CHAPTER 8
PROPERTY TRANSACTIONS:
CAPITAL GAINS AND LOSSES,
SECTION 1231, AND RECAPTURE PROVISIONS
SOLUTIONS TO PROBLEM MATERIALS
Question/
Problem
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10
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Topic
Capital assets
Capital assets
§ 1237 treatment
Options
Issue recognition
Options
Franchise
Issue recognition
Short sale
Definition of a capital asset
Net capital gain
Collectibles
Corporate capital losses
Ethics problem
Issue recognition
Sec. 1231 nonpersonal use property casualty
Capital assets
Section 1231 gain from disposition with
§1245 depreciation recapture
Issue recognition
Ethics problem
Sec. 1231 lookback
Sec. 1231 gain and loss planning
Sec. 1245 recapture
Sec. 197 amortization and § 1245 recapture
Comprehensive §§ 1231, 1245, and 1250
Ethics problem
8-1
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in Prior
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8-2
2003 Entities Volume/Solutions Manual
Status:
Present
Edition
Q/P
in Prior
Edition
Modified
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27
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Financial accounting and tax differences
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Installment sale
Sec 1245 recapture
Definition of capital assets
Sec. 1250 recapture
Internet activity
Internet activity
Internet activity
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Question/
Problem
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Topic
Depreciation recapture and gifts
Depreciation recapture for inherited property
Covenant not to compete versus goodwill
Sec. 1231: timber
Bridge Discipline
Problem
1
Research
Problem
1
2
3
4
5
6
7
PROBLEM MATERIAL
1.
The vacation home is a personal use asset and is, therefore, a capital asset. The $31,000
loss is nondeductible because it arose from the disposition of a personal use asset. The
antique clock is a capital asset held for personal use. The basis of the clock is $12,000 -- its
value in Mariah's grandmother's estate. The clock is sold at a $1,500 LTCG gain. The
$48,000 song payment is ordinary income because Mariah was in the business of being a
songwriter.
Song payment
Clock
Gross income
$48,000
1,500
$49,500
pp. 8-3 to 8-5
2.
By the close of business on the day Hyacinth purchases the shares, it must designate them
as held for investment. The $48 ($63 - $15) per share gain would be long-term capital gain
if the firm sells the shares after holding them more than a year.
Smith, Raabe, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
Property Transactions: Capital, Section 1231
8-3
March 17, 2002
Vice-President, Finance
Hyacinth, Inc.
200 Morningside Drive
Hattiesburg, Mississippi 39406
Dear Sir or Madam:
The purpose of this letter is to discuss the rules for purchases of stock by a securities dealer
such as your firm. A securities dealer may have a long-term capital gain from the sale of
stock. The tax law allows you to designate stock you purchase as being held for
investment. You must make this designation by the end of the business day on which the
stock is acquired. I suggest you check with your account supervisor on how this
“designation” is normally done. It is a relatively simple procedure.
As long as you continue to hold the designated shares for investment until you sell them,
the shares will be a capital asset. When you sell them at $63 per share, your $48 per share
gain will be long-term capital gain if you have held the shares for more than one year.
Thank you for the opportunity to be of service. Please telephone me if you have additional
questions.
Sincerely,
Michelle Brown, CPA
Partner
p. 8-6
3.
Because Eagle Partnership. has sold more than five lots, it has potential ordinary income
equal to 5% of the selling price of each lot. However, since Eagle’s selling expenses are
7% per lot, it will have no ordinary income because all of the potential ordinary income is
first absorbed by the selling expenses. Eagle has a total gain of $96,000. None of this gain
is ordinary and $96,000 is long-term capital gain. The computations are shown below.
Selling price ($60,000 X 20)
Less: Selling expenses ($1,200,000 X 7%)
$1,200,000
(84,000)
Amount realized
Basis ($51,000 X 20)
Realized and recognized gain
$1,116,000
(1,020,000)
$ 96,000
Classification of recognized gain:
Ordinary income
Five percent of selling price
($1,200,000 X 5%)
Less: Selling expenses
Ordinary gain
Capital gain
pp. 8-6 and 8-7
$
60,000
84,000
0
$
96,000
8-4
4.
2003 Entities Volume/Solutions Manual
The option Swan Songs, Inc. holds is an ordinary asset because the firm is a dealer in
songs. The tax status of the option is the same as the tax status which the option property
would have in the hands of the option holder. Consequently, the gain from selling the
option or exercising the option and then selling it is ordinary income. Swan will have the
best after-tax cash flow by purchasing the song and then selling it.
Exercise Option
Sell Option & Sell Song
Selling price
Cost of option
Cost of song
Ordinary gain
Tax @ 34%
After tax cash flow (selling price - option cost - song
cost - tax)
$10,000
( 2,000)
$ 8,000
( 2,720)
$ 5,280
$35,000
( 2,000)
(20,000)
$13,000
( 4,420)
$ 8,580
pp. 8-8 and 8-9
5.
Daffodil Enterprises Co. would face the following tax issues:

What would be the purpose for which Daffodil Enterprises Co. was acquiring the
property?

Is Daffodil Enterprises Co. a dealer in real estate?

Does the lapse of the option constitute a sale or exchange?
pp. 8-8 and 8-9
6.
Since the landowner holds the land as an investment, it is a capital asset to him or her.
Because the partnership intends to hold the land for investment, the option is a capital asset
to it. The tax status of the option is determined by the firm’s tax status for the underlying
option property.
a.
The landowner (grantor) does not recognize gross income when he or she grants the
option and receives $20,000. The option represents a quasi-liability.
b.
The option is a legal right, which has some value. Thus, it is an asset with a $20,000
tax basis.
c.
The landowner recognizes a $20,000 ordinary gain when the option lapses. The
$20,000 does not constitute a capital gain because § 1234 does not treat the
expiration of the option on land as a sale or exchange of the property by the grantor.
The partnership recognizes a $20,000 short-term capital loss because § 1234 treats
the expiration of the option as a sale or exchange by the grantee, and the option (in
this fact pattern) was a capital asset that the partnership did not hold for greater than
one year.
d.
The seller would recognize a $358,000 long-term capital gain ($20,000 option price
+ $400,000 other amount realized - $62,000 adjusted basis). The partnership has an
adjusted basis of $420,000 for the property because the cost of the option is treated as
a down payment on the land. pp. 8-8, 8-9, and Concept Summary 8-1
Property Transactions: Capital, Section 1231
7.
Freys, Inc. has retained significant powers and rights in the franchise agreement.
Therefore, Freys has not made a sale or exchange, but has created a license to use its
trademarks, trade name, and mode of operation. Section 1253 requires that Freys treat the
$40,000 lump-sum noncontingent payment and the $25,000 contingent payment as
ordinary income. Red Company may amortize the $40,000 noncontingent payment over
15 years. The amortization is treated as a business expense. Red may currently deduct the
$25,000 contingent payment as a business expense. pp. 8-11 and 8-12
8.
Meredith has a zero tax basis for the supplies because she has already deducted their cost.
Therefore, she has a gain of $3,000 from selling them. The supplies are not a capital asset
because § 1221 specifically defines supplies as not a capital asset. Meredith has an
ordinary gain from disposition of the supplies. pp. 8-13 and 8-14
9.
Thrasher Corporation has not engaged in a "short sale against the box" because it did not
own substantially identical stock on the date of the short sale. Also, since Thrasher did not
own substantially identical stock at the date of the short sale, any gain or loss from closing
the short sale is short-term.
a.
The price of the shares rose after Thrasher made the short sale. It lost $5 per share for
a total of $500 short-term capital loss from closing the short sale.
b.
The holding period for the remaining 100 shares begins with the closing date of the
short sale (May 2, 2002). Because the remaining shares were acquired after the short
sale date (January 15, 2002), they have a holding period which commences with the
earlier of the closing date of the short sale or the sale date of the remaining shares.
c.
Thrasher has a $2 per share gain (total of $200) when it sells the remaining shares on
January 20, 2003. This gain is short-term because the holding period did not start
until the short sale closing date (May 2, 2002). Thrasher must hold the stock more
than one year to receive long-term treatment.
pp. 8-15 and 8-16
10.
Accounts receivable are not a capital asset because § 1221 specifically defines them as not
a capital asset. Magenta has a tax basis for the receivables equal to its face value because
Magenta’s revenues were increased by that amount when the account receivable was
recorded. Therefore, Magenta has a $35,400 ordinary loss [$236,000 – ($236,000 X .85)]
from the disposition of the receivables. p. 8-4
8-5
8-6
11.
2003 Entities Volume/Solutions Manual
Net long-term capital gain ($32,000 - $25,000)
Net short-term capital loss ($29,000 - $33,000)
Net capital gain
$7,000
(4,000)
$3,000
Smith, Raabe, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
March 17, 2002
Ms. Latisha Case
300 Ireland Avenue
Shepherdstown, West Virginia 25443
Dear Ms. Case:
The purpose of this letter is to discuss the result of your stock transactions for 2002. You
had $7,000 (net) of long-term capital gains and $4,000 (net) of short-term capital losses.
Subtracting the $4,000 of losses from the $7,000 of gains resulted in a $3,000 net long-term
capital gain.
The $3,000 net long-term capital gain and the details of your stock transactions will be
reported on the Schedule D attached to your Form 1040. The $3,000 net capital gain
qualifies for the alternative tax and will be taxed at a 20% rate rather than at your marginal
tax rate of 35%.
Thank you for the opportunity to be of service. Please telephone me if you have additional
questions.
Sincerely,
Michelle Brown, CPA
Partner
pp. 8-17 and 8-18
12.
Sally's sculpture is a "collectible" and, as such, is taxable at a maximum rate of 28%. Since
Sally is already in the 35% tax bracket, the 28% rate will apply. A 28% tax of $15,000
translates into a taxable gain of $53,571. Therefore, Sally should sell enough stock to
generate a capital loss of $36,429 ($90,000 gain on the sculpture - $53,571 desired gain).
This loss can be any combination of short-term, 28% property, and long-term capital
losses. pp. 8-18 and 8-19
13.
Platinum, Inc. has a net long-term capital loss of $23,000 [($39,000 STCG - $24,000
STCL) - $38,000 LTCL]. A corporation cannot deduct a net capital loss from current year
ordinary income. Therefore, Platinum’s 2002 taxable income is $215,000. Platinum has a
short-term capital loss carryover of $23,000 because all capital loss carryovers of
corporations are treated as short-term. p. 8-24
Property Transactions: Capital, Section 1231
14.
8-7
If the antiques collector is a dealer in antiques, the antique is inventory and, therefore, an
ordinary asset. What the antiques collector is trying to accomplish by each of the options
listed for disposing of the antique is to make it clear that the antique is a capital asset.
Transferring the antique to his daughter as a gift would probably accomplish the capital
asset goal because the daughter would hold the antique as an investment. However, if the
daughter has the property and sells it, she has the net proceeds from the sale, not the
antiques collector. Such an outcome may or may not be what he was trying to achieve.
If the antiques collector merely assumes that the antique is a capital asset, he runs an audit
risk. If his return is audited and the IRS disagrees with the treatment, the antiques collector
will not only owe the additional $40,000 in taxes, but will also owe substantial interest and
penalties. If the “capital asset” approach is used on his return, there should be substantial
tax authority for that approach and documentation of the authority should be kept with his
tax records so it is available when (and if) the return is audited.
Exchanging the antique for another antique will postpone the gain if both antiques are not
inventory. However, if the antique he presently holds is inventory, the like-kind exchange
rules do not apply and a taxable disposition of the antique has occurred. Thus, the
exchange does not help solve the basic capital asset versus ordinary asset dilemma for this
taxpayer. pp. 8-4, 8-17, and 8-18
15.
The tax issues that Cheryl must properly handle are:

Should the two casualty items be netted against one another?

If the items are netted, what type of gain or loss results from the netting?

How are the results of the netting integrated with Cheryl’s other gains and losses (if
any)?

Should
Cheryl
postpone
the
gain
by
reinvesting
in
similar
property?
pp. 8-27 to 8-30, and Concept Summary 8-4
16.
Tulip & Co. has had two nonpersonal use property casualties. The $30,000 gain is netted
against the $27,000 loss and results in a $3,000 net gain. The $3,000 net gain is treated as
a § 1231 gain. Since there are no other property transaction gains or losses, and because
Tulip has no lookback losses, it has a $3,000 net § 1231 gain for the year. That gain is
treated as a long-term capital gain. pp. 8-27, 8-28, and Concept Summary 8-4
8-8
2003 Entities Volume/Solutions Manual
Smith, Raabe, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
November 23, 2002
Chief Financial Officer
Tulip & Co.
2000 Meridian Road
Hannibal Point, Missouri 34901
Dear Sir or Madam:
Thank you for the opportunity to discuss the tax effect of the two casualties your company
suffered this year. Both the painting and the vase were assets you were holding for
investment. The painting casualty resulted in a $30,000 gain because it was insured. The
vase casualty resulted in a $27,000 loss because it was not insured.
The $30,000 gain is netted against the $27,000 loss and results in a $3,000 net gain. The
$3,000 net gain is treated as a "§ 1231 gain" -- a special type of gain for tax purposes. Since
there are no other property transaction gains or losses this year, and because you had no §
1231 losses in prior years, the $3,000 net § 1231 gain for the year is treated as a long-term
capital gain. That gain is eligible for a tax rate of no more than 20%.
If you have any questions concerning these transactions or other tax matters, please feel
free to telephone me. Thank you.
Sincerely,
Sheila Dailey, CPA
Partner
17.
All the assets are capital assets because they do not fit any of the items listed in § 1221 as
not capital assets. The 1974 Dodge is a “collectible.” Therefore, the $13,000 loss
($32,000 sale price - $45,000 basis) is a long-term capital loss that would first be netted
against any 28% long-term capital gain. The Blue Growth Fund $11,000 gain ($23,000
sale price - $12,000 basis) is a long-term capital gain that is potentially taxable at 10%
and/or 20%. The Orange Bonds are sold for a $7,250 gain ($42,000 proceeds - $750
interest income - $34,000 basis). The gain is a long-term capital gain potentially taxable at
10% and/or 20%. The sale of the Green stock results in a $2,000 ($11,000 sale price $13,000 basis) short-term capital loss because the stock was held one year or less. The
$750 interest income is includible in Eric’s gross income.
pp. 8-3 to 8-6 and 8-16 to 8-19
18.
The machine would have to be sold for more than the amount that was paid for it. p. 8-31
19.
To properly handle this transaction, Sylvia must determine the following:

The tax status of the property (§ 1231 asset, capital asset, or ordinary asset).

The applicability of § 1245 depreciation recapture.

The outcome of the § 1231 netting process.
Property Transactions: Capital, Section 1231
8-9
Both assets are § 1231 assets. Section 1245 depreciation recapture causes the entire gain of
$2,510 ($40,000 - $37,490) to be taxed as ordinary income since the selling price does not
exceed the $100,000 original cost of the asset. Since the loss of $14,490 ($23,000 $37,490) on the other asset is the only § 1231 gain or loss, there is a net loss of $14,490 that
is treated as an ordinary loss. Consequently, Sylvia is partially correct, the $2,510 gain
from one of the items does offset the $14,490 loss from the other item. However, these
transactions are reported separately from her 2002 business income. The $11,980 net loss
is deductible for adjusted gross income on her 2002 tax return. pp. 8-25 to 8-34
20.
The issue here is whether it is acceptable to ignore complex tax provisions when ignoring
them makes no difference in the ultimate tax result. The answer is clearly “no.” The tax
return preparer does not really know for sure whether proper versus improper compliance
makes a difference unless the proper compliance is worked out. But once that has been
done, why wouldn’t the proper approach be used? Ignoring complex tax provisions
because “it won’t make any difference” is simply an excuse for shoddy work. pp. 8-28 to
8-30
21.
Net § 1231 gains must jump a final hurdle before being netted with capital transactions.
The net § 1231 gain must exceed the sum of nonrecaptured net § 1231 losses recognized in
the five most recent preceding years. The years 1997 through 1999 have a combined
nonrecaptured net § 1231 loss of $81,000. The $81,000 nonrecaptured § 1231 loss is
partially absorbed by the 2000 $21,000 § 1231 gain and the 2001 $30,000 § 1231 gain.
Thus, $30,000 of the nonrecaptured § 1231 loss remains for offset against the 2002
$39,000 § 1231 gain.
Net Sec. Before Lookback:
1231 Loss
Current Year
Subject to
Net Sec.
Recapture
1231 Gain
1997 - 1999
($81,000)
2000
21,000
$21,000
Remaining potential recapture ($60,000)
2001
30,000
30,000
Remaining potential recapture ($30,000)
2002
30,000
39,000
Totals
$
-0$90,000
Ordinary
Income
$21,000
Long-Term
Capital
Gain
$
-0-
30,000
-0-
30,000
$81,000
9,000
$9,000
pp. 8-29 and 8-30
22.
Delphinium should sell the § 1231 gain asset this year and the § 1231 loss asset next year.
This year, Delphinium would have $40,000 net § 1231 gain; there would be no lookback
nonrecaptured § 1231 loss; the net § 1231 gain would be treated as a long-term capital gain,
and the $25,000 short-term capital loss carryover would be offset against this capital gain.
For this year, Delphinium would have a $15,000 net long-term capital gain which would be
taxed at a maximum rate of 20%. Next year, Delphinium could sell the § 1231 loss asset;
the $30,000 loss would generate a net § 1231 loss, and that loss would be an ordinary loss
deductible for AGI. By selling the § 1231 gain asset the year before the § 1231 loss asset,
Delphinium avoids having the § 1231 loss “taint” the § 1231 gain, converting that gain into
ordinary gain. p. 8-29 and Examples 44 and 45
8-10
23.
2003 Entities Volume/Solutions Manual
a.
Green has $67,000 ($60,000 + $7,000) of ordinary income due to § 1245 recapture
and $28,000 ($35,000 - $7,000) of net § 1231 gain.
Asset
Sold For
Rack
Forklift
Bin
b.
Less Adjusted Basis
Gain or Loss
Character
$135,000 $40,000 ($100,000 $60,000)
$95,000
$60,000
ordinary
income due
to § 1245
recapture;
$35,000
§ 1231 gain
$5,000 $12,000 ($35,000 $23,000)
($7,000)
§ 1231 loss
$60,000 $53,000 ($87,000 $34,000)
$7,000
All ordinary
income due
to § 1245
recapture
Green has a $28,000 net § 1231 gain which is treated as long-term capital gain since
Green has no nonrecaptured prior years § 1231 losses.
pp. 8-29 to 8-34
24.
The patent amortization of $4,275 is subject to § 1245 recapture as ordinary income. The
balance of the gain is § 1231 gain. pp. 8-29 to 8-34
Selling price
Cost
Amortization (19 months X $225)
Adjusted basis
Recognized gain
§ 1245 ordinary gain
§ 1231 gain
$60,000
$40,500
( 4,275)
(36,225)
$23,775
$ 4,275
$19,500
Smith, Raabe, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
November 23, 2002
Mr. Siddim Sadatha, Controller
Gray Manufacturing Company
6734 Grover Street
Back Bay Harbor, ME 23890
Dear Siddim:
Thank you for the opportunity to respond to your question concerning the tax treatment of
the gain from the disposition of the patent. As you know, amortization of $225 per month
has been taken on this patent since it was acquired on December 1, 2000. That
Property Transactions: Capital, Section 1231
8-11
amortization totaled $4,275 when you disposed of the patent on June 30, 2002. The $4,275
is taxable as ordinary income because it is "recaptured" by § 1245. The balance of the gain
($19,500) is a "§ 1231 gain." That gain will be taxed as long-term capital gain as no other
business property dispositions have occurred this year.
If you have any questions concerning these transactions or other tax matters, please feel
free to telephone me. Thank you.
Sincerely,
Rose Goodwin, CPA
Partner
25.
a.
Land:
Condemnation proceeds
Allocable basis
Realized and recognized § 1231 loss
$25,000
(40,000)
($15,000)
Truck:
Depreciation taken: $3,491 ($6,000 - $2,509).
Adjusted basis: $2,509.
Realized gain: $3,500 - $2,509 = $991.
Recognized gain: $991 ordinary income under § 1245.
Rowing machine:
Realized and recognized gain = Amount realized - Adjusted basis of
machine on date of sale = $3,900 - $0 = $3,900.
Section 1245 recapture = Amount of depreciation claimed ($5,200) or gain
recognized ($3,900), whichever is less = $3,900.
Apartment building:
Realized gain = Amount realized - Adjusted basis = $200,000 - $124,783 =
$75,217.
Section 1231 gain recognized = $75,217. No § 1250 recapture is recognized
because the taxpayer used the straight-line method of depreciation. Of the
$75,217 § 1231 gain, $25,217 is unrecaptured § 1250 gain because the
depreciation taken of $25,217 ($150,000 cost - $124,783 basis) is less than the
$75,217 recognized gain.
Yacht:
Personal casualty loss (without regard to the 10% of AGI limitation) = Fair
market value at date of theft - Insurance proceeds - Floor = $20,000 - $12,500 $100 = $7,400.
Auto:
Realized loss = Amount realized - Adjusted basis = $9,600 - $20,800 =
$11,200. The loss relates to a personal use asset. Therefore, it is not
recognized.
8-12
2003 Entities Volume/Solutions Manual
Copy machine:
Realized and recognized gain = Amount realized - Adjusted basis = $135 - $95
= $40. Section 1245 recapture = Amount of depreciation claimed ($255) or
gain recognized ($40), whichever is less = $40.
Trampoline:
$6,000 business casualty loss is deductible for AGI. The casualty loss is
measured by the adjusted basis of the property at the time of the theft. There is
no $100 or 10% of AGI floor for a business casualty.
b.
Item
Land
Truck
Rowing machine
Building
Yacht
Auto
Copy machine
Trampoline
Recognized
Gain/Loss
($15,000)
991
3,900
75,217
(7,400)
-040
(6,000)
Section
1245
Casualty and
Recapture Theft Loss
Section
1231
Gain
($15,000)
$ 991
3,900
75,217
($ 7,400)
40
( 6,000)
$4,931
Ordinary
income
Adjusted gross income computation:
Other sources
Ordinary income from depreciation recapture, as above
Long-term capital gain, as above
Business casualty loss, as above
Adjusted gross income
$6,000 Net
business loss
for AGI;
No Net
personal loss
from AGI*
$60,217
Gain:
Receives
LTCG
treatment
**
$36,000
4,931
60,217
(6,000)
$95,148
*None of the personal use activity property casualty loss is deductible from AGI because
10% of the $95,148 AGI is greater than the casualty loss of $7,400.
**Of the $60,217 § 1231 gain, $25,217 is unrecaptured § 1250 gain because according to
the 2001 Form 1040, Schedule D instructions, if the net § 1231 gain is greater than the
potential unrecaptured § 1250 gain, all of the unrecaptured § 1250 gain is in the § 1231 gain
that is carried from Form 4797 to line 11 of the 2001 Form 1040 Schedule D. Thus, the
$60,217 § 1231 gain is comprised of $25,217 of unrecaptured § 1250 gain and $35,000 of
10%/20% gain. There is no 8% gain because the taxpayer is probably going to be out of the
15% bracket due to his very high AGI. References are to the 2001 tax forms because the
2002 forms were not yet available.
pp. 8-31 to 8-38
26.
The old drafting table has a $450 value which has been received by Macklin when the table
is converted to his personal use. Macklin should file a Form 4797 reporting the disposition
of the drafting table for $450 and report § 1245 depreciation recapture gain of $450 since
the table has a zero tax basis and $3,700 of depreciation has been taken. If the conversion
Property Transactions: Capital, Section 1231
8-13
to personal use of fully depreciated (but still valuable) business assets could be done
tax-free, the tax law would have a significant gap. p. 8-32
27.
Joanne has two alternatives for helping Susan:
(1)
Joanne could sell the equipment, but probably not to Susan since she could not afford
it. Joanne would have a taxable ordinary gain of $50,000 [$85,000 sale price ($135,000 cost - $100,000 depreciation)] due to depreciation recapture under § 1245.
After paying her tax of $19,300 ($50,000 X 38.6%), Joanne would have $65,700
($85,000 sale price - $19,300 tax) to give to Susan. That may not be enough cash for
Susan to buy the equipment she needs. It would not be beneficial for Joanne to sell
the equipment on the installment basis because all the gain would be immediately
recognized since all the gain is recapture gain. pp. 8-31 to 8-34
(2)
Joanne could give the equipment to Susan. The $100,000 depreciation recapture
potential would carry over to Susan and Susan would take Joanne’s basis ($35,000)
for the property. Any depreciation which Susan takes on the property would increase
the depreciation recapture potential. However, it appears that Susan may not sell the
property for quite a while and is probably in a lower tax bracket than Joanne. pp.
8-31 to 8-34 and 8-39
28.
Death eliminates all recapture potential and the inheritor of the property gets a basis for the
property equal to its value at the date of the decedent’s death. Thus, Alvin would have a
$173,000 basis for the equipment. p. 8-40
29.
The process that Hsui is selling is an intangible asset with a zero tax basis to Hsui. It is in
the nature of goodwill and is probably a capital asset. If the process is copyrighted, it is not
a capital asset. A copyright is specifically defined as not being a capital asset by § 1221. If
the process is patented, the payment might automatically be long-tem capital gain under §
1235. But the process is not patented. The specific exclusions from capital asset status of
§ 1221 do not seem to include this situation. Therefore, the conclusion is that the process is
a capital asset. The covenant not to compete payments are ordinary income to Hsui as they
are received and will be taxed at ordinary income rates. Consequently, Hsui should take
the $850,000 for the process, treat it as long-term capital gain, and pay tax on it of 20%.
The $45,000 per year should be taken as a covenant not to compete payment and be treated
as ordinary income when it is received. For the acquirer, both payments are § 197
intangible assets that have to be capitalized and amortized over 15 years. pp. 8-4 and 8-11
30.
Since Sue-Jen elected to treat the cutting as a sale, the recognized gain and loss are
calculated as follows:
a. and b. 2000:
2001:
2002:
$0 recognized gain or loss.
A § 1231 gain of $20,000 is recognized. The contract had been held for
the long-term holding period when the timber was cut in November
2001.
FMV at January 1, 2001
Adjusted basis
§ 1231 gain recognized
$80,000
(60,000)
$20,000
A loss of $2,000 is recognized.
FMV at January 30, 2002
$78,000
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2003 Entities Volume/Solutions Manual
FMV at January 1, 2001
Ordinary loss recognized
(80,000)
($ 2,000)
c.
The $2,000 ordinary loss would be recognized in 2001 if the sale occurred in 2001.
d.
2000: $0 recognized gain or loss.
2001: A § 1231 loss of $12,000 and an ordinary gain of $1,000 are recognized.
FMV at January 1, 2001
Adjusted basis
§ 1231 loss recognized
FMV at sale in December, 2001
FMV at January 1, 2001
Ordinary gain recognized
$48,000
(60,000)
($12,000)
$49,000
(48,000)
$ 1,000
2002: No gain or loss realized or recognized.
pp. 8-25 and 8-26
BRIDGE DISCIPLINE PROBLEM
1.
Increases after-tax income: Use of LIFO accounting, completed contract method,
incentive stock options, qualified retirement and fringe benefit plans, off-shore financing.
Decreases after-tax income: Treatment of prepayments, lack of the use of reserves for tax
purposes, unused business and foreign tax credits, deferral of recognition for gift income of
a tax exempt subsidiary.
RESEARCH PROBLEMS
1.
Jennifer’s adjusted basis is $420,000 ($500,000 cost - $80,000 depreciation taken), and her
gain is $180,000 ($600,000 sale price - $420,000 adjusted basis). This gain consists of
$80,000 of unrecaptured § 1250 gain taxable at 25%, and $100,000 of § 1231 gain taxable
at 20%. This transaction, however, is an installment sale, with the profit to be recognized
over three taxable years. The profit ratio of each payment received is 30% ($180,000 profit
 $600,000 contract price). Accordingly, Jennifer will recognize $60,000 of gain on each
payment ($200,000 payment X 30%). The question, then, is what tax rate will apply to the
$60,000 of gain recognized each year – 20% or 25%?
Regulations finalized in 1999 require that when more than one type of capital gain is
involved in an installment sale, the higher taxed gain is recognized first. Thus, the entire
$60,000 of gain recognized in the year of sale is taxed at 25%, because this amount is less
than the $80,000 of unrecaptured § 1250 gain on the transaction. The remaining $20,000
of unrecaptured § 1250 ($80,000 - $60,000 recognized in the year of sale) will be
recognized the next year. The other $40,000 of gain recognized that year ($60,000 $20,000 of unrecaptured § 1250 gain) and all of the $60,000 of gain recognized the final
year will be taxed at 20%. See Reg. § 1.453-12(a), (d) Example 1.
Property Transactions: Capital, Section 1231
2.
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Section 1245(a)(4) designates player contracts as § 1245 property. Previously
unrecaptured depreciation with respect to initial contracts is depreciation taken on
contracts acquired with the purchase of the franchise that has not already been recaptured
due to earlier sales of those contracts. The purpose of this recapture is to force recognition
of ordinary income on disposition of the player contracts. See § 1245(a)(4)(B).
3.
CLIENT LETTER
Smith, Raabe, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
February 10, 2002
Mr. Salvio Guitterez, Controller
Clean Corporation
4455 Whitman Way
San Mateo, CA 44589
Dear Mr. Guitterez:
This letter is in response to your request for us to review your company’s tax question on
the type of gain derived from your sale of Dig Corporation stock. Our conclusions are
based upon the facts as outlined in our previous discussions on this matter. Any change in
the facts may affect our conclusions.
Clean Corporation runs a chain of dry cleaners. Borax is used heavily in Clean’s dry
cleaning process and has been in short supply several times in the past. Several years ago,
Clean purchased a controlling interest in Dig Corporation—a borax mining concern.
Clean’s sole reason for purchasing the Dig stock was to ensure Clean of a continuous
supply of borax if another shortage developed. Although borax must be refined before it is
usable for dry cleaning purposes, a well-established commodities market exists for trading
unrefined borax for refined borax.
After owning Dig’s stock for several years, Clean recently sold the Dig stock at a loss. The
stock had declined in value because Dig was in financial difficulty. Clean no longer
needed to own Dig because Clean had obtained an alternative source of Borax.
You have asked us to express our opinion on the nature of the loss Clean incurred by
selling the Dig stock. We conclude that the loss is an ordinary loss because the Dig stock
seems to fit the “source of supply” exception to the general rule that stock is a capital asset.
Clean was, in effect, “hedging” to make sure that it had a sufficient supply of borax. This
ordinary loss can be deducted against the operating income of Clean. If the loss was a
capital loss, it could only be deducted against Clean’s capital gains. If the capital gains
were insufficient to absorb the loss, Clean would have to carry over the capital loss.
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2003 Entities Volume/Solutions Manual
Should you need more information or need to clarify our conclusions, do not hesitate to
contact me.
Sincerely,
John Jones, Partner
TAX FILE MEMORANDUM
January 13, 2002
Tax File Memorandum:
Clean Corporation
Prepared by:
John Jones, Partner
Subject:
Character of Loss from Sale of Controlled Corporation’s
Stock
Today I met with Salvio Guitterez, Controller of Clean Corporation, concerning the sale of
the Dig Corporation stock formerly owned by Clean Corporation. The facts can be
summarized as follows: Clean Corporation runs a chain of dry cleaners. Borax is used
heavily in Clean’s dry cleaning process and has been in short supply several times in the
past. Several years ago, Clean purchased a controlling interest in Dig Corporation—a
borax mining concern.
Clean’s sole reason for purchasing the Dig stock was to ensure Clean of a continuous
supply of borax if another shortage developed. Although borax must be refined before it is
usable for dry cleaning purposes, a well-established commodities market exists for trading
unrefined borax for refined borax.
After owning Dig’s stock for several years, Clean recently sold the Dig stock at a loss. The
value of the stock had declined because Dig was in financial difficulty. Clean no longer
needed to own Dig because Clean had obtained an alternative source of borax.
Salvio would like to know whether the loss on the sale of the Dig Corporation stock should
be treated as a long-term capital loss or as an ordinary loss. The Clean Corporation does
not have any net capital gains in its three prior tax years, does not have any expectation of
substantial capital gains this year, nor any prospect of future substantial capital gains.
Thus, Salvio is concerned that if the loss is a long-term capital loss, it will be wasted.
ISSUE: Is the loss on the Dig Corporation stock sale an ordinary loss or a long-term capital
loss.
CONCLUSION: The loss is an ordinary loss because the Dig stock seems to fit the “source
of supply” exception to the general rule that stock is a capital asset. Clean was, in effect,
“hedging” to make sure that it had a sufficient supply of borax. This ordinary loss can be
Property Transactions: Capital, Section 1231
8-17
deducted against the operating income of Clean. If the loss was a capital loss, it could only
be deducted against Clean’s capital gains. If the capital gains were insufficient to absorb
the loss, Clean would have to carry over the capital loss.
4.
Zane R. Tollis, 65 TCM 1951, Z.T. Memo. 1993-63 has nearly identical facts. The gain the
taxpayer recognized from sales of the vacant land held for development was ordinary
income. The purpose for which the taxpayer held the land (for sale to customers in the
course of his real estate development and sales business) hadn’t changed. The taxpayer’s
argument that several parcels were sold to aid the taxpayer’s retirement objectives, so the
land became a capital asset, was rejected by the Tax Court. It ruled that the character of the
parcels didn’t change because of the taxpayer’s decision to terminate his business.
However, the taxpayer in Tollis recognized gain from the sale of 8 or 9 condominium units.
The units were used in real estate management activities, were kept separate from the
development business, and were not held for sale to customers in the normal course of
business. The gain, therefore, was § 1231 gain that was treated as long-term capital gain.
In the present situation, the residential rental real estate is also a § 1231 asset, but the
property was sold at a loss. Consequently, there is a § 1231 loss from disposition of the
property that is treated as an ordinary loss. That loss will offset the ordinary gain from the
sale of the land.
5.
The Internet Activity research problems require that the student access various sites on the
Internet. Thus, each student’s solution likely will vary from that of the others.
You should determine the skill and experience levels of the students before making the
assignment, coaching them where necessary so as to broaden the scope of the exercise to
the entire available electronic world.
Make certain that you encourage students to explore all parts of the World Wide Web in
this process, including the key tax sites, but also information found through the web sites of
newspapers, magazines, businesses, tax professionals, government agencies, political
outlets, and so on. They should work with Internet resources other than the Web as well,
including newsgroups and other interest-oriented lists.
Build interaction into the exercise wherever possible, asking the student to send and
receive e-mail in a professional and responsible manner.
6.
See the Internet Activity comment above.
7.
See the Internet Activity comment above.
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NOTES