Federal Taxation of Property Transactions (5-15%) Flashcards
what is the tax basis of an asset purchased for use in a trade or business?
property basis consideration which means the amount paid
what is the tax basis of property received as a gift or as an inheritance from a descendent?
The basis for determining the gain or loss on the sale of converted property depends on whether the property appreciated or declined in value during the time the property was used personally. For appreciated property (i.e., the fair market value at the date of the conversion is greater than the taxpayer’s basis in the property), the taxpayer will use their basis to calculate depreciation and gain or loss at disposition.
For property with a basis greater than value, taxpayers may try to convert nondeductible personal losses to business losses by converting the property into business property and then selling it. In order to prevent this from occurring, the dual basis rules apply. If the fair market value at the date of conversion is below the taxpayer’s basis, the taxpayer will use the fair market value at the date of conversion as the basis for calculating loss and will use the basis at date of conversion to calculate gain. The fair market value at the date of conversion is also the basis used to calculate depreciation on property that has declined in value prior to the conversion regardless of whether the taxpayer subsequently sells the property for a gain or a loss. After conversion, the taxpayer adjusts the basis (whether gain or loss) for depreciation deductions from the date of conversion to the date of disposition. If the property later sells for an amount that falls between the adjusted basis for gain and the adjusted basis for loss, the basis for the sale is treated as the sales price so that the taxpayer does not recognize gain or loss on the sale.6
refer to “what if example” exhibit
what is the tax basis of stock acquired through a wash sale?
Consider the case of a taxpayer attempting to do some tax planning near the end of the year: The taxpayer invested in the stock of several corporations; some of these investments have appreciated, while others have declined in value. The taxpayer wants to capture the tax benefit of the stock losses in the current year to offset ordinary income (up to $3,000) or to offset other capital gains already recognized during the year. However, the losses cannot be deducted until the taxpayer sells the stock. Why might this be a problem? If the taxpayer believes that the stocks with unrealized losses are likely to appreciate in the near future, the taxpayer may prefer not to sell those stocks but rather to keep them in the investment portfolio. What might this taxpayer do to deduct the losses while continuing to hold the investment in the stocks? For one, the taxpayer might be tempted to sell the stocks and then immediately buy them back. Or the taxpayer might buy more of the same stock and then sell the stock they originally held to recognize the losses. With this strategy, the taxpayer hopes to realize (and then recognize or deduct) the losses and, at the end of the day, still hold the stocks in their investment portfolio.
Although that might sound like a great plan, certain wash sale tax rules prevent this strategy from accomplishing the taxpayer’s objective.33 A wash sale occurs when an investor sells or trades stock or securities at a loss and within 30 days either before or after the day of sale buys substantially identical stocks or securities.34 Because the day of sale is included but not the day of acquisition, the 30 days before and after period creates a 61-day window during which the wash sale provisions may apply. When the wash sale provisions apply to a sale of stock, realized losses are not recognized; instead, the amount of the unrecognized loss is added to the basis of the newly acquired stock. Congress created this rule to prevent taxpayers from accelerating losses on securities that have declined in value without actually altering their investment in the securities. The 61-day period ensures that taxpayers cannot deduct losses from stock sales without exposing themselves to the risk that the stock they sold will subsequently increase in value. Interestingly, because Bitcoin is considered property rather than a security, absent new legislation, the wash sale provisions don’t apply to Bitcoin (or other crypto assets). Given the volatile nature of Bitcoin, many Bitcoin investors sell and immediately buy the Bitcoin back in order to recognize the losses while still owning the Bitcoin. Some suggest that the fact that the wash sale rules don’t apply to Bitcoin contributes to its volatility.
refer to “what if example” exhibit
what is the basis of intangible assets, including organization costs, start up costs, and loan costs?
Organizational expenditures include expenditures to form and organize a business in the form of a corporation or an entity taxed as a partnership.62 Organizational expenditures typically include costs of organizational meetings, state fees, accounting service costs incident to organization, and legal service expenditures such as document drafting, taking minutes of organizational meetings, and creating terms of the original stock certificates. These costs are generally incurred prior to the starting of business (or shortly thereafter) but relate to creating the business entity. The costs of selling or marketing stock do not qualify as organizational expenditures and cannot be amortized.63
Businesses may immediately expense up to $5,000 of organizational expenditures.64 However, corporations and partnerships incurring more than $50,000 in organizational expenditures must phase out (reduce) the $5,000 immediate expense amount dollar-for-dollar for expenditures exceeding $50,000. Thus, businesses incurring at least $55,000 of organizational expenditures are not allowed to immediately expense any of the expenditures.
refer to “what if example” exhibit and “organizational expenditures” exhibit
what is adjusted basis?
- Adjusted Basis of Property. Gain or loss from the sale or other disposal of property is the difference between the amount realized from the sale and taxpayer’s basis in the property (Code Sec. 1011; Reg. § 1.1011—1). Basis is generally the taxpayer’s original investment in the property (cost basis), but the taxpayer may have :1 substitute or carryover basis in certain cases (1] 1607) (Code Sec. 1012). If property is acquired in a fully taxable exchange, the cost of the property acquired is the fair market value of the property given up. In an arm’s—length transaction, both are presumed to be equal in value.
Regardless of the manner in Which the taxpayer’s original basis in property is determined, certain upward or downward adjustments are made to that basis. For example, capital expenditures increase basis (1] 1611), while depreciation decreases basis (1] 1617). The original basis, increased or decreased by these adjustments, is the taxpayer’s adjusted basis.
- Additions to Basis of Property. In computing gain or loss on the sale of business or investment property, or gain on the sale of personal property, the cost or other basis must be adjusted for any expenditure, receipt, loss, or other item that is a capital expenditure other than taxes or carrying charges (1] 1614) that the taxpayer deducts in determining taxable income (Code Sec. 1016(a) (1); Reg. § 1.1016-2).
refer to “adjusted basis” exhibit and “what if example” exhibit
how are section 1231 assets defined?
~ depreciable property used in the taxpayer’s trade or business and 1.) held more than one year, other than;
(i) property includible in inventory, (ii) property held primarily for sale to customers, (iii) a copyright, a literary, musical or artistic composition, or a letter, memorandum, or similar property, and a patent, invention,
model, design, secret formula, or process, and (iv) certain federal government publications;
IT DOES INCLUDE ;
~ real property used in the trade or business and held for more than one year, other than property that is includible in inventory or held primarily for sale to customers;
~ trade or business property held for more than one year and compulsorily or involuntarily converted (1] 1748);
~capital assets held for more than one year in connection with a trade or business or a transaction entered into for profit, and compulsorily or involuntarily converted;
~ an unharvested crop on land used in the trade or business and held for more than one year, if the crop and land are sold, exchanged, or involuntarily converted at the same time to the same person;
~certain livestock, but not poultry (1] 1750); and
~timber, domestic iron ore, and coal (1] 1772).
If section 1231 property is subject to depreciation recapture, the section 1231 gain is the amount by Which the total gain exceeds the amounts recaptured and taxed at ordinary income rates (1] 1779). The recapture of certain farmland expenses may also reduce section 1231 gain (1] 1797). A gain or loss that is disallowed by other rules,_ such as a loss on a sale between related parties (1] 1717), is not taken into account in determining section 1231 gains and losses.
Recapture 0f Net Section 1231 Losses. Net section 1231 losses must be recaptured by treating the current year’s net section 1231‘gain (section 1231 gain that exceeds current- year 1231 losses).
refer to “section 1231 assets” exhibit
what is section 1245?
FULL DEPRECIATION RE-CAPTURE
§ 1245 is a subset of § 1231
Does not include depreciable real property, building or a warehouse.
EQUIPMENT
EXAMPLES
When taxpayers sell or dispose of §1245 property, they encounter one of the following three scenarios involving gain or loss:
Scenario 1: They recognize a gain created solely through depreciation deductions.
Scenario 2: They recognize a gain created through both depreciation deductions and actual asset appreciation.
Scenario 3: They recognize a loss.
refer to “section 1245” exhibits
what is section 1250?
Depreciable real property, such as an office building or a warehouse, sold at a gain is not subject to §1245 depreciation recapture. Rather, it is potentially subject to a different type of recapture called §1250 depreciation recapture. Thus, depreciable 1250 is a subset of 1231.
PARTIAL DEPRECIATION RE-CAPTURE
IS A DEPRECIATION RE-CAPTURE METHOD.
FOR AN OFFICE BUILDING OR WAREHOUSE
Depreciable real property, such as an office building or a warehouse, sold at a gain is not subject to §1245 depreciation recapture. Rather, it is potentially subject to a different type of recapture called §1250 depreciation
recapture. Thus, depreciable real property is frequently referred to as §1250 property
when depreciable real property is sold at a gain, the amount of gain recaptured as ordinary
income is limited to additional depreciation, defined as the excess of accelerated depreciation
deductions on the property over the amount that would have been deducted if the taxpayer had
used the straight-line method of depreciation to depreciate the asset. In addition, depreciation
taken on property held for one year or less (even if straight- line) is subject to §1250 recapture.
This classification is relatively unimportant because any gain or loss on property held one year
or less is classified as ordinary (not §1231).
refer to “Section 1250 Depreciation Recapture” exhibit
what is the netting process of capital gains and losses on the sale of property?
SHORT-TERM
AFTER ALL PROCEDURES IF RESULTS IN A GAIN
TAX AT ORD INCOME RATES
AFTER ALL PROCEDURES IF RESULTS IN A LOSS
APPLY LOSS LIMITS
($3,000 OR $1,500)
LONG-TERM
AFTER ALL RESULTS IN A GAIN
TAX BASED UPON RESPECTIVE CATEGORIES WHERE IT ENDS
AFTER ALL PROCEDURES RESULTS IN A LOSS APPLY LOSS LIMITS ($3,000 OR $1,500)
Thus, both net long-term capital losses and net short—term capital losses may be used to offset up to $3,000 of an
individual’s ordinary income ($1,500 for married individuals filing separate returns).
FINAL NETTING IS GAINS VERSUS LOSSES (REGARDLESS OF S-T OR L-T).
refer to “Netting Process” exhibit
when is the 25 percent and 28 percent rate used for capital gains and losses?
refer to “25 Percent and 28 Percent Rate Capital Gains” exhibit
what is the limitation on capital losses?
- Limitation on Capital Losses. To determine the deductibility of capital losses (1[ 1735), the taxpayer totals all capital gains and losses, both long term and short term, incurred during the year.
For a noncorporate taxpayer, capital losses are deductible only to the extent of capital gains, plus $3,000 of ordinary income (Code Sec. 1211(b); Reg. §1.1211-1(b)). Thus, both net long-term capital losses and net short—term capital losses may be used to offset up to $3,000 of an individual’s ordinary income ($1,500 for married individuals filing separate returns). Special rules apply to married individuals, whether filing joint or separate returns (1] 1757). Unused losses are carried forward (1] 1754).
how do you calculate tax depreciation for tangible business property using MACRS,
including identification of the applicable recovery period and convention?
Personal property includes all tangible property, such as computers, automobiles, furniture, machinery, and equipment, other than real property. Note that personal property and personal-use property are not the same thing. Personal property denotes any property that is not real property (e.g., building and land), while personal-use property is any property used for personal purposes (e.g., a personal residence is personal-use property even though it is real property). Personal property is relatively short-lived and subject to obsolescence, as compared to real property.
Depreciation Method
MACRS provides three acceptable methods for depreciating personal property: 200 percent (double) declining balance (DB), 150 percent declining balance, and straight-line.23 The 200 percent declining balance method is the default method. This method takes twice the straight-line percentage of depreciation in the first year and continues to take twice the straight-line percentage on the asset’s declining basis until switching to the straight-line method in the year that the straight-line method over the remaining life provides a greater depreciation expense. Fortunately, as we describe below, the IRS provides depreciation tables to simplify the calculations.
Profitable businesses with relatively high marginal tax rates generally choose to use the 200 percent declining balance method because it generates the largest depreciation deduction in the early years of the asset’s life and, thus, the highest current-year, after-tax cash flows. For tax planning purposes, taxpayers that currently have lower marginal tax rates but expect their marginal tax rates to increase in the near future may elect to use the straight-line method because that method generates less depreciation in the early years of the asset’s life, relatively, and more depreciation in the later years when their marginal tax rates may increase.
Depreciation Recovery Period
For financial accounting purposes, an asset’s recovery period (depreciable life) is based on its taxpayer-determined estimated useful life. In contrast, for tax purposes, an asset’s recovery period is predetermined by the IRS in Rev. Proc. 87-56. This revenue procedure helps taxpayers categorize each of their assets based upon the property’s description. Once the business has determined the appropriate categories for its assets, it can use the revenue procedure to identify the recovery period for all assets in a particular category.
refer to “tax depreciation” and “recovery period for most common business assets” exhibits
what are the depreciation conventions?
N0 depreciation deduction is allowed if MACRS property is
placed in service and disposed of in the same tax year.
- Half-Year Convention:
- Definition: Assumes that all assets are placed in service or disposed of at the midpoint of the year.
- Application: Used under the Modified Accelerated Cost Recovery System (MACRS) for most property. This convention simplifies calculations by assuming a half-year of depreciation in the year the asset is placed in service and the year it is disposed of.
This convention is typically used when assets are acquired at various times throughout the year. It simplifies depreciation calculations by assuming all assets are placed in service at the midpoint of the year, regardless of their actual acquisition date.
- Impact : if an asset is acquired at any time during the year, it is treated as if it were acquired in the middle of the year, resulting in half a year’s depreciation being allowed in the first year.
- Mid-Quarter Convention:
- Definition: Applies if more than 40% of the total depreciable basis of property is placed in service during the last three months of the tax year.
- Application: Under MACRS, this convention assumes assets are placed in service or disposed of at the midpoint of the quarter in which the transaction occurs. It is used to prevent taxpayers from gaining an unfair tax advantage by placing a large portion of depreciable property in service at the end of the year.
This convention comes into play if more than 40% of the total depreciable basis of all property is placed in service in the last three months of the tax year.
- Impact: If an asset is acquired in the last three months of the year and the total acquisitions for this period exceed 40% of the total depreciable basis of all property placed in service during the year, the mid-quarter convention must be used. This convention assumes assets are placed in service at the midpoint of the quarter (1st 2nd, etc) in which they are acquired, spreading depreciation more evenly throughout the year.
- Mid-Month Convention:
- Definition: Assumes that all assets are placed in service or disposed of at the midpoint of the month.
- Application: Primarily used for real property, such as buildings and improvements, under MACRS. It ensures that half a month’s depreciation is taken for the month the asset is placed in service and the month it is disposed of.
This convention is primarily used for real property, such as buildings and improvements.
- Impact: If real property is acquired during any month, the mid-month convention assumes the property is placed in service at the midpoint of that month. This means that half a month’s depreciation is taken for the month of acquisition, regardless of the specific date within the month when the property was placed in service.
refer to “mid-quarter convention” exhibit
how do you determine property eligible for a Section 179 deduction?
refer to “1245 assets:179 expenses” and “section 179” exhibits
how do you calculate tax amortization for intangible assets?
refer to “tax amortization for intangible assets” exhibit
Review a tax depreciation and amortization schedule for the current year
and supporting documentation, including any source data used to create
the schedule, to determine the completeness and accuracy of the expense
amounts deducted for tax purposes.
Review and resolve discrepancies identified by automated diagnostic and
validation checks to ensure the completeness and accuracy of the depreciation
and amortization expense reported on a tax return based on the source data used
to prepare the return.
