10. What basic tax-planning strategy should a taxpayer with a large net capital gain for the year pursue before the end of the year?
A taxpayer in a net capital gain situation should consider selling any capital assets he or she has that have unrealized losses. This will reduce the amount of tax that will be paid on the capital gain income. However, if the taxpayer does not want to get rid of the loss stock permanently, he or she will have to be careful not to buy back any stock sold at a loss within 30 days or the wash sale rules to disallow the loss. 12. When does a taxpayer realize a loss on a worthless security? What is the amount of realized loss? What rules govern the recognition of a loss on a worthless security? Explain.
The last day of a tax year in which the security is determined to be worthless is the date of realization of the loss. The amount of the realized loss is the adjusted basis of the security. Following the capital recovery concept, taxpayers may deduct the basis of their investments when those securities are determined to be worthless. Generally, the recognized loss on worthless securities is a capital loss. Therefore, if an individual has no net capital gains for the year, the loss deduction is limited to $3,000 annually. The last day of the tax year is the date of realization for determining the holding period for classification of whether the loss is long-term, mid-term, or short-term. If the stock is classified as small business stock, the loss from worthlessness is deductible as an ordinary loss. 14. What is the tax advantage of selling a Section 1231 property at a gain?
A gain on a Section 1231 property is subject to the Section 1231 netting procedure. If the netting procedure results in a gain for the year, the gain is treated as a long-term capital gain. The long-term capital gain from the Section 1231 netting procedure becomes part of the capital gain and loss netting procedure. Within this procedure, there are two possible benefits. First, if the capital gain and loss procedure results in a net long-term capital gain, the tax rate applicable to the gain for an individual taxpayer is 15%. Second, if the taxpayer has a net capital loss, the Section 1231 long-term capital gain effectively allows deduction of a loss which may have otherwise been limited. 17. The chapter noted that all depreciable property is subject to the depreciation recapture rules. What is the intent of the depreciation recapture rules?
The intent of the depreciation recapture rules is to reclassify gains which are due to the deduction of depreciation (an ordinary expense deduction) as ordinary income, rather than either capital gain or Section 1231 gain. Section 1245 recaptures all gain which is due to the depreciation deduction as ordinary income. For there to be either a capital gain or a Section 1231 gain on a Section 1245 asset, the asset must be sold for more than its original cost. That is, only the true appreciation in the price of a Section 1245 gain is accorded capital gain or Section 1231 gain status. Section 1250 recaptures excess depreciation as ordinary income. Excess depreciation is defined as the actual depreciation deducted less the allowable straight-line depreciation. Therefore, straight-line depreciation on Section 1250 assets can create capital gain or Section 1231 gain. As long as a straight-line depreciation is taken on a Section 1250 asset, no recapture occurs. PROBLEMS 22. Determine the amount realized in each of the following property dispositions:
a. Herbert sells some land he owns to Elroy in exchange for $23,000 in cash and 2 breeding hogs worth $1,500 each (adjusted basis of $500 each). In closing the sale, Herbert incurs legal fees of $600, title search costs of $250, and document filing fees of $50.
The amount is realized is $25,100: Cash received $ 23,000
Value of hogs (2 x $1,500) 3,000
Gross sales price $ 26,000
Less: Legal fees $600
Title search 250
Filing fees 50 (900)
Amount realized $ 25,100 b. Saada Corporation sells a building it owned to Paris, who finances the purchase by obtaining a $200,000 loan and pays an additional $20,000 in cash. As part of the sales agreement, Saada agrees to pay the $4,000 in points that Paris had to pay to obtain the loan. The corporation incurs commission costs of $12,000 and $5,000 in legal fees in making the sale.
The gross sales price is $216,000. The $200,000 loan and the $20,000 cash payment is reduced by the $4,000 of points Saada paid on Paris' loan. The $17,000 ($12,000 + $5,000) of commissions and various legal fees reduce the amount realized to $199,000: Cash received $ 20,000
Value of loan payable 200,000
Less: Points paid (4,000)
Gross sales price $ 216,000
Less: Commissions $ 12,000
Legal fees 5,000 (17,000)
Amount realized $ 199,000
c. Andrew and Sandra agree to exchange land that each owns. Andrew's land is worth $46,000, and Sandra's land is worth $51,000. Therefore, in the exchange of the land, Andrew has to pay Sandra $5,000.
Andrew's amount realized is $46,000 ($51,000 value of land received less $5,000 of cash paid). Sandra's amount realized is $51,000 ($46,000 value of land received plus $5,000 of cash received). d. Artworld, Inc., sells its building to Paula for $22,000 in cash. As part of the sales agreement, Paula agrees to assume Artworld's $90,000 mortgage on the property.
Artworld's amount realized is $112,000. Artworld receives $22,000 of cash and has its $90,000 mortgage assumed in the sale. The debt assumption is equivalent to the payment of $90,000 of cash, which is then used to pay off the debt. 26. Determine the amount of gain or loss realized and the amount of gain or loss to be recognized in each of the following dispositions:
a. Jorge owns 800 shares of Archer Company stock. He had purchased 300 of the shares for $9,000 and 500 of the shares for $10,000. During the current year, Jorge instructs his broker to sell 400 of the shares when their market value hits $29. He pays a $300 commission on the sale.
Jorge has a realized and recognized gain on the sale of $300: Amount realized [(400 shares x $29) - $300] $ 11,300
Basis of shares sold (FIFO):
300 shares from 1st purchase $ 9,000
100 shares from 2nd purchase (100 x $20) 2,000 (11,000)
Realized and recognized gain $ 300
b. Alana owns 300 shares of Courtney Common Stock that had cost her $6,000. On February 1, she sells the 300 shares for $4,800 and pays a $300 commission on the sale. On February 19, Alana purchases 500 shares of Courtney common stock for $5,300 plus a $400 commission.
Alana has realized a loss of $1,500 [($4,800 - $300) - $6,000] on the sale of the 300 shares of stock. However, none of the loss is recognized because Alana replaced the shares of stock within 30 days of the sale at a loss. Under the wash sale rules, the $1,500 of realized loss is added to the basis of the replacement shares, thus deferring recognition of the loss until the replacement shares are sold. Alana's basis in the 500 shares purchased on February is determined as follows: Total cost = $5,300 + $400 = $ 5,700
Cost per share = $5,700 ÷ 500 = $11.40
Basis of 500 shares
300 wash sale shares = (300 x $11.40) + $1,500 $ 4,920
200 shares = (200 x $11.40) 2,280
Total Basis $ 7,200 28. Elvira owns an office building, and Jared Partnership owns an apartment building. Each property is encumbered by a mortgage. Elvira and Jared Partnership agree to exchange their properties and mortgages, with any difference to be paid in cash. The fair market values, mortgages, and adjusted bases for the properties are as follows:
a. Write a letter to Elvira explaining who will have to pay cash to complete the exchange, the amount of her gross selling price, and the amount of gain or loss she will realize on the exchange.
Elvira's Jared Partnership
Building Building Difference
Fair market value $ 220,000 $ 250,000 $ 30,000
Mortgage debt (80,000) (150,000) (70,000)
Equity in building $ 140,000$ 100,000$ (40,000) Jared Partnership will need to pay Elvira $40,000 cash to complete the exchange. Elvira realizes a gross selling price of $220,000: Cash received from Jared $ 40,000
Value of building received 250,000
Mortgage assumed by Jared 80,000
Less: Assumption of Jared's mortgage (150,000)
Gross selling price $ 220,000 Elvira's gain realized on the exchange is $120,000: Gross selling price $ 220,000
Less: Adjusted basis (100,000)
Realized gain $ 120,000
b. Write a letter to Jared Partnership explaining who will have to pay cash to complete the exchange, the amount of the gross selling price of its property, and the amount of gain or loss it will realize on the exchange.
Jared Partnership will need to pay Elvira $40,000 to complete the exchange. Jared realizes a gross selling price of $250,000: Value of land received $ 220,000
Gross selling price $ 250,000 Jared's gain realized on the exchange is $75,000: Gross selling price $ 250,000
Less: Adjusted basis (175,000)
Realized gain $ 75,000 29. Guerda owns 1,500 shares of Ditchdirt common stock. During the current year, she sells 500 shares of the stock for $15 per share and pays a commission of $300 on the sale. Guerda had purchased the 1,500 shares as follows:
Purchase Purchase Commissions Cost
Date # of Shares Price Paid Per Share
1/18/05 200 $ 1,600 $ 200 $ 9
5/12/05 100 1,100 100 $12
9/11/05 300 3,000 300 $11
2/15/06 400 5,500 500 $15
12/31/06 500 2,700 300 $ 6
What is Guerda's gain or loss on the sale of the stock?
Absent specific identification of the shares sold, the basis of the shares is determined on a FIFO basis. Therefore, the first step is to calculate the cost per share for each date Guerda purchased the Ditchdirt stock. 1/18/05 - $1,600 + $200 = $1,800 200 = $ 9 per share
12/31/06 - $2,700 + $300 = $3,000 500 = $ 6 per share The basis of the first 500 shares purchased are used to calculate gain (loss) on the sale: Basis of first 500 shares purchased: 1/18/05 purchase (200 Shares x $ 9) $ 1,800
5/12/05 purchase (100 Shares x $12) 1,200
9/11/05 purchase (200 Shares x $11) 2,200
Total basis of 500 shares $ 5,200
Calculation of Gain on Sale: Amount realized [(500 x $15) - $300] $ 7,200
Adjusted basis of shares sold (5,200)
Gain on sale $ 2,000
38. For each of the following capital asset dispositions, determine whether the taxpayer has realized a gain or loss and whether that gain or loss is short-term or long-term:
a. Larry's aunt June dies on May 4, 2007. He inherits some land that she purchased in 1988 for $2,000. On May 4, 2007, the land is worth $40,000. Larry receives title to the land on October 15, 2007, and sells it on November 27, 2007, for $40,000. He pays $3,000 in commissions and other selling expenses.
Larry has a long-term capital loss of $3,000. Larry's basis in the land is the fair market value on the date of death, $40,000. Even though Larry held the land for less than two months, inherited property is always deemed to be held long-term. Amount realized ($40,000 - $3,000) $ 37,000
Adjusted basis (40,000)
Long-term capital loss $ (3,000)
b. Sterling receives 4,000 shares of Suburb Corporation stock as a birthday present from his mother-in-law on May 6, 2007. His mother-in-law had paid $18,000 for the stock 8 years earlier. On May 6, 2007, the stock has a fair market value of $4,000. On June 18, 2007, Sterling sells 1,000 shares of the stock for $800.
Because the shares of stock have declined in value, the split basis rule for gifts applies. Sterling's basis for gain is $4.50 per share ($18,000 ÷ 4,000) and his basis for loss is $1 per share ($4,000 ÷ 4,000). Sterling sold the 1,000 shares for $800, resulting in a loss of $200 [$800 - (1,000 x $1)]. Because Sterling uses the fair market value on the date of the gift as his basis, the sale of the 1,000 shares is a short-term capital loss since the stock was held < 12 months (May 6 to June 18). c. Assume the same facts as in part b. Suburb Corporation becomes the target of a takeover attempt in July, and its stock soars. Sterling sells the remaining 3,000 shares for $19,000 on August 6, 2007.
Sterling has a gain of $5,500 on the sale of the stock [$19,000 - (3,000 x $4.50)]. Because Sterling's basis is his mother-in law's basis, he gets her holding period and the gain is a long-term capital gain (held > 12 months). d. Bert owns 1,000 shares of Crooner Capital Corporation common stock for which he paid $8,000 in 2000. On March 13, 2006, Crooner declares a dividend of 1 share of preferred stock for each 10 shares of common stock owned. On the date the preferred shares are distributed, Crooner’s common shares are selling for $7 per share, and its preferred shares are selling for $10 per share. On November 14, 2007, Bert sells the 100 preferred shares for $1,100.
The basis in the preferred shares is $1,000. The $8,000 original basis of the common shares is allocated between the common and the preferred based on the relative market values at the date of distribution. FMV of Common (1,000 x $7) = $ 7,000
FMV of Preferred ( 100 x $10) = 1,000
Total FMV $ 8,000 Preferred stock allocation ($1,000 ÷ $8,000) x $8,000 = $1,000 Bert's $100 ($1,100 - $1,000) gain on the sale is a long-term capital gain (held > 12 months). The $1,000 of basis obtained from the common is considered held from the date of the common purchase because the basis is made by reference to the basis of the common shares.
39. Rudy has the following capital gains and losses for the current year. What is the effect of the capital asset transactions on his taxable income? Explain, and show any calculations.
Short-term capital loss $ 15,500
Long-term capital gain 11,600
Long-term capital loss 4,500
Rudy has a net short-term capital loss of $15,500 and a net long-term capital gain of $7,100. Because the short-term and long-term positions are opposite, they are netted together, producing a net short-term capital loss of $8,400. Only $3,000 of the loss is deductible. The remaining $5,400 of loss is carried forward and retains its character as a short term capital loss. Short-term capital loss $ (15,500) Long-term capital gain $ 11,600
Long-term capital loss (4,500) 7,100
Net short-term capital loss $ (8,400) Net short-term capital loss deduction (maximum) $ 3,000 Short-term capital loss carryforward $ 5,400
43. Troy has the following gains and losses from sales of capital assets during the current year. What is the effect of the capital asset transactions on his taxable income? Explain, and show any calculations.
Short-term capital gain $ 7,800
Short-term capital loss 9,000
Long-term capital gain 5,400
Long-term capital loss 2,100
Troy has a net short-term capital loss of $1,200 and a net long-term capital gain of $3,300. Because the short-term and long-term positions are opposite, the two positions are netted, resulting in a $2,100 net long-term gain. The $2,100 long-term capital gain is added to gross income, although it is taxed at 15% (5% if he is in the 10% or 15% tax rate bracket) Short-term capital gain $ 7,800
Short-term capital loss (9,000) $ (1,200) Long-term capital gain $ 5,400
Long-term capital loss (2,100) 3,300
Net long-term capital gain $ 2,100 45. Loretta has the following capital gains and losses during the current year:
Short-term capital loss $ 4,000
Collectibles gain 10,000
Long-term capital gain 8,000
Long-term capital loss carryover 2,000
Loretta is single and has a taxable income of $96,000 before considering the effect of her capital gains and losses. What is the effect of Loretta's capital gains and losses on her taxable income and her income tax liability?
Loretta has a $4,000 short-term capital loss and a $16,000 net long-term capital gain. The short-term loss and the long-term gain are netted, resulting in a $12,000 net long-term capital gain for the year: Short-term capital loss $ (4,000)
Net long-term capital gain $ 12,000 The $12,000 gain is added to gross income, increasing Loretta's taxable income to $108,000. The net long-term capital gain of $12,000 consists of an adjusted net capital gain of $8,000 and a 28% tax rate gain of $4,000: 28% rate gain = $10,000 - $4,000 - $2,000 = $4,000
Adjusted net capital gain = $12,000 - $4,000 = $8,000 The adjusted net capital gain is taxed at 15%. Because Loretta is in the 33% marginal tax rate bracket, the $4,000 net 28% tax rate gain is taxed at 28%. Loretta's income tax liability increases by $2,320: Tax on adjusted net capital gain - $8,000 x 15% $1,200
Tax on 28% tax rate gain - $4,000 x 28% 1,120
Tax on capital gains $2,320 56. Fred's Foam Foundations (FFF) is a sole proprietorship that Fred started in 2002. Before the current year, FFF had not disposed of any property it owned. During the current year, FFF has the following gains and losses:
Casualty Loss on foam truck $ 3,200
Section 1231 gains $ 9,400
Section 1231 losses $ 3,000
What is the effect of these transactions on Fred's taxable income? Explain, and show the calculations.
The Section 1231 netting results in an ordinary loss of $3,200 and a net long-term capital gain of $6,400. The $3,200 ordinary loss is deducted directly from Fred's gross income. The $6,400 is combined with Fred's other capital gains and losses in the capital gain and loss netting procedure. Step 1 Netting:
Casualty loss on foam truck (Ordinary Loss) $3,200 Because the 1st netting results in a loss, the loss is ordinary. It is not carried to the second netting. Step 2 Netting:
Section 1231 gains $ 9,400
Section 1231 losses (3,000)
Net Section 1231 gain - Long-term capital gain $6,400 Step 3 Netting:
Because Fred has never sold any property before the current year, there are no ordinary loss deductions to recapture under the lookback rule. The entire $6,400 net Section 1231 gain is a long-term capital gain. 57. Refer to the facts in problem 56. In the following year, FFF has these gains and losses:
Casualty gain on building $ 5,000
Section 1231 gains $ 3,000
Section 1231 losses $ 17,000
What is the effect of these transactions on Fred's taxable income? Explain, and show the required calculations.
The Section 1231 netting results in an ordinary loss deduction of $9,000, reducing Fred's taxable income by $9,000. Step 1 Netting:
Net casualty gain $ 5,000 Step 2 Netting:
Net casualty gain from step 1 $ 5,000
Section 1231 gains 3,000
Section 1231 losses (17,000)
Net section 1231 loss $ (9,000) The net casualty gain from step 1 is combined with other Section 1231 gains and losses in step 2. This allows the net casualty gain to be offset against other Section 1231 gains and losses. Because there is a net Section 1231 loss for the year, there is no lookback recapture rule to apply. 62. Avalon Inc., buys equipment costing $150,000 in 2004 and sells it in 2007. Avalon deducts $94,000 in depreciation on the equipment before the sale. What is the character of the gain or loss on the sale of the equipment if the selling price is
Equipment is Section 1231 property. It is also subject to recapture under Section 1245. Any gain on the sale must be recaptured as ordinary income to the extent of the $94,000 in depreciation that has been deducted on the equipment. The adjusted basis of the equipment is $56,000 ($150,000 - $94,000) at the date of sale. a. $90,000?
Avalon realizes a $34,000 gain on the sale. The entire gain is recaptured as ordinary income: Amount realized $ 90,000
Adjusted basis ($150,000 - $94,000) (56,000)
Gain on sale $ 34,000
Section 1245 - Ordinary income 34,000
Section 1231 gain $ -0- b. $155,000?
Avalon realizes a $99,000 gain on the sale. The $94,000 of depreciation is recaptured as ordinary income, leaving a $5,000 Section 1231 gain: Amount realized $155,000
Adjusted basis ($150,000 - $94,000) (56,000)
Gain on sale $ 99,000
Section 1245 - Ordinary income 94,000
Section 1231 gain $ 5,000 c. $40,000?
Avalon realizes a $16,000 loss on the sale. The $16,000 loss is a Section 1231 loss — depreciation recapture applies only to gains: Amount realized $ 40,000
Adjusted basis ($150,000 - $94,000) (56,000)
Loss on sale $ (16,000) 63. Maria sells the automobile she uses in her job as a marketing representative for $3,000. The car cost $15,000 four years earlier. Maria uses the automobile 80% of the time in her job and 20% of the time for personal purposes. At the date of sale, Maria had taken $10,000 in depreciation on the automobile. Write a letter to Maria explaining the amount and character of her realized gain or loss from the sale and how much she must recognize for tax purposes.
Because Maria uses the automobile for business and personal purposes, the basis and the sale of the automobile must be broken into the portions attributable to both uses: 80% 20%
The $400 gain on the business portion of the automobile is a Section 1231 gain. However, because the automobile is Section 1245 property, the $400 gain is recaptured as ordinary income. The $2,400 loss is a non-deductible personal use loss. 68. Thuy buys a rental house in 2000 for $75,000. In 2007, she sells it for $86,000. Thuy properly deducted $22,000 in depreciation on the house before its sale. What is the amount and character of the gain on the sale?
Thuy realizes a $33,000 gain on the sale. The rental house is Section 1250 property but there is no depreciation recapture because MACRS uses straight-line depreciation. However, the $22,000 in depreciation is characterized as unrecaptured Section 1250 gain, leaving an $11,000 long-term capital gain on the sale: Amount realized $ 86,000
Adjusted basis - ($75,000 - $22,000) (53,000)
Realized gain $ 33,000
Section 1250 recapture -0-
Unrecaptured Section 1250 gain 22,000
Long-term capital gain $ 11,000 a. Thuy also sells the following securities:
Purchase Sales Sales
Determine the amount of tax that Thuy will pay on her capital asset transactions. Assume that she is in the 35% marginal tax rate bracket.
Thuy realizes a $4,000 ($7,000 - $3,000) long-term gain on the 4/08/07 sale, a $2,000 ($10,000 - $12,000) long-term loss on the 7/15/07 sale, and a $5,000 ($19,000 - $14,000) short-term gain on the 8/13/07 sale. The capital gain and loss netting produces a $5,000 short-term capital gain and a $35,000 long-term capital gain: Short-term capital gain $ 5,000 Unrecaptured Section 1250 gain $ 22,000
Long-term capital loss (2,000)
Long-term gain - stock 4,000
Long-term gain - rental house 11,000
Net long-term capital gain $35,000
Because the short-term and long-term positions are both gains, no further netting is necessary. In calculating the tax on the capital gains, there is no 28% rate gain. Thuy's adjusted net capital gain is $13,000 ($35,000 - $22,000). The short-term capital gain is taxed at Thuy's 35% marginal tax rate. The adjusted net capital gain is taxed at 15% and the unrecaptured Section 1250 gain is taxed at 25%. The tax on Thuy's capital gains is $9,200: Tax on short-term capital gain - $5,000 x 35% $ 1,750
Tax on unrecaptured Section 1250 gain - $22,000 x 25% 5,500
Tax on adjusted net capital gain - $13,000 x 15% 1,950