Chapter 10

Realization & Recognition of Gain or Loss

(Rev 01-11-2017)

Taxable income generally includes gain from the sale, exchange, or other disposition of property. To deduct losses, you must rely on statutory permission.

Gains- Taxed on any disposition of property, generally, whether by sale, exchange, or other means of disposition.

Losses- Deductible without limit for business property, generally; not deductible at all for personal property transactions.

Determining amount of gain or loss

Gain/Loss = Amount Realized – Adjusted Basis

  • The gain or loss does NOT usually equal the cash received on the sale.
  • The "Amount Realized" is the total (sum) of

1. Money received, and the

2. (Appraised) FMV of any property or services received, BUT:

It does not include the prorated property taxes received.

Reduced by:

1. Selling commissions

2. Other expenses of sale

  • The "basis" of property being disposed of

Start with "unadjusted basis":

Usually it is cost;but sometimes basis is determined by:

1. The FMV of property when received;

2. The basis of the property in the hands of the transferor (the person from whom the property was received), or

3. The basis of other property held by the taxpayer.

.

Adjustments to basis:

Add: capital expenditures, improvements, etc.

Subtract: depreciation, amortization, etc.

  • No gain or loss is realized until the transaction is "closed".
  • Just because a gain or loss is "realized" does not mean that it will be "recognized"(taxed or deducted).

Example:

House sells for $200,000. The seller pays a 6% real estate commission ($12,000), as well as $1,800 in other costs.

Amount Realized: $186,200(200,000 - (12,000 + 1,800))

If the property had cost $60,000, and the owner had added a room, which cost $12,000, and a pool, which cost $10,000.

Unadjusted basis is: $60,000

Plus adjustments to basis:

Room$12,000

Pool 10,00022,000

Adjusted basis $82,000

Gain/Loss realized

Amount realized $186,200

Less:

Adjusted basis82,000

Gain Realized $104,200

Determination of Basis

"Cost"

  • Includes any amounts paid in cash, mortgages assumed, settlement fees, closing costs, commissions, transfer taxes, etc.
  • The cost of constructed assets is the sum of all costs attributable to construction (materials, labor, and overhead) allocable to the project.
  • The basis of property transferred from one spouse to another for consideration is the same basis as the basis of the transferor spouse (pre 7/19/84 transfers, see cost rule).
  • The basis of property to the transferee is the basis of the property to transferor (post 7/18/84) if made within 1 year of the divorce. For a pre 7/19/84divorce, the basis is the FMV of the property at time of the transfer.
  • For property converted to Income producing use
  • Generally basis is cost increased by cost of improvements.
  • The basis for depreciation is thelesser of FMV or cost (anti-churning rule).

Adjustments to Basis

  • Additions
  • Capital improvements arecosts that are chargeable to the capital account, e.g. an item having a benefit greater than 1 year, as well as any taxes and interest the taxpayer elects to capitalize.
  • Not included are costs to acquire a mortgage, e.g. points, credit checks, etc.
  • Subtractions
  • Depreciation (allowed or allowable), including Section 179 deductions, amortization, depletion, and some other transactions.
  • The basis cannot be reduced below zero.

If an asset is used part for business and part for personal use, depreciation is allowed only on the business portion, and the basis is reduced accordingly

Allocation of Basis to Separate Items

  • When items are purchased for one lump sum, allocate the basis among items based on the ratio of relative FMV of each item to the FMV of all items purchased:

Example:A lot, with a building on it, was purchased for $150,000 (total cost). The cost must be allocated among both the land and the building as follows:

% 0f Value Allocated Cost

Land valued at $ 30,000 18.75% $ 28,125

Bldg valued at 130,000 81.25% 121,875

Total value$160,000 100.00% $ 150,000

Stock Dividends and Stock Rights

  • Basis must be allocated for nontaxable stock dividends and tax rights.
  • The basis of the original shares is allocated to both the old and newly received shares from a nontaxable stock dividend. If identical stock type (common) allocate the basis to the total number of shares owned. If different types of stock (common and preferred) allocate the basis according to the relative market values, similar to the example of the lot and building above.
  • In the case of taxable stock dividends, e income is the stock’s FMV at the date of distribution, and the basis of these shares is the FMV.
  • See the Text for a discussion of nontaxable stock rights.

Fair Market Value (FMV)

  • The price a willing buyer and a willing seller would reach after bargaining, where neither party is related or acting under any compulsion.
  • If property is received in exchange for services, there is a taxable transaction. If property is received in a taxable exchange, the basis of the property received is generally its FMV at the time of the exchange.

Basis of property acquired by Gift

  • Generally, the basis of gifted property in the hands of the recipient (the donee) will be what the basis was in the hands of the donor at the time of the gift. However, if the gifted propertyis sold by the donee, the basis used to calculate gain or loss must be determined by comparing the FMV at the time of the gift to the basis in the hands of the donorwith the donee’s selling price.
  • If the FMV at the time of the gift is more than the donor’s adjusted basis, then the basis for determining gain is the donor’s adjusted basis.
  • If the FMV at the time of the gift is less than the donor’s adjusted basis, then the basis for determining lossis the FMV at the time of the gift.
  • A selling price of gift property that is between the basis for determining gain and the basis for determining loss will result in neither a gain nor a loss.
  • SEE TREE DIAGRAM HANDOUT
  • Basis and Gift Tax Adjustments to Basis
  • Gifts made before 1921: basis is FMV of property at time of acquisition.
  • Gifts made after 1920 and before 1977: basis is the same as the basis of the last preceding owner (a "transferred basis), increased by the amount of any gift tax paid, but only to extent that the basis does not exceed the FMV at time the gift was made.
  • Gifts made after 1976: The basis is the same basis of the previous owner, adding only that portion of the gift tax attributable to the gifts appreciation in value over the cost at the time of the gift.
  • Example:

Gifted property sold for$125,000

Fair Market Value of the gift $100,000

Donor's Basis of gift $ 20,000

Appreciation$ 80,000

Gift tax paid $ 16,000

  • Basis of the gifted property, if the gift was made in 1976

Donor’s Basis$20,000

Gift tax paid 16,000

Donee’s adjusted basis$36,000

  • Basis of the gifted property if the gift was made in 1988

Donor's basis$20,000

Gift tax adjustment:

16,000 x (80,000/100,000) 12,800

Donee's adjustedbasis$32,800

  • If the gifted property is sold at a Loss, then:
  • The basis is the lesser of the transferred basis adjusted for any gift tax paid

or

  • The FMV of the gifted property

These rules havethe effect of maximizing gains and minimizing losses.

  • Summary of Gift Gain/Loss Rules
  • If loss rules produce a gain, and gain rules produce a loss, than there is no gain or loss:

Example:Selling Transferred FMVTaxableTaxable

Price Basis at Gift Gain Loss

1.$15,000$10,000$12,000$5,000 none

2. 5,000 10,000 7,000 none $2,000

3. 5,000 10,000 3,000 none none

  • Holding Period of Gift Property
  • Begins with the date the property was acquired by the donor; unless if the FMV of the property on the date of the gift was less than the donor’s adjusted basis, and the property is sold at a loss, the holding period begins on the date of the gift.

******NOBODY EVER SAID GIFT TAX RULES WERE EASY!******

Property acquired from a decedent (transferred at death)

  • The basis of the property is the FMV at the date of death or "alternate valuation date" (6 months after date of death - elected by the executor).
  • The basis of property received on the death of a joint tenant is the FMV of the amount included in the decedent's estate (one-half of joint property).
  • All property received from a decedent is considered to be held long-term.

Stock Transactions

  • If stock shares can be specifically identified as to when they were acquired, the basis for sale will be the actual cost.
  • If stock shares cannot be specifically identified, the First-In, First-Out (FIFO) method will be used to assign the cost to the sold shares.
  • A “Wash Sale” transaction occurs when substantially identical shares of stock are acquired within 30 days - before or after - the sale of the originally held shares of stock. Losses are not allowed for the sale of shares of stock that qualify as a Wash Sale. Any loss that would have been realized except for the Wash Sale rule is added to the basis of the newly acquired stock, which reduces the gain or increases the loss at subsequent sale.

Related Parties

  • No loss deduction is allowed on sales or exchanges of property, directly or indirectly, between certain related parties.
  • Disallowed losses on such transactions may be used by the original transferee seller on the subsequent sale of the property to offset gain.
  • Related parties are considered to be (among others):
  • Members of a family, including ancestors, and lineal descendants.
  • A corporation where the taxpayer owns > 50 % of the value of the stock.
  • A grantor and a fiduciary of any trust.

Installment Sales

  • Any sale where at least one payment is to be received after the close of the tax year in which the sale occurs.
  • The gain is recognized by calculating the gross profit ratio, and multiplying that percentage times the amount of payments received during the year.The calculation of gross profit ratio was discussed in Chapter 13.