9 Property Transactions: Basis and Gains

Question 1

What are the steps to analyze the income tax consequences of property transactions?

Answer 1

1. Determine gain or loss realized
2. Apply capital loss rules
3. Apply other loss limits - at-risk values, passive activity loss rules, excess business loss rules, net operating loss rules
4. Report gross income, claim deductions, and computer taxable income and tax liability in accordance with other rules. Ex. - apply installment sales rules, deduct allowable capital losses, separate capital gains from other income, apply tax rates separately to capital gains and other income

Question 2

When a business is sold how is the consideration allocated to the assets transferred?

Answer 2

When more than one asset of a business is transferred in bulk (total consideration exchanged for assets in combination), including all the assets of a sole proprietorship, gain or loss must be accounted for separately for each asset transferred. Allocation among assets of consideration paid or to be paid is by agreement of parties, by relative FMV of assets, or by the residual method.

Question 3

What happens when a business buys or sells assets that have no fixed or determinable useful life, such as goodwill that was not amortized under Sec 197 (self-created goodwill) or an exclusive franchise?

Answer 3

A capital gain or loss might arise

Question 4

When a business is sold or purchased, what assets might cause ordinary income or loss?

Answer 4

Ordinary income or loss might arise from the following assets:

• inventory
• accounts receivable
• covenants not to compete (all ordinary)
• section 1231 property, ex. land and depreciable trade or business property held for greater than 1 year, which includes section 1245 property (equipment) and section 1250 property (depreciable realty)

Question 5

When a taxpayer acquires property, what are the types of basis in the property?

Answer 5

• initial cost
• transferred basis
• exchanged basis

Question 6

What is cost basis?

Answer 6

The sum of the capitalized acquisition costs. Cost includes the FMV of property given up, if it is not determinable with reasonable certainty, use FMV of property received.

Question 7

If a purchaser receives a rebate, how is that treated regarding cost basis?

Answer 7

It is a reduction of the purchase price, it is not included in gross income

Question 8

Do amounts included in gross income increase cost basis?

Answer 8

Yes

Question 9

What is transferred basis?

Answer 9

It is computed by reference to basis in the property in the hands of another. This is also commonly referred to as carryover basis.

Question 10

What is exchanged basis?

Answer 10

It is computed by reference to basis in other property previously held.

Question 11

What happens to the basis of property when it is converted personal property to business property?

Answer 11

The basis of property converted into business use is the lesser of the FMV of the property at the conversion date or the adjusted basis at conversion. This prevents personal losses from being converted into business losses.

Question 12

What is stepped-up (or down) basis?

Answer 12

This occurs when property is acquired through inheritance and basis reflects FMV at the time of death.

Question 13

What is unit of property?

Answer 13

The unit of property is a group of functionally interdependent components and can either be an asset, group of assets, or a defined portion of an asset.

Question 14

How are tangible property costs determined to be deducted or capitlized?

Answer 14

By examining the unit of property

Question 15

What is the functional interdependence test?

Answer 15

Components of property are functionally interdependent if the placing in service of one component by the taxpayer is dependent on the placing in service of the other component by the taxpayer.

Question 16

What types of property are included in the functionally interdependent classification unit of property?

Answer 16

• personal and other real property
• improvements to a unit of property
• components with different property classes
• plant property
• network assets

Question 17

What type of property generally remains subject to the functional interdependence test?

Answer 17

Non-building property, personal or real property other than a building, all components that are functionally interdependent comprise a single unit of property.

Question 18

How must taxpayers identify units of property?

Answer 18

Taxpayers must further divide identified units of property into major components and substantial structural parts.

Question 19

How are costs to replace a major component or structural part treated?

Answer 19

If there is not an available exception, the costs must be capitalized.

Question 20

What is the initial basis of purchased property?

Answer 20

The cost of acquiring it, only capital costs are included.

Question 21

How may capital expenditures be made?

Answer 21

By cash, cash equivalent, property, with liability or by services.

Question 22

when must improvement expenditures be capitalized?

Answer 22

If it results in a betterment to the unit of property, adapts the unit of property to a new or different use, or results in a restoration of the unit of property.

Question 23

What expenditures are betterments of a unit of property?

Answer 23

An expenditure is a betterment if it ameliorates a condition or defect that existed before acquisition of the property or arose during the production of the property; it is a material addition to the property; or increases the property’s productivity, efficiency, strength, etc.

Question 24

What expenditures are adaptations of a unit of property?

Answer 24

An expenditure is an adaptation to a new or different use if it adapts the unit of property to a use inconsistent with the taxpayer’s intended ordinary use at the time the taxpayer originally placed the property into service.

Question 25

What expenditures are restorations of a unit of property?

Answer 25

An expenditure is a restoration if it restores a basis that has been taken into account, returns the unit of property to working order from a state of nonfunctional disrepair, results in a rebuilding of the unit of property to a like-new condition after the end of the property’s alternative depreciation system class life, or replaces a major component or substantial structural part of the unit of property.

Question 26

What are the capitalization rules for repainting a building’s exterior?

Answer 26

If painting is the only thing being done, the painting costs are expensed. If painting is part of a larger project that includes capital improvements to the building’s structure, the painting costs are capitalized.

Question 27

When a taxpayer acquires real or personal property how are the costs paid to facilitate the acquisition treated?

Answer 27

A taxpayer must capitalize amounts paid to facilitate the acquisition. This treatment applies when the amount is paid in the process of investigating or otherwise pursuing the acquisition. Examples include:

• appraisal fees
• transportation costs
• inspection costs
• sales and transfer taxes
• finders’ fees
• title and registration costs

Question 28

What is not included in facilitative costs?

Answer 28

Amounts paid to determine whether to acquire real property or which real property to acquire. Such amounts are current deductions. Amounts paid for employee compensation and overhead are not included in facilitative costs.

Question 29

What expenses are not chargeable to a capital account?

Answer 29

Costs of maintaining and operating property

Question 30

What are the uniform capitalization rules?

Answer 30

Costs for construction (manufacture) of real or tangible personal property to be used in trade or business and costs of producing or acquiring property for sale to customers (retail) are capitalized.

Question 31

How are costs and losses associated with demolishing a structure allocated?

Answer 31

They are allocated to the land. The basis of any new building constructed on the land is its original cost (not FMV).

Question 32

Are construction period interest and taxes capitalized as part of building cost?

Answer 32

Yes

Question 33

What indirect costs are not capitalized under the uniform capitalization rules?

Answer 33

• marketing
• selling
• advertising
• distribution
• research
• experimental
• sec 179
• strike
• warranty
• unsuccessful bid
• deductible service costs

Question 34

When do uniform capitalization rules not apply?

Answer 34

To producers and resellers if the company’s average annual gross receipts (for the last 3 years) do not exceed $27 million

Question 35

What is a de minimis expense?

Answer 35

A cost that is so small that it is not work tracking. Taxpayers can make an election to deduct a de minimis amount for each transaction relating to tangible property with an economic useful life of at least 12 months. Taxpayers may expense any purchased assets with a cost of less than $2,500 (per invoice or per item) provided they also use this policy for financial accounting purposes.

Question 36

What is the de minimis expense limit for a taxpayer that has audited or other approved financial statements?

Answer 36

Assets up to $5,000 per invoice or per item may be expensed

Question 37

How is the value of an asset determined for de minimis expense?

Answer 37

The value includes all capitalized costs, but the limit is applied on a per unit basis.

Question 38

How is the basis determined for lump-sum assets?

Answer 38

Each is computed pro rata by apportioning the total cost based on the relative FMV of each asset

(FMV of asset / FMV of all assets purchased) x lump sum purchase price

Question 39

What is the alternative apportioning of basis for lump-sum assets when the basis is not computed pro rata?

Answer 39

The transferor and transferee may agree in writing as to the allocation of consideration or the FMV of any assets. The agreement is binding unless the IRS deems it improper.

Question 40

When is the residual method used for basis in the purchase of lump-sum assets?

Answer 40

The residual method must be used for any transfers of a group of assets that constitutes a trade or business and for which the buyer’s basis is determined only by the amount paid for assets.

Question 41

What is the residual method of allocating basis?

Answer 41

The residual method allocates purchase price for both transferor and transferee to asset categories up to FMV in the following order:

1. cash and cash equivalents
2. near-cash items, such as CDs, U.S. government securities, foreign currency, and other marketable securities
3. accounts receivable, mortgages, and credit card receivables acquired in the ordinary course of business
4. property held primarily for sale to customers in the ordinary course of a trade or business or stocks included in dealer inventory
5. assets not listed in 1-4 above
6. Section 197 intangibles, such as patents and covenants not to compete except goodwill and going-concern value
7. goodwill and going-concern value

When the purchase price is lower than the aggregate FMV of the assets other than goodwill/going-concern value, the price is allocated first to the face amount of cash and then to assets 2-6 above, according to relative FMVs

Question 42

What is the basis when property is exchanged for services?

Answer 42

The FMV of property received in exchange for services is income (compensation) to the provider when it is not subject to a substantial risk of forfeiture and not restricted as to transfer. The property acquired has a tax cost basis equal to the FMV of the property.

Question 43

What is the basis of restricted stock sold to an employee?

Answer 43

Sale of restricted stock to an employee is treated as gross income to the extent the FMV exceeds the price paid. This amount is included in gross income in the first taxable year in which the property is unrestricted.

Question 44

What is the basis of property that is gifted?

Answer 44

The donee’s basis in property acquired by gift is the donor’s basis (transferred basis), increased for any gift tax paid attributable to appreciation. The donee’s basis is increased by:

gift tax x (FMV at time of gift - donor’s basis / FMV at time of gift - annual exclusion)

Question 45

What is the 2022 annual exclusion for gift tax purposes?

Answer 45

$16,000 per person, a donor can give a donee $16,000 each year without paying gift tax or using a portion of their lifetime exemption.

Question 46

What happens if the FMV on the date of the gift is less than the donor’s basis?

Answer 46

The donee has a dual basis for the property, which minimizes the gain(loss) recognized on a subsequent transfer.

Question 47

What is loss basis?

Answer 47

The FMV at the date of the gift is used if the property is later transferred at a loss

Question 48

What is gain basis?

Answer 48

The donor’s basis is used if the property is later transferred at a gain

Question 49

What happens if property is later transferred for more than FMV at the date of the gift but for less than the donor’s basis at the date of the gift?

Answer 49

No gain(loss) is recognized

Question 50

What is the basis when property other than money is contributed as a gift by a nonshareholder (ex. the goverment)?

Answer 50

The transferred basis is $0

Question 51

How is the basis determined for inherited property?

Answer 51

The basis is the FMV on the date of death or 6 months after if the executor elects the alternate valuation date for the estate tax return.

Question 52

What other types of inherited property follow the basis at the FMV on the date of death or 6 months after rule?

Answer 52

• property received prior to death without full and adequate consideration (if a life estate was retained in it) or subject to a right of revocation, basis is reduced by the depreciation deductions allowed to the donee
• one-half of community property interests
• property acquired by form of ownership, ex. by right of survivorship, except if consideration was paid to acquire the property from a nonspouse

Question 53

What is adjusted basis?

Answer 53

When the initial basis is adjusted consistent with tax-relevant events.

Question 54

What are adjustments to the initial basis?

Answer 54

• certain expenditures subsequent to acquisition are property costs, and they increase basis, ex. legal fees to defend title or title insurance premiums.
• Basis must be increased for expenditures that prolong the life of the property by at least 1 year or materially increase its value, ex. improve the unit of property. Assessments/improvements that increase the value of property should be capitalized. ex. major improvements such as new roof, addition to building, and zoning changes

Question 55

How are repairs and maintenance expenses treated with regard to adjustments to basis?

Answer 55

Generally repairs and maintenance expenses are considered a current period deduction. However, certain repairs may be classified as an improvement, which must be capitalized. There are multiple safe harbors that allow repairs and maintenance to always be classified as current period expense instead of capitalized.

Question 56

Can taxpayers who have elected to use the de minimis expense treatment capitalize repairs below the de minimis amount?

Answer 56

No, all repairs up to the de minimis amount must be expensed.

Question 57

What is the safe harbor that allows routine repairs and maintenance to be expensed if they result in an improvement to the unit of property?

Answer 57

A safe harbor allows routine repairs and maintenance to be expensed even though the costs of performing certain routine maintenance activities for property may result in an improvement to the unit of property. This safe harbor applies to actions that maintain the asset and is reasonably expected to be performed more than once for the asset’s class life under the alternative depreciation system.

Question 58

How is basis adjusted for depreciation?

Answer 58

Basis must be reduced by the larger of the amount of depreciation allowed or allowable (even if not claimed). Unimproved land is not depreciated.

Question 59

How do voluntary contributions of capital to a corporation affect shareholder basis?

Answer 59

The shareholder’s stock basis equals their basis in the contributed property. The corporation has a transferred basis in the property. A shareholder does not recognize gain on the voluntary contribution of capital to a corporation.

Question 60

How does a return of capital distribution affect shareholders?

Answer 60

A return of capital distribution reduces basis and becomes a capital gain when the shareholder’s basis in the stock reaches zero.

Question 61

How is basis determined for stock acquired in a nontaxable distribution, ex. stock rights?

Answer 61

The stock is allocated a portion of the basis of the stock upon which the distribution was made.

• If the new shares and old shares are not identical, the basis is allocated in proportion to the FMV of the original stock and the distribution as of the date of distribution.
• If the new and old shares are identical, ex. stock splits, the old basis is simply divided among the new total of shares.
• If the FMV of the stock rights is less than 15% of the FMV of the stock upon which it was issued, the rights have a basis of zero, unless an election is made to allocate basis.

Question 62

What are examples of certain specific items that represent a tax benefit that requires basis adjustment?

Answer 62

• casualty losses reduce basis by the amount of the loss, by any amounts recovered by insurance, and by any amounts for which no tax benefit was received, ex. $100 floor for individuals with losses only attributed to a federally declared disaster and losses to the extent of casualty gains are deductible
• debt discharge, specific exclusion from gross income is allowed to certain insolvent persons for debt discharged. Taxpayers may elect to reduce basis in depreciable assets by the amount of the exclusion. If an election is not made, they must reduce certain tax attributes
• credit for building rehabilitation. The full amount of credit must be deducted from the basis.

Question 63

What are common examples of decreases to basis?

Answer 63

• exclusion from income of subsidies for energy conservation measures
• casualty for theft loss deductions (losses only attributed to a federally declared disaster and losses to the extent of casualty gains are deductible) and insurance reimbursements
• certain vehicle credits
• section 179 deduction
• deductions previously allowed (or allowable) for amortization, depreciation, and depletion
• depreciation
• nontaxable corporate distributions
• rebates treated as adjustments to the sales price

Question 64

What are capital assets?

Answer 64

All property is characterized as a capital asset, unless expressly excluded. Property held either for personal use or for the production of income is a capital asset, but dealer property (property held primarily for sale to customers in the ordinary course of trade or business) is not.

Question 65

What are types of property that are not considered capital assets?

Answer 65

• inventory (or stock in trade) - property held primarily for sale to customers in the ordinary course of a trade or business
• real or depreciable property used in a trade or business
• accounts or notes receivable acquired in the ordinary course of trade or business for services rendered for 1 or 2 above
• copyrights and artistic compositions held by the person who composed them
• certain U.S. government publications acquired at reduced cost

Question 66

Are stocks, bonds, and commodities capital assets?

Answer 66

Yes, unless they are dealer property

Question 67

If land held primarily for investment is subdivided is it a capital asset?

Answer 67

It is a capital asset until subdivided, and then may be treated as converted to property held for sale in a trade or business.

Question 68

What is goodwill generated within the business?

Answer 68

If a business sells its assets and receives more than the FMV of those assets, the remainder is considered a capital gain from the sale of goodwill and is then a capital asset.

Question 69

When are gains (losses) realized regarding property?

Answer 69

Generally, all gains (losses) are realized on the sale or other disposition of property. This includes sales or exchanges that are required in characterizing a realized gain or loss as capital. For capital assets that become wholly worthless during the year, the sales or disposition date is considered to be the last day of the year.

Question 70

For real property what is the date of sale/exchange?

Answer 70

The date of conveyance or the date that the burdens of ownership pass to the buyer.

Question 71

How are liquidating distributions and losses on worthless securities treated?

Answer 71

As sales or exchanges

Question 72

What happens if in a transfer of a franchise, the transferor retains significant power, rights, or continuing interest with respect to the franchise?

Answer 72

The transfer of the franchise is not treated as a sale or exchange of a capital asset.

Question 73

What is the formula for calculating a gain (loss)?

Answer 73

Money received + FMV of other property received + liability relief - money or other property given up - selling expenses - liabilities assumed = amount realized

amount realized - adjusted basis = gain (loss) realized

Question 74

According to the IRC how must gains and losses be treated?

Answer 74

All realized gains must be recognized unless the IRC expressly provides otherwise and no deduction is allowed for a realized loss unless the IRC expressly provides for it.

Question 75

Are losses on personal-use property deductible?

Answer 75

Though personal-use property is a capital asset and gains from such property are recognized, a loss is not deductible.

Question 76

What is the holding period of an asset?

Answer 76

The period beginning the day after acquisition and including the disposal date, measured in months.

Question 77

What is long-term capital gain or loss?

Answer 77

A gain or loss realized from a capital asset held for more than 1 year.

Question 78

What is a short-term capital gain or loss?

Answer 78

A gain or loss realized from a capital asset held for 1 year or less.

Question 79

For individuals, what is net capital gain (NCG)?

Answer 79

The excess of net capital LTCG over STCL, STCG is not included in NCG

Question 80

What is short-term capital gain (STCG)?

Answer 80

STCG= STCG - STCL

This is treated as ordinary income, net capital gain rates do not apply to net STCG. STCG may be offset by net LTCL

Question 81

How are capital transactions involving long-term holding periods taxed for individuals?

Answer 81

They are grouped by tax rates based on filing status

Question 82

What is the capital gains rate for unrecaptured Sec. 1250 gains?

Answer 82

25%

Question 83

What is the maximum capital gains rate of 28% applied to?

Answer 83

Gains and losses from the sale of collectibles and the taxable portion of gains from qualified Sec. 1202 stock (gains from certain small business stock after the 50% or 75% exclusion is applied)

Question 84

How are long-term gains/losses classified into the appropriate capital gains rate “basket”?

Answer 84

By separating by amount and then using losses to offset gains starting with the highest basket. Ex. loss of 10k, would first offset a gain in the 28% basket, and any remaining loss would go to the 25%, and then 15% baskets. Any remaining long-term capital loss is carried over to the next year and is then used to offset net gain beginning with the 28% basket, etc.

Question 85

How much can an individual deduct as a net capital loss in the current year?

Answer 85

Up to the lesser of $3,000 ($1,500 if MFS) or ordinary income. Excess CLs are carried forward indefinitely. The carryforward is treated as a CL incurred in the subsequent year. No carryover is allowed from a decedent to his or her estate.