Choice "B" is correct. The $40,000 gain realized by Potter ($100,000 − $60,000) on the sale to Sly is an intercompany gain that is eliminated in consolidation. Therefore, the Year 1 consolidated return gain is $0. In Year 2 when Sly sells the land to an outside party, the full gain of $65,000 is recognized ($125,000 − $60,000 original basis) on the consolidated return.Choice "c" is incorrect. The $40,000 gain on the sale from Potter to Sly is intercompany gain and would be eliminated during consolidation. Once the sale is completed from Sly to another party (not in the consolidated return), the full $65,000 gain would be recognized in the tax return.
Choice "a" is incorrect. The gain recognized by Sly on the sale should be calculated as the difference between the original basis to Potter, $60,000, and not the fair market value of $75,000. Choice "d" is incorrect. The Year 1 gain in this question is utilizing the fair market value of the land instead of the basis. The gain reported in Year 2 is also incorrect as discussed in the explanation to choice "a" above.