CH 14: Property Transactions: Capital Gains and Losses, 1231, and Recapture Provisions

Corporations selling depreciable real estate may have ordinary income in addition to that required by § 1250.49 Under this provision, corporations selling depreciable real property are required to recapture as ordinary income the smaller of two amounts:

(1) 20 percent of the recognized gain or (2) 20 percent of the depreciation taken.

All taxpayers net their capital gains and losses. Short-term gains and losses (if any) are netted against one another, and long-term gains and losses (if any) are netted against one another. The results will be net short-term gain or loss and net long-term gain or loss. If these two net positions are of opposite sign (one is a gain and one is a loss), they are netted against each other. Six possibilities exist for the result after all possible netting has been completed.

1.A net long-term capital gain (NLTCG). 2.A net short-term capital gain (NSTCG). 3.Both NLTCG and NSTCG. 4.A net long-term capital loss (NLTCL). 5.A net short-term capital loss (NSTCL). 6.Both NLTCL and NSTCL.

Property Dividends

A corporation generally recognizes gain if it distributes appreciated property as a dividend. Recapture under §§ 1245 and 1250 applies to the extent of the lower of the recapture potential or the excess of the property's fair market value over the adjusted basis.

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.5 Therefore, any loss or gain can be a capital loss or capital gain because a sale or exchange has taken place.

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.

Nonbusiness Bad Debts

A loan not made in the ordinary course of business is classified as a nonbusiness receivable. In the year the receivable becomes completely worthless, it is a nonbusiness bad debt, and the bad debt is treated as a short-term capital loss. Even if the receivable was outstanding for more than one year, the loss is still a short-term capital loss.

Section 1237 does not apply to losses.

A loss from the sale of subdivided real property is an ordinary loss unless the property qualifies as a capital asset under § 1221.

Franchises, Trademarks, and Trade Names (§ 1253)

A mode of operation, a widely recognized brand name (trade name), and a widely known business symbol (trademark) are all valuable assets. These assets may be licensed (commonly known as franchising) by their owner for use by other businesses. Many fast-food restaurants (such as McDonald's and Taco Bell) are franchises. The franchisee usually pays the owner (franchisor) an initial fee plus a contingent fee. The contingent fee is often based upon the franchisee's sales volume.

Inventions and Processes

A patent, invention, model, or design (whether or not patented) and a secret formula or process are excluded from being a capital asset. These are ordinary assets. The assets may be held either by the taxpayer who created the property or by a taxpayer who received the asset from the taxpayer who created the property. As a result, gains or losses from the sale or exchange of these assets do not receive capital gain treatment. In limited circumstances, patents (even though they are not capital assets) may be treated as capital assets.

Sale or exchange

A requirement for the recognition of capital gain or loss. Generally, the seller of property must receive money or relief from debt to have sold the property. An exchange involves the transfer of property for other property. Thus, collection of a debt is neither a sale nor an exchange. The term sale or exchange is not defined by the Code.

Short sale

A sale that occurs when a taxpayer sells borrowed property (usually stock) and repays the lender with substantially identical property either held on the date of the short sale or purchased after the sale. No gain or loss is recognized until the short sale is closed, and such gain or loss is generally short term. § 1233.

Use of Capital Loss Carryovers

A short-term capital loss carryover to the current year retains its character as short term and is combined with the short-term items of the current year. A net long-term capital loss carries over as a long-term capital loss and is combined with the current-year long-term items. The long-term loss carryover is first offset with 28% gain of the current year, then 25% gain, and then 0%/15%/20% gain until it is absorbed.

Collectibles

A special type of capital asset, the gain from which is taxed at a maximum rate of 28 percent if the holding period is more than one year. Examples include art, rugs, antiques, gems, metals, stamps, some coins and bullion, and alcoholic beverages held for investment.

Example 54:

Alice purchased a $100,000 business machine and deducted $70,000 depreciation before selling it for $80,000. If it were not for § 1245, the $50,000 gain would be § 1231 gain ($80,000 amount realized − $30,000 adjusted basis). Section 1245 prevents this potentially favorable result by treating as ordinary income (not as § 1231 gain) any gain to the extent of depreciation taken. In this example, the entire $50,000 gain would be ordinary income. If Alice had sold the machine for $120,000, she would have a gain of $90,000 ($120,000 amount realized − $30,000 adjusted basis). The § 1245 gain would be $70,000 (equal to the depreciation taken), and the § 1231 gain would be $20,000 (equal to the excess of the sales price over the original cost).

To receive favorable capital gain treatment, all substantial rights to the patent must be transferred. The sale of a partial interest qualifies if the sale places no restrictions on the use of the patent by the purchaser.

All substantial rights have not been transferred when the transfer is limited geographically within the issuing country or when the transfer is for a period less than the remaining life of the patent. All the facts and circumstances of the transaction, not just the language of the transfer document, are examined when making this determination.

Maximizing Benefits: Ordinary losses generally are preferable to capital losses because of the limitations imposed on the deductibility of net capital losses and the requirement that capital losses be used to offset capital gains. The taxpayer may be able to convert what would otherwise have been capital loss to ordinary loss. For example, business (but not nonbusiness) bad debts, losses from the sale or exchange of small business investment company stock, and losses from the sale or exchange of small business corporation stock all result in ordinary losses.

Although capital losses can be carried over indefinitely, indefinite becomes definite when a taxpayer dies. Any loss carryovers not used by the taxpayer are permanently lost. That is, no tax benefit can be derived from the carryovers subsequent to death.55 Therefore, the potential benefit of carrying over capital losses diminishes when dealing with older taxpayers. It is usually beneficial to spread gains over more than one taxable year. In some cases, this can be accomplished through the installment sales method of accounting.

Timing of § 1231 Gain

Although § 1245 recaptures much of the gain from the disposition of business property, sometimes § 1231 gain is still substantial. For instance, land held as a business asset will generate either § 1231 gain or § 1231 loss. If the taxpayer already has a capital loss fo the year, the sale of land at a gain should be postponed so that the net § 1231 gain is not netted against the capital loss. The capital loss deduction will therefore be maximized for the current tax year, and the capital loss carryforward (if any) may be offset against the gain when the land is sold. If the taxpayer already has a § 1231 loss, § 1231 gains might be postponed to maximize the ordinary loss deduction this year. However, the carryforward of unrecaptured § 1231 losses will make the § 1231 gain next year an ordinary gain.

Franchise

An agreement that gives the transferee the right to distribute, sell, or provide goods, services, or facilities within a specified area. The cost of obtaining a franchise may be amortized over a statutory period of 15 years. In general, the franchisor's gain on the sale of franchise rights is an ordinary gain because the franchisor retains a significant power, right, or continuing interest in the subject of the franchise. §§ 197 and 1253.

Patent

An intangible asset that may be amortized over a statutory 15-year period as a § 197 intangible. The sale of a patent usually results in favorable long-term capital gain treatment. §§ 197 and 1235.

Alternative tax

An option that is allowed in computing the tax on net capital gain. For noncorporate taxpayers, the rate is usually 15 percent (but is 25 percent for unrecaptured § 1250 gain and 28 percent for collectibles). However, the alternative tax rate is 0 percent (rather than 15 percent) for lower-income taxpayers (e.g., taxable income of $80,000 or less for married persons filing jointly). Certain high-income taxpayers (e.g., taxable income of more than $496,600 for married persons filing jointly) have an alternative tax rate of 20 percent. § 1(h).

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.

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.

Unrecaptured § 1250 Gain (Real Estate 25% Gain)

Any unrecaptured § 1250 gain is subject to a 25 percent tax rate. This gain, which relates to the sale of depreciable real estate, is used in the alternative tax computation for net capital gain discussed earlier in this chapter. Unrecaptured § 1250 gain (25% gain) is some or all of the § 1231 gain that is treated as long-term capital gain. The maximum amount of this 25% gain is the depreciation taken on real property sold at a recognized gain. That maximum amount is computed in one or more of the following ways: •The recognized gain from disposition is more than the depreciation taken. The 25% gain is equal to the depreciation taken. Refer to Example 59. The depreciation taken was $20,909, but the recognized gain was $170,909. Consequently, some of the recognized gain is potential 25% § 1231 gain. •The recognized gain from disposition is less than or equal to the depreciation taken. In this case, the 25% gain is all of the recognized gain. Refer to Example 59, but assume that the building sales price is $285,000. The recognized gain is $5,909 ($285,000 − $279,091), all of this gain is a § 1231 gain, and it is entirely a 25% § 1231 gain. •There is § 1245 depreciation recapture because the property is nonresidential real estate acquired in 1981-1986 on which accelerated depreciation was taken. No 25% § 1231 gain will be left because § 1245 will recapture all of the depreciation or the recognized gain, whichever is less. Refer to Example 58. Depreciation of $100,000 was taken, but all of it was recaptured as ordinary income by § 1245. Thus, there is no remaining potential 25% § 1231 gain. The entire $20,000 § 1231 gain in Example 58 is potential 0%/15%/20% gain. •Section 1231 loss from disposition of other § 1231 assets held long term reduces the gain from real estate. •Section 1231 lookback losses convert some or all of the potential 25% § 1231 gain to ordinary income.

The basis of the shares in the deemed transfer of shares is used to compute the gain or loss on the short sale.

As Examples 32 and 33 illustrate, when shares are actually transferred to the broker to close the short sale, there may be a gain or loss because the shares transferred will have a basis equal to the short sale date price and the value at the actual short sale closing date may be different from the short sale date price.

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.

The rules regarding § 1231 treatment do not apply to all business property. Section 1231 has specific holding period requirements and, in general, requires that the property must be either depreciable property or real estate used in business.

As a result, neither inventory nor receivables are § 1231 assets. Nor is § 1231 necessarily limited to business property. Transactions involving certain capital assets may fall into the § 1231 category.

Section 1231 requires netting of § 1231 gains and losses . If the result is a gain, it may be treated as a long-term capital gain. The net gain is added to the "real" long-term capital gains (if any) and netted with capital losses (if any).

As a result, the net § 1231 gain may eventually be eligible for beneficial capital gain treatment or help avoid the deduction limitations that apply to a net capital loss. If the § 1231 gain and loss netting results in a loss, it is an ordinary loss. Finally, § 1231 assets are treated the same as capital assets for purposes of the appreciated property charitable contribution provisions.

Example 33:

Assume the same facts as in Example 32, except that Rita did not own any Owl Corporation stock on the short sale date and acquired the 200 shares of Owl Corporation stock for $1,000 on December 12, 2020 (after the November 11, 2020 short sale date). The deemed closing of the short sale is December 12, 2020, because Rita held substantially identical shares at the end of 2020 and did not close the short sale before January 31, 2021. Her 2020 short sale gain is a short-term gain of $300 ($1,300 short sale price − $1,000 basis), and she still has a short-term capital loss of $700 on February 10, 2021.

Example 31:

Assume the same facts as in the previous example, except that Donald closes the short sale on January 28, 2021, by repaying the borrowed stock with five shares purchased on January 27, 2021, for $200. Because Donald's substantially identical property (purchased on January 4, 2020) was short-term property at the April 14, 2020 short sale date, his $50 capital loss ($200 cost of stock purchased on January 27, 2021, and a short sale selling price of $150) is short term.

Timing of Recapture

Because recapture is usually not triggered until the property is sold or disposed of, it may be possible to plan for recapture in low tax bracket or loss years. If a taxpayer has net operating loss (NOL) carryovers, the recognition of ordinary income from recapture may be advisable to absorb the loss carryovers.

To the seller, a covenant produces ordinary income. So, the seller would prefer that the residual portion of the selling price be allocated to goodwill—a capital asset. If the buyer does not need the legal protection provided by a covenant, the buyer is neutral regarding whether the residual amount is allocated to a covenant or to goodwill.

Because the seller would receive a tax advantage from labeling the residual amount as goodwill, the buyer should factor this into the negotiation of the purchase price.

Capital asset

Broadly speaking, all assets are capital except those specifically excluded from that definition by the Code. Major categories of noncapital assets include property held for resale in the normal course of business (inventory), trade accounts and notes receivable, and depreciable property and real estate used in a trade or business (§ 1231 assets). § 1221.

Planning for Capital Asset Status

Capital asset status often is a question of objective evidence. Property that is not a capital asset to one person may qualify as a capital asset to another person. With proper tax planning, even a dealer may obtain long-term capital gain treatment on the sale of property normally held for resale.

Definition of Collectibles

Capital assets that are collectibles, even though they are held long term, are not eligible for the 0%/15%/20% alternative tax rate. Instead, a 28 percent alternative tax rate applies. For capital gain or loss purposes, collectibles include:24 •Any work of art. •Any rug or antique. •Any metal or gem. •Any stamp. •Any alcoholic beverage. •Most coins. •Any historical objects (documents, clothes, etc.).

As a result, a § 1231 asset disposed of by casualty may or may not get § 1231 treatment, depending on whether the netting process results in a gain or a loss. Also, a non-personal use capital asset disposed of by casualty may get § 1231 treatment or ordinary treatment, but will not get capital gain or loss treatment.

Casualties, thefts, and condemnations are involuntary conversions. Involuntary conversion gains may be deferred if conversion proceeds are reinvested; involuntary conversion losses are recognized currently (refer to Chapter 13) regardless of whether the conversion proceeds are reinvested. Thus, the special netting process discussed previously for casualties and thefts would not include gains that are not currently recognizable because the insurance proceeds are reinvested.

Accounts and Notes Receivable

Collection of an accrual basis account or note receivable does not result in a gain or loss because the amount collected equals the receivable's basis. If sold, an ordinary gain or loss is generated if the receivable is sold for more or less than its basis (the receivable is an ordinary asset). If the receivable is partially or wholly worthless, the creditor has a "bad debt," which may result in an ordinary deduction. Collection of a cash basis account or note receivable does not result in a gain or loss because the amount collected is ordinary income. In addition, a cash basis receivable has a zero basis since no revenue is recorded until the receivable is collected. If sold, an ordinary gain is generated (the receivable is an ordinary asset). There is no bad debt deduction for cash basis receivables because they have no basis.

Final Results of the Capital Gain and Loss Netting Process and How They are Taxed: Result: Each net long-term capital gain component of taxable income is taxed at the lower of the regular tax on that component or the alternative tax.

Comments: The alternative tax on net long-term capital gain can never increase the tax on taxable income, but it can reduce the tax on taxable income.

Final Results of the Capital Gain and Loss Netting Process and How They are Taxed: Result: The net long-term capital gain is the last portion of taxable income.

Comments: The components are taxed in the following order: 25%, 28%, 0%, 15%, 20%. They are taxed after the non-long-term capital gain portion of taxable income has been taxed. The 0%/15%/20% component may include qualified dividend income.

Concept Summary 14.4: Income Layers for Alternative Tax on Capital Gain Computation

Compute tax on: Other taxable income (including net short-term capital gain) using the regular tax rates. Compute tax on: Each of the layers below using the lower of the alternative tax rate or the regular tax rate for that layer (or portion of a layer) of taxable income. +25% long-term capital gain (unrecaptured § 1250 gain) portion of taxable income. +28% long-term capital gain. +0% long-term capital gain [portion of 0%/15%/20% gain and/or qualified dividend income (QDI) that is taxed at 0%; available only if other taxable income plus 25% and 28% capital gain layers do not put the taxpayer above specified thresholds in the 12% regular tax bracket*; 0% rate is no longer available once income, including the portion of the gain and/or QDI taxed at 0%, puts the taxpayer above these thresholds]. +15% long-term capital gain (portion of 0%/15%/20% gain and/or QDI that is taxed at 15%; available only if other taxable income plus the 25%, 28%, and 0% layers put the taxpayer above the 12% regular tax bracket and only until other taxable income plus the 25%, 28%, 0%, and 15% layers put the taxpayer at or below specified thresholds in the 35% regular tax rate bracket)**. +20% long-term capital gain (portion of 0%/15%/20% gain and/or QDI that is taxed at 20%; available when other taxable income plus the 25%, 28%, 0%, and 15% layers put the taxpayer above the specified thresholds in the 35% regular tax rate bracket). =Alternative tax on taxable income * See Exhibit 14.1 for the taxable income ranges where the 0%/15%/20% rates apply. In 2020, the last $250 (married filing jointly and surviving spouse), $125 (single), $100 (heads of household), and $125 (married filing separately) of the 12% bracket is subject to the 15% alternative tax rate. As the normal tax rate of 12% is less than the alternative tax rate of 15%, any 0%/15%/20% gain or QDI in these ranges will be taxed at 12%. ** See Exhibit 14.1 for the taxable income amounts where the 20% rate begins to apply.

The crux of capital asset determination hinges on whether the asset is held for personal use (capital asset), investment (capital asset), or business (ordinary asset). How a taxpayer uses the property typically answers this question.

David buys an expensive painting. •If David purchased the painting for personal use (as a decoration in his home) and it is not of investment quality, it is a capital asset. However, any loss on its sale is not usable, whereas gain from its sale is taxable. Investment quality generally means that the painting is expected to appreciate in value. •If the painting is used to decorate David's business office and is of investment quality, the painting is not depreciable and, therefore, is a capital asset. •If David's business is buying and selling paintings, the painting is inventory and, therefore, an ordinary asset. •If the painting is not of investment quality and the business did not purchase it for investment, the painting is an ordinary asset and it is depreciable even though it serves a decorative purpose in David's office. If David depreciates the painting, that is evidence that the painting is held for use in his business (and not being held for investment or as inventory). As a result, it is not a capital asset.

Section 1231 property

Depreciable assets and real estate used in trade or business and held for the required long-term holding period. § 1231(b).

Business Fixed Assets

Depreciable personal property and real estate (both depreciable and nondepreciable) used by a business are not capital assets. Although business fixed assets are not capital assets, a long-term capital gain can sometimes result from their sale. The potential capital gain treatment for business fixed assets under § 1231 is also discussed later in this chapter.

Qualified dividend income (QDI)

Distributions made by domestic (and certain non-U.S.) corporations to noncorporate shareholders that are subject to tax at the same rates as those applicable to net long-term capital gains (i.e., 0 percent, 15 percent, or 20 percent). The 20 percent rate applies to certain high-income taxpayers. The dividend must be paid out of earnings and profits, and the shareholders must meet certain holding period requirements as to the stock. §§ 1(h)(1) and (11).

Concept Summary 14.1: Options: Consequences to the Grantor and Grantee

Event: Option is Granted/Grantor: Receives value and has a contract obligation (a liability)./ Grantee: Pays value and has a contract right (an asset). Event: Option is Exercised./Grantor: Amount received for option increases proceeds from sale of the option property./Grantee: Amount paid for option becomes part of the basis of the option property purchased. Event: Option is Sold or Exchanged by Grantee./Grantor: Result depends upon whether option later expires or is exercised (see above)./Grantee: Could have gain or loss (capital gain or loss if option property would have been a capital asset for the grantee). Event: Option expires./Grantor: Has a short-term capital gain if the option property is stocks, securities, commodities, or commodity futures. Otherwise, gain is ordinary income./Grantee: Has a loss (capital loss if option property would have been a capital asset for the grantee).

The tax law requires capital gains and capital losses to be separated from other types of gains and losses. There are two reasons for this treatment.

First, long-term capital gains may be taxed at a lower rate than ordinary gains. Second, a net capital loss is subject to deduction limitations. For noncorporate taxpayers, a net capital loss is only deductible up to $3,000 per year. Any excess loss over the annual limit carries over and may be deductible in a future tax year.

Copyrights and Creative Works

Generally, the person whose efforts led to the copyright or creative work has an ordinary asset, not a capital asset. Creative works include the works of authors, composers, and artists. Also, the person for whom a letter, a memorandum, or another similar property was created has an ordinary asset. Finally, a person receiving a copyright, a creative work, a letter, a memorandum, or similar property by gift from the creator or the person for whom the work was created has an ordinary asset. A taxpayer may elect to treat the sale or exchange of a musical composition or a copyright of a musical work as the disposition of a capital asset.

When a business is being sold, one of the major decisions usually concerns whether a portion of the sales price is for goodwill. For the seller, goodwill generally represents the disposition of a capital asset. Goodwill has no basis and represents a residual portion of the selling price that cannot be allocated reasonably to the known assets. As a result, the amount of goodwill represents capital gain.

From a legal perspective, the buyer may prefer that the residual portion of the purchase price be allocated to a covenant not to compete (a promise that the seller will not compete against the buyer by conducting a business similar to the one the buyer has purchased). Both purchased goodwill and a covenant not to compete are § 197 intangibles. As a result, both must be capitalized and can be amortized over a 15-year statutory period.

Unrecaptured § 1250 gain

Gain from the sale of depreciable real estate held more than one year. The gain is equal to or less than the depreciation taken on such property and is reduced by § 1245 and § 1250 gain.

Recognition of capital gain or loss usually requires a sale or exchange of a capital asset. The Code uses the term sale or exchange , but does not define it.

Generally, a property sale involves the receipt of money by the seller and/or the assumption by the purchaser of the seller's liabilities. An exchange involves the transfer of property for other property. So an involuntary conversion (casualty, theft, or condemnation) is not a sale or exchange.

CONSIDERATIONS COMMON TO §§ 1245 AND 1250

Gifts Depreciation recapture potential carries over to the donee. Death Although not a very attractive tax planning approach, death eliminates all recapture potential.41 Any depreciation recapture potential is eliminated when property passes from a decedent to an estate or heir. Charitable Transfers If depreciable property is contributed to a charity, the contribution deduction (normally fair market value) must be reduced by any ordinary gain that would have resulted had the property been sold (e.g., from depreciation recapture). Certain Nontaxable Transactions In certain transactions, the transferor's adjusted basis of property carries over to the transferee.43 If this is the case, any depreciation recapture potential also carries over to the transferee.44 Included in this category are the following transfers of property: •Nontaxable incorporations under § 351 (see Chapter 18). •Certain subsidiary liquidations under § 332 (see Chapter 20). •Nontaxable contributions to a partnership under § 721 (see Chapter 21). •Nontaxable reorganizations (see Chapter 20). Gain may be recognized in these transactions if boot is received. If gain is recognized, it is treated as ordinary income to the extent of the recapture potential or recognized gain, whichever is lower. Like-Kind Exchanges (§ 1031) and Involuntary Conversions (§ 1033) Realized gain is recognized to the extent of boot received in a like-kind exchange. Realized gain also will be recognized to the extent the proceeds from an involuntary conversion are not reinvested in similar property. Any recognized gain is subject to recapture as ordinary income under §§ 1245 and 1250. However, since only real property can be the subject of a like-kind exchange, § 1245 recapture is not likely because it generally only applies to tangible personal property. Section 1250 recapture is also not likely because it infrequently applies to dispositions of real property. On the other hand, unrecaptured § 1250 gain (25% gain) is likely to be present if depreciable real property was the subject of the exchange. The remaining recapture potential, if any, carries over to the property received in the exchange. Realized losses are not recognized in like-kind exchanges, but are recognized in involuntary conversions.

Example 41: Alternative Tax on Net Capital Gain: In Example 40, Joan had $118,000 taxable income. Now assume that Joan's $10,000 net capital gain is made up of $7,000 25% gain and $3,000 0%/15%/20% gain. In addition, she has $2,000 of QDI. Examination of the 2020 tax rates reveals that $106,000 ($118,000 − $12,000) of other taxable income for a single individual puts Joan at a marginal tax rate of 24%. Consequently, she uses the alternative tax on the $7,000 gain, the $3,000 gain, and the $2,000 QDI.

Her alternative tax liability for 2020 is $21,950: $19,520(tax on $106,000 of other taxable income) +1,680($7,000 × 0.24; 24% rate on 25% gain) +450($3,000 × 0.15; 15% rate on 0%/15%/20% gain) +300($2,000 × 0.15; 15% rate on QDI) =$21,950Alternative tax liability Since her marginal tax rate is still 24% after taxing the $106,000 other taxable income, she uses the 24% regular tax rate rather than the 25% alternative tax rate on the $7,000 25% gain. As the combination of the $106,000 other taxable income and her $7,000 25% gain puts her above the 12% regular tax bracket, none of the $3,000 0%/15%/20% gain or $2,000 QDI is taxed at 0%. Her regular tax liability on $118,000 is $22,400. As a result, Joan saves $450 ($22,400 − $21,950) by using the alternative tax calculation. Because Joan's taxable income is $441,450 or less, none of her 0%/15%/20% gain or QDI is taxed at the 20% alternative tax rate.

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.

Failure to Exercise Options

If an option holder (grantee) fails to exercise the option, the lapse of the option is considered a sale or exchange on the option expiration date. As a result, the loss is a capital loss if the property subject to the option is (or would be) a capital asset in the hands of the grantee. The grantor of an option on stocks, securities, commodities, or commodity futures receives short-term capital gain treatment upon the expiration of the option. Options on property other than stocks, securities, commodities, or commodity futures (for instance, vacant land) result in ordinary income to the grantor when the option expires.

Effect of Capital Asset Status in Transactions Other Than Sales: The nature of an asset (capital or ordinary) is important in determining the tax consequences that result when a sale or exchange occurs. It may, however, be just as significant in circumstances other than a taxable sale or exchange. When a capital asset is disposed of, the result is not always a capital gain or loss. Rather, in general, the disposition must be a sale or exchange. Collection of a debt instrument having a basis less than the face value results in a capital gain if the debt instrument is a capital asset. The collection is a sale or exchange. Sale of the debt shortly before the due date for collection will produce a capital gain.

If selling the debt in such circumstances could produce a capital gain but collecting could not, the consistency of what constitutes a capital gain or loss would be undermined. Another illustration of the sale or exchange principle involves a donation of certain appreciated property to a qualified charity. Recall that in certain circumstances, the measure of the charitable contribution is fair market value when the property, if sold, would have yielded a long-term capital gain.

A net capital loss is deductible for AGI, but limited to no more than $3,000 per tax year.27 So although a net capital gain receives favorable tax treatment, there is unfavorable treatment for capital losses due to the $3,000 annual limitation.

If the NCL includes both long- and short-term capital loss, the short-term capital loss is counted first toward the $3,000 annual limitation.

Section 1231 gains and losses

If the combined gains and losses from the taxable dispositions of § 1231 assets plus the net gain from business involuntary conversions (of both § 1231 assets and long-term capital assets) is a gain, the gains and losses are treated as long-term capital gains and losses. In arriving at § 1231 gains, however, the depreciation recapture provisions (e.g., § 1245) are applied first to produce ordinary income. If the net result of the combination is a loss, the gains and losses from § 1231 assets are treated as ordinary gains and losses. § 1231(a).

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.

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.

Transfer of a patent is treated as the sale or exchange of a long-term capital asset when all substantial rights to the patent are transferred by a holder.8 The transferor/holder may receive payment in virtually any form, including contingent payments based on the transferee/purchaser's productivity, use, or disposition of the patent.

If the transfer meets these requirements, any gain or loss is automatically a long-term capital gain or loss. Whether the asset was a capital asset for the transferor, whether a sale or exchange occurred, and how long the transferor held the patent are not relevant.

If the result of step 5 is only a short-term capital gain, the taxpayer is not eligible for a reduced tax rate. If the result of step 5 is a loss, the taxpayer may be eligible for a capital loss deduction (discussed later in this chapter).

If there was no offsetting in step 5 because the short-term and step 4 results were both gains or if the result of the offsetting is a long-term gain, a net capital gain exists and the taxpayer may be eligible for a reduced tax rate. The net capital gain may consist of 28% gain, 25% gain, and/or 0%/15%/20% gain.

Section 1250 Recapture Situations

In addition to residential real estate acquired before 1987 and nonresidential real estate acquired before 1981, accelerated depreciation may be taken on other types of real property. The § 1250 recapture rules apply to the following property for which accelerated depreciation was used: •Real property used predominantly outside the United States. •Certain government-financed or low-income housing

The alternative tax applies only if taxable income includes some long-term capital gain (there is net capital gain) and/or qualified dividend income (QDI). Taxable income includes all of the net capital gain and/or QDI unless taxable income is less than the net capital gain and/or QDI.

In addition, the net capital gain and/ or QDI is taxed last, after other taxable income (including any short-term capital gain). The 0%/15%/20% rates are applied to any net capital gain and qualified dividend income based on the taxpayer's filing status and taxable income.

Capital assets are not directly defined in the Code. Instead, § 1221(a) defines what is not a capital asset.

In general, a capital asset is property other than inventory, accounts and notes receivable, supplies, and most fixed assets of a business.

If the disposition of depreciable property and real property used in business results in a net loss, § 1231 treats the loss as an ordinary loss rather than as a capital loss. Ordinary losses are fully deductible for adjusted gross income (AGI). Capital losses offset capital gains, and if any loss remains, the loss is deductible to the extent of $3,000 per year for individuals and currently is not deductible at all by regular corporations.

In general, § 1231 provides the best of both potential results: net gain may be treated as long-term capital gain, and net loss is treated as ordinary loss.

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.

Significant Power, Right, or Continuing Interest

In most franchising operations, the transferor retains some powers or rights. As a result, the transaction is not a capital asset transfer. Significant powers, rights, or continuing interests include control over franchise assignment, quality of products and services, sale or advertising of products or services, the requirement that substantially all supplies and equipment be purchased from the transferor, and the right to terminate the franchise. In the unusual case where the transferor does not retain any significant power, right, or continuing interest, a capital gain or loss may occur. For capital gain or loss treatment to be available, the asset transferred must qualify as a capital asset.

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.

After the net capital gain or loss has been determined, the QDI is added to the net long-term capital gain portion of the net capital gain and is taxed as 0%/15%/20% gain. If there is a net capital loss, the net capital loss is still deductible for AGI up to $3,000 per year with the remainder of the loss (if any) carrying forward.

In this case, the QDI is still eligible to be treated as 0%/15%/20% gain in the alternative tax calculation (it is not offset by the net capital loss).

Long-term nonpersonal use capital assets

Includes investment property with a long-term holding period. Such property disposed of by casualty or theft may receive § 1231 treatment.

Personal use assets and investment assets are the most common capital assets owned by individual taxpayers. Personal use assets usually include things like a residence, furniture, clothing, recreational equipment, and automobiles.

Investment assets usually include stocks, bonds, and mutual funds. Remember, however, that losses from the sale or exchange of personal use assets are not recognized.

Final Results of the Capital Gain and Loss Netting Process and How They are Taxed: Result: Net short-term capital loss and net long-term capital loss:

Max Tax Rate: N/A Comments: Eligible for capital loss deduction ($3,000 maximum per year). Short-term capital losses are counted first toward the deduction.

An asset's holding period is based on calendar months and fractions of calendar months (not the number of days).

It does not matter that different months have different numbers of days.

Postponing and Shifting Recapture

It is also possible to postpone recapture or to shift the burden of recapture to others. For example, recapture is postponed and shifted on the exchange of a § 1231 asset if the taxpayer exchanges the property for stock in a § 351 nontaxable incorporation. In this instance, the recapture potential is shifted to the corporation. Recapture can be shifted to others through the gratuitous transfer of § 1245 or § 1250 property to family members. A subsequent sale of such property by the donee will trigger recapture to the donee rather than the donor (refer to Example 61). This procedure would be advisable only if the donee was in a lower income tax bracket compared with the donor.

Final Results of the Capital Gain and Loss Netting Process and How They are Taxed: Result: Net short-term capital gain and net long-term capital gain

M10%-37% on net short-term capital gain; 0%-28% on net long-term capital gain Comments: The net short-term capital gain is taxed as ordinary income; the net long-term capital gain is taxed as discussed above for just net long-term capital gain.

Final Results of the Capital Gain and Loss Netting Process and How They are Taxed: Result: Net long-term capital gain

Max Tax Rate: 0% - 28% Comments: The net long-term capital gain may have as many as five tax rate components: 25%, 28%, and 0%/15%/20%.

Final Results of the Capital Gain and Loss Netting Process and How They are Taxed: Result: Net short-term capital gain

Max Tax Rate: 10% - 37% Comments: Taxed as ordinary income.

Final Results of the Capital Gain and Loss Netting Process and How They are Taxed: Result: Net long-term capital loss:

Max Tax Rate: N/A Comments: Eligible for capital loss deduction ($3,000 maximum per year).

Final Results of the Capital Gain and Loss Netting Process and How They are Taxed: Result: Net short-term capital loss:

Max Tax Rate: N/A Comments: Eligible for capital loss deduction ($3,000 maximum per year).

Net short-term capital gain is not eligible for any special tax rate. It is taxed at the same rate as the taxpayer's other taxable income.

Net long-term capital gain is eligible for one or more of five alternative tax rates: 0 percent, 15 percent, 20 percent, 25 percent, and 28 percent. The 25 percent and 28 percent rates are used only in unique circumstances. The net long-term capital gain components are referred to as the 0%/15%/20% gain, the 25% gain, and the 28% gain.

When § 1231 assets are disposed of by casualty or theft, a special netting rule is applied. For simplicity, the term casualty is used to mean both casualty and theft dispositions. First, the casualty gains and losses from § 1231 assets and the casualty gains and losses from long-term nonpersonal use capital assets are determined.33 A nonpersonal use capital asset might be art held as an investment or a baseball card collection held by a nondealer.

Next, the § 1231 asset casualty gains and losses and the nonpersonal use capital asset casualty gains and losses are netted together (see Concept Summary 14.6). •If the result is a net loss, the § 1231 casualty gains and the nonpersonal use capital asset casualty gains are treated as ordinary gains, the § 1231 casualty losses are deductible for AGI, and the nonpersonal use capital asset casualty losses are deductible from AGI as miscellaneous itemized deductions (which are not deductible from 2018 through 2025). •If the result of the netting is a net gain, the net gain is treated as a § 1231 gain.

Concept Summary 14.2: Franchises: Consequences to the Franchisor and Franchisee: Event: Franchisor Retains Significant Powers and Rights

Noncontingent Payment: Effect on Franchisor = Ordinary Income. Effect on Franchisee = Capitalized and amortized over 15 years as an ordinary deduction; if franchise is sold, amortization is subject to recapture under § 1245. Contingent Payment: Effect on Franchisor = Ordinary Income. Effect on Franchisee = Ordinary Deduction.

Concept Summary 14.2: Franchises: Consequences to the Franchisor and Franchisee: Event: Franchisor Does Not Retain Significant Powers and Rights

Noncontingent Payment: Effect on Franchisor = Ordinary income if franchise rights are an ordinary asset; capital gain if franchise rights are a capital asset (unlikely). Effect on Franchisee = Capitalized and amortized over 15 years as an ordinary deduction; if the franchise is sold, amortization is subject to recapture under § 1245. Contingent Payment: Effect on Franchisor = Ordinary Income. Effect on Franchisee = Ordinary Deduction.

Worthless Securities and § 1244 Stock

Occasionally securities such as stock and, especially, bonds may become worthless due to the insolvency of their issuer. If such a security is a capital asset, the loss is deemed to have occurred as the result of a sale or exchange on the last day of the tax year.4 This last-day rule may have the effect of converting what otherwise would have been a short-term capital loss into a long-term capital loss.

Example 32: Short Sales and Short Sales against the Box

On January 18, 2018, Rita purchases 200 shares of Owl Corporation stock for $1,000. On Novem ber 11, 2019, she sells short, for $1,300, 200 shares of Owl Corporation stock that she borrows from her broker. On February 10, 2020, Rita closes the short sale by delivering the 200 shares of Owl Corporation stock that she had acquired in 2018. On that date, Owl Corporation stock had a market price of $3 per share. Because Rita owned substantially identical stock on the date of the short sale and did not close the short sale before January 31, 2020, she is deemed to have closed the short sale on November 11, 2019 (the date of the short sale). On her 2019 tax return, she reports a $300 long-term capital gain ($1,300 short sale price − $1,000 basis). On February 10, 2020, Rita has a $700 short-term capital loss [$600 short sale closing date price (200 shares × $3 per share) − $1,300 basis] because the holding period of the shares used to close the short sale commences with the date of the short sale.

Example 30: Short Sales and Short Sales against the Box 1

On January 4, 2020, Donald purchases five shares of Osprey Corporation common stock for $100. On April 14, 2020, he engages in a short sale of five shares of the same stock for $150. On August 15, Donald closes the short sale by repaying the borrowed stock with the five shares purchased on January 4. Because his substantially identical shares were held short term as of the short sale date, Donald's $50 capital gain is short term.

Original Issue Discount (§§ 1272-1288)

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.

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.

Sports Franchises

Professional sports franchises (e.g., the Detroit Tigers) are subject to § 1253. Player contracts are usually one of the major assets acquired with a sports franchise. These contracts last only for the time stated in the contract. By being classified as § 197 intangibles, the player contracts and other intangible assets acquired in the purchase of the sports franchise are amortized over a statutory 15-year period.

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.

Section 1245 property

Property that is subject to the recapture of depreciation under § 1245. For a definition of § 1245 property, see § 1245(a)(3).

Section 1250 property

Real estate that is subject to the recapture of depreciation under § 1250. For a definition of § 1250 property, see § 1250(c).

Installment Sales

Recapture gain is recognized in the year of the sale regardless of whether gain is otherwise recognized under the installment method.47 All gain is ordinary income until the recapture potential is fully absorbed. Nonrecapture (§ 1231) gain is recognized under the installment method as cash is received. Gain is also recognized on installment sales in the year of the sale in an amount equal to the § 179 (immediate expensing) deduction taken with respect to the property sold, because § 179 immediate expensing is depreciation subject to recapture.

tion 1250 Property for Purposes of the Unrecaptured § 1250 Gain

Section 1250 property includes any real property (other than § 1245 property) that is or has been depreciable. Land is not § 1250 property because it is not depreciable.

Generally § 1250 property is depreciable real property (principally buildings and their structural components) that is not subject to § 1245.38 Intangible real property, such as leaseholds of § 1250 property, is also included.

Section 1250 recapture rarely applies because only the amount of additional depreciation (depreciation in excess of straight-line depreciation) is subject to recapture. Straight-line depreciation is not recaptured (except for property held one year or less). Because the straight-line depreciation method is required for depreciable real property placed in service after 1986, there will usually be no § 1250 depreciation recapture on such property. Finally, § 1250 does not apply if the real property is sold at a loss.

For Federal income tax purposes, a franchise is an agreement that gives the franchisee the right to distribute, sell, or provide goods, services, or facilities within a specified area.10 A franchise transfer includes the grant of a franchise, a transfer by one franchisee to another person, or the renewal of a franchise.

Section 1253 provides that a transfer of a franchise, trademark, or trade name is not a transfer of a capital asset when the transferor retains any significant power, right, or continuing interest in the property transferred.

The holder of a patent must be an individual. Usually, this is the invention's creator or an individual who purchases the patent rights from the creator before the patented invention is put into production ("reduced to practice").

So if the creator's employer has all rights to an employee's inventions, the employer is not eligible for long-term capital gain treatment. The employer normally will have an ordinary asset because the patent was developed as part of its business.

The §§ 1245 and 1250 recapture rules override all other Code Sections.

Special applications include installment sales and property dividends.

The ordering procedure, which ensures that any long-term capital gain is taxed at the lowest preferential rate possible, includes the following steps:

Step 1. Group all gains and losses into four groups: short term, and 28%, 25%, and 0%/15%/20% long term. Step 2. Net the gains and losses within each group. Step 3. Offset the net 28% and net 25% amounts, if they are of opposite sign. Step 4. Offset the results after step 3 against the 0%/15%/20% amount, if they are of opposite sign. If the 0%/15%/20% amount is a loss, offset it against the highest-taxed gain first. After this step, there is a net long-term capital gain or loss. If there is a net long-term capital gain, it may consist of only 28% gain, only 25% gain, only 0%/15%/20% gain, or some combination of all of these gains. If there is a net long-term capital loss, it is simply a net long-term capital loss. Step 5. Offset the net short-term amount against the long-term results of step 4, if they are of opposite sign. The netting rules offset net short-term capital loss against the highest-taxed gain first. So a net short-term capital loss first offsets any 28% gain, then any 25% gain, and finally any 0%/15%/20% gain.

Consequently, the tax treatment of § 1231 gains and losses depends on the results of a complex netting procedure. When there are no casualties and/or thefts (the usual case), step 1 below can be skipped and the procedure is much simpler. Here are the steps that need to be followed:

Step 1: Casualty Netting Net all recognized long-term gains and losses from casualties of § 1231 assets and non-personal use capital assets. Casualty gains result when insurance proceeds exceed the adjusted basis of the property. These are gains remaining after any depreciation recapture (discussed later in text Sections 14-9 and 14-10). This casualty netting is beneficial because if there is a net gain, the gain may receive long-term capital gain treatment. If there is a net loss, it receives ordinary loss treatment. a.If the casualty gains exceed the casualty losses, add the excess to the other § 1231 gains for the taxable year. b.If the casualty losses exceed the casualty gains, exclude all casualty losses and gains from further § 1231 computation. If this is the case, all casualty gains are ordinary income. Section 1231 asset casualty losses are deductible for AGI. Other casualty losses may be deductible from AGI. Step 2: § 1231 Netting After adding any net casualty gain from step 1a to the other § 1231 gains and losses (including recognized § 1231 asset condemnation gains and losses), net all § 1231 gains [gains remaining after any depreciation recapture (discussed later in text Sections 14-9 and 14-10)] and losses. a.If the gains exceed the losses, the net gain is offset by the "lookback" nonrecaptured § 1231 losses (see step 3). b.If the losses exceed the gains, all gains are ordinary income. Section 1231 asset losses are deductible for AGI. Other casualty losses may be deductible from AGI. Step 3: § 1231 Lookback Provision The net § 1231 gain from step 2a is offset by the nonrecaptured net § 1231 losses for the five preceding taxable years (the § 1231 lookback provision). For transactions in 2020, the lookback years are 2015, 2016, 2017, 2018, and 2019. a.To the extent of the nonrecaptured net § 1231 loss, the current-year net § 1231 gain is ordinary income. The nonrecaptured net § 1231 losses are those that have not already been used to offset net § 1231 gains. b.Only the net § 1231 gain exceeding this net § 1231 loss carryforward is given long-term capital gain treatment.

Real Property Subdivided for Sale (§ 1237)

Substantial real property development activities may result in the owner being considered a dealer for tax purposes. If so, ordinary income will result from any lots sold. However, § 1237 allows real estate investors capital gain treatment if they engage only in limited development activities.

Carryovers

Taxpayers are allowed to carry over unused capital losses indefinitely The short-term capital loss (STCL) retains its character as STCL.Likewise, the long-term capital loss retains its character as LTCL.

Intangible drilling and development costs (IDCs)

Taxpayers may elect to expense or capitalize (subject to amortization) intangible drilling and development costs. However, ordinary income recapture provisions apply to oil and gas properties on a sale or other disposition if the expense method is elected. §§ 263(c) and 1254(a).

If these requirements are met, all gain is capital gain until the tax year in which the sixth lot is sold. Sales of contiguous lots to a single buyer in the same transaction count as the sale of one lot. Beginning with the tax year the sixth lot is sold, 5 percent of the revenue from lot sales is potential ordinary income.

That potential ordinary income is offset by any selling expenses from the lot sales. As sales commissions often are at least 5 percent of the sales price, typically none of the gain is treated as ordinary income.

The 25% gain is called the unrecaptured § 1250 gain and is related to gain from disposition of § 1231 assets.

The 28% gain relates to collectibles and qualified small business stock.

Special Rules for Short Sales

The Code provides special holding period rules for short sales.19 A short sale occurs when a taxpayer sells borrowed property and repays the lender with substantially identical property either held on the date of the sale or purchased after the sale (even though they are not capital assets). Short sales usually involve corporate stock. The seller's objective is to make a profit in anticipation of a decline in the stock's price. If the price declines, the seller in a short sale recognizes a profit equal to the difference between the sales price of the borrowed stock and the price paid for the replacement stock.

Intent also matters. What happens when a taxpayer who does not normally acquire stock for resale to customers acquires stock but intends to resell it?

The Supreme Court decided that because the stock was not acquired primarily for sale to customers (the taxpayer did not sell the stock to its regular customers), the stock was a capital asset.

Net § 1231 Gain Limitation

The amount of unrecaptured § 1250 gain may not exceed the net § 1231 gain that is eligible to be treated as long-term capital gain. The unrecaptured § 1250 gain is the lesser of the unrecaptured § 1250 gain or the net § 1231 gain that is treated as capital gain. Thus, if there is a net § 1231 gain but it is all converted to ordinary income by the five-year § 1231 lookback loss provision, there is no surviving § 1231 gain or unrecaptured § 1250 gain. Refer to Example 52. There was $200 of § 1231 gain from the building fire that would also be potential 25% gain if at least $200 of depreciation was taken. The net § 1231 gain was $1,100 including the $200 building gain. (The $500 loss from Asset C would offset the potential 0%/15%/20% § 1231 gain and not the potential 25% gain, so all of the potential 25% gain of $200 is in the $1,100 net § 1231 gain.) However, the $700 of § 1231 lookback losses would first absorb the $200 building gain, so the $400 of § 1231 gain that is treated as long-term capital gain includes no 25% gain.

The Supreme Court follows a literal interpretation of the categories. For instance, because corporate stock is not mentioned in § 1221, it is usually a capital asset. However, what if corporate stock is purchased for resale to customers?

Then it is inventory (and not a capital asset) because inventory is one of the categories in § 1221.

Original issue discount (OID)

The difference between the issue price of a debt obligation (e.g., a corporate bond) and the maturity value of the obligation when the issue price is less than the maturity value. OID represents interest and must be amortized over the life of the debt obligation using the effective interest method. The difference is not considered to be original issue discount for tax purposes when it is less than one-fourth of 1 percent of the redemption price at maturity multiplied by the number of years to maturity. §§ 1272 and 1273(a)(3).

Net capital loss (NCL)

The excess of the losses from sales or exchanges of capital assets over the gains from sales or exchanges of such assets. Up to $3,000 per year of the net capital loss may be deductible by noncorporate taxpayers against ordinary income. The excess net capital loss carries over to future tax years. For corporate taxpayers, the net capital loss cannot be offset against ordinary income, but it can be carried back three years and forward five years to offset net capital gains. §§ 1211, 1212, and 1221(10).

Net capital gain (NCG)

The excess of the net long-term capital gain for the tax year over the net short-term capital loss. The net capital gain of an individual taxpayer is eligible for the alternative tax. § 1222(11).

Section 1245 requires taxpayers to treat all gain as ordinary gain unless the property is disposed of for more than its original cost. This result is accomplished by requiring that all gain be treated as ordinary gain to the extent of the depreciation taken on the property disposed of.

The excess of the sales price over the original cost is § 1231 gain. Section 1245 applies primarily to non-real-estate property like machinery, trucks, and office furniture. Section 1245 does not apply if property is disposed of at a loss. Generally, the loss will be a § 1231 loss unless the form of the disposition is a casualty.

Stock Sales

The following rules apply in determining the date of a stock sale: •The date the sale is executed is the date of the sale. The execution date is the date the broker completes the transaction on the stock exchange. •The settlement date is the date the cash or other property is paid to the seller of the stock. This date is not relevant in determining the date of sale.

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.

Nontaxable Exchanges

The holding period of property received in a like-kind exchange includes the holding period of the former asset if the property that has been exchanged is a capital asset or a § 1231 asset. In these settings, the holding period of the former property is tacked on to the holding period of the newly acquired property.

Avoiding Recapture

The immediate expensing election (§ 179) and additional first-year (bonus) depreciation [§ 168(k)] are subject to § 1245 recapture. If the elections are not made, the § 1245 recapture potential will accumulate more slowly (refer to Chapter 8). Because using the immediate expense election and/or additional first-year depreciation deduction complicates depreciation and book accounting for the affected asset(s), not taking these deductions may make sense even though the time value of money might indicate that they should be taken.

Section 1245 recapture provides, in general, that the portion of recognized gain from the sale or other disposition of § 1245 property that represents depreciation is recaptured as ordinary income.37 As a result, in Example 54, $50,000 of the $70,000 depreciation taken is recaptured as ordinary income when the business equipment is sold for $80,000. Only $50,000 is recaptured rather than $70,000 because Alice is only required to recognize § 1245 recapture ordinary gain equal to the lower of the depreciation taken or the gain recognized.

The method of depreciation (e.g., accelerated or straight-line) does not matter. All depreciation taken is potentially subject to recapture. For this reason, § 1245 recapture is often referred to as full recapture. Any remaining gain after subtracting the amount recaptured as ordinary income will usually be § 1231 gain.

Holding period

The period of time during which property has been held for income tax purposes. The holding period is significant in determining whether gain or loss from the sale or exchange of a capital asset is long or short term. § 1223.

Options

The sale or exchange of an option to buy or sell property results in capital gain or loss if the property is a capital asset. Generally, the closing of an option transaction results in short-term capital gain or loss to the writer of the call and the purchaser of the call option. § 1234.

Section 1244 allows an ordinary deduction on disposition of stock at a loss.

The stock must be that of a small business corporation, and the ordinary deduction is limited to $50,000 ($100,000 for married taxpayers filing jointly) per year.

If the property is disposed of in a casualty event, however, the remaining gain will be casualty gain. If the business machine in Example 54 had been disposed of by casualty and the $80,000 received had been an insurance recovery, Alice would still have a gain of $50,000, and the gain would still be recaptured by § 1245 as ordinary gain.

The § 1245 recapture rules apply before there is any casualty gain. Because all the $50,000 gain is recaptured, no casualty gain arises from the casualty.

Special Holding Period Rules

There are several special holding period rules.18 The application of these rules depends upon the type of asset and how it was acquired.

Taxpayers may elect to either expense or capitalize intangible drilling and development costs for oil, gas, or geothermal properties.51 Intangible drilling and development costs (IDCs) include operator (one who holds a working or operating interest in any tract or parcel of land) expenditures for wages, fuel, repairs, hauling, and supplies.

These expenditures must be incident to and necessary for the drilling of wells and preparation of wells for production. In most instances, taxpayers elect to expense IDCs to maximize tax deductions during drilling. Intangible drilling and development costs are subject to § 1254 recapture when the property is sold. Any gain realized on the disposition is recognized as ordinary income to the extent of IDCs expensed (but limited to the realized gain).

Noncapital gains and losses are reported on Form 4797 (Sales of Business Property). However, before Form 4797 is filled out, Part B of Form 4684 (Casualties and Thefts) must be completed to determine whether any casualties will enter into the § 1231 computation procedure. Recall that recognized gains from § 1231 asset casualties may be recaptured by § 1245 or § 1250.

These gains will not appear on Form 4684. The § 1231 gains and nonpersonal use long-term capital gains are netted against § 1231 losses and nonpersonal use long-term capital losses on Form 4684 to determine if there is a net gain to transfer to Form 4797, Part I.

In several situations, Congress has created rules that specifically provide for sale or exchange treatment. For example, assume that the expiration of a right to personal property (other than stock) that would be a capital asset in the hands of the taxpayer results in a recognized gain or loss.

This is a capital gain or loss.3 Several of these special rules are discussed below, including worthless securities, the retirement of corporate obligations, options, patents, franchises, and lease cancellation payments.

If related parties sell or exchange property that is depreciable in the hands of the transferee (principally machinery, equipment, and buildings, but not land), any gain recognized by the transferor is ordinary income.

This rule applies to both direct and indirect sales or exchanges. A related party is defined as an individual and his or her controlled corporation or partnership or a taxpayer and any trust in which the taxpayer (or the taxpayer's spouse) is a beneficiary.

The special netting process for casualties and thefts also does not include condemnation gains and losses. Consequently, a § 1231 asset disposed of by condemnation will receive § 1231 treatment.

This variation between recognized casualty and condemnation gains and losses sheds considerable light on what § 1231 is all about. Section 1231 has no effect on whether realized gain or loss is recognized. Instead, § 1231 merely dictates how such recognized gain or loss is classified (ordinary, capital, or § 1231) under certain conditions.

Net long-term capital gains of noncorporate taxpayers are eligible for an alternative tax calculation that normally results in a lower tax liability. Neither NLTCLs nor NSTCLs are treated as ordinary losses.

Treatment as an ordinary loss generally is preferable to capital loss treatment because ordinary losses are deductible in full while the deductibility of capital losses is subject to certain limitations. An individual taxpayer may deduct a maximum of $3,000 of net capital losses for a taxable year.

U.S. Government Publications

U.S. government publications received from the U.S. government (or its agencies) for a reduced price are not capital assets. This prevents a taxpayer from later donating the publications to charity and claiming a charitable contribution deduction equal to the fair market value of the publications. Normally the charitable contribution of an ordinary asset provides a deduction equal to the asset's basis. If the taxpayer received the property at no cost, its basis is equal to zero. If this property is given to someone else, it retains its ordinary asset status.

Certain Disallowed Loss Transactions

Under several Code provisions, realized losses are disallowed. When a loss is dis allowed, 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.

Section 1245 recapture

Upon a taxable disposition of § 1245 property, all depreciation claimed on the property is recaptured as ordinary income (but not to exceed any recognized gain from the disposition).

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.

Related party

Various Code Sections define related parties and often include a variety of persons within this (usually detrimental) category. Generally, related parties are accorded different tax treatment from that applicable to other taxpayers who enter into similar transactions. For instance, realized losses that are generated between related parties are not recognized in the year of the loss. However, these deferred losses can be used to offset recognized gains that occur upon the subsequent sale of the asset to a nonrelated party. Other uses of a related-party definition include the conversion of gain upon the sale of a depreciable asset into all ordinary income (§ 1239) and the identification of constructive ownership of stock relative to corporate distributions, redemptions, liquidations, reorganizations, and compensation.

Inventory

What constitutes inventory is determined by the taxpayer's business. Whether an asset is capital or ordinary therefore, depends entirely on the relationship of the asset to the taxpayer who sold it.

Importance of Capital Asset Status

Why is capital asset status important? Because of the alternative tax on net capital gain. Individuals who receive income in the form of long-term capital gains or qualified dividend income have an advantage over taxpayers who cannot receive income in these forms. If a net capital loss results, the maximum deduction is $3,000 per year. Consequently, capital gains and losses must be segregated from other types of gains and losses and must be reported separately on Schedule D of Form 1040.

The writer of the call receives a premium (e.g., 10 percent) for writing the option. If the price of the stock does not increase during the option period, the option will expire unexercised.

When the option expires, the grantor must recognize short-term capital gain (whereas the grantee recognizes a loss, the character of which depends on the underlying asset). These rules do not apply to options held for sale to customers (the inventory of a securities dealer).

Special 25% Gain Netting Rules

Where there is a § 1231 gain from real estate and that gain includes both potential 25% gain and potential 0%/15%/20% gain, any § 1231 loss from disposition of other § 1231 assets first offsets the 0%/15%/20% portion of the § 1231 gain and then offsets the 25% gain portion of the § 1231 gain. Also, any § 1231 lookback loss first recharacterizes the 25% gain portion of the § 1231 gain and then recharacterizes the 0%/15%/20% portion of the § 1231 gain as ordinary income.

If § 1245 property is disposed of in a transaction other than a sale, exchange, or involuntary conversion,

the maximum amount recaptured is the excess of the property's fair market value over its adjusted basis.

Because depreciable property and real property used in business are not capital assets, the recognized gains from the disposition of this property would appear to be ordinary income rather than capital gain. Due to § 1231, however, net gain from the disposition of this property is sometimes treated as long-term capital gain. In order for this to occur:

•A long-term holding period requirement must be met (held for more than a year); •The disposition must generally be from a sale, exchange, or involuntary conversion; and •Certain recapture provisions must be satisfied. Section 1231 may also apply to involuntary conversions of capital assets even though such a disposition, which is not a sale or exchange, normally would not result in a capital gain.

The following property is also subject to § 1245 treatment:

•Amortizable personal property such as goodwill, patents, copyrights, and leaseholds of § 1245 property. •Professional baseball and football player contracts. •Certain depreciable tangible real property (other than buildings and their structural components) employed as an integral part of certain activities such as manufacturing and production. For example, a natural gas storage tank where the gas is used in the manufacturing process is § 1245 property. •Pollution control facilities, railroad grading and tunnel bores, on-the-job training, and child care facilities. •Single-purpose agricultural and horticultural structures and petroleum storage facilities (e.g., a greenhouse or silo). •Fifteen-year, 18-year, and 19-year nonresidential real estate for which accelerated cost recovery is used. This property, known as ACRS property, would have been placed in service after 1980 and before 1987.

The layers are taxed in the following order:

•Any 25% gain, •Any 28% gain, •The 0 percent portion of the 0%/15%/20% gain and/or QDI, •The 15 percent portion of the 0%/15%/20% gain and/or QDI, and then •The 20 percent portion of the 0%/15%/20% gain and/or QDI.

Section 1231 property generally includes the following assets if they are held for more than one year:

•Depreciable or real property used in business or for the production of income (principally machinery and equipment, buildings, and land). •Timber, coal, or domestic iron ore. •Livestock held for draft, breeding, dairy, or sporting purposes. •Unharvested crops on land used in business. •Certain purchased intangible assets (such as patents and goodwill) that are eligible for amortization. These assets are ordinary assets until they have been held for more than one year. Only then do they become § 1231 assets.

Lease cancellation payments received by a lessee are treated as an exchange.13 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.

Year-End Planning: The following general rules can be applied for timing the recognition of capital gains and losses near the end of a taxable year:

•If the taxpayer already has recognized more than $3,000 of capital loss, sell assets to generate capital gain equal to the excess of the capital loss over $3,000. •If the taxpayer already has recognized capital gain, sell assets to generate capital loss equal to the capital gain. The gain will not be taxed, and the loss will be fully deductible against the gain. •Generally, if the taxpayer has a choice between recognizing short-term capital gain or long-term capital gain, long-term capital gain should be recognized because it is subject to a lower tax rate.

Observations on § 1245

•In most instances, the total depreciation taken will exceed the recognized gain. Therefore, the disposition of § 1245 property usually results in ordinary income rather than § 1231 gain. No § 1231 gain will occur unless the § 1245 property is disposed of for more than its original cost. Refer to Examples 55 and 56. •Recapture applies to the total amount of depreciation allowed or allowable regardless of the depreciation method used. •Recapture applies regardless of the holding period of the property. If the property is held for less than the long-term holding period, the entire recognized gain is ordinary income because § 1231 does not apply. •Section 1245 does not apply to losses, which receive § 1231 treatment. •Gains from the disposition of § 1245 assets may also be treated as passive activity gains

Specifically, the Code defines a capital asset as property held by the taxpayer (when it is connected with the taxpayer's business) that is not any of the following:

•Inventory or property held primarily for sale to customers in the ordinary course of a business. •Accounts and notes receivable generated from the sale of goods or services in a business. •Depreciable property or real estate used in a business. •A patent, invention, model, or design (whether or not patented); a secret formula or process; certain copyrights; literary, musical, or artistic compositions; or letters, memoranda, or similar property created by or for the taxpayer.1 •Certain U.S. government publications. •Supplies used in a business.

A short sale against the box occurs when the stock is borrowed from a broker by a seller and the seller already owns substantially identical securities on the short sale date or acquires them before the closing date.20 To remove the taxpayer's flexibility as to when the short sale gain must be reported, a constructive sale approach is used. If the taxpayer has not closed the short sale by delivering the short sale securities to the broker before January 31 of the year following the short sale, the short sale is deemed to have been closed on the earlier of two events:

•On the short sale date if the taxpayer owned substantially identical securities at that time. •On the date during the year of the short sale that the taxpayer acquired substantially identical securities.

Property Excluded Section 1231 property generally does not include the following:

•Property not held for the long-term holding period.32 •Nonpersonal use property where casualty losses exceed casualty gains for the taxable year. If a taxpayer has a net casualty loss, the individual casualty gains and losses are treated as ordinary gains and losses. •Inventory and property held primarily for sale to customers. •A patent, invention, model, or design (whether or not patented); a secret formula or process; certain copyrights; literary, musical, or artistic compositions; and certain U.S. government publications. •Accounts receivable and notes receivable arising in the ordinary course of the trade or business.

In most settings, short sale gain or loss results in a capital gain or loss. The gain or loss is not recognized until the short sale is closed. Generally, the holding period of the short sale property is determined by how long the property used to close the short sale was held. However, when substantially identical property (e.g., other shares of the same stock) is held by the taxpayer, the holding period is determined as follows:

•The short sale gain or loss is short term when, on the short sale date, the substantially identical property has been held short term (i.e., for one year or less). (See Examples 30 and 31.) •The short sale gain is long term when, on the short sale date, the substantially identical property has been held long term (i.e., for more than one year) and is used to close the short sale. If the long-term substantially identical property is not used to close the short sale, the short sale gain is short term. (See Example 32.) •The short sale loss is long term when, on the short sale date, the substantially identical property has been held long term (i.e., for more than one year). •The short sale gain or loss is short term if the substantially identical property is acquired after the short sale date and on or before the closing date. (See Example 33.)

Recognized gains and losses must be properly classified. Proper classification depends on three characteristics:

•The tax status of the property (capital, § 1231, or ordinary). •The manner of the property's disposition (sale, exchange, casualty, theft, or condemnation). •The holding period of the property (short-term: one year or less; long-term: more than one year).

As a result of this layering:

•The taxpayer benefits from the 0 percent portion of the net capital gain and/or QDI if the taxpayer is still in the 10 percent or 12 percent regular tax bracket after taxing other taxable income and the 25 percent and 28 percent portions of the net capital gain. Depending on the taxpayer's filing status, however, a portion of income in the taxpayer's 12 percent tax bracket is subject to the 15 percent alternative tax rate. In 2020, the 0 percent alternative tax rate applies only through $80,000 of taxable income for married taxpayers filing jointly or surviving spouses, $40,000 for single taxpayers, $53,600 for heads of household, and $40,000 for married taxpayers filing separately. These "break points" for the alternative tax rates do not correspond with the normal tax bracket "break points" (see the 2020 Tax Rate Schedules in Appendix A). This means that in 2020, the last $250 (married, filing jointly and surviving spouses), $125 (single), $100 (heads of household), and $125 (married, filing separately) in the 12 percent bracket is subject to the 15 percent alternative rate. As the normal tax rate (12 percent) is less than the alternative tax rate (15 percent), this means that for these small ranges, any net capital gain or QDI will be taxed at 12 percent (rather than 15 percent). •The taxpayer benefits from the 15 percent portion of the net capital gain and/or QDI if the taxpayer is in the 22 percent, 24 percent, and 32 percent brackets or a portion of the 35 percent regular rate bracket after taxing other taxable income and the 25 percent, 28 percent, and 0 percent portions of the net capital gain and/or QDI. In 2020, the 15 percent tax rate applies until taxable income exceeds $496,600 for married taxpayers filing jointly, $469,050 for heads of household, and $248,300 for married taxpayers filing separately. •The taxpayer benefits from the 20 percent portion of the net capital gain and/or QDI when taxable income exceeds the maximum taxable income thresholds for the 15 percent alternative tax rate.

To be eligible for § 1237 treatment, the following requirements must be met:

•The taxpayer may not be a corporation. •The taxpayer may not be a real estate dealer. •No substantial improvements may be made to the lots sold. Substantial generally means more than a 10 percent increase in the value of a lot. Shopping centers and other commercial or residential buildings are considered substantial improvements, while filling, draining, leveling, and clearing operations are not. •The taxpayer must have held the lots sold for at least 5 years, except for inherited property. The substantial improvements test is less stringent if the property is held at least 10 years.

The treatment of a corporation's net capital gain or loss differs from the rules for individuals. Briefly the differences are as follows:

•There is no NCG alternative tax rate. •Capital losses offset only capital gains. No deduction of capital losses is permitted against other taxable income (whereas a $3,000 deduction is allowed to individuals).28 •Corporations may carry back net capital losses (whether long term or short term) as short-term capital losses for three years; if losses still remain after the carryback, the remaining losses may be carried forward five years.29 Individuals may carry forward unused capital losses indefinitely, but there is no carryback.