cch federal taxation basic principles chapter 12 property transactions: treatment of capital and...

CCH Federal TaxationBasic Principles

Chapter 12Property Transactions:

Treatment of Capital and Section 1231 Assets

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CCH Federal Taxation Basic Principles 2 of 92

Chapter 12 Exhibits

1. Capital Assets—Definition of “Capital” 2. Capital Assets—Other Definitions 3. Determining the Capital/1231 Gains Rate “Basket” 4. Computing Capital Gain Tax—10% Rate 5. Computing Capital Gain Tax—20% Rate 6. Tax Treatment for Ordinary Income Property and Capital Assets 7. Patents 8. Franchises, Trademarks, and Trade Names 9. Lease Cancellation Payments10. Options—General Rules11. Options—Example12. Subdivided Real Estate Sold by Investors13. Worthless Securities14. Depreciation Recapture—Example 115. Depreciation Recapture—Example 2

Chapter 12, Exhibit Contents A


16. Business Asset Dispositions—Template for Problem Solving17. Business Asset Dispositions—Example 118. Business Asset Dispositions—Example 219. The First Netting—Capital Gains and Losses20. The First Netting—Example 121. The First Netting—Example 222. The First Netting—Personal-Use Casualty/Theft Gains/Losses 23. The First Netting—Business/Investment Use Casualty/Theft

Gains/Losses 24. The First Netting—Personal-Use Condemnation Gains/Losses25. The First Netting—Business/Investment-Use Condemnation

Gains/Losses26. The First Netting—Long-Term Business Assets 27. The First Netting—Recap28. The Second Netting—Examples29. The Second Netting—Recap of the Rules30. Applying the $3,000 Capital Loss Limitation

Chapter 12 Exhibits

Chapter 12, Exhibit Contents B


Capital Assets—Definition of “Capital”

The term “capital” has different meanings among different professions. Here are some examples:

Profession Definition of Capital

Financial Accountant “Capital stock” generally refers to the owners equity of a corporation less its retained earnings.

Banker “Capital” generally refers to the total assets of a company at book value.

Investor A “cap” is a quick way of placing an approximate price tag on a company. “Cap” refers to the capitalization of a firm, which can be calculated by multiplying the stock price by the number of shares outstanding. For example, if DEF, Inc. has 10 million shares outstanding priced at $60 each, its capitalization is $600 million.

Chapter 12, Exhibit 1a


Some general terms applied by investment brokers to companies with varying capitalization levels are listed below.

Terms Capitalization Level

Large Cap $5 billion or higher

Mid Cap Between $500 million and $5 billion

Small Cap $150 million to $500 million

Micro Cap Less than $150 million

Chapter 12, Exhibit 1b



“Capital assets” generally refer to any property other than:

1. Ordinary income property (e.g., inventory, receivables,

creative works created by the taxpayer)

2. Depreciable business property (e.g., buildings,

equipment)

3. Non-depreciable business property (e.g., land)

Thus, capital assets would include land held for investment, cars used for personal travel, principal residences, household furnishings, stock, and jewelry. Paintings, manuscripts, and other creative works are capital assets if created by someone other than the taxpayer.

Tax Accountant

Chapter 12, Exhibit 1c



Capital Assets—Other Definitions

Collectibles Collectibles are defined by the Internal Revenue Code as any of the following investments: works of art, rugs, antiques, gems, metals (e.g., gold, silver), stamps, coins, or alcoholic beverages (e.g., older vintages of wines held for investment). [Code Sec. 408(m)(2)] (Note that works of art, rugs, antiques, and the other items listed above, if held by dealers, are ordinary income property, not collectible investments. Why? Because dealers hold these assets as inventory, not as investments.)



Collectibles

The pre-May 7, 1997 rates apply to the sale of collectibles.

These old rates consist of:

1. 15% long-term capital gain rate (not the new 10% rate) fortaxpayers within the 15% ordinary income tax bracket;

2. 28% long-term capital gain rate (not the new 20% rate) for

taxpayers above the 15% ordinary income tax bracket.




Ordinary Income Property

Ordinary income property includes any property that would result in the recognition of income taxed at the ordinary income rates if the property were sold. Thus, ordinary income property includes inventory, receivables, works of art or manuscripts created by the taxpayer, and capital assets that have been held for one year or less.




Code Sec. 1231 Assets. Generally, business assets held over 12 months fall under the category “Section 1231.” These assets include personal and real property, both depreciable and nondepreciable, that are used in a business. Examples include a fleet of delivery trucks, the portion of a car’s basis allocable to business transportation, the portion of a principal residence used for a home office, factory machinery, office computers, land held for future business expansion, warehouses, office buildings, apartment buildings, and rental houses.

Chapter 12, Exhibit 2d



Long-Term Holding Period

Capital assets held for more than one year are long-term.

Chapter 12, Exhibit 2e



Two Categories of Long-Term Holding Period

More than 12 Months. If a capital asset (other than a collectible) or a Code Sec. 1231 asset sold after May 6, 1997, had been held for more than 12 months, it is subject to the 20% capital gains rate (or the 10 % rate for taxpayers in the 15% bracket).

More than 5 Years. (See following slide for explanation.)

Chapter 12, Exhibit 2f



Two Categories of Long-Term Holding Period

More than 5 Years. For capital assets (other than collectibles) sold after 2006, and Code Sec. 1231 assets sold after 2006, the top long-term capital gain rate is 18% if the assets had been held for more than five years (or 8% for taxpayers in the 15% bracket). To get the special 18% rate, a taxpayer must either:1. Acquire the capital asset after December 31, 2000, and hold it for over 5

years; or 2. Acquire the capital asset before January 1, 2001; “pretend” to sell it on

January 1, 2001, by recognizing any realizable gain (commonly referred

to as “marking to market,” the taxpayer pays a 20% capital gains tax on

the difference between FMV on January 1, 2001, and adjusted basis);

then hold the asset for over 5 years before actually selling it. [Note that 15%-bracket taxpayers who acquire property before January 1, 2001, need not mark-to-market the property on January 1, 2001, in order to get the special 8% rate. They need hold it only until after 2006 to get the favorable 8% rate.]

Chapter 12, Exhibit 2g



Determining the Capital/1231 Gains Rate “Basket”

Long-term capital gains and losses and Section 1231 gains and losses fall into one of five rate “baskets”: 10%, 15%, 20%, 25% and 28%. Two variables, (1) marginal ordinary tax rate, and (2) type of asset sold or exchanged, must be identified in order to determine the appropriate rate basket. Different combinations of these two variables result in different rate baskets.



Rate Basket

Two Variables Affecting Rate Baskets

(1) Marginal

Ordinary Rate

(2) Type of Asset Sold

10% 15 %Non-Collectible Capital Assets; or Code Sec. 1231 Assets

15 % 15 % Collectibles

20 % Above 15 %

Non-Collectible Capital Assets; or Code Sec. 1231 Assets (other than 1231 gain attributable to unrecaptured Code Sec. 1250 depreciation)

25 % Above 15 %

Code Sec.1231 Assets (to the extent of gain attributable to unrecaptured Code Sec. 1250 depreciation)

28 % Above 15 % Collectible


Determining The Capital/1231 Gains Rate “Basket”


Computing Capital Gain Tax—10% Rate

FACTS: Ben, a single individual, has 2003 taxable income in the amount of $29,000. This amount includes a $4,000 long-term capital gain on stock held over 12 months.

QUESTION: What is Ben’s tax liability for 2003?

SOLUTION: $3,910 as in the following calculations.




$3,910.00$29,000Totals(g) = (c) + (d) + (e) + (f)

$120.0020%$600($4,000 – $3,400)

Long-term cap. gain subject to 20% rate

(f) = (b) – (e)

$340.0010%$3,400(Lesser of: $4,000, or

$3,400 = $28,400 – $25,000)

Long-term capital gain subject to 10% rate

(e) = Lesser of:

(b), or $28,400 – (c)

$0.0027% $0(Lesser of: $40,400, or $0 = $29,000 – $4,000 – $25,000)

Ordinary income subject to 27% rate

(d) = Lesser of:

$40,400 (i.e., top 27% bracket for single individuals, $68,800, less top 15% bracket,

$28,400), or (a) – (b) – (c)

$3,450.0010, 15%$25,000 (Lesser of: $28,400, or $25,000=$29,000 – $4,000)

Ordinary income subject to 10% and 15% rates

(c) = Lesser of:

$28,400, or (a) – (b)

$4,000Long-term cap. gain(b)

$29,000Taxable income(a)

TaxTax RateTaxable IncomeDescription


SOLUTION:


Ben’s ordinary income is $25,000 ($29,000 – $4,000). According to the “single individual” rate table, the 10% and 15% tax rates apply to ordinary income up to $28,400. Since Ben’s ordinary income amount of $25,000 is below the $28,400 limit, a portion of his long-term capital gain gets taxed at the favorable 10% rate. The amount subject to the 10% rate is the difference between $28,400 (i.e., the 15% bracket’s upper limit), and $25,000 (i.e., Ben’s actual ordinary income). Any remaining long-term capital gain gets the favorable 20% long-term capital gain rate. Based on the computations above, Ben’s tax liability is $3,910.





FACTS: Conor, a single individual, has 2003 taxable income in the amount of $29,000. This amount includes a $1,000 long-term capital gain on stock held over 12 months.

QUESTION: What is Conor’s tax liability for 2003?

SOLUTION: $4,060.00 as shown in the following calculation.



$4,060.00$29,000Totals(g) = (c) + (d) + (e) + (f)

$120.0020%$600

($7,000 – $400)

Long-term cap. gain subject to 20% rate

(f) = (b) – (e)

$40.0010%$400(Lesser of: $1,000, or

$400 = $28,400 – $28,000)

Long-term capital gain subject to 10% rate

(e) = Lesser of:

(b), or $28,400 – (c)

$027% $0(Lesser of:

$40,400, or $0 = $29,000 – $1,000 – $28,000)


(d) = Lesser of:

$40,400 (i.e., top 27% bracket for single individuals, $68,800, less top 15% bracket,

$28,400), or(a) – (b) – (c)

$3,900.0015%$28,000 (Lesser of: $28,400, or$28,000 = $29,000 – $1,000)


(c) = Lesser of:

$28,400, or (a) – (b)

$1,000Long-term cap. gain(b)

$29,000Taxable income(a)

TaxTax RateTaxable IncomeDescription



SOLUTION:



Conor’s ordinary income is $28,000 ($29,000 – $1,000). According to the rate tables, all of this $28,000 of ordinary income is subject to 10% and 15% ordinary rates. $400.00 of his long-term capital gain is taxed at 10% and $600.00 is taxed at 20%. Based on the computations, Conor must pay $4,060.00 in taxes.



Tax Treatment for Ordinary Income Property and Capital Assets

Accounts receivable

Inventory

Worthless securities held by non-dealers.

* (Holding period always ends on last day of tax year in which securities became worthless)

Worthless securities held by dealers

Non-business bad debts *(always short-term, regardless of holding period.)

Business bad debts

Subdivided real estate sold by investors

Subdivided real estate sold by dealers

Options

Lease cancellation payments received by tenant

Lease cancellation payments received by landlord

Franchises, trademarks, trade names

Patents

Always CapitalSometimes Ordinary Income, Sometimes Capital

Always Ordinary Income

Tax Treatment

Chapter 12, Exhibit 6


Patents

Substantial RightsGain or loss on sale of patents receives capital treatment if “all substantial rights” have been sold. Otherwise, gain or loss would get ordinary tax treatment. All substantial rights are deemed to have been sold if there are no restrictions regarding: Geographic areas within the country of issuance Time allowed to use the patent Markets or industries in which patent-related products may be sold Products or inventions related to the patent.



Patents

Holding Period

Regardless of how brief a patent is held, if it receives capital treatment, the holding period is ALWAYS long-term.



Patents

Contingent Payments Are Ok

Patents, unlike franchises, may receive capital treatment, even though the seller's receipt of patent royalties is contingent upon the patent's productivity, use, or disposition.



Patents

Ordinary Treatment for Certain Sellers

Authors, composers, and artists who sell their creations ALWAYS must report ordinary income or loss. Code Sec. 1221(3). However, the inventor of a patent may get long-term capital gain treatment if “all substantial rights” have been sold.



Franchises, Trademarks, and Trade Names

To qualify for capital treatment, the seller must (1) transfer all significant rights; and (2) receive noncontingent payments.




Significant Rights

“Significant rights” refers to the ability of the seller to make on-going decisions for the buyer, after the franchise, trademark, or trade name has been sold.




Contingent Payments Are Not Ok

Franchises, trademarks, and trade names do not receive capital treatment if the seller's receipt of payments is contingent upon productivity, use, or disposition.



Franchises, Trademarks, or Trade Names

Special Rules for Buyers of Franchises, Trademarks,or Trade Names

Contingent payments are deductible. Noncontingent payments must be amortized over 15 years.



Lease Cancellation Payments

Landlord. Lease cancellation payments are always ordinary income. Tenant. Lease cancellation payments are either ordinary or capital, depending upon the character of the leased asset. For example, a lease cancellation payment for retail space is ordinary income to the tenant; however, a lease cancellation payment for a principal residence is capital gain to the tenant.



Options—General Rules

Grantor = The maker of an option who receives value in exchange for a contractual obligation to sell or buy at a certain price



Grantor’s Tax Treatment

If an option expires, the option money received by the grantor is either short-term capital gain or ordinary income, depending on the character of the property.




Grantor's tax treatment upon expiration of option to buy or sell

Stock and Securities Other property

Tax treatment ALWAYS short-term capital gain, regardless of holding period

ALWAYS ordinary income

Examples Stock, commodity futures, calls, puts, etc.

Land, warehouse, car, computer, etc.




Grantee = The holder of an option who pays a price for the right to buy or sell at a certain price




Grantee’s Tax Treatment

If the option is sold, or allowed to expire, the character of the property dictates the tax treatment. If the option is exercised, the option payment is added to the grantee's (if grantee is buyer and grantor is seller), or subtracted from the grantee's amount realized (if grantee is seller and grantor is buyer).




Options—Example


($2,000) Long-term capital loss

($3,000 – $5,000)

No effect($2,000) Long-term capital loss

($3,000 – $5,000)

No effect1. Two years later, Tina sells the option to Fred for $3,000.

GranteeGrantorGranteeGrantorAlternate Assumptions

Other PropertyStock and Securities

Tax treatment

FACTS: On 6/30/x1, George grants Tina a $5,000, 2-year option to buy investment property for $100,000. QUESTION: Consider the tax treatment if the investment property were stocks or land under the 6 alternative assumptions below.


$3,000 Long-term capital gain

($8,000 – $5,000)

No effect$3,000 Long-term

capital gain ($8,000 – $5,000)

No effect2. Two years later, Tina sells the option to Fred for $8,000.



Tax treatment


Options—Example


$3,000 Long-term capital gain

($8,000 – $5,000)

No effect$3,000 Short-term capital gain

($8,000 – $5,000)

No effect3. One year later, Tina sells the option to Fred for $8,000.



Tax treatment


Options—Example


Tax treatment

Stock and Securities Other Property

Alternate Assumptions

Grantor Grantee Grantor Grantee

4. The option expires on 6/30/x3.

$5,000 Short-term capital gain


$5,000 Ordinary income



Options—Example


Tax treatment




5. Tina exercises the option on 6/30/x1.

$105,000 amount realized

$105,000 basis $105,000 amount realized

$105,000 basis


Options—Example


Tax treatment




6. Same facts as 5, except Tina is paying for the option to sell, not buy, the property.



Chapter 12, Exhibit 11f

Options—Example


Subdivided Real Estate Sold by Investors

Qualifying Property

To qualify for capital gains treatment, three requirements must be met: 1. The subdivided lots must not have been previously held

primarily for sale to customers in the ordinary course of business

2. The subdivided lots have not been “substantially improved”

3. The subdivided lots must be held for at least 5 years




Substantial Improvements

Improvements such as infrastructure are substantial if they increase the value of the lots by over 10%. However, certain costs are deemed NEVER to be “substantial improvements.” Examples include: surveying, clearing drainage, and minimum all-weather access roads.




Tax Treatment for the First 5 Lot Sales. Gains on the first 5 lots sold receive capital treatment. Losses are ALWAYS ordinary.

Tax Treatment for Gains on Subsequent Lot Sales. Gains receive BOTH capital and ordinary treatment, beginning in the year in which the 6th lot is sold, using the following formula:

Total gain – (a)Capital treatment(b)

(5% SP) – (100% selling exp.)Ordinary treatment(a)

Tax treatment for GAINS after the fifth lot sale



Worthless SecuritiesTax Treatment. Generally capital. However, if held by a dealer, then ordinary.

Holding Period. The holding period for worthless securities begins on the day after the acquisition date and ends on the LAST DAY OF THE YEAR in which the securities are deemed to be worthless.

Long-term or Short-term?

Holding period end. date?

Holding period beginning date?

Worthless datePurchase date

Example

Long term12/31/x212/31/x11/1/x212/30/x1

Short-term12/31/x21/1/x212/31/x212/31/x1



Depreciation Recapture—Example 1


FACTS:1. A taxpayer has $2 million of gross income in year 1.2. The taxpayer purchases a machine for $800,000 and depreciates it for $500,000 in year 1. 3. The machine is sold in year 2 for $1 million.4. The taxpayer’s capital gains rate is 20%; the ordinary tax rate is 40%. (Actual tax brackets, actual MACRS depreciation computations, and deductions “from” AGI are ignored for purposes of simplifying this illustration.)

QUESTION:Compare the results in years 1 and 2 with and without depreciation.

Example 1



200

($800 – $600); or ($500 x 40%)

Tax Benefit from Depreciation

$800$600Ordinary Income Tax

40%40%Ordinary Tax Rate

$2,000$1,500Taxable Income

$0$500Depreciation, Year 1

$2,000$2,000Gross Income

Without Depreciation

WithDepreciation

Year 1

Tax “Benefit” from Depreciation Deduction




$100

($140 – $40); or ($500 x 20%)

Tax Burden From Depreciation, Absent Any Depreciation Recapture

$40$140Capital Gain Tax (Ignoring Depreciation Recapture)

20%20%Capital Gain Tax Rate

$200$700Realized Gain

$800$300Adjusted Basis

$0$500Less: Accumulated Depreciation

$800$800Cost of Machine

$1,000$1,000Sales Price

Without Depreciation

With Depreciation

Year 2

Tax “Burden” from Depreciation Adjustment to Basis



Observation: Overall tax advantage from depreciation if depreciation is not recaptured: $100 ($200 benefit in year 1, minus $100 tax burden in year 2.)





Rationale for Recapture RulesThe foregoing illustration demonstrates how unrecaptured depreciation would create an overall tax advantage—this, despite a reduced basis equivalent to the amount of accumulated depreciation deductions. The overall advantage was eliminated in the early 1960s with the enactment of the depreciation recapture rules. The depreciation recapture rules recharacterize capital gains as ordinary income to the extent of all or a portion of accumulated depreciation. Using the facts from Example 1, the following example shows how the recapture rules work.




Example 2

$700Realized Gain

$300Adjusted Basis

$500Less: Accumulated Depreciation

$800Cost of Machine

$1,000Sales Price

Year 2: Sale of the Machinery




$100

($240 – $140)

Additional taxes attributable to Depreciation Recapture

$140$240Total Tax

$140$40$200Tax

20%20%40%Ordinary/Capital Tax Rates

$700$200$500Recharacterized Gain

(Capital)

Code Sec. 1231

(Capital)

Code Sec. 1245

(Ordinary)

Without Depreciation Recapture

With Depreciation Recapture



Observation: The $100 additional taxes offsets the $100 tax advantage that would have resulted if depreciation had not been recaptured.




Business Asset Dispositions—Template for Problem Solving


[Realized gain – (a)]

N/AN/ALesser of:

1. Accumulated depreciation, or

2. Realized gain.

(1) Gains on all depreciable personal property.

20% Basket

(for any remaining gain or

any loss)

25% Basket

(for unrecaptured

Code Sec. 1250 Gain)

38.6% Basket

(Always Ordinary Income)

38.6% Basket


Category #/Description

(d)(c)(b)(a)

Code Sec. 1231 Gain/Loss

(Send to 2nd Netting)

Code Sec. 1250 Depreciation

Recapture

Code Sec. 1245

Depreciation Recapture

CCH Federal Taxation Basic Principles 56 of 92Chapter 12, Exhibit 16b


Recapture


Recapture



(a) (b) (c) (d)


38.6% Basket


38.6% Basket


25% Basket(For

unrecaptured Sec. 1250

Gain)

20% Basket

(For any remaining

gain or any loss)

(2) Gains on non-residential real property acquired 1981-1986, with ACRS depreciation.

Lesser of:

1. Accumulated depreciation, or

2. Realized gain.

N/A N/A [Realized gain – (a)]


CCH Federal Taxation Basic Principles 57 of 92Chapter 12, Exhibit 16c


[Realized gain – (b) – (c)]

[Note that (b) = 0]

Lesser of: 1. Straight-line accumulated depreciation

2. Realized gain – (b)

Lesser of: 1. Actual accumulated depreciation – straight-line accumulated depreciation,* or 2. Realized gain

N/A(3) Gains on residential and non-residential real property acquired after 1986.

20% Basket

(For any remaining

gain or any loss)

25% Basket

(For unrecaptured


38.6% Basket


38.6% Basket



(d)(c)(b)(a)




Recapture

Code Sec. 1245


* (always 0 for individuals since actual accumulated depreciation = straight-line accumulated depreciation)

CCH Federal Taxation Basic Principles 58 of 92Chapter 12, Exhibit 16d

[Real gain – (b) – (c)]

Lesser of:

1. Straight-line accumulated depreciation

2. Realized gain – (b)

Lesser of:

1.Actual accumulated depreciation – straight-line accumulated depreciation; or

2. Realized gain

N/A(4) Gains on residential real property acquired 1981-1986, with ACRS depreciation.

20% Basket

(For any remaining gain or

any loss)

25% Basket

(For unrecaptured


38.6% Basket


38.6% Basket



(d)(c)(b)(a)




Recapture


Recapture


CCH Federal Taxation Basic Principles 59 of 92Chapter 12, Exhibit 16e


[Note that (b) = 0]

Lesser of: 1. Straight-line accumulated depreciation 2. Realized gain – (b).

Lesser of:1. Actual accumulated depreciation – straight-line accumulated depreciation; or 2. Realized gain

N/A(5) Gains on non-residential real property acquired 1981-1986, with straight-line depreciation.

20% Basket

(For any remaining gain or any loss)

25% Basket

(For unrecaptured Code Sec. 1250

Gain)

38.6% Basket


38.6% Basket



(d)(c)(b)(a)




Recapture


Recapture


CCH Federal Taxation Basic Principles 60 of 92Chapter 12, Exhibit 16f

[Real gain – (a)]N/AN/ALesser of:

1. Accumulated amortization or

2. Realized gain

(6) Gains on amortizable personal property used in business (e.g., patents, copyrights, leaseholds).

20% Basket


any loss)

25% Basket(For

unrecaptured Code Sec.

1250 Gain)

38.6% Basket


38.6% Basket



(d)(c)(b)(a)




Recapture


Recapture


CCH Federal Taxation Basic Principles 61 of 92Chapter 12, Exhibit 16g

Code Sec. 1245



Recapture



(a) (b) (c) (d)


38.6% Basket


38.6% Basket


25% Basket

(For unrecaptured


20% Basket


any loss)

(7) All losses on any long-term business assets.

N/A N/A N/A 100% losses are Code Sec. 1231.


CCH Federal Taxation Basic Principles 62 of 92Chapter 12, Exhibit 16h

Code Sec. 1245



Recapture



(a) (b) (c) (d)


38.6% Basket


38.6% Basket


25% Basket

(For unrecaptured


20% Basket


any loss)

(8) G/L on sale of short-term business assets.

100% ordinary. (Short-term gains or losses on business property are neither Code Sec. 1231, 1245, nor 1250.)



Business Asset Dispositions—Example 1

FACTS:

David, a 38.6% taxpayer, purchases a building in 1988 for $390,000. He takes $90,000 of depreciation using the straight-line method. On October 15, 20x1, he sells the building for $440,000.

QUESTION:

How much taxes are attributable to the sale?




Computation of Taxes on Code Sec. 1250 and Code Sec. 1231 Gains


(Sent to 2nd Netting)


Recapture


Recapture

20% Basket(for any

remaining gain or any

loss)

25% Basket

(for unrecaptured Code Sec. 1250

Gain)

38.6% Basket


Category #/

Type of Gain

(d)(c)(b)(a)

[Realized gain – (b) – (c)]

[Note that (b) = 0]

Lesser of:

1. Actual accumulated depreciation – straight-line accumulated depreciation,* or

2. Realized gain

Lesser of: 1. Straight-line accumulated depreciation

2. Realized gain – (b).

N/A# 3/Gains on residential and non-residential real property acquired after 1986.

* (always 0 for individuals since actual accumulated depreciation = straight-line accumulated depreciation)






(Sent to 2nd Netting)


Recapture


Recapture

20% Basket(for any

remaining gain or any loss)

25% Basket

(for unrecaptured Code Sec. 1250

Gain)

38.6% Basket


Category #/

Type of Gain

(d)(c)(b)(a)

$10,000$22,5000 Tax amount ($32,500 total)

20%25%38.6% Tax rates

$50,000

[$140,000 – 0 – $90,000]

$90,000

Lesser of

1. $90,000, or

2. $140,000 – 0

$0

The lesser of :

1. 0 = $90,000 – $90,000

2. $140,000

Computation of realized gain:

Sale Price…. ……...$440,000

Cost ……….………$390,000

Straight-line depr...... $90,000

Adjusted basis……..$300,000

Realized gain……...$140,000




FACTS:

Conor, a 38.6% taxpayer, purchased an apartment building in 1986 for $390,000. He had taken $99,000 of ACRS depreciation. Straight-line depreciation would have been $90,000. On October 15, 19x1, he sells the building for $440,000.

QUESTION:

What are his taxes on the transaction?








Recapture

Code Sec. 1245


20% Basket(For any


25% Basket(For unrecaptured


38.6% Basket


Category #/ Type of Gain

(d)(c)(b)(a)


Lesser of:

1. Actual accumulated depreciation – straight-line accumulated depreciation; or

2. Realized gain

Lesser of:

1. Straight-line accumulated depreciation

2. Realized gain – (b).

N/A# 4 /Gains on residential real property acquired 1981-1986, with ACRS depreciation.





$10,000$22,500$3,474Tax amount ($36,064 total)

20%25%38.6%Rate baskets

$50,000

[$149,000 – $9,000 – $90,000]

$90,000

Lesser of

1. $90,000, or

2. $149,000 – $9,000

$9,000

The lesser of :

1. $9,000 = $99,000 – $90,000

2. $149,000

Computation of realized gain:

Sale Price…….....…$440,000 Cost ………….....…$390,000

ACRS depr................ $99,000

Adjusted basis .. ......$291,000

Realized gain …......$149,000


20% Basket(For any


25% Basket(For unrecaptured


38.6% Basket


Category #/ Type of Gain

(d)(c)(b)(a)




Recapture

Code Sec. 1245



The First Netting—Capital Gains and Losses

Offset Gains and Losses Within Each Basket

Offset capital gains and losses within each basket (i.e., the 10%, 15%, 20%, and 28% baskets). (The 25% basket is not listed here because it holds only gains, never losses. Why no losses? Because the 25% basket applies only to that portion of Code Sec. 1231 gain attributable to unrecaptured Code Sec. 1250 depreciation.)



Offset Gains and Losses from Separate Baskets

If, after step 1, there are opposites (i.e., one or more baskets has a net gain and one or more a net loss), then the gains and losses must be further offset. The pecking order in selecting “net gain” and “net loss” baskets to offset is as follows.





Pecking Order of Baskets Selected For The First Netting

“Net gain baskets” to be offset against “net loss baskets”

Start with short-term capital gains (might be as high as the 38.6% bracket), then long-term capital gains beginning with the highest-rate baskets holding net gains (i.e., 28%, then 20%, then 15%, then 10%).

“Net loss baskets” to be offset against “net gain baskets”

Start with short-term capital losses (might be as high as the 38.6% bracket), then long-term capital losses beginning with the highest-rate baskets holding net losses (i.e., 28%, then 20%, then 15%, then 10%).



The First Netting—Example 1


FACTS: Fred reports the following gains and losses:

QUESTION: How is the first netting performed?

$4,000 gain; ($7,000) loss38.6%Short-Term

$1,000 gain28%Long-Term

$7,000 gain; ($4,000) loss20%Long-Term


AmountBasketHolding Period


STEP 1: Offset Gains and Losses Within Each Basket

Basket Net Amount Within Each Basket

Result after 1st Netting

15% $2,000 gain $2,000 LTCG at 15%*

20% $3,000 net gain $1,000 LTCG at 20%*

28% $1,000 gain $0

38.6% ($3,000) net loss $0* These rates are only relevant if the Long-Term Capital Gains survive the 2nd netting.



Two-Step Solution


STEP 2: Offset Gains and Losses From Separate Baskets

The $3,000 net loss from the 38.6% basket is first used to offset the $1,000 gain from the 28% basket; then $2,000 of the $3,000 net gain from the 20% basket. The result of the 1st netting is a $1,000 long-term capital gain subject to a 20% rate and a $2,000 long-term capital gain subject to a 15% rate (if they survive the second netting).


Two-Step Solution





QUESTION: How is the first netting performed?

FACTS: Wilma reports the following gains and losses:

$7,000 gain; ($3,000) loss38.6%Short-Term


$4,000 gain; ($7,000) loss20%Long-Term

($6,000) loss10%Long-Term

AmountBasketHolding Period


STEP 1: Offset Gains and Losses Within Each Basket

Basket Net Amount Within Each Basket

Result after 1st Netting

10% ($6,000) loss ($1,000) long-term capital loss subject to ordinary loss treatment if it survives the second netting

20% ($3,000) net loss 0 net loss

28% $4,000 gain 0 net gain

38.6% $4,000 net gain 0 net gain



Two-Step Solution


STEP 2: Offset Gains and Losses From Separate Baskets

The $4,000 net gain from the 38.6% basket is first netted against the ($3,000) loss from the 20% basket, then against ($1,000) of the ($6,000) loss from the 10% basket. Next, the $4,000 gain from the 28% basket is netted against ($4,000) of the remaining ($5,000) loss from the 10% basket. The result of the 1st netting is a ($1,000) long-term capital loss within the 10% basket. This long-term capital loss, as with all long- and short-term capital losses not exceeding $3,000, is treated as an ordinary loss if it survives the 2nd netting.



Two-Step Solution


The First Netting—Personal-Use Casualty/Theft Gains/Losses

Combine casualty/theft gains and losses less $100 per event, on personal-use property.

If a net gain, both gains and losses are capital. Transfer the net gain to the second netting. Recall that the losses had been reduced by $100 per event but NOT by the 10% AGI floor.

If a net loss, the net amount is treated as an ordinary itemized deduction, having been reduced by $100 per event AND to be further reduced by the 10% AGI floor. (No need to transfer to the second netting; rather, report on Schedule A.)



The First Netting—Business/Investment Use Casualty/Theft Gains/Losses

Combine casualty/theft gains and losses on business and PI property held long-term. (If the holding period is short-term, the gain or losses get ordinary treatment and are NOT part of the netting process.)

If a net gain, then treat the net amount as a Code Sec. 1231 gain and transfer it to the second netting.

If a net loss, then treat the net amount as an ordinary deduction for AGI. (No need to transfer to the second netting; rather, report on Schedule C.)



The First Netting—Personal-Use Condemnation Gains/Losses

Long-term gains receive capital treatment; short-term gains receive ordinary treatment; losses are not deductible. Transfer any personal-use condemnation long-term gains to the second netting.



The First Netting—Business/Investment-Use Condemnation Gains/Losses

Long-term gains and losses BOTH get Code Sec. 1231 treatment. (Code Sec. 1231 gains get capital tax rates; Code Sec. 1231 losses are deductible at ordinary tax rates. Also, note the difference in tax treatment for (1) business/investment casualty/theft net losses and (2) business/investment condemnation losses. Transfer the Code Sec. 1231 condemnation gains and losses to the second netting.)



The First Netting—Long-Term Business Assets

Upon the sale of a long-term business asset, any gain remaining after Code Sec. 1245 or Code Sec. 1250 depreciation recapture is a Code Sec. 1231 gain. Any loss is a Code Sec. 1231 loss. Transfer both Code Sec. 1231 gains and losses to the second netting.

(Note that gains or losses on the sale of short-term business assets are always ordinary. No need to transfer to the second netting.)



The First Netting—Recap


15% 28%20%25%20% 10%10%

15% 28%20%25%20%

N/A for nettingNet gain or loss “38.6%”

Net Gain or LossNet Gain or LossNet totals for 2nd Netting

Code Sec. 1245 and 1250 recaptured as ordinary income

Gains, net of depr. Recap.; losses

L-T business asset G/L

Gains and lossesBus./inv. Condemnation G/L

Gains (losses not deductible)Gains (losses not deductible)

Personal-use condemnation gains & losses

Net losses, for AGINet gain

Bus./inv. Casualty net gain

Net losses, from AGI, reduced $100 per event

& 10% AGI (if net loss)

Net gainNet gainPersonal casualty net gain

Gains or lossesCapital gains & losses

“38.6%”

Gains or losses10%10%

Short-termLong-termCode Sec. 1231Description

Capital Gains and Losses (This column is not part of the netting process.) Always Ordinary Income


The Second Netting—Examples

$4,000, i.e.,

$3,000 offsets the “28% LTCL basket”

(Capital gains may not be offset against Code Sec. 1231 losses)

($4,000), i.e.,

($3,000) is offset against the “25% Code Sec. 1231 basket”

(Code Sec. 1231 losses may not be offset against capital gains)

Solution

($3,000)$7,000$3,000($7,000)Gains (Losses)

28%20%25%20%Problem # 1

Short-TermLong-TermCode Sec. 1231 G/L’s

Rate Basket for Capital Gains and LossesRate Basket for

QUESTION: For each independent set of gains and losses below, determine the tax treatment after the second netting.




$6,000 net STCG, taxed at ordinary rate

00($4,000) ordinary loss

deduction

Solution

$21,000$3,000($18,000)$3,000($7,000)Gains (Losses)

28%20%25%20%Problem # 2







($3,000) ordin. loss deduction;

($2,000) STCL carryover

000($4,000) ordinary loss

deduction

Solution

($27,000)$3,000$19,000$3,000($7,000)Gains (Losses)

28%20%25%20%Problem # 3







($2,000) ordinary loss deduction

($21,000 - $19,000)

($19,000 = $18,000 + $4,000 - $3,000)

0000 (Code Sec. 1231 gains

offset capital losses, first

from the highest LTCL basket, then

from STCLs!)

Solution

($21,000)($3,000)$18,000($3,000)$7,000Gains (Losses)

28%20%25%20%Problem # 4






The Second Netting—Recap of the Rules

To complete the second netting, follow these steps:

1. Net each category by totaling the columns.

2. If the long-term capital column still shows a gain after offsetting any net short-term capital losses (STCLs) treat the net amount as a net long-term capital gain

(LTCG) subject to a maximum 10%, 15%, 20%, or 28% tax rate, depending on which basket survives the netting.

3. If the short-term capital column still shows a gain after offsetting any net LTCLs, treat the net amount as a net STCG subject to the ordinary marginal tax rate.

4. If the Code Sec. 1231 column total shows a net loss, treat the net amount as an ordinary loss, deductible for AGI, without the $3,000 limitation. Do not offset it against net long-term or short-term capital gains.

5. If the Code Sec. 1231 column total shows a net gain: Treat as ordinary income to the extent of Code Sec. 1231 net losses for the previous five years that have not been recaptured. (Refer to the example regarding 5-Year Look-Back Rules in the following slide.)




(b) If any Code Sec. 1231 gain survives, offset it against any net LTCLs, starting with the highest baskets containing LTCLs.(c) If a Code Sec. 1231 gain still survives, offset it against any net STCLs.(d) If yet a Code Sec. 1231 gain survives, treat it as a long-term capital gain, subject to a maximum 25% tax rate.

10,00010,000Surviving Code Sec. 1231 gain treated as L-T capital gain

40,00030,000

10,000

30,00020,000

10,000

Recharacterized as ordinary income

50,000(30,000)(10,000)40,000(20,000)(10,000)Code Sec. 1231 G/L before look-back

20x620x520x420x320x220x1

QUESTION: Given the following facts, how much of the Code Sec. 1231 gains in 20x3 and 20x6 should be recharacterized as ordinary income?

Example on the 5-Year Look-Back Rules




If LTCLs or STCLs survive after netting with Code Sec. 1231 gains, first treat STCLs as ordinary losses, limited to $3,000. If any part of the $3,000 remains, treat any LTCLs as ordinary to the extent of the remainder (starting with the highest basket). Unused STCLs and LTCLs are carried forward indefinitely.



Applying the $3,000 Capital Loss Limitation

Only $3,000 may be deducted each year for the aggregate of “net” short-term and “net” long-term capital losses. Short-term capital losses (STCLs) are used up first, then long-term capital losses (LTCLs) beginning with the highest LTCL “baskets.” Note that STCLs and LTCLs get “ordinary” treatment to the extent of the $3,000 deduction noted above. Any remaining capital losses (i.e., in excess of $3,000) are carried over. However, also note that STCLs and LTCLs on the sale of personal use property such as a principal residence or a car used for commuting, are NEVER deductible, and NEVER carried forward!


CCH Federal Taxation Basic Principles 92 of 92Chapter 12, Exhibit 30b

Applying the $3,000 Capital Loss Limitation

Note that there is no 25% basket for losses since this basket applies only to the portion of Code Sec. 1231 gain attributable to unrecaptured Code Sec. 1250 depreciation.

$3,000 – (a) – (b) – (c) – (d)LTCLs, 10% Basket(e)

$3,000 – (a) – (b) – (c)LTCLs, 15% Basket(d)

$3,000 – (a) – (b)LTCLs, 20% Basket(c)

$3,000 – (a)LTCLs, 28% Basket(b)

$3,000Short-Term Capital Losses(a)

Deductible against ordinary income, limited to:

Pecking Order of Loss “Baskets”

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