OUTLINE
Thursday, December 10, 2020
12:03 AM
A. GENERAL TEST FOR INCOME
The Glenshaw Glass Court held that an item is “income” if it represents an instance of “undeniable
accessions to wealth, clearly realized, and over which the taxpayer [has] complete dominion.” 26
This Part A of the checklist breaks down the test for income from Glenshaw Glass into three discrete
components. Remember that all three components must be met in order to conclude that the
taxpayer has income.
1.
Accession to Wealth—Does the item add to the taxpayer’s wealth?
2.
Clearly Realized—Has the taxpayer realized the benefit of the addition to wealth?
a. Realization—A taxpayer “realizes” the benefit of an addition to wealth if the taxpayer has
received something severable for his or her use or benefit. The realization element here
primarily serves to distinguish items of income from the mere appreciation in the value of
preexisting assets. So while a taxpayer’s receipt of $1,000 cash as compensation for services is
a clearly realized accession to wealth, the fact that a taxpayer’s personal investment portfolio
of stocks and securities grows by $1,000 is not income because there has been no “realization”
of the growth in value. Note that realization does not require the receipt of cash or a sale of an
asset. A taxpayer has realized an accession to wealth, for example, by accepting a vehicle as
compensation for services performed by the taxpayer.
B. SPECIFIC ITEMS OF INCOME
1. Treasure Trove—Did the taxpayer discover the item and take possession of it?
a. Yes—If yes, the value of the “treasure trove” is included in gross income. Treas. Reg. §
1.61–14(a). In Cesarini v. United States, 296 F.Supp. 3 (N.D. Ohio 1969), for example, the
court held that money found inside a piano purchased at an auction sale was gross income to
the taxpayers in the year they discovered the money inside the piano.
3.
Prizes and Awards—Did the taxpayer receive the item as a prize or award?
Exception for Certain Awards Donated to Charity—Gross income does not include the value
of any prize or award given primarily in recognition of religious, charitable, scientific,
educational, artistic, literary, or civic achievement, provided: (i) the taxpayer was chosen
without any action on the taxpayer’s part to enter the contest; (ii) the taxpayer is not required
to render substantial future services as a condition to receiving the award; and (iii) the prize is
transferred to a governmental or charitable organization. IRC § 74(b).
d. Employee Achievement Awards—A taxpayer need not include the value of an employee
achievement award in gross income to the extent the employer’s cost in providing the award does
not exceed the amount the employer may deduct for furnishing the award. IRC § 74(c). An
employee achievement award is any item of tangible personal property awarded to an employee by
and employer in a meaningful presentation for length of service or safety achievement and not as
disguised compensation. IRC § 274(j)(3)(A).
5. Third Party Satisfaction of Taxpayer’s Liability—Did a third party pay or otherwise satisfy an
obligation of the taxpayer?
a. Yes—If yes, then the taxpayer has gross income unless a specific exclusion provision
applies. See Chapter 3. To determine the amount included in gross income, pretend the third
party paid the taxpayer directly and that the taxpayer then used that payment to satisfy the
liability. Thus, for example, if the taxpayer’s employer pays the taxpayer’s federal income tax
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liability. Thus, for example, if the taxpayer’s employer pays the taxpayer’s federal income tax
liability directly to the Internal Revenue Service, the taxpayer has gross income equal to the
amount paid to the Service by the employer. Old Colony Trust Company v. Commissioner,
279 U.S. 716 (1929).
6.
Discharge of Indebtedness—Was a debt of the taxpayer discharged or canceled to any extent?
a. Yes—If yes, the taxpayer has gross income equal to the amount discharged unless a
specific exclusion provision applies. IRC § 61(a)(12); United States v. Kirby Lumber
Company.
8.
Compensation for Services—Did the taxpayer receive the item as compensation for services?
Yes—If yes, then the item must be included in gross income. IRC § 61(a)(1). Note that any
form of compensation is subject to this rule, including fees, wages, commissions, fringe
benefits, and tips. Treas. Reg. § 1.61–2(a)(1)
c. Property Transferred in Connection with Performance of Services—Under IRC § 83(a), a
taxpayer has gross income if property is transferred to the taxpayer or to a third party in connection
with services performed by the taxpayer if either of the following conditions is met:
i. No Substantial Future Services Required—The recipient’s rights to the property are not
conditioned upon the performance of substantial future services by anyone. IRC § 83(c)(1).
ii. Property is Transferable—The rights of any transferee are not conditioned on the future
performance of substantial services by anyone. IRC § 83(c)(2). If neither of these conditions
exist, IRC § 83(a) does not apply. Nonetheless, the taxpayer may elect to include the value of
the property received (less any amount paid for the property) in the year of receipt by making
an election under IRC § 83(b). Such an election is advisable if the taxpayer anticipates that the
value of the property will surge between the year of receipt and the year in which one of the
two conditions above is met.
If a taxpayer has gross income under IRC § 83(a), the amount included is equal to the
fair market value of the property received less any amount paid for the property.
Importantly, when IRC § 83(a) applies, the taxpayer has gross income in the year of
receipt.
C. ITEMS NOT INCOME
1. Imputed Income—Does the accession to wealth stem from the taxpayer’s own efforts or from
the use of the taxpayer’s own property?
a. Yes—If yes, the accession to wealth represents “imputed income” and will not be included
in gross income. While economic theory would conclude that imputed income is like any
other form of gross income (in that it is either consumed or enhances the taxpayer’s net worth),
Congress and the Internal Revenue Service recognize the insurmountable practical obstacles
inherent in enforcing the taxation of imputed income. As a result, benefits from growing one’s
own garden vegetables, occupying one’s own home on a rent-free basis, or (in the case of a
lawyer, at least) writing one’s own will are not subject to taxation.
3. Unrealized Appreciation—Does the accession to wealth represent an increase in the value of a
property interest that the taxpayer did not sell or otherwise dispose of during the taxable year?
a. Yes—If yes, there is no gross income yet. As explained in Part A of this checklist,
taxpayers do not have income from the mere increase in the value of property owned during
the year. The appreciation will not be taxed until there is a “realization event” with respect to
the property (i.e., a sale or other disposition of part or all of the property). Thus, for example, a
taxpayer does not have gross income if stocks purchased at the beginning of the year for $1,000
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taxpayer does not have gross income if stocks purchased at the beginning of the year for $1,000
have a value of $1,800 at the end of the year.
b5. Loans—Did the taxpayer borrow the amount received under a consensual arrangement under
which the taxpayer has an obligation to repay the lender?
a. Yes—If yes, the transaction is a loan and the taxpayer does not have gross income from
the transaction. A borrower does not have an “accession to wealth” from the receipt of loan
proceeds because there is an offsetting liability to repay the amount borrowed.
D. ATTRIBUTING INCOME TO THE PROPER TAXPAYER
Having determined that an item is gross income unless a specific exclusion provision applies, it is
often important to consider to whom the income should be taxed. Most of the time, this will be
obvious. But where it appears that the person whose efforts or assets created the income attempts to
assign that income to another person (often a related person in a lower tax bracket), the issues in this
Part D are triggered.
1. Income from Services—Does the income represent compensation for services, or is the income
item attributable to services performed by a person?
a. Yes—If yes, then the income is generally taxed to the person who performed the services,
not necessarily the person who receives the income. Lucas v. Earl, 281 U.S. 111 (1929).
i. Earner Has No Rights to Income—If the person performing the services has no right
to receive the income, the income cannot be taxed to that person even though he or she
performed the services that generated the income. For example, in Teschner v.
Commissioner, 38 T.C. 1003 (1962), a father entered a contest that would award an
education annuity to an individual who was under a stipulated age. The father named
his daughter as the beneficiary on the contest entry form. The taxpayer’s entry form was
selected as the winner, and the prize was awarded to the daughter. The Tax Court held
that the daughter should be taxed on the value of the prize and not the father, for
although he performed the services necessary to generate the income, he was never
entitled to have the income and had no claim to it under the contest rules.
ii. Direction and Control—If the service provider has the final say as to who receives
the income, the service provider will be the one who is taxed. If the service provider
disclaims all rights to the income and such income passes to person related to the service
provider, the service provider likely would not be taxed on the income because the
service provider had no control over the recipient of the income. See Commissioner v.
Giannini, 129 F.2d 638 (9th Cir. 1942). If, however, the service provider knows that a
disclaimer will cause the income to be paid to the related person, the Internal Revenue
Service might succeed in claiming that the service provider indirectly controlled the
payment of the income and therefore should still be taxed on it.
IDENTIFYING GROSS INCOME
I.SECTION 61—INCOME
The linchpin of the Code, §61, defines gross income as “all income from whatever source
derived” (emphasis added). Thus, it is important to define “income” in order to determine
what is included in gross income (even if it is excluded by another statute later).
II.DEFINITIONS OF INCOME
A.Haig-Simons definition—theoretical approach: Under this approach, income is the sum of
(1) the market value of rights exercised in consumption, plus (2) the change in the value of the
store of property rights between the beginning and end of the period in question (usually a
taxable year). The Haig-Simons definition defines a comprehensive tax base, but difficulties
may arise in measuring all consumption and in valuing assets each year.
B.“Economic benefit”—a more practical approach: Under this approach, income is the
value of any economic benefit received by the taxpayer regardless of the form of the benefit.
1.Tangible items: The receipt of cash or other property generates income under this
approach, even if it comes from an unusual source, such as a windfall.
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approach, even if it comes from an unusual source, such as a windfall.
3.Intangible benefits: The receipt of an intangible benefit would be included in gross
income under this approach. For example, if one taxpayer satisfies another taxpayer’s
legal obligation, the latter has income in the amount of the satisfaction. Old Colony Trust
Co. v. Commissioner, 279 U.S. 716 (1929). But noneconomic benefits (such as a sunny day
in Oregon) are not income under this principle.
III.CERTAIN ITEMS THAT ARE NOT INCOME
Certain items are not considered income by general understanding of that term in federal tax law,
even though they might qualify as “income” under a theoretical definition of income.
A.Imputed income: The value of any services one performs for oneself or one’s family and the
value of any property used that one owns are imputed income, which is not considered income
for purposes of federal income tax.
B.Capital recovery: A taxpayer’s income from the sale or exchange of property is his or her
profit on the transaction, not the total amount received. A taxpayer is entitled to receive his or
her capital investment in the property tax-free, although the timing of this recovery is a matter
for legislative determination.
C.Loans: Neither the creation nor the repayment of a loan is a taxable event. However,
forgiveness or discharge of a loan may generate income to the debtor.
D.General welfare exclusion: As a matter of IRS practice, governmental payments made to a
person as part of a system of general welfare are not included, unless specifically addressed by
the Code.
SPECIFIC INCLUSIONS IN GROSS INCOME
I.SECTION 61
Section 61 provides that gross income includes “all income” from all sources. Courts construe §61
broadly to include most types of income in gross income, unless they are specifically excepted by
statute.
II.SPECIFIC ITEMS
Section 61(a) provides a nonexclusive list of types of income specifically included in gross income.
A. Compensation income—§61(a)(1): Compensation income is the consideration transferred for
the performance of services, whether in the form of salary, fees, commissions, or fringe
benefits, and whether in the form of cash, property, or other services.
a. Amount included: The amount of compensation income is the amount of cash received
or the fair market value of the property or services received.
b. Timing issues: The taxable year in which a taxpayer will include an amount of
compensation income will depend on the taxpayer’s method of accounting and, if
restricted property is involved, rules of §83.
c. Character: Compensation income is ordinary income, potentially taxable at the highest
tax rate.
B. Gross income from business—§61(a)(2): A taxpayer engaged in business as a sole proprietor
will include his or her gross income from business and will subtract available deductions from
that amount, reporting the net result (income or loss) on the tax return.
C. Gains derived from dealings in property—§61(a)(3): When a taxpayer sells, trades, or
otherwise disposes of property, the taxpayer may realize and recognize gain or loss. Gain is
included in gross income unless there is a specific statutory exception.
D. Investment income—§61(a)(4)–(7): Various types of investment income are included in gross
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D. Investment income—§61(a)(4)–(7): Various types of investment income are included in gross
income, including dividends, interest (both explicit and imputed), rents.
E. Discharge of indebtedness income—§61(a)(11): Creation of a loan is not a taxable event to
either the creditor or the debtor, for neither has a net economic benefit. If, however, the
creditor forgoes collection under the debt, the debtor will have a benefit equal in amount of the
debt forgone. This is discharge of indebtedness income and must be included in the debtor’s
gross income.
a. Enforceable debt: To have discharge of indebtedness income, there must be an
enforceable debt. See Zarin v. Commissioner, 916 F.2d 110 (3d Cir. 1990).
b. Identifying discharge: A discharge occurs when the creditor agrees to (or is forced to)
take something less than he or she originally agreed to take in satisfaction of the loan.
Payment of a debt is not a discharge, nor is payment of a debt by another, or payment
deferral. If the creditor receives what he or she bargained for, even if that amount is
different from the amount loaned, there is no discharge.
c. Contested liability doctrine: If a taxpayer in good faith disputes the amount of the debt,
a subsequent settlement of the debt is treated as the amount of the debt for tax purposes.
d. Possible exclusion—§108: Certain types of discharge of indebtedness income are
excluded from the gross income of the taxpayer. In general, if a taxpayer excludes
discharge of indebtedness income, he or she may also be required to reduce his or her
“tax attributes.”
III.PRIZES, AWARDS, HELPFUL PAYMENTS, EMBEZZLEMENTS, DAMAGES,
ALIMONY, AND OTHER
Code sections other than §61 provide for specific inclusions in gross income and judicial doctrines
also include some amounts in gross income.
A. Prizes and awards—§74: Prizes and awards are included in gross income unless they consist
of qualified scholarships, employee achievement awards, or were in recognition of religious,
charitable, scientific, educational, artistic, literary or civic achievement, but only if the
recipient did nothing to be selected, the recipient is not required to render substantial future
services as a condition of receiving the prize, and he or she immediately transfers the prize to
charity.
B. Helpful payments—§§82, 85, 86: Various types of helpful payments are included in gross
income, such as unemployment compensation, and a portion of Social Security benefits
received, depending on the income of the recipient.
C. Damages: Damages received for injury are includable in a taxpayer’s gross income, unless
specifically excluded under §104.
E. Alimony: Qualified alimony received pursuant to any divorce or separation agreement
executed prior to December 31, 2018 will be included in the gross income of the payee, unless
the divorce or separation agreement is expressly modified to provide for an exclusion.
F. Other Income: Items of income not listed in §61, such as windfalls and treasure trove, are
includable in income. Income can be realized in any form, including property and services.
Reg. §1.61-1(a).
SPECIFIC EXCLUSIONS FROM GROSS INCOME
I.EXCLUSIONS—IN GENERAL
An item must fit within the precise requirements of an exclusion statute in order to be excluded
from gross income. Always construe exclusions narrowly.
GIFTS—§102
The recipient of a gift or an inheritance may exclude the cash or value of the property received from
gross income regardless of amount.
A. Definition: A gift is a transfer made with detached and disinterested generosity. See
Commissioner v. Duberstein, 363 U.S. 278 (1960). Most intrafamily transfers are gifts.
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Commissioner v. Duberstein, 363 U.S. 278 (1960). Most intrafamily transfers are gifts.
B. Exceptions
a. Income from property: The exclusion does not apply to the income derived from
property received by gift.
b. Employee gifts: The exclusion does not apply to any transfer made by an employer to an
employee; these amounts are considered compensation income, not gifts.
C. Basis: A recipient of property by gift, inheritance, or divorce must determine the basis he or
she has in the property.
a. Property received by gift—§1015: The recipient of property by gift takes the donor’s
basis in the gift, plus a portion of any gift tax paid on the transfer. However, if, at the
time of the gift, the fair market value of the property was less than its basis, for purposes
of determining loss on subsequent sale or disposition, the donee takes the fair market
value of the gift on the date of the gift. §1015(a).
b. Property received by inheritance—§1014: The recipient of property through inheritance
takes as his or her basis in the property the fair market value of the property on the date
of the decedent’s death or the alternate valuation date if that date is elected.
c. Property received from spouse or in a divorce—§1041: The recipient of the property
takes it with the adjusted basis it had immediately before the transfer. §1041(b)(2).
DISCHARGE OF INDEBTEDNESS INCOME—§108
- Section 61(a)(12) of the Internal Revenue Code (the “Code”) provides that gross income
includes income from discharge of indebtedness. Treasury Regulation §1.61- 12(c)(2)(ii)
provides that a debtor realizes income from the discharge of indebtedness upon the repurchase
of a debt instrument for an amount less than its adjusted issue price. The amount of discharge
of indebtedness income is equal to the excess of the adjusted issue price over the repurchase
price
Policy (Kirby Lumber Co):
- When a taxpayer borrows money, it is not taxed on the loan proceeds received because of the
offsetting liability to repay the loan. If the loan is cancelled for less than full payment, part of
the loan proceeds that were not taxed by reason of the taxpayer repayment obligation is no
longer subject to that corresponding obligation. Since the basis for not taxing that part of the
loan proceeds no longer exists, the taxpayer realizes income in the amount equal to the
difference between the original amount of the loan and the amount paid to cancel the loan.
The cancellation of the loan for less than full payment has resulted in a net increase in the
assets of the taxpayer.
Statutory Scheme
- Section 61(a)(12):
○ Gross income includes income from discharge of indebtedness. Indebtedness of the
taxpayer means any indebtedness: for which the taxpayer is liable or subject to which the
taxpayer holds property.
 Section 61(a)(12) of the IRC codified the rule of Kirby Lumber.
○ Discharge means a termination or cancellation of an obligation for less than full
payment.
- Section 108:
○ Rules for applying the COD concept. Pursuant to this section, gross income does not
include any amount which would otherwise be includible in gross income by reason of
COD, in whole or in part, if:
 discharge occurs in a Title 11 [bankruptcy] case. §108(a)(1)(A);
 discharge occurs when TP is insolvent, to the extent of the insolvency. §108(a)(1)
(B); §108(a)(3);
□ Insolvency is amount of taxpayer’s debts over the fair market value of his or
her property.
- COD is taxed as ordinary income.
1. Recourse Loans
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1. Recourse Loans
- If debt is discharged without a transfer of property, all COD is ordinary income.
- If property is transferred in connection with discharge of the debt, the transaction will be
bifurcated into two parts:
○ The sale of the property for an amount equal to its fair market value, which generally
results in capital gain or capital loss.
○ COD income equal to the balance of the gain
2. Non-Recourse Loans:
- If debt is discharged without a transfer of property, all COD is ordinary income.
○ Rev. Rul. 82-202, 1982-2 C.B. 35; Rev. Rul. 91-31, 1991-1 C.B. 19.
- If property is transferred in connection with the discharge of the debt, there is no COD and all
of the gain or loss will be determined under §1001 of the IRC (usually resulting in a capital
gain or capital loss).
EXCLUSION FOR GAIN ON SALE OF PRINCIPAL RESIDENCE—§121
Section 121 allows a taxpayer to exclude from gross income $250,000 ($500,000 for joint returns) of
gain on the sale of a principal residence, if the taxpayer has owned and used the dwelling as a
principal residence for at least two of the past five years.
EMPLOYMENT-RELATED EXCLUSIONS
The Code provides a variety of employment-related exclusions.
A. Meals and lodging—§119: An employee may exclude from gross income the value of meals
and lodging provided by an employer if the meals or lodging are provided for the convenience
of the employer, are provided on the business premises of the employer, and in the case of
lodging, the employee is required to accept the lodging as a condition of employment.
a. Convenience of the employer: “Convenience of the employer” means that the employer
has a “substantial non-compensatory business reason” for supplying the meals and
lodging, considering all the facts and circumstances of the situation.
b. Business premises: The business premises of an employer are the grounds of the
employer’s place of business.
c. Condition of employment: The condition of employment requirement is generally
satisfied by showing that the employee is on call for the business of the employer.
B. Statutory fringe benefits—§132: The value of any fringe benefit that qualifies as any of the
following eight fringe benefits is excluded from the gross income of the employee. In some
cases, the provision of the benefit must meet antidiscrimination rules.
a. No additional cost service—§132(b): If the employer regularly provides the service to
the public and provides it to the employee without incurring any significant additional
cost, it will be excluded from the gross income of the employee who receives the service.
b. Qualified employee discounts—§132(c): If employees enjoy a discount on property or
services provided to the public by the employer, and the discount does not exceed a
certain percentage, the value of the discount will be excluded from the gross income of
the employees taking advantage of the discount.
c. Working condition fringe—§132(d): An employee receiving a benefit that would have
generated a deduction as a trade or business expense or as depreciation to the employee
had he or she purchased the benefit individually may exclude the benefit from gross
income.
d. De minimis fringe—§132(e): If the benefit provided to the employees is so small that
accounting for it would be unreasonable or administratively impractical, it will be
excluded from the gross income of the employees receiving it.
5.Qualified transportation fringe—§132(f): An employee who receives transit passes, van
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5.Qualified transportation fringe—§132(f): An employee who receives transit passes, van
transportation, or parking may exclude the benefit from gross income, within specified dollar
limitations.
6.Qualified moving expense reimbursement—§132(g): If a member of the armed services is on
active duty and receives reimbursement for amounts to move pursuant to a military order and
incident to a permanent change of station, he or she may exclude these amounts from gross income.
ROLE OF DEDUCTIONS
Deductions figure prominently in two phases of computation of taxable income. One group of
deductions is subtracted from gross income in computing AGI. Another group is subtracted from
AGI in computing taxable income. The benefit of many deductions is limited for higher-income
taxpayers through the mechanism of phaseouts based, directly or indirectly, on AGI.
III.COMMON THEMES OF DEDUCTION CONTROVERSIES
Three common themes arise in deduction controversies. Always construe deductions narrowly; each
and every requirement of a deduction statute must be met in order for a taxpayer to qualify for a
deduction.
A. An event: A taxpayer must experience an outlay, an outflow, or a loss in which there is no
realistic possibility of recovery of the item.
B. Personal versus business expenses: A common theme in the analysis of deductions is the
question whether an expense is “personal” or “business.” This distinction is important
because, as a general rule, personal expenses are not deductible unless a specific statute
provides otherwise. Business expenses are generally deductible. Taxpayers seek to characterize
deductions as business related, rather than personal, in order to deduct them.
C. Expense or capital expenditure? An expense may be deducted currently, but if an expenditure
is for a capital item (a capital expenditure), its cost must be added to basis (or capitalized) and
be recovered in accordance with the statutory scheme governing capital recovery. Taxpayers
prefer to characterize expenditures as expenses rather than capital expenditures in order to
accelerate capital recovery.
PERSONAL DEDUCTIONS
A.Compare exclusion: By contrast, an exclusion causes an item of income not to be included in
gross income. An exclusion and a deduction will have the same tax effect for taxpayers but will
reach this result by very different paths.
B.Compare tax credit: A tax credit is a dollar-for-dollar reduction in the amount of tax due.
I.IN GENERAL—§262
While personal expenditures are not generally deductible, specific Code provisions allow a taxpayer
to deduct certain personal expenses if statutory requirements are met. Many personal deductions,
like some exclusions, are subject to phaseouts based on some measure of income.
II.TWO KINDS OF PERSONAL DEDUCTIONS
A. “Above-the-line” deductions: This group of deductions is subtracted from gross income in
computing AGI. Taxpayers seek to increase “above-the-line” deductions because AGI serves
as a measure for certain itemized deductions, and lowering AGI will potentially increase the
deductible portion of these itemized deductions.
B. “Below-the-line” deductions: This group of deductions is subtracted from AGI in computing
taxable income and consists of either the standard or the itemized deduction. The itemized
deduction is the sum of a number of deductions, including home mortgage interest, taxes,
casualty losses, medical expenses, charitable contributions, and allowable miscellaneous
expenses.
III.“ABOVE-THE-LINE” PERSONAL DEDUCTIONS
A. Contributions to regular IRAs—§219: A taxpayer may claim a deduction for certain
retirement savings. In general, an individual may deduct the lesser of $5,000 of his or her
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B.
C.
D.
E.
F.
retirement savings. In general, an individual may deduct the lesser of $5,000 of his or her
earned income to an individual retirement account (IRA). Taxpayers 50 years of age and older
can make an additional contribution. If the taxpayer participates in a qualified plan and has
income in excess of a certain amount, the contribution may be made, but no deduction is
allowable.
Interest on education loans—§221: Up to $2,500 of the interest paid on certain student loans
is potentially deductible, depending on income limitations and other tests.
Certain contributions to medical savings accounts—§223: A taxpayer subject to a highdeductible health plan can deduct certain contributions to a Health Savings Account (HSA).
Costs incurred in unlawful discrimination, civil rights, or whistleblower actions—§§
162/212: A taxpayer who incurs attorneys’ fees or other costs in certain unlawful
discrimination, civil rights, or whistleblower actions may deduct such expenses. Only a limited
number of actions qualify. Otherwise, the taxpayer may be unable to deduct attorney fees and
other costs as these might constitute disallowed miscellaneous itemized deductions under §67.
Losses—§165: A taxpayer may deduct losses incurred during a taxable year that are not
compensated for by insurance or otherwise. However, an individual taxpayer may deduct only
three types of loss.
a. Trade or business losses—§165(c)(1): A taxpayer may deduct losses incurred in a trade
or business. Neither the Code nor the regulations include a definition of a “trade or
business,” but a good working definition is “engaged in regular and continuous activity
for the purpose of profit.” See Figure 7.
b. Investment losses—§165(c)(2): A taxpayer may deduct losses incurred in an activity
engaged in for profit, which does not constitute a trade or business. For example, losses
on the sale of stock would be investment losses, but losses on the sale of a principal
residence would not be, as a principal residence is held for personal, rather than
investment, purposes.
Moving expenses—§217: A member of the armed services on active duty may deduct
qualifying moving expenses associated with a move pursuant to military order for a permanent
change of station.
G. Alimony—§215: A taxpayer may deduct the amount of alimony or separate maintenance paid
during the year under a divorce or separation agreement executed before January 1, 2019,
assuming all federal law requirements of alimony are met.
THE CHOICE: STANDARD OR ITEMIZED DEDUCTION
A taxpayer may deduct either the standard or the itemized deduction, but not both. The rational
taxpayer will choose the larger of the two. The standard deduction is a specified amount based on
filing status, and the itemized deduction is the sum of the taxpayer’s itemized deductions.
ITEMIZED DEDUCTIONS
A number of deductions are available to the taxpayer only if he or she claims the itemized
deductions. The principal itemized deductions are discussed below.
A. Interest—§163: Personal (or consumer) interest is not deductible. Personal interest is interest
other than (1) trade or business interest, (2) qualified residence interest, or (3) investment
interest.
a. Qualified residence interest—§163(h): Qualified residence interest is deductible by
individuals on acquisition indebtedness of up to $750,000. A qualified residence is the
taxpayer’s principal residence and one other qualifying residence (which the taxpayer
uses at least 14 days per year for personal purposes).
b. Investment interest—§163(d): A taxpayer may deduct interest to finance the purchase of
investments, but only to the extent of net income from those investments.
B. Taxes—§164: A taxpayer may deduct state and local real property, personal property, and
income taxes, but only up to a limit of $10,000 per tax return. A taxpayer may elect to deduct
state and local taxes in lieu of state and local income taxes, but not both.
D. Medical expenses—§213: A taxpayer may deduct medical expenses, but only to the extent
that they exceed 7.5% of his or her AGI. Medical expenses are expenses for the cure,
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that they exceed 7.5% of his or her AGI. Medical expenses are expenses for the cure,
treatment, or management of a disease or accident, and include health insurance premiums
paid by the taxpayer but do not include certain other items such as nonprescription drugs and
certain elective cosmetic surgery.
E. Charitable contributions—§170: A taxpayer may deduct contributions to qualifying
charitable organizations. The amount of the deduction is the amount of cash or the fair market
value of any property contributed. Limitations based on a taxpayer’s AGI are imposed;
usually, this is 50% or 60% of AGI. The taxpayer must not receive a personal benefit as a
result of the contribution.
F. Miscellaneous expenses: A number of expenses are not deductible as they constitute
miscellaneous itemized expenses under §67. These include employee’s unreimbursed business
expenses, investment expenses, hobby losses, and many legal fees. On the other hand, some
expenses are allowable miscellaneous deductions, such as gambling losses to the extent of
gambling income, casualty and theft losses from income-producing property, and losses from
Ponzi-type investment schemes
Determining the Deductible Amount
The deduction available for charitable contributions is generally dependent on:
- (1) the type of property donated,
- (2) the type of charitable organization receiving the donation,
- (3) the fair market value (FMV) of the property donated,
- (4) the value of any goods or services received from the charity and
- (5) the donor’s income.
No deduction is available if the donor retains a substantial right or interest in the donated property
unless an exception applies. Furthermore, the deduction may be reduced, deferred or disallowed if
the donor places restrictions on a charity’s use of the donated property.
Determining FMV.
- FMV is the price that property would sell for on the open market between a willing buyer and
a willing seller, with neither being required to act, and both having reasonable knowledge of
the relevant facts. In making and supporting the valuation of property, all factors affecting
value are relevant and must be considered:
○ The cost or selling price of the item
○ Sales of comparable properties,
○ Replacement cost and
○ Opinions of experts
AGI Limits on Charitable Contributions
- The deduction for charitable contributions cannot exceed 60% of the taxpayer’s adjusted gross
income (AGI).
○ A reduced limit of 30% or 20% applies for certain contributions
- The Tax Cuts and Jobs Act of 2017 (TCJA) increased the limitation under IRC Sec. 170(b) for
cash contributions to public charities and certain private foundations from 50% to 60% of AGI
for 2018–2025.
○ Contributions exceeding the limitation are generally allowed to be carried forward and
deducted for up to five years, subject to the later year’s ceiling [IRC Sec. 170(b)(1)(G)].
Five-Year Contribution Carryover
- Contributions that exceed the AGI limit in the current year can be carried over to each of the
five succeeding years [IRC Sec. 170(b)(1) and (d)(1)].
- Carryover contributions are subject to the original percentage limits in the carryover years and
are deducted after deducting allowable contributions for the current year.
○ If there are carryovers from two or more years, use the earlier year carryover first
CHARITABLE DEDUCTION LIMITS:
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Ordinary Income and Short-Term Capital Gain Property
- Ordinary income property is property that, if sold, would result in ordinary income or shortterm capital gain.
○ Ordinary income property includes:
 Capital assets held for 12 months or less.
 Property created by the donor (such as works of art, literary compositions, letters,
etc.).
 Inventory
 Property used in a trade or business
○ The charitable contribution deduction for ordinary income property is limited to:
 its FMV less the amount that would be ordinary income.
○ This generates a charitable contribution deduction essentially equal to the taxpayer’s
basis. [IRC Sec. 170(e)(1)(A)]
Long-Term Capital Gain Property:
- Long-term capital gain (LTCG) property is property that would generate LTCG (including
any Section 1231 gain on assets used in a trade or business) if it were sold it at FMV on the
contribution date.
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-
Depreciated Property
Donating property with a FMV that is less than the taxpayer’s basis should be avoided because:
- The deduction is limited to FMV.
- The donor cannot claim a tax loss for the decline in value. It is almost always more beneficial
to sell the property, deduct the loss and donate the sales proceeds.
○ Exception: If the donated property is not used in a trade or business or held for
investment, a loss on its sale is generally not deductible, so donating the property would
produce the same tax result as selling it and donating the resulting cash (for example,
personal use items such as clothing and household goods).
BUSINESS AND INVESTMENT DEDUCTIONS
Net business income is included in a taxpayer’s gross income, and net loss from a trade or business
constitutes a deduction subject to certain limitations. To compute net income or loss from business,
a taxpayer begins with gross income from the business and subtracts available deductions. A
taxpayer doing business as a sole proprietor reports this income and the available deductions on
Schedule C, and the net result (income or loss) is then reported on his or her own tax return, subject
to certain limits on losses. A taxpayer who owns rental or royalty property will compute the income
and deductions associated with this activity on Schedule E and report the net result (profit or loss)
on his or her own tax return, subject to certain limitations. In both situations, it is critical to identify
available deductions.
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II.ORDINARY AND NECESSARY BUSINESS EXPENSES—§162
A taxpayer may claim a deduction for all the ordinary and necessary expenses paid or incurred in
carrying on a trade or business, or while traveling away from home, and rental payments for
business property.
A. Five requirements: There are five distinct requirements for deduction of an expenditure under
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A. Five requirements: There are five distinct requirements for deduction of an expenditure under
§162.
a. Ordinary: Ordinary means “usual in the course of general and accepted business
practice,” arising from a transaction commonly encountered in the type of business in
question, even if the expenditure is unique for the particular taxpayers. See Deputy v.
DuPont, 308 U.S. 488 (1940). In addition, the expenditure must be reasonable in amount.
This particular issue often arises in the area of compensation.
b. Necessary: There must be a reasonable connection between the expense and the
furtherance of the business. Necessary means “appropriate and helpful” to the business,
but the courts are reluctant to second-guess the judgment of business people, except in
extreme cases.
c. Expense: The expense requirement distinguishes between expenses (which may be
deductible) and capital expenditures (which must be capitalized).
d. Trade or business: To be deductible, the expense must be incurred in connection with a
taxpayer’s trade or business. If the taxpayer’s trade or business is that of an employee,
then no ordinary and necessary business expenses are deducible unless reimbursed by his
or her employer. The principal function of the trade or business requirement is to
distinguish between personal activities and business activities.
i. Definition: To be engaged in a trade or business, a taxpayer must be involved in
an activity with continuity and regularity and must have the primary purpose of
creating income or profit rather than merely engaging in a hobby. See Commissioner
v. Groetzinger, 480 U.S. 23 (1987). To be engaged in a trade or business of an
employee, the IRS examines 20 factors including right to control, working for one
firm, working only on firm’s premises, furnishing of tools, and method of payment.
Rev. Rul. 87-41, 1987-1 C.B. 296.
ii. Hobbies: A trade or business requires a profit motive, which is not characteristic of
hobbies. Hobbies may generate income, however, and certain deductions may be
available under §183.
iii. Carrying on: The expense must be incurred during the time the taxpayer is
actually engaged in carrying on a trade or business.
B. Limits on deduction: Section 162 is riddled with exceptions and special rules. Other statutory
restrictions may also apply. Only the principal exceptions are discussed here.
a. Unreimbursed employee expenses: Unreimbursed employee business expenses are
disallowed miscellaneous itemized deductions under §67; whereas, sole proprietor or
independent contractor expenses are above-the-line deductions. Thus, it becomes
extremely important to determine if the taxpayer is an employee.
b. Public policy: No deduction is allowed for illegal bribes and kickbacks, for lobbying
expenses or other payments to support a political candidate, for fines or similar penalties
paid to the government, for sexual harassment settlements containing a nondisclosure
agreement, or for the two-thirds portion of the treble damages of antitrust damages. In
addition, no deduction is allowed for expenses of illegal drug trafficking, including
growing and selling marijuana.
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OTHER DEDUCTIONS FOR A TRADE OR BUSINESS
A taxpayer engaged in business may deduct other expenses of doing business, including bad debts,
interest on debt incurred in connection with the trade or business, taxes, losses incurred in the
business, and certain charitable contributions.
DEDUCTIONS FOR CAPITAL RECOVERY
A. In general—§263: A taxpayer may not claim a current deduction for capital expenditures,
generally defined as “permanent improvements or betterments made to increase the value of
any property or estate.”
a. Capital recovery: When a capital expenditure is made, the cost is said to be
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B.
C.
D.
E.
a. Capital recovery: When a capital expenditure is made, the cost is said to be
“capitalized.” The taxpayer will be entitled to recover that capitalized amount at some
point during his or her ownership of the asset (capital recovery). “Recovery” means that
the taxpayer’s economic investment in the asset will constitute a tax benefit, either as a
deduction during the ownership of the asset, or at sale when the taxpayer reports as gain
the amount received in excess of his or her investment in the property.
b. Timing: The timing of capital recovery is completely within the discretion of Congress.
Taxpayers prefer to recover capital as soon as possible, preferring accelerated
depreciation systems to systems that defer capital recovery until sale or other disposition
of the asset.
Definition of capital expenditure: Neither the Code nor the regulations offer a precise
definition of a capital expenditure.
a. Separate asset test: If an expenditure creates a separate, identifiable asset with a useful
life that will extend substantially beyond the taxable year, the expenditure is probably a
capital expenditure. See Commissioner v. Lincoln Savings & Loan Ass’n., 403 U.S. 345
(1971), and Treas. Reg. §1.263(a)-2(a).
b. Future benefits test: Even if a separate asset is not created, if an expenditure creates
more than an insignificant future benefit, it is a capital expenditure. See Indopco, Inc. v.
Commissioner, 503 U.S. 79 (1992).
Section 179 deduction: Section 179 allows a taxpayer to elect to deduct up to a specified
amount attributable to capital expenditures for equipment and tools purchased for the
business. This deduction also reduces the basis of the asset(s) by the amount of the deduction
claimed. In 2018, the §179 amount is $1,000,000, reduced by the cost of §179 property the
taxpayer places in service that exceeds $2,500,000. The §179 deduction cannot exceed the
taxable income of the taxpayer computed without regard to this deduction.
Bonus depreciation—§168(k): A taxpayer may take an additional first-year depreciation equal
to 100% of the basis for certain property acquired or placed in service after September 27,
2017. The rate phases down after January 1, 2023.
Modified accelerated cost recovery system (MACRS) deduction for tangible business
assets—§§167, 168: MACRS is the method by which taxpayers claim capital recovery for
tangible business assets.
a. Dual function of deduction: The MACRS deduction is a deduction from gross income
in computing net business income or loss. Each time the taxpayer claims a MACRS
deduction, the basis of the asset is reduced by the same amount (producing the “adjusted
basis” of the asset).
b. Calculation of MACRS deduction: The MACRS deduction is computed by applying
the “applicable recovery method” to the “basis” of the asset over the “applicable
recovery period,” taking into account “applicable conventions.”
i. Applicable recovery method: Three different recovery methods are available
under MACRS: straight-line and two accelerated methods.
ii. Basis: The basis of an asset is generally its cost, unless it is acquired by some other
means.
iii. Applicable recovery period: The recovery period for an asset is the period of years
over which the taxpayer claims capital recovery for the item. The recovery period
for assets is defined by statute or by the IRS.
1) Real property: Qualified improvement property has a recovery period of 15
years. Residential real property has a recovery period of 27.5 years.
Nonresidential real property has a recovery period of 39 years.
2) Personal property: Personal property can be 3-, 5-, 7-, 10-, 15-, or 20-year
property. For example, office furniture is 10-year property.
3) Applicable conventions: The applicable convention expresses the beginning
date of capital recovery. Recovery generally begins when property is placed
in service, and the conventions provide that regardless of when the property
is actually placed in service, it will be deemed placed in service on a
particular date. Real property uses a midmonth convention, and personal
property a midyear convention.
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A. CAPITAL EXPENDITURES
Capital expenditures are not deductible. IRC § 263(a). If a taxpayer pays or incurs a capital
expenditure, the cost is “capitalized,” meaning it creates or adds to basis.
1. Cost to Acquire New Tangible Asset—Does the cost result in the acquisition of a separate and
distinct tangible asset that will have a useful life substantially beyond the taxable year in which
the cost is paid or incurred?
a. Yes—If yes, then the cost must be capitalized. Treas. Reg. § 1.263(a)–2(a). The cost
becomes the taxpayer’s basis in the new asset. To determine whether this cost can be
depreciated or amortized, proceed to Part D of this checklist
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depreciated or amortized, proceed to Part D of this checklist
2. 12–Month Rule—In determining whether an asset or other economic benefit has a useful life
substantially beyond the taxable year, the so-called “12–month rule” provides that if the
benefit of the cost will last no more than 12 months and not beyond the end of the year
following the year in which the cost is paid, the cost need not be capitalized. Prop. Reg. §
1.263(a)–2(d)(4)(i). In that case, the cost is an expense, and analysis shifts to Part B of this
checklist.
3. Cost to Construct or Produce New Tangible Asset—Does the cost relate to the creation or
production of real property or tangible personal property?
a. Yes—If yes, then the cost must be capitalized. IRC § 263A generally requires all direct
and indirect costs allocable to the construction or production of real property and
tangible personal property be capitalized. Direct costs include raw materials and wages
paid to employees. Treas. Reg. § 1.263A–1(e)(2). Indirect costs include repairs,
depreciation on equipment used in the construction or production process, utilities,
taxes, insurance, and storage. Treas. Reg. § 1.263A–1(e)(3). Such costs are added to the
taxpayer’s basis in the constructed or produced property. These costs may be eligible for
cost recovery deductions if the constructed or produced property meets the requirements
for depreciation, so proceed to Part D of this checklist.
4. Exceptions—The rule of capitalization in IRC § 263A does not apply to the construction or
production of personal-use property. IRC § 263A(c)(1). Accordingly, such costs must be
analyzed individually to determine whether they are capitalized or expensed. Likewise, IRC §
263A does not apply to certain animals and plants produced by farmers and ranchers. IRC §
263A(d). It also does not apply to free-lance photographers, writers, and artists. IRC §
263A(h).
5. Tangible Property Held for Resale—Does the cost result in the acquisition or creation of
tangible property that the taxpayer intends to sell to another party?
a. Yes—If yes, then the cost must be capitalized even if the taxpayer intends to sell the asset
in the very near future. Prop. Reg. § 1.263(a)–2(d)(1)(i). The cost becomes the taxpayer’s
basis in the new asset. To determine whether this cost can be depreciated, proceed to
Part D of this checklist, although generally such property will not be subject to
deductions for cost recovery.
6. Substantial Future Intangible Benefit—Does the cost provide the taxpayer with a substantial
future benefit?
a. Yes—If yes, then the cost must be capitalized even though it does not result in the
creation of a separate and distinct asset. INDOPCO, Inc. v. Commissioner, 503 U.S. 79
(1992). Such cost adds to the basis of the tangible and intangible assets to which such
benefit relates. For instance, if the taxpayer pays attorney fees to defend against a hostile
takeover of the taxpayer’s business, the cost should be added to the basis of the
taxpayer’s business assets. To the extent those assets are eligible for cost recovery
deductions, then Part D or Part E of this checklist applies.
7. Amounts Paid to Acquire Intangible Asset—Does the taxpayer incur the cost to acquire an
intangible asset from another party?
a. Yes—If yes, then the cost must be capitalized. Treas. Reg. §§ 1.263(a)–4(b)(1)(i)
and–4(c). The cost becomes the taxpayer’s basis in the acquired intangible asset. The
basis may be eligible for the IRC § 197 amortization deduction, so proceed to Part E of
this checklist.
8. Facilitation Costs—Costs to acquire an intangible asset include the costs paid to “facilitate”
the acquisition. Treas. Reg. §§ 1.263(a)–4(b)(1)(v) and–4(e)(1). Facilitation costs include the
costs paid to investigate or pursue the transaction, including attorney fees, accountant fees,
inspections, and appraisals.
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9. Amounts Paid to Create Intangible Asset—Does the taxpayer incur the cost to create an
intangible asset that will last more than 12 months or beyond the year after the year payment?
a. Yes—If yes, then the cost must be capitalized. Treas. Reg. §§ 1.263(a)–4(b) (1)(ii)
and –4(d). The cost becomes the taxpayer’s basis in the acquired intangible asset. The
basis is usually not eligible for the IRC § 197 amortization deduction, but proceed to Part
E of this checklist to make sure.
c. Facilitation Costs—Costs to create an intangible asset include the costs paid to “facilitate” the
creation. Treas. Reg. §§ 1.263(a)–4(b)(1)(v) and–4(e)(1). Facilitation costs include the costs paid to
investigate or pursue the creation of the asset, including attorney fees, accountant fees, inspections,
and appraisals.
d. 12–Month Rule—Costs paid to create (or facilitate creation of) any intangible benefit that does
not last more than 12 months or beyond the end of the year after the year of payment need not be
capitalized. Treas. Reg. § 1.263(a)–4(f)(1).
B. BUSINESS EXPENSES
This Part B applies to a cost paid or incurred by a taxpayer that is not capitalized under Part A of
this checklist. Such a cost is an expense, and the deductibility of the expense turns on the activity or
activities to which the expense relates. Start by considering whether the expense is a business
expense deductible under IRC § 162(a). This is the usually the best result because the IRC § 162(a)
deduction is generally an above-the-line deduction available to the taxpayer regardless of whether
the taxpayer chooses to itemize deductions or claim the standard deduction.
1. Trade or Business—Does the expense bear a proximate relationship to a trade or business
activity?
Full-Time Effort and Profit Motive—The Supreme Court has said that “to be engaged in a trade
or business, the taxpayer must be involved in the activity with continuity and regularity and …
the taxpayer’s primary purpose for engaging in the activity must be for income or profit.”
Commissioner v. Groetzinger, 480 U.S. 23 (1987). Accordingly, a taxpayer must both have a
profit motive and regularly participate in the activity in order for it to rise to the level of a trade
or business. If a taxpayer has a profit motive but is not regularly involved in the activity, it is
an investment activity and not a trade or business. If the taxpayer is regularly involved but
lacks a profit motive, it is a hobby activity and not a trade or business.
2. Ordinary and Necessary Expense—Is the expense ordinary and necessary to the taxpayer’s
business?
- Ordinary—An expense is ordinary if its “common and accepted” within that industry. Welch
v. Helvering, 290 U.S. 111 (1933). The focus is not on whether the taxpayer himself or herself
regularly incurs such an expense but whether the cost is not uncommon within the community
of which the taxpayer’s business is part. There is no magic set of factors to apply in
determining whether an expense is ordinary. Indeed, Justice Cardozo in Welch said that “life
in all its fullness” is to supply the answer.
- Necessary—Welch says that an expense is necessary to the taxpayer’s business if it is
“appropriate and helpful” to the business. Courts give significant deference to the business
judgment of taxpayers in this regard, so it is rare for a business expense to be rendered nondeductible because of the necessity requirement.
C. INVESTMENT EXPENSES
This Part C applies to expenses that do not bear a proximate relationship to a trade or business
activity.
1. Production or Collection of Income—Is this an ordinary and necessary expense paid or
incurred in the production or collection of income (an investment activity)?
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incurred in the production or collection of income (an investment activity)?
Yes—If yes, then the expense is deductible under IRC § 212(1).
2. Maintenance of Property Held for Production or Collection of Income—Is this an ordinary
and necessary expense paid or incurred in managing, conserving, or maintaining property held for
the production of income (an investment activity)?
Yes—If yes, then the expense is deductible under IRC § 212(2).
3. Tax Matters—Is this an ordinary and necessary expense paid or incurred in connection with the
determination, collection, or refund of any tax?
Yes—If yes, then the expense is deductible under IRC § 212(3).
No—If no, then the expense is neither a business expense nor an investment expense. It is
therefore a personal expense. Personal expenses are not generally deductible. IRC § 262. But
there are many exceptions to this general rule. To determine whether the personal expense is
deductible, see Chapter 5.
D. DEPRECIATION DEDUCTIONS
Tangible property depreciation rules.
What amount is deductible? Consider:
1) Property classification - §168(e).
2) Recovery period - §168(c).
3) Depreciation method - §168(b).
4) Applicable convention - §168(d).
Note: no salvage value is required - §168(b)(4).
5) Bonus Depreciation - §168(k)
Real Property Depreciation Rules:
- No depreciation is available for land (since not a wasting asset).
○ Residential real property
 27.5 years 168(c)
○ nonresidential property depreciation
 39 years (nonresidential) recover §168(e)(2).
- Straight line depreciation. §168(b)(3).
- A mid-month convention is applicable for the year the asset is placed into service
As previously explained, a capitalized cost creates or adds to basis in property. If the property is not
subject to depreciation or amortization deductions, the taxpayer will get the benefit of this basis
upon a sale or other disposition of the property. Although the taxpayer can control when such a
disposition will occur, the taxpayer must dispose of the asset in order to claim the benefit of the extra
basis. Most taxpayers would prefer to recover the capitalized cost throughout the useful life of the
property to which the cost relates. Depreciation deductions under IRC § 168 and amortization
deductions under IRC § 197 provide the rules for claiming these deductions. This Part D concerns
the depreciation deductions under IRC § 168.
1. Tangible Property Subject to Wear and Tear—Is the property to which a capitalized cost
relates tangible property subject to wear and tear?
No—If no, then the property is not eligible for depreciation deductions. If the problem is
that the property is not tangible property, proceed to Part E of this checklist. If the
problem is that the property is not subject to wear and tear in the taxpayer’s hands, no
form of cost recovery deductions applies, so the taxpayer must wait until a sale or other
disposition of the asset in order to claim the benefit of the added basis.
2. Wear and Tear—A taxpayer need not prove the estimated useful life of a tangible asset in
order to claim depreciation deductions. Indeed, there is not even a requirement that the value
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order to claim depreciation deductions. Indeed, there is not even a requirement that the value
of the asset decline over time. It is sufficient that the asset is subject to wear and tear given the
taxpayer’s use of the asset. Simon v. Commissioner, 68 F.3d 41 (2d Cir. 1995).
3. Used for Business or Investment—Does the taxpayer use the property in a business activity or
hold it for the production of income?
a. Yes—If yes, then the asset is eligible for depreciation deductions. The method for
computing depreciation deductions is described generally in Part D(3).
b. No—If no, then the tangible property is not eligible for depreciation deductions or any
other form of cost recovery. The taxpayer simply sits on the capitalized cost and waits
for a sale or other disposition of the property.
c. Mixed Personal Use—If the asset is held both for business and personal purposes (or both for
investment and personal use), then only a portion of the asset may be depreciable. For instance, if a
taxpayer owns a vehicle that is used 80 percent of the time in the taxpayer’s business and 20 percent
of time for the taxpayer’s personal pursuits, then the taxpayer can depreciation 80 percent of the cost
of the vehicle.
3. Mechanics of Depreciation—This Part D(3) only explains how depreciation deductions are
computed. It does not provide a checklist for computing the depreciation deductions with respect to
any particular asset. If your instructor expects you to be able to perform these computations, be sure
to work out your own flow chart or checklist for this purpose.
a. Depreciation Base—The taxpayer is entitled to depreciate his or her entire cost basis in the
asset; there is no reduction for the asset’s “salvage value” (what the asset can be sold for at the
end of its estimated useful life). IRC § 167(c)(1).
b. Depreciation Method—Assuming there is still some basis left to recover after the application
of the IRC § 168(k) bonus depreciation election, the taxpayer must determine the “applicable
depreciation method.” IRC § 168(b). Generally, unless the taxpayer elects or is required to use
the “straight-line method” (where the cost is recovered ratably over the asset’s recovery
period), the applicable depreciation method is the “double-declining balance method.” Under
this method, a taxpayer each year deducts a portion of the asset’s adjusted basis equal to twice
the percentage that would apply to the original cost if the straight-line method were used. IRC
§ 168(b)(1)(A). For example, a taxpayer using the double-declining balance method to
depreciate an asset with a five-year recovery period would deduct 40 percent of the asset’s
adjusted basis each year (40 percent is double the 20 percent that would be used if the taxpayer
depreciated the original cost of the asset over its five-year recovery period). Importantly, the
double-declining balance method switches over to the straight-line method in the first year in
which the taxpayer would have a larger deduction if he or she used the straight-line method for
the adjusted basis over the asset’s remaining recovery period. IRC § 168(b)(1)(B). This
conversion to the straight-line method enables the taxpayer to recover the entirety of the asset’s
basis. Note that the double-declining balance method is not available for depreciable real
property; these assets must be depreciated on a straight-line basis. IRC § 168(b)(3).
d. Recovery Period—The recovery period is the number of years over which depreciation
deductions with respect to the property will be claimed. While it is intended to be a rough
approximation of the asset’s estimated useful life, the applicable recovery period is determined
by reference to a table that generally provides for accelerated recovery periods. Property is
assigned to a recovery period under IRC § 168(c) based on its classification in IRC § 168(e).
Classification, in turn, often depends on the asset’s “class life,” another arbitrary estimation of
an asset’s estimated useful life provided in official pronouncements of the Internal Revenue
Service.
e. Convention—Most property is depreciated using the “half-year convention.” IRC § 168(d)(1).
The half-year convention is an assumption that the asset is first placed in service at the
midpoint of the taxable year. IRC § 168(d)(4)(A). In other words, the first year’s depreciation
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midpoint of the taxable year. IRC § 168(d)(4)(A). In other words, the first year’s depreciation
deduction with respect to any asset placed in service during the taxable year is equal to half of
a full-year’s deduction amount. The half-year convention relieves the taxpayer from having to
compute a more complicated fraction based on the exact number of days the property was in
service during its first year. The same convention applies if the depreciable asset is sold before
the end of the recovery period; regardless of when a taxpayer disposes of the asset, he or she
may claim a deduction equal to half of the amount that would be allowed if the asset were held
for the entire year. A mid-month convention applies in the case of depreciable real property.
IRC § 168(d)(2). If the taxpayer acquires more than 40 percent of his or her depreciable
property during the last three months of the year, a special mid-quarter convention applies
instead of the half-year convention. IRC § 168(d)(3)(A).
AMORTIZATION DEDUCTIONS
Just as IRC § 168 depreciation is the general cost recovery regime for tangible assets subject to wear
and tear, IRC § 197 amortization is the general cost recovery regime for intangible assets.
1. IRC § 197 Intangible—Is the property to which a capitalized cost relates a “IRC § 197
intangible?”
a. Definition—IRC § 197(d)(1) provides that a “IRC § 197 intangible” means any of the
following:
a. (1) goodwill; (2) going concern value; (3) workforce in place (including its composition
and the terms of any employment agreements); (4) business books and records and other
information bases; (5) a patent, copyright, formula, process, design, pattern, knowhow,
format or similar item of intellectual property; (6) a customer-based intangible (market
share, market makeup, and similar value from providing future goods or services to
customers in the ordinary course of business); (7) a supplier-based intangible (value from
certain relationships with suppliers); (8) a license, permit or other right granted by a
governmental unit or agency; (9) a covenant not to compete entered into in connection
with the acquisition of a trade or business or an interest in a trade or business; and (10)
any franchise, trademark, or trade name.
No—If no, then the asset is not subject to IRC § 197 amortization. Unless the asset
is an intangible asset eligible for depreciation under IRC § 167(f) or Treas. Reg. §
1.167–3, there is no cost recovery for the asset. Instead, the taxpayer will claim the
benefit of the capitalized cost when the intangible asset is sold or otherwise
disposed of by the taxpayer.
2. Not Excepted Out—Is the property expressly excluded from the definition of a “IRC § 197
intangible?”
a. Exceptions—IRC § 197(e) provides that the term “IRC § 197 intangible” does not include any
of the following (this is not a complete list, but it covers most of the exceptions):
a. (1) interests in corporations, partnerships, estates, or trusts; (2) interests under existing
futures contracts, foreign currency contracts, notional principal contracts, or similar
financial contracts; (3) any interests in land; (4) any readily available computer software
(although such software is eligible for depreciation under IRC § 167(f)); (5) any other
software not acquired as part of the acquisition of a trade or business; (5) interests in
films, sound recordings, video tapes, books, or similar property not acquired as part of
the acquisition of a trade or business; (6) rights to tangible property or services under a
government contract not acquired as part of the acquisition of a trade or business; (7)
interests in patents or copyrights not acquired as part of the acquisition of a trade or
business; (8) rights in certain government contracts lasting less than 15 years and not
acquired as part of the acquisition of a trade or business; (9) interests under existing
leases of tangible property; (10) interests under any existing debt instrument; and (11)
professional sports franchises
i. Yes—If yes, then the asset is not subject to IRC § 197 amortization. Unless the
asset is an intangible asset eligible for depreciation under IRC § 167(f) or Treas.
Reg. § 1.167–3, there is no cost recovery for the asset. Instead, the taxpayer will
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Reg. § 1.167–3, there is no cost recovery for the asset. Instead, the taxpayer will
claim the benefit of the capitalized cost when the intangible asset is sold or
otherwise disposed of by the taxpayer.
4. Not Self–Created—Is the IRC § 197 intangible any of the following: self-created goodwill; selfcreated going concern value; self-created workforce in place (including its composition and the terms
of any employment agreements); self-created business books and records and other information
bases; self-created patents, copyrights, formulas, processes, designs, patterns, knowhow, formats or
similar items of intellectual property; self-created customer-based intangibles (market share, market
makeup, and similar value from providing future goods or services to customers in the ordinary
course of business); or self-created supplier-based intangibles (value from certain relationships with
suppliers)?
a. Yes—If yes, then the asset is not subject to IRC § 197 amortization unless it was created in
connection with an asset acquisition transaction (one involving the acquisition of assets
constituting a trade or business). Unless the asset is an intangible asset eligible for depreciation
under IRC § 167(f) or Treas. Reg. § 1.167–3, there is no cost recovery for the asset. Instead, the
taxpayer will claim the benefit of the capitalized cost when the intangible asset is sold or
otherwise disposed of by the taxpayer.
b. No—If no, then the asset is an “amortizable IRC § 197 intangible.” IRC § 197(c). IRC § 197
will apply to this asset; in fact, it represents the exclusive form of cost recovery for this asset.
IRC § 197(b). Continue in this Part E of the checklist.
5. 15–Year Amortization—The taxpayer can amortize an amortizable IRC § 197 intangible over a
15–year period beginning with the month in which the asset is acquired. IRC § 197(a). The taxpayer
therefore divides the asset’s adjusted basis by 180 to determine the monthly amortization deduction
amount. Treas. Reg. § 1.197–2(f)(1).
V.DEDUCTION FOR QUALIFIED BUSINESS INCOME
Section 199A allows a business owner to deduct 20% of their qualified business income when their
taxable income is below a threshold amount. The deduction is phased-out over the next $50,000
(single) or $100,000 (married) with complex rules.
A. Businesses below the threshold amount: For a sole proprietor or an independent contractor
whose taxable income from the business for the tax year does not exceed the threshold amount
(defined in 2018 as $157,500 for singles and $315,000 for joint filers), the §199A calculation is
not subject to any special rules or limitation other than the requirement that the bona fide trade
or business income be from a qualified trade or business and not be disguised wages.
B. Businesses in the phaseout level: Several restrictions apply to businesses in the phaseout level:
(1) the business may not be a “specified service business,” and (2) the rules require either that
the business pay a specified amount of W2 wages (generally twice the amount of the claimed
deduction) or that it have a specified amount of investments in depreciable property (generally
an original cost equal to 40 times the amount of the annual deduction.)
a. Specified service business: A specified service business involves the performance of
services in the fields like health, law, accounting, actuarial science, performing arts,
consulting, athletics, financial services, brokerage services including investing and
investment management, trading, or dealing in securities, partnership interest, or
commodities. Engineering and architecture services are specifically excluded from this
definition. However, a service business does not include any trade or business where the
“principal asset of such trade or business is the reputation or skill” of the owner or of one
more of its employees.
b. Deduction amount: The deductible amount is generally the lesser of (1) 20% of the
taxpayer’s qualified business income from the trade or business, or (2) a W-2
wages/qualified property limit, which is the greater of (a) 50% of the W2 wages or (b)
the sum of 25% of the W2-wages plus 2.5% of the unadjusted basis immediately after
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the sum of 25% of the W2-wages plus 2.5% of the unadjusted basis immediately after
acquisition of all qualified property.
c. Phaseout rule: The deduction is phased out for those businesses with over $50,000
(single) and $100,000 (married filing jointly) of the threshold amount. The phaseout is
accomplished by only taking into account the applicable percentage of the qualified items
of income, gain, deduction or loss—and the W2 wages and qualified property—in
calculating the deductible amount
d. Businesses ineligible for the deduction: Those sole proprietors or independent
contractors whose taxable income (in 2018) from their business exceeds $207,500 (if
single) and $415,000 (if married filing jointly) will be ineligible to receive a §199A
deduction.
VI.ACTIVITIES ENGAGED IN FOR PROFIT THAT ARE NOT TRADES OR BUSINESSES
A taxpayer who owns rental property, or property that generates royalties, probably is not engaged
in a trade or business. Nevertheless, the taxpayer may deduct the ordinary and necessary expenses
incurred to generate this income and may depreciate or amortize assets that are subject to periodic
capital recovery.
A. Investment activities: The expenses of carrying on investment activities, like safety deposit
box fees or subscriptions to investment publications, are not deductible as these are disallowed
miscellaneous itemized deductions under §67. However, interest incurred to purchase
investments is deductible to the extent of investment income (as these are allowed
miscellaneous itemized deductions.) Some investment expenses, such as commissions on the
purchase of stock, must be capitalized.
B. Passive activities: A taxpayer that holds real or personal property for rental is entitled to
deduct the expenses of that property, including interest, taxes, repairs, and the usual
deductions for capital recovery. A taxpayer that actively participates in the rental activity and
has limited AGI, may be able to take $25,000 as an allowed loss deduction that can offset
other income.
VII.SUBSTANTIATION
A taxpayer must be able to substantiate his or her deductions.
MIXED BUSINESS AND PERSONAL EXPENSES
I. IN GENERAL
Business expenses are usually deductible, while personal expenses are not. Some expenses, however,
have a mixed character. They are connected to the taxpayer’s business but also have a connection to
his or her personal life. This mixed character raises questions about their deductibility. The Code
takes a variety of approaches to these types of expenses. After the Tax Cuts and Jobs Act of 2017, an
employee will not be able to deduct business expenses unless reimbursed by his or her employer.
III. TRAVEL
A taxpayer’s expenses while traveling away from the taxpayer’s tax home primarily for business are
deductible. Commuting expenses are not deductible. A taxpayer’s tax home is the taxpayer’s
principal place of business or the taxpayer’s primary abode in a real sense. See Rosenspan v. United
States, 438 F.2d 905 (2d Cir. 1971), cert. denied, 404 U.S. 864.
IV. CLOTHING
A taxpayer may deduct the cost of special clothing, such as a uniform, that is required for his or her
job or business. But the cost of clothing that can be worn for regular purposes is not deductible.
- Under general tax principles, the value of employer-provided clothing is a taxable benefit
unless the clothing qualifies for an exclusion. Sometimes individual items of clothing, like Tshirts, can be excluded as de minimis fringe benefits, but that exclusion is unlikely to apply
when a uniform is provided to a readily identifiable group of employees.
- A more likely basis for exclusion in your situation is the working condition fringe benefit
exclusion under Code § 132(a)(3), which allows an employer to provide property or services to
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exclusion under Code § 132(a)(3), which allows an employer to provide property or services to
employees on a nontaxable basis if the expenses would qualify for a business expense
deduction (under Code § 162) if the employees paid for them. Whether your company’s
uniforms will qualify for that exclusion is uncertain based on the facts you’ve provided.
- Code § 162 generally allows a deduction for “ordinary and necessary expenses paid or
incurred…in carrying on any trade or business.” Required clothing might seem to fit that
description, but the deductibility issue for clothing is complicated by another Code provision,
Code § 262, which bars any deduction for “personal, living, or family expenses.” T
- CODE RULE: permitting deductibility, and thus a potential working condition fringe benefit
exclusion, for clothing provided in-kind if the clothes:
○ (1) are specifically required to be worn as a condition of employment and
○ (2) are not “adaptable to street wear" i.e. not suits; and
 Adaptability for personal or general use is judged objectively. Further, the clothes
will not be deductible simply because: they have company logos or the employer
prohibits wearing the clothing away from work. There must be something about
the clothes that makes them unsuitable for everyday use.
○ (3) not so worn (subjective aspect). Sometimes, the second part of the rule is said to
require clothing that is not “adaptable to street wear.”
V. EDUCATION EXPENSES
A taxpayer may deduct the cost of education that improves his or her skills in the taxpayer’s current
trade or business, or is required as a condition of remaining licensed in that business. Education that
prepares a taxpayer for a new trade or business is not deductible.
VI. MEALS AND ENTERTAINMENT
On Sept. 30, 2020, the IRS issued final regulations that provide guidance for meal and entertainment
deductions under section 274 of the Internal Revenue Code. The following is a general summary of
the final regulations
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Documenting Expenses:
- In order to deduct business meal expenses, the expense must be directly related to, or
associated with the active conduct of a trade or business, or for the production or collection of
income.
- A deductible expenditure is incurred in carrying on business.
- The repeal for entertainment expense deductions will also eliminate the deduction for meals, if
the meal is entertainment related, and business is not conducted.
- Documentation is still required so that a taxpayer can prove:
○ The amount of the expenditure, the time, date and place of the expenditure
○ The purpose of the business discussion.
○ The identification of the people who participated.
Because entertainment-related meals are now treated differently from client business meals, it may
be necessary to establish new documentation procedures or information management systems in
order to account for each separate category of meals.
- Client business meals are deductible only if they are not lavish or extravagant, and only if the
taxpayer is present with the client.
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taxpayer is present with the client.
- Because a deduction for an entertainment expenditure is now denied, it will be necessary to
cause the activity at which the meal expense is incurred to not be entertainment related.
○ For instance, it is necessary to conduct business with the client to be otherwise
deductible, and the presence of substantial distractions might inhibit the business
argument (e.g., meals expenses at night clubs, cocktail lounges, theaters, country clubs,
golf and athletic clubs, sporting events, and on hunting, fishing, vacation and similar
trips.)
50% Deductible:The following expenses remain deductible subject to the 50% limit:
- Meal expenses for business meetings of employees, stockholders, agents, and directors.
○ Office meetings and partner meetings fall into this category.
○ If there is no business function to the meal, it is completely non-deductible for tax
purposes.
- Generally, any meals during business travel.
○ If a portion of a business trip can be considered personal and not related to the business
function of the trip, then a portion of the meals expense should also be considered
personal and not deductible.
- Meals at a convention, seminar, or any type of meeting
- Meals with people related to the business such as clients, customers and vendors provided that:
○ there is a business purpose or some benefit to the business will result
○ the taxpayer is present
○ and the amount is not lavish or extravagant.
100% Deductible
- Meal expenses for a company picnic or holiday party.
- Food made available to the public for free – usually as part of a promotional campaign.
- If the meals expense is included as taxable compensation to the employee or independent
contractor, then the expense is fully deductible to the employer.
- Meals expenses that are sold to a client or customer.
Nondeductible Items:
Some business expenses remain nondeductible and need to be categorized as such. Examples
include:
- Lunch with customer, client or employee without a business purpose/discussion
- Club dues; for example, country clubs, golf and athletic clubs
- Lavish or extravagant entertainment expenses
- Entertainment expenses are now non-deductible as are meals associated with entertainment
activities.
- Expenses incurred at a club organized for business, pleasure, recreation, or other social
purposes are now non-deductible as well, even if related to an active trade or business
VII. HOME OFFICES AND VACATION HOMES—§280A
When a taxpayer uses a portion of his or her residence as an office or rents out a vacation home
while still using it for part of the year for personal purposes, an allocation must be made between
deductible (business) and nondeductible (personal) expenses associated with use of the residence.
A. Home offices: In order to deduct any expenses attributable to a home office, the taxpayer must
use the office as the principal place of business, or as a place where the taxpayer regularly
meets with patients, clients, or customers. In order for an employee to qualify for this
deduction, he or she must exclusively use the home office for the “convenience of the
employer.” Even then, if the employee is not reimbursed for this expense, then no deduction is
allowed, as these expenses will be miscellaneous itemized deductions under §67.
a. Restriction on deductions: If the taxpayer meets this test, a portion of the expenses
allocable to the business activity may be deducted, or a safe harbor amount is allowed,
but not in excess of the gross income from the business.
b. Remember §121: Section 121 allows a taxpayer to exclude from gross income some or
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b. Remember §121: Section 121 allows a taxpayer to exclude from gross income some or
all of the gain on the sale of a principal residence. This exclusion does not apply to
deductions previously claimed for depreciation on a home. Thus, taxpayers must
carefully consider whether it is worthwhile to claim the home office deduction.
IX. HOBBY LOSSES—§183
A taxpayer who has no profit motive for an activity may deduct only the expenses associated with
the activity to the extent that such expenses are above-the-line deductions under the Code (such as
those for the production of rents or royalties) or are deductions allowed without regard to a profit
motive, (such as mortgage interest or real estate taxes) but only to the extent that these expenses do
not exceed the amount of the gross income from the activity. Finally, any miscellaneous itemized
deductions related to the hobby under §67 will be denied.
A. Existence of profit motive—Treas. Reg. §1.183-2: Whether a taxpayer has engaged in an
activity for profit is to be determined from all of the facts and circumstances of the situation.
The regulations offer nine factors indicative of a profit motive.
B. Exception—§183(d): If an activity produces income in three out of the five consecutive years
ending in the year in question, it is rebuttably presumed to be engaged in for profit
.
X.GAMBLING LOSSES—§165(d):
Gambling losses (including travel and other trade or business type expenses) are deductible only to
the extent of gains from gambling.
TRANSACTIONS IN PROPERTY
Upon any sale or other disposition of property, IRC § 1001(a) applies a formula to determine
whether the taxpayer realizes a gain or loss. Under this formula, gain is the excess of the amount
realized over the adjusted basis for determining gain, and loss is the excess of the adjusted basis for
determining loss over the amount realized. IRC § 1001(a) can be expressed in formula form for
convenience:
Amount Realized
-Adjusted Basis
REALIZED GAIN
Adjusted Basis
-Amount Realized
REALIZED LOSS
Although the statute does not use the terms “realized gain” and “realized loss,” the regulations do.
See Treas. Reg. § 1.1001–1(a).
The “amount realized” by a taxpayer is the sum of any money received plus the fair market value of
property (other than money) received. IRC § 1001(b). The taxpayer’s “adjusted basis” in the
property disposed of is “the basis (determined under section 1012 or other applicable sections of this
subchapter …), adjusted as provided in section 1016.” IRC § 1011. So one must determine the
“basis” of property under IRC § 1012 and then determine whether that basis is subject to any of the
adjustments listed in IRC § 1016.
IRC § 1012 generally defines basis as “cost.” And IRC § 1016(a) lists no less than 28 possible
adjustments to basis. Generally, a taxpayer increases basis by the cost of any improvements made to
the property, and decreases basis by the amount of any depreciation deductions that are claimed
with respect to the property.
Under IRC § 1001(c), “the entire amount of the gain or loss, determined under this section, on the
sale or exchange of property shall be recognized.” In the case of realized gains, this means the
realized gain is included in gross income. In the case of realized losses, it means the realized loss is
deductible. But IRC § 1001(c)’s rule of recognition expressly takes a back seat to other Code
provisions that provide otherwise. Thus, for example, if another Code provision states that gain shall
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provisions that provide otherwise. Thus, for example, if another Code provision states that gain shall
not be recognized upon a particular transaction, that Code provision outweighs IRC § 1001(c)’s
general rule of recognition.
In the case of losses, IRC § 165(c) imposes such a significant exception to the rule of recognition that
it is fair to conclude that the general rule is one of disallowance instead of recognition. IRC § 165(c)
limits loss deductions for individuals to three types of losses: business losses, investment losses, and
casualty or theft losses of personal-use assets.
A. REALIZATION EVENT
The framework set forth beginning in Part B of this checklist applies only if there has been a
realization event. In many cases, it is easy to determine whether a realization event has occurred.
Three common realization events are identified below. If there is a transaction involving the
taxpayer’s property that does not come within one of these three realization events, it may well be
the case that no taxable event has occurred.
1. Sale or Exchange—Did the taxpayer sell or exchange an interest in property? This is the most
common form of realization event and the easiest to identify. A sale or exchange involves a
disposition whereby the taxpayer transfers the property interest to another party and receives back
cash or some other property interest.
2.
Other Non–Gift Disposition—Did the taxpayer dispose of the property other than by a gift?
Common Dispositions—A sale or exchange is not required for realization to occur.
Realization can occur through other dispositions of property interests, including the
involuntary conversion of property (whether because of damage, theft, bankruptcy, requisition,
or condemnation), or abandonment of the property, for example.
3. Gifts are Not Realization Events—Taxpayers often dispose of their property interests through
inter-vivos gifts and testamentary bequests. Theoretically, perhaps, gifts of property should be
realization events in the sense that the donor receives the benefit of the property’s value by
gifting it to his or her selected donee. A gift of raw land, for example, may bring the same
satisfaction to the donor as if the donor sold the property for cash (a clear realization event)
and then gifted the cash to the donee. Yet it is well accepted that a gift of property is not a
realization event for federal income tax purposes. Instead, any lurking gain in the donor’s
hands (but generally not lurking loss) will pass to the donee.
3. Satisfaction of Obligation—Did the taxpayer transfer the property in satisfaction of an
enforceable obligation?
Yes—If yes, a realization event has occurred. The Supreme Court confirmed this result in
United States v. Davis, 370 U.S. 65 (1962), holding that the transfer of appreciated stock to a
taxpayer’s former spouse pursuant to a property settlement agreement results in realized gain.
The specific result in Davis (that property transfers incident to a divorce could be taxable) was
overturned by Congress through the enactment of IRC § 1041(a), but the general principle—
that the transfer of appreciated property in satisfaction of an enforceable obligation gives rise to
gain—remains good law. Thus, for example, where an employer transfers appreciated property
to an employee as compensation for services, the employer realizes gain.
B. AMOUNT REALIZED
Because IRC § 1001(b) defines the “amount realized” as the sum of any cash received and the fair
market value of any property received, one must always take into account all of the cash and noncash consideration received by the taxpayer.
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1.
Cash—Did the taxpayer receive cash in exchange for the disposed property?
2.
Non–Cash Property—Did the taxpayer received property other than cash in the exchange?
Yes—If yes, then include the fair market value of such property in the taxpayer’s amount
realized. Continue in this Part B to see if there is more to the amount realized.
Fair Market Value—The fair market value of any property is the price at which such
property would trade between a willing buyer and a willing seller, both having
knowledge of all material facts and neither acting under compulsion to buy or sell. Treas.
Reg. § 20.2031–1(b). In many cases it is easy to determine the fair market value of an
asset. The value of publicly-traded stock, for example, is the average of the stock’s
highest and lowest trading prices on the day of the sale (or on the day closest to the sale if
the sale occurs on a day when the markets are closed). Other assets, like real estate, can
often be valued by a professional appraiser.
Hard-to-Value Assets—If the property received by the taxpayer is particularly hard to value
for whatever reason, one can look to the value of the property transferred assuming the
transaction occurs at arm’s-length. Philadelphia Park Amusement Company v. United
States, 126 F.Supp. 184 (Ct. Cl. 1954). In the Philadelphia Park case, for example, the
court indicated that if the taxpayer could not value the property it received in the
exchange (an extension of a railway franchise), it could assume that the value of the
property received is equal to the value of the property the taxpayer gave up (a bridge)
because the facts indicated that the transaction was at arm’s-length (a negotiated
transaction between unrelated parties, in this case).
3. Debt Relief—Did the taxpayer dispose of property encumbered by one or more liabilities for
which the other party directly or indirectly became responsible?
a. If yes, then the amount realized by the taxpayer includes the outstanding balance of such
liabilities as of the date of the transfer. Treas. Reg. § 1.1001–2(a)(1); Commissioner v.
Tufts, 461 U.S. 300 (1983). For this purpose, it does not matter whether the other party
formally assumes the debt encumbering the property transferred by the taxpayer (i.e., the
other party becomes the obligor on the debt and the lender discharges the taxpayer from
any further liability on the debt) or simply takes the property subject to the debt (i.e., the
other party does not become the obligor and the taxpayer is not discharged, but the other
party may still lose the property if the debt is not repaid because the property remains
collateral for the debt). Add up all components of the taxpayer’s amount realized in this
Part B and proceed to Part C of this checklist
i. Assumption of Debt—Where the other party formally assumes the debt, it is like
the other party gives the taxpayer cash in an amount equal to the debt which the
taxpayer uses to discharge the taxpayer’s liability. In this latter case, the receipt of
additional cash would clearly add to the taxpayer’s amount realized. Accordingly,
the economic equivalent—the other part assuming liability for the debt—must be
treated like additional cash received by the taxpayer.
i. Transfers Subject to Debt—Likewise, when the other party takes the property
subject to the liability there is a benefit to the taxpayer because the taxpayer no
longer has the risk of losing that particular property if the debt is not repaid.
Functionally that is the same as formally relieving the taxpayer of the liability,
especially where the value of the transferred property exceed the outstanding
balance of the debt.
a. No—If no, then there is no additional component to the taxpayer’s amount realized.
Add up the other components to the taxpayer’s amount realized in this Part B and
proceed to Part C of this checklist.
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C. ADJUSTED BASIS
IRC § 1001(a) defines gain or loss the difference between the taxpayer’s amount realized and the
taxpayer’s adjusted basis in the property transferred. IRC § 1011(a), in turn, defines adjusted basis as
the taxpayer’s “basis” as “adjusted” under other Code provisions. Accordingly, one begins by
computing the taxpayer’s basis and then determining whether any adjustments are required.
1.
Cost—What cost did the taxpayer incur to acquire the property?
a. General Cost—IRC § 1012 defines a taxpayer’s basis as his or her “cost” to acquire the
property. Thus, where a taxpayer pays $1,000 to purchase an asset, the taxpayer has a
cost basis of $1,000
b. Tax Cost—If the taxpayer realizes a gain in the course of acquiring property, such gain is
considered part of the cost of acquiring the property. Philadelphia Park Amusement
Company v. United States, 126 F.Supp. 184 (Ct. Cl. 1954). This “tax cost” (realization
of gain) is thus added to the taxpayer’s basis in the property. For example, if a taxpayer
purchases a $10,000 piano by transferring $10,000 worth of Microsoft stock in which the
taxpayer has a basis of $3,000, the taxpayer will realize and recognize a gain of $7,000.
Thus, the taxpayer’s cost basis in the piano is $10,000: in order to acquire the piano, the
taxpayer transferred an asset that cost $3,000 and incurred a $7,000 gain.
2. Impact of Debt—If the taxpayer takes on debt to acquire the property, the amount of the debt
is part of the taxpayer’s cost basis. Crane v. Commissioner, 331 U.S. 1 (1947). This can occur
in several different contexts:
a. Taxpayer Liable to Seller—If the taxpayer pays for the property by giving a promissory
note to the seller, the taxpayer’s cost basis includes the principal amount of the note.
This is because the taxpayer agrees to the obligation to pay the principal amount of the
note to the seller, and is thus part of the cost to acquire the property.
b. Taxpayer Assumes Seller’s Liability—If the taxpayer agrees to assume a debt of the seller
that encumbers the property, the taxpayer certainly incurs an additional cost by agreeing
to pay off the seller’s debt.
c. Taxpayer Takes Seller’s Property Subject to Liability—If the taxpayer takes the property
subject to a debt of the seller, the taxpayer incurs the risk of losing the property if the debt
is not repaid. As explained in Part B, this is the equivalent of paying additional cash to
the seller, so necessarily it is likewise seen as an additional cost incurred by the taxpayer
d. Taxpayer Borrows to Purchase from Seller—If the taxpayer borrows money from a thirdparty lender and uses the cash to pay the seller for the property, the taxpayer’s obligation
to repay the lender is a cost incurred to acquire the property so the loaned monies are
considered part of the taxpayer’s basis in the property.
3. Gifted Property Generally—A taxpayer acquiring property by gift by definition has incurred
no cost. But IRC § 1015(a) provides that for purposes of computing realized gain, the taxpayer
takes the donor’s basis in the gifted property. If, at the time of the gift, the fair market value of
the property was less than the donor’s basis in the property, then the taxpayer’s basis in the
property is equal to such fair market value but only for purposes of computing the amount of
any realized loss. Note that if the donor pays federal gift taxes as a result of the gift, the
taxpayer is permitted to add a portion of such gift tax paid to the taxpayer’s basis in the
property. IRC § 1015(d)(1), (6). The addition to basis can be expressed in formula form as
follows:
a. Property Acquired in Part–Gift, Part–Sale Transaction—If the taxpayer acquired the
property in a part-gift, part-sale transaction (the taxpayer purchased the property for less
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property in a part-gift, part-sale transaction (the taxpayer purchased the property for less
than its value at the time of the purchase and the reason for the discount was because of
the seller’s detached and disinterested generosity), then the taxpayer’s basis in the
property is either the amount paid for the property or the seller’s basis in the property,
whichever is greater. Treas. Reg. § 1.1015–4.
b. Property Passing from a Decedent—If the property passed to the taxpayer from a
decedent, the taxpayer’s basis in the property is its fair market value at the date of the
decedent’s death. IRC § 1014(a)(1). This is often referred to as a “stepped-up” basis, but
that phrase is somewhat misleading because sometimes the value of property at a
decedent’s death is less than the decedent’s basis. Property is considered to have passed
from a decedent if it meets any of the conditions set forth in IRC § 1014(b). These
include: acquiring the property by bequest, devise, or inheritance; receiving the property
from a revocable living trust created by the decedent during the decedent’s lifetime;
acquiring the property through the decedent’s exercise of a testamentary power of
appointment; and any property included in the decedent’s gross estate for federal estate
tax purposes. Note, too, that surviving spouses in community property states enjoy a
nice bonus: not only does the decedent’s one-half share of community property get a
stepped-up basis but so too does the surviving spouse’s one-half share. IRC § 1014(b)(6).
2. Adjustments to Basis—Are there any adjustments to the taxpayer’s cost basis? IRC § 1016(a)
lists all of the adjustments to basis, but two such adjustments are especially common:
a. Increase Basis for Improvements—Under IRC § 1016(a)(1), a taxpayer’s basis is adjusted
upward (increased) by the cost of permanent improvements made to the property. For
example, if a taxpayer spends $10,000 for a station wagon and then spends another $7,000 to
make the wagon suitable as an ambulance, the taxpayer’s basis in the wagon-turnedambulance is $17,000: the taxpayer’s basis is increased by the $7,000 spent to make
improvements to the property.
b. Decrease Basis for Depreciation Deductions—Under § 1016(a)(2), the taxpayer’s basis in
property is adjusted downward (decreased) by depreciation deductions.
i. Property Must be Depreciable—This adjustment only applies in the case of tangible
property and buildings subject to wear and tear and used for business or investment
purposes. See Chapter 4.
ii. Greater of Amount Allowed or Allowable—The flush language to IRC § 1016(a)(2)
requires that the reduction in basis for depreciation be the greater of the amount allowed
as a deduction (i.e., the amount actually claimed on the taxpayer’s return and
unchallenged by the Internal Revenue Service) and the amount allowable as a deduction
(i.e., the proper amount of depreciation to which the taxpayer was entitled to claim as a
deduction).
i. For example, assume a taxpayer with an asset costing $100,000 is entitled to claim
a $10,000 depreciation deduction with respect to the asset in the first year of
ownership but, for whatever reason, only claims a $2,000 deduction on the
taxpayer’s tax return that year. The taxpayer’s adjusted basis in the asset is
$90,000: the $100,000 original cost less the $10,000 amount allowable as a
depreciation deduction. If instead, for whatever reason, the taxpayer claims a
$13,000 deduction that year and the Service does not challenge the deduction
within the applicable statute of limitations, then the taxpayer’s asset as of the end
of the first year would be $87,000: $100,000 less the $13,000 allowed as a
deduction.
D. REALIZED GAIN OR LOSS
1. Realized Gain—Does the amount realized (Part B) exceed the taxpayer’s adjusted basis (Part
C)?
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C)?
a. Yes—If yes, there is a realized gain. IRC § 1001(c) generally provides that all realized gains are
“recognized,” meaning they are included in gross income. Realized gains are not recognized
only to the extent some other Code provision expressly provides for nonrecognition.
b. Character of Recognized Gain—If all or any portion of the realized gain is recognized, the
character or flavor of the gain becomes relevant. Items of ordinary income will be taxed at the
progressive tax rates set forth in § 1(a)–(d), but a taxpayer’s net capital gain will be taxed at a
preferential rate as set forth in § 1(h).
2. Realized Loss—Does the taxpayer’s adjusted basis (Part C) exceed the amount realized (Part
B)?
a. Yes—If yes, there is a realized loss. IRC § 165(a) permits a deduction for losses that are
“sustained” during the taxable year. This means that there has been a “closed and completed
[transaction], fixed by identifiable events.” Treas. Reg. § 1.165–1(b). The realization events
described in Part A of this checklist typically fix the loss for purposes of IRC § 165(a) so it is
not usually an issue in this context. The mere decline in value in an asset is not a realization
event; likewise, no loss is “sustained” merely because of a reduction in value.
Deductible Losses for Individuals—IRC § 165(c) imposes an additional limitation on
the deductibility of losses by individual taxpayers. It provides that an individual taxpayer
can only deduct three kinds of realized losses. First, a taxpayer can deduct losses
incurred in a trade or business activity. IRC § 165(c)(1). So when a taxpayer sells an item
of inventory to a customer at a loss, the realized loss is deductible. Second, a taxpayer
can deduct losses incurred in a transaction entered into for profit even if it is not related
to the taxpayer’s business. IRC § 165(c)(2). So when a taxpayer sells an asset held for
investment purposes (like stocks and bonds, raw land, or a collectible) at a loss, the
realized loss is deductible. Finally, an individual taxpayer can deduct losses not
connected with a business activity or a transaction entered into for profit only if the
losses result from “fire, storm, shipwreck, or other casualty, or from theft.” IRC § 165(c)
(3). Thus, for example, if a taxpayer sells his or her personal residence at a loss, the loss
is not deductible because it is not described in IRC § 165(c).
Other Loss Limitations—Assuming the realized loss fits within IRC § 165(c), the loss
will be deductible unless some other Code provision disallows the deduction. Common
examples of losses that are disallowed even though these pass muster under IRC § 165(c)
are losses from transactions between related parties (IRC § 267), losses from so-called
“wash sales,” (IRC § 1091), and passive activity losses (IRC § 469). These and other
limitations on the deductibility of losses are discussed in Chapter 8.
Special Rule for Worthless Securities—IRC § 165(g)(1) permits a loss deduction when
securities have become “worthless,” meaning that they have completely lost value based
on all the facts and circumstances. Boehm v. Commissioner, 326 U.S. 287 (1945). Such
loss is deemed to arise from the sale or exchange of a capital asset, meaning the
deductible loss will be either a short-term capital loss (if the securities were held for one
year or less) or a longterm capital loss (if the securities were held for more than one
year). For purposes of this special rule, “securities” generally consist of stocks and bonds;
a complete definition is provided in IRC § 165(g)(2).
Character of Deductible Loss—If a realized loss is recognized (i.e., it is described in IRC §
165(c) in the case of an individual taxpayer and it not otherwise disallowed), one must
determine the character of the loss. As explained in Chapter 9, ordinary losses offset all forms
of income but capital losses generally offset only capital gains plus up to $3,000 of ordinary
income.
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income.
I. SECTION 1001—IN GENERAL
Section 1001 defines realized gain or loss as the difference between the amount realized (what the
taxpayer receives in the transaction) and the taxpayer’s adjusted basis in the property transferred.
II. TRANSACTIONS IN PROPERTY
While most transactions in property are easy to identify—sales or trades of real estate, personal
property, or stocks—in some situations, it can be difficult to distinguish between sales of property
and acceleration of streams of ordinary income. Only the former potentially generates capital gain.
III. REALIZATION EVENT—§1001
A realization event occurs when a taxpayer exchanges property, receiving some materially different
item. A “materially different” item of property is one that bestows on a taxpayer a different legal
interest than what he or she had before. See Cottage Savings Ass’n v. Commissioner, 499 U.S. 554
(1991). Thus, all sales and most exchanges will be realization events. A gift is not a realization event
because there is no quid pro quo; compare a bargain sale, which is treated as part gift and part sale.
IV. REALIZED GAIN OR LOSS—§1001(a)
Realized gain or loss is equal to the difference between the amount realized on a sale or other
disposition of property and the adjusted basis of the property transferred.
A. Amount realized—§1001(b): A taxpayer’s amount realized on the sale or other disposition of
property is equal to the sum of the cash and fair market value of property or services received,
plus the amount of liabilities assumed by the other party to the transaction. The amount
realized can be adjusted for selling expenses (such as commissions), fixing-up expenses, and
closing costs.
B. Adjusted basis: The adjusted basis of property is equal to its initial basis adjusted upward for
improvements and downward for capital recovery (depreciation) deductions.
a. Basis—purchases—§1012: The basis of property is usually equal to its cost. If a taxpayer
performs services and receives property in payment, the amount the taxpayer includes in
gross income as payment will constitute the basis of the property.
b. Basis—other transactions: The basis of property received other than by purchase is
determined under specific Code sections.
i. Property received from a decedent—§1014: Property received from a decedent
takes a basis equal to its fair market value on the date of death.
ii. Property received by gift—§1015: If property is received by gift, the donee
generally takes the property with the same basis as the donor had in the property,
increased by a portion of any gift tax paid. If, at the time of the gift, the adjusted
basis of the property in the donor’s hands is greater than its fair market value, for
purposes of determining loss on sale or other disposition by the donee, the donee’s
basis is the fair market value of the property on the date of the gift.
iii. Property received in divorce—§1041(d): Property received incident to a divorce
has the same basis that it had immediately prior to the transfer.
V. RECOGNIZED GAIN OR LOSS—§1001(c)
Realized gain is recognized unless a specific Code section prohibits or limits recognition. Realized
loss is recognized if allowed by the Code. See, e.g., §165.
VI.TRANSFERS OF ENCUMBERED PROPERTY
A. Amount realized includes liabilities assumed: A taxpayer’s amount realized includes the face
amount of the liabilities that another party assumes as part of the transaction, regardless of the
fair market value of the property.
B. Recourse vs. nonrecourse loans: In the sale of property subject to a nonrecourse loan, the
greater of the fair market value of the property or the face amount of the loan minus the
taxpayer’s adjusted basis in the property produces the realized gain or loss on the transaction.
If the loan is recourse, however, the transaction is bifurcated: (1) gain or loss equal to the
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If the loan is recourse, however, the transaction is bifurcated: (1) gain or loss equal to the
difference between the fair market value of the property and the adjusted basis, and (2)
discharge of debt equal to the difference (if any) between the debt discharged and the fair
market value of the property.
C. Distressed real estate: Distressed real estate can produce several different kinds of
transactions: sale, foreclosure, “short sales,” and renegotiation with the lender. These can
produce very different tax consequences.
VII. BASIS OF PROPERTY RECEIVED IN THE SALE OR DISPOSITION
If the taxpayer sells property for cash, there is no need to determine the basis of the property received
(because cash neither appreciates nor depreciates in value, there is no need to assign cash a basis for
tax purposes). If, however, the taxpayer receives property in an exchange, the basis of that property
must be determined, for later the taxpayer may sell or otherwise dispose of the property.
A. Full-recognition transactions: In a transaction in which the selling taxpayer recognizes all
realized gain or loss, the property received will have a basis equal to its fair market value.
B. Nonrecognition transactions: In transactions in which the selling taxpayer does not recognize
all or part of the realized gain or loss, the property received will have a basis different than its
fair market value, determined under specific Code sections.
VIII. CHARACTER
The character of the gain or loss recognized will depend on the nature of the asset in the hands of the
transferor.
NONRECOGNITION TRANSACTIONS
I. IN GENERAL
In some property transactions, realized gain or loss is not recognized in whole or in part at the time
of the transaction. These transactions are called “nonrecognition transactions” and include like-kind
exchanges, involuntary conversions, divorce transactions, and other transactions. When realized
gain or loss is deferred rather than recognized, the property received in the transaction takes a basis
that preserves that realized gain or loss for later recognition.
Like-Kind Exchanges. If a taxpayer exchanges one asset for another asset that is of “like kind,” no
realized gain or loss is recognized. Any such gain or loss is generally preserved in the new asset by
giving the taxpayer a basis in the new asset equal to his or her basis in the property exchanged. A
“like-kind exchange” is any transaction where the properties exchanged have the same nature or
character.
As explained above, the principal justification for nonrecognition in a like-kind exchange is
that the taxpayer has not changed the substantive nature of his or her investment; instead, only
the exact form of the investment has changed. For instance, if a landlord swaps one apartment
building for another apartment building, one can justify nonrecognition on the grounds that
the landlord remains invested in rental real estate after the exchange. As long as any gain or
loss from the old property is carried over into the new property, there is no serious harm in
letting the landlord change the form of his or her investment. When one considers the breadth
of IRC § 1031(a), however, some of this justification is lost. A taxpayer can, for example, swap
an acre of farmland for a metropolitan apartment building and qualify for nonrecognition
under IRC § 1031(a).
IRC § 1031(a)(1) provides that if a taxpayer exchanges property held for business or investment
purposes solely for property “of like kind” that will be held for business or investment purposes, no
gain or loss is recognized. If a taxpayer receives both like-kind property and other property in the
exchange (cash or property not of like kind), IRC § 1031(b) states that the taxpayer must recognize
gain (but not loss) to the extent of the value of the other property.
If a transaction qualifies under IRC § 1031, the taxpayer will generally take a basis in the new
property that preserves any unrecognized gain or loss. The formula for computing the taxpayer’s
basis in the new property is set forth in the first sentence of IRC § 1031(d).
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basis in the new property is set forth in the first sentence of IRC § 1031(d).
II. LIKE-KIND EXCHANGES—§1031.
A. Requirements: There are five requirements for a qualifying like-kind exchange.
a. Exchange of property: The taxpayer must exchange property for property, rather than
selling property or engaging in some other transaction. See Jordan Marsh Co. v.
Commissioner, 269 F.2d 453 (2d Cir. 1959).
b. Nature of property—§1031(a)(2): The property must be real estate. It cannot be personal
property, such as equipment, nor inventory, stocks, bonds, notes, other evidences of
indebtedness, interests in a partnership, certificates of trust or beneficial interest, or
choses in action.
c. Property transferred—use: The taxpayer must have held the relinquished property for
use in a trade or business, or for investment.
d. Property received—use: The taxpayer must intend to hold the replacement property for
use in a trade or business, or for investment.
e. Like kind: The replacement property received must be like kind to the relinquished
property. “Like kind” refers to the nature and character of the property rather than to its
grade or quality. An exchange of real property for real property is a like-kind exchange
regardless of the development status of the two properties. Koch v. Commissioner , 71 T.C.
54 (1978).
B. Effect of qualifying like-kind exchange: If a taxpayer engages in a qualifying like-kind
exchange of property for property, he or she will not recognize any of the realized gain or loss
on the transaction.
a. Effect of boot—§1031(b): If the taxpayer receives boot (nonlike-kind property), the
taxpayer will recognize gain, but not loss, in the amount of the lesser of the fair market
value of the boot or the realized gain.
b. Basis of property received—§1031(d): The basis of like-kind property received in a likekind exchange is equal to the basis of the property transferred, plus the gain recognized,
minus the fair market value of the boot received, minus any loss recognized, plus any
boot paid (additional investment in the property). The basis of any boot (nonlike-kind
property) received is its fair market value.
C. Deferred and three-party exchanges—§1031(a)(3): A potential problem arises when the
taxpayer wishes to transfer property in a like-kind exchange, but the potential buyer who wants
the taxpayer’s property does not have suitable property to exchange. This problem can be
overcome by creating a deferred exchange, but the property to be received by the taxpayer
must be identified within 45 days after the taxpayer relinquishes his or her property and must
be received before the earlier of the 180th day after the date the taxpayer relinquishes his or her
property or the due date of the taxpayer’s return for the year of transfer of the relinquished
property. Any intermediary used must meet specific identity requirements to avoid agent
status.
D. Effect of mortgages in like-kind exchanges
a. One mortgage: If the property transferred in a like-kind exchange is subject to a
mortgage, the transferee’s assumption of that mortgage as a part of the transaction is
treated as boot to the transferor. The mortgage assumption is also treated as boot for
purposes of computing the taxpayer’s basis in the property received.
b. Two mortgages: If both the property transferred and the property received are subject to
mortgages assumed in the like-kind exchange, the regulations allow the “netting” of the
mortgages. The party with the net relief from liabilities (i.e., whose property was subject
to the higher mortgage at the outset) is treated as having received boot in the amount of
the net relief from liability. The mortgage netting rule applies only to the computation of
gain recognition; the full amounts of the mortgages are considered in the computation of
basis of the properties received by each party.
c. Two mortgages plus boot: The mortgage netting rule allows the party with net
assumption of debt to avoid recognition of gain. But this applies only to the mortgage
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assumption of debt to avoid recognition of gain. But this applies only to the mortgage
portion of the transaction. If the person with net assumption of debt receives boot, the
usual recognition rules will apply so that realized gain will be recognized to the extent of
the fair market value of the boot received.
LIKE-KIND EXCHANGES (IRC § 1031)
Use this Part A to determine if the transaction qualifies for nonrecognition under IRC § 1031.
Remember that IRC § 1031 is not elective; if the transaction fits within IRC § 1031, nonrecognition
will result even if the taxpayer would prefer to recognize the realized gain or loss
1. Old Property Held for Business or Investment—Was the property surrendered by the taxpayer
held for use in a business or investment activity?
a. No—If no, then IRC § 1031 does not apply. Property held by the taxpayer for personal
use is not eligible for IRC § 1031 treatment. This includes the taxpayer’s residence,
personal automobile, and personal effects like a television.
2. Exchange for Like–Kind Property—Is the property acquired in the exchange of “like-kind”
with the property surrendered?
a. General Definition—The Code contains no guidance as to whether an exchange involves
property of like kind. The regulations provide that the term “like kind” refers to “the nature or
character of the property and not to its grade or quality.” Thus, for example, improved real
property and unimproved real property are of like kind because they share the same nature or
character (they are both interests in land) even though they have different grades or qualities.
b. Real Property—Nearly every exchange of real property for other real property will qualify.
The regulations state that “[t]he fact that any real estate involved is improved or unimproved is
not material, for that facts relates only to the grade or quality of the property and not its kind
or class.” Treas. Reg. § 1.1031(a)–1(b). Thus, an exchange of unimproved land for improved
land is a like-kind exchange. See Treas. Reg. § 1.1031(a)–1(c)(2).
3. New Property Held for Business or Investment—Is the like-kind property received in the
exchange going to be held by the taxpayer for use in a business or investment activity?
Yes—If yes, then continue in this Part A. Note that there is no requirement that the
taxpayer use the new property in the same activity in which the taxpayer used the old
property. For example, a taxpayer can swap land used in his or her business for rental
real estate that will be held for investment purposes. The only restriction is that the new
property cannot be held for personal use. Presumably a taxpayer ultimately intending to
use the acquired property for personal purposes may not simply hold the property for
business or investment purposes for only a brief time; however, there is no firm guidance
on this point.
4. Loss—Does the taxpayer realize a loss in the transaction?
Yes—If yes, the realized loss is not recognized. IRC § 1031(a). This is true even if the
taxpayer receives consideration in addition to the like-kind property. IRC § 1031(c). Go
to A(6) below to determine the basis in the acquired property.
5. Boot—Does the taxpayer receive cash or some other property (referred to as “boot”) in
addition to the like-kind property?
a. Debt Relief is Treated as Boot—If the old property is encumbered by debt, remember
that the amount realized includes the amount of the debt no matter whether the debt is
recourse or nonrecourse and no matter whether the other party formally assumes the
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recourse or nonrecourse and no matter whether the other party formally assumes the
debt or merely takes the property subject to the debt. In addition, the last sentence of IRC
§ 1031(d) treats such debt relief as money received by the taxpayer. Thus, where the
taxpayer transfers property that secures a debt, the taxpayer is deemed to receive cash
equal to the amount of the debt relief, meaning the taxpayer receives boot.
Effect of Receiving Boot:
- If an Exchanger receives money or non-like-kind property (i.e., boot) in a transaction that
otherwise qualifies for Section 1031 treatment, the taxpayer may be required to recognize gain
on the transaction.
○ The amount of gain such taxpayer may be required to recognize will be equal to the
amount of money or the fair market value of non-like-kind property received, but shall
not exceed the gain realized.
○ If the taxpayer is relieved of a liability as part of a transaction, such relief shall be treated
as money received by the taxpayer on the exchange
GAIN RULES: BOOT RECEIVED
- If gain realized is greater than boot received:
○ gain recognized = boot received
- If boot received is greater than gain realized:
○ gain recognized = gain realized
Loss Disallowed:
- Although realized gain must be recognized if boot is received, loss is not allowed in the likekind exchange context even though boot may be received.
ADJUSTED BASIS:
- Step One: Unadjusted basis in Replacement Property equal to the adjusted basis the Exchanger
had in Relinquished Property.
- Step Two: The adjusted basis is decreased by the amount of money received in the exchange,
increased by any gain recognized, and decreased by any loss recognized.
○ If other property is received, the adjusted basis of the Relinquished Property is allocated
among the properties received. Any non like-kind property is assigned a basis equal to its
fair market value.
6. Basis in Property Received—A taxpayer’s basis in property received in a like-kind exchange is
computed under the formula provided in the first sentence of IRC § 1031(d):
Basis in Old Property
Minus Money Received
Plus Recognized Gain
Minus Recognized Loss
Basis in New Property
a. Debt Relief Treated as Money Received—The last sentence of IRC § 1031(d) treats debt relief
as money received by the taxpayer “for purposes of this section,” meaning IRC § 1031. Thus
any debt relief should be treated as “money received” for purposes of computing the basis of
the new property received.
b. Taking on Extra Debt—If the taxpayer takes the new property subject to a different liability,
and if the amount of that liability exceeds the amount of the liability attached to the taxpayer’s
old property, then there is no net debt relief to the taxpayer. Accordingly, the taxpayer in such
a situation is not deemed to receive any cash under IRC § 1031(d). See Treas. Reg. §
1.1031(d)–2, Example (2). The other party to the exchange, of course, will be deemed to
receive cash because that party necessarily has been relieved of more debt than he or she is
assuming in the transaction.
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assuming in the transaction.
c. Basis in Other Property—If the taxpayer received boot in addition to the like-kind property,
the basis computed under the formula in the first sentence of IRC § 1031(d) must be
apportioned between the like-kind property and the boot.
a. Boot Gets Fair Market Value Basis—The second sentence of IRC § 1031(d) provides that
any non-cash boot receives a basis equal to the fair market value of such property.
b. Remaining Basis Goes to Like–Kind Property—Any basis remaining after assigning a
fair market value basis to the boot becomes the basis in the like-kind property received.
SPOUSAL AND DIVORCE TRANSFERS—§1041
A. Nonrecognition: Section 1041 provides that no gain or loss will be recognized on transfers of
property between spouses or on transfers incident to a divorce.
a. Incident to a divorce: A transfer of property is incident to a divorce if it occurs within
one year of the date the marriage is terminated, or if it is contemplated by the divorce
decree and occurs within six years of the date of termination of the marriage (or later if
there is a good reason for the delay).
b. Indirect transfers: A transfer usually occurs directly from one spouse to the other.
However, a qualifying transfer also can be made to a third person if made by direction or
ratification of the other spouse or provided for in the divorce decree.
c. Effect of qualifying transfer to spouse or former spouse: The transferor in a §1041
transfer will not recognize gain or loss on the transfer. In addition, the recipient of
property will not include any amount in gross income and will take the property with the
same basis as the property had immediately prior to the transfer.
TIMING ISSUES:
- Transfers Taking Place Within One Year of the Divorce
○ No support or evidence is required when a transaction takes place within one year of the
divorce. The presumption is that property transferred between former spouses is merely a
shifting around of jointly owned assets and therefore, is not subject to taxation. This rule
applies even if the transferred property was acquired after the divorce was final
- Transfers Taking Place After the Six-Year Anniversary of the Divorce:
○ In general, property transferred more than six years after the divorce is final does not
qualify for Section 1041 treatment. Any transfer that is not pursuant to a divorce or
separation instrument and occurs more than six years after the divorce becomes final is
presumed to be unrelated to the cessation of the marriage
- Transfers Taking Place Between the One-Year and Six Year Anniversary of the Divorce:
○ A transfer of property that occurs between the one-year and six-year anniversary must
be made pursuant to a divorce or separation instrument to be presumed related to the
cessation of the marriage and qualify for Section 1041 treatment. A divorce or separation
instrument includes a decree of divorce or separate maintenance, a written separation
agreement, or other court decree
ALIMONY PAYMENTS AND CHILD SUPPORT
A. Alimony: Alimony paid in divorces and separation agreements executed after December 31,
2018 will be tax neutral. In addition, any divorce or separation agreement executed before
2019 can be modified to expressly provide for tax neutrality. For divorces prior to 2019, the old
rules may apply—allowing for an alimony deduction to the payer and requiring inclusion in
gross income to the recipient.
B. Child support: Child support is treated like a gift and is tax neutral.
CHARACTER OF INCOME AND LOSS IN GENERAL
When a taxpayer sells or exchanges property and recognizes gain or loss, the character of that gain
or loss—as capital or ordinary—must be determined.
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or loss—as capital or ordinary—must be determined.
II. CAPITAL/ORDINARY DISTINCTION
The capital/ordinary distinction has implications for both income and loss.
A. Income—§1(h): Tax is imposed on an individual’s ordinary income at rates up to 37%.
However, the maximum rate on “net capital gain” is potentially much lower, ranging generally
from 0% to 28%. Thus, taxpayers prefer to characterize income as capital gain subject to the
preferential rate.
B. Loss—§1211: Losses are not allowed unless a Code section (such as §165) allows the loss. If
the loss is an allowable capital loss, §1211 imposes a significant restriction on the deductibility.
Individuals may deduct capital losses to the extent of their capital gain income, plus $3,000 of
ordinary income. §1211(b). Unused capital losses carry forward to other taxable years.
C. Taxpayer preference: Taxpayers prefer capital gain and ordinary loss.
D. Policy: Several rationales are suggested for the preference for capital gain, including the
general incentive toward savings and investment, preventing lock-in, avoiding bunching of
income, and countering the effect of inflation.
III.AN APPROACH TO CHARACTERIZING GAIN OR LOSS
A. An approach to characterization problems: analysis of the following issues
a. Did the taxpayer experience a realization event with respect to which gains or losses
are recognized?
b. Did that event constitute a “sale or exchange” of “property”?
c. Was the property a “capital asset”?
d. Was the property a §1231 asset?
e. Do any special recharacterization rules apply?
B. Did the taxpayer experience a realization event with respect to which gains or losses are
recognized? For a taxpayer to have a capital gain or loss, there must be a realization event,
and any gains or losses from that event must be recognized.
C. Did that event constitute a “sale or exchange” of “property”? For the taxpayer to have a
capital gain or loss, the recognized gain or loss must arise from the “sale or exchange” of
“property.” This generally requires a “giving, a receipt, and a causal connection between the
two.” See Yarbro v. Commissioner, 737 F.2d 479 (5th Cir. 1984). Some events that might not
otherwise meet this standard are deemed to be sales or exchanges by statute, such as losses
from the worthlessness of stock or securities. Moreover, the item in question must constitute a
sale or exchange of property, not the prepayment of income. See Hort v. Commissioner, 313 U.S.
28 (1941) (lease cancellation payment).
D. Was the property a “capital asset”? For the taxpayer to have a capital gain or loss, the
recognized gain or loss must be from sale or exchange of a property that qualifies as a “capital
asset.”
a. Excluded categories: Section 1221 defines a capital asset as “property held by the
taxpayer (whether or not in connection with his trade or business)” except for eight
enumerated categories of property, of which only five are usually important in the basic
tax class. Thus, an item is a capital asset unless it falls within any of these five categories.
b. Inventory/stock in trade—§1221(a)(1): A taxpayer’s stock in trade or inventory held
primarily for sale to customers in the ordinary course of business is not a capital asset.
i. Definition: “Primarily” means “of first importance” or “principal.”
ii. Dealers: To have inventory, the taxpayer must hold the property primarily for sale
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ii. Dealers: To have inventory, the taxpayer must hold the property primarily for sale
to customers in the ordinary course of business. It is the relationship of the
taxpayer to the assets, not the taxpayer’s status generally, that determines whether
assets constitute inventory. See Van Suetendael v. Commissioner, 3 T.C.M. 987
(1944), aff’d, 152 F.2d 654 (2d Cir. 1945).
iii. Real estate: Whether a taxpayer holds real estate as an investor or as a dealer
depends on the analysis of seven factors discussed in United States v. Winthrop, 417
F.2d 905 (5th Cir. 1969).
c. Real and depreciable property—§1221(a)(2): Real property used in a trade or business
or property used in a trade or business that is subject to depreciation under §167 is not a
capital asset. This type of property is §1231 property, discussed below.
d. Creative works—§1221(a)(3): Creative works generated by the taxpayer, such as
material subject to copyright, letters, and memoranda, are not capital assets. There is an
exception for certain musical works, for which the taxpayer may elect capital asset
treatment.
e. Accounts/notes receivable—§1221(a)(4): A taxpayer’s accounts or notes receivable
from the sale of inventory are not capital assets.
f. Supplies—§1221(a)(8): Supplies and similar items used in a taxpayer’s business are not
capital assets.
g. “Related to” the trade or business: Relying on the case of Corn Products Refining Co. v.
Commissioner, 350 U.S. 46 (1955), taxpayers asserted that items that were integrally
connected with their trade or business should be treated as noncapital assets. In Arkansas
Best Corp. v. Commissioner, 485 U.S. 212 (1988), the U.S. Supreme Court reexamined Corn
Products, concluding that the relation of an asset to a taxpayer’s business was irrelevant in
determining its status as a capital or noncapital asset. In determining whether an item
was included in the noncapital category of inventory, certain “inventory substitutes”
could be included in that category. The Court limited the holding of Corn Products to an
application of the inventory substitute idea.
E. Was the property a §1231 asset? Section 1221(a)(2) excludes from the definition of a capital
asset real and depreciable property used in a trade or business or held for investment. But all is
not lost. Section 1231 may apply to treat net gains from this kind of property as capital.
a. An approach to §1231:The first question is whether the property sold is §1231 property.
If the property is not §1231 property, its character is determined under the usual rules. If
the property is §1231 property, the next question is whether the recapture rules of §§1245
or 1250 apply, because recapture income cannot be classified as §1231 gain. Then, the
taxpayer determines all of the recognized gains and losses from §1231 assets involving
casualties, and if such losses exceed such gains, all are removed from the calculation. If
such losses do not exceed gains, all are included, along with all other §1231 gains and
losses, and the losses and gains are netted against one another. If the final result is a net
loss, all §1231 gains and losses are ordinary. If the final result is a net gain, all gains and
losses are capital, except to the extent of unrecaptured §1231 losses during the previous
five years.
a. Section 1231 property: Section 1231 gains and losses arise from the sale of property used
in the trade or business of the taxpayer, or from the involuntary or compulsory
conversion of property used in the trade or business, or any capital asset held for more
than a year and held in connection with the taxpayer’s trade or business.
b. Recapture rule: The recapture rule may limit the recharacterization of gains as capital
under §1231. If the taxpayer has had, within the previous five years, §1231 losses that
were characterized as ordinary, the current year’s gain must be characterized as ordinary
to the extent of the previous loss.
CALCULATING CAPITAL GAIN AND LOSS
The final step in addressing character issues is determining the taxpayer’s net capital gain (which is
included in the taxpayer’s gross income and is taxed at preferential rates) or deductible capital loss,
and the net capital loss carryforward.
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and the net capital loss carryforward.
A. Definitions: Section 1222 sets forth a number of definitions relating to capital gains and losses
that are relevant in calculating capital gain and loss. There are three baskets of capital
gain/loss: the 28% group (collectibles), the 25% group (unrecaptured §1250 gain), and the
20%/0% group (everything else). If a taxpayer is in the 10% or 12% bracket for ordinary
income, for example, he or she will enjoy the 0% rate on capital gains. If the taxpayer is in the
15-36% brackets for ordinary income, he or she will enjoy a 15% rate. Those taxpayers in the
top 37% bracket for ordinary income will enjoy a 20% capital gain rate.
B. Holding period: Capital gains and losses must be characterized as long-term or short-term.
Long-term gain or loss is gain or loss from the sale of an asset held for more than one year.
Short-term gain or loss is gain or loss from the sale of an asset held for one year or less. The
period of time during which a taxpayer owns (or is deemed to own) an asset is his or her
holding period for the asset. The calculation of a taxpayer’s capital gain and loss depends on
the taxpayer’s holding period of the assets generating capital gain and loss. The holding period
usually begins with the taxpayer’s acquisition of the asset, but in some cases, the taxpayer’s
holding period will include another person’s holding period for the asset or the taxpayer’s
holding period for another asset.
a. Exchanged basis property—§1223(1): For exchange transactions involving the transfer
of capital or §1231 assets in which a taxpayer’s gain is deferred in whole or in part, the
taxpayer’s holding period for the property received in the transaction will include the
period the taxpayer held the property he or she transferred in the transaction. An
example of this is the holding period for property received in a qualifying like-kind
exchange.
b. Transferred basis property—§1223(2): If a taxpayer receives property in a transaction in
which the taxpayer’s basis is determined by reference to another person’s basis in the
same property, the taxpayer’s holding period includes the period of time that other
person held the property. An example of this is the holding period for a gift.
C. An approach to calculating net capital gain and net capital loss: A systematic approach for
calculating net capital gain and net capital loss is helpful in solving problems in which the
taxpayer disposes of varying kinds of assets. First, the taxpayer’s long- and short-term capital
gains and losses are categorized into each group (28%, 25%, and 20%/0%). Then, the gains
and losses in each group are netted against one another to produce gain or loss in each
category. Then, any losses in the short-term, 28%, or 20%/0% group are applied to reduce
gains in the other categories. This produces a net gain or a net loss in each category. The
maximum rate of tax is the tax rate applicable to the group (such as 28%), but if the taxpayer’s
regular rate is lower, that rate will apply.
TAX RATES AND CREDITS
I. IN GENERAL
The applicable tax rate is applied to taxable income to produce the tentative tax. Available tax
credits are subtracted from the tentative tax to produce the actual tax due.
II. TAX RATES
The current tax rate on ordinary income is progressive within a limited range, with tax rates for
individuals ranging from 10% to 37% (in 2018). The specific rate applicable to an individual depends
on his or her taxable income and filing status.
A. Children: Children with sufficient income to owe tax file their own tax returns reporting their
gross income and available deductions and credits. Certain unearned income of children may
be taxed at trusts and estate tax rates pursuant to the kiddie tax.
B. Preferential rates on capital gains: Net capital gain is taxed at a maximum rate of 28%
(collectibles), 25% (unrecaptured §1250 gain), or 20%, 15% or 0% (everything else). If the
taxpayer’s rate on ordinary income is lower, the taxpayer gets the benefit of that rate.
C. Qualified dividend income: Qualified dividend income is subject to the 20%/0% tax rate
regime applicable to capital gains in the 20%/0% category, removing the distinction between
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regime applicable to capital gains in the 20%/0% category, removing the distinction between
capital gain and ordinary income for many corporate distributions.
IV. TAX CREDITS
A tax credit is a dollar-for-dollar reduction in the amount of tax due. A refundable credit can reduce
tax below zero, generating a refund. A nonrefundable credit can only reduce tax to zero and will not
generate a refund.
A. Contrast deductions and exclusions: While a tax credit is a dollar-for-dollar reduction in the
amount of tax due, a deduction is a subtraction from either gross income or AGI in computing
taxable income. Moreover, if an amount is excluded from gross income, it is never included in
the computation of gross income.
B.
Credit for tax withheld—§31: Perhaps the most familiar tax credit is the credit for the amount
of tax withheld from wages, salaries, bonuses, and similar payments.
C. Dependent care credit—§21: Expenses for care of a dependent are not deductible because they
are personal expenses. Section 21 allows a taxpayer who maintains a household with at least
one qualifying individual to claim a nonrefundable tax credit for certain expenses, equal to the
taxpayer’s “applicable percentage” multiplied by the “employment-related expenses.”
a. Qualifying individual: A qualifying individual is a dependent of the taxpayer and under
the age of 13, or any other dependent or a spouse of a taxpayer who is physically or
mentally unable to care for himself or herself.
b. Applicable percentage: The taxpayer’s applicable percentage ranges from 35% for
taxpayers with AGI of $15,000 or less, to 20% for taxpayers with AGI above $43,000.
c. Employment-related expenses: Employment-related expenses are those incurred for
care of a qualifying individual while the taxpayer works, subject to two limitations.
d. Dollar limitation: Employment-related expenses are limited to $3,000 for one qualifying
individual and $6,000 for two or more qualifying individuals.
e. Earned income limitation: Employment-related expenses are limited to the earned
income of a single taxpayer, or if a married couple files a joint return, to the earned
income of the lesser-earning spouse. Special rules impute an amount of income to
students and disabled taxpayers for purposes of this limitation.
f. Coordination with §129: Section 129 allows a taxpayer to exclude from gross income
up to $5,000 of dependent care assistance provided by an employer. A taxpayer may not
claim both the exclusion and the tax credit for the same dollar of dependent care
assistance.
D. Child tax credit and dependent tax credit—§24: Section 24 provides for both a per child tax
credit for a qualifying child under the age of 17 and a dependent tax credit for a qualifying
dependent.
1. Child tax credit: A $2,000 child tax credit is allowed for a taxpayer’s child, step-child, adopted
child, or descendant under the age of 17 if that qualifying child has a valid social security
number. Income limitations start at modified adjusted gross income (MAGI) of $400,000 for
married taxpayers filing jointly and $200,000 for other taxpayers. This is a partially refundable
credit.
2. Dependent tax credit: A $500 dependent tax credit is allowed for qualifying children who
might not meet the child tax credit rules and qualifying relatives who meet the relationship,
gross income, and support texts. The same income limitations apply here as for the child tax
credit but none of this credit is refundable.
E. Earned income tax credit—§32: A low-income, eligible individual may claim a refundable tax
credit. To compute the amount of the credit, the credit percentage is multiplied by the
taxpayer’s earned income, up to a certain amount known as the “earned income amount.”
Then, from that figure is subtracted the taxpayer’s phaseout percentage, multiplied by the
taxpayer’s AGI, reduced (but not below zero) by the phaseout amount. These percentages and
amounts vary depending on the income and family status of the taxpayer. For current credit
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amounts vary depending on the income and family status of the taxpayer. For current credit
percentages, earned income amounts, and phaseout amounts, see
www.aspenlawschool.com/books/tax_outline.
a. Eligible individual: An eligible individual is an individual with a dependent child under
the age of 19 or a taxpayer who is a U.S. resident between the ages of 25 and 65 and who
cannot be claimed as a dependent on another person’s tax return.
b. Earned income amount: Earned income includes wages, salary, and self-employment
income.
F. Education credits: Section 25A allows taxpayers to claim tax credits for certain education
expenses. The American Opportunity tax credit is a $2,500 credit available for certain qualified
educational expenses. The Lifetime Learning tax credit is a credit equal to 20% of certain
expenses. Income level restrictions apply.
IDENTIFYING THE TAXPAYER
I. IN GENERAL
The identification of the proper taxpayer to report income and claim deductions is crucial in
maintaining a tax system that fairly allocates income tax among various taxpayers. This question is
inherent in all tax questions.
II. “PERSONS” SUBJECT TO TAX
Both natural persons and legal entities may be subject to tax.
A. Individuals—§1: Single individuals, including children, file a tax return reporting only their
income. Married couples can, and usually do, file a joint return reporting their combined
income and deductions. Married couples have the option of filing separately but usually do
not, as this can produce a higher joint tax liability.
a. Child’s services income—§73: Income from a child’s services is reported on the child’s
tax return, even if the parent is entitled to the income under state law.
b. The kiddie tax—§1(g): A child’s investment income (other than capital gains and
qualifying dividends) may be subject to tax at the rates of trusts and estates. A “child” is
a person under age 19, or under age 24 if a full-time student.
B. Legal entities: A legal entity—such as a corporation, partnership, estate, or trust—may be
required to file a tax return reporting its items of income, deduction, and credit. These are
usually beyond the scope of the basic tax class.
III.ASSIGNMENT OF INCOME
In a progressive tax system, an incentive exists for those in high tax brackets to direct income to
related persons in lower tax brackets in order to reduce the overall tax imposed on the group. This
strategy is known as “assignment of income.” Because assignment of income threatens to undermine
the integrity of the progressive tax structure, a variety of judicial and legislative responses have
arisen over the years to combat it.
A. Judicial views on services income: A common scenario involves the taxpayer who performs
services for compensation but attempts to direct the compensation to another person (usually a
relative in a lower tax bracket) prior to receiving it.
a. Diversion by private agreement: If a taxpayer who performs services attempts to direct
the compensation to another person by private agreement, the taxpayer (not the
transferee) will be required to include the amount in gross income. See Lucas v. Earl, 281
U.S. 111 (1930).
b. Diversion by operation of law: By contrast, if the law governing the legal relationships
provides that both the taxpayer and another person have legal rights to the income, the
tax consequences will follow from these legal relationships. As a result, the taxpayer and
the other party will include their proportionate shares of the income in gross income. See
Poe v. Seaborn, 282 U.S. 101 (1930).
Judicial
views on income from property: If an owner of income-producing property gives
B.
some interest in the property to another person, the issue arises of which person (the donor or
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some interest in the property to another person, the issue arises of which person (the donor or
donee) should be taxable on the income from the property.
a. Transfers of property: If the donor transfers the property itself, the donee will properly
report the income from the property.
b. Transfers of income only: The general rule is that attempts to transfer only the income
from the property to another, without a transfer of the property itself, will be respected
only if the income interest is transferred for its entire duration. Otherwise, the donor will
be taxed on the income and will be deemed to have made a gift of the income to the
donee. See Blair v. Commissioner, 300 U.S. 5 (1937); Helvering v. Horst, 311 U.S. 112
(1940).
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