Rita forms Finch Corporation by transferring land (basis of 125,000; fair market value of 750,000) which is subject to a mortgage of 375,000. Two weeks prior to incorporating Finch, Rita borrows 125,000 for personal purposes and gives the lender a second mortgage on the land. Finch Corporation issues stock worth 250,000 to Rita and assumes the two mortgages on the land. What are the tax consequences to Rita and Finch Corporation?
To determine the tax consequences to Rita and Finch Corporation, we need to analyze the various transactions involved. Let's break it down step by step:
1. Transfer of land to Finch Corporation:
Rita transfers the land to the newly formed Finch Corporation. The tax consequences to Rita for this transfer will depend on whether it is considered a taxable event or a non-taxable contribution to the corporation.
a) If the transfer is a taxable event: In this case, Rita would recognize a gain or loss on the transfer of the land. The gain or loss is calculated by subtracting Rita's adjusted basis in the land ($125,000) from the fair market value of the land ($750,000) at the time of the transfer. However, since the land is subject to a mortgage of $375,000, this mortgage is considered a liability assumed by the corporation, reducing the amount realized by Rita. Rita's gain or loss will be calculated as ($750,000 - $375,000 - $125,000).
b) If the transfer is a non-taxable contribution: If the transfer is considered a non-taxable contribution of property to the corporation, Rita won't recognize any gain or loss at this time. Her basis in the Finch Corporation stock she received will be equal to her adjusted basis in the transferred property ($125,000).
2. Borrowing and second mortgage:
Two weeks before incorporating Finch Corporation, Rita borrows $125,000 for personal purposes and gives the lender a second mortgage on the land. This transaction is separate from the transfer of the land to the corporation.
The tax consequences of this borrowing will depend on whether the loan is considered a recourse or non-recourse loan and the use of the borrowed funds.
a) Recourse loan: If the loan is recourse, Rita will not recognize any taxable income from the borrowing. The loan proceeds are not considered income, but rather a liability that Rita is responsible for repaying.
b) Non-recourse loan: If the loan is non-recourse, Rita would generally recognize cancellation of debt (COD) income equal to the difference between the outstanding loan balance and the value of the property securing the loan. However, in this case, since Rita transferred the land to Finch Corporation, any COD income would be recognized by the corporation, not Rita.
3. Issuance of stock and assumption of mortgages:
Finch Corporation issues stock worth $250,000 to Rita and assumes the two mortgages on the land as part of the transaction.
For Finch Corporation, the assumption of the mortgages will increase its liabilities and reduce its stock basis by the amount of the liabilities assumed.
In Rita's case, the issuance of stock worth $250,000 would increase her basis in the Finch Corporation stock.
Overall, the tax consequences to Rita and Finch Corporation will depend on multiple factors, including the tax treatment of the land transfer, the nature of the loan, and the specific provisions of the tax code. It is recommended to consult a tax professional or accountant for a thorough analysis of the situation based on all relevant facts and circumstances.