvement; thus, 40% of second mortgage is AI within the meaning of 163(h)(3)(B)(i). Since total AI (800k) is less than $1 million, 40% of second mortgage interest payments in 1999 also deductible.

The remaining $300k of second mortgage is possible home-equity indebtedness ("HEI") in 163(h)(3)(C). If we calculate the "equity" limitation in 163(h)(C)(i) at the time the second mortgage debt is incurred (and not, for example, every year), which seems reasonable, the equity limitation is $1.2MM -$600k-$200k = $400k. The remaining $300k is within this limitation but it exceeds the $100k ceiling by $200k. Thus only 1/3 of interest on remaining $300k of second mortgage is deductible.

Problem 2

Mortgage is AI. If we assume that Jack made no principal payments on the 1998 debt, his 163(h)(3)(C)(i) equity limitation is only $40,000 ($200k-$160k). Thus, only $40,000 of 1999 debt is HEI and only 53% (40k/75k) of interest paid is deductible if Jack spends loan proceeds for his child's medical needs. If Jack ignores child's plight and uses the loan proceeds to add a racquetball court and sauna to his home, the 1999 debt becomes AI, assuming these are "substantial improvements," and all of the interest thereon is deductible because the sum of the two acquisition debts is safely within the $1,000,000 ceiling of 163(h)(3)(B)(ii).

Chapter 28

Problem 1(a)(i)

If exchange is taxable to both parties, Bugs realizes and recognizes $100,000 of gain [AR (200)- AB (100)] and takes a $170,000 cost basis in Blackacre. (The $30,000 cash received by Bugs has its own basis.). Daffy: realize and recognize $80,000 of gain (net amount realized of $170,000-$90,000 basis) and take a cost basis of $200,000 in Whiteacre. If both immediately sold properties before any change in value, neither would recognize further gain.

Problem 1(a)(ii)

Section 1031(a) doesn't apply because of the "solely for" requirement. But the nonrecognition rule of 1031(b) will apply if the "solely for" requirement is the only requirement of 1031(a) that is not satisified. Under 1031(b), Bugs recognizes $30,000 of $100,000 realized gain due to the boot received. Although Bugs receives boot, under section 1031(b), gain recognized only to extent of boot received, and remaining $70,000 of gain is deferred. Under section 1031(d), his basis in Blackacre is $100,000 [old basis of $100,000 - $30,000 money received + $30,000 gain recognized]. Check: How much gain would Bugs recognize if he immediately sold Blackacre for its FMV? Ans: $70,000, which equals gain realized but not recognized.

Daffy's exchange satisfies all the requirements of section 1031(a). Daffy's $80,000 realized gain goes entirely unrecognized, and his basis in Whiteacre is $120,000 [old basis in Blackacre plus $30,000 cash]. Check: How much gain would Daffy recognize if he immediately sold Whiteacre for its FMV? Ans: $80,000, which equals gain realized but not recognized on the exchange.

Problem 3.a.

Absent section 121, Patricia would realize and recognized $80k gain under 1001, 1222. Under section 121, however, gain is entire excludable, since she lived in house for at least 2 or last 5 years, regardless of whether she purchases a replacement home or rents. Unrecognized gain is not deferred but is completely forgiven.

Problem 3.b.

Involuntary conversion is "sale" for purposes of section 121. Her realized gain of $50k ($120k insurance proceeds - $70k AB) is completely excludable and she would take a $90k cost basis in her constructed home. Also note that reimbursement of personal living expenses is excludable under 123.

Problem 3.c.

Involuntary conversion triggers 1033. Without 1033, P's $50k realized gain (120k insurance proceeds - 70k AB) would be taxed in full. Under 1033, if all of the proceeds from involuntarily converted property are rolled over into "property similar in service or use" within the required time period, the realized gain can go unrecognized, at the taxpayer's election. To extent proceeds are not rolled over, they are like "boot" under 1031, and gain is recognized to this extent. Like 1031, and unlike 121, unrecognized gain is merely deferred, not forgiven. The basis of the replacement property is its cost less any gain is not recognized on the conversion. 1033(b)(2).

P must recognize 30k of her realized gain (120k insurance-90k AB). The basis of the reconstructed coffee shop is 70k (90k cost of new replacement property less 20k of gain that went unrecognized under 1033). If she sold new shop before it changed value, she would realized and recognize 20k of gain that went unrecognized on the involuntary conversion.