Chapter 5 Property Transactions: Capital Gains and Losses 1

Learning Objectives Determine the realized gain or loss from the sale or other disposition of property Determine the amount realized from the sale or other disposition of property Determine the basis of property 2

Learning Objectives Distinguish between capital assets and other assets Understand how capital gains and losses affect taxable income Recognize when a sale or exchange has occurred Determine the holding period for an asset when a sale or disposition occurs

Determination Of Gain Or Loss Realized gain or loss Amount realized $ less the assets’ adjusted basis 3

Determination Of Gains And Losses Amount realized consists of money and FMV of property received plus taxpayer’s debt assumed by the buyer less costs of sale 4

Determination Of Basis Original basis (Cost) + plus additions (i.e., Capital improvements) less reductions (i.e., Depreciation) = Adjusted basis 5

Recognized Gain Or Loss The amount of recognized gain or loss on disposition may be less than the realized gain or loss due to special statutory provisions Like-kind exchange rules Involuntary conversions rules 6

Basis Considerations In most cases the cost of acquired property is the basis. 7

Basis Considerations Original cost basis includes Cash FMV of other property Debt Transactional cost Uniform capitalization rules are mandated for inventory 8

Basis Considerations Construction period interest and taxes must be capitalized for certain “ long useful life” property Homogenous property Specific identification may not be possible Tax law requires a FIFO approach 9

Property Received As A Gift After 1921 Donee’s adjusted basis for gain is donor’s basis plus a gift tax adjustment The donee’s adjusted basis for loss is the lesser of the gain basis or FMV at the date of gift The gain basis is used for calculating any depreciation The amount of depreciation is subtracted from applicable gain basis or loss basis in the event of disposition 10

Property Received From A Decedent Basis of inherited property FMV at date of death, or Alternate valuation date (AVD) Six months from date of death or Disposition date if not held for six month 11

Property Converted From Personal Use To Business Use Basis is the lower of the personal use adjusted basis or the property’s FMV at conversion 12

Allocation Of Basis If multiple assets are acquired for a single purchase price, the acquisition cost must be allocated to individual assets on the basis of their FMV See example in textbook on page 5-10. 13

Definition Of Capital Assets For tax purposes capital assets are defined as assets other than inventory, depreciable property, or real property used in a trade or business 14

Definition Of A Capital Asset Influence of the courts Corn Products Refining CO Arkansas Best Corporation 15

Other Code Provisions Relevant To Capital Gains And Losses Dealers usually treat securities as inventory Non-business bad debts are treated as short-term capital losses Certain taxpayers can subdivide land and sell a limited number of lots and retain capital gain treatment 16

Tax Treatment For Capital Gains And Losses Of Non-corporate Taxpayers Net capital gains result when net long-term capital gains exceed net short-term capital losses Capital losses Net capital losses offset ordinary income to a $3,000 maximum, with an unlimited carryover to future years 17

Long Term Capital Assets Capital assets held for more than 12 months. Tax rate for Net Capital Gains may be taxed 5%, 15%, 25%, 28% Be sure to read this section in the carefully. 18

Sale Or Exchange Worthless securities Securities that become totally worthless in a tax year are treated as a capital loss on the last day of the year 19

Sale or Exchange Retirement of Debt Instruments Options Patents Franchises, Trademarks and Trade Names Lease Cancellation Payments

Holding Period Holding period for long-term treatment is more than 12 months Holding period of more than 5 years After December 31, 2000 Maximum rate is 18% (8% for taxpayers whose tax rate is 15%)

Holding Period Property received as a gift If the donee’s adjusted basis is determined by reference to the donor’s adjusted basis, the donor’s holding period is added to the donee’s holding period If the donee’s adjusted basis is the FMV at date of gift, the holding period begins on the day after the date of gift 20

Holding Period Property received from a decedent is always subject to a long-term holding period Non-taxable exchanges Property given in a tax-free exchange is added to the holding period of the property received in the exchange Non-taxable stock dividends and stock rights Generally includes the holding period of the underlying stock 21

Justification for Preferential Treatment of Net Capital Gains Mobility of capital Mitigation of the effects of inflation and the progressive tax system Lower the cost of capital

Tax Planning Considerations Selection of property to transfer by gift Decision may be influenced by annual exclusion Unwise to gift depreciated property Selection of property to transfer at time of death Highly appreciated property should be retained until death Loss property should be sold before death 22

Compliance and Procedural Considerations Capital gains and losses are reported by individuals on Schedule D To improve taxpayer compliance, every broker is required to furnish the government with information pertaining to each customer. This is reported to the taxpayer on Form 1099-B. Taxpayer must use Schedule D to reconcile amounts shown on Form 1099-B