Entire Course (including glossary) (2024)

Chapter 2. Capital Gains and Losses

In this chapter, we discuss capital gains and losses, including the definition of capital assets, assets and transactions that do not qualify for capital asset treatment, assets and transactions that yield partial capital gain and partial ordinary income, and the sale or taxable exchange that must occur for the capital gain and loss rules to apply.

Upon successful completion of this chapter, the user should be able to:

recognize capital assets,
calculate tax on sales of assets and transactions that do not qualify for capital asset treatment and that yield partial capital gain and partial ordinary income, and
determine whether a sale or taxable exchange has occurred for capital gain and loss purposes.

Assets and Events That Produce Capital Gain and Loss

As a general rule, only capital assets can produce short- or long-term capital gain or loss. Some assets may fully or partially qualify for capital asset treatment and others cannot be considered capital assets at all.

A taxpayer recognizes short- or long-term capital gain or loss only by disposing of a capital asset in a transaction treated as a taxable sale or exchange.

What Is a Capital Asset?

As a general rule, a capital asset includes any property held for personal use or for investment use. The asset cannot be held as inventory or held primarily for sale to customers in the ordinary course of business (IRC §1221). In addition, depreciable property used in a trade or business is not a capital asset. Capital assets used for personal purposes, such as a car, principal residence, or vacation home are typical capital assets.

Caution
A loss generally is not recognized on the sale or taxable exchange of personal assets. A loss may be recognized if it arises from a casualty (such as a fire) or theft (IRC §165(c)).

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Interactivity information:

Typical investment property capital assets include the following:

Stocks, bonds, and mutual funds held for investment
Collectibles, such as stamps, coins, and artwork (unless created by the artist and held by the artist), and precious metals, such as gold and silver held for investment
Self-created musical compositions and copyrights (at the election of the taxpayer)
Land held for investment purposes and life estates in property
Options, if the underlying property is a capital asset
Minerals sold in place in the ground
Patents
Notes and accounts receivable, but only if bought and held by a taxpayer who is not a dealer in such property. (Receivables acquired in the ordinary course of business are not capital assets.)

Property held as inventory or held primarily for sale in the ordinary course of business is not a capital asset.

IRC §1221(a)(1)

Example
Dealers may hold some assets as investments even though they hold identical assets for sale to customers in the ordinary course of business. The dealer must have objective evidence to show that a particular property is held for investment rather than for sale to customers.
A developer makes his living by buying large tracts of land, subdividing them, putting in roads and sewer lines, and then selling lots to builders. The developer has set aside one parcel of land for long-term investment. If he has not improved the parcel or advertised it for sale or is otherwise able to show the parcel was held for investment rather than for sale to customers in the ordinary course of his business, the property should qualify as a capital asset.

Real estate held for use in a trade or business and depreciable property used in a trade or business are not capital assets.

IRC §1221(a)(2)

Note
Part or all of the gain realized on trade or business real estate or depreciable business property may effectively be taxed as long-term capital gain under IRC Section 1231. Section 1231 property is depreciable property or realty used in a trade or business and held for more than one year.

An asset may be held partially for personal use and partially for trade or business use. The sale or taxable exchange of such a mixed-use asset is handled as two transactions—the sale of a capital asset and the sale of a business asset that gives rise to IRC Section 1231 gain or loss and/or ordinary income.

Example
An artist bought a vacation home and used 75% of it as a summer residence and 25% of it as a studio in her business. When she sells the home, 75% of the amount realized will be treated as received from the sale of a capital asset. The balance of the amount realized will be treated as received from the sale of a trade or business asset.

Per IRC Section 1221(a)(3), copyrights; literary, musical, and artistic compositions; and similar types of property are not capital assets if they are:

held by the taxpayer who created them, or
held by a taxpayer whose basis in the property is determined in whole or in part by reference to the property's basis in the hands of the creator (such as a donee that acquired property as a gift, or certain qualifying transfers to a corporation or partnership).

Note
The rules apply to virtually any creative type of work—photographs, films, voice recordings, books, manuscripts, etc.

The tax code allows the taxpayer who created a musical composition or copyright in a musical work to elect capital gains treatment for the sale of these items. Taxpayers are also eligible for the election if they have a basis in the work that is determined by reference to the basis of the property in the hands of the taxpayer who created the property (e.g., a gift).

The election is made separately for each musical composition or copyright in a musical work. It must be made on Schedule D (of Form 1040, Form 1065, or Form 1120), on or before the due date (including extensions) of the income tax return for the taxable year of the sale or exchange.

Reg. §1.1221-3

Letters, memoranda, and similar property are not capital assets if they are held by:

the taxpayer who created them,
a taxpayer whose basis in the property is determined in whole or in part by reference to the property's basis in the hands of the creator (such as a donee that acquired property as a gift, or certain qualifying transfers to a corporation or partnership), or
the person for whom they were created.

Per IRC Section 1221(a)(4), accounts or notes receivable are not capital assets if they are acquired:

in the ordinary course of business for services rendered, or
from the sale of inventory property or property held for sale in the ordinary course of business.

Example
A dealer sells an item of inventory for cash plus a note. If the dealer later sells the note, she realizes ordinary income or loss.

Government publications received for free or purchased for less than the price they are sold to the general public are not capital assets if they are:

held by the taxpayer who received them, or
held by a taxpayer whose basis in the publications is determined in whole or in part by reference to the publications' basis in the hands of the transferor (such as a done that acquired property as a gift, or certain qualifying transfers to a corporation or partnership).

IRC §1221(a)(5)

Other assets specifically excluded from the definition of a capital asset are as follows:

A commodities derivative financial instrument held by a dealer in such instruments, unless the instrument has no connection to the dealer's activities as a dealer and certain technical recordkeeping requirements are met
IRC §1221(a)(6)
Certain clearly identified hedging transactions
IRC §1221(a)(7)
Supplies of a type regularly used or consumed by the taxpayer in the ordinary course of the taxpayer's trade or business
IRC §1221(a)(8)

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Interactivity information:

If depreciable property is sold or conveyed via an exchange to a related party, any gain recognized is taxed as ordinary income. Related parties for this purpose include the following:

Controlled and commonly controlled entities (more than 50% directly or indirectly owned corporation or partnership)
Trusts in which the taxpayer or taxpayer's spouse is a beneficiary (other than a remote contingent beneficiary)
Employers and welfare benefit funds that they control
An executor of an estate and a beneficiary of that estate (except in the case of a sale or exchange in satisfaction of a pecuniary bequest)

Note
The constructive ownership rules of IRC Section 267 generally apply in determining these relationships. IRC §1239

Only part of the gain on the actual or deemed sale or taxable exchange of certain assets is treated as capital gain; the balance of the gain is taxed as ordinary income.

In addition, part of the gain realized on some transactions is automatically ineligible for capital gain treatment. We will now discuss the more common assets and transactions that yield partial capital gain.

Gain Recaptured as Ordinary Income

Section 1245

The recapture rules of IRC Section 1245 prevent taxpayers from converting ordinary income into capital gain. The depreciation or amortization deductions that offset ordinary income (and reduce basis) during ownership generally must be taxed as ordinary income (rather than capital gain) when the asset is sold or exchanged. The recapture rules affect the sale of the following:

	Capital assets held for investment, which would otherwise yield capital gain
	Trade or business depreciable property that under IRC Section 1231 may yield long-term capital gain

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Interactivity information:

According to IRC Sections 1245(a)(2)(C),(a)(3), and (b)(8), the following are the principal items that must be recaptured as ordinary income:

Depreciation or cost recovery deductions claimed on personal property under IRC Section 167
Expensing deductions claimed under IRC Section 179
Deductions claimed under IRC Section 190 for expenses to remove barriers to the disabled and elderly
Deductions claimed under IRC Section 193 for qualified tertiary injectant expenses
Deductions for amortization of purchased goodwill and other intangibles (IRC §197(f)(7))
Deductions allowed under IRC Section 179A relating to qualified clean-fuel vehicle property and qualified clean-fuel vehicle refueling property
Deductions for capital costs incurred in complying with EPA sulfur regulations (IRC §179B)
Deductions for expensing of certain refineries (IRC §179C)
Deductions for energy efficient commercial buildings (IRC §179D)
Deductions for advanced mine safety equipment (IRC §179E)
Deductions for certain film and television production expenses (IRC §181)
Deductions under IRC Section 194 for reforestation expenditures

Any expensing deductions allowed before January 1, 2012, under IRC Section 198 for environmental remediation costs, are also subject to recapture under IRC Section 1245 (IRC §198(e)).

The amount recaptured as ordinary income is limited to the lesser of:

gain realized on the disposition of the asset, or
cumulative deductions claimed for depreciation, amortization, and expensing.

Example
A self-employed printer bought a $1,000 machine many years ago and has depreciated the basis down to zero. The machine now is a rarity, much sought after for custom printing. This year, the printer sells the machine and has no other sales of business or investment property.
If the printer sells the machine for $1,000, his gain also would be $1,000 (since his basis is zero) and all of it would be recaptured and taxed as ordinary income.
If the printer sells the machine for $1,250, only $1,000 of his gain would be recaptured as ordinary income. The $250 balance would be taxed as long-term capital gain.
IRC §1245

Special Rules for Real Property under Sections 1245 and 1250

Accelerated depreciation for real property is subject to recapture under IRC Sections 1245 and 1250.

Real property placed in service before 1987: Prior to 1987, accelerated depreciation was used to deduct the cost of real property. Under Section 1250, when the property is sold, the difference between the deduction claimed using accelerated depreciation and the deduction that would have been claimed if straight-line depreciation was used, is subject to recapture and taxed at ordinary rates.

Due to the passage of time, both commercial and residential properties placed in service before 1987 would be fully depreciated under the straight-line method based on the useful lives allowed at that time. Therefore, the recapture potential will be relatively small.

Real property placed in service after 1986: Real property placed in service after 1986 can only be depreciated using straight-line depreciation. There would be no recapture for such property under IRC Section 1250.

However, any Section 179 deduction or bonus depreciation claimed on qualified improvement property is subject to Section 1250 recapture, equal to the difference between the deduction claimed and that amount that would have been claimed if straight-line depreciation was used.

Oil, Gas, Geothermal, or Other Mineral Properties Covered by Section 1254

Deductions for depletion, intangible drilling costs, and mine development and exploration expenses also are subject to recapture provisions when the property is sold at a gain (IRC §1254).

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Interactivity information:

Sale of Business Assets

The sale of stock in an incorporated business normally yields capital gain or loss. By contrast, the sale of business assets yields mixed results:

Some assets, such as goodwill and similar intangibles, yield capital gain or loss (unless the seller had written off the goodwill, or similar intangibles, under IRC Section 197).
The seller may dispose of assets governed by IRC Section 1231, such as depreciable property used in a trade or business. A gain on the sale of such assets may effectively be taxed as long-term capital gain to the extent that the recapture provisions do not apply.
Some business assets, such as inventory, produce ordinary income for the seller.

IRC §§1221, 1231, 1245, and 1250

Market Discount on Bonds

Market discount is the excess (if any) of a bond's redemption or par value over its purchase price. When the bond is redeemed, market discount is included in taxable income. For bonds purchased after April 30, 1993, market discount on all bonds (exempt or taxable) is ordinary income, not capital gain.

For taxable bonds purchased before May 1, 1993, but issued after July 18, 1984, the market discount is treated as ordinary income. For taxable bonds purchased before May 1, 1993, but issued before July 1, 1984, the market discount is treated as capital gain.

For tax-exempt bonds purchased before May 1, 1993, the market discount is taxed as capital gain.

Taxpayers can elect to currently include market discount in interest income. If the election is not made, the market discount is recognized upon disposal, redemption, or maturity of the bond.

In September of 1993, an investor bought a $1,000 par value corporate bond for $950. If he subsequently sells or redeems the bond for $1,000, he will have $50 of ordinary income (§13206(b) of Public Law 103-66 (93 Tax Act); IRC §§1276, 1277, and 1278).
Original issue discount (generally the excess of a bond's redemption price over its issue price) is taxed as ordinary income in the case of corporate bonds but is nontaxable if the bond is a tax-exempt obligation.

Election to Treat Pre-1974 Portion of Qualified Plan Lump-Sum Distribution as Capital Gain

Normally, the taxable portion of a distribution from a qualified retirement plan is all ordinary income. There is, however, an important exception.

Exception
A taxpayer may make a one-time election to treat the pre-1974 portion of a lump-sum distribution from a qualified plan (including a Keogh plan) as long-term capital gain taxed at a 20% rate if:
the plan participant was born before January 2, 1936, and
the payout otherwise qualifies as a lump-sum distribution.

A taxpayer can choose to report the total distribution (both pre-1974 and post-1973 portions) as ordinary income. A taxpayer in a lower tax bracket would most likely not want to elect the 20% capital gain treatment.

The pre-1974 portion of a lump-sum distribution from a qualified retirement plan is found as follows:

the pre-1974 months of active plan participation (partial years count as a full 12 months).
the total months of active plan participation (participation for a partial month counts as a full month).
divide the number of months from Item A above by the number of months from Item B.
multiply the percentage calculated from Item C with the total taxable amount of the distribution.

IRS Publication 575 (2022)

Land Subdivided for Sale

Normally, the subdivision and sale of land lots is a dealer-type activity that yields ordinary income or loss. Partial or complete long-term capital gain treatment, however, may apply to lots sold from a tract held for five years or more in the following circ*mstances:

	The tract was not held for sale to customers in the ordinary course of business.
	In the year of sale, other real property was not held for sale.
	The taxpayer made no substantial improvements to the property.
	The taxpayer is not a C corporation.

The gain from the sale of the first five lots or parcels is treated as long-term capital gain. Gain from the sale of subsequent lots is treated as ordinary income to the extent of 5% of the selling price; the balance is long-term capital gain.

IRC §1237

Study Question 3

John Swift is a self-employed computer programmer. Two years ago, he bought a computer for $3,000 and expensed the entire amount under IRC Section 179. This year, he sells the computer for $1,000. John does not sell any other assets this year. If John is in the 24% tax bracket, how much tax does he pay on his profit?

A	$0
B	$150
C	$240
D	$720

Short- and long-term capital gains and losses can result only if the taxpayer disposes of eligible assets in a sale or taxable exchange or in a transaction treated as a sale or taxable exchange.

IRC §1222

Bond Redemption

The redemption or retirement of a bond held for investment is treated as a sale or taxable exchange yielding capital gain or loss.

IRC §1271(a)

Stock Redemption

Not all stock redemptions qualify for treatment as a sale or taxable exchange. Only the transactions on the following screens will yield capital gain or loss if the stock was held as a capital asset.

According to IRC 302, an exchange of stock has occurred if the redemption qualifies as any of the following:

a redemption not essentially equivalent to a dividend
a substantially disproportionate redemption
a redemption in termination of a shareholder's interests
a partial liquidation redemption from a noncorporate shareholder
a distribution in redemption of stock of a publicly offered RIC (regulated investment company) if:
- the redemption is on the demand of the stockholder, and
- the RIC issues only stock that is redeemable on the demand of the stockholder.

A redemption qualifies as a sale or taxable exchange if it is not essentially equivalent to a dividend (IRC §302(b)(1)).

Note
A redemption avoids dividend equivalency only if it results in a meaningful reduction of the shareholder's proportionate interest in the corporation (U.S. v. Davis 397 U.S. 301 (1970)). A reduction that reduces the following rights may result in a meaningful reduction: the right to vote and thereby exercise control, the right to participate in current earnings and accumulated surplus, and the right to share in net assets on liquidation of the entity (Rev. Rul. 75-502, 1975-2 CB 111).

A redemption qualifies as a sale or taxable exchange if the distribution in payment for the stock is substantially disproportionate with respect to the shareholder. IRC §§302(b)(2)(B) and (C) state that the substantially disproportionate test is met if after the redemption:

	the shareholder owns less than 50% of the combined voting power of all classes of voting stock, and
	the ratio of the shareholder's voting stock to total voting stock is less than 80% of the pre-redemption ratio of the shareholder's voting stock to total stock. The shareholder's common stock ownership also must meet this test.

A redemption qualifies as a sale or taxable exchange if all of the shareholder's stock is redeemed (IRC §302(b)(3)).

In closely held corporations, the family attribution rules generally would prevent the complete redemption condition from being met. The family attribution rules, however, will not apply if the departing shareholder:

	does not have an interest in the corporation immediately after the distribution, other than as a creditor,
	does not reacquire an interest in the corporation (other than by bequest or inheritance) within 10 years from the date of the distribution, and
	files an agreement to notify the IRS in the event the shareholder reacquires stock within 10 years.

IRC §302(c)(2)

Within the 10 years preceding redemption, the departing shareholder may have acquired some of the redeemed stock from a person whose stock ownership would be attributed to him. Alternatively, someone whose stock ownership would be attributed to the departing shareholder may have acquired stock from the departing shareholder within the 10 years preceding redemption and may still hold these shares when the departing shareholder's stock is redeemed.

If a principal purpose of these transactions is tax avoidance, the family attribution rules will apply, and the departing shareholder will not be treated as having redeemed all of the shares.

A stock redemption will qualify as a sale or taxable exchange if it represents a distribution to a noncorporate shareholder in partial liquidation of the corporation (IRC §302(b)(4)).

The partial liquidation requirement is met if the distribution:

	is not essentially equivalent to a dividend (determined at the corporate level), and
	is pursuant to a plan and occurs within the tax year in which the plan is adopted or within the following year.

IRC §302(e)

Complete Liquidations

Amounts distributed to a shareholder in complete liquidation of a corporation are treated as payment in full in exchange for the stock. IRC §331(a)

Worthless Securities

Securities (stocks, bonds, debentures, etc.) that become totally worthless are treated as having been sold or exchanged on the last day of the tax year in which the worthlessness occurs.

IRC §165(g)

Foreclosures, Repossessions, and Abandonments

All of the following have been held to be the equivalent of a sale of property by the mortgagor:

Involuntary foreclosure followed by sale
Electro-Chemical Engraving Co., 311 U.S. 513
Conveyance of mortgaged property to lender instead of foreclosure
Freeland, 74 TC 970
Abandonment of property by mortgagor
Yarbro (CA-5), 737 F.2d 479

Sale versus Lease

A transaction that is in fact a sale may be cast in the form of a lease to benefit one of the parties.

Example
A business may prefer to characterize a transaction as the rental of equipment rather than as a straight purchase of the assets. Lease payments generally are fully deductible. A lease may yield larger deductions than would be possible with a purchase (which yields depreciation deductions plus interest deductions if the purchase is leveraged).

Whether a transaction is a sale or lease depends primarily on the facts and circ*mstances of each case.

Each of the following tends to show that a lease of personal property is in fact a conditional sale:

“Rent” payments build equity in the asset.
The lessee can obtain title upon payment of a stated amount of “rentals” that under the contract he is required to make.
Total payments for a relatively short period of use constitute an inordinately large portion of the sum required to get the title.
“Rent” payments materially exceed the asset's current fair rental value.
The lessee has the option to purchase the property for a nominal price.
A part of the payment is called interest or is readily recognizable as such.

Rev. Rul. 55-540, 1955-2 CB 39

Lease Cancellation Payments

Amounts received by a lessee for the cancellation of a lease of personal or real property are treated as received in exchange for the lease. The deemed exchange produces capital gain or loss if the lease was held as a capital asset.

IRC 1241; Reg. 1.1241-1

Study Question 4

A C corporation redeems shares of a shareholder who realizes a gain on the transaction. Which of the following circ*mstances will yield a capital gain or loss from the transaction?

A	Before the redemption, the shareholder owned 75% of the voting stock. After the redemption, the shareholder owns 60% of the voting stock.
B	The distribution is not essentially equivalent to a dividend.
C	The redemption represents a distribution to a corporate taxpayer in a partial liquidation of the C corporation.
D	The shareholder's stock is redeemed except the portion owned by family members. The main purpose of the redemption is tax avoidance.

Chapter 3. Capital Gain or Loss

In this chapter, we discuss capital gain or loss, including the amount realized and basis.

Upon successful completion of this chapter, the user should be able to:

calculate the amount realized in a capital transaction, and
determine the basis of capital assets.

The sale or taxable exchange of an asset results in:

	a gain if the amount realized exceeds the taxpayer's adjusted basis in the asset, or
	a loss if the taxpayer's adjusted basis exceeds the amount realized.

For capital assets, the result is either a capital gain or loss. If the asset sold is IRC Section 1231 property (depreciable property or realty used in a trade or business), the profit generally is treated as capital gain if the year's Section 1231 gains exceed Section 1231 losses. A loss from the sale of Section 1231 property generally is treated as an ordinary loss if the year's Section 1231 losses exceed Section 1231 gains.

IRC §§1001, 1221, and 1231

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Interactivity information:

The amount realized from a sale or other disposition of property includes all of the following items:

Cash received
Fair market value (FMV) of property (other than cash) received as part of the transaction
Fair market value of services received as part of the transaction
See Also
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The outstanding balance of recourse or nonrecourse obligations that the purchaser assumes or takes the property subject to
Generally, the full-face amount of a note or other obligation of the purchaser tendered to the seller as partial or full payment
IRC §1001(b); Reg. §§1.1001-1 and 1.1001-2

Under the following circ*mstances, the full-face amount of the buyer's note may not be included in the amount realized:

If insufficient interest is charged on a note issued in connection with the sale, the face amount of the note and the amount realized are reduced by the amount of the original issue discount (OID) or interest imputed to the transaction.
IRC §1274
A property's sale price may have been inflated through the use of a large, seller-held, nonrecourse mortgage. This device was used in the past to inflate the buyer's tax benefits. The courts have held that all or part of the mortgage must be disregarded.
Estate of Franklin, CA-9, 544 F.2d 1045; Pleasant Summit Land Corp. (Prussin), CA-3, 863 F.2d 263, cert. denied

When an inflated nonrecourse mortgage is reduced, the seller's amount realized also is reduced to the fair market value of the property.

Selling expenses reduce the amount realized on a sale or other taxable disposition. It is well established that the following selling expenses of a nondealer reduce the amount realized on a transaction:

Advertising
Commissions or brokerage fees
Legal, accounting, recording, and escrow fees
Cost of maps, surveys, etc.
State transfer tax (e.g., deed transfer tax)

Expenses the seller pays as a condition of the sale also reduce the amount realized. For example, a seller of realty may have to buy out a tenant's lease before the sale is closed.

An owner of IRC Section 1231 property has a choice of selling appreciated property at one price as is or at a higher price if all necessary repairs are made to the property before it is put on the market. The latter approach yields tax savings if the owner is in a high tax bracket. The repairs are currently deductible and offset highly taxed ordinary income. When the property is sold, the greater sales price it will command because of the repairs results in additional low-taxed long-term capital gain (assuming that the property has been held for more than one year).

Amount Realized in Foreclosure of Encumbered Property

The amount realized in a foreclosure (or abandonment) of encumbered property depends on the following three factors:

	The property's value at that time
	Whether the loan is nonrecourse (borrower not personally liable) or recourse (borrower is personally liable)
	Whether the borrower is insolvent or in a Chapter 11 bankruptcy proceeding

Now we will discuss the general rules.

Property's Fair Market Value Equals or Exceeds the Loan Balance

If a property's fair market value (FMV) equals or exceeds the outstanding loan balance, the amount realized includes the entire outstanding loan balance, whether or not the borrower is personally liable for repayment of the loan.

Reg. §§1.1001-2(a)(1) and (b)

Outstanding Recourse Loan Balance Exceeds the Property's Fair Market Value

If the outstanding recourse loan balance exceeds the property's FMV, the loan amount up to the property's FMV is included in the amount realized. Excess of loan over FMV of foreclosed property is treated as forgiven debt (Reg. §§1.1001-2(a)(2) and (b)).

If the borrower is not insolvent or in a Chapter 11 bankruptcy proceeding, excess debt generally results in ordinary income under IRC Section 61(a)(12). If the loan is qualified real property business debt, the borrower can elect under IRC Section 108(c) to exclude excess debt.

If the borrower is insolvent or in a Chapter 11 bankruptcy proceeding, the excess of debt over property's FMV may be excluded under IRC Section 108(a)(1).

Outstanding Nonrecourse Loan Balance Exceeds Property's Fair Market Value

Whether or not the borrower is insolvent or in a Chapter 11 bankruptcy proceeding, the entire loan amount is considered an amount realized from the sale or other disposition of property.

Reg. §§1.1001-2(a)(1) and 1.1001-2(c), Example (7)

Amount Realized in Foreclosure of Encumbered Property
Type of Loan	FMV > Loan	Loan > FMV
Recourse	Loan amount	FMV (the excess loan is forgiven debt)^*
Nonrecourse	Loan amount	Loan amount
^*If the borrower is not in Chapter 11 bankruptcy, this condition causes the excess loan over FMV for a recourse loan to be realized as income.

Study Question 5

Jackson Greene sold an unimproved land parcel for $10,000 cash, a $10,000 face value Acme Inc. bond with a current market value of $8,000, and a buyer's note in the amount of $5,000. The buyer also assumed an $8,000 mortgage on the property. What is Greene's amount realized?

A	$18,000
B	$23,000
C	$31,000
D	$33,000

The taxpayer's basis in an asset depends on three factors:

Beginning basis. The taxpayer's beginning (or unadjusted) basis in an asset depends on how it was acquired (e.g., by purchase, exchange for other assets, gift, or inheritance) and occasionally on the method of payment.
Additions to basis. The most common basis increase is a capital expenditure. There are circ*mstances where paying tax in connection with property increases basis. Some basis increase rules protect against double taxation or payment of tax on tax-exempt income.
Reductions in basis. Usually, basis reductions occur when a taxpayer has recovered part of the cost of an asset by way of depreciation, amortization, or depletion deductions.

Beginning Basis in Arm's-Length Purchases

If an asset is purchased in an arm's length transaction, beginning basis generally is the price paid increased by nondeductible buyer-paid expenses associated with the transaction, such as broker's commissions, legal fees, cost of removing a cloud on the title, owner's title insurance, and transfer taxes.

Basis does not include any charges related to obtaining or refinancing a mortgage.

IRC §1012

Options: If the taxpayer purchases an option to buy property and subsequently exercises the option, the cost of the option is added to the property's basis. If the option expires unexercised, it is deemed to have been sold on the expiration date and (if the underlying asset is a capital asset) results in a short- or long-term capital loss, depending on the holding period.

Rev. Rul. 58-234, 1958-1 CB 279; Rev. Rul. 78-182, 1978-1 CB 265

Example
An investor pays $500 for an option to buy 100 shares of XYZ stock at $80 per share. If the investor exercises the option, the basis in the XYZ shares will be $8,500. If the option expires unexercised, the investor will have a short- or long-term capital loss of $500.

Price paid usually consists of the cash paid plus the proceeds of a loan obtained or assumed to purchase the asset. That is true whether or not the purchaser is personally liable for repayment.

Crane, 331 U.S. 1

Caution
A nonrecourse loan (no personal liability for the borrower) may be disregarded or only be included partially in beginning basis if the obligation is artificially inflated to enhance deductions (e.g., depreciation).
Estate of Franklin, (9th Cir) 544 F.2d 1045

Beginning Basis of Property Built by the Taxpayer

If the asset built is personal-use property (such as a home), beginning basis generally is determined the same way as it would be if the asset had been purchased. When the property is built, developed, or improved by the taxpayer for use in a trade or business or income-producing activity (as well as for sale), basis is determined with reference to the uniform inventory capitalization (UNICAP) rules.

These rules generally require the indirect costs of producing the asset to be capitalized as part of its basis along with the direct costs (such as labor and materials).

Indirect costs capitalized under UNICAP include expenses such as construction period interest, utilities, indirect labor, materials and supplies, engineering and design, and pension and insurance costs.

For 2023, small business taxpayers are exempted from §263A if their average annual gross receipts for the prior three years are less than $29 million.

IRC §263A

Beginning Basis of Asset Obtained from Spouse or Former Spouse

No gain or loss is recognized when property is transferred between spouses (unless the spouse is a nonresident alien) or, if incident to a divorce proceeding, transferred between ex-spouses. The nonrecognition rule applies even if the transfer is made in the form of a sale. As a result of this nonrecognition rule, the recipient's basis in the property is the same as the transferor's adjusted basis when the transfer is made.

IRC §1041; Reg. §1.1041-1T, Q&As 2 and 11

Beginning Basis of Asset Acquired by Gift

As a general rule, the donee's (i.e., gift recipient's) beginning basis equals the donor's adjusted basis in the asset when the gift is made. For gifts made after 1976, beginning basis is increased by the portion of gift taxes paid (if any) attributable to the net appreciation element of the gift. For any gift received before 1977, increase the beginning basis by any gift tax paid on the asset, but do not increase the basis above the FMV of the gift at the time it was given (IRS Publication 551 (2022)).

IRC §1015(d)

If at the time of the gift the donor's adjusted basis in the asset is greater than its fair market value (FMV) and the donee subsequently sells the asset at a loss, the donee's basis is equal to the FMV when the gift was made. Neither gain nor loss is realized if the donee later sells the asset for more than the FMV of the asset when the gift was made but less than the donor's adjusted basis.
IRC §1015(a), Reg. §1.1015-1(a)

Beginning Basis of Property Acquired by Bargain Purchase

In a bargain purchase where there is clear donative intent on the part of the seller, the buyer's beginning basis is equal to the greater of:

	the amount paid for the property, or
	the seller's adjusted basis for the property.

The buyer's basis is increased by the portion of gift taxes paid (if any) attributable to the net appreciation element of the gift. For determining loss, however, the buyer's beginning basis is not greater than the fair market value of the property at the time of the bargain purchase.

Example
Dad sells Son a valuable antique for $5,000. Dad bought the property years ago for $7,000 and it is currently worth $10,000. Dad does not have to pay gift tax (transfer is sheltered by the annual gift tax exclusion of $17,000 in 2023). Son's beginning basis in the antique is $7,000.
Reg. §1.1015-4(a)

If an employer sells property to an employee at a bargain price, the employee's beginning basis equals the property's fair market value (FMV). The amount actually paid by the employee plus the bargain element (FMV less consideration paid) that is taxed as compensation will equal the property's FMV. Similar rules apply if property is sold to an independent contractor and the bargain represents compensation for services.

Reg. §1.61-2(d)(2)

Beginning Basis of Property Acquired by Inheritance

General Rule

The beginning basis of inherited property generally is equal to its fair market value at the date of death or at the alternate valuation date (six months after death). Look to the federal estate tax return or an appraisal performed for state inheritance or transmission taxes for this valuation.

The Economic Growth and Tax Relief Reconciliation Act of 2001, which provided for zero federal estate taxes in 2010, changed the carryover basis rules for property inherited from a decedent dying in 2010 to be the lesser of:

	the adjusted basis of the decedent, or
	the fair market value of the property at the date of the decedent's death.

Appreciated Property Received after It Was Gifted to the Decedent

If the decedent received the property from the person inheriting it (or the person's spouse) within one year of death, beginning basis equals the decedent's adjusted basis in the property.

IRC §1014(e)

To the extent that inherited land subject to a qualified conservation easem*nt is excluded from the estate, its basis is equal to the decedent's basis.
IRC §1014(a)(4)

Joint Ownership in Property

For property held jointly with right of survivorship, the survivor's basis equals the property's fair market value at the date of death (or alternate valuation date) if the survivor made no contribution to the purchase of the property.

For joint tenancies between spouses (sometimes called tenancies by the entirety), however, the survivor's basis generally is equal to one-half of the beginning basis of the property when it was acquired (usually cost) plus one-half of its fair market value at death (or alternate valuation date), regardless of who purchased the property (IRC Publication 551 (2022), p. 10).

The special spousal rule does not apply to joint tenancies created before 1977 (Hahn (110 TC 140, acq.)). For such joint tenancies, the survivor's basis is determined under the general rule. Basis equals the fair market value of the property at the date of death (or alternate valuation date) if the survivor made no contribution for the purchase. Where this rule applies, there can be substantial income tax savings on a taxable disposition of the property by the survivor.

Whether the property is held jointly with right of survivorship or by joint tenancy depends on state law.

Beginning Basis of Property Acquired by Way of Exchange

If an asset is acquired through a taxable exchange for non-like-kind property, the beginning basis is determined in the same way as it would be for a purchase. “Cost” would equal the fair market value of the property given up in the exchange (plus any cash tendered).

Reg. §1.1012-1(a)

The exchange of a home used as a personal residence for investment land is an example of a taxable exchange.

Nontaxable Exchanges

There are some types of nontaxable exchanges (or deemed exchanges) where a property's beginning basis is determined with reference to the property disposed of or given up in the exchange. These nontaxable exchanges include the following:

Exchanges of real property used in a trade or business or held for investment for like-kind property (IRC §1031)
Involuntary conversions, where the proceeds are timely reinvested in eligible property (usually property similar or related in service or use) (IRC §1033)

The TCJA modified the rules for like-kind exchanges under §1031. Beginning January 1, 2018, only real estate used in a trade or business or held for investment is eligible for like-kind exchange treatment. Prior to the TCJA, personal property qualified as a tax-free exchange under IRC §1031.

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Beginning Basis of Property Contributed to or Received from Entity

Here is a capsule summary of the most important basis rules involving entities.

Property transfers to controlled corporation: The corporation's basis in the property is equal to the transferor's basis plus any gain recognized by the transferor (IRC §362(a)).

The transferor's basis in the stock received generally equals the basis of the property transferred (IRC §358).

Property transfers to partnership in exchange for an interest in it: No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership (IRC §721(a)).

The partner's basis for the partnership interest generally equals the basis of the property transferred (IRC §722).

Note
The partnership can value the assets received at the higher current value. The contributing partner is not required to recognize gain at that time. If the assets are sold or distributed within two years, then the partner must recognize gain. The partner will have an outside basis for tax purposes that is smaller than the inside basis of the partnership's shares.

Distribution of property by a corporation: The shareholder's beginning basis usually equals the property's fair market value, whether the property is distributed as a dividend, as part of a stock redemption, or in connection with a liquidation (IRC §301(d)).

Distribution of property by a partnership: In a nonliquidating distribution, the partner's beginning basis generally is determined by the partnership's basis (IRC §732).

Special rules apply to events such as distributions made on liquidation of the entity or within two years after the partner acquired the partnership interest (IRC §§732(b) and (d)).

Additions to Basis

The most common basis increase is a capital expenditure. There are circ*mstances, however, where paying tax in connection with property increases basis. Some basis increase rules protect against double taxation or payment of tax on tax-exempt income. Circ*mstances that result in an increase in basis are described in the following screen.

Improvements and Additions to Property

The cost of improvements or additions to property that have a useful life longer than a year are capitalized and added to basis. Improvements:

add to value,
prolong the property's useful life, or
make property useful for a different purpose even though they do not add to value or prolong useful life.

Reg. §1.1016-2; IRC §263

Example
Capitalized improvements that add to basis are as follows:
Replacing a roof
Expanding a building
Complete repaving of a parking lot
Retooling a machine for heavier duty

By contrast, currently deductible repairs keep property in efficient operating condition and do not add to value or prolong useful life (Reg. §1.162-4(a)).

Example

Deductible repairs are as follows:
Patching a roof or sidewalk
Repairing stairs
Fixing a broken part in a machine

Taxpayers can elect to capitalize amounts paid for repairs and maintenance consistent with the method of accounting used in the books and records (§1.263(a)-3(n)).

A taxpayer that has audited financial statements may elect the de minimis safe harbor under §1.263(a)-1(f) where capital expenditures of $5,000 or less may be expensed on their tax return. This must be a company policy and these expenditures must be expensed on their financial statements in order to be deductible on the tax return.

The same de minimis election provisions apply to taxpayers that do not have an audited financial statement, however the amount paid for property must not exceed $2,500.

Under the “restoration principle,” a company that pollutes property it bought in clean condition can deduct the cost of cleaning it up because it is restoring the property to its prepurchase condition rather than “improving” it (requiring capitalization of the expense) (Rev. Rul. 94-38). The IRS, backed up by several courts, says that if a business purchases property with an environmental problem, the cost of cleaning it up is not deductible and must be capitalized (e.g., United Dairy Farmers, Inc., 88 AFTR 2d 2001-6116, Oct. 3, 2001).

Under IRC Section 198, a business was allowed to elect to currently expense the cost of qualified environmental remediation expenses paid or incurred after August 5, 1997, and before January 1, 2012. Expenses qualified if they would otherwise have to be capitalized and were paid or incurred in connection with the abatement or control of hazardous substances at a qualified contaminated site. These expenditures paid or incurred after December 31, 2011 are capitalized and, therefore, added to the basis.

The IRS position is that the cost of asbestos removal and EPA-ordered environmental cleanups are capital expenses added to basis (PLRs 9240004 and 9315004). Re-encapsulation of asbestos is currently deductible as a repair (PLR 9411002). One court, however, permitted the cost of asbestos removal and re-encapsulation to be deducted currently, where the work did not refurbish the building or prepare it for a new function (Cinergy Corp., 91 AFTR 2d 2003-1229, March 10, 2003).

Cost of Acquiring or Defending Property Rights

An owner adds to basis the expenses involved in getting an easem*nt or right-of-way and the cost of defending property rights. Typical expenses are as follows:

	Legal
	Accounting
	Engineering
	Appraisal fees

Johnson v. Commr, 162 F.2d 844; McEwan v. Commr, TC Memo 1956-27

Example
Actions defending a property right are as follows:

Filing suit to invalidate a local building code
Fighting a condemnation
Defending title to property
Engaging in a will contest

Note
Amounts paid by a landlord to a tenant to cancel a lease (e.g., to enable a building to be torn down) are paid to obtain a property right and are thus additions to basis.
Jones' Estate v. Commr, 127 F.2d 231

Capitalized Tax Assessments and Levies

Special property assessments and levies that tend to enhance property values (e.g., paving, sewer, sidewalk) are not deductible as taxes and must be added to basis.

Reg. §1.164-4(a)

Contribution to Corporation's Capital

A shareholder who makes a cash contribution to a corporation's capital is entitled to a basis increase in the shares in the amount of the contribution.

Chesshire v. Commr, PH TCM P 52042, 11 CCH TCM 146

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Tax Rules That Result in Increased Basis

In the following circ*mstances, payment of federal income tax in connection with property results in a basis adjustment, which protects the owner from being taxed twice on the same income or from being taxed on tax-free income.

Original issue discount (OID) on taxable bonds: The spread between redemption value and original issue price of a bond, known as OID, is taxable over the period of bond ownership. The OID included in income is added to the taxpayer's basis in the bond (IRC §1272(d)(2)).
Market discount bonds: A taxpayer may elect to include the accrued market discount (excess of bond's redemption value over its purchase price) in income currently, instead of paying a tax on the discount at sale or maturity. If the election is made, the basis of the bond is increased by the amount of market discount included in income (IRC §1278(b)(4)).
Original issue discount (OID) on tax-exempt bonds: The OID on a tax-exempt bond is not taxable. Nevertheless, the amount that accrues during ownership is added to the basis in the bond; otherwise, the OID would effectively be taxed when the bond was sold or redeemed (IRC §1288(a)(2)).
Seller-financed real property that is repossessed: A taxpayer who sells nondealer realty for cash and a note may be able to report gain on the installment method under IRC Section 453. If the purchaser defaults on the note, the seller may wind up with a taxable gain on the repossession of the property. This in turn results in an upward adjustment in basis. Basis in the repossessed property is equal to adjusted basis of the purchaser's debt obligation plus gain taxed as a result of the repossession plus costs of repossession (IRC §1038(c)).
Recapture of tax credits: Tax credits such as the credit for rehabilitating qualifying structures, the energy credit, or the reforestation credit reduce an eligible taxpayer's tax bill on a dollar-for-dollar basis. The taxpayer subsequently may have to recapture part or all of the tax benefit received from the credit if the property is disposed of prematurely or ceases to qualify. The amount of credit recaptured is added to the basis of property in connection with which the credit was claimed (IRC §50(c)(2)).

Reductions in Basis

A basis reduction usually is required whenever a taxpayer recovers part of the capital investment through deductions or credits or has sold or given away part of a property interest.

All of the following reduce basis on a dollar-for-dollar basis:

Amounts deducted as depreciation, depletion, amortization, and that part of an asset that is expensed under IRC Section 179 (IRC §1016(a)(2)).
Bond premium: A taxpayer who pays more than par value for a bond has bond premium. If the bond yields taxable interest, the holder may elect to amortize bond premium over the period remaining until redemption. For bonds bought after 1987, the amortized amount offsets interest income. If the bond is a tax-exempt obligation, bond premium must be amortized but is not deductible. Amortized bond premium on a taxable or tax-exempt bond reduces the taxpayer's basis in the bond (IRC §1016(a)(5)).
A taxpayer who claims the credit for rehabilitating qualifying structures reduces basis in the underlying property by the full amount of the credit claimed. A taxpayer who claimed any energy credit reduces basis in the underlying property by only 50% of the credit (IRC §§50(c)(1) and (3)).
Under the alternative motor vehicle credit, the basis of the vehicle is reduced by the amount of credit allowed (IRC §30B(h)(4)).
Tax-free distributions to a shareholder reduce the basis in the stock. A tax-free distribution occurs when a corporation's distributions to shareholders exceed its current and accumulated earnings and profits (IRC §301(c); Reg. §1.1016-5).

Example
Art Abelson has a basis of $5,000 in his ABX shares. This year, ABX makes a distribution in excess of its earnings and profits. Art's share of this distribution is $500. The distribution is a nontaxable return of capital and reduces Art's basis in his stock to $4,500. If and when Art's basis in the stock is reduced to zero, additional distributions in excess of earnings and profits are treated as gain from the sale or exchange of property (capital gain if the shares are held for investment).
IRC §301(c)(3)(A)

Basis Reduction for Forgiven Debt That Is Excluded

As a general rule, a solvent borrower who obtains a loan reduction from a third-party lender has ordinary income equal to the amount of discharged debt (IRC §61(a)(12)). There are, however, some instances where discharge of debt income is currently excluded. In each case, the tax law provides a mechanism to defer tax on the discharge-of-debt income. A common mechanism is a reduction in basis.

Discharge of debt is excluded from current taxable income if it occurs in a Chapter 11 bankruptcy case or when the borrower is insolvent (special rules apply to qualified farm debt). Discharge of debt income can also be excluded when the debt is qualified real property business indebtedness or qualified principal residence indebtedness.

In exchange, the borrower must reduce the so-called tax attributes in the following order (IRC §108(b)(2)):

Net operating losses (NOLs) and NOL carryovers
General business credit
Minimum tax credit
Capital loss carryovers
Basis of depreciable and nondepreciable property
Passive activity loss or credit carryover
Foreign tax credit carryovers

A taxpayer may elect to reduce basis in depreciable property first. The basis reduction cannot exceed the aggregate adjusted bases of depreciable property held by the taxpayer as of the beginning of the tax year following the tax year in which the discharge occurs.
IRC §108(b)(5)

Qualified Real Property Business Debt

Discharge of qualified real property business debt that would otherwise be currently taxed as discharge of debt may be excluded currently (for taxpayers that are not C corporations). The exclusion is limited to the excess of:

the dollar amount of the debt prior to the debt reduction over
the property's fair market value at the time of the debt reduction, reduced by
outstanding loan balance over any other loans that are secured by the property

The amount of discharged qualified debt that is excluded from income reduces the taxpayer's basis in depreciable real property. The exclusion cannot be greater than the taxpayer's basis in depreciable real property.

There are two types of nonfarm real property business debt that qualify for the discharged-debt exclusion:

	Debt incurred or assumed before January 1, 1993, in connection with real property used in a trade or business and secured by the property
	Debt incurred or assumed on or after January 1, 1993, to buy, build, rebuild, or substantially improve real property used in a trade or business and secured by the property

The refinancing of debt in either category also qualifies, but only to the extent of the debt being refinanced.

IRC §108(c)(3)

Discharge of seller-held debt is not currently taxed, but only if the debt reduction would otherwise result in taxable income and does not occur:

in a Chapter 11 bankruptcy case, or
when the borrower is insolvent.

The loan reduction is treated as a reduction in the original purchase price of the property and therefore has the effect of reducing the borrower's basis in the property.

IRC §108(e)(5)

Example
Ted Stone buys investment land from Art Fredericks for $200,000. Ted pays $50,000 cash and gives Art a note secured by the land for $150,000, payable over 10 years, plus interest. After two years, when the value of the property has declined to $150,000, Ted asks for a $50,000 reduction in the loan amount. Ted is solvent at that time and is not involved in a Chapter 11 bankruptcy case. If the reduction is granted, Ted's basis in the land will be $150,000.

Partial dispositions of property also result in a basis reduction. This includes the sale or gift of part of a taxpayer's property, the sale of an easem*nt, and the partial contribution of property to a partnership or corporation.

Study Question 6

Father bought 100 shares of ABC Inc. common stock for $6,000. It now has a fair market value of $12,000. Although Father knows that the stock is worth $12,000, he sells it to Son for $5,000. No gift tax was paid because the gift element of the transaction qualified for the annual gift tax exclusion. How much is Son's beginning basis in the stock for purposes of figuring future gain?

A	$5,000
B	$6,000
C	$7,000
D	$12,000

Study Question 7

Jason Johns had repairs and improvements made to his home. Which of the following will increase Jason's basis in the home?

A	Addition of a driveway and garage
B	Bathroom tile repair
C	Painting the kitchen walls
D	Sidewalk patches

Chapter 4. Character of Capital Gain: Short- versus Long-Term

In this chapter, we discuss the character of capital gain, including the holding period rule, the tacked-on holding period, special holding period rules, net capital gain, the annual capital loss limit for individuals, capital loss carryovers of noncorporate taxpayers, and corporate capital loss carryovers and carrybacks.

Upon successful completion of this chapter, the user should be able to:

determine the holding period for assets based on the general rule, the tacking rules, and other special holding rules,
calculate net capital gain tax, and
identify the capital loss limitation and carryback/carryover rules for capital losses.

Reminder
A capital asset yields short-term capital gain or loss if it is held for one year or less. If the asset is held for more than one year, a sale or other taxable disposition will result in long-term capital gain or loss.
IRC §1222

The holding period of an asset begins on the day after the day on which it is acquired and ends on the day it is disposed of. The acquisition date is ignored, but the disposal date is counted as part of the holding period. To be considered held for more than one year, an asset must be held at least until the numerical day succeeding the acquisition day in the 12^th month following the date of acquisition (Rev. Rul. 70-598, 1970-2 CB 168).

Example
An investor bought 100 shares of stock on August 15, Year 1. If the investor waits until at least August 16, Year 2, to sell the shares, the investor will have a long-term capital gain or loss. If the investor sells the shares before August 16, Year 2, any gain or loss will be short-term. For tax purposes, the trade date-not the settlement date-is the date that stock is bought or sold.

End-Of-Month Rule

A special rule applies if an asset is bought on the last day of a month. In this case, the asset must be held at least until the first day of the 13^th month following the date of acquisition for the capital gain or loss to be considered long-term.

Rev. Rul. 66-7, 1966-1 CB 188

This ruling came out when the long-term holding period was more than six months. With the long-term holding period now being more than one year, the end-of-month rule only applies when an asset is purchased on February 28^th and the next year is a leap year.

An investor bought 100 shares of stock on February 28, Year 1 (a non-leap year). If the investor holds the shares until at least March 1, Year 2 (a leap year), a sale will yield long-term capital gain or loss. A sale before March 1, Year 2, including a sale on February 29, Year 2 will result in short-term capital gain or loss.

Study Question 8

Marie Martin purchased 1,000 shares of Acme Inc. stock on June 3, Year 1. What is the first day that she can sell the shares and qualify for long-term capital gain?

A	December 4, Year 1
B	June 3, Year 2
C	June 4, Year 2
D	July 1, Year 2

There are two broad categories of transactions where the taxpayer may “tack on” or add to the holding period. The first category includes transactions where the taxpayer's holding period includes the transferor's holding period. The second category includes transactions where the taxpayer's holding period for property includes the holding period for other property.

Holding Period Includes Transferor's Holding Period

A taxpayer's basis in an asset sometimes is wholly or partially determined with reference to someone else's basis. Where that is the case, the taxpayer's holding period includes the other party's holding period (IRC §1223(2)).

The most common situation of basis being determined by reference to someone else's basis—and therefore resulting in a tacked-on holding period—is property acquired by gift.

Jack Smyth bought a collection of rare coins on April 15, Year 1. In December of Year 1, he makes a gift of the coins to his favorite nephew. The nephew's holding period is considered to begin on the same date as Smyth's. Therefore, if the nephew sells the coins on or after April 16, Year 2, he will recognize a long-term capital gain or loss.

Other instances where basis is determined by reference to someone else's basis and therefore results in a tacked-on holding period include the following:

Property transfers to a controlled corporation (the entity's holding period includes the transferor's holding period)
Property transfers to a partnership in exchange for an interest in the partnership (the partnership's holding period includes the transferor's holding period)
See Also
The Current Policy On Kidney Donation Effectively Sets A Price Ceiling Of Zero.a. Trueb. False
Property transferred by a partnership to a partner (the partner's holding period includes the partnership's holding period)
Property acquired from a spouse or, if incident to a divorce, a former spouse (the recipient's holding period includes the other person's holding period)

Holding Period Includes Holding Period of Other Property

A taxpayer can “tack on” to the holding period in any exchange where:

the basis of the new property is determined in whole or in part by reference to the exchanged property, and
the property given up was a capital asset or an IRC Section 1231 asset (depreciable property used in a trade or business and held for more than one year).

In such cases, the holding period for the old, exchanged property is tacked on (added) to the holding period of the new property.

IRC §1223(1)

There are other situations where the taxpayer is treated as continuing an investment even though one asset has been replaced with another. Under these circ*mstances, the Internal Revenue Code (IRC) allows the taxpayer to tack on the holding period for the disposed-of asset to the holding period for the new asset.

The more common examples of exchanges where the taxpayer gets a tacked-on holding period are as follows:

Exchanges of property held for productive use in a trade or business or for investment in like-kind property (IRC §1031) (Remember, as of January 1, 2018, only real estate used in a trade or business or held for investment is eligible for like-kind exchange treatment. Assets acquired in a like-kind exchange prior to 2018 will continue to use the tacked-on holding period.)
Involuntary conversions where the proceeds are timely reinvested in property similar or related in service or use to the destroyed or condemned property (IRC §1033; Rev. Rul. 72-451, 1972-2 CB 480)
A nontaxable distribution in the form of stock of the issuing corporation or a stock split

Example
An investor bought 100 shares of ZYX stock on June 15, Year 1. In Year 2, ZYX announces a stock split and on August 15, Year 2, the investor receives an additional 50 shares of ZYX. Because the new stock's holding period includes the holding period of the original shares, the investor can immediately sell the new shares and recognize a long-term capital gain or loss.

Conversion of bond into stock, preferred into common, convertible debenture into stock (Rev. Rul. 72-265, 1972-1 CB 222)
Tax-deferred sale of publicly traded securities and reinvestment in the stock or partnership interest in a specialized small business investment company (IRC §1044)
Tax-deferred sale of qualified small business stock (QSBS) and reinvestment in other qualified small business stock (IRC §1223(13))
Seller-financed realty that is repossessed (when the property is reacquired, the owner's holding period includes the holding period prior to the original sale) (Reg. §1.1038-1(g)(3))
A taxpayer who sells qualified securities to an employee stock ownership plan (ESOP) may elect to defer the tax on the gain if the taxpayer timely reinvests the proceeds in qualified replacement property (generally, stock in another domestic operating corporation). The holding period for the qualified securities that are sold is tacked on to the holding period for the qualified replacement property (IRC §1223(11))

Property Acquired by Inheritance

Standard Rule

Assets inherited from a decedent's death that occurred before January 1, 2010, or after December 31, 2010, automatically are considered to have been held for more than one year. As a result, the sale of inherited capital assets at a profit will produce long-term capital gain taxed no higher than 20% regardless of the decedent's or the recipient's holding period. The capital gain on these assets may also be subject to the additional 3.8% net investment income tax.

If the decedent's death occurred during 2010 and the estate's executor elected out of the estate tax, the inherited assets generally will be treated as if transferred by gift subject to a number of exceptions. The holding period for such property is the same as the holding period for property transferred by way of gift. Under these circ*mstances, the holding period of the decedent is tacked-on to that of the recipient. More information on the basis and holding period of assets inherited from a decedent in 2010 can be found in IRS Publication 4895, Tax Treatment of Property Acquired from a Decedent Dying in 2010.

Revenue Procedure 2011-41

Example
In 2023, Alexis Bundy inherits a vacation home from her grandfather. The home's date of death value is $150,000, which is her basis in the asset under IRC Section 1014. If she sells the property for $160,000 five months after she receives it, Alexis will have a $10,000 long-term capital gain and will pay 0%, 15%, or 20% tax on that gain depending on her taxable income in the year of sale, and possibly an additional 3.8% net investment income tax, depending on her AGI.

Wash Sales

Under IRC Section 1091, a loss on the sale of stock or securities is currently disallowed if the taxpayer acquires substantially identical stock or securities within the period of time:

beginning 30 days before the loss sale, and
ending 30 days after the loss sale.

If this so-called wash sale rule applies, the holding period for the stock sold at a loss is added on to the substantially identical stock or securities acquired within the prohibited time period.

The taxpayer's basis of any remaining replacement shares may increase by the amount of disallowed loss.

Incentive Stock Options

Incentive stock options (ISOs) that qualify under the tests of IRC Sections 421 and 422 offer special tax benefits to the employees that receive them, including the following:

The employee is not taxed on the option when it is granted or when it is exercised.
If the stock that is bought pursuant to the ISO is subsequently sold at a profit, all of the gain is treated as long-term capital gain if a dual holding period is met.

According to IRC Section 422(a)(1), to qualify for full long-term capital gain treatment, stock bought by exercising an ISO must be held:

at least two years from the date that the ISO is granted, and
at least one year after the shares bought pursuant to the ISO are transferred to the employee.

Note
These holding periods also apply to employee stock purchase plans qualifying under IRC Section 423.

If either the 2-year or 1-year ISO holding period is not met, the employee will have ordinary income when the shares bought through exercise of an ISO are sold. The amount of the gain treated as ordinary income is limited to the excess of the fair market value of the stock when the ISO is exercised over the option price of the stock specified in the ISO (IRC §421(b); Reg. §1.422-1(b)).

Example
On September 24, Year 1, PBY Corp. gave executive employee Sanford White an option to buy 1,000 shares of PBY stock. The stock was selling at $10 per share and that is the price at which the option is exercisable. On May 5, Year 2, when PBY shares are selling for $15 per share, White exercises his ISO and buys 1,000 shares of PBY at $10. The shares are delivered to him on that date. On May 10, Year 3, White sells his 1,000 shares at $20 per share.

Result
White realizes a gain of $10,000 ($20,000 amount realized less $10,000 cost basis). Because the sale of PBY shares occurred within two years from September 24, Year 1 (the date the ISO was granted), $5,000 of the gain is taxed as ordinary income ($15 per share price when he exercised the option, less $10 per share exercise price, multiplied by 1,000 shares). The $5,000 balance of gain is long-term capital gain because White held the shares for more than one year. If his sale had occurred after the 2-year time period had elapsed, all of his gain would have been long-term capital gain.

The exercise of an ISO has alternative minimum tax (AMT) ramifications. The bargain element—fair market value of the stock when exercised less the exercise price under the ISO—is an adjustment that increases alternative minimum taxable income (AMTI). Recall that no regular taxable income is recognized at the time the option is exercised. For AMT purposes, the tax basis of the stock is increased by the AMT adjustment.

If the stock is sold in the same year that the ISO is exercised, the tax treatment for regular tax and AMT are the same.

Example
Clay Grady exercises an ISO on VBX stock and buys 100 shares at the exercise price of $30 per share. VBX is selling at $50 at that time.

Result
Result for regular tax purposes: Grady will not realize any gain until the shares are sold. He must determine the character of that gain based on the rule already discussed:
To qualify for full long-term capital gain treatment, stock bought by exercising an ISO must be held:
at least two years from the date that the ISO is granted, and
at least one year after the shares bought pursuant to the ISO are transferred to the employee.
Result for AMT purposes: Grady's alternative minimum taxable income is increased by $2,000 ($50 per share fair market value at the time of exercising the option less $30 per share exercise price) and for AMT purposes his basis in the shares is $50 ($30 purchase price plus $20 bargain element).

Holding Period for Capital Gains Exclusion for Qualified Small Business Stock

A noncorporate taxpayer may exclude 50% of the gain from the sale of qualified small business stock if two key requirements are met:

The stock must have been originally issued after August 10, 1993, by a C corporation that is a qualified small business.
The stock must be held for more than five years.

The nonexcluded balance of the taxpayer's gain is taxed at a maximum rate of 28%.

IRC §§1(h) and 1202

Example
An investor in the 32% tax bracket buys 500 shares of qualified small business stock on April 1, Year 1, for $10,000 and sells the shares for $40,000 on or after April 2, Year 6. His total gain is $30,000, of which one-half ($15,000) is tax-free. The regular income tax on the other half of his profit ($15,000) would be a maximum of $4,200 (28% of $15,000).

The 50% exclusion applies for regular income tax purposes only. For purposes of the alternative minimum tax, 7% of the gain excluded on qualified stock is a preference.

IRC §57(a)(7)

The five-year holding period also applies to the qualified small business stock acquired:

	after February 17, 2009 and before September 28, 2010 that is eligible for the 75% exclusion, and
	after September 27, 2010 that is eligible for the 100% exclusion.

Holding Period for Qualified Dividend Income

Dividends treated as qualified dividend income and paid to noncorporate shareholders are taxed at the same 0%, 15% or 20% maximum tax rate that applies to net capital gain (IRC §1(h)(11)).

A dividend is treated as qualified dividend income eligible for the favorable capital gains tax rates only if it meets a number of conditions, including a holding period requirement: The stock that paid the otherwise qualifying dividend must have been held for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. The ex-dividend date is the first date following the declaration of a dividend on which the buyer of a stock will not receive the next dividend payment. Preferred stock must have been held for more than 90 days during the 181-day period that begins 90 days before the ex-dividend date, but only if the dividends are attributable to periods totaling more than 366 days (IRC §1(h)(11)(B)).

When counting the number of days the stock was held, the day that the stock was acquired is not included, but the day the stock is sold is included (IRS Pub. 550 (2022)).

Example
Alice Jones bought 1,000 shares of Widget Corp. common stock on July 8. Widget paid a $500 cash dividend, and the ex-dividend date was July 9. Alice sold the stock on September 9 of the same year. She held the stock for 63 days (from July 9 through September 9). The cash dividend is taxed at the favorable capital gain rates (assuming that the other conditions are met) because she held the stock for 61 days (from July 9 through September 7) of the 121-day period (May 10 through September 7).

When determining if the qualified dividend holding periods are met, the taxpayer cannot count any day during which:

the taxpayer had an option to sell, was under a contractual obligation to sell, or had made (and not closed) a short sale of substantially identical stock or securities,
the taxpayer was a grantor (writer) of an option to buy substantially identical stock or securities, or
the taxpayer's risk of loss is diminished by holding one or more other positions in substantially similar or related property.
IRC §1(h)(11)(B)

Only net capital gain is favorably taxed, and it is defined as the excess of net long-term capital gain for the tax year over the net short-term capital loss for that year (IRC §1222(11)). The maximum tax on net capital gain depends in some instances on the type of capital asset sold (e.g., collectibles and depreciated realty).

Netting Gains and Losses

To determine the rate at which net capital gain is taxed (28%, 25%, or 20%/15%/0%), a complex procedure must be followed. First, the taxpayer nets gains and losses in each of the three long-term rate groups (28%, 25%, and 20%/15%/0%) and then determines whether the taxpayer has net short-term capital gain or loss. Then the taxpayer applies a series of netting rules if there are gains in one group and losses in another.

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Following are the rules, step by step, which must be followed to determine a taxpayer's tax on net capital gain.

Instructions to Schedule D, Form 1040

Step 1: Combine capital gains and losses in the 28% group. The 28% group consists of:

capital gains and losses from collectibles (including works of art, rugs, antiques, metals, gems, stamps, coins, and alcoholic beverages) held for more than one year, and
for sales of qualified small business stock, an amount equal to the gain not excluded on the sale.

The 28% group also includes long-term capital loss carryovers.

IRC §1(h)(4) and (5); Instructions to Schedule D

Example
For the current year, Steve Wein has a $6,000 gain from the sale of a collectible he held for more than one year and a $2,000 long-term capital loss carryover from the preceding year.

Result
Steve has a $4,000 net gain from the 28% group ($6,000 collectibles gain less $2,000 long-term capital loss carryover).

Step 2: Combine gains and losses in the 25% group. The 25% group consists of unrecaptured IRC Section 1250 gain (there are no losses in this group). Unrecaptured IRC Section 1250 gain is long-term capital gain that is not otherwise recaptured as ordinary income attributable to depreciation deductions claimed on realty that was held for more than one year.

IRC §1(h)(6)

Step 3: Combine gains and losses in the 20%/15%/0% group. The 20%/15%/0% group consists of long-term capital gains and losses that are not in the 28% or 25% group. Thus, a rate of 20%/15%/0% generally applies to net capital gain (other than collectibles gain or unrecaptured IRC Section 1250 gain) from capital assets held for more than one year.

Example
For the current year, Sam Deal has $40,000 of gain from the sale of stock he held for more than one year and a $10,000 loss from the sale of land he bought as an investment 10 years ago. Sam has a $30,000 net gain in the 20%/15%/0% group.

Note
Although qualified dividend income is taxed at a rate determined as if it were in the 20%/15%/0% group, it cannot be offset by long-term capital losses in Step 3.

Step 4: Combine short-term capital gains and losses for the year to find net short-term capital gain or loss. These are gains and losses from capital assets held for one year or less prior to sale.

Example
For the current tax year, Jerry Fila has a $3,000 profit on the sale of Able Inc. shares that he has held for six months, a $2,000 loss on the sale of Baker Inc. shares that he has held for nine months, and a $2,500 loss on the sale of Charles Inc. shares held for 11 months. Jerry has a net short-term loss of $1,500 for the current tax year—that is, $4,500 of losses less $3,000 of gains.

Step 5: The excess of any net short-term capital gain (Step 4) over any long-term capital losses (from the 28% group and/or the 20%/15%/0% group) is taxed at the same rates as ordinary income. If there is a net short-term capital loss, it is applied to:

reduce any net long-term gain from the 28% group, then to
reduce gain from the 25% group, and finally to
reduce net gain from the 20%/15%/0% group.

Example
Mark Able has taxable income over $500,000. For the current year, he has $10,000 of short-term capital loss, $8,000 of net long-term gain from the 28% group, and $5,000 of net gain from the 20%/15%/0% group. The short-term capital loss completely offsets the $8,000 of net long-term gain from the 28% group, and the remaining $2,000 of short-term capital loss offsets $2,000 of net gain from the 20%/15%/0% group. Able winds up with $3,000 of net gain taxed at 20%.

Step 6: Losses from the 28% and 20%/15%/0% groups are applied as follows:

A net loss from the 28% group (including long-term capital loss carryovers) is used first to reduce gain from the 25% group, then to reduce net gain from the 20%/15%/0% group.
A net loss from the 20%/15%/0% group is used first to reduce net gain from the 28% group, then to reduce gain from the 25% group.

Any remaining net capital gain attributable to a particular rate group is taxed at that group's marginal tax rate.

Election to Treat Net Capital Gain from Investments as Ordinary Income

Noncorporate taxpayers may only deduct their investment interest expense to the extent of their investment income. Net capital gains from dispositions of investment property generally are not considered investment income. A taxpayer may elect, however, to treat part or all of net capital gains from dispositions of investment property as investment income. (A similar election applies to qualified dividend income, which is generally taxed at the long-term capital gain rates.) As a trade-off, the amount of net capital gain for which the election is made is taxed as ordinary income.

Net capital gain is reduced by the amount of net capital gain that a taxpayer elects to treat as investment income.

IRC §1(h)(2) and 163(d)(4)(B)

Study Question 9

For the current tax year, Rod Somersby has $10,000 of net short-term capital gain, $5,000 of long-term capital losses in the 28% group, and $5,000 of capital gains in the 20%/15%/0% group. Rod is in the 32% tax bracket, with $185,000 of taxable income. How much tax does Rod pay on his gain?

A	$2,000
B	$2,400
C	$2,800
D	$3,200

Capital losses first offset capital gains. If capital losses exceed capital gains, the losses produce a limited benefit for noncorporate taxpayers. The excess short- or long-term capital losses may offset only up to $3,000 of ordinary income each year ($1,500 for married persons filing separate returns) (IRC §1211(b)). There is, however, an unlimited carryforward of unused amounts (IRC §1212(b)(1)).

Entire Course (including glossary) (100)

In November of the current year, Susan Perry, an unmarried taxpayer, recognizes a capital loss of $8,000 from the sale of stock. If she has no other capital transactions, Susan may deduct only $3,000 of the loss against other income on her return for the current year; the $5,000 balance is carried forward.

Tax Tip

Susan may have paper gains—short- or long-term—on other capital assets. She can turn these paper gains into tax-free profits by recognizing enough of them before year-end to absorb her losses. How much additional capital gain should she recognize?

In our example, the answer is $5,000. This way, the $5,000 of capital gain (short- or long-term) would be fully offset by $5,000 of capital loss and Susan would still be able to use the $3,000 balance of her loss currently to offset $3,000 of ordinary income.

Entire Course (including glossary) (102)

Entire Course (including glossary) (103)

Noncorporate taxpayers whose capital losses for a tax year exceed the sum of the year's capital gains plus $3,000 ($1,500 for married persons filing separately) may carry forward the unused balance:

	A capital loss that is carried over to another year retains its tax character as either a short- or long-term capital loss. A long-term loss does not retain the character of the gain-or-loss group that it arose from (28% group or 20%/15%/0% group).
	In determining the amount of a carryover, special computations are necessary for taxpayers who have an overall loss (deductions exceed income) in the year in which the capital loss carryover arose.

Retention of Character for Loss Carryovers

Entire Course (including glossary) (106)

A noncorporate taxpayer with a net capital loss for a tax year combines the taxpayer's short-term capital gains and losses for the year. For this purpose, up to $3,000 of loss allowed under IRC Section 1211(b) is treated as a short-term capital gain. (For those for whom special computations are required, the adjusted taxable income is treated as a short-term capital gain, as explained later.) If the result is a net short-term loss, it is applied against net long-term capital gains (if any). The remaining balance is treated as a short-term capital loss in the succeeding tax year.

Next, the taxpayer combines the long-term capital gains and losses for the year. If there is a net long-term capital loss, it is applied against net short-term capital gain (if any). Here, too, the up to $3,000 loss allowed under IRC Section 1211(b) is treated as a short-term capital gain. (For those for whom special computations are required, the adjusted taxable income is treated as a short-term capital gain, as explained later.) The remaining balance is then treated as a long-term capital loss in the succeeding tax year.

IRC §1212(b); Reg. §1.1212-1(b); and Instructions to Schedule D, Form 1040

Example
Example of short-term capital loss carryover: For 20X1, Jerry Abel has a short-term capital gain of $4,000, a long-term capital gain of $2,000, and a short-term capital loss of $14,000. He has $40,000 of income from wages, interest, and dividends.

Result
Jerry's $6,000 of capital gains are fully offset by $6,000 of his $14,000 short-term loss, plus $3,000 of that loss is allowed against ordinary income. In addition, the $5,000 balance of Jerry's loss is carried over to 20X2 as a short-term capital loss determined as follows: Jerry nets his $4,000 short-term capital gain, his deemed $3,000 short-term capital gain, and his $14,000 short-term capital loss to arrive at a net short-term capital loss of $7,000. The $2,000 of long-term capital gain is subtracted from this $7,000. The $5,000 balance is treated as a short-term capital loss in 20X2.

Example
Example of long-term capital loss carryover: For 20X1, Mr. Smith has a $2,000 short-term capital loss, a $1,000 long-term capital gain, and an $8,000 long-term capital loss. He has $90,000 of income from wages, interest, and dividends.

Result
The $1,000 long-term capital gain is fully offset by $1,000 of his long-term capital loss, plus $3,000 of the remaining capital loss is allowed against ordinary income. In addition, the $6,000 balance of Smith's loss is allowed as a long-term capital loss in 20X2, determined as follows. Smith nets his $1,000 long-term capital gain and his $8,000 long-term capital loss. The $7,000 is then reduced by the net short-term capital gain of $1,000 (deemed short-term gain of $3,000 less short-term loss of $2,000). The $6,000 balance is treated as a long-term capital loss in 20X2.

Where the taxpayer has both short- and long-term losses, the losses that are carried over retain their character as short- or long-term.

Example
For 20X1, Jill Honig has a $4,000 short-term capital gain, a $10,000 short-term capital loss, and a $6,000 long-term capital loss. She has $70,000 of income from salary, dividends, and interest.

Result
For 20X1, Jill's $4,000 short-term capital gain is offset by $4,000 of her $10,000 short-term capital loss, plus $3,000 of that loss is allowed against ordinary income. In addition, the remaining $3,000 of her short-term capital loss is treated as a short-term capital loss in 20X2 and the remaining $6,000 long-term capital loss is treated as a long-term capital loss in 20X2.

Net Capital Losses in Years with Negative Income

Special computations apply to taxpayers with negative taxable income for the year in which capital losses exceed capital gains. Per IRC Section 1212(b)(2), in determining the capital loss carried over to succeeding years, the lesser of the following amounts is treated as a short-term capital gain:

	The amount normally allowed as a deduction against ordinary income in the loss year (i.e., the excess of capital losses over capital gains, up to a maximum deduction of $3,000—$1,500 for married persons filing separately)
	Taxable income for the loss year, plus the amount normally allowed as a deduction against ordinary income
	Personal exemption deductions for the year (if the taxpayer had an overall loss for the year—deductions exceed income—the excess is taken into account as negative taxable income)

Note
The Tax Cuts and Jobs Act of 2017 reduced personal and dependent exemptions to $0 for tax years 2018-2025. IRC Section 1212(b)(2) still includes personal exemptions in the computation for determining the capital loss carry over because the exemption itself has not been eliminated, only the amount of the exemption. Use the appropriate exemption amount when computing a capital loss carryover using the special computation for years prior to 2018.

Example
In 2023, Sally Jones has a $14,000 long-term net capital loss and $2,000 of negative taxable income. The negative taxable income includes a $3,000 capital loss deduction. The capital loss carryover to the year 2024 is $13,000, calculated as follows (the $2,000 negative taxable income is treated as a negative number, but the capital loss deduction, and the personal exemption deduction for years where there is an exemption amount, are treated as positive numbers):
Negative income $ (2,000)
Capital loss deduction 3,000
Personal exemption 0
Difference $ 1,000
Long-term capital loss $ 14,000
Long-term capital loss used in 2023 – 1,000
Carryforward to 2024 $ 13,000
Without this provision, some of the tax benefit of the capital loss deduction would be wasted when the deduction drives taxable income below zero.

Carryovers of spouses: Spouses who file joint returns generally are treated as one unit for purposes of the capital loss carryover rules. The following special rules should be noted:

If married persons file separate returns in a year in which a capital loss carryover arises and subsequently file a joint return, their capital loss carryovers are taken into account on the joint return.
If married persons file a joint return in the year in which a capital loss carryover arises and subsequently file separate returns, the carryover is allocated to the spouses based on their individual net capital losses that created the carryover.

Reg. §1.1212-1(c)

Example

Mark and Martha Markham are married filing jointly for 20X1. For that year, they had a net capital loss of $5,000, all attributable to sales of stock owned by Mark as an individual. They used $3,000 of that amount to offset $3,000 of ordinary income and wound up with a net capital loss carryforward of $2,000. For tax year 20X2, Mark and Martha file separate returns.

Result
For 20X2, the $2,000 loss carryforward is available only to Mark, not to Martha. If Mark has no other capital gains for 20X2, he can use up to $1,500 of the loss carryforward to offset ordinary income.

No carryover to estate: Capital losses remaining after an individual dies are only deductible on the final return; they cannot be claimed by the estate. Rev. Rul. 74-175, 1974-1 CB 52

Study Question 10

For 20X4, John and Cindy Grey filed a joint return showing taxable income of $100,000. For that year, Cindy had a $6,000 long-term capital loss. For 20X5, Cindy and John file separate returns. In 20X5, Cindy realizes a $10,000 long-term capital loss on a sale of land. Under the carryover rules, Cindy will be treated as having a long-term capital loss carryover to 20X6 in an amount equal to what?

A	$7,000
B	$10,000
C	$11,500
D	$13,000

Entire Course (including glossary) (117)

Regular C corporations do not get any tax bargain for net capital gains—they are taxed at the same rates as other income. In addition, none of a corporation's net capital losses can be used to offset ordinary income.

Corporations have some flexibility in matching capital losses with gains. Capital losses generally can be carried back three years and forward five years. Net capital losses are treated as short-term capital losses in the tax year to which they are carried back.

IRC §1212(a); Reg. §1.1212-1(a)(3)(i)(b)

Net capital losses of S corporations cannot be carried to other years, nor can a corporation carry a net capital loss to a year in which it is an S corporation.

IRC §1371(b); Reg. §§1.1212-1(a)(3)(iii)(c) and (iii)(d)

This means that capital losses cannot be carried back to a year the corporation was an S corporation in order to carry forward losses—which may otherwise go unused by the corporation—to shareholders' individual returns.

A regular C corporation that has a net capital loss for the current year carries it back to offset capital gain net income in the third tax year preceding the current year. Next, any remaining net capital loss is carried back to offset capital gain net income in the second tax year preceding the current year. Then, any remaining net capital loss is carried back to offset capital gain net income in the tax year preceding the current year. The objective of each of the carrybacks is to receive a refund of corporate income taxes paid in that year by filing an amended tax return.

Any remaining net capital loss is then carried forward to the first year succeeding the tax year in which the net capital loss arose, then to the second, third, fourth, and fifth succeeding tax years.

Example
Corporate carryback example: Trebor Inc. has the following net capital gain and loss amounts:
Tax year 20X2 Capital gain net income $14,000
Tax year 20X3 Capital gain net income 8,000
Tax year 20X4 Capital gain net income 2,000
Tax year 20X5 Net capital loss $20,000
Trebor Inc. must use its $20,000 net capital loss first to offset its net $14,000 capital gain income in 20X2. The $6,000 balance is then used to offset $6,000 of the $8,000 capital gain net income for 20X3.

Operating Rules

A corporation's net capital loss of one tax year can be used only to offset capital gain net income of another year and cannot increase or create a net operating loss in another year (IRC §1212(a)(1)). Where a corporation has net capital losses in more than one tax year, the earliest is used up first.

Example
Carryback example: LBO Inc. shows the following figures for tax years 20X1 through 20X4:
Year Regular Operating
Income (Loss) Capital
Gain (Loss)
20X1 $(20,000) $24,000
20X2 40,000 0
20X3 30,000 0
20X4 25,000 (20,000)
LBO Inc. can only use $4,000 of its 20X4 net capital loss to offset $4,000 of its 20X1 capital gain. That is the maximum amount to which the net capital loss can be applied without creating a net operating loss for 20X1.
The $16,000 balance of the 20X4 net capital loss can be carried forward to 20X5, 20X6, 20X7, 20X8, and 20X9, in that order.

Year	Regular Operating Income (Loss)	Capital Gain (Loss)
20X1	$(20,000)	$24,000
20X2	40,000	0
20X3	30,000	0
20X4	25,000	(20,000)

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Special Corporate Capital Loss Carryover and Carryback Rules

A foreign expropriation capital loss may not be carried back but may be carried forward for up to 10 tax years. This tax treatment applies to losses resulting from the expropriation of property by a foreign government or instrumentality or to losses resulting from stock that becomes worthless as a result of a foreign expropriation (IRC §1212(a)(1)(C)).

A regulated investment company is permitted an unlimited carryforward of capital losses (no carrybacks are allowed). In addition, the capital loss maintains its character as short- or long-term (IRC §1212(a)(3)).

A corporation's net capital losses cannot be carried back to a tax year in which it was a foreign personal holding corporation, a regulated investment company, or a real estate investment trust. (IRC §1212(a)(4))

Study Question 11

Widget Inc. is a regular C corporation that has a net capital loss for its 20X5 tax year. Which of the following is true?

A	Widget carries the loss back to 20X2 and may use it to offset capital gain net income in 20X2.
B	Widget carries the loss back to 20X2 and may use it to offset capital gain net income or ordinary income in 20X2.
C	Widget carries this loss forward 10 years to offset future capital gains.
D	Widget may use the loss to offset $3,000 of income for its 20X5 tax year and any remaining net capital loss is carried forward indefinitely.

Chapter 5. IRC Section 1231 Gains and Losses

Entire Course (including glossary) (121)

In this chapter, we discuss IRC Section 1231, including Section 1231 property, gains or losses from compulsory or involuntary conversions, and how to handle Section 1231 gain or loss.

Upon successful completion of this chapter, the user should be able to:

determine the nature and treatment of Section 1231 gains and losses, and
calculate Section 1231 gains or losses from compulsory or involuntary conversions.

IRC Section 1231 is a complex provision dealing with recognized gain or loss of corporate or noncorporate taxpayers from:

sales or other taxable dispositions of business or rental property that qualifies as Section 1231 property, and
the compulsory or involuntary conversion of business or investment property (treated as Section 1231 gains and losses under certain circ*mstances).

Whether Section 1231 produces a tax benefit depends on the mix of gain and loss transactions.

Entire Course (including glossary) (122)

Section 1231 Losses Exceed Section 1231 Gains

If Section 1231 transactions produce more losses during the tax year than gains, the resulting net Section 1231 loss is treated as an ordinary loss.

Impact: Ordinary losses may fully offset a corporate or noncorporate taxpayer's income for the year or result in a net operating loss deduction. By contrast, capital losses are of limited utility to taxpayers.

IRC §1231(a)(2)

Section 1231 Gains Exceed Section 1231 Losses

If Section 1231 transactions produce more gains during the tax year than losses, the resultant net gain is treated as long-term capital gain (i.e., the Section 1231 gain is combined with the taxpayer's other long-term capital gains and losses for the year).

IRC §1231(a)(1)

This favorable tax treatment only applies if the taxpayer did not have net Section 1231 losses in the five years immediately preceding the current tax year. If there were net Section 1231 losses in the lookback years, current net Section 1231 gain is recaptured as ordinary income to the extent of unrecaptured net Section 1231 losses in the five immediately preceding tax years.

Entire Course (including glossary) (123)

The balance of net Section 1231 gain is treated as long-term capital gain.

IRC §1231(c)

Entire Course (including glossary) (124)

Net Section 1231 Gains as Favorably Taxed Long-Term Capital Gains

A noncorporate taxpayer's net Section 1231 gains that are combined with the taxpayer's other long-term capital gains or losses for the year are included in the appropriate rate group (currently 28%, 25%, 20%/15%/0%), depending on the nature of the particular asset.

Dan's net Section 1231 gain for the current year is $50,000 from the sale of land bought 20 years ago and used in his farming business. He did not claim Section 1231 losses in any previous years. He held the land for more than one year, so his $50,000 gain is combined with other gains or losses in the 20%/15%/0% group.

Allocating Section 1231 Gain Recaptured as Ordinary Income

If part of a taxpayer's net Section 1231 gain for the year is recaptured as ordinary income, the recaptured portion of the gain consists first of any net Section 1231 gain in the 28% group, then any Section 1231 gain in the 25% group, and finally any net Section 1231 gain in the 20%/15%/0% group.

Section 1231 property includes several broad classes of assets as well as specific types of property.

Real Property Used in a Trade or Business

Entire Course (including glossary) (126)

Real estate is Section 1231 property if it is:

held for more than one year,
not inventory and not held primarily for sale to customers in the ordinary course of a trade or business, and
used in a trade or business.

IRC §1231(b)(1)

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When Is Real Estate Considered Used in a Trade or Business?

The question of when real estate is considered used in a trade or business is not significant if real estate is sold at a profit, because the gain will be capital gain whether or not the property is Section 1231 property. However, if the real estate sold was not considered as used in a trade or business (i.e., it is a passive investment), the capital gain may be subject to the 3.8% net investment income tax for an individual taxpayer.

If rental real estate is sold at a loss, the question is highly significant. The owner will be able to claim ordinary loss treatment only if the property is considered used in a trade or business. If it is not, the loss will be a capital loss of limited utility.

A shopping center or a building used in a business or leased to business tenants clearly qualifies as real estate used in a trade or business. What if the taxpayer's involvement in the rental activity is limited or the taxpayer owns only one rental property? Taxpayers, the courts, and the IRS have long grappled with this question. Unfortunately, there are no clear-cut answers.

What the courts say: A number of earlier cases declared flatly that use of real estate for rental purposes constituted use of the property in a trade or business (see H. L. Stern Trust, 26 TC 1213; R.W. Post, 26 TC 1055). However, later cases tend to consider whether the owner's activities, or the activities of the agents, are extensive enough to be considered a trade or business (see Bauer (Ct. Cl.), 168 F. Supp. 539).

What the IRS says: The IRS position on when real estate is considered used in a trade or business is not well defined:

The IRS acquiesced in an early case that held the rental of one piece of real estate constituted a trade or business (Hazard, 7 TC 372, acq., 1946-2 CB 3). The IRS argued for trade-or-business treatment of a single rental property (converted residence) where that characterization suited its purpose (Wasnok, TC Memo 1971-6). A 1980 Technical Advice Memo (PLR 8048006) held that rental of one piece of property was a trade or business for Section 1231 purposes.

A 1983 Technical Advice Memo (PLR 8350008) reversed the 1980 Memo holding that one piece of property was a trade or business and instead held that land that was triple-net-leased to a business tenant was not Section 1231 property. The IRS said that to meet the trade-or-business test, income or gain must be derived from properties used in the active conduct of a trade or business as opposed to property that generates passive income (e.g., portfolio investments).

Note
Any depreciation recaptured as ordinary income on the sale or other taxable disposition of property is not treated as gain from the sale of Section 1231 property. In the real property context, however, the concept of depreciation recapture only applies to property placed in service before 1987. The reason why will be discussed later in the course.
IRC §1250

Depreciable Property Used in a Trade or Business

Entire Course (including glossary) (127)

Depreciable property is Section 1231 property if it is:

held for more than one year,
not inventory or held primarily for sale to customers in the ordinary course of a trade or business, and
used in a trade or business.

IRC §1231(b)(1)

A taxpayer may buy depreciable property in anticipation of beginning a trade or business. If the trade or business never gets off the ground, the property will not be considered Section 1231 property.

Depreciation recapture: Depreciation recaptured as ordinary income on the sale or other taxable disposition of the property is not treated as gain from the sale of Section 1231 property.

IRC §1245(a)(1)

Example
Widget Inc. bought five computers for a total of $10,000 and has depreciated all of them down to zero basis. This year, Widget sells the computers for $3,000.

Result
Because of depreciation recapture, Widget's $3,000 profit (sales price less zero basis) is all ordinary income. None of the sale proceeds is treated as coming from Section 1231 property. On our facts, Widget would have a Section 1231 gain only if and to the extent that the profit exceeded $10,000 (the amount of depreciation claimed).

Natural Resources Treated as Section 1231 Property

The following types of natural resources are Section 1231 property:

Timber, coal, or domestic iron ore held for more than one year and disposed of under a contract is considered property used in a trade or business for Section 1231 purposes if the owner retains an economic interest in the resource. Per IRC Sections 1231(b)(2) and 631, timber also qualifies if:
1. the taxpayer owns or holds a contractual right to cut it for a period of more than one year before the timber actually is cut,
2. the timber is cut for sale or for use in a trade or business, and
3. the taxpayer elects to treat the timber cutting as a sale or exchange of property held for use in a trade or business.
Livestock (other than poultry) of any age are considered property used in a trade or business for Section 1231 purposes if held by the taxpayer for draft, breeding, dairy, or sporting purposes and held for 12 or more months from the date of acquisition (24 or more months in the case of cattle and horses) (IRC §1231(b)(3)).
Unharvested crops are considered property used in a trade or business for Section 1231 purposes if grown on land used in a trade or business and held for more than one year and crops and land are sold or exchanged (or compulsorily or involuntarily converted) at the same time and to the same person (IRC §1231(b)(4)).

To view this interactivity please view chapter 5, page 12

Interactivity information:

Ineligible Assets

The following assets cannot be treated as Section 1231 property:

Patents, inventions, models or designs (whether or not patented), secret formulas or processes, copyrights, literary, musical, and artistic compositions, letters or memorandums, and similar types of property if they are held by the taxpayer who created them or held by a taxpayer (such as a donee that acquired property as a gift, or certain qualifying transfers to a corporation or partnership) whose basis in the property is determined in whole or in part by reference to the property's basis in the hands of the creator. The property may be treated as Section 1231 property if it meets the other requirements, such as it is used in a trade or business by a taxpayer that purchased the property.
Government publications received for free or purchased for less than the price they are sold to the general public if held by the taxpayer who received them or held by a taxpayer (such as a donee that acquired property as a gift, or certain qualifying transfers to a corporation or partnership) whose basis in the publications is determined in whole or in part by reference to the publications' basis in the hands of the transferor.

IRC §§1231(b)(1)(C) and (D)

Study Question 12

In which of the following is the real property most likely to be considered by the IRS as being used in a trade or business?

A	Claude Kelly's ski chalet, which he rents out for two weeks a year
B	Jack Spratt's only commercial building, which is triple-net-leased for 20 years to a business tenant
C	X Co.'s shopping center, which it actively manages and leases to retail tenants
D	X Co.'s undeveloped land, while not considered inventory, is being held for sale to investors

Entire Course (including glossary) (130)

Special rules apply under IRC Section 1033 to business or investment property that is compulsorily converted (e.g., state takes land) or involuntarily converted (e.g., stolen or destroyed due to events such as earthquake or fire). Gain realized is not recognized currently, if the proceeds (from the condemning authority or from insurance) are timely reinvested in property similar or related in service or use to the converted property and the taxpayer elects deferral. Gain is recognized if the deferral election is not made or the proceeds are not timely reinvested. Generally, losses from conversions of business or income property are deductible under IRC Section 165.

Interaction with Section 1231

Recognized gains and losses from compulsory or involuntary conversions are treated as Section 1231 gains and losses under the rules described on the following screens.

Involuntary Conversions

A special rule applies if a taxpayer has a gain or loss due to theft or involuntary conversion (e.g., by fire or storm) of:

	property used in a trade or business, or
	any capital asset that is held for more than one year and is held in connection with a trade or business or a transaction entered into for profit.

If involuntary conversion gains exceed losses, the gains are treated as Section 1231 gains. If involuntary conversion losses exceed gains, however, the gains and losses are not considered Section 1231 gains and losses. Instead, the excess of losses from involuntary conversions over gains from involuntary conversions is considered an ordinary loss. These losses do not have to be grouped with other voluntary Section 1231 transactions to determine the overall Section 1231 gain or loss.

IRC §1231(a)(4)(C); Reg. §1.1231-1(e)(3)

Example

Involuntary conversion example: In the current year, a truck Mr. Able used in his unincorporated business was stolen. Able's adjusted basis in the truck was $10,000. Able recovered $9,000 from his insurance policy, resulting in a loss of $1,000 ($10,000 basis less $9,000 insurance proceeds). One of Able's business garages was destroyed by fire and the insurance payment less his basis in the building left him with a gain of $18,000. Able does not intend to replace the garage, which he bought five years ago.

Result
Because Able's involuntary conversion gains ($18,000) exceed his losses ($1,000), the net $17,000 gain is treated as a Section 1231 gain. If Able has no other Section 1231 transactions and no other capital transactions, the $17,000 of gain will not be taxed at a rate in excess of 20%.

Gain or Loss from Compulsory Conversions

Per IRC Sections 1231(a)(3) and (4), long-term gain or loss from the compulsory conversion of property (e.g., because of condemnation by a governmental authority) is treated as Section 1231 gain or loss if:

the property is used in a trade or business, or
the property is any capital asset that is held for more than one year in connection with a trade or business or a transaction entered into for profit.

Example
Condemnation example: Jane Jackson owns a piece of investment land that is taken by the state because it stands in the way of a new highway's construction. After subtracting her basis from the amount paid to her by the state, Jane has a $200,000 gain from the condemnation. She bought the land 10 years ago.

Result
The $200,000 gain is a Section 1231 gain. If Jane has no other Section 1231 transactions for the year, the $200,000 gain is treated as a long-term capital gain and is aggregated with Jane's other capital gain and losses from capital assets she held for more than one year.

The extent to which Section 1231 produces a tax benefit for the taxpayer depends on the mix of gain and loss from affected transactions in previous years as well as in the current year.

Entire Course (including glossary) (134)

Net Section 1231 Loss in Current Year

The excess of current-year Section 1231 losses over current-year Section 1231 gains is treated as an ordinary loss rather than as a capital loss (IRC §1231(a)(2)).

Tax tip: Any ordinary loss may fully offset ordinary income or create a net operating loss. By contrast, a capital loss may offset only capital gains plus no more than $3,000 of a noncorporate taxpayer's ordinary income each year. Capital losses of corporations can only offset capital gains.

Example
Net Section 1231 loss example: XYZ Corp. owns office buildings that it rents to others. For its current tax year, XYZ sells one of its buildings at an $800,000 loss. It also sells a parking lot at a $200,000 gain.

Result
XYZ winds up with a net Section 1231 loss of $600,000 as a result of the two sales ($800,000 loss from the office building sale minus $200,000 gain from the parking lot sale). The $600,000 net loss is treated as an ordinary loss.

Net Section 1231 Gain in Current Year

If the current year's Section 1231 transactions produce more gain than loss, the tax results depend on whether or not there were net Section 1231 losses in the five years immediately preceding the current year. If the taxpayer did not have any net Section 1231 losses in the five years immediately preceding the current year, the current year's net Section 1231 gain is treated as a long-term capital gain (IRC §§1231(a)(1) and (c)).

Example
For tax year 2023, Jane Smart, a self-employed businessperson, has a $10,000 gain from the sale of a parking lot she bought seven years earlier for use in her business and a $2,000 loss on the sale of some business equipment. Jane has a $3,000 long-term capital loss from the sale of stock she has held for more than one year. Jane did not have a net Section 1231 loss in tax years 2018 through 2022.

Result
Jane has a net Section 1231 gain of $8,000 for 2023. This gain, which is treated as long-term capital gain, is aggregated with her $3,000 long-term capital loss from the stock sale. Jane has a net capital gain of $5,000 for 2023 ($8,000 less $3,000), all of which is 20%/15%/0% gain (gain that is not taxed at a rate in excess of 20%).

Recapture Rule

Entire Course (including glossary) (135)

If the current year's Section 1231 transactions produce more gain than loss and the taxpayer did have net Section 1231 losses in the five years immediately preceding the current year, the current year's net Section 1231 gain is treated as follows:

Net Section 1231 gain is taxed as ordinary income up to the amount of unrecaptured net Section 1231 losses from the five immediately preceding tax years. The term “unrecaptured net Section 1231 losses” refers to net Section 1231 losses for the five immediately preceding tax years that have not been offset against Section 1231 gains. The taxpayer must use up net Section 1231 losses from the earliest of the five preceding tax years.
Net Section 1231 gain in excess of the Section 1231 gain taxed as ordinary income is treated as long-term capital gain.

IRC §§1231(a)(1) and (c)

Example
Recapture example: Assume the following transactions for a taxpayer:
Tax Year
20X1 Net Section 1231 loss $24,000
20X2 Section 1231 gain or loss 0
20X3 Net Section 1231 loss 6,000
20X4 Net Section 1231 gain 12,000
20X5 Gain from sale of Section 1231 property 40,000
20X5 Loss from sale of Section 1231 property 10,000

Tax Year
20X1	Net Section 1231 loss	$24,000
20X2	Section 1231 gain or loss	0
20X3	Net Section 1231 loss	6,000
20X4	Net Section 1231 gain	12,000
20X5	Gain from sale of Section 1231 property	40,000
20X5	Loss from sale of Section 1231 property	10,000

Result
In tax year 20X4, all of the net Section 1231 gain is ordinary income, leaving $12,000 of unrecaptured net Section 1231 loss for 20X1 ($24,000 less $12,000) and $6,000 of unrecaptured net Section 1231 loss for 20X2. For tax year 20X5, the taxpayer has a net Section 1231 gain of $30,000 ($40,000 gain less $10,000 loss). Of the net Section 1231 gain, $18,000 is taxed as ordinary income (equal to previously unrecaptured $18,000 of net Section 1231 losses) and the $12,000 balance is long-term capital gain.

Study Question 13

Argo Properties Inc. owns and manages commercial and residential properties. In the current year, Argo sold an Atlanta residential rental property at a gain of $500,000. It also sold a Texas office building at a $600,000 loss. Argo has no other Section 1231 transactions for the year. What is the result of these transactions?

A	A $100,000 long-term capital gain.
B	A $100,000 ordinary loss.
C	A $500,000 long-term capital gain and a $600,000 ordinary loss.
D	A $100,000 capital loss.

Additional depreciation is the excess of accelerated depreciation allowed or allowable over the amount of straight-line depreciation that would have been allowed or allowable on the same asset. When a recognized gain results on the disposition of an asset, the additional depreciation is recaptured and reported as ordinary income. The amount recaptured is the lesser of the additional depreciation or the recognized gain. This occurs when real property is disposed of and a recognized gain results. It applies to property depreciated under an accelerated method subject to recapture under IRC Section 1250. It applies to the following types of real property:

Pre-ACRS nonresidential property—property purchased and placed in service prior to 1981 (This is not applicable to nonresidential property subject to ACRS recovery because the recapture for this property is 100% of ACRS depreciation allowed or allowable, not just the additional depreciation.)
Residential rental property placed in service after December 31, 1969
Qualified U.S. government low-income property
Qualified real property for which bonus depreciation is claimed

Example
In 1994, Janus Corporation sold a warehouse for a $55,000 gain. The warehouse was purchased in 1979 for $500,000 and they deducted $180,000 depreciation using the declining-balance method (straight-line would have been $150,000). The amount of depreciation recaptured under IRC Section 1250 will be the lesser of the realized gain or the additional depreciation. Additional depreciation is $30,000 ($180,000 accelerated less $150,000 straight-line). Thus, $30,000 of the gain is ordinary income and $25,000 is IRC Section 1231.
If the gain had been only $25,000, the ordinary income from recapture of additional depreciation would be $25,000.

Adjusted gross income (AGI) is total income minus adjustments to income above the line, such as educator expenses, certain business expenses of reservists, performing artists, and fee-basis government officials, contributions to retirement plans (Keogh, IRA), deduction for education-related interest, allowed Archer medical savings account deduction, health savings accounts, deductible portion of self-employment tax, self-employed health insurance, interest forfeited on premature withdrawals, and deductible alimony (for agreements executed before 2019). When applicable, AGI is used as a standard for limiting the overall amount of itemized deductions (except for years 2010-2012), and amounts recognized for certain itemized deductions, such as medical expenses, casualty losses (limited to federally declared disasters through 2025), charitable contributions, and for the child and dependent care credit, and the phase out of other tax benefits, such as the child tax credit, qualified business income deduction, and personal exemptions (suspended until years after 2025).

The AMT is a special tax computation that is compared to the regular tax (before credits) computation with the excess amount (alternative computation over regular) being an additional tax payable.

The AMT is designed to prevent individual taxpayers from escaping a fair share of tax liability by excessive use of certain tax breaks. A taxpayer is subject to this tax if certain minimum tax adjustments or tax preference items and AMTI (including adjustment for any net operating loss) exceed the exemption allowed for filing status and income level. The AMT is computed on Form 6251.

The alternative minimum taxable income (AMTI) is used to arrive at the alternative minimum tax (AMT). Generally, AMTI starts with the taxpayer's taxable income. To this amount, the taxpayer adds preference items, adds or subtracts adjustments, and subtracts any alternative minimum tax net operating loss (AMTNOL) deduction to arrive at AMTI.

	Regular taxable income
Plus:	AMT tax preferences
Plus/Minus:	AMT adjustments
Equals:	AMTI
Minus:	(Exemption)
Equals:	Amount subject to tax

Amortization is the tax deduction for the cost or other basis of an intangible asset that can be recovered over the asset's estimated useful life.

Amortizable intangibles include patents, copyrights, and leasehold interests.

Under IRC Section 197, purchased intangibles are amortized over 15 years beginning with the month of acquisition.

Amortizable IRC Section 197 intangibles include goodwill; going concern value; work force in place; business records and systems; patents and similar items; any customer-based intangible; any supplier-based intangible; any license from a government; any covenant not to compete; and any franchise, trademark, or trade name.

Basis is the amount used by the taxpayer to compute the amount of gain or loss upon sale or disposition of an asset. In most cases, the basis is the carrying value (acquisition cost plus additions or improvements minus accumulated depreciation).

Initial basis is typically the acquisition cost (i.e., fair market value); however, in some cases a new owner uses (assumes) the basis of the asset in the hands of the previous owner (usually lower than fair market value) as with a gift or tax deferred exchange.

The interest of owner(s) in the net assets (total assets minus total liabilities) of an entity.

Capital assets are properties specified in the tax law that give rise to capital gain or loss. All property is considered to be a capital asset except the following:

Property held for resale (inventory)
Real or depreciable property used in a trade or business (e.g., operational or fixed assets) (IRC §§1231, 1245, and 1250)
Accounts or notes receivable acquired in the normal course of business
A patent, invention, model or design, a secret formula or process, a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property held by the creator, or in the hands of the taxpayer for whom such property was prepared or created, or anyone who assumes the creator's basis (e.g., the property was received as a gift from the creator)
U.S. government publications received from the government at a reduced price
Commodities derivative financial instruments held by a commodities derivative financial dealer, with exceptions
Certain hedging transactions
Supplies of a type regularly used or consumed by the taxpayer in the ordinary course of the trade or business of the taxpayer

Capital expenditures are expenditures for creation, prolongation, or improvement of operational assets. They are capitalized and depreciated over the remaining useful life of the asset, which is in contrast to revenue expenditures.

Gain from the sale or exchange of a capital assets (most property owned by individuals) that is either long-term (if held for more than one year) or short term (if held one year or less). Long-term gain qualifies for favorable tax treatment.

Capital gain or loss is derived from the sale or exchange of capital assets. The transaction may result in short-term or long-term gain or loss. Short-term gain or loss results when an asset is held for one year or less. Long-term gain or loss results when an asset is held for more than one year.

Corporations are taxed on capital gains at the ordinary corporate income tax rates. There are no special capital gains rates for corporations. Capital losses may offset capital gains, but net capital losses do not reduce corporate taxable income. Unused net capital losses are carried back for three years and carried forward to offset future capital gains for five years.

For individuals, capital losses are allowable only to the extent of capital gains plus, if losses exceed gains, by an additional amount. The additional amount is the least of: (a) taxable income, (b) $3,000, or (c) the sum of net short-term capital losses and net long-term capital losses. Losses are applied in the order of occurrence. All short-term capital losses are applied before long-term capital losses.

Gain or loss from the sale or exchange of a capital asset is known as capital gain or loss.

An individual or other noncorporate entity can carry forward capital losses indefinitely for federal tax purposes. These losses can be used to offset capital gains, or if the loss is in excess of capital gains, they can be used to offset up to $3,000 of ordinary income ($1,500 if married filing separately). The carryforward retains its original long-term or short-term character.

A corporate taxpayer can carry back losses three years and carry forward capital losses up to five years. These losses can only offset capital gain and not ordinary income. The carryforward is treated as a short-term capital loss.

A closely held corporation is a corporation having a relatively small number of shareholders. The owners are usually active in the operation of the business. Stockholders are often directors. Its bylaws restrict stock transfers so that control by the small ownership group is maintained. For tax purposes, a closely held corporation is defined as one in which five or fewer individuals owned more than 50% of the value of all outstanding stock at any time during the last half of the year.

Common stock is ownership interest that is subordinate to all other classes of stock (and to all creditors) of the issuing corporation in participation rights and in dividend and liquidation preferences (i.e., holders of common stock are paid after debt and preferred stock obligations have been met). Common stock is also known as residual ownership interest and usually carries voting rights (at stockholders' meetings) although some classes of common stock may be nonvoting.

A convertible is a provision specifying that a debt instrument or preferred stock can be exchanged for (converted into) other securities of the issuing corporation, usually common stock, at the option of the debt holder or stockholder at a specified rate within a specified time period. The conversion rate specifies as a ratio the number of shares of common stock that will be issued upon the conversion of some unit of the convertible instrument or security (e.g., 3:1, three shares of common for each share of preferred or three shares for each $1,000 bond). A convertible is an important consideration in the computation of earnings per share. Converted preferred shares are formally retired.

FASB ASC 260-10-20 (Convertible Security)

A convertible is recorded on the basis of the book value of the converted security.

A copyright is an exclusive right granted by law for a specific period of time to make and dispose of copies of a literary, artistic, or musical work. It is also an intangible asset that is identifiable and separable, may be purchased or developed internally, and has a legal life equal to the life of the author (or artist or composer) plus 70 years.

A copyright is recorded at cost (if purchased) and amortized straight-line over 15 years. If the copyright was created internally, it may not be amortized.

Credits are amounts deducted from tentative tax to compute income tax payable, such as the credit for the elderly or the disabled, the credit for child and dependent care, the foreign tax credit, the general business credit, the earned income credit, the adoption credit, the American Opportunity credit for higher education, and the Lifetime Learning credit.

A debenture is an unsecured promissory note (bond) to pay a specified amount on a specified date.

Depletion is the systematic and rational allocation of the cost of a natural (wasting) resource (e.g., timber, minerals, oil, gas, coal) against revenue earned as the resource is extracted and sold. The depletion method is usually based on units of production:

Depletion per unit = capitalized costs ÷ total estimated units economically recoverable

Depletion per unit is revised as the denominator estimate changes. This is a change in the engineering reserves estimate that is accounted for prospectively:

Depletion expense = depletion rate × units extracted, current year

Earnings and profits are how corporations track their after-tax earnings which is used to determine the amount of taxable dividends. Current E&P means only the current year E&P. Accumulated E&P is prior year E&P plus current year E&P. Some adjustments are only applicable to current E&P and do not affect accumulated E&P.

Easem*nt is the right to use the land of another or to have the land of another used in a particular way. It may be a title defect.

An employee stock ownership plan (ESOP) is a stock bonus plan that is qualified, or a stock bonus and a money purchase plan, both of which are qualified under IRC Section 401(a) and that are designed to invest primarily in qualifying employer securities. In addition, the participant is entitled to demand that benefits be distributed in the form of employer securities. If the stock is not readily tradable on an established market, the participant has a right to require that the employer repurchase the securities under a fair valuation formula.

IRC §409(h)(1)

Congress in S. Rep. 94-938 at 180, 1976-3 CB, 218 states that an ESOP “is a technique of corporate finance designed to build beneficial equity ownership of shares in the employer corporation in its employees.”

A foreclosure is a procedure where mortgaged property is sold because of the default of a mortgagor to satisfy the unpaid mortgage debt. It is enforcement of a lien, trust deed, or mortgage as allowed by law.

A foreclosure is a legal procedure brought by the mortgage holder (the creditor) or representative of a trust deed (the trustee) to claim the property in satisfaction of a debt in default.

A stock option gives an individual the right to purchase a stated number of shares of stock from a corporation at a certain price within a specified period of time. The optionee must be under no obligation to purchase the stock and the option may be revocable by the corporation. The option must be in writing; its terms must be clearly expressed.

An ISO causes no tax consequences for either the issuing corporation or the recipient when the option is granted. The spread [the excess of the fair market value (FMV) of the share at the date of exercise over the option price], however, is a tax-adjustment item to the recipient for purposes of the alternative minimum tax. After the option is exercised and when the stock is sold, any gain from the sale is taxed as a long-term capital gain if certain holding period requirements are met. For a gain to qualify as a long-term capital gain, the employee must not dispose of the stock within two years after the option is granted or within one year after acquiring the stock. If the employee meets the holding period requirements, none of these transactions generates any business deduction for the employer.

An independent contractor is a party who is not subject to control and supervision by the party who employs the contractor. The employer seeks results only; the contractor controls the methods. No agency relationship exists, and the employer is not liable for the torts of the contractor. Control is the key element. Outside attorneys and CPAs are usually independent contractors.

In the general equity sense (financial accounting), insolvent is a financial condition such that the entity is unable to meet its obligations as they become due. It may be simply a cash flow problem (e.g., insufficient funds to cover checks). This is a looser definition than that used in voluntary bankruptcy. It is used in cases of involuntary petitioning under Chapter 7 and is simpler, less demanding, and more easily proven than insolvency in the bankruptcy sense.

In bankruptcy, insolvent is the financial condition in which debts exceed the fair value of nonexempt assets. It is the definition used in the Bankruptcy Act in all cases except involuntary petitioning under Chapter 7. Insolvent is a stricter, more demanding definition than in the equity sense.

An involuntary conversion is the change of nonmonetary (operational assets) to monetary assets (insurance proceeds) as a result of circ*mstances beyond the control of the enterprise (e.g., partial or total destruction due to fire, theft, seizure, condemnation, or expropriation). It is a monetary transaction for which gain or loss must be recognized even though the enterprise reinvests the monetary assets received in replacement of nonmonetary assets.

FASB ASC 605-40-05

Joint tenancy is concurrent or multiple ownership of real property, created when equal interests to the same property are conveyed to two or more persons in an instrument expressly stating the joint tenancy. (For example, a will can create a joint tenancy.) Joint tenancy requires four unities:

time (all tenants take their interest at the same time),
title (all tenants take their interest from the same source, such as a deed or will),
interest (every tenant has an identical interest in the property), and
possession (every tenant owns the undivided whole and does not own a fractional interest).

Joint tenancy conveys the right of survivorship.

Liquidation is a form of relief granted under the uniform bankruptcy laws (Chapter 7) that results in the distribution of the debtor's nonexempt, unsecured assets to creditors and a final discharge of the individual debtor from its obligations. Liquidation is the ultimate remedy, the remedy that embodies finality, providing the debtor with a “fresh start.” All entities may use Chapter 7 except governmental units, family farms, railroads, insurance companies, and financial institutions. An entity can liquidate voluntarily or involuntarily, and Chapter 7 can be converted to a Chapter 11 or Chapter 13 proceeding.

A net operating loss (NOL) is a net loss for the year attributable to business or casualty losses. In order to mitigate the effect of the annual accounting period concept, the law allows taxpayers to use an excess loss of one year as a deduction for certain past or future years.

NOLs prior to 2018 may be carried back two years and forward for up to 20 years. (IRC §172(b)(1)(A)) In general, after 2017, NOLs can no longer be carried back but may be carried forward indefinitely. Exceptions do exist for farms and some non-life insurance companies. The NOL is equal to the lesser of: (1) the aggregate of the NOL carryovers to such year, plus the NOL carrybacks to such year, or (2) 80% of taxable income (determined without regard to the NOL deduction). Sec 172(a)

Prior to 2018, a 3-year carryback was retained for individuals' casualty or theft losses and NOLs of farmers and small businesses due to losses incurred in presidentially declared disaster areas. Farming losses (those not attributable to federally declared disasters) can be carried back five years. (IRC §§172(b)(1)(E) and (F)). As noted above, there is no longer a carryback for individuals, unless they are engaged in farming. After 2017, a farming loss is only allowed a two-year carryback. Sec. 172(b)(1)(B)(i)

As a response to COVID-19, the CARES Act made changes to losses earned in 2018, 2019, and 2020:

It provides a 5-year carry back for losses in 2018, 2019, and 2020.
It suspended the NOL limit of 80% of taxable income.
It allows pass-through business owners to use NOLs to offset their non-business income above the $250,000 ($500,000 if married filing jointly) limit for 2018, 2019, and 2020.

Generally, for years beginning after December 31, 2020, a corporation may carryforward an NOL indefinitely, but NOL carrybacks are not permitted. Further, any NOL carryforward after 2020 may only reduce 80% of taxable income.

The NOL deduction allowed for years after 2020 is limited to the lesser of:

The aggregate of all net operating losses carried over to the tax year (plus any allowed NOL carrybacks to the tax year), or
80% of taxable income computed without regard to any NOLs allowed in the tax year.

IRC § 172(a)

A note receivable is a contractual right to receive a sum certain of money on fixed or determinable dates at a fixed rate of interest. It is a formal and unconditional written agreement. A note receivable may be interest-bearing or noninterest-bearing; however, even “noninterest-bearing” notes have an interest element included in the face amount of the note. Notes receivable are of longer term (e.g., 3–24 months) than accounts receivable and accrue interest over time at a stated rate. Notes receivable should be recorded at present value.

Notes receivable are usually negotiable and may be sold or transferred, usually at a discount (i.e., the seller receives an amount less than the face value, the buyer or payee collects the higher face value at maturity, and the seller recognizes a loss on the sale). Notes receivable may be sold with or without recourse.

Accounting for notes receivable involves recognition at the origination date (recording the liability), valuation and accrual of interest during the time to maturity, and disposal at or before maturity.

An option price is a specified price at which a stock option may be exercised. It is the specific price that must be paid to acquire shares of stock under a stock option and is specified in the stock option agreement.

The original issue discount (OID) is the amount of the original issue price of a bond or other debt instrument discounted below par or face value. This can apply also to a collateralized mortgage obligation.

Bonds that are issued with a coupon rate well below the current interest rate for bonds carrying that length of maturity and risk must be sold at substantial discounts from par. Price volatility or price risk tends to be higher for original issue deep-discount bonds than for comparable maturity coupon bonds. Corporations pioneered this new strategy early in 1980.

The Internal Revenue Service (IRS) treats the increase in price from the original issue discount (OID) as interest subject to income tax. Even though no interest is received, taxes are due on the accretion of bond interest. Municipal units (state and local governments) have also issued OID bonds and (if they are a general obligation of the government unit) the accretion of interest is not subject to federal taxation.

A partnership is an association of two or more persons to carry on as co-owners of a business for profit. Partnerships are governed in the various states of the United States by the Uniform Partnership Act (UPA). A partnership may be a general partnership, limited partnership, limited liability company, or joint venture.

For taxable years after 1986, income and losses were divided into three categories: passive, active, and portfolio.

If a taxpayer materially participates in a trade or business on a regular, continuous, and substantial basis, the income or loss resulting is active.

If the taxpayer does not materially participate in an activity, the income or loss resulting is passive.

The passive loss rules limit the amount of losses from passive activities that can reduce income from nonpassive sources. Generally, losses from passive activities in excess of passive income may not reduce nonpassive income (active income and portfolio income). Passive losses that cannot offset other types of income are suspended losses and must be carried forward to offset future passive income.

Preferred stock is ownership interest (class of stock) that carries preferences or specified priorities when compared to common stock; it is usually nonvoting and senior to common stock in dividend and liquidation preference and participation rights (to specified limits). It has characteristics of both debt and equity and may have other features, such as convertibility to other securities, call features, and redemption. Preferred stock is a security.

Dividend and liquidation preferences are senior to common stock; preferred stock must be paid before common stock but is paid after creditors.

Dividend preference is usually expressed as a percentage of the par value of the preferred stock, but it may also be expressed as a specific dollar amount per share. Preference may be cumulative or noncumulative and participating, nonparticipating, or partially participating (with common stock, in dividends in excess of the stated preferred dividend).

A principal residence is the taxpayer's main home. A taxpayer can only have one main home. If the taxpayer owns and lives in more than one home, they must apply a “facts and circ*mstances” test. The most important factor is where the taxpayer spends most of their time. Other factors that come into play when determining a principal residence include a taxpayer's mailing address, where the taxpayer is registered to vote, and where the taxpayer works. The term principal residence is very important in many situations involving federal income taxes.

A qualified small business is a small trade or business other than one involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business in which the principal asset of the trade or business is the reputation or skill of one or more of its employees.

A qualified small business is a C corporation that generally cannot own real property not used in the active conduct of the business exceeding a value of 10% of its total assets or portfolio stock or securities exceeding in value 10% of the total assets over liabilities.

During substantially all of the taxpayer's holding period of the stock, at least 80% by value of the corporation's gross assets (including intangible assets) must be used by the corporation in the active conduct of one or more qualified trades or businesses.

The term qualified trade or business excludes any banking, insurance, leasing, financing, investing, or similar business; any farming business (including the business of raising or harvesting trees); any business involving the production or extraction of products of a character for which percentage depletion is allowable; and any business of operating a hotel, motel, restaurant, or similar business.

As of the date of the issuance of its stock, the corporation's aggregate gross assets cannot exceed $50 million valued at the amount of cash and the aggregate adjusted basis of the other property held by the corporation.

IRC sec 1202

To recapture is to recover the tax benefits of a deduction or credit previously taken.

Example
Examples of recapture or assets with recapture potential include the following:
Depreciation recapture under IRC Sections 291, 1245, and 1250
Deferred last-in, first-out (LIFO) gains
Deferred installment method gains
Investment tax credits

Recognized gain or loss is the portion of a realized gain or loss that is subject to income taxation and therefore recognized for tax purposes. Those realized transactions that are not recognized for tax purposes are referred to as unrecognized gains and losses.

S corporation is a tax status election for corporations that meet the specified requirements under which they are taxed similar to a partnership (i.e., income passes through to the owners, who are then taxed on their share of the corporate earnings on their personal income tax returns). S corporations do not pay the corporate income tax, and corporate losses can be claimed by the shareholders, subject to the basis, at-risk, and passive loss rules. The requirements are located in Subchapter S of the Internal Revenue Code (IRC).

A stock split is an increase in the number of shares outstanding and a corresponding decrease in par value of each share. It has no effect on the shareholder's proportional interest in the corporation, on total shareholders' equity, or on retained earnings, but it does decrease earnings per share (because of the increase in the number of shares). It does not change the total earnings per share (EPS) earned by each shareholder. No accounting entry is required. The primary purpose is to decrease the market price per share and stimulate market activity.

FASB ASC 505-20-20

Taxable income is the amount of income on which the taxpayer owes tax under current tax law.

UNICAP rules require certain taxpayers to capitalize direct costs and an allocable portion of most indirect costs that are related to production of personal property for resale activities. Costs attributable to production must be capitalized, and costs attributable to inventory must be capitalized.

A vacation home is a second residence usually used by taxpayers for short periods of time during the year. It is not the taxpayer's principal residence.

A vacation home can be any kind of dwelling unit, including houses, apartments, condos, house boats, other boats with sleeping facilities, motor homes, house trailers, and other similar property. A vacation home can also be rented to third parties by the owner. Special rules and restrictions apply to the treatment of income and expenses if the vacation home is also rented.

A wash sale is a sale (usually of stock) that is nullified by its reversal or offset within a short time of its initiation.

For federal income tax purposes, losses on wash sales (stock that is sold within 30 days of its purchase) may not be recognized. The wash sale rules apply when, within a period beginning 30 days before the date of sale or disposition and ending 30 days after that date, the taxpayer has acquired substantially identical securities.

Welcome to Capital Gains and Losses - Identification, Classification, and Applicable Tax Rates. Below is the full list of final exam questions associated with this course. When you launch the final exam for this course, it will contain a randomized subset of the questions below, totaling 15 questions. During the actual final exam, the questions will not appear in the same order as they do below. Note: Each attempt at the final exam will result in a new randomized subset of the questions below. You must earn a score of at least 70.00% in order to pass the exam and receive CPE credit for this course.After you have answered all the questions, select the "Submit Answers" button to receive your score.

Exam Question 1

For 2023, what is the highest long-term capital gains tax rate that applies to the sale of stock?

A	0%
B	5%
C	15%
D	20%

Exam Question 2

What is the maximum tax rate that applies to the sale of collectibles?

A	0%
B	14%
C	28%
D	50%

Exam Question 3

Mr. Adelman has owned for many years an empty lot that he rents out to long-term parkers. This year, he sells the lot at a profit. Which of the following is true?

A	His profit is taxed as a mixed-use asset.
B	His profit is taxed as Section 1231 gain rather than a capital gain.
C	His profit is taxed as short-term capital gain.
D	His profit is not subject to tax.

Exam Question 4

A taxpayer purchased a computer for $3,000 and used it in her business for five years. The taxpayer sold the computer in the current year for $1,200. The computer was fully depreciated over the five years, so its basis is $0 at the time it was sold. How much of the gain realized on the sale is taxed as ordinary income?

A	$0
B	$1,200
C	$1,500
D	$3,000

Exam Question 5

Amounts distributed to a shareholder in complete liquidation of a corporation are treated as:

A	ordinary dividends.
B	payment in full in exchange for the stock.
C	Section 1245 property.
D	interest income.

Exam Question 6

Which one of the following assets is not considered a capital asset?

A	Inventory
B	Stocks
C	Collectibles
D	Land held for investment purposes

Exam Question 7

Harris Richards sold a piece of investment real estate and received $100,000 cash, a $10,000 face value corporate bond with a market value of $7,000, and a note in the amount of $15,000. What is Richards' amount realized?

A	$100,000
B	$107,000
C	$115,000
D	$122,000

Exam Question 8

Jackie Segal sells her personal residence. Which of the following is not a selling expense which will reduce the amount realized on the sale?

A	Repairs
B	Advertising
C	Broker fees
D	Legal fees

Exam Question 9

During 2023, a company exchanged the following assets used in its business. Which of the assets is eligible for like-kind exchange treatment?

A	Vehicle
B	Land
C	Equipment
D	Inventory

Exam Question 10

A taxpayer paid $1,000 for an option to purchase 10,000 shares of common stock of XYZ at $30 per share. The taxpayer exercised the option. Which of the following is true regarding the payment to purchase the option?

A	The $1,000 payment is added to the taxpayer's basis in XYZ stock.
B	The $1,000 payment is deducted from the taxpayer's basis in XYZ stock.
C	The taxpayer has a $1,000 short—term loss.
D	The taxpayer has a long-term capital gain of $1,000.

Exam Question 11

Jeremy Nickels made several repairs and improvements to his vacation home. Which of the following costs will not increase Jeremy's basis in the home?

A	Enlarging the home
B	Finishing the basem*nt
C	Fixing a leaky faucet
D	Replacing the roof

Exam Question 12

A taxpayer purchased stock on May 13, 2023. What is the first day the taxpayer can sell the shares and qualify for long-term capital gain treatment?

A	May 1, 2024
B	May 14, 2024
C	December 31, 2024
D	May 14, 2025

Exam Question 13

Which of the following is correct regarding the holding period of an asset received as a gift?

A	The holding period is always considered short-term by the recipient.
B	The recipient tacks on the holding period of the previous owner.
C	The holding period will begin on the day the recipient receives the gift.
D	Assets received by gift are always considered as long-term by the recipient.

Exam Question 14

A taxpayer has a $3,000 long-term capital gain and a $1,000 long-term capital loss. How much of the taxpayer's net capital gain is subject to tax at a maximum rate of 20%/15%/0%?

A	$0
B	$2,000
C	$3,000
D	$4,000

Exam Question 15

An individual taxpayer's only stock transaction during the year is a $6,000 short-term capital loss. How is this loss treated?

A	The taxpayer can use $3,000 of the short-term capital loss to reduce ordinary income in the current year and carry forward the remaining $3,000 loss.
B	The taxpayer can carry forward the short-term capital loss for five years and only offset future capital gains. After five years, the loss carryforward expires.
C	The taxpayer must carry forward the entire $6,000 short-term capital loss to a future year to offset future capital gains.
D	The taxpayer can elect to carryback the $6,000 short-term capital loss to the previous tax year.

Exam Question 16

A married couple that files jointly has $60,000 of ordinary income and a $5,000 short-term capital loss. What is the allowable short-term capital loss that the taxpayers may deduct on their return for this year?

A	$0
B	$1,000
C	$1,500
D	$3,000

Exam Question 17

A regular C corporation can carry forward unused capital losses up to how many years?

A	3 years
B	5 years
C	10 years
D	Indefinitely

Exam Question 18

How is a net Section 1231 loss treated?

A	As a capital loss
B	As a Section 1231 loss carryforward
C	As a Section 1231 loss carryback
D	As an ordinary loss

Exam Question 19

How is a long-term gain or loss from the compulsory conversion of property used in a trade or business handled?

A	It's not taxable.
B	It's treated as Section 1231 property.
C	It's treated as investment property.
D	it's treated as personal use property.

Exam Question 20

A net Section 1231 gain may be treated as ordinary income if a taxpayer had Section 1231 losses within the past ______ .

A	5 years
B	7 years
C	10 years
D	15 years

Negative income	$ (2,000)
Capital loss deduction	3,000
Personal exemption	0
Difference	$ 1,000
Long-term capital loss	$ 14,000
Long-term capital loss used in 2023	– 1,000
Carryforward to 2024	$ 13,000

Tax year 20X2	Capital gain net income	$14,000
Tax year 20X3	Capital gain net income	8,000
Tax year 20X4	Capital gain net income	2,000
Tax year 20X5	Net capital loss	$20,000