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Welcome back. Recall, that in the previous videos we

introduced an important non-taxable exchange, the Involuntary Conversion.

Under Section 1033, realized gains due to involuntary conversions can be deferred,

but the taxpayer must qualify either due

to the functional use test or the taxpayer used test.

And obtain the replacement property between

the earliest and latest dates for replacement.

In this video, we'll look more closely at the non-recognition rules under Section 1033.

The non-recognition rules under Section 1033 for

realized losses on an involuntary conversion of property are mandatory.

Here, a realized loss on involuntary conversion

of business or income producing property is recognized.

That is, there is no deferral of realized losses.

The tax payer must recognize the losses in the year they occur.

For personal use property a realized loss on

an involuntary conversion depends on a few factors.

If the involuntary conversion is a condemnation,

a realized loss is not recognized.

But, if the involuntary conversion is a casualty or a theft,

recall from many videos ago that under this scenario,

the realized loss is recognized only if it exceeds the $100

per event floor and 10% of adjusted gross income of the taxpayer.

So, in general, taxpayers recognize any realized losses from involuntary conversions

except condemnations and some rather large personal casualties and thefts.

Now, the rules for a realized gain on

an involuntary conversion depend on whether the conversion is direct or indirect.

Recall that a direct conversion was old property into replacement property directly.

While an indirect conversion was old property into cash,

likely obtained from an insurance claim, into replacement property.

Here, realize gains in a direct involuntary conversion are postponed.

This is mandatory treatment.

And this should make sense because without an insurance claim and no cash,

the taxpayer doesn't have the wherewithal to pay tax on any realized gains.

Therefore, the realized gains are not recognized in a direct involuntary conversion.

On the other hand, in an indirect involuntary conversion, so,

property to cash to property will be recognized

unless the taxpayer elects to postpone the gain under Section 1033.

That is Section 1033 is not automatic.

The taxpayer must elect this treatment.

If the postponement is elected under Section 1033,

then the amount of recognized gain is the lesser of first,

the realized gain or second,

the amount realized that's not reinvested in replacement property.

What this means is that to the extent to which cash

was received from the involuntary conversion,

may be due to an insurance claim,

and that cash is not used to buy replacement property,

then you can think of that as the tax payer liquidating some of

the value of the old property that is getting cash for it and thus,

to the extent cash is received,

it looks like a sale,

and thus gain must be recognized.

Some other items here relate to basis.

Recall the boot is something that the taxpayer receives that

is not a qualifying part of the nontaxable exchange.

So, in a like kind exchange,

cash or a reduction in the seller's liabilities reflect boot received,

because they're not like kind property.

In an involuntary conversion context,

the boot received might be any extra cash or other property that the taxpayer

receives from an insurance claim and does not use it to buy replacement property.

Therefore, the basis of any boot received will be the fair market value of that boot.

Second, the basis of the new qualifying replacement property received is simply

the fair market value of the new property received minus any postpone gains,

or the postponed gains reflect the difference

between the realized gains and the recognized gains.

In terms of holding period,

the holding period of any boot received begins on the date the boot is received.

However, for the new qualifying property received under Section 1033,

the taxpayer will use a carry over holding period.

That is, add the holding period of

the old property to any holding period of the new property.

So, to illustrate the main points in this video,

let's look at three examples.

First, Lena's Warehouse with a $500,000 basis is destroyed by a hurricane.

She collects $650,000 from

the insurance company and purchases a new warehouse for $720,000.

What is Lena's realized gain or loss from this involuntary conversion?

How much can Lena elect to defer in gain or loss due to this involuntary conversion?

And what is her basis in the new warehouse?

So, to figure out Lena's realized gain from this involuntary conversion,

as we learned in previous videos,

the realized gain is simply the amount realized minus adjusted basis or more

broadly the fair market value of what the tax payer

got minus the basis of what the tax payer gave up.

Here, Lena got $650,000 from

the insurance company and she gave up her warehouse that had a basis of $500,000.

Therefore, her realized gain is $150,000.

If Lina elects to defer her gain under Section 1033,

how much can she defer?

That is how much can she defer and how much must she recognize?

Here, since we're looking at an indirect involuntary conversion

or property to cash to property,

her recognized gain equals the lesser of her realized gain,

or a $150,000 that we got from the previous slide,

or the amount realized that is not reinvested in replacement property.

Here, recall that Lena collected $650,000 from her insurance company,

but bought a warehouse for $720,000.

Therefore, she reinvested all $650,000 and more into the replacement property.

As a result, zero is not reinvested,

and all her recognized gain is zero,

which means that all $150,000 of her realized gain is

eligible to be deferred under Section 1033.

Now, what's Lena's basis in the replacement warehouse?

To figure out the basis of qualifying property received,

we take the fair market value of the qualifying property

received and subtract any postpone gains,

where the postpone gains are the difference

between the recognized gain and the realized gain.

So, if the Section 1033 election is made,

the basis of the new warehouse is $720,000 minus $150,000 or $570,000.

Notice, that the $150,000 gain is deferred rather than excluded.

You can see that because an immediate sale of the replacement property at its $720,000

fair market value would result in a recognized gain equal to the $150,000 postpone gain.

So, if the new warehouse is sold for $720,000 and the basis is $570,000,

we get a recognized gain of $150,000.

So, you can see here that the deferral of gain is built into

a downward adjustment in the basis relative to the new assets fair market value.

It basically sits there and waits to be unlocked

upon a subsequent taxable exchange, like a sale.

In our second example,

Bob owns a restaurant with a $200,000 basis.

The restaurant is destroyed by fire,

and he receives insurance proceeds of $300,000.

He purchases another restaurant for $275,000.

So, what's Bob's realized gain or loss from this involuntary conversion?

How much can Bob elect to defer in gain or loss due to this involuntary conversion?

And what's his basis in the new restaurant?

First, Bob's realized gain is $100,000 or the $300,000

insurance proceeds minus the basis in the voluntarily converted property of $200,000.

How much can Bob elect to defer of this $100,000 gain?

Well, because this is an indirect involuntary conversion,

his recognized gain is the lesser of

his realized gain or $100,000 from the previous slide,

or any amount not reinvested in replacement property.

Recall that Bob collected $300,000 from his insurance company,

but bought a new restaurant for only $275,000.

Therefore, he reinvested only $275,000 and essentially cashed out the other $25,000.

Therefore, his recognized gain is $25,000.

Because he's recognizing $25,000 of the $100,000 realized gain,

the remaining $75,000 of the gain is deferred.

So, what's Bob's basis in the new restaurant?

Well, his basis in the new restaurant is $200,000,

or the fair market value of property received of $275,000

minus the postponed gain of $75,000.

That $75,000 represents the difference between the

$100,000 realized gain and the $25,000 recognized gain.

Okay, our final example here.

So, we have Barry's Offshore Drilling Rig and it has an $800,000 adjusted basis.

It's destroyed by a tsunami.

He collects $700,000 from

the insurance company and purchases a new drilling rig for $760,000.

What's Barry's realized gain or loss from this involuntary conversion?

How much can Barry elect to defer in gain or loss

due to this involuntary conversion and finally,

what is Barry's basis in the new drilling rig?

First, what is Barry's realized gain or loss from this involuntary conversion?

Here, Barry realizes a $100,000 loss or the

$700,000 in insurance proceeds minus the $800,000 adjusted basis in the old drilling rig.

And so, how much can Barry elect to defer

in gain or loss due to this involuntary conversion?

While under Section 1033,

realized losses must be recognized,

this is a mandatory rule.

Therefore, the entire $100,000 realized loss is recognized.

Finally, what's Barry's basis in the new drilling rig?

Well, we can still use our handy formula for calculating basis.

We have the $760,000 fair market value of

the new drilling rig minus zero postponed gains.

There are no gains because Barry had a loss.

Therefore, the basis in the new drilling rig is $760,000.

This should of course makes sense,

because in a loss situation,

if it's recognized immediately then the basis in the new asset

would be simply what Barry paid for, or $760,000.

In summary, under Section 1033,

realized losses are always recognized.

If elected, any realized gains generated by indirect involuntary conversions are

recognized as the lesser of the realized gain or

any amount realized that's not reinvested in replacement property.

Finally, the basis in the qualifying property received equals

the fair market value of the qualifying property received minus any postponed gains only,

where the postponed gain is the difference

between the realized gain and the recognized gain.