©2003 South-Western College Publishing, Cincinnati, Ohio Chapter 8 Capital Gains and Losses

© 2003 South-Western College PublishingTransparency 8-2 Objective Know the definition of the term capital asset

© 2003 South-Western College PublishingTransparency 8-3 Capital Gains and Losses A capital asset is any asset other than inventory, receivables, and depreciable or real property used in a trade or business.

© 2003 South-Western College PublishingTransparency 8-4 Capital Gains and Losses rA sale or other disposition of capital assets results in a capital gain or loss <Capital gains and losses receive special tax treatment rA collectible gain or loss results from the sale or exchange of works of art, gems, metals, antiques, rugs, stamps, wine, etc. held more than 12 months.

© 2003 South-Western College PublishingTransparency 8-5 Objective Know the holding periods and tax rates applied to sales of capital assets

© 2003 South-Western College PublishingTransparency 8-6 Capital Gains and Losses Holding Period rThe holding period for capital assets is how long the taxpayer owned the asset. 12 months. <Short-term means the asset was held for < 12 months. rDetermining holding period is the first step in determining tax treatment.

© 2003 South-Western College PublishingTransparency 8-7 Property Disposition Amount realized from disposition less:Adjusted basis of property Realized gain (loss) less:Allowed deferral Recognized gain (loss)

© 2003 South-Western College PublishingTransparency 8-8 Amount Realized rAmount realized = gross sales price less selling expenses <Gross sales price is the amount received by the seller from the buyer and includes ÙCash and FMV of property or services received ÙSellers liability assumed by or paid by the buyer <Gross sales price is decreased by amounts given to the buyer by the seller ÙBuyers expenses paid by or assumed by the seller

© 2003 South-Western College PublishingTransparency 8-9 Adjusted Basis Original cost plus: Capital improvements less: Accumulated depreciation Adjusted basis

© 2003 South-Western College PublishingTransparency 8-10 Juliana sold stock in Arco she had purchased in The stock had cost her $10,000 and she sold it for $19,000 with a commission of $1,300. What is amount realized and gain realized? Answer Amount realized = $19,000 - $1,300 = $17,700 Gain realized = $17,700 - $10,000 = $7,700 LT Examples of Calculating Gain/Loss

© 2003 South-Western College PublishingTransparency 8-11 Long-term gains netted against Long-term losses Net Long-term Gain or Loss Short-term gains netted against Short-term losses Net Short-term Gain or Loss = = Capital Gains and Losses: Netting Procedures

© 2003 South-Western College PublishingTransparency 8-12 Capital Gains and Losses Netting Procedures rThe following are treated as long-term gains and losses for the netting procedure <Collectible gains and losses <Gains on qualified small business stock <Unrecaptured Section 1250 gain (applies to sales of real estate)

© 2003 South-Western College PublishingTransparency 8-13 If net short-term & long-term are opposite signs: Net Short-term Gain or Loss netted against Net Long-term Gain or Loss Net Capital Gain or Loss = Capital Gains and Losses: Netting Procedures If short-term & long-term net results are same sign: Do not net. You will have a net STC and LTC gain or loss

© 2003 South-Western College PublishingTransparency 8-14 Tax Treatment for Net Long-term Gain: Individual Taxpayers rNet long-term gain (minus net collectibles gain, gain on qualified small business stock, and unrecaptured Section 1250 gain) is taxed at a maximum rate of 20% (10% for taxpayers in <20% bracket) rCollectibles held more than 12 months are taxed at a maximum rate of 28%. r50% of the gain on qualified small business stock is excluded, the remainder taxed at a maximum rate of 28%. rUnrecaptured Section 1250 gain is taxed at a maximum rate of 25%.

© 2003 South-Western College PublishingTransparency 8-15 rSpecial rate for assets held > 5 years <20% become 18% (in 2006) <10% becomes 8% (currently) Tax Treatment for Net Long-term Gain: Individual Taxpayers

© 2003 South-Western College PublishingTransparency 8-16 Tax Treatment for Net Short-term Gain: Individual Taxpayers rNet short-term capital gain is taxed as ordinary income (i.e., taxpayers marginal tax rate).

© 2003 South-Western College PublishingTransparency 8-17 Gain Treatment for Corporations rCorporations do not receive special treatment for capital gains.

© 2003 South-Western College PublishingTransparency 8-18 Tax Treatment for Net Loss rIndividuals may use only $3,000 to offset other income <Excess loss is carried forward indefinitely rCorporations cannot deduct a net capital loss <Excess loss carried back 3 then forward 5 years to offset capital gains

© 2003 South-Western College PublishingTransparency 8-19 Juan has the following capital gains and losses in the current year: Short-term capital loss$ (2,000) Long-term capital gain 12,000 Long-term capital loss carryover (7,000) Example

© 2003 South-Western College PublishingTransparency 8-20 Short-term: Short-term capital loss $ (2,000) Long-term: Long-term capital gain $12,000 Long-term capital loss carryover ( 7,000) Long-term capital gain $ 5,000 Net long-term capital gain $ 3,000 Tax on adjusted net capital gain: $3,000 x 20% = $ 600 Example

© 2003 South-Western College PublishingTransparency 8-21 Qualified Small Business Stock rQualified stock is stock that <Has been held for more than 5 years <Was purchased directly from a small corporation ÙCorporation with gross assets < $50 million <Was purchased after 8/10/93 rUp to 50% of gain from sale may be excluded <Limited to the greater of Ù10 times basis in the stock, or Ù$10 million for each small business <Exclusion is based on a 28% rate ÙNot eligible for new special CG rates

© 2003 South-Western College PublishingTransparency 8-22 Amount realized from disposition less:Adjusted basis of property Realized gain (loss) less:Allowed deferral Recognized gain (loss) Ordinary §1231 (Form 4797) Capital (Schedule D) Personal Use Character of gain (loss) Character of Gain or Loss

© 2003 South-Western College PublishingTransparency 8-23 Section 1231 Assets rAsset must be held > 12 months and used in a trade or business <not held for investment rNet all §1231 gains against losses

© 2003 South-Western College PublishingTransparency 8-24 Net Section 1231 gains may be allowed capital gain treatment even though they arise from ordinary assets. Section 1231

© 2003 South-Western College PublishingTransparency 8-25 Section 1231 Netting Results rNet Section 1231 gain is classified as long- term capital gain rNet Section 1231 loss is classified as ordinary loss

© 2003 South-Western College PublishingTransparency 8-26 Objective Understand what depreciation recapture is and how it is calculated

© 2003 South-Western College PublishingTransparency 8-27 Prevents taxpayers from receiving the dual benefits of a depreciation deduction and special §1231 capital gain treatment Depreciation Recapture

© 2003 South-Western College PublishingTransparency 8-28 Depreciation Recapture rApplies to Section 1231 gain property only rRequires gains to be treated as ordinary to the extent of prior depreciation deductions

© 2003 South-Western College PublishingTransparency 8-29 Depreciation Recapture rSection 1245 <Applies to ÙDepreciable personal property and ÙNonresidential real estate placed in service between 1981 and 1986 and depreciated under ACRS <Requires full recapture of all depreciation ÙGains are treated as ordinary income to the extent of any depreciation taken <Any gain in excess of depreciation is netted with Section 1231

© 2003 South-Western College PublishingTransparency 8-30 Depreciation Recapture rSection 1250 <Applies to depreciable real property ÙNot covered by Section 1245 and ÙNot depreciated using the straight-line method <Requires partial recapture of depreciation ÙGains are treated as ordinary income to the extent of depreciation taken over straight-line amount <Any gain in excess of depreciation in netted with Section 1231

© 2003 South-Western College PublishingTransparency 8-31 Unrecaptured Section 1250 Gain rRequires that the portion of the gain attributable to depreciation that is not §1250 recapture is taxed at a rate of 25%. rApplies to depreciable real property sold after 5/7/97. rAny gain not attributable to depreciation (in excess of original cost) is a §1231 gain.

© 2003 South-Western College PublishingTransparency 8-32 Ella purchases an apartment complex for $7,000,000 on 1/1/85. The property is depreciated on an accelerated basis and her accumulated depreciation is $4,000,000. She sells the property on 1/1/02 for $8,500,000. What is the realized gain and how is it split between §1231 gain (taxed as capital) and §1250 recap (taxed as ordinary income)? [straight line depreciation would have totaled $2,692,000.] Answer Realized gain = $8,500,000 - ($7,000,000 - $4,000,000) = $5,500,000. Excess depreciation taken = $4,000,000 - $2,692,000 = $1,308,000. §1250 recaptures the $1,308,000 as ordinary income. The remainder of the gain, $4,192,000, is taxed as §1231 gain. §1250 Recapture Example

© 2003 South-Western College PublishingTransparency 8-33 Objective Know how casualty losses are treated for both personal and business purposes

© 2003 South-Western College PublishingTransparency 8-34 Casualty Gains & Losses: Personal rLoss is the lesser of <The propertys adjusted basis, or <The decline in the value of the property (repair cost) rLoss is reduced by <Insurance proceeds received, <$100 per event, and <10% of AGI per year rAny insurance reimbursement reduces loss and may cause gain <Gains are separated into ST and LT and included with appropriate CG or CL

© 2003 South-Western College PublishingTransparency 8-35 rBusiness casualty and theft losses result from damage caused by a sudden, unexpected and/or unusual event <For property fully destroyed, deduct the adjusted basis <For property partially destroyed, deduct the lesser of the propertys adjusted basis, or the decline in the propertys value <Any insurance reimbursement reduces loss and may cause gain Casualty Gains & Losses: Business

© 2003 South-Western College PublishingTransparency 8-36 rTreatment of gains and losses depends on holding period <For property held < one year, ÙNet gains and losses are treated as ordinary income/loss one year, ÙGains are §1231 ÙLosses must have components analyzed separately Casualty Gains & Losses: Business

© 2003 South-Western College PublishingTransparency 8-37 Hurricane results in a casualty gain = $8,000 - $15,000 = $7,000. Windstorm results in a casualty loss = ($44,000 - $10,000) + ($8,000 - $0) = $42,000 - $100 - $41,900. The total net casualty loss of $34,900 is further reduced by 10% of AGI. Casualty Gains and Losses: Example Sherry incurred the following casualty gains/losses and insurance reimbursements in one year (all personal assets). The fence was destroyed by a hurricane & the boat and trailer by a windstorm:

© 2003 South-Western College PublishingTransparency 8-38 Objective Be able to calculate income from installment sales

© 2003 South-Western College PublishingTransparency 8-39 Installment Sales - Form 6252 rInstallment sale treatment is utilized when real or personal property or business/rental property is sold and payment is collected over time rAllows taxable gain to be reported as cash is received, not when transaction completed <Must recapture any §1245 or §1250 income first, then calculate gross profit percentage and multiply that by cash received in that year.

© 2003 South-Western College PublishingTransparency 8-40 Taxable Gain = Realized Gain Contract price where, Realized Gain = Sales Price less: Selling Expense less: §1245 or §1250 Recapture less: Adjusted Basis and, Contract Price = Sales Price – Assumed Liabilities Installment Sales Computations x Cash

© 2003 South-Western College PublishingTransparency 8-41 Installment Sales Example Baker sold his prize bulls to Larry for $10,000 down and $25,000/year for 4 years (plus interest). Baker had purchased the bulls for $95,000 and had depreciated them $15,000. Realized gain: $110,000 - $0 - $15,000 (§1245 recap) - $80,000 = $15,000 Gross profit percentage: $15,000/$110,000 = 13.64% Taxable gain in year of sale: Capital gain: $10,000 x.1364 = $1,364 Ordinary income (§1245 recap) = $15,000 Taxable gain in subsequent years: $25,000 x.1364 = $3,410 Interest Income would be reported on each years Schedule B

© 2003 South-Western College PublishingTransparency 8-42 Objective Have a basic understanding of several provisions allowing deferral or non-recognition of gain or loss on disposition of an asset

© 2003 South-Western College PublishingTransparency 8-43 §1031 Like-Kind Exchanges rNo gain/loss is recognized when an exchange of like-kind property occurs, <Like-kind property is real property for real property or personal property for personal property of the same asset class <Rules only apply to business or investment property rMay have some recognized gain if boot is received <Boot is cash or any property (inventory, stocks, bonds, or other securities) that is not like-kind

© 2003 South-Western College PublishingTransparency 8-44 Like Kind Exchanges (models) rRealized Gain = FMV of property received – adjusted basis of property given up rRecognized Gain = Lesser of (1) gain realized, or (2) boot received rBasis of new property = Adjusted basis of property given up + boot paid – boot received + gain recognized

© 2003 South-Western College PublishingTransparency 8-45 Barry exchanges his apartments for Adolphs land. The apartments have a FMV $250,000 and an adjusted basis of $175,000. The land has a FMV of $305,000. Barry also gives $25,000 cash. What is Barrys realized gain, recognized gain, and new basis in the land? Realized gain: $305,000 – ($175,000 + $25,000) = $105,000 Recognized gain: $0 since no boot was received Basis for land: ($175,000 + $25,000) +$0 – $0 + $0 = $200,000 Like Kind Exchange Example

© 2003 South-Western College PublishingTransparency 8-46 Involuntary Conversions rWhen a taxpayer involuntarily disposes of property due to an act of God, theft, condemnation, etc., gain does not need to be recognized if: <Insurance proceeds are reinvested in similar property within 2 years after close of tax year in which conversion occurred rMust recognize gain if insurance proceeds exceed adjusted basis of property rLosses are not deferred

© 2003 South-Western College PublishingTransparency 8-47 Sale of Personal Residence Post-5/6/97 rNo gain need be recognized on sale of home, as long as taxpayer has used it as a personal residence for two of the last five years rGain exclusion is up to $500,000 (MFJ) or $250,000 (S) <May prorate gain exclusion if residence rule isnt met due to employment or health

© 2003 South-Western College PublishingTransparency 8-48 Done!