I.
The Nature of Gross Income
a. Economists’ Concept of Income
i. “Haig-Simons” definition of income:
1. The algebraic sum of
a. The market value of rights exercised in consumption and
b. The change in the value of the store of property rights between
the beginning and end of the period in question
ii. Imputed Income
1. Imputed income refers to the monetary value of goods and services
which someone produces and consumes within the family unit, as well
as the monetary value of using property which someone owns.
2. Imputed income is not included in the concept of income within the U.S.
income tax system
iii. Accreation in Value
1. Although increases in the value of property are within an economic
concept of income, they are not included in the income tax concept of
income for 2 basic reasons:
a. There would be considerable practical problems of compliance,
administration and enforcement because of the need to
annually determine the value of virtually all of a taxpayer’s
property
b. There is a liquidity problem
i. If an income tax is computed by reference to the increase
in value of an individual’s property, a particular taxpayer
may be required to pay income tax even though he has
not received any money or other property during the
year.
iv. The income tax concept of income departs from the Haig-Simons definition of
income by requiring that any appreciation in the value of property must be
realized before it is included in gross income.
b. Tax Law Concept of Income:
1
Less
Equals
Less
Equals
Times
Equals
Less
Plus
Equals
Gross Income
IRC § 62 Deductions
Adjusted Gross Income
Personal Exemptions & either the Standard Deduction or Itemized Deductions
Taxable Income
Tax Rate
Gross Tax Liability
Tax Credits
Alternative Minimum Tax
Net Tax Liability or Tax Refund
i. Realization Requirement
1. For income tax purposes, income does not include the mere increase in
the value of an item of property between two points in time.
2. Income tax confined the concept of income to “gain derived from”
property or labor.
3. There must be some sale or other disposition of an item of property
before the appreciation is “realized” and becomes gain included in gross
income.
ii. Receipt of an Economic Benefit
1. GI may arise indirectly if someone receives an economic benefit, even
though there is no direct receipt of money or other property.
2. If someone receives an economic benefit, it is generally appropriate to
include it in their tax base, even though the amount of the economic
benefit is not attributable to capital, or labor, or both combined.
iii. Borrowing
1. GI doesn’t include amounts of money (or the value of other property)
which is borrowed, because there is a concurrent obligation to repay
that which was borrowed,
2. The borrower doesn’t have any net “accession to wealth” – the
borrowed assets may increase the value of his “sore of wealth” but it is
completely offset by an equal liability, his obligation to repay the loan
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iv. Illegal Gains
1. Money or other property which is illegally acquired is included in gross
income.
v. Rebates
1. If the seller of an item of property provides a rebate of a portion of the
purchase to a purchaser, the amount of the rebate is not income to the
purchaser; rather, it is a reduction of the purchase price of the item of
property.
vi. Damages
1. Amounts received as damages may provide an economic benefit to the
recipient, and thus the amount received may be included in GI.
II.
Examples of Gross Income
a. Compensation for Services: Compensation received for services, including fees,
commissions, most fringe benefits, and similar items, are GI to the recipient.
Compensation includes salary or wages paid in cash, as well as the value of property
and other economic benefits received because of services, which the recipient has
performed, or will perform in the future, unless excluded by statute.
i. Payments “In Kind”
ii. Bargain-Purchase
iii. Compensation Without the Receipt of Cash or Property
iv. Excessive Compensation
v. Fringe Benefits
b. Fringe Benefits (§ 132)
i. The term “fringe benefit” is generally used to describe an economic benefit,
other than cash salary or wages, which is provided to an employee by her
employer as compensation for services
ii. § 132 provides rules for excluding several categories of fringe benefits from GI
including:
1. No-Additional-Cost Services
a. The economic benefit of a service provided to an employee by
her employer is excluded from the employee’s GI if the service is
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of a type offered for sale to customers in the ordinary course of
the employer’s line of business in which the employee is
performing services, and if the employer incurs no substantial
additional cost in providing the service to the employee
[132(a)(1), (b)]
b. To qualify for this exclusion, generally the services must be
provided by employee’s own employer
c. Provision is made for 2 or more employers engaged in the same
line of business to enter into a written reciprocal agreement
under which services may be provided to an employee of
another employer if non of the employers incurs any substantial
additional cost (including lost revenue) in providing the services
under the agreement [§ 132(i), Regs 1.132-2(b)]
2. Qualified Employee Discounts
a. § 132(c)(1) provides an exclusion from GI for the amount of a
“qualified employee discount,” which is the “employee
discount” w/ respect to “qualified property services”
i. Qualified property services includes services or property
(other than real property or investment property) which
are offered for sale by the employer to nonemployee
customers in the ordinary course of the employer’s line
of business in which the employee works [132(c)(4)]
ii. Employee discount is the difference in the price of
property or services which are provided to employees,
and the price at which the same property or services are
offered to nonemployee customers [ 132(c)(3)]
b. QED for Property
i. The exclusion may not exceed an amount equal to the
“gross profit percentage” of the price at which the
property is offered for sale to customers.
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1. Gross profit percentage is essentially the
employer’s average mark-up of the goods, and is
determined by dividing the different between
the aggregate sales price of such property sold to
customers by the employer, less the cost of the
goods, divided by the aggregate sales price of the
property [132(c )(1)(A), (2), (4)]
2. Gross Profit % = (Aggregate sales price – Cost of
goods)  (Aggregate sales price)
c. QED for Services
i. The exclusion may not exceed 20% of the price at which
the services are offered to customers in the ordinary
course of business, regardless of the employer’s gross
profit percentage [132(c)(1)(B)]
3. Working Condition Fringe Benefits
a. Under § 132(d), GI does not include the value of any property or
services provided to an employee by her employer to the extent
that, if the employee paid for the property or services herself,
she would be entitled to a deduction under § 162 or 167.
4. De Minimis Fringe Benefits
a. Defined as any property or service which is so small as to make
accounting for it unreasonable or administratively impractical
b. To determine if de minimis rule applies, consideration is given to
the frequency with which similar benefits are provided to
employees [132(e)(1)]
c. i.e. An eating facility operated by an employer for its employees
is treated as a de minimis fringe if the facility is located on or
near the business premises and if the price charged to
employees for meals is equal to or greater than the costs of
operating the facility [132(e)(2)]
5. Qualified Transportation Fringe Benefits
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a. Transportation Between Residence and Place of Employment
i. T may exclude up to $100/month for employer-provided
transportation in a commuter highway vehicle or for any
transit pass [132(f)(2)(A)]
1. This exclusion applies to the aggregate of the
commuter highway vehicle and transit pass
benefits.
ii. Commuter highway vehicle is one that can seat at least 6
adults (not including the driver) and is used at least 80%
of the time, measured by mileage, to either:
1. Transport employees between their residences
and work, or
2. Transport at least 3 employees on businessrelated trips [132(f)(5)(B)]
iii. Transit pass is any pass or similar item allowing the T to
travel on any mass transit or similar facility [132(f)(5)(A)]
b. Qualified Parking
i. Parking provided by an employee on or near the
employer’s business premises can be excluded from the
employee’s GI up to $175/month (adjusted for inflation
after 1993) [132(f)(1)(C), (f)(2)(B) and (f)(5)(C)]
c. Limitations on Transportation Fringe Benefits
i. If the employer offer the employee a choice between
qualified transportation fringe or cash, the employee has
GI only if chooses the cash [132(f)(4)]
ii. Cash reimbursements for qualified transportaion fringes
qualify for the exclusion, BUT, if the reimbursement is for
a transit pass it will not qualify if a voucher could have
been exchanged for a transit pass by an employer to
employees [132(f)(3)]
6. Qualified Moving Expense Reimbursements
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a. Amounts which an employer pays (or reimburses the employee)
for an employee’s moving expenses are excluded from GI to the
extent that such moving expenses would have been deductible
under § 217 if paid by the employee.
b. Reimbursements for amounts which would not be deductible by
the employee must be included in GI [§ 82}
7. Qualified Retirement Planning Services
a. § 132(a)(7) excludes “qualified retirement planning services”
from GI
i. Qualified retirement planning services include retirement
planning advice furnished by an employer to an
employee and the employee’s spouse about the
employee’s qualified retirement plan, but does not
include services related to retirement planning, such as
tax preparation, accounting, legal or brokerage services
[132(m)]
8. On the Premises Athletic Facilities
a. GI doesn’t include the value of using a gym or other athletic
facility provided to an employee by employer.
b. The athletic facility must be on the premises of the employer, it
must be operated by the employer, and substantially all of the
use of the facility must be by employees [132(j)(4)]
9. Non-discrimination Rules [132(e)(2), (j)(1)]
a. If a benefit is provided under an agreement which discriminates
in favor of the employer’s highly compensated employees, the
exclusions of the following fringe benefits do not apply to those
highly compensated employees:
i. No-additional-cost-services
ii. Qualified employee discounts
iii. Employer provided eating facilities
10. Definition of “Employee”
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a. § 132(h)
c. Gains Derived From Dealings in Property
i. There are 2 factors considered in determining whether a transaction produces
gain, and, if so, how much gain:
1. Amount Realized from the disposition of property – how much in
money or money’s worth (including economic benefit), the property
woner received for the property
2. Adjusted Basis of the property – basic rule for AB is the amount which
the property owner has invested in the property.
3. Thus, a gain realized from the disposition of property is the excess of
the AR over the AB of the property.
ii. Basis:
1. A taxpayer’s basis in an item of property is determined initially upon
acquiring the property, by purchase, gift, bequest, or some other
means, and then may be adjusted upward or downward as a
consequence of subsequent events.
2. Cost Basis
a. The basis of property shall be the cost of such property.
b. If property is purchased for cash, it is clear that the cost basis of
the property is the amount which was paid
c. The costs of acquiring property, such as sales commissions,
which are paid by the purchasers are properly included in the
property’s cost basis, even though such amounts are not paid to
the seller.
3. Deferred Payment
a. The cost basis of property is generally determined at the time
the property is acquired, based upon the amount the party
acquiring the property pays at the time of acquisition, or agrees
to pay in the future (not including interest).
4. Exchanges
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a. Property is often acquired for consideration other than money
(cash) or its equivalent (such as a check) such as when one item
of property is exchanged for another item of property.
b. With regard to the property which is given up, it has an adjusted
basis to the transferor, and thus there will be a gain or loss
depending on what the “amount realized” is in the exchange
i. The AR for the property which is given up is the FMV of
the property received.
c. As to the property which is received in the exchange, the T must
determine its proper cost basis:
i. Because it is the FMV of the property received in an
exchange which determines the AR with regard to the
property given up, it is appropriate in an income tax
context to determine the “cost” of property received in a
taxable exchange to be the FMV of the property
received, rather than the FMV of the property given up.
(Philadelphia Park)
5. “Tax Cost” Basis
a. A person may receive property without transferring cash or
other property to the transferor, and yet receipt of the property
results in tax consequences to the transferee.
b. The cost basis of the property received is its FMV
6. Property Acquired From a Decedent
a. The basis of property acquired from a decedent is generally the
FMV of the property as of the date of decedent’s death. (§ 1014)
b. Because the date of death FMV of the property is often higher
than its adjusted basis in the hands of the decedent just prior to
the decedent’s death  stepped up basis
7. General FMV Rule
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a. The general rule for determining the basis of property acquired
from a decedent is to use the FMV as of the date of the
decedent’s death.
i. This basis rule parallels the general rule of the estate tax
for determining the value of property which is included
in a decedent’s gross estate. (§ 2031)
8. Special Community Property Rule
a. Only ½ of community property is included in a deceased
spouse’s gross estate, thereby receiving a date of death FMV
basis
b. § 1014(b)(6) treats the surviving spouse’s remaining ½ share in
such community property as if it was also “acquired from a
decedent,” thus effectively permitting the surviving spouse to
have a date of death FMV basis in her ½ of the property.
9. § 1014(e) Denial of Stepped-up Basis
a. Enacted to prevent families from abusing tax code to get a
stepped up basis in property – if appreciated property was given
to an ill individual, who would then bequeath it back to the
donor, the property would return to the hands of the initial
donor with a stepped up basis
b. Under § 1014(e) appreciated property will not receive a stepped
up basis if it is acquired by gift by a decedent within 1 year of his
death and if it passes back to the initial donor or the donor’s
spouse. Instead, the property will take a transferred basis, equal
to the donor’s basis in the property prior to the gift to the
decedent
10. Property Acquired by Gift
a. A donor does not have any realized gain when he transfers
property by gift because he generally does not have any AR on
the transfer
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b. The donee is generally treated as stepping into the shoes of the
donor with respect to the gift property and in doing so the
adjusted basis of the property acquired by the gift is the same in
the hands of the donee as it was in the hands of the donor
c. Property acquired by gift is referred to as having a “transferred
basis” (§ 1015)
d. Exception:
i. The general rule does not apply if:
1. The donor’s AB in the property is greater than the
FMV of the property, both amounts computed as
of the date of the gift, and
2. The donee sells or otherwise disposes of the
property in a transaction which would produce a
loss
ii. If the exception applies, the property’s basis (prior to any
adjustments which might be necessary because of events
which have transpired while the property was in the
hands of the donee) is its date of gift FMV (§ 1015(a))
iii. The exception prevents one person who holds loss
property from effectively transferring (i.e. assigning) that
loss deduction to someone else
11. Part Gift Part Sale
a. The transferor-donor recognizes gain only to the extent that her
AR on the sale exceeds her total AB in the property § 1.1001-1(e)
b. The transferee-donee takes the property with a basis = to the
larger of:
i. The amount the transferee pays for the property, or
ii. The amount of the transferor’s basis in the property §
1.1015-4(a)
12. Property Acquired From a Spouse
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a. When property is transferred from an individual to her spouse
(or to her former spouse, if the property is transferred incident
to their divorce), the property is treated as received by the
transferee as a gift, and its value is thereby excluded from his GI
§1041(b)(1)
b. The AB of such property in the hands of the recipient is the same
as the transferor’s AB, § 1041(b)(2)
c. This special rule applies for transfers of property between
spouses (or former spouses); the “gift” basis rules of § 1015 do
not apply., § 1015(e)
13. Adjustments to Basis
a. The AB for determining gain or loss upon the disposition of
property is the property’s basis determined under the
appropriate provisions such as § 1012-1015, adjusted as
provided by § 1016., § 1011(a)
b. Property’s basis is increased in the amount of any capital
additions to the property and decreased in the amount of any
deductions which have been taken reflecting a return to the T of
his investment in the property
c. Increases:
i. The basis of property is increased by the amount of
capital expenditures, such as the cost of capital
improvements made to the property, § 1016(a)(1)
d. Reductions:
i. The amount of the reduction in basis on account of a
deduction for depreciation, amortization or depletion is
the greater of the amount “allowed” (taken) or the
amount “allowable” (could have taken), § 1016(a)(2)
ii. Allowable:
1. The basis of property must be reduced by the
amount such a deduction was “allowable,” even
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though no deduction was actually taken, in order
to discourage T from taking depreciation
deductions only in taxable years in which it is
advantageous for them to do so
iii. Allowed:
1. The basis of property must be reduced to the
extent such a deduction was “allowed” and
resulted in a reduction in the T’s income tax
2. A deduction is “allowed” if it was claimed on the
T’s return, and it was not challenged by the IRS
3. The “tax benefit” element requires a reduction in
the property’s basis only when the T has had an
effective return of his investment, in a tax sense.
iii. Amount Realized
1. The AR is the consideration received for the property; it includes the
sum of any money plus the FMV of any other property received in the
transaction, § 1001(b)
2. FMV of Consideration Received
a. If the value of property received in a taxable exchange cannot be
determined directly, it is presumed to be equal to the value of
the property given up in the exchange (Philadelphia Park)
b. The AR includes the receipt of services and other economic
benefits, including being relieved from liability (Crane)
3. Selling Expenses
a. Commissions and other expenses connected with the disposition
of property which are incurred by a non-dealer seller reduce the
AR
b. Generally, the type of expenditures which reduce the AR, if paid
by the seller, are the same expenditures which would be
included in the cost basis of property if paid by the purchaser
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c. It should be emphasized that the proper treatment of selling
expenses is to reduce the AR – they are not deductions
4. Role of Liabilities
a. If property which is encumbered by a liability is sold or
otherwise disposed of and the liability is either assumed by the
buyer (personal liability) or the property is taken subject to the
liability (nonrecourse liability)
b. If a taxpayer borrows money and mortgages property which he
owns as security for the loan, he does not have gain or GI
because borrowing is not a taxable event as there is no
accession to wealth
c. *Crane and Tufts
d. Gifts and Inheritances
i. Amounts received as a gift, or by bequest, devise or inheritance, are excluded
from GI, § 102(a)
ii. The exclusion does not apply to income from the property received by gift or
inheritance; nor does the exclusion apply to a gift or devise of income from
property [§ 102(b)]; nor does it apply to a gift from an employer to an
employee [§ 102(c)(1)]
iii. Gifts:
1. § 102(a) excludes from GI the value of property “acquired by gift”
2. The Court has concluded that a “gift” is made if the trier of fact
determines that the dominant reason for the transfer (the transferor’s
intention) was “out of affection, respect, admiration, charity or like
impulses,” or from the transferor’s “detached and disinterested
generosity” (Duberstein)
3. When property is transferred to a spouse (or to a former spouse, if the
transfer is incident to a divorce), there is no need to determine the
transferor’s motive; the property is treated as received by the
transferee as a gift, and thus it is excluded from the transferee’s GI [§
1041(b)(1)]
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4. “Tips” received by waiters, taxicab drivers, barbers and others in similar
occupations are not excludable gifts, nor are “tokes” received by casino
craps dealers from gamblers who are motivated by impulsive generosity
and superstition
5. No amount received by an employee from his employer is excluded
from GI as a gift, although some employer provided economic benefits,
such as fringe benefits, are excluded under other provisions of the Code
[§ 132]
iv. Inheritances:
1. The value of property acquired by bequest, devise or inheritance is
excludable from GI [§ 102(a)]
2. The Regs refer to property “received under a will or under statutes of
descent and distribution…” [§ 1.102-1(a)]
3. The statute has been broadly construed to exclude from GI virtually all
acquisitions made with donative intent in the devolution of a
decedent’s estate
4. An amount is not excluded from GI merely because it is provided for in a
will; the exclusion does not apply if the legacy is not of a donative
nature and instead is compensation for services, payment for property,
or some other payment which would be included in income if received
directly rather than by means of a will
III.
Depreciation Deductions
a. A depreciation deduction is allowed in the amount of a “reasonable allowance” for the
exhaustion, wear and tear, or obsolescence of property which is either used in a trade
or business or held for the production of income. 167(a)
i. The “reasonable allowance” for most tangible property is provided under the
Accelerated Cost Recovery System (ACRS)
ii. The “reasonable allowance” for depreciation is a function of the property’s
basis, salvage value, and useful life, as well as the method of depreciation used.
b. The deduction for depreciation is not available for inventory, property held for sale to
customers, or property used for personal purposes.
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c. A deduction may be taken only with respect to property which, by its nature, is subject
to being exhausted, worn out, or becoming obsolete.
d. Cost or Other Basis
i. The depreciation deduction for an item of property is generally computed with
reference to its adjusted basis used for determining gain on the sale or other
disposition of property 167(c)
ii. If the property has been used for personal purposes before being used for
income seeking activities, the FMV of the property as of the date of conversion
is used to compute the depreciation deduction, if that amount is lower than
the property’s AB Reg. 1.167(g)-1
iii. If an item of property is used partly for personal purposes and partly for
business purposes during a taxable year, the property must be divided between
its business and personal uses, and depreciation deductions are allowed only
with respect to the property’s basis allocated to the business use
1. Sharp v. United States – example Hugh purchased an airplane for $54K
which he used 25% for business purposes and 75% for personal
purposes. Depreciation deductions are only allowed on the basis of
$13.5K (25% of $54K)
e. Useful Life
i. The useful life of an item of property is the length of time the property may
reasonably be expected to be used in the T’s particular income seeking activity;
it is not the period of time the property might be actually, physically useful in
some other trade or business or to some other T.
ii. Determining useful life of a particular piece of property to a certain T is
generally a question of fact
iii. To reduce controversies between Ts and the IRS, Congress authorized the IRS
to prescribe useful lives for various classes of property.
1. If an item of property was described in one of the classes, the
corresponding useful life could be used by the T w/o having to provide
proof of its useful life to her in her particular income seeking activity
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iv. If the useful life of property is indefinite or unascertainable, i.e. antique
furniture, no depreciation deduction may be taken
f. Salvage Value
i. The salvage value of property is the amount, determined at the time of
acquisition, which is estimated the property could be sold for at the end of its
useful life to the taxpayer.
ii. The salvage value of a property may represent a significant portion of the value
of the property and not merely its value as scrap.
iii. The salvage value is significant because the total amount of deductions for
depreciation under § 167 may not exceed the excess of the cost or other basis
for computing depreciation over the salvage value of the property
g. Methods for Computing Depreciation
i. For depreciable property not covered by the ACRS rules, there are 3 significant
methods for computing depreciation deductions. Each requires that the
depreciable base of the property be multiplied by the depreciation rate for
each taxable year in which a deduction is allowable.
ii. Straight Line Method
1. Depreciable base = the cost or other basis of the property less its
salvage value
2. Depreciation rate = 1 / The # of years of the property’s useful life
3. The SLM results in an equal amount of depreciation deduction in each
of the years involved.
4. Example: An item of property cost $10K, and it has a salvage value of
$2K and a useful life of 5 years. Under the SLM, the depreciation
deduction in each of the 5 years is $1600 [ ($10K - $2K = $8K) x (1/5) ].
Reg. § 1.167(b)-1. Thus, over 5 years the total depreciation deductions
are $8K
iii. Declining Balance Method
1. Depreciable base = the cost or other basis of the property less the
depreciation deductions allowed or allowable in prior years.
a. Note: cost is not reduced by the property’s salvage value.
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b. Although the salvage value is not taken into consideration in
determining the depreciable base, an item of property may not
be depreciated below its salvage value
2. Depreciation rate = [ 1 / useful life ] x [ factor not exceeding 2 ]
a. If the factor is 2, the method is the double declining balance
method
b. If the factor is 1 ½ it is a 150% declining balance method
3. In each year of the property’s useful life, the depreciable base changes,
but the depreciation rate remains constant [Reg. 1.167(b)-2]
4. Example: same facts as example under SLM, depreciation deductions
under the double declining balance method would be:
Year
Depreciable Base
Depreciation Rate
Depreciation
Allowance
1
$10K
40% (2 x 1/5)
$4K
2
$6K
40%
$2,400
3
$3,600
40%
$1,440
4
$2,160
40%
$160 *
Total Deductions:
$8K
5. * Even though the depreciation allowance for year 4 would seem to be
$864 (40% of $2,160), it is limited to $160 because the salvage value of
the property is $2K. For the same reason, no depreciation deduction
will be allowed in year 5.
iv. Sum of the Years-Digits Method
1. Depreciable base = cost or other basis of the property less its salvage
value
2. Depreciation Rate = # of years remaining the useful life of the property,
including the year the computation is made (changes every year) / the
sum of all the years digits in the useful life of the property
3. In each year of the property’s useful life the depreciable base remains
the same, but eh depreciation rate changes [Reg. 1.167(b)-3]
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4. Example: same facts as above, computation under sum of the yearsdigits method:
Year
Depreciable Base
Depreciation Rate
Depreciation
Allowance
1
$8K
5/15
$2,667
2
$8K
4/15
$2,133
3
$8K
3/15
$1,600
4
$8K
2/15
$1,067
5
$8K
1/15
$533
Total Deductions:
$8K
h. Relationship of Depreciation Deductions to Basis
i. The basis of property must be reduced to account for the amounts allowed
(actually taken) or allowable (could have been taken) for deductions for
depreciation [1016(a)(2)]
ii. So if depreciation is actually taken (depreciation allowed), its basis is reduced
by the amount of deductions taken (except to the extent that there was no
reduction in tax from the deductions)
iii. If property was subject to a depreciation allowance, but no deduction was
taken (the allowable situation) the basis of the property must still be reduced b
the amount the deduction which could have been taken under the SLM
i.
ACRS (Accelerated Cost Recovery System)
i. The general thrust of ACRS is to allow deductions in the nature of depreciation
to be taken at a rate faster than prior law permitted.
ii. Principle Features of ACRS that distinguish it from § 167:
1. The useful life of the property in the T’s business is generally irrelevant
a. Property is assigned to 1 of 10 classes and deductions are spread
over periods ranging from 3 to 50 years
2. The salvage value of the property is not taken into consideration in
computing ACRS deductions, thus 100% of the cost of the property is
deductible
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3. There is no distinction between old and new property; and
4. There are only 2 methods for computing ACRS deductions – either the
accelerated rate prescribed by statute or the straight line method
iii. Deductions are allowed under current ACRS with respect to “any tangible
property” [ 168(a) ]
iv. The deduction allowed under ACRS is deemed to be the “reasonable
allowance” otherwise provided for the exhaustion, wear and tear or
obsolescence of property under § 167 and 168.
v. The basis of property is reduced by the amount of ACRS deductions (allowed or
allowable) [ § 1016(a)(2) ]
vi. Tangible Property
1. Under the ACRS the property must be used in the T’s trade or business
or it must be held for the production of income. The property must, by
its nature, be subject to being exhausted, worn out, or becoming
obsolete, the property must have an ascertainable useful life, and it
must otherwise be of a character subject to the allowance of
depreciation
2. There are 2 cases where the court held that property subject to
depreciation includes antique musical instruments if used by
professional musicians, b/c the instruments are used in a trade or
business, and are subject to wear and tear, which affects the tonal
quality.
3. ACRS does not apply to:
a. Intangible property
b. Certain public utility property
c. Motion picture films and video tapes
d. Sound recordings
e. Property under the unit-of-production method
j.
Anti-Churning Rules
i. Under anti-churning rules, a T may not use current ACRS with respect to
property acquired from a “related person” who had placed the property in
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service before 1987 if the deduction under current ACRS is greater than the
deduction under the method the related person would have to use [ § 168(f)(5)
]
ii. “Related person” means:
1. Spouse
2. Children and other family members
3. Corporations
4. Partnerships
5. Trusts or estates in which the T has an economic interest
k. Operation of Current ACRS
i. The allowable depreciation deductions under current ACRS are determined by
using 3 variables:
1. The applicable depreciation method
2. The applicable recovery period
3. The applicable convention
IV.
Depreciation – Special Rules for Personal Property
a. Personal property used in a trade or business or held for the production of income
may qualify for the bonus depreciation deduction under § 179 AND the ACRS
deduction under § 168
b. § 179 Depreciation
i. T may elect to expense (deduct rather than capitalize) all or a portion of the
cost of any “§ 179 property” in the taxable year its placed in service
1. “Bonus depreciation” is commonly used to describe this deduction
because it’s allowed in addition to the amount of depreciation
deduction otherwise allowable
ii. If deductions are taken under § 179, the property’s basis must be reduced just
like the depreciation deduction and the basis of the property must be reduced
before computing any depreciation deductions under 168
c. § 179 Property
i. Is property which qualifies for current ACRS deductions and which is Ҥ 1245
property” [defined in § 1245(a)(3)]
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1. Thus, the concept is generally confined to tangible personal property
ii. The property must be acquired by purchase for use in the active conduct of
trade or business [§ 179(d)(1)]
1. “Purchase” means any acquisition of property with a cost basis, unless
the property is acquired from certain related individuals, or w/in a
controlled group of corporations, and so long as the property does not
have a substituted basis or a basis determined under the rules
applicable to property acquired from a decedent [§ 179(d)(2)]
iii. The property must be held in a trade or business – property that’s merely held
for the production of income does not qualify
d. Limitations
i. The total amount of deductions which may be taken by a T w/ respect to § 179
property w/in a taxable year is subject to several limitations
1. Dollar Limitation ?????
2. Taxable Income Limitation
a. The bonus depreciation deduction is limited in a taxable year to
the amount of the T’s taxable income (computed w/o regard to
the cost of § 179 property) derived from the active conduct of all
trades or businesses.
b. Amounts disallowed under this limitation are carried over to the
next taxable year [§ 179(b)(3)]
e. Recapture
i. The deduction is allowed w/ respect to specific items of § 179 property which
the T must identify on her income tax return [§ 179(c)(1)]
ii. If a deduction is taken under § 179 w/ respect to an item of property and if at
any time the property ceases to be used predominantly in a trade or business,
even though the property is not disposed of or sold, the T must include in
income the tax benefit derived from the deduction [§ 179(d)(10)]
f. § 168 ACRS
i. Deductions under ACRS may be taken w/ respect to most tangible property
[168(a)]
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ii. ACRS deductions are computed by using the applicable depreciation method,
recovery period and convention concepts (discussed below)
iii. If property qualifies under ACRS, § 168(a) or (g) must be used to compute
depreciation deductions
iv. ACRS is mandatory, not elective
1. Exception: property depreciated under the unit-of-production method
or any other method which is not expressed in a term of years
(excluding the retirement-replacement-betterment method) [§
168(f)(1)]
g. Applicable Depreciation Methods
i. Method applicable to most personal property is the DDBM, switching to the
SLM in the taxable year the SLM (applied to the AB as of the beginning of the
year) produces a deduction larger than that computed under the DDBM for
that year [§ 168(b)(1)]
ii. For property in the 15-year and 20-year classifications the 150% declining
balance method is used initially (again switching to the SLM when that
produces the larger deduction) [§ 168(b)(2)]
iii. Alternatively, the T may use the SLM if he makes an irrevocable election,
applicable to all items of property in the same classification placed in service
during the taxable year [§ 168(b)(5)]
iv. Regardless of the method of depreciation used, the salvage value of property is
treated as zero [§ 168(b)(4)
h. Applicable Recovery Period
i. Determined by its classification which, in turn, takes its name from the
recovery period
1. Thus, the recovery period for 3-year property is 3 years, the recovery
period for 5-year property is 5 years, etc
ii. There are 6 classifications of property which include personal property
[168(e)(1)]
iii. The classification of an item of property is determined by the property’s “class
life” [168(i)(1)]
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1. The “class life” is determined by the IRS according to the physical
characteristics of the property and the nature of the trade or business
in which it is used by the T
iv. Property is assigned to a classification in accordance with its class life under the
following table in § 168(e)(1):
Property shall be treated as:
If such property has a class life (in years) of:
3-year property
4 or less
5-year property
More than 4 but less than 10
7-year property
10 or more but less than 16
10-year property
16 or more but less than 20
15-year property
20 or more but less than 25
20-year property
25 or more
v. Some items of property are specifically assigned to a classification regardless of
the class life of the property, i.e.:
1. Race horses more than 2 years old when first placed into service are
assigned to 3 year property
2. Automobiles and general purpose trucks – specifically assigned to 5year property
3. Single-purpose agricultural or horticultural structures (i.e. greenhouses)
– deemed 10-year property
i.
Applicable Convention
i. The depreciation deduction is allowed for property used in a trade or business
or held for the production of income, and is confined to the time period while it
is being so used – no deduction is appropriate or allowed before the property is
placed in service (or after it is removed from service) in the trade, business or
income producing activity
ii. Various conventions have been developed to deal with the start-up and ending
time periods:
1. Half-year Convention
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a. Treats all personal property placed in service during a taxable
year as if it were placed in service (or removed from service)
precisely in the middle of the year [168(d)(4)(A)]
b. Thus, a depreciation deduction for the taxable year in which
property is first placed in service is computed for half of the
year, regardless of the exact date during the year it was actually
placed in service.
c. Because of the half-year convention, the taxable years over
which the recovery period runs extends into the first half of the
year after the number of years in the recovery period.
2. Mid-quarter Convention
a. Applies if the total basis of property placed in service during the
last 3 months of a taxable year exceeds 40% of the total basis of
property placed in service during the entire year –
nonresidential real property and residential rental property are
disregarded [168(d)(3)]
b. The mid-quarter convention treats property placed in service
during any quarter of the taxable year as if it were placed in
service at the mid-point of the quarter.
c. If the mid-quarter convention applies, then all property placed in
service during a taxable year is subject to the mid-quarter
convention and the mid-year convention doesn’t apply
[168(d)(4)(C)]
V.
Capital Gains and Losses
a. A capital gain or loss arises from the “sale or exchange” of property which is a capital
asset
b. Net Capital Gain
i. § 1222(11) defines as the excess (if any) of a T’s net long-term capital gain for a
taxable year over the T’s net short-term capital losses for that year
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ii. § 1222(7) defines net long-term capital gain as the excess (if any) of a T’s longterm capital gains for a taxable year over the T’s long-term capital losses for the
year
iii. § 1222(6) defines net short-term capital loss as the excess (if any) of T’s shortterm capital losses over the short-term capital gains for the year
c. 28% Rate Gain
i. Gain subject to tax at the 28% rate is the excess (if any) of the sum of
collectibles gain plus 1202 gain over the sum of collectibles loss plus net short
term capital loss for the year, taking into consideration any 1212(b)(1)(A)
carryovers and LTCL carried over
d. Collectibles Gain
i. Gain from the sale or exchange of a collectible which is a capital asset held for
more than one year is known as a collectibles gain [§ 1(h)(5)(A)]
e. Section 1202 Gain
i. Under 1202, a noncorporate T who sells a qualified small business stock held
for more than 5 years can exclude 50% of realized gain from GI
ii. Section 1202 gain is the amount of gain not excluded under that section
[1(h)(7)]
f. Unrecaptured § 1250 Gain
i. When real property is sold or exchanged, a portion of the gain, reflecting
previously taken depreciation deductions, may be required to be recognized as
OI under § 1250(a)
ii. To the extent gain on such property held more than 1 year is attributable to
depreciation deductions and is not recapture under § 1250 or treated as OI
under § 1231, it is unrecaptured § 1250 gain
iii. The net capital gain is excess of unrecaptured § 1250 gain and collectibles gain
is treated as adjusted net capital gain
g. Maximum Rates for Capital Gains
h. Application of Capital Gain Rates
i.
Netting of Net Capital Gains under § 1(h)
i. Netting first occurs w/in each rate classification (28%, 25%, 15%)
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ii. If there are losses w/in any classification, they wipe out net gains that would
otherwise be taxed as the highest rate or combination of rates
iii. Similarly, net STCL first wipes out net 28% gains, then net 25% gains and then
net 15% gains
j.
Treatment of Capital Losses
k. Limitation of Capital Losses
i. Capital losses may be deducted by an individual T only to the extent of capital
gains recognized during a taxable year plus an additional amount
ii. Losses to the Extent of Gains
1. Capital gains must be included in GI, and deduction is allowed for
capital losses incurred up to the amount of such gains recognized - §
1211(b)
iii. Additional Amount
1. Capital losses may be deducted to the extent they exceed capital gains
recognized in a taxable year up to the smallest of the following:
a. $3,000 (or $1,500 if the T is married, filing a separate return), or
b. The excess of capital losses over capital gains – 1211(b)
l.
Capital Loss Carryovers
i. § 1212(b) – if a non-corporate T has a capital loss in excess of the amount
which may be deducted in that year because of the limitations under § 1211,
the excess amount may be carried over and treated as a capital loss incurred in
subsequent tax years
ii. Excess STCL will be carried over as STCL and excess LTCL will be carried over as
LTCL
VI.
Quasi-Capital Assets
a. § 1221(a)(2) – Property used in a T’s trade or business of a character which is subject
to the allowance for depreciation and real property used in a T’s trade or business are
excluded from the statutory definition of capital asset, therefore, the sale or exchange
of such property produces ordinary income
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b. § 1221(1)-(4) – An involuntary conversion (such as by fire or theft) of property does
not involve a sale or exchange, thus, an involuntary conversion of a capital asset
technically produces ordinary income (or loss)
c. Under the special rules of § 1231, capital gain (or loss) treatment may be provided to
the sale or exchange of property used in a trade or business, and to the involuntary or
compulsory conversion of certain capital assets or property used in a trade or business
i. Referred to as “quasi-capital assets”
d. 1231 Property
i. The rules of 1231 apply to 2 categories of property included in the classification
of “1231 Property”:
1. Property used in the trade or business (1231(b)(1)), and
2. Capital assets held for more than 1 year and held in connection w/ a
trade or business or a transaction entered into for profit
ii. 1231(b)(1)
1. Defines property used in a trade or business as property held for more
than 1 year and used in a trade or business, which is either real property
or property of a character subject to the allowance of depreciation
2. Specifically excluded from the definition of property used in t/b are
items of property excluded from the definition of a capital asset under
1221(a)(1), (3), and (5) which are inventory, copyrights and similar
property, and publications of the US Gov
3. Accounts receivable are excluded from the definition of a capital asset
under 1221(a)(4), but are not property used in t/b because they are not
subject to allowance for depreciation
4. Timber, coal, domestic iron ore, livestock and unharvested crops are
also property used in the t/b
e. Subhotchpot
i. Under § 1231, recognized gains and losses arising from fire, storm, shipwreck,
or other casualty, or from theft (involuntary conversion) “§ 1231 property”
which are recognized in a taxable year are netted against each other
ii. Note: condemnations are not included
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iii. If losses > gains, then OI
1. If the losses exceed the gains, then 1231 has no further application in
determining the character of such gains/losses, and because no s/e
(sale or exchange), they are OI (ordinary income)  1231(a)(4)(C)
iv. If gains = or > losses, then each gain/loss will enter the main hotchpot
f. Main Hotchpot
i. The main hotchpot collects all 1231 gains/losses for a taxable year (not thrown
out by the subhotchpot)
ii. §1231(a)(1) – If the 1231 gains > 1231 losses  then each gain/loss is treated
as a long-term capital-gain/loss
iii. § 1231(a)(2) – If 1231 losses = or > 1231 gains  then each gain/loss is treated
as OI
iv. § 1231(a)(3) – a 1231 gain (or loss) is the sum of the recognized gains/losses
from the s/e of property used in the t/b, PLUS the recognized gains/losses from
compulsory or involuntary conversion of 1231 property
g. Recapture
i. If a T has a NET 1231 LOSS for a prior taxable yr, it may affect the character of
NET 1231 GAINS in the current yr
ii. § 1231(c)(1) – If a T has a NET 1231 GAIN in the current yr, it is treated as OI to
the extent of the T’s nonrecaptured NET 1231 LOSS
1. § 1231(c)(2) – Non-recaptured NET 1231 LOSS is the excess of the total
amount of NET 1231 LOSSES for the 5 most preceding taxable yrs over
the portion of such losses previously recaptured
iii. See example in supplement p. 379
VII.
Recapture of Depreciation Under § 1245
a. § 1245 recapture rules override 1231 recapture rules
b. If 1245 property is disposed of, the excess of the lower of either (a) the recomputed
basis of the property, or (b) the AR (if the property is sold/exchanged or involuntarily
converted) or the FMV of the property (if it is otherwise disposed of) OVER the AB of
the property is required to be treated as OI [§ 1245(a)(1)]
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i. The amount of gain required to treated as OI under this provision is required to
recognized, unless an exception is provided in 1245 itself
ii. The general effect of 1245 is to required any recognized gain to be treated as
OI to the extent of any previously allowed depreciation deductions
c. Section 1245 Property
i. Generally includes tangible and intangible property which is or has been
property of a character subject to the allowance for depreciation under § 167
ii. Generally does not include real property, although some items of property
which may be treated as real property under local law, such as a “single
purpose agricultural or horticultural structure” (i.e. greenhouse), are included
in 1245 property
iii.
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