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Chapter 16

Chapter 16. Property Transactions: Capital Gains and Losses. The Big Picture (slide 1 of 3). Maurice has come to you for tax advice regarding his investments.

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Chapter 16

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  1. Chapter 16 Property Transactions: Capital Gains and Losses

  2. The Big Picture (slide 1 of 3) Maurice has come to you for tax advice regarding his investments. He inherited $500,000 from his Uncle Joe and, following the advice of a financial adviser, made the following investments 9 months ago. $200,000 in the stock of Purple, a publicly held bank that does not pay dividends. At one time, the stock had appreciated to $300,000, but now it is worth only $210,000. Maurice is considering unloading this stock. 2

  3. The Big Picture (slide 2 of 3) $50,000 for a 50% interest in a patent that Kevin, an unemployed inventor, had obtained for a special battery he had developed to power ‘‘green’’ cars. To date, Kevin has been unable to market the battery to an auto manufacturer or supplier. $150,000 in tax-exempt bonds. The interest rate is only 3%. Maurice is considering moving this money into taxable bonds that pay 3.5%. $100,000 for a 10% limited partnership interest in a real estate development. Lots in the development are selling well. 3

  4. The Big Picture (slide 3 of 3) Maurice read an article that talked about the beneficial tax rates for capital assets and dividends. He really liked the part about ‘‘costless’’ capital gains, although he did not understand it. Maurice has retained his job as a toll booth operator at the municipal airport. His annual compensation is $35,000. Respond to Maurice’s inquiries. Read the chapter and formulate your response. 4

  5. Taxation of Capital Gains and Losses Capital gains and losses must be separated from other types of gains and losses for two reasons: Long-term capital gains may be taxed at a lower rate than ordinary gains A net capital loss is only deductible up to $3,000 per year 5

  6. Proper Classification of Gains and Losses • Depends on three characteristics: 1.The tax status of the property • Capital asset, §1231 asset, or ordinary asset 2. The manner of the property’s disposition • By sale, exchange, casualty, theft, or condemnation 3. The holding period of the property • Short term and long term

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

  8. Capital Assets(slide 2 of 6) • §1221 defines capital assets as everything except (cont’d): • Certain copyrights; literary, musical, or artistic compositions; or letters, memoranda, or similar property • Taxpayers may elect to treat a sale or exchange of certain musical compositions or copyrights in musical works as the disposition of a capital asset • Certain publications of U.S. government • Supplies of a type regularly used or consumed in the ordinary course of a business

  9. Capital Assets(slide 3 of 6) • Thus, capital assets usually include: • Assets held for investment (e.g., stocks, bonds, land) • Personal use assets (e.g., residence, car) • Miscellaneous assets selected by Congress

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

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

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

  13. Sale or Exchange • Recognition of capital gains and losses generally requires a sale or exchange of assets • Sale or exchange is not defined in the Code • There are some exceptions to the sale or exchange requirement

  14. Sale or Exchange–Worthless Securities and § 1244 Stock (slide 1 of 2) • A security that becomes worthless creates a deductible capital loss without being sold or exchanged • The Code sets an artificial sale date for the securities on the last day of the year in which worthlessness occurs • Section 1244 allows an ordinary deduction on disposition of stock at a loss • The stock must be that of a small business company • The ordinary deduction is limited to $50,000 ($100,000 for married individuals filing jointly) per year

  15. Sale or Exchange–Worthless Securities (slide 2 of 2) • Worthless securities example: • Calendar year taxpayer purchased stock on December 5, 2010 • The stock becomes worthless on April 5, 2011 • The loss is deemed to have occurred on December 31, 2011 • The result is a long-term capital loss

  16. Sale or ExchangeRetirement of Corporate Obligations • Collection of the redemption value of corporate obligations (e.g., bonds payable) is treated as a sale or exchange and may result in a capital gain or loss • OID amortization increases basis and reduces gain on disposition or retirement

  17. Sale or Exchange–Options(slide 1 of 2) • For the grantee of the option, if the property subject to the option is (or would be) a capital asset in the hands of the grantee • Sale of an option results in capital gain or loss • Lapse of an option is considered a sale or exchange resulting in a capital loss • For the grantor of an option, the lapse creates • Short-term capital gain, if the option was on stocks, securities, commodities or commodity futures • Otherwise, ordinary income

  18. Sale or Exchange–Options(slide 2 of 2) • Exercise of an option by a grantee • Increases the gain (or reduces the loss) to the grantor from the sale of the property • Gain is ordinary or capital depending on the tax status of the property • Grantee adds the cost of the option to the basis of the property acquired

  19. Sale or Exchange–Patents • When all substantial rights to a patent are transferred by a holder to another, the transfer produces long-term capital gain or loss • The holder of a patent must be an individual, usually the creator, or an individual who purchases the patent from the creator before the patented invention is reduced to practice

  20. The Big Picture - Example 14Patents (slide 1 of 2) Return to the facts of The Big Picture on p. 16-2. Kevin transfers his rights in the battery patent to the Green Battery Co. In exchange, he receives $1 million plus $.50 for each battery sold. 20

  21. The Big Picture - Example 14Patents (slide 2 of 2) Assuming Kevin has transferred all substantial rights, Kevin automatically has a long-term capital gain. Both his share of the lump-sum payment and the $1 per battery royalty qualify (less his basis in the patent). Kevin also had an automatic long-term capital gain when he sold 50% of his rights in the patent to Maurice. Whether Maurice gets long-term capital gain treatment on the transfer to Green Battery will depend on whether he is a holder (see the discussion below in Example 15). 21

  22. The Big Picture - Example 15Holder of a Patent (slide 1 of 2) Return to the facts of The Big Picture on p. 16-2 and continuing with the facts of Example 14 Kevin is clearly a holder of the patent He is the inventor and was not an employee when he invented the battery. 22

  23. The Big Picture - Example 15Holder of a Patent (slide 2 of 2) When Maurice purchased a 50% interest in the patent, he became a holder if the patent had not yet been reduced to practice. Since the patent was not being manufactured at the time of the purchase, it had not been reduced to practice. Consequently, Maurice is also a holder. He has an automatic long-term capital gain or loss when the patent is transferred to Green Battery Co. Maurice’s basis for his share of the patent is $50,000, and his share of the proceeds is $1 million plus $.50 for each battery sold. Thus, Maurice has a long-term capital gain even though he has not held his interest in the patent for more than one year. 23

  24. Sale or Exchange–Franchises, Trademarks, and Trade Names (slide 1 of 3) • The licensing of franchises, trade names, trademarks, and other intangibles is generally not considered a sale or exchange of a capital asset • Therefore, ordinary income results to transferor • Exception: Capital gain (loss) may result if the transferor does not retain any significant power, right, or continuing interest

  25. Sale or Exchange–Franchises, Trademarks, and Trade Names (slide 2 of 3) • Significant powers, rights, or continuing interests include: • Control over assignment, quality of products and services • Sale or advertising of other products or services • The right to require that substantially all supplies and equipment be purchased from the transferor • The right to terminate the franchise at will, and • The right to substantial contingent payments

  26. Sale or Exchange–Franchises, Trademarks, and Trade Names (slide 3 of 3) • Noncontingent payments are ordinary income to the transferor • The franchisee capitalizes the payments and amortizes them over 15 years • Contingent payments are ordinary income for the franchisor and an ordinary deduction for the franchisee

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

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

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

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

  31. The Big Picture - Example 21Holding Period Return to the facts of The Big Picture on p. 16-2 Assume that Maurice purchased the Purple stock on January 15, 2010. If he sells it on January 16, 2011, Maurice’s holding period is more than one year. If instead Maurice sells the stock on January 15, 2011, the holding period is exactly one year, and the gain or loss is short term. 31

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

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

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

  35. Tax Treatment of Capital Gains and Losses (slide 4 of 7) Income Layers for Alternative Tax on Capital Gain Computation *May include qualified dividend income 35

  36. Tax Treatment of Capital Gains and Losses (slide 5 of 7) • Collectibles, even though they are held long term, are subject to a 28% alternative tax rate • Collectibles include any: • Work of art • Rug or antique • Metal or gem • Stamp • Alcoholic beverage • Historical objects (documents, clothes, etc.) • Most coins

  37. Tax Treatment of Capital Gains and Losses (slide 6 of 7) • Qualified dividend income paid from current or acc. E & P is eligible for the 0%/15% long-term capital gain rates • After determining net capital gain or loss, qualified dividend income is added to the net long-term capital gain portion of the net capital gain and is taxed as 0%/15% gain • If there is a net capital loss, it is still deductible for AGI • Limited to $3,000 per year with the remainder of the loss carrying over • In this case, the qualified dividend income is still eligible to be treated as 0%/15% gain in the alternative tax calculation • It is not offset by the net capital loss

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

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

  40. Refocus On The Big Picture (slide 1 of 3) Maurice is correct that certain capital gains and dividends are eligible for preferential tax treatment Tax rates of 0% or 15% may apply rather than regular tax rates. You then discuss the potential tax consequences of each of his investments. Purple stock - To qualify for the beneficial tax rate, the holding period for the stock must be longer than one year. From a tax perspective, Maurice should retain his stock investment for at least an additional three months and a day. To be eligible for the ‘‘costless’’ capital gains, his taxable income should not exceed $34,500 for 2011. 40

  41. Refocus On The Big Picture (slide 2 of 3) Patent - Since he is a ‘‘holder’’ of the patent, it will qualify for the beneficial capital gain rate regardless of the holding period if the patent should produce income in excess of his $50,000 investment. However, if he loses money on the investment, he will be able to deduct only $3,000 of the loss per year (assuming no other capital gains). Tax-exempt bonds. The after-tax return on the taxable bonds would be less than the 3% on the tax-exempt bonds. In addition, the interest on the taxable bonds would increase his taxable income, possibly moving it out of the desired 15% marginal tax rate into the 25% marginal tax rate. 41

  42. Refocus On The Big Picture (slide 3 of 3) Partnership interest. The tax treatment associated with his partnership interest depends on whether he is reporting His share of profits or losses Ordinary income or ordinary loss, or He is reporting recognized gain or loss from the sale of his partnership interest Capital gain or capital loss. You conclude your tax advice to Maurice by telling him that whatever he does regarding his investments should make economic sense. There are no 100% tax rates. For example, disposing of the bank stock in the current market could be the wise thing to do. 42

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

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