13-1
$20,000 − $0
Tax Policy Considerations
Overview and Priority Of Credits
13-2
Refundable versus Nonrefundable Credits
13-2a
LO.2
Distinguish between refundable and nonrefundable credits and understand the order in which they can be used by
taxpayers.
Exhibit 13.1 identifies some of the more common refundable and nonrefundable credits. Refundable credits are paid to the taxpayer even if the amount
of the credit (or credits) exceeds the taxpayer’s tax liability.
hibit 13.1
Partial Listing of Refundable and Nonrefundable Credits
Exhibit 13.1
Partial Listing of Refundable and Nonrefundable Credits
Refundable Credits
Taxes withheld on wages (Income tax withheld on wages is an example of a refundable credit.)
Earned income credit
Affordable Care Act premium tax credit
Nonrefundable Credits
Credit for elderly and disabled
Adoption expenses credit
Child and dependent tax creditFootnote
Credit for child and dependent care expenses
Education tax creditsFootnote
Energy credits
Credit for certain retirement plan contributions
Small employer health insurance credit
General business credit, which includes:
Tax credit for rehabilitation expenditures
Work opportunity tax credit
Research activities credit
Low-income housing credit
Disabled access credit
Credit for small employer pension plan startup costs
Credit for employer-provided child care
Credit for employer-provided family and medical leave
Credit for Child and Dependent Care Expenses
15,800
The credit for child and dependent care expenses mitigates the inequity felt by working taxpayers who must pay for child care services to work outside
the home. The credit is a specified percentage of child and dependent care expenses. The credit percentage varies based on the taxpayer’s AGI, and
expenses are capped at a maximum of $6,000.
200,000
Full credit and capitalize and elect
to amortize costs over 60 months
$20,000 − $0
Eligibility
20,000
($200,000/60) × 12
40,000


Basic Research Credit
Corporations (other than S corporations or personal service corporations) are allowed an additional 20 percent credit for basic research payments made
Bill
in excess of a base amount. Basic research is defined generally as any original
investigation for the advancement of scientific knowledge not having a
$250 States and in the social sciences, arts, or humanities does not qualify. This
specific commercial objective. Basic research conducted outside the United
reflects the intent of Congress to use the credit to encourage domestic350
high-tech research.
The basic research credit calculation is complex and is based on expenditures in excess of a specially defined base amount. The portion of the basic
research expenditures not in excess of the base amount qualifies for the incremental research activities credit.
Example 15
Orange Corporation pays $75,000 to a university for basic research. Orange’s base amount for the basic research credit is $50,000. The basic research
activities credit allowed is $5,000 [($75,000 − $50,000) × 20%]. The $50,000 of basic research expenditures that equal the base amount also can be
treated as research expenses for purposes of the regular incremental research activities credit.
Energy Research Credit
This component of the research credit encourages taxpayers to support a specific type of exempt organization conducting energy research (called an
energy research consortium). The credit is equal to 20 percent of payments made to these organizations.
13- 3d
Low-Income Housing Credit
To encourage the development of affordable housing for low-income individuals, a credit is available to owners of qualified low-income housing projects.
More than any other credit, the low-income housing credit is influenced by nontax factors. For example, these credits are distributed nationally to
various state and local agencies. So the property must be approved by the appropriate agency authorized to provide low-income housing credits.
The credit is based on the number of units rented to low-income tenants. Tenants are low-income tenants if their income does not exceed a specified
percentage of the area median gross income. The amount of the credit is determined by multiplying the qualified basis by a credit rate.
Generally, first-year credits are prorated based on the date the project is placed in service. A full year’s credit is taken in each of the next nine years, and
any remaining first-year credit is claimed in the eleventh year. The credit is claimed over a 10-year period if the property continues to meet the required
conditions.
Example 16
To be eligible for the credit, an individual must have either:
A dependent under age 13, or
A dependent or spouse who is physically or mentally incapacitated and who lives with the taxpayer for more than one-half of the year.
Generally, married taxpayers must file a joint return to obtain the credit.
Eligible Employment-Related Expenses
Carmen
Eligible expenses include amounts paid for household services and care of a qualifying individual that are incurred to enable the taxpayer to be
$250
employed.
The care can be provided in the home (e.g., by a nanny) or outside the home (e.g., at a day-care center).
−0−
Out-of-the-home
expenses incurred for an older dependent or spouse who is physically or mentally incapacitated qualify for the credit if that person
regularly spends at least eight hours each day in the taxpayer’s household. This makes the credit available to taxpayers who keep handicapped older
children and elderly relatives in the home instead of institutionalizing them.
Child care payments to a relative are eligible for the credit unless the relative is a child (under age 19) of the taxpayer.
Example 24
Wilma is an employed mother of an eight-year-old child. She pays her mother, Rita, $1,500 per year to care for the child after school. Wilma pays her
daughter Eleanor, age 17, $900 for the child’s care during the summer. Of these amounts, only the $1,500 paid to Rita qualifies as employment-related
child care expenses.
Earned Income Ceiling
Qualifying employment-related expenses are limited to an individual’s earned income. For married taxpayers, this limitation applies to the spouse with
the lesser amount of earned income. Special rules are provided for taxpayers with nonworking spouses who are disabled or are full-time students. Here,
the nonworking spouse is deemed to have earned income of $250 per month if there is one qualifying individual in the household or $500 per month.
The maximum credit for child and dependent are expenses is $2,100 if only one spouse is employed and the other spouse is a full-time student. If there
are two or more qualifying individuals in the household. In the case of a student-spouse, only months when the student is enrolled on a full-time basis
are counted.
Calculation of the Credit
In general, the credit is equal to a percentage of unreimbursed employment-related expenses up to $3,000 for one qualifying individual and $6,000 for
two or more individuals. The credit rate varies between 20 percent and 35 percent, depending on the taxpayer’s AGI (see Exhibit 13.3).
Exhibit 13.3
Child and Dependent Care Credit Computations
Sarah spends $1 million to build a qualified low-income housing project that is completed on January 1 of the current year. The entire project is rented to
low-income families. Assume that the credit rate for property placed in service during January is 7.48%. Sarah may claim a credit of $74,800 ($1,000,000
× 7.48%) in the current year and in each of the following nine years.
If Sarah only made 75% of the project’s units available to low-income families, her credit would be $56,100 [($1,000,000 × 75%) × 7.48%].
Recapture of a portion of the credit may be required if certain events occur (e.g., if the number of low-income tenant units falls below a minimum
threshold or if the taxpayer sells the property).
Adjusted Gross Income
Over
Example 5
Example 6
Tina is single, age 67, and retired. Her taxable income for 2018 is $1,320, and the tax on this amount is $132. Tina’s tax credit for the elderly is $225. This
nonrefundable credit can be used to reduce her net tax liability to zero, but it will not result in a refund, even though the credit ($225) exceeds Tina’s tax
liability ($132).
Some nonrefundable credits, like the general business credit, can be “carried over” to other tax years if they exceed the credit allowed in a given year.
Other nonrefundable credits, like the tax credit for the elderly, simply are lost if they exceed the limitations. Because some credits are refundable and
others are not and because some credits are subject to carryover provisions while others are not, the order in which credits are offset against the tax
liability can be important.
Business Credit
The general business credit is composed of a number of other credits, each of which is computed separately under its own set of rules. The general
business credit combines these credits into one amount to limit the amount of business credits that can be used to offset a taxpayer’s income tax
liability.
Two special rules apply to the general business credit. First, any unused credit must be carried back 1 year, then forward 20 years. Second, for any tax
year, the general business credit is limited to the taxpayer’s net income tax reduced by the greater of:
The tentative minimum tax.
25 percent of net regular tax liability that exceeds $25,000.
Net regular tax liability is the regular tax liability reduced by certain nonrefundable credits (e.g., credit for child and dependent care expenses and foreign
tax credit).
Example 7
Aleshia’s general business credit for the current year is $70,000. Her net income tax is $150,000, tentative minimum tax is $130,000, and net regular tax
liability is $150,000. She has no other tax credits. Aleshia’s general business credit allowed for the tax year is computed as follows.
The disabled access credit encourages eligible small businesses to make their facilities accessible to disabled individuals. The credit is 50 percent of the
eligible expenditures that exceed $250 but do not exceed $10,250. As a result, the maximum credit is $5,000 ($10,000 × 50%).
An eligible small business is a business that during the previous year either had gross receipts of $1 million or less or had no more than 30 full-time
employees. An eligible business can include a sole proprietorship, a partnership, a regular corporation, or an S corporation.
Eligible expenditures include reasonable and necessary amounts that are paid or incurred to make older buildings accessible (only buildings first placed
in service before November 6, 1990, qualify). Qualifying projects include installing ramps, widening doorways, and adding raised markings on elevator
control buttons. Costs to assist hearing- or visually-impaired employees or customers who interact with the business also qualify. These costs can include
both personnel (e.g., an interpreter) or equipment (e.g, audio or visual equipment or modifications to existing equipment).
The property’s tax basis is reduced by the amount of the credit.
This year, Red, Inc., an eligible small business, makes $11,000 of capital improvements to a building that had been placed in service in June 1990. The
improvements make Red’s business more accessible to the disabled and are eligible expenditures for purposes of the disabled access credit.
The amount of the credit is $5,000 [($10,250 − $250) × 50%]. Although $11,000 of eligible expenditures are incurred, only $10,000 qualifies for the credit.
The capital improvements have a depreciable basis of $6,000 [$11,000 (cost) − $5,000 (amount of the credit)].
13-3f
Treatment of Unused General Business Credits
13-
2c
Unused general business credits are initially carried back one year and are applied to reduce the tax liability during that year. Thus, the taxpayer may
receive a tax refund as a result of the carryback. Any remaining unused credits are then carried forward 20 years.
A FIFO method is applied to the carrybacks, carryovers, and utilization of credits earned during a particular year. By using the oldest credits first, the FIFO
method minimizes the potential for loss of a general business credit benefit due to the expiration of credit carryovers.
Example 8
This example illustrates the use of general business credit carryovers.
Example 18
Maple Company decides to establish a qualified retirement plan for its employees. In the process, it pays consulting fees of $1,200 to a firm that will
provide educational seminars to Maple’s employees and will assist the payroll department in making necessary changes to the payroll system.
Maple may claim a credit for the pension plan startup costs of $500 ($1,200 of qualifying costs, limited to $1,000 × 50%), and its deduction for these
expenses is reduced to $700 ($1,200 − $500).
Credit for Employer-Provided Child Care
13An employer’s expenses to provide for the care of employee children is a deductible business expense. Alternatively, employers may claim a credit for
providing child care facilities to their employees during normal working hours.
The credit for employer-provided child care, limited annually to $150,000, is composed of the aggregate of two components: 25 percent of qualified
child care expenses and 10 percent of qualified child care resource and referral services. Qualified child care expenses include the costs of acquiring,
constructing, rehabilitating, expanding, and operating a child care facility. Child care resource and referral services include amounts paid or incurred
under a contract to provide child care resource and referral services to an employee.
Any qualifying expenses otherwise deductible by the taxpayer are reduced by the amount of the credit. In addition, the taxpayer’s basis for any property
acquired or constructed and used for qualifying purposes is reduced by the amount of the credit. If within 10 years of being placed in service a child care
facility ceases to be used for a qualified use, the taxpayer will be required to recapture a portion of the credit previously claimed.
3g
During the year, Tan Company constructed a child care facility for $400,000. The facility will be used by Tan employees who have preschool-aged children
in need of child care services while their parents are at work. In addition, Tan incurred salaries for child care workers and other administrative costs
associated with the facility of $100,000.
As a result, Tan’s credit for employer-provided child care is $125,000 [($400,000 + $100,000) × 25%]. Correspondingly, the basis of the facility is reduced
to $300,000 ($400,000 − $100,000), and the deduction for salaries and administrative costs is reduced to $75,000 ($100,000 − $25,000).
13- 3h
Credit for Employer-Provided Family and Medical Leave
Employers can claim a general business credit equal to 12.5 percent of the wages paid to qualifying employees while they are on family and medical
leave. To claim the credit for employer-provided family and medical leave, employers must pay a minimum of 50 percent of the wages normally paid to
an employee during the leave. If the wages paid during the leave exceed 50 percent of normal wages, the credit is increased by .25 percentage point for
each percentage point above 50 percent. For example, if the employer pays 60 percent of the usual wages, then the credit is 15 percent [12.5 percent +
(0.25 × 10)].
The credit is capped at 25 percent of wages paid (this would be allowed if the employer paid 100 percent of the employee’s wages during the leave). The
credit is limited to 12 weeks of leave per employee during any taxable year.
An employer must have a written policy in place that allows all qualifying full-time employees no less than two weeks of annual paid family and medical
leave (non-full-time employees must be offered leave on a pro rata basis). Wages paid as vacation leave, personal leave, or other medical or sick leave
are not considered to be family and medical leave. The credit applies to wages paid in taxable years beginning after 2017 and before 2020.
Other Tax Credits
Earned Income Credit
13-4
13-4a
LO.4
Describe various tax credits that are available primarily to individual taxpayers.
Specific Business-Related Tax Credits
LO.3
Describe various business-related tax credits.
Each component of the general business credit is determined separately under its own set of rules. Some of the more important credits that make up the
general business credit are explained here in the order listed in Exhibit 13.1.
Tax Credit for Rehabilitation Expenditures
13-3a
The rehabilitation expenditures credit is intended to discourage businesses from moving from older, economically distressed areas (e.g., inner cities) to
newer locations and to encourage the preservation of historic structures. The credit is 20 percent of qualified rehabilitation expenditures related to a
certified historic structure (either residential or nonresidential). No credit is allowed for the rehab of a non-historic structure. The 20 percent credit is
taken ratably over a five-year period starting with the year the rehabilitated building is placed in service. When taking the credit, the basis of a
rehabilitated building must be reduced by the full rehabilitation credit allowed. Basis is increased to meet the incurred qualifying expenditures and then
minus the credit.
The earned income credit provides income tax equity to the working poor. In addition, the credit helps to offset other Federal taxes, such as the gasoline
tax, that impose a relatively larger burden on low-income taxpayers. Further, the credit encourages economically disadvantaged individuals to become
contributing members of the workforce.
The earned income credit is determined by multiplying a maximum amount of earned income by the appropriate credit percentage (see Exhibit 13.2).
Generally, earned income includes employee compensation and net earnings from self-employment; it excludes items such as interest, dividends,
pension benefits, nontaxable employee compensation, and alimony. If a taxpayer has children, the credit percentage used in the calculation depends on
the number of qualifying children. REMEMBER DANA, THE PHASEOUT IS SUBTRACTED FROM BASE CALC.
Exhibit 13.2Earned Income Credit and Phaseout Percentages
13-3b
The credit is generally equal to 40 percent of the first $6,000 of wages (per eligible employee) for the first 12 months of employment. In general, the
credit is not available for any wages paid to an employee after the first year of employment. HOWEVER; If the employee’s first year overlaps two of the
employer’s tax years, however, the employer may take the credit over two tax years. If the credit is taken, the employer’s tax deduction for wages is
reduced by the amount of the credit.
For an employer to qualify for the 40 percent credit, the employee must (1) be certified by a designated local agency as being a member of one of the
targeted groups and (2) have completed at least 400 hours of service to the employer. If an employee meets the first condition but not the second, the
credit rate is reduced to 25 percent provided the employee has completed a minimum of 120 hours of service to the employer.
Example 10
Work Opportunity Credit Calculation
In January 2018, Green Company hires four individuals who are certified to be members of a qualifying targeted group. Each employee works 800 hours
and is paid wages of $8,000 during the year. Green Company’s work opportunity credit is $9,600 [($6,000 × 40%) × 4 employees].
If the tax credit is taken, Green must reduce its deduction for wages paid by $9,600. No credit is available for wages paid to these employees after their
first year of employment.
Example 11
Work Opportunity Credit Calculation
On June 1, 2018, Maria, a calendar year taxpayer, hires Joe, a certified member of a targeted group. During the last seven months of 2018, Joe is paid
$3,500 for 500 hours of work. Maria is allowed a credit of $1,400 ($3,500 × 40%) for 2018. Joe continues to work for Maria in 2019 and is paid $7,000
through May 31, 2019.
Because up to $6,000 of first-year wages are eligible for the credit, Maria is allowed a 40% credit on $2,500 [$6,000 − $3,500 (wages paid in 2018)] of
wages paid in 2019. The credit is $1,000 ($2,500 × 40%). None of Joe’s wages paid after May 31, 2019, the end of the first year of Joe’s employment, are
eligible for the credit.

13-3c

To encourage business-related research and experimentation, also termed research and development (R&D), a credit is allowed for certain qualifying
expenditures paid or incurred by a taxpayer. The research activities credit is the sum of three components: an incremental research activities credit, a
basic research credit, and an energy research credit.
Research Activities Credit
Incremental Research Activities Credit
The incremental research activities credit is equal to 20 percent of the excess of qualified research expenses for the taxable year over the base amount.
In general, research expenditures qualify if the research relates to discovering technological information that is intended for use in the development of a
new or improved business component of the taxpayer. If the research is performed in-house (by the taxpayer or employees), all of the expenses qualify.
If the research is contracted to others outside the taxpayer’s business, only 65 percent of the amount paid qualifies for the credit.
Example 12
Javiera incurs the following research expenditures.
In-house wages, supplies, computer time
Paid to Cutting Edge Scientific (a contractor)

Javiera’s qualified research expenditures are $69,500 [$50,000 + ($30,000 × 65%)].

The incremental research credit is not allowed for:
Research conducted once commercial production begins.
Surveys and studies such as market research, testing, or routine data collection.
Research conducted outside the US United States, Puerto Rico, or U.S. possessions.
Research in the social sciences, arts, or humanities.
Determining the base amount involves a relatively complex series of computations meant to approximate recent historical levels of research activity by
the taxpayer. As a result, the credit is allowed only for increases in research expenses.
Example 13
Jack, a calendar year taxpayer, incurs qualifying research expenditures of $200,000 at the beginning of the year. Assuming that the base amount is
$100,000, the incremental research activities credit is $20,000 [($200,000 − $100,000) × 20%].
In addition to qualifying for the research credit, research expenditures also can be deducted in the year incurred. One of three options must be chosen by
the taxpayer.
Use the full credit and reduce the expense deduction for research expenses by 100 percent of the credit,
Retain the full expense deduction and reduce the credit by the product of the full credit times the corporate income tax rate (21 percent), or
Use the full credit, capitalize the research expenses, and amortize them over 60 months or more.
Example 14
Assume the same facts as in Example 13, which shows that the potential incremental research activities credit is $20,000. In the current year, the
expense that the taxpayer can deduct and the credit amount under each of the three choices are as follows.
Credit Amount
Deduction Amount
Full credit and reduced deduction
35%
17,000
34%
17,000
19,000
33%
19,000
21,000
32%
21,000
23,000
31%
23,000
25,000
30%
25,000
27,000
29%
27,000
29,000
28%
29,000
31,000
27%
31,000
33,000
26%
33,000
35,000
25%
35,000
37,000
24%
37,000
39,000
23%
39,000
41,000
22%
41,000
43,000
21%
43,000
No limit
20%
Example 25
Nancy, who has two children under age 13, worked full-time while her spouse, Ron, was attending college for 10 months during the year. Nancy earned
$22,000 and incurred $6,200 of child care expenses. Ron is deemed to have earned $500 for each of the 10 months (or a total of $5,000).
Because Nancy and Ron report AGI of $22,000, they are allowed a credit rate of 31%. Nancy and Ron are limited to $5,000 in qualified child care expenses
($6,000 maximum expenses, limited to Ron’s deemed earned income of $5,000). Therefore, they are entitled to a tax credit of $1,550 (31% × $5,000).
Ethics & Equity
Is This the Right Way to Use the Credit for Child and Dependent Care Expenses?
Your friends, Tim and Susan, have hired a child care provider (Rebecca) to come into their home while they are at work to care for their two children.
Rebecca charges $4,500 for her services for the year. Tim and Susan have discovered that up to $6,000 of qualifying expenditures will generate a credit
for child and dependent care expenses and that qualifying expenditures can include payments for housecleaning services.
As a result, they ask Rebecca whether she would be interested in working several hours more per week, after Tim returns from work, for the sole
purpose of cleaning the house. Tim and Susan offer to pay Rebecca $1,500 for the additional work. For Tim and Susan, the net cost of the additional
services would be $1,200 [$1,500 − ($1,500 × 20%)] due to the availability of the credit for child and dependent care expenses.
You learn of Tim and Susan’s opportunity but think it is unfair. If you hired someone to perform similar housecleaning services at the same price, your net
cost would be $1,500, not $1,200, because you do not qualify for the credit. You are troubled by this inequity. Is your intuition correct?
Dependent Care Assistance Program
A taxpayer is allowed an exclusion from gross income for a limited amount of employer- reimbursed child or dependent care expenses. If this occurs, the
$3,000 and $6,000 ceilings for allowable child and dependent care expenses are reduced dollar for dollar by the amount of reimbursement.
Education Tax Credits
13-4f
In 2018, the maximum earned income credit for a taxpayer with one qualifying child is $3,461 ($10,180 × 34%), $5,716 ($14,290 ×3 40%) for a taxpayer
with two qualifying children, and $6,431 (14,290 × 45%) for a taxpayer with three or more qualifying children. However, the maximum earned income
credit is phased out completely if the taxpayer’s earned income or AGI exceeds certain thresholds, as shown in Exhibit 13.2.
To the extent that the greater of earned income or AGI exceeds $24,350 in 2018 for married taxpayers filing a joint return ($18,660 PHASEOUT for other
taxpayers), the difference, multiplied by the appropriate phaseout percentage, is subtracted from the maximum earned income credit.
Example 20
Computation of the Work Opportunity Tax Credit: General
$15,000
15,000
Example 26
Work Opportunity Tax Credit
The work opportunity tax credit encourages employers to hire individuals from one or more of a number of targeted and economically disadvantaged
groups. Examples include long-term unemployed individuals (those unemployed for at least 27 weeks), qualified ex-felons, high-risk youths, food stamp
recipients, veterans, summer youth employees, and long-term family assistance recipients.
$0
Assume the same facts as in Example 25, except that of the $6,200 paid for child care, Nancy was reimbursed $2,500 by her employer under a qualified
dependent care assistance program. Under the employer’s plan, the reimbursement reduces Nancy’s taxable wages. As a result, Nancy and Ron have AGI
of $19,500 ($22,000 − $2,500).
In this case, the child care ceiling of $6,000 is reduced by the $2,500 reimbursement, resulting in a tax credit of $1,120 [32% × ($6,000 − $2,500)].
Example 9
In the current year, Juan spent $100,000 to rehabilitate a certified historic structure (adjusted basis of $40,000). He is allowed a $20,000 (20% ×
$100,000) credit for rehabilitation expenditures. The credit will be spread equally over five years ($4,000 per year). Juan then increases the basis of the
building by $80,000 [$100,000 (rehabilitation expenditures) − $20,000 (credit allowed)].
To qualify for the credit, certified historic structures must be substantially rehabilitated during a 24-month period. A building has been substantially
rehabilitated if qualified rehabilitation expenditures exceed the greater of:
The adjusted basis of the property before the rehabilitation expenditures, or
$5,000.
Qualified rehabilitation expenditures do not include the cost of acquiring a building, the cost of facilities related to a building (such as a parking lot), and
the cost of enlarging an existing building.
Applicable Rate of Credit
Credit for Small Employer Pension Plan Startup Costs
Small businesses are entitled to a nonrefundable credit for administrative costs associated with establishing and maintaining certain qualified retirement
plans. While these costs (e.g., payroll system changes, retirement-related education programs, and consulting fees) are deductible as ordinary and
necessary business expenses, the credit lowers the after-tax cost of establishing a qualified retirement program and encourages eligible employers to
offer retirement plans for their employees.
The credit for small employer pension plan startup costs is 50 percent of qualified startup costs. An eligible employer is one with fewer than 100
employees who have earned at least $5,000 of compensation. The maximum credit is $500 (based on a maximum $1,000 of qualifying expenses), and
the deduction for the startup costs incurred is reduced by the amount of the credit. The credit can be claimed for qualifying costs incurred in each of the
three years beginning with the tax year in which the retirement plan becomes effective (maximum total credit over three years of $1,500).
Example 19
Aleshia then has $50,000 ($70,000 − $20,000) of unused general business credits that may be carried back or forward as discussed below.
But Not Over
Disabled Access Credit
13- 3e
Example 17
Ted, who is single, had taxable income of $21,000 in 2018. His income tax from the 2018 Tax Rate Schedule is $2,674. During 2018, Ted’s employer
withheld income tax of $3,200. Ted is entitled to a refund of $526, because the credit for tax withheld on wages is a refundable credit.
Nonrefundable credits are not paid if they exceed the taxpayer’s tax liability.
13-2bGeneral
partially refundable (up to $1,400 per child, but no more than 15 percent of earned income in excess of $2,500). The dependent tax credit is not
refundable. See text Section 3-4e for a complete discussion of these credits.
$180,000
13- 4e
$20,000 − [(100% × $20,000) ×
21%]
$200,000 − $0
Example 4
Assume that Congress wants to encourage a certain type of expenditure. One way to accomplish this objective is to allow a tax credit of 25% for these
expenditures. Another way is to allow an itemized deduction for the expenditures. Assume that Abby’s tax rate is 15% and Bill’s tax rate is 35% and that
each itemizes deductions. In addition, assume that Carmen does not incur enough qualifying expenditures to itemize deductions. The following tax
benefits are available to each taxpayer for a $1,000 expenditure.
Abby
Tax benefit if a 25% credit is allowed
$250
Tax benefit if an itemized deduction is allowed
150
As these results indicate, tax credits provide benefits on a more equitable basis than do tax deductions—all three taxpayers reduce their tax liabilities by
the same amount. Equally apparent is that the deduction approach in this case benefits only taxpayers who itemize deductions, while the credit
approach benefits all taxpayers who make the specified expenditure.
$20,000
$200,000 − $20,000
Reduced credit and full deduction
Congress generally uses tax credits to achieve social or economic objectives or to promote equity among different types of taxpayers. For example, the
disabled access credit was enacted to accomplish a social objective: to encourage taxpayers to renovate older buildings so that they would be in
compliance with the Americans with Disabilities Act. The research activities credit encourages high-tech and energy research in the United States. The
use of tax credits as a tax policy tool continues to evolve as economic and political circumstances change.
A tax credit is much different from an income tax deduction. Income tax deductions reduce a taxpayer’s tax base; tax credits reduce a taxpayer’s tax
liability. As a result, the tax benefit received from a tax deduction depends on the tax rate; a tax credit is not affected by the tax rate of the taxpayer.
In 2018, Grace Brown, who is married, files a joint return and otherwise qualifies for the earned income credit. Grace receives wages of $26,000, and she
and her husband earn no other income. The Browns have one qualifying child. The current earned income credit is $3,461($10,180 × 34%) reduced by
$264 [($26,000 − $24,350) × 15.98%]. As a result, the earned income credit is $3,197.
If, instead, the Browns have three or more qualifying children, the calculation produces a credit of $6,431($14,290 × 45%) reduced by $347 [($26,000 −
$24,350) × 21.06%]. As a result, the Browns’ earned income credit is $6,084.
Earned Income Credit Table
It is not necessary to compute the credit as shown in Example 20. To simplify the compliance process, the IRS issues an Earned Income Credit Table for
the determination of the appropriate amount of the credit. This table and a worksheet are included in the instructions available to individual taxpayers.
Eligibility Requirements
Eligibility for the credit depends not only on the taxpayer meeting the earned income and AGI thresholds but also on whether he or she has a qualifying
child. The term qualifying child generally has the same meaning here as it does for purposes of determining who qualifies as a dependent (see text
Section 3-4a).
In addition to being available for taxpayers with qualifying children, the earned income credit is also available to certain workers without children. It is
available only to taxpayers ages 25 through 64 who cannot be claimed as a dependent on another taxpayer’s return. As shown in Exhibit 13.2, the credit
for 2018 is calculated on a maximum earned income of $6,780 times 7.65 percent and reduced by 7.65 percent of earned income over $14,170 for
married taxpayers filing a joint return ($8,490 for other taxpayers).
The American Opportunity credit and the lifetime learning credit are available to help qualifying low- and middle-income individuals defray the cost of
higher education. The credits are available for qualifying tuition and related expenses incurred by students pursuing undergraduate or graduate degrees
or vocational training. Books and other course materials are eligible for the American Opportunity credit (but not the lifetime learning credit). Room and
board are ineligible for both credits.
Maximum Credit
The American Opportunity credit permits a maximum credit of $2,500 per year (100 percent of the first $2,000 of tuition expenses plus 25 percent of the
next $2,000 of tuition expenses) for the first four years of postsecondary education. The lifetime learning credit permits a credit of 20 percent of
qualifying expenses (up to $10,000 per year) incurred in a year in which the American Opportunity credit is not claimed. Generally, the lifetime learning
credit is used for individuals who are beyond the first four years of postsecondary education.
Eligible Individuals
Both education credits are available for qualified expenses incurred by a taxpayer, taxpayer’s spouse, or taxpayer’s dependent. The American
Opportunity credit is available per eligible student, while the lifetime learning credit is calculated per taxpayer. To be eligible for the American
Opportunity credit, a student must take at least one-half the full-time course load for at least one academic term at a qualifying educational institution.
No comparable requirement exists for the lifetime learning credit. So taxpayers who are seeking new job skills or maintaining existing skills through
graduate training or continuing education are eligible for the lifetime learning credit. Taxpayers who are married must file a joint return to claim either
education credit.
Income Limitations and Refundability
Both education credits are subject to income limitations, which differ by credit. Forty percent of the American Opportunity credit is refundable, and it
can offset a taxpayer’s alternative minimum tax (AMT) liability (the lifetime learning credit is neither refundable nor an AMT liability offset).
The American Opportunity credit amount is phased out beginning when the taxpayer’s AGI (modified for this purpose) reaches $80,000 ($160,000 for
married taxpayers filing jointly). The credit is phased out proportionally over a $10,000 ($20,000 for married taxpayers filing jointly) phaseout range. As a
result, the credit is eliminated when modified AGI reaches $90,000 ($180,000 for married taxpayers filing jointly).
For 2018, the lifetime learning credit amount is phased out beginning when the taxpayer’s AGI (modified for this purpose) reaches $57,000 ($114,000 for
married taxpayers filing jointly). The credit is phased out proportionally over a $10,000 ($20,000 for married taxpayers filing jointly) range. As a result,
the credit is eliminated when AGI reaches $67,000 ($134,000 for married taxpayers filing jointly).
Example 27
Example 21
Walt, who is single, is 28 years of age, and is not claimed as a dependent on anyone else’s return, earns $8,700 during 2018. Even though he does not
have any qualifying children, he qualifies for the earned income credit. His credit is $519 ($6,785 × 7.65%) reduced by $16 [($8,700 − $8,490) × 7.65%]. As
a result, Walt’s earned income credit is $503.
If, instead, Walt’s earned income is $8,000, his earned income credit is $519. Here, there is no phaseout of the maximum credit because his earned
income does not exceed $8,490.
13-4bTax
Credit for Elderly or Disabled Taxpayers
The credit for the elderly provides tax relief to individuals who are not receiving substantial benefits from tax-free Social Security payments. The tax
credit for the elderly or disabled is available to:
Taxpayers age 65 or older, or
Taxpayers under age 65 who are retired with a permanent and total disability and who have disability income from a public or private employer on
account of the disability.
The maximum allowable credit is 15 percent of qualifying retirement income (in general, $5,000 for single taxpayers or married taxpayers where one
spouse qualifies; $7,500 for married taxpayers filing jointly where both spouses qualify). This qualifying income amount is reduced by (1) Social Security,
Railroad Retirement, and certain excluded pension benefits and (2) one-half of the taxpayer’s AGI in excess of a threshold amount based on filing status
(in general, $10,000 for married filing jointly, $7,500 for single or head of household, and $5,000 for married filing separately). Given the AGI thresholds,
very few taxpayers qualify for this credit.
EX: $7,500 (BASE AMOUNT MFJ)- ssa BENEFITS- 50% OF AGI THAT IS IN EXCESS OF $10,000.
13-4c
Adoption Expenses Credit
The adoption expenses credit assists taxpayers who incur nonrecurring costs directly associated with the adoption process, such as adoption fees,
attorney fees, court costs, social service review costs, and transportation costs.
In 2018, up to $13,810 of costs incurred to adopt an eligible child qualify for the credit. An eligible child is either:
Under 18 years of age at the time of the adoption, or
Physically or mentally incapable of taking care of himself or herself.
In general, taxpayers claim the credit in the year the adoption is completed. If the adoption is not completed, the credit can be claimed in a following
year. A married couple must file a joint return to claim the credit.
Example 22
In late 2017, Sam and Martha pay $4,000 in legal fees, adoption fees, and other expenses directly related to the adoption of an infant daughter, Susan. In
2018, the year in which the adoption is completed, they pay an additional $10,000. Sam and Martha are eligible for a $13,810 credit in 2018 (for
expenses of $14,000, paid in 2017 and 2018, limited by the $13,810 ceiling in 2018).
The credit is phased out for taxpayers whose AGI (modified for this purpose) exceeds $207,140 in 2018, and the credit is completely eliminated when AGI
reaches $247,140. The resulting credit is calculated by reducing the allowable credit (determined without this reduction) by the allowable credit

multiplied by the ratio of the excess of the taxpayer’s AGI over $207,140 to $40,000.

Example 23

Assume the same facts as in the previous example, except that Sam and Martha’s AGI is $232,140 in 2018. As a result, their available credit in 2018 is
reduced from $13,810 to $5,179 {$13,810 − [$13,810 × ($25,000/$40,000)]}.
The adoption credit is nonrefundable. However, any unused adoption expenses credit may be carried forward for up to five years, being utilized on a
first-in, first-out basis.
Child and Dependent Tax Credits
13-4d
A child tax credit and dependent tax credit are provided to individual taxpayers based on the number of their qualifying children and dependents.
These credits are two of several “family-friendly” provisions in the Federal income tax law. To be eligible for these credits, the child must be under age
17, must be a U.S. citizen, and must be a dependent of the taxpayer. The child tax credit is $2,000 per child, and the dependent tax credit is $500 per
non-child dependent. The child tax credit phases out as AGI exceeds $400,000 (married filing joint) or $200,000 (other taxpayers). The child tax credit is
The Big Picture
Return to the facts of The Big Picture. Recall that Tom and Jennifer Snyder are married; file a joint tax return; have modified AGI of $158,000; and have
two children, Lora and Sam. The Snyders paid $7,500 of tuition and $8,500 for room and board for Lora (a freshman) and $8,100 of tuition plus $7,200 for
room and board for Sam (a junior). Both Lora and Sam are full-time students and are Tom and Jennifer’s dependents.
Lora’s tuition and Sam’s tuition are qualified expenses for the American Opportunity credit. For 2018, Tom and Jennifer may claim a $2,500 American
Opportunity credit for both Lora’s and Sam’s expenses [(100% × $2,000) + (25% × $2,000)]; in total, they qualify for a $5,000 American Opportunity
credit.
Example 28
The Big Picture
Return to the facts of The Big Picture. Now assume that Tom and Jennifer’s 2018 modified AGI is $172,000 instead of $158,000. In this case, Tom and
Jennifer can claim a $2,000 American Opportunity credit for 2018 (rather than a $5,000 credit).
The credit is reduced because the taxpayers’ modified AGI exceeds the $160,000 limit for married taxpayers. The reduction is the amount by which
modified AGI exceeds the limit, expressed as a percentage of the phaseout range. In this case, the reduction is 60%, computed as [($172,000 −
$160,000)/$20,000]. Therefore, the maximum available credit for 2018 is $2,000 ($5,000 × 40% allowable portion).
Example 29
The Big Picture
Return to the facts of The Big Picture. Now assume that Tom and Jennifer’s modified AGI is $128,000. In addition, assume that Tom is going to school on
a part-time basis to complete a graduate degree and pays qualifying tuition and fees of $4,000 during 2018.
As Tom and Jennifer’s modified AGI is below $160,000, a $5,000 American Opportunity credit is available to them ($2,500 for both Lora and Sam).
In addition, Tom’s qualifying expenses are eligible for the lifetime learning credit. The potential lifetime learning credit of $800 ($4,000 × 20%) is reduced
because the Snyders’ modified AGI$50,000
exceeds the $114,000 limit for married taxpayers. As modified AGI exceeds the $114,000 limit by $14,000 and the
30,000
phaseout range is $20,000, the couple’s
lifetime learning credit is reduced by 70%.
Therefore, the lifetime learning credit for 2018 is $240 ($800 × 30%), and total education credits amount to $5,240 ($5,000 American Opportunity credit
and $240 lifetime learning credit).
Restrictions on Double Tax Benefit
Taxpayers who claim an education credit may not deduct the expenses, nor may they claim the credit for amounts that are otherwise excluded from
gross income (e.g., scholarships and employer-paid educational assistance).
Energy Credits
13-4g
The Internal Revenue Code contains a variety of credits for businesses and individuals to encourage the conservation of natural resources and the
development of energy sources other than oil and gas. The energy tax credits include incentives to:
Install energy-efficient windows, insulation, and heating and cooling equipment;
Purchase solar and other energy-efficient water heaters; and
Install equipment in a business to produce electricity using solar, wind, or geothermal sources.
Credit amounts and expiration dates differ for the various provisions.
Credit for Certain Retirement Plan Contributions
13-4h
Taxpayers may claim a nonrefundable credit for certain retirement plan contributions based on eligible contributions of up to $2,000 to certain qualified
retirement plans, like traditional and Roth IRAs and § 401(k) plans. This credit, sometimes referred to as the “saver’s credit,” encourages lower- and
middle-income taxpayers to contribute to qualified retirement plans. If a taxpayer (and/or spouse) contributes to and receives distributions from a
qualifying plan, these amounts must be netted. Distributions in the tax year, in the two prior tax years, and during the period prior to the due date of the
return are used in this netting process.
The credit rate applied to the eligible contributions depends on the taxpayer’s AGI and filing status as shown in Exhibit 13.4. However, the maximum
credit allowed to an individual is $1,000 ($2,000 × 50%). Once AGI exceeds the upper end of the applicable range, no credit is available. To qualify for the
credit, the taxpayer must be at least 18 years of age and cannot be a dependent of another taxpayer or a full-time student.
can direct the employer to withhold a certain dollar amount in addition to the required amount. With the Tax Cuts and Jobs Act (TCJA) of 2017 changes,
ensuring that the correct amount of taxes is withheld has become more complicated (as has the Form W–4 and its related instructions).
Exhibit 13.4“Saver’s” Credit Rate and AGI Thresholds (2018)
Carl G. and Carol D. Simmons live at 4886 Sycamore Lane, Elmhurst, IL 60126. Carl earns $95,000 as a software engineer, and Carol earns $55,000 as a
marketing manager. They have three dependent children and will claim the standard deduction. Assume that two of their children qualify for the child
tax credit.
Carl is paid twice a month. Given the expansion of the child tax credit and the fact that Carl and his spouse both work, completion of the Form W–4 is
more complicated than in prior years.
A Form W–4 has been completed for Carl. With the expansion of the child tax credit, Carl will claim six withholding allowances: one for himself, one for
filing a joint return, and four for his children eligible for the child tax credit. Completing the Two Earner/Multiple Jobs Worksheet (not included in the
text) results in no change to the withholding allowances claimed and no additional tax needing to be withheld.
Example 30
Earl and Josephine, married taxpayers, each contribute $2,500 to § 401(k) plans offered through their employers. AGI reported on their joint return is
$45,000. The eligible retirement plan contributions for purposes of the credit are limited to $2,000 for Earl and $2,000 for Josephine.
As a result, Earl and Josephine may claim a $400 retirement plan contributions credit [($2,000 × 2) × 10%]. They would not qualify for the credit if their
AGI had exceeded $63,000.
Concept Summary 13.1 provides an overview of the tax credits discussed in this chapter.
Concept Summary 13.1
Tax Credits
Credit
Tax withheld on
wages (§ 31)
Earned income
(§ 32)
Child and
dependent care
(§ 21)
Elderly or
disabled (§ 22)
Adoption
expenses (§ 23)
Child and
Dependent (§ 24)
Education (§
25A)
Credit for certain
retirement plan
contributions (§
25B)
General business
(§ 38)
Computation
Amount is reported to employee on Form
W–2.
Amount is determined by reference to
Earned Income Credit Table published by
IRS. Computations of underlying amounts in
Earned Income Credit Table are illustrated
in Example 20.
Rate ranges from 20% to 35% depending on
AGI. Maximum base for credit is $3,000 for
one qualifying individual, $6,000 for two or
more.
15% of sum of base amount minus
reductions for (1) Social Security and other
nontaxable benefits and (2) excess AGI.
Base amount is fixed by law (e.g., $5,000 for
a single taxpayer).
Up to $13,810 of costs incurred to adopt an
eligible child qualify for the credit. Taxpayer
claims the credit in the year qualified
expenses were paid or incurred if they were
paid or incurred during or after year in
which adoption was finalized. For expenses
paid or incurred in a year prior to when
adoption was finalized, credit must be
claimed in tax year following the tax year
during which the expenses are paid or
incurred.
Credit is based on number of qualifying
children under age 17 and dependents.
Maximum credit is $2,000 per child and
$500 per dependent. Child tax credit is
phased out for higher-income taxpayers.
American Opportunity credit is available for
qualifying education expenses of students in
first four years of postsecondary education.
Maximum credit is $2,500 per year per
eligible student. Credit is phased out for
higher-income taxpayers.
Lifetime learning credit permits a credit of
20% of qualifying expenses (up to $10,000
per year) provided American Opportunity
credit is not claimed with respect to those
expenses. Credit is calculated per taxpayer,
not per student, and is phased out for
higher-income taxpayers.
Calculation is based on amount of
contribution multiplied by a percentage that
depends on the taxpayer’s filing status and
AGI.
May not exceed net income tax minus the
greater of tentative minimum tax or 25% of
net regular tax liability that exceeds
$25,000.
Rehabilitation
expenditures (§
47)
Qualifying expenditures times 20% rate for
certified historic structures.
Research
activities (§ 41)
Incremental credit is 20% of excess of
computation year expenditures over the
base amount. Basic research credit is
allowed to certain corporations for 20% of
cash payments to qualified organizations
that exceed a specially calculated base
amount. Energy research credit also
available.
Appropriate rate times eligible basis
(portion of project attributable to lowincome units). Credit is available each year
for 10 years. Recapture may apply.
Low-income
housing (§ 42)
Disabled access
(§ 44)
Credit for small
employer
pension plan
startup costs (§
45E)
Credit for
employerprovided child
care (§ 45F)
Credit for
employerprovided family
and medical
leave (§ 45S)
Work
opportunity (§
51)
13-5
Credit is 50% of eligible access expenditures
that exceed $250 but do not exceed
$10,250. Maximum credit is $5,000.
Available only to eligible small businesses.
Credit equals 50% of qualified startup costs
incurred by eligible employers. Maximum
annual credit is $500. Deduction for related
expenses is reduced by the amount of the
credit.
Credit is equal to 25% of qualified child care
expenses plus 10% of qualified expenses for
child care resource and referral services.
Maximum credit is $150,000. Deduction for
related expenses or basis must be reduced
by the amount of the credit.
Credit is equal to 12.5% of wages paid to
qualifying employees while they are on
family and medical leave (limited to 12
weeks per employee per year). Employers
must pay a minimum of 50% of the wages
normally paid; if wages paid during the
leave exceed 50% of normal wages, the
credit is increased by .25% for each
percentage point above 50% to a maximum
credit of 25%.
Credit is limited to 40% of the first $6,000 of
wages paid to each eligible employee.
Comments
Refundable credit.
Refundable credit. A form of negative income
tax to assist low-income taxpayers. Earned
income and AGI must be less than certain
threshold amounts. Generally, one or more
qualifying children must reside with the taxpayer.
Nonrefundable personal credit. No carryback or
carryforward. Benefits taxpayers who incur
employment-related child or dependent care
expenses in order to work or seek employment.
Eligible taxpayers must have a dependent under
age 13 or a dependent (any age) or spouse who is
physically or mentally incapacitated.
Nonrefundable personal credit. No carryback or
carryforward. Provides relief for taxpayers not
receiving substantial tax-free retirement benefits.
Nonrefundable credit. Unused credit may be
carried forward five years. Purpose is to assist
taxpayers who incur nonrecurring costs
associated with the adoption process.
Example 34
Reporting and Payment Procedures
Exhibit 13.9
Employers devote a significant amount of time and expense in complying with the various employment tax and income tax withholding rules. Among the
Federal forms that must be filed are the following.
Tax Form
W–2
940 or 940 EZ
941
Form W–2 furnishes essential information to employees concerning wages paid, FICA, and income tax withholdings. This form (reporting information for
the previous calendar year) must be furnished to an employee not later than January 31 (see Exhibit 13.6). Employees then report the relevant amounts
on the appropriate lines of their Form 1040. For example, the amount in box 1 (Wages, tips, other compensation) is reported on Form 1040, page 1, line
7; the amount in box 2 (Federal income tax withheld) is included on page 2, line 64 of the Form 1040. If the taxpayer itemizes deductions, amounts
reported in boxes 17 and 19 (state and local income taxes, respectively) can be included on line 5 of Schedule A (Form 1040). These amounts also
typically are used on the state and/or local tax return.
Exhibit 13.6Form W–2
2017 Self-Employment Tax Worksheet
1.
2.
3.
4.
Net earnings from self-employment.
Title
Multiply line 1 by 92.35%.
Wage and
Tax2Statement
If the amount
on line
is $127,200 or less, multiply the line 2 amount by 15.3%. This is the selfEmployer’s
employment
tax. Annual Federal Unemployment (FUTA) Tax Return
Employer’s
Quarterly
Federal
Tax Return
If the amount
on line
2 is more
than $127,200,
multiply the excess of line 2 over $127,200 by 2.9%
and add $19,461.60. This is the self-employment tax.
_____
_____
_____
_____
Affordable Care Act Provisions
13-6
LO.7
Explain some of the key tax provisions of the Affordable Care Act.
The Affordable Care Act (ACA) was enacted to increase the quality and affordability of health insurance, reduce the number of uninsured individuals in
the United States by expanding public and private insurance coverage, and lower health care costs for individuals and the government.
To assist in achieving these goals, the ACA enacted a number of individual tax provisions, including providing a premium tax credit for low-income
taxpayers and assessing additional Medicare taxes on the net investment income and the wages of certain high-income taxpayers. Both of these tax
provisions are discussed briefly below. A more complete discussion of ACA provisions is available in an online appendix to the text.
13-6aPremium Tax Credit
Form 940 (or Form 940 EZ) is the employer’s annual accounting of its FUTA liability. Generally, it is due one month after the end of the calendar year (i.e.,
no later than January 31, 2019, for the 2018 calendar year) and must include any remaining FUTA due.
Employers make deposits of employment taxes, usually weekly or monthly, and they pay any outstanding amounts at the end of every quarter, using
Form 941.
Backup Withholding
Child tax credit is partially refundable (up to
$1,400), but limited to 15% of earned income in
excess of $2,500. Dependent tax credit is not
refundable. Purpose is to assist families with
children or dependents.
Credit is partially refundable. Credit is designed to
help defray costs of first four years of higher
education for low- to middle-income families.
Although there is a limit on Social Security taxes ($128,400 maximum base in 2018), no such limit exists for the Medicare portion of the self-employment
tax. Therefore, all of Kelly’s net self-employment income is subject to the 2.9% Medicare portion of the self-employment tax. The self-employment tax
on this portion is $2,303.21($79,421 × 2.9%).
If Kelly’s wages were only $30,000, then the net ceiling in the table above would be $98,400. Because her net self-employment income ($79,421) is less
than this amount, she would compute her self-employment tax using the format in Exhibit 13.8.
For 2017, the self-employment tax computations are different from those for 2018, as the tax base was lower (see Exhibit 13.9).
Some payments made to individuals by banks or businesses are subject to backup withholding. Backup withholding is designed to ensure that income tax
is collected on interest income and other payments reported on a Form 1099. Backup withholding is required if the taxpayer does not give his or her
Social Security number to the business or bank when required. If backup withholding applies, the payor withholds 24 percent of the gross amount.
Individuals and families whose household incomes are at least 100 percent but no more than 400 percent of the federal poverty level (also called the
federal poverty line, or FPL) may be eligible to receive a federal subsidy (the premium tax credit, or PTC) if they purchase insurance via the Health
Insurance Marketplace (the Marketplace). Individuals whose income exceeds 400% of the FPL are not eligible for a PTC. For 2018 tax returns, the FPL for
claiming a PTC is $12,060 ($12,140 for 2019) for a single person (an additional $4,180 ($4,320 in 2019) is added to that amount for each person in the
household).
Individuals can choose to receive their PTC in advance, and the Marketplace will send the money directly to the insurer to reduce the monthly insurance
payments. Alternatively, individuals can receive the PTC as a refundable credit when they file their tax return for the year. Most individuals choose to
receive their PTC in advance. In either case, however, taxpayers will be required to complete Form 8962 (Premium Tax Credit) when their tax return is
filed.
Taxpayers who enrolled in health care coverage via the Marketplace will receive information necessary to complete Form 8962 by the end of January
each year. Taxpayers who received the credit in advance must reconcile the credit based on actual income that year with the amounts that were
subsidized through the Marketplace. They will receive a refund (if the advance credit was too low) or owe an additional tax obligation (if the advance
credit was too large).
13-5cAdditional Medicare Taxes on High-Income Individuals
LO.7
Explain the additional Medicare taxes assessed on high-income individuals.
Two provisions result in increased Medicare taxes for high-income individuals: (1) an additional .9 percent tax on wages received in excess of specified
amounts and (2) an additional 3.8 percent tax on unearned income.
Additional Tax on Wages
4.
Nonrefundable credit. Credit is designed to help
defray costs of higher education beyond first four
years and of costs incurred in maintaining or
improving existing job skills for low- to middleincome taxpayers.
5.
An additional .9 percent Medicare tax is imposed on wages received in excess of $250,000 for married taxpayers filing a joint return ($125,000 if married
filing separately) and $200,000 for all other taxpayers. Unlike the general 1.45 percent Medicare tax on wages, the additional tax on a joint return is
based on the combined wages of the employee and the employee’s spouse. As a result, the Medicare tax rate is:
1.45 percent on the first $200,000 of wages ($125,000 on a married filing separate return; $250,000 of combined wages on a married filing joint return),
and
2.35 percent (1.45% + .9%) on wages in excess of $200,000 ($125,000 on a married filing separate return; $250,000 of combined wages on a married
filing joint return).
Example 38
Additional Medicare Tax on Wages
Jenna, who is single, earns wages of $500,000 in 2018. Jenna will pay $2,900 of Medicare taxes on the first $200,000 of her wages ($200,000 × 1.45%)
and $7,050 of Medicare taxes on her wages in excess of $200,000 ($300,000 × 2.35%). In total, her Medicare tax is $9,950, of which $2,700 ($300,000 ×
.9%) represents Jenna’s additional Medicare tax.
Nonrefundable credit. Purpose is to encourage
contributions to qualified retirement plans by
low- and middle-income taxpayers.
Example 39
Additional Medicare Tax on Wages
Nonrefundable credit. Components include tax
credit for rehabilitation expenditures, work
opportunity tax credit, research activities credit,
low-income housing credit, disabled access credit,
credit for small employer pension plan startup
costs, credit for employer-provided child care,
and credit for employer-provided medical and
family leave. Unused credit may be carried back 1
year and forward 20 years. FIFO method applies
to carrybacks, carryovers, and credits earned
during current year.
Nonrefundable credit. Part of general business
credit and therefore subject to same carryback,
carryover, and FIFO rules. Purpose is to
discourage businesses from moving from
economically distressed areas to newer locations.
Nonrefundable credit. Part of general business
credit and therefore subject to same carryback,
carryover, and FIFO rules. Purpose is to encourage
high-tech and energy research in the United
States.
Patrick and Paula file a joint return in 2018. During the year, Patrick earns wages of $125,000, and Paula earns wages of $175,000—so their total wages
are $300,000. Patrick and Paula will pay total Medicare taxes of $4,800 ($250,000 × 1.45% plus $50,000 × 2.35%), of which $450 ($50,000 × .9%)
represents Patrick and Paula’s additional Medicare tax.
Employers must withhold the additional .9 percent Medicare tax on wages paid in excess of $200,000. An employer is not responsible for determining
wages earned by an employee’s spouse (and the implications of those wages on the total Medicare tax to be paid).
Example 40
6.
7.
Return to the facts of Example 39. In 2018, neither Patrick’s nor Paula’s employer will withhold the additional Medicare tax as both wage amounts are
less than $200,000. Therefore, Paula will have $2,537.50 of Medicare tax withheld ($175,000 × 1.45%), and Patrick will have $1,812.50 of Medicare tax
withheld ($125,000 × 1.45%). Total Medicare tax withheld is $4,350.00 ($2,537.50 + $1,812.50). Patrick and Paula pay an additional $450.00 of Medicare
taxes when they file their return.
The additional Medicare tax also applies to self-employed individuals—with net earnings from self-employment being used for the threshold
computations. As a result, the tax rate for the Medicare tax on self-employment income will be:
2.9 percent on the first $200,000 of net earnings from self-employment ($125,000 on a married filing separate return; $250,000 on a married filing joint
return); and
3.8 percent (2.9% + .9%) on net earnings from self-employment in excess of $200,000 ($125,000 on a married filing separate return; $250,000 on a
married filing joint return).
For married taxpayers, one of whom has wages and one of whom has self-employment income, the thresholds are reduced (but not below zero) by the
amount of wages taken into account in determining the additional .9 percent Medicare tax on wages. Although self-employed individuals are allowed an
income tax deduction for part of the self-employment tax, this additional .9 percent Medicare tax will not create a deduction (i.e., the deduction is
determined without regard to this additional tax).
Additional Tax on Unearned Income (Net Investment Income Tax)
Nonrefundable credit. Part of general business
credit and therefore subject to same carryback,
carryover, and FIFO rules. Purpose is to encourage
construction of housing for low-income
individuals.
Nonrefundable credit. Part of general business
credit and therefore subject to same carryback,
carryover, and FIFO rules. Purpose is to encourage
small businesses to become more accessible to
disabled individuals.
Nonrefundable credit. Part of general business
credit and therefore subject to same carryback,
carryover, and FIFO rules. Purpose is to encourage
small employers to establish qualified retirement
plans for their employees.
Nonrefundable credit. Part of general business
credit and therefore subject to same carryback,
carryover, and FIFO rules. Purpose is to encourage
employers to provide child care for their
employees’ children during normal working
hours.
Nonrefundable credit. Part of general business

credit and therefore subject to same carryback, 
carryover, and FIFO rules. Purpose is to encourage
employers to provide leave to their employees for
family and medical purposes (e.g,, birth of a child;
care for a sick child, spouse, or parent).
8.
9.
Self-Employed Taxpayers
13-5b
LO.6
Payment Procedures
LO.5
Describe the tax withholding and payment procedures applicable to employers.
The tax law contains elaborate “pay-as-you-go” rules that require the prepayment of various Federal taxes. In addition, these rules carry penalties for any
lack of compliance. Prepayment procedures fall into two major categories: those applicable to employers and those applicable to self-employed persons.
For employers, both payroll taxes (FICA and FUTA) and income taxes may be involved. With self-employed taxpayers, the focus is on the income tax and
the self-employment tax.
Employers
13-5a
Employment taxes include FICA (Federal Insurance Contributions Act; commonly known as Social Security) and FUTA (Federal Unemployment Tax Act).
The employer usually is responsible for withholding the employee’s share of FICA and appropriate amounts for income taxes. In addition, the employer
must match the FICA portion withheld and fully absorb the cost of FUTA. Employers are required to pay these amounts to the IRS on a regular basis
(usually weekly or monthly).
The key to employer compliance in this area involves the following.
Identifying which employees and wages are covered by employment taxes and are subject to withholding for income taxes.
Determining the amount to be paid and / or withheld.
Reporting and paying employment taxes and income taxes withheld to the IRS on a timely basis through the use of proper forms and procedures.
IRS Publication 15, Employer’s Tax Guide (Circular E), is a key resource for employers.
Amount of FICA Taxes
Although the following discussion largely centers on self-employed taxpayers, employed taxpayers may be required to pay estimated tax if they have
income other than wages that is not subject to withholding (e.g., investment income, or a second trade or business in a self-employment capacity).
Estimated Tax Payments for Individuals
Estimated tax is the amount of tax (including AMT and self-employment tax) an individual expects to owe for the year after subtracting tax credits and
income tax withheld. Any individual who has estimated tax of $1,000 or more and whose withholding does not equal or exceed the required annual
payment (discussed below) must make quarterly payments. If these payments are not made, a penalty may be assessed. No quarterly payments are
required (and no penalty will apply) if the taxpayer’s estimated tax is under $1,000. In addition, no penalty will apply if the taxpayer had a zero tax
liability for the prior tax year, provided the prior tax year was 12 months (i.e., not a short year) and the taxpayer was a citizen or resident for that entire
year.
The required annual payment must be computed first. This is the smaller of the following amounts.
Ninety percent of the tax shown on the current year’s return.
One hundred percent of the tax shown on the preceding year’s return (the return must cover the full 12 months of the preceding year). If the AGI on the
preceding year’s return exceeds $150,000 ($75,000 if married filing separately), the 100 percent requirement is increased to 110 percent.
In general, one-fourth of this required annual payment is due on April 15, June 15, and September 15 of the tax year and January 15 of the following
year.
An equal part of withholding is deemed paid on each due date. So if $10,000 has been withheld during the year, $2,500 is applied to each quarter. If the
quarterly estimates are determined to be $3,000, then $500 ($3,000 − $2,500) must be paid each quarter. Payments are submitted with the payment
voucher for the appropriate quarter from Form 1040–ES.
A nondeductible penalty is imposed on any estimated tax underpayment. The penalty rate is adjusted quarterly to reflect changes in the average prime
rate.
An underpayment occurs when any installment (the sum of estimated tax paid and income tax withheld) is less than 25 percent of the required annual
payment. The penalty is applied to the amount of the underpayment for the period of the underpayment.
Example 35
Marta made the following payments of estimated Federal income tax for 2018. Marta had no Federal income tax withheld.
April 17, 2018
June 15, 2018
September 17, 2018
January 15, 2019
Marta’s actual tax for 2018 is $8,000, and her tax in 2017 was $10,000. As a result, each installment should have been at least $1,800 [($8,000 × 90%) ×
25%]. Of the payment on June 15, $400 will be credited to the unpaid balance of the first quarterly installment due on April 17, effectively stopping the
underpayment penalty for the first quarter. Of the remaining $1,900 payment on June 15, $100 is credited to the September 17 payment, resulting in this
third quarterly payment being $200 short.
Then $200 of the January 15 payment is credited to the September 17 shortfall, ending the underpayment period for that amount. The January 15, 2019
installment is now underpaid by $200, and a penalty will apply from January 15, 2019, to April 16, 2019 (unless some tax is paid sooner). Marta’s
underpayments for the periods of underpayment are as follows.
1st installment due
2nd installment due
3rd installment due
4th installment due
If a possible underpayment of estimated tax is indicated, Form 2210 is filed to compute the penalty due or to justify that no penalty applies.
Self-Employment Tax
The tax on self-employment income is levied to provide Social Security and Medicare benefits (old age, survivors, and disability insurance and hospital
insurance) for self-employed individuals. Individuals with net earnings of $400 or more from self-employment are subject to the self-employment tax.
For 2018, the self-employment tax is 15.3 percent of self-employment income up to $128,400 and 2.9 percent of self- employment income in excess of
$128,400 (see Exhibit 13.7).
The FICA tax has two components: Social Security tax (old age, survivors, and disability insurance) and Medicare tax (hospital insurance). The tax rates
and wage base under FICA have increased substantially over the years. The base amount is adjusted each year for inflation.The base amount for social
security portion(old age, survivors, and disability insurance) is different from that for the medicare portion of FICA. Exhibit 13.5 shows the base amounts
for both the Social Security and Medicare taxes and the related employee tax rates. The employer must match the employee’s portion, so the total Social
Security tax rate is 12.4 percent and the total Medicare tax rate is 2.9 percent.
Exhibit 13.7Self-Employment Tax: Social Security and Medicare Portions
Exhibit 13.5FICA Rates and Base


Net earnings from self-employment includes gross income from a trade or business less allowable trade or business deductions, the distributive share of
any partnership income or loss derived from a trade or business activity, and net income from rendering personal services as an independent contractor.
This amount includes profits from sales of inventory.
Self-employed taxpayers are allowed a deduction from net earnings from self-employment, at one-half of the self-employment rate, for purposes of
determining self-employment tax and an income tax deduction (normally, one-half of the self-employment tax liability).
Determining the amount of self-employment tax to be paid for 2018 involves completing the steps in Exhibit 13.8. The result of step 3 or 4 is the amount
of self-employment tax to be paid. For income tax purposes, the amount to be reported is net earnings from self-employment before the deduction for
the self-employment tax. Then the taxpayer is allowed a deduction for AGI of the appropriate amount of the self-employment tax.
Employee withholdings continue until the maximum base amount is reached. In 2018, for example, FICA withholding for the Social Security portion (6.2
percent) ends once the employee has earned $128,400 of wages. However, the employer will continue to withhold Medicare taxes on wages above
$128,400 as there is no limit on this portion of the FICA tax.
Example 31
In 2018, Keshia earned a salary of $140,000 from her employer. Therefore, FICA taxes withheld from her salary are $7,960.80 ($128,400 × 6.2%) plus
$2,030.00 ($140,000 × 1.45%) for a total of $9,990.80. In addition to paying the amount withheld from Keshia’s salary to the Federal government, her
employer also must pay $9,990.80.
In at least two situations, changing jobs during the year or having multiple jobs at the same time, it is possible for an employee to have paid excess FICA
taxes during a tax year, and therefore the excess amount should be claimed as credit on the Federal Income Tax return of the employee.
Example 32
Excess FICA Taxes Withheld
During 2018, Kevin changed employers in the middle of the year and earned $67,500 (all of which was subject to FICA) from each job. As a result, each
employer withheld $5,163.75 [(6.2% × $67,500) + (1.45% × $67,500)] for a total of $10,327.50.
Although each employer acted properly, Kevin’s total FICA tax liability for the year is only $9,918.30 [(6.2% × $128,400) + (1.45% × $135,000)]. As a result,
Kevin has overpaid his share of FICA taxes by $409.20 [$10,327.50 (amount paid) − $9,918.30 (amount of correct liability)]. Kevin can claim this amount
as a tax credit when filing his 2018 income tax return.
Example 33
Excess FICA Taxes Withheld
During 2018, Lori earned $106,000 from her regular job and $29,000 from a part-time job (all of which was subject to FICA). As a result, one employer
withheld $8,109.00 [(6.2% × $106,000) + (1.45% × $106,000)] while the other employer withheld $2,218.50 [(6.2% × $29,000) + (1.45% × $29,000)], for a
total withheld for Lori of $10,327.50.
Lori’s total FICA tax liability for the year is only $9,918.30 [(6.2% × $128,400) + (1.45% × $135,000)]. As a result, Lori has overpaid her share of FICA taxes
by $409.20 [$10,327.50 (amount paid) − $9,918.30 (amount of correct liability)]. Lori can claim this amount as a tax credit when filing her 2018 income
tax return.
Subject to FICA tax: The FICA tax must be paid for an individual employed by his or her spouse. No tax is collected for children under the age 18 who are
employed in a parent’s trade or business.
Amount of Income Tax Withholding
Three steps are used to determine the employee’s income tax withholdings.

1Have the employee complete Form W–4, Employee’s Withholding Allowance Certificate.
Determine the employee’s payroll period.
Compute the amount to be withheld, usually using either the wage-bracket tables or the percentage method.
Form W–4 reflects the employee’s marital status and withholding allowances. Generally, this form need not be filed with the IRS and is retained by the
employer as part of its payroll records.
On the Form W–4, an employee may claim withholding allowances based on a variety of factors, including what the filing status is, whether the child and
dependent tax credit is available, and whether the taxpayer will use the standard deduction or itemize deductions.
To avoid having too little tax withheld, some employees may find it necessary to reduce the number of withholding allowances. This might be the case
for an employee who has more than one job or who has other sources of income that are not subject to adequate withholding. In addition, an employee
Example 41
Explain and illustrate the payment procedures applicable to self-employed persons.
Penalty on Underpayments
Nonrefundable credit. Part of the general
business credit and therefore subject to the same
carryback, carryover, and FIFO rules. Purpose is to
encourage employment of individuals in specified
groups.
An additional 3.8 percent Medicare tax is imposed on the unearned income of individuals, estates, and trusts. Also known as the net investment income
tax, the tax is 3.8 percent of the lesser of:
Net investment income or
The excess of modified adjusted gross income over $250,000 for married taxpayers filing a joint return ($125,000 if married filing separately) and
$200,000 for all other taxpayers.
In general, “net investment income” includes interest, dividends, annuities, royalties, rents, income from passive activities, and net gains from the sale of
investment property less deductions allowed in generating that income. Modified adjusted gross income (MAGI) is adjusted gross income (AGI) increased
by any foreign earned income exclusion. For individuals who don’t incur any excluded foreign earned income, MAGI is the same as AGI.
Exhibit 13.8
2018 Self-Employment Tax Worksheet
1.
2.
3.
4.
Net earnings from self-employment.
Multiply line 1 by 92.35%.
If the amount on line 2 is $128,400 or less, multiply the line 2 amount by 15.3%. This is the self-employment tax.
If the amount on line 2 is more than $128,400, multiply the excess of line 2 over $128,400 by 2.9% and add
$19,645.20. This is the self-employment tax.
Example 36
In 2018, Ned and Terry report net earnings from self-employment of $55,000 and $145,000, respectively. Using the format in Exhibit 13.8, determine
their self-employment tax.
Ned’s Self-Employment Tax Worksheet
1.
Net earnings from self-employment.
$55,000.00
2.
Multiply line 1 by 92.35%.
$50,792.50
3.
If the amount on line 2 is $128,400 or less, multiply the line 2 amount by 15.3%. This is the self$ 7,771.25
employment tax.
4.
If the amount on line 2 is more than $128,400, multiply the excess of line 2 over $128,400 by
2.9% and add $19,645.20. This is the self-employment
Terry’s Self-Employment Tax Worksheet
1.
Net earnings from self-employment.
$145,000.00
2.
Multiply line 1 by 92.35%.
$133,907.50
3.
If the amount on line 2 is $128,400 or less, multiply the line 2 amount by 15.3%. This is the selfemployment tax.
4.
If the amount on line 2 is more than $128,400, multiply the excess of line 2 over $128,400 by
$ 19,804.92
2.9% and add $19,645.20. This is the self-employment tax.
For income tax purposes, Ned has net earnings from self-employment of $55,000 and a deduction for AGI of $3,885.63 ($7,771.25 × 50%). Terry has net
earnings from self-employment of $145,000 and a deduction for AGI of $9,902.46 ($19,804.92 × 50%). Both taxpayers benefit from the self-employment
tax deduction.
If an individual also receives wages subject to the FICA tax, the ceiling amount of the Social Security portion on which the self-employment tax is
computed is reduced. However, a combination of FICA wages and self-employment earnings will not reduce the Medicare component of the selfemployment tax, as there is no ceiling on this component of the tax.
Example 37
In 2018, Kelly reported $86,000 of net earnings from a data imaging services business she owns. During the year, she also received wages of $54,000 as
an employee of a small accounting firm. The amount of Kelly’s self-employment income subject to the Social Security portion (12.4%) is $74,400
($128,400 − $54,000), producing a tax of $9,225.60 ($74,400 × 12.4%); note that $74,400 is less than $79,421 of net self-employment income.
Additional Medicare Tax on Unearned Income
In 2018, Xinran earns net investment income of $50,000 and MAGI of $180,000 and files as a single taxpayer. As Xinran’s MAGI does not exceed
$200,000, she need not pay the additional Medicare tax on unearned income.
Example 42
Additional Medicare Tax on Unearned Income
Assume the same facts as in Example 41, except that Xinran reports net investment income of $85,000 and MAGI of $220,000.
In this case, she pays a Medicare tax on the lesser of (1) $85,000 (her net investment income) or (2) $20,000 (the amount by which her MAGI exceeds the
$200,000 threshold). As a result, Xinran’s additional Medicare tax on unearned income is $760 ($20,000 × 3.8%).
Example 43
Additional Medicare Tax on Unearned Income
Assume the same facts as Example 42, except that Xinran’s MAGI is $290,000.
Because her MAGI exceeds the threshold amount by $90,000, she pays a Medicare tax on the entire $85,000 of net investment income. As a result,
Xinran’s additional Medicare tax on unearned income is $3,230 ($85,000 × 3.8%).
The 3.8 percent additional Medicare tax on unearned income is in addition to the additional .9 percent Medicare tax on wages or self-employment
income. Taxpayers who have both high wages (or self-employment income) and high investment income may be subject to both taxes.
Example 44
Assume the same facts as Example 43, except that Xinran reports MAGI of $325,000 (including $240,000 of wages and $85,000 of net investment
income).
In this case, Xinran must pay an additional Medicare tax on wages of $360 ($40,000 × .9%, her wages in excess of $200,000). In total, Xinran pays $3,590
in additional Medicare taxes ($3,230 on unearned income and $360 on wages).
Tax Planning
Credit for Child and Dependent Care Expenses
13.7
13- 7a
LO.8
Identify tax planning opportunities related to tax credits and payment procedures.
A taxpayer may incur employment-related expenses that also qualify as medical expenses (e.g., a nurse is hired to provide in-home care for an
incapacitated dependent parent). These expenses may be either deducted as medical expenses (generally subject to the 7.5 percent of AGI limitation) or
used in determining the child and dependent care credit. If the child and dependent care credit is chosen and the employment-related expenses exceed
the limitation ($3,000, $6,000, or earned income, as the case may be), the excess will qualify as a medical expense. If, however, the taxpayer chooses to
deduct qualified employment-related expenses as medical expenses, any portion that is not deductible because of the percentage limitation may not be
used in computing the credit for child and dependent care expenses.
Example 45
Alicia reports the following information for the current year.
$400 from April 17 to June 15, 2018
Paid in full
$200 from September 17, 2018, to January 15, 2019
All of Alicia’s medical expenses were
to provide
nursing
care16,
for2019
her disabled father while she was working. Alicia’s father lives with her and
$200 incurred
from January
15, 2019,
to April
qualifies as her dependent.
What should Alicia do in this situation? One approach would be to use $3,000 of the nursing care expenses to obtain the maximum child and dependent
care credit allowed of $810 (27% × $3,000). The remaining expenses should be claimed as medical expenses. After a reduction of 7.5 percent of AGI, this
would produce a medical expense deduction of $1,350 [$3,600 (remaining medical expenses) − (7.5% × $30,000)].
Another approach would be to claim the full $6,600 as a medical expense and forgo the child and dependent care credit. After applying the 7.5%-of-AGI
floor of $2,250 (7.5% × $30,000), a deduction of $4,350 remains.
The choice, then, is between a credit of $810 plus a deduction of $1,350 or a credit of $0 plus a deduction of $4,350. Which is better, of course, depends
on the relative tax savings involved, which in turn are dependent on the taxpayer’s marginal tax rate.
One of the traditional goals of family tax planning is to minimize the present value of the total tax burden of the family unit. With proper planning and
implementation, the child and dependent care credit can be used to help achieve this goal. For example, payments to certain relatives for the care of
qualifying dependents and children qualify for the credit if the care provider is not a child (under age 19) of the taxpayer. So if the care provider is in a
lower tax bracket than the taxpayer, the following benefits result.
Income is shifted to a lower-bracket family member.
The taxpayer qualifies for the credit for child and dependent care expenses.
In addition, the goal of minimizing the family income tax liability can be enhanced in some other situations, but only if the credit’s limitations are
recognized and avoided. For example, tax savings may be enjoyed even if the qualifying expenditures incurred by a cash basis taxpayer have reached the
annual ceiling ($3,000 or $6,000). To the extent that any additional payments can be shifted into future tax years, the benefit from the credit may be
preserved on these excess expenditures.
Example 46
Andre, a calendar year and cash basis taxpayer, has spent $3,000 by December 1 on qualifying child care expenditures for his dependent 11-year-old son.
The $250 that is due the care provider for child care services rendered in December does not generate a tax credit benefit if the amount is paid in the
current year because the $3,000 ceiling has been reached. However, if the payment can be delayed until the next year, the total credit over the two-year
period for which Andre is eligible may be increased.
A similar shifting of expenses to the next year may be wise if the potential credit would be limited by the tax liability.
13-7b
Adjustments to Increase Withholding
The penalty for underpayment of estimated tax by individuals is computed for each quarter of the tax year. A taxpayer can play catch-up to a certain
extent. Each quarterly payment is credited to the unpaid portion of any previous required installment. As a result, the penalty stops on that portion of
the underpayment for the previous quarter. However, because income tax withheld is assumed to have been paid evenly throughout the year and is
allocated equally among the four installments in computing any penalty, a taxpayer who otherwise would be subject to a penalty for underpayment
should increase withholdings late in the year. This can be done by changing the number of allowances claimed on Form W–4 or by making a special
arrangement with the employer to increase the amount withheld.
A similar way to avoid (or reduce) a penalty for underpayment is to have the employer continue Social Security withholding beyond the base amount.
Example 47
Kylie, a calendar year taxpayer, earns $141,400 from her job. In late October 2018, she realizes that she will be subject to a penalty for underpayment of
estimated tax due to income from outside sources. As a result, she instructs her employer to continue FICA withholdings for the rest of 2018.
If this is done, an extra $13,000 [$141,400 (annual salary) − $128,400 (base amount of the Social Security portion for 2018)] is subject to the 6.2% Social
Security portion of the FICA tax [7.65% (total FICA rate) − 1.45% (Medicare portion of the FICA rate)]. As a result, Kylie generates an additional $806 (6.2%
× $13,000) that is considered withheld throughout 2018 (not just during the last quarter).
13-7c
Adjustments to Avoid Overwithholding
Publication 505, Tax Withholding and Estimated Tax, contains worksheets that taxpayers may use to take advantage of special provisions for avoiding
overwithholding. Extra exemptions for withholding purposes are allowed if the taxpayer has unusually large itemized deductions, deductions for AGI, or
tax credits. Net losses from Schedules C, D, E, and F may be considered in computing the number of extra withholding exemptions. Net operating loss
carryovers may also be considered in the computation. A taxpayer who is entitled to extra withholding exemptions for any of these reasons should file a
new Form W–4, Employee’s Withholding Allowance Certificate, with his or her employer.cus on The Big Education Tax Credits
The American Opportunity tax credit provides some relief for Tom and Jennifer Snyder.
Both Lora and Sam qualify for the American Opportunity credit in 2018 as they are both in their first four years of postsecondary education. Lora and Sam
both qualify for a $2,500 credit (100 percent of the first $2,000 and 25 percent of the next $2,000 of qualified expenses).
These credits phase out over a range of $20,000 once married taxpayers’ AGI exceeds $160,000. As the Snyders’ AGI ($158,000) is less than this amount,
the total education credits available to them amount to $5,000, and they may claim this amount as a credit on their 2018 income tax return (see Example
27). In addition, this credit may be used to offset any AMT liability, and 40 percent ($2,000) is refundable to the Snyders.
14-1Determination of Gain or Loss
LO.1
State and explain the computation of realized gain or loss on property dispositions.
Gains and losses result from “realization events” such as a sales, exchanges, or other dispositions of property. Very few gains and losses are
recognized without first being realized. Realization events involve a significant change in ownership rights, and once a realization event has
occurred, a realized gain or loss can be determined. Many, but not all, realized gains and losses are also recognized (included in the determination
of taxable income) at the time of the realization event.
Realized Gain or Loss
14-1a
Sale or Other Disposition
Recognized gain is the amount of the realized gain that is included in the taxpayer’s gross income. A recognized loss, on the other hand, is the
amount of a realized loss that is deductible for tax purposes. As a general rule, the entire amount of a realized gain or loss is recognized.
Conce pt Sum mar y 14.2
Real i zed an d Reco gni zed Gai n or Loss
Example 1
Computation of Realized Gains and Losses
Realized gain or loss is the difference between the amount realized from the sale or other disposition of property and the property’s
adjusted basis on the disposition date. If the amount realized exceeds the property’s adjusted basis, the result is a realized gain. On the other
hand, if the property’s adjusted basis exceeds the amount realized, the result is a realized loss.
Example 2
Carl sells Swan Corporation stock with an adjusted basis of $3,000 for $5,400. Carl’s realized gain is $2,400. If Carl had sold the stock for $1,750, he
would have had a realized loss of $1,250.
Conce pt Sum mar y 14.1
Real i z ed Gai n or Loss
14-1cNonrecognition of Gain or Loss
In certain cases, a realized gain or loss on a property disposition is not recognized. Nontaxable exchanges, which are covered in Chapter 15, are
one example. Others include losses realized on the sale, exchange, or condemnation of personal use assets (as opposed to business or incomeproducing property) and gains realized on the sale of a residence. In addition, realized losses from the sale or exchange of business or incomeproducing property between certain related parties are not recognized.
Sale, Exchange, or Condemnation of Personal Use Assets
A realized loss from the sale, exchange, or condemnation of personal use assets (e.g., a personal residence or an automobile used only for personal
purposes) is not recognized for tax purposes. An exception exists for certain casualty or theft losses from personal use assets. On the other hand,
any gain realized from the sale or other disposition of personal use assets is, generally, fully taxable.
Example 12
The Big Picture
Return to the facts of The Big Picture. Assume that Alice sells the boat, which she has held exclusively for personal use, for $23,000. Recall that her
adjusted basis of the boat is $22,000. Alice has a realized and recognized gain of $1,000.
Example 13
The Big Picture
Assume that Alice sells the boat in Example 12 for $20,000. She has a realized loss of $2,000, but the loss is not recognized because the boat is a
personal use asset.
Amount Realized
The amount realized from a sale or other disposition of property is a measure of the economic value received for property given up. In
general, it is the sum of any money received (which includes any debt relief) plus the fair market value of other property received.
Debt relief includes any liability (like a mortgage) assumed by the buyer when the property is sold. Debt relief also occurs if property is sold
subject to the mortgage. In addition, debt relief is not limited by the fair market value of the property.
A realized gain that is never recognized results in the permanent recovery of more tha the taxpayer’s cost or other basis for tax purposes.
Example 3
Amount Realized
Juan sells a machine used in his landscaping business to Peter for $20,000 cash plus four acres of property that Peter owns in a nearby town with a
fair market value of $36,000. Juan’s amount realized on this sale is $56,000 ($20,000 + $36,000).
Example 4
Amount Realized
Barry owns property on which there is a mortgage of $20,000. He sells the property to Cole for $50,000 cash and Cole’s agreement to assume the
mortgage. Barry’s amount realized from the sale is $70,000 ($50,000 cash + $20,000 debt relief).
In a property transaction, the fair market value of property received is the price determined by a willing seller and a willing buyer when neither
is compelled to sell or buy and both have reasonable knowledge of relevant facts. All of the relevant factors must be considered, and if the fair
market value of the property received cannot be determined, the value of the property given up by the taxpayer may be used.
When the assets of a business are acquired in a lump-sum purchase, the purchase price is allocated in accordance with the FMV of the assets on
the date of acquisition. Any excess is assigned to goodwill.
Example 5
There are several ways one can determine the fair market value of the land Juan is receiving. An appraiser can be paid to provide an appraisal of
the land. City or county property tax assessment information may also be helpful; the city or county assessor is tasked with the responsibility of
determining the fair market value of property so that property taxes are levied appropriately. Finally, if the exchange is between a willing buyer
and seller, determining the fair market value of Juan’s landscaping machine could answer the question (i.e., given the facts of the case, it should be
worth $56,000).
In calculating the amount realized, selling expenses (such as advertising, commissions, and legal fees) relating to the sale are deducted. As a result,
the amount realized is the net amount the taxpayer received directly or indirectly, in the form of cash or anything else of value, from the
disposition of the property.
The calculation of the amount realized may appear to be one of the least complex areas associated with property transactions. However, because
numerous positive and negative adjustments may be required, this calculation can be complex and confusing. In addition, determining the fair
market value of the items received by the taxpayer can be difficult. The following example provides insight into various items that can affect the
amount realized.The seller’s amount realized is increased by the amount of the seller’s liabilities assumbed by the buyer.
14-2Basis Considerations
LO.3
Review and illustrate how basis is determined for various methods of asset acquisition.
A key element in calculating gain or loss from a property transaction is the asset’s basis at the time of the transaction. Various methods for
determining basis apply, depending on how the asset was acquired.
Determination of Cost Basis
14-2a
As noted earlier, the basis of property is generally the property’s cost. Cost is the amount paid for the property in cash or other property.
A bargain purchase of property is an exception to the general rule for determining basis. A bargain purchase results when an employer transfers
property to an employee at less than the property’s fair market value (as compensation) or when a corporation transfers property to a
shareholder at less than the property’s fair market value (a dividend). The amount included in income as either compensation for services or
dividend income is the difference between the bargain purchase price and the property’s fair market value. The basis of property acquired in a
bargain purchase is the property’s fair market value. If the basis of the property were not increased by the bargain amount, the taxpayer
would be taxed on this amount again at disposition.
Example 14
Wade buys land from his employer for $10,000 on December 30. The fair market value of the land is $15,000.
Wade must include the $5,000 difference between the cost and the fair market value of the land in gross income for the taxable year. The bargain
element represents additional compensation to Wade. His basis for the land is $15,000, the land’s fair market value.
Identification Problems



Some of the assets acquired may be depreciable (e.g., buildings), while others are not (e.g., land).
If one of the assets acquired is sold, its basis must be known in order to compute realized gain or loss.
Some of the assets may be capital or § 1231 assets that receive special tax treatment when sold in the future.
The lump-sum cost is allocated on the basis of the fair market values of the individual assets acquired.
Example 16
Harry purchases a building and land for $800,000. Because of the depressed nature of the industry in which the seller was operating, Harry was
able to negotiate a very favorable purchase price. Appraisals of the individual assets indicate that the fair market value of the building is $600,000
and that of the land is $400,000.
Harry’s basis for the building is $480,000 [($600,000/$1,000,000) × $800,000], and his basis for the land is $320,000 [($400,000/$1,000,000) ×
$800,000].
If a business is purchased and goodwill is involved, a special allocation rule applies. Initially, the purchase price is allocated among the assets
acquired, other than goodwill, based on their fair market value. Goodwill is then assigned the residual amount of the purchase price. This
allocation applies to both the buyer and the seller. However, a $0 basis is assigned to developed or self-created goodwill.
+ Capital additions
Example 17
− Capital recoveries
Rocky sells his business to Paul. An independent appraisal indicates that the fair market value of the business assets, other than goodwill, are as
follows:
= Adjusted basis on date of disposition
Inventory
Capital Additions
Capital additions include the cost of capital improvements made to the property by the taxpayer. These costs are different from repair and
maintenance expenses, which are neither capitalized nor added to the original basis.Repair and maintenance expenses are deductible in the
current taxable year if they are related to business or income-producing property. Any liability on property that is assumed by the buyer is also
included in the buyer’s original basis of the property. The same rule applies if property is acquired subject to a liability. Amortization of the
discount on bonds increases the adjusted basis of the bonds. The buyer’s adjusted basis is decreased by the amount of liability assumed.
Capital Recoveries
Depreciation and Cost Recovery
The original basis of depreciable property is reduced by any cost recovery or depreciation
allowed while the property is held by the taxpayer. The amount subtracted annually from the original basis is the greater of
the allowed or allowable cost recovery or depreciation.
George, age 58, was entitled to a salary payment of $18,000 and a bonus of $20,000 at the time of his death. In addition, George had been
contributing to a traditional IRA for over 20 years. The IRA has a basis of $83,000 (due to some nondeductible contributions over the years) and a
current value of $560,000. George’s estate collects the salary and bonus payments, and George’s wife (his only beneficiary) cashes in the IRA.
Both the estate and George’s wife have income in respect of a decedent (IRD) and must include ordinary income in their computation of taxable
income for the year. The estate has IRD of $38,000 (salary of $18,000 + bonus of $20,000), and George’s wife has IRD of $477,000 ($560,000
proceeds – $83,000 basis). A better outcome might be achieved for George’s wife if she rolled over the inherited IRA into an IRA in her name and
deferred receiving distributions until required. (Note: Only a surviving spouse can roll over an inherited IRA without tax consequences.)
Survivor’s Share of Property
Both the decedent’s share and the survivor’s share of community property have a basis equal to the fair market value on the date of the decedent’s
death. This occurs because the decedent’s share of the community property is included in the estate and assumes a fair market value basis, while
the surviving spouse’s share is treated as if it were received from the decedent at its fair market value.
Example 27
Floyd and Vera are married and reside in a community property state. They own, as community property, 200 shares of Biltmore Company stock
acquired in 1991 for $100,000. Floyd dies in 2018, when the securities are valued at $300,000. One-half of the Biltmore stock is included in Floyd’s
estate. If Vera inherits Floyd’s share of the community property, the basis for gain or loss is $300,000, determined as follows:
In a common law state, only one-half of jointly held property of spouses (tenants by the entirety or joint tenants with rights of survivorship) is
included in the estate. In such a case, no adjustment of the basis is permitted for the excluded property interest (the surviving spouse’s share).
Example 28
Assume the same facts as in Example 27, except that the property is jointly held by Floyd and Vera who reside in a common law state. Floyd
purchased the property and made a gift of one-half of the property to Vera when the stock was acquired. No gift tax was paid. Only one-half of the
Biltmore stock is included in Floyd’s estate. Vera’s basis for determining gain or loss in the excluded half is not adjusted upward for the increase in
value to date of death. As a result, Vera’s basis is $200,000, determined as follows:
The holding period of inherited property is deemed to be long term (held for the required long-term holding period). This rule applies regardless of
whether the property is disposed of at a gain or at a loss.
14-2d
Disallowed Losses
Describe various loss disallowance provisions.
In certain situations, realized losses that normally would be recognized are disallowed. Transactions between related parties and wash sales are
two of these situations.
Related Taxpayers
Section 267 provides that realized losses from sales or exchanges of property, directly or indirectly, between certain related parties are not
recognized. This loss disallowance rule applies to several types of related-party transactions. The most common involve (1) members of a family
and (2) an individual and a corporation (where the individual owns, directly or indirectly, more than 50 percent in value of the corporation’s
outstanding stock.) The loss disallowance rules (1) prevent a taxpayer from directly transferring an unrealized loss to a related taxpayer in a
higher tax bracket who could receive a greater tax benefit from recognition of the loss and (2) eliminate a substantial administrative burden on
the Internal Revenue Service (there is no need to determine whether the selling price is equal to the asset’s fair market value). The rules
governing the relationships covered by § 267 were discussed in Chapter 6.
If income-producing or business property is transferred to a related taxpayer and a loss is disallowed, the related-party buyer’s basis is equal to
the amount paid (i.e., its cost). However, if the related-party buyer later sells the property and realizes a gain, the gain is reduced by the loss that
was previously disallowed. The seller’s disallowed loss can be used to offset any gain the buyer might have on a later resale of the
property. This right of offset is not applicable if the original sale involved the sale of a personal use asset (e.g., the sale of a personal residence
between related taxpayers). Furthermore, the right of offset is available only to the original transferee (the related-party buyer).
Example 29
Pedro sells business property with an adjusted basis of $50,000 to his daughter, Josefina, for its fair market value of $40,000. Pedro’s realized loss
of $10,000 is not recognized.

How much gain does Josefina recognize if she sells the property for $52,000? Josefina recognizes a $2,000 gain. Her realized gain is
$12,000 ($52,000 less her basis of $40,000), but she can offset Pedro’s $10,000 loss against the gain.

How much gain does Josefina recognize if she sells the property for $48,000? Josefina recognizes no gain or loss. Her realized gain is
$8,000 ($48,000 less her basis of $40,000), but she can offset $8,000 of Pedro’s $10,000 loss against the gain. The balance of Pedro’s disallowed
loss ($2,000) disappears and cannot be used. Note that Pedro’s loss can only offset Josefina’s gain. It cannot create a loss for Josefina.
$ 50,000
How much loss does Josefina recognize if she sells the property for $38,000? Josefina recognizes a $2,000 loss, the same as her
realized loss ($38,000 less $40,000 basis). Pedro’s loss does not increase Josefina’s loss. His500,000
loss can be offset only against a gain. Because Josefina
has no realized gain, Pedro’s loss cannot be used and is never recognized. Note that if the property was a personal use asset (not business), her
$2,000 loss would be personal and would not be recognized.
200,000
The holding period of the buyer for the property is not affected by the holding period of the seller. That is, the buyer’s holding period includes
only the period of time he or she has held the property.

Building
Land
After negotiations, Rocky and Paul agree on a sales price of $1 million. Applying the residual method with respect to goodwill results in the
following allocation of the $1 million purchase price:
Inventory
Capital recoveries decrease the adjusted basis of property. The prominent types of capital recoveries are discussed below.
Example 26
LO.4
Polly purchases 100 shares of Olive Corporation stock on July 1, 2016, for $5,000 ($50 a share) and another 100 shares of Olive stock on July 1,
2017, for $6,000 ($60 a share). She sells 50 shares of the stock on January 2, 2018.
The cost of the stock sold, assuming that Polly cannot adequately identify the shares, is $50 a share, or $2,500. This is the cost Polly will compare
with the amount realized in determining the gain or loss from the sale. If Polly was able to specifically identify the shares sold as the shares
purchased in 2017, the cost basis would be $60 a share and the holding period (see Chapter 16) would be short term.
When a taxpayer acquires multiple assets in a lump-sum purchase, the total cost must be allocated among the individual assets. Allocation is
necessary for several reasons:
Cost (or other adjusted basis) on date of acquisition
Income in respect of a decedent (IRD) usually exists when a cash basis taxpayer dies and, on the date of death, is entitled to some form of income
(e.g., compensation, interest, or dividends) but has yet to receive it. IRD is most frequently applicable to decedents using the cash basis of
accounting. IRD also occurs, for example, when a taxpayer at the time of death held installment notes receivable on which the gain has been
deferred. For both cash and accrual taxpayers, IRD includes most post-death distributions from retirement plans, including traditional IRAs and §
401(k) plans. With the exception of Roth IRAs, distributions from retirement plans invariably contain an income component that has not yet been
subject to income tax.
IRD is included in the gross estate at its fair market value (on the appropriate valuation date). Because IRD is not subject to the step-up or stepdown rules applicable to property passed by death, the income tax basis of the decedent transfers to the estate or heirs. Furthermore, the recipient
of IRD must classify it in the same manner (e.g., ordinary income or capital gain) as the decedent would have.
Example 15
Ridge sells an office building and the associated land on October 1, 2018. Under the terms of the sales contract, Ridge is to receive $600,000 in
cash. The purchaser is to assume Ridge’s mortgage of $300,000 on the property. To assist the purchaser, Ridge agrees to pay $15,000 of the
purchaser’s closing costs (a “closing cost credit”). The broker’s commission on the sale is $45,000. The amount realized by Ridge is determined as
follows:




Income in Respect of a Decedent
Holding Period of Inherited Property
Allocation Problems
The adjusted basis of property disposed of is the property’s original basis adjusted to the date of disposition. Original basis is the cost or other
basis of the property on the date acquired by the taxpayer. Many assets are acquired without purchasing them (e.g., via gift or inheritance). We’ll
discuss how to determine basis for these acquisitions later in the chapter. Capital additions increase and capital recoveries decrease the original
basis. As a result, adjusted basis is determined as follows:
Assume the same facts as in Example 24, except that the house’s fair market value at the date of Paula’s death was $260,000.
Alice’s basis for income tax purposes is $260,000. This is commonly referred to as a stepped-down basis.
The alternate valuation date and amount are only available to estates for which an estate tax return must be filed [generally, estates with a
valuation in excess of $11.18 million in 2018 ($5.49 million in 2017)]. In addition, the alternate valuation date can be elected only if, as a result of
the election, both the value of the gross estate and the estate tax liability are lower than they would have been if the primary valuation date had
been used. Even if an estate tax return is filed and the executor elects the alternate valuation date, the six months after death date is available only
for property that the executor has not distributed before this date. Any assets distributed during this 6 month period are valued as of the
distribution date.
Cost identification problems are frequently encountered in securities transactions. For example, the Regulations require that the taxpayer identify
the particular stock that has been sold (specific identification). A problem arises when the taxpayer has purchased separate lots of stock on
different dates or at different prices and cannot adequately identify the lot from which a particular sale takes place. In this case, the
stock is presumed to come from the first lot or lots purchased (a FIFO presumption). Brokers are now required to provide investors with an
annual report on the cost basis of stock sold during the year (this information is included on Form 1099–B and reported to the IRS).
Example 6
Adjusted Basis
Return to the facts of The Big Picture. Alice and various other family members inherited property from Paula, who died in 2017. At the date of
death, Paula’s basis for the property Alice inherited—Paula’s house—was $275,000. The house’s fair market value at the date of death was
$475,000. The alternate valuation date was not elected.
Alice’s basis for income tax purposes is $475,000. This is commonly referred to as a stepped-up basis.
Example 25
The Big Picture
The term sale or other disposition is defined broadly in the tax law and includes virtually any disposition of property. Transactions such as tradeins, casualties, condemnations, thefts, and bond retirements are all treated as property dispositions. Sales or exchanges are the most common
dispositions of property. Identifying a specific economic event (e.g., a sale) is a key factor in determining whether a disposition has occurred. A
change in the value of the property is not sufficient.
Lori owns Tan Corporation stock that she bought for $3,000. The stock has appreciated in value and is now worth $5,000. Lori has no realized gain
because a change in value is not an identifiable event for tax purposes. Here, Lori has an unrealized gain of $2,000.
The same is true if the stock had declined in value to $1,000. As there was no identifiable event, there is no realized loss. Here, Lori would have
an unrealized loss of $2,000.
The Big Picture
Building
Land
Example 7
Goodwill
The machine Juan sold was acquired four years ago for $100,000. It was 7-year MACRS property, and Juan did not take either an immediate
expense deduction (§179) or bonus depreciation on the property. Juan’s adjusted basis is $37,485, computed as follows:
The residual method requires that the excess of the purchase price over the fair market value of the assets other than goodwill be allocated to
goodwill.
In the case of nontaxable stock dividends, the allocation depends on whether the dividend is a common stock dividend on common stock or a
preferred stock dividend on common stock. If the stock dividend is common on common, the cost of the original common shares is allocated to the
total shares owned after the dividend.
Nontaxable stock dividends result in a lower cost per share for all shares than before the stock dividend.
Wash Sales
$ 50,000
The wash sale rules (§ 1091) are designed to eliminate the opportunity to sell stock at a loss,
recognize the loss for tax purposes, but replace the
stock sold by buying identical shares shortly before or after the sale. If § 1091 applies, a realized loss on the sale or exchange of stock or securities
is not recognized. Recognition of the loss is disallowed because the taxpayer is considered 500,000
to be in substantially the same economic position after
the sale and repurchase as before the sale and repurchase.
200,000
The wash sale rule applies if a taxpayer sells or exchanges stock or securities at a loss
and within 30 days before or after the date of the
sale or exchange acquires substantially identical stock or securities. An option to purchase substantially identical securities is treated the
250,000 substantially identical to the corporation’s
same as actually buying the stock. Corporate bonds and preferred stock normally are not considered
common stock. Attempts to avoid the application of the wash sales rules by having a related taxpayer repurchase the securities have been
unsuccessful. The wash sales provisions do not apply to gains.
Conce pt Sum mar y 14.3
Wash Sal e Rul es
Example 18
As Juan’s amount realized on the sale was $56,000, his realized gain is $18,515, computed as follows:
Casualties and Thefts
A casualty or theft may result in the reduction of the adjusted basis of property. The adjusted basis is
reduced by the amount of the deductible loss. In addition, the adjusted basis is reduced by the amount of insurance proceeds received.
However, the receipt of insurance proceeds may result in a recognized gain rather than a deductible loss. The gain increases the adjusted basis of
the property. The adjusted basis of property that is stolen is reduced by the amount of insurance proceeds received and reduced by any
recognized loss.
Susan owns 100 shares of Sparrow Corporation common stock for which she paid $1,100. She receives a 10% common stock dividend, giving her
a new total of 110 shares. Before the stock dividend, Susan’s basis was $11 per share ($1,100 ÷ 100 shares). The basis of each share after the stock
dividend is $10 ($1,100 ÷ 110 shares).
If the nontaxable stock dividend is preferred stock on common, the cost of the original common shares is allocated between the common and
preferred shares on the basis of their relative fair market values on the date of distribution.
Example 19
Fran owns 100 shares of Cardinal Corporation common stock for which she paid $1,000. She receives a nontaxable stock dividend of 50 shares of
preferred stock on her common stock. The fair market values on the date of distribution of the preferred stock dividend are $30 a share for
common stock and $40 a share for preferred stock.
Example 8
Capital Recoveries: Casualties and Thefts
An insured truck that Marvin used in his trade or business is destroyed in an accident. At the time of the accident, the adjusted basis was $8,000,
and the fair market value was $6,500. Marvin receives insurance proceeds of $6,500.
The amount of the casualty loss is $1,500 ($6,500 insurance proceeds − $8,000 adjusted basis). The truck’s adjusted basis is reduced by the $1,500
casualty loss and the $6,500 of insurance proceeds received .
Example 9
Capital Recoveries: Casualties and Thefts
How would your answer to Example 8 change if the basis of the truck was $6,000, its fair market value was $9,000, and Marvin received a $9,000
insurance settlement? Now Marvin has a casualty gain of $3,000 ($9,000 insurance proceeds − $6,000 adjusted basis). The truck’s adjusted basis is
increased by the $3,000 casualty gain and is reduced by the $9,000 of insurance proceeds received .
Certain Corporate Distributions
A nontaxable corporate distribution is treated as a return of capital, and it reduces the
shareholder’s stock basis. Corporations normally disclose this information to shareholders. Once the basis of the stock is reduced to zero, the
amount of any subsequent distributions is a capital gain if the stock is a capital asset. If the amount of a corporate distribution is less than
the amount of the corporate earnings and profits, the return of capital concept does not apply and the shareholders’ adjusted basis for
the stock remains unchanged. The distribution to a shareholder in this situation is classifed as dividend income, therefore there is no
effect on the shareholders’ stock basis.
Amortizable Bond Premium
The basis in a bond purchased at a premium is reduced by the amortizable portion of the bond
premium. Investors in taxable bonds may elect to amortize the bond premium, with an interest deduction allowed for the amount of the amortized
premium. So the election enables the taxpayer to take an annual interest deduction to offset ordinary income in exchange for a larger capital gain
or smaller capital loss on the disposition of the bond. The amortization deduction is allowed for taxable bonds because the premium is viewed as a
cost of earning the taxable interest from the bonds.
Unlike taxable bonds, the premium on tax-exempt bonds must be amortized (and the basis is reduced even though the amortization is not allowed
as a deduction). No amortization deduction is permitted on tax-exempt bonds because the interest income is exempt from tax and the
amortization of the bond premium merely represents an adjustment of the tax-exempt income earned on the bond.
Example 10
Antonio purchases Eagle Corporation taxable bonds with a face value of $100,000 for $110,000, thus paying a premium of $10,000. The annual
interest rate is 7%, and the bonds mature 10 years from the date of purchase. The annual interest income is $7,000 (7% × $100,000).
If Antonio elects to amortize the bond premium, the $10,000 premium is deducted over the 10-year period. Antonio’s basis for the bonds is
reduced each year by the amount of the amortization deduction.
If the bonds were tax-exempt, amortization of the bond premium and the basis adjustment would be mandatory. However, no deduction would be
allowed for the amortization.
Easements
An easement is the legal right to use another’s land for a special purpose. Historically, easements have been used to obtain
rights-of-way for utility lines, roads, and pipelines. In recent years, grants of conservation easements have become a popular means of obtaining
charitable contribution deductions and reducing the value of real estate for transfer tax (i.e., estate and gift) purposes. For example, a conservation
easement on property containing a rare wildlife habitat might prohibit any development, while one on a farm might allow continued farming and
the building of additional agricultural structures but no other development. Although a conservation easement can be sold, typically it is donated
to a charitable organization (like the Nature Conservancy). If donated, the difference between the value of the land with and without the easement
would be a charitable contribution. Likewise, scenic easements (granted to protect open spaces or scenic views) are used to reduce the value of
land as assessed for property tax purposes.
The amount received for granting an easement is subtracted from the basis of the property. If the taxpayer does not retain any right to the use of
the land, all of the basis is assigned to the easement. However, if the use of the land is only partially restricted, an allocation of some of the basis to
the easement is appropriate. If, however, it is impossible or impractical to separate the basis of the part of the property on which the easement is
granted, the basis of the whole property is reduced by the amount received. If the amount received for the easement exceeds the basis, a taxable
gain results. The amount received for a utility easement reduces the basis of the land. Does not have to include any of it in gross income.
Additional Complexities
Three types of issues tend to complicate the determination of adjusted basis. First, the applicable tax provisions for calculating the adjusted basis
depend on how the property was acquired (e.g., purchase, taxable exchange, nontaxable exchange, gift, or inheritance). These complications are
discussed in text Section 14-2. Second, if the asset is subject to depreciation, cost recovery, amortization, or depletion, adjustments must be made
to the basis during the time period the asset is held by the taxpayer. When the asset is sold, the taxpayer’s records for both acquisition basis and
adjustments to basis may not be complete. For example, the donee may not know the amount of the donor’s basis. Third, the complex positive and
negative adjustments encountered in calculating the amount realized are also involved in calculating the adjusted basis.
Example 11
Jane purchased a personal residence in 2009. The purchase price and the related closing costs were as follows:
Purchase price
Recording costs
Title fees and title insurance
When a taxpayer receives property as a gift, there is no cost to the donee (recipient). Thus, under the cost basis provision, the donee’s basis would
be zero. However, this would violate the statutory intent that gifts not be subject to the income tax. With a zero basis, if the donee sold the
property, all of the amount realized would be treated as realized gain. Therefore, a basis is assigned to the property received depending on the
following:




The date of the gift.
The basis of the property to the donor.
The amount of the gift tax paid.
The fair market value of the property.
Gift Basis Rules, in General
The basis rules for gifts of property are as follows:

If the fair market value of the property on the date of the gift exceeds (or is equal to) the donor’s basis, then the
recipient’s (donee’s) basis is the same as the donor’s (i.e., a carryover basis).
Example 20
Melissa purchased stock in 2017 for $10,000. In 2018, she gave the stock to her son, Joe, when the fair market value was $15,000. Joe
subsequently sells the property for $18,000. Joe’s basis is $10,000, and he has a realized gain of $8,000.
If Joe sold the stock for $12,000, he would have a realized gain of $2,000 (his basis is $10,000). If Joe sold the stock for $7,000, he would have a
realized loss of $3,000 ($7,000 – $10,000).

If the fair market value of the property on the date of the gift is less than the donor’s basis, then special dual basis rules
apply. Here, the donee has one basis for measuring a gain and a different basis for measuring a loss. This special rule is in place to prevent the
shifting of losses (typically among family members) to the individual who would receive the greatest benefit. Under this rule, the donee’s gain
basis is the donor’s adjusted basis; the donee’s loss basis is the fair market value of the property.
Example 21
Burt purchased stock in 2017 for $10,000. In 2018, he gave the stock to his son, Cliff, when the fair market value was $7,000. Cliff later sells the
stock for $6,000.
Cliff’s basis is $7,000 (fair market value is less than donor’s adjusted basis of $10,000), and the realized loss from the sale is $1,000 ($6,000
amount realized – $7,000 basis).
The amount of the loss basis will differ from the amount of the gain basis only if, at the date of the gift, the adjusted basis of the property exceeds
the property’s fair market value. Note that the loss basis rule prevents the donee from receiving a tax benefit from a decline in value that occurred
while the donor held the property.
Therefore, in Example 21, Cliff has a loss of only $1,000 rather than a loss of $4,000 ($6,000 – $10,000). The $3,000 difference represents the
decline in value that occurred while Burt held the property. Ironically, however, the donee may be subject to income tax on the appreciation that
occurred while the donor held the property, as illustrated in Example 20.
If the amount realized from a sale is between the donee’s loss basis and gain basis, no gain or loss is realized.
Example 30
The Big Picture
Return to the facts of The Big Picture. Alice owned 100 shares of Green Corporation stock (basis of $20,000). She sold 50 shares for $8,000. Ten
days later, she purchased 50 shares of the same stock for $7,000.
Alice’s realized loss of $2,000 ($8,000 amount realized – $10,000 basis of 50 shares) is not recognized because it resulted from a wash sale. Alice’s
basis in the newly acquired stock is $9,000 ($7,000 purchase price + $2,000 unrecognized loss from the wash sale).
A taxpayer may acquire fewer shares than the number sold in a wash sale. In this case, the loss from the sale is prorated between recognized and
unrecognized loss on the basis of the ratio of the number of shares acquired to the number of shares sold. The wash sale rules do not apply to
taxpayers engaged in the business of buying and selling securities.
Conversion of Property from Personal Use to Business
or Income-Producing Use
14-2e
As discussed previously, losses from the sale of personal use assets are not recognized for tax purposes, but losses from the sale of business and
income-producing assets are deductible. Can a taxpayer convert a personal use asset that has declined in value to business or income-producing
use and then sell the asset to recognize a business or income-producing loss?
The tax law prevents this practice by specifying that the original basis for loss on personal use assets converted to business or income-producing
use is the lower of the property’s adjusted basis or fair market value on the date of conversion. If property that has been conveted from personal
use to biz use has appreciated in value, the basis for gain will be the same as the basis for loss. The gain basis for converted property is the
property’s adjusted basis on the date of conversion. The basis for loss of the converted property is the lower of the adjusted basis or the fmv on
the date of conversion. the basis for gain is the adjusted basis at the date of conversion.
The tax law is not concerned with gains on converted property because gains are recognized regardless of whether property is business, incomeproducing, or personal use.
Example 31
Diane’s personal residence has an adjusted basis of $175,000 and a fair market value of $160,000. Diane converts the personal residence to rental
property. Her basis for loss is $160,000 (lower of $175,000 adjusted basis and fair market value of $160,000). The $15,000 decline in value is a
personal loss and can never be recognized for tax purposes. Diane’s basis for gain is $175,000.
The basis for loss is also the basis for depreciating the converted property. This is an exception to the general rule that the basis for depreciation is
the gain basis (e.g., property received by gift). This exception prevents the taxpayer from recovering a personal loss indirectly through
depreciation of the higher original basis. After the property is converted, both its basis for loss and its basis for gain are adjusted for depreciation
deductions from the date of conversion to the date of disposition. These rules apply only if a conversion from personal to business or incomeproducing use has actually occurred.
Example 32
At a time when his personal residence (adjusted basis of $140,000) is worth $150,000, Keith converts one-half of it to rental use. For simplicity,
assume that the property is not covered by MACRS, will be depreciated using the straight-line method, has an estimated useful life of 20 years, and
has no salvage value. As a result, annual depreciation will be $3,500 ($70,000 ÷ 20 years).
After renting the converted portion for five years, Keith sells the property for $144,000. All amounts relate only to the building; assume that the
land has been accounted for separately. Keith has a $2,000 realized gain from the sale of the personal use portion of the residence and a $19,500
realized gain from the sale of the rental portion. These gains are computed as follows:
Example 22
Assume the same facts as in Example 21, except that Cliff sells the stock for $8,000. Application of the gain basis rule produces a loss of $2,000
($8,000 – $10,000). Application of the loss basis rule produces a gain of $1,000 ($8,000 – $7,000).
Because the amount realized is between the gain basis and the loss basis, Cliff recognizes neither a gain nor a loss.
Adjustment for Gift Tax
Because of the size of the unified estate and gift tax exemption ($11.18 million in 2018), basis adjustments for gift taxes paid are rare. If, however,
gift taxes are paid by the donor, the portion of the gift tax paid that is related to any appreciation is taken into account in determining the donee’s
gain basis.
For gifts made before 1977, the full amount of the gift tax paid is added to the donor’s basis, with basis capped at the donor’s fair market value at
the date of the gift.Basis in the stock is the lesser of the adjusted basis + paid gift tax or the FMV of the stock. (if gift was made before 1977). Loss
basis is equal to the lesser of the fmv of the gifted property on the date of the gift or the donors adjusted basis. In circumstance where the fmv of
the gifted property exceeds the donors adjusted basis, the gain basis and the loss basis amounts will be the same. If no gift tax is paid, it is the
donors adjusted basis at the date of the gift. If gift occurred after 1977, all gift tax paid is added to the adjusted basis for the recipient.
As discussed in Chapter 15, Keith may be able to exclude the $2,000 realized gain from the sale of the personal use portion of the residence (see
text Section 15-4). If the exclusion applies, only $17,500 (equal to the depreciation deducted) of the $19,500 realized gain from the rental portion
is recognized.
Example 33
Assume the same facts as in Example 32, except that the fair market value on the date of conversion is $130,000 and the sales proceeds are
$90,000. Keith has a $25,000 realized loss from the sale of the personal use portion of the residence and a $3,750 realized loss from the sale of the
$325,000
rental portion. These losses are computed as follows:
140
815
225
750
Basis for Depreciation
Appraisal fee
Other relevant tax information for the house during the time Jane owned it is as follows:


Basis
The holding period for property acquired by gift begins on the date the donor acquired the property if the gain basis rule applies. The holding
period starts on the date of the gift if the loss basis rule applies.
Attorney’s fees
expense.
14-2bGift
Holding Period
Survey costs

The basis per share for the common stock is $6 ($600/100 shares). The basis per share for the preferred stock is $8 ($400/50 shares).
The holding period for a nontaxable stock dividend, whether received in the form of common stock or preferred stock, includes the
holding period of the original shares. The significance of the holding period for capital assets is discussed in Chapter 16.
Realized loss that is not recognized is added to the basis of the substantially identical stock or securities whose acquisition resulted in the
nonrecognition of loss. In other words, the basis of the replacement stock or securities is increased by the amount of the unrecognized loss. If the
loss were not added to the basis of the newly acquired stock or securities, the taxpayer would never recover the entire basis of the old stock or
securities.
The basis of the new stock or securities includes the unrecovered portion of the basis of the formerly held stock or securities. As a result,
the holding period of the new stock or securities begins on the date of acquisition of the old stock or securities.
Constructed a swimming pool for medical reasons. The cost was $20,000, of which $5,000 was deducted as a medical
Added a solar heating system. The cost was $18,000.
The basis for depreciation on depreciable gift property is the donee’s gain basis. This rule is applicable even if the donee later sells the property at
a loss and uses the loss basis rule in calculating the amount of the realized loss.
Example 23
Vito gave a machine (a MACRS 5-year asset) to Tina in 2018. At that time, the adjusted basis was $32,000 (cost of $40,000 less accumulated
depreciation of $8,000), and the fair market value was $26,000. No gift tax was paid. Tina’s gain basis at the date of the gift is $32,000, and her loss
basis is $26,000. During 2018, Tina deducts depreciation (cost recovery) of $6,400 ($32,000 × 20%). At the end of 2018, Tina’s gain basis and loss
basis are calculated as follows:
Deducted home office expenses of $6,000. Of this amount, $5,200 was for depreciation.
The adjusted basis of the house is $354,980, calculated as follows:
14-2c
Inherited Property
Special basis rules apply for inherited property (property acquired from a decedent). Typically, these rules are favorable to the taxpayer receiving
this property.
General Rules
Recognized Gain or Loss
14-1b
LO.2
Distinguish between realized and recognized gain or loss.
The basis of inherited property is generally the property’s fair market value at the date of death (referred to as the primary valuation amount). The
property’s basis is the fair market value six months after the date of death if the executor or administrator of the estate elects the alternate
valuation date for estate tax purposes. This amount is referred to as the alternate valuation amount. Can only elect it if it is less than what it would
have been on date of death. BUT even if an estate tax return is filed and the executor elects the alternate valuation date, the six months after death
date is available only for property that the executor has not distributed before this date.
Example 24
14-2f
The $25,000 loss from the sale of the personal use portion of the residence is not
recognized. The $3,750 loss from the rental portion is recognized.
250
Summary
of Basis Adjustments
Some of the more common items that either increase or decrease the basis of an asset appear in Concept Summary 14.4.
Adjustme nts to Basi s
Conce pt Sum mar y 14.4
Item
Amortization of bond
discount
Amortization of bond
premium
Amortization of
covenant not to compete
Amortization of
intangibles
Assessment for local
benefits
Increase
Effect
Refer to
Chapter
16
Decrease
14
Decrease
8
Decrease
8
Increase
10
Decrease
7
Capital additions
Increase
14
Casualty
Decrease
7
Bad debts
Explanation
Amortization is mandatory for certain taxable bonds and elective
for tax-exempt bonds.
Amortization is mandatory for tax-exempt bonds and elective for
taxable bonds.
Covenant must be for a definite and limited time period. The
amortization period is a statutory period of 15 years.
Intangibles are amortized over a 15-year period.
To the extent not deductible as taxes (e.g., assessment for streets
and sidewalks that increase the value of the property versus one
for maintenance or repair or for meeting interest charges).
Only the specific charge-off method is permitted.
Certain items, at the taxpayer’s election, can be capitalized or
deducted (e.g., selected medical expenses).
For a casualty loss, the amount of the adjustment is the sum of
the deductible loss and the insurance proceeds received. For a
casualty gain, the amount of the adjustment is the insurance
proceeds received reduced by the recognized gain.
Condemnation
Decrease
15
Cost recovery
Decrease
8
Depletion
Decrease
Depreciation
Decrease
8
Easement
Decrease
14
Improvements by lessee
to lessor’s property
Increase
5
Imputed interest
Inventory: lower of cost
or market
Decrease
Decrease
Limited expensing under
§ 179
Decrease
8
Medical capital
expenditure permitted
as a medical expense
Real estate taxes:
apportionment between
the buyer and seller
Decrease
10
Increase or
decrease
10
8
18
18
See casualty explanation.
In this case, Jason’s $97,000 realized gain is deferred, and the basis of his new boat must reflect that deferral. As a result, his new boat’s
basis is $83,000 ($180,000 cost − $97,000 deferred gain).
§ 168 is applicable to tangible assets placed in service after 1980
whose useful life is expressed in terms of years.
Use the greater of cost or percentage depletion. Percentage
depletion can still be deducted when the basis is zero.
§ 167 is applicable to tangible assets placed in service before
1981 and to tangible assets not depreciated in terms of years.
If the taxpayer does not retain any use of the land, all of the basis
is allocable to the easement transaction. However, if only part of
the land is affected by the easement, only part of the basis is
allocable to the easement transaction.
Example 17
Involuntary Conversions: General Rules
Adjustment occurs only if the lessor is required to include the fair
market value of the improvements in gross income under § 109.
Example 18
Occurs only if the taxpayer elects § 179 treatment.
Adjustment is the amount of the deduction (the effect on basis is
to increase it by the amount of the capital expenditure net of the
deduction).
To the extent the buyer pays the seller’s pro rata share, the
buyer’s basis is increased. To the extent the seller pays the
buyer’s pro rata share, the buyer’s basis is decreased.
Because the rebate is treated as an adjustment to the purchase
price, it is not included in the buyer’s gross income.
Stock dividend
Decrease
14
Adjustment occurs only if the stock dividend is nontaxable. While
the basis per share decreases, the total stock basis does not
change.
Stock rights
Decrease
14
Adjustment to stock basis occurs only for nontaxable stock rights
and only if the fair market value of the rights is at least 15% of the
fair market value of the stock or, if less than 15%, the taxpayer
elects to allocate the basis between the stock and the rights.
7
See casualty explanation.




Example 27
Mitch graduates from college and moves to Boston, where he is employed. He decides to rent an apartment in Boston because of its
proximity to his place of employment. He purchases a beach condo in the Cape Cod area that he occupies most weekends. Mitch does not
intend to live at the beach condo except on weekends. The apartment in Boston is his principal residence.
Refer to the facts of Example 15, but assume that Jason had only partial coverage on his boat and his insurance settlement is only $50,000.
In this case, Jason has a loss of $28,000, computed as follows:
15-4bRequirements
Reference to the asset’s cost.
Reference to the basis of another asset.
Reference to the asset’s fairmarket value.
Reference to the basis of the asset to another taxpayer.
Example 28
Melissa sells her principal residence on September 18, 2018. She had purchased it on July 5, 2016, and lived in it since then. The sale of
Melissa’s residence qualifies for the § 121 exclusion.
The ownership and use requirements are two separate tests. Although in most situations ownership and use overlap (as in Example 28),
there is no requirement that they do for purposes of § 121. Further, the law does not require that the two-year periods be continuous.
Involuntary Conversion Defined
An involuntary conversion results from the destruction (complete or partial), theft, seizure, condemnation, or sale or exchange under
threat of condemnation (e.g., a city seizing property under its right of eminent domain) of the taxpayer’s property. A voluntary act (e.g., a
taxpayer destroying the property by arson), is not an involuntary conversion.
Government seizures are unique events, and as a result, a unique set of rules have developed under § 1033. In general, for § 1033 to apply,
the government entity must have made a decision to acquire the property for public use, and the taxpayer must have reasonable grounds to
believe the property will be taken.
Example 29
Ownership and Use Tests
Sarah purchased a home in San Diego in May 2003 and lived in it until she took a new job in Los Angeles on January 1, 2014. From January
2014 until she sold the house on July 31, 2018, she only used the home occasionally, as she lived in an apartment near her job in downtown
Los Angeles. As the house was sold on July 31, 2018, the five-year window runs from August 1, 2013, to the date of sale.
In determining whether the § 121 exclusion is available, Sarah has met the ownership test because she owned the house for two of the five
years prior to its sale. However, she fails the use test because she did not use the home as her principal residence for two of the five years
before its sale (during the five-year window, she used the house as her principal residence from August 1, 2013, to December 31, 2013—
only five months).
Computing the Amount Realized
15-3b
The amount realized from an involuntary conversion is normally any insurance proceeds received. In the case of the condemnation of
property, the amount realized usually includes only the amount received as compensation for the property.
Any amount received that is designated as severance damages by both the government and the taxpayer is not included in the amount
realized. Severance awards usually occur when only a portion of the property is condemned (e.g., a strip of land is taken to build a
highway). Severance damages are awarded because the value of the taxpayer’s remaining property has declined as a result of the
condemnation. In general, severance damages are a tax-free recovery of capital and reduce the basis of the property.
Example 30
Ownership and Use Tests
Charles lives in a townhouse that he rents from 2011 through January 17, 2015. On January 18, 2015, he purchases the townhouse. On
February 1, 2016, due to a decline in health, Charles moves into his daughter’s home. On May 25, 2018, while still living in his daughter’s
home, Charles sells his townhouse.
The § 121 exclusion will apply because Charles owned the townhouse for at least two years out of the five years preceding the sale (from
January 19, 2015, until May 25, 2018) and he used the townhouse as his principal residence for at least two years during the five-year
period preceding the sale [from May 25, 2013 (the beginning of the five-year window) until February 1, 2016].
In applying the use test, short absences (i.e., vacation or other seasonal absence) are counted as periods of use. In addition, short-term
rental of the property is ignored.
Example 19
The government condemns a portion of Ron’s farmland to build part of an interstate highway. Because the highway denies his cattle access
to a pond and some grazing land, Ron receives severance damages in addition to the condemnation proceeds for the land taken.
Ron must reduce the basis of the property by the amount of the severance damages. If the amount of the severance damages received
exceeds the adjusted basis, Ron recognizes gain.
Replacement Property
Example 31
The requirements for replacement property generally are more restrictive than those for like-kind property under § 1031. The basic
requirement is that the replacement property be similar or related in service or use to the involuntarily converted property.
Different interpretations of the phrase similar or related in service or use apply depending on whether the involuntarily converted property
is held by an owner-user (e.g., in a business or by an individual) or by an owner-investor (e.g., lessor). For an owner-investor, the taxpayer
use test applies, and for an owner-user, the functional use test applies. As you might guess, the functional use test is more restrictive than
the taxpayer use test. In addition, a special test applies in the case of involuntary conversions that result from condemnations.
Aaron has owned and used his house as his principal residence since 2002. On January 31, 2015, Aaron moves to another state. Aaron rents
his house to tenants from that date until April 18, 2017, when he sells it.
Aaron is eligible for the § 121 exclusion because he has owned and used the house as his principal residence for at least two of the five
years preceding the sale.
The five-year window enables the taxpayer to qualify for the § 121 exclusion even though the property is not his or her principal residence
at the date of the sale.
Taxpayer Use Test
Example 32
The taxpayer use test for owner-investors provides much more flexibility in terms of what qualifies as replacement property. Essentially,
the properties must be used by the owner-investor in similar endeavors. For example, rental property held by an owner-investor qualifies
if replaced with other rental property, regardless of the type of rental property involved. For example, the test is met if the owner-investor
of a building being rented to a manufacturing business replaces the facility with a building rented to a business using the facility as a
grocery warehouse. The replacement of a rental residence with a personal residence does not meet the test.
Benjamin sells his former principal residence on August 16, 2018. He had purchased it on April 1, 2010, and lived in it until July 1, 2017,
when he converted it to rental property.
Even though the property is rental property on August 16, 2018, rather than Benjamin’s principal residence, the sale qualifies for the § 121
exclusion. During the five-year period from August 16, 2013, to August 16, 2018, Benjamin owned and used the property as his principal
residence for at least two years.
In addition to the ownership and use requirements, § 121 can only be used once every two years. This rule restricts taxpayers who might
be tempted to make liberal use of the § 121 exclusion as a means of speculating when the price of residential housing is rising. Without any
time restriction on its use, § 121 would permit the exclusion of realized gain on multiple sales of principal residences.
Functional Use Test
14-3Tax Planning
LO.5
The functional use test applies to owner-users. Under this test, the taxpayer’s use of the replacement property and of the involuntarily
converted property must be the same. A manufacturer whose manufacturing plant is destroyed by fire is required to replace the plant with
another facility of similar functional use. Replacing a manufacturing plant with an office building (both used in the same business)
does not meet this test. The manufacturing plant would have to be replaced with another manufacturing plant. Replacing a rental residence
with a personal residence also does not pass the test.
Identify tax planning opportunities related to selected property transactions.
for Exclusion Treatment
To qualify for exclusion treatment, at the date of the sale, the residence must have been owned and used by the taxpayer as the principal
residence for at least two years during the five-year period ending on the date of the sale.
15-3a
15-3c
There are a number of techniques for determining basis for tax purposes, with the method dependent on the manner in which the asset was
acquired. In summary, the basis of an asset can be determined by:
Residence
Whether property is the taxpayer’s principal residence “depends upon all of the facts and circumstances in each case.” According to the
Regulations, the most important factor is where the taxpayer spends most of his or her time. A residence does not have to be a house. For
example, a houseboat, a house trailer, or a motor home can qualify. The principal residence includes the land on which a home sits (so any
gain on the land also qualifies for exclusion). An adjacent lot can qualify if it is regularly used by the owner as part of the residential
property.
In this case, § 1033 will not apply to the transaction, and Jason’s realized loss of $28,000 is recognized.
With this background, we will now explore the various terms (and related definitions) that are part of § 1033, the reinvestment timing
required to secure gain deferral, and the related reporting requirements.
Decrease
Decrease
15-4aPrincipal
Continuing with the facts of Example 15, assume that Jason is able to negotiate an excellent price for his new boat. In fact, he is able to
replace his old boat for only $168,000 and uses the $7,000 remaining from the insurance settlement to pay for other business expenses.
What happens in this case?
Here, Jason must recognize a gain of $7,000, the difference between the $175,000 insurance settlement and the amount he paid for the new
boat ($168,000; the amount of the insurance proceeds he reinvested in replacement property).
The balance of the realized gain is deferred, and the basis of his new boat must reflect that deferral. As a result, his new boat’s basis is
$78,000 ($168,000 cost − $90,000 deferred gain).
If an involuntary conversion results in a loss, § 1033 does not change the normal loss recognition rules. In other words, if a realized loss
would otherwise be recognized, § 1033 does not change the result.
Amount deducted is not part of the cost of the asset.
Not available if the LIFO method is used.
Rebate from
manufacturer
Theft
What if the Atwoods sold their home for $500,000? In this case, since their home is a personal use asset, they would have a $25,000
realized loss that would not be recognized.
Main content
Example 33
Mike sells his principal residence (the first residence) in June 2017 for $150,000 (realized gain of $60,000). He then buys and sells the
following (all of which qualify as principal residences):
Special Rule for Condemnations
If business real property or investment real property is condemned, the broader replacement rules for like-kind exchanges can be used
instead of the narrower involuntary conversion replacement rules. This gives the taxpayer substantially more flexibility in selecting
replacement property. For example, improved real property can be replaced with unimproved real property.
The rules concerning the nature of replacement property are illustrated in Concept Summary 15.2.
Cost Identification and
Documentation Considerations
14-3a
Conce pt Sum mar y 15.2
Invol u ntar y Co nv ersi ons: Re pl acem ent Prop erty Tests
When multiple assets are acquired in a single transaction, the contract price must be allocated for several reasons.
First, some of the assets may be depreciable, while others are not. Here, the buyer and the seller may have different
tax perspectives that will need to be reconciled. The seller will likely prefer a high allocation for nondepreciable
assets (see Chapters 16 and 17), while the purchaser will likely prefer a high allocation for depreciable assets
subject to cost recovery. Second, the seller must be able to characterize gains and losses appropriately as capital or
ordinary. Allocating the price among the assets sold allows this to happen. For example, an allocation to goodwill or
to a covenant not to compete (see Chapters 8, 16, and 17) produces different tax consequences to the seller. Third,
the buyer must be able to identify the adjusted basis of each asset to be able to determine cost recovery,
amortization, or depletion (if available) and to calculate the realized gain or loss if an asset is sold.
14-3b
Type of Property and User
Taxp
ayer
Use
Test
Second residence
Func
tion
al
Use
Test
Selection of Property for Making Gifts
A donor can achieve several tax advantages by making gifts of appreciated property. The donor avoids income tax
on the unrealized gain that would have occurred had the property been sold. And if the donee is in a lower tax
bracket than the donor, there will be tax savings if the property is sold. Any increase in value after the gift will also
be taxed at a lower rate. Such gifts of appreciated property can be an effective tool in family tax planning.
Taxpayers should generally not make gifts of depreciated property (property that, if sold, would produce a realized
loss) because the donor does not receive an income tax deduction for the unrealized loss element. In addition, the
donee receives no benefit from this unrealized loss upon the subsequent sale of the property because of the loss
basis rule. If the donor anticipates that the donee will sell the property upon receiving it, the donor should sell the
property and take the loss deduction, assuming that the loss is deductible. The donor can then give the proceeds
from the sale to the donee.
14-3c
Date of Purchase
Date of Sale
July 2017
Second residence
Spec
ial
Rule
for
Con
dem
nati
ons
Third residence
April 2018
May 2018
Because multiple sales have taken place within a period of two years, § 121 does not apply to the sale of the second residence. Thus, the
realized gain of $20,000 [$180,000 (selling price) − $160,000
15-4cCalculation of the Exclusion Amount
General Rule
An investor’s rented shopping mall is destroyed by fire; the mall may be
X
replaced with other rental properties (e.g., an apartment building).
Selection of Property for Inheritances
A taxpayer should generally distribute appreciated property via his or her will. Doing so enables both the decedent
and the heir to avoid income tax on the unrealized gain because the recipient takes the fair market value as his or
her basis.
Taxpayers generally should not distribute depreciated property (property that, if sold, would produce a realized
loss) via his or her will because the decedent does not receive an income tax deduction for the unrealized loss. In
addition, the heir will receive no benefit from this unrealized loss upon the subsequent sale of the property.
Example 34
On the date of her death in 2018, Marta owned land held for investment purposes. The land had an adjusted basis of $130,000 and a fair market value of
$100,000. If Marta had sold the property before her death, the recognized loss would have been $30,000.
If Roger inherits the property and later sells it for $90,000, the recognized loss is $10,000 (the decline in value since Marta’s death). In addition,
regardless of the period of time Roger holds the property, the holding period is long term (see Chapter 16).
From an income tax perspective, it is better to transfer appreciated property as an inheritance rather than as a gift.
Why? Because inherited property receives a step-up in basis, while property received by gift has a carryover basis
to the donee. However, in making this decision, the estate tax consequences of the inheritance should also be
weighed against the gift tax consequences of the gift.
Disallowed Losses
A manufacturing plant is destroyed by fire; replacement property must
consist of another manufacturing plant that is functionally the same as
the property converted.
X
Personal residence of a taxpayer is condemned by a local government authority;
replacement property must consist of another personal residence.
X
The § 121 exclusion available on the sale of a principal residence is $250,000. If the realized gain does not exceed $250,000, there is no
recognized gain.
Realized gain is calculated in the normal manner. The amount realized is the selling price less any selling expenses (e.g., real estate broker
commissions, advertising expenses, and legal fees). Repairs and maintenance costs to aid in selling the property are personal expenses and
not deductible (and they do not increase the home’s basis).
Example 34
The Big Picture
Return to the facts of The Big Picture. Recall that one of Alice’s options is to sell her current house and move into the inherited house.
Assume that Alice, who is single, sells her current personal residence (adjusted basis of $130,000) for $348,000. She has owned and lived in
the house for 15 years. Her selling expenses are $18,000. Three weeks prior to the sale, Alice pays a carpenter and a painter $1,000 to make
some repairs and paint the two bathrooms. Her recognized gain would be calculated as follows:
Land used by a manufacturing company is condemned by a local government authority.
X
Apartment and land held by an investor are sold due to the threat or imminence of
condemnation.
X
Since the available § 121 exclusion of $250,000 exceeds Alice’s realized gain of $200,000, her recognized gain is $0.
Example 35
The Big Picture
Continue with The Big Picture and the facts of Example 34, but assume that the selling price is $490,000.
14-3d
Section 267 Disallowed Losses
Time Limitation on Replacement
15-3d
Taxpayers should avoid transactions that activate the related-party loss disallowance rules. Even with the ability of
the related-party buyer to offset his or her realized gain by the related-party seller’s disallowed loss, several
inequities exist. First, any tax benefit associated with the disallowed loss is shifted to the related-party buyer (the
related-party seller receives no tax benefit). Second, the tax benefit of this offset is delayed until the related-party
buyer sells the property. Third, if the property does not appreciate during the time period the related-party buyer
holds it, part or all of the disallowed loss is permanently lost. Fourth, the right of offset is available only to the
original transferee (the related-party buyer). As a result, the disallowed loss will be permanently lost if the original
transferee transfers the property by gift or inheritance.
Example 20
Example 35
Tim sells property with an adjusted basis of $35,000 to Wes, his brother, for $25,000, the fair market value of the property. The $10,000 realized loss to
Tim is disallowed by § 267.
If Wes subsequently sells the property to an unrelated party for $37,000, he has a recognized gain of $2,000 (realized gain of $12,000 reduced by
disallowed loss of $10,000). Therefore, from the perspective of the family unit, the original $10,000 realized loss ultimately is recognized.
However, if Wes sells the property for $29,000, he has a recognized gain of $0 (realized gain of $4,000 reduced by disallowed loss of $4,000 necessary to
offset the realized gain). From the perspective of the family unit, $6,000 of the realized loss of $10,000 is permanently lost ($10,000 realized loss – $4,000
offset permitted).
Wash Sales
The wash sale rules can be avoided if the security that was sold is replaced with a similar rather than a
substantially identical security. For example, a sale of AT&T common stock accompanied by a purchase of Verizon
common stock is not treated as a wash sale. This can enable the taxpayer to use an otherwise unrealized capital
loss to offset any capital gains recognized during the year. The taxpayer can sell the security before the end of the
taxable year, offset the recognized capital loss against the capital gain, and invest the sales proceeds in a similar
security.
The wash sale rules do not apply to gains. As a result, taxpayers with capital losses (or capital loss carryovers from
prior years) can use a wash sale gain to offset these losses. Because the basis of the replacement stock will be the
purchase price, the taxpayer gets an increased basis for the stock while using the capital gain to offset otherwise
nondeductible capital losses.
As a child, Alice lived in the house for 10 years. She has not lived there during the 25 years she has been married.
The house has been vacant during the seven months Alice has owned it. She has been trying to decide whether she should
sell it for its fair market value or sell it to her nephew for $275,000. Alice has suggested a $275,000 price for the sale to Dan because she believes this is
the amount at which she will have no gain or loss.



Alice intends to invest the $275,000 in stock.
You advise Alice that her adjusted basis for the house is the $475,000 fair market value on the date of Paula’s death. If Alice sells the house for $485,000
(assuming no selling expenses), she would have a recognized gain of $10,000 ($485,000 amount realized – $475,000 adjusted basis). The house is a
capital asset, and Alice’s holding period is long term because she inherited the house. Thus, the gain would be classified as a long-term capital gain. If,
instead, Alice sells the house to her nephew for $275,000, she will have a part sale and part gift. The realized gain on the sale of $5,670 is recognized.

If the amount reinvested in replacement property equals or exceeds the amount realized, realized gain is not recognized.
If the amount reinvested in replacement property is less than the amount realized, realized gain is recognized to the extent of the deficiency.
Example 15
Involuntary Conversions: General Rules
Jason operates a charter fishing business in Port St. Lucie, Florida, taking customers out in the Atlantic Ocean on daylong fishing trips.
Unfortunately, his boat was completely destroyed when Hurricane Matthew hit the Florida coast. His boat had a basis of $78,000 ($120,000
cost − $42,000 of accumulated depreciation). Fortunately, Jason had marine insurance (which included a replacement cost rider). He filed
an insurance claim shortly after his boat was destroyed and received $175,000 in insurance proceeds three weeks later.
Jason has a realized gain of $97,000, computed as follows:
Jason can defer the entire gain provided he uses all of the insurance proceeds to purchase a new boat.
Example 16
Involuntary Conversions: General Rules
Refer to the facts of Example 15, and assume that Jason buys a new boat for $180,000. He uses the entire insurance settlement as part of
the purchase.
If the conversion is directly into replacement property rather than into money, nonrecognition of realized gain is mandatory. In this case,
the basis of the replacement property is the same as the adjusted basis of the converted property. Direct conversion is rare in practice and
usually involves condemnations.
Example 23
Lupe’s property, with an adjusted basis of $20,000, is condemned by the state. Lupe receives property with a fair market value of $50,000
as compensation for the property taken.
Because the nonrecognition of realized gain is mandatory for direct conversions, Lupe’s realized gain of $30,000 is not recognized and the
basis of the replacement property is $20,000 (adjusted basis of the condemned property).
Conversion into Money

In most cases, taxpayers sell property (or exchange it) when they need to do so. There are times, however, when the
taxpayer involuntarily (i.e., outside the taxpayer’s control) disposes of property. When this happens, the taxpayer usually receives some
sort of compensation, like insurance proceeds or a condemnation award. Section 1033 provides that a taxpayer who experiences an
involuntary conversion of property may postpone recognition of gain realized from the conversion. As a result, this provision provides
relief to a taxpayer who has experienced an involuntary conversion and does not have the wherewithal to pay the tax on any gain realized
as a result of the conversion.
Realized gain is postponed to the extent that the taxpayer reinvests the amount realized (e.g., insurance proceeds) in replacement property.
The rules for nonrecognition of gain are as follows:
Both spouses meet the at-least-two-years use requirement.
Neither spouse sold a principal residence within the prior two years and used the § 121 exclusion.
Example 36
Because the realized gain of $460,000 is less than the available § 121 exclusion amount of $500,000, no gain is recognized.
A surviving spouse can use the $500,000 exclusion amount on the sale of a personal residence for the two years following the deceased
spouse’s death. If the sale occurs in the year of death, however, a joint return must be filed by the surviving spouse.
15-4dExceptions to the Two-Year Rules
Direct Conversion
Alice inherited the house from her mother, Paula. The fair market value of the house at the date of Paula’s death, based on the
estate tax return, was $475,000. Based on an appraisal, the house currently is worth $485,000. Paula lived in the house for 38 years. According to Paula’s
attorney, her adjusted basis for the house was $275,000.
Explain the nonrecognition provisions available on the involuntary conversion of property.
Either spouse meets the at-least-two-years ownership requirement.
Margaret sells her personal residence (adjusted basis of $150,000) for $650,000. She has owned and lived in the residence for six years.
Her selling expenses are $40,000. Margaret is married to Ted, and they file a joint return. Ted has lived in the residence since they were
married two and one-half years ago.
Nonrecognition of gain can be either mandatory or elective, depending on whether the conversion is direct (into replacement property) or
indirect (into money).
iStock.com/Michael CourtneyAs Alice’s tax adviser, you asked a number of questions to advise her on her proposed transaction for the house. Alice
provided the following answers (refer to Example 24):
15-3Involuntary Conversions—§1033
LO.3
Assume the same facts as in the previous example, except that Megan’s building is condemned. Megan receives notification of the future
condemnation on November 1, 2017. The condemnation occurs on December 16, 2017, with the condemnation proceeds being received on
February 2, 2018.
The latest date for replacement is December 31, 2021 (the end of the taxable year in which realized gain occurred plus three years).
The earliest date for replacement typically is the date the involuntary conversion occurs. However, if the property is condemned, it is
possible to replace the condemned property before this date. In this case, the earliest date is the date of the threat of condemnation of the
property. This rule allows the taxpayer to make an orderly replacement of the condemned property.
15-3eNonrecognition of Gain
Re f ocus on T he B ig P icture
Proposed Sal e of a Hous e a nd Ot her Propert y Tra nsacti on s
The gain is classified as a long-term capital gain. Alice is then deemed to have made a gift to Dan of $210,000 ($485,000 – $275,000). With this
information, Alice can make an informed selection between the two options.
Example 21



Assume the same facts as in Example 21. The earliest date that Megan can replace the building is November 1, 2017, which is the date of the
condemnation of the building.
Sam owns 1,500 shares of Eagle, Inc. stock that he purchased over 10 years ago for $80,000. Although the stock has a current market value of $52,000,
Sam still views the stock as a solid long-term investment. He has sold other stock during the year with overall gains of $30,000, so he would like to sell
the Eagle stock and offset the $28,000 loss against these gains—but somehow keep his Eagle investment. He has devised a plan to keep his Eagle
investment by using funds in his traditional IRA to purchase 1,500 Eagle shares immediately after selling the shares he currently owns. Evaluate Sam’s
treatment of these stock transactions. Can his plan work?

Married Couples
If a married couple files a joint return, the $250,000 amount is increased to $500,000 if the following requirements are met:
Megan’s building is destroyed by fire on December 16, 2017. The adjusted basis is $325,000. Megan receives $400,000 from the insurance
company on February 2, 2018. She is a calendar year and cash method taxpayer.
The latest date for replacement is December 31, 2020 (the end of the taxable year in which realized gain occurred plus two years). The
critical date is not the date the involuntary conversion occurred, but rather the date of gain realization.
In the case of a condemnation of real property used in a trade or business or held for investment, a three-year period is substituted for the
normal two-year period.
Example 22
Ethics & Equity
Washi ng a Loss U si ng a n IRA


Since the realized gain of $342,000 exceeds the § 121 exclusion amount of $250,000, Alice’s recognized gain is $92,000.
In general, the taxpayer must acquire replacement property within a two-year period after the close of the taxable year in which gain is
realized. Typically, gain is realized when insurance proceeds or damages are received.
If the conversion is into money, the realized gain is recognized only to the extent the amount realized from the involuntary conversion
exceeds the cost of the qualifying replacement property. This is the usual case, and nonrecognition (postponement) is elective. If the
election is not made, the realized gain is recognized.
The basis of the replacement property is the property’s cost less any postponed (deferred) gain. If the election to postpone gain is made,
the holding period of the replacement property includes the holding period of the converted property.
Section 1033 applies only to gains and not to losses. Losses from involuntary conversions are recognized if the property is held for business
or income-producing purposes. Certain personal casualty losses are recognized (subject to the limitations discussed in Chapter 7), but
condemnation losses related to personal use assets (e.g., a personal residence) are neither recognized nor postponed.
The two-year ownership and use requirements and the “only once every two years” rule could create a hardship for taxpayers in certain
situations that are beyond their control. As a result, under the following special circumstances, the requirements are waived:



Example 37
Assume the same facts as in Example 33, except that in March 2018, Mike’s employer transfers him to a job in another state that is 400
miles away.
As a result, the sale of the second residence and the purchase of the third residence were due to relocation of employment. Consequently,
the § 121 exclusion is partially available on the sale of the second residence.
Health
Walt has until December 31, 2020, to make the new investment and qualify for the nonrecognition election.
The health exception can be satisfied using either a general facts and circumstances approach or a safe harbor established in the
Regulations. If a physician recommends a change of location due to health issues (or to obtain specialized care), the safe harbor should be
met. A sale that is merely beneficial to the general health or well-being of the individual will not qualify.
Walt’s realized gain is $50,000 ($100,000 insurance proceeds received − $50,000 adjusted basis of old building).
Example 25
Involuntary Conversion Gain or Loss
Assume the same facts as in the previous example, except that Walt receives only $45,000 of insurance proceeds. He has a realized and
recognized loss of $5,000. The basis of the new building is the building’s cost of $80,000.
If the destroyed building in Example 25 had been held for personal use, the recognized loss would have been subject to the casualty loss
limitations. Beginning in 2018, personal casualty losses are allowed only if they occur in a Federally declared disaster area. In that case, the
loss of $5,000 would have been limited to the decline in fair market value of the property, and the amount of the loss would have been
reduced first by $100 and then by 10 percent of adjusted gross income (refer to Chapter 7).
15-3f Reporting
Considerations
Involuntary conversions from casualty and theft are reported first on Form 4684, Casualties and Thefts. Casualty and theft losses on
personal use property for the individual taxpayer are carried from Form 4684 to Schedule A of Form 1040. For other casualty and theft
items, the Form 4684 amounts are generally reported on Form 4797, Sales of Business Property, unless Form 4797 is not required. In the
latter case, the amounts are reported directly on the tax return involved.
Except for personal use property, recognized gains and losses from involuntary conversions other than by casualty and theft are reported
on Form 4797. If the property involved in the involuntary conversion (other than by casualty and theft) is personal use property, any
realized loss is not recognized. Any realized gain is treated as gain on a voluntary sale.
What if the taxpayer intends to acquire qualifying replacement property but has not done so by the time the tax return is filed? The
taxpayer should elect § 1033 and report all of the details of the transaction on a statement attached to the return. When the qualifying
replacement property is acquired, the taxpayer should attach a statement to the tax return that contains relevant information on the
replacement property.
An amended return must be filed if qualified replacement property is not acquired during the replacement time period. An amended return
also is required if the cost of the replacement property is less than the amount realized from the involuntary conversion. In this case, the
return would recognize the portion of the
15-4Sale of a Residence—§ 121
LO.4
Unforeseen circumstances (as identified in Treasury Department Regulations).
Guidance on these three exceptions has been provided by Treasury Department Regulations and are discussed in the sections that
follow. Each of these exceptions provides a partial exclusion. The calculation of the partial exclusion is discussed later in this section.
For this exception to apply, the distance requirements related to the moving expense deduction must be met (see Chapter 9). As a result,
the location of the taxpayer’s new employment must be at least 50 miles further from the old residence than the old residence was from the
old job. In addition, the house being sold must be used as the principal residence of the taxpayer when the employment change happens.
The exception applies whether the taxpayer takes a job with a new employer; is transferred by the current employer; or, if self-employed,
moves the proprietorship to a new location.
Walt’s building (used in his trade or business), with an adjusted basis of $50,000, is destroyed by fire on October 5, 2018. Walt is a calendar
year taxpayer. On November 17, 2018, he receives an insurance reimbursement of $100,000 for the loss. Walt invests $80,000 in a new
building and uses the other $20,000 of insurance proceeds to pay off credit card debt.
Walt’s basis in the new building is $50,000. This is the building’s cost of $80,000 less the postponed gain of $30,000 (realized gain of
$50,000 − recognized gain of $20,000).
Health.
Change in Place of Employment
Example 24
Involuntary Conversion Gain or Loss
Assuming that the replacement property qualifies as similar or related in service or use, Walt’s recognized gain is $20,000. Because he
reinvested $20,000 less than the insurance proceeds received ($100,000 proceeds − $80,000 reinvested), his realized gain is recognized to
that extent.
Change in place of employment.
Unforeseen Circumstances
For the unforeseen circumstances exception to apply, the primary reason for the sale or exchange of the residence must be an event the
taxpayer did not anticipate before purchasing and occupying the residence. The Regulations provide a safe harbor that applies in any of the
following instances:







Involuntary conversion of the residence.
Natural or human-made disasters or acts of war or terrorism resulting in a casualty to the residence.
Death of a qualified individual.
Cessation of employment that results in eligibility for unemployment compensation.
Change in employment or self-employment that results in the taxpayer being unable to pay housing costs and reasonable basic living
expenses for the taxpayer’s household.
Divorce or legal separation.
Multiple births resulting from the same pregnancy.
If none of the safe harbor instances apply, the taxpayer can use a general facts and circumstances approach to justify the exception.
Example 38
Debra and Roy are engaged and buy a house (sharing the mortgage payments) and live in it as their personal residence. Eighteen months
after the purchase, they cancel their wedding plans, and Roy moves out of the house. Because Debra cannot afford to make the payments
alone, they sell the house.
While the sale does not fit under the safe harbor, the broken engagement is an unforeseen event and the sale will qualify under the
unforeseen circumstances exception.
Partial § 121 Exclusion
A partial § 121 exclusion is available when one of the exceptions applies. In this case, the § 121 exclusion amount ($250,000 or $500,000) is
multiplied by a fraction, the numerator of which is the number of qualifying months and the denominator of which is 24 months. The
resulting amount is the excluded gain.
Describe the provision for the permanent exclusion of gain on the sale of a personal residence.
Example 39
A taxpayer’s personal residence is a personal use asset. Therefore, a realized loss from the sale of a personal residence is not recognized.
A realized gain from the sale of a personal residence is taxable. However, taxpayers meeting the § 121 exclusion requirements are allowed
to exclude up to $250,000 of realized gain on the sale of a principal residence. Any gain in excess of this amount normally qualifies as a
long-term capital gain (with preferential tax rates).
On October 1, 2017, Rich and Audrey, who file a joint return and live in Chicago, sell their personal residence, which they have owned and
lived in for eight years. The realized gain of $325,000 is excluded under § 121. They purchase another personal residence for $525,000 on
October 2, 2017. Audrey’s employer transfers her to the Denver office in August 2018. Rich and Audrey sell their Chicago residence on
August 2, 2018, and they purchase a residence in Denver shortly thereafter. The realized gain on the sale is $300,000.
The $325,000 gain on the first Chicago residence is excluded under § 121. The sale of the second Chicago residence is within the two-year
window of the prior sale, but because it resulted from a change in employment, Rich and Audrey can qualify for partial § 121 exclusion
treatment as follows:
Example 26
Tom and Eileen Atwood bought their home in 2009 for $525,000 and have used it as their principal residence since that time. In July 2018,
they sell their home for $670,000. The Atwoods have a realized gain of $145,000 on the sale ($670,000 − $525,000), and the entire gain is
excluded as a result of § 121.

Basis of New Residence
Because § 121 is an exclusion provision rather than a postponement of gain provision, the basis of a new residence is its cost.
15-4eInvoluntary
Conversion and Using §§ 121 and
1033
A taxpayer can use both the § 121 exclusion of gain provision and the § 1033 postponement of gain provision. The taxpayer initially can
elect to exclude realized gain under § 121 to the extent available. Then, a qualified replacement of the residence under § 1033 can be used
to postpone the remainder of the realized gain. In applying § 1033, the amount of the required reinvestment is reduced by the amount of
the § 121 exclusion.



Example 40
Angel’s principal residence is destroyed by a tornado. Her adjusted basis for the residence is $140,000. She receives insurance proceeds of
$480,000.
If Angel does not elect to use the § 121 exclusion, her realized gain on the involuntary conversion of her principal residence is $340,000
($480,000 amount realized–$140,000 adjusted basis). Thus, to postpone the $340,000 realized gain under § 1033, she would need to
acquire qualifying property costing at least $480,000.
Using the § 121 exclusion enables Angel to reduce the amount of the required reinvestment for § 1033 purposes from $480,000 to
$230,000. That is, by using § 121 in conjunction with § 1033, the amount realized, for § 1033 purposes, is reduced to $230,000 ($480,000
insurance proceeds – $250,000 §121 exclusion).
Note that if Angel does not acquire qualifying replacement property for § 1033 purposes, her recognized gain is $90,000 ($480,000
insurance proceeds – $140,000 adjusted basis – $250,000 §121 exclusion).
15-5Tax Planning
LO.5
Review and apply various tax planning opportunities related to the nonrecognition provisions discussed
in the chapter.
15-5aLike-Kind
Exchanges
Because the like-kind exchange provisions are mandatory rather than elective, in certain instances, it may be preferable to avoid qualifying
for § 1031 nonrecognition. If so, the taxpayer can structure the transaction so that at least one of the § 1031 like-kind exchange
requirements is failed. If the like-kind exchange provisions do not apply, the end result may be the recognition of capital gain and a higher
basis in the newly acquired asset. The immediate recognition of gain may be preferable when the taxpayer has:
Recognition of capital gain or loss usually requires a sale or exchange of a capital asset. The Code uses the term sale or exchange, but does
not define it. Generally, a property sale involves the receipt of money by the seller and/or the assumption by the purchaser of the seller’s
liabilities. An exchange involves the transfer of property for other property. So an involuntary conversion (casualty, theft, or condemnation)
is not a sale or exchange.
In several situations, Congress has created rules that specifically provide for sale or exchange treatment. For example, assume that the
expiration of a right to personal property (other than stock) that would be a capital asset in the hands of the taxpayer results in a
recognized gain or loss. This is a capital gain or loss. Several of these special rules are discussed below, including worthless securities, the
retirement of corporate obligations, options, patents, franchises, and lease cancellation payments.
If David purchased the painting for personal use (as a decoration in his home) and it is not of investment quality, it is a capital asset;
however, any loss on its sale is not usable, whereas gain from its sale is taxable. Investment quality generally means that the painting is
expected to appreciate in value.
If the painting is used to decorate David’s business office and is of investment quality, the painting is not depreciable and, therefore, is a
capital asset.
Worthless Securities and § 1244 Stock
16-3a
Occasionally, securities such as stock and, especially, bonds may become worthless due to the insolvency of their issuer. If such a security is
a capital asset, the loss is deemed to have occurred as the result of a sale or exchange on the last day of the tax year. This last-day rule may
have the effect of converting what otherwise would have been a short-term capital loss into a long-term capital loss. Section 1244 allows an
ordinary deduction on disposition of stock at a loss. The stock must be that of a small business corporation, and the ordinary deduction is
limited to $50,000 ($100,000 for married taxpayers filing jointly) per year. See Chapter 7 (and text Sections 7-2a and 7-2b) for a more
complete discussion of these rules.
If David’s business is buying and selling paintings, the painting is inventory and, therefore, an ordinary asset.
If the painting is not of investment quality and the business did not purchase it for investment, the painting is an ordinary asset and it is
depreciable even though it serves a decorative purpose in David’s office. If David depreciates the painting, that is evidence that the painting
is held for use in his business (and not being held for investment or as inventory). As a result, it is not a capital asset.
Since capital assets receive preferential tax treatment, taxpayers prefer capital gains rather than ordinary gains. So the definition of a
capital asset is critically important. As discussed next, this definition has been the subject of many court cases and rulings.
16-2aDefinition
Retirement of Corporate Obligations
16-3b
A debt obligation (e.g., a bond or note payable) may have a tax basis in excess of or less than its redemption value because it may have been
acquired at a premium or discount. Consequently, the collection of the redemption value may result in a loss or gain. Generally, the
collection of a debt obligation is treated as a sale or exchange. Therefore, any loss or gain can be a capital loss or capital gain because a sale
or exchange has taken place.
of a Capital Asset (§ 1221)
Capital assets are not directly defined in the Code. Instead, § 1221(a) defines what is not a capital asset. In general, a capital asset is
property other than inventory, accounts and notes receivable, supplies, and most fixed assets of a business.
Specifically, the Code defines a capital asset as property held by the taxpayer (when it is connected with the taxpayer’s business) that
is not any of the following:






Example 11
Fran acquires $1,000 of Osprey Corporation bonds for $980 in the open market. If the bonds are held to maturity, the $20 difference
between Fran’s collection of the $1,000 redemption value and her cost of $980 is treated as capital gain.
Original Issue Discount (§§ 1272–1288)
The benefit of the sale or exchange exception that allows a capital gain from the collection of certain obligations is reduced when the
obligation has original issue discount. Original issue discount (OID) arises when the issue price of a debt obligation is less than the
maturity value of the obligation. OID must generally be amortized over the life of the debt obligation using the effective interest method.
The OID amortization increases the basis of the bond.
Most new publicly traded bond issues do not carry OID because the stated interest rate is set to make the market price on issue the same as
the bond’s face amount. In addition, even if the issue price is less than the face amount, the difference is not considered to be OID if the
difference is less than one-fourth of 1 percent of the redemption price at maturity multiplied by the number of years to maturity.
In the case where OID does exist, it may or may not have to be amortized, depending upon the date the obligation was issued. When OID is
amortized, the amount of gain upon collection, sale, or exchange of the obligation is correspondingly reduced. The obligations covered by
the OID amortization rules and the method of amortization are presented in §§ 1272–1275. Similar rules for other obligations can be found
in §§ 1276–1288.
Inventory or property held primarily for sale to customers in the ordinary course of a business.
Accounts and notes receivable generated from the sale of goods or services in a business.
Depreciable property or real estate used in a business.
A patent, invention, model or design (whether or not patented); a secret formula or process; certain copyrights; literary, musical, or artistic
compositions; or letters, memoranda, or similar property created by or for the taxpayer.
Example 12
Jerry purchases $10,000 of newly issued White Corporation bonds for $6,000. The bonds have OID of $4,000. Jerry must amortize the
discount over the life of the bonds. The OID amortization increases his interest income. (The bonds were selling at a discount because the
market rate of interest was greater than the bonds’ stated interest rate.) After Jerry has amortized $1,800 of OID, he sells the bonds for
$8,000. Jerry has a capital gain of $200 [$8,000 – ($6,000 cost + $1,8000 OID amortization)].
The OID amortization rules prevent him from converting ordinary interest income into capital gain. Without the OID amortization, Jerry
would have capital gain of $2,000 ($8,000 – $6,000 cost).
Certain U.S. government publications.
Supplies used in a a business.
Often, the only business asset that is a capital asset is “self-generated” goodwill (purchased goodwill is a § 1231 asset). The following
discussion provides further detail on each part of the capital asset definition.
16-3cOptions
Inventory
Unused net operating loss carryovers.
What constitutes inventory is determined by the taxpayer’s business.
Green Company buys and sells used cars. Its cars are inventory. Its gains from the sale of the cars are ordinary income.
Suspended or current passive activity losses.
Alicia sells land and a building (used in her business) with an adjusted basis of $300,000 for $400,000. She also acquires a new building and
land for $900,000.
If § 1031 applies, the $100,000 realized gain is not recognized and the basis of the new land and building is reduced by $100,000 (from
$900,000 to $800,000).
If § 1031 does not apply, a $100,000 gain is recognized and may receive favorable capital gain treatment (see Chapters 16 and 17). In
addition, the basis for depreciation on the new land and building is $900,000 rather than $800,000 because the entire gain was recognized.
The like-kind exchange rules should also be avoided when a realized loss exists (adjusted basis exceeds the fair market value).
Rex has real property with an adjusted basis of $40,000 and a fair market value of $100,000. Sandra wants to buy Rex’s property, but Rex
wants to limit the amount of recognized gain on the proposed transaction. Sandra acquires other like-kind property (from an outside
party) for $80,000. She then exchanges this property and $20,000 of cash for Rex’s property.
Rex has a realized gain of $60,000 ($100,000 amount realized – $40,000 adjust basis). His recognized gain is only $20,000, the lower of the
$20,000 boot received or the $60,000 realized gain. Rex’s basis for the like-kind property is $40,000 ($40,000 adjusted basis + $20,000 gain
recognized – $20,000 boot received). Further, it is permissible for Rex to identify the like-kind property that he wants Sandra to purchase.
If Rex had sold the property to Sandra for its fair market value of $100,000, the result would have been a $60,000 recognized gain
($100,000 amount realized – $40,000 adjusted basis).
One final point: the beneficial result of tax deferral of realized gain could be more than offset by future tax rate increases. Taxpayers may
prefer to pay no more than 20 percent today (the maximum tax rate on long-term capital gains) if they believe that tax rates will go up in
the future. Although turning down a tax deferral may sound like a strange strategy, it fits the notion of “pay a tax today to avoid a higher tax
tomorrow.”
Depreciable personal property and real estate (both depreciable and nondepreciable) used by a business are not capital assets. The tax law
related to this property is very complex; most of these rules are discussed in Chapter 17. Although business fixed assets are not capital
assets, a long-term capital gain can sometimes result from their sale. Chapter 17 discusses the potential capital gain treatment for business
fixed assets under § 1231. Another rule—real property subdivided for sale (§ 1237)—is discussed in text Section 16-2c.
Inventions and Processes
A patent, invention, model, or design (whether or not patented) and a secret formula or process are excluded from being a capital asset.
These are ordinary assets. The assets may be held either by the taxpayer who created the property or by a taxpayer who received the asset
from the taxpayer who created the property (or for whom the property was created). As a result, gains or losses from the sale or exchange
of these assets do not receive capital gain treatment. In limited circumstances, patents may be treated as capital assets. Those special rules
are discussed in text Section 16-3d.
Ahmad has a $40,000 realized gain from the involuntary conversion of an office building. He reinvests the entire proceeds of $450,000 in a
new office building. He does not elect to postpone gain under § 1033, however, because of an expiring net operating loss carryover that is
offset against the gain.
As a result, none of the realized gain of $40,000 is postponed. Because Ahmad did not elect § 1033 postponement, his basis in the
replacement property is the property’s cost of $450,000 rather than $410,000 ($450,000 reduced by the $40,000 realized gain).
Example 5
15-5cSale of a Principal Residence
Abigail invents a multifunctional case for a popular brand of cell phones. She has a manufacturer produce them for her and sells them via
the internet. Her cost is $2.30 per case, and she sells each one for $10. To her surprise, she quickly achieves $45,000 in total sales. She has
not capitalized any of the costs of developing the invention and has not patented it.
She sells all of her rights to the invention for $350,000 to a company that is in the business of producing cell phone cases. Her profit from
sales of the cases is ordinary income because the cases are inventory. The $350,000 gain from selling the rights to the invention is an
ordinary gain because the invention is not a capital asset.
Waiving the Exclusion
The § 121 exclusion automatically applies if the taxpayer is eligible (i.e., the taxpayer need not make an election). However, a taxpayer can
elect to waive the § 121 exclusion.
Example 45
George owns two personal residences that satisfy the two-year ownership and use test with respect to the five-year window. The Elm
Street residence has appreciated by $25,000, and the Maple Street residence has appreciated by $230,000. He intends to sell both of them
and move into rental property. He sells the Elm Street residence in December 2018 and expects to sell the Maple Street residence early
next year.
Unless George elects not to apply the § 121 exclusion to the sale of the Elm Street residence, he will exclude the $25,000 realized gain on
that residence in 2018. In 2019, however, he will have a recognized gain of $230,000 on the sale of the Maple Street residence.
If George makes the election to forgo, he will report a recognized gain of $25,000 on the sale of the Elm Street residence in 2018. But by
using the § 121 exclusion in 2019, he will eliminate the recognized gain of $230,000 on the sale of the Maple Street residence.
Copyrights and Creative Works
Generally, the person whose efforts led to the copyright or creative work has an ordinary asset, not a capital asset. Creative works include
the works of authors, composers, and artists. Also, the person for whom a letter, a memorandum, or another similar property was created
has an ordinary asset. Finally, a person receiving a copyright, creative work, a letter, a memorandum, or similar property by gift from the
creator or the person for whom the work was created has an ordinary asset. A taxpayer may elect to treat the sale or exchange of a musical
composition or a copyright of a musical work as the disposition of a capital asset.
Example 6
Creative Works
Implications of Renting or Using as a Home Office
The residence does not have to be the taxpayer’s principal residence at the date of sale to qualify for the § 121 exclusion. During part of the
five-year window, it could have been rental property (e.g., either a vacation home or entirely rental property). Or the taxpayer might have
used part of the principal residence as a qualifying home office.
In either of these circumstances, the taxpayer may claim deductions for the expenses attributable to the rental or business use. But what
effect, if any, do such deductions have on a later sale of the residence? Will the sales proceeds still qualify for nonrecognition of gain
treatment under § 121?
As long as the various § 121 requirements are met, an income exclusion will be available. However, if the taxpayer deducted depreciation,
any realized gain on the sale that is attributable to depreciation claimed after May 5, 1997, is not eligible for the § 121 exclusion.
Wanda is a part-time music composer. A music publisher purchases one of her songs for $5,000.
Wanda has a $5,000 ordinary gain from the sale of an ordinary asset unless she elects to treat the gain as a capital gain.
Example 7
Creative Works
Ed received a letter from the President of the United States in 1982. In the current year, Ed sells the letter to a collector for $300.
Ed has a $300 ordinary gain from the sale of an ordinary asset (because the letter was created for Ed).
Example 8
Creative Works
Example 46
On December 5, 2018, Amanda sells her principal residence, which qualifies for the § 121 exclusion. Her realized gain is $190,000. From
January through November 2017, she was temporarily out of town on a job assignment in another city and rented the residence to a college
student. For this period, she deducted MACRS cost recovery of $7,000.
Without the depreciation provision, Amanda could exclude the $190,000 realized gain. However, the depreciation taken requires her to
recognize $7,000 of the realized gain.
Isabella gives her son a song she composed. The son sells the song to a music publisher for $5,000.
The son has a $5,000 ordinary gain from the sale of an ordinary asset unless he elects to treat the gain as a capital gain.
If the son inherits the song from Isabella, his basis for the song is its fair market value at Isabella’s death. In this situation, the song is a
capital asset because the son’s basis is not related to Isabella’s basis for the song.
The key requirement for the § 121 exclusion is that the taxpayer must have owned and used the property as a principal residence for at
least two years during the five-year window. As taxpayers advance in age, they quite frequently make decisions related to their personal
residence(s):
Cynthia is a successful sculptor who created a work that is now worth $400,000 and has no tax basis. Cynthia forms a corporation and
contributes the sculpture to it in exchange for the corporation’s shares. Fourteen months later, she sells all the stock for $400,000. She
wants to treat the sale of the stock as a long-term capital gain. Evaluate the propriety of Cynthia’s actions.
U.S. government publications received from the U.S. government (or its agencies) for a reduced price are not capital assets. This prevents a
taxpayer from later donating the publications to charity and claiming a charitable contribution deduction equal to the fair market value of
the publications. Normally, the charitable contribution of an ordinary asset provides a deduction equal to the asset’s basis. If the taxpayer
received the property at no cost, its basis is equal to zero. If this property is given to someone else, it retains its ordinary asset status (see
text Section 10-4e for more about property contributions).
Sell vacation homes they own.
16-2bEffect
Sell homes they are holding as rental property.
These properties may have experienced substantial appreciation while owned by the taxpayers. Proper planning can make it possible for
multiple properties to qualify for the exclusion. Although this strategy may require taxpayers to be flexible about where they live, it can
result in substantial tax savings.
Thelma and David, residents of Virginia, are approaching retirement. They have substantial appreciation on their principal residence (in
Richmond) and on a house they own in Virginia Beach (about two hours away). After retirement, they plan to move to Florida. They have
owned and lived in the principal residence for 28 years and have owned the beach house for 9 years.
If they sell their principal residence, it qualifies for the § 121 exclusion. At retirement, they could move into their beach house for two years
and make it eligible for the exclusion before they relocate to Florida.
If the beach house were close enough, they could sell the principal residence now and move into the beach house to start the running of the
two-year use period. As noted above, any realized gain on the beach house attributable to depreciation is not eligible for the § 121
exclusion. In addition, a reduction in the § 121 exclusion for prior use as a vacation home is required.
16-2cStatutory
Expansions
In several instances, Congress has clarified its general definition of what is not a capital asset.
Re f ocus on T he B ig P icture
Al ternati ve U ses of Prop erty
Dealers in Securities
As a general rule, securities (stocks, bonds, and other financial instruments) held by a dealer are considered to be inventory and are,
therefore, not subject to capital gain or loss treatment. A dealer in securities is a merchant (e.g., a brokerage firm) that regularly engages in
the purchase and resale of securities to customers.
The dealer must identify any securities being held for investment. Generally, if a dealer clearly identifies certain securities as held for
investment purposes by the close of business on the acquisition date, gain from the securities’ sale will be capital gain. However, the gain
will not be capital gain if the dealer ceases to hold the securities for investment prior to the sale. Losses are capital losses if at any time the
securities have been clearly identified by the dealer as held for investment.
Iain Masterton/Alamy Stock Photo
Alice needs to be aware of the different tax consequences of her proposals and whether there are any limits to these consequences.
Sale of the inherited house. This is by far the simplest transaction for Alice. Based on the facts, her recognized gain would be:
Example 9
Tracy is a securities dealer. She purchases 100 shares of Swan stock. If Tracy takes no further action, the stock is inventory and an ordinary
asset.
If she designates in her records that the stock is held for investment, the stock is a capital asset. Tracy must designate the investment
purpose by the close of business on the acquisition date. If Tracy maintains her investment purpose and later sells the stock, the gain or
loss is capital gain or loss.
If Tracy redesignates the stock as held for resale (inventory) and then sells it, any gain is ordinary, but any loss is capital loss.
Because the sale of the house is not eligible for the § 121 exclusion, the tax liability is $14,250 ($95,000 × 15%). So Alice’s net cash flow
would be $555,750 ($570,000 – $14,250).
Conversion into a vacation home with only personal use. With this alternative, the only tax benefit Alice would receive is the deduction for
property taxes as an itemized deduction (subject to the $10,000 limit on state and local taxes). She would continue to incur upkeep costs
(e.g., repairs, utilities, and insurance). At the end of the two-year period, the sales results are similar to those of a current sale. The sale of
the house would not be eligible for the § 121 exclusion.
Real Property Subdivided for Sale (§ 1237)
Substantial real property development activities may result in the owner being considered a dealer for tax purposes. If so, ordinary income
will result from any lots sold. However, § 1237 allows real estate investors capital gain treatment if they
engage only in limited development activities. To be eligible for § 1237 treatment, the following requirements must be met:




The taxpayer may not be a corporation.
The taxpayer may not be a real estate dealer.
No substantial improvements may be made to the lots sold. Substantial generally means more than a 10 percent increase in the value of a
lot. Shopping centers and other commercial or residential buildings are considered substantial improvements, while filling, draining,
leveling, and clearing operations are not.
The taxpayer must have held the lots sold for at least 5 years, except for inherited property. The substantial improvements test is less
stringent if the property is held at least 10 years.
If these requirements are met, all gain is capital gain until the tax year in which the sixth lot is sold. Sales of contiguous lots to a single buyer
in the same transaction count as the sale of one lot. Beginning with the tax year the sixth lot is sold, 5 percent of the revenue from lot sales
is potential ordinary income. That potential ordinary income is offset by any selling expenses from the lot sales. As sales commissions often
are at least 5 percent of the sales price, typically none of the gain is treated as ordinary income.
Section 1237 does not apply to losses. A loss from the sale of subdivided real property is an ordinary loss unless the property qualifies as a
capital asset under § 1221. The following example illustrates the application of § 1237.
Example 10
Jack owns a large tract of land and subdivides it for sale. Assume that Jack meets all of the requirements of § 1237 and during the tax year
sells the first 10 lots to 10 different buyers for $10,000 each. Jack’s basis in each lot sold is $3,000, and he incurs total selling expenses of
$4,000 ($400 for each lot) on the sales. Jack’s gain is computed as follows:
David buys an expensive painting.








If the call is exercised by the grantee on August 1, 2018, Maurice has $1,500 ($6,000 + $500 – $5,000) of short-term capital gain from the
sale of the stock. The grantee has a $6,500 ($500 option premium + $6,000 purchase price) basis for the stock.
Investors sometimes get nervous and want to “lock in” gains or losses.
Assume that Maurice, prior to exercise of the grantee’s call, decides to sell his stock for $6,000 and enters into a closing transaction by
purchasing a call on 100 shares of Eagle Company stock for $5,000.
Because the Eagle stock is selling for $6,000, Maurice must pay a call premium of $1,000.
He recognizes a $500 short-term capital loss [$500 (call premium received) – $1,000 (call premium paid)] on the closing transaction.
On the actual sale of the Eagle stock, Maurice has a short-term capital gain of $1,000 [$6,000 (selling price) – $5,000 (cost)].
The original grantee is not affected by Maurice’s closing transaction. The original option is still in existence, and the grantee’s tax
consequences depend on what action the grantee takes—exercising the option, letting the option expire, or selling the option.
Assume that the original option expired unexercised. Maurice has a $500 short-term capital gain equal to the call premium received for
writing the option. This gain is not recognized until the option expires. The grantee has a loss from expiration of the option. The nature of
the loss will depend upon whether the option was a capital asset or an ordinary asset.
Concept Summary 16.1 summarizes the consequences of various transactions involving options to both the grantor and grantee.
Conce pt Sum mar y 16.1
Opti ons : Cons equ en ces to th e Gr antor an d Gr ant ee
Event
Grantor
Option is granted.
Receives value and has a contract obligation (a liability).
Option expires.
Has a short-term capital gain if the option property is stocks, securities, commoditi
Option is exercised.
Amount received for option increases proceeds from sale of the option property.
Option is sold or exchanged by grantee.
Result depends upon whether option later expires or is exercised (see above).
16-3dPatents
Transfer of a patent is treated as the sale or exchange of a long-term capital asset when all substantial rights to the patent are transferred
by a holder. The transferor/holder may receive payment in virtually any form, including contingent payments based on the
transferee/purchaser’s productivity, use, or disposition of the patent. If the transfer meets these requirements, any gain or loss
is automatically a long-term capital gain or loss. Whether the asset was a capital asset for the transferor, whether a sale or exchange
occurred, and how long the transferor held the patent are not relevant.
Substantial Rights
To receive favorable capital gain treatment, all substantial rights to the patent must be transferred. All substantial rights have not been
transferred when the transfer is limited geographically within the issuing country or when the transfer is for a period less than the
remaining life of the patent. All the facts and circumstances of the transaction, not just the language of the transfer document, are examined
when making this determination.
Example 15 illustrates the special treatment for patents.
Example 15
The Big Picture
Return to the facts of The Big Picture. Kevin transfers his remaining 50% share of the rights in the patent to Green Battery Company, Inc., in
exchange for a $1 million lump-sum payment plus $.50 for each battery sold. Assuming that Kevin has transferred all substantial rights, the
question of whether the transfer is a sale or exchange of a capital asset is not relevant. Kevin automatically has a long-term capital gain
from both the $1 million lump-sum payment and the $.50 per battery royalty to the extent those proceeds exceed his basis for the patent.
Kevin also had an automatic long-term capital gain when he sold the other 50% of his rights in the patent to Maurice, because Kevin
transferred an undivided interest that included all substantial rights in the patent.
Whether Maurice gets long-term capital gain treatment depends upon whether Maurice is a holder. See the following discussion
and Example 16.
Holder Defined
The holder of a patent must be an individual (normally the invention’s creator or an individual who purchases the patent rights from the
creator before the patented invention is reduced to practice). So if the creator’s employer has all rights to an employee’s inventions, the
employer is not eligible for long-term capital gain treatment. The employer will normally have an ordinary asset because the patent was
developed as part of its business.
Example 16
The Big Picture
Return to the facts of The Big Picture. Continuing with the facts of Example 15, Kevin is clearly a holder of the patent because he is the
inventor and was not an employee when he invented the battery. When Maurice purchased a 50% interest in the patent nine months ago,
he became a holder if the patent had not yet been reduced to practice. Because the patent apparently was not being utilized in the
manufacturing process at the time of the purchase, it had not been reduced to practice.
Consequently, Maurice is also a holder, and he has an automatic long-term capital gain or loss if he transfers all substantial rights in his
50% interest to Green Battery Company. Maurice’s basis for his share of the patent is $50,000, and his proceeds equal $1 million plus $.50
for each battery sold. As a result, Maurice has a long-term capital gain even though he has not held his interest in the patent for more than
one year.
Compare the results here to those in Example 5. There, Abigail sold all substantial rights, but she had no patent and the invention had been
reduced to practice because it was being manufactured and sold.
Main content
16-3eFranchises,
Trademarks, and Trade Names (§ 1253)
A mode of operation, a widely recognized brand name (trade name), and a widely known business symbol (trademark) are all valuable
assets. These assets may be licensed (commonly known as franchising) by their owner for use by other businesses. Many fast-food
restaurants (such as McDonald’s and Taco Bell) are franchises. The franchisee usually pays the owner (franchisor) an initial fee plus a
contingent fee. The contingent fee is often based upon the franchisee’s sales volume.
For Federal income tax purposes, a franchise is an agreement that gives the franchisee the right to distribute, sell, or provide goods,
services, or facilities within a specified area. A franchise transfer includes the grant of a franchise, a transfer by one franchisee to another
person, or the renewal of a franchise.
Section 1253 provides that a transfer of a franchise, trademark, or trade name is not a transfer of a capital asset when the transferor retains
any significant power, right, or continuing interest in the property transferred.
Significant Power, Right, or Continuing Interest
The manner of the property’s disposition (sale, exchange, casualty, theft, or condemnation).
Example 1
Return to the facts of The Big Picture. On February 1, 2018, Maurice purchases 100 shares of Eagle Company stock for $5,000. On April 1,
2018, he writes a call option on the stock, giving the grantee the right to buy the stock for $6,000 during the following six-month period.
Maurice (the grantor) receives a call premium of $500 for writing the call.
of Judicial Action
Because the Code only lists categories of what are not capital assets, judicial interpretation is sometimes required to determine whether a
specific item fits into one of those categories. The Supreme Court follows a literal interpretation of the categories. For instance, because
corporate stock is not mentioned in § 1221, it is usually a capital asset. However, what if corporate stock is purchased for resale to
customers? Then it is inventory (and not a capital asset) because inventory is one of the categories in § 1221.
Intent also matters. What happens when a taxpayer who normally does not acquire stock for resale to customers acquires stock but intends
to resell it? The Supreme Court decided that because the stock was not acquired primarily for sale to customers (the taxpayer did not sell
the stock to its regular customers), the stock was a capital asset.
Because of the uncertainty associated with capital asset status, Congress has enacted several Code Sections to clarify its definition. These
clarifications are discussed next.
Example 47
Personal use assets and investment assets are the most common capital assets owned by individual taxpayers. Personal use assets usually
include things like a residence, furniture, clothing, recreational equipment, and automobiles. Investment assets usually include stocks,
bonds, and mutual funds. Remember, however, that losses from the sale or exchange of personal use assets are not recognized.
The crux of capital asset determination hinges on whether the asset is held for personal use (capital asset), investment (capital asset), or
business (ordinary asset). How a taxpayer uses the property typically answers this question.
Example 14
The Big Picture
U.S. Government Publications
Sell the principal residence and buy a smaller residence or rent the principal residence.
Distinguish capital assets from ordinary assets.
If the option is exercised, the amount paid for the option is added to the optioned property’s selling price. This increases the gain (or
reduces the loss) to the grantor resulting from the sale of the property. The grantor’s gain or loss is capital or ordinary depending on the
tax status of the property. The grantee adds the cost of the option to the basis of the property purchased.
Ethics & Equity
Scul pt ure as a Capi tal Asset
Qualification for § 121 Exclusion
16-2Capital Assets
LO.2
Exercise of Options by Grantee
Business Fixed Assets
Example 44
The holding period of the property (short-term: one year or less; long-term: more than one year).
The major focus of this chapter is capital gains and losses. Chapter 17 discusses § 1231 assets. Both chapters discuss ordinary gains and
losses.
Main content
If an option holder (grantee) fails to exercise the option, the lapse of the option is considered a sale or exchange on the option expiration
date. As a result, the loss is a capital loss if the property subject to the option is (or would be) a capital asset in the hands of the grantee.
The grantor of an option on stocks, securities, commodities, or commodity futures receives short-term capital gain treatment upon the
expiration of the option. Options on property other than stocks, securities, commodities, or commodity futures (for instance, vacant land)
result in ordinary income to the grantor when the option expires.
For example, an individual investor who owns certain stock (a capital asset) may sell a call option, entitling the buyer of the option to
acquire the stock at a specified price higher than the value at the date the option is granted. The writer of the call receives a premium (e.g.,
10 percent) for writing the option. If the price of the stock does not increase during the option period, the option will expire unexercised.
When the option expires, the grantor must recognize short-term capital gain (whereas the grantee recognizes a loss, the character of which
depends on the underlying asset). These rules do not apply to options held for sale to customers (the inventory of a securities dealer).
Oriole Company has accounts receivable of $100,000. Because Oriole needs working capital, it sells the receivables for $83,000 to a
financial institution.
If Oriole is an accrual basis taxpayer, it has a $17,000 ordinary loss. Revenue of $100,000 would have been recorded, and a $100,000 basis
would have been established when the receivable was created.
If Oriole is a cash basis taxpayer, it has $83,000 of ordinary income because it would not have recorded any revenue earlier; as a result, the
receivable has no tax basis.
In certain cases, a taxpayer may prefer to recognize gain from an involuntary conversion. Keep in mind that § 1033, unlike § 1031 (dealing
with like-kind exchanges), generally is an elective provision.
The tax status of the property (capital, § 1231, or ordinary).
Failure to Exercise Options
Example 4
15-5bInvoluntary Conversions
Recognized gains and losses must be properly classified. Proper classification depends on three characteristics:
Rosa wants to buy some vacant land for investment purposes. However, she cannot afford the full purchase price at the present time.
Instead, Rosa (grantee) pays the landowner (grantor) $3,000 to obtain an option to buy the land for $100,000 anytime in the next two
years. The option is a capital asset for Rosa because if she actually purchased the land, the land would be a capital asset.
Three months after purchasing the option, Rosa sells it for $7,000. She has a $4,000 ($7,000 – $3,000) short-term capital gain on this sale
because she held the option for one year or less.
Accounts and notes receivable are often created as part of a business transaction. These assets may be collected by the creditor, be sold by
the creditor, or become completely or partially worthless. Also, the creditor may be on the accrual or cash basis of accounting.
Collection of an accrual basis account or note receivable does not result in a gain or loss because the amount collected equals the
receivable’s basis. If sold, an ordinary gain or loss is generated if the receivable is sold for more or less than its basis (the receivable is an
ordinary asset). If the receivable is partially or wholly worthless, the creditor has a “bad debt,” which may result in an ordinary deduction
(see text Section 7-1).
Collection of a cash basis account or note receivable does not result in a gain or loss because the amount collected is ordinary income. In
addition, a cash basis receivable has a zero basis since no revenue is recorded until the receivable is collected. If sold, an ordinary gain is
generated (the receivable is an ordinary asset). There is no bad debt deduction for cash basis receivables because they have no basis. See
text Section 16-3 for more details on “sale or exchange.”
Example 43
Explain the general scheme of taxation for capital gains and losses.
Example 13
Accounts and Notes Receivable
Assume the same facts as in the previous example, except that the fair market value of the land and building is $250,000. If § 1031 applies,
the $50,000 realized loss is not recognized.
To recognize the loss, Alicia should sell the old land and building and purchase the new one. The purchase and sale transactions should be
with different taxpayers.
The like-kind exchange procedure can also be used to control the amount of recognized gain.
16-1General Scheme of Taxation
LO.1
A grantee may sell or exchange the option rather than exercising it or letting it expire. Generally, the grantee’s sale or exchange of the
option results in capital gain or loss if the option property is (or would be) a capital asset to the grantee.
Soong sells her personal use automobile at a $500 gain. The automobile is a personal use asset and, therefore, a capital asset. The gain is a
capital gain.
No asset is inherently capital or ordinary. If Soong (Example 3) sells her “capital asset” automobile to Green Company (Example 2), that
same automobile loses its capital asset status, because the automobile is inventory to Green Company. Whether an asset is capital or
ordinary, therefore, depends entirely on the relationship of the asset to the taxpayer who sold it. This classification dilemma is but one
feature of capital asset treatment that makes this area so confusing and complicated.
Example 42
Current sale of present home with sale of inherited home in two years. The present sale of her current principal residence and the future sale
of her inherited residence would enable Alice to qualify for the § 121 exclusion as to each sale (see Example 34). She would satisfy the twoyear ownership requirement, the two-year use requirement, and the allowance of the § 121 exclusion only once every two years. Alice
must be careful to occupy the inherited residence for at least two years. Also, the period between the sales of the first and second houses
must be greater than two years. Qualifying for the § 121 exclusion of up to $250,000 would allow Alice to avoid any Federal income tax
liability.
With this information, Alice can make an informed choice. In all likelihood, she probably will select the strategy of selling her current house
now and the inherited house in the future. A noneconomic benefit of this option is that she will have to sell only one house at the time of
her retirement.
Sale of an Option
Example 3
Inventory Determination
Example 41
Conversion into a vacation home with partial personal use and partial rental use. In this case, Alice would be able to deduct 40 percent of
costs such as property taxes, the agent’s management fee, depreciation, maintenance and repairs, utilities, and insurance. However, this
amount cannot exceed the rent income generated. The remaining 60 percent of the property taxes can be claimed as an itemized deduction
(subject to the $10,000 limit on state and local taxes).
At the end of the two-year period, the sales results would be similar to those of a current sale. In determining recognized gain, adjusted
basis must be reduced by the amount of the depreciation claimed. The sale of the house would not be eligible for the § 121 exclusion.
Frequently, a potential buyer of property wants some time to make the purchase decision, but wants to control the sale and/or the sale
price in the meantime. Options are used to achieve these objectives. The potential purchaser (grantee) pays the property owner (grantor)
for an option on the property. The grantee then becomes the option holder. The option, which usually sets a price at which the grantee can
buy the property, expires after a specified period of time.
Example 2
Inventory Determination
Unused general business credit carryovers.
In most franchising operations, the transferor retains some powers or rights. As a result, the transaction is not a capital asset
transfer. Significant powers, rights, or continuing interests include control over franchise assignment, quality of products and services,
sale or advertising of products or services, the requirement that substantially all supplies and equipment be purchased from the transferor,
and the right to terminate the franchise.
In the unusual case where the transferor does not retain any significant power, right, or continuing interest, a capital gain or loss may
occur. For capital gain or loss treatment to be available, the asset transferred must qualify as a capital asset.
Nonbusiness Bad Debts
Example 17
The Big Picture
A loan not made in the ordinary course of business is classified as a nonbusiness receivable. In the year the receivable becomes completely
worthless, it is a nonbusiness bad debt, and the bad debt is treated as a short-term capital loss. Even if the receivable was outstanding for
more than one year, the loss is still a short-term capital loss. Chapter 7 discusses nonbusiness bad debts more thoroughly (see text Section
7-1b).
Return to the facts of The Big Picture. Maurice sells for $210,000 to Mauve, Inc., the franchise purchased from Orange, Inc., nine months
ago. The $210,000 received by Maurice is not contingent, and all significant powers, rights, and continuing interests are transferred.
The $115,000 gain ($210,000 proceeds – $95,000 basis) is a short-term capital gain because Maurice has held the franchise for only nine
months.
16-3Sale or Exchange
LO.3
Franchise Payments
In most franchise settings, when the transferor retains significant power or rights, both contingent (e.g., based on sales) and noncontingent
payments occur.
State and explain the relevance of a sale or exchange to classification as a capital gain or loss and apply
the special rules for the capital gain or loss treatment of the retirement of corporate obligations, options,
patents, franchises, and lease cancellation payments.
Any noncontingent payments made by the franchisee to the franchisor are ordinary income to the
franchisor. The franchisee capitalizes the payments and amortizes them over 15 years. If the franchise is sold, the amortization is subject to
recapture under § 1245.
A portion of the gain is given ordinary treatment because the sixth lot is sold in the current year.
Noncontingent Payments
Example 18
Grey Company signs a 10-year franchise agreement with DOH Donuts. Grey (the franchisee) makes payments of $3,000 per year for the
first 8 years of the franchise agreement—a total of $24,000. Grey cannot deduct $3,000 per year as the payments are made. Instead, Grey
may amortize the $24,000 total over 15 years. As a result, Grey may deduct $1,600 per year for each of the 15 years of the amortization
period.
The same result would occur if Grey made a $24,000 lump-sum payment at the beginning of the franchise period. Assuming that DOH
Donuts (the franchisor) retains significant powers, rights, or a continuing interest, it will have ordinary income when it receives the
payments from Grey.
Illustrations
The following examples illustrate the treatment of short sales and short sales against the box.
Example 30
Short Sales and Short Sales against the Box
Any contingent franchise payments are ordinary income for the franchisor and an ordinary deduction
for the franchisee. Contingent payments must meet the following requirements:
On January 4, 2018, Donald purchases five shares of Osprey Corporation common stock for $100. On April 14, 2018, he engages in a short
sale of five shares of the same stock for $150. On August 15, Donald closes the short sale by repaying the borrowed stock with the five
shares purchased on January 4. Because his substantially identical shares were held short term as of the short sale date, Donald’s $50
capital gain is short term.
The payments are made at least annually throughout the term of the transfer agreement.
Example 31
Short Sales and Short Sales against the Box
Contingent Payments
Example 19
Professional sports franchises (e.g., the Detroit Tigers) are subject to § 1253. Player contracts are usually one of the major assets acquired
with a sports franchise. These contracts last only for the time stated in the contract. By being classified as § 197 intangibles, the player
contracts and other intangible assets acquired in the purchase of the sports franchise are amortized over a statutory 15-year period.
Concept Summary 16.2 reviews the effects of transactions involving franchises on both the franchisor and franchisee.
Cancellation Payments
Franchisor
Assume the same facts as in the preceding example, except that Rachel sold her stock in January 2019 and used $3.5 million of the sale
proceeds to purchase other qualified small business stock one month later. Rachel’s gain is recognized to the extent that the sale proceeds
were not reinvested—namely, $500,000 ($4,000,000 sale proceeds − $3,500,000 reinvested). A 50% exclusion will apply, however, to the
$500,000.
Main content
Qualified Dividend Income
16-5b
Dividends paid by domestic and certain foreign corporations are eligible to be taxed at the 0%/15%/20% long-term capital gain rates if
they are qualified dividend income (QDI) (see the discussion of QDI in text Section 4-3b). Here, the discussion focuses on how the
qualified dividend income is taxed.
Example 33
Short Sales and Short Sales against the Box
Ordinary income.
Ordinary income.
Example 41
Capitalized and amortized over 15 years as an ordinary deduction; if franchise is sold, amortization is subject to recapture under § 1245.
The Big Picture
Ordinary
Assume the same facts as in Example 32, except that Rita did not own any Owl Corporation stock
on thededuction.
short sale date and acquired the
Return to the facts of The Big Picture. After holding the Purple stock for 10 months, Maurice receives $350 of dividends. If Purple is a
200 shares of Owl Corporation stock for $1,000 on December 12, 2018 (after the November 11, 2018 short sale date).
domestic or qualifying foreign corporation, these are qualified dividends eligible for the 0%/15%/20% tax rate.
Ordinary income if franchise rights are an ordinary asset;
if franchise
rights
a capital
Capitalized
amortized
over
Thecapital
deemedgain
closing
of the short
sale isare
December
12,asset
2018,(unlikely).
because Rita held substantially identical
sharesand
at the
end of 2018
and15
didyears
not as an ordinary deduction; if the franchise is sold, amortization is subject to recapture under § 1245.
After the net capital gain or loss has been determined, the QDI is added to the net long-term capital gain portion of the net capital gain and is
Ordinary income.
Ordinary
deduction.
close the short sale before January 31, 2019. Her 2018 short sale gain is a short-term gain of $300
($1,300
short sale price – $1,000 basis),
taxed as 0%/15%/20% gain. If there is a net capital loss, the net capital loss is still deductible for AGI up to $3,000 per year with the
and she still has a short-term capital loss of $700 on February 10, 2019.
remainder of the loss (if any) carrying forward. In this case, the QDI is still eligible to be treated as 0%/15%/20% gain in the alternative tax
Main content
calculation (it is not offset by the net capital loss).
16-5Tax Treatment of Capital Gains and Losses of Noncorporate Taxpayers
LO.5
The tax treatment of payments received for canceling a lease depends on whether the recipient is the lessor or the lessee and whether the
lease is a capital asset.
Lessee Treatment
Example 42
Refer to Example 35, but assume that there is qualified dividend income (QDI) of $2,500 in addition to the items shown. The QDI is not
netted against the capital gains and losses. Instead, the taxpayer has $1,000 of 28% gain, $4,000 of 25% gain, and $2,500 of QDI taxed at
0%/15%/20%.
Refer to Example 36, but assume that there is QDI of $2,500 in addition to the items shown. The QDI is not netted against the net capital
loss. The taxpayer has a $1,000 capital loss deduction and $2,500 of QDI taxed at 0%/15%/20%.
Main content
Describe the beneficial tax treatment for capital gains and the detrimental tax treatment for capital
losses for noncorporate taxpayers.
Lease cancellation payments received by a lessee are treated as an exchange. The treatment of these payments depends on the underlying
use of the property and how long the lease has existed.
All taxpayers net their capital gains and losses. Short-term gains and losses (if any) are netted against one another, and long-term gains and
losses (if any) are netted against one another. The results will be net short-term gain or loss and net long-term gain or loss. If these two net
positions are of opposite sign (one is a gain and one is a loss), they are netted against each other.
Six possibilities exist for the result after all possible netting has been completed.
1.
A net long-term capital gain (NLTCG).
2.
A net short-term capital gain (NSTCG).
3.
Both NLTCG and NSTCG.
4.
A net long-term capital loss (NLTCL).
5.
A net short-term capital loss (NSTCL).
6.
Both NLTCL and NSTCL.
Net long-term capital gains of noncorporate taxpayers are eligible for an alternative tax calculation that normally results in a lower tax
liability. Neither NLTCLs nor NSTCLs are treated as ordinary losses. Treatment as an ordinary loss generally is preferable to capital loss
treatment because ordinary losses are deductible in full while the deductibility of capital losses is subject to certain limitations. An
individual taxpayer may deduct a maximum of $3,000 of net capital losses for a taxable year.
If the property was used personally (e.g., an apartment used as a residence), the payment results in a capital gain (and long term if the lease
existed for more than one year).
If the property was used for business and the lease existed for one year or less, the payment results in ordinary income.
If the property was used for business and the lease existed for more than one year, the payment results in a § 1231 gain.
Example 20
Mark owns an apartment building that he is going to convert into an office building. Vicki is one of the apartment tenants and receives
$1,000 from Mark to cancel the lease.
Vicki has a capital gain of $1,000 (which is long term or short term depending upon how long she has held the lease). Mark has an ordinary
deduction of $1,000.
16-5c
Example 43
Joan, a single taxpayer, has taxable income of $118,000, including a $10,000 net capital gain and $2,000 QDI. The last $12,000 of her
$118,000 taxable income is the layer related to the net capital gain and/or QDI. The first $106,000 ($118,000 – $12,000) of her taxable
income is her other taxable income and is not subject to any special tax rate, so it is taxed using the regular tax rates.
Because the net capital gain and/or QDI may be made up of various rate layers, it is important to know in what order those layers are taxed.
(Review the five-step ordering procedure discussed in text Section 16-5a and the related examples.) For each of the layers, the taxpayer
compares the regular tax rate on that layer of income and the alternative tax rate on that portion of the net capital gain and/or QDI.
The layers are taxed in the following order:
Capital Gain and Loss Netting Process
Net short-term capital gain is not eligible for any special tax rate. It is taxed at the same rate as the taxpayer’s other taxable income.
Net long-term capital gain is eligible for one or more of five alternative tax rates: 0 percent, 15 percent, 20 percent, 25 percent, and 28
percent. The 25 percent and 28 percent rates are used only in unique circumstances. The net long-term capital gain components are
referred to as the 0%/15%/20% gain, the 25% gain, and the 28% gain.
The 25% gain is called the unrecaptured § 1250 gain and is related to gain from disposition of § 1231 assets (discussed in Chapter 17).
Here, the discussion focuses only on how the 25% gain is taxed and not how it is determined. The 28% gain relates to collectibles and small
business stock gain (both discussed later in this section).
In 2018, the 0% gain portion of the 0%/15%/20% gain applies to long-term capital gains that, when coupled with other forms of taxable
income, do not exceed $77,200 for married taxpayers filing jointly, $51,700 for heads of household, and $38,600 for single taxpayers and
married taxpayers filing separately. The 15% gain portion of the 0%/15%/20% gain applies to long-term capital gains that, when coupled
with other forms of taxable income, exceed the 0% gain thresholds and do not exceed $479,000 for married taxpayers filing jointly,
$452,400 for heads of household, $425,800 for single taxpayers, and $239,500 for married taxpayers filing separately. The 20%
gain portion of the 0%/15%/20% gain applies to long-term capital gains that, when coupled with other forms of taxable income, exceed
the 15% gain thresholds.
When the long-term capital gain exceeds short-term capital loss, a net capital gain (NCG) exists. Net capital gain qualifies for beneficial
alternative tax treatment (see the coverage later in the chapter).
Because there are both short- and long-term capital gains and losses and because the long-term capital gains may be taxed at various rates,
an ordering procedure is required. The ordering procedure, which ensures that any long-term capital gain is taxed at the lowest preferential
rate possible, includes the following steps:
1.
Step 1
Group all gains and losses into four groups: short term, and 28%, 25%, and 0%/15%/20% long term.
2.
Step 2
Net the gains and losses within each group.
3.
Step 3
Offset the net 28% and net 25% amounts, if they are of opposite sign.
4.
Step 4
Offset the results after step 3 against the 0%/15%/20% amount, if they are of opposite sign. If the 0%/15%/20% amount is a loss, offset it
against the highest-taxed gain first. After this step, there is a net long-term capital gain or loss. If there is a net long-term capital gain, it may
consist of only 28% gain, only 25% gain, only 0%/15%/20% gain, or some combination of all of these gains. If there is a net long-term
capital loss, it is simply a net long-term capital loss.
5.
Step 5
Offset the net short-term amount against the long-term results of step 4, if they are of opposite sign. The netting rules offset net short-term
capital loss against the highest-taxed gain first. So a net short-term capital loss first offsets any 28% gain, then any 25% gain, and finally
any 0%/15%/20% gain.
If the result of step 5 is only a short-term capital gain, the taxpayer is not eligible for a reduced tax rate. If the result of step 5 is a loss, the
taxpayer may be eligible for a capital loss deduction (discussed later in this chapter). If there was no offsetting in step 5 because the shortterm and step 4 results were both gains or if the result of the offsetting is a long-term gain, a net capital gain exists and the taxpayer may be
eligible for a reduced tax rate. The net capital gain may consist of 28% gain, 25% gain, and/or 0%/15%/20% gain.
As you might suspect, this ordering procedure can produce many different results. The following series of examples illustrates some of
these outcomes.
Payments received by a lessor for a lease cancellation are always ordinary income because they are considered to be in lieu of rental
payments.
Example 21
Floyd owns an apartment building near a university campus. Hui-Fen is one of the tenants. Hui-Fen is graduating early and offers Floyd
$800 to cancel the apartment lease. Floyd accepts the offer.
Floyd has ordinary income of $800. Hui-Fen has a nondeductible payment because the apartment was personal use property.
16-4Holding Period
LO.4
Determine whether the holding period for a capital asset is long term or short term.
Main content
Rules
Property must be held more than one year to qualify for long-term capital gain or loss treatment. Property held for one year or less results
in short-term capital gain or loss. To compute the holding period, start counting on the day after the property was acquired and include
the day of disposition.
Example 22
The Big Picture
Return to the facts of The Big Picture. Assume that Maurice purchased the Purple stock on January 15, 2018. If he sells it on January 16,
2019, Maurice’s holding period is more than one year and the gain or loss is long term.
If, instead, Maurice sells the stock on January 15, 2019, the holding period is exactly one year and the gain or loss is short term.
To be held for more than one year, a capital asset acquired on the last day of any month must not be sold until on or after the first day of the
thirteenth succeeding month.
Example 23
Leo purchases a capital asset on February 28, 2018. If Leo sells the asset on February 28, 2019, the holding period is one year and Leo will
have a short-term capital gain or loss.
If Leo sells the asset on March 1, 2019, the holding period is more than one year and he will have a long-term capital gain or loss.
Special Holding Period Rules
16-4b
There are several special holding period rules. The application of these rules depends upon the type of asset and how it was acquired.
Nontaxable Exchanges
The holding period of property received in a like-kind exchange includes the holding period of the former asset if the property that has
been exchanged is a capital asset or a § 1231 asset. In these settings, the holding period of the former property is tacked on to the holding
period of the newly acquired property.
Example 24
Alternative Tax on Net Capital Gain and Qualified Dividend Income
Code § 1 contains the rules that enable the net capital gain to be taxed at special rates (0, 15, 20, 25, and 28 percent). This calculation is
referred to as the alternative tax on net capital gain. The alternative tax applies only if taxable income includes some long-term capital
gain (there is net capital gain) and/or qualified dividend income (QDI). Taxable income includes all of the net capital gain and/or QDI
unless taxable income is less than the net capital gain and/or QDI. In addition, the net capital gain and/or QDI is taxed last, after other
taxable income (including any short-term capital gain).
16-5a
Lessor Treatment
16-4aGeneral
Example 40
On January 18, 2017, Rita purchases 200 shares of Owl Corporation stock for $1,000. On November 11, 2018, she sells short, for $1,300,
200 shares of Owl Corporation stock that she borrows from her broker. On February 10, 2019, Rita closes the short sale by delivering the
200 shares of Owl Corporation stock that she had acquired in 2017. On that date, Owl Corporation stock had a market price of $3 per share.
Because Rita owned substantially identical stock on the date of the short sale and did not close the short sale before January 31, 2019, she
is deemed to have closed the short sale on November 11, 2018 (the date of the short sale). On her 2018 tax return, she reports a $300 longterm capital gain ($1,333 short sale price − $1,000 basis).
On February 10, 2019, Rita has a $700 short-term capital loss [$600 short sale closing date price
(200
Effect
onshares × $3 per share) − $1,300
basis] because the holding period of the shares used to close the short sale commences with Franchisee
the date of the short sale.
Sports Franchises
16-3fLease
Example 39
Example 32
Short Sales and Short Sales against the Box
TAK, a spicy chicken franchisor, transfers an eight-year franchise to Phyllis. TAK retains a significant power, right, or continuing interest.
Phyllis, the franchisee, agrees to pay TAK 15% of sales. This contingent payment is ordinary income to TAK and a business deduction for
Phyllis as the payments are made.
The corporation does not engage in banking, financing, insurance, investing, leasing, farming, mineral extraction, hotel or motel operations,
restaurant operations, or any business whose principal asset is the reputation or skill of its employees (such as accounting, architecture,
health, law, engineering, or financial services).
Even if each of these requirements is met, the amount of gain eligible for the exclusion is limited to the greater of 10 times the taxpayer’s
basis in the stock or $10 million per taxpayer per company, computed on an aggregate basis.
Rachel purchased $100,000 of qualified small business stock when it was first issued in October 2002. This year, she sold the stock for $4
million. Her gain is $3.9 million ($4,000,000 − $100,000). Although this amount exceeds 10 times her basis , it is less than $10 million. As a
result, the entire $3.9 million gain is eligible for a 50% exclusion.
Transactions that fail to satisfy any one of the applicable requirements are taxed as capital gains (and losses) realized by noncorporate
taxpayers generally.
Gains are also eligible for nonrecognition treatment if the sale proceeds are invested in other qualified small business stock within 60
days. To the extent that the sale proceeds are not so invested, gain is recognized, but the exclusion still applies. To be eligible for this
treatment, the stock sold must have been held more than six months.
Assume the same facts as in the previous example, except that Donald closes the short sale on January 28, 2019, by repaying the borrowed
stock with five shares purchased on January 27, 2019, for $200. Because Donald’s substantially identical property (purchased on January 4,
2018) was short-term property at the April 14, 2018 short sale date, his $50 capital loss ($200 cost of stock purchased on January 27, 2019,
and a short sale selling price of $150) is short term.
The payments are substantially equal in amount or are payable under a fixed formula.
Event
Franchisor Retains Significant Powers and Rights
Noncontingent payment
Contingent payment
Franchisor Does Not Retain Significant Powers and Rights
Noncontingent payment
Contingent payment
Main content






Any 25% gain,
Any 28% gain,
The 0 percent portion of the 0%/15%/20% gain and/or QDI,
The 15 percent portion of the 0%/15%/20% gain and/or QDI, and then
The 20 percent portion of the 0%/15%/20% gain and/or QDI.
As a result of this layering:



The taxpayer benefits from the 0 percent portion of the net capital gain and/or QDI if the taxpayer is still in the
10 percent or 12 percent regular tax bracket after taxing other taxable income and the 25 percent and 28 percent portions of the net capital
gain. Depending on the taxpayer’s filing status, however, a portion of income in the taxpayer’s 12 percent tax bracket is subject to the 15
percent alternative tax rate. In 2018, the 0 percent alternative rate applies only through $77,200 of taxable income for married taxpayers
filing jointly or surviving spouses, $51,700 for heads of household, and $38,600 for single taxpayers and married taxpayers filing
separately. This means that in 2018, the last $200 (married, filing jointly and surviving spouses) or $100 (single, head of household, and
married, filing separately) in the 12 percent bracket is subject to the 15 percent alternative rate. As the normal tax rate (12 percent) is less
than the alternative tax rate (15 percent), this means that for these $200 or $100 ranges, any net capital gain or QDI will be taxed at 12
percent (rather than 15 percent). These threshold amounts are adjusted annually for inflation.
The taxpayer benefits from the 15 percent portion of the net capital gain and/or QDI if the taxpayer is in the 22 percent, 24 percent, and 32
percent brackets or a portion of the 35 percent regular rate bracket after taxing other taxable income and the 25 percent, 28 percent, and 0
percent portions of the net capital gain and/or QDI. In 2018, the 15 percent tax rate applies until taxable income exceeds $479,000 for
married taxpayers filing jointly, $452,400 for heads of household, $425,800 for single taxpayers, and $239,500 for married taxpayers filing
separately. These threshold amounts are adjusted annually for inflation.
The taxpayer benefits from the 20 percent portion of the net capital gain and/or QDI when taxable income exceeds the maximum taxable
income thresholds for the 15 percent alternative tax rate.
Concept Summary 16.4 summarizes the alternative tax computation.
Conce pt Sum mar y 16.4
Incom e L ay ers f or Al terna ti ve Ta x o n Ca pi tal Gai n Com put ati on
Compute
tax on:
Example 34
Capital Gain and Loss Netting Process
On April 22, 2018, Vern exchanges a business building he acquired on March 15, 2015, for another business building in a qualifying likekind exchange.
The holding period of the replacement building begins March 15, 2015, because the holding period of the building given up in the
exchange tacks to the holding period of the replacement building.
Other taxable income (including net short-term capital gain) using the regular tax rates.
Each of the layers below using the lower of the alternative tax rate or the regular tax rate
for that layer (or portion of a layer) of taxable income.
Compute
tax on:
This example shows how a net short-term capital gain may result from the netting process.
Gifts
+
25% long-term capital gain (unrecaptured § 1250 gain) portion of taxable income
+
28% long-term capital gain
+
0% long-term capital gain [portion of 0%/15%/20% gain and/or qualified dividend income
(QDI) that is taxed at 0%; available only if other taxable income plus 25% and 28% capital
gain layers do not put the taxpayer above specified thresholds in the 12% regular tax
bracket; 0% rate is no longer available once income, including the portion of the gain
and/or QDI taxed at 0%, puts the taxpayer above these thresholds]
+
15% long-term capital gain (portion of 0%/15%/20% gain and/or QDI that is taxed at
15%; available only if other taxable income plus the 25%, 28%, and 0% layers put the
taxpayer above the 12% regular tax bracket and only until other taxable income plus the
25%, 28%, 0%, and 15% layers put the taxpayer at or below specified thresholds in the
35% regular tax rate bracket)
+
20% long-term capital gain (portion of 0%/15%/20% gain and/or QDI that is taxed at
20%; available when other taxable income plus the 25%, 28%, 0%, and 15% layers put
the taxpayer above the specified thresholds in the 35% regular tax rate bracket)
=
Alternative tax on taxable income
When a gift occurs, if the donor’s basis carries over to the recipient, the donor’s holding period is tacked on to the recipient’s holding
period. This will occur when the property’s fair market value at the date of the gift is greater than the donor’s adjusted basis. These
transactions are discussed in Chapter 14.
Example 25
Carryover Basis
Kareem acquires 100 shares of Robin Corporation stock for $1,000 on December 31, 2014. He transfers the shares by gift to Megan on
December 31, 2017, when the stock is worth $2,000. Kareem’s basis of $1,000 becomes the basis for determining gain or loss on a
subsequent sale by Megan. Megan’s holding period begins with the date the stock was acquired by Kareem.
Example 26
Carryover Basis
Example 35
Capital Gain and Loss Netting Process
Assume the same facts as in Example 25, except that the fair market value of the shares is only $800 on the date of the gift. The holding
period begins on the date of the gift if Megan sells the stock for a loss. The value of the shares on the date of the gift is used in the
determination of her basis for loss. If she sells the shares for $500 on April 1, 2018, Megan has a $300 recognized capital loss and the
holding period is from December 31, 2017, to April 1, 2018 (as a result, the loss is short term).
This example shows how a net long-term capital gain may result from the netting process.
Certain Disallowed Loss Transactions
Example 44
Alternative Tax on Net Capital Gain
Under several Code provisions, realized losses are disallowed. When a loss is disallowed, there is no carryover of holding period. Losses can
be disallowed under § 267 (sale or exchange between related taxpayers) and § 262 (sale or exchange of personal use assets) as well as
other Code Sections. Taxpayers who acquire property in a disallowed loss transaction will have a new holding period begin and will have a
basis equal to the purchase price.
Assume that Joan’s $10,000 net capital gain in Example 43 is made up of $7,000 25% gain and $3,000 0%/15%/20% gain. In addition, she
has $2,000 of QDI. Examination of the 2018 tax rates reveals that $106,000 ($118,000 – $12,000) of other taxable income for a single
individual puts Joan at a marginal tax rate of 24%. Consequently, she uses the alternative tax on the $7,000 gain, the $3,000 gain, and the
$2,000 QDI.
Her alternative tax liability for 2018 is $22,160:
Example 27
Janet sells her personal automobile at a loss. She may not deduct the loss because it arises from the sale of personal use property. Janet
purchases a replacement automobile for more than the selling price of her former automobile. Janet has a basis equal to the cost of the
replacement automobile, and her holding period begins when she acquires the replacement automobile.
Example 36
Capital Gain and Loss Netting Process
Inherited Property
The holding period for inherited property is treated as long term no matter how long the property is actually held by the heir. The holding
period of the decedent or the decedent’s estate is not relevant for the heir’s holding period.
This example shows how a net long-term capital loss may result from the netting process.
Example 28
Since her marginal tax rate is still 24% after taxing the $106,000 other taxable income, she uses the 24% regular tax rate rather than the
25% alternative tax rate on the $7,000 25% gain. As the combination of the $106,000 other taxable income and her $7,000 25% gain puts
her above the 12% regular tax bracket, none of the $3,000 0%/15%/20% gain or $2,000 QDI is taxed at 0%.
Her regular tax liability on $118,000 is $22,610. As a result, Joan saves $450 ($22,610 – $22,610) by using the alternative tax calculation.
Since Joan’s taxable income is $425,800 or less, none of her 0%/15%/20% gain or QDI is taxed at the 20% alternative tax rate.
Shonda inherits Blue Company stock from her father, who died in 2018. She receives the stock on April 1, 2018, and sells it on November 1,
2018. Even though Shonda did not hold the stock more than one year, she receives long-term capital gain or loss treatment on the sale.
16-4c
Special Rules for Short Sales
Example 45
Alternative Tax on Net Capital Gain
General
The Code provides special holding period rules for short sales. A short sale occurs when a taxpayer sells borrowed property and repays
the lender with substantially identical property either held on the date of the sale or purchased after the sale.
Short sales usually involve corporate stock. The seller’s objective is to make a profit in anticipation of a decline in the stock’s price. If the
price declines, the seller in a short sale recognizes a profit equal to the difference between the sales price of the borrowed stock and the
price paid for the replacement stock.
Example 29
A short-term capital loss carryover to the current year retains its character as short term and is combined with the short-term items of the
current year. A net long-term capital loss carries over as a long-term capital loss and is combined with the current-year long-term items.
The long-term loss carryover is first offset with 28% gain of the current year, then 25% gain, and then 0%/15%/20% gain until it is
absorbed.
Chris does not own any shares of Brown Corporation. However, Chris sells 30 shares of Brown. The shares are borrowed from Chris’s
broker and must be replaced within 45 days. Chris has a short sale because he was short the shares he sold. He will close the short sale by
purchasing Brown shares and delivering them to his broker.
If the original 30 shares were sold for $10,000 and Chris later purchases 30 shares for $8,000, he has a gain of $2,000. Chris’s hunch that
the price of Brown stock would decline was correct. Chris was able to profit from selling high and buying low.
If Chris had to purchase Brown shares for $13,000 to close the short sale, he would have a loss of $3,000. In this case, Chris would have sold
low and bought high—not the result he wanted. Chris would be making a short sale against the box if he borrowed shares from his broker
to sell and then closed the short sale by delivering other Brown shares he owned at the time he made the short sale.
Concept Summary 16.3 summarizes the short sale rules. These rules are intended to prevent the conversion of short-term capital gains into
long-term capital gains and long-term capital losses into short-term capital losses.
Conce pt Sum mar y 16.3
Short Sal es of Se curi ti es
In most settings, short sale gain or loss results in a capital gain or loss. The gain or loss is not recognized until the short sale is closed.
Generally, the holding period of the short sale property is determined by how long the property used to close the short sale was held.
However, when substantially identical property (e.g., other shares of the same stock) is held by the taxpayer, the holding period is
determined as follows:
The short sale gain or loss is short term when, on the short sale date, the substantially identical property has been held short term (i.e., for
one year or less). (See Examples 30 and 31.)
The short sale gain is long term when, on the short sale date, the substantially identical property has been held long term (i.e., for more than
one year) and is used to close the short sale. If the long-term substantially identical property is not used to close the short sale, the short
sale gain is short term. (See Example 32.)
Example 37
In 2018, Abigail has a $4,000 short-term capital gain, a $36,000 28% long-term capital gain, and a $13,000 0%/15%/20% long-term capital
gain. She also has a $3,000 short-term capital loss carryover and a $2,000 long-term capital loss carryover from 2017.
As a result, in 2018, Abigail has a $1,000 net short-term capital gain ($4,000 − $3,000), a $34,000 net 28% long-term capital gain ($36,000
− $2,000), and a $13,000 net 0%/15%/20% long-term capital gain.
Capital assets that are collectibles, even though they are held long term, are not eligible for the 0%/15%/20% alternative tax rate. Instead, a
28 percent alternative tax rate applies.
For capital gain or loss purposes, collectibles include:







On the short sale date if the taxpayer owned substantially identical securities at that time.
On the date during the year of the short sale that the taxpayer acquired substantially identical securities.
The basis of the shares in the deemed transfer of shares is used to compute the gain or loss on the short sale. As Examples
32 and 33 illustrate, when shares are actually transferred to the broker to close the short sale, there may be a gain or loss because the
shares transferred will have a basis equal to the short sale date price and the value at the actual short sale closing date may be different
from the short sale date price.
Example 46
Assume the same facts as in Example 45, except that Joan’s 2018 taxable income is $40,000, consisting of $11,000 of net capital gain, $1,000
of QDI, and $28,000 of other taxable income.
Not all of the combined 0%/15%/20% gain and QDI ($3,700; 2,700 + $1,000) is taxed at 0% because Joan’s taxable income exceeds
$38,600, taking her out of the 0% alternative tax. Consequently, the last $1,400 ($40,000 – $38,600) of the $3,700 is taxed at 12% and 15%
rather than 0%.
Her tax liability using the alternative tax computation is $4,373:
Any work of art.
Any rug or antique.
Any metal or gem.
Any stamp.
Joan’s regular tax liability on $40,000 is $4,740. As a result, she saves $367 ($4,740 – $4,373) by using the alternative tax calculation.
Main content
Any alcoholic beverage.
16-5d



A net capital loss (NCL) results if capital losses exceed capital gains for the year. An NCL may be all long term, all short term, or part long
and part short term. The characterization of an NCL as long or short term is important in determining the capital loss deduction (discussed
next).
Any historical objects (documents, clothes, etc.).
Example 47
Small Business Stock
Three different individuals have the following capital gains and losses during the year:
100 percent of the gain is excluded for qualified stock acquired after September 27, 2010.
Paulina’s NCL of $1,300 is all long term. Carlos’s NCL of $1,300 is all short term. Anibal’s NCL is $1,500, $700 of which is short term and
$800 of which is long term.
75 percent of the gain is excluded for qualified stock acquired after February 17, 2009, and before September 28, 2010.
Capital Loss Deduction
A net capital loss is deductible for AGI, but limited to no more than $3,000 per tax year. So although a net capital gain receives favorable tax
treatment, there is unfavorable treatment for capital losses due to the $3,000 annual limitation. If the NCL includes both long-term and
short-term capital loss, the short-term capital loss is counted first toward the $3,000 annual limitation.
50 percent of the gain is excluded for qualified stock acquired before February 18, 2009.
As a result, the maximum effective tax rate on gains from the sale of qualified small business stock is 0 percent (28% × 0%), 7 percent (28%
× 25%), or 14 percent (28% × 50%).
Example 48
Example 38
In March 2018, Yolanda realized a $100,000 gain on the sale of qualified small business stock that she acquired in 2006. Yolanda’s marginal
tax rate is 32% without considering this gain. As the stock was acquired before February 18, 2009, $50,000 of this gain (50%) is excluded
from gross income, and the other $50,000 is taxed at the maximum rate of 28%. As a result, Yolanda owes Federal income tax of $14,000 on
the stock sale ($50,000 × 28%), an effective tax rate of 14% on the entire $100,000 gain.
If, instead, Yolanda acquired the stock any time after September 27, 2010, she would exclude 100% of the gain.
Given this very favorable treatment, Congress wanted to ensure that the gain exclusion only applied in very specific situations. As a result,
they imposed the following restrictions:




Treatment of Net Capital Losses
Computation of Net Capital Loss
Most coins.
A special exclusion is available to noncorporate taxpayers who derive capital gains from the sale or exchange of qualified small business
stock. Any amount not excluded from income is taxed at a maximum rate of 28 percent (as noted earlier). The exclusion amount varies,
depending on when the qualified small business stock was acquired:
The short sale gain or loss is short term if the substantially identical property is acquired after the short sale date and on or before the
closing date. (See Example 33.)
A short sale against the box occurs when the stock is borrowed from a broker by a seller and the seller already owns substantially identical
securities on the short sale date or acquires them before the closing date. To remove the taxpayer’s flexibility as to when the short sale gain
must be reported, a constructive sale approach is used. If the taxpayer has not closed the short sale by delivering the short sale securities to
the broker before January 31 of the year following the short sale, the short sale is deemed to have been closed on the earlier of two events:
Because her marginal rate is still 12% after taxing the $13,000 of other taxable income, she uses the 12% regular tax rate rather than the
25% alternative tax rate on the $8,300 25% gain. After taxing the $13,000 and the $8,300, a total of $21,300 of the $25,000 taxable income
has been taxed. Because her remaining taxable income ($3,700) remains in the 12% tax bracket (and her total taxable income does not
exceed $38,600), she uses the 0% alternative rate for the $2,700 of 0%/15%/20% gain and $1,000 QDI.
Joan’s regular tax liability on $25,000 is $2,810. As a result, she saves $444 ($2,810 – $2,366) by using the alternative tax calculation.
The alternative tax computation allows the taxpayer to receive the lower of the regular tax or the alternative tax on each layer of net capital
gain and/or QDI or portion of each layer of net capital gain and/or QDI.
Definition of Collectibles
The short sale loss is long term when, on the short sale date, the substantially identical property has been held long term (i.e., for more than
one year).
Disposition Rules for Short Sales against the Box
Assume that Joan, a single taxpayer, has 2018 taxable income of $25,000. Of this amount, $11,000 is net capital gain, $1,000 is QDI, and
$13,000 is other taxable income. The $11,000 net capital gain is made up of $8,300 of 25% gain and $2,700 of 0%/15%/20% gain.
Her alternative tax liability for 2018 is $2,366:
Use of Capital Loss Carryovers
The stock must have been newly issued after August 10, 1993.
The taxpayer must have held the stock more than five years.
The issuing corporation must use at least 80 percent of its assets, determined by their value, in the active conduct of a trade or business.
When the stock was issued, the issuing corporation’s assets must not have exceeded $50 million, at adjusted basis, including the proceeds
of the stock issuance.
Burt has an NCL of $5,500, of which $2,000 is STCL and $3,500 is LTCL. Burt has a capital loss deduction of $3,000 ($2,000 of STCL and
$1,000 of LTCL). He has an LTCL carryforward of $2,500 ($3,500 − $1,000).
Carryovers
Taxpayers are allowed to carry over unused capital losses indefinitely. The short-term capital loss (STCL) retains its character as STCL.
Likewise, the long-term capital loss retains its character as LTCL.
Example 49
In 2018, Mark incurred $1,000 of STCL and $11,000 of LTCL. In 2019, Mark has a $400 LTCG.


Mark’s NCL for 2018 is $12,000. Mark deducts $3,000 ($1,000 STCL and $2,000 LTCL). He has $9,000 of LTCL carried forward to 2019.
Mark combines the $9,000 LTCL carryforward with the $400 LTCG for 2019. He has an $8,600 NLTCL for 2019. Mark deducts $3,000 of
LTCL in 2019 and carries forward $5,600 of LTCL to 2020.
Concept Summary 16.5 summarizes the rules for noncorporate taxpayers’ treatment of capital gains and losses.
Result
Maximum Tax Rate
Net short-term capital loss
—
Net long-term capital loss
—
Net short-term capital loss and net long-term capital loss
—
Net short-term capital gain
10%–37%
Net long-term capital gain
0%–28%
Result
Maximum Tax Rate
The net long-term capital gain is the last portion of taxable income.
Each net long-term capital gain component of taxable income is taxed at the lower of the
regular tax on that component or the alternative tax.
Net short-term capital gain and net long-term capital gain
10%–37% on net short-term capital gain; 0%–28%
on net long-term capital gain
Reporting Procedures
Both properties were held for use in her business for the long-term holding period and, therefore, are § 1231 assets. Hazel’s net § 1231 loss
Comments
The components are taxed in the following order: 25%, 28%, 0%, 15%, 20%. They are taxed afteristhe
$200,
non-long-term
and that net loss
capital
is an ordinary
gain portion
loss. of
The rules regarding § 1231 treatment do not apply to all business property. Section 1231 has specific holding period requirements and, in
taxable income has been taxed. The 0%/15%/20% component may include qualified dividend income.
general, requires that the property must be either depreciable property or real estate used in business. As a result, neither inventory nor
are § 1231
Nortaxable
is § 1231
necessarily limited to business property. Transactions involving certain capital assets may fall
The alternative tax on net long-term capital gain can never increase the tax on taxable income, receivables
but it can reduce
theassets.
tax on
income.
into the § 1231 category.
As discussed in Chapter 16, long-term capital gains receive beneficial tax treatment. Section 1231 requires netting of § 1231 gains and
losses. If the result is a gain, it may be treated as a long-term capital gain. The net gain is added to the “real” long-term capital gains (if any)
and netted
with capital
losses
any).
Aslong-term
a result, the net § 1231 gain may eventually be eligible for beneficial capital gain treatment or
The net short-term capital gain is taxed as ordinary income; the net long-term capital gain is taxed
as discussed
above
for(ifjust
net
help avoid the deduction limitations that apply to a net capital loss. If the § 1231 gain and loss netting results in a loss, it is an ordinary loss.
capital gain.
Finally, § 1231 assets are treated the same as capital assets for purposes of the appreciated property charitable contribution provisions
(refer to Chapter 10).
16-5e
The following example is used to discuss and illustrate the tax forms used for reporting (2017 forms are used because the 2018 tax forms
are not yet available).
17-1b
Example 50
LO.2
During 2017, Joan Rapson (Social Security number 123-45-6789) had the following sales of capital assets. In addition, she has $300 of
qualified dividend income and $65,700 of other taxable income. Joan is single and has no dependents.
Description
100 shares Blue stock
Section 1231 property generally includes the following assets if they are held for more than one year:
Acquired On
Date Sold
Sales Price
Tax Basis
1/21/17
11/11/17
$11,000
$17,000
100 shares Yellow stock
9/12/12
100 shares Purple stock
3/14/15
Property Included
Distinguish § 1231 assets from ordinary assets and capital assets and calculate the § 1231 gain or loss.

or Loss
Character
Depreciable or realGain
property
used in business or for the production of income (principally
machinery and equipment,
buildings, and land).




G lobal Tax Issue s
Capi tal
Gai n Tre atme nt i n th e U ni te d St ates36,000
an d Oth er Co untri es
10/12/17
17-1c




Importance of Capital Asset Status
Why is capital asset status important? Because of the alternative tax on net capital gain. Individuals who receive income in the form of longterm capital gains or qualified dividend income have an advantage over taxpayers who cannot receive income in these forms.
If a net capital loss results, the maximum deduction is $3,000 per year. Consequently, capital gains and losses must be segregated from
other types of gains and losses and must be reported separately on Schedule D of Form 1040.
Main content
16-7b

Timber
In order to encourage reforestation of timberlands, Congress has provided preferential treatment relative to the natural growth value of
timber, which takes a relatively long time to mature. If timber is held for investment, the timber is a capital asset. If timber is used in a
business, it will be a § 1231 asset if held for more than a year. But if the timber is inventory, an ordinary gain or loss will normally result. If
the timber is inventory, the taxpayer can elect to treat the cutting of timber as a sale or exchange and, if the election is made, to treat the
sale as the disposition of a § 1231 asset.
The recognized § 1231 gain or loss is determined at the time the timber is cut and is equal to the difference between the timber’s fair
market value as of the first day of the taxable year and the adjusted basis for depletion. If a taxpayer sells the timber for more or less than
the fair market value as of the first day of the taxable year in which it is cut, the difference is ordinary income or loss.
Example 53
Jim, a real estate dealer, segregates Tract A from the real estate he regularly holds for resale and designates the property as being held for
investment purposes. The property is not advertised for sale and is disposed of several years later. The negotiations for the subsequent sale
were initiated by the purchaser and not by Jim. Under these circumstances, it would appear that any gain or loss from the sale of Tract A
should be a capital gain or loss.
When a business is being sold, one of the major decisions usually concerns whether a portion of the sales price is for goodwill. For the
seller, goodwill generally represents the disposition of a capital asset. Goodwill has no basis and represents a residual portion of the selling
price that cannot be allocated reasonably to the known assets. As a result, the amount of goodwill represents capital gain.
From a legal perspective, the buyer may prefer that the residual portion of the purchase price be allocated to a covenant not to compete (a
promise that the seller will not compete against the buyer by conducting a business similar to the one the buyer has purchased). Both
purchased goodwill and a covenant not to compete are § 197 intangibles. As a result, both must be capitalized and can be amortized over a
15-year statutory period.
To the seller, a covenant produces ordinary income. So, the seller would prefer that the residual portion of the selling price be allocated to
goodwill—a capital asset. If the buyer does not need the legal protection provided by a covenant, the buyer is neutral regarding whether
the residual amount be allocated to a covenant or to goodwill. Because the seller would receive a tax advantage from labeling the residual
amount as goodwill, the buyer should factor this into the negotiation of the purchase price.
If the taxpayer has a net long-term capital gain that includes either 28% or 25% long-term capital gain, then the alternative tax is calculated
using the Schedule D Tax Worksheet from the Schedule D instructions.
These worksheets do not have to be filed with the tax return, but are kept for the taxpayer’s records.
Main content
16-6Tax Treatment of Capital Gains and Losses of Corporate Taxpayers
LO.6
Describe the tax treatment for capital gains and the detrimental tax treatment for capital losses for
corporate taxpayers.
Example 3
Several years ago Tom, a timber dealer, purchased a tract of land with a substantial stand of trees on it. The land cost $40,000, and the
timber cost $100,000. On the first day of 2018, the timber was appraised at $250,000. In August 2018, Tom cut the timber and sold it for
$265,000. Tom elects to treat the cutting as a sale or exchange under § 1231. He has a $150,000 § 1231 gain ($250,000 − $100,000) and a
$15,000 ordinary gain ($265,000 − $250,000).
What if the timber had been sold for $235,000? Tom would still have a $150,000 § 1231 gain, but he would also have a $15,000 ordinary
loss. The price for computing § 1231 gain is the price at the beginning of the tax year. Any difference between that price and the sales price
is ordinary gain or loss. Here, because the price declined by $15,000, Tom has an ordinary loss in that amount.
Livestock
Cattle and horses must be held 24 months or more and other livestock must be held 12 months or more
to qualify under § 1231. Poultry is not livestock for purposes of § 1231.
Section 1231 Assets Disposed of by Casualty or Theft
When § 1231 assets are disposed of by casualty or theft, a special netting rule is applied. For simplicity, the term casualty is used to mean
both casualty and theft dispositions. First, the casualty gains and losses from § 1231 assets and the casualty gains and losses from longterm nonpersonal use capital assets are determined. A nonpersonal use capital asset might be art held as an investment or a baseball
card collection held by a nondealer.
Next, the § 1231 asset casualty gains and losses and the nonpersonal use capital asset casualty gains and losses are netted together
(see Concept Summary 17.1 later in the chapter).If the result is a net loss, the § 1231 casualty gains and the nonpersonal use capital asset
casualty gains are treated as ordinary gains, the § 1231 casualty losses are deductible for AGI, and the nonpersonal use capital asset
casualty losses are deductible from AGI as miscellaneous itemized deductions (which are not deductible from 2018 through 2025).If the
result of the netting is a net gain, the net gain is treated as a § 1231 gain.
As a result, a § 1231 asset disposed of by casualty may or may not get § 1231 treatment, depending on whether the netting process results
in a gain or a loss. Also, a nonpersonal use capital asset disposed of by casualty may get § 1231 treatment or ordinary treatment, but it will
not get capital gain or loss treatment.
Casualties, thefts, and condemnations are involuntary conversions. Involuntary conversion gains may be deferred if conversion proceeds
are reinvested; involuntary conversion losses are recognized currently (refer to Chapter 15) regardless of whether the conversion
proceeds are reinvested. Thus, the special netting process discussed previously for casualties and thefts would not include gains that are
not currently recognizable because the insurance proceeds are reinvested.
The special netting process for casualties and thefts also does not include condemnation gains and losses. Consequently, a § 1231 asset
disposed of by condemnation will receive § 1231 treatment. This variation between recognized casualty and condemnation gains and
losses sheds considerable light on what § 1231 is all about. Section 1231 has no effect on whether realized gain or loss is recognized.
Instead, § 1231 merely dictates how such recognized gain or loss is classified (ordinary, capital, or § 1231) under certain conditions.
Example 54
Marcia is buying Jack’s dry cleaning proprietorship. An appraisal of the assets indicates that a reasonable purchase price would exceed the
value of the known assets by $30,000. If the purchase contract does not specify the nature of the $30,000, the amount will be for goodwill
and Jack will have a long-term capital gain of $30,000. Marcia will have a 15-year amortizable $30,000 asset.
If Marcia is paying the extra $30,000 to prevent Jack from conducting another dry cleaning business in the area (a covenant not to
compete), Jack will have $30,000 of ordinary income. Marcia will have a $30,000 deduction over the statutory 15-year amortization period
rather than over the actual life of the covenant (e.g., 5 years).
Main content
The treatment of a corporation’s net capital gain or loss differs from the rules for individuals. Briefly, the differences are as follows:
There is no NCG alternative tax rate.
Capital losses offset only capital gains. No deduction of capital losses is permitted against other taxable income (whereas a $3,000
deduction is allowed to individuals).
16-7c
Effect of Capital Asset Status in Transactions Other Than Sales
The nature of an asset (capital or ordinary) is important in determining the tax consequences that result when a sale or exchange occurs. It
may, however, be just as significant in circumstances other than a taxable sale or exchange. When a capital asset is disposed of, the result is
not always a capital gain or loss. Rather, in general, the disposition must be a sale or exchange. Collection of a debt instrument having a
basis less than the face value results in a capital gain if the debt instrument is a capital asset. The collection is a sale or exchange. Sale of the
debt shortly before the due date for collection will produce a capital gain. If selling the debt in such circumstances could produce a capital
gain but collecting could not, the consistency of what constitutes a capital gain or loss would be undermined. Another illustration of the sale
or exchange principle involves a donation of certain appreciated property to a qualified charity. Recall that in certain circumstances, the
measure of the charitable contribution is fair market value when the property, if sold, would have yielded a long-term capital gain (refer to
the discussion of contributions of capital gain property in Chapter 10).
Corporations may carry back net capital losses (whether long-term or short-term) as short-term capital losses for three years; if losses still
remain after the carryback, the remaining losses may be carried forward five years. Individuals may carry forward unused capital losses
indefinitely, but there is no carryback.
Example 51
Sparrow Corporation has a $15,000 NLTCL for the current year and $57,000 of other taxable income. Sparrow may not offset the $15,000
NLTCL against its other income by taking a capital loss deduction.
The $15,000 NLTCL becomes a $15,000 STCL for carryback and carryover purposes. This amount may be offset against capital gains in the
three-year carryback period or, if not absorbed there, offset capital gains in the five-year carryforward period. Any amount remaining after
this carryforward period expires is permanently lost.
The rules applicable to corporations are discussed in greater detail in Chapter 20.
General Procedure for § 1231 Computation
Example 55
Sharon wants to donate a tract of unimproved land (basis of $40,000 and fair market value of $200,000) held for the required long-term
holding period to State University (a qualified charitable organization). However, Sharon currently is under audit by the IRS for capital
gains she reported on certain real estate transactions during an earlier tax year. Although Sharon is not a licensed real estate broker, the
IRS agent conducting the audit is contending that she has achieved dealer status by virtue of the number and frequency of the real estate
transactions she has conducted.
Under these circumstances, Sharon would be well advised to postpone the donation to State University until her status is clarified. If she
has achieved dealer status, the unimproved land may be inventory (refer to Example 53 for another possible result) and Sharon’s
charitable contribution deduction would be limited to $40,000. If not and if the land is held as an investment, Sharon’s deduction is
$200,000 (the fair market value of the property).
Stock Sales
16-7d
The following rules apply in determining the date of a stock sale:


The date the sale is executed is the date of the sale. The execution date is the date the broker completes the transaction on the stock
exchange.
The settlement date is the date the cash or other property is paid to the seller of the stock. This date is not relevant in determining the date
of sale.
Example 56
Lupe, a cash basis taxpayer, sells stock that results in a gain. The sale was executed on December 29, 2017. The settlement date is January 2,
2018. The date of sale is December 29, 2017 (the execution date). The holding period for the stock sold ends with the execution date.
Maximizing Benefits
16-7e
Ordinary losses generally are preferable to capital losses because of the limitations imposed on the deductibility of net capital losses and
the requirement that capital losses be used to offset capital gains. The taxpayer may be able to convert what would otherwise have been
capital loss to ordinary loss. For example, business (but not nonbusiness) bad debts, losses from the sale or exchange of small business
investment company stock, and losses from the sale or exchange of small business corporation stock all result in ordinary losses.
Although capital losses can be carried over indefinitely, indefinite becomes definite when a taxpayer dies. Any loss carryovers not used by
the taxpayer are permanently lost. That is, no tax benefit can be derived from the carryovers subsequent to death. Therefore, the potential
benefit of carrying over capital losses diminishes when dealing with older taxpayers.
It is usually beneficial to spread gains over more than one taxable year. In some cases, this can be accomplished through the installment
sales method of accounting.
16-7f
Special Rules for Certain § 1231 Assets
A rather diverse group of assets is included under § 1231. The following discussion summarizes the special rules for some of those assets.
Diane, a real estate dealer, transfers by gift a tract of land to Jeff, her son. The land was recorded as part of Diane’s inventory (it was held for
resale) and was therefore not a capital asset to her. Jeff, however, treats the land as an investment. The land is a capital asset in Jeff’s hands,
and any later taxable disposition of the property by him will yield a capital gain or loss.
With proper tax planning, even a dealer may obtain long-term capital gain treatment on the sale of property normally held for resale.
If the taxpayer has a net long-term capital gain that does not include any 28% or 25% long-term capital gain, then the alternative tax is
calculated using the Qualified Dividends and Capital Gain Worksheet from the Form 1040 instructions.
Accounts receivable and notes receivable arising in the ordinary course of the trade or business.
17-1d
Planning for Capital Asset Status
Example 52
Capital gain and loss transactions for which a Form 1099–B was not received.
Part III of Form 1040 Schedule D summarizes the results of Parts I and II and indicates whether the taxpayer has a net capital gain or a net
capital loss. Part III then helps determine which alternative tax worksheet is used to calculate the alternative tax on long-term capital gains
and qualified dividends.
Inventory and property held primarily for sale to customers.
A patent, invention, model, or design (whether or not patented); a secret formula or process; certain
copyrights; literary, musical, or artistic compositions; and certain U.S. government publications.
Capital asset status often is a question of objective evidence. Property that is not a capital asset to one person may qualify as a capital asset
to another person.
Capital gain and loss transactions for which a Form 1099–B has been received and the provider of the form had information on the sales
proceeds but did not have information on the tax basis of the assets disposed of.
LTCG
Property not held for the long-term holding period.
Nonpersonal use property where casualty losses exceed casualty gains for the taxable year. If a taxpayer has a
net casualty loss, the individual casualty gains and losses are treated as ordinary gains and losses.
Identify tax planning opportunities arising from the sale or exchange of capital assets.
Capital gain and loss transactions for which a Form 1099–B (Proceeds from Broker and Barter Exchange Transactions) has been received
and the provider of the form had information on the sales proceeds and the tax basis of the assets disposed of.
Property Excluded
2,000
Section 1231 property generally does not include the following:
16-7Tax Planning
LO.7
16-7a
STCL
Unharvested crops on land used in business.
16,000
LTCG
Certain purchased intangible assets (such as patents and goodwill) that are eligible for amortization.
These assets are ordinary assets until they have been held for more than one year. Only then do they become § 1231 assets.
20,000
The United States currently requires a very complex tax calculation when taxable income includes net long-term capital gain. However, the
alternative tax on net long-term capital gain can generate tax savings even when the taxpayer is in the lowest regular tax bracket (10
percent) because there is an alternative tax rate of 0 percent. Many other countries also have an alternative tax rate on long-term capital
gains. Consequently,
10/12/17 even though the U.S. system is complex, it may be preferable
14,000 because of the lower tax rates and because the lower
12,000
rates are available to taxpayers in all tax brackets.
Joan has a net capital gain of $12,000 ($16,000 0%/15%/20% gain + $2,000 0%/5%/20% gain − $6,000 short-term capital loss).
Consequently, all of the net capital gain is composed of 0%/15%/20% gain. Joan’s $78,000 taxable income includes $65,700 of other
taxable income, a $12,000 net capital gain, and $300 qualified dividend income.
Joan’s stockbroker reported total stock sales to her on Form 1099–B, which showed the sales proceeds and adjusted basis for each of her
transactions. Following a discussion of the reporting rules, Joan’s completed forms and a related worksheet are presented.
Capital gains and losses are reported on Schedule D of Form 1040 (Capital Gains and Losses). Part I of Schedule D is used to report shortterm capital gains and losses. Part II of Schedule D is used to report long-term capital gains and losses. The information shown in Parts I
and II comes from Form 8949 (Sales and Other Dispositions of Assets). Form 8949 is used to accumulate gains and losses from three
sources:
Timber, coal, or domestic iron ore to which § 631 applies.
($ 6,000)
Livestock held for draft, breeding, dairy, or sporting purposes.
17-1e
1.
1.
2.
2.
1.
Most of the time, § 1231 gains and losses result from the sale of business assets. However, as we have already discussed, disposition by
casualty and/or theft can also be part of the § 1231 discussion. Consequently, the tax treatment of § 1231 gains and losses depends on the
results of a complex netting procedure. When there are no casualties and/or thefts (the usual case), step 1 below can be skipped and the
procedure is much simpler. Here are the steps that need to be followed:
Step 1:
Casualty Netting
Net all recognized long-term gains and losses from casualties of § 1231 assets and nonpersonal use capital assets. Casualty gains result when
insurance proceeds exceed the adjusted basis of the property. These are gains remaining after any depreciation recapture (discussed later in
text Sections 17-2 and 17-3). This casualty netting is beneficial because if there is a net gain, the gain may receive long-term capital gain
treatment. If there is a net loss, it receives ordinary loss treatment.
If the casualty gains exceed the casualty losses, add the excess to the other § 1231 gains for the taxable year.
If the casualty losses exceed the casualty gains, exclude all casualty losses and gains from further § 1231 computation. If this is the case, all
casualty gains are ordinary income. Section 1231 asset casualty losses are deductible for AGI. Other casualty losses may be
deductible from AGI.
Step 2:
§ 1231 Netting
After adding any net casualty gain from step 1a to the other § 1231 gains and losses (including recognized § 1231 asset condemnation
gains and losses), net all § 1231 gains [gains remaining after any depreciation recapture (discussed later in text Sections 17-2 and 17-3)]
and losses.
If the gains exceed the losses, the net gain is offset by the “lookback” nonrecaptured § 1231 losses (see step 3).
2. If the losses exceed the gains, all gains are ordinary income. Section 1231 asset losses are deductible for AGI. Other casualty losses may
be deductible from AGI.
3. Step 3:
§ 1231 Lookback Provision
The net § 1231 gain from step 2a is offset by the nonrecaptured net § 1231 losses for the five preceding taxable years (the § 1231
lookback provision). For transactions in 2018, the lookback years are 2013, 2014, 2015, 2016, and 2017.
1. To the extent of the nonrecaptured net § 1231 loss, the current-year net § 1231 gain is ordinary income. The nonrecaptured net § 1231
losses are losses that have not already been used to offset net § 1231 gains.
2. Only the net § 1231 gain exceeding this net § 1231 loss carryforward is given longterm capital gain treatment.
Concept Summary 17.1 summarizes the § 1231 computation procedure. Examples 4, 5, 6, and 7 illustrate its application without the § 1231
lookback provision. Examples 6 and 7 illustrate its application with the § 1231 lookback provision.
Conce pt Sum mar y 17.1
Secti on 1231 Netti n g Pro ced ure
Year-End Planning
The following general rules can be applied for timing the recognition of capital gains and losses near the end of a taxable year:

If the taxpayer already has recognized more than $3,000 of capital loss, sell assets to generate capital gain equal to the excess of the capital
loss over $3,000.
Example 57
Kevin has already incurred a $7,000 STCL. Kevin should generate $4,000 of capital gain. The gain will offset $4,000 of the loss. The
remaining loss of $3,000 can be deducted against ordinary income.


If the taxpayer already has recognized capital gain, sell assets to generate capital loss equal to the capital gain. The gain will not be taxed,
and the loss will be fully deductible against the gain.
Generally, if the taxpayer has a choice between recognizing short-term capital gain or long-term capital gain, long-term capital gain should
be recognized because it is subject to a lower tax rate.
Re f ocus on T he B ig P icture
Ma nagi n g Ca pi tal Asset Tr ansa cti ons
Auremar/Shutterstock.comYou explain to Maurice that your area of expertise is tax, so you are providing tax advice and not investment
advice. From an overall perspective, he is correct that certain capital gains and dividends are eligible for either a 0 percent, a 15 percent, or
a 20 percent tax rate rather than the regular income tax rates that go as high as 37 percent. You then discuss the potential tax consequences
of each of his investments.





Example 4
Section 1231 Computations
During 2018, Ross had $125,000 of AGI before considering the following recognized gains and losses:
Capital Gains and Losses
Purple stock and Eagle stock. To qualify for the beneficial tax rate, the holding period for the stock must be longer than one year. From a tax
perspective, Maurice should retain his stock investments for at least an additional three months and a day. To be eligible for the “costless”
capital gains (i.e., capital gains taxed at 0%), his taxable income should not exceed $38,600 for 2018. The dividends received on the Purple
stock are “qualified dividends” eligible for the 0%/15%/20% alternative tax rate.
Patent. Because he is a “holder” of the patent, it will qualify for the beneficial capital gain rate regardless of the holding period if the patent
should produce income in excess of his $50,000 investment. However, if he loses money on the investment, he will be able to deduct only
$3,000 of the loss per year against his ordinary income (assuming that there are no offsetting capital gains).
Tax-exempt bonds. The after-tax return on the taxable bonds would be less than the 3 percent on the tax-exempt bonds. In addition, the
interest on the taxable bonds would increase his taxable income, possibly moving it out of the desired 12 percent marginal tax rate into the
22 percent marginal tax rate.
Long-term capital gain
$3,000
Long-term capital loss
(400)
Short-term capital gain
1,000
Short-term capital loss
(200)
Franchise rights. The franchise rights purchased from Orange, Inc., probably require the payment of a franchise fee based upon the sales in
the franchise business. Maurice should either start such a business or sell the franchise rights.
Casualties
Partnership interest. Whether Maurice receives capital or ordinary treatment associated with his partnership interest depends on whether
he is reporting his share of profits or losses (ordinary income or ordinary loss) or is reporting recognized gain or loss from the sale of his
partnership interest (capital gain or capital loss).
You conclude your tax advice to Maurice by telling him that whatever he does regarding his investments should make economic sense.
There are no 100 percent tax rates. For example, disposing of the bank stock in the current market could be the wise thing to do.
Main content
17-1Section 1231 Assets
17-1aRelationship to Capital Assets
LO.1
Theft of diamond ring (owned four months)
($800)
Fire damage to personal residence (owned 10 years)
(400)
Gain from insurance recovery on fire loss to business building (owned two years)
200
State the rationale for and the nature and treatment of gains and losses from the disposition of business
assets.
Because depreciable property and real property used in business are not capital assets, the recognized gains from the disposition of this
property would appear to be ordinary income rather than capital gain. Due to § 1231, however, net gain from the disposition of this
property is sometimes treated as long-term capital gain. In order for this to occur:



§ 1231 Gains and Losses from Depreciable Business Assets Held Long Term
Asset A
$ 300
Asset B
1,100
Asset C
(500)
A long-term holding period requirement must be met (held for more than a year);
The disposition must generally be from a sale, exchange, or involuntary conversion; and
Certain recapture provisions must be satisfied.
Section 1231 may also apply to involuntary conversions of capital assets even though such a disposition, which is not a sale or exchange,
normally would not result in a capital gain.
In general, § 1231 provides the best of both potential results: net gain may be treated as long-term capital gain, and net loss is treated as
ordinary loss; note the results in Examples 1 and 2.
Example 1
The Big Picture
Return to the facts of The Big Picture. If Hazel sells the parking lot for $18,000, she will have disposed of a § 1231 asset because it was
property used in a trade or business and held for the long-term holding period (more than one year).
Hazel’s gain will be $3,000 ($18,000 selling price − $15,000 adjusted basis). Because the asset is a § 1231 asset, all of the gain is § 1231
gain, and it may be treated as long-term capital gain (depending on its netting with any other § 1231 gains or losses during the year).
Example 2
The Big Picture
Return to the facts of The Big Picture. Assume that Hazel sells the snow removal equipment for $100, generating a $900 loss, and the
parking lot for $15,700, generating a $700 gain.
Gains and Losses from Sale of Depreciable Business Assets Held Short Term
Asset D
$ 200
Asset E
(300)
Ross had no net § 1231 losses in tax years before 2018.
Ross’s gains and losses receive the following tax treatment. [The gains on the business building and Assets A and B are after any
depreciation recapture (discussed later in the chapter)].
The diamond ring and the residence are personal use assets. Therefore, these casualties are not § 1231 transactions. The $800 (ring) plus
$400 (residence) losses are not deductible because they are not Federal disaster area losses and there are no personal use property
casualty gains to offset these losses.
Step 1: Only the business building (a § 1231 asset) casualty gain remains. The netting of the § 1231 asset and nonpersonal use capital asset
casualty gains and losses contains only one item—the $200 gain from the business building. Consequently, there is a net gain, and that gain
is treated as a § 1231 gain (and added to the § 1231 gains).
Step 1 (a): The gains from § 1231 transactions (Assets A and B and the § 1231 asset casualty gain) exceed the losses (Asset C) by $1,100
($1,600 − $500). This excess is a long-term capital gain and is added to Ross’s other long-term capital gains.
Step 2: Ross’s net long-term capital gain is $3,700 ($3,000 + $1,100 from§ 1231 transactions − $400 long-term capital loss). Ross’s net
short-term capital gain is $800 ($1,000 − $200). The result is capital gain net income of $4,500. The $3,700 net long-term capital gain
portion is eligible for beneficial capital gain treatment [assume that all of the gain is 0%/15%/20% gain (see the discussion in Chapter 16)].
The $800 net short-term capital gain is subject to tax as ordinary income.


The Big Picture
Return to the facts of The Big Picture. Assume that Hazel could sell the used equipment for $28,000 down, with the $100,000 balance
received in five yearly installments of $20,000 plus interest.
Helen would have to recognize her entire $53,040 gain ($128,000 sales price − $74,960 adjusted basis) in 2018. All of the gain is § 1245
depreciation recapture gain because the $375,040 depreciation taken exceeds the $53,040 recognized gain.
Sanjay’s recognized gain is $170,909 ($450,000 − $279,091).
All of the gain is § 1231 gain.
17-3a
Property Dividends
Section 1250 Recapture Situations
A corporation generally recognizes gain if it distributes appreciated property as a dividend. Recapture under §§ 1245 and 1250 applies to
the extent of the lower of the recapture potential or the excess of the property’s fair market value over the adjusted basis.
In addition to residential real estate acquired before 1987 and nonresidential real estate acquired before 1981, accelerated depreciation
may be taken on other types of real property. The § 1250 recapture rules apply to the following property for which accelerated
depreciation was used:



Ross treats the gain and loss from Assets D and E (depreciable business assets held for less than the long-term holding period) as ordinary
gain and loss.
Ross will have personal use property casualty losses of $1,200 [$800 (diamond ring) + $400 (personal residence)]. The $1,200 is not
deductible because the losses are not Federal disaster area losses and there are no personal use property casualty gains to offset these
losses.
Example 5
Section 1231 Computations
Assume the same facts as in Example 4, except that the loss from Asset C was $1,700 instead of $500.
The treatment of the casualty losses is the same as in Example 4.
Step 1 (b): The losses from § 1231 transactions now exceed the gains by $100 ($1,700 − $1,600). As a result, the gains from Assets A and B
and the § 1231 asset casualty gain are ordinary income, and the loss from Asset C is a deduction for AGI (a business loss). The same result
can be achieved by simply treating the $100 net loss as a deduction for AGI.
Capital gain net income is $3,400 ($2,600 long term + $800 short term). The $2,600 net long-term capital gain portion is eligible for
beneficial capital gain treatment, and the $800 net short-term capital gain is subject to tax as ordinary income.
Example 20
Any immediate expense deduction (§ 179) and/or additional first-year depreciation [§ 168(k)] exceeding straight-line depreciation taken
on leasehold improvements and qualified improvement property.
Emerald Corporation distributes § 1245 property as a dividend to its shareholders. The amount of the recapture potential is $300, and the
excess of the property’s fair market value over the adjusted basis is $800. Emerald recognizes $300 of ordinary income and $500 of § 1231
gain.
Concept Summary 17.3 integrates the depreciation recapture rules with the § 1231 netting process. It is an expanded version of Concept
Summary 17.1.
Real property used predominantly outside the United States.
Conce pt Sum mar y 17.3
Depr eci ati on R eca ptur e a nd § 1231 Netti ng Proce dure
Certain government-financed or low-income housing.
Concept Summary 17.2 compares and contrasts the § 1245 and § 1250 depreciation recapture rules.
§ 1245
§ 1250
Property
All depreciable personal property,
Nonresidential real property
affected
but also nonresidential real
acquired after December 31,
property acquired after December
1969, and before January 1,
31, 1980, and before January 1,
1981, on which accelerated
1987, for which accelerated cost
depreciation was taken.
recovery was used. Also includes
Residential rental real property
miscellaneous items such as §
acquired after December 31,
179 expense and § 197
1975, and before January 1,
amortization of intangibles such
1987, on which accelerated
as goodwill, patents, and
depreciation was taken.
copyrights.
Depreciation
Potentially all depreciation taken.
Normally, there is no
recaptured
If the selling price is greater than
depreciation recapture, but in
or equal to the original cost, all
the special situations listed
depreciation is recaptured. If the
above, there can be § 1250
selling price is between the
depreciation recapture of
adjusted basis and the original
additional depreciation (the
cost, only some depreciation is
excess of accelerated cost
recaptured.
recovery over straight-line cost
recovery or the excess of
accelerated depreciation over
straight-line depreciation).
Limit on
Lower of depreciation taken or
Lower of additional depreciation
recapture
gain recognized.
or gain recognized.
Treatment of
Usually § 1231 gain.
Usually § 1231 gain.
gain
exceeding
recapture gain
Treatment of
No depreciation recapture; loss is
No depreciation recapture; loss
loss
usually § 1231 loss.
is usually § 1231 loss.
Main content
17-3b
G lobal Tax Issue s
Depr eci ati on R eca ptur e i n Oth er Co untri es
The rules for dispositions of depreciated property are more complex in the United States than in any other country. Most countries treat
the gain or loss from the disposition of business depreciable assets as ordinary income or loss. Consequently, although the U.S. rules are
more complex, they can be more beneficial than those of other countries because at least some gains from the disposition of depreciable
business property may be taxed at the lower capital gain rates.
17-5Special Recapture Provisions
LO.6
Recognize special recapture provisions that are part of the tax law.
Unrecaptured § 1250 Gain (Real Estate 25% Gain)
Any unrecaptured § 1250 gain is subject to a 25 percent tax rate. This gain, which relates to the sale of depreciable real estate, is used in
the alternative tax computation for net capital gain discussed in Chapter 16. Unrecaptured § 1250 gain (25% gain) is some or all of the §
1231 gain that is treated as long-term capital gain.
The maximum amount of this 25% gain is the depreciation taken on real property sold at a recognized gain. That maximum amount is
computed in one or more of the following ways:
17-5a
1.
2.
Gain from Sale of Depreciable Property between Certain Related Parties

17-5b
If related parties sell or exchange property that is depreciable in the hands of the transferee (principally machinery, equipment, and
buildings, but not land), any gain recognized by the transferor is ordinary income. This rule applies to both direct and indirect sales or
exchanges. A related party is defined as an individual and his or her controlled corporation or partnership or a taxpayer and any trust in
which the taxpayer (or the taxpayer’s spouse) is a beneficiary.
The recognized gain from disposition is more than the depreciation taken. The 25% gain is equal to the
depreciation taken. Refer to Example 13. The depreciation taken was $20,909, but the recognized gain was $170,909.
Consequently, some of the recognized gain is potential 25% § 1231 gain.

Main content
The recognized gain from disposition is less than or equal to the depreciation taken. In this case, the 25%
gain is all of the recognized gain. Refer to Example 13, but assume that the building sales price is $285,000. The recognized gain is $5,909
($285,000 − $279,091), all of this gain is a § 1231 gain, and it is entirely a 25% § 1231 gain.
17-2Section 1245 Recapture
LO.3


In the current year, Gary sold for $13,000 a machine acquired several years ago for $12,000. He had taken $10,000 of depreciation on the
machine.
Intangible Drilling Costs
Taxpayers may elect to either expense or capitalize intangible drilling and development costs for oil, gas, or geothermal
properties. Intangible drilling and development costs (IDCs) include operator (one who holds a working or operating interest in any
tract or parcel of land) expenditures for wages, fuel, repairs, hauling, and supplies. These expenditures must be incident to and necessary
for the drilling of wells and preparation of wells for production. In most instances, taxpayers elect to expense IDCs to maximize tax
deductions during drilling.
Intangible drilling and development costs are subject to § 1254 recapture when the property is sold. Any gain realized on the disposition is
recognized as ordinary income to the extent of IDCs expensed (but limited to the realized gain).
Section 1231 lookback losses convert some or all of the potential 25% § 1231 gain to ordinary income.
Where there is a § 1231 gain from real estate and that gain includes both potential 25% gain and potential 0%/15%/20% gain, any § 1231
loss from disposition of other § 1231 assets first offsets the 0%/15%/20% portion of the § 1231 gain and then offsets the 25% gain portion
of the § 1231 gain. Also, any § 1231 lookback loss first recharacterizes the 25% gain portion of the § 1231 gain and then recharacterizes
the 0%/15%/20% portion of the § 1231 gain as ordinary income.
17-6Reporting ProceduresLO .7
Describe and apply the reporting procedures for §§ 1231, 1245, and 1250.
Net § 1231 Gain Limitation
Noncapital gains and losses are reported on Form 4797 (Sales of Business Property). However, before Form 4797 is filled out, Part B of
Form 4684 (Casualties and Thefts) must be completed to determine whether any casualties will enter into the § 1231 computation
procedure. Recall that recognized gains from § 1231 asset casualties may be recaptured by § 1245 or § 1250. These gains will not appear
on Form 4684. The § 1231 gains and nonpersonal use long-term capital gains are netted against § 1231 losses and nonpersonal use longterm capital losses on Form 4684 to determine if there is a net gain to transfer to Form 4797, Part I.
Because 2018 tax forms are not yet available, 2017 tax forms are used for the remainder of the discussion.
Form 4797 is divided into four parts; each part’s function is summarized below.
The amount of unrecaptured § 1250 gain may not exceed the net § 1231 gain that is eligible to be treated as long-term capital gain. The
unrecaptured § 1250 gain is the lesser of the unrecaptured § 1250 gain or the net § 1231 gain that is treated as capital gain. Thus, if there is
a net § 1231 gain but it is all converted to ordinary income by the fiveyear § 1231 lookback loss provision, there is no surviving § 1231 gain
or unrecaptured § 1250 gain.
Refer to Example 6. There was $200 of § 1231 gain from the building fire that would also be potential 25% gain if at least $200 of
depreciation was taken. The net § 1231 gain was $1,100 including the $200 building gain. (The $500 loss from Asset C would offset the
potential 0%/15%/20% § 1231 gain and not the potential 25% gain, so all of the potential 25% gain of $200 is in the $1,100 net § 1231
gain.) However, the $700 of § 1231 lookback losses would first absorb the $200 building gain, so the $400 of § 1231 gain that is treated as
long-term capital gain includes no 25% gain.
Part
Function
I
To report regular § 1231 gains and losses [including recognized gains and losses from certain
involuntary conversions (condemnations)].
II
To report ordinary gains and losses.
III
To determine the portion of the gain that is subject to recapture (e.g., §§ 1245 and 1250 gain).
IV
Computation of recapture amounts under §§ 179 and 280F when business use of depreciable
property drops to 50% or less.
Section 1250 Property for Purposes of the Unrecaptured § 1250 Gain
Section 1250 property includes any real property (other than § 1245 property) that is or has been depreciable. Land is not § 1250 property
because it is not depreciable.
Example 14
Bridget is a single taxpayer with 2018 taxable income of $120,000 composed of:




The recognized gain from the sale is $11,000. This is the amount realized of $13,000 less the adjusted basis of $2,000 ($12,000 cost −
$10,000 depreciation taken).
Depreciation taken is $10,000. Therefore, because § 1245 recapture gain is the lower of depreciation taken or gain recognized, $10,000 of
the $11,000 recognized gain is ordinary income, and the remaining $1,000 gain is § 1231 gain.
$100,000 ordinary taxable income,
$3,000 short-term capital loss,
$15,000 long-term capital gain from sale of stock, and
$8,000 § 1231 gain that is all unrecaptured § 1250 gain (the actual unrecaptured gain was $11,000, but net § 1231 gain is only $8,000).
Bridget’s net capital gain is $20,000 ($15,000 long-term capital gain + $8,000 unrecaptured § 1250 gain/net § 1231 gain − $3,000 shortterm capital loss). The $3,000 short-term capital loss is offset against the $8,000 unrecaptured § 1250 gain, reducing that gain to $5,000
(see the discussion in Chapter 16 concerning netting of capital losses). Bridget’s adjusted net capital gain is $15,000 ($20,000 net capital
gain − $5,000 unrecaptured § 1250 gain).
Bridget’s total tax (using the alternative tax calculation discussed in Chapter 16) is $21,740 [$18,290 (tax on $100,000 other taxable
income) + $1,200 ($5,000 unrecaptured § 1250 gain × 24%) + $2,250 ($15,000 adjusted net capital gain × 15%)]. Bridget uses the regular
24% tax rate on the $5,000 unrecaptured § 1250 gain because it is less than the 25% alternative tax rate on the gain.
Generally, the best approach to completing Form 4797 is to start with Part III. Once the recapture amount has been determined, it is
transferred to Part II. Any gain remaining after the recapture has been accounted for is transferred from Part III to Part I. Also transferred
to Part I is any net gain from certain casualties and thefts as reported on Form 4684, Part B (refer to the beginning of this section
and Chapter 15). If the netting process in Form 4797, Part I results in a gain, it is reduced by the nonrecaptured net § 1231 losses from
prior years (line 8 of Part I). Any remaining gain is shifted to Schedule D (Capital Gains and Losses) of Form 1040. If the netting process in
Part I of Form 4797 results in a loss, the loss moves to Part II to be treated as an ordinary loss.
The complex rules for the alternative tax on net capital gain for individuals, estates, and trusts affect the reporting of gains and losses from
the disposition of business and rental assets. For example, a partnership or an S corporation that uses Form 4797 must provide
information to its partners or shareholders related to the gain surviving Form 4797, Part I. Although this gain is a § 1231 gain, it goes to the
partner’s or shareholder’s Form 4797 Part I. There it must again survive the § 1231 netting process to be treated as a long-term capital
gain on the partner’s or shareholder’s return. The flow-through entity must identify what portion of this gain is 28% gain, 25% gain,
or 0%/15%/20% gain.
The process followed in Example 22 is based on an analysis of Form 1040, Schedule D, and Form 4797 and their instructions. Here are
some key points:
Ethics & Equity
The S al e of a “Cost -S egre gat ed” B ui l di ng
Many taxpayers have “cost-segregated” their buildings. This means that an engineering study is done to determine whether some of a
building’s cost can be segregated into tangible personal property (generally a 5-year or 7-year MACRS life with accelerated depreciation)
rather than real property (a 27.5-year or 39-year MACRS life with straightline depreciation). The faster depreciation for the tangible
personal property yields significant tax savings. A CPA is determining the gain or loss from disposition of an office building. A sale
document details the selling price of the land and building. However, the building was cost-segregated and the CPA finds records of cost
and related depreciation for the tangible personal property that was part of the cost segregation. No mention of this tangible personal
property was made in the sale agreement, but the building and all of its contents were sold. What should the CPA do?
The § 1231 gain of $1,000 is also equal to the excess of the sales price over the original cost of the property §.
Example 10
Section 1245 Recapture Computations
Assume the same facts as in the previous example, except that the asset is sold for $9,000 instead of $13,000.
The recognized gain from the sale is $7,000. This is the amount realized of $9,000 less the adjusted basis of $2,000.
17-4Considerations Common to §§ 1245 and 1250
LO.5
Depreciation taken is $10,000. Therefore, because the $10,000 depreciation taken exceeds the recognized gain of $7,000, the entire $7,000
recognized gain is ordinary income.
Identify considerations common to §§ 1245 and 1250.
Main content
Exceptions
The § 1231 gain is zero. There is no § 1231 gain because the selling price ($9,000) does not exceed the original purchase price ($12,000).
17-4a
Example 11
Section 1245 Recapture Computations
Gifts



Depreciation recapture potential carries over to the donee.
Assume the same facts as in Example 9, except that the asset is sold for $1,500 instead of $13,000.
Example 15
The recognized loss from the sale is $500. This is the amount realized of $1,500 less the adjusted basis of $2,000.
Wade gives his daughter, Helen, § 1245 property with an adjusted basis of $1,000. The amount of recapture potential is $700. Helen uses
the property in her business and claims further depreciation of $100 before selling it for $1,900.
Helen’s recognized gain is $1,000 ($1,900 amount realized − $900 adjusted basis), of which $800 is recaptured as ordinary income ($100
depreciation taken by Helen + $700 recapture potential carried over from Wade). The remaining gain of $200 is § 1231 gain. Even if Helen
used the property for personal purposes, the $700 recapture potential would still be carried over.
Because there is a loss, there is no depreciation recapture. All of the loss is § 1231 loss.
If § 1245 property is disposed of in a transaction other than a sale, exchange, or involuntary conversion, the maximum amount recaptured
is the excess of the property’s fair market value over its adjusted basis. See the discussion under Considerations Common to §§ 1245 and
1250 in text Section 17-4.
Main content

Amortizable personal property such as goodwill, patents, copyrights, and leaseholds of § 1245 property.
Charitable Transfers
The 25% gain (if any) from Form 4797 is part of the Schedule D, line 11, gain. Nothing on the face of Form 4797 or Schedule D identifies this
gain. Only when the alternative tax on net capital gain is computed is the 25% gain portion of the Form 4797 net gain specifically
mentioned (see Schedule D, line 19).
Section 1231 assets are assets held more than one year. Therefore, no gain or loss is reportable on Form 4797, Part I or Part III, unless that
holding period requirement is satisfied. Instead, gains and losses from these assets are reported directly in Form 4797, Part II.
Sale of Depreciable Business Assets Held Long Term
Example 16
Generally, § 1245 property includes all depreciable personal property (e.g., machinery and equipment), including livestock. Buildings and
their structural components generally are not § 1245 property. The following property is also subject to § 1245 treatment:
The net § 1231 gain goes from Part I of Form 4797 to line 11 of Schedule D (as a long-term capital gain).
For 2017, Troy Williams, a single taxpayer (Social Security Number: 111-11-1111), has taxable income of $133,000 including the following
recognized gains and losses (assume that Troy has no nonrecaptured § 1231 losses from prior years):
Although not a very attractive tax planning approach, death eliminates all recapture potential. Any depreciation recapture potential is
eliminated when property passes from a decedent to an estate or heir.
Section 1245 Property
All gains and losses treated as ordinary gains and losses (those that end up in Part II of Form 4797) are not eligible for any of the special tax
rates for net capital gain.
Example 22
Death
Assume the same facts as in Example 15, except that Helen receives the property as a result of Wade’s death. The $700 recapture potential
from Wade is extinguished. Helen has a basis for the property equal to the property’s fair market value at Wade’s death (assume that the
FMV is $1,700).
Helen will have a $300 gain when the property is sold because the selling price ($1,900) exceeds the property’s adjusted basis of $1,600
($1,700 original basis to Helen − $100 depreciation) by $300. Because of § 1245, $100 is ordinary income. The remaining gain of $200 is §
1231 gain.
17-2a
17-5c
Section 1231 loss from disposition of other § 1231 assets held long term reduces the gain from real estate.
Special 25% Gain Netting Rules
Example 8
The Big Picture
Example 9
Section 1245 Recapture Computations
Isabella sells a personal use automobile (therefore nondepreciable) to her controlled corporation. The automobile, which was purchased
two years ago, originally cost $5,000 and is sold for $7,000. The automobile is to be used in the corporation’s business.
If the related-party provision did not exist, Isabella would realize a $2,000 long-term capital gain. The income tax consequences would be
favorable because Isabella’s controlled corporation is entitled to depreciate the automobile based on the purchase price of $7,000. Under
the related-party provision, Isabella’s $2,000 gain is ordinary income.
There is § 1245 depreciation recapture because the property is nonresidential real estate acquired in 1981–
1986 on which accelerated depreciation was taken. No 25% § 1231 gain will be left because § 1245 will recapture all of the depreciation or
the recognized gain, whichever is less. Refer to Example 12. Depreciation of $100,000 was taken, but all of it was recaptured as ordinary
income by § 1245. Thus, there is no remaining potential 25% § 1231 gain. The entire $20,000 § 1231 gain in Example 12 is
potential 0%/15%/20% gain.
Now that the basic rules of § 1231 have been introduced, it is time to add some complications. The Code contains two
major recapture provisions—§§ 1245 and 1250. These provisions cause gain to be treated initially as ordinary gain. Thus, what may appear
to be a § 1231 gain is ordinary gain instead. This recapture phenomenon applies exclusively to § 1231 gains; § 1231 assets generating
losses are unaffected by these recapture provisions.
These recapture provisions may also cause a gain in a nonpersonal use casualty to be initially ordinary gain rather than casualty gain.
Classifying gains (and losses) properly is important; improper initial classification may lead to incorrect mixing and matching of gains and
losses. We begin by discussing the § 1245 recapture rules; the § 1250 recapture rules are discussed in text Section 17-3.
Section 1245 requires taxpayers to treat all gain as ordinary gain unless the property is disposed of for more than its original cost. This
result is accomplished by requiring that all gain be treated as ordinary gain to the extent of the depreciation taken on the property
disposed of. The excess of the sales price over the original cost is § 1231 gain. Section 1245 applies primarily to non-real-estate property
like machinery, trucks, and office furniture. Section 1245 does not apply if property is disposed of at a loss. Generally, the loss will be a §
1231 loss unless the form of the disposition is a casualty.
Refer to the facts of The Big Picture. Hazel purchased the equipment for $450,000 and has deducted $375,040 of depreciation ($250,000 §
179 expense + $125,040 regular MACRS depreciation). As a result, the equipment’s adjusted basis is $74,960.
If Hazel sells the equipment for $128,000, she will have a gain of $53,040 ($128,000 − $74,960). If it were not for § 1245, the $53,040 gain
would be § 1231 gain. Section 1245 prevents this potentially favorable result by treating as ordinary income (not as § 1231 gain) any gain
to the extent of depreciation taken. In this example, the entire $53,040 gain would be ordinary income.
If, instead, Hazel sold the equipment for $485,000, she would have a gain of $410,040 ($485,000 − $74,960 adjusted basis). The § 1245 gain
would be $375,040 (equal to the depreciation taken), and the § 1231 gain would be $35,000 (equal to the excess of the sales price over the
$450,000 original cost).
Section 1245 recapture provides, in general, that the portion of recognized gain from the sale or other disposition of § 1245 property that
represents depreciation is recaptured as ordinary income. As a result, in Example 8, $53,040 of the $375,040 depreciation taken is
recaptured as ordinary income when the business equipment is sold for $128,000. Only $53,040 is recaptured rather than $375,040
because Hazel is only required to recognize § 1245 recapture ordinary gain equal to the lower of the depreciation taken or the gain
recognized.
The method of depreciation (e.g., accelerated or straight-line) does not matter. All depreciation taken is potentially subject to recapture.
For this reason, § 1245 recapture is often referred to as full recapture. Any remaining gain after subtracting the amount recaptured as
ordinary income will usually be § 1231 gain.
If the property is disposed of in a casualty event, however, the remaining gain will be casualty gain. If the business equipment in Example
8 had been disposed of by casualty and the $128,000 received had been an insurance recovery, Hazel would still have a gain of $53,040 and
the gain would still be recaptured by § 1245 as ordinary gain. The § 1245 recapture rules apply before there is any casualty gain. Because
all of the $53,040 gain is recaptured, no casualty gain arises from the casualty.
The following examples illustrate the general application of § 1245.
Example 21

Determine when § 1245 recapture applies and how it is computed.
Special Recapture for Corporations
Corporations selling depreciable real estate may have ordinary income in addition to that required by § 1250. Under this provision,
corporations selling depreciable real property are required to recapture as ordinary income the smaller of two amounts:
20 percent of the recognized gain or
20 percent of the depreciation taken.
See the discussion of this topic in Chapter 20.
Asset A (Note 1)
Asset B (Note 2)
Depreciation recapture potential reduces the amount of the charitable contribution deduction.
Professional baseball and football player contracts.
Example 17
The Big Picture
Asset C (Note 3)
Certain depreciable tangible real property (other than buildings and their structural components) employed as an integral part of certain
activities such as manufacturing and production. For example, a natural gas storage tank where the gas is used in the manufacturing
process is § 1245 property.
Return to the facts of The Big Picture. If instead of selling the old equipment Hazel gives it to a charity, her charitable contribution will be
zero.
The potential § 1245 recapture on the equipment is $375,040 (the depreciation taken). When that amount is subtracted from the
equipment’s $128,000 fair market value, the result is zero because the charitable contribution cannot be less than zero.
Sale of Depreciable Business Assets Held Short Term
Certain Nontaxable Transactions
In certain transactions, the transferor’s adjusted basis of property carries over to the transferee. If this is the case, any depreciation
recapture potential also carries over to the transferee. Included in this category are the following transfers of property:
Pollution control facilities, railroad grading and tunnel bores, on-the-job training, and child care facilities.
Single-purpose agricultural and horticultural structures and petroleum storage facilities (e.g., a greenhouse or silo).
Fifteen-year, 18-year, and 19-year nonresidential real estate for which accelerated cost recovery is used. This property, known as ACRS
property, would have been placed in service after 1980 and before 1987.
Example 12
Steve acquired nonresidential real estate on December 1, 1986, for $100,000. He used the required ACRS accelerated method to compute
the cost recovery. He sells the asset on January 15, 2018, for $120,000. The amount and nature of Steve’s gain are computed as follows:




Asset D (Note 4)
Nontaxable incorporations under § 351.
Capital Assets
Certain subsidiary liquidations under § 332.
Long-term gain (Note 5)
Nontaxable contributions to a partnership under § 721.
Nontaxable reorganizations.
Gain may be recognized in these transactions if boot is received. If gain is recognized, it is treated as ordinary income to the extent of the
recapture potential or recognized gain, whichever is lower.
Short-term loss (Note 6)
Like-Kind Exchanges (§ 1031) and Involuntary Conversions (§ 1033)
The gain of $120,000 is treated as ordinary income to the extent of all depreciation taken because the property is 19-year nonresidential
real estate for which accelerated depreciation was used. As a result, Steve reports ordinary income of $100,000 and § 1231 gain of $20,000
($120,000 − $100,000).
17-2b
Observations on § 1245
In most instances, the total depreciation taken will exceed the recognized gain. Therefore, the disposition of § 1245 property usually results in ordinary income
rather than § 1231 gain. No § 1231 gain will occur unless the § 1245 property is disposed of for more than its original cost. Refer to Examples 9 and 10.
Recapture applies to the total amount of depreciation allowed or allowable regardless of the depreciation method used.
Recapture applies regardless of the holding period of the property. If the property is held for less than the long-term holding period, the entire recognized gain is
ordinary income because § 1231 does not apply.
Section 1245 does not apply to losses, which receive § 1231 treatment.
Gains from the disposition of § 1245 assets may also be treated as passive activity gains (see Chapter 11).
Main content
17-3Section 1250 Recapture
LO.4
Determine when § 1250 recapture applies.
Generally, § 1250 property is depreciable real property (principally buildings and their structural components) that is not subject to §
1245. Intangible real property, such as leaseholds of § 1250 property, is also included.
Section 1250 recapture rarely applies because only the amount of additional depreciation (depreciation in excess of straight-line
depreciation) is subject to recapture. Straight-line depreciation is not recaptured (except for property held one year or less). Because the
straight-line depreciation method is required for depreciable real property placed in service after 1986, there will usually be no § 1250
depreciation recapture on such property. Finally, § 1250 does not apply if the real property is sold at a loss.
Although there is no depreciation recapture on § 1250 property, the gain from this property may be subject to a special 25 percent tax rate.
See the discussion of Unrecaptured § 1250 Gain (Real Estate 25% Gain) in text Section 17-3b.
Example 13
Sanjay acquires a residential rental building on January 1, 2017, for $300,000. He receives an offer of $450,000 for the building in 2018 and
sells it on December 23, 2018.
Sanjay takes of total depreciation for 2017 and 2018, and the adjusted basis of the property is $279,091 ($300,000 − $20,909).
Note 1.
Asset A was acquired on June 23, 2014, for $50,000. It was 5-year MACRS property, and four years’
Note 2.
Asset B was purchased on May 10, 2007, for $37,000. It was 27.5-year residential rental real estate,
Note 3.
Asset C was purchased on December 9, 2014, for $16,000. It was 5-year MACRS property, and four y
Note 4.
Asset D was purchased for $7,000 on July 27, 2017. It was 5-year MACRS property but proved unsuit
Example 18
The Big Picture
Note 5.
The LTCG resulted from the sale of 100 shares of Orange Corporation stock purchased for $10,000 o
Note 6.
The STCL resulted from the sale of 50 shares of Blue Corporation stock purchased for $350 on March
Refer to the facts of The Big Picture. Sometimes transactions structured as exchanges do not qualify as § 1031 like-kind exchanges. Rather
than sell the equipment, assume that Hazel exchanges it by “trading it in” on replacement property. If the equipment received in the
exchange was worth $150,000, Hazel would have to pay $22,000 of cash ($150,000 − value of the equipment given up in the exchange) to
acquire the replacement property. Hazel, however, would not have a § 1031 like-kind exchange because this was not an exchange of real
property.
Instead, her realized and recognized ordinary gain is $53,040 ($128,000 fair market value of the equipment given up − $74,960 adjusted
basis of the equipment given up). All of the gain is recaptured by § 1245 because it is less than $375,040 depreciation taken.
The remaining recapture potential of $322,000 ($375,040 − $53,040) is extinguished, and the basis of the replacement equipment is its fair
market value, $150,000.
Main content
Reporting Consequences
Realized gain is recognized to the extent of boot received in a like-kind exchange. Realized gain also will be recognized to the extent the
proceeds from an involuntary conversion are not reinvested in similar property. Any recognized gain is subject to recapture as ordinary
income under §§ 1245 and 1250. However, since only real property can be the subject of a like-kind exchange, §1245 recapture is not likely
because it generally only applies to tangible personal property. Section 1250 recapture is also not likely because it infrequently applies to
dispositions of real property. On the other hand, unrecaptured § 1250 gain (25% gain) is likely to be present if depreciable real property
was the subject of the exchange. The remaining recapture potential, if any, carries over to the property received in the exchange. Realized
losses are not recognized in like-kind exchanges, but are recognized in involuntary conversions (see Chapter 15).
17-4bOther Applications
The §§ 1245 and 1250 recapture rules override all other Code sections. Special applications include installment sales and property
dividends.
Installment Sales
Recapture gain is recognized in the year of the sale regardless of whether gain is otherwise recognized under the installment method. All
gain is ordinary income until the recapture potential is fully absorbed. Nonrecapture (§ 1231) gain is recognized under the installment
method as cash is received.
Gain is also recognized on installment sales in the year of the sale in an amount equal to the § 179 (immediate expensing) deduction taken
with respect to the property sold.
Example 19
Form 4797
Part III. The sales of Assets A and B are reported here because both generated gains.




Asset A (§ 1245 Recapture Potential). The sale of Asset A results in the recapture of cost recovery (depreciation) deductions. Here, the
depreciation recapture potential ($38,480) is greater than the realized gain. So all of the gain is depreciation recaptured under § 1245 (and
ordinary income). That recapture is shown on line 25b and is carried to line 31.
Asset B (§ 1250 Recapture Potential). As straight-line cost recovery was used on Asset B, there is no § 1250 recapture. The $20,126 gain
from the sale of Asset B is included on lines 30 and 32 and then is carried from line 32 to Part I, line 6.
Part I. Gains and losses from § 1231 assets not appearing in Part III are reported here. In addition, the § 1231 netting process occurs here
(on lines 7 to 9).
Asset C. The loss from Asset C is reported on line 2.
§ 1231 Netting. The § 1231 gains and losses are netted and appear on line 7. Given that Troy has no nonrecaptured net § 1231 losses from
prior years (these would be reported on line 8), the net gain on line 7 is transferred to Schedule D, line 11.
Part II. Any ordinary gains and losses are accumulated here.
Asset D. The loss from Asset D is reported on line 10.
The depreciation recapture from Part III, line 31 appears on line 13.
The net gain on line 18 is ordinary income and is transferred to Form 1040, line 14.
Schedule D (Form 1040)
Part I. Short-Term Capital Gains and Losses.
Blue Corporation Stock. The short-term capital loss from the Blue Corporation stock is reported on line 1a. It is assumed that the sale of
the Blue Corporation stock was reported to Troy on a Form 1099–B that showed the adjusted basis and selling price of the stock. If not, a
Form 8949 would be required.
Part II. Long-Term Capital Gains and Losses.
Orange Corporation Stock. The long-term capital gain from the Orange Corporation stock is reported on line 8a. It is assumed that the sale
of the Orange Corporation stock was reported to Troy on a Form 1099–B that showed the adjusted basis and selling price of the stock. If
not, a Form 8949 would be required.
Net § 1231 Gain. The net § 1231 gain transferred from Form 4797 appears on line 11.
Part III. Summary.
The combination of short-term and long-term capital gains and losses appears on line 16. In this case, the amount is a net capital gain. The
net capital gain is then carried to line 13 of Form 1040.
Tax Computation
In 2017, five alternative tax rates applied: 25%, 28%, and 0%/15%/20%.
On Form 4797, Part III, the $20,126 § 1231 gain from Asset B is made up of $14,126 of potential 25% gain (equal to the depreciation taken)
and $6,000 of potential 0%/15%/20% gain.
The $880 § 1231 loss from Form 4797, Part I, line 2 offsets the potential 0%/15%/20% portion of the $20,126 § 1231 gain on Form 4797,
Part I, line 6.
Consequently, the $19,246 § 1231 gain that goes from Form 4797, Part I, line 7 to Schedule D, line 11 is made up of (1) $14,126 25%
gain and (2) $5,120 0%/15%/20% gain.
Schedule D, Part III, line 19 shows an unrecaptured § 1250 gain of $13,926. A worksheet in the Form 1040 Schedule D instructions must be
used to determine this amount. This gain results from the $14,126 25% gain being reduced by the $200 short-term capital loss from
Schedule D, line 7.
Troy’s 2017 tax liability is $28,610, computed as follows:
The 2017 tax form solution for Example 22.
Ethics & Equity
Incorr ect De preci ati on a nd Re cogni z e d Gai n
A staff accountant for a large international company is calculating the tax gain from a disposition of business equipment. The equipment
was 7-year MACRS property and has been fully depreciated for tax purposes. The staff accountant notices that the equipment was used in
Germany, not the United States, although it is listed as an asset of the U.S. company for which the staff accountant works. Because the
property was used outside the United States, it should have been depreciated using straight-line over a nine-year life. Consequently, the tax
depreciation has been overstated, and the tax basis should be greater than zero, causing a smaller gain. What should the staff accountant
do?
17-7Tax Planning
LO.8
Identify tax planning opportunities associated with §§ 1231, 1245, and 1250.
Main content
17- Timing of § 1231 Gain
Although § 1245 recaptures much of the gain from the disposition of business property, sometimes § 1231 gain is still substantial. For
instance, land held as a business asset will generate either § 1231 gain or § 1231 loss. If the taxpayer already has a capital loss for the year,
the sale of land at a gain should be postponed so that the net § 1231 gain is not netted against the capital loss. The capital loss deduction
will therefore be maximized for the current tax year, and the capital loss carryforward (if any) may be offset against the gain when the land
is sold. If the taxpayer already has a § 1231 loss, § 1231 gains might be postponed to maximize the ordinary loss deduction this year.
However, the carryforward of unrecaptured § 1231 losses will make some or all of the § 1231 gain next year an ordinary gain.
In the examples below, the 2018 and 2019 long-term capital gain rates are assumed to be the same.
7a
Example 23
Section 1231 Planning
Mark has a $2,000 net STCL for 2018. He could sell business land held 27 months for a $3,000 § 1231 gain. He will have no other capital
gains and losses or § 1231 gains and losses in 2018 or 2019. He has no nonrecaptured § 1231 losses from prior years. Mark is in the 24%
tax bracket in 2018 and will be in the 22% bracket in 2019. If he sells the land in 2018, he will have a $1,000 net LTCG ($3,000 § 1231 gain
− $2,000 STCL) and will pay a tax of $150 ($1,000 × 15%).
If Mark sells the land in 2019, he will have a 2018 tax savings of $480 ($2,000 capital loss deduction × 24% tax rate on ordinary income). In
2019, he will pay tax of $450 ($3,000 × 15%).
By postponing the sale by a year, Mark gets the use of $630 ($480 + $150) of tax savings until he has to pay $450 in 2019, for a net savings
of $180 between the two years without considering the time value of money and other factors.
Example 24
Section 1231 Planning
Beth has a $15,000 § 1231 loss in 2018. She could sell business equipment held 30 months for a $20,000 § 1231 gain and a $12,000 § 1245
gain. Beth is in the 24% tax bracket in 2018 and will be in the 22% bracket in 2019. She has no nonrecaptured § 1231 losses from prior
years. If she sold the equipment in 2018, she would have a $5,000 net § 1231 gain and $12,000 of ordinary gain. Her tax would be $3,630
[($5,000 § 1231 gain × 15%) + ($12,000 ordinary gain × 24%)].
If Beth postponed the equipment sale until 2019, she would have a 2018 ordinary loss of $15,000 and tax savings of $3,600 ($15,000 ×
24%). In 2019, she would have $5,000 of § 1231 gain (the 2018 § 1231 loss carries over and recaptures $15,000 of the 2019 § 1231 gain as
ordinary income) and $27,000 of ordinary gain. Her tax would be $6,690 [($5,000 § 1231 gain × 15%) + ($27,000 ordinary gain × 22%)].
By postponing the sale of the § 1231 property until 2019. Beth gets the use of $7,230 ($3,600 + $3,630) of tax savings until she has to pay
$6,690 in 2019, for a net savings of $540 between the two years without considering the time value of money and other factors.
17-7bTiming
of Recapture
Because recapture is usually not triggered until the property is sold or disposed of, it may be possible to plan for recapture in low tax
bracket or loss years. If a taxpayer has net operating loss (NOL) carryovers, the recognition of ordinary income from recapture may be
advisable to absorb the loss carryovers.
Example 25
Ahmad has a $15,000 NOL carryover. He owns a machine that he plans to sell in the early part of next year. The expected gain of $17,000
from the sale of the machine will be recaptured as ordinary income under § 1245. Ahmad sells the machine before the end of this year and
uses the $15,000 NOL carryover to offset $15,000 of the ordinary income.
17- Postponing and Shifting Recapture
It is also possible to postpone recapture or to shift the burden of recapture to others. For example, recapture is avoided upon the
disposition of a § 1231 asset if the taxpayer replaces the property by entering into a like-kind exchange. In this instance, recapture
potential is merely carried over to the newly acquired property.
Recapture can be shifted to others through the gratuitous transfer of § 1245 or § 1250 property to family members. A subsequent sale of
such property by the donee will trigger recapture to the donee rather than the donor (refer to Example 15). This procedure would be
advisable only if the donee was in a lower income tax bracket compared with the donor.
Main content
7c
17-7dAvoiding Recapture
The immediate expensing election (§ 179) and additional first-year (bonus) depreciation [§ 168(k)] are subject to § 1245 recapture. If the
elections are not made, the § 1245 recapture potential will accumulate more slowly (refer to Chapter 8). Because using the immediate
expense election and/or additional first-year depreciation deduction complicates depreciation and book accounting for the affected
asset(s), not taking these deductions may make sense even though the time value of money might indicate that they should be taken.
Re f ocus on T he B ig P icture
Depr eci ati on R eca ptur e
Even though Hazel did not maximize her depreciation deductions when she acquired the store equipment in 2015, she still has ordinary
income when she sells the equipment in 2018. She has a basis lower than the store equipment’s value due to the § 179 immediate expense
deduction she took and the rapid 7-year MACRS depreciation. Section 1245 “recaptures” this gain as ordinary income.
Hazel cannot avoid currently recognizing the $53,040 ($128,000 sale price − $74,960 adjusted basis) by exchanging the property because
that is not a qualifying like-kind exchange (see Example 18). The only way she could avoid the ordinary gain is by not disposing of the
equipment.