CH 13 and 14
selling stocks (FIFO presumption) In the year of purchase, Wade must include in his gross income the $5,000 difference between the cost and the fair market value of the land. The bargain element represents additional compensation to Wade. His basis for the land is $15,000, the land's fair market value.
50 shares $50 = 2,500
Ridge sells an office building and the associated land on October 1, 2020. Under the terms of the sales contract, Ridge is to receive $600,000 in cash. The purchaser is to assume Ridge's mortgage of $300,000 on the property. To assist the purchaser, Ridge agrees to pay $15,000 of the purchaser's closing costs (a "closing cost credit"). The broker's commission on the sale is $45,000. The amount realized by Ridge is calculated as follows:
600k +300k -15k -45k = 840, 000
Sale of a Residence—§ 121 A taxpayer's personal residence is a personal use asset. Therefore, a realized loss from the sale of a personal residence is not recognized.
A realized gain from the sale of a personal residence is recognized. However, taxpayers meeting the § 121 exclusion requirements are allowed to exclude up to $250,000 ($500,000 on certain joint returns) of realized gain on the sale of a principal residence. Any gain in excess of this amount normally qualifies as a long-term capital gain (with preferential tax rates).
Married Couples If a married couple files a joint return, the $250,000 amount is increased to $500,000 if the following requirements are met:
A surviving spouse can use the $500,000 exclusion amount on the sale of a personal residence for the two years following the year of the deceased spouse's death. If the sale occurs in the year of death, however, a joint return must be filed by the surviving spouse.
Aaron has owned and used his house as his principal residence since 2003. On January 31, 2017, Aaron moves to another state. Aaron rents his house to tenants from that date until April 18, 2019, when he sells it.
Aaron is eligible for the § 121 exclusion because he has owned and used the house as his principal residence for at least two of the five years preceding the sale.
Susan owns 100 shares of Sparrow Corporation common stock for which she paid $1,100. She receives a 10% common stock dividend, giving her a new total of 110 shares. Before the stock dividend, Susan's basis was $11 per share ($1,100 ÷ 100 shares).
The basis of each share after the stock dividend is $10 ($1,100 ÷ 110 shares).
Jane purchased a personal residence. The purchase price and the related closing costs were: Purchase price$325,000Recording costs140Title fees and title insurance815Survey costs225Attorney's fees750Appraisal fee250 Other relevant tax information for the house during the time Jane owned it includes: Constructed a swimming pool for medical reasons. The cost was $20,000, of which $5,000 was deducted as a medical expense. Added a solar heating system. The cost was $18,000. Deducted home office expenses of $6,000. Of this amount, $5,200 was for depreciation.
Adjusted Basis = 325k, 140 +815 + 225 +750 +250 + (20k -5k) +18+ - 5.2k = 354, 980
Involuntary Conversions In certain cases, a taxpayer may prefer to recognize gain from an involuntary conversion, a possibility because involuntary conversion treatment generally is an elective provision.
Ahmad has a $40,000 realized gain from the involuntary conversion of an office building. He reinvests the entire proceeds of $450,000 in a new office building. He does not elect to postpone gain under § 1033, however, because a net operating loss carryforward offsets the gain. Because Ahmad did not elect gain postponement, his basis in the replacement property is the property's cost of $450,000 rather than $410,000 ($450,000 reduced by the $40,000 realized gain).
Like-Kind Exchanges Because the like-kind exchange provisions are mandatory rather than elective, in certain instances, it may be preferable to avoid qualifying for § 1031 nonrecognition. For example, immediate recognition of gain (which also will result in a higher basis for the newly acquired asset) may be preferable if the taxpayer has unused capital loss carryovers. If so, the taxpayer can structure the transaction so that at least one of the § 1031 like-kind exchange requirements is not met.
Alicia sells land and a building (used in her business) with an adjusted basis of $300,000 for $400,000. She also acquires a new building and land for $900,000. Alicia has a $125,000 capital loss carryover. If § 1031 applies, the $100,000 realized gain is not recognized and the basis of the new land and building is reduced by $100,000 (from $900,000 to $800,000). Assuming no other capital asset transactions, Alicia can deduct only $3,000 of her capital loss carryover. If § 1031 does not apply, a $100,000 gain is recognized and can be used to offset her $125,000 capital loss carryover. In addition, the basis of the new land and building is $900,000 rather than $800,000 because the entire gain was recognized (allowing for a larger depreciation deduction on the new building).
Carl sells Swan Corporation stock with an adjusted basis of $3,000 for $5,400.
Amount Realized 5,400 - Adjusted Basis (3000) = Realized Gain of 2,400 If Carl had sold the stock for $1,750, he would have had a realized loss of $1,250 ($1,750 − $3,000).
Mandy, who is single, sells her personal residence (adjusted basis of $130,000) for $290,000. She has owned and lived in the residence for three years. Her selling expenses are $18,000. Three weeks prior to the sale, Mandy paid a carpenter and a painter $1,000 to make some repairs and paint two rooms. Her recognized gain is $0.
Amount realized = 290k - 18k = 272,000 -adjusted basis (130k) =realized gain 142k -Section 121 exclusion (142,000) =Recognized gain of $0 Assume the same facts as in the previous example, but the selling price is $490,000. Since the realized gain of $342,000 exceeds the § 121 exclusion amount of $250,000, Mandy's recognized gain is $92,000 ($342,000 − $250,000). amounts realized (490-18k) = 472k -adjusted basis (130k) =realized gain 342k - S 121 exclusion (250k) = recognized gain 92k
Involuntary Conversion Defined
An involuntary conversion results from the destruction (complete or partial), theft, seizure, condemnation, or sale or exchange under threat of condemnation (e.g., a city seizing property under its right of eminent domain) of the taxpayer's property. A voluntary act (e.g., a taxpayer destroying the property by arson) is not an involuntary conversion. Government seizures are unique events, and as a result, a unique set of rules has developed. In general, the government entity must have made a decision to acquire the property for public use and the taxpayer must have reasonable grounds to believe the property will be taken.
Barry owns property on which there is a mortgage of $20,000. He sells the property to Cole for $50,000 cash and Cole's agreement to assume the mortgage.
Barry's amount realized from the sale is $70,000 ($50,000 cash + $20,000 debt relief ).
Lessor Treatment Payments received by a lessor for a lease cancellation are always ordinary income because they are considered to be in lieu of rental payments
Floyd owns an apartment building near a university campus. Hui-Fen is one of the tenants. Hui-Fen is graduating early and offers Floyd $800 to cancel the apartment lease. Floyd accepts the offer. Floyd has ordinary income of $800. Hui-Fen has a nondeductible payment because the apartment was personal use property.
Debra completes a nontaxable exchange of property with an adjusted basis of $10,000 and a fair market value of $12,000 for property with a fair market value of $12,000.
Debra has a realized gain of $2,000 ($12,000 amount realized - $10,000 adjusted basis). Her recognized gain is $0. Her basis in the replacement property is a carryover basis of $10,000. Assume that the replacement property is nondepreciable and that Debra subsequently sells it for $12,000. Her realized and recognized gain will be the $2,000 gain that was postponed (deferred) in the nontaxable transaction. If the replacement property is depreciable, the carryover basis of $10,000 is used in calculating depreciation.
Burt purchased stock in 2018 for $10,000. In 2019, he gave the stock to his son, Cliff, when the fair market value was $7,000. Cliff later sells the stock for $6,000.
Cliff's basis is $7,000 (fair market value is less than donor's adjusted basis of $10,000), and the realized loss from the sale is $1,000 ($6,000 amount realized − $7,000 basis). Assume the same facts as in Example 21, except that Cliff sells the stock for $8,000. Application of the gain basis rule produces a loss of $2,000 ($8,000 − $10,000). Application of the loss basis rule produces a gain of $1,000 ($8,000 − $7,000).
Benjamin sells his former principal residence on August 16, 2020. He had purchased it on April 1, 2012, and lived in it until July 1, 2019, when he converted it to rental property.
Even though the property is rental property on August 16, 2020, rather than Benjamin's principal residence, the sale qualifies for the § 121 exclusion. During the five-year period from August 16, 2015, to August 16, 2020, Benjamin owned and used the property as his principal residence for at least two years.
Qualification for § 121 Exclusion The key requirement for the § 121 exclusion is that the taxpayer must have owned and used the property as a principal residence for at least two years during the five-year window. As taxpayers advance in age, they frequently make decisions related to their personal residence(s). Sell the principal residence and buy a smaller residence or rent a principal residence. Sell vacation homes they own. Sell homes they are holding as rental property. These properties may have experienced substantial appreciation while owned by the taxpayers. Proper planning can make it possible for multiple properties to qualify for the exclusion. Although this strategy may require taxpayers to be flexible about where they live, it can result in substantial tax savings.
Eleanor and David, residents of Virginia, are approaching retirement. They have substantial appreciation on their principal residence in Richmond and on a house they own in Virginia Beach (about two hours away). After retirement, they plan to move to Florida. They have owned and lived in the principal residence for 28 years and have owned the beach house for 9 years. If they sell their principal residence, it qualifies for the § 121 exclusion. At retirement, they could move into their beach house for two years and make it eligible for the exclusion before they relocate to Florida. If the beach house were close enough to things they needed to do in Richmond currently (e.g., work), they could sell the principal residence now and move into the beach house to start the running of the two-year use period. As noted previously, any realized gain on the beach house attributable to depreciation is not eligible for the § 121 exclusion. In addition, a reduction in the § 121 exclusion for prior use as a vacation home is required.
Emily and Fran exchange land, and the exchange qualifies as like kind. Because Emily's land (adjusted basis of $20,000) is worth $24,000 and Fran's land has a fair market value of $19,000, Fran also gives Emily cash of $5,000.
Emily's recognized gain is $4,000, the lesser of the realized gain ($24,000 amount realized − $20,000 adjusted basis) or the fair market value of the boot received ($5,000). Assume the same facts as in the previous example, except that Fran's land is worth $21,000 (not $19,000). Under these circumstances, Fran gives Emily cash of $3,000 to make up the difference. Emily's recognized gain is $3,000, the lesser of the realized gain of $4,000 ($24,000 amount realized − $20,000 adjusted basis) or the fair market value of the boot received of $3,000.
Melissa purchased stock in 2019 for $10,000. In 2020, she gave the stock to her son, Joe, when the fair market value was $15,000.
Joe subsequently sells the property for $18,000. Joe's basis is $10,000, and he has a realized gain of $8,000 ($18,000 − $10,000). If Joe sold the stock for $12,000, he would have a realized gain of $2,000 ($12,000 − $10,000). If Joe sold the stock for $7,000, he would have a realized loss of $3,000 ($7,000 − $10,000).
Retirement of Corporate Obligations A debt obligation (e.g., a bond or note payable) may have a tax basis in excess of or less than its redemption value because it may have been acquired at a premium or discount. Consequently, the collection of the redemption value may result in a loss or gain. Generally, the collection of a debt obligation is treated as a sale or exchange. Therefore, any loss or gain can be a capital loss or capital gain because a sale or exchange has taken place.
Fran acquires $1,000 of Osprey Corporation bonds for $980 in the open market. If the bonds are held to maturity, the $20 difference between Fran's collection of the $1,000 redemption value and her cost of $980 is treated as capital gain.
Sale of a Principal Residence Waiving the Exclusion The § 121 exclusion automatically applies if the taxpayer is eligible (i.e., the taxpayer need not make an election). However, a taxpayer can waive the § 121 exclusion.
George owns two personal residences that satisfy the two-year ownership and use test with respect to the five-year window. The Elm Street residence has appreciated by $25,000, and the Maple Street residence has appreciated by $230,000. He intends to sell both of them and move into a rental property. He sells the Elm Street residence in December 2020 and expects to sell the Maple Street residence early next year. Unless George elects not to apply the § 121 exclusion to the sale of the Elm Street residence, he will exclude the $25,000 realized gain on that residence in 2020. In 2021, however, he recognizes a gain of $230,000 on the sale of the Maple Street residence. If George elects to waive the exclusion on the Elm Street residence sale, he will report a recognized gain of $25,000 on this sale in 2020. But by using the § 121 exclusion in 2021, he will eliminate the recognized gain of $230,000 on the sale of the Maple Street residence.
Juan sells a machine used in his landscaping business to Peter for $20,000 cash plus four acres of property that Peter owns in a nearby town with a fair market value of $36,000.
Juan's amount realized on this sale is $56,000 ($20,000 cash + $36,000 land).
Franchise Payments In most franchise settings, when the transferor retains significant power or rights, both contingent (e.g., based on sales) and noncontingent payments occur. Noncontingent Payments Any noncontingent payments made by the franchisee to the franchisor are ordinary income to the franchisor. The franchisee capitalizes the payments and amortizes them over 15 years. If the franchise is sold, the amortization is subject to recapture under § 1245.
Grey Company signs a 10-year franchise agreement with DOH Donuts. Grey (the franchisee) makes payments of $3,000 per year for the first 8 years of the franchise agreement—a total of $24,000. Grey cannot deduct $3,000 per year as the payments are made. Instead, Grey may amortize the $24,000 total over 15 years. As a result, Grey may deduct $1,600 per year for each of the 15 years of the amortization period. The same result would occur if Grey made a $24,000 lump-sum payment at the beginning of the franchise period. Assuming that DOH Donuts (the franchisor) retains significant powers, rights, or a continuing interest, it will have ordinary income when it receives the payments from Grey.
Antonio purchases Eagle Corporation taxable bonds with a face value of $100,000 for $110,000, thus paying a premium of $10,000. The annual interest rate is 7%, and the bonds mature 10 years from the date of purchase. The annual interest income is $7,000 (7% × $100,000).
If Antonio elects to amortize the bond premium, the $10,000 premium is deducted over the 10-year period. Antonio's basis for the bonds is reduced each year by the amount of the amortization deduction. If the bonds were tax-exempt, amortization of the bond premium and the basis adjustment would be mandatory. However, no deduction would be allowed for the amortization.
Bargain Purchase Wade buys land from his employer for $10,000 on December 30. The fair market value of the land is $15,000.
In the year of purchase, Wade must include in his gross income the $5,000 difference between the cost and the fair market value of the land. The bargain element represents additional compensation to Wade. His basis for the land is $15,000, the land's fair market value.
George, age 58, was entitled to a salary payment of $18,000 and a bonus of $20,000 at the time of his death. In addition, George had been contributing to a traditional IRA for over 20 years. The IRA has a basis of $83,000 (due to some nondeductible contributions over the years) and a current value of $560,000. George's estate collects the salary and bonus payments, and George's wife (his only beneficiary) cashes in the IRA.
Income in Respect of a Descendant IRD The estate has IRD of $38,000 (salary of $18,000 + bonus of $20,000), and George's wife has IRD of $477,000 ($560,000 proceeds − $83,000 basis).
Certain Disallowed Loss Transactions Under several Code provisions, realized losses are disallowed. When a loss is disallowed, there is no carryover of holding period. Losses can be disallowed under § 267 (sale or exchange between related taxpayers) and § 262 (sale or exchange of personal use assets) as well as other Code Sections. Taxpayers who acquire property in a disallowed loss transaction will have a new holding period begin and will have a basis equal to the purchase price.
Janet sells her personal automobile at a loss. She may not deduct the loss because it arises from the sale of personal use property. Janet purchases a replacement automobile for more than the selling price of her former automobile. Janet has a basis equal to the cost of the replacement automobile, and her holding period begins when she acquires the replacement automobile.
Original Issue Discount (§§ 1272-1288) The benefit of the sale or exchange exception that allows a capital gain from the collection of certain obligations is reduced when the obligation has original issue discount. Original issue discount (OID) arises when the issue price of a debt obligation is less than the maturity value of the obligation. OID must generally be amortized over the life of the debt obligation using the effective interest method. The OID amortization increases the basis of the bond. Most new publicly traded bond issues do not carry OID because the stated interest rate is set to make the market price on issue the same as the bond's face amount. In addition, even if the issue price is less than the face amount, the difference is not considered to be OID if the difference is less than one-fourth of 1 percent of the redemption price at maturity multiplied by the number of years to maturity. In the case where OID does exist, it may or may not have to be amortized, depending upon the date the obligation was issued. When OID is amortized, the amount of gain upon collection, sale, or exchange of the obligation is correspondingly reduced. The obligations covered by the OID amortization rules and the method of amortization are presented in §§ 1272-1275. Similar rules for other obligations can be found in §§ 1276-1288.
Jerry purchases $10,000 of newly issued White Corporation bonds for $6,000. The bonds have OID of $4,000. Jerry must amortize the discount over the life of the bonds. The OID amortization increases his interest income. (The bonds were selling at a discount because the market rate of interest was greater than the bonds' stated interest rate.) After Jerry has amortized $1,800 of OID, he sells the bonds for $8,000. Jerry has a capital gain of $200 [$8,000 − ($6,000 cost + $1,800 OID amortization)]. The OID amortization rules prevent him from converting ordinary interest income into capital gain. Without the OID amortization, Jerry would have capital gain of $2,000 ($8,000 − $6,000 cost).
Harry purchases a building and land for $800,000. Because of the depressed nature of the industry in which the seller was operating, Harry was able to negotiate a favorable purchase price. Appraisals of the individual assets indicate that the fair market value of the building is $600,000, and that of the land is $400,000.
Land = 40% * 800k Building 60% * 800k Similar to armchair problem
Direct Conversion If the conversion is directly into replacement property rather than into money, nonrecognition of realized gain is mandatory. In this case, the basis of the replacement property is the same as the adjusted basis of the converted property. Direct conversion is rare in practice and usually involves condemnations.
Lupe's property, with an adjusted basis of $20,000, is condemned by the state. Lupe receives property with a fair market value of $50,000 as compensation for the property taken. Because the nonrecognition of realized gain is mandatory for direct conversions, Lupe's realized gain of $30,000 is not recognized and the basis of the replacement property is $20,000 (adjusted basis of the condemned property).
Lease Cancellation Payments The tax treatment of payments received for canceling a lease depends on whether the recipient is the lessor or the lessee and whether the lease is a capital asset. Lessee Treatment Lease cancellation payments received by a lessee are treated as an exchange. The treatment of these payments depends on the underlying use of the property and how long the lease has existed. If the property was used personally (e.g., an apartment used as a residence), the payment results in a capital gain (and long term if the lease existed for more than one year). If the property was used for business and the lease existed for one year or less, the payment results in ordinary income. If the property was used for business and the lease existed for more than one year, the payment results in a § 1231 gain.
Mark owns an apartment building that he is going to convert into an office building. Vicki is one of the apartment tenants and receives $1,000 from Mark to cancel the lease. Vicki has a capital gain of $1,000 (which is long term or short term depending upon how long she has held the lease). Mark has an ordinary deduction of $1,000.
Requirements for Exclusion Treatment To qualify for exclusion treatment, at the date of the sale, the residence must have been owned and used by the taxpayer as the principal residence for at least two years during the five-year period ending on the date of the sale of a taxpayer's principal residence.
Melissa sells her principal residence on September 18, 2020. She had purchased it on July 5, 2018, and lived in it since then. The sale of Melissa's residence qualifies for the § 121 exclusion.
Tom and Eileen Atwood bought their home in 2011 for $525,000 and have used it as their principal residence since that time. In July 2020, they sell their home for $670,000
The Atwoods have a realized gain of $145,000 on the sale ($670,000 − $525,000), and the entire gain is excluded as a result of § 121. What if the Atwoods sold their home for $500,000? In this case, since their home is a personal use asset, they would have a $25,000 realized loss that would not be recognized.
Principal Residence Whether property is the taxpayer's principal residence "depends upon all of the facts and circumstances in each case." According to the Regulations, the most important factor is where the taxpayer spends most of his or her time. A residence does not have to be a house. For example, a houseboat, a house trailer, or a motor home can qualify. The principal residence includes the land on which a home sits (so any gain on the land also qualifies for exclusion). An adjacent lot can qualify if it is regularly used by the owner as part of the residential property.
Mitch graduates from college and moves to Boston, where he is employed. He decides to rent an apartment in Boston because of its proximity to his office. He purchases a beach condo in the Cape Cod area that he occupies most weekends. Mitch does not intend to live at the beach condo except on weekends. The apartment in Boston is his principal residence.
In a nontaxable exchange, realized gains or losses are not recognized. Instead, the recognition of gain or loss is postponed (deferred) until the property received in the nontaxable exchange is subsequently sold in a taxable transaction. This "deferral" is accomplished by assigning a carryover basis to the replacement property.
Nontaxable Exchanges
Selection of Property to Pass at Death A taxpayer generally should distribute appreciated property via his or her will. Doing so enables both the decedent and the heir to avoid income tax on the unrealized gain because the recipient takes the fair market value as his or her basis. A taxpayer generally should not distribute property that, if sold, would produce a realized loss via his or her will because the decedent does not receive an income tax deduction for the unrealized loss. In addition, the heir will receive no benefit from this unrealized loss upon the subsequent sale of the property.
On the date of her death in 2020, Marta owned land held for investment purposes. The land had a basis of $130,000 and a fair market value of $100,000. If Marta had sold the property before her death, the recognized loss would have been $30,000. If instead, Roger inherits the property and later sells it for $90,000, the recognized loss is $10,000 (the decline in value since Marta's death). In addition, regardless of the period of time Roger holds the property, the holding period is long term.
Property must be held more than one year to qualify for long-term capital gain or loss treatment. Property held for one year or less results in short-term capital gain or loss. To compute the holding period, start counting on the day after the property was acquired and include the day of disposition.
Return to the facts of The Big Picture. Assume that Maurice purchased the Purple stock on January 15, 2020. If he sells it on January 16, 2021, Maurice's holding period is more than one year, and therefore, long term. If, instead, Maurice sells the stock on January 15, 2021, the holding period is exactly one year and the gain or loss is short term. Leo purchases a capital asset on February 29, 2021. If Leo sells the asset on February 28, 2022, the holding period is one year and Leo will have a short-term capital gain or loss. If Leo sells the asset on March 1, 2022, the holding period is more than one year and he will have a long-term capital gain or loss.
Options Frequently, a potential buyer of property wants some time to make the purchase decision, but wants to control the sale and/or the sale price in the meantime. Options are used to achieve these objectives. The potential purchaser (grantee) pays the property owner (grantor) for an option on the property. The grantee then becomes the option holder. The option, which usually sets a price at which the grantee can buy the property, expires after a specified period of time. Exercise of Options by Grantee If the option is exercised, the amount paid for the option is added to the optioned property's selling price. This increases the gain (or reduces the loss) to the grantor resulting from the sale of the property. The grantor's gain or loss is capital or ordinary depending on the tax status of the property. The grantee adds the cost of the option to the basis of the property purchased. Sale of an Option A grantee may sell or exchange the option rather than exercise it or let it expire. Generally, the grantee's sale or exchange of the option results in capital gain or loss if the option property is (or would be) a capital asset to the grantee.
Rosa wants to buy some vacant land for investment purposes. However, she cannot afford the full purchase price at the present time. Instead, Rosa (grantee) pays the landowner (grantor) $3,000 to obtain an option to buy the land for $100,000 anytime in the next two years. The option is a capital asset for Rosa because if she actually purchased the land, the land would be a capital asset. Three months after purchasing the option, Rosa sells it for $7,000. She has a $4,000 ($7,000 − $3,000) short-term capital gain on this sale because she held the option for one year or less.
Ownership and use tests
Sarah purchased a home in San Diego in May 2005 and lived in it until she took a new job in Los Angeles on January 1, 2016. From January 2016 until she sold the house on July 31, 2020, she only used the home occasionally since she lived in an apartment near her job in downtown Los Angeles. Because the house was sold on July 31, 2020, the five-year window runs from August 1, 2015, to the date of sale. In determining whether the § 121 exclusion is available, Sarah meets the ownership test because she owned the house for two of the five years prior to its sale. However, she fails the use test. During the five-year window, she used the house as her principal residence for only five months (from August 1, 2015, to December 31, 2015). ------------------ Charles lives in a townhouse that he rents from 2013 through January 17, 2017. On January 18, 2017, he purchases the townhouse. On February 1, 2018, due to a decline in health, Charles moves into his daughter's home. On May 25, 2020, while still living in his daughter's home, Charles sells his townhouse. The § 121 exclusion applies because Charles owned the townhouse for at least two years out of the five years preceding the sale (from January 19, 2017, until May 25, 2020) and he used the townhouse as his principal residence for at least two years during the five-year period preceding the sale [from May 25, 2015 (the beginning of the five-year window) until February 1, 2018].
Inherited Property The holding period for inherited property is treated as long term no matter how long the property is actually held by the heir. The holding period of the decedent or the decedent's estate is not relevant for the heir's holding period.
Shonda inherits Blue Company stock from her father, who died in 2020. She receives the stock on April 1, 2020, and sells it on November 1, 2020. Even though Shonda did not hold the stock more than one year, she receives long-term capital gain or loss treatment on the sale.
Contingent Payments Any contingent franchise payments are ordinary income for the franchisor and an ordinary deduction for the franchisee. Contingent payments must meet the following requirements: The payments are made at least annually throughout the term of the transfer agreement. The payments are substantially equal in amount or are payable under a fixed formula.
TAK, a spicy chicken franchisor, transfers an eight-year franchise to Phyllis. TAK retains a significant power, right, or continuing interest. Phyllis, the franchisee, agrees to pay TAK 15% of sales. This contingent payment is ordinary income to TAK and a business deduction for Phyllis as the payments are made.
Diane's personal residence has an adjusted basis of $175,000 and a fair market value of $160,000. Diane converts the personal residence to rental property. Her basis for loss is $160,000 (lower of $175,000 adjusted basis and fair market value of $160,000).
The $15,000 decline in value is a personal loss and can never be recognized for tax purposes. Diane's basis for gain is $175,000.
Jaime exchanges a building (used in his business) with an adjusted basis of $430,000 and a fair market value of $438,000 for land with a fair market value of $438,000.
The exchange qualifies as like kind (an exchange of business real property for investment real property) and the $8,000 realized gain is deferred. The basis of the land is $430,000 (land's fair market value of $438,000 − $8,000 postponed gain on the building). If the land later is sold for its fair market value of $438,000, the $8,000 postponed gain is recognized.
Megan's warehouse is destroyed by fire on December 16, 2019. The adjusted basis is $325,000. Megan receives $400,000 from the insurance company on February 2, 2020. She is a calendar year and cash method taxpayer.
The latest date for replacement is December 31, 2022 (the end of the taxable year in which realized gain occurred plus two years). The critical date is not the date the involuntary conversion occurred, but rather the date of gain realization.
Disallowed Losses Taxpayers should avoid transactions that activate the related-party loss disallowance rules. Even with the ability of the related-party buyer to offset his or her realized gain by the related-party seller's disallowed loss, several inequities exist. First, any tax benefit associated with the disallowed loss is shifted to the related-party buyer (the related-party seller receives no tax benefit). Second, the tax benefit of this offset is delayed until the related-party buyer sells the property. Third, if the property does not appreciate during the time period the related-party buyer holds it, part or all of the disallowed loss is permanently lost. Fourth, the right of offset is available only to the original transferee (the related-party buyer). As a result, the disallowed loss is eliminated permanently if the original transferee transfers the property by gift or inheritance.
Tim sells property with an adjusted basis of $35,000 to Wes, his brother, for $25,000, the fair market value of the property. The $10,000 realized loss to Tim is disallowed by § 267. If Wes subsequently sells the property to an unrelated party for $37,000, he has a recognized gain of $2,000 (realized gain of $12,000 reduced by disallowed loss of $10,000). Therefore, from the perspective of the family unit, the original $10,000 realized loss ultimately is recognized. However, if Wes sells the property for $29,000, he has a recognized gain of $0 (realized gain of $4,000 reduced by disallowed loss of $4,000 necessary to offset the realized gain). From the perspective of the family unit, $6,000 of the realized loss of $10,000 is permanently lost ($10,000 realized loss − $4,000 offset permitted).
Statutory Expansions In several instances, Congress has clarified its general definition of what is not a capital asset. Dealers in Securities As a general rule, securities (stocks, bonds, and other financial instruments) held by a dealer are considered to be inventory and are, therefore, not subject to capital gain or loss treatment. A dealer in securities is a merchant (e.g., a brokerage firm) that regularly engages in the purchase and resale of securities to customers. The dealer must identify any securities being held for investment. Generally, if a dealer clearly identifies certain securities as held for investment purposes by the close of business on the acquisition date, gain from the securities' sale will be capital gain. However, the gain will not be capital gain if the dealer ceases to hold the securities for investment prior to the sale. Losses are capital losses if at any time the securities have been clearly identified by the dealer as held for investment.
Tracy is a securities dealer. She purchases 100 shares of Swan stock. If Tracy takes no further action, the stock is inventory and an ordinary asset. If she designates in her records that the stock is held for investment, the stock is a capital asset. Tracy must designate the investment purpose by the close of business on the acquisition date. If Tracy maintains her investment purpose and later sells the stock, the gain or loss is capital gain or loss. If Tracy redesignates the stock as held for resale (inventory) and then sells it, any gain is ordinary, but any loss is capital loss.
Involuntary Conversions—§ 1033 In most cases, taxpayers sell property (or exchange it) when they need to do so. There are times, however, when the taxpayer involuntarily (i.e., outside the taxpayer's control) disposes of property.
When this happens, the taxpayer usually receives some sort of compensation (e.g., insurance proceeds or a condemnation award). Section 1033 provides that a taxpayer who experiences an involuntary conversion of property may postpone recognition of gain realized from the conversion. As a result, this provision provides relief to a taxpayer who has experienced an involuntary conversion and does not have the wherewithal to pay the tax on any gain realized as a result of the conversion.
Property that is not like-kind, including cash, is referred to as boot. Although the term boot does not appear in the Code, tax practitioners commonly use it rather than saying "property that is not like-kind property."
boot
Gifts When a gift occurs, if the donor's basis carries over to the recipient, the donor's holding period is tacked on to the recipient's holding period. This will occur when the property's fair market value at the date of the gift is greater than the donor's adjusted basis. Transactions of this nature are discussed in Chapter 13.
carryover basis Kareem acquires 100 shares of Robin Corporation stock for $1,000 on December 31, 2016. He transfers the shares by gift to Megan on December 31, 2019, when the stock is worth $2,000. Kareem's basis of $1,000 becomes the basis for determining gain or loss on a subsequent sale by Megan. Megan's holding period begins with the date the stock was acquired by Kareem. Assume the same facts as in Example 25, except that the fair market value of the shares is only $800 on the date of the gift. The holding period begins on the date of the gift if Megan sells the stock for a loss. The value of the shares on the date of the gift is used in determining her basis for loss. If she sells the shares for $500 on April 1, 2020, Megan has a $300 recognized capital loss and the holding period is from December 31, 2019, to April 1, 2020 (as a result, the loss is short term).
How would your answer to Example 8 change if the basis of the truck was $6,000, its fair market value was $9,000, and Marvin received a $9,000 insurance settlement?
casualty gain = 3k Adjusted basis = 6K + 3k - 9K = $0
An insured truck that Marvin used in his trade or business is destroyed in an accident. At the time of the accident, the adjusted basis of the truck was $8,000, and its fair market value was $6,500. Marvin receives insurance proceeds of $6,500.
casualty loss = 1,500 Adjusted basis = 8k - 6.5k - 1.5k = $0
Jason operates a charter fishing business in Panama City, Florida, taking customers out in the Gulf of Mexico on daylong fishing trips. Unfortunately, his boat was completely destroyed when Hurricane Michael hit the Florida coast. His boat had a basis of $78,000 ($120,000 cost − $42,000 of accumulated depreciation). Fortunately, Jason had marine insurance (which included a replacement cost rider). He filed an insurance claim shortly after his boat was destroyed and received $175,000 in insurance proceeds three weeks later.
realized gain = 175k - 78k = 97k assume that Jason buys a new boat for $180,000. He uses the entire insurance settlement as part of the purchase. In this case, Jason's $97,000 realized gain is deferred, and the basis of his new boat must reflect that deferral. As a result, his new boat's basis is $83,000 ($180,000 cost − $97,000 deferred gain). assume that Jason had only partial coverage on his boat and his insurance settlement is only $50,000. In this case, Jason has a loss of $28,000, computed as follows:
The receipt of boot will trigger recognition of gain if there is realized gain. The amount of the recognized gain is the lesser of the boot received or the realized gain (realized gain serves as the ceiling on recognition).
receipt of boot
Amortization of bond discountIncrease14Amortization is mandatory for certain taxable bonds and elective for tax-exempt bonds.Amortization of bond premiumDecrease13Amortization is mandatory for tax-exempt bonds and elective for taxable bonds.Amortization of covenant not to competeDecrease8Covenant must be for a definite and limited time period. The amortization period is a statutory period of 15 years.Amortization of intangiblesDecrease8Intangibles are amortized over a 15-year period.Assessment for local benefitsIncrease10To the extent not deductible as taxes (e.g., assessment for streets and sidewalks that increase the value of the property versus one for maintenance or repair or for meeting interest charges).Bad debtsDecrease7Only the specific charge-off method is permitted.Capital additionsIncrease13Certain items, at the taxpayer's election, can be capitalized or deducted (e.g., selected medical expenses).CasualtyDecrease7For a casualty loss, the amount of the adjustment is the sum of the deductible loss and the insurance proceeds received. For a casualty gain, the amount of the adjustment is the insurance proceeds received reduced by the recognized gain.CondemnationDecrease13Same as for Casualty.Cost recoveryDecrease8§ 168 is applicable to tangible assets placed in service after 1980 whose useful life is expressed in terms of years; includes additional first-year (bonus) depreciation.DepletionDecrease8Use the greater of cost or percentage depletion. Percentage depletion can still be deducted when the basis is zero.DepreciationDecrease8§ 167 is applicable to tangible assets placed in service before 1981 and to tangible assets not depreciated in terms of years.EasementDecrease13If the taxpayer does not retain any use of the land, all of the basis is allocable to the easement transaction. However, if only part of the land is affected by the easement, only part of the basis is allocable to the easement transaction.Expensing under § 179Decrease8Occurs only if the taxpayer elects § 179 treatment.Improvements by lessee to lessor's propertyIncrease1Adjustment occurs only if the lessor is required to include the fair market value of the improvements in gross income under § 109.Imputed interestDecrease16Amount deducted is not part of the cost of the asset.Medical capital expenditure permitted as a medical expenseDecrease10Adjustment is the amount of the deduction (the effect on basis is to increase it by the amount of the capital expenditure net of the deduction).Real estate taxes: apportionment between the buyer and sellerIncrease or decrease10To the extent the buyer pays the seller's pro rata share, the buyer's basis is increased. To the extent the seller pays the buyer's pro rata share, the buyer's basis is decreased.Rebate from manufacturerDecrease5Because the rebate is treated as an adjustment to the purchase price, it is not included in the buyer's gross income.Stock dividendDecrease13Adjustment occurs only if the stock dividend is nontaxable. Although the basis per share decreases, the total stock basis does not change.Stock rightsDecrease13Adjustment to stock basis occurs only for nontaxable stock rights and only if the fair market value of the rights is at least 15% of the fair market value of the stock or, if less than 15%, the taxpayer elects to allocate the basis between the stock and the rights.TheftDecrease7Same as for Casualty.
summary of basis adjustment
13-5c Replacement Property In general, the taxpayer must acquire replacement property within a two-year period after the close of the taxable year in which gain is realized. Typically, gain is realized when insurance proceeds or damages are received.
taxpayer use test functional use test special rule for condemnations
