Capital Gains Taxation

Question 1

What is the main tax consideration with the disposition of property?

Answer 1

Whether the property is transferred at a gain or loss

This gain or loss can be capital or ordinary (e.g. selling a personal-use item), though capital gains and losses (i.e. involving capital assets) are most relevant to taxation

Question 2

As regards property disposition, how do taxable exchanges and nontaxable exchanges differ?

Answer 2

Taxable exchanges require a gain or loss to be recognized – usually as the difference between the value received for the item and the item’s adjusted basis with the transferor

Nontaxable exchanges do not require a gain or loss to be recognized either because they permanently exclude all taxable gain or loss, or (more commonly) because they realize the gain or loss but defer its recognition until a taxable transaction occurs

Question 3

What kind of property does not count as a capital asset?

Answer 3

(1) inventory
(2) receivables
(3) property used in the course of business
(4) copyrights or other properties whose basis is determined from the creator (e.g. art)
(5) U.S. gov’t publications received for free

Question 4

When does a holding period count as long-term or short-term?

Answer 4

Long-term = longer than twelve months
Short-term = twelve months or shorter

Short-term capital gains and losses are taxed with the rest of ordinary income, while long-term ones receive a special tax rate

Question 5

If property is transferred in some tax-free exchange (e.g. as a gift), how is the holding period affected?

Answer 5

If the donor’s basis becomes the donee’s basis, then the holding period extends from the donor’s holding period, but if its basis is FMV, then a new holding period begins

Question 6

If property is transferred from a decedent, how is the holding period affected?

Answer 6

All property transferred this way is automatically considered to have a long-term holding period for the recipients

Question 7

How do capital losses affect one’s tax liability?

Answer 7

They offset capital gains

If a taxpayer has a net capital loss, he can only deduct it to the lesser of $3,000 or his taxable income – any remaining capital losses can be carried forward indefinitely (but not carried back)

Question 8

What is the tax rate for net long-term capital gains?

Answer 8

For 2013, taxpayers in the bottom two tax brackets (10% and 15%) pay no tax on capital gains, the very highest bracket (39.6%) pays 20%, and everyone else pays 15%

Question 9

Does the reduced capital gains tax rate apply to all gains?

Answer 9

No, it does not apply to collectibles (e.g. artwork, metals), which have a maximum rate of 28%

Question 10

How do capital gains and losses differ for corporations?

Answer 10

Corporations cannot deduct net capital losses past capital gains, yet they can carry capital losses back three years, though forward only five years

Moreover, capital gains rates for corporations are the same as for income

Question 11

What is Section 1231 property?

Answer 11

Depreciable property or land utilized for business purposes which receives a special tax treatment

Question 12

What is the special tax treatment for Section 1231 property?

Answer 12

Net capital losses on such property are treated as ordinary losses, while net capital gains are treated as capital gains

Question 13

Under what circumstances would the disposal of Section 1231 property result in a recapture of previous deductions?

Answer 13

Since Section 1231 property is depreciable and depreciation expense reduces ordinary taxable income, then some of a capital gain (upon disposal) will have to be recaptured as ordinary income in order to offset the higher taxes avoided with the previous depreciation

Question 14

What other property can have recaptured capital gains?

Answer 14

Section 1245 property – mostly personal property

Section 1250 property – mostly real property

Question 15

How do related-party transactions affect capital gains and losses?

Answer 15

Such transactions cannot give rise to capital losses

Related parties can involve family, >50% owned entities, commonly controlled corporations, and trusts

Question 16

What is a like-kind exchange, and what are the tax implications related to it?

Answer 16

A transaction involving property of the same nature

These exchanges, if they involve property used for business or investment purposes, can avoid recognizing any gain or loss – not if they involve personal-use property

Question 17

Does an exchange count as a like-kind exchange if one item is business-use and the other is investment-use?

Answer 17

Yes

Question 18

Related to like-kind exchanges, what property counts as personal-use property?

Answer 18

(1) securities (e.g. stocks and bonds)
(2) certificates of trust
(3) partnership interests
(4) beneficial interests

Question 19

In a like-kind exchange where no gain is recognized, how is the basis determined?

Answer 19

The adjusted basis of the property disposed of is the new basis for the property received

Question 20

What is boot?

Answer 20

Any money or non-like-kind property given in a like-kind exchange (usually doesn’t constitute the majority of the transaction)

A liability assumed by one party would count as boot given by that party to the other

Question 21

How does boot affect the recognition of a capital gain or loss?

Answer 21

If boot is given, a loss cannot be recognized, and a gain must be either (a) the gain realized or (b) the boot received, whichever is lesser

Question 22

How does boot affect the basis of received property?

Answer 22

Basis of property given
+ basis of boot given
- FMV of boot received
= basis of property received

Question 23

For boot transactions, what is the difference between a realized gain and a recognized gain?

Answer 23

The realized gain is simply the FMV of property received less the basis of property given up

The recognized gain is the lesser of the realized gain and the boot received – in which case someone who receives no boot has a recognized gain of $0

This affects the final calculation, since the basis in the asset is the FMV received less the UNRECOGNIZED gain – that is, the realized gain less the recognized gain

Question 24

What is an example of a like-kind exchange with boot?

Answer 24

Frank gives a piece of equipment with a FMV of $2,500 and a basis of $1,800 to Joe in exchange for equipment with a FMV of $2,000 and a basis of $1,100. Joe also gives Frank $700 in cash.

Frank’s realized gain is the FMV received ($2,000 + $700) less the basis of property given up ($1,800) = $900. Joe’s realized gain = $2,500 - ($1,100 + $700) = $700. The recognized gain is the lesser of realized gain and boot received, so Frank’s recognized gain is $700 and Joe’s is $0. Unrecognized gain = (realized gain) - (recognized gain), so Frank’s unrecognized gain = $900 - $700 = $200. Joe’s = $700 - 0 = $700.

The basis in the new property = (FMV of property received) - (unrecognized gain), so Frank’s new basis = $2,000 - $200 = $1,800. Joe’s new basis = $2,500 - $700 = $1,800.

Question 25

How does the sale of a taxpayer’s home affect his capital gains?

Answer 25

So long as the home has been his principal residence for two of the five years before the sale, he can exclude a gain of $250,000 (or $500,000 if married filing jointly) for 2013

Question 26

For the sale of a home, what can a taxpayer deduct if he has not lived within the home for two of the last five years?

Answer 26

A pro rata portion of the deduction

This applies only if he does not meet the two-year requirement due to relocation for work, health problems, or some other type of unforeseen events

Question 27

How does the deduction for a gain on a home sale apply if the married couple did not live there together for two full years?

Answer 27

For 2013, only $250,000 can then be deducted, rather than $500,000

Question 28

How does the deduction for a gain on a home sale apply if one of the spouses died?

Answer 28

So long as the home was sold within two years of the death, the full marital deduction ($500k for 2013) can still be used

Question 29

Besides a failure to live in the home for two of the last five years, how else might a gain from a home sale not receive a full deduction?

Answer 29

Any use of the home for vacations or rentals in 2009 or later counts as a “non-qualifying use” which then lowers the deduction from the capital gain

The 2009 date is because of the Housing Assistance Tax Act of 2008 (HATA), which allowed rental/vacation use to be qualifying only up until Dec. 31, 2008

Question 30

For a home sale, how does a non-qualifying use of the home decrease the deduction of a capital gain?

Answer 30

The percentage of time attributable to a non-qualifying use causes that same percentage of the home’s capital gain to be included in taxable income

E.g. if a home was sold after being owned for 10 years, and it was used as a rental house for 3 of those years, then a capital gain of $50,000 would cause the taxpayer to pay taxes on $15,000 (30% x $50k) of those, the rest being deductible

Question 31

What are involuntary conversions?

Answer 31

Events where property is involuntarily disposed of (e.g. because destroyed or stolen), to be replaced by some other property (e.g. insurance proceeds)

Question 32

How is a gain or loss on an involuntary conversion recognized?

Answer 32

It is recognized as normal unless the lost property is one’s home

There are some exceptions to this, however

Question 33

Under what circumstances could someone not deduct a capital loss resulting from an involuntary conversion?

Answer 33

If there is a capital loss on personal-use property, that cannot be deducted except if it was caused by casualty or theft

Question 34

Under what circumstances would someone not need to recognize a capital gain from an involuntary conversion?

Answer 34

If similar-use property (which has a narrower meaning than “like-kind”) is acquired in exchange for the disposed property, then no gain is recognized, and the basis of the new property is the same as the basis of the old (disposed) property

Likewise, if non-similar-use property is acquired from the involuntary conversion (usually cash), then if that property is used to attain replacement similar-use property, the gain is not recognized (but deferred)

Question 35

How quickly must proceeds from an involuntary conversion be used to purchase a replacement item for the capital gain to be avoided?

Answer 35

This “replacement period” begins when either the property was stolen/destroyed or (if applicable) a condemnation was threatened or made imminent

This period ends two years (three years for real property) from the end of the first tax year in which any amount of gain was realized

Question 36

How are the tax consequences of involuntary conversions affected by special disasters (i.e. with a declaration from the president)?

Answer 36

They receive various special breaks, e.g. extending the replacement period to four years’ duration

Question 37

What is a wash sale?

Answer 37

The selling of a financial asset right before or after purchasing one of the same kind – done to gain a deduction based on an unrealized loss

Consequently these transactions are required to have 30 days between them

Question 38

How do stock dividends affect capital gains and losses?

Answer 38

Stock dividends are not taxable – the original basis is distributed among the total stock after the dividend according to their relative FMV

Question 39

If stockholders have an option to receive cash in lieu of stock dividends, do they still avoid taxation?

Answer 39

No, it then becomes a taxable transaction even if the stockholder opts for the stock dividends rather than the cash

Question 40

How do stock splits affect capital gains and losses?

Answer 40

They only affect the par value and quantity of stocks, not the total dollar investment in stock, so they have no effect

Question 41

What occurs if stock becomes entirely worthless?

Answer 41

The loss for such stock becomes deductible in the year that it becomes worthless

This is generally a capital loss, though it can be an ordinary loss in some circumstances

Question 42

Under what circumstances can worthless stock lead to an ordinary (rather than a capital) loss?

Answer 42

With Section 1244 stock – original investors in the first million stocks for a small business company can deduct an ordinary rather than capital loss

This maxes out at $50,000, however, or $100,000 for married filing jointly taxpayers

Question 43

How does qualified small-business stock (QSBS) relate to capital gains and losses?

Answer 43

Non-corporate investors who hold such stocks from their issuance for at least five years can deduct 50% of any gain they receive from disposing of such stock

This has a max deduction of either (a) 10 times the stock’s basis or (2) $10 million, whichever is greater

Question 44

Which businesses qualify to issue qualified small-business stock (QSBS)?

Answer 44

C corporations with under $50 million in capital when the stock was issued, and with at least 80% of its assets employed for business use

These corporations cannot be involved in personal services (e.g. accounting or healthcare), or be in finance, real estate, farming, or similar industries