Chapter 16
Property Transactions:
Capital Gains and Losses
Individual Income Taxes
Copyright ©2009 Cengage Learning
Individual Income Taxes
C16-1
Taxation of Capital
Gains and Losses
• Capital gains and losses must be separated
from other types of gains and losses for two
reasons:
– Long-term capital gains may be taxed at a
lower rate than ordinary gains
– A net capital loss is only deductible up to
$3,000 per year
Individual Income Taxes
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Proper Classification of
Gains and Losses
• Depends on three characteristics:
– The tax status of the property
• Capital asset, §1231 asset, or ordinary asset
– The manner of the property’s disposition
• By sale, exchange, casualty, theft, or condemnation
– The holding period of the property
• Short term and long term
Individual Income Taxes
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Capital Assets
(slide 1 of 6)
• §1221 defines capital assets as everything
except:
– Inventory (stock in trade)
– Notes and accounts receivables acquired from
the sale of inventory or performance of services
– Realty and depreciable property used in a trade
or business (§1231 assets)
Individual Income Taxes
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Capital Assets
(slide 2 of 6)
• §1221 defines capital assets as everything except
(cont’d):
– Certain copyrights; literary, musical, or artistic
compositions; or letters, memoranda, or similar
property when created by taxpayer (or for which
taxpayer takes a carryover basis from the creator)
• Taxpayers may elect to treat a sale or exchange of musical
compositions or copyrights in musical works as the disposition
of a capital asset
– Certain publications of U.S. government
– Supplies of a type regularly used or consumed in the
ordinary course of a business
Individual Income Taxes
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Capital Assets
(slide 3 of 6)
• Thus, capital assets are:
– Assets held for investment (e.g., stocks, bonds,
land)
– Personal use assets (e.g., residence, car)
– Miscellaneous assets selected by Congress
Individual Income Taxes
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Capital Assets
(slide 4 of 6)
• Dealers in securities
– In general, securities are the inventory of
securities dealers, thus ordinary assets
– However, a dealer can identify securities as an
investment and receive capital gain treatment
• Clear identification must be made on the day of
acquisition
Individual Income Taxes
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Capital Assets
(slide 5 of 6)
• Real property subdivided for sale
– Taxpayer may receive capital gain treatment on the
subdivision of real estate if the following requirements
are met:
•
•
•
•
•
Taxpayer is not a corporation
Taxpayer is not a real estate dealer
No substantial improvements made to the lots
Taxpayer held the lots for at least 5 years
Capital gain treatment occurs until the year in which the 6th lot
is sold
– Then up to 5% of the revenue from lot sales is potential ordinary
income
– That potential ordinary income is offset by any selling expenses
from the lot sales
Individual Income Taxes
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Capital Assets
(slide 6 of 6)
• Nonbusiness bad debts
– A nonbusiness bad debt is treated as a shortterm capital loss in the year it becomes
completely worthless
• Even if outstanding for more than one year
Individual Income Taxes
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Sale or Exchange
(slide 1 of 11)
• Recognition of capital gains and losses
generally requires a sale or exchange of
assets
• Sale or exchange is not defined in the Code
• There are some exceptions to the sale or
exchange requirement
Individual Income Taxes
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Sale or Exchange–Worthless
Securities and § 1244 Stock (slide 2 of 11)
• A security that becomes worthless creates a
deductible capital loss without being sold or
exchanged
– The Code sets an artificial sale date for the securities on
the last day of the year in which worthlessness occurs
• Section 1244 allows an ordinary deduction on
disposition of stock at a loss
– The stock must be that of a small business company
– The ordinary deduction is limited to $50,000 ($100,000
for married individuals filing jointly) per year
Individual Income Taxes
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Sale or Exchange
(slide 3 of 11)
• Worthless securities example:
– Calendar year taxpayer purchased stock on
December 5, 2007
– The stock becomes worthless on April 5, 2008
– The loss is deemed to have occurred on
December 31, 2008
• The result is a long-term capital loss
Individual Income Taxes
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Sale or Exchange–Retirement of
Corporate Obligations (slide 4 of 11)
• Collection of the redemption value of
corporate obligations (e.g., bonds payable)
is treated as a sale or exchange and may
result in a capital gain or loss
– OID amortization increases basis and reduces
gain on disposition or retirement
Individual Income Taxes
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Sale or Exchange–Options
(slide 5 of 11)
• For the grantee of the option
– Sale of an option results in capital gain or loss if the
option property is a capital asset to the grantee
– Lapse of an option on a capital asset is considered a
sale or exchange resulting in a capital loss
• For the grantor of an option, the lapse creates
– Short-term capital gain, if the option was on stocks,
securities, commodities or commodity futures
– Otherwise, ordinary income
Individual Income Taxes
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Sale or Exchange–Options
(slide 6 of 11)
• Exercise of an option by a grantee
– Increases the gain (or reduces the loss) to the
grantor from the sale of the property
– Gain is ordinary or capital depending on the tax
status of the property
• Grantee adds the cost of the option to the
basis of the property acquired
Individual Income Taxes
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Sale or Exchange–Patents
(slide 7 of 11)
• When all substantial rights to a patent are
transferred by a holder to another, the
transfer produces long-term capital gain or
loss
– The holder of a patent must be an individual,
usually the creator, or an individual who
purchases the patent from the creator before the
patented invention is reduced to practice
Individual Income Taxes
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Sale or Exchange–Franchises,
Trademarks, and Trade Names
(slide 8 of 11)
• The licensing of franchises, trade names,
trademarks, and other intangibles is
generally not considered a sale or exchange
of a capital asset
– Therefore, ordinary income results to transferor
• Exception: Capital gain (loss) may result if the
transferor does not retain any significant power,
right, or continuing interest
Individual Income Taxes
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Sale or Exchange–Franchises,
Trademarks, and Trade Names
(slide 9 of 11)
• Significant powers, rights, or continuing interests
include:
– Control over assignment, quality of products and
services
– Sale or advertising of other products or services
– The right to require that substantially all supplies and
equipment be purchased from the transferor
– The right to terminate the franchise at will, and
– The right to substantial contingent payments
Individual Income Taxes
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Sale or Exchange–Franchises,
Trademarks, and Trade Names
(slide 10 of 11)
• Noncontingent payments are ordinary
income to the transferor
– The franchisee capitalizes the payments and
amortizes them over 15 years
• Contingent payments are ordinary income
for the franchisor and an ordinary deduction
for the franchisee
Individual Income Taxes
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Sale or Exchange–Lease
Cancellation Payments
(slide 11 of 11)
• Lessee treatment
– Treated as received in exchange for underlying leased property
• Capital gain results if asset leased was a capital asset (e.g., personal
use )
• Ordinary income results if asset leased was an ordinary asset (e.g.,
used in lessee’s business and lease has existed for one year or less
when canceled)
• Lease could be a § 1231 asset if the property is used in lessee’s trade
or business and the lease has existed for > a year when it is canceled
• Lessor treatment
– Payments received are ordinary income (rents)
Individual Income Taxes
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Holding Period
(slide 1 of 3)
• Short-term
– Asset held for 1 year or less
• Long-term
– Asset held for more than 1 year
• Holding period starts on the day after the
property is acquired and includes the day of
disposition
Individual Income Taxes
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Holding Period
(slide 2 of 3)
• Nontaxable Exchanges
– Holding period of property received includes holding
period of former asset if a capital or §1231 asset
• Transactions involving a carryover basis
– Former owner’s holding period tacks on to present
owner’s holding period if a nontaxable transaction and
basis carries over
• Inherited property is always treated as long term
no matter how long it is held by the heir
Individual Income Taxes
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Holding Period
(slide 3 of 3)
• Short sales
– Taxpayer sells borrowed securities and then repays the
lender with substantially identical securities
– Gain or loss is not recognized until the short sale is
closed
– Generally, the holding period for a short sale is
determined by how long the property used for
repayment is held
• If substantially identical property (e.g., other shares of the
same stock) is held by the taxpayer, the short-term or long-term
character of the short sale gain or loss may be affected
Individual Income Taxes
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Tax Treatment of Capital
Gains and Losses (slide 1 of 7)
• Noncorporate taxpayers
– Capital gains and losses must be netted by holding
period
• Short-term capital gains and losses are netted
• Long-term capital gains and losses are netted
• If possible, long-term gains or losses are then netted with
short-term gains or losses
– If the result is a loss:
– The capital loss deduction is limited to a maximum
deduction of $3,000
– Unused amounts retain their character and carryforward
indefinitely
Individual Income Taxes
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Tax Treatment of Capital
Gains and Losses
(slide 2 of 7)
• Noncorporate taxpayers (cont’d)
– If net from capital transactions is a gain, tax
treatment depends on holding period
• Short-term (assets held 12 months or less)
– Taxed at ordinary income tax rates
• Long-term (assets held more than 12 months)
– An alternative tax calculation is available using
preferential tax rates
Individual Income Taxes
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Tax Treatment of Capital
Gains and Losses (slide 3 of 7)
• Noncorporate taxpayers (cont’d)
– Net long-term capital gain is eligible for one or
more of four alternative tax rates: 0%, 15%,
25%, and 28%
• The 25% rate applies to unrecaptured §1250 gain
and is related to gain from disposition of §1231
assets
• The 28% rate applies to collectibles
• The 0%/15% rates apply to any remaining net longterm capital gain
Individual Income Taxes
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Tax Treatment of Capital
Gains and Losses (slide 4 of 7)
• Collectibles, even though they are held long term,
are subject to a 28% alternative tax rate
• Collectibles include any:
–
–
–
–
–
–
–
Work of art
Rug or antique
Metal or gem
Stamp
Alcoholic beverage
Historical objects (documents, clothes, etc.)
Most coins
Individual Income Taxes
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Tax Treatment of Capital
Gains and Losses (slide 5 of 7)
• Qualified dividend income paid from current or
acc. E & P is eligible for the 0%/15% long-term
capital gain rates
– After determining net capital gain or loss, qualified
dividend income is added to the net long-term capital
gain portion of the net capital gain and is taxed as
0%/15% gain
• If there is a net capital loss, it is still deductible for AGI
– Limited to $3,000 per year with the remainder of the loss
carrying over
• In this case, the qualified dividend income is still eligible to be
treated as 0%/15% gain in the alternative tax calculation
– It is not offset by the net capital loss
Individual Income Taxes
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Tax Treatment of Capital
Gains and Losses (slide 6 of 7)
• The alternative tax on net capital gain applies only
if taxable income includes some net long-term
capital gain
– Net capital gain may be made up of various rate layers
• For each layer, compare the regular tax rate with the alternative
tax rate on that portion of the net capital gain
• The layers are taxed in the following order: 25% gain, 28%
gain, the 0% portion of the 0%/15% gain, and then the 15%
portion of the 0%/15% gain
• This allows the taxpayer to receive the lower of the regular tax
or the alternative tax on each layer of net capital gain
Individual Income Taxes
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Tax Treatment of Capital
Gains and Losses (slide 7 of 7)
• Corporate taxpayers
– Differences in corporate capital treatment
• There is a NCG alternative tax rate of 35 %
– Since the max corporate tax rate is 35 %, the
alternative tax is not beneficial
• Net capital losses can only offset capital gains (i.e.,
no $3,000 deduction in excess of capital gains)
• Net capital losses are carried back 3 years and
carried forward 5 years as short-term losses
Individual Income Taxes
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If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta
Individual Income Taxes
C16-31