104-7 Tax Consequences of Property Transactions: Part 1 Flashcards
Capital Assets
Personal use assets (e.g., a personal residence) and most investment assets
Noncapital assets / ordinary income asset examples
These generate ordinary income and losses:
- Accounts receivable or notes receivable of a trade or business
- Copyrights and creative works held by the creator
- Inventory or property held for sale to customers in a taxpayer’s trade or business
- Depreciable personal and real property used by a business
Think: ACID
Holding period
Length of time a taxpayer has owned an asset of any type
Short-term capital gain (STCG)
Gain on capital assets owned 1 year or less
Taxed at ordinary income (marginal) tax rates
Long-term capital gains rate
0%
15%
20%
The capital gain tax is progressive in nature. If the taxpayer has $40k in long-term capital gains and $60k in income, a portion will be taxed at the 12% ordinary income tax rate
Summary of holding periods and the different types of assets
Type: LTCG, Holding Period: > 1 yr
Type: STCG, Holding Period: < 1 yr
Type: Unrecaptured Section 1250 gain (depreciable real property), Holding Period: > 1 yr, up to 25% rate
Type: Qualifying dividend income, Holding Period: Received after 12.31.2002
Type: Collectibles, > 1 yr (up to the 28% rate)
Amount realized
Sum of any money received + FMV of other property received in the transaction
Recovery of Capital Doctrine
Allows taxpayers to recover the cost or other original basis of property tax-free
For example, the cost or other basis of depreciable property is recovered through annual depreciation deductions
Exceptions to the rule that property must be owned longer than 1 year to qualify for long-term capital gains tax rates
- Gift property
- Inherited property
- Section 1031 (like-kind)
- Mark-to-market rules
- Worthless securities
Qualifying (qualified) dividend income
A distribution to the shareholder of either cash or property out of the corporation’s current or accumulated earnings and profits
A dividend distribution is considered ordinary income to the investor-taxpayer and is not deductible by the distributing corporation
Qualifying dividend distributions are eligible for the same 20%/15%/0% rate as are long-term capital gains and most dividends declared by a corporate BOD of a domestic corporation
Reporting of a taxpayer’s capital gains & losses
Done on schedule D of IRA form 1040
Capital gains netting procedure
- STCG and STCL are netted against each other
- LTCG and LTCL are netted against each other
- If any gains and losses remain (whatever their character), they are again netted
- If a capital loss still remains after netting, only $3,000 ($1,500 for taxpayers filing as MFS) of the net loss may be used to offset ordinary income in any 1 year
Individuals may generally carry over a net capital loss to future tax years (indefinitely) until the loss if fully used. However, in some cases (e.g., the application of the related party rules), the loss may be disallowed entirely.
Fair Market Value (FMV)
The price at which property will change hands between a willing buyer and a willing seller, both w/ knowledge of the relevant facts, when neither is compelled to buy nor to sell
Basis
The measure of the unrecovered dollars assigned to a taxpayer’s investment in an asset
- Original or cost basis
- Adjusted basis
- Carryover basis
- Stepped-up basis
- Substituted basis
Original or cost basis
This is where the calculation of basis begins and is the amount of the taxpayer’s original funds used to make the investment plus any improvements made to the investment, legal fees, and permits to build (e.g., real property)
Adjusted basis
The investment’s original or cost basis (including any improvements, legal fees, and permits), and for financial intangibles (securities) commissions and other fees to acquire the security will increase the basis of the intangible less any cost recovery deductions, commonly referred to as depreciation
Carryover basis
Basis that is transferred or carried over from 1 party to another
Its most notable application is appreciated property gifted from the donor to the donee
Stepped-up basis
Basis that is increased to some point in time, free of any intervening income taxation; its most notable application is property that appreciates during a taxpayer’s lifetime and is received by the heirs at time of death and, generally receives a stepped-up basis to the FMV at the date of death for the property inherited by the heir
Substituted basis
The property’s FMV less any deferred gain or plus any postponed loss
Most notable application is a nontaxable exchange of qualifying real property (aka like-kind exchange)
For purposes of determining a taxpayer’s basis in property
The basis of an asset is equal to the purchase price plus the cost to place the property into service.
- Improvements increase original basis
- Repairs do not add to or impact original basis
Basis is also increased by legal fees, commissions, sales tax, and transportation charges
Taxpayers recovering their original cost or investment in certain assets used in a trade or business
May be done through depreciation, amortization, or depletion
Modified Accelerated Cost Recovery System (MACRS)
Property Type: Autos, light-duty trucks, computers
Useful Life: 5 yrs
Property Type: Office furniture, fixtures
Useful Life: 7 yrs
Property Type: Residential rental property
Useful Life: 27.5 yrs
Property Type: Commercial Rental Property
Useful Life: 39 yrs
Alternate Depreciation System (ADS)
Must be used for listed property that is used 50% or less in business
Includes passenger autos, entertainment assets, computer, and phones
Depreciation under ADS is based on a straight-line method
Straight-line depcreciation
Simplest form of depreciation
Assumes depreciation is uniform throughout the useful life of the asset
SL = (cost - residual value) / useful life
Expensing Policies
If a repair adds value or adds to the useful life of the asset, the expense can be depreciated
Expenses that keep the asset in an ordinary working condition do not add value and are considered a current expense
Section 179 expense election
Allows an annual expensing of the cost of tangible personal property (such as business computers or business trucks) in any 1 year up to a certain amount
To be eligible for this election, the property must be used at least 50% for business in the first year that it is placed in service
2 annual limitations associated w/ use of the Section 170 expense election:
A) If the total amount of qualifying property placed in service for a given year is > $2.55 million (for 2019), the allowance is reduced dollar-for-dollar for any amount > $2.55 million. No carryover is allowed.
B) A loss cannot be created through the use of the election
Intangible assets
aka Section 197 assets
Amortized over a period (useful life) of 15 years
Goodwill Trademarks Covenants not to compete Copyrights Patents
Amortization = deduction
Natural resources (such as oil and gas wells)
Subject to depletion
Owner is entitled to a deduction for AGI (an above-the-line deduction) to recover the costs of exhausting the natural resource
2 Depletion Methods
- Cost depletion: asset basis is divided by the total # of recoverable units of the asset and then multiplied by the # of units sold
- Percentage depletion: statutory % applied to the gross income from the property (limited to 50% of the gross income)
- More aggressive of the 2 depletion methods
Cost-recovery (depreciation) deductions
When a taxpayer-businessowner purchases real or personal property for use in a business and takes cost-recovery (deprecation) deductions, these deductions offset the businessowner’s ordinary income
Recapture
When selling the property for a gain, the businessowner must look back and recapture all or part of those previous cost-recovery deductions
Section 1231 Property
Any depreciable real property or personal property used in a trade or business or for the production of income
Does not include inventory or costs of goods sold, which is not depreciable
1231 is a business-friendly section of tax code which is designed to encourage businesses to invest in property and thus stimulate the larger economy
Take caution - if previous depreciation has been taken exceeding any recognized gain, this portion is ordinary income to the extent of the previous depreciation taken
Section 1245 Property
Depreciable tangible personal property used in a trade or business
Requires any recognized gain on the sale of Section 1245 property to be treated as ordinary income to the extent of any depreciation taken
The application of Section 1245 is also termed full recapture
Section 1245 does not apply to losses. Rather, Section 1231 rules are used, resulting in ordinary loss treatment
Section 1250
Applies to depreciable real property used in a trade or business or for the production of income
For taxpayers whose marginal rate is 32% or higher; 25% is the max rate at which the unrecaptured Section 1250 gain will be taxed
Any gain not attributable to depreciation is subject to a long-term capital gain rate
Installment Sale
Any sale of property in which the seller receives at least 1 payment after the year of sale
As such, the installment method permits the taxpayer to spread out the taxable gain as payments are received using the following formula
Profit / Total Contract = Gross Profit Percentage
Not available for:
- property held for sale in the ordinary course of business (inventory)
- securities traded in a secondary market
Related Parties
Losses from sales of property between related parties are disallowed for income tax purposes
Related parties are defined here as:
1. lineal descendants (grandfather, father, child, and so forth)
2. brothers and sisters
3. corporations in which the taxpayer has a 50% or greater interest
4. several other complex tax relationships
