Tax Consequences of Property Transactions

Question 1

Capital Assets Defined

Answer 1

• all of the taxpayers assets, except:
• inventory or property held primarily for sale to customers
• depreciable property used in the taxpayers trade or business
• real estate used in the taxpayers trade or business
• accounts or notes receivable acquired in the ordinary course of trade or business from the sale of property or for services rendered
• supplies used in the taxpayers trade or business
• copyright, composition, or artwork, if held by the creator

Question 2

Basis

Answer 2

• the taxpayers investment in the property
• the original basis will include payments used to purchase the property, such as commissions, advertising, and legal fees
• basis is adjusted downward when a taxpayer takes depreciation deductions
• basis is adjusted upwards when the taxpayer makes improvements to the property.

Question 3

Basis for Gifts

Answer 3

-Donor’s basis is increased by the gift tax paid by the donor on appreciation (except: if sold for a loss, FMV on the date of the gift, when less than the donor’s basis)

Question 4

Basis for Inherited Assets

Answer 4

• the fair market value on the date of death
• can also use an alternate 6 month valuation date, which can be selected by the executor of an estate if assets have gone down in value between the date of death and 6 months from the date of death

Question 5

Basis of Property received by gift and in nontaxble transactions (carryover basis)

Answer 5

• the basis of property acquired by gift is generally the donor’s basis.
• the holding period will also transfer over
• the carryover basis rule applies when the donee will report a gain on the sale of the gift property

Question 6

Double Basis Rule

Answer 6

• if the donee will report a loss, the basis is the lower of the donor’s basis or the fair market value of the property on the date of the gift.
• the sale of gift property can result in no gain or loss, this result occurs when the sale is above the gift’s FMV but below the donor’s basis.

Question 7

Basis adjustment for gift taxes paid on appreciated property

Answer 7

• any gift tax paid by the donor or donee will increase the donee’s cost basis to the extent the gift tax is paid on any appreciation of the property.
• gift tax paid x appreciation/value of the taxable gift
• where the fair market value of a gift is below or equal to the donor’s adjusted basis, any gift tax paid will not increase the donee’s basis

Question 8

The impact on basis of community-property and common-law property

Answer 8

• the general rule is that property owned jointly by a decedent and another person is included in its entirety in the estate of the decedent unless the executor of the estate can show that the surviving joint owner contributed part or the entire purchase price
• with married spouses, when one spouse dies, one-half of the property owned jointly with the other spouse is included in the estate of the first to die, and, thus the surviving spouse receives a step-up in basis on half of the assets.

Question 9

Modified Accelerated Cost-Recovery System (MACRS)

Answer 9

• allows for the recovery of the cost of an asset

- an owners basis is the amount used to calculate depreciation

Question 10

Recovery Periods for Asset Classes

Answer 10

• 5 years - Autos, most trucks, computers
• 7 years - office furniture and equipment (except computers), most machinery
• 27.5 years - residential rental property
• 39 years - non residential real property

Question 11

Conventions

Answer 11

• all assets acquired by a client in a given year are treated as being acquired on July 1
• this means that there is a half year of depreciation in the year of acquisition and a half year taken in the year of disposition
• all realty is depreciated using the mid-month convention in the year of acquisition (property purchased on july 30 is treated as if it was purchased on July 15 and is depreciated for 5.5 months)

Question 12

Depreciation Methods

Answer 12

• the method of depreciation is determined by class life.
• property that is 3,5,7,10 year property is depreciated using double-declining method, switching to straight-line when that would result in a higher deduction.
• 15,20 year property is depreciated using the 150% declining method, switching to straight-line when that would result in a higher deduction
• 27.5, 39 year property use the straight-line method

Question 13

Straight-Line Depreciation

Answer 13

-can be used for any class of asset if elected by the client, but it then must be used for the entire class.

Question 14

Expensing Policy

Answer 14

• when a cost is incurred to lengthen the useful life or increase the market value of an asset, this cost is considered a betterment and must be added to the cost of the asset and depreciated over its life
• if the cost is incurred only to bring the asset back to its normal use, then it is considered a repair and can be expensed, to reduce current income.

Question 15

Section 179

Answer 15

• available to small businesses to further accelerate the pace of depreciation
• a business can deduct section 179 depreciation only to the extent of its income for the year the asset was acquired and no loss can be created or increased.
• cannot be used for rental property, and it is limited for automobiles
• assets must be used at least 50% in trade or business to qualify
• for partnerships and S corps the deduction is passed through to owners.

Question 16

Capital Losses

Answer 16

-losses from the sale of capital assets can be used without limit to offset gains, but only $3,000 per year of net capital losses can be used to reduce ordinary income.

Question 17

Sale of Residence

Answer 17

• married individuals can exclude from income up to $500,000 in gain ($250,000 for single) on the sale of a principal residence.
• Must have been the principal place of residence for 2 of the past 5 years.
• if the taxpayer had to sell the house for unforeseen circumstances, the maximum exclusion is multiplied by the number of months lived in the home, divided by 24.

Question 18

Deduction for Home Office Expenses

Answer 18

• permitted where the home office is used exclusively and on a regular basis as the taxpayer’s principal place of business.
• the taxpayer must use no other fixed location to conduct substantial administrative or management activities.

Question 19

Assets Used in a Trade or Business

Answer 19

• depreciable assets and real property used in a trade or business are specifically excluded from the definition of capital assets by the IRC
• the net gain on the sale of these assets is taxed as a capital gain, but a net loss on the sale of these assets is treated as ordinary loss.
• if a section 1231 loss is deducted and a section 1231 gain is realized in any of the subsequent 5 years, then subsequent gains are treated as ordinary income, to the extent of the loss.
• overridden by the provisions of depreciation recapture.

Question 20

Depreciation Recapture - section 1245

Answer 20

• covers personal property
• for a property that has been depreciated, the gain is separated into two parts: 1) the depreciation deduction that reduced basis 2) the remaining gain
• the gain attributable to the depreciation deduction is taxed as ordinary income and is called the depreciation recapture.
• any remaining gain is a capital gain
• section 179 and bonus depreciation are treated as depreciation deductions for depreciation recapture purposes.

Question 21

Depreciation Recapture - section 1250

Answer 21

• the amount of real property depreciation to be recaptured is the difference between the actual depreciation deductions taken and the amount figured using the straight-line method
• Because MACRS uses straight-line depreciation for all real estate, depreciation recapture does not apply to any real estate depreciated under MACRS. However, any gain on the sale of real estate, up to the amount of any depreciation taken, is taxed at a 25% maximum rate, rather than a 15% rate.

Question 22

Related Parties

Answer 22

• a gain on the sale of assets to a related party is treated the same as any other gain.
• if a loss is realized on a sale to a related party, however, it is not recognized for tax purposes until the related party sells the asset to an unrelated 3rd party.

Question 23

Bargain Sales

Answer 23

• if a corporation sells an asset at a substantially reduced rate to an employee or shareholder, the difference between the FMV of the asset and the price it was sold at would be taxable compensation to an employee or a taxable constructive dividend to a shareholder.
• a donor might sell an asset at a bargain price to a charitable organization, which would be treated as a partial sale and partial contribution
• in a bargain sale to an individual, the difference between the sale price and FMV is intended as a gift. the donor will only recognize a gain if the sale price is higher than the donor’s basis.

Question 24

Section 1244 Stock

Answer 24

• stock qualifies for special treatment if is it stock for a domestic corporation and it is issued for money or other property (not securities or services). The corporation must not have received more than $1 MM total in exchange for its stock and must receive 50% of its receipts from business operations.
• owners of 1244 stock can deduct up to $50,000 (100k for MFJ) per year in losses on the sale of section 1244 stock against ordinary income.

Question 25

Depreciation Recapture in the Year of a Sale

Answer 25

• the installment sale method cannot be used with sales the result in a loss.
• when an asset is sold that is subject to depreciation recapture (tangible personal property) and an installment contract is used, the amount of ordinary income recaptured is included in income in the year of the sale, and only the additional capital gain is reported using the installment method.

Question 26

Involuntary Conversions

Answer 26

• if a taxpayers property is destroyed in a fire, hurricane, or earthquake,the taxpayer can postpone any gain from the insurance proceeds in excess of his or her basis if the taxpayer purchases or builds a qualified replacement property within the replacement period.
• in order to postpone the entire gain, the taxpayer must use all of the net proceeds to purchase or build the replacement property.

Question 27

Like-Kind Exchanges

Answer 27

• not available on any property held for sale (inventory), partnership interests, property solely for personal use, stocks, bonds, and other securities.
• the property must be held for use in a trade or business or for investment.
• no loss or gain is recognized in these exchanges
• the qualifying property must generally be of the same type

Question 28

Liabilities

Answer 28

-when a taxpayer gives up property that is subject to a liability and the liability is assumed by the transferee, then the taxpayer is treated as having received cash in the transaction equal to the amount of the liability being transferred.

Question 29

Boot

Answer 29

• if the replacement property has a lower value than the property given up, then the seller will either receive cash or other unlike property as proceeds from the sale.
• the cash or unlike property is called a boot.
• if the boot received is less than the realized gain, then the total boot received represents the recipients total recognized gain.
• if not boot is received there is no recognizable gain.

Question 30

Long-Term Contract

Answer 30

-contracts longer than 1 year requires the profit on the contract to be included in income over the life of the contract.

Question 31

Inventory Methods

Answer 31

• LIFO is advantageous for a business during periods of rising prices. The most recently acquired products are the highest priced, so the cost of goods sold is high, and inventory is valued at the lowest possible level. This reduces taxable income and defers taxes, but also reduces EPS for investors
• FIFO has the opposite effect, increasing taxable income, taxes, and EPS.

Question 32

Additions to Basis

Answer 32

• Capital Improvements
• Sales Tax
• Commissions
• Freight
• Unharvested crops on land sales
• Assessments for Local Improvements

Question 33

Decreases to Basis

Answer 33

• Depletion Allowances
• Return of Capital
• Losses from Casualty and Theft
• Depreciation, Amortization, MACRs Deductions
• Cancelled Debt excluded from income
• Amortized Bond Premium