McGraw-Hill/Irwin

Chapter 7

Capital Gains and Other Sales of Property

“If a client asks in any but an extreme case whether, in your opinion, his sale will result in capital gain, your answer should probably be, ‘I don’t know, and no one else in town can tell you.’” -- James L. Wood

LO #1 Terms & Tax Forms

• • Basis of property purchased is the cost of the asset including cash, debt obligations, and other property or services included in acquiring the asset.

Basis of assets transferred by inheritance are valued at the FMV of the property at the date of death or FMV on the alternate valuation date if an estate return is being filed and the estate income is reduced by the valuation.

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LO #1 Terms & Tax Forms

• • Basis of property transferred to a taxpayer from a spouse or former spouse incident to a divorce settlement, is the same as the spouse’s or former spouse’s adjusted basis before the transfer.

Assets transferred by gift can be valued at FMV or basis of the donor depending if the FMV is < or = > basis.

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LO #1 Terms & Tax Forms

• • Adjusted basis is the cost of the asset less any accumulated depreciation.

The difference between the amount realized from the sale and the adjusted basis of the asset; –

Amount realized > adjusted basis = gain

–

Amount realized < adjusted basis=(loss)

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LO #1 Terms & Tax Forms

• The nature of tax reporting for gains and losses on the sale of property depends primarily on the “use” of the asset rather than on the asset “form.” 7-5

LO #1 Terms & Tax Forms

• • • Form 4797 – Sales of Business Property – Use to report any and all gains or losses from sale or liquidation of business property.

– The form has four parts to it and is very detailed to include all possible situations involving property used in a business Schedule D – Capital Gains and Losses – Use to report any and all gains or losses from sale of property held for investment.

Form 8949 – Record transactions 7-6

LO # 2 Classifying Assets

• • Ordinary Asset – Ordinary income property is any asset that is “not” a capital asset.

Capital Asset ( §1221) – Any asset used for personal purposes or investment.

• Eight exceptions to this definition 7-7

LO # 2 Classifying Assets

• § 1231 Business Asset – Depreciable or nondepreciable property used in a trade or business – Held for more than one year • Any business asset disposed of within one year of acquisition is an ordinary income asset and is taxed to the taxpayer at ordinary tax rates.

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LO # 3 Ordinary Assets

• • • • Inventory and accounts receivable are not ordinary income assets unless they are sold outside the normal course of business.

Sale of business property held less than one year.

Gains are taxed at the taxpayer’s regular rate – There is no preferential tax treatment Losses are fully deductible 7-9

LO #4 Capital Assets

• Tax treatment depends on holding period of the asset. Assets must be held for

more than

one year for preferential tax treatment.

– Exceptions: • Property received through a gift or nontaxable exchange generally has same holding period as the transferor.

• Property acquired through inheritance is

always

considered long-term property.

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LO #4 Capital Assets

• Long term capital gain rates: – 0%,15%, or 20% for most capital assets – 25% rate for depreciable real property used in a trade or business ( § 1250) – 28% rate for “collectibles” and gains on §1202 (Qualified Small Business Stock) property.

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LO #4 Capital Assets

• • • All short-term gains and losses are netted.

All long-term gains and losses are netted.

The resultant gain or loss determines the deductibility of a loss and the tax rate used for gain.

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LO #5 §1231 Business Assets

• • • Recall that § 1231 assets are those used in a trade or business that are held for > 1 year.

Gains and losses from the sale of §1231 assets are netted before tax rates are applied.

A net §1231 gain is taxed as a long term capital gain subject to recapture provisions 7-13

LO #5 §1231 Business Assets

• Recapture provisions apply to depreciation taken as a deduction in prior years.

• Depreciation recapture rules are designed to “transform” some or all of the §1231 gain into an

ordinary

gain.

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LO #5 §1231 Business Assets

• Net §1231 gains receive preferential tax rate treatment • Net §1231 losses are treated as ordinary losses not subject to deductibility limit provisions of $3,000 per year.

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LO #5 §1231 Business Assets

• §1245 applies to personal trade or business property and is a subset of §1231 property – Tax rate to “recapture” the depreciation portion of a gain is taxed at ordinary rates – Remaining gain, if any, is taxed at preferential rates.

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LO #5 §1231 Business Assets

• § 1250 applies to buildings – residential or nonresidential (commercial) and is a subset of §1231 property – The amount of capital gain attributable to depreciation previously taken is taxed at the 25% rate up to the depreciation amount considered “unrecaptured”.

– Remaining gain, if any, is taxed at preferential rates 7-17

LO # 6 Special Types of Sales

• Sales of stock purchased as blocks of stock at different prices and/or dates are valued either using specific identification or the first-in, first-out method for determining basis.

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LO # 6 Special Types of Sales

• • • A mutual fund pools resources from various investors and purchases shares of stock in a portfolio Form 1099-DIV is the form sent annually to individual investors in the mutual fund to record dividends, capital gains, and distributions from the fund for the year.

Capital gains distributions from mutual funds are reported on Schedule D (or directly on Form 1040 if Schedule D is not required to be filed).

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LO # 6 Special Types of Sales

• Three methods to calculate the “basis” of shares in a mutual fund purchased throughout a period – – – First-In, First-Out – assumes first shares purchased are the first shares sold.

Specific Identification – assumes that the shares sold can be identified with a specific purchase.

Average Basis – Calculate the average of shares purchased for a period and use an average to determine the cost basis of shares sold.

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LO # 6 Special Types of Sales

• Worthless securities are treated as losses from a sale or exchange of a capital asset on the last day of the taxable year.

– Declaration of bankruptcy is not sufficient to indicate worthlessness.

– Often difficult to pinpoint exactly when a security becomes worthless to determine a “sale date” for long-term versus short term treatment.

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LO # 6 Special Types of Sales

• Sales of assets given as gifts: – FMV

– FMV=>donor’s adjusted basis at time of gift • Use donor’s adjusted basis for a gain or loss 7-22

LO # 6 Special Types of Sales

• • Basis to beneficiaries is the FMV at the date of death or alternate valuation date (AVD applies only if valuing the asset reduces the overall estate amount). The holding period is always considered long-term – Example: Property inherited with a basis of $3,000 is sold six months later for $4,000. The $1,000 gain is considered long-term and qualifies for preferential tax treatment. 7-23