Income Taxation - Exam III - Chapter 14 Problems

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.

Collectibles

One who rents property to another. In the case of real estate, the lessor is also known as the landlord.

Lessor

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).

Qualified Dividend Income (QDI)

Renata Corporation purchased equipment in 2018 for $180,000 and has taken $83,000 of regular MACRS depreciation. Renata Corporation sells the equipment in 2020 for $110,000. What is the amount and character of Renata's gain or loss?

Renata's equipment gain is subject to § 1245 depreciation recapture. The property had an adjusted basis of $97,000 ($180,000 cost − $83,000 depreciation). The gain is $13,000 ($110,000 selling price − $97,000 adjusted basis) and is all ordinary gain due to recapture because the gain is less than or equal to the depreciation taken.

On December 1, 2018, Lavender Manufacturing Company (a corporation) purchased another company's assets, including a patent. The patent was used in Lavender's manufacturing operations; $49,500 was allocated to the patent, and it was amortized at the rate of $275 per month. On July 30, 2020, Lavender sold the patent for $95,000. Twenty months of amortization had been taken on the patent. What are the amount and nature of the gain Lavender recognizes on the disposition of the patent?

The patent amortization is subject to § 1245 recapture as ordinary income. The balance of the gain is § 1231 gain. A Microsoft Excel spreadsheet could be created to match the solution below. Selling Price: $95,000 - Adjusted Basis (Cost: $49,500 - Amortization (20 months*$275): (5,500) : (44,000) = Recognized gain: $51,000 1245 Ordinary gain: $5,500 1231 gain: $45,500

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.

Capital Asset

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.

Holding Period

Joanne is in the 24% tax bracket and owns depreciable business equipment that she purchased several years ago for $135,000. She has taken $100,000 of depreciation on the equipment, and it is worth $55,000. Joanne's niece, Susan, is starting a new business and is short of cash. Susan has asked Joanne to gift the equipment to her so that Susan can use it in her business. Joanne no longer needs the equipment. Identify the alternatives available to Joanne if she wants to help Susan and the tax effects of those alternatives. (Assume that all alternatives involve the business equipment in one way or another, and ignore the gift tax.)

(1) Joanne could sell the equipment but probably not to Susan because Susan could not afford it. Joanne would have a taxable ordinary gain of $20,000 [$55,000 sale price − ($135,000 cost − $100,000 depreciation)] due to depreciation recapture under § 1245. After paying her tax of $4,800 ($20,000 × 24%), Joanne would have $50,200 ($55,000 sale price − $4,800 tax) to give to Susan. That may not be enough cash for Susan to buy the equipment she needs. It would not be beneficial for Joanne to sell the equipment on the installment basis because all the gain would be immediately recognized because all the gain is recapture gain. (2) Joanne could give the equipment to Susan. The $100,000 depreciation recapture potential would carry over to Susan, and Susan would take Joanne's basis ($35,000) for the property. Any depreciation Susan takes on the property would increase the depreciation recapture potential. However, it appears that Susan may not sell the property for quite a while and is probably in a lower tax bracket than Joanne is.

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).

Alternative Tax

For 2020, Ashley has gross income of $38,350 and a $5,000 long-term capital loss. She claims the standard deduction. Ashley is 35 years old and unmarried with two dependent children. How much of Ashley's $5,000 capital loss carries over to 2021?

Ashley has a $3,000 capital loss deduction for AGI. The remaining $2,000 of the $5,000 carries forward as a long-term capital loss.

Dexter owns a large tract of land and subdivides it for sale. Assume that Dexter meets all of the requirements of § 1237 and during the tax year sells the first eight lots to eight different buyers for $22,000 each. Dexter's basis in each lot sold is $15,000, and he incurs total selling expenses of $900 on each sale. What is the amount of Dexter's capital gain and ordinary income?

Dexter has $1,600 ordinary income and $47,200 long-term capital gain. Note: The solution mimics how a spreadsheet response could be formatted. Selling price (8 × $22,000): $176,000 - Less: Selling expenses (8 × $900): (7,200) = Amount realized: $168,800 - Basis (8 × $15,000): (120,000) = Realized and recognized gain $48,800 Classification of recognized gain: Ordinary income Five percent of selling price ($176,000 × 0.05): $8,800 - Less: Selling expenses: (7,200) = Ordinary Income: (1,600) Long-term capital gain: $47,200

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.

Options

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).

Original Issue Discount

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.

Patent

Enzo is a single taxpayer with the following gains and losses for 2020: *$2,100 short-term capital loss. *$24,000 long-term capital gain from sale of stock. *$14,000 § 1231 gain that is all unrecaptured § 1250 gain. What is the amount and character of Enzo's gain or loss?

The $2,100 short-term capital loss first offsets the unrecaptured § 1250 gain, reducing it to $11,900. The total long-term capital gain is $35,900 ($24,000 + $11,900), and it is potential $11,900 25% rate gain and $24,000 0%/15%/20% rate gain.

An apartment building was acquired in 2011. The depreciation taken on the building was $123,000, and the building was sold for a $34,000 gain. What is the maximum amount of 25% gain?

The maximum amount of unrecaptured § 1250 gain is equal to the depreciation taken on the property or the gain from disposition, whichever is lower. Because the gain ($34,000) is less than the depreciation taken ($123,000), the maximum amount of unrecaptured gain is $34,000.

On May 9, 2020, Glenna purchases 500 shares of Ignaz Company stock for $7,500. On June 30, 2020, she writes a call option on the stock, giving the grantee the right to buy the stock for $9,000 during the following 12-month period. Glenna receives a call premium of $750 for writing the call. The call is exercised by the grantee on December 15, 2020. a. What is the amount and character of Glenna's gain or loss? b. Assume that the original option expired unexercised. What is the amount and character of Glenna's gain or loss?

a. When the stock option is exercised, Glenna has an amount realized of $9,750 (the $9,000 sales price of the stock plus the $750 call premium). Her short-term capital gain is $2,250 ($9,750 amount realized − $7,500 adjusted basis). b. If the option expired unexercised, the $750 call premium is a short-term capital gain.

David contributes to charity some tangible personal property that he had used in his business and depreciated. At the date of the donation, the property has a fair market value of $233,000 and an adjusted basis of zero; it was originally acquired for $400,000. What is the amount of David's charitable contribution?

hen depreciable tangible property is contributed to charity, the contribution is limited to the fair market value of the property reduced by any ordinary gain that would have resulted if the property was sold (here, the gain related to the $400,000 § 1245 depreciation recapture potential). Had the property been sold for its fair market value ($233,000), the $233,000 gain would have been ordinary income (due to depreciation recapture). As a result, there is no charitable contribution deduction.

Asok's AGI for 2020 is $133,250. Included in this AGI is a $45,000 25% long-term capital gain and a $13,000 0%/15%/20% long-term capital gain. Asok is single and uses the standard deduction. Compute his taxable income, the tax liability, and the tax savings from the alternative tax on net capital gain.

ok's taxable income is $120,850 ($133,250 AGI − $12,400 standard deduction), and the tax liability using the alternative tax approach is $21,914. Asok saves $1,170 by using the alternative tax rather than the regular tax computation. Tax on $62,850 other taxable income ($120,850 TI − $45,000 25% gain − $13,000 0%/15%/20% gain) from 2020 Single Tax Rate Schedule: $9,617 + 22% tax on $22,675 of 25% gain (alternative tax rate of 25% is higher than the regular tax rate of 22%; this income fills the remainder of the 22% rate bracket): $4,989 + 24% tax on $22,325 of remaining 25% gain (alternative tax rate of 25% is higher than the regular tax rate of 24%): $5,358 + 15% tax on $13,000 0%/15%/20% gain (alternative tax rate of 15% is lower than regular tax rate of 24%): $1,950 = Total tax liability using the alternative tax calculation: $21,914 - Regular tax liability on $120,850 TI: (23,084) = Tax savings from alternative tax computation: ($ 1,170)

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).

Section 1245 recapture

Upon a taxable disposition of § 1250 property, accelerated depreciation or cost recovery claimed on the property may be recaptured as ordinary income.

Section 1250 Recapture

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

Section 1250 property

One who rents property from another. In the case of real estate, the lessee is also known as the tenant.

Lessee

For gain to be classified as § 1231 gain, the gain must survive the § 1231 lookback. To the extent of nonrecaptured § 1231 losses for the five prior tax years, the gain is classified as ordinary income. § 1231(c).

Section 1231 lookback

Jinjie owns two parcels of business land (§ 1231 assets). One parcel can be sold at a loss of $60,000, and the other parcel can be sold at a gain of $70,000. Jinjie has no nonrecaptured § 1231 losses from prior years. The parcels could be sold at any time because potential purchasers are abundant. Jinjie has a $35,000 short-term capital loss carryover from a prior tax year and no capital assets that could be sold to generate long-term capital gains. Both land parcels have been held more than one year. What should Jinjie do based upon these facts? (Assume that tax rates are constant, and ignore the present value of future cash flow.)

jie should sell the § 1231 gain asset this year and the § 1231 loss asset next year. This year Jinjie would have $70,000 net § 1231 gain, there would be no lookback nonrecaptured § 1231 loss, the net § 1231 gain would be treated as a long-term capital gain, and the $35,000 short-term capital loss carryover would be offset against this capital gain. For this year, Jinjie would have a $35,000 net long-term capital gain that would be taxed at a maximum rate of 20%. Next year Jinjie could sell the § 1231 loss asset; the $60,000 loss would generate a net § 1231 loss, and that loss would be an ordinary loss deductible for AGI. By selling the § 1231 gain asset the year before the § 1231 loss asset, Jinjie avoids having the § 1231 loss "taint" the § 1231 gain, converting that gain into ordinary gain.

Coline has the following capital gain and loss transactions for 2020: *Short-term Capital Gain: $5,000 *Short-term Capital Loss: ($2,100) *Long-term Capital Gain (28%): $6,000 *Long-term Capital Gain (15%): $2,000 *Long-term Capital Loss (28%): ($10,500) After the capital gain and loss netting process, what is the amount and character of Coline's gain or loss?

Coline first nets the short-term gains and losses against each other and the long-term gains and losses against each other. There is a net short-term capital gain of $2,900 ($5,000 − $2,100) and a net long-term capital loss of $2,500 ($6,000 + $2,000 − $10,500). These offset each other and net to a $400 short-term capital gain.

During the year, Eugene had the four property transactions summarized below. Eugene is a collector of antique glassware and occasionally sells a piece to get funds to buy another. What are the amount and nature of the gain or loss from each of these transactions? Property / Date Acquired / Date Sold / Adjusted Basis Antique Vase / 06/18/09 / 05/23/20 / $37,000 Blue Growth Fund (100 shares) / 12/23/11 / 11/22/20 / 22,000 Orange Bonds / 02/12/12 / 04/11/20 / 34,000 Green Stock (100 Shares) / 02/14/20 / 11/23/20 / 11,000

All the assets are capital assets because they do not fit any of the items listed in § 1221 as notcapital assets. •The antique vase is a "collectible." Therefore, the $5,000 gain ($42,000 sale price − $37,000 basis) is a 28% long-term capital gain that would first be netted against any 28% long-term capital loss. •The Blue Growth Fund $16,000 gain ($38,000 sale price − $22,000 basis) is a long-term capital gain that is potentially taxable at 0%, 15%, and/or 20%. •The Orange bonds are sold for a $7,250 gain ($42,000 proceeds − $750 interest income − $34,000 basis). The gain is a long-term capital gain potentially taxable at 0%, 15%, and/or 20%. •The sale of the Green stock results in a $2,000 ($13,000 sale price − $11,000 basis) short-term capital gain because the stock was held one year or less. •The $750 interest income is includible in Eugene's gross income.

Angie owns numerous strip malls. A major tenant of one of the strip malls wanted to cancel its lease because it was moving to another city. After lengthy negotiations, the tenant paid Angie $60,000 to cancel its obligations under the lease. If the tenant had fulfilled the lease terms, Angie would have received rent of $700,000. What factors should Angie consider to determine the amount and character of her income from these circumstances?

Angie must determine whether she is in the business of being a lessor and what her tax basis is for the lease. She clearly is in the business of being a lessor and has no tax basis for the lease. Lessors always have ordinary income from cancellation of a lease because it is considered to be received in lieu of rental income.

Olivia wants to buy some vacant land for investment purposes. She cannot afford the full purchase price. Instead, Olivia pays the landowner $8,000 to obtain an option to buy the land for $175,000 anytime in the next four years. Fourteen months after purchasing the option, Olivia sells the option for $10,000. What is the amount and character of Olivia's gain or loss?

Because Olivia intended to use the land as an investment (and, thus, it would have been a capital asset), the option is also a capital asset. The $2,000 ($10,000 amount realized − $8,000 adjusted basis) is a long-term capital gain because she held the option more than one year.

Benny purchased $400,000 of Peach Corporation face value bonds for $320,000 on November 13, 2019. The bonds had been issued with $80,000 of original issue discount because Peach was in financial difficulty in 2019. On December 3, 2020, Benny sold the bonds for $283,000 after amortizing $1,000 of the original issue discount. What are the nature and amount of Benny's gain or loss?

Because the Peach Corporation bonds were original issue discount bonds, the discount amortization is treated as interest income by Benny and added to his basis for the bonds. Thus, his basis is $321,000 ($320,000 cost + $1,000 discount amortization) and his loss is $38,000 ($283,000 sale price − $321,000 basis). The loss is long-term capital loss because Benny held the bonds for investment (making them a capital asset) for more than one year.

Sarah received a gift of farmland from her father. The land was worth $4,000,000 at the date of the gift, had been farmed by her father for 40 years, and had a tax basis for her father of $30,000. Sarah never farmed the land and sold it eight months after receiving it from her father for $4,200,000. What is Sarah's holding period for the farmland? What is the nature of the gain from its disposition?

Because the value of the farmland exceeded the donor's basis at the time of the gift, the donor's basis and holding period carried over to Sarah (see Chapter 13 for further details). Consequently, Sarah has a long-term holding period, and because she held the farmland for investment, she had a capital asset. She has a $4,170,000 ($4,200,000 selling price − her father's $30,000 tax basis) long-term capital gain from the sale of the farmland.

Faith Godwin is a dealer in securities. She has spotted a fast-rising company and would like to buy and hold its stock for investment. The stock is currently selling for $2 per share, and Faith thinks it will climb to $40 a share within two years. Faith's coworkers have told her that there is "no way" she can get long-term capital gain treatment when she purchases stock because she is a securities dealer. Faith has asked you to calculate her potential gain and tell her whether her coworkers are right.

By the close of business on the day Faith purchases the shares, she must designate them as held for investment. The $38 ($40 − $2) per share gain will be long-term capital gain if she sells the shares after holding them more than a year.

The gain from the sale or exchange of a capital asset.

Capital Gains

The loss from the sale or exchange of a capital asset.

Capital Loss

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.

Franchise

Consuela was a tenant in a campus apartment. She is a student at State University. Her lease began on August 1, 2020, and was due to expire on July 31, 2021. However, her landlord sold the building, and the new owner wanted to demolish it to build a retail building. Consuela's landlord paid her $1,000 to cancel the lease. Consuela received the $1,000 on November 30, 2020; moved out; and rented another apartment. How should Consuela treat the $1,000?

Consuela's use of the apartment was personal use, so the lease was a capital asset. The lease had a zero basis, so the entire $1,000 is taxable gain. The gain is short-term capital gain because the lease was held one year or less.

Dennis sells short 100 shares of ARC stock at $20 per share on January 15, 2020. He buys 200 shares of ARC stock on April 1, 2020, at $25 per share. On May 2, 2020, he closes the short sale by delivering 100 of the shares purchased on April 1. a. What are the amount and nature of Dennis's loss upon closing the short sale? b. When does the holding period for the remaining 100 shares begin? c. If Dennis sells (at $27 per share) the remaining 100 shares on January 20, 2021, what will be the nature of his gain or loss?

Dennis has engaged in a short sale against the box because although he did not own substantially identical property on the short sale date (January 15, 2020), he did acquire substantially identical property before the end of the short sale year (on April 1, 2020). However, because he closed the short sale by the end of the year of the short sale (2020), the deemed closing rules do not apply. Also, because Dennis did not own substantially identical stock at the date of the short sale, any gain or loss from closing the short sale is short term. a. The price of the shares rose after Dennis made the short sale. He lost $5 per share for a total of a $500 short-term capital loss from closing the short sale. b. The holding period for the remaining 100 shares begins with the closing date of the short sale (May 2, 2020). Because the remaining shares were acquired after the short sale date (January 15, 2020), they have a holding period that commences with the earlier of the closing date of the short sale or the sale date of the remaining shares. c. Dennis has a $2 per-share gain (total of $200) when he sells the remaining shares on January 20, 2021. This gain is short term because the holding period did not start until the short sale closing date (May 2, 2020). Dennis must hold the stock more than one year to receive long-term treatment.

Elliott has the following capital gain and loss transactions for 2020: *Short-term Capital Gain: $1,500 *Short-term Capital Loss: ($3,600) *Long-term Capital Gain (28%): $12,000 *Long-term Capital Gain (25%): $4,800 *Long-term Capital Gain (15%): $6,000 *Long-term capital Loss (28%): ($4,500) *Long-term Capital Loss (15%): ($9,000) After the capital gain and loss netting process, what is the amount and character of Elliott's gain or loss?

Elliott first nets the short-term gains and losses against each other and the long-term gains and losses against each other. There is a net short-term capital loss of $2,100 ($1,500 − $3,600). The 28% long-term items are netted and leave a net $7,500 28% gain. The 0%/15%/20% items are netted and leave a $3,000 loss. That loss is netted against the $7,500 28% gain, leaving a $4,500 28% gain. That gain is offset against the $2,100 short-term capital loss, leaving a $2,400 28% gain and a $4,800 25% gain for a total long-term capital gain of $7,200.

Carla was the owner of vacant land that she was holding for investment. She paid $2,000,000 for the land in 2018. Raymond was an investor in vacant land. He thought Carla's land might be the site of an exit ramp from a new freeway. Raymond gave Carla $836,000 for an option on her land in 2019. The option was good for two years and gave Raymond the ability to purchase Carla's land for $4,765,000. The freeway was not approved by the government, and Raymond's option expired in 2020. Does Carla have $836,000 of long-term capital gain upon the expiration of the option? Explain.

Even though Carla's vacant land is a capital asset, the expiration of the option is not a capital gain. Because the land is not a security, stock, commodities, or commodities futures, the expiration of the option results in 2020 ordinary income of $836,000 for Carla.

Hilde purchased all of the rights to a patent on a new garden tool developed by a friend of hers who is an amateur inventor. The inventor obtained the patent rights, set up a manufacturing company to produce and sell the garden tool, and produced substantial quantities of the tool, but he then became discouraged when no large garden company would agree to distribute the tool for him. Hilde purchased the patent rights (but not the manufacturing company) for $120,000 on October 24, 2019. Hilde had never engaged in such a transaction before, but she is a salesperson in the garden industry and thought she could succeed where her friend had failed. On June 27, 2020, she sold all patent rights to Garden Tool Company for $1,233,000. Garden Tool will manufacture the tool in its own factory and sell it to its customers. What is the nature of Hilde's gain from this transaction?

Even though Hilde purchased the patent as an investment, § 1221(a)(3) specifically defines patents as not capital assets. Her gain of $1,113,000 ($1,233,000 sales proceeds - $120,000 adjusted basis) is an ordinary gain unless § 1235 applies and treats the gain as capital gain. Hilde does not qualify under § 1235 as a "holder" of the patent because she did not invent the garden tool and it had been "reduced to practice" by the inventor.

Freys, Inc., sells a 12-year "stuffed potato" franchise to Reynaldo. The franchise contains many restrictions on how Reynaldo may operate his store. For instance, Reynaldo cannot use less than Grade 10 Idaho potatoes, must bake the potatoes at a constant 410 degrees, must dress store personnel in Freys-approved uniforms, and must have a Freys sign that meets detailed specifications on size, color, and construction. When the franchise contract is signed, Reynaldo makes a noncontingent $160,000 payment to Freys. During the same year, Reynaldo pays Freys $300,000—14% of Reynaldo's sales. How does Freys treat each of these payments? How does Reynaldo treat each of the payments?

Freys, Inc., has retained significant power and rights in the franchise agreement. Therefore, Freys has not made a sale or exchange, but has created a license to use its trademarks, trade name, and mode of operation. Section 1253 requires that Freys treat the $160,000 lump-sum noncontingent payment and the $300,000 contingent payment as ordinary income. Reynaldo may amortize the $160,000 noncontingent payment over 15 years. The amortization is treated as a business expense. Reynaldo may currently deduct the $300,000 contingent payment as a business expense.

Gray, Inc., a C corporation, has taxable income from operations of $1,452,000 for 2020. It also has a net long-term capital loss of $355,000 from the sale of a subsidiary's stock. The year 2020 is the first year in the last 10 years that Gray has not had at least $500,000 per year of net long-term capital gains. What is Gray's 2020 taxable income? What, if anything, can it do with any unused capital losses?

Gray, Inc., has taxable income of $1,452,000 because the 2020 $355,000 net long-term capital loss cannot be deducted. Gray can carry back that loss as a short-term capital loss against its 2017 capital gains, recalculate its 2017 tax liability, and file a claim for refund.

Helena has the following long-term capital gains and losses for 2020: $65,000 28% gain, $53,000 28% loss, $28,000 25% gain, and $24,000 0%/15%/20% loss. She also has a $33,000 short-term loss and a $65,000 short-term gain. What is Helena's AGI from these transactions? If she has a net long-term capital gain, what is its makeup in terms of the alternative tax rates?

Helena has $48,000 AGI, $16,000 from net LTCG and $32,000 from net STCG. She has $12,000 ($65,000 − $53,000) 28% net gain. That gain is offset by $12,000 of the 0%/15%/20% loss, resulting in a zero net 28% gain or loss. The remaining $12,000 ($24,000 − $12,000) 0%/15%/20% gain reduces the $28,000 25% gain to $16,000. So there is $16,000 of net LTCG, all of which is 25% gain, and $32,000 net STCG ($65,000 − $33,000).

Jacob purchased business equipment for $56,000 in 2017 and has taken $35,000 of regular MACRS depreciation. Jacob sells the equipment in 2020 for $26,000. What is the amount and character of Jacob's gain or loss?

Jacob has a $5,000 ordinary gain due to § 1245 depreciation recapture because the property's $21,000 adjusted basis ($56,000 cost − $35,000 depreciation) is less than the selling price of $26,000 and the gain is less than or equal to the depreciation taken.

Jane and Blair are married taxpayers filing jointly and have 2020 taxable income of $107,000. The taxable income includes $5,000 of gain from a capital asset held five years, $2,100 of gain from a capital asset held seven months, and $13,000 of gain from a capital asset held four years. All of the capital assets were stock in publicly traded corporations. Jane and Blair also have qualified dividend income of $3,000. What is the couple's tax on taxable income and the related tax savings from the alternative tax computation (if any)?

Jane and Blair's $107,000 taxable income is comprised of $86,000 other taxable income (includes STCG of $2,100), $18,000 0%/15%/20% net long-term capital gain ($5,000 + $13,000), and $3,000 qualified dividend income. Their tax on taxable income using the alternative tax calculations is $13,650. The 15% alternative rate applies because their other taxable income (which includes the $2,100 net short-term capital gain) puts them above the breakpoint for the 0% rate ($80,000 in 2020) and below the 37% bracket. The tax calculation is shown below: Tax on $86,000 other taxable income ($107,000 TI - $18,000 0%/15%/20% gain - $3,000 qualified dividend) from 2020 MFJ Tax Rate Schedule : $10,500 + 15% tax on $18,000 0%/15%/20% gain and $3,000 qualified dividend income: $3,150 = Total tax using alternative tax calculation: $,13,650 - Regular tax on $107,000 TI : ($15,120) = Tax savings from alternative tax computation: ($1,470)

A sculpture that Korliss Kane held for investment was destroyed in a flood. The sculpture was insured, and Korliss had a $60,000 gain from this casualty. He also had a $17,000 loss from an uninsured antique vase that was destroyed by the flood. The vase was also held for investment. Korliss had no other property transactions during the year and has no nonrecaptured § 1231 losses from prior years. Both the sculpture and the vase had been held more than one year when the flood occurred (i.e., both are long-term nonpersonal use capital assets). Compute Korliss's net gain or loss, and identify how it would be treated.

Korliss has had two nonpersonal use property casualties. The $60,000 gain is netted against the $17,000 loss and results in a $43,000 net casualty gain. The $43,000 net casualty gain is treated as a § 1231 gain. Because there are no other property transaction gains or losses and because Korliss has no lookback losses, he has a $43,000 net § 1231 gain for the year. That gain is treated as a long-term capital gain because both assets had been held more than 12 months when the flood occurred.

Lena is a sole proprietor. In April of this year, she sold equipment purchased four years ago for $26,000 with an adjusted basis of $15,500 for $17,000. Later in the year, Lena sold another piece of equipment purchased two years ago with an adjusted basis of $8,200 for $5,500. What is the amount and character of Lena's gain or loss?

Lena has an ordinary gain (due to § 1245 depreciation recapture) of $1,500 ($17,000 − $15,500) from the sale of the first equipment and a § 1231 loss of $2,700 ($5,500 − $8,200) from the sale of the second equipment.

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

Long-term nonpersonal use capital assets

Shen purchased corporate stock for $20,000 on April 10, 2018. On July 14, 2020, when the stock was worth $12,000, Shen died and his son, Mijo, inherited the stock. Mijo sold the stock for $14,200 on November 12, 2020. What is the amount and character of Mijo's gain or loss?

Mijo has a fair market value at date of Shen's death basis and an automatic long-term holding period for the stock. His long-term capital gain is $2,200 ($14,200 amount realized − $12,000 fair market value at Shen's death).

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).

Net Capital Gain (NCG)

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 Loss (NCL)

Elaine Case (single with no dependents) has the following transactions in 2020: *AGI (exclusive of capital gains and losses): $540,000 *Long-term Capital gain: $22,000 *Long-term Capital Loss: ($8,000) *Short-term Capital Gain: $19,000 *Short-term Capital Loss: ($23,000) What is Elaine's net capital gain or loss? Draft a letter to Elaine describing how the net capital gain or loss will be treated on her tax return. Note that Elaine's income from other sources puts her in the 37% tax bracket.

Net long-term capital gain ($22,000 − $8,000 long-term loss): $14,000 - Net short-term capital loss ($19,000 − $23,000): (4,000) = Net capital gain $10,000

Mac, an inventor, obtained a patent on a chemical process to clean old aluminum siding so that it can be easily repainted. Mac has a $50,000 tax basis in the patent. Mac does not have the capital to begin manufacturing and selling this product, so he has done nothing with the patent since obtaining it two years ago. Now a group of individuals has approached him and offered two alternatives. Under one alternative, they will pay Mac $600,000 (payable evenly over the next 15 years) for the exclusive right to manufacture and sell the product. Under the other, they will form a business and contribute capital to it to begin manufacturing and selling the product; Mac will receive 20% of the company's shares of stock in exchange for all of his patent rights. Discuss which alternative is better for Mac.

Normally, patents are an ordinary asset rather than a capital asset because § 1221(a)(3) excludes patents from capital asset status. However, patent gains and losses can be treated as capital gains and losses if the requirements of § 1235 are met. If Mac sells the patent for $600,000, he has automatic long-term capital gain of $550,000 ($600,000 − $50,000 basis) because he is a "holder." He is the inventor, the patent has not yet been reduced to practice, and he will have sold all substantial rights to the patent. His maximum long-term capital gain tax rate is 20%. He will receive $40,000 per year for the next 15 years and could use the installment sale method (see Chapter 16) to recognize the gain as the sale proceeds are received. However, he will be taking a risk that he will receive the payments and should consider the time value of money in analyzing this alternative. If Mac contributes the patent to a new business and receives shares of stock of that business, he has made a nontaxable exchange under § 351 (see Chapter 18). He will not be taxed on the exchange currently, but is taking a risk that the business will be profitable and he will be able to sell the shares of stock later at a gain equal to or greater than what he could receive in cash over the next 15 years. Once he has held the company's shares of stock for more than one year, he will have long-term capital gain treatment from disposition of the shares of stock. Without much more information (such as the creditworthiness of the investors and the income potential from manufacturing and selling the process), it is not possible to make an informed decision.

Paul has the following long-term capital gains and losses for 2020: $62,000 28% gain, $21,000 28% loss, $18,000 25% gain, and $64,000 0%/15%/20% gain. He also has a $53,000 short-term loss and a $5,000 short-term gain. What is Paul's AGI from these transactions? If he has a net long-term capital gain, what is its makeup in terms of the alternative tax rates?

Paul has AGI and net LTCG of $75,000. The $62,000 28% gain is netted against the $21,000 28% loss for a net of $41,000 28% gain. The net $48,000 ($5,000 − $53,000) short-term capital loss is first offset against the net $41,000 28% gain, reducing it to zero. The remaining $7,000 of STCL next offsets $7,000 of the $18,000 25% gain, reducing it to $11,000. The $75,000 net LTCG is made up of the $11,000 25% gain and the $64,000 0%/15%/20% gain.

Pebble Securities is a corporation that buys and sells financial assets. It purchases notes receivable from manufacturers that need cash immediately and cannot wait to collect the notes. Pebble pays about 88% of the face value of the receivables and then collects them. Because of the quality of the notes, Pebble collected less than it paid for some of the notes. Does Pebble have a capital loss when it collects the receivables for less than it paid for them? Explain.

Pebble is in the business of buying and selling financial assets. Consequently, the notes receivable it acquires are its "inventory" and, therefore, ordinary assets. The loss from the disposition of the receivables is an ordinary loss.

Phil and Susan Hammond are married taxpayers filing a joint return. The couple have two dependent children. Susan has wages of $34,000 in 2019. Phil does not work due to a disability, but he is a buyer and seller of stocks. He generally buys and holds for long-term gain, but occasionally gets in and out of a stock quickly. The couple's 2019 stock transactions are detailed below. In addition, they have $2,300 of qualifying dividends. Item / Date Acquired / Date Sold / Cost Blue Stock (10 Share) / 11/10/18 / 03/12/19 / $3,000 Purple Stock (100 Shares) / 12/13/17 / 05/23/19 / $36,000 Beige Stock (50 Shares) / 12/14/14 / 07/14/19 / $26,000 Red Stock (100 Shares) / 06/29/18 / 05/18/19 / $26,000 Black Stock (100 Shares) / 05/15/18 / 10/18/19 / $67,000 Gray Stock (100 Shares) / 04/12/17 / 10/18/19 / $89,000 What is Phil and Susan's AGI?

Phil and Susan have $37,800 AGI. There is a net short-term capital gain of $4,000 ($3,000 + $1,000) and a net long-term capital loss of $2,500 ($1,500 − $4,000 + $800 − $800). Consequently, there is a net short-term capital gain of $1,500 ($4,000 − $2,500). So their AGI is $34,000 wages + $1,500 STCG + $2,300 qualifying dividends = $37,800. The results of the couple's stock transactions are detailed below: Item/ Date Acquired/ Date Sold/ Cost / Sales Price/ S-T or L-T / Gain(Loss) Blue stock / 11/10/18 03/12/19 / $3,000 / $6,000 / S-T / $3,000 Purple stock / 12/13/17 / 05/23/19 / $36,000 / $32,000 / L-T / ($4,000) Beige stock / 12/14/14 / 07/14/19 / $13,000 / $14,500 / L-T / $1,500 Red stock / 06/29/18 / 05/18/19 / $26,000 / $27,000 / S-T / $1,000 Black stock / 05/15/18 / 10/18/19 / $67,000 /$67,800 / L-T / $800 Gray stock / 04/12/17 / 10/18/19 / $89,000 / $88,200 / L-T / ($ 800)

In a § 1031 like-kind exchange, Rafael exchanges a business building that originally cost $200,000. On the date of the exchange, the building given up has an adjusted basis of $85,000 and a fair market value of $110,000. Rafael pays $15,000 and receives a building with a fair market value of $125,000. What is the amount and character of Rafael's gain or loss?

Rafael has no recognized gain or loss. There was a realized gain of $25,000 ($110,000 value − $85,000 adjusted basis) on the property relinquished, but because no boot was received, none of the gain is recognized. However, the unrecaptured § 1250 gain (25% gain) potential of $115,000 (equal to the depreciation taken) carries over to the replacement property.

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.

Related Party

Rennie owns a video game arcade. He buys vintage video games from estates, often at much less than the retail value of the property. He usually installs the vintage video games in a special section of his video game arcade that appeals to players of "classic" video games. Recently, Rennie sold a classic video game that a customer "just had to have." Rennie paid $11,250 for it, owned it for 14 months, and sold it for $18,000. Rennie had suspected that this particular classic video game would be of interest to collectors; so he had it refurbished, put it on display in his video arcade, and listed it for sale on the internet. No customers in the arcade had played it other than those testing it before considering it for purchase. Rennie would like the gain on the sale of the classic video game to be a long-term capital gain. Did he achieve that objective? Why or why not?

Rennie wants the $6,750 gain to be a long-term capital gain, he must show objective evidence that he held the classic video game as an investment and, therefore, a capital asset. Such objective evidence might include not listing it as a depreciable asset or an inventory item on his books and records and not having had similar sales on a regular basis. Rennie does not appear to be a dealer in classic video games because he usually buys them for use in his business. For this video game, Rennie's intention seems to have been to hold it for investment. Consequently, it was a capital asset. The $6,750 gain ($18,000 amount realized − $11,250 basis) would be a long-term capital gain because the asset was held more than a year. Based on the facts available, Rennie seems to have achieved his objective.

Roger inherited 100 shares of Periwinkle stock when his mother, Emily, died. Emily had acquired the stock for a total of $60,000 on November 15, 2016. She died on August 10, 2020, and the shares were worth a total of $55,000 at that time. Roger sold the shares for $36,000 on December 22, 2020. How much gain or loss does Roger recognize? What is the nature of that gain or loss?

Roger has an adjusted basis equal to the $55,000 fair market value of the Periwinkle stock at the time of Emily's death. He has an automatic long-term holding period because the stock was inherited property. Therefore, his loss of $19,000 ($36,000 amount realized − $55,000 adjusted basis) is a long-term capital loss. See the discussion in Chapter 13 on basis of inherited property.

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.

Sale or Exchange

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).

Section 1231 gains and losses

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

Section 1231 property

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

Section 1245 property

Sheila purchases $50,000 of newly issued Gingo Corporation bonds for $45,000. The bonds have original issue discount (OID) of $5,000. After Sheila amortized $2,300 of OID and held the bonds for four years, she sold the bonds for $48,000. What is the amount and character of her gain or loss?

Sheila adds the $2,300 of OID amortization to her $45,000 cost basis for an adjusted basis of $47,300. The long-term capital gain is $700 ($48,000 amount realized − $47,300 adjusted basis).

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.

Short Sale

Siena Industries (a sole proprietorship) sold three § 1231 assets during 2020. Data on these property dispositions are as follows: Asset / Cost / Acquired / Acc. Dep. / Sold For /Sold on Rack/ $100,000/ 10/16/16/ $62,000/ $85,000/ 10/10/20 Forklift / $35,000 / 10/16/17 / $23,000 /$5,000 / 10/10/20 Bin / $87,000 / 03/12/19 / $34,000 / $60,000 / 10/10/20 a. Determine the amount and the character of the recognized gain or loss from the disposition of each asset. b. Assuming that Siena has no nonrecaptured net § 1231 losses from prior years, analyze these transactions and determine the amount (if any) that will be treated as a long-term capital gain.

Siena has $54,000 ($47,000 + $7,000) of ordinary income due to § 1245 recapture and $7,000 of § 1231 loss. Asset / Sold for / Less Adjusted Basis / Gain or Loss / Character Rack / $85,000 / $38,000 ($100,000 - $62,000) / $47,000 / All Ordinary income due 1245 recapture Forklift / $5,000 / $12,000 ($35,000 - $23,000) / ($7,000) / 1231 loss Bin / $60,000 / $53,000 ($87,000 - $34,000) / $7,000 / All ordinary income due 1245 recapture b. Siena does not have a net § 1231 gain (it has a net § 1231 loss). As a result, none of the gains are treated as capital gains.

Harriet, who is single, is the owner of a sole proprietorship. Two years ago, Harriet developed a process for preserving doughnuts that gives the doughnuts a much longer shelf life. The process is not patented or copyrighted, and only Harriet knows how it works. Harriet has been approached by a company that would like to buy the process. Harriet insists that she receive a long-term employment contract with the acquiring company as well as be paid for the rights to the process. The acquiring company offers Harriet a choice of two options: (1) $650,000 in cash for the process and a 10-year covenant not to compete at $65,000 per year or (2) $650,000 in cash for a 10-year covenant not to compete and $65,000 per year for 10 years in payment for the process. Which option should Harriet accept? What is the tax effect on the acquiring company of each approach?

Since the process is not patented, it does not qualify for capital gain treatment under § 1235. Section 1221 specifically excludes such processes from capital asset status, so whichever alternative Harriet accepts, she will have ordinary income from both the portion of the payment from sale of the process and the covenant not to compete. Therefore, she should make her decision based on other factors such as the creditworthiness of the buyer. For the acquirer, both payments are § 197 intangible assets that must be capitalized and amortized over 15 years.

Tan Corporation purchased depreciable tangible personal property for $100,000 in 2018 and immediately expensed the entire cost under § 179. In 2020, when the property was worth $80,000, Tan distributed it as a dividend to the corporation's sole shareholder. What was the tax status of this property for Tan? What is the nature of the recognized gain or loss from the distribution of the property?

Tan's distribution of the property as a dividend to its shareholder is a taxable transaction for Tan. Tan had a zero adjusted basis for the property; it took $100,000 (the property's cost) of deprecation on the property. The entire $80,000 fair market value at the date of distribution is taxable as ordinary income due to § 1245 depreciation recapture.

In 2020, Bertha Jarow had a $28,000 loss from the sale of a personal residence. She also purchased a patent on a rubber bonding process from an individual inventor for $7,000 (and resold it in two months for $18,000). The patent had not yet been reduced to practice. Bertha purchased the patent as an investment. In addition, she had the following capital gains and losses from stock transactions: *Long-term Capital Loss: ($6,000) *Long-term Capital loss carryover from 2019: ($12,000) *Short-term Capital Gain: $21,000 *Short-term Capital Loss: ($7,000) What is Bertha's net capital gain or loss?

The $28,000 loss on the sale of the personal residence is not deductible because it is a loss on the sale or exchange of a personal use asset. The patent is subject to automatic long-term capital treatment because an unrelated party purchased it from the individual creator; the invention had not yet been reduced to practice; and when Bertha sold it, she transferred all rights to the patent. Thus, under § 1235, the $11,000 ($18,000 sale price − $7,000 cost) gain on her sale of the patent is a long-term capital gain. Patent LTCG: $11,000 - 2020 stock LTCL: (6,000) - 2019 LTCL carryover: (12,000) = Net LTCL ($ 7,000) STCG: $21,000 - STCL: (7,000) = Net STCG: $14,000 Net STCG ($14,000 − $7,000): $7,000

Dedriea contributes to her wholly owned corporation some tangible personal property she had used in her sole proprietorship business and depreciated. She had acquired the property for $566,000 and had taken $431,000 of depreciation on it before contributing it to the corporation. At the date of the contribution, the property had a fair market value of $289,000. The corporation took $100,000 of depreciation on the property and then sold it for $88,000 in 2020. What are the tax status of the property to the corporation and the nature of the recognized gain or loss when the corporation sells the property?

The corporation has a carryover of Dedriea's basis and depreciation recapture potential because this is a "tax-free" incorporation contribution. The property had an adjusted basis of $135,000 ($566,000 cost − $431,000 depreciation) at the date of contribution. It had an adjusted basis of $35,000 ($135,000 − $100,000 corporate depreciation) at the time of its sale. The $53,000 gain ($88,000 − $35,000) is all recaptured as ordinary income by § 1245.

On May 2, 1990, Hannah Weather (Social Security number: 111-22-3333) acquired residential real estate for $450,000. Of the cost, $100,000 was allocated to the land and $350,000 to the building. On August 20, 2019, the building, which then had an adjusted basis of $0, was sold for $545,000 and the land for $200,000. a. Determine the amount and character of the recognized gain from the sale of the building. b. Determine the amount and character of the recognized gain from the sale of the land.

The gain on the sale of the building is not subject to § 1250 depreciation recapture because it is residential real estate acquired after 1986 (and on which no accelerated depreciation was taken; straight-line depreciation was used). The gain from the sale is $545,000, $0 is ordinary income due to § 1250, and there is $545,000 § 1231 gain. The unrecaptured § 1250 gain is $350,000 because that is the depreciation taken, and $350,000 is less than the gain recognized. Selling price of building: $545,000 - August 20,2019 Adj. Basis (Cost of building $350,000 - 1990-2018 depreciation (1.000 × $350,000) (350,000)) (-0-) = Gain on sale $545,000 b. The land is also a § 1231 asset because it was part of the residential real estate. However, it was not depreciated. The § 1231 gain from the sale of the land is $100,000 ($200,000 selling price − $100,000 adjusted basis).

Anna received tangible personal property with a fair market value of $65,000 as a gift in 2018. The donor had purchased the property for $77,000 and had taken $77,000 of depreciation. Anna used the property in her business. Anna sells the property for $23,000 in 2020. What are the tax status of the property and the nature of the recognized gain when she sells the property?

The property is a § 1231 asset for Anna because it is depreciable property used in her business and held more than a year. At the time of the gift to Anna, the property has § 1245 depreciation recapture potential equal to the depreciation taken by the donor of $77,000. Anna could not depreciate the property because the carryover basis to her was zero. When she sells the property for $23,000, the entire gain is § 1245 depreciation recapture gain because of the "taint" when she received the property.

Miguel receives tangible personal property as an inheritance in 2018. The property was depreciated by the deceased (Miguel's father), and Miguel will also depreciate it. At the date of the deceased's death, the property was worth $532,000. The deceased had purchased it for $900,000 and taken $523,000 of depreciation on the property. Miguel takes $223,000 of depreciation on the property before selling it for $482,000 in 2020. What are the tax status of the property and the nature of the recognized gain when Miguel sells the property?

The property is a § 1231 asset for Miguel because it is depreciable property used in his business and is held more than a year. Miguel's basis for the asset is its fair market value at the date of his father's death, or $532,000. The father's depreciation recapture taint is extinguished at the father's death. However, Miguel takes $223,000 of the depreciation after acquiring the property. Miguel has a gain of $173,000 [$482,000 sales price in 2020 − ($532,000 basis equal to fair market value at father's death − $223,000 depreciation taken by Miguel)], $173,000 of which is treated as ordinary income due to § 1245 and zero § 1231 gain.

Larry is the sole proprietor of a trampoline shop. During 2020, the following transactions occurred: *Unimproved land adjacent to the store was condemned by the city on February 1. The condemnation proceeds were $15,000. The land, acquired in 1987, had an allocable basis of $40,000. Larry has additional parking across the street and plans to use the condemnation proceeds to build his inventory. *A truck used to deliver trampolines was sold on January 2 for $3,500. The truck was purchased on January 2, 2016, for $6,000. On the date of sale, the adjusted basis was zero. *Larry sold an antique rowing machine at an auction. Net proceeds were $4,900. The rowing machine was purchased as used equipment 17 years ago for $5,200 and is fully depreciated. *Larry sold an apartment building for $300,000 on September 1. The rental property was purchased on September 1, 2017, for $150,000 and was being depreciated over a 27.5-year life using the straight-line method. At the date of sale, the adjusted basis was $124,783. *Larry's personal yacht was stolen on September 5. The yacht had been purchased in August at a cost of $25,000. The fair market value immediately preceding the theft was $19,600. Larry was insured for 50% of the original cost, and he received $12,500 on December 1. *Larry sold a Buick on May 1 for $9,600. The vehicle had been used exclusively for personal purposes. It was purchased on September 1, 2016, for $20,800. *Larry's trampoline stretching machine (owned two years) was stolen on May 5, but the business's insurance company will not pay any of the machine's value because Larry failed to pay the insurance premium. The machine had a fair market value of $8,000 and an adjusted basis of $6,000 at the time of theft. *Larry had AGI of $102,000 from sources other than those described above. *Larry has no nonrecaptured § 1231 lookback losses. a. For each transaction, what are the amount and nature of recognized gain or loss? b. What is Larry's 2020 AGI?

a. Land: Condemnation proceeds: $15,000 - Allocable basis: (40,000) = Realized and recognized § 1231 loss: ($25,000) Truck: Depreciation taken: $6,000 ($6,000 − $0) Adjusted basis: $0 Realized gain: $3,500 − $0 = $3,500 Recognized gain: $3,500 ordinary income under § 1245 Rowing machine: Realized and recognized gain = Amount realized − Adjusted basis of machine on date of sale = $4,900 - $0 = $4,900. Section 1245 recapture = Amount of depreciation claimed ($5,200) or gain recognized ($4,900), whichever is less = $4,900. Apartment building: Realized gain = Amount realized − Adjusted basis = $300,000 - $124,783 = $175,217. Section 1231 gain recognized = $175,217. No § 1250 recapture is recognized because the taxpayer used the straight-line method of depreciation. Of the $175,217 § 1231 gain, $25,217 is unrecaptured § 1250 gain because the depreciation taken of $25,217 ($150,000 cost − $124,783 basis) is less than the $175,217 recognized gain. Yacht: Personal use property casualty loss = Fair market value at date of theft − Insurance proceeds = $19,600 − $12,500 = $7,100. Personal use property casualty losses are not deductible unless they offset personal use property casualty gains and/or are losses arising in a Federal disaster area. As a result, the loss on the yacht is not deductible. Auto: Realized loss = Amount realized − Adjusted basis = $9,600 − $20,800 = $11,200. The loss relates to a personal use asset. Therefore, it is not recognized. Trampoline stretching machine: $6,000 business casualty loss is deductible for AGI. The casualty loss is measured by the adjusted basis of the property at the time of the theft. There is no $100 or 10%-of-AGI floor for a business casualty. Item / Recognized gain/loss / Section 1245 Recapture / Casualty and Theft Loss / Section 1231 Gain Land: ($25,000) / - / - / ($25,000) Truck: $3,500 / $3,500 / - / 0 Rowing Machine: $4,900 / $4,900 / - / - Building $175,217 / - / ($71,000) / - Yacht: ($7,100) / - / ($7,100) / - Auto: -0- / - / - / - Stretching Machine: ($6,000) / - / ($6,000) / - Section 1245 Recapture: $8,400 Ordinary Income Casualty and Theft Loss: $6,000 Net business loss for AGI; no net personal loss from AGI* Section 1231 Gain: Gain: Received LTCG Treatment: $150,217** Adjusted gross income computation: Other sources: $102,000 + Ordinary income from depreciation recapture, as above: 8,400 + Long-term capital gain, as above: 150,217 - Business casualty loss, as above: (6,000) = Adjusted gross income: $254,617 *None of the personal use activity property casualty loss is deductible from AGI because the loss did not occur in a Federal disaster area and there is no personal use property casualty gain to offset the loss. **Of the $150,217 § 1231 gain, $25,217 is unrecaptured § 1250 gain because according to the 2019 Form 1040, Schedule D instructions, if the net § 1231 gain is greater than the potential unrecaptured § 1250 gain, all of the unrecaptured § 1250 gain is in the § 1231 gain that is carried from Form 4797 to line 11 of the 2019 Form 1040, Schedule D. Thus, the $150,217 § 1231 gain is comprised of $25,217 of unrecaptured § 1250 gain and $125,000 of 0%/15%/20% gain. References are to the 2019 tax forms because the 2020 forms were not yet available.

Shannon owns two items of business equipment. Both were purchased in 2016 for $100,000, both have a 7-year MACRS recovery period, and both have an adjusted basis of $37,490. Shannon is considering selling these assets in 2020. One of them is worth $60,000, and the other is worth $23,000. Because both items were used in her business, Shannon simply assumes that the loss on one will offset the gain from the other and that the net gain or loss will increase or reduce her business income. What is the amount and character of Shannon's gain or loss?

To handle this transaction properly, Shannon must determine the following: •The tax status of the property (§ 1231 asset, capital asset, or ordinary asset). •The applicability of § 1245 depreciation recapture. •The outcome of the § 1231 netting process. Both assets are § 1231 assets. Section 1245 depreciation recapture causes the entire gain of $22,510 ($60,000 − $37,490) to be taxed as ordinary income because the selling price does not exceed the $100,000 original cost of the asset. Because the loss of $14,490 ($23,000 − $37,490) on the other asset is the only § 1231 gain or loss, there is a net loss of $14,490 that is treated as an ordinary loss. Consequently, Shannon is partially correct: the $22,510 gain from one of the items does offset the $14,490 loss from the other item. However, these transactions are reported separately from her 2020 business income. The $8,020 net gain increases adjusted gross income on her 2020 tax return.

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.

Unrecaptured § 1250 gain

Fred is an investor in vacant land. When he thinks he has identified property that would be a good investment, he approaches the landowner, pays the landowner for a "right of first refusal" to purchase the land, records this right in the property records, and then waits to see if the land increases in value. The right of first refusal is valid for four years. Fourteen months ago, Fred paid a landowner $9,000 for a right of first refusal. The land was selected as the site of a new shopping center, and the landowner was offered $1,000,000 for the land. In its title search on the land, the buyer discovered Fred's right of first refusal and involved him in the purchase negotiations. Ultimately, the landowner paid Fred $220,000 to give up his right of first refusal; the landowner then sold the land to the buyer for $4,220,000. Fred has a marginal tax rate of 37%. a. What difference does it make whether Fred treats the right of first refusal as an option to purchase the land? b. What difference does it make whether Fred is a "dealer" in land?

a. An option usually sets the price at which the grantee (Fred) can buy the property, and the option expires after a specified period of time. The right of first refusal did not specify a price at which Fred could buy the property. Generally, the grantee's sale or exchange of the option results in capital gain if the option property is (or would be if purchased) a capital asset to the grantee. Thus, if Fred treats the right of first refusal as an option, he will have a holding period that exceeds one year and will have $211,000 ($220,000 proceeds from sale of the right of first refusal − $9,000 adjusted basis) of long-term capital gain. If the amount paid for the right of first refusal is not an asset whose holding period began 14 months ago, then Fred either has an ordinary gain of $211,000 or has a short-term capital gain of $211,000. Therefore, it is best to treat the right of first refusal as an option and get long-term capital gain treatment. b. If Fred is a dealer in land, then the right of first refusal is an ordinary asset because the land would be an ordinary asset if Fred purchased it. Instead of being taxed no higher than 20% on a long-term capital gain, Fred has $211,000 of ordinary income.

On June 1, 2016, Skylark Enterprises, a calendar year LLC reporting as a sole proprietorship, acquired a retail store building for $500,000 (with $100,000 being allocated to the land). The store building was 39-year real property, and the straight-line cost recovery method was used. The property was sold on June 21, 2020, for $385,000. a. Compute the cost recovery and adjusted basis for the building using Exhibit 8.8 from Chapter 8. b. What are the amount and nature of Skylark's gain or loss from disposition of the property? What amount, if any, of the gain is unrecaptured § 1250 gain?

a. Building cost: $400,000 * total recovery rate (2016 cost recovery rate: 0.01391 + 2017 cost recovery rate: 0.02564 + 2018 cost recovery rate: 0.02564 + 2019 cost recovery rate: 0.02564 + 2020 cost recovery rate (0.02564 × 5.5/12): 0.01175): 0.10258 = Total cost recovery $41,032 Adjusted basis of building ($400,000 − $41,032): $358,968 b. Selling price $385,000 - Adjusted basis ($358,968 building + $100,000 land) : (458,968) = Recognized loss ($73,968) Because the retail store building was real estate used in business, it is a § 1231 asset. Since the property was sold for a loss, there is no unrecaptured § 1250 gain. All of the loss is a § 1231 loss.

Copper Industries (a sole proprietorship) sold three § 1231 assets during 2020. Data on these property dispositions are as follows: Asset / Cost / Acquired / Acc. Dep. / Sold for / Sold on Rack/ $110,000 / 10/10/17 / $70,000 /$55,000 / 10/10/20 Forklift / 45,000 / 10/16/19 / 21,000 /15,000 / 10/10/20 Bin / 97,000 / 03/12/19 / 31,000 / 60,000 / 10/10/20 a. Determine the amount and the character of the recognized gain or loss from the disposition of each asset. b. Assuming that Copper has $6,000 nonrecaptured net § 1231 losses from prior years, analyze these transactions and determine the amount (if any) that will be treated as a long-term capital gain.

a. Copper has $15,000 of ordinary income due to § 1245 recapture and $15,000 of § 1231 loss. Asset / Sold For / Less Adj. Basis / Gain or Loss / Character Rack / $55,000 / $40,000 ($10,000-$70,000) / $15,000 / All ordinary income due to 1245 recapture Forklift / $15,000 / $24,000 ($45,000 - $21,000) / ($9,000) / 1231 loss Bin / $60,000 / $66,000 ($97,000-$31,000) / ($6,000) / 1231 loss b. Because Copper has a $15,000 ($9,000 + $6,000) net § 1231 loss, there is no gain to be treated as capital gain. The $15,000 § 1245 depreciation recapture gain is treated as ordinary income, and the $15,000 net § 1231 loss is treated as an ordinary loss deduction for AGI.

On January 1, 2011, Stephanie Bridges acquired depreciable real property for $50,000. She used straight-line depreciation to compute the asset's cost recovery. The asset was sold for $96,000 on January 3, 2020, when its adjusted basis was $38,000. a. What are the amount and nature of the gain if the real property is residential? b. Stephanie is curious about how the recapture rules differ for tangible personal property and for residential rental real estate acquired in 1987 and thereafter.

a. If the property is residential real property, the gain is § 1231 gain. Selling price: $96,000 - Adjusted basis: (38,000) = Recognized § 1231 gain: $58,000 Of the $58,000 § 1231 gain, $12,000 is unrecaptured § 1250 gain because the $12,000 of depreciation taken is less than the $58,000 § 1231 gain. b. Tangible personal property depreciation subjects any gain on the property's disposition to tax as ordinary income (to the extent of the depreciation taken). There is generally no depreciation recapture (i.e., reclassifying gains as ordinary income) for residential rental real estate acquired in 1987 (and later years).

Maria meets all of the requirements of § 1237 (subdivided realty). In 2020, she begins selling lots and sells four separate lots to four different purchasers. She also sells two contiguous lots to another purchaser. The sales price of each lot is $30,000. Maria's basis for each lot is $15,000. Selling expenses are $500 per lot. a. What are the realized and recognized gain? b. Explain the nature of the gain (i.e., ordinary income or capital gain). c. Would your answers change if, instead, the lots sold to the fifth purchaser were not contiguous? If so, how?

a. Sales price (6 lots × $30,000): $180,000 - Sales expenses (6 lots × $500): (3,000) = Amount realized $177,000 - Less: Basis (6 lots × $15,000): (90,000) = Realized and recognized gain $87,000 b. The entire $87,000 is long-term capital gain from the sale of the first five lots. Contiguous or adjacent lots sold to a single purchaser are considered to be one lot. Thus, under § 1237, five lots (not six) were sold. c. If the two lots sold to the fifth purchaser were not contiguous, the total lots sold would be six rather than five. Because Maria has now sold six or more lots, 5% of the total selling price of all the lots sold in 2020 is treated as ordinary income. This ordinary income is offset by any selling expenses associated with selling the lots. 5% of the sale price of all the lots: $9,000 - Sales expenses (3,000) = Ordinary income: $6,000 The remaining $81,000 recognized gain is long-term capital gain.

George is the owner of numerous classic automobiles. His intention is to hold the automobiles until they increase in value and then sell them. He rents the automobiles for use in various events (e.g., antique automobile shows) while he is holding them. In 2020, he sold a classic automobile for $1,500,000. He had held the automobile for five years, and it had a tax basis of $750,000. a. Was the automobile a capital asset? Why or why not? b. Assuming a rate of return of 7%, how much would he have had to invest five years ago (instead of putting $750,000 into the car) to have had $1,500,000 this year? See Appendix G for the present value factors.

a. Section 1221 defines what is not a capital asset. Included on the list is depreciable property or real estate used in a business. Renting the automobiles is treated as a business. Therefore, even though George is holding the property for appreciation (an investment motive), it is not a capital asset. See text Section 14-8 for further details on the proper characterization of the $750,000 gain from the disposition of the automobile. b. The present value of $1,500,000 five years from now discounted at 7% is $1,069,500 ($1,500,000 × 0.7130; see Appendix G).

Jasmine owned rental real estate that she sold to her tenant in an installment sale. Jasmine acquired the property in 2008 for $400,000; took $178,000 of depreciation on it; and sold it for $210,000, receiving $25,000 immediately and the balance (plus interest at a market rate) in equal payments of $18,500 for 10 years. a. What is the nature of the recognized gain or loss from this transaction? b. Assuming that the interest rate on the installment contract is 5%, what is the present value of the installment payments? See Appendix G for present value factors

a. The property is a § 1231 asset because it was depreciable real property used in the business of rental. There is a § 1231 loss of $12,000 [$210,000 sales price − ($400,000 cost − $178,000 depreciation)] on the disposition. Jasmine will not use the installment method for this transaction because that method is only used to postpone realized gains. The $12,000 § 1231 loss is recognized in the year of the sale. b. Even though the installment method is not used for tax purposes, Jasmine still receives the $18,500 payments for ten years. If the interest rate is 5%, she has a 10-year annuity and its present value is $142,851.45 [$18,500 × 7.7217 (Appendix G: Present Value of an Ordinary Annuity of $1; 5% for 10 periods)].

Melaney has had a bad year with her investments. She lent a friend $8,000; the friend did not repay the loan when it was due and then declared bankruptcy. The loan is totally uncollectible. Melaney also was notified by her broker that the Oak corporate bonds she owned became worthless on October 13, 2020. She had purchased the bonds for $22,000 on November 10, 2019. Melaney also had a $60,000 loss on the disposition of § 1244 corporate stock that she purchased several years ago. Melaney is single. a. What are the nature and amount of Melaney's losses? b. What is Melaney's AGI for 2020 assuming that she has $65,000 of ordinary gross income from sources other than those discussed? c. What are the nature and amount of Melaney's loss carryforwards?

a. When Melaney made the loan to a friend, she had a nonbusiness receivable. When the loan is not repaid, she has an $8,000 nonbusiness bad debt, assuming that the debt is a bona fide debt. The $8,000 is treated as a short-term capital loss no matter how long Melaney held the loan. Whether the receivable was a capital asset and whether its holding period was long or short term are not relevant because the Code defines the loss as a short-term capital loss. Melaney also is the holder of a worthless bond. The bond is deemed to have become worthless on the last day of 2020—the year in which it became worthless. Melaney's holding period for the bond is long term because the time period from November 10, 2019, through December 31, 2020, is more than one year. The $22,000 loss on the bond is a long-term capital loss. The $60,000 loss on the § 1244 stock is a $50,000 ordinary loss deductible forAGI ($50,000 is the annual maximum for an unmarried taxpayer) and a $10,000 long-term capital loss. b. Melaney's adjusted gross income is $12,000 [$65,000 − $3,000 (capital loss deduction) − $50,000 (§ 1244 ordinary loss deduction)]. c. Because short-term capital losses are used first to make up the capital loss deduction, Melaney has a $5,000 ($8,000 − $3,000) short-term capital loss carryforward and a $32,000 long-term capital loss carryforward.

Barbella purchased a wedding ring for $15 at a yard sale in May. She thought the ring was costume jewelry, but it turned out to be a real diamond ring. She is not in the business of buying and selling anything. She researched the ring on the internet and discovered that it was worth at least $1,000. She sold it on an internet auction site for $1,100 in July. Was the ring a capital asset? What were the amount and nature of the gain or loss from its sale by Barbella?

arbella originally purchased the ring as a personal use asset. However, when she discovered that it had value, her intention changed and she began to hold it as an investment. Either way, the asset is a capital asset because personal use assets and investment assets are capital assets. She held the ring for a year or less. So her $1,085 gain ($1,100 amount realized − $15 adjusted basis) is short-term capital gain. The ring is not inventory (and, as a result, not an ordinary asset) because Barbella is not in the business of buying and selling rings.

Keshara has the following net § 1231 results for each of the years shown. What would be the nature of the net gains in 2019 and 2020? 2015: Net 1231 Loss: $18,000 2016: Net 1231 Loss: $33,000 2017: Net 1231 Loss: $42,000 2018: Net 1231 Gain: $41,000 2019: Net 1231 Gain: $30,000 2020: Net 1231 Gain: $41,000

et § 1231 gains must jump a final hurdle before being netted with capital transactions. The net § 1231 gain must exceed the sum of nonrecaptured net § 1231 losses recognized in the five most recent preceding years. The years 2015 through 2017 have a combined nonrecaptured net § 1231 loss of $93,000. The $93,000 nonrecaptured § 1231 loss is partially absorbed by the 2018 $41,000 § 1231 gain and the 2019 $30,000 § 1231 gain. Thus, $22,000 of the nonrecaptured § 1231 loss remains for offset against the 2020 $41,000 § 1231 gain. Net 1231 Loss Subject to recapture / Before Look back: Cutten year net 1231 Gain / Ordinary income / Net 1231 Gain treated as long-term capital gain 2015-2017: ($93,000)-Net 1213 Loss Sub. to recapture + 2018: 41,000 / 41,000 / 41,000 /0 = Remaining Potential to recapture: ($52,000) + 2019: $30,000 / $30,000 / $30,000 / 0 = Remaining potential recapture: ($22,000) + 2020: $22,000 / $41,000 / $22,000 / $19,000 = TOTALS: 0 / $112,000 / $93,000 / $19,000 In summary, the 2019 and 2020 net § 1231 gains are affected by the § 1231 lookback rule. The 2019 net § 1231 gain of $30,000 is treated as ordinary income. The 2020 net § 1231 gain of $41,000 is treated as $22,000 of ordinary income and $19,000 of net § 1231 gain (and long-term capital gain).

Jay sold three items of business equipment for a total of $300,000. None of the equipment was appraised to determine its value. Jay's cost and adjusted basis for the assets are shown below. Asset / Cost / Adj. Basis Skidder / $230,000 / $40,000 Driller / $120,000 / $60,000 Platform / $620,000 / $0 TOTAL: Cost: $970,000 and Adj. Basis: $100,000 Jay has been unable to establish the fair market values of the three assets. All he can determine is that combined they were worth $300,000 to the buyer in this arm's length transaction. How should Jay allocate the sales price and figure the gain or loss on the sale of the three assets?

he key to this problem is that all equipment depreciation taken is subject to recapture as ordinary income due to § 1245. However, if the equipment is sold for more than was paid for it, the excess of the selling price over the original cost is § 1231 gain. There appears to be three ways to allocate the purchase price. (1) Subtract the $100,000 total adjusted basis from the $300,000 selling price to yield a $200,000 gain. Because total depreciation on the three assets exceeds $200,000, all of the gain is § 1245 gain. (2) Allocate the $300,000 selling price to each asset based on its relative original cost. For instance, the driller would be sold for $37,113 ($120,000/$970,000 × $300,000). The gains and losses using this approach are shown below. Asset / Allocated Sales Price / Adj. Basis / Gain Skidder / $71,134 / $40,000 / $31,134 Driller / $37,113 / $60,000 / ($22,887) Platform / $191,753 / -0- / $191,753 TOTALS: Allocated Sales Price: $300,000, Adj. Basis: $100,000, Gain: $200,000 All of the $31,134 gain would be § 1245 gain because the skidder cost $230,000 and was "sold" for $71,134. The $22,887 loss on the driller would be a § 1231 loss. All of the $191,753 gain on the platform would be § 1245 gain because it cost $620,000 and was "sold" for $191,753. (3) Allocate the $300,000 selling price to each asset based on its relative adjusted basis. For instance, the driller would be sold for $180,000 ($60,000/$100,000 × $300,000). The gains using this approach are shown below: Asset / Allocated Sales Price / Adj. Basis / Gain Skidder / $120,000 / $40,000 / $80,000 Driller / $180,000 / $60,000 / $120,000 Platform / -0- / -0- / -0- TOTALS: Allocated SAles Price: $300,000, Adjusted Basis: $100,000, Gain: $200,000 All of the $80,000 skidder gain would be § 1245 gain because the skidder cost $230,000 and was "sold" for $120,000. The $120,000 gain on the driller would be a $60,000 § 1245 gain (equals depreciation taken) and a $60,000 § 1231 gain (equals excess of sales price over original cost of $120,000). The sale of the platform would generate no gain or loss because it was "sold" for nothing and the adjusted basis was $0.

Bridgette is known as the "doll lady." She started collecting dolls as a child, always received one or more dolls as gifts on her birthday, never sold any dolls, and eventually owned 600 dolls. She is retiring and moving to a small apartment and has decided to sell her collection. She lists the dolls on an internet auction site and, to her great surprise, receives an offer from another doll collector of $45,000 for the entire collection. Bridgette sells the entire collection, except for five dolls she purchased during the last year. She had owned all of the dolls sold for more than a year. What tax factors should Bridgette consider in deciding how to report the sale?

he tax factors Bridgette must consider include (1) the tax status of the dolls, (2) the tax basis for the dolls, (3) the holding period for the dolls, and (4) whether the dolls are "collectibles." The tax status of the dolls is clearly capital asset because they were either personal use assets or investment assets. The tax basis of the dolls will be very hard to determine because Bridgette has owned many of them for a long time and/or she received them as gifts. However, the tax basis must be established somehow; otherwise, she will have to treat them as having no tax basis and the entire $45,000 sale proceeds will be treated as a gain. In addition, some of the dolls may have been disposed of at a loss, and if the dolls are personal use assets, the loss is nondeductible. The gain is long-term capital gain because all the dolls sold were held for more than one year. If the dolls are collectibles, the alternative tax rate on the long-term capital gain is 28%. If they are not collectibles, the alternative tax rate on the long-term capital gain is 0%/15%/20%. From a tax perspective, most of the dolls are probably not collectibles. Although Bridgette (and the buyer) certainly think the dolls are beautiful, they are not a "work of art" or "historical objects"—although some of them could be.

For 2020, Wilma has properly determined taxable income of $36,000, including $3,000 of unrecaptured § 1250 gain and $8,200 of 0%/15%/20% gain. Wilma qualifies for head-of-household filing status. Compute Wilma's tax liability and the tax savings from the alternative tax on net capital gain.

ilma has $24,800 of other taxable income [$36,000 taxable income − $3,000 unrecaptured § 1250 gain (25% gain) − $8,200 (0%/15%/20% gain)]. The 0% alternative rate applies because Wilma's taxable income puts her below the breakpoint for the 0% rate ($53,600 in 2020). The liability is $3,054 computed as shown below. Tax on $24,500 of other taxable income [$36,000 taxable income - $3,000 unrecaptured 1250 gain (25% gain) - $8,200 (0%/15%/20% gain)] The 0% alternative rate applies because Wilma's taxable income puts her below the breakpoint for the 0% rate ($53,600 in 2020). the liability is $3,054 computed as shown below: Tax on $24,800 other taxable income ($36,000 TI − $3,000 25% gain − $8,200 0%/15%/20% gain) from 2020 Head of household Tax Rate Schedule: $2,694 + 12% tax on $3,000 25% gain (regular tax rate is used because it is lower than the alternative tax rate): $360 + % tax on $8,200 0%/15%/20% gain (alternative tax rate of 0% is lower than the regular tax rate of 12%): 0 = Total tax liability using the alternative tax calculation: $3054 - Regular tax liability on $36,000 TI: (4,038) = Tax Savings from alternative tax computation: ($984)

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).

intangible drilling and development costs (IDCs)