tax: ch. 16
Often, the only business asset that is a capital asset is
"self-generated" goodwill (purchased goodwill is a § 1231 asset).
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.
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.
As a result, the maximum effective tax rate on gains from the sale of qualified small business stock is
0 percent (28% × 0%), 7 percent (28% × 25%), or 14 percent (28% × 50%).
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.
The exclusion amount varies, depending on when the qualified small business stock was acquired.
100 percent of the gain is excluded for qualified stock acquired after September 27, 2010. 75 percent of the gain is excluded for qualified stock acquired after February 17, 2009, and before September 28, 2010. 50 percent of the gain is excluded for qualified stock acquired before February 18, 2009.
If the taxpayer has a net long-term capital gain that includes either
28% or 25% long-term capital gain, then the alternative tax is calculated using the Schedule D Tax Worksheet from the Schedule D instructions.
Six possibilities exist for the result after all possible netting has been completed.
A net long-term capital gain (NLTCG). A net short-term capital gain (NSTCG). Both NLTCG and NSTCG. A net long-term capital loss (NLTCL). A net short-term capital loss (NSTCL). Both NLTCL and NSTCL.
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.
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.
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 $78,750 or less for married persons filing jointly). Certain high-income taxpayers (e.g., taxable income of more than $488,850 for married persons filing jointly) have an alternative tax rate of 20 percent. § 1(h).
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.
For capital gain or loss purposes, collectibles include:
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.).
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.
The information shown in Parts I and II comes from Form 8949 (Sales and Other Dispositions of Assets). Form 8949 is used to accumulate gains and losses from three sources:
Capital gain and loss transactions for which a Form 1099-B (Proceeds from Broker and Barter Exchange Transactions) has been received and the provider of the form had information on the sales proceeds and the tax basis of the assets disposed of.
2
Capital gain and loss transactions for which a Form 1099-B has been received and the provider of the form had information on the sales proceeds but did not have information on the tax basis of the assets disposed of.
3
Capital gain and loss transactions for which a Form 1099-B was not received
The Code provides special holding period rules for short sales. 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.
Unrecaptured sec. 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.
1
Group all gains and losses into four groups: short term, and 28%, 25%, and 0%/15%/20% long term.
Lease cancellation payments received by a lessee are treated as an exchange.Footnote 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.
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.
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.Footnote 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. Certain U.S. government publications. Supplies used in a business.
2
Net the gains and losses within each group.
3
Offset the net 28% and net 25% amounts if they are of opposite sign.
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.
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.
2 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
Lessee
One who rents property from another. In the case of real estate, the lessee is also known as the tenant.
Lessor
One who rents property to another. In the case of real estate, the lessor is also known as the landlord.
ntent also matters. What happens when a taxpayer who normally does not 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
In most settings, short sale gain or loss results in a capital gain or loss. The gain or loss
s 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.
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
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.
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
Qualified small business stock
Stock in a qualified small business corporation, purchased as part of an original issue after August 10, 1993. The shareholder may exclude from gross income 100 (or 50 or 75) percent of the realized gain on the sale of the stock if he or she held the stock for more than five years. The exclusion percentage depends on when the stock was acquired. § 1202.
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.
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).
Capital gains
The gain from the sale or exchange of a capital asset.
Capital losses
The loss from the sale or exchange of a capital asset.
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.
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.
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.
Given this very favorable treatment, Congress wanted to ensure that the gain exclusion only applied in very specific situations. As a result, they imposed the following restrictions:
The stock must have been newly issued after August 10, 1993, by a regular corporation, not a Subchapter S corporation. The taxpayer selling the stock must not be a corporation (either regular or Subchapter S). The taxpayer must have held the stock more than five years. The issuing corporation must use at least 80 percent of its assets, determined by their value, in the active conduct of a trade or business. When the stock was issued, the issuing corporation's assets must not have exceeded $50 million at adjusted basis, including the proceeds of the stock issuance. The corporation does not engage in banking, financing, insurance, investing, leasing, farming, mineral extraction, hotel or motel operations, restaurant operations, or any business whose principal asset is the reputation or skill of its employees (such as accounting, architecture, health, law, engineering, or financial services).
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 2019, the 0 percent alternative rate applies only through $78,750 of taxable income for married taxpayers filing jointly or surviving spouses, $52,750 for heads of household, and $39,375 for single taxpayers and married taxpayers filing separately. This means that in 2019, the last $200 (married, filing jointly and surviving spouses) or $100 (single; head of household; and married, filing separately) in the 12 percent bracket is subject to the 15 percent alternative rate. Since the normal tax rate (12 percent) is less than the alternative tax rate (15 percent), for these $200 or $100 ranges, any net capital gain or QDI will be taxed at 12 percent (rather than 15 percent). These threshold amounts are adjusted annually for inflation.
2
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 2019, the 15 percent tax rate applies until taxable income exceeds $488,850 for married taxpayers filing jointly, $461,700 for heads of household, $434,550 for single taxpayers, and $244,425 for married taxpayers filing separately. These threshold amounts are adjusted annually for inflation (in 2018, these amounts were $479,000, $452,400, $425,800, and $239,500, respectively).
3
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, but 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).Footnote 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.Footnote Individuals may carry forward unused capital losses indefinitely, but there is no carryback.
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
Accounts and notes receivable are often created as part of
a business transaction. These assets may be collected by the creditor, be sold by the creditor, or become completely or partially worthless. Also, the creditor may be on the accrual or cash basis of accounting.
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.
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.
Consequently, the collection of the redemption value may result in
a loss or gain. Generally, the collection of a debt obligation is treated as a sale or exchange. Therefore, any loss or gain can be a capital loss or capital gain because a sale or exchange has taken place.
When the long-term capital gain exceeds short-term capital loss,
a net capital gain (NCG) exists.
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.
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, 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.
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.
Frequently, a potential buyer of property wants some time to make the purchase decision but wants to control the sale and/or the sale price in the meantime. Options are used to
achieve these objectives. The potential purchaser (grantee) pays the property owner (grantor) for an option on the property. The grantee then becomes the option holder. The option, which usually sets a price at which the grantee can buy the property, expires after a specified period of time.
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.
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.
Because there are both short- and long-term capital gains and losses and because the long-term capital gains may be taxed at various rates,
an ordering procedure is required. The ordering procedure, which ensures that any long-term capital gain is taxed at the lowest preferential rate possible, includes the following steps:
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.
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.
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.
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
Gains are also eligible for nonrecognition treatment if the sale proceeds are invested in other qualified small business stock within 60 days. Any gain postponed reduces the
basis of the stock purchased. To the extent that the sale proceeds are not so invested, gain is recognized, but the exclusion still applies. To be eligible for this treatment, the stock sold must have been held more than six months
Dividends paid by domestic and certain foreign corporations are eligible to
be taxed at the 0%/15%/20% long-term capital gain rates if they are qualified dividend income (QDI)
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 (or for whom the property was created).
Depreciable personal property and real estate (both depreciable and nondepreciable) used by a
business are not capital assets. The tax law related to this property is very complex. Although business fixed assets are not capital assets, a long-term capital gain can sometimes result from their sale.
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
For example, an individual investor who owns certain stock (a capital asset) may sell a
call option, entitling the buyer of the option to acquire the stock at a specified price higher than the value at the date the option is granted.
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
Transactions that fail to satisfy any one of the applicable requirements are taxed as
capital gains (and losses) realized by noncorporate taxpayers generally.
A net capital loss (NCL) results if capital losses exceed
capital gains for the year. An NCL may be all long term, all short term, or part long and part short term.Footnote The characterization of an NCL as long or short term is important in determining the capital loss deduction (discussed next).
A special exclusion is available to noncorporate taxpayers who derive
capital gains from the sale or exchange of qualified small business stock.Footnote Any amount not excluded from income is taxed at a maximum rate of 28 percent (as noted earlier).
Since capital assets receive preferential tax treatment, taxpayers prefer
capital gains rather than ordinary gains. So the definition of a capital asset is critically important. As discussed next, this definition has been the subject of many court cases and rulings.
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.
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.
No asset is inherently
capital or ordinary.
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.
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.
These rules are intended to prevent the
conversion of short-term capital gains into long-term capital gains and long-term capital losses into short-term capital losses.
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.
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.
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").
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.Footnote Therefore, the potential benefit of carrying over capital losses diminishes when dealing with older taxpayers.
Because the Code only lists categories of what are not capital assets, judicial interpretation is sometimes required to
determine whether a specific item fits into one of those categories. 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.
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.
A grantee may sell or exchange the option rather than
exercising it or letting 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.
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 25% gain is called the unrecaptured § 1250 gain and is related to
gain from disposition of § 1231 assets (discussed in Chapter 17). Here, the discussion focuses only on how the 25% gain is taxed and not how it is determined. The 28% gain relates to collectibles and small business stock gain (both discussed later in this section).
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. A franchise transfer includes the grant of a franchise, a transfer by one franchisee to another person, or the renewal of a franchise.
Because the net capital gain and/or QDI may be made up of various rate layers, it is important to know
in what order those layers are taxed. (Review the five-step ordering procedure discussed in text Section 16-5a and the related examples.) For each of the layers, the taxpayer compares the regular tax rate on that layer of income and the alternative tax rate on that portion of the net capital gain and/or QDI.
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.
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.
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.
As a general rule, securities (stocks, bonds, and other financial instruments) held by a dealer are considered to be
inventory and are, therefore, not subject to capital gain or loss treatment. A dealer in securities is a merchant (e.g., a brokerage firm) that regularly engages in the purchase and resale of securities to customers.
The dealer must identify any securities being held for
investment. Generally, if a dealer clearly identifies certain securities as held for investment purposes by the close of business on the acquisition date, gain from the securities' sale will be capital gain.
These worksheets do not have to be filed with the tax return, but are
kept for the taxpayer's records.
Payments received by a
lessor for a lease cancellation are always ordinary income because they are considered to be in lieu of rental payments
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.
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
With proper tax planning, even a dealer may obtain
long-term capital gain treatment on the sale of property normally held for resale.
If the taxpayer has a net long-term capital gain that does not include any 28% or 25%
long-term capital gain, then the alternative tax is calculated using the Qualified Dividends and Capital Gain Worksheet from the Form 1040 instructions.
The 20% gain portion of the 0%/15%/20% gain applies to
long-term capital gains that, when coupled with other forms of taxable income, exceed the 15% gain thresholds.
Net long-term capital gains of noncorporate taxpayers are eligible for an
lternative 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 but 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
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.
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
As you might suspect, this ordering procedure can produce
many different results. The following series of examples illustrates some of these outcomes.
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.
Under several Code provisions, realized losses are disallowed. When a loss is disallowed, there is
no carryover of holding period. Losses can be disallowed under § 267 (sale or exchange between related taxpayers) and § 262 (sale or exchange of personal use assets) as well as other Code Sections. Taxpayers who acquire property in a disallowed loss transaction will have a new holding period begin and will have a basis equal to the purchase price.
A net capital loss is deductible for AGI, but limited to
no more than $3,000 per tax year. 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-term and short-term capital loss, the short-term capital loss is counted first toward the $3,000 annual limitation.
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 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.
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.
Property must be held more than
one year to qualify for long-term capital gain or loss treatment.Footnote 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
If the option is exercised, the amount paid for the option is added to the
optioned property's selling price. This increases the gain (or reduces the loss) to the grantor resulting from the sale of the property. The grantor's gain or loss is capital or ordinary depending on the tax status of the property. The grantee adds the cost of the option to the basis of the property purchased.
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.
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.
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.
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. The following example illustrates the application of § 1237.
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.
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.
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.
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.
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.
As a result, gains or losses from the sale or exchange of these assets do not
receive capital gain treatment. In limited circumstances, patents may be treated as capital assets.
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 be allocated to a covenant or to goodwill.
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.
There are several special holding period rules. The application of these
rules depends upon the type of asset and how it was acquired.
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.Footnote Several of these special rules are discussed below, including worthless securities, the retirement of corporate obligations, options, patents, franchises, and lease cancellation payments.
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:
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 loss. The total long-term loss is first offset with 28% gain of the current year, then 25% gain, and then 0%/15%/20% gain until it is absorbed.
Capital gains and losses are reported on Schedule D of Form 1040 (Capital Gains and Losses). Part I of Schedule D is used to report
short-term capital gains and losses. Part II of Schedule D is used to report long-term capital gains and losses.
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. 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
In most franchise settings, when the transferor retains
significant power or rights, both contingent (e.g., based on sales) and noncontingent payments occur.
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 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.
Even if each of these requirements is met, the amount of gain eligible for the exclusion is limited to
the greater of 10 times the taxpayer's basis in the stock or $10 million per taxpayer per company, computed on an aggregate basis.
Code § 1 contains the rules that enable the net capital gain to be taxed at special rates (0, 15, 20, 25, and 28 percent). This calculation is referred to as
the alternative tax on net capital gain.Footnote 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).
Property transactions involve
the disposition of assets.
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.
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 will normally have an ordinary asset because the patent was developed as part of its business.
As a result of the need to distinguish and separately match capital gains and losses,
the individual tax forms include very extensive reporting requirements for capital gains and losses.
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).
The benefit of the sale or exchange exception that allows a capital gain from the collection of certain obligations is reduced when
the obligation has original issue discount. Original issue discount (OID) arises when the issue price of a debt obligation is less than the maturity value of the obligation. OID must generally be amortized over the life of the debt obligation using the effective interest method. The OID amortization increases the basis of the bond.
The alternative tax computation allows the taxpayer to receive the lower of
the regular tax or the alternative tax on each layer of net capital gain and/or QDI or portion of each layer of net capital gain and/or QDI.
Whether an asset is capital or ordinary, therefore, depends entirely on
the relationship of the asset to the taxpayer who sold it. This classification dilemma is but one feature of capital asset treatment that makes this area so confusing and complicated.
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.
What constitutes inventory is determined by
the taxpayer's business.
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.
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.
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.
In 2019, the 0% gain portion of the 0%/15%/20% gain applies to long-term capital gains that,
when coupled with other forms of taxable income, do not exceed $78,750 for married taxpayers filing jointly, $52,750 for heads of household, and $39,375 for single taxpayers and married taxpayers filing separately (in 2018, these amounts were $77,200, $51,700, and $38,600, respectively).
The 15% gain portion of the 0%/15%/20% gain applies to long-term capital gains that,
when coupled with other forms of taxable income, exceed the 0% gain thresholds and do not exceed $488,850 for married taxpayers filing jointly, $461,700 for heads of household, $434,550 for single taxpayers, and $244,425 for married taxpayers filing separately (in 2018, these amounts were $479,000, $452,400, $425,800, and $239,500, respectively).
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.
The tax treatment of payments received for canceling a lease depends on
whether the recipient is the lessor or the lessee and whether the lease is a capital asset.
Part III of Form 1040 Schedule D summarizes the results of Parts I and II and indicates
whether the taxpayer has a net capital gain or a net capital loss. Part III then helps determine which alternative tax worksheet is used to calculate the alternative tax on long-term capital gains and qualified dividends.
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).
Professional sports franchises (e.g., the Detroit Tigers) are subject to
§ 1253.Footnote 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
