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Chapter 8

Chapter 8. Capital Gains and Losses. Objective. Know the definition of the term “capital asset”. A capital asset is any asset other than inventory, receivables, and depreciable or real property used in a trade or business. Capital Gains and Losses. Capital Gains and Losses.

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Chapter 8

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  1. Chapter 8 Capital Gains and Losses

  2. Objective Know the definition of the term “capital asset”

  3. A capital asset is any asset other than inventory, receivables, and depreciable or real property used in a trade or business. Capital Gains and Losses

  4. Capital Gains and Losses • A sale or other disposition of capital assets results in a capital gain or loss • Capital gains and losses receive special tax treatment • A collectible gain or loss results from the sale or exchange of works of art, gems, metals, antiques, rugs, stamps, wine, etc. held more than 12 months.

  5. Objective Know the holding periods and tax rates applied to sales of capital assets

  6. Capital Gains and LossesHolding Period • The holding period for capital assets is how long the taxpayer owned the asset. • Long-term means the asset was held for > 12 months. • Short-term means the asset was held for < 12 months. • Determining holding period is the first step in determining tax treatment.

  7. Property Disposition Amount realized from disposition less: Adjusted basis of property Realized gain (loss) less: Allowed deferral Recognized gain (loss)

  8. Amount Realized • Amount realized = gross sales price less selling expenses • Gross sales price is the amount received by the seller from the buyer and includes • Cash and FMV of property or services received • Seller’s liability assumed by or paid by the buyer • Gross sales price is decreased by amounts given to the buyer by the seller • Buyer’s expenses paid by or assumed by the seller

  9. Adjusted Basis Original cost plus: Capital improvements less: Accumulated depreciation Adjusted basis

  10. Juliana sold stock in Arco she had purchased in 1997. The stock had cost her $10,000 and she sold it for $19,000 with a commission of $1,300. What is amount realized and gain realized? Answer Amount realized = $19,000 - $1,300 = $17,700 Gain realized = $17,700 - $10,000 = $7,700 LT Examples of Calculating Gain/Loss

  11. Capital Gains and Losses:Netting Procedures Long-term gains netted against Long-term losses Net Long-term Gain or Loss = Short-term gains netted against Short-term losses Net Short-term Gain or Loss =

  12. Capital Gains and LossesNetting Procedures • The following are treated as long-term gains and losses for the netting procedure • Collectible gains and losses • Gains on qualified small business stock • Unrecaptured Section 1250 gain (applies to sales of real estate)

  13. Capital Gains and Losses:Netting Procedures If net short-term & long-term are opposite signs: Net Short-term Gain or Loss netted against Net Long-term Gain or Loss Net Capital Gain or Loss = If short-term & long-term net results are same sign: Do not net. You will have a net STC and LTC gain or loss

  14. Tax Treatment for Net Long-term Gain: Individual Taxpayers • Net long-term gain (minus net collectibles gain, gain on qualified small business stock, and unrecaptured Section 1250 gain) is taxed at a maximum rate of 20% (10% for taxpayers in <20% bracket) • Collectibles held more than 12 months are taxed at a maximum rate of 28%. • 50% of the gain on qualified small business stock is excluded, the remainder taxed at a maximum rate of 28%. • Unrecaptured Section 1250 gain is taxed at a maximum rate of 25%.

  15. Tax Treatment for Net Long-term Gain: Individual Taxpayers • Special rate for assets held > 5 years • 20% become 18% (in 2006) • 10% becomes 8% (currently)

  16. Tax Treatment for Net Short-term Gain: Individual Taxpayers • Net short-term capital gain is taxed as ordinary income (i.e., taxpayer’s marginal tax rate).

  17. Gain Treatment for Corporations • Corporations do not receive special treatment for capital gains.

  18. Tax Treatment for Net Loss • Individuals may use only $3,000 to offset other income • Excess loss is carried forward indefinitely • Corporations cannot deduct a net capital loss • Excess loss carried back 3 then forward 5 years to offset capital gains

  19. Juan has the following capital gains and losses in the current year: Short-term capital loss $ (2,000) Long-term capital gain 12,000 Long-term capital loss carryover (7,000) Example

  20. Short-term: Short-term capital loss $ (2,000) Long-term: Long-term capital gain $12,000 Long-term capital loss carryover ( 7,000) Long-term capital gain $ 5,000 Net long-term capital gain $ 3,000 Tax on adjusted net capital gain: $3,000 x 20% = $ 600 Example

  21. Qualified Small Business Stock • Qualified stock is stock that • Has been held for more than 5 years • Was purchased directly from a small corporation • Corporation with gross assets < $50 million • Was purchased after 8/10/93 • Up to 50% of gain from sale may be excluded • Limited to the greater of • 10 times basis in the stock, or • $10 million for each small business • Exclusion is based on a 28% rate • Not eligible for new special CG rates

  22. Character of Gain or Loss Amount realized from disposition less: Adjusted basis of property Realized gain (loss) less: Allowed deferral Recognized gain (loss) Character of gain (loss) §1231 (Form 4797) Personal Use Capital (Schedule D) Ordinary

  23. Section 1231 Assets • Asset must be held > 12 months and used in a trade or business • not held for investment • Net all §1231 gains against losses

  24. Net Section 1231 gains may be allowed capital gain treatment even though they arise from “ordinary” assets. Section 1231

  25. Section 1231 Netting Results • Net Section 1231 gain is classified as long-term capital gain • Net Section 1231 loss is classified as ordinary loss

  26. Objective Understand what depreciation recapture is and how it is calculated

  27. Prevents taxpayers from receiving the dual benefits of a depreciation deduction and special §1231 capital gain treatment Depreciation Recapture

  28. Depreciation Recapture • Applies to Section 1231 gain property only • Requires gains to be treated as ordinary to the extent of prior depreciation deductions

  29. Depreciation Recapture • Section 1245 • Applies to • Depreciable personal property and • Nonresidential real estate placed in service between 1981 and 1986 and depreciated under ACRS • Requires full recapture of all depreciation • Gains are treated as ordinary income to the extent of any depreciation taken • Any gain in excess of depreciation is netted with Section 1231

  30. Depreciation Recapture • Section 1250 • Applies to depreciable real property • Not covered by Section 1245 and • Not depreciated using the straight-line method • Requires partial recapture of depreciation • Gains are treated as ordinary income to the extent of depreciation taken over straight-line amount • Any gain in excess of depreciation in netted with Section 1231

  31. Unrecaptured Section 1250 Gain • Requires that the portion of the gain attributable to depreciation that is not §1250 recapture is taxed at a rate of 25%. • Applies to depreciable real property sold after 5/7/97. • Any gain not attributable to depreciation (in excess of original cost) is a §1231 gain.

  32. Ella purchases an apartment complex for $7,000,000 on 1/1/85. The property is depreciated on an accelerated basis and her accumulated depreciation is $4,000,000 . She sells the property on 1/1/02 for $8,500,000. What is the realized gain and how is it split between §1231 gain (taxed as capital) and §1250 recap (taxed as ordinary income)? [straight line depreciation would have totaled $2,692,000.] Answer Realized gain = $8,500,000 - ($7,000,000 - $4,000,000) = $5,500,000. Excess depreciation taken = $4,000,000 - $2,692,000 = $1,308,000. §1250 recaptures the $1,308,000 as ordinary income. The remainder of the gain, $4,192,000, is taxed as §1231 gain. §1250 Recapture Example

  33. Objective Know how casualty losses are treated for both personal and business purposes

  34. Casualty Gains & Losses: Personal • Loss is the lesser of • The property’s adjusted basis, or • The decline in the value of the property (repair cost) • Loss is reduced by • Insurance proceeds received, • $100 per event, and • 10% of AGI per year • Any insurance reimbursement reduces loss and may cause gain • Gains are separated into ST and LT and included with appropriate CG or CL

  35. Casualty Gains & Losses: Business • Business casualty and theft losses result from damage caused by a sudden, unexpected and/or unusual event • For property fully destroyed, deduct the adjusted basis • For property partially destroyed, deduct the lesser of the property’s adjusted basis, or the decline in the property’s value • Any insurance reimbursement reduces loss and may cause gain

  36. Casualty Gains & Losses: Business • Treatment of gains and losses depends on holding period • For property held < one year, • Net gains and losses are treated as ordinary income/loss • For property held > one year, • Gains are §1231 • Losses must have components analyzed separately

  37. Casualty Gains and Losses: Example Sherry incurred the following casualty gains/losses and insurance reimbursements in one year (all personal assets). The fence was destroyed by a hurricane & the boat and trailer by a windstorm: Hurricane results in a casualty gain = $8,000 - $15,000 = $7,000. Windstorm results in a casualty loss = ($44,000 - $10,000) + ($8,000 - $0) = $42,000 - $100 - $41,900. The total net casualty loss of $34,900 is further reduced by 10% of AGI.

  38. Objective Be able to calculate income from installment sales

  39. Installment Sales - Form 6252 • Installment sale treatment is utilized when real or personal property or business/rental property is sold and payment is collected over time • Allows taxable gain to be reported as cash is received, not when transaction completed • Must recapture any §1245 or §1250 income first, then calculate gross profit percentage and multiply that by cash received in that year.

  40. Taxable Gain = Realized Gain Contract price where, Realized Gain = Sales Price less: Selling Expense less: §1245 or §1250 Recapture less: Adjusted Basis and, Contract Price = Sales Price – Assumed Liabilities Installment Sales Computations x Cash

  41. Installment Sales Example Baker sold his prize bulls to Larry for $10,000 down and $25,000/year for 4 years (plus interest). Baker had purchased the bulls for $95,000 and had depreciated them $15,000. Realized gain: $110,000 - $0 - $15,000 (§1245 recap) - $80,000 = $15,000 Gross profit percentage: $15,000/$110,000 = 13.64% Taxable gain in year of sale: Capital gain: $10,000 x .1364 = $1,364 Ordinary income (§1245 recap) = $15,000 Taxable gain in subsequent years: $25,000 x .1364 = $3,410 Interest Income would bereported on each year’s Schedule B

  42. Objective Have a basic understanding of several provisions allowing deferral or non-recognition of gain or loss on disposition of an asset

  43. §1031 Like-Kind Exchanges • No gain/loss is recognized when an exchange of like-kind property occurs, • Like-kind property is real property for real property or personal property for personal property of the same asset class • Rules only apply to business or investment property • May have some recognized gain if “boot” is received • Boot is cash or any property (inventory, stocks, bonds, or other securities) that is not like-kind

  44. Like Kind Exchanges (models) • Realized Gain = FMV of property received – adjusted basis of property given up • Recognized Gain = Lesser of (1) gain realized, or (2) boot received • Basis of new property = Adjusted basis of property given up + boot paid – boot received + gain recognized

  45. Barry exchanges his apartments for Adolph’s land. The apartments have a FMV $250,000 and an adjusted basis of $175,000. The land has a FMV of $305,000. Barry also gives $25,000 cash. What is Barry’s realized gain, recognized gain, and new basis in the land? Realized gain: $305,000 – ($175,000 + $25,000) = $105,000 Recognized gain: $0 since no boot was received Basis for land: ($175,000 + $25,000) +$0 – $0 + $0 = $200,000 Like Kind Exchange Example

  46. Involuntary Conversions • When a taxpayer involuntarily disposes of property due to an act of God, theft, condemnation, etc., gain does not need to be recognized if: • Insurance proceeds are reinvested in similar property within 2 years after close of tax year in which conversion occurred • Must recognize gain if insurance proceeds exceed adjusted basis of property • Losses are not deferred

  47. Sale of Personal Residence Post-5/6/97 • No gain need be recognized on sale of home, as long as taxpayer has used it as a personal residence for two of the last five years • Gain exclusion is up to $500,000 (MFJ) or $250,000 (S) • May prorate gain exclusion if residence rule isn’t met due to employment or health

  48. Done!

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