Chapter 13 Flashcards
The Taxation of Capital Gains and Losses
Definition of a capital asset
Under Sec. 1221 of the Internal Revenue Code, a capital asset is defined as any property the taxpayer owns (connected with a business activity or not) except for the following types of property that are specifically excluded from the definition:
• “stock in trade” (that is, inventory) of the taxpayer or other property held by the tax- payer primarily for sale to customers in the ordinary course of the taxpayer’s business
• depreciable or real property used in the taxpayer’s trade or business
• patent; invention; model or design (whether patented or not); a secret formula or pro- cess; a copyright; a literary or artistic composition; a letter or memorandum; or similar property held either by the creator of the property
• accounts or notes receivable acquired in the ordinary course of business for services rendered or for the sale of inventory or inventory-type property
• supplies of a type regularly used or consumed in the ordinary course of a trade or business
• publications of the United States government that are held by a taxpayer who did not purchase the publication or by a nonpurchasing transferee (i.e., a gift) of such a taxpayer
Corporate capital gain or loss
For corporations, there is no tax significance regarding the holding period of a capital asset. This is so because no special tax rates apply to corporate capital gains and losses; such gains and losses are simply netted against one another. If there is a net capital gain for the year, the corporation pays tax on the net gain at ordinary income tax rates. If there is a net loss, the corporation cannot deduct the net capital loss against its other income but can carry it over to offset past or future capital gain.
Corporate taxpayers may carry capital losses back to each of the three preceding years (earliest year first) and forward to the next five years to offset capital gains in such years. Corporate carryback or carryover losses are deemed short-term capital losses for netting purposes.
Exceptions to the long term capital gains 20% max for individuals?
- The sale of depreciable real property that is attributable to unrecaptured depreciation (unrecaptured Sec. 1250 gain) claimed on the property
is taxed at a rate of no higher than 25 percent. - Second, long-term gain from the sale of collectible capital assets is taxed at a rate of no higher than 28 percent. “Collectible” assets include works of art, rugs, antiques, certain stamps, coins, precious stones and metals, and alcoholic beverages.
Maximum Tax Rates for Long-Term Capital Gains
- 28 percent: “collectibles” gain
- 25 percent: gain attributable to unrecaptured depreciation on real estate
- 20 percent: maximum long-term gains for single filers with taxable income exceeding $425,800 and married filing jointly filers greater than $479,000
- rate of 0 for single filers up to taxable income of $38,600 and 15% between $38,601- $425,800
- rate of 0 for married filing jointly up to taxable income of $77,200 and 15% between $77,201-$479,000
Individual Capital Losses
capital losses may be deducted from the taxpayer’s ordinary income in an amount up to $3,000 per year. If such net capital losses exceed $3,000, the excess may be carried forward to future tax years by individual taxpayers until the excess losses are used up.
Process for determining gain
1) basket all gains and losses in their respective categories and come up with a net gain or loss
2) if any of the categories have net loss, net short-term capital losses are netted against the capital gains subject to the highest rates first.
3) Any net long term capital losses are netted against the capital gains subject to the highest rates first
Sec. 1231 Assets
“depreciable or real property used in the taxpayer’s trade or business.”
Taxation of Sec. 1231 Assets
Simply stated, upon the sale or taxable exchange of property that meets the definition of a Sec. 1231 asset, gain will be treated as long-term capital gain and loss will be treated as ordinary loss.
Example
Michael owns a pickup truck that he acquired for $22,000 and uses exclusively in his business. His adjusted basis in the truck is $19,000 (after deducting depreciation of $3,000). He sells the truck for $12,000 and does not acquire another vehicle at the time of the sale. His $7,000 loss on the sale of the truck is treated as an ordinary loss. If he had sold the truck for $25,000, his $6,000 of gain would be treated as a capital gain of $3,000 and ordinary income of $3,000 (The ordinary income of $3,000 represents that portion of his gain subject to recapture of depreciation).
Calculation of net investment income tax
A single taxpayer, Harry, has $250,000 in wages and net investment income of $50,000 for a MAGI of $300,000. Harry would owe net investment income of 3.8 percent on the lesser of (1) net investment income of $50,000 or (2) $300,000 less $200,000 or $100,000. The tax would be 3.8% of $50,000 or $1,900. Contrast the tax result for Sally who has identical MAGI of $300,000 consisting of net investment income of $70,000 and wages of $230,000. Her net investment income tax would be 3.8 percent of $70,000 or $2,660.
Strategies to Minimize Application of the Tax
A taxpayer with MAGI less than the applicable amount avoids taxation of his net investment income. Taxpayers will seek to derive income from distributions from qualified plans or IRAs as well as interest from tax-exempt bonds, all of which are exempt from the tax. Income from a trade or business as well as self-employment income are also exempt from the tax. In addition, charitable remainder trusts and other tax-exempt trusts are not subject to the net investment income tax.
Two single taxpayers with identical amounts of MAGI over the threshold amount will always pay identical investment income tax.
Individuals are subject to a tax of net investment income for each year of 3.8 percent imposed on the lesser of (a) net investment income or (b) the excess of modified adjusted gross income over the threshold amount. It is possible for taxpayers to have identical modified adjusted gross income yet have differing amounts of net investment income. Consider the example of two couples filing jointly with identical modified adjusted gross income of $325,000. However, they may pay different amounts of net investment income tax because they have differing amounts of net investment income. Thus each couple will pay a differing amount of net investment income tax.
The portion of an individual’s long-term capital gains from the sale of real estate that is attributable to unrecaptured depreciation is subject to a maximum tax rate of 25 percent.
True
Individuals may deduct up to $5,000 of net capital losses per year against ordinary income.
False
The maximum annual amount of net capital losses that can be deducted against ordinary income is $3,000 ($1,500 if married filing separately).
Sales of collectibles qualify for the lowest maximum tax rate on long-term capital gains of individuals.
False
The gain on collectibles is subject to a maximum capital-gains rate of 28 percent.
Short-term capital gains and losses of individual taxpayers are netted together to determine the taxpayer’s net short-term capital gain or loss.
True
