Module 36: Transactions in Property

Overview

This module presents the income tax consequences of property transactions including the sale, exchange, or other disposition of property. Basis is covered first with a review of the basis of property acquired by purchase, gift, and from a decedent. Tax-deferred transactions are covered next with a review of like-kind exchanges, involuntary conversions, and the sale of a principal residence. Next, sales and exchanges of securities are reviewed as well as the treatment of losses and expenses incurred in transactions with related taxpayers. Finally, capital gains and losses, as well as gains and losses from business property including Sec. 1231 and depreciation recapture are reviewed. Not only is it important to determine the extent of gain or loss recognition, but it is also important to be able to determine whether the character of the recognized gain or loss is capital, Sec. 1231, or ordinary.

A. Sales and Other Dispositions

B. Capital Gains and Losses

C. Personal Casualty and Theft Gains and Losses

D. Gains and Losses on Business Property

Key Terms

Multiple-Choice Questions

Multiple-Choice Answers and Explanations

Simulations

Simulation Solutions

A. Sales and Other Dispositions

A sale or other disposition is a transaction that generally gives rise to the recognition of gain or loss. Gains or losses may be categorized as ordinary or capital. If an exchange is nontaxable, the recognition of gain or loss is generally deferred until a later sale of the newly acquired property. This is accomplished by giving the property received the basis of the old property exchanged.
1. The basis of property to determine gain or loss is generally its cost or purchase price.
a. The cost of property is the amount paid for it in cash or the FMV of other property, plus expenses connected with the purchase such as abstract of title fees, installation of utility services, legal fees (including title search, contract, and deed fees), recording fees, surveys, transfer taxes, owner’s title insurance, and any amounts the seller owes that the buyer agrees to pay (e.g., back taxes and interest, recording or mortgage fees, charges for improvements or repairs, sales commissions).
b. If property is acquired subject to a debt, or the purchaser assumes a debt, this debt is also included in cost.
EXAMPLE
Susan purchased a parcel of land by paying cash of $30,000 and assuming a mortgage of $60,000. She also paid $400 for a title insurance policy on the land. Susan’s basis for the land is $90,400.
c. If acquired by gift, the basis for gain is the basis of the donor (transferred basis) increased by any gift tax paid attributable to the net appreciation in the value of the gift.
(1) Basis for loss is lesser of gain basis (above), or FMV on date of gift.
(2) Because of this rule, no gain or loss is recognized when use of the basis for computing loss results in a gain, and use of the basis for computing gain results in a loss.
EXAMPLE
Jill received a boat from her father as a gift. Father’s adjusted basis was $10,000 and FMV was $8,000 at date of gift. Jill’s basis for gain is $10,000, while her basis for loss is $8,000. If Jill later sells the boat for $9,200, no gain or loss will be recognized.
(3) The increase in basis for gift tax paid is limited to the amount (not to exceed the gift tax paid) that bears the same ratio to the amount of gift tax paid as the net appreciation in value of the gift bears to the amount of the gift.
(a) The amount of gift is reduced by any portion o the $14,000 annual exclusion ($13,000 for 2012) allowable with respect to the gift.
(b) Where more than one gift of a present interest is made to the same donee during a calendar year, the $14,000 exclusion is applied to gifts in chronological order.
EXAMPLE
Tom received a gift of property with an FMV of $104,000 and an adjusted basis of $74,000. The donor paid a gift tax of $18,000 on the transfer. Tom’s basis for the property would be $80,000 determined as follows:
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d. If acquired from decedent, basis is property’s FMV on date of decedent’s death, or alternate valuation date (generally six months after death).
(1) Use FMV on date of disposition if alternate valuation is elected and property is distributed, sold, or otherwise disposed of during six-month period following death.
EXAMPLE
Ann received 100 shares of stock as an inheritance from her uncle Henry, who died January 20, 2013. The stock had an FMV of $40,000 on January 20, and an FMV of $30,000 on July 20, 2013. The stock’s FMV was $34,000 on June 15, 2013, the date the stock was distributed to Ann.
If the alternate valuation is not elected, or no estate tax return is filed, Ann’s basis for the stock is its FMV of $40,000 on the date of Henry’s death. If the alternate valuation is elected, Ann’s basis will be the stock’s $34,000 FMV on June 15 (the date of distribution) since the stock was distributed to Ann within six months after the decedent’s death.
(2) FMV rule not applicable to appreciated property acquired by the decedent by gift within one year before death if such property then passes from the donee-decedent to the original donor or donor’s spouse. The basis of such property to the original donor (or spouse) will be the adjusted basis of the property to the decedent immediately before death.
(3) The portion of jointly held property that is included in a decedent’s estate is considered to be acquired from the decedent (i.e., its basis is FMV on date of death, or the alternate valuation). The basis for the portion of jointly held property not included in a decedent’s estate is its cost or other basis.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 1 THROUGH 13
e. The basis of stock received as a dividend depends upon whether it was included in income when received.
(1) If included in income, basis is its FMV at date of distribution.
(2) If nontaxable when received, the basis of shareholder’s original stock is allocated between the dividend stock and the original stock in proportion to their relative FMVs. The holding period of the dividend stock includes the holding period of the original stock.
EXAMPLE
T owns 100 shares of XYZ Corp. common stock that was acquired in 2009 for $12,000. In 2013, T received a nontaxable distribution of 10 XYZ Corp. preferred shares. At date of distribution the FMV of the 100 common shares was $15,000, and the FMV of the 10 preferred shares was $5,000. The portion of the $12,000 basis allocated to the preferred and common shares would be
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f. The basis of stock rights depends upon whether they were included in income when received.
(1) If rights were nontaxable and allowed to expire, they are deemed to have no basis and no loss can be deducted.
(2) If rights were nontaxable and exercised or sold
(a) Basis is zero if FMV of rights is less than 15% of FMV of stock, unless taxpayer elects to allocate basis
(b) If FMV of rights at date of receipt is at least 15% of FMV of stock, or if taxpayer elects, basis is
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(3) If rights were taxable and included in income, basis is their FMV at date of distribution.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 14 THROUGH 16
g. Detailed rules for basis are included in following discussions of exchanges and involuntary conversions.
2. In a sale, the gain or loss is generally the difference between
a. The cash or fair market value received, and the adjusted basis of the property sold
b. If the property sold is mortgaged (or encumbered by any other debt) and the buyer assumes or takes the property subject to the debt
(1) Include the amount of the debt in the amount realized because the seller is relieved of the obligation
EXAMPLE
Property with a $10,000 mortgage, and a basis of $15,000, is sold for $10,000 cash and buyer assumes the mortgage. The amount realized is $20,000, and the gain is $5,000.
(2) If the amount of the mortgage exceeds basis, use the same rules.
EXAMPLE
Property with a $15,000 mortgage, and a basis of $10,000, is given away subject to the mortgage. The amount realized is $15,000, and the gain is $5,000.
c. Casual sellers of property (as opposed to dealers) reduce selling price by any selling expenses.
3. In a taxable exchange, the gain or loss is the difference between the adjusted basis of the property exchanged and the FMV of the property received. The basis of property received in a taxable exchange is its FMV.
4. Nontaxable exchanges generally are not taxed in the current period. Questions concerning nontaxable exchanges often require a determination of the basis of property received, and the effect of boot on the recognition of gain.
a. Like-kind exchange—an exchange of business or investment property for property of a like-kind
(1) Does not apply to property held for personal use, inventory, stocks, bonds, notes, intangible evidences of ownership, and interests in a partnership
(2) Property held for business use may be exchanged for investment property or vice versa.
(3) Like-kind means “same class of property.”
(a) Real property must be exchanged for real property; personal property must be exchanged for personal property within the same General Asset Class or within the same Product Class. For example
[1] Land held for investment exchanged for apartment building
[2] Real estate exchanged for a lease on real estate to run thirty years or more
[3] Truck exchanged for a truck
(b) Exchange of personal property for real property does not qualify.
(c) Exchange of US real property for foreign real property does not qualify.
(4) To qualify as a like-kind exchange (1) the property to be received must be identified within 45 days after the date on which the old property is relinquished, and (2) the exchange must be completed within 180 days after the date on which the old property is relinquished, but not later than the due date of the tax return (including extensions) for the year that the old property is relinquished.
(5) The basis of like-kind property received is the basis of like-kind property given.
(a) + Gain recognized
(b) + Basis of boot given (money or property not of a like-kind)
(c) − Loss recognized
(d) − FMV of boot received
(6) If unlike property (i.e., boot) is received, its basis will be its FMV on the date of the exchange.
(7) If property is exchanged solely for other like-kind property, no gain or loss is recognized. The basis of the property received is the same as the basis of the property transferred.
(8) If boot (money or property not of a like-kind) is given, no gain or loss is generally recognized. However, gain or loss is recognized if the boot given consists of property with an FMV different from its basis.
EXAMPLE
Land held for investment plus shares of stock are exchanged for investment real estate with an FMV of $13,000. The land transferred had an adjusted basis of $10,000 and FMV of $11,000; the stock had an adjusted basis of $5,000 and FMV of $2,000. A $3,000 loss is recognized on the transfer of stock. The basis of the acquired real estate is $12,000 ($10,000 + $5,000 basis of boot given − $3,000 loss recognized).
(9) If boot is received
(a) Any realized gain is recognized to the extent of the lesser of (1) the realized gain, or (2) the FMV of the boot received
(b) No loss is recognized due to the receipt of boot
EXAMPLE
Land held for investment with a basis of $10,000 was exchanged for other investment real estate with an FMV of $9,000, an automobile with an FMV of $2,000, and $1,500 in cash. The realized gain is $2,500. Even though $3,500 of “boot” was received, the recognized gain is only $2,500 (limited to the realized gain). The basis of the automobile (unlike property) is its FMV $2,000; while the basis of the real estate acquired is $9,000 ($10,000 + $2,500 gain recognized − $3,500 boot received).
(10) Liabilities assumed (or liabilities to which property exchanged is subject) on either or both sides of the exchange are treated as boot.
(a) Boot received—if the liability was assumed by the other party
(b) Boot given—if the taxpayer assumed a liability on the property acquired
(c) If liabilities are assumed on both sides of the exchange, they are offset to determine the net amount of boot given or received.
EXAMPLE
A owns investment land with an adjusted basis of $50,000, FMV of $70,000, but which is subject to a mortgage of $15,000. B owns investment land with an adjusted basis of $60,000, FMV of $65,000, but which is subject to a mortgage of $10,000. A and B exchange real estate investments with A assuming B’s $10,000 mortgage, and B assuming A’s $15,000 mortgage. The computation of realized gain, recognized gain, and basis for the acquired real estate for both A and B is as follows:
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(d) Boot given in the form of an assumption of a liability does not offset boot received in the form of cash or unlike property; however, boot given in the form of cash or unlike property does offset boot received in the form of a liability assumed by the other party.
EXAMPLE
Assume the same facts as above except that the mortgage on B’s old real estate was $6,000, and that A paid B cash of $4,000 to make up the difference. The tax effects to A remain unchanged. However, since the $4,000 cash cannot be offset by the liability assumed by B, B must recognize a gain of $4,000, and will have a basis of $69,000 for the new real estate.
(11) If within two years after a like-kind exchange between related persons [as defined in Sec. 267(b)] either person disposes of the property received in the exchange, any gain or loss that was not recognized on the exchange must be recognized (subject to the loss limitation rules for related persons) as of the date that the property was disposed of. This gain recognition rule does not apply if the subsequent disposition was the result of the death of one of the persons, an involuntary conversion, or where neither the exchange nor the disposition had tax avoidance as one of its principal purposes.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 17 THROUGH 22
b. Involuntary conversions
(1) Occur when money or other property is received for property that has been destroyed, damaged, stolen, or condemned (even if property is transferred only under threat or imminence of condemnation).
(2) If payment is received and gain is realized, taxpayer may elect not to recognize gain if converted property is replaced with property of similar or related use.
(a) Gain is recognized only to the extent that the amount realized exceeds the cost of the replacement.
(b) The replacement must be purchased within a period beginning with the earlier of the date of disposition or the date of threat of condemnation, and ending two years after the close of the taxable year in which gain is first realized (three years for condemned business or investment real property, other than inventory or property held primarily for resale).
(c) Basis of replacement property is the cost of the replacement decreased by any gain not recognized.
EXAMPLE
Taxpayer had unimproved real estate (with an adjusted basis of $20,000) which was condemned by the county. The county paid him $24,000 and he reinvested $21,000 in unimproved real estate. $1,000 of the $4,000 realized gain would not be recognized. His tax basis in the new real estate would be $20,000 ($21,000 cost − $1,000 deferred gain).
EXAMPLE
Assume the same facts as above except the taxpayer reinvested $25,000 in unimproved real estate. None of the $4,000 realized gain would be recognized. His basis in the new real estate would be $21,000 ($25,000 cost − $4,000 deferred gain).
(3) If property is converted directly into property similar or related in service or use, complete non recognition of gain is mandatory. The basis of replacement property is the same as the property converted.
(4) The meaning of property similar or related in service or use is more restrictive than “like-kind.”
(a) For an owner-user—property must be functionally the same and have same end use (business vehicle must be replaced by business vehicle that performs same function).
(b) For a lessor—property must perform same services for lessor (lessor could replace a rental manufacturing plant with a rental-wholesale grocery warehouse even though tenant’s functional use differs).
(c) A purchase of at least 80% of the stock of a corporation whose property is similar or related in service or use also qualifies.
(d) More liberal “like-kind” test applies to real property held for business or investment (other than inventory or property held primarily for sale) that is converted by seizure, condemnation, or threat of condemnation (e.g., improved real estate could be replaced with unimproved real estate).
(5) If property is not replaced within the time limit, an amended return is filed to recognize gain in the year realized.
(6) Losses on involuntary conversions are recognized whether the property is replaced or not. However, a loss on condemnation of property held for personal use (e.g., personal residence) is not deductible.
c. Sale or exchange of principal residence
(1) An individual may exclude from income up to $250,000 of gain that is realized on the sale or exchange of a residence, if the individual owned and occupied the residence as a principal residence for an aggregate of at least two of the five years preceding the sale or exchange. The amount of excludable gain is increased to $500,000 for married individuals filing jointly if either spouse meets the ownership requirement, and both spouses meet the use requirement.
(a) The sale of a residence that had been jointly owned and occupied by the surviving and deceased spouse is entitled to the $500,000 gain exclusion provided the sale occurs no later than 2 years after the date of death of the individual’s spouse.
(b) The exclusion does not apply to property acquired in a like-kind exchange of the property occurs during the five-year period beginning with the date of acquisition of the property.
(c) Gain in excess of the $250,000 (or $500,000) exclusion must be included in income even though the sale proceeds are reinvested in another principal residence.
(2) The exclusion is determined on an individual basis.
(a) A single individual who otherwise qualifies for the exclusion is entitled to exclude up to $250,000 of gain even though the individual marries someone who has used the exclusion within two years before the marriage.
(b) In the case of married taxpayers who do not share a principal residence but file joint returns, a $250,000 exclusion is available for a qualifying sale or exchange of each spouse’s principal residence.
(3) Special rules apply to divorced taxpayers.
(a) If a residence is transferred to a taxpayer incident to a divorce, the time during which the taxpayer’s spouse or former spouse owned the residence is added to the taxpayer’s period of ownership.
(b) A taxpayer who owns a residence is deemed to use it as a principal residence while the taxpayer’s spouse or former spouse is given use of the residence under the terms of a divorce or separation.
(4) A taxpayer’s period of ownership of a residence includes the period during which the taxpayer’s deceased spouse owned the residence so long as the taxpayer does not remarry before date of sale.
(5) Tenant-stockholders in a cooperative housing corporation can qualify to exclude gain from the sale of the stock.
(6) If the taxpayer does not meet the two-year ownership or use requirements, a pro rata amount of the $250,000 or $500,000 exclusion applies if the sale or exchange is due to a change in place of employment, health, or unforeseen circumstances. A taxpayer is deemed to satisfy the change in employment condition if the taxpayer moves at least fifty miles from his former place of employment, or if previously unemployed at least fifty miles from his former residence. To satisfy the change of health condition, the taxpayer must be instructed to relocate by a physician for health reasons (e.g., advanced age-related infirmities, severe allergies, emotional problems). Unforeseen circumstances include natural or man-made disasters such as war or acts of terrorism, cessation of employment, death, divorce or legal separation, and multiple births from the same pregnancy.
EXAMPLE
Harold, an unmarried taxpayer, purchased a home in a suburb of Chicago on October, 2011. Eighteen months later his employer transferred him to St. Louis and Harold sold his home for a gain of $200,000. Since Harold sold his home because of a change in place of employment and had owned and used the home as a principal residence for eighteen months, the exclusion of his gain is limited to $250,000 × 18/24 = $187,500.
(7) If a taxpayer was entitled to take depreciation deductions because the residence was used for business purposes or as rental property, the taxpayer cannot exclude gain to the extent of any depreciation allowed or allowable as a deduction after May 6, 1997.
EXAMPLE
Ron sold his principal residence during 2013 for a gain of $20,000. He used one room of the residence for business and deducted $1,000 of depreciation in 2012. Although Ron meets the ownership and use tests to exclude residence sale gain from income, he can exclude only $20,000 − $1,000 = $19,000 from income. The remaining $1,000 of gain is taxable and must be included in gross income.
(8) For sales and exchanges of a principal residence after 2008, the exclusion does not apply to the amount of gain allocated to periods of nonqualified use after December 31, 2008. Nonqualified use is generally any use other than as a principal residence.
(a) Nonqualified use does not include (1) any portion of the 5-year period ending on the date of sale or exchange after the last use of the property as a principal residence; (2) any period of 10 years or less when the taxpayer or spouse is serving on extended duty in the military; and, (3) any period of two years or less for temporary absence due to a change of employment, health, or unforeseen circumstances.
(b) To determine the amount of gain allocated to nonqualified use, multiply the gain by the following fraction:
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(c) Any gain recognized because of post-May 6, 1997 depreciation [see (7) above] is not taken into account in determining the amount of gain allocated to nonqualified use.
EXAMPLE
On January 2, 2009, Diane buys a residence for $400,000 and uses it as rental property for two years, claiming $30,000 of depreciation deductions. On January 2, 2011, Diane converts the property to her principal residence. She moves out on January 11, 2013, and sells the property for $700,000 on January 2, 2014, resulting in a gain of $700,000 − $370,000 = $330,000.
The $30,000 of gain that is attributable to depreciation deductions must be included in income. Of the remaining $300,000 of gain, 2 years/5 years × $300,000 = $120,000 of gain is allocated to nonqualified use and is not eligible for exclusion. Since the remaining gain of $300,000 − $120,000 = $180,000 does not exceed the maximum exclusion ($250,000), Diane can exclude a total of $180,000 of gain from gross income. As a result, Diane must include $330,000 − $180,000 = $150,000 in gross income. Finally, note that the period from January 11, 2013, to January 2, 2014, is after she last used the home as her principal residence so it is not a period of nonqualified use.
(9) Gain from the sale of a principal residence generally cannot be excluded from gross income if, during the two-year period ending on the date of the sale, the taxpayer sold another residence at a gain and excluded all or part of that gain from income. However, part of the gain may be excluded if the sale is due to a change in employment, health, or unforeseen circumstances. If the taxpayer cannot exclude the gain, it must be included in gross income.
EXAMPLE
In September 2011, Anna purchased a new principal residence. In November 2011, Anna sold her old residence for a gain of $50,000. Since she met the ownership and use tests, Anna excluded the $50,000 gain from gross income for 2011. On October 1, 2013, Anna sold the residence she had purchased in September 2011 for a gain of $30,000. The sale was not due to a change in place of employment, health, or unforeseen circumstances. Because Anna had excluded gain from the sale of another residence within the two-year period ending on October 1, 2013, she cannot exclude the gain on this sale.
(10) A loss from the sale of personal residence is not deductible.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 23 THROUGH 26
d. Exchange of insurance policies. No gain or loss is recognized on an exchange of certain life, endowment, and annuity contracts to allow taxpayers to obtain better insurance.
5. Sales and exchanges of securities
a. Stocks and bonds are not included under like-kind exchanges
b. Exchange of stock of same corporation
(1) Common for common, or preferred for preferred is nontaxable
(2) Common for preferred, or preferred for common is taxable, unless exchange qualifies as a recapitalization
c. Exercise of conversion privilege in convertible stock or bond is generally nontaxable.
d. The first-in, first-out (FIFO) method is used to determine the basis of securities sold unless the taxpayer can specifically identify the securities sold and uses specific identification.
e. Capital gains exclusion for small business stock
(1) A noncorporate taxpayer can exclude 50% of capital gains resulting from the sale of qualified small business stock (QSBS) held for more than five years. The exclusion is increased to 75% if the QSBS was acquired after February 17, 2009, and before September 28, 2010, and 100% for QSBS acquired after September 27, 2010, and before January 1, 2014.
(2) To qualify, the stock must be acquired directly (or indirectly through a pass-through entity) at its original issuance.
(3) A qualified small business is a C corporation with $50 million or less of capitalization. Generally, personal service, banking, leasing, investing, real estate, farming, mineral extraction, and hospitality businesses do not qualify as eligible small businesses.
(4) Gains eligible for exclusion are limited to the greater of $10 million, or 10 times the investor’s stock basis.
(a) 7% of the excluded gain is generally treated as a tax preference for AMT purposes. However, there is no tax preference for gains qualifying for the 100% exclusion.
(b) Only gains net of exclusion are included in determining the investment interest expense and capital loss limitations.
f. Rollover of capital gain from publicly traded securities
(1) An individual or C corporation may elect to roll over an otherwise currently taxable capital gain from the sale of publicly traded securities if the sale proceeds are used to purchase common stock or a partnership interest in a specialized small business investment company (SSBIC) within sixty days of the sale of the securities.
(2) An SSBIC is a partnership or corporation licensed by the Small Business Administration under the Small Business Investment Act of 1958 as in effect on May 13, 1993.
(3) The amount of gain eligible for rollover is limited to $50,000 per year for individuals (lifetime cap of $500,000) and $250,000 per year for corporations (lifetime cap of $1 million).
(4) The taxpayer’s basis in the SSBIC stock or partnership interest must be reduced by the gain that is rolled over.
g. Market discount bonds
(1) Gain on the disposition of a bond (including a tax-exempt bond) that was acquired for a price that was less than the principal amount of the bond is treated as taxable interest income to the extent of the accrued market discount for bonds purchased after April 30, 1993.
(2) Accrued market discount is the difference between the bond’s cost basis and its redemption value at maturity amortized over the remaining life of the bond.
h. Wash sales
(1) Wash sale occurs when stock or securities (or options to acquire stock or securities) are sold at a loss and within thirty days before or after the sale, substantially identical stock or securities (or options to acquire them) in the same corporation are purchased.
(2) Wash sale loss is not deductible, but is added to the basis of the new stock.
(3) Wash sale rules do not apply to gains.
EXAMPLE
C purchased 100 shares of XYZ Corporation stock for $1,000. C later sold the stock for $700, and within thirty days acquired 100 shares of XYZ Corporation stock for $800. The loss of $300 on the sale of stock is not recognized. However, the unrecognized loss of $300 is added to the $800 cost of the new stock to arrive at the basis for the new stock of $1,100. The holding period of the new stock includes the period of time the old stock was held.
(4) Does not apply to dealers in stock and securities where loss is sustained in ordinary course of business.
i. Worthless stock and securities
(1) Treated as a capital loss as if sold on the last day of the taxable year they become worthless.
(2) Treated as an ordinary loss if stock and securities are those of an 80% or more owned corporate subsidiary that derived more than 90% of its gross receipts from active-type sources.
6. Losses on deposits in insolvent financial institutions
a. Loss resulting from a nonbusiness deposit in an insolvent financial institution is generally treated as a nonbusiness bad debt deductible as a short-term capital loss (STCL) in the year in which a final determination of the amount of loss can be made.
b. As an alternative, if a reasonable estimate of the amount of loss can be made, an individual may elect to
(1) Treat the loss as a personal casualty loss subject to the $100 floor and 10% of AGI limitation. Then no bad debt deduction can be claimed.
(2) In lieu of (1) above, treat up to $20,000 as a miscellaneous itemized deduction subject to the 2% of AGI floor if the deposit was not federally insured. Then remainder of loss is treated as a STCL.
EXAMPLE
An individual with no capital gains and an AGI of $70,000, incurred a loss on a federally insured deposit in a financial institution of $30,000. The individual may treat the loss as a $30,000 STCL subject to the $3,000 net capital loss deduction limitation, with the remaining $27,000 carried forward as a STCL; or, may treat the loss as a personal casualty loss and an itemized deduction of [($30,000 − $100) − (10% × $70,000)] = $22,900. If the deposit had not been federally insured, the individual could also have taken a miscellaneous itemized deduction of [$20,000 − (2% × $70,000)] = $18,600, with the remaining $10,000 treated as a STCL (i.e., $3,000 net capital loss deduction and a $7,000 STCL carryover).
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 27 THROUGH 31
7. Losses, expenses, and interest between related taxpayers
a. Loss is disallowed on the sale or exchange of property to a related taxpayer.
(1) Transferee’s basis is cost; holding period begins when transferee acquires property.
(2) On a later resale, any gain recognized by the transferee is reduced by the disallowed loss (unless the transferor’s loss was from a wash sale, in which case no reduction is allowed).
(3) Related taxpayers include
(a) Members of a family, including spouse, brothers, sisters, ancestors, and lineal descendants
(b) A corporation and a more than 50% shareholder
(c) Two corporations which are members of the same controlled group
(d) A person and an exempt organization controlled by that person
(e) Certain related individuals in a trust, including the grantor or beneficiary and the fiduciary
(f) A C corporation and a partnership if the same persons own more than 50% of the corporation, and more than 50% of the capital and profits interest in the partnership
(g) Two S corporations if the same persons own more than 50% of each
(h) An S corporation and a C corporation if the same persons own more than 50% of each
EXAMPLE
During August 2012, Bob sold stock with a basis of $4,000 to his brother Ray for $3,000, its FMV. During June 2013, Ray sold the stock to an unrelated taxpayer for $4,500. Bob’s loss of $1,000 is disallowed; Ray recognizes a STCG of ($4,500 − $3,000) − $1,000 disallowed loss = $500.
(4) Constructive stock ownership rules apply in determining if taxpayers are related. For purposes of determining stock ownership
(a) Stock owned, directly or indirectly, by a corporation, partnership, estate, or trust is considered as being owned proportionately by its shareholders, partners, or beneficiaries.
(b) An individual is considered as owning the stock owned, directly or indirectly, by his brothers and sisters (whole or half blood), spouse, ancestors, and lineal descendants.
(c) An individual owning stock in a corporation [other than by (b) above] is considered as owning the stock owned, directly or indirectly, by his partner.
b. The disallowed loss rule in a. above does not apply to transfers between spouses, or former spouses incident to divorce, as discussed below.
c. Any loss from the sale or exchange of property between corporations that are members of the same controlled group is deferred (instead of disallowed) until the property is sold outside the group. Use controlled group definition found in Module 37, D.2., but substitute “more than 50%” for “at least 80%.”
EXAMPLE
Mr. Gudjob is the sole shareholder of X Corp. and Y Corp. During 2013, X Corp. sold non depreciable property with a basis of $8,000 to Y Corp. for $6,000, its FMV. During 2014, Y Corp. sold the property to an unrelated taxpayer for $6,500. X Corp.’s loss in 2013 is deferred. In 2014, X Corp. recognizes the $2,000 of deferred loss, and Y Corp. recognizes a gain of $500.
d. An accrual-basis payor is effectively placed on the cash method of accounting for purposes of deducting accrued interest and other expenses owed to a related cash-basis payee.
(1) No deduction is allowable until the year the amount is actually paid.
(2) This rule applies to pass-through entities (e.g., a partnership and any partner; two partnerships if the same persons own more than 50% of each; an S corporation and any shareholder) in addition to the related taxpayers described in a.(3) above, but does not apply to guaranteed payments to partners. This rule also applies to a personal service corporation and any employee-owner.
EXAMPLE
A calendar-year S corporation accrued a $500 bonus owed to an employee-shareholder in 2013 but did not pay the bonus until February 2014. The $500 bonus will be deductible by the S corporation in 2014, when the employee-shareholder reports the $500 as income.
8. Transfers in part a sale and in part a gift
a. If a transfer of property is in part a sale and in part a gift, the transferor recognizes gain to the extent that the amount realized exceeds the transferor’s adjusted basis for the property transferred. However, no loss can be recognized by the transferor.
b. The basis of the property to the transferee is generally the greater of (1) the amount paid by the transferee for the property, or (2) the transferor’s basis for the property at the time of the transfer. However, for purposes of determining a loss, the basis of the property in the hands of the transferee shall not be greater than the fair market value of the property at the time of the transfer.
EXAMPLE
Brett transfers property to his sister, Brianna, for $60,000. The property has a basis of $40,000 and an FMV of $90,000 at date of transfer. Brett must recognize a gain of $60,000 − $40,000 = $20,000, and has made a gift to Brianna of $90,000 − $60,000 = $30,000. Brianna’s basis for the property is $60,000.
EXAMPLE
Brian transfers property to his brother, Carl, for $30,000. The transferred property has a basis of $40,000 and an FMV of $90,000 at date of transfer. Brian’s realized loss of $40,000 − $30,000 = $10,000 cannot be recognized, and he has made a gift to Carl of $90,000 − $30,000 = $60,000. Carl’s basis for the property is $40,000.
EXAMPLE
Henry transfers property to his son, Edan, for $30,000. The property has a basis of $90,000 and an FMV of $60,000 at date of transfer. Henry’s realized loss of $90,000 − $30,000 = $60,000 cannot be recognized, and he has made a gift to Edan of $60,000 − $30,000 = 30,000. Edan’s basis for the property is $90,000. However, for purposes of determining a loss on a later sale or other disposition of the propery by Edan, the property’s basis is limited to its FMV at date of transfer of $60,000.
9. Transfer between spouses
a. No gain or loss is generally recognized on the transfer of property from an individual to (or in trust for the benefit of)
(1) A spouse (other than a nonresident alien spouse), or
(2) A former spouse (other than a nonresident alien former spouse), if the transfer is related to the cessation of marriage, or occurs within one year after marriage ceases
b. Transfer is treated as if it were a gift from one spouse to the other.
c. Transferee’s basis in the property received will be the transferor’s basis (even if FMV is less than the property’s basis).
EXAMPLE
H sells property with a basis of $6,000 to his spouse, W, for $8,000. No gain is recognized to H, and W’s basis for the property is $6,000. W’s holding period includes the period that H held the property.
d. If property is transferred to a trust for the benefit of a spouse or former spouse (incident to divorce)
(1) Gain is recognized to the extent that the amount of liabilities assumed exceeds the total adjusted basis of property transferred.
(2) Gain or loss is recognized on the transfer of installment obligations.
10. Gain from the sale or exchange of property will be entirely ordinary gain (no capital gain) if the property is depreciable in hands of transferee and the sale or exchange is between
a. A person and a more than 50% owned corporation or partnership
b. A taxpayer and any trust in which such taxpayer or spouse is a beneficiary, unless such beneficiary’s interest is a remote contingent interest
c. Constructive ownership rules apply; use rules in Section 7.a.(4)(a) and (b) above
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 32 THROUGH 37

B. Capital Gains and Losses

1. Capital gains and losses result from the “sale or exchange of capital assets.” The term capital assets includes investment property and property held for personal use. The term specifically excludes
a. Stock in trade, inventory, or goods held primarily for sale to customers in the normal course of business
b. Depreciable or real property used in a trade or business
c. Copyrights or artistic, literary, etc., compositions created by the taxpayer
(1) They are capital assets only if purchased by the taxpayer.
(2) Patents are generally capital assets in the hands of the inventor.
d. Accounts or notes receivable arising from normal business activities
e. US government publications acquired other than by purchase at regular price
f. Supplies of a type regularly used or consumed by a taxpayer in the ordinary course of the taxpayer’s trade or business
2. Whether short-term or long-term depends upon the holding period
a. Long-term if held more than one year
b. The day property was acquired is excluded and the day it is disposed of is included.
c. Use calendar months (e.g., if held from January 4 to January 4 it is held exactly one year)
d. If stock or securities which are traded on an established securities market (or other property regularly traded on an established market) are sold, any resulting gain or loss is recognized on the date the trade is executed (transaction date) by both cash and accrual taxpayers.
e. The holding period of property received in a nontaxable exchange (e.g., like-kind exchange, involuntary conversion) includes the holding period of the property exchanged, if the property that was exchanged was a capital asset or Sec. 1231 asset.
f. If the basis of property to a prior owner carries over to the present owner (e.g., gift), the holding period of the prior owner “tacks on” to the present owner’s holding period.
g. If using the lower FMV on date of gift to determine loss, then holding period begins when the gift is received.
EXAMPLE
X purchased property on July 14, 2012, for $10,000. X made a gift of the property to Z on June 10, 2013, when its FMV was $8,000. Since Z’s basis for gain is $10,000, Z’s holding period for a disposition at a gain extends back to July 14, 2012. Since Z’s $8,000 basis for loss is determined by reference to FMV at June 10, 2013, Z’s holding period for a disposition at a loss begins on June 11.
h. Property acquired from a decedent is generally given long-term treatment, regardless of how long the property was held by the decedent or beneficiary, and is treated as property held more than twelve months.
3. Computation of capital gains and losses for all taxpayers
a. First net STCG with STCL and net LTCG with LTCL to determine
(1) Net short-term capital gain or loss (NSTCG or NSTCL)
(2) Net long-term capital gain or loss (NLTCG or NLTCL)
b. Then net these two together to determine whether there is a net capital gain or loss (NCG or NCL)
4. The following rules apply to individuals:
a. Capital gains offset capital losses, with any remaining net capital gains included in gross income.
b. Net capital gains are subject to tax at various rates, depending on the type of assets sold or exchanged and length of time the assets were held.
(1) Capital gain from assets held one year or less is taxed at the taxpayer’s regular tax rates (up to 39.6%).
(2) Capital gain from the sale of collectibles held more than twelve months (e.g., antiques, art, metals, gems, rugs, stamps, coins, alcoholic beverages) is taxed at a maximum rate of 28%.
(3) Capital gain attributable to unrecaptured depreciation on Sec. 1250 property held more than twelve months is taxed at a maximum rate of 25%.
(4) Capital gain from assets held more than twelve months (other than from collectibles and unrecaptured depreciation on Sec. 1250 property) is taxed (for tax years beginning after December 31, 2012) at a rate of 0% for individuals in the 10% or 15% tax brackets, 15% for most taxpayers, and 20% for certain higher-income taxpayers.
(5) For installment sales of assets held more than twelve months, the date an installment payment is received (not the date the asset was sold) determines the capital gains rate that should be applied
c. Gains and losses (including carryovers) within each of the rate groups are netted to arrive at a net gain or loss. A net loss in any rate group is applied to reduce the net gain in the highest rate group first (e.g., a net short-term capital loss is applied to reduce any net gain from the 28% group, then the 25% group, then the 20% group, and finally to reduce gain from the 15% group).
EXAMPLE
Kim, who is in the 35% tax bracket, had the following capital gains and losses for calendar-year 2013:
Net short-term capital loss $(1,500)
28% group—collectibles net gain 900
25% group—unrecaptured Sec. 1250 net gain 2,000
15% group—net gain 5,000
Net capital gain $ 6,400
In this case, the NSTCL of $1,500 first offsets the $900 of collectibles gain, and then offsets $600 of the unrecaptured Sec. 1250 gain. As a result of this netting procedure, Kim has $1,400 of unrecaptured Sec. 1250 gain that will be taxed at a rate of 25%, and $5,000 of capital gain that will be taxed at a rate of 15%.
d. If there is a net capital loss the following rules apply:
(1) A net capital loss is a deduction in arriving at AGI, but limited to the lesser of
(a) $3,000 ($1,500 if married filing separately), or
(b) The excess of capital losses over capital gains
(2) Both a NSTCL and a NLTCL are used dollar-for-dollar in computing the capital loss deduction.
EXAMPLE
An individual had $2,000 of NLTCL and $500 of NSTCL for 2012. The capital losses are combined and the entire net capital loss of $2,500 is deductible in computing the individual’s AGI.
(3) Short-term losses are used before long-term losses. The amount of net capital loss that exceeds the allowable deduction may be carried over for an unlimited period of time. Capital loss carryovers retain their identity; short-term losses carry over as short-term losses, and long-term losses carry over as long-term losses in the 28% group. Losses remaining unused on a decedent’s final return are extinguished and provide no tax benefit.
EXAMPLE
An individual has a $4,000 STCL and a $5,000 LTCL for 2012. The $9,000 net capital loss results in a capital loss deduction of $3,000 for 2012, while the remainder is a carryover to 2013. Since $3,000 of the STCL would be used to create the capital loss deduction, there is a $1,000 STCL carryover and a $5,000 LTCL carryover to 2013. The $5,000 LTCL carryover would first offset gains in the 28% group.
(4) For purposes of determining the amount of excess net capital loss that can be carried over to future years, the taxpayer’s net capital loss for the year is reduced by the lesser of (1) $3,000 ($1,500 if married filing separately), or (2) adjusted taxable income.
(a) Adjusted taxable income is taxable income increased by $3,000 ($1,500 if married filing separately) and the amount allowed for personal exemptions.
(b) An excess of deductions allowed over gross income is taken into account as negative taxable income.
EXAMPLE
For 2012, a single individual with no dependents had a net capital loss of $8,000, and had allowable deductions that exceeded gross income by $4,000. For 2012, the individual is entitled to a net capital loss deduction of $3,000, and will carry over a net capital loss of $5,200 to 2013. This amount represents the 2012 net capital loss of $8,000 reduced by the lesser of (1) $3,000, or (2) − $4,000 + $3,000 + $3,800 personal exemption = $2,800.
5. Corporations have special capital gain and loss rules.
a. Capital losses are only allowed to offset capital gains, not ordinary income.
b. A net capital loss is carried back three years, and forward five years to offset capital gains in those years. All capital loss carrybacks and carryovers are treated as short-term capital losses.
EXAMPLE
A corporation has a NLTCL of $8,000 and a NSTCG of $2,000, resulting in a net capital loss of $6,000 fo 2013. The $6,000 NLTCL is not deducble fo 2013, but is first carried back as a STCL to 2010 to offset capital gains. If not used up in 2010, the STCL is carried to 2011 and 2012, and then forward to 2014, 2015, 2016, 2017, an 2018 to offset capital gains in those years.
c. Although an alternative tax computation still exists for a corporation with a net capital gain, the alternative tax computation applies the highest corporate rate (35%) to a net capital gain and thus provides no benefit.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 38 THROUGH 53

C. Personal Casualty and Theft Gains and Losses

Gains and losses from casualties and thefts of property held for personal use are separately netted, without regard to the holding period of the converted property.
1. If gains exceed losses (after the $100 floor for each loss), then all gains and losses are treated as capital gains and losses, short-term or long-term depending upon holding period.
EXAMPLE
An individual incurred a $25,000 personal casualty gain, and a $15,000 personal casualty loss (after the $100 floor) during the current taxable year. Since there was a net gain, the individual will report the gain and loss as a $25,000 capital gain and a $15,000 capital loss.
2. If losses (after the $100 floor for each loss) exceed gains, the losses (1) offset gains, and (2) are an ordinary deduction from AGI to the extent in excess of 10% of AGI.
EXAMPLE
An individual had AGI of $40,000 (before casualty gains or losses), and also had a personal casualty loss of $25,000 (after the $100 floor) and a personal casualty gain of $15,000. Since there was a net personal casualty loss, the net loss will be deductible as an itemized deduction of [$25,000 − $15,000 − (10% × $40,000)] = $6,000.

D. Gains and Losses on Business Property

Although property used in a business is excluded from the definition of “capital assets,” Sec. 1231 extends capital gain and loss treatment to business assets if the gains from these assets exceed losses. However, before Sec. 1231 becomes operative, Sections 1245, 1250, and 291 provide for recapture of depreciation (i.e., gain is taxed as ordinary income to the extent of certain depreciation previously deducted).
1. All gains and losses are ordinary on business property held one year or less.
2. Section 1231
a. All property included must have been held for more than one year.
(1) Section 1231 gains and losses include those from
(a) Sale or exchange of property used in trade or business (or held for production of rents or royalties) and which is not
[1] Inventory
[2] A copyright or artistic composition
(b) Casualty, theft, or condemnation of
[1] Property used in trade or business
[2] Capital assets held in connection with a trade or business, or a transaction entered into for profit
(c) Infrequently encountered items such as cut timber, coal and domestic iron ore, livestock, and unharvested crop
b. The combining of Sec. 1231 gains and losses is accomplished in two steps. First, net all casualty and theft gains and losses on property held for more than one year.
(1) If the losses exceed gains, treat them all as ordinary losses and gains and do not net them with other Sec. 1231 gains and losses.
(2) If the gains exceed losses, the net gain is combined with other Sec. 1231 gains and losses.
c. Second, net all other Sec. 1231 gains and losses (except casualty and theft net loss per above).
(1) Include casualty and theft net gain
(2) Include gains and losses from condemnations (other than condemnations on nonbusiness, non-income-producing property)
(3) Include gains and losses from the sale or exchange of property used in trade or business
d. If losses exceed gains, treat all gains and losses as ordinary.
e. If gains exceed losses, treat the Sec. 1231 net gain as a long-term capital gain.
EXAMPLE
Taxpayer has a gain of $10,000 from the sale of land used in his business, a loss of $4,000 on the sale of depreciable property used in his business, and a $2,000 (noninsured) loss when a car used in his business was involved in a collision.
The net gain or loss from casualty or theft is the $2,000 loss. The net casualty loss of $2,000 is treated as an ordinary loss and not netted with other Sec. 1231 gains and losses.
The $10,000 gain is netted with the $4,000 loss resulting in a net Sec. 1231 gain of $6,000, which is then treated as a long-term capital gain.
f. Net Sec. 1231 gain will be treated as ordinary income (instead of LTCG) to the extent of nonrecaptured net Sec. 1231 losses for the five most recent taxable years.
(1) Losses are deemed recaptured in the chronological order in which they arose
(2) Any Sec. 1231 gain recharacterized as ordinary income consists first of gain in the 28% group, then gain in the 25% group, and finally gain in the 20% or 15% group
EXAMPLE
Corp. X, on a calendar year, has a net Sec. 1231 gain of $10,000 for 2013. For the years 2008 through 2012, Corp. X had net Sec. 1231 losses totaling $8,000. Of the $10,000 net Sec. 1231 gain for 2013, the first $8,000 will be treated as ordinary income, with only the remaining $2,000 treated as long-term capital gain.
3. Section 1245 Recapture
a. Requires the recapture as ordinary income of all gain attributable to
(1) Post-1961 depreciation on the disposition of Sec. 1245 property
(2) Post-1980 recovery deductions on the disposition of Sec. 1245 recovery property (including amount expensed under Sec. 179 expense election)
b. Sec. 1245 property generally includes depreciable tangible and intangible personal property, for example
(1) Desks, machines, equipment, cars, and trucks
(2) Special-purpose structures, storage facilities, and other property (but not buildings and structural components); for example, oil and gas storage tanks, grain storage bins and silos, and escalators and elevators
c. Sec. 1245 recovery property means all ACRS recovery property placed in service after 1980 and before 1987 other than nineteen-year real property that is classified as real residential rental property, real property used outside the US, subsidized low-income housing, and real property for which a straight-line election was made.
NOTE: If the cost of nineteen-year nonresidential real property placed in service before 1987 was recovered using the prescribed percentages of ACRS, the gain on disposition is ordinary income to extent of all ACRS deductions. Such recapture is not limited to the excess of accelerated depreciation over straight-line. However, if the straight-line method was elected for nineteen-year real property, there is no recapture and all gain is Sec. 1231 gain.
d. Sec. 1245 does not apply to real residential rental property and nonresidential real property placed in service after 1986 because only straight-line depreciation is allowable.
e. Upon the disposition of property subject to Sec. 1245, any recognized gain will be ordinary income to the extent of all depreciation or post-1980 cost recovery deductions.
(1) Any remaining gain after recapture will be Sec. 1231 gain if property held more than one year.
EXAMPLE
Megan sold equipment used in her business for $11,000. The equipment had cost $10,000 and $6,000 of depreciation had been taken, resulting in an adjusted basis of $4,000. Megan’s recognized gain is $11,000 − $4,000 = $7,000. Since the equipment was Sec. 1245 property, the gain must be recognized as Sec. 1245 ordinary income to the extent of the $6,000 of depreciation deducted. The remaining $1,000 gain ($7,000 gain − $6,000 ordinary income) is recognized as Sec. 1231 gain.
EXAMPLE
Assume the same facts as in the preceding example, except the equipment was sold for $9,000. Megan’s recognized gain would be $9,000 − $4,000 = $5,000. Now, since the $6,000 of depreciation deducted exceeds the recognized gain of $5,000, the amount of Sec. 1245 ordinary income would be limited to the recognized gain of $5,000. There would be no Sec. 1231 gain.
EXAMPLE
Assume the same facts as in the first example, except the equipment was sold for only $3,500. Megan’s sale of the equipment now results in a recognized loss of $3,500 − $4,000 = ($500). Since there is a loss, there would be no Sec. 1245 depreciation recapture and the $500 loss would be classified as a Sec. 1231 loss.
(2) If the disposition is not by sale, use FMV of property (instead of selling price) to determine gain.
(a) When boot is received in a like-kind exchange, Sec. 1245 will apply to the recognized gain.
EXAMPLE
Taxpayer exchanged his old machine (adjusted basis of $2,500) for a smaller new machine worth $5,000 and received $1,000 cash. Depreciation of $7,500 had been taken on the old machine. The realized gain of $3,500 ($6,000 − $2,500) will be recognized to the extent of the $1,000 boot, and will be treated as ordinary income as the result of Sec. 1245.
(b) Sec. 1245 recapture does not apply to transfers by gift (including charitable contributions) or transfers at death.
4. Section 1250 Recapture
a. Applies to all real property (e.g., buildings and structural components) that is not Sec. 1245 recovery property.
(1) If Sec. 1250 property was held twelve months or less, gain on disposition is recaptured as ordinary income to extent of all depreciation (including straight-line).
EXAMPLE
Alan, who is in the 35% tax bracket, owned an office building purchased for $900,000 during March 2012. The building was sold for $890,000 during February 2013, when its adjusted basis was $880,000. Since the building was not held for more than one year, the $10,000 gain is treated as ordinary income and is subject to tax at Alan’s 35% rate.
(2) If Sec. 1250 property was held more than twelve months, gain is recaptured as ordinary income to the extent of post-1969 additional depreciation (generally depreciation in excess of straight-line).
EXAMPLE
Baker, who is in the 35% tax bracket, owned an office building purchaed for $900,000 during March 2012. Baker deducted $30,000 of straight-line depreciation, and sold the building for $890,000 during May 2013. Since the building was held for more than one year and only straight-line depreciation was deducted, there is no Sec. 1250 recapture. However, the $890,000 − $870,000 = $20,000 of Sec. 1231 gain represents unrecaptured Sec. 1250 depreciation and will be subject to tax at a maximum rate of 25% if treated as LTCG.
EXAMPLE
Curt, who is in the 35% tax bracket, sold an office building with an adjusted basis of $40,000 for $350,000. The building had been purchased for $400,000 in 1980 and $360,000 of accelerated depreciation had been deducted. Straight-line depreciation would have totaled $330,000.
Total gain ($350,000 − $40,000) $310,000
Sec. 1250 ordinary income ($360,000 − $330,000) (30,000)
Sec. 1231 gain $280,000
The $30,000 of ordinary income will be taxed at 35%, while the $280,000 of Sec. 1231 gain represents unrecaptured Sec. 1250 depreciation and is subject to tax at a maximum rate of 25% if treated as LTCG.
5. Section 291 Recapture
a. The ordinary income element on the disposition of Sec. 1250 property by corporations is increased by 20% of the additional amount that would have been ordinary income if the property had instead been Sec. 1245 property or Sec. 1245 recovery property.
EXAMPLE
Assuming the same facts as in the above example except that the building was owned and sold by Ajax Corporation, the computation of gain would be
Total gain ($350,000 − $40,000) $310,000
Sec. 1250 ordinary income ($360,000 − $330,000) (30,000)*
Additional ordinary income—20% of $280,000 (the additional amount
that would have been ordinary income if the property were Sec. 1245
property)		 (56,000)*
Sec. 1231 gain $224,000
*All $86,000 ($30,000 + $56,000) of recapture is referred to as Sec. 1250 ordinary income.
6. Summary of Gains and Losses on Business Property. The treatment of gains and losses (other than personal casualty and theft) on property held for more than one year is summarized in the following four steps (also enumerated on flowchart at end of this section):
a. Separate all recognized gains and losses into four categories
(1) Ordinary gain and loss
(2) Sec. 1231 casualty and theft gains and losses
(3) Sec. 1231 gains and losses other than by casualty or theft
(4) Gains and losses on capital assets (other than by casualty or theft)
NOTE: (2) and (3) are only temporary classifications and all gains and losses will ultimately receive ordinary or capital treatment.
b. Any gain (casualty or other) on Sec. 1231 property is treated as ordinary income to extent of Sec. 1245, 1250, and 291 depreciation recapture.
c. After depreciation recapture, any remaining Sec. 1231 casualty and theft gains and losses on business property are netted.
(1) If losses exceed gains—the losses and gains receive ordinary treatment
(2) If gains exceed losses—the net gain is combined with other Sec. 1231 gains and losses in d. below
d. After recapture, any remaining Sec. 1231 gains and losses (other than by casualty or theft), are combined with any net casualty or theft gain from c. above.
(1) If losses exceed gains—the losses and gains receive ordinary treatment
(2) If gains exceed losses—the net gain receives LTCG treatment (except ordinary income treatment to extent of nonrecaptured net Sec. 1231 losses for the five most recent tax years)

TAX TREATMENT OF GAINS AND LOSSES (OTHER THAN PERSONAL CASUALTY AND THEFT)

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EXAMPLE
Taxpayer incurred the following transactions during the current taxable year:
Loss on condemnation of land used in business held fifteen months $ (500)
Loss on sale of machinery used in business held two months (1,000)
Bad debt loss on loan made three years ago to friend (2,000)
Gain from insurance reimbursement for tornado damage to business property held ten years 3,000
Loss on sale of business equipment held three years (4,000)
Gain on sale of land held four years and used in business 5,000
The gains and losses would be treated as follows: Note that the loss on machinery is ordinary because it was not held more than one year.
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NOW REVIEW MULTIPLE-CHOICE QUESTIONS 54 THROUGH 62

KEY TERMS

Adjusted basis. The original cost or other basis of property increased by capital improvements and reduced by depreciation and losses.

Boot. Cash or other property not permitted to be received tax-free in certain nontaxable transactions. The receipt of boot will generally cause a realized gain to be recognized to the extent of the lesser of the fair market value of such boot received or the amount of realized gain.

Capital asset. Generally all assets except inventory, notes and accounts receivable, and depreciable and non depreciable property used in a trade or business. Capital assets generally consist of property held for investment and property held for personal use.

Involuntary conversion. Occurs when money or other property is received for property that has been destroyed, damaged, stolen, or condemned. Generally the recognition of any realized gain resulting from an involuntary conversion can, at the taxpayer’s election, be deferred if the taxpayer reinvests the proceeds of conversion within a specified period of time in property that is similar or related in service or use.

Like-kind exchange. An exchange of property held for productive use in a trade or business or for investment (excluding inventory, stocks and bonds, and partnership interests) for property of a like kind. Real property must be exchanged for real property, personal property must be exchanged for personal property within the same general asset class. Generally no gain is recognized unless unlike property (boot) is received.

Long-term capital gain or loss. Gain or loss realized from the sale or exchange of a capital asset held for more than one year.

Related-taxpayer transactions. Generally no loss can be recognized from the sale or exchange of property between related taxpayers. Related taxpayers included members of a family (spouse, brothers, sisters, ancestors, and lineal descendants), and an individual and a more than 50% owned entity. Additionally, gains resulting from transactions between related taxpayers that might otherwise be classified as capital or Sec. 1231 gains may instead be taxed as ordinary income.

Section 1231 property. Depreciable and nondepreciable property used in a trade or business and held for more than one year. Inventory, accounts and notes receivable, US government publications, copyrights, literary, musical, or artistic compositions in the hands of their creator are excluded from the definition.

Section 1245 property. Generally depreciable personal property used in a trade or business or held for the production of income (e.g., machinery, equipment, trucks, autos).

Section 1245 recapture. The gain from the sale or exchange of Sec. 1245 property must be reported as ordinary income to the extent of the lesser of (1) all depreciation (including straight-line), or the recognized gain.

Section 1250 property. Any real property (e.g., building) that (1) is not Sec. 1245 property and (2) is subject to the allowance of depreciation.

Section 1250 recapture. The gain from the sale or exchange of Sec. 1250 property must be reported as ordinary income to the extent that actual depreciation deductions exceeded what straight-line would have been. If Sec. 1250 property was held twelve months or less, gain on disposition is recaptured as ordinary income to the extent of all depreciation (including straight-line).

Wash sale. A loss from the sale of stock or securities is disallowed because the taxpayer, within 30 days before or after the sale, has acquired stock or securities that are substantially identical to those sold.

Multiple-Choice Questions (1–62)

A.1. Basis of Property

1. Ralph Birch purchased land and a building which will be used in connection with Birch’s business. The costs associated with this purchase are as follows:

Cash down payment $ 40,000
Mortgage on property 350,000
Survey costs 2,000
Title and transfer taxes 2,500
Charges for hookup of gas, water, and sewer lines 3,000
Back property taxes owed by the seller that were paid by Birch 5,000

What is Birch’s tax basis for the land and building?

a. $ 44,500

b. $394,500

c. $397,500

d. $402,500

2. Fred Berk bought a plot of land with a cash payment of $40,000 and a purchase money mortgage of $50,000. In addition, Berk paid $200 for a title insurance policy. Berk’s basis in this land is

a. $40,000

b. $40,200

c. $90,000

d. $90,200

A.1.c. Acquired by Gift

3. Smith made a gift of property to Thompson. Smith’s basis in the property was $1,200. The fair market value at the time of the gift was $1,400. Thompson sold the property for $2,500. What was the amount of Thompson’s gain on the disposition?

a. $0

b. $1,100

c. $1,300

d. $2,500

4. Julie received a parcel of land as a gift from her Aunt Agnes. At the time of the gift, the land had a fair market value of $84,000 and an adjusted basis of $24,000. This was the only gift that Julie received from Agnes during 2013. If Agnes paid a gift tax of $14,000 on the transfer of the gift to Julie, what tax basis will Julie have for the land?

a. $23,000

b. $35,000

c. $36,000

d. $84,000

Items 5 and 6 are based on the following data:

In 2010 Iris King bought shares of stock as an investment, at a cost of $10,000. During 2012, when the fair market value was $8,000, Iris gave the stock to her daughter, Ruth.

5. If Ruth sells the shares of stock in 2013 for $7,000, Ruth’s recognized loss would be

a. $3,000

b. $2,000

c. $1,000

d. $0

6. Ruth’s holding period of the stock for purposes of determining her loss

a. Started in 2010.

b. Started in 2012.

c. Started in 2013.

d. Is irrelevant because Ruth received the stock for no consideration of money or money’s worth.

Items 7 through 9 are based on the following data:

Laura’s father, Albert, gave Laura a gift of 500 shares of Liba Corporation common stock in 2012. Albert’s basis for the Liba stock was $4,000. At the date of this gift, the fair market value of the Liba stock was $3,000.

7. If Laura sells the 500 shares of Liba stock in 2013 for $5,000, her basis is

a. $5,000

b. $4,000

c. $3,000

d. $0

8. If Laura sells the 500 shares of Liba stock in 2013 for $2,000, her basis is

a. $4,000

b. $3,000

c. $2,000

d. $0

9. If Laura sells the 500 shares of Liba stock in 2013 for $3,500, what is the reportable gain or loss in 2013?

a. $3,500 gain.

b. $ 500 gain.

c. $ 500 loss.

d. $0.

A.1.d. Acquired from Decedent

10. On June 1, 2013, Ben Rork sold 500 shares of Kul Corp. stock. Rork had received this stock on May 1, 2013, as a bequest from the estate of his uncle, who died on February 1, 2013. Rork’s basis was determined by reference to the stock’s fair market value on February 1, 2013. Rork’s holding period for this stock was

a. Short-term.

b. Long-term.

c. Short-term if sold at a gain; long-term if sold at a loss.

d. Long-term if sold at a gain; short-term if sold at a loss.

11. Fred Zorn died on June 5, 2013, bequeathing his entire $6,000,000 estate to his sister, Ida. The alternate valuation date was validly elected by the executor of Fred’s estate. Fred’s estate included 2,000 shares of listed stock for which Fred’s basis was $380,000. This stock was distributed to Ida nine months after Fred’s death. Fair market values of this stock were

At the date of Fred’s death $400,000
Six months after Fred’s death 450,000
Nine months after Fred’s death 480,000

Ida’s basis for this stock is

a. $380,000

b. $400,000

c. $450,000

d. $480,000

Items 12 and 13 are based on the following data:

On October 1, 2013, Lois Rice learned that she was bequeathed 1,000 shares of Elin Corp. common stock under the will of her uncle, Pat Prevor. Pat had paid $5,000 for the Elin stock in 2009. Fair market value of the Elin stock on October 1, 2013, the date of Pat’s death, was $8,000 and had increased to $11,000 six months later. The executor of Pat’s estate elected the alternative valuation for estate tax purposes. Lois sold the Elin stock for $9,000 on December 1, 2013, the date that the executor distributed the stock to her.

12. Lois’ basis for gain or loss on sale of the 1,000 shares of Elin stock is

a. $ 5,000

b. $ 8,000

c. $ 9,000

d. $11,000

13. Lois should treat the 1,000 shares of Elin stock as a

a. Short-term Section 1231 asset.

b. Long-term Section 1231 asset.

c. Short-term capital asset.

d. Long-term capital asset.

A.1.e. Stock Received as a Dividend

Items 14 and 15 are based on the following data:

In January 2013, Joan Hill bought one share of Orban Corp. stock for $300. On March 1, 2013, Orban distributed one share of preferred stock for each share of common stock held. This distribution was nontaxable. On March 1, 2013, Joan’s one share of common stock had a fair market value of $450, while the preferred stock had a fair market value of $150.

14. After the distribution of the preferred stock, Joan’s bases for her Orban stocks are

  Common Preferred
a. $300 $0
b. $225 $ 75
c. $200 $100
d. $150 $150

15. The holding period for the preferred stock starts in

a. January 2013.

b. March 2013.

c. September 2013.

d. December 2013.

16. On July 1, 2008, Lila Perl paid $90,000 for 450 shares of Janis Corp. common stock. Lila received a nontaxable stock dividend of 50 new common shares in August 2013. On December 20, 2013, Lila sold the 50 new shares for $11,000. How much should Lila report in her 2013 return as long-term capital gain?

a. $0

b. $ 1,000

c. $ 2,000

d. $11,000

A.4.a. Like-Kind Exchange

17. Tom Gow owned a parcel of investment real estate that had an adjusted basis of $25,000 and a fair market value of $40,000. During 2013, Gow exchanged his investment real estate for the items of property listed below.

Land to be held for investment (fair market value) $35,000
A small sailboat to be held for personal use (fair market value) 3,000
Cash 2,000

What is Tom Gow’s recognized gain and basis in his new investment real estate?

  Gain recognized Basis for real estate
a. $2,000 $22,000
b. $2,000 $25,000
c. $5,000 $25,000
d. $5,000 $35,000

18. In a “like-kind” exchange of an investment asset for a similar asset that will also be held as an investment, no taxable gain or loss will be recognized on the transaction if both assets consist of

a. Convertible debentures.

b. Convertible preferred stock.

c. Partnership interests.

d. Rental real estate located in different states.

19. Pat Leif owned an apartment house that he bought in 2000. Depreciation was taken on a straight-line basis. In 2013, when Pat’s adjusted basis for this property was $200,000, he traded it for an office building having a fair market value of $600,000. The apartment house has 100 dwelling units, while the office building has 40 units rented to business enterprises. The properties are not located in the same city. What is Pat’s reportable gain on this exchange?

a. $400,000 Section 1250 gain.

b. $400,000 Section 1231 gain.

c. $400,000 long-term capital gain.

d. $0.

20. On July 1, 2013, Riley exchanged investment real property, with an adjusted basis of $160,000 and subject to a mortgage of $70,000, and received from Wilson $30,000 cash and other investment real property having a fair market value of $250,000. Wilson assumed the mortgage. What is Riley’s recognized gain in 2013 on the exchange?

a. $ 30,000

b. $ 70,000

c. $ 90,000

d. $100,000

21. On October 1, 2013, Donald Anderson exchanged an apartment building having an adjusted basis of $375,000 and subject to a mortgage of $100,000 for $25,000 cash and another apartment building with a fair market value of $550,000 and subject to a mortgage of $125,000. The property transfers were made subject to the outstanding mortgages. What amount of gain should Anderson recognize in his tax return for 2013?

a. $0

b. $ 25,000

c. $125,000

d. $175,000

22. The following information pertains to the acquisition of a six-wheel truck by Sol Barr, a self-employed contractor:

Cost of original truck traded in $20,000
Book value of original truck at trade-in date 4,000
List price of new truck 25,000
Trade-in allowance for old truck 6,000
Business use of both trucks 100%

The basis of the new truck is

a. $27,000

b. $25,000

c. $23,000

d. $19,000

A.4.b. Involuntary Conversions

23. An office building owned by Elmer Bass was condemned by the state on January 2, 2012. Bass received the condemnation award on March 1, 2013. In order to qualify for nonrecognition of gain on this involuntary conversion, what is the last date for Bass to acquire qualified replacement property?

a. August 1, 2014.

b. January 2, 2015.

c. March 1, 2016.

d. December 31, 2016.

A.4.c. Sale or Exchange of Residence

24. In March 2013, Davis, who is single, purchased a new residence for $200,000. During that same month he sold his former residence for $380,000 and paid the realtor a $20,000 commission. The former residence, his first home, had cost $65,000 in 1994. Davis added a bathroom for $5,000 in 2009. What amount of gain is recognized from the sale of the former residence on Davis’ 2013 tax return?

a. $160,000

b. $ 90,000

c. $ 40,000

d. $0

25. The following information pertains to the sale of Al and Beth Oran’s principal residence:

Date of sale February 2013
Date of purchase October 1996
Net sales price $760,000
Adjusted basis $170,000

Al and Beth owned their home jointly and had occupied it as their principal residence since acquiring the home in 1996. In June 2013, the Orans bought a condo for $190,000 to be used as their principal residence. What amount of gain must the Orans recognize on their 2013 joint return from the sale of their residence?

a. $ 90,000

b. $150,000

c. $340,000

d. $400,000

26. Ryan, age fifty-seven, is single with no dependents. In January 2013, Ryan’s principal residence was sold for the net amount of $400,000 after all selling expenses. Ryan bought the house in 2000 and occupied it until sold. On the date of sale, the house had a basis of $180,000. Ryan does not intend to buy another residence. What is the maximum exclusion of gain on sale of the residence that may be claimed in Ryan’s 2013 income tax return?

a. $250,000

b. $220,000

c. $125,000

d. $0

A.5. Sales and Exchanges of Securities

27. Miller, an individual calendar-year taxpayer, purchased 100 shares of Maples Inc. common stock for $10,000 on July 10, 2012, and an additional fifty shares of Maples Inc. common stock for $4,000 on December 24, 2012. On January 8, 2013, Miller sold the 100 shares purchased on July 10, 2012, for $7,000. What is the amount of Miller’s recognized loss for 2013 and what is the basis for her remaining fifty shares of Maples Inc. stock?

a. $3,000 recognized loss; $4,000 basis for her remaining stock.

b. $1,500 recognized loss; $5,500 basis for her remaining stock.

c. $1,500 recognized loss; $4,000 basis for her remaining stock.

d. $0 recognized loss; $7,000 basis for her remaining stock.

28. Smith, an individual calendar-year taxpayer, purchased 100 shares of Core Co. common stock for $15,000 on December 15, 2012, and an additional 100 shares for $13,000 on December 30, 2012. On January 3, 2013, Smith sold the shares purchased on December 15, 2012, for $13,000. What amount of loss from the sale of Core stock is deductible on Smith’s 2012 and 2013 income tax returns?

  2012 2013
a. $0 $0
b. $0 $2,000
c. $1,000 $1,000
d. $2,000 $0

29. On March 10, 2013, James Rogers sold 300 shares of Red Company common stock for $4,200. Rogers acquired the stock in 2010 at a cost of $5,000.

On April 4, 2013, he repurchased 300 shares of Red Company common stock for $3,600 and held them until July 18, 2013, when he sold them for $6,000.

How should Rogers report the above transactions for 2013?

a. A long-term capital loss of $800.

b. A long-term capital gain of $1,000.

c. A long-term capital gain of $1,600.

d. A long-term capital loss of $800 and a short-term capital gain of $2,400.

30. Murd Corporation, a domestic corporation, acquired a 90% interest in the Drum Company in 2009 for $30,000. During 2013, the stock of Drum was declared worthless. What type and amount of deduction should Murd take for 2013?

a. Long-term capital loss of $1,000.

b. Long-term capital loss of $15,000.

c. Ordinary loss of $30,000.

d. Long-term capital loss of $30,000.

A.6. Losses on Deposits in Insolvent Financial Institutions

31. If an individual incurs a loss on a nonbusiness deposit as the result of the insolvency of a bank, credit union, or other financial institution, the individual’s loss on the nonbusiness deposit may be deducted in any one of the following ways except:

a. Miscellaneous itemized deduction.

b. Casualty loss.

c. Short-term capital loss.

d. Long-term capital loss.

A.7. Losses, Expenses, and Interest between Related Taxpayers

Items 32 and 33 are based on the following:

Conner purchased 300 shares of Zinco stock for $30,000 in 2009. On May 23, 2013, Conner sold all the stock to his daughter Alice for $20,000, its then fair market value. Conner realized no other gain or loss during 2013. On July 26, 2013, Alice sold the 300 shares of Zinco for $25,000.

32. What amount of the loss from the sale of Zinco stock can Conner deduct in 2013?

a. $0

b. $ 3,000

c. $ 5,000

d. $10,000

33. What was Alice’s recognized gain or loss on her sale?

a. $0.

b. $5,000 long-term gain.

c. $5,000 short-term loss.

d. $5,000 long-term loss.

34. In 2013, Fay sold 100 shares of Gym Co. stock to her son, Martin, for $11,000. Fay had paid $15,000 for the stock in 2009. Subsequently in 2013, Martin sold the stock to an unrelated third party for $16,000. What amount of gain from the sale of the stock to the third party should Martin report on his 2013 income tax return?

a. $0

b. $1,000

c. $4,000

d. $5,000

35. Among which of the following related parties are losses from sales and exchanges not recognized for tax purposes?

a. Mother-in-law and daughter-in-law.

b. Uncle and nephew.

c. Brother and sister.

d. Ancestors, lineal descendants, and all in-laws.

36. On May 1, 2013, Daniel Wright owned stock (held for investment) purchased two years earlier at a cost of $10,000 and having a fair market value of $7,000. On this date he sold the stock to his son, William, for $7,000. William sold the stock for $6,000 to an unrelated person on July 1, 2013. How should William report the stock sale on his 2013 tax return?

a. As a short-term capital loss of $1,000.

b. As a long-term capital loss of $1,000.

c. As a short-term capital loss of $4,000.

d. As a long-term capital loss of $4,000.

37. Al Eng owns 50% of the outstanding stock of Rego Corp. During 2013, Rego sold a trailer to Eng for $10,000, the trailer’s fair value. The trailer had an adjusted tax basis of $12,000, and had been owned by Rego and used in its business for three years. In its 2013 income tax return, what is the allowable loss that Rego can claim on the sale of this trailer?

a. $0

b. $2,000 capital loss.

c. $2,000 Section 1231 loss.

d. $2,000 Section 1245 loss.

B. Capital Gains and Losses

38. For a cash basis taxpayer, gain or loss on a year-end sale of listed stock arises on the

a. Trade date.

b. Settlement date.

c. Date of receipt of cash proceeds.

d. Date of delivery of stock certificate.

39. Lee qualified as head of a household for 2013 tax purposes. Lee’s 2013 taxable income was $100,000, exclusive of capital gains and losses. Lee had a net long-term capital loss of $8,000 in 2013. What amount of this capital loss can Lee offset against 2013 ordinary income?

a. $0

b. $3,000

c. $4,000

d. $8,000

40. For the year ended December 31, 2013, Sol Corp. had an operating income of $20,000. In addition, Sol had capital gains and losses resulting in a net short-term capital gain of $2,000 and a net long-term capital loss of $7,000. How much of the excess of net long-term capital loss over net short-term capital gain could Sol offset against ordinary income for 2013?

a. $5,000

b. $3,000

c. $1,500

d. $0

41. In 2013, Nam Corp., which is not a dealer in securities, realized taxable income of $160,000 from its business operations. Also, in 2013, Nam sustained a long-term capital loss of $24,000 from the sale of marketable securities. Nam did not realize any other capital gains or losses since it began operations. In Nam’s income tax returns, what is the proper treatment for the $24,000 long-term capital loss?

a. Use $3,000 of the loss to reduce 2013 taxable income, and carry $21,000 of the long-term capital loss forward for five years.

b. Use $6,000 of the loss to reduce 2013 taxable income by $3,000, and carry $18,000 of the long-term capital loss forward for five years.

c. Use $24,000 of the long-term capital loss to reduce 2013 taxable income by $12,000.

d. Carry the $24,000 long-term capital loss forward for five years, treating it as a short-term capital loss.

42. For assets acquired in 2013, the holding period for determining long-term capital gains and losses is more than

a. 18 months.

b. 12 months.

c. 9 months.

d. 6 months.

43. On July 1, 2013, Kim Wald sold an antique for $12,000 that she had bought for her personal use in 2011 at a cost of $15,000. In her 2013 return, Kim should treat the sale of the antique as a transaction resulting in

a. A nondeductible loss.

b. Ordinary loss.

c. Short-term capital loss.

d. Long-term capital loss.

44. Paul Beyer, who is unmarried, has taxable income of $30,000 exclusive of capital gains and losses and his personal exemption. In 2013, Paul incurred a $1,000 net short-term capital loss and a $5,000 net long-term capital loss. His capital loss carryover to 2014 is

a. $0

b. $1,000

c. $3,000

d. $5,000

B.1. Capital Assets

45. Capital assets include

a. A corporation’s accounts receivable from the sale of its inventory.

b. Seven-year MACRS property used in a corporation’s trade or business.

c. A manufacturing company’s investment in US Treasury bonds.

d. A corporate real estate developer’s unimproved land that is to be subdivided to build homes, which will be sold to customers.

46. Joe Hall owns a limousine for use in his personal service business of transporting passengers to airports. The limousine’s adjusted basis is $40,000. In addition, Hall owns his personal residence and furnishings, that together cost him $280,000. Hall’s capital assets amount to

a. $320,000

b. $280,000

c. $ 40,000

d. $0

47. In 2013, Ruth Lee sold a painting for $25,000 that she had bought for her personal use in 2007 at a cost of $10,000. In her 2013 return, Lee should treat the sale of the painting as a transaction resulting in

a. Ordinary income.

b. Long-term capital gain.

c. Section 1231 gain.

d. No taxable gain.

48. In 2013, a capital loss incurred by a married couple filing a joint return

a. Will be allowed only to the extent of capital gains.

b. Will be allowed to the extent of capital gains, plus up to $3,000 of ordinary income.

c. Will be allowed to the extent of capital gains, plus up to $6,000 of ordinary income.

d. Is not an allowable loss.

49. Platt owns land that is operated as a parking lot. A shed was erected on the lot for the related transactions with customers. With regard to capital assets and Section 1231 assets, how should these assets be classified?

  Land Shed
a. Capital Capital
b. Section 1231 Capital
c. Capital Section 1231
d. Section 1231 Section 1231

50. In 2009, Iris King bought a diamond necklace for her own use, at a cost of $10,000. In 2013, when the fair market value was $12,000, Iris gave this necklace to her daughter, Ruth. No gift tax was due. This diamond necklace is a

a. Capital asset.

b. Section 1231 asset.

c. Section 1245 asset.

d. Section 1250 asset.

51. Which of the following is a capital asset?

a. Delivery truck.

b. Personal-use recreation equipment.

c. Land used as a parking lot for customers.

d. Treasury stock, at cost.

52. Don Mott was the sole proprietor of a high-volume drug store which he owned for fifteen years before he sold it to Dale Drug Stores, Inc. in 2013. Besides the $900,000 selling price for the store’s tangible assets and goodwill, Mott received a lump sum of $30,000 in 2013 for his agreement not to operate a competing enterprise within ten miles of the store’s location for a period of six years. The $30,000 will be taxed to Mott as

a. $30,000 ordinary income in 2013.

b. $30,000 short-term capital gain in 2013.

c. $30,000 long-term capital gain in 2013.

d. Ordinary income of $5,000 a year for six years.

53. In June 2013, Olive Bell bought a house for use partially as a residence and partially for operation of a retail gift shop. In addition, Olive bought the following furniture:

Kitchen set and living room pieces for the
residential portion		 $ 8,000
Showcases and tables for the business portion 12,000

How much of this furniture comprises capital assets?

a. $0

b. $ 8,000

c. $12,000

d. $20,000

C. Personal Casualty and Theft Gains and Losses

54. An individual’s losses on transactions entered into for personal purposes are deductible only if

a. The losses qualify as casualty or theft losses.

b. The losses can be characterized as hobby losses.

c. The losses do not exceed $3,000 ($6,000 on a joint return).

d. No part of the transactions was entered into for profit.

D. Gains and Losses on Business Property

55. Evon Corporation, which was formed in 2010, had $50,000 of net Sec. 1231 gain for its 2013 calendar year. Its net Sec. 1231 gains and losses for its three preceding tax years were as follows:

Year Sec. 1231 results
2010 Gain of $10,000
2011 Loss of $15,000
2012 Loss of $20,000

As a result, Evon Corporation’s 2013 net Sec. 1231 gain would be characterized as

a. A net long-term capital gain of $50,000.

b. A net long-term capital gain of $35,000 and ordinary income of $15,000.

c. A net long-term capital gain of $25,000 and ordinary income of $25,000.

d. A net long-term capital gain of $15,000 and ordinary income of $35,000.

56. Which one of the following would not be Sec. 1231 property even though held for more than twelve months?

a. Business inventory.

b. Unimproved land used for business.

c. Depreciable equipment used in a business.

d. Depreciable real property used in a business.

57. Vermont Corporation distributed packaging equipment that it no longer needed to Michael Jason who owns 20% of Vermont’s stock. The equipment, which was acquired in 2008, had an adjusted basis of $2,000 and a fair market value of $9,000 at the date of distribution. Vermont had properly deducted $6,000 of straight-line depreciation on the equipment while it was used in Vermont’s manufacturing activities. What amount of ordinary income must Vermont recognize as a result of the distribution of the equipment?

a. $0

b. $3,000

c. $6,000

d. $7,000

58. Tally Corporation sold machinery that had been used in its business for a loss of $22,000 during 2013. The machinery had been purchased and placed in service sixteen months earlier. For 2013, the $22,000 loss will be treated as a

a. Capital loss.

b. Sec. 1245 loss.

c. Sec. 1231 loss.

d. Casualty loss because the machinery was held less than two years.

59. On January 2, 2011, Bates Corp. purchased and placed into service seven-year MACRS tangible property costing $100,000. On July 31, 2013, Bates sold the property for $102,000, after having taken $47,525 in MACRS depreciation deductions. What amount of the gain should Bates recapture as ordinary income?

a. $0

b. $ 2,000

c. $47,525

d. $49,525

60. Thayer Corporation purchased an apartment building on January 1, 2010, for $200,000. The building was depreciated using the straight-line method. On December 31, 2013, the building was sold for $220,000, when the asset balance net of accumulated depreciation was $170,000. On its 2013 tax return, Thayer should report

a. Section 1231 gain of $42,500 and ordinary income of $7,500.

b. Section 1231 gain of $44,000 and ordinary income of $6,000.

c. Ordinary income of $50,000.

d. Section 1231 gain of $50,000.

61. For the year ended December 31, 2013, McEwing Corporation, a calendar-year corporation, reported book income before income taxes of $120,000. Included in the determination of this amount were the following gain and losses from property that had been held for more than one year:

Loss on sale of building depreciated on the
straight-line method		 $(7,000)
Gain on sale of land used in McEwing’s
business		 16,000
Loss on sale of investments in marketable
securities		 (8,000)

For the year ended December 31, 2013, McEwing’s taxable income was

a. $113,000

b. $120,000

c. $125,000

d. $128,000

62. David Price owned machinery which he had acquired in 2012 at a cost of $100,000. During 2013, the machinery was destroyed by fire. At that time it had an adjusted basis of $86,000. The insurance proceeds awarded to Price amounted to $125,000, and he immediately acquired a similar machine for $110,000.

What should Price report as ordinary income resulting from the involuntary conversion for 2013?

a. $14,000

b. $15,000

c. $25,000

d. $39,000

Multiple-Choice Answers and Explanations

Answers

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Explanations

1. (d) The requirement is to determine Birch’s tax basis for the purchased land and building. The basis of property acquired by purchase is a cost basis and includes not only the cash paid and liabilities incurred, but also includes certain settlement fees and closing costs such as abstract of title fees, installation of utility services, legal fees (including title search, contract, and deed fees), recording fees, surveys, transfer taxes, owner’s title insurance, and any amounts the seller owes that the buyer agrees to pay, such as back taxes and interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions.

2. (d) The requirement is to determine the basis for the purchased land. The basis of the land consists of the cash paid ($40,000), the purchase money mortgage ($50,000), and the cost of the title insurance policy ($200), a total of $90,200.

3. (c) The requirement is to determine the amount of gain recognized by Thompson resulting from the sale of appreciated property received as a gift. A donee’s basis for appreciated property received as a gift is generally the same as the donor’s basis. Since Smith had a basis for the property of $1,200 and Thompson sold the property for $2,500, Thompson must recognize a gain of $1,300.

4. (c) The requirement is to determine Julie’s basis for the land received as a gift. A donee’s basis for gift property is generally the same as the donor’s basis, increased by any gift tax paid that is attributable to the property’s net appreciation in value. That is, the amount of gift tax that can be added is limited to the amount that bears the same ratio as the property’s net appreciation bears to the amount of taxable gift. For this purpose, the amount of gift is reduced by any portion of the $14,000 annual exclusion that is allowable with respect to the gift. Thus, Julie’s basis is $24,000 + [$14,000 ($84,000 − 24,000) / ($84,000 − $14,000)] = $36,000.

5. (c) The requirement is to determine Ruth’s recognized loss if she sells the stock received as a gift for $7,000. Since the stock’s FMV ($8,000) was less than its basis ($10,000) at date of gift, Ruth’s basis for computing a loss is the stock’s FMV of $8,000 at date of gift. As a result, Ruth’s recognized loss is $8,000 − $7,000 = $1,000.

6. (b) The requirement is to determine Ruth’s holding period for stock received as a gift. If property is received as a gift, and the property’s FMV on date of gift is used to determine a loss, the donee’s holding period begins when the gift was received. Thus, Ruth’s holding period starts in 2012.

7. (b) The requirement is to determine the basis of the Liba stock if it is sold for $5,000. If property acquired by gift is sold at a gain, its basis is the donor’s basis ($4,000), increased by any gift tax paid attributable to the net appreciation in value of the gift ($0).

8. (b) The requirement is to determine the basis of the Liba stock if it is sold for $2,000. If property acquired by gift is sold at a loss, its basis is the lesser of (1) its gain basis ($4,000 above), or (2) its FMV at date of gift ($3,000).

9. (d) The requirement is to determine the amount of reportable gain or loss if the Liba stock is sold for $3,500. No gain or loss is recognized on the sale of property acquired by gift if the basis for loss ($3,000) results in a gain and the basis for gain ($4,000) results in a loss.

10. (b) The requirement is to determine the holding period for stock received as a bequest from the estate of a deceased uncle. Property received from a decedent is deemed to be held long-term regardless of the actual period of time that the decedent or beneficiary actually held the property and is treated as held for more than twelve months.

11. (c) The requirement is to determine Ida’s basis for stock inherited from a decedent. The basis of property received from a decedent is generally the property’s FMV at date of the decedent’s death, or FMV on the alternate valuation date (six months after death). Since the executor of Zorn’s estate elected to use the alternate valuation for estate tax purposes, the stock’s basis to Ida is its $450,000 FMV six months after Zorn’s death. Note, if the stock had been distributed to Ida within six months of Zorn’s death, the stock’s basis would be its FMV on date of distribution.

12. (c) The requirement is to determine Lois’ basis for gain or loss on the sale of Elin stock acquired from a decedent. Since the alternate valuation was elected for Prevor’s estate, but the stock was distributed to Lois within six months of date of death, Lois’ basis is the $9,000 FMV of the stock on date of distribution (12/1/13).

13. (d) The requirement is to determine how Lois should treat the shares of Elin stock that she inherited from her uncle who died during 2012. The stock should be treated as a capital asset held long-term since (1) property acquired from a decedent is considered to be held for more than twelve months regardless of its actual holding period, and (2) the stock is an investment asset in Lois’ hands. The stock is not a Sec. 1231 asset because it was not held for use in Lois’ trade or business.

14. (b) The requirement is to determine the basis for the common stock and the preferred stock after the receipt of a nontaxable preferred stock dividend. Joan’s original common stock basis must be allocated between the common stock and the preferred stock according to their relative fair market value.

Common stock (FMV) $450
Preferred stock (FMV) 150
Total value $600

The ratio of the common stock to total value is $450/$600 or 3/4. This ratio multiplied by the original common stock basis of $300 results in a basis for the common stock of $225. The basis of the preferred stock would be ($150/$600 × $300) = $75.

15. (a) The requirement is to determine the holding period for preferred stock that was received in a nontaxable distribution on common stock. Since the tax basis of the preferred stock is determined in part by the basis of the common stock, the holding period of the preferred stock includes the holding period of the common stock (i.e., the holding period of the common stock tacks on to the preferred stock). Thus, the holding period of the preferred stock starts when the common stock was acquired, January 2013.

16. (c) The requirement is to determine the amount of long-term capital gain to be reported on the sale of fifty shares of stock received as a nontaxable stock dividend. After the stock dividend, the basis of each share would be determined as follows:

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Since the holding period of the new shares includes the holding period of the old shares, the sale of the fifty new shares for $11,000 results in a LTCG of $2,000 [$11,000 − (50 shares × $180)].

17. (c) The requirement is to determine Gow’s recognized gain and basis for the investment real estate acquired in a like-kind exchange. In a like-kind exchange of property held for investment, a realized gain ($15,000 in this case) will be recognized only to the extent of unlike property (i.e., boot) received. Here the unlike property consists of the $2,000 cash and $3,000 FMV of the sailboat received, resulting in the recognition of $5,000 of gain. The basis of the acquired like-kind property reflects the deferred gain resulting from the like-kind exchange, and is equal to the basis of the property transferred ($25,000), increased by the amount of gain recognized ($5,000), and decreased by the amount of boot received ($2,000 + $3,000), or $25,000.

18. (d) The requirement is to determine which exchange qualifies for nonrecognition of gain or loss as a like-kind exchange. The exchange of business or investment property solely for like-kind business or investment property is treated as a nontaxable exchange. Like-kind means “the same class of property.” Real property must be exchanged for real property, and personal property must be exchanged for personal property. Here, the exchange of rental real estate is an exchange of like-kind property, even though the real estate is located in different states. The like-kind exchange provisions do not apply to exchanges of stocks, bonds, notes, convertible securities, the exchange of partnership interests, and property held for personal use.

19. (d) The requirement is to determine the reportable gain resulting from the exchange of an apartment building for an office building. No gain or loss is recognized on the exchange of business or investment property for property of a like-kind. The term “like-kind” means the same class of property (i.e., real estate must be exchanged for real estate, personal property exchanged for personal property). Thus, the exchange of an apartment building for an office building qualifies as a like-kind exchange. Since no boot (money or unlike property) was received, the realized gain of $600,000 − $200,000 = $400,000 is not recognized.

20. (d) The requirement is to determine the amount of recognized gain resulting from a like-kind exchange of investment property. In a like-kind exchange, gain is recognized to the extent of the lesser of (1) “boot” received, or (2) gain realized.

FMV of property received $ 250,000
Cash received 30,000
Mortgage assumed 70,000
Amount realized $ 350,000
Basis of property exchanged (160,000)
Gain realized $190,000

Since the “boot” received includes both the cash and the assumption of the mortgage, gain is recognized to the extent of the $100,000 of “boot” received.

21. (b) The requirement is to determine the amount of gain recognized to Anderson on the like-kind exchange of apartment buildings. Anderson’s realized gain is computed as follows:

FMV of building received   $550,000
Mortgage on old building   100,000
Cash received   25,000
Amount realized   $675,000
Less:    
Basis of old building $375,000  
Mortgage on new building 125,000 500,000
Realized gain   $175,000

Since the boot received in the form of cash cannot be offset against boot given in the form of an assumption of a mortgage, the realized gain is recognized to the extent of the $25,000 cash received.

22. (c) The requirement is to determine the basis of a new truck acquired in a like-kind exchange. The basis of the new truck is the book value (i.e., adjusted basis) of the old truck of $4,000 plus the additional cash paid of $19,000 (i.e., the list price of the new truck of $25,000 less the trade-in allowance of $6,000).

23. (d) The requirement is to determine the end of the replacement period for nonrecognition of gain following the condemnation of real property. For a condemnation of real property held for productive use in a trade or business or for investment, the replacement period ends three years after the close of the taxable year in which the gain is first realized. Since the gain was realized in 2013, the replacement period ends December 31, 2016.

24. (c) The requirement is to determine the amount of gain from the sale of the former residence that is recognized on Davis’ 2013 return. An individual may exclude from income up to $250,000 of gain that is realized on the sale or exchange of a residence, if the individual owned and occupied the residence as a principal residence for an aggregate of at least two of the five years preceding the sale or exchange. Davis’ former residence cost $65,000 and he had made improvements costing $5,000, resulting in a basis of $70,000. Since Davis sold his former residence for $380,000 and paid a realtor commission of $20,000, the net amount realized from the sale was $360,000. Thus, Davis realized a gain of $360,000 − $70,000 = $290,000. Since Davis qualifies to exclude $250,000 of the gain from income, the remaining $40,000 of gain is recognized and included in Davis’ income for 2013.

25. (a) The requirement is to determine the amount of gain to be recognized on the Orans’ 2013 joint return from the sale of their residence. An individual may exclude from income up to $250,000 of gain that is realized on the sale or exchange of a residence, if the individual owned and occupied the residence as a principal residence for an aggregate of at least two of the five years preceding the sale or exchange. The amount of excludable gain is increased to $500,000 for married individuals filing jointly if either spouse meets the ownership requirement, and both spouses meet the use requirement. Here, the Orans realized a gain of $760,000 − $170,000 = $590,000, and qualify to exclude $500,000 of the gain from income. The remaining $90,000 of gain is recognized and taxed to the Orans for 2013.

26. (b) The requirement is to determine the maximum exclusion of gain on the sale of Ryan’s principal residence. An individual may exclude from income up to $250,000 of gain that is realized on the sale or exchange of a residence, if the individual owned and occupied the residence as a principal residence for an aggregate of at least two of the five years preceding the sale or exchange. Since Ryan meets the ownership and use requirements, and realized a gain of $400,000 − $180,000 = $220,000, all of Ryan’s gain will be excluded from his gross income.

27. (b) The requirement is to determine Miller’s recognized loss and the basis for her remaining fifty shares of Maples Inc. stock. No loss can be deducted on the sale of stock if substantially identical stock is purchased within thirty days before or after the sale. Any loss that is not deductible because of this rule is added to the basis of the new stock. If the taxpayer acquires less than the number of shares sold, the amount of loss that cannot be recognized is determined by the ratio of the number of shares acquired to the number of shares sold. Miller purchased 100 shares of Maples stock for $10,000 and sold the stock on January 8, 2013, for $7,000, resulting in a loss of $3,000. However, only half of the loss can be deducted by Miller because on December 24, 2012 (within thirty days before the January 8, 2013 sale), Miller purchased an additional 50 shares of Maples stock. Since only $1,500 of the loss can be recognized, the $1,500 of loss not recognized is added to the basis of Miller’s remaining 50 shares resulting in a basis of $4,000 + $1,500 = $5,500.

28. (a) The requirement is to determine the amount of loss from the sale of Core stock that is deductible on Smith’s 2012 and 2013 income tax returns. No loss can be deducted on the sale of stock if substantially identical stock is purchased within thirty days before or after the sale. Any loss that is not deductible because of this rule is added to the basis of the new stock. In this case, Smith purchased 100 shares of Core stock for $15,000 and sold the stock on January 3, 2013, for $13,000, resulting in a loss of $2,000. However, the loss cannot be deducted by Smith because on December 30, 2012 (within thirty days prior to the January 3, 2013 sale), Smith purchased an additional 100 shares of Core stock. Smith’s disallowed loss of $2,000 is added to the $13,000 cost of the 100 Core shares acquired on December 30 resulting in a tax basis of $15,000 for those shares.

29. (c) The purchase of substantially identical stock within thirty days of the sale of stock at a loss is known as a wash sale. The $800 loss incurred in the wash sale ($5,000 basis less $4,200 amount realized) is disallowed. The basis of the replacement (substantially identical) stock is its cost ($3,600) plus the disallowed wash sale loss ($800). The holding period of the replacement stock includes the holding period of the wash sale stock. The amount realized ($6,000) less the basis ($4,400) results in a long-term gain of $1,600.

30. (c) Worthless securities generally receive capital loss treatment. However, if the loss is incurred by a corporation on its investment in an affiliated corporation (80% or more ownership), the loss is generally treated as an ordinary loss.

31. (d) A loss resulting from a nonbusiness deposit in an insolvent financial institution is generally treated as a nonbusiness bad debt deductible as a short-term capital loss. However, subject to certain limitations, an individual may elect to treat the loss as a casualty loss or as a miscellaneous itemized deduction.

32. (a) The requirement is to determine the amount of the $10,000 loss that Conner can deduct from the sale of stock to his daughter, Alice. Losses are disallowed on sales or exchanges of property between related taxpayers, including members of a family. For this purpose, the term family includes an individual’s spouse, brothers, sisters, ancestors, and lineal descendants (e.g., children, grandchildren, etc.). Since Conner sold the stock to his daughter, no loss can be deducted.

33. (a) The requirement is to determine the recognized gain or loss on Alice’s sale of the stock that she had purchased from her father. Losses are disallowed on sales or exchanges of property between related taxpayers, including family members. Any gain later realized by the related transferee on the subsequent disposition of the property is not recognized to the extent of the transferor’s disallowed loss. Here, her father’s realized loss of $30,000 − $20,000 = $10,000 was disallowed because he sold the stock to his daughter, Alice. Her basis for the stock is her cost of $20,000. On the subsequent sale of the stock, Alice realizes a gain of $25,000 − $20,000 = $5,000. However, this realized gain of $5,000 is not recognized because of her father’s disallowed loss of $10,000.

34. (b) The requirement is to determine the amount of gain from the sale of stock to a third party that Martin should report on his 2013 income tax return. Losses are disallowed on sales of property between related taxpayers, including family members. Any gain later realized by the transferee on the disposition of the property is not recognized to the extent of the transferor’s disallowed loss. Here, Fay’s realized loss of $15,000 − $11,000 = $4,000 is disallowed because she sold the stock to her son, Martin. Martin’s basis for the stock is his cost of $11,000. On the subsequent sale of the stock to an unrelated third party, Martin realizes a gain of $16,000 − $11,000 = $5,000. However, this realized gain of $5,000 is recognized only to the extent that it exceeds Fay’s $4,000 disallowed loss, or $1,000.

35. (c) The requirement is to determine among which of the related individuals are losses from sales and exchanges not recognized for tax purposes. No loss deduction is allowed on the sale or exchange of property between members of a family. For this purpose, an individual’s family includes only brothers, sisters, half-brothers and half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.). Since in-laws and uncles are excluded from this definition of a family, a loss resulting from a sale or exchange with an uncle or between in-laws would be recognized.

36. (a) Losses are disallowed on sales between related taxpayers, including family members. Thus, Daniel’s loss of $3,000 is disallowed on the sale of stock to his son, William. William’s basis for the stock is his $7,000 cost. Since William’s stock basis is determined by his cost (not by reference to Daniel’s cost), there is no “tack-on” of Daniel’s holding period. Thus, a later sale of the stock for $6,000 on July 1 generates a $1,000 STCL for William.

37. (c) The requirement is to determine the amount of loss that Rego Corp. can deduct on a sale of its trailer to a 50% shareholder. Losses are disallowed on transactions between related taxpayers, including a corporation and a shareholder owning more than 50% of its stock. Since Al Eng owns only 50% (not more than 50%), the loss is recognized by Rego. Since the trailer was held for more than one year and used in Rego’s business, the $2,000 loss is a Sec. 1231 loss. Answer (d) is incorrect because Sec. 1245 only applies to gains.

38. (a) The requirement is to determine when gain or loss on a year-end sale of listed stock arises for a cash basis taxpayer. If stock or securities that are traded on an established securities market are sold, any resulting gain or loss is recognized on the trade date (i.e., the date on which the trade is executed) by both cash and accrual method taxpayers.

39. (b) The requirement is to determine the amount of an $8,000 net long-term capital loss that can be offset against Lee’s taxable income of $100,000. An individual’s net capital loss can be offset against ordinary income up to a maximum of $3,000 ($1,500 if married filing separately). Since a net capital loss offsets ordinary income dollar for dollar, Lee has a $3,000 net capital loss deduction for 2013 and a long-term capital loss carryover of $5,000 to 2014.

40. (d) The requirement is to determine the amount of excess of net long-term capital loss over net short-term capital gain that Sol Corp. can offset against ordinary income. A corporation’s net capital loss cannot be offset against ordinary income. Instead, a net capital loss is generally carried back three years and forward five years as a STCL to offset capital gains in those years.

41. (d) The requirement is to determine the proper treatment for a $24,000 NLTCL for Nam Corp. A corporation’s capital losses can only be used to offset capital gains. If a corporation has a net capital loss, the net capital loss cannot be currently deducted, but must be carried back three years and forward five years as a STCL to offset capital gains in those years. Since Nam had not realized any capital gains since it began operations, the $24,000 LTCL can only be carried forward for five years as a STCL.

42. (b) The requirement is to determine the holding period for determining long-term capital gains and losses. Long-term capital gains and losses result if capital assets are held more than twelve months.

43. (a) The requirement is to determine the treatment for the sale of the antique by Wald. Since the antique was held for personal use, the sale of the antique at a loss is not deductible.

44. (c) The requirement is to determine the capital loss carryover to 2014. The NSTCL and the NLTCL result in a net capital loss of $6,000. LTCLs are deductible dollar for dollar, the same as STCLs. Since an individual can deduct a net capital loss up to a maximum of $3,000, the net capital loss of $6,000 results in a capital loss deduction of $3,000 for 2013, and a long-term capital loss carryover to 2014 of $3,000.

45. (c) The requirement is to determine the item that is included in the definition of capital assets. The definition of capital assets includes property held as an investment and would include a manufacturing company’s investment in US Treasury bonds. In contrast, the definition specifically excludes accounts receivable arising from the sale of inventory, depreciable property used in a trade or business, and property held primarily for sale to customers in the ordinary course of a trade or business.

46. (b) The requirement is to determine the amount of Hall’s capital assets. The definition of capital assets includes investment property and property held for personal use (e.g., personal residence and furnishings), but excludes property used in a trade or business (e.g., limousine).

47. (b) The requirement is to determine the proper treatment for the gain recognized on the sale of a painting that was purchased in 2007 and held for personal use. The definition of “capital assets” includes investment property and property held for personal use (if sold at a gain). Because the painting was held for more than one year, the gain from the sale of the painting must be reported as a long-term capital gain. Note that if personal-use property is sold at a loss, the loss is not deductible.

48. (b) The requirement is to determine the correct treatment for a capital loss incurred by a married couple filing a joint return for 2013. Capital losses first offset capital gains, and then are allowed as a deduction of up to $3,000 against ordinary income, with any unused capital loss carried forward indefinitely. Note that a married taxpayer filing separately can only offset up to $1,500 of net capital loss against ordinary income.

49. (d) The requirement is to determine the proper classification of land used as a parking lot and a shed erected on the lot for customer transactions. The definition of capital assets includes investment property and property held for personal use, but excludes any property used in a trade or business. The definition of Sec. 1231 assets generally includes business assets held more than one year. Since the land and shed were used in conjunction with a parking lot business, they are properly classified as Sec. 1231 assets.

50. (a) The requirement is to determine the classification of Ruth’s diamond necklace. The diamond necklace is classified as a capital asset because the definition of “capital asset” includes investment property and property held for personal use. Answers (b), (c), and (d) are incorrect because Sec. 1231 generally includes only assets used in a trade or business, while Sections 1245 and 1250 only include depreciable assets.

51. (b) The requirement is to determine which asset is a capital asset. The definition of capital assets includes personal-use property, but excludes property used in a trade or business (e.g., delivery truck, land used as a parking lot). Treasury stock is not considered an asset, but instead is treated as a reduction of stockholders’ equity.

52. (a) The requirement is to determine how a lump sum of $30,000 received in 2013, for an agreement not to operate a competing enterprise, should be treated. A covenant not to compete is not a capital asset. Thus, the $30,000 received as consideration for such an agreement must be reported as ordinary income in the year received.

53. (b) The requirement is to determine the amount of furniture classified as capital assets. The definition of capital assets includes investment property and property held for personal use (e.g., kitchen and living room pieces), but excludes property used in a trade or business (e.g., showcases and tables).

54. (a) The requirement is to determine the correct statement regarding the deductibility of an individual’s losses on transactions entered into for personal purposes. An individual’s losses on transactions entered into for personal purposes are deductible only if the losses qualify as casualty or theft losses. Answer (b) is incorrect because hobby losses are not deductible. Answers (c) and (d) are incorrect because losses (other than by casualty or theft) on transactions entered into for personal purposes are not deductible.

55. (d) The requirement is to determine the characterization of Evon Corporation’s $50,000 of net Sec. 1231 gain for its 2013 tax year. Although a net Sec. 1231 gain is generally treated as a long-term capital gain, it instead must be treated as ordinary income to the extent of the taxpayer’s nonrecaptured net Sec. 1231 losses for its five preceding taxable years. Here, since the nonrecaptured net Sec. 1231 losses for 2011 and 2012 total $35,000, only $15,000 of the $50,000 net Sec. 1231 gain will be treated as a long-term capital gain.

56. (a) The requirement is to determine which item would not be characterized as Sec. 1231 property. Sec. 1231 property generally includes both depreciable and nondepreciable property used in a trade or business or held for the production of income if held for more than twelve months. Specifically excluded from Sec. 1231 is inventory and property held for sale to customers, as well as accounts and notes receivable arising in the ordinary course of a trade or business.

57. (c) The requirement is to determine the amount of ordinary income that must be recognized by Vermont Corporation from the distribution of the equipment to a shareholder. When a corporation distributes appreciated property, it must recognize gain just as if it had sold the property for its fair market value. As a result Vermont must recognize a gain of $9,000 − $2,000 = $7,000 on the distribution of the equipment. Since the distributed property is depreciable personal property, the gain is subject to Sec. 1245 recapture as ordinary income to the extent of the $6,000 of straight-line depreciation deducted by Vermont. The remaining $1,000 of gain would be treated as Sec. 1231 gain.

58. (c) The requirement is to determine the nature of a loss resulting from the sale of business machinery that had been held sixteen months. Property held for use in a trade or business is specifically excluded from the definition of capital assets, and if held for more than one year is considered Sec. 1231 property. Answer (b) is incorrect because Sec. 1245 only applies to gains.

59. (c) The requirement is to determine the amount of gain from the sale of property that must be recaptured as ordinary income. A gain from the disposition of seven-year tangible property is subject to recapture under Sec. 1245 which recaptures gain to the extent of all depreciation previously deducted. Here, Bates’ gain from the sale of the property is determined as follows:

Selling price   $102,000
Cost $100,000  
Depreciation –47,525  
Adjusted basis   – 52,475
Gain   $49,525

Under Sec. 1245, Bates Corp’s gain is recaptured as ordinary income to the extent of the $47,525 deducted as depreciation. The remaining $2,000 of gain would be classified as Sec. 1231 gain.

60. (b) The requirement is to determine the proper treatment of the $50,000 gain on the sale of the building, which is Sec. 1250 property. Sec. 1250 recaptures gain as ordinary income to the extent of “excess” depreciation (i.e., depreciation deducted in excess of straight-line). The total gain less any depreciation recapture is Sec. 1231 gain. Since straight-line depreciation was used, there is no recapture under Sec. 1250. However, Sec. 291 requires that the amount of ordinary income on the disposition of Sec. 1250 property by corporations be increased by 20% of the additional amount that would have been ordinary income if the property had instead been Sec. 1245 property. If the building had been Sec. 1245 property the amount of recapture would have been $30,000 ($200,000 − $170,000). Thus, the Sec. 291 ordinary income is $30,000 × 20% = $6,000. The remaining $44,000 is Sec. 1231 gain.

61. (b) The requirement is to determine McEwing Corporation’s taxable income given book income plus additional information regarding items that were included in book income. The loss on sale of the building ($7,000) and gain on sale of the land ($16,000) are Sec. 1231 gains and losses. The resulting Sec. 1231 net gain of $9,000 is then treated as LTCG and will be offset against the LTCL of $8,000 resulting from the sale of investments. Since these items have already been included in book income, McEwing’s taxable income is the same as its book income, $120,000.

62. (a) The realized gain resulting from the involuntary conversion ($125,000 insurance proceeds − $86,000 adjusted basis = $39,000) is recognized only to the extent that the insurance proceeds are not reinvested in similar property ($125,000 − $110,000 = $15,000). Since the machinery was Sec. 1245 property, the recognized gain of $15,000 is recaptured as ordinary income to the extent of the $14,000 of depreciation previously deducted. The remaining $1,000 is Sec. 1231 gain.

Simulations

Task-Based Simulation 1

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Situation

Lou Thomas (social security #123-45-6789) reported the following transactions for calendar-year 2012:

  • Lou sold 100 shares of Copperleaf Industries on October 20, 2012, for $4,200. Lou had acquired the stock for $2,500 on March 1, 2011.
  • Lou sold 200 shares of King Corporation stock for $5,000 on November 15, 2012. He had purchased the stock on February 24, 2012, for $4,000.
  • Thomas had a net short-term capital loss carryforward from 2011 of $7,300, and during December 2012 received a $1,500 capital gain distribution from the Brooks Mutual fund.
  • Thomas did not receive any qualified dividends during this year.

Use the above information to complete the following 2012 Form 8949 and Form 1040 Schedule D for Thomas.

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Task-Based Simulation 2

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Thomas contacts you and indicates that he expects to incur a substantial net capital loss for calendar-year 2013 and wonders what the treatment of the carryforwards will be in future years. Which code section and subsection provides for the treatment of an individual’s capital loss carryforward? Indicate the reference to that citation in the shaded boxes below.

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Simulation Solutions

Task-Based Simulation 1

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Task-Based Simulation 2

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Internal Revenue Code Section 1212, subsection (b) provides that for taxpayers other than corporations, an excess of net short-term capital loss over net long-term capital gain for a taxable year shall be treated as a short-term capital loss in the succeeding taxable year. Similarly, an excess of net long-term capital loss over net short-term capital gain for a taxable year shall be treated as a long-term capital loss in the succeeding taxable year.

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