1. Individual Income Taxes C16-1 Chapter 16 Property Transactions: Capital Gains and Losses Property Transactions: Capital Gains and Losses Copyright ©2009 Cengage Learning Individual Income Taxes

2. C16-2 Taxation of Capital Gains and Losses Capital gains and losses must be separated from other types of gains and losses for two reasons: –Long-term capital gains may be taxed at a lower rate than ordinary gains –A net capital loss is only deductible up to $3,000 per year Capital gains and losses must be separated from other types of gains and losses for two reasons: –Long-term capital gains may be taxed at a lower rate than ordinary gains –A net capital loss is only deductible up to $3,000 per year

3. Individual Income Taxes C16-3 Proper Classification of Gains and Losses Depends on three characteristics: –The tax status of the property Capital asset, §1231 asset, or ordinary asset –The manner of the property’s disposition By sale, exchange, casualty, theft, or condemnation –The holding period of the property Short term and long term Depends on three characteristics: –The tax status of the property Capital asset, §1231 asset, or ordinary asset –The manner of the property’s disposition By sale, exchange, casualty, theft, or condemnation –The holding period of the property Short term and long term

4. Individual Income Taxes C16-4 Capital Assets (slide 1 of 6) §1221 defines capital assets as everything except: –Inventory (stock in trade) –Notes and accounts receivables acquired from the sale of inventory or performance of services –Realty and depreciable property used in a trade or business (§1231 assets) §1221 defines capital assets as everything except: –Inventory (stock in trade) –Notes and accounts receivables acquired from the sale of inventory or performance of services –Realty and depreciable property used in a trade or business (§1231 assets)

5. Individual Income Taxes C16-5 Capital Assets (slide 2 of 6) §1221 defines capital assets as everything except (cont’d): –Certain copyrights; literary, musical, or artistic compositions; or letters, memoranda, or similar property when created by taxpayer (or for which taxpayer takes a carryover basis from the creator) Taxpayers may elect to treat a sale or exchange of musical compositions or copyrights in musical works as the disposition of a capital asset –Certain publications of U.S. government –Supplies of a type regularly used or consumed in the ordinary course of a business §1221 defines capital assets as everything except (cont’d): –Certain copyrights; literary, musical, or artistic compositions; or letters, memoranda, or similar property when created by taxpayer (or for which taxpayer takes a carryover basis from the creator) Taxpayers may elect to treat a sale or exchange of musical compositions or copyrights in musical works as the disposition of a capital asset –Certain publications of U.S. government –Supplies of a type regularly used or consumed in the ordinary course of a business

6. Individual Income Taxes C16-6 Capital Assets (slide 3 of 6) Thus, capital assets are: –Assets held for investment (e.g., stocks, bonds, land) –Personal use assets (e.g., residence, car) –Miscellaneous assets selected by Congress Thus, capital assets are: –Assets held for investment (e.g., stocks, bonds, land) –Personal use assets (e.g., residence, car) –Miscellaneous assets selected by Congress

7. Individual Income Taxes C16-7 Capital Assets (slide 4 of 6) Dealers in securities –In general, securities are the inventory of securities dealers, thus ordinary assets –However, a dealer can identify securities as an investment and receive capital gain treatment Clear identification must be made on the day of acquisition Dealers in securities –In general, securities are the inventory of securities dealers, thus ordinary assets –However, a dealer can identify securities as an investment and receive capital gain treatment Clear identification must be made on the day of acquisition

8. Individual Income Taxes C16-8 Capital Assets (slide 5 of 6) Real property subdivided for sale –Taxpayer may receive capital gain treatment on the subdivision of real estate if the following requirements are met: Taxpayer is not a corporation Taxpayer is not a real estate dealer No substantial improvements made to the lots Taxpayer held the lots for at least 5 years Capital gain treatment occurs until the year in which the 6 th lot is sold –Then up to 5% of the revenue from lot sales is potential ordinary income –That potential ordinary income is offset by any selling expenses from the lot sales Real property subdivided for sale –Taxpayer may receive capital gain treatment on the subdivision of real estate if the following requirements are met: Taxpayer is not a corporation Taxpayer is not a real estate dealer No substantial improvements made to the lots Taxpayer held the lots for at least 5 years Capital gain treatment occurs until the year in which the 6 th lot is sold –Then up to 5% of the revenue from lot sales is potential ordinary income –That potential ordinary income is offset by any selling expenses from the lot sales

9. Individual Income Taxes C16-9 Capital Assets (slide 6 of 6) Nonbusiness bad debts –A nonbusiness bad debt is treated as a short- term capital loss in the year it becomes completely worthless Even if outstanding for more than one year Nonbusiness bad debts –A nonbusiness bad debt is treated as a short- term capital loss in the year it becomes completely worthless Even if outstanding for more than one year

10. Individual Income Taxes C16-10 Sale or Exchange (slide 1 of 11) Recognition of capital gains and losses generally requires a sale or exchange of assets Sale or exchange is not defined in the Code There are some exceptions to the sale or exchange requirement Recognition of capital gains and losses generally requires a sale or exchange of assets Sale or exchange is not defined in the Code There are some exceptions to the sale or exchange requirement

11. Individual Income Taxes C16-11 Sale or Exchange–Worthless Securities and § 1244 Stock (slide 2 of 11) A security that becomes worthless creates a deductible capital loss without being sold or exchanged –The Code sets an artificial sale date for the securities on the last day of the year in which worthlessness occurs Section 1244 allows an ordinary deduction on disposition of stock at a loss –The stock must be that of a small business company –The ordinary deduction is limited to $50,000 ($100,000 for married individuals filing jointly) per year A security that becomes worthless creates a deductible capital loss without being sold or exchanged –The Code sets an artificial sale date for the securities on the last day of the year in which worthlessness occurs Section 1244 allows an ordinary deduction on disposition of stock at a loss –The stock must be that of a small business company –The ordinary deduction is limited to $50,000 ($100,000 for married individuals filing jointly) per year

12. Individual Income Taxes C16-12 Sale or Exchange (slide 3 of 11) Worthless securities example: –Calendar year taxpayer purchased stock on December 5, 2007 –The stock becomes worthless on April 5, 2008 –The loss is deemed to have occurred on December 31, 2008 The result is a long-term capital loss Worthless securities example: –Calendar year taxpayer purchased stock on December 5, 2007 –The stock becomes worthless on April 5, 2008 –The loss is deemed to have occurred on December 31, 2008 The result is a long-term capital loss

13. Individual Income Taxes C16-13 Sale or Exchange–Retirement of Corporate Obligations (slide 4 of 11) Collection of the redemption value of corporate obligations (e.g., bonds payable) is treated as a sale or exchange and may result in a capital gain or loss –OID amortization increases basis and reduces gain on disposition or retirement Collection of the redemption value of corporate obligations (e.g., bonds payable) is treated as a sale or exchange and may result in a capital gain or loss –OID amortization increases basis and reduces gain on disposition or retirement

14. Individual Income Taxes C16-14 Sale or Exchange– Options (slide 5 of 11) For the grantee of the option –Sale of an option results in capital gain or loss if the option property is a capital asset to the grantee –Lapse of an option on a capital asset is considered a sale or exchange resulting in a capital loss For the grantor of an option, the lapse creates –Short-term capital gain, if the option was on stocks, securities, commodities or commodity futures –Otherwise, ordinary income For the grantee of the option –Sale of an option results in capital gain or loss if the option property is a capital asset to the grantee –Lapse of an option on a capital asset is considered a sale or exchange resulting in a capital loss For the grantor of an option, the lapse creates –Short-term capital gain, if the option was on stocks, securities, commodities or commodity futures –Otherwise, ordinary income

15. Individual Income Taxes C16-15 Sale or Exchange– Options (slide 6 of 11) Exercise of an option by a grantee –Increases the gain (or reduces the loss) to the grantor from the sale of the property –Gain is ordinary or capital depending on the tax status of the property Grantee adds the cost of the option to the basis of the property acquired Exercise of an option by a grantee –Increases the gain (or reduces the loss) to the grantor from the sale of the property –Gain is ordinary or capital depending on the tax status of the property Grantee adds the cost of the option to the basis of the property acquired

16. Individual Income Taxes C16-16 Sale or Exchange–Patents (slide 7 of 11) When all substantial rights to a patent are transferred by a holder to another, the transfer produces long-term capital gain or loss –The holder of a patent must be an individual, usually the creator, or an individual who purchases the patent from the creator before the patented invention is reduced to practice When all substantial rights to a patent are transferred by a holder to another, the transfer produces long-term capital gain or loss –The holder of a patent must be an individual, usually the creator, or an individual who purchases the patent from the creator before the patented invention is reduced to practice

17. Individual Income Taxes C16-17 Sale or Exchange–Franchises, Trademarks, and Trade Names (slide 8 of 11) The licensing of franchises, trade names, trademarks, and other intangibles is generally not considered a sale or exchange of a capital asset –Therefore, ordinary income results to transferor Exception: Capital gain (loss) may result if the transferor does not retain any significant power, right, or continuing interest The licensing of franchises, trade names, trademarks, and other intangibles is generally not considered a sale or exchange of a capital asset –Therefore, ordinary income results to transferor Exception: Capital gain (loss) may result if the transferor does not retain any significant power, right, or continuing interest

18. Individual Income Taxes C16-18 Sale or Exchange–Franchises, Trademarks, and Trade Names (slide 9 of 11) Significant powers, rights, or continuing interests include: –Control over assignment, quality of products and services –Sale or advertising of other products or services –The right to require that substantially all supplies and equipment be purchased from the transferor –The right to terminate the franchise at will, and –The right to substantial contingent payments Significant powers, rights, or continuing interests include: –Control over assignment, quality of products and services –Sale or advertising of other products or services –The right to require that substantially all supplies and equipment be purchased from the transferor –The right to terminate the franchise at will, and –The right to substantial contingent payments

19. Individual Income Taxes C16-19 Sale or Exchange–Franchises, Trademarks, and Trade Names (slide 10 of 11) Noncontingent payments are ordinary income to the transferor –The franchisee capitalizes the payments and amortizes them over 15 years Contingent payments are ordinary income for the franchisor and an ordinary deduction for the franchisee Noncontingent payments are ordinary income to the transferor –The franchisee capitalizes the payments and amortizes them over 15 years Contingent payments are ordinary income for the franchisor and an ordinary deduction for the franchisee

20. Individual Income Taxes C16-20 Sale or Exchange–Lease Cancellation Payments (slide 11 of 11) Lessee treatment –Treated as received in exchange for underlying leased property Capital gain results if asset leased was a capital asset (e.g., personal use ) Ordinary income results if asset leased was an ordinary asset (e.g., used in lessee’s business and lease has existed for one year or less when canceled) Lease could be a § 1231 asset if the property is used in lessee’s trade or business and the lease has existed for > a year when it is canceled Lessor treatment –Payments received are ordinary income (rents) Lessee treatment –Treated as received in exchange for underlying leased property Capital gain results if asset leased was a capital asset (e.g., personal use ) Ordinary income results if asset leased was an ordinary asset (e.g., used in lessee’s business and lease has existed for one year or less when canceled) Lease could be a § 1231 asset if the property is used in lessee’s trade or business and the lease has existed for > a year when it is canceled Lessor treatment –Payments received are ordinary income (rents)

21. Individual Income Taxes C16-21 Holding Period (slide 1 of 3) Short-term –Asset held for 1 year or less Long-term –Asset held for more than 1 year Holding period starts on the day after the property is acquired and includes the day of disposition Short-term –Asset held for 1 year or less Long-term –Asset held for more than 1 year Holding period starts on the day after the property is acquired and includes the day of disposition

22. Individual Income Taxes C16-22 Holding Period (slide 2 of 3) Nontaxable Exchanges –Holding period of property received includes holding period of former asset if a capital or § 1231 asset Transactions involving a carryover basis –Former owner’s holding period tacks on to present owner’s holding period if a nontaxable transaction and basis carries over Inherited property is always treated as long term no matter how long it is held by the heir Nontaxable Exchanges –Holding period of property received includes holding period of former asset if a capital or § 1231 asset Transactions involving a carryover basis –Former owner’s holding period tacks on to present owner’s holding period if a nontaxable transaction and basis carries over Inherited property is always treated as long term no matter how long it is held by the heir

23. Individual Income Taxes C16-23 Holding Period (slide 3 of 3) Short sales –Taxpayer sells borrowed securities and then repays the lender with substantially identical securities –Gain or loss is not recognized until the short sale is closed –Generally, t he holding period for a short sale is determined by how long the property used for repayment is held If substantially identical property (e.g., other shares of the same stock) is held by the taxpayer, the short-term or long- term character of the short sale gain or loss may be affected Short sales –Taxpayer sells borrowed securities and then repays the lender with substantially identical securities –Gain or loss is not recognized until the short sale is closed –Generally, t he holding period for a short sale is determined by how long the property used for repayment is held If substantially identical property (e.g., other shares of the same stock) is held by the taxpayer, the short-term or long- term character of the short sale gain or loss may be affected

24. Individual Income Taxes C16-24 Tax Treatment of Capital Gains and Losses (slide 1 of 7) Noncorporate taxpayers –Capital gains and losses must be netted by holding period Short-term capital gains and losses are netted Long-term capital gains and losses are netted If possible, long-term gains or losses are then netted with short-term gains or losses –If the result is a loss: –The capital loss deduction is limited to a maximum deduction of $3,000 –Unused amounts retain their character and carryforward indefinitely Noncorporate taxpayers –Capital gains and losses must be netted by holding period Short-term capital gains and losses are netted Long-term capital gains and losses are netted If possible, long-term gains or losses are then netted with short-term gains or losses –If the result is a loss: –The capital loss deduction is limited to a maximum deduction of $3,000 –Unused amounts retain their character and carryforward indefinitely

25. Individual Income Taxes C16-25 Tax Treatment of Capital Gains and Losses (slide 2 of 7) Noncorporate taxpayers (cont’d) –If net from capital transactions is a gain, tax treatment depends on holding period Short-term (assets held 12 months or less) –Taxed at ordinary income tax rates Long-term (assets held more than 12 months) –An alternative tax calculation is available using preferential tax rates Noncorporate taxpayers (cont’d) –If net from capital transactions is a gain, tax treatment depends on holding period Short-term (assets held 12 months or less) –Taxed at ordinary income tax rates Long-term (assets held more than 12 months) –An alternative tax calculation is available using preferential tax rates

26. Individual Income Taxes C16-26 Tax Treatment of Capital Gains and Losses (slide 3 of 7) Noncorporate taxpayers (cont’d) –Net long-term capital gain is eligible for one or more of four alternative tax rates: 0%, 15%, 25%, and 28% The 25% rate applies to unrecaptured §1250 gain and is related to gain from disposition of §1231 assets The 28% rate applies to collectibles The 0%/15% rates apply to any remaining net long- term capital gain Noncorporate taxpayers (cont’d) –Net long-term capital gain is eligible for one or more of four alternative tax rates: 0%, 15%, 25%, and 28% The 25% rate applies to unrecaptured §1250 gain and is related to gain from disposition of §1231 assets The 28% rate applies to collectibles The 0%/15% rates apply to any remaining net long- term capital gain

27. Individual Income Taxes C16-27 Tax Treatment of Capital Gains and Losses (slide 4 of 7) Collectibles, even though they are held long term, are subject to a 28% alternative tax rate Collectibles include any: –Work of art –Rug or antique –Metal or gem –Stamp –Alcoholic beverage –Historical objects (documents, clothes, etc.) –Most coins Collectibles, even though they are held long term, are subject to a 28% alternative tax rate Collectibles include any: –Work of art –Rug or antique –Metal or gem –Stamp –Alcoholic beverage –Historical objects (documents, clothes, etc.) –Most coins

28. Individual Income Taxes C16-28 Tax Treatment of Capital Gains and Losses (slide 5 of 7) Qualified dividend income paid from current or acc. E & P is eligible for the 0%/15% long-term capital gain rates –After determining net capital gain or loss, qualified dividend income is added to the net long-term capital gain portion of the net capital gain and is taxed as 0%/15% gain If there is a net capital loss, it is still deductible for AGI –Limited to $3,000 per year with the remainder of the loss carrying over In this case, the qualified dividend income is still eligible to be treated as 0%/15% gain in the alternative tax calculation –It is not offset by the net capital loss Qualified dividend income paid from current or acc. E & P is eligible for the 0%/15% long-term capital gain rates –After determining net capital gain or loss, qualified dividend income is added to the net long-term capital gain portion of the net capital gain and is taxed as 0%/15% gain If there is a net capital loss, it is still deductible for AGI –Limited to $3,000 per year with the remainder of the loss carrying over In this case, the qualified dividend income is still eligible to be treated as 0%/15% gain in the alternative tax calculation –It is not offset by the net capital loss

29. Individual Income Taxes C16-29 Tax Treatment of Capital Gains and Losses (slide 6 of 7) The alternative tax on net capital gain applies only if taxable income includes some net long-term capital gain –Net capital gain may be made up of various rate layers For each layer, compare the regular tax rate with the alternative tax rate on that portion of the net capital gain The layers are taxed in the following order: 25% gain, 28% gain, the 0% portion of the 0%/15% gain, and then the 15% portion of the 0%/15% gain This allows the taxpayer to receive the lower of the regular tax or the alternative tax on each layer of net capital gain The alternative tax on net capital gain applies only if taxable income includes some net long-term capital gain –Net capital gain may be made up of various rate layers For each layer, compare the regular tax rate with the alternative tax rate on that portion of the net capital gain The layers are taxed in the following order: 25% gain, 28% gain, the 0% portion of the 0%/15% gain, and then the 15% portion of the 0%/15% gain This allows the taxpayer to receive the lower of the regular tax or the alternative tax on each layer of net capital gain

30. Individual Income Taxes C16-30 Tax Treatment of Capital Gains and Losses (slide 7 of 7) Corporate taxpayers –Differences in corporate capital treatment There is a NCG alternative tax rate of 35 % –Since the max corporate tax rate is 35 %, the alternative tax is not beneficial Net capital losses can only offset capital gains (i.e., no $3,000 deduction in excess of capital gains) Net capital losses are carried back 3 years and carried forward 5 years as short-term losses Corporate taxpayers –Differences in corporate capital treatment There is a NCG alternative tax rate of 35 % –Since the max corporate tax rate is 35 %, the alternative tax is not beneficial Net capital losses can only offset capital gains (i.e., no $3,000 deduction in excess of capital gains) Net capital losses are carried back 3 years and carried forward 5 years as short-term losses

31. Individual Income Taxes C16-31 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta