1. ©The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin McGraw-Hill Education Copyright © 2015 by the McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website in whole or part. Chapter 7 Capital Gains and Other Sales of Property “If a client asks in any but an extreme case whether, in your opinion, his sale will result in capital gain, your answer should probably be, ‘I don’t know, and no one else in town can tell you.’” -- James L. Wood

2. LO #1 Terms & Tax Forms Basis of property purchased is the cost of the asset including cash, debt obligations, and other property or services included in acquiring the asset. Basis of assets transferred by inheritance are valued at the FMV of the property at the date of death or FMV on the alternate valuation date if an estate return is being filed and the estate income is reduced by the valuation. 7-2

3. LO #1 Terms & Tax Forms Basis of property transferred to a taxpayer from a spouse or former spouse incident to a divorce settlement, is the same as the spouse’s or former spouse’s adjusted basis before the transfer. Assets transferred by gift can be valued at FMV or basis of the donor depending if the FMV is basis. 7-3

4. 7-4 LO #1 Terms & Tax Forms Adjusted basis is the cost of the asset less any accumulated depreciation. The difference between the amount realized from the sale and the adjusted basis of the asset; –Amount realized > adjusted basis = gain –Amount realized < adjusted basis=(loss)

5. 7-5 LO #1 Terms & Tax Forms The nature of tax reporting for gains and losses on the sale of property depends primarily on the “use” of the asset rather than on the asset “form.”

6. 7-6 LO #1 Terms & Tax Forms Form 4797 – Sales of Business Property –Use to report any and all gains or losses from sale or liquidation of business property. –The form has four parts to it and is very detailed to include all possible situations involving property used in a business Schedule D – Capital Gains and Losses –Use to report any and all gains or losses from sale of property held for investment. Form 8949 – Record Transactions

7. 7-7 LO #1 Concept Check 7-1 1.A gain or loss on a sale is the difference between the cash received and the original cost of the asset. False 2.The gain or loss on the sale of an asset used for investment or in a trade or business operation appears on Form 4797. False 3.When the buyer assumes the seller’s liability, the seller includes this amount in computing the amount realized from the sale True

8. 7-8 LO # 2 Classifying Assets Ordinary Asset –Ordinary income property is any asset that is “not” a capital asset. Capital Asset (§1221) –Any asset used for personal purposes or investment. Eight exceptions to this definition

9. 7-9 LO # 2 Classifying Assets § 1231 Business Asset –Depreciable or nondepreciable property used in a trade or business –Held for more than one year Any business asset disposed of within one year of acquisition is an ordinary income asset and is taxed to the taxpayer at ordinary tax rates.

10. 7-10 LO # 2 Concept Check 7-2 1. Inventory sold by a company is an ordinary income asset that appears on Form 4797-Sale of Business Assets. False 2. A capital asset includes all of the following except: a. taxpayer vacation home b. inherited property c. property used in a trade or business d. stock portfolio Answer: C

11. 7-11 LO # 2 Concept Check 7-2 3.An ordinary income asset is any short-term or long-term asset used in a business. False 4.A §1221 asset is any asset held for investment. True 5. A §1231 asset is any depreciable or nondepreciable property used in a trade or business and not considered an ordinary income asset. True

12. 7-12 LO # 3 Ordinary Assets Inventory and accounts receivable are not ordinary income assets unless they are sold outside the normal course of business. Sale of business property held less than one year. Gains are taxed at the taxpayer’s regular rate –There is no preferential tax treatment Losses are fully deductible

13. 7-13 LO # 3 Concept Check 7-3 1.When an ordinary asset is sold, the gain or loss is subject to capital gain or loss tax treatment. False 2. Why is the distinction between “ordinary” and “capital” so important? Because of the preferential tax rate treatment on capital gains versus ordinary gains.

14. 7-14 LO # 3 Concept Check 7-3 3.Ordinary gains or losses produced outside the normal course of business relate to the sale of business property held for less than one year or the sale of receivables. True

15. 7-15 LO #4 Capital Assets Tax treatment depends on holding period of the asset. Assets must be held for more than one year for preferential tax treatment. –Exceptions: Property received through a gift or nontaxable exchange generally has same holding period as the transferor. Property acquired through inheritance is always considered long-term property.

16. 7-16 LO #4 Capital Assets Long term capital gain rates: –0%, 15%, or 20% for most capital assets –25% rate for depreciable real property used in a trade or business (§ 1250) –28% rate for “collectibles” and gains on §1202 (Qualified Small Business Stock) property.

17. 7-17 LO #4 Capital Assets All short-term gains and losses are netted. All long-term gains and losses are netted. The resultant gain or loss determines the deductibility of a loss and the tax rate used for gain.

18. 7-18 LO #4 Concept Check 7-4 1. The tax treatment of a capital gain or loss varies depending on all of the following except: a. the holding period. b. the basis of the asset sold. c. the taxpayer’s tax bracket. d. the netting of all gains and losses. Answer: B

19. 7-19 LO #4 Concept Check 7-4 2.If property received has the same basis as the basis in the hands of the transferor, the holding period includes the holding period of the transferor. True 3. The holding period of inherited property can be either short-term or long-term to the beneficiary. False

20. 7-20 LO #4 Concept Check 7-4 4. The 3.8% surtax is charged on long- term capital gains only if a taxpayer is in the top tax bracket. True or False? False

21. 7-21 LO #4 Concept Check 7-4 5. For sales after 2012, what are the maximum capital gain rates on the following? a. Collectibles gains b. §1202 gains c. Unrecaptured §1250 gains d. Taxpayer’s regular tax rate =>25% and <39.6% e. Taxpayer’s regular tax rate < 25% f. Taxpayer’s regular tax rate > 35%

22. LO #4 Concept Check 7-4 a. 28% b. 28% c. 25% d. 15% e. 0% f. 20%

23. 7-23 LO #5 §1231 Business Assets Recall that §1231 assets are those used in a trade or business that are held for > 1 year. Gains and losses from the sale of §1231 assets are netted before tax rates are applied. A net §1231 gain is taxed as a long- term capital gain subject to recapture provisions

24. 7-24 LO #5 §1231 Business Assets Recapture provisions apply to depreciation taken as a deduction in prior years. Depreciation recapture rules are designed to “transform” some or all of the §1231 gain into an ordinary gain.

25. 7-25 LO #5 §1231 Business Assets Net §1231 gains receive preferential tax rate treatment Net §1231 losses are treated as ordinary losses not subject to deductibility limit provisions of $3,000 per year.

26. 7-26 LO #5 §1231 Business Assets §1245 applies to personal trade or business property and is a subset of §1231 property –Tax rate to “recapture” the depreciation portion of a gain is taxed at ordinary rates –Remaining gain, if any, is taxed at preferential rates.

27. 7-27 LO #5 §1231 Business Assets § 1250 applies to buildings – residential or nonresidential (commercial) and is a subset of §1231 property –The amount of capital gain attributable to depreciation previously taken is taxed at the 25% rate up to the depreciation amount considered “unrecaptured”. –Remaining gain, if any, is taxed at preferential rates

28. 7-28 LO #5 Concept Check 7-5 1.Under §1231, gains receive preferential tax rate treatment but losses are limited to $3,000 per year. False 2. The only pure §1231 asset is land used in a trade or business. True

29. 7-29 LO #5 Concept Check 7-5 3. What is meant by the term depreciation recapture? Depreciation recapture rules transform some or all of a §1231 gain into an ordinary gain.

30. 7-30 LO #5 Concept Check 7-5 4. What is the difference between a §1245 asset and a §1250 asset? §1245 assets are personal trade or business property subject to depreciation. §1250 assets include depreciable real property used in a trade of business that has never been considered §1245 property

31. 7-31 LO #5 Concept Check 7-5 5. What is the difference between “recapture” and “unrecaptured” gain provisions? Unrecaptured gain is taxed at a maximum 25% rate for all straight-line depreciation taken on the property. Recaptured gain is taxed at ordinary rates to the extent the depreciation taken exceeds straight- line deprecation.

32. LO # 6 Special Types of Sales Sales of stock purchased as blocks of stock at different prices and/or dates are valued either using specific identification or the first-in, first-out method for determining basis. 7-32

33. 7-33 LO # 6 Special Types of Sales A mutual fund pools resources from various investors and purchases shares of stock in a portfolio Form 1099-DIV is the form sent annually to individual investors in the mutual fund to record dividends, capital gains, and distributions from the fund for the year. Capital gains distributions from mutual funds are reported on Schedule D (or directly on Form 1040 if Schedule D is not required to be filed).

34. 7-34 LO # 6 Special Types of Sales Three methods to calculate the “basis” of shares in a mutual fund purchased throughout a period –First-In, First-Out – assumes first shares purchased are the first shares sold. –Specific Identification – assumes that the shares sold can be identified with a specific purchase. –Average Basis – Calculate the average of shares purchased for a period and use an average to determine the cost basis of shares sold.

35. 7-35 LO # 6 Special Types of Sales Worthless securities are treated as losses from a sale or exchange of a capital asset on the last day of the taxable year. –Declaration of bankruptcy is not sufficient to indicate worthlessness. –Often difficult to pinpoint exactly when a security becomes worthless to determine a “sale date” for long-term versus short- term treatment.

36. 7-36 LO # 6 Special Types of Sales Sales of assets given as gifts: –FMV<donor’s adjusted basis at time of gift Use donor’s adjusted basis for a gain Use FMV for a loss Special provision, if the sell price is between the adjusted basis and the FMV, there is no gain or loss on the sale. –FMV=>donor’s adjusted basis at time of gift Use donor’s adjusted basis for a gain or loss

37. LO # 6 Special Types of Sales Basis to beneficiaries is the FMV at the date of death or alternate valuation date (AVD applies only if valuing the asset reduces the overall estate amount). The holding period is always considered long-term –Example: Property inherited with a basis of $3,000 is sold six months later for $4,000. The $1,000 gain is considered long-term and qualifies for preferential tax treatment. 7-37

38. 7-38 LO # 6 Concept Check 7-6 1. Explain the three types of methods used to determine the basis of units in a mutual fund. First-In, First-Out – First shares purchased are the first shares sold. Specific Identification – Specifies exactly which units are for sale from the fund. Average Basis – Take total cost basis and divide by the total units to get an average cost per unit.

39. 7-39 LO # 6 Concept Check 7-6 2.It is often difficult to pinpoint exactly when a security becomes worthless, so the loss on a worthless security is treated as occurring on the last day of the taxable year. True 3. The basis for property given as a gift is always the FMV of the property at the time of the gift. False

40. 7-40 LO # 6 Concept Check 7-6 4.The tax treatment of a gain on the sale of inherited property depends on the holding period of the deceased taxpayer. False