Income Tax II
Prof. Davis
Spring 2011

Ch. 31 - Capital Gains Losses

  1. EXPLAIN SIGNIFICANCE OF THE CHARACTER OF GAIN AND LOSS
  2. Preferential Tax Rates Applied To LTCG
  3. CGis a gain derived from the sale of a capital asset.
  4. LTCG taxed at a lower rate than OI.
  5. NLTCG taxed at 15%.
  6. LT held for more than 12 months.
  7. Limitation on the Deduction of CL
  8. CL can be deducted a/gCG for the year (STor LT) plus $3000.
  9. If CL exceeds CG + $3000, the excess loss can be carried forward into future years and offset against CG in that year + $3000.
  10. Justification For CGTreatment
  11. Bunching
  12. Get lumped into a higher tax bracket, the gain is accrued each year
  13. But … is only realized in one.
  14. Encourage Investments
  15. Allows people with excess income to investand receive preferential rates
  16. Problem?
  17. Plus of encouraging investment occurs with new investment, not shifting around existing investment.
  18. If want to really encourage investment, would applyCG treatment only to new stocks, those that generate additional investment.
  19. Does not account for the risk element of investment
  20. Winners in investing are already compensated
  21. Losers don’t get any benefit.
  22. Lock In Effect
  23. I bought the asset, it has appreciated, and as long as I hold on to the asset I don’t have to pay the tax liability
  24. If I sell it then I must pay the taxes.
  25. Inflation
  26. Many of the gains are inflationary gains.
  27. Traditionally the tax code has been very bad at dealing with inflation, which leads to over taxing people.
  28. Tradeoff between complexity and accuracy.
  1. IDENTIFY CAPITAL ASSETS - §1221(a) - PROPERTY HELD BY TP, BUT NOT…
  2. (1)Stock in trade, inventory, or property held by TP primarily for sale to customers in the OCOB
  3. Language is an attempt to exclude TP’s normal, operating profits
  4. Note:
  5. Specially made inventory may or may not be categorized as stock in trade (depends on whether in OCOB)
  6. (2)T/B real property (non-depreciable) or T/B property eligible for §167 T/B deductions
  7. Has its own code section for preferential ax treatment
  8. See infra
  9. (3)Copyright or literary/musical/artistic composition held by…
  10. (A) TP who created the property;
  11. (B)IF a letter or memo, TP for whom it was made (Anti-Agnew Provision); OR
  12. (C)TP who takes the same AB as the creator (gift)
  13. (4)A/R acquired in OCOB
  14. Prevents you from taking A/R, selling them, and categorizing as CG.
  15. Ex:
  16. Sale car, get note, sell note to bank and attempt to categorize as CG.
  17. Works same way w/ salary, can’t convert salary to CG.
  18. Back stop / Anti-Abuse Provision
  19. (5)Fed Gov’t publication
  20. Anti-politician
  21. (6)Commodities held by commodities dealer
  22. Arkansas Best
  23. Corn Products
  24. Inventory / dealer provision
  25. (7)Hedging Transactions
  26. (8)Supplies regularly used by the TP in OCOB
  27. Ex:
  28. Airline company w/ jets, primary cost is fuel. If prices , worried will continue, buy a lot of fuel. Stockpile. However, prices .
  29. Costing a lot to hold fuel. Decide to sale for loss.
  30. W/out this provision, would be capital loss. Congress added provision b/c would normally be § 162 ordinary deduction.
  31. Ex:
  32. Don’t buy actual fuel, but options to purchase fuel. Prices , options now worth essentially nothing.
  33. Statue says were buy options to hedge ordinary transactions, any loss deduction will also be ordinary.
  1. CHARACTERIZE GAIN OR LOSS IN ANY GIVEN SITUATION
  2. Issue:
  3. What constitutes inventory, property held primarily for sale to customers in the OCOB?
  4. Rule:
  5. Balance of factors under Bynum
  6. Frequency and substantiality of sales
  7. Improvements made to the land
  8. TP’s solicitation and advertising efforts
  9. Utilization of real estate brokers and agents
  10. Proportion of income
  11. Bynum
  12. Facts:
  13. Own land used as nursery in T or B. Divided / developed land for sale.
  14. IRS says income from sale was OI and the TP says it is CG.
  15. Held land for a long period of time
  16. There is a bunching problem
  17. There is likely an inflation problem
  18. Also a gain from the development of the land, which looks like OI.
  19. Analysis:
  20. For someone in the business of developing land it would definitely be OI.
  21. Is there an alternative view for the policy of CG?
  22. Treat the ordinary profit of a business as OI and everything else as CG.
  23. However here the TP has both.
  24. Shows the “all or nothing” problem, i.e. classify as either all CG or no CG.
  25. Rule: The only time you can divide between CG and OI is if sale falls under §1237, real property subdivided for sale
  26. Rule: if take land and subdivide it, sale is capital UNLESS…
  27. You are a dealer
  28. No substantial improvement to value has been made upon the land;
  29. Property has been held for five years
  30. Note: Can’t use your family to do it (anti-abuse provisions)
  31. §1237(b) gives pass for the first five that are sold, but on the sixth, 5% of the gain is OI and the rest is CG
  32. (b)(3)
  33. Can improve if have held ppty for 10 years, and improvements are limited to those listed.
  34. If don’t qualify for 1237 you can still argue it is not in 1221(a)(1) anyway.
  35. Holding:
  36. Bynum’s argue they started selling off property because they were in a financial jam and bank suggested.
  37. If had sold off big lots, would not have generate enough $ so decided to sell off in smaller lots.
  38. If Bynums had just sold off enough ppty to satisfy the bank then they may have had a more sympathetic position to argue not in T or B.
  39. Argument doesn’t work b/c sold a lot more than they would have needed to satisfy the bank debt.
  40. Conclusion:
  41. Property? Yes.
  42. Held for sale? Advertised property, had a large number of lots, listed with other realtors
  43. To customers? Automatic if selling real property
  44. In OCOB? Regularly selling, not something unusual or exceptional
  45. In T or B? Husband spent a lot of time on it, regularity of sales, he gets a realtor license
  1. RECOGNIZE OI SUBSTITUTES, UNDER HORTDAVIS
  2. Lease buyout, where disputed amount was essentially a substitute for rental payments which are GI
  3. Must be regarded as OI.
  4. Note:
  5. Also applies to lottery payments
  6. Sale of rights to payments is OI, NOT CG
  7. Hort
  8. Facts:
  9. Mr. Hort has commercial rental building received by bequest, at which time there was an existing lease on building for 15 yrs
  10. So, got the building and 14 year lease.
  11. Bank decided to cancel lease and had to pay $140,000 for cancellation.
  12. TP claims loss of 20K, b/c under lease would have collected $160,000.
  13. Issue:
  14. Does he have a tax loss?
  15. Analysis:
  16. Basis in the uncollected rent is 0, b/c received it by devise and it went into the building.
  17. He has never paid tax on the uncollected rent b/c only paid tax as it was received.
  18. Court says the 140K is GI b/c it was a substitution for the rent and the rent would have been OI.
  19. Doesn’t fit nicely into the statute.
  20. Judicially created exception, substitution for another type of income.
  21. What if the bank had not paid to cancel the lease but had sold the lease, would they have GI
  22. Davis
  23. Facts:
  24. TP wins lottery w/ winnings paid out over time
  25. Collects the first couple of payments of 600K and then sells right to receive the rest of payments for a lump sum.
  26. TP argues this should be a capital asset and therefore a CG. What is different from Hort?
  27. Hort had a right to underlying building and the rent payments, here there is no other underlying ppty to function as the capital asset
  28. He only has stream of income.
  29. The right to the payments is property but the court says this is like Hort in that it is only a substitute for income.
  30. TP second argument is that b/c of Arkansas Best it should be CG.
  31. Ark Best- shouldn’t have carved out list of judicial exceptions but should stick to the statute.
  32. TP argues Ark Best overturns the other cases that made judicial exceptions.
  33. Court said that Ark best only applied to its own particular situation
  34. Rule: if something is merely a substitute of OI, will STILL be treated as OI
  35. Keenan
  1. RECOGNIZE CORN PRODUCTS PROPERTY
  2. Corn Products
  3. Facts:
  4. TP protected self from price increases by buying “futures” whenever the K price was favorable
  5. Treated as OI
  6. Holding:
  7. Preferential treatment of §1221 applies to transactions of property which are not the normal source of business income
  8. Note:
  9. TPs were using the holding of Corn Products to take ordinary losses on holdings that had a dual purpose: Stock assuring a source of supply AND investment
  10. Arkansas Best
  11. Facts:
  12. TP buys stock in bank, end up w/ loss.
  13. Differs from Corn Products in the rights available to TP by exercising option. Don’t get right to particular asset, so doesn’t fit.
  14. TPs used the Corn Products doctrine to avoid characterization of stock losses as capital losses. Arguing investment, not business purpose.
  15. Holding:
  16. Narrow Corn Products to simply a broad reading of the inventory exclusion of §1221
  17. Significance:
  18. Buying stock in companies is buying a capital asset, t/f it is a CL
  19. Went to Far:
  20. Congress makes adjustment via § 1221(a)(7) - as soon as buy asset, must classify as hedging or not hedging
  21. Defined in (b)(2)
  22. Normal course of T or B
  23. If actual item would have been ordinary asset, hedging risk of that asset will be ordinary
  24. Managing risk of price or interest rate changes
  25. Essentially, reinstating part of Corn Products
  26. Note that regs say can NOT use stocks as a hedge for reasons contained in Arkansas Best
  1. COMPUTE NCGADJUSTED NCG
  2. NCG
  3. Preferential rates only apply when TP has Net CG(§1211(11))
  4. Net CG:Excess of Net LTCG over Net STCL
  5. Net LTCG = LTCG – LTCL
  6. Net STCL = STCG – STCL
  7. STCG are subject to OI rates
  8. Adjusted NCG
  9. 15% and 5% rates
  10. §1(h)(3) NCGby 28% gains and un-recaptured §1250 gain = adjusted NCG
  11. If TP in the 15% tax bracket he will get a preferential rate of 5%.
  12. Qualified dividend income
  13. Previously
  14. Taxed as OI
  15. However, Congress felt preferential rate would cost of capital and lead to economic growth / job creation.
  16. Currently
  17. Treated as part of ANCG and will thus be taxed at the 15% or 5% rates.
  18. Expires at the end of 2008 unless extended.
  19. §1(h)(3)
  20. ANCG determined by subtracting the 28% gains from the NCG and then adding the qualified dividend income.
  21. This assures that gain from dividend income will be preserved even where there is no NCG or when there is a CL
  1. §1(h) AND MAX RATES APPLICABLE TO VARIOUS COMPONENTS OF NCG
  2. Components of Net CG
  3. 28%,
  4. 25%,
  5. 15%
  6. 28% Rate Gain: Collectibles Gain and §1202 Gain
  7. Note
  8. IF TP OI rate bracket is lower than 28%, the CG gets OI rate
  9. Collectibles Gain (§1(h)(5))
  10. Gain from sale/exchange of any rug, antique, metal, gem stamp, coin, or other collectible under §408(m), which is a capital asset held for more than one year
  11. §1202 Gain
  12. 50% of the gain from the sale/exchange of certain stock under §1202
  13. Policy
  14. Small corps generate employment and ideas, but are risky.
  15. Want to encourage investment in these, t/f give preferential rate of tax for investment.
  16. Questionable, b/c no guarantee if corp fails. To get benefit of preferential rate, corp must succeed (i.e. have gain)
  17. 25% Rate Gain: Unrecaptured §1250 Gain
  18. LTCG attributable to depreciation allowed w/r/t RE (buildings) held for more than 1 year taxed at 25%. §1(h)(6)
  19. Other part of gain gets 15% rate
  20. Any time TP sells depreciable real property at a gain, TP must determine how much of gain constitutes un-recaptured §1250 gain
  21. Policy
  22. Much RE gains caused not by appreciation of RE, but b/c depreciation, which generates OI deductions.
  23. Want to give RE a good deal, but not quite that good of a deal.
  24. Ex: 25 min
  25. Technical catchup provision
  26. 15% Rate Gain: Adjusted Net CG
  27. Leftover CG - everything not taxed somewhere else
  28. Qualified Dividend Income: §1(h)(11)(B)
  29. Included in NCG computation; dividend income increases NCG
  30. Taxed at 15% even if there is no NCG
  31. NOT a CG, b/c not gain from sale or exchange of a capital asset
  32. Can NOT be used to offset capital losses
  1. TAX PREFERENCE AFFORDED QUALIFIED SMALL BUSINESS STOCK HELD > 5 YEARS27 min - 1/20
  2. §1202
  3. Partial Exclusion for Gain from Certain Small Business Stock
  4. Exclusion from GI of 50% of the gain from the sale or exchange of qualified small business stock held for more than five years.
  5. Congressional Steps
  6. If have 1202 stock acquired w/in certain period of time, 75% would be excluded
  7. 1(h) taxes only 25% of your gain, creating effective tax rate of 7%
  8. Latest step
  9. Completely excluded, if acquired during certain years
  10. Kicked in 2010, been extended
  11. See statutory handout - 1/25, 27 min
  1. COMPUTE AMOUNT OF CL WHICH MAY BE DEDUCTED BY TP IN GIVEN YEAR
  2. CL may be deducted $ for $ to the extent of CG; doesn’t matter if they are LT or ST.
  3. Up to 3K of the excess may be deducted as well to offset OI
  4. Any amount that was disallowed can carryover to the next year.
  5. Dividend income, although taxed at the preferential rate, is not CG, and t/f is not considered in the loss calculation.
  6. STCL are netted first against STCG.
  7. The excess will then be netted a/g LTCG.
  8. STCL will be deemed to have been deducted first in the OI offset part of §1211(b).
  9. First applied to STCG, any net STCL is then applied to 28% net gain property, then 25% then 15%
  10. Limitation on Deduction of CL
  11. §1211(b)
  12. To the extent that CL CG, up to $3K may be deducted
  13. Note that § 1211 is NOT a deduction granting provision
  14. § 165
  15. (f) Permits CL to be deducted to extent of 1211
  16. (c)(2) Permits deduction on loss of sale of stock as transaction entered into for profit
  17. §1212(b)
  18. Losses that could not be used will be carried over
  1. APPLY THE ARROWSMITH RULE
  2. IF you have a transaction in this year that is related to previous transaction it is legitimate to look at the characterization of the transaction in the previous year
  3. Holding:
  4. In the previous year, it would have been a capital gain/loss transaction.
  5. So deduction is going to be a capital loss
  6. Significance:
  7. Gains/losses generated as a result of a transaction covering more than one year may be characterized as CG/CL even though technically the sale/exchange requirement may not be met
  1. IMPACT OF CG & CL ON TI
  2. Sale or Exchange Requirement
  3. Broad meaning
  4. Satisfaction of a bequest with appreciated property
  5. Abandonment of unimproved real estate subject to a nonrecourse mortgage exceeding FMV is a capital loss
  6. Owner’s conveyance of land by quitclaim deed
  7. §165(g)(1)
  8. IF any security which is a capital asset becomes worthless, shall be treated as sale/exchange of a capital asset
  9. §1271(a)
  10. Amounts received on the retirement of a debt instrument shall be treated as received in exchange for that instrument
  11. §1231 property, involuntary conversions may get sale or exchange treatment
  12. Holding Period
  13. LT must be held for more than one year
  14. Kenan1/25
  15. Facts:
  16. Someone dies and put their property into trust, income to beneficiary, corpus distributed later
  17. Trust got a step up in basis, the trustees had the option of paying cash or in securities at their discretion, may avoid transaction cost that way.
  18. Analysis:
  19. Assume the trust pays in cash, what happens?
  20. They would have to sell assets to a third party and recognize gain because sell or exchange transaction.
  21. What if they had to give specified property?
  22. This would not be a sell because it would be specific property held for the beneficiary
  23. The beneficiary would then bear the risk of fluctuations in the price.
  24. So why does the court decide here that the trust essentially sold the assets?
  25. Because she had a right to cash or property worth that much
  26. The trustee owes this beneficiary $5M
  27. The trust has satisfied their obligation to pay this amount.
  28. Significance:
  29. Giving assets to satisfy an obligation is a sell or exchange,
  30. Also judicial gloss on foreclosure or abandonment cases, doesn’t matter if done voluntarily or forced, it satisfies debt so it is a sell or exchange.

Ch. 32 - Quasi-Capital Assets - § 1231

  1. INTRODUCTION1/2533 min
  2. Davis
  3. Win on upside, best possible treatment on downside
  4. Gains losses are characterized under §1231, which is NOT deduction granting provision
  5. Deductions are granted under §§165, 167 and 179
  6. Deductions disallowed under §267
  7. Primary Purpose of § 1231
  8. Provide special, favorable tax treatment to the sale, exchange or involuntary conversion of real or depreciable property used in the TP’s T or B
  9. Under § 1231, a recognized gain on the sale, exchange or involuntary conversion of such property may be characterized as CG, where a recognized loss may remain characterized as an ordinary loss
  1. TYPES OF PROPERTY TYPES OF DISPOSITIONS TO WHICH §1231 APPLIES
  2. Applies to…
  3. Sale or exchange or involuntary conversion (theft, seizure, destruction, or threat or imminence of condemnation);
  4. Davis: typically, can’t have sale or exchange if unable to resale property
  5. Of real or depreciable property used in T/B; OR
  6. Any capital asset which is held for more than 1 year and is held in connection with a
  7. T or B; OR
  8. Transaction entered into for profit
  9. Essentially, property that is included in §1221(2)
  10. T/f, NO inventory
  11. Summary: to determine whether a TP’s recognized gains or losses are §1231 gains or losses and thus subject to the rules of § 1231, one must consider both…
  12. The event that triggers the gain or loss; AND
  13. The nature of the property involved
  14. Examples
  15. Gain / loss recognized on sale / exchange of depreciable equip held > year and used in TP’s business will get § 1231 treatment, as would involuntary conversion of such
  16. However, gain / loss from sale / exchange of a capital asset held > year would NOT get § 1231 treatment
  17. Not needed, though, b/c will be LT CG or CL under § 1222
  1. NETTING PROVISIONS OF §1231 HOW THEY FAVOR TP
  2. Introduction
  3. Once TP has identified all of their §1231 gains and losses for the year, §1231(a)(1) and (2) require the TP to compare total §1231 gains to total §1231 losses
  4. If gains losses THEN its CG
  5. If gains losses THEN its ordinary loss
  6. Hotchpot analysis, i.e. all § 1231 gains and losses are combined in a hotchpot for purposes of characterization
  7. The SUB Netting Process (Preliminary Netting Analysis)
  8. Essentially, § 1231 gains / losses resulting from certain involuntary conversions will not be subject to characterization under § 1231
  9. Will NOT enter the Principal Hotchpot
  10. Thus, will be ignored for §1231 purposes, if the total of such losses exceeds the total of such gains
  11. (a)(4)(C): In the case of any involuntary conversion arising from fire, storm, shipwreck, or other casualty, or from theft, of any—
  12. (i) property used in the T/B, or
  13. (ii) any capital asset which is held for more than 1 year AND is held in connection with a T/B or a transaction entered into for profit
  14. Note:
  15. Does NOT include condemnation
  16. IF Gains exceed the Losses THEN put assets in the REG Netting
  17. IF Losses exceed the Gains THEN these assets are ordinary
  18. TP will deduct losses as ordinary under §165 or other;
  19. Gain reported under §61
  20. If Losses = Gains, enter REG analysis
  21. See examples p. 799-800
  22. The REG Netting Process (Primary Netting Process)
  23. (a)(1): GAINS EXCEED LOSSES
  24. IF 1231 gains for any taxable year exceed 1231 losses for such taxable year, THEN
  25. Such gains and losses shall be treated as LTCG or LTCL
  26. (a)(2): GAINS DO NOT EXCEED LOSSES
  27. IF 1231 gains for any taxable year, do NOT exceed 1231 losses for such taxable year, THEN
  28. Such gains and losses shall NOT be treated as LTCG or LTCL
  29. *Note this catches situations where gains = losses
  1. RECAPTURE OF NET ORDINARY LOSSES: § 1231(c)55 min
  2. Introduction
  3. Certain tax problems create situations whereby if two assets are sold in the same year, a LTCG and LTCL will be generated
  4. If the same assets were sold in different years, would have LTCG and ordinary loss
  5. Recapture provision is attempt to curtail such tax planning problems
  6. (c)(1)
  7. “The net § 1231 gain for any taxable year shall be treated as OI to the extent such gain does not exceed the “non-recaptured net section 1231 losses.”
  8. Functions as Anti-Abuse Provision
  9. Non-Recaptured Net Section 1231 Losses
  10. EXCESS of the aggregate amount of the net section 1231 losses for the 5 most recent years beginning OVER
  11. The portion of such losses taken into account as net 1231 gain for such preceding taxable years
  12. Rule
  13. Only applies to taking losses first
  14. IF TP takes gains first then 1231(c) does not apply

Ch. 33 - Recapture of Depreciation