p r e v i e w g u i d e

P R E V I E W G U I D E

Preview Guide — Hoffman/Maloney/Young/Raabe/Nellen — SWFT 2016 ISBN-13: 9781305652347 ©2016 Designer: XxxxxxxXxxxxxText & Cover printer: XXXXXXXX Binding: Paper Trim: 8.5” x 10” CMYK

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We talked with hundreds of tax instructors across the country and received the following answers when we asked: What are the most significant challenges you face when teaching your tax course?

n Students’ failure to read the textbook

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The South-Western Federal Taxation Series and CengageNOW will help you elevate student thinking with each stage of the learning process from motivation to mastery. This integrated solution motivates and prepares students to learn, provides practice opportunities, and helps students achieve mastery with tools that help them make connections and see the big picture.

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n Selected content has been streamlined to guide students in focusing on the most important concepts for the CPA exam while still providing in-depth coverage of topics

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New! Full-Color Design: We understand that students struggle with learning difficult tax code concepts and applying them to real-world scenarios. The 2016 edition has been developed with an invigorating use of color that brings the text to life, captures student attention and presents the tax code in a simple, yet logical format.

To uphold our commitment to being the most trusted series in college taxation, the 2016 edition of the SWFT series has been updated to include these invaluable features:


New! Computational exerCises: Students need lots of practice in computing tax return problems, adjusting rates, etc. We’ve developed these new exercises to give students practice in calculating the numbers they need to make business decisions.

New! roger Cpa exam review Questions: We understand many of your students plan to take the CPA exam. While the SWFT series has always provided the most in-depth coverage of tax concepts, Roger CPA Exam Review questions have been added to further prepare students for success.

n Found in end-of-chapter section in the textbook

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The Big PicTure: Tax Solutions for the Real World. Taxation comes alive at the start of each chapter as The Big Picture Examples give a glimpse into the lives, families, careers, and tax situations of typical filers. Students will follow this one family or individual throughout the chapter showing students how the concept they are learning plays out in the real world.

See how the SWFT series helps students understand the big picture and the relevancy behind what they are learning.


concePT SummarieS: Each chapter is filled with concept summaries to help students understand the big picture being discussed. More concept summaries have been added to help simplify the tax code.

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FrameWork 1040: Fitting it all Together. This chapter opening feature demonstrates how topics fit together. Using the Income Tax Formula for Individuals as the framework, students see how the topics relate to the basic tax formula and how these items are reported on the Form 1040.


Tax in The neWS: Tax in the News presents current issues that illustrate the chapter material and apply them to real life. These plentiful news items show students the relevancy of the tax law concepts they are learning.

The SWFT series has always been known for its strong end-of-chapter assignments. now it is even better with the addition of two new assignment items, computational exercises and roger cPa review questions.


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each title in the SWFT series is accompanied by the leading industry software to equip students to think like tax professionals.

Student Edition

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n Personalized Study Plan. Complete with pre-tests, post-tests an eBook and practice quizzes. Designed to help give students additional support and prepare them for the exam.


And now, a sneak peak into the 2016 edition...


Property Transactions:Determination of Gain or Lossand Basis Considerations

L E A R N I N G O B J E C T I V E S : After completing Chapter 14, you should be able to:

LO.1State and explain the computation of realized gain orloss on property dispositions.

LO.2Distinguish between realized and recognized gain orloss.

LO.3Review and illustrate how basis is determined forvarious methods of asset acquisition.

LO.4Describe various loss disallowance provisions.

LO.5Identify tax planning opportunities related toselected property transactions.

C H A P T E R O U T L I N E

14-1 Determination of Gain or Loss, 14-214-1a Realized Gain or Loss, 14-214-1b Recognized Gain or Loss, 14-514-1c Nonrecognition of Gain or Loss, 14-6

14-2 Basis Considerations, 14-714-2a Determination of Cost Basis, 14-714-2b Gift Basis, 14-1014-2c Property Acquired from a Decedent, 14-1214-2d Disallowed Losses, 14-1414-2e Conversion of Property from Personal Use to Business

or Income-Producing Use, 14-16

14-2f Additional Complexities in Determining RealizedGain or Loss, 14-17

14-2g Summary of Basis Adjustments, 14-19

14-3 Tax Planning, 14-1914-3a Cost Identification and Documentation

Considerations, 14-1914-3b Selection of Property for Making Gifts, 14-1914-3c Selection of Property for Making Bequests, 14-2114-3d Disallowed Losses, 14-21

C H A P T E R

14

THE BIG PICTURE

PROPOSED SALE OF A HOUSE AND OTHER PROPERTY TRANSACTIONS

Alice owns a house that she received from her mother seven months ago. Her mother’s cost for the house

was $275,000. Alice is considering selling the house to her favorite nephew, Dan, for $275,000. Alice antici-

pates that she will have no gain or loss on the transaction. She comes to you for advice.

As Alice’s tax adviser, you need answers to the following questions:

• You are aware that Alice’s mother died around the time Alice indicates that she received the house from

her mother. Did Alice receive the house by gift prior to her mother’s death? If so, what was the mother’s

adjusted basis? Did Alice instead inherit the house from her mother? If so, what was the fair market value

of the house on the date of her mother’s death?

• Has the house been Alice’s principal residence during the period she has owned it? Was it her principal

residence before she received it from her mother?

• How long did Alice’s mother own the house?

• What is the current fair market value of the house?

• Does Alice intend for the transaction with Dan to be a sale or part sale and part gift?

• What does Alice intend to do with the sale proceeds?

Alice would also like to know the tax consequences of selling her boat, which she purchased for $22,000

four months ago and has used exclusively for personal use. She has been disappointed with its layout and

capacity. Because it is a new model, there is significant demand for the boat, and based on listings in her

area, she anticipates that she can sell it for $20,000 to $23,000.

In addition, earlier this year, Alice sold some stock at a realized loss and subsequently repurchased some

shares of the same stock. She has also asked you about the tax consequences of these transactions.

Once you have more information, you can advise Alice on the tax consequences of these various

transactions.

Read the chapter and formulate your response.

ª MIKESPICS/ISTOCKPHOTO.COM

14-1

FRAMEWORK 1040 Tax Formula for Individuals

This chapter covers theboldfaced portions ofthe Tax Formula forIndividuals that wasintroduced in ConceptSummary 3.1 on p. 3-3.Below those portionsare the sections ofForm 1040 where theresults are reported.

Income (broadly defined) .......................................................................................... $xx,xxx

Less: Exclusions ..................................................................................................... (x,xxx)

Gross income......................................................................................................... $xx,xxx

FORM 1040 (p. 1)

12 Business income or (loss). Attach Schedule C or C-EZ . . . . . . . . . .

13 Capital gain or (loss). Attach Schedule D if required. If not required, check here ▶

14 Other gains or (losses). Attach Form 4797 . . . . . . . . . . . . . .

Less: Deductions for adjusted gross income......................................................... (x,xxx)

Adjusted gross income............................................................................................ $xx,xxx

Less: The greater of total itemized deductions or the standard deduction .............. (x,xxx)

Personal and dependency exemptions ........................................................... (x,xxx)

Taxable income ...................................................................................................... $xx,xxx

Tax on taxable income (see Tax Tables or Tax Rate Schedules) ................................. $ x,xxx

Less: Tax credits (including income taxes withheld and prepaid) ................................ (xxx)

Tax due (or refund) .................................................................................................. $ xxx

T his chapter and the following three chapters are concerned with the income taxconsequences of property transactions (the sale or other disposition of property).The following questions are considered with respect to the sale or other disposi-

tion of property:

• Is there a realized gain or loss?

• If so, is the gain or loss recognized?

• If the gain or loss is recognized, is it ordinary or capital?

• What is the basis of any replacement property that is acquired?

Chapters 14 and 15 discuss the determination of realized and recognized gain orloss and the basis of property. Chapters 16 and 17 cover the classification of the rec-ognized gain or loss as ordinary or capital.

14-1 DETERMINATION OF GAIN OR LOSS

14-1a Realized Gain or LossRealized gain or loss is the difference between the amount realized from the sale orother disposition of property and the property’s adjusted basis on the date of disposition.If the amount realized exceeds the property’s adjusted basis, the result is a realizedgain . Conversely, if the property’s adjusted basis exceeds the amount realized, the resultis a realized loss .1

LO.1

State and explain thecomputation of realized gainor loss on propertydispositions.

1§ 1001(a) and Reg. § 1.1001–1(a).

14-2 PART 5 Property Transactions

Sale or Other DispositionThe term sale or other disposition is defined broadly in the tax law and includes virtuallyany disposition of property. Thus, transactions such as trade-ins, casualties, condemna-tions, thefts, and bond retirements are treated as dispositions of property. The mostcommon disposition of property is through a sale or exchange. Usually, the key factorin determining whether a disposition has taken place is whether an identifiable eventhas occurred2 as opposed to a mere fluctuation in the value of the property.3

Amount RealizedThe amount realized from a sale or other disposition of property is the sum of anymoney received plus the fair market value of other property received. The amount real-ized also includes any real property taxes treated as imposed on the seller that areactually paid by the buyer.4 The reason for including these taxes in the amount realizedis that by paying the taxes, the purchaser is, in effect, paying an additional amount tothe seller of the property.

The amount realized also includes any liability on the property disposed of, such as amortgage debt, if the buyer assumes the mortgage or the property is sold subject to themortgage.5 The amount of the liability is included in the amount realized even if thedebt is nonrecourse and the amount of the debt is greater than the fair market value ofthe mortgaged property.6

The fair market value of property received in a sale or other disposition has beendefined by the courts as the price at which property will change hands between a will-ing seller and a willing buyer when neither is compelled to sell or buy.7 Fair marketvalue is determined by considering the relevant factors in each case.8 An expertappraiser is often required to evaluate these factors in arriving at fair market value.When the fair market value of the property received cannot be determined, the value ofthe property given up by the taxpayer may be used.9

In calculating the amount realized, selling expenses (such as advertising, commis-sions, and legal fees) relating to the disposition are deducted. The amount realized isthe net amount the taxpayer received directly or indirectly, in the form of cash or any-thing else of value, from the disposition of the property.

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1

Tab sells Swan Corporation stock with an adjusted basis of $3,000 for $5,000. Tab’s realized gain is$2,000. If Tab had sold the stock for $2,000, he would have had a realized loss of $1,000.

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3

Barry sells property on which there is a mortgage of $20,000 to Cole for $50,000 cash. Barry’samount realized from the sale is $70,000 if Cole assumes the mortgage or takes the property sub-ject to the mortgage.

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2

Lori owns Tan Corporation stock that cost $3,000. The stock has appreciated in value by $2,000since Lori purchased it. Lori has no realized gain because mere fluctuation in value is not a disposi-tion or an identifiable event for tax purposes. Nor would Lori have a realized loss if the stockdeclined in value by $2,000.

2Reg. § 1.1001–1(c)(1).3Lynch v. Turrish, 1 USTC {18, 3 AFTR 2986, 38 S.Ct. 537 (USSC, 1918).4§ 1001(b) and Reg. § 1.1001–1(b). Refer to Chapter 10 and Examples 17 and18 for a discussion of this subject.

5Crane v. Comm., 47–1 USTC {9217, 35 AFTR 776, 67 S.Ct. 1047 (USSC,1947). Although a legal distinction exists between the direct assumption ofa mortgage and the taking of property subject to a mortgage, the tax conse-quences in calculating the amount realized are the same.

6Comm. v. Tufts, 83–1 USTC {9328, 51 AFTR 2d 83–1132, 103 S.Ct. 1826(USSC, 1983).

7Comm. v. Marshman, 60–2 USTC {9484, 5 AFTR 2d 1528, 279 F.2d 27(CA–6, 1960).

8O’Malley v. Ames, 52–1 USTC {9361, 42 AFTR 19, 197 F.2d 256 (CA–8,1952).

9U.S. v. Davis, 62–2 USTC {9509, 9 AFTR 2d 1625, 82 S.Ct. 1190 (USSC,1962).

CHAPTER 14 Property Transactions: Determination of Gain or Loss and Basis Considerations 14-3

Adjusted BasisThe adjusted basis of property disposed of is the property’s original basis adjusted to thedate of disposition.10 Original basis is the cost or other basis of the property on the datethe property is acquired by the taxpayer. Considerations involving original basis are dis-cussed later in this chapter. Capital additions increase and recoveries of capital decreasethe original basis so that on the date of disposition, the adjusted basis reflects the unrecov-ered cost or other basis of the property.11 Adjusted basis is determined as follows:

Cost (or other adjusted basis) on date of acquisitionþ Capital additions� Capital recoveries¼ Adjusted basis on date of disposition

Capital AdditionsCapital additions include the cost of capital improvements and betterments made to theproperty by the taxpayer. These expenditures are distinguishable from expenditures forthe ordinary repair and maintenance of the property, which are neither capitalized noradded to the original basis (refer to Chapter 6). The latter expenditures are deductible inthe current taxable year if they are related to business or income-producing property.Amounts representing real property taxes treated as imposed on the seller but paid orassumed by the buyer are part of the cost of the property.12 Any liability on propertythat is assumed by the buyer is also included in the buyer’s original basis of the prop-erty. The same rule applies if property is acquired subject to a liability. Amortization ofthe discount on bonds increases the adjusted basis of the bonds.13

Capital RecoveriesCapital recoveries decrease the adjusted basis of property. The prominent types of capi-tal recoveries are discussed below.

Depreciation and Cost Recovery Allowances The original basis of depreciableproperty is reduced by the annual depreciation charges (or cost recovery allowances)while the property is held by the taxpayer. The amount of depreciation that is sub-tracted from the original basis is the greater of the allowed or allowable depreciationcalculated on an annual basis.14 In most circumstances, the allowed and allowabledepreciation amounts are the same (refer to Chapter 8).

Casualties and Thefts A casualty or theft may result in the reduction of the adjustedbasis of property.15 The adjusted basis is reduced by the amount of the deductible loss.In addition, the adjusted basis is reduced by the amount of insurance proceedsreceived. However, the receipt of insurance proceeds may result in a recognized gainrather than a deductible loss. The gain increases the adjusted basis of the property.16

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4

Capital Recoveries: Casualties and Thefts

An insured truck that Marvin used in his trade or business is destroyed in an accident. At the time ofthe accident, the adjusted basis was $8,000, and the fair market value was $6,500. Marvin receivesinsurance proceeds of $6,500. The amount of the casualty loss is $1,500 ($6,500 insurance proceeds�$8,000 adjusted basis). The truck’s adjusted basis is reduced by the $1,500 casualty loss and the$6,500 of insurance proceeds received ($8,000 basis before casualty� $1,500 casualty loss�$6,500 insurance proceeds ¼ $0 adjusted basis).

10§ 1011(a) and Reg. § 1.1011–1.11§ 1016(a) and Reg. § 1.1016–1.12Reg. §§ 1.1001–1(b)(2) and 1.1012–1(b). Refer to Chapter 10 for a discus-

sion of this subject.13See Chapter 16 for a discussion of bond discount and the related amortization.

14§ 1016(a)(2) and Reg. § 1.1016–3(a)(1)(i).15Refer to Chapter 7 for the discussion of casualties and thefts.16Reg. § 1.1016–6(a).


Certain Corporate Distributions A corporate distribution to a shareholder that isnot taxable is treated as a return of capital, and it reduces the basis of the shareholder’sstock in the corporation.17 For example, if a corporation makes a cash distribution to itsshareholders and has no earnings and profits, the distributions are treated as a return ofcapital. Once the basis of the stock is reduced to zero, the amount of any subsequentdistributions is a capital gain if the stock is a capital asset. These rules are illustrated inExample 25 of Chapter 20.

Amortizable Bond Premium The basis in a bond purchased at a premium isreduced by the amortizable portion of the bond premium.18 Investors in taxable bondsmay elect to amortize the bond premium.19 The amount of the amortized premium ontaxable bonds is allowed as an interest deduction. Therefore, the election enables thetaxpayer to take an annual interest deduction to offset ordinary income in exchange for alarger capital gain or smaller capital loss on the disposition of the bond. The amortizationdeduction is allowed for taxable bonds because the premium is viewed as a cost of earn-ing the taxable interest from the bonds. The reason the basis of taxable bonds is reducedis that the amortization deduction is a recovery of the cost or basis of the bonds.

Unlike taxable bonds, the premium on tax-exempt bonds must be amortized (andthe basis is reduced even though the amortization is not allowed as a deduction). Noamortization deduction is permitted on tax-exempt bonds because the interest incomeis exempt from tax and the amortization of the bond premium merely represents anadjustment of the effective amount of such income.

Easements An easement is the legal right to use another’s land for a special purpose.Historically, easements were commonly used to obtain rights-of-way for utility lines,roads, and pipelines. In recent years, grants of conservation easements have become apopular means of obtaining charitable contribution deductions and reducing the valueof real estate for transfer tax (i.e., estate and gift) purposes. Likewise, scenic easementsare used to reduce the value of land as assessed for ad valorem property tax purposes.

If the taxpayer does not retain any right to the use of the land, all of the basis isassigned to the easement. However, if the use of the land is only partially restricted, anallocation of some of the basis to the easement is appropriate.

14-1b Recognized Gain or LossRecognized gain is the amount of the realized gain that is included in the taxpayer’sgross income.20 A recognized loss , on the other hand, is the amount of a realized loss

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5

Capital Recoveries: Casualties and Thefts

An insured truck that Marvin used in his trade or business is destroyed in an accident. At the time ofthe accident, the adjusted basis was $6,500, and the fair market value was $8,000. Marvin receives in-surance proceeds of $8,000. The amount of the casualty gain is $1,500 ($8,000 insurance proceeds�$6,500 adjusted basis). The truck’s adjusted basis is increased by the $1,500 casualty gain and isreduced by the $8,000 of insurance proceeds received ($6,500 basis before casualtyþ $1,500casualty gain� $8,000 insurance proceeds ¼ $0 adjusted basis).

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6

Antonio purchases Eagle Corporation taxable bonds with a face value of $100,000 for $110,000,thus paying a premium of $10,000. The annual interest rate is 7%, and the bonds mature 10 yearsfrom the date of purchase. The annual interest income is $7,000 (7%� $100,000). If Antonio electsto amortize the bond premium, the $10,000 premium is deducted over the 10-year period.Antonio’s basis for the bonds is reduced each year by the amount of the amortization deduction.Note that if the bonds were tax-exempt, amortization of the bond premium and the basis adjust-ment would be mandatory. However, no deduction would be allowed for the amortization.

17§ 1016(a)(4) and Reg. § 1.1016–5(a).18§ 1016(a)(5) and Reg. § 1.1016–5(b). The accounting treatment of bond

premium amortization is the same as for tax purposes. The amortizationresults in a decrease in the bond investment account.

19§ 171(c).20§ 61(a)(3) and Reg. § 1.61–6(a).

LO.2

Distinguish between realizedand recognized gain or loss.


that is deductible for tax purposes.21 As a general rule, the entire amount of a realizedgain or loss is recognized.22

Concept Summary 14.1 summarizes the realized gain or loss and recognized gain orloss concepts.

14-1c Nonrecognition of Gain or LossIn certain cases, a realized gain or loss is not recognized upon the sale or other disposi-tion of property. One such case involves nontaxable exchanges, which are covered inChapter 15. Others include losses realized upon the sale, exchange, or condemnation ofpersonal use assets (as opposed to business or income-producing property) and gainsrealized upon the sale of a residence (see Chapter 15). In addition, realized losses fromthe sale or exchange of business or income-producing property between certain relatedparties are not recognized.23

Sale, Exchange, or Condemnation of Personal Use AssetsA realized loss from the sale, exchange, or condemnation of personal use assets (e.g., apersonal residence or an automobile not used at all for business or income-producingpurposes) is not recognized for tax purposes. An exception exists for casualty or theftlosses from personal use assets (see Chapter 7). In contrast, any gain realized from thesale or other disposition of personal use assets is, generally, fully taxable.

Concept Summary 14.1Recognized Gain or Loss

–AmountRealized

RealizedGain

RealizedLoss

Deferred (postponed)Gain or

Tax-Free Gain

Recognized Gain(taxable amount)

Recognized Loss(deductible

amount)

Deferred (postponed)Loss or

Disallowed Loss

AdjustedBasis

– =

– =

If amount is

+

If amount is –

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The Big Picture

7

Return to the facts of The Big Picture on p. 14-1. Assume that Alice sells the boat, which she hasheld exclusively for personal use, for $23,000. Recall that her adjusted basis of the boat is $22,000.Alice has a realized and recognized gain of $1,000.

21§ 165(a) and Reg. § 1.165–1(a).22§ 1001(c) and Reg. § 1.1002–1(a).

23§ 267(a)(1).


14-2 BASIS CONSIDERATIONS

14-2a Determination of Cost BasisAs noted earlier, the basis of property is generally the property’s cost. Cost is theamount paid for the property in cash or other property.24 This general rule follows logi-cally from the recovery of capital doctrine; that is, the cost or other basis of property isto be recovered tax-free by the taxpayer.

A bargain purchase of property is an exception to the general rule for determiningbasis. A bargain purchase may result when an employer transfers property to an em-ployee at less than the property’s fair market value (as compensation for services) or

E XAMP L E

The Big Picture

8

Assume that Alice sells the boat in Example 7 for $20,000. She has a realized loss of $2,000, butthe loss is not recognized.

TAX IN THE NEWS Tax Implications of Virtual Currency (Bitcoin)

On March 25, 2014, the Internal Revenue Serv-ice (IRS) issued Notice 2014-21 (2014-16 IRB 938), which,through a series of questions and answers, “describes how exist-ing tax principles apply to transactions using virtual currency.”

Background. Bitcoin is a decentralized virtual store of valuethat is beginning to gain greater acceptance as a mediumof exchange in the mainstream marketplace. Notice 2014-21describes virtual currencies such as Bitcoin as follows:

“[A] digital representation of value that functions as amedium of exchange, a unit of account, and/or a storeof value. … Virtual currency that has an equivalentvalue in real currency, or that acts as a substitute forreal currency, is referred to as ‘convertible’ virtualcurrency. …”

Bitcoin derives value not from governmental backing or alink to an underlying commodity, but purely from its finitenature, the effort required to generate new Bitcoin, and thevalue its users place on it and its acceptance as a mediumof exchange in certain segments of the market. Bitcoin sup-ply is finite (the maximum number of Bitcoin that will everexist is approximately 21 million). A good summary of fun-damental questions and answers surrounding Bitcoin canbe found at http://bitcoin.org/en/faq.

IRS Guidance. Notice 2014-21 provides answers to fre-quently asked questions (FAQs) on virtual currency such asBitcoin. These FAQs provide basic information on the U.S.Federal tax implications of transactions in, or transactionsthat use, virtual currency. In some environments, virtual

currency operates like “real” currency (e.g., the coin and pa-per money of the United States) but it does not have legaltender status in any jurisdiction.

In its guidance, the IRS indicates that Bitcoin is not cur-rency; rather, virtual currency is treated as property for U.S.Federal tax purposes. General tax principles that apply toproperty transactions apply to transactions using virtual cur-rency. Among other things, this means that:

• Wages paid to employees using virtual currency are tax-able to the employee, must be reported by an employeron a Form W–2, and are subject to Federal income taxwithholding and payroll taxes.

• Payments using virtual currency made to independentcontractors and other service providers are taxable, andself-employment tax rules generally apply. Payers aresubject to the same information reporting requirementsas any other payer (so, for example, a Form 1099–MISCmust be issued to an independent contractor if Bitcoinpayments exceed $600 per year).

• The character of gain or loss from the sale or exchangeof virtual currency depends on whether the virtual cur-rency is a capital asset in the hands of the taxpayer.

• A payment made using virtual currency is subject to in-formation reporting to the same extent as any other pay-ment made in property.

The full set of 16 questions and answers provided by the IRScan be found at www.irs.gov/pub/irs-drop/n-14-21.pdf.

LO.3

Review and illustrate howbasis is determined forvarious methods of assetacquisition.

24§ 1012 and Reg. § 1.1012–1(a).


when a corporation transfers property to a shareholder at less than the property’s fairmarket value (a dividend). The amount included in income either as compensation forservices or dividend income is the difference between the bargain purchase price andthe property’s fair market value. The basis of property acquired in a bargain purchase isthe property’s fair market value.25 If the basis of the property were not increased by thebargain amount, the taxpayer would be taxed on this amount again at disposition.

Identification ProblemsCost identification problems are frequently encountered in securities transactions. Forexample, the Regulations require that the taxpayer adequately identify the particularstock that has been sold (specific identification).26 A problem arises when the taxpayerhas purchased separate lots of stock on different dates or at different prices and cannotadequately identify the lot from which a particular sale takes place. In this case, thestock is presumed to come from the first lot or lots purchased (a FIFO presumption).27

When securities are left in the custody of a broker, it may be necessary to provide spe-cific instructions and receive written confirmation as to which securities are being sold.

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10

Polly purchases 100 shares of Olive Corporation stock on July 1, 2013, for $5,000 ($50 a share) andanother 100 shares of Olive stock on July 1, 2014, for $6,000 ($60 a share). She sells 50 shares ofthe stock on January 2, 2015. The cost of the stock sold, assuming that Polly cannot adequatelyidentify the shares, is $50 a share, or $2,500. This is the cost Polly will compare with the amountrealized in determining the gain or loss from the sale.

TAX IN THE NEWS Brokers Provide Cost Basis Data to Taxpayers(and the IRS)

Brokers and others in similar enterprises are now requiredto provide investors with an annual report on the cost basisof their stocks sold during the year (to be included on Form1099–B and reported to the IRS).

The primary reason for the requirement is to enable tax-payers to use the correct basis in calculating the gain or losson the sale of the stock (perhaps many years after the initialpurchase). Nontaxable stock dividends, stock splits, andspin-offs may create confusion and result in unreliable databeing used to determine the basis. For the investor who hasmultiple lots of the same stock, the likelihood of making anincorrect determination of cost basis is even greater.

A secondary reason for the reporting requirement is togenerate more revenue for the Treasury. The Treasury

believes that it will collect an additional $6 billion to $9 billionper year as a result of this requirement. Tax professionals willalso benefit by providing consulting related to the require-ments—some estimate the related compliance costs willexceed $500 million per year.

Although the primary burden for determining cost basisis placed on the broker, the ultimate responsibility forreporting the information correctly remains on the taxpayer(and his or her tax adviser).

Sources: Based on “Cost Basis Reporting: Why Corporate Issuers (and Not JustBrokers) Should Care,” A&M Tax Advisor Weekly, www.taxand.com, July 14, 2011;Laura Saunders, “When Your Broker ‘Outs’ You,” Wall Street Journal, March 2, 2013,p. D3; Tara Siegel Bernard, “New Tax Laws Take Guesswork Out of Investment TaxLiability,” New York Times, March 15, 2013.

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9

Wade buys land from his employer for $10,000 on December 30. The fair market value of the landis $15,000. Wade must include the $5,000 difference between the cost and the fair market value ofthe land in gross income for the taxable year. The bargain element represents additional compen-sation to Wade. His basis for the land is $15,000, the land’s fair market value.

25Reg. §§ 1.61–2(d)(2)(i) and 1.301–1(j). See the discussion in Chapter 5 ofthe circumstances under which what appears to be a taxable bargain pur-chase is an excludible qualified employee discount.

26Reg. § 1.1012–1(c)(1).27Kluger Associates, Inc., 69 T.C. 925 (1978).


Allocation ProblemsWhen a taxpayer acquires multiple assets in a lump-sum purchase, the total cost mustbe allocated among the individual assets.28 Allocation is necessary for several reasons:

• Some of the assets acquired may be depreciable (e.g., buildings), while othersmay not be (e.g., land).

• Only a portion of the assets acquired may be sold.

• Some of the assets may be capital or § 1231 assets that receive special tax treat-ment upon subsequent sale or other disposition.

The lump-sum cost is allocated on the basis of the fair market values of the individualassets acquired.

If a business is purchased and goodwill is involved, a special allocation rule applies.Initially, the purchase price is assigned to the assets, excluding goodwill, to the extentof their total fair market value. This assigned amount is allocated among the assets onthe basis of the fair market value of the individual assets acquired. Goodwill is thenassigned the residual amount of the purchase price. The resultant allocation is applica-ble to both the buyer and the seller.29

In the case of nontaxable stock dividends, the allocation depends on whether thedividend is a common stock dividend on common stock or a preferred stock dividendon common stock. If the stock dividend is common on common, the cost of the originalcommon shares is allocated to the total shares owned after the dividend.30

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12

Rocky sells his business to Paul. They agree that the values of the individual assets are as follows:

Inventory $ 50,000

Building 500,000

Land 200,000

Goodwill 150,000

After negotiations, Rocky and Paul agree on a sales price of $1 million. Applying the residualmethod with respect to goodwill results in the following allocation of the $1 million purchaseprice:

Inventory $ 50,000

Building 500,000

Land 200,000

Goodwill 250,000

The residual method requires that all of the excess of the purchase price over the fair marketvalue of the assets ($1,000,000� $900,000 ¼ $100,000) be allocated to goodwill. Without thisrequirement, the purchaser could allocate the excess pro rata to all of the assets, including good-will, based on their respective fair market values. This would have resulted in only $166,667[$150,000 þ ($150,000� $900,000� $100,000)] being assigned to goodwill.

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11

Harry purchases a building and land for $800,000. Because of the depressed nature of the industryin which the seller was operating, Harry was able to negotiate a very favorable purchase price.Appraisals of the individual assets indicate that the fair market value of the building is $600,000 andthat of the land is $400,000. Harry’s basis for the building is $480,000 [($600,000=$1,000,000)�$800,000], and his basis for the land is $320,000 [($400,000=$1,000,000)� $800,000].

28Reg. § 1.61–6(a).29§ 1060. The classification of the seller’s recognized gain associated with the

goodwill is discussed in Chapter 16.

30§§ 305(a) and 307(a).


If the nontaxable stock dividend is preferred stock on common, the cost of the origi-nal common shares is allocated between the common and preferred shares on the basisof their relative fair market values on the date of distribution.31

The holding period for a nontaxable stock dividend, whether received in the form ofcommon stock or preferred stock, includes the holding period of the original shares.32

The significance of the holding period for capital assets is discussed in Chapter 16.

14-2b Gift BasisWhen a taxpayer receives property as a gift, there is no cost to the donee (recipient).Thus, under the cost basis provision, the donee’s basis would be zero. However, thiswould violate the statutory intent that gifts not be subject to the income tax.33 With azero basis, if the donee sold the property, all of the amount realized would be treated asrealized gain. Therefore, a basis is assigned to the property received depending on thefollowing:

• The date of the gift.

• The basis of the property to the donor.

• The amount of the gift tax paid.

• The fair market value of the property.

Gift Basis Rules If No Gift Tax Is PaidProperty received by gift can be referred to as dual basis property; that is, the basis forgain and the basis for loss might not be the same amount. The present basis rules forgifts of property are as follows:

• If the donee disposes of gift property in a transaction that results in a gain, the ba-sis to the donee is the same as the donor’s adjusted basis.34 The donee’s basis inthis case is referred to as the gain basis. Therefore, a realized gain results if theamount realized from the disposition exceeds the donee’s gain basis.

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Fran owns 100 shares of Cardinal Corporation common stock for which she paid $1,000. Shereceives a nontaxable stock dividend of 50 shares of preferred stock on her common stock. Thefair market values on the date of distribution of the preferred stock dividend are $30 a share forcommon stock and $40 a share for preferred stock.

Fair market value of common ($30 � 100 shares) $3,000

Fair market value of preferred ($40 � 50 shares) 2,000

$5,000

Basis of common: 3=5 � $1,000 $ 600

Basis of preferred: 2=5 � $1,000 $ 400

The basis per share for the common stock is $6 ($600/100 shares). The basis per share for thepreferred stock is $8 ($400/50 shares).

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Susan owns 100 shares of Sparrow Corporation common stock for which she paid $1,100. Shereceives a 10% common stock dividend, giving her a new total of 110 shares. Before the stock divi-dend, Susan’s basis was $11 per share ($1,100� 100 shares). The basis of each share after thestock dividend is $10 ($1,100� 110 shares).

31Reg. § 1.307–1(a).32§ 1223(5) and Reg. § 1.1223–1(e).33§ 102(a).

34§ 1015(a) and Reg. § 1.1015–1(a)(1). See Reg. § 1.1015–1(a)(3) for cases inwhich the facts necessary to determine the donor’s adjusted basis areunknown. Refer to Example 18 for the effect of depreciation deductions bythe donee.


• If the donee disposes of gift property in a transaction that results in a loss, the ba-sis to the donee is the lower of the donor’s adjusted basis or the fair market valueon the date of the gift. The donee’s basis in this case is referred to as the loss basis.Therefore, a realized loss results if the amount realized from the disposition is lessthan the donee’s loss basis.

The amount of the loss basis will differ from the amount of the gain basis only if, at thedate of the gift, the adjusted basis of the property exceeds the property’s fair marketvalue. Note that the loss basis rule prevents the donee from receiving a tax benefit from adecline in value that occurred while the donor held the property. Therefore, in Example 16,Cliff has a loss of only $1,000 rather than a loss of $4,000. The $3,000 difference repre-sents the decline in value that occurred while Burt held the property. Ironically, however,the gain basis rule may result in the donee being subject to income tax on the apprecia-tion that occurred while the donor held the property, as illustrated in Example 15.

If the amount realized from a sale or other disposition is between the basis for lossand the basis for gain, no gain or loss is realized.

Adjustment for Gift TaxBecause of the size of the unified estate and gift tax exemption ($5.43 million in 2015),basis adjustments for gift taxes paid are rare. If, however, gift taxes are paid by the do-nor, the portion of the gift tax paid that is related to any appreciation is taken intoaccount in determining the donee’s gain basis.35

For gifts made before 1977, the full amount of the gift tax paid is added to thedonor’s basis, with basis capped at the donor’s fair market value at the date of the gift.

Holding PeriodThe holding period for property acquired by gift begins on the date the donor acquiredthe property if the gain basis rule applies.36 The holding period starts on the date of thegift if the loss basis rule applies.37 The significance of the holding period for capitalassets is discussed in Chapter 16.

Basis for DepreciationThe basis for depreciation on depreciable gift property is the donee’s gain basis.38 Thisrule is applicable even if the donee later sells the property at a loss and uses the lossbasis rule in calculating the amount of the realized loss.

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16

Burt purchased stock in 2014 for $10,000. He gave the stock to his son, Cliff, in 2015, when the fairmarket value was $7,000. No gift tax is paid on the transfer. Cliff later sells the stock for $6,000.Cliff’s basis is $7,000 (fair market value is less than donor’s adjusted basis of $10,000), and the real-ized loss from the sale is $1,000 ($6,000 amount realized� $7,000 basis).

E XAMP L E

17

Assume the same facts as in Example 16, except that Cliff sells the stock for $8,000. Application ofthe gain basis rule produces a loss of $2,000 ($8,000� $10,000). Application of the loss basis ruleproduces a gain of $1,000 ($8,000� $7,000). Because the amount realized is between the gainbasis and the loss basis, Cliff recognizes neither a gain nor a loss.

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15

Melissa purchased stock in 2014 for $10,000. She gave the stock to her son, Joe, in 2015, when thefair market value was $15,000. No gift tax is paid on the transfer, and Joe subsequently sells theproperty for $15,000. Joe’s basis is $10,000, and he has a realized gain of $5,000.

35§ 1015(d)(6) and Reg. § 1.1015–5(c)(2). Examples illustrating these rulescan be found in Reg. § 1.1015–5(c)(5) and IRS Publication 551 (Basis ofAssets), p. 9.

36§ 1223(2) and Reg. § 1.1223–1(b).

37Rev.Rul. 59–86, 1959–1 C.B. 209.38§ 1011 and Reg. §§ 1.1011–1 and 1.167(g)–1.


14-2c Property Acquired from a Decedent

General RulesThe basis of property acquired from a decedent is generally the property’s fair marketvalue at the date of death (referred to as the primary valuation amount).39 The prop-erty’s basis is the fair market value six months after the date of death if the executor oradministrator of the estate elects the alternate valuation date for estate tax purposes. Thisamount is referred to as the alternate valuation amount.

The alternate valuation date and amount are only available to estates for which anestate tax return must be filed [generally, estates with a valuation in excess of $5.43 mil-lion in 2015 ($5.34 million in 2014)]. Even if an estate tax return is filed and the executorelects the alternate valuation date, the six months after death date is available only forproperty that the executor has not distributed before this date.40

The alternate valuation date can be elected only if, as a result of the election, boththe value of the gross estate and the estate tax liability are lower than they would havebeen if the primary valuation date had been used.41

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18

Vito gave a machine to Tina in 2015. At that time, the adjusted basis was $32,000 (cost of $40,000 �accumulated depreciation of $8,000), and the fair market value was $26,000. No gift tax was paid.Tina’s gain basis at the date of the gift is $32,000, and her loss basis is $26,000. During 2015, Tinadeducts depreciation (cost recovery) of $6,400 ($32,000� 20%). (Refer to Chapter 8 for the costrecovery tables.) At the end of 2015, Tina’s gain basis and loss basis are calculated as follows:

Gain Basis Loss Basis

Donor’s basis or fair market value $32,000 $26,000

Depreciation (6,400) (6,400)

$25,600 $19,600

E XAMP L E

The Big Picture

20

Assume the same facts as in Example 19, except that the house’s fair market value at the date ofthe mother’s death was $260,000. Alice’s basis for income tax purposes is $260,000. This is com-monly referred to as a stepped-down basis.

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The Big Picture

19

Return to the facts of The Big Picture on p. 14-1. Alice and various other family members inheritedproperty from Alice’s mother, who died in 2014. At the date of death, the mother’s adjusted basisfor the property Alice inherited—her mother’s house—was $275,000. The house’s fair market valueat the date of death was $475,000. The alternate valuation date was not elected. Alice’s basis forincome tax purposes is $475,000. This is commonly referred to as a stepped-up basis.

39§§ 1014(a) and 1022. See South-Western Federal Taxation: Corporations, Part-nerships, Estates & Trusts, 2016 Edition, Chapter 18, for additional information.

40§ 2032(a)(1) and Rev.Rul. 56–60, 1956–1 C.B. 443. For any property distrib-uted by the executor during the six-month period preceding the alternatevaluation date, the adjusted basis to the beneficiary will equal the fair mar-ket value on the date of distribution.

41§ 2032(c); this provision prevents the alternate valuation election frombeing used to increase the basis of the property to the beneficiary forincome tax purposes without simultaneously increasing the estate taxliability (because of estate tax deductions or credits).


Income in Respect of a DecedentIncome in respect of a decedent (IRD) is income earned by a decedent to the point ofdeath but not reportable on the final income tax return under the method of accountingused. IRD is most frequently applicable to decedents using the cash basis of accounting.IRD also occurs, for example, when a taxpayer at the time of death held installmentnotes receivable on which the gain has been deferred. For both cash and accrual tax-payers, IRD includes most post-death distributions from retirement plans [e.g., tradi-tional IRA, § 401(k), H.R. 10 (Keogh), § 403(b), and other qualified plans]. With theexception of Roth IRAs, distributions from retirement plans invariably contain an incomecomponent that has not yet been subject to income tax.

IRD is included in the gross estate at its fair market value on the appropriate valua-tion date. Because IRD is not subject to the step-up or step-down rules applicable toproperty passed by death, the income tax basis of the decedent transfers to the estate orheirs.43 Furthermore, the recipient of IRD must classify it in the same manner (e.g., ordi-nary income or capital gain) as the decedent would have.44

Survivor’s Share of PropertyBoth the decedent’s share and the survivor’s share of community property have a basisequal to the fair market value on the date of the decedent’s death.45 This result appliesto the decedent’s share of the community property because the property is included inthe estate and assumes a fair market value basis. Because the surviving spouse’s shareof the community property is treated as if it is acquired from the decedent, it also has abasis equal to the fair market value.

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Floyd and Vera are married and reside in a community property state. They own as communityproperty 200 shares of Crow stock acquired in 1990 for $100,000. Floyd dies in 2015, when thesecurities are valued at $300,000. One-half of the Crow stock is included in Floyd’s estate. If Verainherits Floyd’s share of the community property, the basis for gain or loss is $300,000, determinedas follows:

Vera’s one-half of the community property (stepped up from$50,000 to $150,000 due to Floyd’s death) $150,000

Floyd’s one-half of the community property (stepped up from$50,000 to $150,000 due to inclusion in his gross estate) 150,000

Vera’s new basis $300,000

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21

George, age 58, was entitled to a salary payment of $18,000 and a bonus of $20,000 at the time ofhis death. In addition, George had been contributing to a traditional IRA for over 20 years. The IRAhas a basis of $83,000 (due to some nondeductible contributions over the years) and a currentvalue of $560,000. George’s estate collects the salary and bonus payments, and George’s wife (hisonly beneficiary) cashes in the IRA.

Both the estate and George’s wife have income in respect of a decedent (IRD) and must includeordinary income in their computation of taxable income for the year. The estate has IRD of$38,000 (salary of $18,000 plus bonus of $20,000), and George’s wife has IRD of $477,000($560,000 proceeds less $83,000 basis). A better outcome might be achieved for George’s wife ifshe rolled over the inherited IRA into an IRA in her name and deferred receiving distributionsuntil required. (Note: Only a surviving spouse can roll over an inherited IRA without taxconsequences.42)

42See South-Western Federal Taxation: Corporations, Partnerships, Estates& Trusts, 2016 Edition, Chapter 19, for additional information.

43§ 1014(c).

44§ 691(a)(3).45§ 1014(b)(6). See the listing of community property states in Chapter 4.


In a common law state, only one-half of jointly held property of spouses (tenants bythe entirety or joint tenants with rights of survivorship) is included in the estate.46 Insuch a case, no adjustment of the basis is permitted for the excluded property interest(the surviving spouse’s share).

Holding Period of Property Acquired from a DecedentThe holding period of property acquired from a decedent is deemed to be long term(held for the required long-term holding period). This provision applies regardless ofwhether the property is disposed of at a gain or at a loss.47

14-2d Disallowed Losses

Related TaxpayersSection 267 provides that realized losses from sales or exchanges of property, directlyor indirectly, between certain related parties are not recognized. This loss disallowanceprovision applies to several types of related-party transactions. The most commoninvolve (1) members of a family and (2) an individual and a corporation in which theindividual owns, directly or indirectly, more than 50 percent in value of the corpora-tion’s outstanding stock. Section 707 provides a similar loss disallowance provisionwhere the related parties are a partner and a partnership in which the partner owns,directly or indirectly, more than 50 percent of the capital interests or profits interests inthe partnership. The rules governing the relationships covered by § 267 were discussedin Chapter 6. See Chapter 15 for a discussion of the special rules under § 1041 for prop-erty transfers between spouses or incident to divorce.

If income-producing or business property is transferred to a related taxpayer and aloss is disallowed, the basis of the property to the recipient is the property’s cost to thetransferee. However, if a subsequent sale or other disposition of the property by theoriginal transferee results in a realized gain, the amount of gain is reduced by the lossthat was previously disallowed.48 This right of offset is not applicable if the original saleinvolved the sale of a personal use asset (e.g., the sale of a personal residence betweenrelated taxpayers). Furthermore, the right of offset is available only to the original trans-feree (the related-party buyer).49

E XAMP L E

23

Assume the same facts as in Example 22, except that the property is jointly held by Floyd and Verawho reside in a common law state. Floyd purchased the property and made a gift of one-half ofthe property to Vera when the stock was acquired. No gift tax was paid. Only one-half of the Crowstock is included in Floyd’s estate. Vera’s basis for determining gain or loss in the excluded half isnot adjusted upward for the increase in value to date of death. Therefore, Vera’s basis is $200,000,determined as follows:

Vera’s one-half of the jointly held property (carryover basis of $50,000) $ 50,000

Floyd’s one-half of the jointly held property (stepped up from $50,000 to$150,000 due to inclusion in his gross estate) 150,000

Vera’s new basis $200,000

46§ 2040(b).47§ 1223(11).48§ 267(d) and Reg. § 1.267(d)–1(a).49The loss disallowance rules (1) prevent a taxpayer from directly transfer-

ring an unrealized loss to a related taxpayer in a higher tax bracketwho could receive a greater tax benefit from recognition of the loss and

(2) eliminate a substantial administrative burden on the Internal RevenueService as to the appropriateness of the selling price (i.e., fair market valueor not). The loss disallowance rules are applicable even where the sellingprice is equal to the fair market value and can be validated (e.g., listedstocks).

LO.4

Describe various lossdisallowance provisions.


The holding period of the buyer for the property is not affected by the holding periodof the seller. That is, the buyer’s holding period includes only the period of time he orshe has held the property.50

Wash SalesSection 1091 stipulates that in certain cases, a realized loss on the sale or exchange ofstock or securities is not recognized. Specifically, if a taxpayer sells or exchanges stockor securities and within 30 days before or after the date of the sale or exchange acquiressubstantially identical stock or securities, any loss realized from the sale or exchange isnot recognized because the transaction is a wash sale .51 The term acquire means ac-quire by purchase or in a taxable exchange and includes an option to purchase substan-tially identical securities. Substantially identical means the same in all importantparticulars. Corporate bonds and preferred stock normally are not considered substan-tially identical to the corporation’s common stock. However, if the bonds and preferredstock are convertible into common stock, they may be considered substantially identicalunder certain circumstances.52 Attempts to avoid the application of the wash sales rulesby having a related taxpayer repurchase the securities have been unsuccessful.53 Thewash sales provisions do not apply to gains.

Recognition of the loss is disallowed because the taxpayer is considered to be in sub-stantially the same economic position after the sale and repurchase as before the saleand repurchase. This disallowance rule does not apply to taxpayers engaged in thebusiness of buying and selling securities.54 Investors, however, are not allowed to createlosses through wash sales to offset income for tax purposes.

Realized loss that is not recognized is added to the basis of the substantially identicalstock or securities whose acquisition resulted in the nonrecognition of loss.55 In otherwords, the basis of the replacement stock or securities is increased by the amount ofthe unrecognized loss. If the loss were not added to the basis of the newly acquiredstock or securities, the taxpayer would never recover the entire basis of the old stock orsecurities.

The basis of the new stock or securities includes the unrecovered portion of the basisof the formerly held stock or securities. Therefore, the holding period of the new stockor securities begins on the date of acquisition of the old stock or securities.56

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Pedro sells business property with an adjusted basis of $50,000 to his daughter, Josefina, for its fairmarket value of $40,000. Pedro’s realized loss of $10,000 is not recognized.

• How much gain does Josefina recognize if she sells the property for $52,000? Josefina rec-ognizes a $2,000 gain. Her realized gain is $12,000 ($52,000 less her basis of $40,000), butshe can offset Pedro’s $10,000 loss against the gain.

• How much gain does Josefina recognize if she sells the property for $48,000? Josefina rec-ognizes no gain or loss. Her realized gain is $8,000 ($48,000 less her basis of $40,000), butshe can offset $8,000 of Pedro’s $10,000 loss against the gain. Note that Pedro’s loss canonly offset Josefina’s gain. It cannot create a loss for Josefina.

• How much loss does Josefina recognize if she sells the property for $38,000? Josefina recog-nizes a $2,000 loss, the same as her realized loss ($38,000 less $40,000 basis). Pedro’s lossdoes not increase Josefina’s loss. His loss can be offset only against a gain. Because Josefinahas no realized gain, Pedro’s loss cannot be used and is never recognized. This part of theexample assumes that the property is business or income-producing property to Josefina. Ifnot, her $2,000 loss is personal and is not recognized.

50§§ 267(d) and 1223(2) and Reg. § 1.267(d)–1(c)(3).51§ 1091(a) and Reg. §§ 1.1091–1(a) and (f).52Rev.Rul. 56–406, 1956–2 C.B. 523.53McWilliams v. Comm., 47–1 USTC {9289, 35 AFTR 1184, 67 S.Ct. 1477

(USSC, 1947).

54Reg. § 1.1091–1(a).55§ 1091(d) and Reg. § 1.1091–2(a).56§ 1223(4) and Reg. § 1.1223–1(d).


A taxpayer may acquire fewer shares than the number sold in a wash sale. In thiscase, the loss from the sale is prorated between recognized and unrecognized loss onthe basis of the ratio of the number of shares acquired to the number of shares sold.57

14-2e Conversion of Property from Personal Use to Businessor Income-Producing UseAs discussed previously, losses from the sale of personal use assets are not recognizedfor tax purposes, but losses from the sale of business and income-producing assets aredeductible. Can a taxpayer convert a personal use asset that has declined in value tobusiness or income-producing use and then sell the asset to recognize a business orincome-producing loss? The tax law prevents this practice by specifying that the origi-nal basis for loss on personal use assets converted to business or income-producing useis the lower of the property’s adjusted basis or fair market value on the date of conver-sion.58 The gain basis for converted property is the property’s adjusted basis on the dateof conversion. The tax law is not concerned with gains on converted property becausegains are recognized regardless of whether property is business, income-producing, orpersonal use.

The basis for loss is also the basis for depreciating the converted property.59 This isan exception to the general rule that the basis for depreciation is the gain basis (e.g.,property received by gift). This exception prevents the taxpayer from recovering a per-sonal loss indirectly through depreciation of the higher original basis. After the propertyis converted, both its basis for loss and its basis for gain are adjusted for depreciationdeductions from the date of conversion to the date of disposition. These rules apply

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Diane’s personal residence has an adjusted basis of $175,000 and a fair market value of $160,000.Diane converts the personal residence to rental property. Her basis for loss is $160,000 (lower of$175,000 adjusted basis and fair market value of $160,000). The $15,000 decline in value is a per-sonal loss and can never be recognized for tax purposes. Diane’s basis for gain is $175,000.

TAX IN THE NEWS Triple the Misery!

Although short sales have traditionallyinvolved stocks, today the term short sale also refers to thesale of a personal residence by a homeowner who is“underwater,” owing more on the home than it is worth. In ashort sale, the homeowner sells the residence for its fair mar-ket value, which is less than the mortgage (or mortgages) onthe property. One possible result of this transaction is thatthe taxpayer incurs a realized loss—the selling price is less

than his or her basis in the property. Unfortunately, the real-ized loss cannot be recognized because a residence is a per-sonal use asset. To add to the trauma of losing the home in anondeductible loss sale, the mortgage company may requirethe taxpayer to keep paying on the portion of the mortgagestill outstanding (i.e., the amount of the mortgage in excessof the net sales price). Thus, the taxpayer has triple misery: nohome, a nondeductible loss, and an outstanding debt to pay.

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The Big Picture

25

Return to the facts of The Big Picture on p. 14-1. Alice owned 100 shares of Green Corporationstock (adjusted basis of $20,000). She sold 50 shares for $8,000. Ten days later, she purchased50 shares of the same stock for $7,000. Alice’s realized loss of $2,000 ($8,000 amount realized�$10,000 adjusted basis of 50 shares) is not recognized because it resulted from a wash sale. Alice’sbasis in the newly acquired stock is $9,000 ($7,000 purchase price þ $2,000 unrecognized lossfrom the wash sale).

57§ 1091(b) and Reg. § 1.1091–1(c).58Reg. § 1.165–9(b)(2).

59Reg. § 1.167(g)–1.


only if a conversion from personal to business or income-producing use has actuallyoccurred.

As discussed in Chapter 15, Keith may be able to exclude the $2,000 realized gainfrom the sale of the personal use portion of the residence under § 121. If the § 121 exclu-sion applies, only $17,500 (equal to the depreciation deducted) of the $19,500 realizedgain from the rental portion is recognized.

14-2f Additional Complexities in DeterminingRealized Gain or Loss

Amount RealizedThe calculation of the amount realized may appear to be one of the least complex areasassociated with property transactions. However, because numerous positive and nega-tive adjustments may be required, this calculation can be complex and confusing. Inaddition, determining the fair market value of the items received by the taxpayer can be

E XAMP L E

28

Assume the same facts as in Example 27, except that the fair market value on the date of conver-sion is $130,000 and the sales proceeds are $90,000. Keith has a $25,000 realized loss from the saleof the personal use portion of the residence and a $3,750 realized loss from the sale of the rentalportion. These losses are computed as follows:

Personal Use Rental

Original basis for loss—fair market value on date ofconversion (fair market value is less than theadjusted basis) * $ 65,000

Depreciation—five years (–0–) (16,250)

Adjusted basis—date of sale $70,000 $ 48,750

Amount realized 45,000 45,000

Realized loss ($25,000) ($ 3,750)

* Not applicable.

The $25,000 loss from the sale of the personal use portion of the residence is not recognized.The $3,750 loss from the rental portion is recognized.

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At a time when his personal residence (adjusted basis of $140,000) is worth $150,000, Keith con-verts one-half of it to rental use. Assume that the property is not MACRS recovery property. At thispoint, the estimated useful life of the residence is 20 years, and there is no estimated salvagevalue. After renting the converted portion for five years, Keith sells the property for $144,000. Allamounts relate only to the building; the land has been accounted for separately. Keith has a$2,000 realized gain from the sale of the personal use portion of the residence and a $19,500 real-ized gain from the sale of the rental portion. These gains are computed as follows:

Personal Use Rental

Original basis for gain and loss—adjusted basis on dateof conversion (fair market value is greater than theadjusted basis) $70,000 $ 70,000

Depreciation—five years (–0–) (17,500)

Adjusted basis—date of sale $70,000 $ 52,500

Amount realized 72,000 72,000

Realized gain $ 2,000 $ 19,500


difficult. The following example provides insight into various items that can affect theamount realized.

Adjusted BasisThree types of issues tend to complicate the determination of adjusted basis. First, theapplicable tax provisions for calculating the adjusted basis depend on how the propertywas acquired (e.g., purchase, taxable exchange, nontaxable exchange, gift, or inheri-tance). Second, if the asset is subject to depreciation, cost recovery, amortization, ordepletion, adjustments must be made to the basis during the time period the asset isheld by the taxpayer. Upon disposition of the asset, the taxpayer’s records for both ofthese items may be deficient. For example, the donee does not know the amount of thedonor’s basis or the amount of gift tax paid by the donor, or the taxpayer does not knowhow much depreciation he or she has deducted. Third, the complex positive and nega-tive adjustments encountered in calculating the amount realized are also involved in cal-culating the adjusted basis.

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Jane purchased a personal residence in 2006. The purchase price and the related closing costswere as follows:

Purchase price $325,000

Recording costs 140

Title fees and title insurance 815

Survey costs 225

Attorney’s fees 750

Appraisal fee 250

Other relevant tax information for the house during the time Jane owned it is as follows:

• Constructed a swimming pool for medical reasons. The cost was $20,000, of which$5,000 was deducted as a medical expense.

• Added a solar heating system. The cost was $18,000.

• Deducted home office expenses of $6,000. Of this amount, $5,200 was for depreciation.

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Ridge sells an office building and the associated land on October 1, 2015. Under the terms of thesales contract, Ridge is to receive $600,000 in cash. The purchaser is to assume Ridge’s mortgageof $300,000 on the property. To enable the purchaser to obtain adequate financing, Ridge is topay the $15,000 in points charged by the lender. The broker’s commission on the sale is $45,000.The purchaser agrees to pay the $12,000 in property taxes for the entire year. The amount realizedby Ridge is determined as follows:

Selling price:

Cash $600,000

Mortgage assumed by purchaser 300,000

Seller’s property taxes paid by purchaser ($12,000 � 9=12) 9,000 $909,000

Less:

Broker’s commission $ 45,000

Points paid by seller 15,000 (60,000)

Amount realized $849,000

continued


14-2g Summary of Basis AdjustmentsSome of the more common items that either increase or decrease the basis of an assetappear in Concept Summary 14.2.

In discussing the topic of basis, a number of specific techniques for determining basishave been presented. Although the various techniques are responsive to and mandatedby transactions occurring in the marketplace, they do possess enough common charac-teristics to be categorized as follows:

• The basis of the asset may be determined by reference to the asset’s cost.

• The basis of the asset may be determined by reference to the basis of another asset.

• The basis of the asset may be determined by reference to the asset’s fair market value.

• The basis of the asset may be determined by reference to the basis of the asset toanother taxpayer.

14-3 TAX PLANNING

14-3a Cost Identification and Documentation ConsiderationsWhen multiple assets are acquired in a single transaction, the contract price must be allo-cated for several reasons. First, some of the assets may be depreciable, while others arenot. From the different viewpoints of the buyer and the seller, this may produce a tax con-flict that needs to be resolved. That is, the seller prefers a high allocation for nondepreci-able assets, whereas the purchaser prefers a high allocation for depreciable assets(see Chapters 16 and 17). Second, the seller needs to know the amount realized on thesale of the capital assets and the ordinary income assets so that the recognized gains andlosses can be classified as capital or ordinary. For example, an allocation to goodwill or toa covenant not to compete (see Chapters 8, 16, and 17) produces different tax consequen-ces to the seller. Third, the buyer needs the adjusted basis of each asset to calculate therealized gain or loss on a subsequent sale or other disposition of each asset.

14-3b Selection of Property for Making GiftsA donor can achieve several tax advantages by making gifts of appreciated property.The donor avoids income tax on the unrealized gain that would have occurred had thedonor sold the property. A portion of this amount can be permanently avoided becausethe donee’s adjusted basis is increased by part or all of any gift tax paid by the donor.Even without this increase in basis, the income tax liability on the sale of the propertyby the donee can be less than the income tax liability that would have resulted from thedonor’s sale of the property, if the donee is in a lower tax bracket than the donor. Inaddition, any subsequent appreciation during the time the property is held by the lowertax bracket donee results in a tax savings on the sale or other disposition of the prop-erty. Such gifts of appreciated property can be an effective tool in family tax planning.

The adjusted basis for the house is calculated as follows:

Purchase price $325,000

Recording costs 140

Title fees and title insurance 815

Survey costs 225

Attorney’s fees 750

Appraisal fee 250

Swimming pool ($20,000 � $5,000) 15,000

Solar heating system 18,000

$360,180

Less: Depreciation deducted on home office (5,200)

Adjusted basis $354,980

LO.5

Identify tax planningopportunities relatedto selected propertytransactions.


Concept Summary 14.2Adjustments to Basis

Item EffectRefer toChapter Explanation

Amortization of bond discount Increase 16 Amortization is mandatory for certain taxable bonds and elective fortax-exempt bonds.

Amortization of bond premium Decrease 14 Amortization is mandatory for tax-exempt bonds and elective fortaxable bonds.

Amortization of covenant notto compete

Decrease 8 Covenant must be for a definite and limited time period. Theamortization period is a statutory period of 15 years.

Amortization of intangibles Decrease 8 Intangibles are amortized over a 15-year period.

Assessment for local benefits Increase 10 To the extent not deductible as taxes (e.g., assessment for streetsand sidewalks that increase the value of the property versus one formaintenance or repair or for meeting interest charges).

Bad debts Decrease 7 Only the specific charge-off method is permitted.

Capital additions Increase 14 Certain items, at the taxpayer’s election, can be capitalized ordeducted (e.g., selected medical expenses).

Casualty Decrease 7 For a casualty loss, the amount of the adjustment is the sum of thedeductible loss and the insurance proceeds received. For a casualtygain, the amount of the adjustment is the insurance proceedsreceived reduced by the recognized gain.

Condemnation Decrease 15 See casualty explanation.

Cost recovery Decrease 8 § 168 is applicable to tangible assets placed in service after 1980whose useful life is expressed in terms of years.

Depletion Decrease 8 Use the greater of cost or percentage depletion. Percentagedepletion can still be deducted when the basis is zero.

Depreciation Decrease 8 § 167 is applicable to tangible assets placed in service before 1981and to tangible assets not depreciated in terms of years.

Easement Decrease 14 If the taxpayer does not retain any use of the land, all of the basis isallocable to the easement transaction. However, if only part of theland is affected by the easement, only part of the basis is allocableto the easement transaction.

Improvements by lessee tolessor’s property

Increase 5 Adjustment occurs only if the lessor is required to include the fairmarket value of the improvements in gross income under § 109.

Imputed interest Decrease 18 Amount deducted is not part of the cost of the asset.

Inventory: lower of cost ormarket

Decrease 18 Not available if the LIFO method is used.

Limited expensing under § 179 Decrease 8 Occurs only if the taxpayer elects § 179 treatment.

Medical capital expenditurepermitted as a medical expense

Decrease 10 Adjustment is the amount of the deduction (the effect on basis is toincrease it by the amount of the capital expenditure net of thededuction).

Real estate taxes:apportionment between thebuyer and seller

Increase ordecrease

10 To the extent the buyer pays the seller’s pro rata share, the buyer’sbasis is increased. To the extent the seller pays the buyer’s pro ratashare, the buyer’s basis is decreased.

Rebate from manufacturer Decrease Because the rebate is treated as an adjustment to the purchaseprice, it is not included in the buyer’s gross income.

Stock dividend Decrease 5 Adjustment occurs only if the stock dividend is nontaxable. Whilethe basis per share decreases, the total stock basis does not change.

Stock rights Decrease 14 Adjustment to stock basis occurs only for nontaxable stock rightsand only if the fair market value of the rights is at least 15% of thefair market value of the stock or, if less than 15%, the taxpayer electsto allocate the basis between the stock and the rights.

Theft Decrease 7 See casualty explanation.


Taxpayers should generally not make gifts of depreciated property (property that, if sold,would produce a realized loss) because the donor does not receive an income tax deduc-tion for the unrealized loss element. In addition, the donee receives no benefit from thisunrealized loss upon the subsequent sale of the property because of the loss basis rule. Theloss basis rule provides that the donee’s basis is the lower of the donor’s basis or the fair mar-ket value at the date of the gift. If the donor anticipates that the donee will sell the propertyupon receiving it, the donor should sell the property and take the loss deduction, assumingthe loss is deductible. The donor can then give the proceeds from the sale to the donee.

14-3c Selection of Property for Making BequestsA taxpayer should generally make bequests of appreciated property in his or her will.Doing so enables both the decedent and the heir to avoid income tax on the unrealizedgain because the recipient takes the fair market value as his or her basis.

Taxpayers generally should not make bequests of depreciated property (propertythat, if sold, would produce a realized loss) because the decedent does not receive anincome tax deduction for the unrealized loss element. In addition, the heir will receiveno benefit from this unrealized loss upon the subsequent sale of the property.

From an income tax perspective, it is preferable to transfer appreciated property as abequest rather than as a gift. The reason is that inherited property receives a step-up inbasis, whereas property received by gift has a carryover basis to the donee. However,in making this decision, the estate tax consequences of the bequest should also beweighed against the gift tax consequences of the gift.

14-3d Disallowed Losses

Section 267 Disallowed LossesTaxpayers should be aware of the desirability of avoiding transactions that activate theloss disallowance provisions for related parties. This is so even in light of the provisionthat permits the related-party buyer to offset his or her realized gain by the related-partyseller’s disallowed loss. Even with this offset, several inequities exist. First, the tax bene-fit associated with the disallowed loss ultimately is realized by the wrong party (therelated-party buyer rather than the related-party seller). Second, the tax benefit of thisoffset to the related-party buyer does not occur until the buyer disposes of the property.Therefore, the longer the time period between the purchase and disposition of theproperty by the related-party buyer, the less the economic benefit. Third, if the propertydoes not appreciate to at least its adjusted basis to the related-party seller during thetime period the related-party buyer holds it, part or all of the disallowed loss is perma-nently lost. Fourth, because the right of offset is available only to the original transferee(the related-party buyer), all of the disallowed loss is permanently lost if the originaltransferee subsequently transfers the property by gift or bequest.

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Tim sells property with an adjusted basis of $35,000 to Wes, his brother, for $25,000, the fair marketvalue of the property. The $10,000 realized loss to Tim is disallowed by § 267. If Wes subsequentlysells the property to an unrelated party for $37,000, he has a recognized gain of $2,000 (realized gainof $12,000 reduced by disallowed loss of $10,000). Therefore, from the perspective of the family unit,the original $10,000 realized loss ultimately is recognized. However, if Wes sells the property for$29,000, he has a recognized gain of $0 (realized gain of $4,000 reduced by disallowed loss of$4,000 necessary to offset the realized gain). From the perspective of the family unit, $6,000 of therealized loss of $10,000 is permanently wasted ($10,000 realized loss� $4,000 offset permitted).

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On the date of her death in 2015, Marta owned land held for investment purposes. The land had anadjusted basis of $130,000 and a fair market value of $100,000. If Marta had sold the property beforeher death, the recognized loss would have been $30,000. If Roger inherits the property and later sells itfor $90,000, the recognized loss is $10,000 (the decline in value since Marta’s death). In addition, regard-less of the period of time Roger holds the property, the holding period is long-term (see Chapter 16).


Wash SalesThe wash sales provisions can be avoided if the security that was sold is replaced withinthe statutory time period with a similar rather than a substantially identical security. Forexample, a sale of Dell, Inc. common stock accompanied by a purchase of Hewlett-Packard common stock is not treated as a wash sale. Such a procedure can enable thetaxpayer to use an unrealized capital loss to offset a recognized capital gain. The tax-payer can sell the security before the end of the taxable year, offset the recognized capi-tal loss against the capital gain, and invest the sales proceeds in a similar security.

Because the wash sales provisions do not apply to gains, it may be desirable toengage in a wash sale before the end of the taxable year. The recognized capital gainmay be used to offset capital losses or capital loss carryovers from prior years. Becausethe basis of the replacement stock or securities will be the purchase price, the taxpayerin effect has exchanged a capital gain for an increased basis for the stock or securities.

ETHICS & EQUITY Washing a Loss Using an IRA

Sam owns 1,500 shares of Eagle, Inc. stockthat he purchased over 10 years ago for $80,000. Althoughthe stock has a current market value of $52,000, Sam stillviews the stock as a solid long-term investment. He has soldother stock during the year with overall gains of $30,000,so he would like to sell the Eagle stock and offset the

$28,000 loss against these gains—but somehow keep hisEagle investment. He has devised a plan to keep his Eagleinvestment by using funds in his traditional IRA to purchase1,500 Eagle shares immediately after selling the shares hecurrently owns. Evaluate Sam’s treatment of these stocktransactions. Can his plan work?

REFOCUS ON THE BIG PICTURE

PROPOSED SALE OF A HOUSE AND OTHER PROPERTY TRANSACTIONS

Alice’s tax adviser asked a number of questions to advise her on her proposed trans-action for the house. Alice provided the following answers (refer to Example 19):

• Alice inherited the house from her mother. The fair market value of the house atthe date of her mother’s death, based on the estate tax return, was $475,000.Based on an appraisal, the house currently is worth $485,000. Alice’s mother livedin the house for 38 years. According to the mother’s attorney, her adjusted basisfor the house was $275,000.

• As a child, Alice lived in the house for 10 years. She has not lived there during the25 years she has been married.

• The house has been vacant during the seven months Alice has owned it. She hasbeen trying to decide whether she should sell it for its fair market value or sell it toher nephew for $275,000. Alice has suggested a $275,000 price for the sale to Danbecause she believes this is the amount at which she will have no gain or loss.

• Alice intends to invest the $275,000 in stock.

You advise Alice that her adjusted basis for the house is the $475,000 fair marketvalue on the date of her mother’s death. If Alice sells the house for $485,000 (assum-ing no selling expenses), she would have a recognized gain of $10,000($485,000 amount realized� $475,000 adjusted basis). The house is a capital asset,and Alice’s holding period is long term because she inherited the house. Thus, thegain would be classified as a long-term capital gain. If, instead, Alice sells the houseto her nephew for $275,000, she will have a part sale and part gift. The realized gainon the sale of $5,670 is recognized.

continuedªM

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Key Terms

Adjusted basis, 14-4

Amount realized, 14-3

Fair market value, 14-3

Goodwill, 14-9

Holding period, 14-11

Realized gain, 14-2

Realized loss, 14-2

Recognized gain, 14-5

Recognized loss, 14-5

Wash sale, 14-15

Discussion Questions

1. LO.1 Upon the sale or other disposition of property, what four questions should beconsidered for income tax purposes?

2. LO.1 Ivan invests in land, and Grace invests in taxable bonds. The land appreciatesby $8,000 each year, and the bonds earn interest of $8,000 each year. After

holding the land and bonds for five years, Ivan and Grace sell them. There is a$40,000 realized gain on the sale of the land and no realized gain or loss on the saleof the bonds. Are the tax consequences to Ivan and Grace the same for each of thefive years? Explain.

3. LO.1 Carol and Dave each purchase 100 shares of stock of Burgundy, Inc., a publiclyowned corporation, in July for $10,000 each. Carol sells her stock on December

31 for $8,000. Because Burgundy’s stock is listed on a national exchange, Dave is ableto ascertain that his shares are worth $8,000 on December 31. Does the tax law treatthe decline in value of the stock differently for Carol and Dave? Explain.

4. LO.1 If a taxpayer sells property for cash, the amount realized consists of the netproceeds from the sale. For each of the following, indicate the effect on the

amount realized:

a. The property is sold on credit.

b. A mortgage on the property is assumed by the buyer.

c. A mortgage on the property is assumed by the seller.

d. The buyer acquires the property subject to a mortgage of the seller.

e. Stock that has a basis to the purchaser of $6,000 and a fair market value of$10,000 is received by the seller as part of the consideration.

5. LO.1 Taylor is negotiating to buy some land. Under the first option, Taylor will giveElla $150,000 and assume her mortgage on the land for $100,000. Under the

Amount realized $ 275,000

Less: Adjusted basis (269,330)*

Realized gain $ 5,670

Recognized gain $ 5,670

* [($275,000/$485,000) � $475,000] ¼ $269,330.

The gain is classified as a long-term capital gain. Alice is then deemed to havemade a gift to Dan of $210,000 ($485,000� $275,000). With this information, Alicecan make an informed selection between the two options.

See Examples 7 and 8 for the tax consequences associated with Alice’s questionsregarding selling the boat. See Example 25 for the tax consequences associated withAlice’s questions regarding the wash sale of the stock.

Decision Making

Decision Making


For the latest in changes to tax legislation, visit www.cengagebrain.com.

second option, Taylor will give Ella $250,000, and she will immediately pay off themortgage. Taylor wants his basis for the land to be as high as possible. Given thisobjective, which option should Taylor select?

6. LO.1 Marge owns land and a building (held for investment) with an adjusted basisof $75,000 and a fair market value of $250,000. The property is subject to a

mortgage of $400,000. Because Marge is in arrears on the mortgage payments, thecreditor is willing to accept the property in return for canceling the amount of themortgage.

a. How can the adjusted basis of the property be less than the amount of themortgage?

b. If the creditor’s offer is accepted, what are the effects on the amount realized,the adjusted basis, and the realized gain or loss for Marge?

c. Does it matter in (b) if the mortgage is recourse or nonrecourse? Explain.

7. LO.1 On July 16, 2015, Logan acquires land and a building for $500,000 to use inhis sole proprietorship. Of the purchase price, $400,000 is allocated to the

building, and $100,000 is allocated to the land. Cost recovery of $4,708 is deductedin 2015 for the building (nonresidential real estate).

a. What is the adjusted basis for the land and the building at the acquisition date?

b. What is the adjusted basis for the land and the building at the end of 2015?

8. LO.1 Auralia owns stock in Orange Corporation and Blue Corporation. Shereceives a $10,000 distribution from both corporations. The instructions from

Orange state that the $10,000 is a dividend. The instructions from Blue state that the$10,000 is not a dividend. What could cause the instructions to differ as to the taxconsequences?

9. LO.2 Wanda is considering selling two personal use assets that she owns. One hasappreciated in value by $20,000, and the other has declined in value by

$17,000. Wanda believes that she should sell both assets in the same tax year so thatthe loss of $17,000 can offset the gain of $20,000.

a. Advise Wanda regarding the tax consequences of her plan.

b. Could Wanda achieve better tax results by selling the assets in different taxyears? Explain.

10. LO.2 Ron sold his sailboat for a $5,000 loss in the current year because he wasdiagnosed with skin cancer. His spouse wants him to sell his Harley-Davidson

motorcycle because her brother broke his leg while riding his motorcycle. BecauseRon no longer has anyone to ride with, he is seriously considering accepting hiswife’s advice. Because the motorcycle is a classic, Ron has received two offers. Eachoffer would result in a $5,000 gain. Joe would like to purchase the motorcyclebefore Christmas, and Jeff would like to purchase it after New Year’s. Identify therelevant tax issues Ron faces in making his decision.

11. LO.1, 2, 3, 5 Simon owns stock that has declined in value since acquired. He hasdecided either to give the stock to his nephew, Fred, or to sell it and

give Fred the proceeds. If Fred receives the stock, he will sell it to obtain the pro-ceeds. Simon is in the 15% tax bracket, while Fred’s bracket is 25%. In either case,the holding period for the stock will be short term. Identify the tax issues relevant toSimon in deciding whether to give the stock or the sale proceeds to Fred.

12. LO.3 Robin inherits 1,000 shares of Wal-Mart stock from her aunt in 2015. Accord-ing to the information received from the executor of her aunt’s estate, Robin’s

adjusted basis for the stock is $55,000. Albert, Robin’s fianc�e, receives 1,000 sharesof Wal-Mart stock from his uncle as a gift in 2015. His uncle tells Albert that hisadjusted basis for the Wal-Mart stock is $7,000. What could cause the substantialdifference in the adjusted basis for Robin’s and Albert’s respective 1,000 shares ofWal-Mart stock?

Decision Making

Issue ID

Issue ID


13. LO.3 Thelma inherited land from Sadie on June 7, 2015. The land appreciated invalue by 100% during the six months it was owned by Sadie. The value has

remained stable during the three months Thelma has owned it, and she expects it tocontinue to do so in the near future. Although she would like to sell the land now,Thelma has decided to postpone the sale for another three months. The delay is toenable the recognized gain to qualify for long-term capital gain treatment. EvaluateThelma’s understanding of the tax law.

14. LO.4 Marilyn owns land that she acquired three years ago as an investment for$250,000. Because the land has not appreciated in value as she anticipated,

she sells it to her brother, Amos, for its fair market value of $180,000. Amos sells theland two years later for $240,000.

a. Explain why Marilyn’s realized loss of $70,000 ($180,000 amount realized�$250,000 adjusted basis) is disallowed.

b. Explain why Amos has neither a recognized gain nor a recognized loss on hissale of the land.

c. Is the family unit treated fairly under the related-party disallowance rule under§ 267? Explain.

d. Which party wins, and which party loses?

e. How could Marilyn have avoided the loss disallowance on her sale of the land?

15. LO.4, 5 Comment on the following transactions:

a. Mort owns 500 shares of Pear, Inc. stock with an adjusted basis of $22,000. OnJuly 28, 2015, he sells 100 shares for $3,000. On August 16, 2015, he purchasesanother 100 shares for $3,400. Mort’s realized loss of $1,400 ($3,000� $4,400)on the July 28 sale is not recognized, and his adjusted basis for the 100 sharespurchased on August 16 is $4,800. Explain.

b. How would your answer in (a) change if Mort purchased the 100 shares onDecember 27, 2015, rather than on August 16, 2015?

Computational Exercises

16. LO.1 Sally owns real property for which the annual property taxes are $8,000. Shesells the property to Shelley on February 28, 2015, for $550,000. Shelley pays

the real property taxes for the entire year on October 1.

a. How much of the property taxes can be deducted by Sally and how much byShelley?

b. What effect does the property tax apportionment have on Shelley’s adjustedbasis in the property?

c. What effect does the apportionment have on Sally’s amount realized from thesale?

d. How would the answers in (b) and (c) differ if the taxes were paid by Sally?

17. LO.1 Melba purchases land from Adrian. Melba gives Adrian $225,000 in cashand agrees to pay Adrian an additional $400,000 one year later plus

interest at 5%.

a. What is Melba’s adjusted basis for the land at the acquisition date?

b. What is Melba’s adjusted basis for the land one year later?

18. LO.1 On July 1, 2015, Katrina purchased tax-exempt bonds (face value of $75,000)for $82,000. The bonds mature in five years, and the annual interest rate is

6%. The market rate of interest is 2%.

Decision Making

Decision Making



a. How much interest income and/or interest expense must Katrina report in2015?

b. What is Katrina’s adjusted basis for the bonds on January 1, 2016?

19. LO.3 Luciana, a nonshareholder, purchases a condominium from her employerfor $85,000. The fair market value of the condominium is $120,000. What is

Luciana’s basis in the condominium and the amount of any income as a result ofthis purchase?

20. LO.3 Sebastian purchases two pieces of equipment for $100,000. Appraisals of theequipment indicate that the fair market value of the first piece of equipment

is $72,000 and that of the second piece of equipment is $108,000. What is Sebastian’sbasis in these two assets?

21. LO.3 Heather owns 400 shares of Diego Corporation common stock for whichshe paid $4,000. She receives a nontaxable stock dividend of 20 shares of

preferred stock on her common stock. The fair market values on the date ofdistribution of the preferred stock dividend are $20 a share for common stock and$100 a share for preferred stock. What is Heather’s basis in the common andpreferred shares?

22. LO.3 Juliana purchased land in 2012 for $50,000. She gave the land to Tom, herbrother, in 2015, when the fair market value was $70,000. No gift tax is paid

on the transfer. Tom subsequently sells the property for $63,000.

a. What is Tom’s basis in the land, and what is his realized gain or loss on thesale?

b. Assume, instead, that the land has a fair market value of $45,000 and that Tomsold the land for $43,000. Now what is Tom’s basis in the land, and what is hisrealized gain or loss on the sale?

23. LO.3 Ashley inherited all of the property of her aunt, who died in 2015. Heraunt’s adjusted basis for the property at the date of death was $1,200,000.

The property’s fair market value was $4,500,000 at the date of death and$4,800,000 six months after the date of death. What is Ashley’s adjusted basis ofthe property for income tax purposes?

24. LO.4 Lisa sells business property with an adjusted basis of $130,000 to her son,Alfred, for its fair market value of $100,000.

a. What is Lisa’s realized and recognized gain or loss?

b. What is Alfred’s recognized gain or loss if he subsequently sells the propertyfor $138,000? For $80,000?

25. LO.4 Juan owned 200 shares of Circle Corporation stock (adjusted basis of$30,000). He sold 100 shares for $12,000. Twenty days later he purchased

100 shares of the same stock for $8,500. What is Juan’s realized and recognized loss?What is his basis in the newly acquired shares?

26. LO.4 Arianna’s personal residence has an adjusted basis of $230,000 and a fair mar-ket value of $210,000. Arianna converts the personal residence to rental prop-

erty. What is Arianna’s gain basis? What is her loss basis?

27. LO.4 Peyton sells an office building and the associated land on May 1, 2015. Underthe terms of the sales contract, Peyton is to receive $1,600,000 in cash. The

purchaser is to assume Peyton’s mortgage of $950,000 on the property. To enablethe purchaser to obtain adequate financing, Peyton is to pay the $9,000 in pointscharged by the lender. The broker’s commission on the sale is $75,000. The pur-chaser agrees to pay the $24,000 in property taxes for the entire year. What isPeyton’s amount realized?


Problems

28. LO.1 Anne sold her home for $290,000 in 2015. Selling expenses were $17,400.She purchased it in 2009 for $200,000. During the period of ownership, Anne

did the following:

• Deducted $50,500 office-in-home expenses, which included $4,500 in deprecia-tion. (Refer to Chapter 9.)

• Deducted a casualty loss in 2011 for residential trees destroyed by a hurricane.The total loss was $19,000 (after the $100 floor and the 10%-of-AGI floor),and Anne’s insurance company reimbursed her for $13,500. (Refer toChapter 7.)

• Paid street paving assessment of $7,000 and added sidewalks for $8,000.

• Installed an elevator for medical reasons. The total cost was $20,000, and Annededucted $13,000 as medical expenses. (Refer to Chapter 10.)

What is Anne’s realized gain?

29. LO.1 Kareem bought a rental house in March 2010 for $300,000, of which $50,000is allocated to the land and $250,000 to the building. Early in 2012, he had a

tennis court built in the backyard at a cost of $7,500. Kareem has deducted $30,900for depreciation on the house and $1,300 for depreciation on the court. In January2015, he sells the house and tennis court for $330,000 cash.

a. What is Kareem’s realized gain or loss?

b. If an original mortgage of $80,000 is still outstanding and the buyer assumes themortgage in addition to the cash payment, what is Kareem’s realized gain orloss?

c. If the buyer takes the property subject to the $80,000 mortgage, rather thanassuming it, what is Kareem’s realized gain or loss?

30. LO.1 Norm is negotiating the sale of a tract of his land to Pat. Use the followingclassification scheme to classify each of the items contained in the proposed

sales contract:

Legend

DARN ¼ Decreases amount realized by Norm

IARN ¼ Increases amount realized by Norm

DABN ¼ Decreases adjusted basis to Norm

IABN ¼ Increases adjusted basis to Norm

DABP ¼ Decreases adjusted basis to Pat

IABP ¼ Increases adjusted basis to Pat

a. Norm is to receive cash of $50,000.

b. Norm is to receive Pat’s note payable for $25,000, payable in three years.

c. Pat assumes Norm’s mortgage of $5,000 on the land.

d. Pat agrees to pay the realtor’s sales commission of $8,000.

e. Pat agrees to pay the property taxes on the land for the entire year. If each partypaid his or her respective share, Norm’s share would be $1,000 and Pat’s sharewould be $3,000.

f. Pat pays legal fees of $500.

g. Norm pays legal fees of $750.

31. LO.1 Nissa owns a building (adjusted basis of $600,000 on January 1, 2015) thatshe rents to Len, who operates a restaurant in the building. The municipal



health department closed the restaurant for three months during 2015 because ofhealth code violations. Under MACRS, the cost recovery deduction for 2015 wouldbe $20,500. However, Nissa deducted cost recovery only for the nine months therestaurant was open because she waived the rent income during the three-monthperiod the restaurant was closed.

a. What is the amount of the cost recovery deduction Nissa should report on her2015 income tax return?

b. Calculate the adjusted basis of the building at the end of 2015.

32. LO.1, 2 Pam owns a personal use boat that has a fair market value of $35,000 andan adjusted basis of $45,000. Pam’s AGI is $100,000. Calculate the realized

and recognized gain or loss if:

a. Pam sells the boat for $35,000.

b. Pam exchanges the boat for another boat worth $35,000.

c. The boat is stolen and Pam receives insurance proceeds of $35,000.

d. Would your answer in (a) change if the fair market value and the selling priceof the boat were $48,000?

33. LO.1 Ricky owns stock in Dove Corporation. His adjusted basis for the stock is$90,000. During the year, he receives a distribution from the corporation of

$75,000 that is labeled a return of capital (i.e., Dove has no earnings and profits).

a. Determine the tax consequences to Ricky.

b. Assume instead that the amount of the distribution is $150,000. Determine thetax consequences to Ricky.

c. Assume instead in (a) that the $75,000 distribution is labeled a taxable dividend(i.e., Dove has earnings and profits of at least $75,000).

34. LO.1, 2 Chee purchases Tan, Inc. bonds for $108,000 on January 2, 2015. The facevalue of the bonds is $100,000; the maturity date is December 31, 2019;

and the annual interest rate is 5%. Chee will amortize the premium only if he isrequired to do so. Chee sells the bonds on July 1, 2017, for $106,000.

a. Determine the interest income Chee should report for 2015.

b. Calculate Chee’s recognized gain or loss on the sale of the bonds in 2017.

35. LO.1, 2 Which of the following results in a recognized gain or loss?

a. Kay sells her vacation cabin (adjusted basis of $100,000) for $150,000.

b. Adam sells his personal residence (adjusted basis of $150,000) for $100,000.

c. Carl’s personal residence (adjusted basis of $65,000) is condemned by the city.He receives condemnation proceeds of $55,000.

d. Olga’s land is worth $40,000 at the end of the year. She had purchased the landsix months earlier for $25,000.

e. Vera’s personal vehicle (adjusted basis of $22,000) is stolen. She receives$23,000 from the insurance company and does not plan to replace theautomobile.

f. Jerry sells used clothing (adjusted basis of $500) to a thrift store for $50.

36. LO.1, 2 Yancy’s personal residence is condemned as part of an urban renewal pro-ject. His adjusted basis for the residence is $480,000. He receives condem-

nation proceeds of $460,000 and invests the proceeds in stocks and bonds.

a. Calculate Yancy’s realized and recognized gain or loss.

b. If the condemnation proceeds are $505,000, what are Yancy’s realized and rec-ognized gain or loss?

c. What are Yancy’s realized and recognized gain or loss in (a) if the house wasrental property?


37. LO.3 Buddy Morgan is a real estate agent for Coastal Estates, a residential realestate development. Because of his outstanding sales performance, Buddy is

permitted to buy a lot for $300,000 that normally would sell for $500,000. Buddy isthe only real estate agent for Coastal Estates who is permitted to do so.

a. Does Buddy have gross income from the transaction? Explain.

b. What is Buddy’s adjusted basis for the land?

c. Write a letter to Buddy informing him of the tax consequences of his acquisitionof the lot. His address is 100 Tower Road, San Diego, CA 92182.

38. LO.1, 2, 3 Karen makes the following purchases and sales of stock:

Transaction Date Number of Shares Company Price per Share

Purchase 1-1-2013 300 MDG $ 75

Purchase 6-1-2013 150 GRU 300

Purchase 11-1-2013 60 MDG 70

Sale 12-3-2013 200 MDG 80

Purchase 3-1-2014 120 GRU 375

Sale 8-1-2014 90 GRU 330

Sale 1-1-2015 150 MDG 90

Sale 2-1-2015 75 GRU 500

Assuming that Karen is unable to identify the particular lots that are sold with theoriginal purchase, determine the recognized gain or loss on each type of stock:

a. As of July 1, 2013.

b. As of December 31, 2013.

c. As of December 31, 2014.

d. As of July 1, 2015.

39. LO.1, 2, 3 Kevin purchases 1,000 shares of Bluebird Corporation stock on October3, 2015, for $300,000. On December 12, 2015, Kevin purchases an addi-

tional 750 shares of Bluebird stock for $210,000. According to market quotations,Bluebird stock is selling for $285 per share on December 31, 2015. Kevin sells 500shares of Bluebird stock on March 1, 2016, for $162,500.

a. What is the adjusted basis of Kevin’s Bluebird stock on December 31, 2015?

b. What is Kevin’s recognized gain or loss from the sale of Bluebird stock onMarch 1, 2016, assuming the shares sold are from the shares purchased onDecember 12, 2015?

c. What is Kevin’s recognized gain or loss from the sale of Bluebird stock onMarch 1, 2016, assuming Kevin cannot adequately identify the shares sold?

40. LO.3 Rod Clooney purchases Agnes Mitchell’s sole proprietorship for $990,000 onAugust 15, 2015. The assets of the business are as follows:

AssetAgnes’s Adjusted

Basis FMV

Accounts receivable $ 70,000 $ 70,000

Inventory 90,000 100,000

Equipment 150,000 160,000

Furniture and fixtures 95,000 130,000

Building 190,000 250,000

Land 25,000 75,000

Total $620,000 $785,000

Communications

Communications



Rod and Agnes agree that $50,000 of the purchase price is for Agnes’s five-yearcovenant not to compete.

a. Calculate Agnes’s realized and recognized gain.

b. Determine Rod’s basis for each of the assets.

c. Write a letter to Rod informing him of the tax consequences of the purchase.His address is 300 Riverview Drive, Delaware, OH 43015.

41. LO.3 Donna owns 800 shares of common stock in Macaw Corporation (adjustedbasis of $40,000). She receives a 5% stock dividend when the stock is selling

for $60 per share.

a. How much gross income must Donna recognize because of the stock dividend?

b. What is Donna’s basis for her 840 shares of stock?

42. LO.1, 2, 3 Roberto has received various gifts over the years. He has decided to dis-pose of the following assets he received as gifts:

a. In 1951, he received land worth $32,000. The donor’s adjusted basis was$35,000. Roberto sells the land for $95,000 in 2015.

b. In 1956, he received stock in Gold Company. The donor’s adjusted basis was$19,000. The fair market value on the date of the gift was $34,000. Roberto sellsthe stock for $40,000 in 2015.

c. In 1962, he received land worth $15,000. The donor’s adjusted basis was$20,000. Roberto sells the land for $9,000 in 2015.

d. In 2003, he received stock worth $30,000. The donor’s adjusted basis was$42,000. Roberto sells the stock for $38,000 in 2015.

What is the recognized gain or loss from each of the preceding transactions?Assume for each of the gift transactions that no gift tax was paid.

43. LO.1, 2, 3 Nicky receives a car from Sam as a gift. Sam paid $48,000 for the car.He had used it for business purposes and had deducted $10,000 for

depreciation up to the time he gave the car to Nicky. The fair market value of thecar is $33,000.

a. Assuming that Nicky uses the car for business purposes, what is her basis fordepreciation?

b. Assume that Nicky deducts depreciation of $6,500 and then sells the car for$32,500. What is her recognized gain or loss?

c. Assume that Nicky deducts depreciation of $6,500 and then sells the car for$20,000. What is her recognized gain or loss?

44. LO.3 Margo receives a gift of real estate with an adjusted basis of $175,000 and afair market value of $100,000. The donor paid gift tax of $15,000 on the

transfer. If Margo later sells the property for $110,000, what is her recognized gainor loss?

45. LO.3 On September 18, 2015, Gerald received land and a building from Frank as agift. Frank’s adjusted basis and the fair market value at the date of the gift are

as follows:

Asset Adjusted Basis FMV

Land $100,000 $212,000

Building 80,000 100,000

No gift tax was paid on the transfer.

a. Determine Gerald’s adjusted basis for the land and building.

b. Assume instead that the fair market value of the land was $87,000 and that ofthe building was $65,000. Determine Gerald’s adjusted basis for the land andbuilding.


46. LO.1, 2, 3, 5 Ira Cook is planning to make a charitable contribution to the BoyScouts of Crystal, Inc. stock worth $20,000. The stock has an

adjusted basis of $15,000. A friend has suggested that Ira sell the stock and contrib-ute the $20,000 in proceeds rather than contribute the stock.

a. Should Ira follow the friend’s advice? Why or why not?

b. Assume that the fair market value is only $13,000. In this case, should Ira followthe friend’s advice? Why or why not?

c. Rather than make a charitable contribution to the Boy Scouts, Ira is going tomake a gift to Nancy, his niece. Advise Ira regarding (a) and (b).

d. Write a letter to Ira regarding whether in (a) he should sell the stock and con-tribute the cash or contribute the stock. He has informed you that he purchasedthe stock six years ago. Ira’s address is 500 Ireland Avenue, DeKalb, IL 60115.

47. LO.3 As sole heir, Dazie receives all of Mary’s property (adjusted basis of$1,400,000 and fair market value of $3,820,000). Six months after Mary’s death

in 2015, the fair market value is $3,835,000.

a. Can the executor of Mary’s estate elect the alternate valuation date and amount?Explain.

b. What is Dazie’s basis for the property?

c. Assume instead that the fair market value six months after Mary’s death is$3,800,000. Respond to (a) and (b).

48. LO.3 Dan bought a hotel for $2,600,000 in January 2011. In May 2015, he died andleft the hotel to Ed. While Dan owned the hotel, he deducted $289,000 of cost

recovery. The fair market value in May 2015 was $2,800,000. The fair market valuesix months later was $2,850,000.

a. What is the basis of the property to Ed?

b. What is the basis of the property to Ed if the fair market value six months laterwas $2,500,000 (not $2,850,000) and the objective of the executor was to mini-mize the estate tax liability?

49. LO.3 Helene and Pauline are twin sisters who live in Louisiana and Mississippi,respectively. Helene is married to Frank, and Pauline is married to Richard.

Frank and Richard are killed in an auto accident in 2015 while returning from asporting event.

Helene and Frank jointly owned some farmland in Louisiana (value of $940,000,cost of $450,000). Pauline and Richard jointly owned some farmland in Mississippi(value of $940,000, cost of $450,000). Assume that all of Frank’s and Richard’s prop-erty passes to their surviving wives.

a. Calculate Helene’s basis in the land.

b. Calculate Pauline’s basis in the land.

c. What causes the difference?

50. LO.3, 4 Sheila sells land to Elane, her sister, for the fair market value of $40,000.Six months later when the land is worth $45,000, Elane gives it to Jacob,

her son. (No gift tax resulted.) Shortly thereafter, Jacob sells the land for $48,000.

a. Assuming that Sheila’s adjusted basis for the land is $24,000, what are Sheila’sand Jacob’s recognized gain or loss on the sales?

b. Assuming that Sheila’s adjusted basis for the land is $60,000, what are Sheila’sand Jacob’s recognized gain or loss on the sales?

51. LO.1, 2, 3, 4 Louis owns three pieces of land with an adjusted basis as follows: par-cel A, $75,000; parcel B, $125,000; and parcel C, $175,000. Louis sells

parcel A to his uncle for $50,000, parcel B to his partner for $120,000, and parcel Cto his mother for $150,000.

Decision Making

Communications



a. What is the recognized gain or loss from the sale of each parcel?

b. If Louis’s uncle eventually sells his land for $90,000, what is his recognized gainor loss?

c. If Louis’s partner eventually sells his land for $130,000, what is his recognizedgain or loss?

d. If Louis’s mother eventually sells her land for $165,000, what is her recognizedgain or loss?

52. LO.1, 2, 3, 4 Tyneka inherited 1,000 shares of Aqua, Inc. stock from Joe. Joe’s basiswas $35,000, and the fair market value on July 1, 2015 (the date of

death) was $45,000. The shares were distributed to Tyneka on July 15, 2015. Tynekasold the stock on July 30, 2016, for $33,000. After giving the matter more thought,she decides that Aqua is a good investment and purchases 1,000 shares for $30,000on August 20, 2016.

a. What is Tyneka’s basis for the 1,000 shares purchased on August 20, 2016?

b. Could Tyneka have obtained different tax consequences in (a) if she had soldthe 1,000 shares on December 27, 2015, and purchased the 1,000 shares on Jan-uary 5, 2016? Explain.

53. LO.1, 2, 4 On December 28, 2015, Kramer sells 150 shares of Lavender, Inc. stockfor $77,000. On January 10, 2016, he purchases 100 shares of the same

stock for $82,000.

a. Assuming that Kramer’s adjusted basis for the stock sold is $65,000, what is hisrecognized gain or loss? What is his basis for the new shares?

b. Assuming that Kramer’s adjusted basis for the stock sold is $89,000, what is hisrecognized gain or loss? What is his basis for the new shares?

c. Advise Kramer on how he can avoid any negative tax consequences encoun-tered in part (b).

54. LO.1, 2, 4 Abby’s home had a basis of $360,000 ($160,000 attributable to the land)and a fair market value of $340,000 ($155,000 attributable to the land)

when she converted 70% of it to business use by opening a bed-and-breakfast. Fouryears after the conversion, Abby sells the home for $500,000 ($165,000 attributableto the land).

a. Calculate Abby’s basis for gain, loss, and cost recovery for the portion of herpersonal residence that was converted to business use.

b. Calculate the cost recovery deducted by Abby during the four-year period ofbusiness use, assuming the bed-and-breakfast is opened on January 1 of year 1and the house is sold on December 31 of year 4.

c. What is Abby’s recognized gain or loss on the sale of the business use portion?

55. LO.4, 5 Surendra’s personal residence originally cost $340,000 (ignore land). Afterliving in the house for five years, he converts it to rental property. At the

date of conversion, the fair market value of the house is $320,000. As to the rentalproperty, calculate Surendra’s basis for:

a. Loss.

b. Depreciation.

c. Gain.

d. Could Surendra have obtained better tax results if he had sold his personal resi-dence for $320,000 and then purchased another house for $320,000 to hold asrental property? Explain.

56. LO.3, 5 Hun, age 93, has accumulated substantial assets during his life. Among hismany assets are the following, which he is considering giving to Koji, his

grandson.

Decision Making

Decision Making

Decision Making

Decision Making


Asset Adjusted Basis Fair Market Value

Silver Corporation stock $900,000 $700,000

Red Corporation stock 70,000 71,000

Emerald Corporation stock 200,000 500,000

Hun has been in ill health for the past five years. His physician has informed himthat he probably will not live for more than six months. Advise Hun on which of thestocks should be transferred as gifts and which as bequests.

Cumulative Problems

57. Alton Newman, age 67, is married and files a joint return with his wife, Clair, age 65.Alton and Clair are both retired, and during 2014, they received Social Security ben-efits of $10,000. Alton’s Social Security number is 111-11-1111, and Clair’s is 123-45-6789. They reside at 210 College Drive, Columbia, SC 29201.

Alton, who retired on January 1, 2014, receives benefits from a qualified pensionplan of $2,750 a month for life. His total contributions to the plan (none of whichwere deductible) were $168,250. In January 2014, he received a bonus of $2,000from his former employer for service performed in 2013. Although the formeremployer accrued the bonus in 2013, it was not paid until 2014.

Clair, who retired on December 31, 2013, started receiving benefits of $1,400 amonth on January 1, 2014. Her contributions to the qualified pension plan (none ofwhich were deductible) were $74,100.

On September 27, 2014, Alton and Clair received a 10% stock dividend on 600shares of stock they owned. They had bought the stock on March 5, 2007, for $20 ashare. On December 16, 2014, they sold the 60 dividend shares for $55 a share.

On October 10, 2014, Clair sold the car she had used in commuting to and fromwork for $17,000. She had paid $31,000 for the car in 2008.

On July 14, 2006, Alton and Clair received a gift of 1,000 shares of stock fromtheir son, Thomas. Thomas’s basis in the stock was $35 a share (fair market value atthe date of gift was $25). No gift tax was paid on the transfer. Alton and Clair soldthe stock on October 8, 2014, for $24 a share.

On May 1, 2014, Clair’s mother died, and Clair inherited her personal residence.In February 2014, her mother had paid the property taxes for 2014 of $2,100. Theresidence had a fair market value of $235,000 and an adjusted basis to the mother of$160,000 on the date of her death. Clair listed the house with a real estate agent,who estimated it was worth $240,000 as of December 31, 2014.

Clair received rent income of $6,000 on a beach house she inherited three yearsago from her uncle Charles. She had rented the property for one week during theJuly 4 holiday and one week during the Thanksgiving holidays. Charles’s adjustedbasis in the beach house was $150,000, and its fair market value on the date of hisdeath was $240,000. Clair and Alton used the beach house for personal purposes for56 days during the year. Expenses associated with the house were $3,700 for util-ities, maintenance, and repairs; $2,200 for property taxes; and $800 for insurance.There are no mortgages on the property.

Clair and Alton paid estimated Federal income tax of $3,100 and had itemized deduc-tions of $6,800 (excluding any itemized deductions associated with the beach house). Ifthey have overpaid their Federal income tax, they want the amount refunded. Both Clairand Alton want $3 to go to the Presidential Election Campaign Fund.

Compute their net tax payable or refund due for 2014. If you use tax forms foryour computations, you will need Form 1040 and Schedule D. Suggested software:H&R BLOCK Tax Software.

Tax Return Problem



58. John Benson, age 40, is single. His Social Security number is 111-11-1111, and heresides at 150 Highway 51, Tangipahoa, LA 70465.

John has a 5-year-old child, Kendra, who lives with her mother, Katy. John paysalimony of $6,000 per year to Katy and child support of $12,000. The $12,000 ofchild support covers 65% of Katy’s costs of rearing Kendra. Kendra’s Social Securitynumber is 123-45-6789, and Katy’s is 123-45-6788.

John’s mother, Sally, lived with him until her death in early September 2015. Heincurred and paid medical expenses for her of $12,900 and other support paymentsof $11,000. Sally’s only sources of income were $5,500 of interest income on certifi-cates of deposit and $5,600 of Social Security benefits, which she spent on her medi-cal expenses and on maintenance of John’s household. Sally’s Social Securitynumber was 123-45-6787.

John is employed by the Highway Department of the State of Louisiana in an ex-ecutive position. His salary is $95,000. The appropriate amounts of Social Securitytax and Medicare tax were withheld. In addition, $9,500 was withheld for Federalincome taxes, and $4,000 was withheld for state income taxes.

In addition to his salary, John’s employer provides him with the following fringebenefits:

• Group term life insurance with a maturity value of $95,000. The cost of the pre-miums for the employer was $295.

• Group health insurance plan. John’s employer paid premiums of $5,800 for hiscoverage. The plan paid $2,600 for John’s medical expenses during the year.

Upon the death of his aunt Josie in December 2014, John, her only recognizedheir, inherited the following assets:

Asset Josie’s Adjusted Basis FMV at Date of Death

Car $35,000 $ 19,000

Land—300 acres 90,000 175,000

IBM stock 15,000 40,000

Cash 10,000 10,000

Three months prior to her death, Josie gave John a mountain cabin. Her adjustedbasis for the mountain cabin was $120,000, and the fair market value was $195,000.No gift taxes were paid.

During the year, John had the following transactions:

• On February 1, 2015, he sold for $45,000 Microsoft stock that he inherited fromhis father four years ago. His father’s adjusted basis was $49,000, and the fairmarket value at the date of the father’s death was $41,000.

• The car John inherited from Josie was destroyed in a wreck on October 1, 2015.He had loaned the car to Katy to use for a two-week period while the engine inher car was being replaced. Fortunately, neither Katy nor Kendra was injured.John received insurance proceeds of $16,000, the fair market value of the car onOctober 1, 2015.

• On December 28, 2015, John sold the 300 acres of land to his brother, James, forits fair market value of $160,000. James planned on using the land for his dairyfarm.

Other sources of income for John were as follows:

Dividend income (qualified dividends) $ 3,500

Interest income:

Guaranty Bank 1,000

City of Kentwood water bonds 2,000

Award from state of Louisiana for outstandingsuggestion for highway beautification 10,000

Tax Computation Problem

Decision Making

Communications


Potential itemized deductions for John, in addition to items already mentioned,were as follows:

Property taxes paid on his residence and cabin $7,000

Property taxes paid on personalty 3,500

Estimated Federal income taxes paid 3,000

Charitable contributions 4,500

Mortgage interest on his residence 7,200

Orthodontic expenses for Kendra 4,000

Part 1—Tax ComputationCompute John’s net tax payable or refund due for 2015.

Part 2—Tax PlanningAssume that rather than selling the land to James, John is considering leasing it tohim for $12,000 annually with the lease beginning on October 1, 2015. James wouldprepay the lease payments through December 31, 2015. Thereafter, he would makemonthly lease payments at the beginning of each month. What effect would thishave on John’s 2015 tax liability? What potential problem might John encounter?Write a letter to John in which you advise him of the tax consequences of leasingversus selling. Also prepare a memo for the tax files.

Research Problems

Student Edition

Note: Solutions to Research Problems can be prepared by using the Checkpoint�

Student Edition online research product, which is available to accompany this text. Itis also possible to prepare solutions to the Research Problems by using tax researchmaterials found in a standard tax library.

Research Problem 1. Terry owns real estate with an adjusted basis of $600,000 and afair market value of $1.1 million. The amount of the nonrecourse mortgage on theproperty is $2.5 million. Because of substantial past and projected future losses asso-ciated with the real estate development (occupancy rate of only 37% after threeyears), Terry deeds the property to the creditor.

a. What are the tax consequences to Terry?

b. Assume that the data are the same, except that the fair market value of the prop-erty is $2,525,000. Therefore, when Terry deeds the property to the creditor, shealso receives $25,000 from the creditor. What are the tax consequences to Terry?

Research Problem 2. Your client, Jacob, turned 66 years old this year. Jacob has noheirs and has decided that he would like to sell a life insurance policy to fund a tripto Africa that he has wanted to take.

Jacob knew that he could surrender the policy (a whole-life policy) back to the in-surance company, but a friend told him he could get more for the policy if he sold itto a life settlement company. A life settlement company buys life insurance policiesfrom policyholders who are not ill and who generally have a life expectancy ofbetween 2 and 15 years. In return, the seller of the policy receives a lump-sum pay-ment. The life settlement company either holds the policy to maturity or resells thepolicy to an investor.

The lump sum received depends on factors such as age, health, and the terms andconditions of the policy, but is generally more than the policy’s cash surrender value(which would be received from the life insurance company upon surrender of thepolicy).

In November 2015, Jacob (who was not terminally or chronically ill) sold his pol-icy to a life settlement company for $160,000. During the time he owned the policy,Jacob did not borrow against the policy or receive any distributions. Jacob also had



paid premiums totaling $122,000 (of which $32,000 was paid for the provision of in-surance before the sale of the policy).

How should Jacob calculate his basis in the life insurance policy to determine ifhe has a realized gain or loss on the surrender of the policy?

Research Problem 3. Ruth Ames died on January 10, 2015. In filing the estate taxreturn, her executor, Melvin Sims, elects the primary valuation date and amount (fairmarket value on the date of death). On March 12, 2015, Melvin invests $30,000 ofcash that Ruth had in her money market account in acquiring 1,000 shares of Orange,Inc. ($30 per share). On January 10, 2015, Orange was selling for $29 per share. Thestock is distributed to a beneficiary, Annette Rust, on June 1, 2015, when it is sellingfor $33 per share. Melvin wants you to determine the amount at which the Orangeshares should appear on the estate tax return and the amount of Annette’s adjustedbasis for the stock. Write a letter to Melvin in which you respond to his inquiry andprepare a memo for the tax files. His address is 100 Center Lane, Miami, FL 33124.

Research Problem 4. Many see the “step-up in basis at death” rule of § 1014 as an ex-pensive tax loophole enjoyed by the wealthy. Find the latest estimates of the revenueloss to the Treasury that is attributable to this rule.

a. How does Canada’s tax law determine the basis of property acquired from a decedent?

b. Send an e-mail message to a member of the House Ways and Means Committeeexpressing a preference for the preservation of the current § 1014 rule or themodifications made to it by the Tax Relief Reconciliation Act of 2001 and the TaxRelief Act of 2010.

Research Problem 5. The specific identification method is important when one investsin mutual funds. When taxpayers sell part of their holdings, the basis of the surren-dered shares can be difficult to compute. Go to the site of an investment adviser ormutual fund to find instructions on how to compute the basis of the shares sold.What options are available to the taxpayer according to this information? Illustrateeach of the alternatives.

Roger CPA Review QuestionsPlease note that the Roger CPA Review questions that follow are provided for illustrative purposesonly and will vary from those that are included in the final, published version of this chapter.

1. In the current year, Harper, a married taxpayer filing jointly, sustained an $82,000loss on Code Sec. 1244 stock in WWW Corp., a qualifying small business corpora-tion, and a $27,000 loss on Code Sec. 1244 stock in RRR Corp., another qualifyingsmall business corporation. What is the maximum amount of loss that Harper candeduct for the current year?

a. $106,000 capital loss and $3,000 ordinary loss.

b. $9,000 ordinary loss and $100,000 capital loss.

c. $100,000 ordinary loss and $9,000 capital loss.

d. $109,000 capital loss.

2. In Year 1 Keller, an individual, purchased depreciable real property for $80,000. InYear 5 Keller sold the property for $100,000. At the time of sale the property had a ba-sis of $30,000 due to $50,000 depreciation taken during the holding period. Of thedepreciation taken, $30,000 is in excess of the amount that would have been takenunder straight-line depreciation. Keller is in the 15% long-term capital gain tax bracket.Which will be the net gain (loss) reported by Keller and at what applicable tax rate(s)?

Communications

Communications


InternetActivity

Use the tax resources of the Internet to address the following questions. Do notrestrict your search to the Web, but include a review of newsgroups and general ref-erence materials, practitioner sites and resources, primary sources of the tax law, chatrooms and discussion groups, and other opportunities.

a. $30,000 long-term capital gain at 15% and $40,000 Section 1250 gain at 25%.

b. $70,000 long-term capital gain at 15%.

c. $30,000 ordinary gain at Keller’s income tax rate and $40,000 long-term capitalgain at 15%.

d. $30,000 Section 1250 gain at 25% and $40,000 long-term capital gain at 15%.

3. Individual Smith’s year 2 brokerage account statement listed the following capitalgains and losses from the sale of stock investments:

Short-term capital gain $ 5,000

Long-term capital gain 10,000

Short-term capital loss 7,000

Long-term capital loss 9,000

Additional considerations:

• In Year 2, Smith inherited stock in January which sold for a gain of $2,000 in April.

• In July of Year 2, Smith sold Section 1231 property, acquired by Smith in Decem-ber of Year 1, for a loss of $5,000.

• In July of Year 2, Smith sold Section 1231 property, acquired by Smith in Decem-ber of Year 1, for a gain of $3,000.

What is Smith’s net capital gain or loss?

a. $1,000 net capital loss

b. $1,000 net capital gain

c. $4,000 net capital loss

d. $4,000 net capital gain

4. Individual Halpern’s year 2 brokerage account statement listed the following capitalgains and losses from the sale of stock investments:

Short-term capital gain $ 5,000

Long-term capital gain 8,000

Short-term capital loss 15,000

Long-term capital loss 5,000

Additional considerations:

• In May of Year 2, Halpern was officially informed that stock in Public CompanyX, acquired by Halpern in January of Year 1 for $2,000, had become worthless.

• In April of Year 2, Halpern was officially informed that Section 1244 stock,acquired by Halpern in December of Year 1 for $4,000, had become worthless.

• In July of Year 2, Halpern sold Section 1231 property, acquired by Halpern in Jan-uary of Year 1, for a gain of $3,000.

As a result of all of the above, how much can Halpern claim in Year 2 as loss thatwill offset ordinary income?

a. $6,000

b. $4,000

c. $3,000

d. $7,000

5. The following apply to Cushing, a single individual:

• In January of Year 2, Cushing inherited from her parents Section 1244 stock,which had cost her parents $10,000 and was worth $17,000 at time of inheritance.Later in Year 2, the stock became worthless.

• In July of Year 2, Cushing sold for $10,000 stock acquired by Cushing in Decem-ber of Year 1 for $7,000.

• In May of Year 2, Cushing sold for a $10,000 loss Section 1231 property Cushinghad acquired in November of Year 1.

As a result of the above, what amount of loss offsetting ordinary income can Cush-ing declare in Year 2?

a. $13,000

b. $20,000

c. $3,000

d. $27,000



6. The following apply to Simon, a single individual:

• In July of Year 2, Simon sold for $12,000 Section 1231 property acquired by Simonin December of Year 1 for $7,000.

• In February of Year 2, Simon inherited from her parents Section 1244 stock, whichhad cost her parents $5,000 and was worth $10,000 at time of inheritance. Later inYear 2, the stock became worthless.

• In May of Year 2, Simon sold for $17,000 Section 1231 property Simon hadacquired in January of Year 1 for $10,000.

As a result of the above, what is Simon’s net capital gain (loss)?

a. $0

b. $2,000

c. ($3,000)

d. $7,000

7. An individual had the following capital gains and losses for the year:

Short-term capital loss $60,000

Long-term gain (unrecaptured Section 1250 at 25%) 42,000

Collectibles gain (28% rate) 11,000

Long-term gain (15% rate) 15,000

What will be the net gain (loss) reported by the individual and at what applicabletax rate(s)?

a. Collectibles gain of $8,000 at the 28% rate.

b. Short-term loss of $3,000 at the ordinary rate and long-term capital gain of$68,000 at the 15% rate.

c. Long-term capital gain of $3,000 at the 15% rate, collectibles gain of $11,000 atthe 28% rate, and Section 1250 gain of $42,000 at the 25% rate.

d. Long-term gain of $8,000 at the 15% rate.

8. An individual had the following gains and losses for the year:

Short-term capital loss $30,000

Section 1231 loss 20,000

Long-term capital gain (unrecaptured Section 1250 at 25%) 18,000

Collectibles gain (28% rate) 20,000

Long-term capital gain (15% rate) 15,000

What will be the net capital gain (loss) reported by the individual and at what appli-cable tax rate(s)?

a. Long-term gain of $3,000.

b. Collectibles gain of $3,000.

c. Long-term gain (unrecaptured Section 1250) of $3,000 at 25% and collectiblesgain of $20,000 at 28% rate.

d. Long-term gain (unrecaptured Section 1250) of $8,000 at 25% and long-termgain of $15,000 at 15%.

9. In 20X14, MMI Corporation incurred net capital losses that amounted to $15,000.During the period from 20X8, its year of inception, through 20X13, MMI had netcapital gains of $1,000 each year. How much capital loss may MMI carry forward to20X15?

a. $9,000

b. Depends on how MMI decides to deduct the loss.

c. $10,000

d. $12,000

10. In 20X12 Lawley, a married individual filing jointly, incurred net capital losses thatamounted to $10,000. During the period from 20X09 through 20X11, Lawley had netcapital gains of $2,000 each year. How much capital loss may Lawley carry forwardto 20X13?

a. $10,000

b. $7,000

c. $4,000

d. $3,000


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