Chapter 7
Capital Gains and
Other Sales of
Property
“If a client asks in any but an extreme
case whether, in your opinion, his sale
will result in capital gain, your answer
should probably be, ‘I don’t know, and
no one else in town can tell you.’”
-- James L. Wood
McGraw-Hill
Education
McGraw-Hill/Irwin
Copyright © 2015 by the McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded,
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©The McGraw-Hill
Companies,
Inc. 2008
LO #1 Terms & Tax Forms
• Basis of property purchased is the cost of
the asset including cash, debt obligations,
and other property or services included in
acquiring the asset.
• Basis of assets transferred by inheritance
are valued at the FMV of the property at
the date of death or FMV on the alternate
valuation date if an estate return is being
filed and the estate income is reduced by
the valuation.
7-2
LO #1 Terms & Tax Forms
• Basis of property transferred to a
taxpayer from a spouse or former
spouse incident to a divorce settlement,
is the same as the spouse’s or former
spouse’s adjusted basis before the
transfer.
• Assets transferred by gift can be valued
at FMV or basis of the donor depending
if the FMV is < or = > basis.
7-3
LO #1 Terms & Tax Forms
• Adjusted basis is the cost of the asset
less any accumulated depreciation.
• The difference between the amount
realized from the sale and the adjusted
basis of the asset;
– Amount realized > adjusted basis = gain
– Amount realized < adjusted basis=(loss)
7-4
LO #1 Terms & Tax Forms
• The nature of tax reporting for gains
and losses on the sale of property
depends primarily on the “use” of
the asset rather than on the asset
“form.”
7-5
LO #1 Terms & Tax Forms
• Form 4797 – Sales of Business Property
– Use to report any and all gains or losses
from sale or liquidation of business
property.
– The form has four parts to it and is very
detailed to include all possible situations
involving property used in a business
• Schedule D – Capital Gains and Losses
– Use to report any and all gains or losses
from sale of property held for
investment.
• Form 8949 – Record Transactions
7-6
LO #1 Concept Check 7-1
1. A gain or loss on a sale is the difference
between the cash received and the original
cost of the asset.
False
2. The gain or loss on the sale of an asset
used for investment or in a trade or business
operation appears on Form 4797.
False
3. When the buyer assumes the seller’s
liability, the seller includes this amount in
computing the amount realized from the sale
True
7-7
LO # 2 Classifying Assets
• Ordinary Asset
– Ordinary income property is any
asset that is “not” a capital asset.
• Capital Asset (§1221)
– Any asset used for personal
purposes or investment.
• Eight exceptions to this definition
7-8
LO # 2 Classifying Assets
• § 1231 Business Asset
– Depreciable or nondepreciable property
used in a trade or business
– Held for more than one year
• Any business asset disposed of within
one year of acquisition is an ordinary
income asset and is taxed to the
taxpayer at ordinary tax rates.
7-9
LO # 2 Concept Check 7-2
1. Inventory sold by a company is an ordinary
income asset that appears on Form 4797-Sale of
Business Assets.
False
2. A capital asset includes all of the following
except:
a. taxpayer vacation home
b. inherited property
c. property used in a trade or business
d. stock portfolio
Answer: C
7-10
LO # 2 Concept Check 7-2
3.
An ordinary income asset is any short-term or
long-term asset used in a business.
False
4. A §1221 asset is any asset held for investment.
True
5. A §1231 asset is any depreciable or
nondepreciable property used in a trade or
business and not considered an ordinary income
asset.
True
7-11
LO # 3 Ordinary Assets
• Inventory and accounts receivable are not
ordinary income assets unless they are
sold outside the normal course of
business.
• Sale of business property held less than
one year.
• Gains are taxed at the taxpayer’s regular
rate
– There is no preferential tax treatment
• Losses are fully deductible
7-12
LO # 3 Concept Check 7-3
1. When an ordinary asset is sold, the gain
or loss is subject to capital gain or loss
tax treatment.
False
2. Why is the distinction between “ordinary”
and “capital” so important?
Because of the preferential tax rate
treatment on capital gains versus
ordinary gains.
7-13
LO # 3 Concept Check 7-3
3. Ordinary gains or losses
produced outside the normal
course of business relate to the
sale of business property held for
less than one year or the sale of
receivables.
True
7-14
LO #4 Capital Assets
• Tax treatment depends on holding
period of the asset. Assets must be
held for more than one year for
preferential tax treatment.
– Exceptions:
• Property received through a gift or
nontaxable exchange generally has same
holding period as the transferor.
• Property acquired through inheritance is
always considered long-term property.
7-15
LO #4 Capital Assets
• Long term capital gain rates:
– 0%, 15%, or 20% for most capital assets
– 25% rate for depreciable real property
used in a trade or business (§ 1250)
– 28% rate for “collectibles” and gains on
§1202 (Qualified Small Business Stock)
property.
7-16
LO #4 Capital Assets
• All short-term gains and losses are
netted.
• All long-term gains and losses are
netted.
• The resultant gain or loss determines
the deductibility of a loss and the tax
rate used for gain.
7-17
LO #4 Concept Check 7-4
1. The tax treatment of a capital gain or loss
varies depending on all of the following
except:
a. the holding period.
b. the basis of the asset sold.
c. the taxpayer’s tax bracket.
d. the netting of all gains and losses.
Answer: B
7-18
LO #4 Concept Check 7-4
2. If property received has the same basis
as the basis in the hands of the
transferor, the holding period includes
the holding period of the transferor.
True
3. The holding period of inherited property
can be either short-term or long-term to
the beneficiary.
False
7-19
LO #4 Concept Check 7-4
4. The 3.8% surtax is charged on longterm capital gains only if a taxpayer is in
the top tax bracket. True or False?
False
7-20
LO #4 Concept Check 7-4
5. For sales after 2012, what are the maximum
capital gain rates on the following?
a. Collectibles gains
b. §1202 gains
c. Unrecaptured §1250 gains
d. Taxpayer’s regular tax rate =>25% and
<39.6%
e. Taxpayer’s regular tax rate < 25%
f. Taxpayer’s regular tax rate > 35%
7-21
LO #4 Concept Check 7-4
a.
b.
c.
d.
e.
f.
28%
28%
25%
15%
0%
20%
LO #5 §1231 Business Assets
• Recall that §1231 assets are those
used in a trade or business that are
held for > 1 year.
• Gains and losses from the sale of
§1231 assets are netted before tax
rates are applied.
• A net §1231 gain is taxed as a longterm capital gain subject to recapture
provisions
7-23
LO #5 §1231 Business Assets
• Recapture provisions apply to
depreciation taken as a deduction in
prior years.
• Depreciation recapture rules are
designed to “transform” some or all of
the §1231 gain into an ordinary gain.
7-24
LO #5 §1231 Business Assets
• Net §1231 gains receive preferential
tax rate treatment
• Net §1231 losses are treated as
ordinary losses not subject to
deductibility limit provisions of $3,000
per year.
7-25
LO #5 §1231 Business Assets
• §1245 applies to personal trade or
business property and is a subset of
§1231 property
– Tax rate to “recapture” the depreciation
portion of a gain is taxed at ordinary rates
– Remaining gain, if any, is taxed at
preferential rates.
7-26
LO #5 §1231 Business Assets
• § 1250 applies to buildings –
residential or nonresidential
(commercial) and is a subset of §1231
property
– The amount of capital gain
attributable to depreciation
previously taken is taxed at the 25%
rate up to the depreciation amount
considered “unrecaptured”.
– Remaining gain, if any, is taxed at
preferential rates
7-27
LO #5 Concept Check 7-5
1. Under §1231, gains receive preferential
tax rate treatment but losses are limited
to $3,000 per year.
False
2. The only pure §1231 asset is land used
in a trade or business.
True
7-28
LO #5 Concept Check 7-5
3. What is meant by the term
depreciation recapture?
Depreciation recapture rules transform
some or all of a §1231 gain into an
ordinary gain.
7-29
LO #5 Concept Check 7-5
4. What is the difference between a
§1245 asset and a §1250 asset?
§1245 assets are personal trade or
business property subject to
depreciation. §1250 assets include
depreciable real property used in a
trade of business that has never been
considered §1245 property
7-30
LO #5 Concept Check 7-5
5. What is the difference between
“recapture” and “unrecaptured” gain
provisions?
Unrecaptured gain is taxed at a maximum
25% rate for all straight-line depreciation
taken on the property. Recaptured gain
is taxed at ordinary rates to the extent
the depreciation taken exceeds straightline deprecation.
7-31
LO # 6 Special Types of Sales
• Sales of stock purchased as blocks
of stock at different prices and/or
dates are valued either using
specific identification or the first-in,
first-out method for determining
basis.
7-32
LO # 6 Special Types of Sales
• A mutual fund pools resources from various
investors and purchases shares of stock in a
portfolio
• Form 1099-DIV is the form sent annually to
individual investors in the mutual fund to
record dividends, capital gains, and
distributions from the fund for the year.
• Capital gains distributions from mutual funds
are reported on Schedule D (or directly on
Form 1040 if Schedule D is not required to be
filed).
7-33
LO # 6 Special Types of Sales
• Three methods to calculate the “basis” of
shares in a mutual fund purchased throughout
a period
– First-In, First-Out – assumes first shares
purchased are the first shares sold.
– Specific Identification – assumes that the shares
sold can be identified with a specific purchase.
– Average Basis – Calculate the average of shares
purchased for a period and use an average to
determine the cost basis of shares sold.
7-34
LO # 6 Special Types of Sales
• Worthless securities are treated as
losses from a sale or exchange of a
capital asset on the last day of the
taxable year.
– Declaration of bankruptcy is not
sufficient to indicate worthlessness.
– Often difficult to pinpoint exactly when a
security becomes worthless to determine
a “sale date” for long-term versus shortterm treatment.
7-35
LO # 6 Special Types of Sales
• Sales of assets given as gifts:
– FMV<donor’s adjusted basis at time of
gift
• Use donor’s adjusted basis for a gain
• Use FMV for a loss
• Special provision, if the sell price is between
the adjusted basis and the FMV, there is no
gain or loss on the sale.
– FMV=>donor’s adjusted basis at time of
gift
• Use donor’s adjusted basis for a gain or
loss
7-36
LO # 6 Special Types of Sales
• Basis to beneficiaries is the FMV at the
date of death or alternate valuation date
(AVD applies only if valuing the asset
reduces the overall estate amount).
• The holding period is always considered
long-term
– Example: Property inherited with a basis
of $3,000 is sold six months later for
$4,000. The $1,000 gain is considered
long-term and qualifies for preferential
tax treatment.
7-37
LO # 6 Concept Check 7-6
1. Explain the three types of methods
used to determine the basis of units in a
mutual fund.
First-In, First-Out – First shares
purchased are the first shares sold.
Specific Identification – Specifies exactly
which units are for sale from the fund.
Average Basis – Take total cost basis and
divide by the total units to get an
average cost per unit.
7-38
LO # 6 Concept Check 7-6
2. It is often difficult to pinpoint exactly
when a security becomes worthless, so
the loss on a worthless security is
treated as occurring on the last day of
the taxable year.
True
3. The basis for property given as a gift is
always the FMV of the property at the
time of the gift.
False
7-39
LO # 6 Concept Check 7-6
4.The tax treatment of a gain on the
sale of inherited property
depends on the holding period of
the deceased taxpayer.
False
7-40