Individual Case 1
Mame Green is the owner and operator of the sole proprietorship Green Haven hotel in St. Simons, Georgia. At the beginning of the 2015 tax year, the hotel had a fair market value of $3,000,000 and an adjusted basis of $1,500,000, the hotel furniture and other furnishings had a fair market value of $1,000,000 and an adjusted basis of $100,000, and the hotel had a fair market value of $5,000,000 and an adjusted basis of $3,000,000. Three months ago, Green Haven was completely destroyed by a fair. Green Haven was covered under a fire insurance policy, and as a result, Mame received $4,000,000 after settling the claim. $3,000,000 was allocated to the ...view middle of the document...
2. The construction of the hotel and purchase of furniture and furnishings qualify as replacement property for the hotel building as a whole that was involuntarily converted, so Mame will be able to delay recognition of any gain realized.
1. Does Mame have to recognize any gain on his $500,000 purchase on undeveloped beach property, and if so, what will the character be?
The total destruction of the hotel and furniture and furnishings that if property as a result of destruction is converted into money, the taxpayer will be allowed to delay recognition of any gain so long as the purchased property is “similar or related in service or use to the property so converted”. The question now becomes whether undeveloped beach property is similar or related in service or use to a hotel building. Revenue Ruling 64-237 attempts to address this issue. In this Revenue Ruling, the IRS states they have taken the phrase “similar or related in service or use” to mean that property has close functional similarity. This “functional test” means that physical characteristics and end users of converted and replacement properties are similar. While the IRS doesn’t apply this “functional test” if the taxpayer is a lessor, they will still apply it for owner taxpayers which applies here. Looking at the client’s case, he was previously an owner/operator of the hotel building and his role in the undeveloped beach property is solely that of an owner. Also, the physical characteristics and end users have changed as the involuntarily converted property was a developed building used in the client’s primary trade or business of hospitality while this beach property is at this time just investment property in the form of land. Therefore in applying the “functional test”, this undeveloped beach property will not qualify as replacement property for the involuntarily converted hotel, so the client will have to recognize a gain on the $500,000.
As for the character of the gain, Section 1231(a)(3)(A)(ii) states that any recognized gain from involuntary conversions qualifies as a Section 1231 gain. Thus, the client will recognize $500,000 of 1231 gain (capital gain).
2. Will Mame recognize any gain on the $500,000 spent on the purchase of undeveloped land, and if so, what character will the gain be?
Likewise in analyzing the tax effects of the purchase of the new furniture and furnishings and the construction of the new hotel, the transaction will also fall under Section 1033(a)(2)(A) of involuntary conversions. This time, the hotel and furniture and furnishings will meet the “functional test” as these properties will have the same physical...