Pope Phft2015 Ind Im 05

Chapter I:5

Property Transactions: Capital Gains and Losses

Learning Objectives

After studying this chapter, the student should be able to:

1. Determine the realized gain or loss from the sale or other disposition of property.

2. Determine the basis of property.

3. Distinguish between capital assets and other assets.

4. Understand how capital gains are taxed for noncorporate taxpayers.

5. Understand how capital gains are taxed for corporate taxpayers.

6. Recognize when a sale or exchange has occurred.

7. Determine the holding period for an asset when a sale or disposition occurs.

8. Describe tax planning opportunities for property transactions.

9. Describe compliance and procedural considerations for property transactions.

Areas of Greater Significance

A solid knowledge of the adjusted basis computation and the concept of realized vs. recognized gain or loss is necessary for further tax study by the student. In addition to the applications in the study of individual taxation, many of the special rules for corporations and partnerships deal with the concepts of gain or loss recognition and adjusted basis.

Areas of Lesser Significance

In the interest of time, the instructor may determine that the following areas are best covered by student reading, rather than class discussion:

1. Tax treatment of capital gains and losses - corporate taxpayers.

2. Compliance and procedural considerations.

Problem Areas for Students

The following areas may prove especially difficult for students:

1. Differentiating between realized gain or loss and recognized gain or loss.

2. Determining the basis of gift property, especially when the property has a different basis if sold for a gain, than if sold for a loss.

3. Understanding the tax definition of a capital asset, as compared with the financial definition of a capital asset.

Highlights of Recent Tax Law Changes

The following item of tax law has changed since the 2014 edition of this chapter:

1. The transfer tax unified credit equivalent increased to $5,340,000. Teaching Tips

1. The concepts in this chapter are key to several later chapters in this text and to the study of partnership and corporation taxation. Adjusted basis, realized gain or loss, and recognized gain or loss must be mastered by the students at this point in their tax study careers. Emphasize this urgency to the students and provide sufficient time in and/or out of class to answer student questions.

2. A significant rate preference for gain on sale or exchange of long-term capital assets has revitalized the reasons for knowing the capital asset rules. Spend time on how these special rules should affect transaction planning.

Lecture Outline

I. Determination of Gain or Loss

A. Realized Gain or Loss (Examples I:5-2, I:5-3, I:5-4, I:5-5, I:5-8)

1. If a realizing event occurs (normally a sale or exchange), the amount realized less the asset’s adjusted basis will equal realized gain or loss.

2. Amount realized consists of money and FMV of property received plus taxpayer’s debt assumed by the buyer less costs of sale (i.e., commissions).

3. Adjusted basis equals original basis (i.e., cost, gift, inheritance) plus additions (i.e., capital improvements) less reductions (i.e., depreciation, cost recovery, depletion, casualty loss, severance damages).

EXAMPLE: The taxpayer sells a piece of land for $20,000. Costs of sale are $1,000. The land cost the taxpayer $15,000 two years ago. Realized gain equals the amount realized of $19,000 ($20,000 sale price less $1,000 costs of sale) less the adjusted basis of $15,000 (cost) or $4,000.

B. Recognized Gain or Loss (Example I:5-9)
The amount of recognized gain or loss on disposition of an asset may be less than the realized gain or loss due to special nonrecognition or deferral of recognition statutory provisions.

EXAMPLE: Types of tax nonrecognition provisions are the like-kind exchange rules and the involuntary conversion rules.

II. Basis Considerations (Topic Review I:5-1)

A. Cost of Acquired Property (Examples I:5-10, I:5-11, I:5-14, I:5-15; Question I:5-2)

1. The most frequently applicable original basis is a cost basis. Cost basis includes cash, FMV of other property, debt, and transactional costs incurred in the acquisition.

2. Uniform capitalization rules are mandated for certain kinds of inventory and certain other property.

3. Construction period interest and taxes must be capitalized for certain “long useful life” property.

4. With homogeneous property (i.e., blocks of identical common stock), specific identification of sold property may not be possible. In this case, the tax law requires a FIFO approach.

5. Owners of mutual funds may use an average cost method in addition to FIFO and specific identification.

B. Property Received as a Gift (Examples I:5-16 through I:5-18; Instructor Aid I:5-1; Problem I:5-36)

1. The donee’s adjusted basis for gain is the donor’s adjusted basis plus a gift tax adjustment for the gift tax paid related to the gift property’s appreciation to the date of gift.

2. The donee’s adjusted basis for loss is the lesser of the gain basis or the FMV at the date of gift.

3. The gain basis is used for calculating any depreciation/cost recovery. The amount of depreciation / cost recovery allowed or allowable is subtracted from the applicable gain basis or loss basis in the event of a disposition.

C. Property Received from a Decedent (Examples I:5-20, I:5-24, I:5-25, and I:5-26)

1. Basis of inherited property is generally fair market value at date of death or alternate valuation date. The alternate valuation date is six months after the date of death. If property owned by the decedent at the time of death is not held by the estate six months later, such property is valued at its disposition date for alternate valuation purposes. The alternate valuation can be elected by the executor only if its use lowers the value of the estate and lowers the estate tax liability.

2. Both halves of community property receive a step-up in basis at the death of one of the spouses.

3. Certain items (income in respect of a decedent) for which the decedent did not recognize income during her life because of accounting method or special deferral rules will not receive a step-up in basis at the date of death.

EXAMPLE: If a taxpayer was reporting a sale under the installment method at the time of her death, the person inheriting the installment notes would be income taxable on the unrecognized gain in the transaction on the same basis the decedent taxpayer would have been taxed.

D. Property Converted from Personal Use to Business Use (Examples I:5-27 through I:5-29)
Basis of personal use property converted to business use property is the lower of the personal use adjusted basis or the property’s fair market value at conversion.

EXAMPLE: If a taxpayer converts a personal residence (cost $125,000) into rental property at the time when the residence’s fair market value is $100,000, depreciation / cost recovery must be calculated on the lesser amount - $100,000.

E. Allocation of Basis (Examples I:5-31, I:5-33, I:5-34, I:5-35, I:5-37; Question I:5-7)

1. If multiple assets are acquired for a single purchase price (i.e., basket purchase), the acquisition cost must be allocated to the individual assets on the basis of their relative FMV.

2. If identical shares are received as a nontaxable stock dividend (i.e., common on common) the old adjusted basis is allocated equally to all shares.

3. If different shares (i.e., preferred on common) or rights are received in a nontaxable transaction, the old adjusted basis is allocated based on the relative fair market of each different type of asset.

4. Allocation of basis to a nontaxable stock right received is mandatory if the right has a fair market value of at least 15% of the FMV of the underlying stock. Allocation of basis to other nontaxable stock rights is elective.

III. Definition of a Capital Asset (Examples I:5-38, I:5-39; Question I:5-11)

A. Capital assets for tax purposes are defined as assets other than inventory, depreciable property, or real property used in a trade or business, certain accounts or notes receivable, certain taxpayer produced works, and certain government publications.

EXAMPLE: A taxpayer’s personal residence is a capital asset.

B. Influence of the Courts

Corn Products Refining Co. and Arkansas Best Corporation are two important Supreme Court cases defining capital asset treatment in trade or business situations.

C. Other Code Provisions Relevant to Capital Gains and Losses (Examples I:5-40,
I:5-42, I:5-45)

1. Dealers normally treat securities as inventory which generates ordinary income. Security dealers must use the mark-to-market inventory method [yearly appreciation taxed] for tax years ending December 31, 1993, or later. EXCEPTION: On acquisition, dealers may elect to treat certain securities as held for investment, thereby generating capital gain or loss on disposition.

2. Certain noncorporate, nondealer taxpayers can subdivide land and sell a limited number of lots while retaining capital gain treatment.

3. Nonbusiness bad debts are treated as short-term capital losses.

IV. Tax Treatment for Capital Gains and Losses of Noncorporate Taxpayers (Topic Review I:5-2)

A. Capital Gains (Examples I:5-46 through I:5-51)

1. Net capital gain results when net long-term capital gains exceed net short-term capital losses.

EXAMPLE: If the taxpayer has a $10,000 long-term capital gain on the sale of stock and a $5,000 short-term capital loss from the sale of land, the net long-term capital gain is $5,000.

2. For capital assets held more than one year, the maximum rate on net long-term capital gain is 20% (if the taxpayer’s marginal rate is 39.6%). The applicable rate is 0% if taxpayer is otherwise in the 15% or 10% bracket. The applicable rate is 15% for marginal rates greater than 15% and less than 39.6%. Long-term gains from collectibles are generally taxed at 28%.

B. Capital Losses (Examples I:5-57, I:5-58, I:5-60, I:5-61)

1. Net short-term capital losses are offset against net long-term capital gains in this order: (1) 28% group, (2) 25% group, and (3) 15% group.

2. Net capital losses (whether short-term or long-term) offset ordinary income to a $3,000 maximum, with an unlimited carryover to future years.

EXAMPLE: If the taxpayer has an $8,000 net capital loss (whether short-term or long-term), he may offset $3,000 of ordinary income in the current tax year and carry over $5,000 of net capital loss indefinitely until utilized. C. The 3.8% Net Investment Income Tax (Examples I:5-64; I5:65) 1. Effective from 2013, there is a 3.8% Net Investment Income Tax.

2. The 3.8% rate is applied to the lesser of net investment income or excess over a stated threshold varying with filing status.

V. Sale or Exchange (Example I:5-67)

Generally, a capital gain or loss results from the sale or exchange of a capital asset.

A. Worthless Securities (Example I:5-68)
Securities that become totally worthless in a tax year are treated as a capital loss on the last day of the tax year.
EXAMPLE: If a security becomes worthless on February 1st, a calendar-year taxpayer treats the loss as a capital loss occurring on December 31st.

B. Retirement of Debt Instruments (Examples I:5-70, I:5-73, I:5-75; Table I:5-1)

1. Amounts received on retirement of debt are treated as being received in an exchange, with original issue discount and market discount impacting the final calculation of income or loss.

2. Sale or exchange of market discount bonds purchased after April 30, 1993, may result in additional ordinary income rather than capital gain.

C. Options (Examples I:5-76, I:5-77, I:5-79)
Options that are exercised are added to the cost basis. Options that are sold or lapse give rise to sale or exchange treatment.

D. Patents (Example I:5-81; Question I:5-21)
Under certain conditions, the sale or exchange of patent rights may generate a capital gain.

E. Franchises, Trademarks, and Trade Names (Example I:5-84)
Certain franchises, trademarks, and trade names may generate capital gain or loss on sale or exchange.

F. Lease Cancellation Payments (Example I:5-85)
Lease cancellation payments received by the lessor are treated as ordinary income, while lease cancellation payments received by the lessee are generally treated as capital gain.

VI. Holding Period (Example I:5-87)

The holding period for long-term treatment is more than one year.

A. Property Received as a Gift (Examples I:5-88, I:5-89)

1. If the donee’s adjusted basis is determined by reference to the donor’s adjusted basis, the donor’s holding period is added to the donee’s holding period.

2. If the donee’s adjusted basis is the fair market value at date of gift, the holding period begins at the date of gift.

B. Property Received from a Decedent (Example I:5-90)
Inherited property always receives a long-term holding period.

EXAMPLE: The decedent buys stock on May 1. The decedent dies on May 2. The taxpayer inherits the stock on May 3 and sells the stock on May 4. Even though only a few days are involved, the gain or loss on sale is treated as long-term.

C. Nontaxable Exchanges
The holding period of the property given up in a tax-free exchange is added to the holding period of the property received in the exchange.

EXAMPLE: The taxpayer acquires an apartment building in 1990. On December 30, 2013, she exchanges the apartment building for a shopping center, qualifying under the like-kind exchange rules. The holding period of the shopping center is long-term even if it is sold on January 3, 2014.

D. Receipt of Nontaxable Stock Dividends and Stock Rights (Examples I:5-91, I:5-92)
The holding period of nontaxable stock dividends and stock rights generally includes the holding period of the underlying stock.

EXAMPLE: The taxpayer acquires common stock in 2000. The taxpayer receives stock rights in a nontaxable distribution in 2014. The holding period of the rights is long-term.

VII. Justification for Preferential Treatment of Net Capital Gains (Example I:5-93)

A. Factors supporting preferential treatment for net capital gains are mobility of capital and the mitigation of the effects of inflation and progressive tax rates.

B. While net capital gains may receive a maximum 19.6% (39.6%-20%) rate preference for high-income taxpayers, additional special treatment for net capital gains is a continuing topic of discussion.

VIII. Tax Planning Considerations

A. Selection of Property to Transfer by Gift (Examples I:5-95, I:5-98)

1. The decision to make lifetime gifts may be influenced by available annual exclusions, a desire to reduce future estate tax, and/or a desire to shift the income tax burden.

2. It is usually unwise to gift depreciated property (FMV less than adjusted basis) because the donee may be forced to take the lower FMV basis.

B. Selection of Property to Transfer at Time of Death (Example I:5-101)
Generally, highly appreciated property should be retained until death and loss property should be sold before death.
EXAMPLE: A taxpayer holding property with an adjusted basis of $500,000 and a fair market value of $300,000 would want to sell the property before death to recognize the $200,000 loss. If this property was held until death, the person inheriting would receive a $300,000 adjusted basis, and the benefit of the $200,000 loss would be lost.

Court Case Briefs

Steven D. Strickland and Doris K. Strickland v. CIR, 67 TCM 1927 (1994).

The Stricklands reported the sale of a tractor/trailer rig used in Mr. Strickland’s business on Schedule D. A loss of $7,291 was calculated as the difference between the sales proceeds of $45,709 and the rig’s cost of $53,000.
On audit, the revenue agent determined that the taxpayers had claimed a Sec. 179 expense deduction of $5,000 and depreciation deductions of approximately $12,000. The agent calculated the rig’s adjusted basis at 36,172 with a resulting gain (not loss) of $9,537.
The Strickland’s defense was that Schedule D did not have a column for depreciation taken, and therefore they had just used the wrong form.
The court pointed out that the correct form was 4797. The court disallowed the loss computed by the taxpayers and sustained the additional tax on the gain computed by the government.

Launce Gamble v. CIR, 68 T.C. 800 (1977).

Launce Gamble was engaged in the business of racing thoroughbred horses. In 1969, he purchased for $60,000 a broodmare, Champagne Woman, who was carrying a foal sired by Raise a Native. Both the mare and the stud had excellent pedigrees and impressive racing records. The mare gave birth to a colt which was handled as if expected to be trained and raced. However, as the colt reached the age approaching the time for training, Mr. Gamble sold her for $125,000. In reporting the sale of the colt on his federal income tax return, Mr. Gamble deducted $30,000 as a cost basis for a long-term capital gain. The IRS determined that the sale resulted in ordinary income and assumed a cost basis of zero.
The court found that the taxpayer was primarily in the business of racing thoroughbred horses and that the colt had not been held primarily for sale. The evidence indicated that the owner intended to exploit the colt, but that the possibility of selling the colt did not dominate the possibility of training and racing the colt. The horse was considered “property used in the trade or business” and as such was held to be Sec. 1231 property eligible for capital gain treatment.
The cost basis of the colt was determined as $20,000. This was ruled to be a reasonable allocation of the cost of its mother, Champagne Woman, based on the benefit payable from Live Foal Insurance Coverage.
Instructor Aid I:5-1

Calculation of Donee’s Basis for Gift Property

Basis for Gain = Donor’s Adjusted Basis + Gift Tax Adjustment

Gift Tax Adjustment = Gift Tax Paid x
(FMV of Gift - Donor’s Adjusted Basis)

Amount of Gift [FMV of Gift - Annual Exclusion(s)]

Basis for Loss = Lower of Basis for Gain or FMV Date of Gift

Gain basis may be used for depreciation/cost recovery calculation purposes.

Instructor Aid I:5-2

Allocation of Basis for Nontaxable Stock Dividend

Identical Stock Issued:

Adjusted Basis of Stock Before Stock Dividend = Per Share Adjusted Basis of
Number of Shares Owned After Stock Dividend All Shares*

Different Shares Issued:

Basis of old shares* = Adjusted Basis of Stock Before Dividend x FMV of old shares FMV of old shares + new shares

Basis of new shares* = Adjusted Basis of Stock Before Stock Dividend x FMV of new shares FMV of old shares + new shares

*Holding Period of all shares = Holding Period of Pre-distribution shares