104-7 Tax Consequences of Property Transactions: Part 1

Question 1

Capital Assets

Answer 1

Personal use assets (e.g., a personal residence) and most investment assets

Question 2

Noncapital assets / ordinary income asset examples

Answer 2

These generate ordinary income and losses:

1. Accounts receivable or notes receivable of a trade or business
2. Copyrights and creative works held by the creator
3. Inventory or property held for sale to customers in a taxpayer’s trade or business
4. Depreciable personal and real property used by a business

Think: ACID

Question 3

Holding period

Answer 3

Length of time a taxpayer has owned an asset of any type

Question 4

Short-term capital gain (STCG)

Answer 4

Gain on capital assets owned 1 year or less

Taxed at ordinary income (marginal) tax rates

Question 5

Long-term capital gains rate

Answer 5

0%
15%
20%

The capital gain tax is progressive in nature. If the taxpayer has $40k in long-term capital gains and $60k in income, a portion will be taxed at the 12% ordinary income tax rate

Question 6

Summary of holding periods and the different types of assets

Answer 6

Type: LTCG, Holding Period: > 1 yr

Type: STCG, Holding Period: < 1 yr

Type: Unrecaptured Section 1250 gain (depreciable real property), Holding Period: > 1 yr, up to 25% rate

Type: Qualifying dividend income, Holding Period: Received after 12.31.2002

Type: Collectibles, > 1 yr (up to the 28% rate)

Question 7

Amount realized

Answer 7

Sum of any money received + FMV of other property received in the transaction

Question 8

Recovery of Capital Doctrine

Answer 8

Allows taxpayers to recover the cost or other original basis of property tax-free
For example, the cost or other basis of depreciable property is recovered through annual depreciation deductions

Question 9

Exceptions to the rule that property must be owned longer than 1 year to qualify for long-term capital gains tax rates

Answer 9

1. Gift property
2. Inherited property
3. Section 1031 (like-kind)
4. Mark-to-market rules
5. Worthless securities

Question 10

Qualifying (qualified) dividend income

Answer 10

A distribution to the shareholder of either cash or property out of the corporation’s current or accumulated earnings and profits
A dividend distribution is considered ordinary income to the investor-taxpayer and is not deductible by the distributing corporation
Qualifying dividend distributions are eligible for the same 20%/15%/0% rate as are long-term capital gains and most dividends declared by a corporate BOD of a domestic corporation

Question 11

Reporting of a taxpayer’s capital gains & losses

Answer 11

Done on schedule D of IRA form 1040

Question 12

Capital gains netting procedure

Answer 12

1. STCG and STCL are netted against each other
2. LTCG and LTCL are netted against each other
3. If any gains and losses remain (whatever their character), they are again netted
4. If a capital loss still remains after netting, only $3,000 ($1,500 for taxpayers filing as MFS) of the net loss may be used to offset ordinary income in any 1 year

Individuals may generally carry over a net capital loss to future tax years (indefinitely) until the loss if fully used. However, in some cases (e.g., the application of the related party rules), the loss may be disallowed entirely.

Question 13

Fair Market Value (FMV)

Answer 13

The price at which property will change hands between a willing buyer and a willing seller, both w/ knowledge of the relevant facts, when neither is compelled to buy nor to sell

Question 14

Basis

Answer 14

The measure of the unrecovered dollars assigned to a taxpayer’s investment in an asset

1. Original or cost basis
2. Adjusted basis
3. Carryover basis
4. Stepped-up basis
5. Substituted basis

Question 15

Original or cost basis

Answer 15

This is where the calculation of basis begins and is the amount of the taxpayer’s original funds used to make the investment plus any improvements made to the investment, legal fees, and permits to build (e.g., real property)

Question 16

Adjusted basis

Answer 16

The investment’s original or cost basis (including any improvements, legal fees, and permits), and for financial intangibles (securities) commissions and other fees to acquire the security will increase the basis of the intangible less any cost recovery deductions, commonly referred to as depreciation

Question 17

Carryover basis

Answer 17

Basis that is transferred or carried over from 1 party to another

Its most notable application is appreciated property gifted from the donor to the donee

Question 18

Stepped-up basis

Answer 18

Basis that is increased to some point in time, free of any intervening income taxation; its most notable application is property that appreciates during a taxpayer’s lifetime and is received by the heirs at time of death and, generally receives a stepped-up basis to the FMV at the date of death for the property inherited by the heir

Question 19

Substituted basis

Answer 19

The property’s FMV less any deferred gain or plus any postponed loss
Most notable application is a nontaxable exchange of qualifying real property (aka like-kind exchange)

Question 20

For purposes of determining a taxpayer’s basis in property

Answer 20

The basis of an asset is equal to the purchase price plus the cost to place the property into service.

1. Improvements increase original basis
2. Repairs do not add to or impact original basis

Basis is also increased by legal fees, commissions, sales tax, and transportation charges

Question 21

Taxpayers recovering their original cost or investment in certain assets used in a trade or business

Answer 21

May be done through depreciation, amortization, or depletion

Question 22

Modified Accelerated Cost Recovery System (MACRS)

Answer 22

Property Type: Autos, light-duty trucks, computers
Useful Life: 5 yrs

Property Type: Office furniture, fixtures
Useful Life: 7 yrs

Property Type: Residential rental property
Useful Life: 27.5 yrs

Property Type: Commercial Rental Property
Useful Life: 39 yrs

Question 23

Alternate Depreciation System (ADS)

Answer 23

Must be used for listed property that is used 50% or less in business
Includes passenger autos, entertainment assets, computer, and phones
Depreciation under ADS is based on a straight-line method

Question 24

Straight-line depcreciation

Answer 24

Simplest form of depreciation
Assumes depreciation is uniform throughout the useful life of the asset

SL = (cost - residual value) / useful life

Question 25

Expensing Policies

Answer 25

If a repair adds value or adds to the useful life of the asset, the expense can be depreciated

Expenses that keep the asset in an ordinary working condition do not add value and are considered a current expense

Question 26

Section 179 expense election

Answer 26

Allows an annual expensing of the cost of tangible personal property (such as business computers or business trucks) in any 1 year up to a certain amount

To be eligible for this election, the property must be used at least 50% for business in the first year that it is placed in service

2 annual limitations associated w/ use of the Section 170 expense election:
A) If the total amount of qualifying property placed in service for a given year is > $2.55 million (for 2019), the allowance is reduced dollar-for-dollar for any amount > $2.55 million. No carryover is allowed.

B) A loss cannot be created through the use of the election

Question 27

Intangible assets

Answer 27

aka Section 197 assets

Amortized over a period (useful life) of 15 years

Goodwill
Trademarks
Covenants not to compete
Copyrights
Patents

Amortization = deduction

Question 28

Natural resources (such as oil and gas wells)

Answer 28

Subject to depletion
Owner is entitled to a deduction for AGI (an above-the-line deduction) to recover the costs of exhausting the natural resource

Question 29

2 Depletion Methods

Answer 29

1. Cost depletion: asset basis is divided by the total # of recoverable units of the asset and then multiplied by the # of units sold
2. Percentage depletion: statutory % applied to the gross income from the property (limited to 50% of the gross income)
   - More aggressive of the 2 depletion methods

Question 30

Cost-recovery (depreciation) deductions

Answer 30

When a taxpayer-businessowner purchases real or personal property for use in a business and takes cost-recovery (deprecation) deductions, these deductions offset the businessowner’s ordinary income

Question 31

Recapture

Answer 31

When selling the property for a gain, the businessowner must look back and recapture all or part of those previous cost-recovery deductions

Question 32

Section 1231 Property

Answer 32

Any depreciable real property or personal property used in a trade or business or for the production of income

Does not include inventory or costs of goods sold, which is not depreciable

1231 is a business-friendly section of tax code which is designed to encourage businesses to invest in property and thus stimulate the larger economy

Take caution - if previous depreciation has been taken exceeding any recognized gain, this portion is ordinary income to the extent of the previous depreciation taken

Question 33

Section 1245 Property

Answer 33

Depreciable tangible personal property used in a trade or business
Requires any recognized gain on the sale of Section 1245 property to be treated as ordinary income to the extent of any depreciation taken

The application of Section 1245 is also termed full recapture

Section 1245 does not apply to losses. Rather, Section 1231 rules are used, resulting in ordinary loss treatment

Question 34

Section 1250

Answer 34

Applies to depreciable real property used in a trade or business or for the production of income

For taxpayers whose marginal rate is 32% or higher; 25% is the max rate at which the unrecaptured Section 1250 gain will be taxed
Any gain not attributable to depreciation is subject to a long-term capital gain rate

Question 35

Installment Sale

Answer 35

Any sale of property in which the seller receives at least 1 payment after the year of sale
As such, the installment method permits the taxpayer to spread out the taxable gain as payments are received using the following formula

Profit / Total Contract = Gross Profit Percentage

Not available for:

• property held for sale in the ordinary course of business (inventory)
• securities traded in a secondary market

Question 36

Related Parties

Answer 36

Losses from sales of property between related parties are disallowed for income tax purposes
Related parties are defined here as:
1. lineal descendants (grandfather, father, child, and so forth)
2. brothers and sisters
3. corporations in which the taxpayer has a 50% or greater interest
4. several other complex tax relationships