Cassi FranksSpring 2011Tax II - Professor Davis

CAPITAL GAINS AND LOSSES

DEFINITIONAL SECTIONS

  1. § 1221 defines capital asset as:
  2. Property held by taxpayer
  3. Whether or not used in his trade or business
  4. EXCEPT:
  1. Stock in trade, other property which would be included in inventory of the taxpayer, or property held primarily for sale in the ordinary course of his trade or business
  2. Some things fit in all three (ex: whiskey); some things don’t qualify as inventory b/c special to make, but selling in OC (ex: special made cabinets)
  3. Property, used in T or B, subject to allowance for depreciation, or real property used in T or B
  4. Picked back up in §1231
  5. Copyright, literary, musicial or artistic composition, a letter or memo, held by
  6. A taxpayer who created such property
  7. Or, in case of letter or memo, a TP for whom such property was prepared or produced, or
  8. A TP in whose hands the basis of such property is determined in whole or in part by reference to the basis of the property in the hands of a taxpaper described in above 2 sections
  9. Accounts or notes receivable acquired in OCB for services rendered or from sale of property described in (1)
  10. Publication of the US Government given to politicians/gov’t employees
  11. Any commodities derivative financial instrument held by a dealer
  12. Cases: Arkansas Best, Corn Products
  13. Any hedging transaction which is clearly identified as such before the end of the day on which it was acquired or originated
  14. Supplies of a type regularly used or consumed by the TP in ordinary course of T or B
  15. Jet Fuel example: You stockpile jet fuel; prices fall, and it becomes worth less. You sell it. Absent this provision, it would generate a capital loss, b/c not in the T or B of selling jet fuel. TP capital loss deduction is limited. TP would rather it be ordinary.
  16. Example 2: What if she bought options to purchase jet fuel, and they became worthless? If she had exercised the options, the deduction would be ordinary, so the option to exercise those options would also be ordinary. (this applies to the hedging transaction provision, above)
  1. Bynum factors for determiningwhat constitutes inventory or Property Held Primarily for Sale to Customers in the Ordinary Course of the T/B vs. capital asset: Balance factors:
  2. Frequency and substantiality of sales
  3. Proportionality of income from selling this vs. whatever you claim as real T/B
  4. Improvements made to the land
  5. TP’s solicitation and advertising efforts
  6. Utilization of real estate brokers and agents
  7. Distinctions between long term and short term, gains and losses, and other terms
  8. See § 1222
  9. Holding period of property
  10. See §1223
  11. Maximum Capital Gain rates
  12. § 1(h)(1)(C) Generic 15% rate
  13. Catchall- a NCG that weren’t taxed at the 28% or 25% rates
  14. § 1(h)(1)(D): 25% category - Unrecaptured § 1250 gain
  15. § 1250 gain- generally defined as the LTCG attributable to depreciation allowed with respect to real estate held for more than one year
  16. S 1(h)(1)(E): 28% category - collectibles and § 1202 gain
  17. § 1202 gains: gains on investment in start-up or small corps
  18. § 1202 excludes a specific percentage of the gains from these type of investments
  19. Currently, this percentage is 100% exclusion
  20. Collectibles gain - defined in 1(h)(5)
  21. PROBLEM: Definition of Capital Asset - Problem 1
  22. Computing Net Capital Gain
  23. Must first determine amount of each gain and loss realized, and characterize as LT or ST
  24. Preferential rates of 1(h) only apply when TP has Net CG (§1211(11))
  25. Net CG: Excess of Net LTCG over Net STCL
  26. Net LTCG = LTCG – LTCL
  27. Net STCL = STCG – STCL
  28. Computing the tax under 1(h)(1)(A):
  29. Tax shall not exceed:
  30. The greater of:
  31. Taxable income reduced by NCG, OR
  32. Lesser of
  33. TI taxed at less than 25%, or
  34. TI reduced by ANCG
  35. § 1(h)(3): ANCG= NCG - 28% gain - 1250 recap gains + qualified dividend income
  36. Adjusted Net Capital Gain
  37. Defined in 1(h)(3)
  38. Subject to a maximum tax rate of 15%
  39. But is afforded preferential treatment even if TP is in 15% bracket
  40. In that case, ANCG taxed at 0% - see § 1(h)(1)(B) for calc.
  41. Where ANCG does not exceed [taxable income @ less than 25% - (TI reduced by ANCG)], taxed at 0%
  42. IF ANCG exceeds this calculation, none gets this rate
  43. Includes qualified dividend income (defined in § 1(h)(11)
  44. Attribution of Capital Losses Included in NCG Computation
  45. FIRST NOTE: If capital losses exceed gains, you don’t have any net gains, so forget about 1(h). You look to 1211 & 1212.
  46. Problem 7
  47. Because STCL are offset first against STCG, it is only the excess STCL which must be attributed to one of the categories of LTCG
  48. LTCL & NSTCL attribution rules among multiple categories of LTCG:
  49. Short term capital losses
  50. STCL first reduce STCG
  51. Any NSTCL then reduces any net gain in 28% category
  52. Then reduces an unrecaptured 1250 gain
  53. Then reduces any adjusted net capital gain
  54. Long term capital losses
  55. LTCL are first applied against LTCG in same category
  56. Any net loss in the 28% category is applied to reduce any unrecap. 1250 gain, and then reduces any adjusted net capital gain
  57. Any net loss in the 15% category first reduces gain in 28% category and then the unrecaptured 1250 gain
  58. PROBLEMS 2-6: Rate preference for LTCG and Limits on CL deductions- Steps shown
  59. Application of § 1211(b) limitations on Deduction of Capital Losses
  60. Capital losses may be deducted to the extent of:
  61. Capital gains PLUS
  62. $3,000
  63. The loss must be deductible under some other provision of the code, first, though.
  64. Ex: loss on sale of stock deductible under § 165(c)(2)
  65. Qualified dividends are not part of the 1211(b) calculation
  66. NETTING PROCESS:
  67. STCL net against STCG & LTCL net against LTCG
  68. If STCL > STCG, the excess STCL netted against excess NLTCG
  69. If LTCL > LTCG, the excess LTCL netted against excess STCG
  70. STCL are deemed to have been deducted first in the $3,000 portion of 1211(b)
  71. Problem 7 illustrates net capital loss problem
  72. Hedging & Options: Capital or not?
  73. An option is a K to buy or sell something at a stated price for a certain period of time
  74. STRIKE PRICE - the price the product will eventually be bought for under the option
  75. SPOT PRICE - the market price
  76. Divided into 2 categories:
  77. Call option: right to call property to you; right to force someone to sell you the goods from that option at that stated price
  78. Put option: right to force someone to purchase whatever goods are in the option at the stated price
  79. HEDGING is using the option to hedge against fluctuations in price
  80. § 1221(a)(7) provides ordinary treatment (and not capital) for any hedging transaction which is clearly identified before the close of day on which acquired, originated or entered into (Regs. give more than one day)
  81. § 1221(b)(2) defines hedging: any transaction entered into in the normal course of the TP’s T/B primarily:
  82. To manage risk of price changes w/r/t ordinary property held by TP
  83. To manage risk of interest rate or price changes w/r/t borrowings made or to be made by TP
  84. To manage other risks as defined by Treas. Regs.
  85. If actual item would be an ordinary asset to the TP, then hedging the risk of that asset is going to be ordinary.
  86. Treas. reg. say you CANNOT use stock as a hedging instrument, based on Arkansas Best
  87. Arkansas Best:Buying stock in companies is buying a capital asset, so its a capital loss
  88. Ordinary Income Substitutes
  89. Under HortDavis, even if §1221 literal language it would be capital, if the asset is a mere substitute for ordinary income, it will still be ord. inc.
  90. Lease buyout, where disputed amount was essentially a substitute for rental payments which are GI; must be regarded as OI.
  91. Sale of right to lottery payments OI not CG
  92. Kenan: Using appreciated property to satisfy any other amount owed will be treated as a sale or disposition under § 1001= realization event
  93. So where securities were used to satisfy the debt owed to the heir, it was a realization event
  94. It was a general bequest. The heir bore no risk, b/c she got her $5 mil. in either cash or securities. If it was to be cash, the securities would have to have been sold by the estate, realizing a gain.
  95. And to determine whether it was capital or not, looking at §1222 which says “sale or exchange,” the Court said that b/c treated as a disposition of the asset used to satisfy a debt owed, here it will also be treated as S or E b/c satisfied debt owed to heir (just as if you’d sold stock & then used cash to satisfy bequest) => sale or exchange
  96. NOTE: there will be times when you haave a sale or disposition under § 1001 but don’t have a sale/exchange under § 1222
  97. Ex: involuntary disposition b/c of a fire does equal a disposition but doesn’t equal a sale/exchange
  98. For an involuntary conversion to be treated as capital, must have statutory granting provision.
  99. § 165(h): Casualty losses - doesn’t say S or E  losses will be ordinary
  100. But see (h)(2)(B): Where casualty gains exceed losses, it is treated as all capital G/L

QUASI-CAPITAL ASSETS: SECTION 1231

  1. § 1231 is not a deduction-granting provision
  2. Deductions are granted under §§165, 167 and 179
  3. Deductions disallowed under §267
  4. Ex: no loss allowed on sale of home, so doesn’t enter into § 1231 analysis
  5. § 1231 gains and losses are generated by two categories of transactions:
  6. Sale or exchange of property used in the trade or business
  7. Must be depreciable or real property
  8. Must have been held for more than one year
  9. Must not be excluded under § 1221(1), (3), (5)
  10. Involuntary or compulsory conversion of 2 types of property:
  11. Property used in the trade or business
  12. Capital assets held for more than 1 year in connection with a trade or business or a transaction entered into for profit
  13. § 1231 looks at assets as a pool:
  14. If G > L  everything treated as capital
  15. If L>G  everything treated as ordinary
  16. For certain involuntary conversions (fire, shipwreck, theft, casualty):
  17. If L>G all ordinary, before you even get to the primary netting
  18. Hotchpot analysis
  19. Preliminary Hotchpot Analysis
  20. Determine whether the gains and losses are described in § 1231(a)(3)
  21. Determine whether they arise from transactions listed in §1231(a)(4)(C)
  22. This includes involuntary conversions from fire, storm, shipwreck, or other casualty, or from theft, of any property used in the T/B or any capital asset held for more than 1 year & held in connection with T/B or transaction entered into for profit
  23. It does NOT include condemnations.
  24. Net those arising from transactions listed in § 1231(a)(4)(C)
  25. If losses exceed gains, these amounts do NOT enter into primary hotchpot.
  26. They will not be characterized by §1231.
  27. They will be individually deducted/reported
  28. If gains exceed losses, these gains and losses enter into the Principal hotchpot.
  29. If gains equal losses, they enter into the principal hotchpot.
  30. Primary/Principal Hotchpot Analysis
  31. Determine what gains and losses enter into principal hotchpot
  32. § 1231(a)(3) defines § 1231 gains and losses
  33. Compare the § 1231 gains to § 1231 losses.
  34. If §1231 gains exceed losses, the gains and losses ARE to be treated as LTCG/L
  35. If § 1231 losses exceed gains, the gains and losses ARE NOT treated as capital but are ORDINARY.
  36. Applying § 1222
  37. After doing preliminary & principal hotchpot analyses, then you go to §1222 netting process to determine NCG, which is then taken to 1(h) to determine applicable rates
  38. Recapture of Net Ordinary Losses: §1231(c)
  39. Taxpayers could potentially arrange timing of sales of these §1231 assets so as to generate these G/L in different years, maximizing the benefits of s 1231.
  40. § 1231(c) says that, if you generate any 1231 gains in the next 5 years, to the extent you’ve taken a 1231 loss, it will be 1231 recapture (it will be taxed at ordinary income rates)
  41. This carryover hangs around for five years, unless completely used up before then
  42. Where you have a portion of net § 1231 gain in a year being recharacterized as OI under § 1231(c), the gain recharacterized consists:
  43. First, of any net §1231 gain that is 28% rate gain,
  44. Then any any net §1231 gain that is unrecaptured §1250 gain
  45. Finally, any net §1231 gain that is adjusted net capital gain
  46. Problem 3
  47. Recharacterization of § 1239
  48. Assume A has a piece of equipment which has been used in his T/B, took depreciation ded. as offset against OI, and the equipment has appreciated in value. Assume paid 100k (§ 1012 cost), depreciation deductions have been 80k, & AB now = 20. Assume FMV = 200. Total Gain = 180
  49. If we just sold the property to an unrelated third party:
  50. Will have 1245 recapture: If you sell certain assets on which previously took depreciation, to extent G is generated by depreciation, it will be taxed as OI.
  51. So, here, 80k of gain will be OI under § 1245. Remaining 100 will be § 1231 gain & will be capital, assuming no §1231 losses.
  52. If A sells it to his wholly owned corporation:
  53. In absence of any special rule, would still have 80k OI/ 100 Capital & corporation would take a basis of 200. Corp. can then depreciate the asset, offsetting OI. Thus, recycling assets.
  54. BUT, § 1239 says any gain recognized to transferor is to be treated as ordinary income if the property is in the hands of a transferee subject to § 167 depreciation.
  55. So, entire 180 k will be taxed at OI if you sell it to the related entity. Corp. still gets deductions, but they are deferred & taken over time, so you have to wait for them. This is not so fun anymore to the TP! Thus, the anti-abuse purpose is achieved.

Depreciation Recapture

  1. § 1245
  2. Deals with PERSONAL PROPERTY (tangible & intangible)
  3. §1245 says that recapture income is characterized as ordinary income.
  4. Gain on disposition of personal propertywhich is attributable to depreciation deductions, rather than appreciation in FMV, is NOT eligible for capital gain treatment
  5. Disposition includes sale, exchange, involuntary conversion, or other
  6. If you sell an asset at a loss, you don’t have to worry about §1245 recapture.
  7. Recomputed Basis: depreciation you’ve taken that gets you back up to your original basis:
  8. Any of this depreciation back up to your original basis will be ordinary income
  9. Assets which were subject to accelerated depreciation also goes to § 1245
  10. § 1250
  11. Deals with REAL PROPERTY
  12. §1250 says that when sold, treated as 25% gain instead of at OI rates
  13. § 1250 Essentially DEAD LETTER LAW
  14. When § 1250 property is disposed of at a gain, § 1250 says you only include in OI the amount of depreciation taken on a §1250 asset that was more than straight line
  15. So, only applies if you have property that was placed in service prior to 1986.
  16. Because SL has applied since 1986
  17. BUT, if §1250 property Is not held more than a year, all depreciation taken is additional depreciation.
  18. If a portion of the gain does not fall under § 1245 or § 1250, then it is characterized under § 1231 & § 1221(2)
  19. Unrecaptured § 1250 gain
  20. § 1(h)(6) defines unrecaptured § 1250 gain as the LTCG from § 1250 attributable to depreciation deductions allowed the TP and not otherwise recaptured as ord. inc.
  21. § 179 Election
  22. The current § 179 election to expense certain depreciable business assets is $125,000 (phase-out beginning at $500,000)
  23. Certain type of real property may no longer be expensed under § 179
  24. § 179 has recapture provisions, and kicks in anytime when there is a sale or the property is no longer used predominately for T/B purposes.
  25. § 179(d)(1) says that the benefit of § 179 will be recaptured
  26. The benefit is the excess of the § 179 election taken over the additional depreciation the TP would have been entitled to if they had not made the 179 election
  27. § 1245 Taint
  28. § 1245 taint is preserved for recapture when the property takes a carryover basis
  29. Under § 1245, it doesn’t matter who took the depreciation deductions, it’s still 1245 property & it carries over to any donee recipient to be considered when -they ultimately dispose of it.
  30. The taint DOES NOT carry over with transfers at death, b/c the recipient takes a FMV AB
  31. § 1245(b): exceptions to when it will apply
  32. Sales to related parties
  33. § 1239: if sell it to a related party, and will also be depreciable property in the hands of that related party, then it will all be ordinary income upon disposition
  34. Related parties are defined by the following sections: 1239(b)  1239(c)(2)267(c)(2) & (4)
  35. And NOTE: per § 267(c)(5), can’t have two 267(c)(2) attributions in a row
  36. Problems 11-15

NONRECOURSE DEBT

  1. Recourse v. Nonrecourse Debt
  2. Difference is in the remedies available to the lender
  3. Recourse:
  4. Can either be secured or unsecured
  5. If unsecured, lender has available to it the right to collect the full debt from all of the assets of the borrower, except those that are otherwise protected (ex: bankruptcy laws, state statutes)
  6. Ex: credit card debt
  7. If secured, a particular piece of property stands as security for the loan, and thus the lender can grab that piece of property first & with lesser procedural rules; if the property is insufficient to pay the entire debt, the lender can then go after the other assets of the borrower, b/c the borrower still liable on the note
  8. Ex: home mortgage
  9. Considering it in terms of the risk of loss:
  10. Ex: You purchase a piece of property, borrowing 500 on recourse. If the property loses value, the owner of the property suffers the loss, b/c the owner must pay the $500 no matter what.
  11. Nonrecourse debt:
  12. Always secured
  13. The property standing as security for the debt will always satisfy the entire debt; i.e., even if value of property falls, lenders only recourse is the value of that property
  14. Nonrecourse debt shifts the risk of loss (or at least part of it) to the lender
  15. Example: Borrow $ 500 to buy property worth $500 on a nonrecourse basis. When the property drops to a FMV of $400, the debtor can default on the note and avoid paying the full $500.
  16. Example 2: Borrow $400 & put in $100 of your own cash for property with FMV of $500. The borrower bears the risk of loss for the first $100. The risk of loss shifts to the lender when the value drops below $400. At that point, the debtor has every incentive to let the property go back to the lender when the FMV drops below the debt amount.
  17. Debt & Basis& AR
  18. If you borrow $500 on recourse debt, you are going to have to make the investment eventually, so there is no question as to whether you include recourse debt in basis
  19. Nonrecourse debt is more of a conditional obligation to pay.
  20. Do we still include nonrecourse in basis and amount realized?
  21. Crane v. Comm’r: As long as the value at least equals or exceeds the debt:
  22. Liabilities, whether recourse or nonrecourse, assumed, taken subject to, or otherwise incurred in the acquisition of property are included in TPs basis.
  23. Liabilities of a seller, whether recourse or nonrecourse, assumed or taken subject to by a purchaser, are included in the seller’s AR
  24. Debt is treated as cash received
  25. Why?
  26. Economic benefit: that’s how the borrower will treat it. If the value is > debt, the borrower doesn’t care the type of debt; they are going to pay it to keep the property
  27. Crane Holding (Woodliff): Seller must include in AR any nonrecourse liability taken subject to by a buyer, a mortgagor, not personally liable on a debt who sell the property subject to the mortgage and for additional consideration realizes a benefit in the amount of the mortgage
  28. What about when the FMV is less than the debt (debt owed > value)?
  29. Tufts:In Nonrecourse debt, IF FMV < Debt => AR includes debt assumed + FMV of other property; Debt is treated as Cash
  30. Azaiwa: In Recourse debt, IF FMV < Debt => AR includes FMV of property received
  31. NOTICE: §108 does NOT apply here, only applies to relief of indebtedness not disposition of property
  32. Estate of Franklin: if FMV < debt from beginning, there is no investment in the property by the purchaser & there isn’t going to be, and since you only get basis in the property for the investment, AB doesn’t include debt
  33. But, this tends to be situation when amount of debt is a good amount greater than FMV property.
  34. Sometimes debt can be included in basis when the FMV < debt but by a de minimis amount
  35. § 1.1001-2(a)(1) & (3): If you did not include debt in basis, then you do not include debt in amount realized
  36. Prevents taxpayer from recognizing big gains, even though no appreciation, simply b/c wasn’t allowed to include debt in AB but would have been required to include in AR
  37. Problem 16
  38. Putting it together:
  39. If value < debt & debt is recourse: AR ,≠ debt; AR=amt. of debt satisfied + any cash
  40. If value < debt & debt is nonrecourse: AR = amount of debt
  41. A reduction in the principal amount of NR debt gives rise to cancellation of debt income, rather than a reduction in basis
  42. There was no sale or disposition, thus § 1001 not triggered
  43. § 108 applies, unless some of the exclusions apply
  44. Problem 17, 18
  45. The AR on the disposition of property subject to NR debt may include both the principal balance and accrued interest (Allen)
  46. Thus, if a bank pays the back property taxes and adds it to the mortgage, it’s as if the bank loaned her the money & TP paid them herself. She gets deduction for them. They are added to basis & includable in AR.
  47. The tax benefit does not apply (doesn’t have to be OI).
  48. Problem 19
  49. Nonrecourse Borrowing & the § 108 Insolvency Exclusion
  50. The amount by which a NONRECOURSE debt exceeds FMV of the property securing the debt is taken into account in determining whether, and to what extent, a TP is insolvent within § 108(d)(3), but only to the extent that the excess NR debt is discharged.

LIMITATIONS ON TAX SHELTERS