Lesson 1 of Income Tax Planning: Property Taxation

Question 1

Categorizing Assets for Income Tax Purposes

Answer 1

For income tax purposes, property can be categorized several ways.

(1) How the Property is Held:

• For Personal Use?
• For Investment or Production of Income?
• Trade or Business Purposes?

(2) Whether the Property is what type of asset?

• A Capital Asset
• An Ordinary Income Asset
• A Section 1231 asset.

Question 2

What are Capital Assets?

Answer 2

• Most PERSONAL use assets and most INVESTMENT assets are capital assets.
• Depreciable property used in a trade or business is generally a Section 1231 asset, NOT a capital asset.
• Assets that are NOT capital assets or Section 1231 assets are ordinary income assets.

Question 3

What are NOT Capital Assets

Answer 3

Section 1221(a) of the IRC defines what is NOT a capital asset, including:

• Inventory,
• Depreciable property used in a trade or business,
• Copyrights and creative works (if held by the creator of such works),
• Accounts and notes receivable

EXAM TIP: ACID

Question 4

Exam Question

Which of the following is a capital asset?

a) A copyright on a textbook owned by the author.
b) A painting owned by an art collector.
c) Office furniture used in a business.
d) A note receivable.

Answer 4

Answer: B

A painting owned by an art collector is a capital asset. In contrast, a painting owned by the artist or a copyright owned by the author is an ordinary income asset. Office furniture used in a business is depreciable property used in a trade or business, so it would be Section 1231 property rather than a capital asset. A notes receivable is specifically excluded from being a capital asset under Section 1221.

Question 5

Exam Tips

Answer 5

Remember, all assets are capital assets except ACID
-Accounts/notes receivable,
-Copyrights and creative works,
-Inventory
-Depreciable property used in a trade or business

Question 6

Ordinary Income Assets

Answer 6

Ordinary Income assets are those assets that, when sold, result in ordinary income to the owner of the asset.

Some of the assets listed in Section 1221 (a) that are not capital assets are actually ordinary income assets including:

-Inventory
-Accounts Receivable
-Creations in the hands of the creator
-Copyrights in the hands of the creator

Question 7

Section 1231 Assets

Answer 7

Section 1231 assets are assets USED in a trade or business.

In addition to being used in a trade or business:
Section 1231 assets are either (1) Depreciable property or (2) real property

1231 Assets are LT Depreciable Assets: Broken Down

• 1245 Assets (NOT real estate)
• 1259 Real Estate

Question 8

Section 1231 Assets DO NOT INCLUDE:

Answer 8

-Inventory,

-Property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business, or

-Copyright or creative works

Question 9

Section 1231 Specifically INCLUDES certain property such as:

Answer 9

Timber,

Coal

Iron Ore

Certain Livestock, and

Unharvested Crops (under certain conditions).

Question 10

Determining The Basis

Answer 10

Purpose & Use of Basis
Cost Basis
Adjustments to Basis
Adjusted Taxable Basis -
Special Basis Rules
Tax Rates

A lower cost basis means you’ll recognize a bigger gain, and a higher cost basis means you’ll recognize a loss or simply a smaller gain.

Question 11

Purpose & Use Basis

Answer 11

Property can be acquired by purchase, gift, inheritance, or exchange. The method of acquisition affects the adjusted taxable basis of the property.

The purpose of basis is to allow taxpayers to recover the value of the assets (e.g., cash) used to purchase or acquire property.

Under the recovery of capital doctrine, basis is usually returned to a taxpayer tax free, either as the result of a sale or as the result of depreciation deductions.

Basis is necessary to:
-determine the amount of gain or loss on a sale or other disposition of property

-determine the amount that may be recovered tax free through depreciation deductions

-determine the deduction for obsolescence and sometimes for depletion

Question 12

Cost of Basis

Answer 12

Property received in a sale or exchange generally has a cost basis.

The cost basis is the amount paid in cash, debt obligations, other property, or services.

Cost also includes amounts paid for the following items:
-Sales tax,
-Freight,
-Installation and testing,
-Excise taxes,
-Legal and accounting fees (when they must be capitalized),
-Revenue stamps,
-Recording fees, and
-Real estate taxes (if assumed for the seller).

Question 13

Calculating Cost Basis

Answer 13

When property is acquired in a taxable exchange, the cost is the Fair Market Value (FMV) of the property given in exchange for what is received.

When property is acquired subject to a mortgage, the basis of the property is the FMV of the property.

When property is acquired as a dividend in kind or as compensation for services, the taxpayer’s basis in the property is the FMV of the property at the time of acquisition.

Question 14

Exam Question

Pat buys a new machine costing $58,000. She pays freight of $6,000 to get the new machine to her factory. She has also paid an additional 5% of the purchase price for sales tax. She hired a local company to install the equipment and paid them $10,000. What is Pat’s basis in her new machine?

a) $64,000
b) $66,900
c) $74,000
d) $76,900

Answer 14

Answer: D

Pat’s basis in her new machine is equal to the total costs associated with obtaining the machine and installing it in her factory. Therefore, her basis is $76,900 ($58,000 + $6,000 + $2,900 + $10,00).

Question 15

Adjustments to Basis

Answer 15

Before determining gain or loss on a sale, exchange, or other disposition of property, certain adjustments must be made to the basis of the property. The result of these adjustments to the basis is the adjusted basis.

Question 16

Increase the Basis of an Asset

Answer 16

Capital improvements, such as an addition On your home, a new roof, paving your driveway, installing central air conditioning, or rewiring your home.

Assessments for local improvements, including water connections, sidewalks, and roads.

The cost of restoring damaged property after a casualty loss.

Legal fees, including the cost of defending and perfecting a title to the property.

Zonining Costs

Extend the life of Asset
-Not repairs/Maintenance.

Question 17

Decrease the Basis of an Asset

Answer 17

Usually happens when a taxpayer takes advantages of a tax deduction or tax incentives related to that asset.

Exclusion from income of subsidies for energy conservation measures.

Casualty or theft loss deductions and insurance reimbursements (business only).

Deduction for clean-fuel vehicles and clean-fuel vehicle refueling property.

Section 179 deduction.

Credit for qualified electric vehicles.

Depreciation

Nontaxable corporate distributions.

Question 18

Adjusted Taxable Basis - Property Acquired by Nontaxable Exchnange

Answer 18

When property is acquired in an exchange, the newly acquired property will have a carryover basis if the property is exchanged for property of equal value (no boot is paid).

In the event that property is exchanged for a more valuable asset, and thus boot is paid, the new asset will have a carryover basis (the cost basis of the exchanged property) plus any boot paid.

If the property is exchanged for a less valuable asset, and thus boot is received, the new asset will have a carryover basis reduced by any boot received that was greater than the gain.

Question 19

Example

Answer 19

Mario is considering trading coin collections with his friend Arthur. Mario’s basis in his coin collection is $100 and the FMV of his coin collection is $200. Arthur’s coin collection is worth $350. Arthur will only agree to trade coin collections with Mario if Mario pays him $150 in adition to Mario’s coin collection. If Mario and Arthur trade coin collections, Mario’s basis in his new coin collection will be his carryover basis ($100) plus the boot that he paid ($150), Or $250.

Question 20

Explanations of the Mario Example

Answer 20

Mario’s Basis = $100
Mario’s (FMV) =$200
Arthur’s (FMV) = $350

Mario’s Basis = Carryover Basis + Boot Paid
$100 + $150 = $250

The carryover basis is Mario’s original coin collection.

Question 21

FMV

Answer 21

The Fair Market Value is represents the estimated worth of Mario’s collection in an open and unrestricted market.

Question 22

Special Basic Rules

Answer 22

The basis for inherited property is discussed in the estate planning course; however, the holding period for capital gains is always long-term for inherited property.

Question 23

Exam Question

Aunt Suzie recently died and left her niece, Jean, 1,000 shares of ABC stock. Suzie acquired the stock on December 12, 2022 for $25 per share. Suzie dies February 14, 2023. Assume that Jean sold the stock for $28 per share on February 28, 2023. What is the nature of her gain?

a) Short-term capital gain.
b) Long-term capital gain.
c) Part short-term capital gain, part long-term capital gain.
d) Ordinary income

Answer 23

Answer: B

Gain on all inherited assets is long-term capital gain.

Question 24

Basis of Gifted Property

Answer 24

There are three rules related to the basis of gifted property:

The general rule and two exceptions.

Question 25

General Rule

Answer 25

The general rule is that the donee’s basis in the gifted property is the same as the donor’s basis in the gifted property.

Question 26

Exception 1

Answer 26

The first exception occurs when the FMV of the gifted asset is less than the donor’s basis loss property). When the FMV of the giffed asset is less than the donor’s basis, the Double Basis Rule must be used. (see example with Alex and Beth)

For gains only, the basis of the donor is also the adiusted basis of the donee.

For losses only, the basis to the donee is the FMV of the property on the date of the gift.

If the asset is later sold by the donee and the amount realized is between the fair market value at tie time of the gift and the adjusted basis of the donor, no gain or loss is recognized

Question 27

Determining Loss on the Sale of Gifted Property

Answer 27

The basis of the property in the hands of the donee is the lower of

The donor’s basis, or

The FMV of the property at the time of the gift.

Question 28

Holding Period for Gifted Property

Answer 28

General Rule: The holding period in the hands of the donee includes the holding period of the donor

If double basis asset (gifted asset where the FMV is less than the donor’s basis at the time of the gift) is sold for a loss, then the holding period for donee starts on the date of the gift

Question 29

Example of Gifted Property

Answer 29

Alex received a gift from Beth on June 15 this year. The FMV of the gift on June 15 is $8,000.
Beth’s basis in the asset, which she acquired in 1985, was $10,000.

If Alex sells the asset for $11,000, he will have a $1,000 gain ($11,000 - $10,000).

If Alex sells the asset for $7,000, he will have a $1,000 loss ($7,000 - $8,000). Because the FMV of the asset was less than Beth’s basis at the time of the gift, Alex may use the FMV of the asset as his basis for the purpose of calculating losses.

If Alex sells the asset for $9,000, there is no gain or loss. Because Alex sold the asset for an amount greater than the FMV at the date of the gift, but less than Beth’s basis, he will not have any gain or loss.

Question 30

Exception 2

Answer 30

The second exception occurs when gif tax has been paid. In the event that gift tax has been paid and his asset had appreciated in the hands of the donor, then the portion of the tax which is associated with the appreciation is added to the donor’s basis to determine the donee’s basis

Question 31

Donee’s Basis is determined using the formula:

Answer 31

Donor’s Basis
+
+ ( (Net Appreciation in Value of Gift ÷ Value of Taxable Gift ) x Gift Tax Paid )

Question 32

????? Example of Basis of Gifted Property when Tax is Paid

Cathy received a gift from Darren on June 15 of this year (Darren had already transferred cash equal to the annual exclusion to Cathy). The FMV of the gift on June 15 was $20,000. Darren had a basis in the asset of $17,000 and paid gift tax of $800. What is Cathy’s Basis?

Answer 32

Cathy’s basis in the gifted property is $16,100, calculated as follows:

[$17,000+ (($4,000 ÷ $20,000) × $800)] = $16,160

Question 33

Exam Question

Mike gifted 100 shares of ABC stock to James. Mike (the donor) had a basis in the stock of $40 per share. At the time of the gift, the FMV of each share was $65. What is James’ basis in the 100 shares of stock?

a) $25 per share for a total of $2,500.
b) $40 per share for a total of $4,000.
c) $65 per share for a total of $6,500.
d) $105 per share for a total of $10,500.

Answer 33

Answer: B
Under the general rule, James’ basis is equal to the basis of the donor (Mike).

Question 34

Exam Question

Basis of Gifted Property
Mike gifted 100 shares of ABC stock to James. Mike (the donor) had a basis in the stock of $40 per share and had held the stock for more than two years prior to the gift. At the time of the gift, the FMV of each share was $65. If James sells the ABC stock for $90 per share 10 months after the date of the gift, what will his gain or loss be?

a) $2,500 long-term capital gain
b) $2,500 short-term capital gain
c) $5,000 long-term capital gain
d) $9,000 short-term capital gain

Answer 34

Answer: C

James basis in the stock is $40 per share for a total basis of $4,000. The total sale price was $9,000 ($90 x 100 shares). Therefore, James’ gain is $5,000 ($9,000 - $4,000). The gain is long-term capital gain because James holding period tacks onto that of the donor.

Question 35

Exam Question

Allison gifted 100 shares of XYZ stock to Joe. Allison (the donor) had a basis in the stock of $55 per share and had held the stock for more than two years prior to the gift. At the time of the gift. the FMV of each share was $40. What are the tax consequences to Joe if he sells the stock 2 years after the date of the gift for $48 per share?

a) $700 loss.
b) $800 gain.
c) $1,500 gain.
d) No gain or loss.

Answer 35

Answer: D

There is no gain or loss because the amount realized from the sale ($4,800) is more than the
FMV at the date of the gift ($4,000, but less than the donor’s adjusted basis in the stock ($5,500).

Question 36

Exam Question

Donna gifted 100 shares of DDD stock to Colin. Donna (the donor) had a basis in the stock of $40 per share and had held the stock for more than two years prior to the gift. At the time of the gift, the FMV of each share was $65. Donna paid $2,600 in gift tax on the transfer of the shares of stock and the annual exclusion did not apply to this transfer. What is Colin’s basis in the DDD stock?

a) $25 per share or $2,500 total.
b) $40 per share or $4,000 total.
c) $50 per share or $5,000 total
d) $65 per share or $6,500 total.

Answer 36

Answer: C

Colin gets to add $1,000 to Donna’s basis because Donna paid gift tax on the transfer. Colin’s adjusted basis is calculated as follows:
$4,000 + [(2,500 ÷ 6,500) × 2600] = $5,000

Question 37

Exam Question

Brody and Tanya recently sold some land they owned for $150,000. They received the land five years ago as a wedding gift from Brody’s Aunt Jeanette. Aunt Jeanette purchased the land many years ago when the property was worth $20,000. At the time of the gift, the property was worth $100,000, and Aunt Jeanette paid $47,000 in gift tax (the annual exclusion did not apply to this transfer). What is the long-term capital gain on the sale of the property?

a) $42,400
b) $50,000.
c) $92,400
d) $130,000.

Answer 37

Answer: C

In general, when a donor makes a gift of property other than cash to a donee, the donee will take the property at the donor’s adjusted basis. The holding period of the donee will include the holding period of the donor for purposes of subsequent transfers and the determination of long- or short-term capital gains. An exception to the general basis rule occurs when the donor gives property with a fair market value in excess of his adjusted basis and the donor pays gift tax. The gift tax associated with the appreciation is added to the donor’s original adiusted basis to deter. mine the donee’s basis. Thus, the basis would be:

=$20,000 + [ ( $80,000 ÷ $100,000 ) x $47,000 ]

=$57,600

The Gain on Asset = $150,000 - $57,600
=$92,400

Note: $80,000 = $100,000 - $20,000

$20,000 is the basis.

Question 38

Basis of Property Transferred Between Spouse Incident to Divorce

Answer 38

Transfers of property between spouses incident to divorce are treated the same as gifts. In other words, the carryover basis applies.

No gain or loss is recognized on a transfer between spouses, or between former spouses incident to a divorce.

A transfer is treated as incident to divorce if it occurs within one year of the date on which the marriage legally ended and is related to the cessation of the marriage.

Question 39

Exam Question

Carl and Caroline are getting a divorce. As part of the overall negotiations, Carl agrees to pay Caroline $200 per month and transfer to Caroline the ownership of a second home (not their personal residence) that has a value of $300,000, a mortgage of $140,000, and an adjusted taxable basis of $185,000. They have owned the property for three years. Assuming that they get the divorce and within three months Caroline sells the second home for $310,000, what are her tax consequences?

a) $10,000 STCG; $115,000 LTCG
b) $125,000 LTCG
c) $125,000 STCG
d) No recognized gain due to $250,000 exemption.
e) $10,000 STCG

Answer 39

Answer: B

This is not Section 121 personal residence. The transferee in a divorce takes the basis of the transferor ($185,000) and the holding period tacks on

$310,000 (sale price)
-$185,000 (adjusted taxable basis)
=$125,000 long-term capital gain

This is the same type of question as the Mike gifting the stock and then James selling it. The $185,000 is the basis and it is lower then FMV. So because of that, you subtract that from the Sales Price.

Question 40

Related Party Transactions

Answer 40

Section 267 Rule (sale to a related party)

Only affects transactions where there is a loss.

Transferor’s loss is forever lost, transferee takes asset with double basis rule (FMV for losses, transferor’s basis for gains). The holding period always begins at the date of the sale.

Question 41

Related Parties Include / Do Not Include

Answer 41

Include:
Siblings (including half but not step)
Lineal descendants (children & grandparents)
Ancestors (parents & grandparents)
Spouse

Related parties DO NOT include:
Inlaws
Aunts/Uncles
Cousins

Question 42

Exam Question

Answer 42

Pg. 8

Question 43

Exam Question

Answer 43

Pg. 9

Question 44

Bargain Sales to Charity

Answer 44

If a taxpayer sells property to a charity for less than its FMV, the basis of the property must be allocated between the portion of the property sold and the portion given to charity.

Question 45

Formula for Bargan Sales to Charity

Answer 45

Bargain for Sales Purpose =

( Amount Realized ÷ Fair Market Value)
x
Basis of Property

Need to add formula PG. 9

Question 46

Tax Rates

NEED TO FIND OUT IF THIS CHART IS GIVEN

Answer 46

2023 Long Term Capital gains and qualifying dividends (owned 60 days or longer) are tax as follows:

Question 47

Tax Rates

Answer 47

Taxpayers with AGI over $200,000 (single) or $250,000 (MFJ) will also be subject to the 3.8% Medicare Contribution tax on investment income for taxpayers that AGI exceeds the threshold.

• The tax is imposed on the lesser of an individual’s net investment income for the tax year or modified adjusted gross income in excess of the limits.

Question 48

Tax Rates

Answer 48

Other exceptions include:

• Collectibles, which are taxed at 28%,
• Unrecaptured Section 1250 gain (which is equal to the straight line depreciation), which is taxed at 25%, and
• Qualifying Small Business Stock (Section 1202), for which a percentage of the gain is taxed at 28% if the holding period is at least five years. Legislation over the last several years has change the percentage of the gain that you can exclude based on when you PURCHASED the stock. The amount of gain you can exclude is:
  • 50% if the QSBS is acquired before Feb. 18, 2009;
  • 75% if the QSBS is acquired after Feb. 17, 2009, and before Sept. 28, 2010;
  • 100% if the QSBS is acquired after Sept. 27, 2010 (made permanent by PATH 2015).

Question 49

Tax Rates Holding Period

Answer 49

Although long-term capital gains are generally taxed at a maximum rate of 20%, short-term capital gains are taxed as ordinary income. (37% highest).

In order to qualify for long-term capital gains rate, an asset must be held for more than one year.

Section 1245 recapture.

In calculating the holding period, the day of disposition is included in the holding period, but the day of acquisition is not included in the holding period.

Question 50

Capital Gains And Losses

Answer 50

Capital Assets
Realization & Recognition
Sale or Exchnage Requirements
Calculation of Gain or Loss
Calculation of Amount Realized
Recognition Rules

Question 51

Capital Assets

Answer 51

When a capital asset is disposed of by sale or exchange, the owner of that asset often realizes a gain or loss on the disposition of that asset.

The recognition of gain or loss on the disposition of a capital asset, however, is subject to several rules..

In addition, there are several rules regarding the calculation of the amount realized and the amount recognized upon the disposition of a capital assets.

Question 52

Realization & Recognition

Answer 52

Gains on capital assets are taxed only when there has been both (1) a realization event and (2) a recognition event.

Gains must be realized before they can be recognized. Realization usually occurs when:
- There is a disposition of property (i.e., a sale or exchange), or
- There is a segregation of the gain.

Recognition occurs when a realized gain is taxed.

As a general rule, realized gains are recognized (taxed) unless an exception to this rule can be found in the Internal Revenue Code. An exception will generally provide that:
- The gain is exempt from taxation, or
- The gain is deferred to a future time.

Question 53

Sale or Exchange Requirements

Answer 53

In order for a gain to be realized, an asset must be sold or exchanged.

In many cases, it is obvious that a sale or exchange has occurred.

In other cases, it may be less obvious.

—For example:
Natural disasters that destroy property cause a realization event to occur for income tax purposes since the gain or loss in a particular property can be calculated (is permanently set aside) at that time. Note that the loss may or may not be recognized at that time.

—Another event that could cause realization is the bankruptcy of a company. Note, however, that special rules (covered later in this section) govern the recognition of loss associated with worthless securities.

Question 54

Calculation of Gain or Loss

Answer 54

Once it has been determined that a realization event has occurred, gain or loss must be determined.

Once recognized gains or losses have been determined, they must be classified as ordinary or capital
—Ordinary gains are fully taxable
—Ordinary losses are fully deductible

Capital gains and losses are subject to special tax treatment

Question 55

The Formula for Determining Gain/Loss on an Asset

Answer 55

Question 56

Calculation of Amount Realized

Answer 56

The amount realized on the sale or exchange of an asset is the sum of:
- Cash received, plus
- The FMV of property received in the exchange, plus
- Liabilities shed

In some cases, the person disposing of the property may “shed liabilities” as part of the sale or exchange.
-The party that is giving up, or “shedding” the debt will be deemed to have an additional amount realized.
-Conversely, the party assuming the debt will be deemed to be paying that amount in exchange.

The sale of mortgaged real estate can yield phantom income. This usually occurs when the financing is through nonrecourse loans, the taxpayer takes large write-offs, or the taxpayer disposes of the property subject to the loans.

Question 57

Recognition Rules

Answer 57

Recall that realized gains are recognized, unless an exception applies.

Gain/Loss is recognized in the disposition of property

Recognition of gain occurs:
-When debt is relieved,
—SECURE Act 2019 excludes debt relief on qualified principal residence after December 31, 2017 through January 1, 2021. Taxpayer Certainty and Disaster Tax Relief Act (ICDTRA) of 2020 extended the exclusion for the discharge of qualified principal residence indebtedness for filings before January 1, 2026.

-When money is “taken out of an investment as a loan when the individual is not personally liable for the loan, and

-With net gifts (transfers where the done agrees to pay the gift tax).

Question 58

Example

Answer 58

Diane bought a house on Main Sreet. Unfortunately, Diane can no longer afford the payments on her adjustable rate mortgage. After missing several mortgage payments, Diane’s lender agrees to modify her loan. As part of the loan modification, Diane’s lender forgives $10,000 of her loan.

Diane must recognize gain on this loan forgiveness and will be required to include $10,000 in her income.

Question 59

The following transactions are examples of situations in which gain or loss may be realized, but is not recognized.

Answer 59

Like-kind exchanges of real property held for productive use or investment.

Certain exchanges where cash received is quickly reinvested in similar property.

Transfer of property to controlled corporation.

Exchange for plans of corporate reorganization.

Transfers to, or distributions from, partnerships.

Question 60

Losses generated on the sale or exchange of property that is used for personal purposes is disallowed for income tax purposes.

Answer 60

When an asset is used for personal purposes, any loss incurred during the period of personal use is considered a personal loss, and is not permitted as a tax deduction.

A loss incurred while an asset is used for personal purposes will never be deductible, and results in a permanent loss of capital for the taxpayer.

Question 61

Losses on wash sales are also disallowed

Answer 61

Wash sales occur when a taxpayer disposes of securities at a loss and acquires substantially identical securities within 30 days before or after the date of the loss sale.

The disallowed loss is added to the cost of the new stock or security to determine the new basis of the substantially identical securities.

Wash sales do not apply to gains.

Question 62

Exam Tip

Index fund for Index fund

Index fund for Managed large cap fund

Answer 62

Wash sale rule applies.

Wash sale rules do not apply.

Question 63

Example

Answer 63

Eric bought stock in Hot Tech Inc. for $100 share. The stock subsequently fell to $10 per share and Eric sold on December 20th, in order to recognize a $90 per share loss. Eric, thinking the stock would come back bought the stock back on January 3rd of the following year for $31 per share. What are the tax consequences to Eric?

There are two consequences.

First, Eric may not recognize the loss due to the wash sale rules.

Second, Eric’s new basis is $31 plus $90 (disal-
lowed loss) or $121.

Question 64

Exam Tip

Answer 64

The government does not like losses.

Question 65

Example

Answer 65

Brian James bought stock in AAPL on 1/31 for $100 share. On February 13th, he decided to sell the stock to purchase his wife a Valentine’s gift. Brian James sold the stock February 13th for $95 per share. He then bought the stock back for $80 per share on March 1st. What is his new basis in the stock?

Adjusted Basis - $80 (3/1 Purchase) + $5 (disallowed loss due to wash sale rule) = $85.

Question 66

Wash Sales

Answer 66

Wash sale rules apply to losses from sales of contracts and options on stocks or securities, not to commodity futures or foreign currencies.

If selling common stock at a loss and simultaneously buying warrants for the same stock, wash sale rules apply. The rules also apply if selling warrants at a loss and buying common stock, but only if they are considered substantially identical.

Determining substantial identity considers all facts;
-Stocks of different corporations aren’t usually identical, but they might be in reorganizations.
-Bonds or preferred stock are not identical to common stock unless convertible with similar voting rights, trading conditions, unrestricted convertibility and same dividend restrictions.

When buying more or fewer shares of substantially identical stock within 30 days of selling, apply wash sale rules by matching shares bought with those sold.

Example: You bought 100 shares of M stock on September 24, 2022, for $5,000. On December 18, 2022, you bought 50 shares of substantially identical stock for $2,750. On December 28, 2022, you bought 25 shares of substantially identical stock for $1,125. On January 7, 2023, you sold for $4,000 the 100 shares you bought in September. You have a $1,000 loss on the sale. However, because you bought 75 shares of substantially identical stock within 30 days before the sale, you cannot deduct the loss ($750) on 75 shares. You can deduct the loss ($250) on the other 25 shares. The basis of the 50 shares bought on December 18, 2022, is increased by two-thirds (50 ÷ 75) of the $750 disallowed loss. The new basis of those shares is $3,250 ($2,750 + $500). The basis of the 25 shares bought on December 28, 2022, is increased by the rest of the loss to $1,375 ($1,125 + $250).

Question 67

Realizes a Loss on the Disposition of a Personal Residence

Answer 67

If a taxpayer realizes a loss on the disposition of a personal residence, that loss may not be recognized.

Example: Barb and Bob purchased a house for $300,000 in Broward County, Years later the surrounding land was designated for a landfill. Subsequently, Barb and Bob sold the house for $50,000, realizing a loss of $250,000. For income tax purposes, the loss is not deductible and cannot be recognized because it is a personal asset.

Question 68

If a Taxpayer realizes a gain of a personal residence resulting from casualty, theft or condemnation (involuntary conversion), the gain may either be?

Answer 68

Deferred under Section 1033, or.

Excluded under Section 121 (subject to limitations).

Question 69

Qualification Requirements for the Exclusion under section 121?

Answer 69

First, the property must have been owned and occupied as a principal residence for 2 out of the last 5 years. (Note that a one-year stay in a nursing home does not count toward the 2-year requirement).

Second, the exclusion can only be used once every 2 years.

Any appreciation during non-qualified use periods are not subject to the exclusion.

Question 70

Single and Married Taxpayers

Answer 70

Single taxpayers may exclude up to $250,000 of gain from the sale of their principal residence.

Married taxpayers filing jointly may exclude up to $500,000 of gain from the sale of their principal residence.

For married taxpayers: They must both meet the use requirement and NOT have utilized the exclusion within the last two years but either may meet the ownership requirement.

Question 71

Example of Single Taxpayer

Answer 71

Ken, who is single, purchased a townhouse 5 years ago for $150,000 on Miami beach to use as his personal residence. Today he sold the townhouse for $600,000. Ken would have a capital gain of:

$600,000 - $150,000 = $450,000 - $250,000 exclusion =

$200,000 long-term capital gain

Question 72

Exampler of Married Taxpayer

Answer 72

Jeff and Britt, who are married filing jointly, purchased a townhouse 10 years ago for $400,000 on Santa Monica beach to use as their personal residence. Today they sold the townhouse for $850,000. Jeff and Britt would have a capital gain of

$850,000 - 400,000 = $450,000 - $500,000 exclusion = $0 capital gain

Question 73

Under certain circumstancesm a reduced exclusion may be available even if the taxpayers do not meet the other requirements. A reduced exclusion is available if the sale of the personal residence is due to:

Answer 73

A change in employment - Qualified move for you or your spouse,

A change of health - Diagnosis, Cure, Mitigation, Treatment for parent, grandparent, child,
grandchild, sibling, in-laws, aunt, uncle, niece or cousin, or

Other unforeseen circumstances - fairly broad. The IRS has put out quite a bit of information on What can be considered unforseen circumstances.

It is likely on the exam, they will say something like, “change of employment or change of health.” Things that have been considered unforeseen include diaster area, involuntary conversion, death, unemployment, divorce/breakup of engaged couple, multiple births from the same pregnancy, bullying.

When the reduced exclusion is avaialbe, the amount exclusded is based on the periosd of ownership between the last sale and the current sale (pro rata).

Question 74

Exam Question

Jack and Jill, who are married filing jointly, purchased a personal residence 18 months ago for $685,000. Jack and Jill sold the residence today for $925,000 and want to know the tax consequences of this transaction. They were required to move because of their employment. How much gain must Jack and Jill recognize this year?

a) $0
b) $240.000
c) $375,000
d) $925,0000

Answer 74

Answer: A

Because Jack and Jill sold their house due to employment reasons, they are eligible for a reduced exclusion even though they did not meet the two-year rules. Jack and Jill realized a gain of $240,000 on the sale of their house ($925,000 - $685,000. They are eligible, however, for a reduced exclusion of $375,000 ($500,000 × 18/24). Because their reduced exclusion exceeds their realized gain, they will not have any recognized gain on the sale of their home. They owned and used 18 months out of 24 months, therefore, they have a reduced exclusion equal to 75% of $500,000.

Question 75

Exam Question

Rufus and Jiya purchased a beach-front residence to rent out for the next year until they retire and move there permanently. The purchase price was $300,000 and rents collected over the rental year totaled $45,000. Upon retirement they promptly moved into the beach home and lived there for four years before downsizing to be closer to family. If their sales price was $500,000, how much of the gain is taxable?

a) $0
b) $20,000
c) $40,000
d) $200,000

Answer 75

Answer: C
The $40,000 is taxable because that is the appreciation attributable to the non-qualified use period. (1 year of non-qualified use) ÷ (5 years of ownership) × ($200,000 of appreciation) =
$40,000. Only qualified use as a principal residence qualifies for the exemption, which makes the remaining $160,000 nontaxable. The first year they owned the property it was for rental use, a non-qualified use for section 121 gain exclusion.

Question 76

A Loss resulting from worthless securities is?

Answer 76

A loss resulting from worthless securities is deductible in the year in which the securities become completely worthless.

Section 165 sets the artificial sale date for the securities as the last day of the year in which the securities became worthless.

Question 77

Example

Answer 77

On December 1, 2022, Sally purchased stock for $10,000. The stock became worthless on June 1, 2023. Sally is treated as having sold the stock on December 31, 2023. The result is a long-term capital loss.

Question 78

Chart summarizes the treatment of gains and losses for different types of assets.

The assets are:
-Personal Use
-Capital Assets
-Trade or Buisiness
-Trade Ordinary Income

MEMORIZE

Answer 78

Question 79

Determining Net Capital Gains

Answer 79

Gains and losses from capital asset transactions must be netted against each other.
-Net gains and losses by holding period (long-term against long-term, etc.).
-IF excess losses result, they are shifted to the category carrying the highest tax rate.

Treatment of Net Capital Losses
-Net capital losses of individuals are deductible FOR AGI to the extent of $3,000 per year.
–Excess capital losses are carried over to the next tax year indefinitely.
–When carried over, capital losses retain their classification as either short- or long-term.

The steps below should be followed to determine the net capital gain or loss.

-First, net long-term capital gains and long-term capital losses.

-Second, net short-term capital gains and short-term capital losses.
–If the taxpayer has both long-term net gains and short-term net gains, do not proceed to the next step. Both the net long-term gain and the net short-term gain should be recognized.

-Third, if the taxpayer has a net loss in one category and a net gain in the other category, then the net long-term gain/loss should be netted against the net short-term gain/loss.
–In other words, if the taxpayer has a net long-term capital gain and a net short-term capital loss, the net short-term capital loss reduces the net long-term capital gain.
–Similarly, i the taxpayer has a net long-term capital loss and a net short-term capital gain, the net short-term capital gain reduces the net long-term capital loss.

Question 80

Example

Answer 80

Question 81

Example

Answer 81

Claudi ahas a long-term capital loss of $4,000. Claudia will be allowed to deduct $3,000 of the net capital loss this year, and will carryover $1,000 of capital loss to nect year or beyond. The $1,000 carry-forward will continue to be long-term.

Question 82

Example

Answer 82

Kevin has a net long term capital gain of $6,000, which will be taxed in the current year at 15%.

Question 83

Exam Question

(1) What is Jame’s net capital gain or loss?

(2) What is the net of the long term capital gain and the long term capital loss?

(3) What is the net of the short term capital gain and the short term capital loss?

Answer 83

(1) LTCG of $8,700

(2) LTCG of $22,700

(3) $STCL of $14,000

Question 84

Limitations on Recognition of Capital Losses

Answer 84

If a series of transactions results in a net capital gain, the net capital gain is recognized in the current tax year regardless of its size.

In contrast, if a series of transactions results in a net capital loss, the amount of the loss that may be recognized in the current tax year is limited.
-Under current law, up to $3,000 of capital losses (either short or long-term) may be recognized against other forms of income in any one tax year.
-If a capital loss is realized in a given tax year, but is not recognized due to the imposition of the loss limitation rule, the remaining loss is carried forward indefinitely, and may be used to offset future capital gains, or, alternatively, generate a $3,000 loss deduction each year against other income until the loss is used up.

In addition to the rule that allows up to $3,000 of capital losses to be offset against other income, another rule recategorizes capital losses on small business stock into ordinary losses if certain requirements are met. Under IRC Sec. 1244, a single taxpayer can deduct up to $50,000 ($100,000 for married individuals filing jointly) of the loss on small business stock as an ordinary loss in any given year if the following requirements are met:

-The stock represents ownership in a domestic corporation.
-The corporation was a small business corporation (less than $1 million in total capital contributions plus paid-in capital) at the time the stock was issued.
-The company was incorporated after November 6, 1978.
-The loss was sustained by the original owner of the stock (the person to whom the stock was issued by the corporation), who is not a corporation, trust, or estate.
-The stock was issued to the original owner in exchange for money or property. Stock issued in return for services or other stock does not qualify.
-For the five years prior to the loss, the corporation must have earned more than 50% of its gross receipts from sources other than royalties, rents, dividends, interest, annuities, and capital gains.

-Note that any loss in excess of the per year limit is treated as capital loss. Furthermore, Section 1244 does not apply to gains. Any gains associated with Section 1244 stock are treated as capital gains.

Question 85

Exam Tip

Answer 85

Section 267, 1244 and wash sales do not apply to gains. LOSSES ONLY

Question 86

Example

Answer 86

In YRI, Sam invests in XYZ Corp. stock costing $150,000. (Total XYZ stock outstanding is $800,000.) In YRI, Sam sells all the stock for $65,000. The stock is Section 1244 stock.

Sam, a single taxpayer, has the following tax consequences:

$50,000 ordinary loss in YR1.
$35,000 short-term capital loss ($3,000 deductible in YRI).
$32,000 short-term capital loss carry forward.

(150,000 - 65,000) = 85,000

Question 87

Section 267

Answer 87

Section 267 disallows losses from direct or indirect sales or exchanges of property between related parties. Note that Section 267 applies to losses only and does not apply to gains.

Family and entity relationships apply for purposes of determining whether the transaction occurred between related parties.

Related Parties Include:
* Siblings (include half but not step)
* Lineal descendants (children & grandchildren)
* Ancestors (parents & grandparents)
* Spouse

. Related Parties do not include:
*. In-laws
*. Aunts/Uncles
*. Cousins

Constructive ownership rules apply for determining whether the transaction occurred between related parties.

Losses disallowed reduce gains on subsequent disposition to an unrelated third party.

Question 88

Example

Answer 88

Colin sells to his son Briscoe 100 shares of XYZ stock for $8,000. Colin’s basis was $10,000.
What are tax consequences?

There are two. First, Colin cannot recognize a realized loss of $2,000. Second, Briscoe’s basis is $10,000 gains and $8,000 losses.

Question 89

Exam Tip

Answer 89

Never gift or sell an asset to a related party when the donor’s basis is greater than the FVM of the asset.

Question 90

Exam Question

Bill owns 1,000 shares of KMA stock. He bought it in 1998 for $40,000 ($40.00 per share). The current FMV of the stock is $32,000. Bill sells the KMA stock to his brother Jack Hass for $32,000. Jack sells the KMA stock to Gerry Brennan (a friend for $38,500 six months later.
What are the tax consequences for Bill and Jack?

a) $8,000 LTCL to Bill; $6,500 LTCG to Jack.
b) $8,000 LTCL to Bill, $6,500 STCG to Jack.
c) No gain or loss to Bill; no gain or loss to Jack.
d) No gain or loss to Bill, $3,500 LTCL to Jack.

Answer 90

Answer: C

This is really Section 267 in action. A transferor in a Section 267 transaction cannot take a loss.
If the FMV is below the transferor’s basis, the transferee’s basis is FMV for losses and the transferor’s basis for gains. In this case, there was no loss for Bill because the loss is disallowed under Section 267. Jack had no gain or loss because he had a dual basis and sold the stock at a price between the gain and loss basis.

Question 91

Business Assets

Answer 91

When a taxpayer disposes of a business asset, the gain or loss is usually a Section 1231 gain or loss.

When a taxpayer disposes of depreciable property (either Section 1245 or Section 1250 property) at a gain, the taxpayer may have to recognize all or part of the gain as ordinary income under the depreciation recapture rules.

Any remaining gain is a Section 1231 gain.

Question 92

Section 1231 Assets

Answer 92

Recall that depreciable or real property used in a trade or business is a Section 1231 asset.

To be classified as a Section 1231 asset, the owner of the asset must have a long-term holding period (the owner must have held the asset for more than 1 year) for the asset in addition to the asset being depreciable real or personal property used in a trade or business,

From our discussion of basis rules, we know that any asset used in a trade or business that is expected to decline in value qualifies for depreciation deductions. Therefore, trade or business assets that qualify for depreciation deductions are Section 1231 assets.

Question 93

Exam Question

Which of the following is not a Section 1231 asset?

a) Copyright owned by an author
b) Timber
c) Coal
d) Same-sex livestock

Answer 93

Answer: A

Copyrights owned by the author of the copyrighted work are not depreciable assets used in a trade or business.

Question 94

Benefits of Section 1231

Answer 94

The main benefit of Section 1231 is that the gains generated from the sale of a Section 1231 asset are treated as capital gains for income tax purposes, and losses generated from the sale of a Section 1231 asset are treated as ordinary losses for income tax purposes.
-Therefore, gains will qualify for long-term capital gains tax rate, and
-Losses will not be subject to the limitations that typically apply to capital assets.

Note that, by definition, Section 1231 assets must have a holding period of more than one year. Therefore, it makes sense that any gain on these assets would be subject to long-term capital gains rates.

It is important to realize, however, that the ultimate tax treatment also differs depending on whether an individual or a C corporation generates the Section 1231 gain or loss.

-If an individual (or pass-through entity) owns an asset that generates a Section 1231 gain, the favorable, lower capital gains rate (currently 15% or 20%) will apply. If the taxpayer is in the 15% ordinary income tax bracket or lower, the 0% capital gains tax rate will apply.

-Conversely, if a loss is generated, the individual taxpayer can write off the loss, without limitation, against other forms of income for the current, and possibly, past years. If the loss had been categorized as a capital loss (rather than a Section 1231 loss), the $3,000 loss limitation rule would apply, and the loss may not be fully utilized by the taxpayer in the current tax year.

-C corporations, however, pay the same rate of tax on ordinary income and capital gains. Therefore, the generation of a Section 1231 gain will not result in a tax benefit for the corporation.

-If a corporation generates a Section 1231 loss, however, the loss will be considered an ordinary loss, and may be deducted in full against other income (or carried back if the carryback rule is invoked).

–For corporations, capita losses may not be deducted against other forms of income. Capital losses can only be used to offset capital gains.

–By categorizing an asset as a Section 1231 asset, however, the corporation can recognize losses without having to generate capital gains to offset them.

Question 95

Depreciation Recapture

Answer 95

If a taxpayer disposes of depreciable or amortizable property at a gain, the taxpayer may have to treat all or part of the gain as ordinary income due to depreciation recapture.

Recall that the purpose of depreciation is to allow individuals and businesses who use property in productive use or in a trade or business to recoup their capital over the useful life of the asset against ordinary income as an expense so that capital can be reinvested to generate more income.

-Because it is impractical to allow taxpayers to deduct the actual decline in value of the asset each year, Congress came up with a statutory estimation scheme for depreciation.

-Upon acquisition, each asset is classified into a specific class life based on the general rules set forth in the IRC. Once the class life is determined, a statutorily defined deduction is taken for depreciation of the asset, regardless of the actual decline in value of the asset from year to year.

-Many assets that are purchased for use in a trade or business are completely used up in that trade or business, and are disposed of when their useful life expires. Often, upon disposal, the taxpayer receives nothing in return for the asset. When this happens, the taxpayer has recouped his or her capital investment in that asset over the useful life of that asset, and there is nothing to be concerned about for income tax purposes.

-In the case of the sale of a Section1231 asset, however, the taxpayer must make sure that the depreciation deduction taken under the IRC equals that actual depreciation of the asset.

The sole purpose of depreciation recapture is to ensure that, when an asset is sold, the taxpayer receives his or her capital back tax free - no more, and no less. The rules for depreciation recapture differ depending upon the type of property sold in the exchange.

Question 96

Depreciation Recapture Section 1345 Property Gain

Answer 96

A gain on the disposition of Section 1245 property is treated as ordinary income to the extent of depreciation allowed or allowable on the property.
-Any gain beyond that which must be treated as ordinary income is treated as a Section 1231 gain.

Section 1245 property includes property that is or has been subject to an allowance for depreciation or amortization. Section 1245 property is tangible personalty used in a trade or business and includes depreciable property (e.g., equipment), patents, copyrights, and other intangibles. Note that real property (i.e., land and buildings) is not Section 1245 property.

Question 97

Example

Answer 97

Question 98

1st Result when Section 1245 Property is Sold

Answer 98

The first possibility is that the property will be sold for an amount equal to its adjusted basis, in which case there will be no gain or loss and no depreciation recapture, and thus no tax consequences.

Question 99

Example

Answer 99

Question 100

2nd Result when Section 1245 Property is Sold

Answer 100

The second possibility is that the property will be sold for an amount less than the adjusted basis, in which case the taxpayer will have an ordinary loss and will not have any depreciation recapture.

Note that this is the same as saying that not enough depreciation was taken to achieve economic reality because the FMV was less than the adjusted taxable basis.

Question 101

Example

Answer 101

Continuing with the fact pattern above, if Chelsea sells her mixer for $700, she will have a $100 ordinary loss. In this case, the amount realized ($700) is less than her adjusted basis of $800.
Section 1231 states that losses on the sale of Section 1231 assets are treated as ordinary losses and can, therefore, be used to offset any ordinary income that Chelsea has.

Question 102

3rd Result when Section 1245 Property is Sold

Answer 102

The third possiblity is that the property will be sold for an amount that exceeds the adjusted basis of the property, bur the gain does not exceed the amount of depreciation taken, in which case the taxpayer wit have an ordinary gain to the extent of the gain. Essentially, the taxpayer took too much depreciation and
now must give it back.

Question 103

Example

Answer 103

Continuing with the fact pattern above, if Chelsea sells her mixer for $1,000, she will have a gain of $200. Section 1245 states that depreciation is recaptured as ordinary income to the extent of the gain. Therefore, since Chelsea’s $200 of gain is less than the $400 of depreciation that she took, the entire $200 of gain will be treated as ordinary gain.

Question 104

4th Result when Section 1245 Property is Sold

Answer 104

The fourth possibility is that the property will be sold for an amount that exceeds the adjusted basis of the property and the gain exceeds the amount of depreciation taken, in which case the taxpayer will have ordinary income to the extent of the depreciation taken and capital gain on the remainder of the gain. In actuality, the asset appreciated rather than depreciated and, therefore, the taxpayer shouldn’t have taken any depreciation.

Question 105

Example

Answer 105

Continuing with the fact pattern above, if Chelsea sells her mixer for $1,300, she will have a gain of $500. Section 1245 states that depreciation is recaptured as ordinary income to the extent of the gain. Therefore, the first $400 of gain will be treated as ordinary gain under Section 1245
The remaining $100 of gain will be treated as capital gain under Section 1231.

Question 106

Exam Tip

Answer 106

The only way to have a Section 1231 gain on a Section 1245 property is to sell it for more than it was originally purchased for.

Question 107

Exam Question

Roscoe sells equipment used in his business for $18,000. He had originally purchased the equipment for $15,000 and had taken $7,000 of depreciation. What is the Section 1231 gain for Roscoe?

a) $11,000
b) $8,000
c) $7,000
d) $3,000

Answer 107

Answer: D

This is a Section 1245 depreciable property used in a trade or business. To determine any Section 1231 gain, the full amount of depreciation must be recaptured as ordinary income. There-fore, only when the sale price exceeds the original purchase price will there be a Section 1231 gain.

$18,000 (sale price) - $8,000 (adjusted taxable basis) -$10,000 (gain)

$10,000 (gain) - $7,000 (Section 1245 recapture) - $3,000 (Section 1231 gain)

The new Price is $8,000 after depreciation.

$15,000 - $$7,000 = $8,000

Question 108

Exam Question

In the above question, how much of the gain is taxed as ordinary income?

a) $0
b) $11,000
c) $3,000
d) $7,000

Answer 108

Answer: D
See explanation above.

Question 109

Exam Tip

Answer 109

Note: Any sale amount in excess of the original purchase price of a Section
1245 asset is a Section 1231 gain.

Question 110

Section 1250 about Depreciation

Answer 110

Section 1250 governs the recapture of depreciation on real Section 1231 assets (as opposed to personalty Section 1231 assets, which are governed by Section 1245). Real Section 1231 assets include business realty, such as buildings and real estate.

Currently, all depreciation on real estate is taken on a straight line basis. However, property purchased and place in service before 1/1/81 and between 1981 and 1986 was eligible for accelerated depreciation. When real property that was depreciated on an accelerated basis is sold, Section 1250 requires that the excess depreciatio (depreciation taken less what straight line depreciation would have been) be recaptured as ordinary income at ordinary income rates.

When property subject to Section 1250 is sold, the gain is treated as follows:
-The lesser of the gain or the difference between the depreciation taken and the straight line depreciation will be taxed as ordinary income. This is the recapture of the excess depreciation.

Question 111

Example

Answer 111

Ginny owns a building in which she runs a dance school. Ginny purchased the property for $500,000 and took depreciation deductions of $300,000. Straight line depreciation on the property would have been $250,000. Ginny is now considering selling the property for $800,000.

If Ginny sells the property for $800,000, Ginny will have a gain of $600,000 ($800,000 amount realized less adjusted basis of $200,000. Ginny’s adjusted basis is the cost basis of $500,000
less depreciation deductions of $300,000

Ginny will recognize $50,000 ($300,000 of depreciation taken less $250,000 of straight line depreciation) of excess depreciation, which will be taxed as ordinary income

Question 112

Contuining Section 150 about Depreciation

Answer 112

If the gain exceeds the amount above, the lesser of the remaining gain or the straight line depreciation taken on the property will be taxed at 25%. This is the un-recaptured Section 1250 depreciation.

Amount above refers to 550,000 > 250,000.

Question 113

Example

Answer 113

Continuing with the fact pattern above, Ginny will also recognize $250,000 of un-recaptured Section 1250 depreciation. In this case, the straight line depreciation of $250,000 is less than the remaining gain of $550,000. Ginny’s un-recaptured Section 1250 depreciation will be taxed at 25%.

Question 114

Contuining Section 150 about Depreciation

Answer 114

Any gain in excess of the above is taxed at capital gains rates.

Question 115

Example

Answer 115

Continuing with the fact pattern above, Ginny will also recognize $300,000 of capital gains, which will be taxed at 15%,

Question 116

Example Summary

Answer 116

Note that all Section 1250 losses are ordinary losses.

Question 117

5-Year Lookup Rule

Answer 117

Section 1231 gains and losses, much like capital gains and losses, are subject to a netting process.

A net Section 1231 gain in the current year (which should be taxed at capital gains tax rates) will be taxed at ordinary income tax rates to the extent of any Section 1231 losses claimed in the last five years.

The 5-year lookback rule essentially forces the taxpayer to net Section 1231 gains and losses over a five-year

Question 118

Example

Answer 118

Ashley, Inc., a graphic arts company, is a calendar-year corporation. In year 1, it has a net Section 1231 loss of $8,000. For tax years 2 and 3, the company has net Section 1231 gains of $5,250 and $4,600, respectively. In determining its taxable income for year 2, Ashley treated its net Section 1231 gain of $5,250 as ordinary income by recapturing $5,250 of its $8,000 net Section 1231 loss from year 1. In year 3 it applies its remaining net Section 1231 loss, $2,750 ($8,000 - $5,250) against its net Section 1231 gain, $4,600. For year 3, the company reports $2,750 as ordinary income and $1,850 ($4,600 - $2,750) as long-term capital gain.

Question 119

Exam Tip

Answer 119

This topic is not a high priority for the exam.

Question 120

Nontaxable Exchanges

Answer 120

Congress generally has the power to tax income when it is realized. In some cases, however, Congress has chosen to defer the tax on income that has been realized. In other cases, Congress has chosen not to tax the income at all.

This section reviews the circumstances under which the tax on a realized gain or loss is deferred and the circumstances under which gain is exempt from tax.

Nonrecognition Transactions
- “Realized” but not “Recognized” Income
- Like-Kind Exchanges
- Principal Residence
- Investment Real Estate
- Life Insurance Policies

Nontaxable vs. Tax-Free Transactions
-Nontaxable transaction
–Realized gain/loss not currently recognized
–Recognition is postponed to a future date (via a carryover basis)
–Carryover basis
–Holding period for new asset
—Holding period of the asset surrendered carries over to the asset acquired
–Depreciation recapture
—Potential recapture from the asset surrendered carries over to the new asset
-Tax-free Transaction
–Nonrecognition of gain is permanent.

Question 121

Like-Kind Exchanges

Answer 121

Section 1031 provides for the deferred taxation of gains associated with certain exchange transactions. Only real property transaction will receive 1031 treatment. (ICJA 2017)

If property is exchanged for like-kind property, no gain or loss is recognized if the property is held either.
-For productive use in a trade or business, or
-As an investment.

Section 1031 does not apply to:
- Personal assets.
- Stock in trade held primarily for sale (inventory),
- Stocks, bonds, notes, interests in partnerships, certificates of trust or beneficial interests, or
- Other securities or evidences of indebtedness or interest, or choices in action.
- Tangible personalty

Question 122

Like-Kind Exchanges Continued

Answer 122

When like-kind exchange treatment is available, it is mandatory.
-The taxpayer may not choose whether to subject the transaction to current tax, or defer the gain into the future.
-Taxpayers who wish to subject their gains to current taxation should make sure that they do not meet all of the requirements necessary to qualify for like-kind exchange treatment under Section 1031.

In a like-kind exchange, the exchanged properties must be of similar character and nature; however, the properties do not have to have similar uses.
-This requirement is generally interpreted very broadly.
-Real Estate Exchanges
–Improved realty may be exchanged for unimproved realty.
–US realty, however, may not be exchanged for foreign realty.
–Foreign realty may be exchanged for foreign realty.
-Exchanges of Tangible Property (No longer eligible for 1031 post TCJA 2017)

Question 123

Like-Kind Exchanges Continued

Answer 123

Because of the difficulty involved in simultaneously exchanging two assets, a like-kind exchange often occurs in two transactions. When a taxpayer wishes to defer the gain on property being exchanged, the following requirements must be met to avoid current taxation:

• The proceeds from the sale of the original property must be held by an escrow agent (the proceeds may not be received by the property owner wishing to engage in the Section 1031 exchange);
• A replacement property must be identified within 45 days of the sale of the original property; and.
• The closing on the replacement property must take place by the earlier of
• 180 days from the sale of the original property, or
• the due date (including extensions) of the tax return for the year the original property was sold.

The tax consequences of participating in a like-kind exchange depend on the property received in the exchange.

-If the only thing the taxpayer receives in a like-kind exchange is like-kind property, there will be no immediate tax consequence.
–The taxpayer’s basis in the original property, and the holding period, will carry over to the new
property.
-Non-like-kind property and cash or money received in the exchange is referred to as boot.
–When boot is received in an exchange, the gain realized in an exchange will be taxable to the extent of the boot.
—Note that boot will be received when the taxpayer is trading down, that is the taxpayer who is giving up a more valuable asset in exchange for a less valuable asset plus boot
—To the extent that the boot exceeds the gain realized on the transaction, the reamaining boot is not taxed, but is treated as a tax-free return of basis.
–Loss is not recognized on exchanges involving boot.
-If additional investments are made to acquire the new property, the additional amount will increase the taxpayer’s basis. Basis of the old property is carried over to and becomes the basis of the new property.
–On the other hand, if any money or boot is received by the taxpayer in the exchange, the basis of the new property is reduced by the amount of the boot.
-When a mortgage is transferred with the property, the party transferring the mortgage is treated as having received boot equal to the amount of debt relief, and the party undertaking the mortgage obligation is treated as giving boot.

Question 124

Example

Answer 124

Mike exchanges real estate Asset A (FMV $100,000) in which he has an adjusted basis of $40,000 for Asset B (a like-kind asset) and $70,000 cash. What is Mike’s basis after the exchange in Asset B?

Mike’s realized and recognized gain was $60,000 and the excess boot was $10,000. Mike’s basis in Asset A of $40.000 is reduced by the amount of the excess boot to $30,000. No surprise, the FMV of Asset B is also $30,000. In this case, there is no longer a deferred gain for Mike in Asset B.

Question 125

In Summary, to calculate the income tax consequences of a section 1031 exchnage, remember the following:

Answer 125

Determine whether your client is trading up or down. (Is the exchanged asset being acquired more or less costly?) Clients who receive only like-kind property in the exchange will not have any current income tax consequences.

The party trading up recognizes no gain and adds to their old basis any boot/cash given to the other party.

The party trading down (receiving less like-kind property than given up) will be required to recognize gain to the extent of boot received. If the boot exceeds gain, the amount of boot in excess of the gain is treated as a return of capital and reduces the basis in the new asset.

Losses realized in a like-kind exchange are not recognized until the replacement property is sold. The taxpayer’s basis in the replacement property equals the fair market value of the property received in the exchange plus the disallowed loss.

Debt relief is treated as boot, requiring gain recognition for the party no longer responsible for paying back the loan. The party assuming the debt will increase their basis in the replacement property by a like amount.

Question 126

Basis Adjustments in a like-kind exchange

Answer 126

The basis of the property received equals the basis of the property given,

Less the amount of any money received by the taxpayer, and

Plus/Minus the amount of any gain or loss that was recognized on the exchange.

Basis in boot received is FMV of property.

Question 127

Basis in like-kind exchange:

Answer 127

Question 128

Basis in like-kind property using IRC approach:

Answer 128

Question 129

Example

Answer 129

Zak and Vira exchange real estate of same general business asset class.

Zak: Basis = $25,000; FMV = $40,000
Vira: Basis = $20,000; FMV = $30,000

In addion, Vira also gives Zak securities with a basis of $7,000 and a FMV of $10,00

Zak has a $10,000 recognized gain; $25,000 basis in the real estate, and $10,000 basis in the securities. Vira has a $3,000 recognized gain because she transferred the securities which were not like kind, $30,000 basis in the real estate (the original $20,000 plus the $10,000 worth of boot paid).

Question 130

Example

VERY IMPORTANT THIS IS THE 1031 EXAMPLE

Answer 130

Question 131

Exam Question

Jack and Jill exchange like-kind real estate assets as listed below:

Jack’s Old Asset: FMV $50,000, Adjusted Taxable Basis $23,000

Jill’s Old Asset: FMV $70,000

If Jack pays Jill cash of $20,000 plus Jack’s old asset, how much gain does Jack have to recognize?

a) 0
b) $20,000
c)$23,000
d) $27,000

Answer 131

Answer: A

Jack has exchanged his real estate asset for a more valuable asset. Therefore, recognize no gain and add the boot paid by Jack ($20,000) to the old basis and continue to defer the $27,000 of
gain.

Question 132

Exam Question

Jack and Jill exchange like-kind real estate assets as listed below:

Jack’s Old Asset: FMV $50,000, Adjusted Taxable Basis $23,000

Jill’s Old Asset: FMV $70,000

In the previous problem, what is Jack’s basis in his new asset?
a) $20,000
b) $23,000
c) $27,000
d) $43,000

Answer 132

Answer: D

Jack’s basis is determined by adding the boot that he paid ($20,000) to the basis in his old asset ($23.000) for a total of $43.000.

Question 133

Exam Question

Jack and Jill exchange like-kind real estate assets as listed below:

Jack’s Old Asset: FMV $50,000, Adjusted Taxable Basis $23,000

Jill’s Old Asset: FMV $70,000

In the previous problem, assume Jill’s adjusted basis in her old asset was $45,000. How much gain must Jill recognize?
a) $5,000
b) $1,.000
c) $15,000
d) $20,000

Answer 133

Answer: D

Recall that the FMY of Jills old asset was $70,000. Given that her basis was $45,000, she had $25,000 of deferred gain related to her old asset. Because she received boot of $20,000, she must recognize that amount in gain. Not that Jill still has remaining deferred gain of $5,000 relating to the new asset.

Question 134

Exam Question

Jack and Jill exchange like-kind real estate assets as listed below:

Jack’s Old Asset: FMV $50,000, Adjusted Taxable Basis $23,000

Jill’s Old Asset: FMV $70,000

In the previous problem, how much is Jill’s basis in her new asset given that her basis in her old asset was $45,000?

a) $50,000
b) $25,000
c) $20,000
d) $45,000

Answer 134

Answer: D

Jill still has a $45,000 basis in her new asset because she recognized gain on the boot that she received, but she did not receive boot in excess of her deferred gain

Question 135

Exam Question

Question 136

Exam Question

Jack and Jill exchange like-kind real estate assets as listed below:

Jack’s Old Asset: FMV $50,000, Adjusted Taxable Basis $23,000

Jill’s Old Asset: FMV $70,000

In the previous problem, assume Jill’s basis in the old asset was $55,000. How much gain must Jill recognize on the transaction?

a) $5,000
b)$10,000
c)$15,000
d) $20,000

Answer 136

Answer: C

If Jill’s old asset had a FMV of $70,000 and her basis was $55,000, then she had $15,000 of deferred gain in her old asset. She received $20,000 of boot from Jack, but she is only required to recognize gain on the receipt of boot to the extent of the deferred gain. The excess $5,000 boot will reduce her basis in the new asset to $50,000.

Question 137

Exam Question

Jack and Jill exchange like-kind real estate assets as listed below:

Jack’s Old Asset: FMV $50,000, Adjusted Taxable Basis $23,000

Jill’s Old Asset: FMV $70,000

In the previous problem, what is Jill’s basis in her new asset if her basis in the old asset was $55,000?

a)50,000
b) $45,000
c)$40,000
d) $35,000

Answer 137

Answer: A

Jill’s basis in her old asset was $55,000 and she had $5,000 of excess boot (over the deferred gain related to the old asset). Therefore, her $55,000 carryover basis is reduced by $5,000, for a basis in the new asset of $50,000.

Question 138

Like Kind Exchanges & Related Parties Only

Answer 138

Like Kind Exchanges & Related Parties Only:
- If either related party disposes of the property received in an exchange within 2 years, both parties are required to recognize any gain/loss that was not recognized in the year of the exchange.
- The gain or loss is recognized as of the date the property is sold.
A related party, as specified in Section 267(b), includes brothers and sisters (whole, half blood or adopted), spouses, ancestors, and descendants. In a business context, a related party includes a controlled corporation (a corporation in which the taxpayer owns more than 50% of the equity interest) and corporations that are members of controlled groups.
- Related party rules do not apply if:
* Either party dies before the sale occurs, or
* Taxpayer can demonstrate to the satisfaction of the IRS that avoidance of taxation was not a principal purpose of the sequence of transactions.

Question 139

Exchanges of Stock for Property

Answer 139

No gain or loss is recognized when a corporation receives money or property in return for its stock (including common, preferred, and treasury stock).

Under Section 1032, sale of stock to investors is treated as an infusion of capital and is not subject to income tax.

Question 140

Involuntary Conversions

Answer 140

An involuntary conversion is defined as the destruction, theft, seizure, condemnation, or sale or exchange under threat of condemnation of property.
- A voluntary act by taxpayer is not an involuntary conversion and will not qualify for the tax treatment associated with involuntary conversions.
- Involuntary conversions are often associated with eminent domain.

• Section 1033 permits (but does not require) nontaxable treatment of gains if the amount of reinvestment in replacement property equals or exceeds the amount realized
• Under Section 1033, replacement property must be:
  -similar in function or use as involuntarily converted property
  -acquired within a specified period
  –period starts when involuntary conversion or threat of condemnation occurs
  –period ends 2 years (3 years for condemnation of realty) from the year-end of year that gain is realized

Replacement property is defined very narrowly and is different for an owner-investor than for an owner-user. For business or investment real estate that is condemned, replacement property has same meaning as for like-kind exchanges.
- The functional use test applies to owner-users. The functional use test requires the replacement property. To serve the same functional use as the original property.
- The taxpayer use test applies to owner-investors. The taxpayer use test requires the replacement property to be used by the taxpayer in a similar activity as the original property.

Question 141

Exam Question

Boudreaux’s office building was completely demolished by Hurricane Cindy. When the building was destroyed (August 29, YRI), the building had a FMV of $1,000,000 and Boudreaux’s adjusted basis in the building was $450,000. Assuming that Boudreaux’s insurance adjustor determines on February 14. YR2, that Boudreaux should be paid $1,000,000, what is the last date he can reinvest under Section 1033 to avoid recognition of gain?

a) August 29, YR3
b) August 29, YR4
c) December 31, YR3
d) December 31, YR4

Answer 141

Answer: D

Reinvestment under Section 1033 related to natural disasters must be made by the end of the year of reialization plus two years. Therefore, Boudreaux news must reinvest by December 31, YR4. Realization occurred when the claim was finally determined, which was February 14, YR2.

Question 142

Exam Question

Boudreaux’s office building was completely demolished by Hurricane Cindy. When the building was destroyed (August 29, YRI), the building had a FMV of $1,000,000 and Boudreaux’s adjusted basis in the building was $450,000. Assuming that Boudreaux’s insurance adjustor determines on February 14. YR2, that Boudreaux should be paid $1,000,000.

In the above problem, how much cash must Boudreaux invest in order to avoid recognition.

a) $0
b) $450,000
c) $550,000
d) $1,000,000

Answer 142

Answer: A

There is no requirement to invest cash; however, Boudreaux must replace the destroyed property with property that has a FMV of at least $1,000,000.

Question 143

Insurance Policies - Tax Free Exchange

Answer 143

Section 1035 provides for tax free exchanges of some insurance policies.

An ordinary life insurance contract may be exchanged for:
-A life insurance contract on the same individual, or
-An endowment or annuity contract.

An endowment contract may be exchanged for:
-An endowment policy with payments beginning no later than the date payments would have been made under original contract, or
-An annuity contract.

An annuity contract may be exchanged for another annuity contract (fixed or variable) on the same person under a section 1035 exchange. An annuity contract, however, can not be exchanged for a life insurance contract or an endowment contract under 1035 rules, these would be taxable exchages.

Note that transferred basis rules apply and cash received by the taxpayer will trigger gain to the extent of cash received.

Losses from the sale or surrender of an insurance policy are not deductible.

Question 144

Exam Question

Which of the following are correct tax-free exchanges?
1. Life Insurance for Life Insurance
2. Life Insurance for an Annuity
3. An Annuity for an Annuity
4. An Annuity for a Life Insurance Policy

a) 1 only
b) 1 and 2 only.
c) 1,2, and 3 only.
d) 1, 2, 3, and 4.

Answer 144

Answer: C

The only option that is not a tax-free exchange of like-kind assets under Section 1035 is an annuity exchanged for a life insurance policy.

Question 145

Transactions Between Spouses Incident to Divorce

Answer 145

Transfers of property between spouses or former spouses incident to divorce are nontaxable.

-Carryover basis applies to the property transferred.

-A transfer is treated as incident to divorce if it occurs within one year of the date on which the marriage legally ended and is related to the cessation of the marriage.

Question 146

Example

Answer 146

Victor and Vanna are getting a divorce. Victor owns a house with a FMV of $200,000 and an adjusted basis of $40,000. As part of the divorce settlement, Victor must transfer ownership of the house to Vanna. Since this transfer is an incident to a divorce, it’s a nontaxable transfer.

Vanna’s basis is $40,000 (the carryover basis).