Essentials of taxation 2016 cengage chapter 08

Proper Classification of Gains and Losses • Depends on three characteristics: • Capital asset, §1231 asset, or ordinary asset • By sale, exchange, casualty, theft, or condemnation • Shor

Essentials of Taxation

Chapter 8

Property Transactions:

Capital Gains and Losses, § 1231,

and Recapture Provisions

The Big Picture (slide 1 of 4)

• Alice owns land that she received from her

father 10 years ago as a gift

$2,000 and was worth $10,000 at the time of the

gift

• The property is currently worth about $50,000.

• If Alice sells the land, you previously

determined that she would have a taxable gain

of $48,000.

The Big Picture (slide 2 of 4)

• Alice also owns 500 shares of AppleCo stock.

were worth $30,000 at the time of his death.

• If Alice sells those shares for $120 each, you previously

determined that she would have a $6,000 taxable gain

• The other 200 shares were purchased by Alice two months ago

for $28,000

would have a recognized loss of $4,000.

• Nine months ago, Alice purchased 100 shares of Eagle

Company stock for $5,000.

The Big Picture (slide 3 of 4)

• Nine months ago Alice invested $50,000 in a 50% interest in a

patent that Kathy, an unemployed inventor, had obtained for a

special battery she had developed to power ‘‘green’’ cars

manufacturer or supplier

• Alice also purchased a franchise from Orange, Inc., for

$100,000 which she subsequently sells ot Mauve, Inc for

$101,000 nine months later.

• Alice owns a house that she inherited from her grandmother

two years ago.

death was $475,000.

The Big Picture (slide 4 of 4)

• Finally Alice’s new husband sold depreciable

equipment used in his sole proprietorship.

deducted $35,000 of depreciation before selling it

for $60,000

• Now Alice would like to know more about the

gains and losses and the tax liability that she

and her husband can expect from these

transactions

Taxation of Capital Gains and Losses

• Capital gains and losses must be separated

from other types of gains and losses for two

reasons:

rate than ordinary gains

per year

Taxation of Capital Gains and Losses

• Capital gains and losses must be separated

from other types of gains and losses for two

reasons:

rate than ordinary gains

per year

Proper Classification of

Gains and Losses

• Depends on three characteristics:

• Capital asset, §1231 asset, or ordinary asset

• By sale, exchange, casualty, theft, or condemnation

• Short term and long term

Capital Assets

(slide 1 of 5)

• §1221 defines capital assets as everything

except:

sale of inventory or performance of services

business (§1231 assets)

Capital Assets

(slide 2 of 5)

(cont’d):

– Certain copyrights; literary, musical, or artistic

compositions; or letters, memoranda, or similar property

compositions or copyrights in musical works as the disposition of a capital asset

– Certain publications of U.S government

– Supplies of a type regularly used or consumed in the

ordinary course of a business

Capital Assets

(slide 3 of 5)

• Thus, capital assets usually include:

land)

Capital Assets

(slide 4 of 5)

• Dealers in securities

dealers, thus ordinary assets

investment and receive capital gain treatment

• Clear identification must be made on the day of

acquisition

Capital Assets

(slide 5 of 5)

– Taxpayer may receive capital gain treatment on the

subdivision of real estate if the following requirements are

met:

Capital Assets

(slide 5 of 5)

– Taxpayer may receive capital gain treatment on the

subdivision of real estate if the following requirements are

met:

Sale or Exchange

• Recognition of capital gains and losses

generally requires a sale or exchange of assets

• Sale or exchange is not defined in the Code

• There are some exceptions to the sale or

exchange requirement

Sale or Exchange–Worthless Securities and

§ 1244 Stock (slide 1 of 2)

deductible capital loss without being sold or

exchanged

– The Code sets an artificial sale date for the securities on the

last day of the year in which worthlessness occurs

disposition of stock at a loss

– The stock must be that of a small business company

– The ordinary deduction is limited to $50,000 ($100,000 for

Sale or Exchange –Worthless Securities

(slide 2 of 2)

• Worthless securities example:

December 5, 2013

31, 2014

• The result is a long-term capital loss

Sale or Exchange Retirement of Corporate Obligations

• Collection of the redemption value of

corporate obligations (e.g., bonds payable) is

treated as a sale or exchange and may result in

a capital gain or loss

on disposition or retirement

Sale or Exchange–Options

(slide 1 of 2)

to the option is (or would be) a capital asset in the

hands of the grantee

– Sale of an option results in capital gain or loss

– Lapse of an option is considered a sale or exchange

resulting in a capital loss

– Short-term capital gain, if the option was on stocks,

securities, commodities or commodity futures

– Otherwise, ordinary income

Sale or Exchange–Options

(slide 2 of 2)

• Exercise of an option by a grantee

grantor from the sale of the property

status of the property

• Grantee adds the cost of the option to the basis

of the property acquired

The Big Picture - Example 10

Options (slide 1 of 4)

Eagle Company stock for $5,000

– On April 1, 2015, she writes a call option on the stock,

giving the grantee the right to buy the stock for $6,000

during the following six-month period

– Alice (the grantor) receives a call premium of $500 for

writing the call.

The Big Picture - Example 10

Options (slide 2 of 4)

• Return to the facts of The Big Picture on p 8-1

2015, Alice has $1,500 of short-term capital gain

from the sale of the stock

– $6,000 + $500 − $5,000 = $1,500

– $500 option premium + $6,000 purchase price

The Big Picture - Example 10

Options (slide 3 of 4)

• Return to the facts of The Big Picture on p 8-1.

• Assume that Alice decides to sell her stock prior to exercise

for $6,000 and enters into a closing transaction by purchasing

a call on 100 shares of Eagle Company stock for $5,000

premium of $1,000

• She recognizes a $500 short-term capital loss on the closing

transaction.

• On the actual sale of the Eagle stock, Alice has a short-term

capital gain of $1,000

The Big Picture - Example 10

Options (slide 4 of 4)

• Return to the facts of The Big Picture on p 8-1.

the call premium received for writing the option

• This gain is not recognized until the option expires

option

• The nature of the loss will depend upon whether the

option was a capital asset or an ordinary asset.

Sale or Exchange–Patents

• When all substantial rights to a patent are

transferred by a holder to another, the transfer

produces long-term capital gain or loss

usually the creator, or an individual who purchases

the patent from the creator before the patented

invention is reduced to practice

The Big Picture - Example 11

Patents (slide 1 of 2)

• Kathy transfers her rights in the battery patent

to the Green Battery Co.

each battery sold

The Big Picture - Example 11

Patents (slide 2 of 2)

Kathy automatically has a long-term capital gain

– Both her share of the lump-sum payment and the $1 per

battery royalty qualify (less her basis in the patent)

– Kathy also had an automatic long-term capital gain when

she sold 50% of her rights in the patent to Alice

on the transfer to Green Battery will depend on

whether she is a holder (see the discussion below in

Example 12)

The Big Picture - Example 12

Holder Of A Patent (slide 1 of 2)

• Return to the facts of The Big Picture on p 8-1 and continuing

with the facts of Example 11

• Kathy is clearly a holder of the patent

she invented the battery

The Big Picture - Example 12

Holder Of A Patent (slide 2 of 2)

• When Alice purchased a 50% interest in the patent, she

became a holder if the patent had not yet been reduced to

practice

purchase, the patent had not been reduced to practice

• Consequently, Alice is also a holder.

transferred to Green Battery Co.

• Alice’s basis for her share of the patent is $50,000, and her

share of the proceeds is $1 million plus $.50 for each battery

sold

• Thus, Alice has a long-term capital gain even though she has

not held her interest in the patent for more than one year.

Sale or Exchange–Franchises, Trademarks, and

Trade Names (slide 1 of 3)

• The licensing of franchises, trade names,

trademarks, and other intangibles is generally

not considered a sale or exchange of a capital

asset

• Exception: Capital gain (loss) may result if the

transferor does not retain any significant power, right,

or continuing interest

Sale or Exchange–Franchises, Trademarks, and

Trade Names (slide 2 of 3)

• Significant powers, rights, or continuing

interests include:

services

and equipment be purchased from the transferor

Sale or Exchange–Franchises, Trademarks, and

Trade Names (slide 3 of 3)

• Noncontingent payments are ordinary income

to the transferor

amortizes them over 15 years

• Contingent payments are ordinary income for

the franchisor and an ordinary deduction for

the franchisee

Sale or Exchange–Franchises, Trademarks, and

Trade Names (slide 3 of 3)

• Noncontingent payments are ordinary income

to the transferor

amortizes them over 15 years

• Contingent payments are ordinary income for

the franchisor and an ordinary deduction for

the franchisee

The Big Picture - Example 13

Sale of Franchise

purchased from Orange, Inc., nine months ago

– The $101,000 received by Alice is not contingent, and all

significant powers, rights, and continuing interests are

transferred

– The $1,000 gain ($101,000 proceeds − $100,000 adjusted

basis) is a short-term capital gain because Alice has held

the franchise for only nine months.

Sale or Exchange Lease Cancellation Payments

used in lessee’s business and lease has existed for one year or less when canceled)

trade or business and the lease has existed for > a year when it is canceled

– Payments received are ordinary income (rents)

• Holding period starts on the day after the

property is acquired and includes the day of

disposition

The Big Picture - Example 18

Holding Period

• Return to the facts of The Big Picture on p 8-1

• Assume that Alice purchased the AppleCo

stock on January 15, 2014

period is more than one year

2015, the holding period is exactly one year, and

the gain or loss is short term

Holding Period

(slide 2 of 3)

– Holding period of property received includes holding

period of former asset if a capital or §1231 asset

– Former owner’s holding period tacks on to present owner’s

holding period if a nontaxable transaction and basis carries

over

matter how long it is held by the heir

Holding Period

(slide 3 of 3)

– Taxpayer sells borrowed securities and then repays the

lender with substantially identical securities

– Gain or loss is not recognized until the short sale is closed

– Generally, the holding period for a short sale is determined

by how long the property used for repayment is held

stock) is held by the taxpayer, the short-term or long-term character

of the short sale gain or loss may be affected

Tax Treatment of Capital Gains and Losses (slide 1 of 6)

• Noncorporate taxpayers

period

• Short-term capital gains and losses are netted

• Long-term capital gains and losses are netted

• If possible, long-term gains or losses are then netted

with short-term gains or losses

– If the result is a loss:

of $3,000

Tax Treatment of Capital Gains and Losses (slide 2 of 6)

• Noncorporate taxpayers (cont’d)

treatment depends on holding period

• Short-term (assets held 12 months or less)

• Long-term (assets held more than 12 months)

tax rates

Tax Treatment of Capital Gains and Losses (slide 3 of 6)

• Noncorporate taxpayers (cont’d)

more of five alternative tax rates: 0%, 15%, 20%,

25%, and 28%

• The 25% rate applies to unrecaptured §1250 gain and is

related to gain from disposition of §1231 assets

• The 28% rate applies to collectibles

• The 0%/15%/20% rates apply to any remaining net

long-term capital gain

Tax Treatment of Capital Gains and Losses (slide 4 of 6)

Income Layers for Alternative Tax on Capital Gain Computation

Tax Treatment of Capital Gains and Losses (slide 5 of 6)

subject to a 28% alternative tax rate

Tax Treatment of Capital Gains and Losses (slide 6 of 6)

taxable income includes some net long-term capital

gain

– Net capital gain may be made up of various rate layers

rate on that portion of the net capital gain

– The layers are taxed in the following order:

15% portion of the 0%/15%/20% gain, and then the 20% portion of the 0%/15%/20% gain

• This allows the taxpayer to receive the lower of the

regular tax or the alternative tax on each layer of net

Tax Treatment of Capital Gains and Losses (slide 6 of 6)

taxable income includes some net long-term capital

gain

– Net capital gain may be made up of various rate layers

rate on that portion of the net capital gain

– The layers are taxed in the following order:

15% portion of the 0%/15%/20% gain, and then the 20% portion of the 0%/15%/20% gain

Tax Treatment of Capital Gains and Losses - Corporate Taxpayers

• Differences in corporate capital treatment

• Since the max corporate tax rate is 35 %, the alternative

tax is not beneficial

no $3,000 deduction in excess of capital gains)

carried forward 5 years as short-term losses

§1231 Assets

(slide 1 of 4)

• §1231 assets defined

for production of income and held >1 year

crops

§1231 Assets

(slide 1 of 4)

• §1231 assets defined

for production of income and held >1 year

crops

§1231 Assets

(slide 2 of 4)

– Property not held for the long-term holding period

– Nonpersonal use property where casualty losses exceed

casualty gains for the taxable year

– Inventory and property held primarily for sale to customers

– Copyrights, literary, musical, or artistic compositions and

certain U.S government publications

– Accounts receivable and notes receivable arising in the

ordinary course of a trade or business

§1231 Assets

(slide 3 of 4)

• If transactions involving §1231 assets result in:

§1231 Assets

(slide 4 of 4)

• Provides the best of potential results for the

taxpayer

Special Rules For Certain §1231 Assets (slide 1 of 2)

• Casualty gains and losses from §1231 assets

and from long-term nonpersonal use capital

assets are determined and netted together

• If a net loss, items are treated separately

casualty gains are treated as ordinary gains

from AGI subject to the 2% of AGI limitation

• If a net gain, treat as §1231 gain

Special Rules For Certain §1231 Assets (slide 2 of 2)

• The special netting process for casualties & thefts

does not include condemnation gains and losses

– A § 1231 asset disposed of by condemnation receives

§ 1231 treatment

are not subject to the § 1231 rules

– Gains are capital gains

– Losses are nondeductible

General Procedure for

§ 1231 Computation (slide 1 of 3)

– Net all recognized long-term gains & losses from casualties

of § 1231 assets and nonpersonal use capital assets

§ 1231 gains for the taxable year

and gains from further § 1231 computation

– All casualty gains are ordinary income– Section 1231 asset casualty losses are deductible for AGI– Other casualty losses are deductible from AGI

General Procedure for

§ 1231 Computation (slide 2 of 3)

– After adding any net casualty gain from previous step to

the other § 1231 gains and losses, net all § 1231 gains and

losses

nonrecaptured § 1231 losses from the 5 prior tax years

– To the extent of this offset, the net § 1231 gain is classified as

ordinary gain

– Any remaining gain is long-term capital gain

– Section 1231 asset losses are deductible for AGI