 Hello, and welcome to this session in which we will discuss section 351, built-in loss. Now so far up to this point, we discussed section 351, and we assume that the property that we contribute will have a gain. So what is section 351? Let's go ahead and review real quick. We have a bunch of people, shareholders, that they want to form a corporation. So what they do, they contribute money or property to form this corporation. They contribute, and they will have a control over this corporation after the contribution. If that's the case, then we have section 351. And if it's section 351, the property contributed will not recognize any gain. We will not have to pay taxes on gains of property contributed. Now in return, the corporation will issue stocks, form of ownership to the shareholder. So a fair market value is greater than the adjusted basis we have unrealized gain. If we have a section 351 transaction, we don't have to worry about the gain. How about, we never thought about this, how about if we contributed property, land, building, warehouse, and we have an unrealized loss. In other words, the property that we are contributing will have a fair market value lower than the adjusted basis. What do we have to do under those circumstances? This is what we will discuss in this session. Let's go ahead and get started. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today. Basis adjustment for loss property. So when built in loss property is contributed to a corporation built in means the property we are contributing already have a lower fair market value than the adjusted basis. Under those circumstances we have to make an adjustment. An adjustment is required when the aggregate adjusted basis. So notice, not one asset. We have to look all the adjusted basis and we compare them to the fair market value and adjusted basis in the property transfer exceeds the fair market value of the asset transfer, all of it together. What's the adjustment? Well, the corporate aggregate basis in the property received will have a step down. Okay, what does that mean? It means we are going to reduce the basis. We're going to reduce the basis of the property on the corporate books. So corporate aggregate basis in the property is a step down reduced by the loss so the basis does not exceed the fair market value of property transferred. And this is the general rule. Why is this the general rule? Because we're going to have an alternative method which we're going to see how and why. Let me ask you this. Would the company prefer higher basis or lower basis? So what would you prefer and why? Always, if you have a property, you would rather have a higher basis. Why? Because eventually you are going to sell this property. So when you sell this property and you have a higher basis, you are going to have a lower gain. But if you have a lower basis, then you will have a higher gain. So when you reduce, when you lower the basis, the corporation don't like this because when they sell it, they're going to have a lower gain. But this step is necessary to prevent parties from obtaining double benefit from losses involved. So that's why you have to reduce the basis because if you don't reduce the basis, well, and you received the corporation received a property that's already have losses, well, there's a benefit because you did not reduce the basis and now the losses are basically blended with that property. When you sell the property, you have a higher basis, you benefit from the loss twice. So what's going to happen? You're going to have to step down your basis. Step down your basis. And the best way to illustrate this is to take a look at an example. So let's assume Adam contributed equipment, land, and building. And these are the tax basis, 100,000, 200, and 150 total basis of 450. Fair market value of the equipment is 90. Fair market value of the land is 230. And fair market value of the building is 100,000. Let's compute whether we have a built-in loss or a gain. Equipment, 10,000 loss, land, 30,000 gain, and building 50,000 loss. If we add up the gains and the losses, we will have an aggregate loss of 30,000. Aggregate of 30,000. But remember, the loss itself, the losses are only 60, 50, and 10 because the land has a gain. But when we net them out, the aggregate loss is 30. What does that mean? It means we have to take this aggregate loss and allocate this 30,000 to the equipment into the building, reducing the equipment and the building basis on the corporate books. Well, how do we do that? Well, remember, the loss is how much? 60,000 between the two, between the two equipment and building. Well, equipment is 10,000, represent 10,000 out of the total. The building represents 50,000 out of the total. What we do is we say the percentage of loss allocated to the equipment should be 16.67. The percentage loss allocated to the building should be 83.33. Well, what we're going to do now, we're going to take the loss of 30,000 multiplied by this percentage. 30,000 multiplied by this percentage. And we're going to allocate 5,000 to the equipment. And as a result, now the equipment will have a basis on the corporate books at 95. The building will have a basis on the books of 125, which is 150. Remember, the basis are transferred minus the 25, which is minus the 25, which will give us 125. So what's going to happen is this. The corporation will have a basis of 420. How? Well, they're going to have a building equipment of 95,095K. The land will have a basis of 200,000. The land will have a basis of 200,000. And the equipment will have a basis of 125. Let's add them up. 95 plus 200 plus 125 will give us 420,000. So this is the corporate basis. Adam is going to have, because this is section 351, it's going to be the basis 450,000. Now we have a loss. Who absorbed the loss? The corporation absorbed the loss. Now let's assume the following day, the next day. The corporation sold those assets and they sold them for 420. So if the corporation sold the asset 420 minus the basis of 420, the corporation will have no loss. Let's assume Adam sells his stock for 420. If Adam sells his stocks for 420, his basis are 450, Adam would realize a loss of 30,000. So notice what happened here. All what we did is we took the loss and we gave it to the corporation. That's all what we did. Adam has the basis of 450. Now, what would happen, the alternative is to do what? Is to do the opposite. If the corporation and Adam is the shareholder and the corporation agrees, we can reverse this. This is an alternative election. The IRS or Congress don't care who's going to absorb the losses. If you are not told anything, the corporation would absorb the loss. If you are told they are using the alternative method, then it's a reverse. Then Adam will have the 420 in basis and the corporation will have the 450. Now think about it from a business perspective. I would rather have the corporation have the loss. If I'm not going to sell my share in the near future, why? From the corporation perspective, higher basis means higher depreciation. Higher depreciation means lower taxable income. Lower taxable income means lower taxes to Adam down right now, because higher depreciation gives you more deduction. More deduction means lower taxes. But also at the same time, if Adam sells his stock, he has a lower basis. Lower basis means a higher gain. But in the absence of any specific instruction, for example on the CPA exam, if you are not told anything, the built-in loss goes to the corporate, goes to the asset that's on the corporate books. Unless you are told there's an alternative treatment. What you should do now to understand this concept better? Go to Fahat lectures, work MCQs, multiple choice, two-fold questions, look at additional exercises that can help you understand this concept. Invest in yourself, invest in your career. Good luck, study hard, and of course, stay safe.