Transcript Property Transactions: Treatment of Capital and Section

CCH Federal Taxation
Basic Principles
Chapter 12
Property Transactions:
Treatment of Capital and
Section 1231 Assets
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Chapter 12 Exhibits
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
Capital Assets—Definition of “Capital”
Capital Assets—Other Definitions
Determining the Capital/1231 Gains Rate “Basket”
Computing Capital Gain Tax—10% Rate
Computing Capital Gain Tax—20% Rate
Tax Treatment for Ordinary Income Property and Capital Assets
Patents
Franchises, Trademarks, and Trade Names
Lease Cancellation Payments
Options—General Rules
Options—Example
Subdivided Real Estate Sold by Investors
Worthless Securities
Depreciation Recapture—Example 1
Depreciation Recapture—Example 2
Chapter 12, Exhibit Contents A
CCH Federal Taxation Basic Principles
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Chapter 12 Exhibits
16.
17.
18.
19.
20.
21.
22.
23.
24.
25.
26.
27.
28.
29.
30.
Business Asset Dispositions—Template for Problem Solving
Business Asset Dispositions—Example 1
Business Asset Dispositions—Example 2
The First Netting—Capital Gains and Losses
The First Netting—Example 1
The First Netting—Example 2
The First Netting—Personal-Use Casualty/Theft Gains/Losses
The First Netting—Business/Investment Use Casualty/Theft
Gains/Losses
The First Netting—Personal-Use Condemnation Gains/Losses
The First Netting—Business/Investment-Use Condemnation
Gains/Losses
The First Netting—Long-Term Business Assets
The First Netting—Recap
The Second Netting—Examples
The Second Netting—Recap of the Rules
Applying the $3,000 Capital Loss Limitation
Chapter 12, Exhibit Contents B
CCH Federal Taxation Basic Principles
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Capital Assets—Definition of “Capital”
The term “capital” has different meanings among different professions. Here are some
examples:
Profession
Definition of Capital
Financial Accountant
“Capital stock” generally refers to the owners equity of a
corporation less its retained earnings.
Banker
“Capital” generally refers to the total assets of a company at
book value.
Investor
A “cap” is a quick way of placing an approximate price tag on
a company. “Cap” refers to the capitalization of a firm, which
can be calculated by multiplying the stock price by the
number of shares outstanding. For example, if DEF, Inc. has
10 million shares outstanding priced at $60 each, its
capitalization is $600 million.
Chapter 12, Exhibit 1a
CCH Federal Taxation Basic Principles
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Capital Assets—Definition of “Capital”
Some general terms applied by investment brokers to
companies with varying capitalization levels are listed below.
Terms
Capitalization Level
Large Cap
$5 billion or higher
Mid Cap
Between $500 million and $5 billion
Small Cap
$150 million to $500 million
Micro Cap
Less than $150 million
Chapter 12, Exhibit 1b
CCH Federal Taxation Basic Principles
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Capital Assets—Definition of “Capital”
Tax
Accountant
Chapter 12, Exhibit 1c
“Capital assets” generally refer to any property other than:
1. Ordinary income property (e.g., inventory, receivables,
creative works created by the taxpayer)
2. Depreciable business property (e.g., buildings,
equipment)
3. Non-depreciable business property (e.g., land)
Thus, capital assets would include land held for
investment, cars used for personal travel, principal
residences, household furnishings, stock, and jewelry.
Paintings, manuscripts, and other creative works are capital
assets if created by someone other than the taxpayer.
CCH Federal Taxation Basic Principles
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Capital Assets—Other Definitions
Collectibles
Collectibles are defined by the Internal Revenue Code as
any of the following investments: works of art, rugs,
antiques, gems, metals (e.g., gold, silver), stamps, coins, or
alcoholic beverages (e.g., older vintages of wines held for
investment). [Code Sec. 408(m)(2)]
(Note that works of art, rugs, antiques, and the other items
listed above, if held by dealers, are ordinary income
property, not collectible investments. Why? Because
dealers hold these assets as inventory, not as investments.)
Chapter 12, Exhibit 2a
CCH Federal Taxation Basic Principles
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Capital Assets—Other Definitions
Collectibles
The pre-May 7, 1997 rates apply to the sale of collectibles.
These old rates consist of:
1. 15% long-term capital gain rate (not the new 10% rate) for
taxpayers within the 15% ordinary income tax bracket;
2. 28% long-term capital gain rate (not the new 20% rate) for
taxpayers above the 15% ordinary income tax bracket.
Chapter 12, Exhibit 2b
CCH Federal Taxation Basic Principles
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Capital Assets—Other Definitions
Ordinary Income Property
Ordinary income property includes any property that would
result in the recognition of income taxed at the ordinary
income rates if the property were sold. Thus, ordinary
income property includes inventory, receivables, works of
art or manuscripts created by the taxpayer, and capital
assets that have been held for one year or less.
Chapter 12, Exhibit 2c
CCH Federal Taxation Basic Principles
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Capital Assets—Other Definitions
Code Sec. 1231 Assets.
Generally, business assets held over 12 months fall
under the category “Section 1231.” These assets
include personal and real property, both depreciable
and nondepreciable, that are used in a business.
Examples include a fleet of delivery trucks, the portion
of a car’s basis allocable to business transportation, the
portion of a principal residence used for a home office,
factory machinery, office computers, land held for
future business expansion, warehouses, office
buildings, apartment buildings, and rental houses.
Chapter 12, Exhibit 2d
CCH Federal Taxation Basic Principles
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Capital Assets—Other Definitions
Long-Term Holding Period
Capital assets held for more than one year are long-term.
Chapter 12, Exhibit 2e
CCH Federal Taxation Basic Principles
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Capital Assets—Other Definitions
Two Categories of Long-Term Holding Period
More than 12 Months. If a capital asset (other than a collectible) or a
Code Sec. 1231 asset sold after May 6, 1997, had been held for more
than 12 months, it is subject to the 20% capital gains rate (or the 10 %
rate for taxpayers in the 15% bracket).
More than 5 Years. (See following slide for explanation.)
Chapter 12, Exhibit 2f
CCH Federal Taxation Basic Principles
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Capital Assets—Other Definitions
Two Categories of Long-Term Holding Period
More than 5 Years. For capital assets (other than collectibles) sold after 2006, and
Code Sec. 1231 assets sold after 2006, the top long-term capital gain rate is 18% if the
assets had been held for more than five years (or 8% for taxpayers in the 15%
bracket). To get the special 18% rate, a taxpayer must either:
1. Acquire the capital asset after December 31, 2000, and hold it for over 5
years; or
2. Acquire the capital asset before January 1, 2001; “pretend” to sell it on
January 1, 2001, by recognizing any realizable gain (commonly referred
to as “marking to market,” the taxpayer pays a 20% capital gains tax on
the difference between FMV on January 1, 2001, and adjusted basis);
then hold the asset for over 5 years before actually selling it.
[Note that 15%-bracket taxpayers who acquire property before January 1, 2001, need
not mark-to-market the property on January 1, 2001, in order to get the special 8%
rate. They need hold it only until after 2006 to get the favorable 8% rate.]
Chapter 12, Exhibit 2g
CCH Federal Taxation Basic Principles
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Determining the Capital/1231 Gains Rate “Basket”
Long-term capital gains and losses and Section 1231 gains
and losses fall into one of five rate “baskets”: 10%, 15%,
20%, 25% and 28%. Two variables, (1) marginal ordinary
tax rate, and (2) type of asset sold or exchanged, must be
identified in order to determine the appropriate rate basket.
Different combinations of these two variables result in
different rate baskets.
Chapter 12, Exhibit 3a
CCH Federal Taxation Basic Principles
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Determining The Capital/1231 Gains Rate “Basket”
Two Variables Affecting Rate Baskets
Rate Basket
(1) Marginal
Ordinary Rate
(2) Type of Asset Sold
10%
15 %
Non-Collectible Capital Assets; or Code Sec. 1231
Assets
15 %
15 %
Collectibles
Above 15 %
Non-Collectible Capital Assets; or Code Sec. 1231
Assets (other than 1231 gain attributable to
unrecaptured Code Sec. 1250 depreciation)
25 %
Above 15 %
Code Sec.1231 Assets (to the extent of gain attributable
to unrecaptured Code Sec. 1250 depreciation)
28 %
Above 15 %
Collectible
20 %
Chapter 12, Exhibit 3b
CCH Federal Taxation Basic Principles
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Computing Capital Gain Tax—10% Rate
FACTS: Ben, a single individual, has 2003 taxable income in the amount
of $29,000. This amount includes a $4,000 long-term capital gain on
stock held over 12 months.
QUESTION: What is Ben’s tax liability for 2003?
SOLUTION: $3,910 as in the following calculations.
Chapter 12, Exhibit 4a
CCH Federal Taxation Basic Principles
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Computing Capital Gain Tax—10% Rate
SOLUTION:
Description
Taxable Income
(a)
Taxable income
$29,000
(b)
Long-term cap. gain
$4,000
(c) = Lesser of:
$28,400, or (a) – (b)
Ordinary income
subject to 10% and
15% rates
$25,000
(d) = Lesser of:
$40,400 (i.e., top 27%
Ordinary income
subject to 27% rate
$0
bracket for single individuals,
$68,800, less top 15% bracket,
$28,400), or (a) – (b) – (c)
$3,450.00
27%
$0.00
10%
$340.00
20%
$120.00
(Lesser of: $40,400,
or $0 = $29,000 – $4,000
– $25,000)
Long-term capital
gain subject to 10%
rate
$3,400
(f) = (b) – (e)
Long-term cap. gain
subject to 20% rate
$600
Totals
$29,000
Chapter 12, Exhibit 4b
10, 15%
Tax
(Lesser of: $28,400, or
$25,000=$29,000 – $4,000)
(e) = Lesser of:
(b), or $28,400 – (c)
(g) = (c) + (d) + (e) + (f)
Tax Rate
(Lesser of: $4,000, or
$3,400 = $28,400 –
$25,000)
($4,000 – $3,400)
CCH Federal Taxation Basic Principles
$3,910.00
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Computing Capital Gain Tax—10% Rate
Ben’s ordinary income is $25,000 ($29,000 – $4,000). According to
the “single individual” rate table, the 10% and 15% tax rates apply to
ordinary income up to $28,400. Since Ben’s ordinary income amount of
$25,000 is below the $28,400 limit, a portion of his long-term capital
gain gets taxed at the favorable 10% rate. The amount subject to the
10% rate is the difference between $28,400 (i.e., the 15% bracket’s
upper limit), and $25,000 (i.e., Ben’s actual ordinary income). Any
remaining long-term capital gain gets the favorable 20% long-term
capital gain rate. Based on the computations above, Ben’s tax liability
is $3,910.
Chapter 12, Exhibit 4c
CCH Federal Taxation Basic Principles
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Computing Capital Gain Tax—20% Rate
FACTS: Conor, a single individual, has 2003 taxable income in the amount
of $29,000. This amount includes a $1,000 long-term capital gain on stock
held over 12 months.
QUESTION: What is Conor’s tax liability for 2003?
SOLUTION: $4,060.00 as shown in the following calculation.
Chapter 12, Exhibit 5a
CCH Federal Taxation Basic Principles
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Computing Capital Gain Tax—20% Rate
SOLUTION:
Description
Taxable Income
(a)
Taxable income
$29,000
(b)
Long-term cap. gain
$1,000
(c) = Lesser of:
$28,400, or (a) – (b)
Ordinary income
subject to 15% rate
$28,000
(d) = Lesser of:
$40,400 (i.e., top 27%
Ordinary income
subject to 27% rate
$0
bracket for single individuals,
$68,800, less top 15% bracket,
$28,400), or (a) – (b) – (c)
(e) = Lesser of:
(b), or $28,400 – (c)
Tax Rate
Tax
15%
$3,900.00
27%
$0
10%
$40.00
20%
$120.00
(Lesser of: $28,400, or
$28,000 = $29,000 – $1,000)
(Lesser of:
$40,400, or $0 = $29,000 –
$1,000 – $28,000)
Long-term capital gain $400
subject to 10% rate
(Lesser of: $1,000, or
$400 = $28,400 –
$28,000)
(f) = (b) – (e)
Long-term cap. gain
subject to 20% rate
(g) = (c) + (d) + (e) + (f) Totals
Chapter 12, Exhibit 5b
$600
($7,000 – $400)
$29,000
CCH Federal Taxation Basic Principles
$4,060.00
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Computing Capital Gain Tax—20% Rate
Conor’s ordinary income is $28,000 ($29,000 – $1,000).
According to the rate tables, all of this $28,000 of ordinary
income is subject to 10% and 15% ordinary rates. $400.00 of
his long-term capital gain is taxed at 10% and $600.00 is taxed
at 20%. Based on the computations, Conor must pay
$4,060.00 in taxes.
Chapter 12, Exhibit 5c
CCH Federal Taxation Basic Principles
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Tax Treatment for Ordinary Income Property and Capital Assets
Tax Treatment
Always Ordinary Income
Sometimes Ordinary Income,
Sometimes Capital
Always Capital
Patents
Franchises, trademarks, trade names
Lease cancellation payments
received by landlord
Lease cancellation payments
received by tenant
Options
Subdivided real estate sold by
dealers
Subdivided real estate sold by
investors
Business bad debts
Non-business bad debts *(always shortterm, regardless of holding period.)
Worthless securities held by
dealers
Worthless securities held by non-dealers.
* (Holding period always ends on last
day of tax year in which securities
became worthless)
Inventory
Accounts receivable
Chapter 12, Exhibit 6
CCH Federal Taxation Basic Principles
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Patents
Substantial Rights
Gain or loss on sale of patents receives capital treatment if “all
substantial rights” have been sold. Otherwise, gain or loss
would get ordinary tax treatment. All substantial rights are
deemed to have been sold if there are no restrictions regarding:
 Geographic areas within the country of issuance
 Time allowed to use the patent
 Markets or industries in which patent-related products may
be sold
 Products or inventions related to the patent.
Chapter 12, Exhibit 7a
CCH Federal Taxation Basic Principles
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Patents
Holding Period
Regardless of how brief a patent is held, if it receives capital
treatment, the holding period is ALWAYS long-term.
Chapter 12, Exhibit 7b
CCH Federal Taxation Basic Principles
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Patents
Contingent Payments Are Ok
Patents, unlike franchises, may receive capital treatment, even
though the seller's receipt of patent royalties is contingent upon
the patent's productivity, use, or disposition.
Chapter 12, Exhibit 7c
CCH Federal Taxation Basic Principles
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Patents
Ordinary Treatment for Certain Sellers
Authors, composers, and artists who sell their creations
ALWAYS must report ordinary income or loss. Code Sec.
1221(3). However, the inventor of a patent may get long-term
capital gain treatment if “all substantial rights” have been sold.
Chapter 12, Exhibit 7d
CCH Federal Taxation Basic Principles
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Franchises, Trademarks, and Trade Names
To qualify for capital treatment, the seller must (1) transfer
all significant rights; and (2) receive noncontingent
payments.
Chapter 12, Exhibit 8a
CCH Federal Taxation Basic Principles
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Franchises, Trademarks, and Trade Names
Significant Rights
“Significant rights” refers to the ability of the seller to make
on-going decisions for the buyer, after the franchise,
trademark, or trade name has been sold.
Chapter 12, Exhibit 8b
CCH Federal Taxation Basic Principles
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Franchises, Trademarks, and Trade Names
Contingent Payments Are Not Ok
Franchises, trademarks, and trade names do not receive capital
treatment if the seller's receipt of payments is contingent upon
productivity, use, or disposition.
Chapter 12, Exhibit 8c
CCH Federal Taxation Basic Principles
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Franchises, Trademarks, or Trade Names
Special Rules for Buyers of Franchises, Trademarks,
or Trade Names
Contingent payments are deductible. Noncontingent
payments must be amortized over 15 years.
Chapter 12, Exhibit 8d
CCH Federal Taxation Basic Principles
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Lease Cancellation Payments
Landlord. Lease cancellation payments are always ordinary
income.
Tenant. Lease cancellation payments are either ordinary or
capital, depending upon the character of the leased asset.
For example, a lease cancellation payment for retail space is
ordinary income to the tenant; however, a lease cancellation
payment for a principal residence is capital gain to the
tenant.
Chapter 12, Exhibit 9
CCH Federal Taxation Basic Principles
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Options—General Rules
Grantor = The maker of an option who receives value in
exchange for a contractual obligation to sell or buy at a
certain price
Chapter 12, Exhibit 10a
CCH Federal Taxation Basic Principles
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Options—General Rules
Grantor’s Tax Treatment
If an option expires, the option money received by the grantor
is either short-term capital gain or ordinary income, depending
on the character of the property.
Chapter 12, Exhibit 10b
CCH Federal Taxation Basic Principles
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Options—General Rules
Grantor's tax treatment upon expiration of option to buy or sell
Stock and Securities
Tax treatment
Examples
Chapter 12, Exhibit 10c
ALWAYS short-term capital
gain, regardless of holding
period
Stock, commodity futures,
calls, puts, etc.
CCH Federal Taxation Basic Principles
Other property
ALWAYS ordinary
income
Land, warehouse, car,
computer, etc.
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Options—General Rules
Grantee = The holder of an option who pays a price
for the right to buy or sell at a certain price
Chapter 12, Exhibit 10d
CCH Federal Taxation Basic Principles
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Options—General Rules
Grantee’s Tax Treatment
If the option is sold, or allowed to expire, the character of the
property dictates the tax treatment. If the option is exercised,
the option payment is added to the grantee's (if grantee is buyer
and grantor is seller), or subtracted from the grantee's amount
realized (if grantee is seller and grantor is buyer).
Chapter 12, Exhibit 10e
CCH Federal Taxation Basic Principles
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Options—Example
FACTS: On 6/30/x1, George grants Tina a $5,000, 2-year option to buy investment
property for $100,000.
QUESTION: Consider the tax treatment if the investment property were stocks or land
under the 6 alternative assumptions below.
Tax treatment
Stock and Securities
Other Property
Alternate
Assumptions
Grantor
Grantee
Grantor
Grantee
1. Two years
later, Tina sells
the option to Fred
for $3,000.
No effect
($2,000)
Long-term
capital loss
No effect
($2,000)
Long-term
capital loss
Chapter 12, Exhibit 11a
($3,000 – $5,000)
CCH Federal Taxation Basic Principles
($3,000 – $5,000)
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Options—Example
Tax treatment
Stock and Securities
Other Property
Alternate
Assumptions
Grantor
Grantee
Grantor
Grantee
2. Two years
later, Tina sells
the option to Fred
for $8,000.
No effect
$3,000
Long-term
capital gain
($8,000 – $5,000)
No effect
$3,000
Long-term
capital gain
($8,000 – $5,000)
Chapter 12, Exhibit 11b
CCH Federal Taxation Basic Principles
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Options—Example
Tax treatment
Stock and Securities
Other Property
Alternate
Assumptions
Grantor
Grantee
Grantor
Grantee
3. One year later,
Tina sells the
option to Fred for
$8,000.
No effect
$3,000
Short-term
capital gain
($8,000 – $5,000)
No effect
$3,000
Long-term
capital gain
($8,000 – $5,000)
Chapter 12, Exhibit 11c
CCH Federal Taxation Basic Principles
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Options—Example
Tax treatment
Stock and Securities
Alternate
Assumptions
4. The option
expires on
6/30/x3.
Chapter 12, Exhibit 11d
Other Property
Grantor
Grantee
Grantor
Grantee
$5,000
Short-term
capital gain
($5,000)
Long-term
capital loss
$5,000
Ordinary
income
($5,000)
Long-term
capital loss
CCH Federal Taxation Basic Principles
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Options—Example
Tax treatment
Stock and Securities
Other Property
Alternate
Assumptions
Grantor
Grantee
Grantor
Grantee
5. Tina exercises
the option on
6/30/x1.
$105,000
amount
realized
$105,000 basis
$105,000
amount realized
$105,000 basis
Chapter 12, Exhibit 11e
CCH Federal Taxation Basic Principles
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Options—Example
Tax treatment
Stock and Securities
Alternate
Assumptions
Grantor
Grantee
6. Same facts as 5, $95,000 basis
$95,000
except Tina is
amount realized
paying for the
option to sell, not
buy, the property.
Chapter 12, Exhibit 11f
Other Property
Grantor
Grantee
$95,000 basis
$95,000
amount realized
CCH Federal Taxation Basic Principles
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Subdivided Real Estate Sold by Investors
Qualifying Property
To qualify for capital gains treatment, three requirements must
be met:
1. The subdivided lots must not have been previously held
primarily for sale to customers in the ordinary course of
business
2. The subdivided lots have not been “substantially
improved”
3. The subdivided lots must be held for at least 5 years
Chapter 12, Exhibit 12a
CCH Federal Taxation Basic Principles
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Subdivided Real Estate Sold by Investors
Substantial Improvements
Improvements such as infrastructure are substantial if they
increase the value of the lots by over 10%. However, certain
costs are deemed NEVER to be “substantial improvements.”
Examples include: surveying, clearing drainage, and minimum
all-weather access roads.
Chapter 12, Exhibit 12b
CCH Federal Taxation Basic Principles
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Subdivided Real Estate Sold by Investors
Tax Treatment for the First 5 Lot Sales. Gains on the first 5 lots sold receive
capital treatment. Losses are ALWAYS ordinary.
Tax Treatment for Gains on Subsequent Lot Sales. Gains receive BOTH
capital and ordinary treatment, beginning in the year in which the 6th lot is
sold, using the following formula:
Tax treatment for GAINS after the fifth lot sale
(a)
Ordinary treatment
(5% SP) – (100% selling exp.)
(b)
Capital treatment
Total gain – (a)
Chapter 12, Exhibit 12c
CCH Federal Taxation Basic Principles
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Worthless Securities
Tax Treatment. Generally capital. However, if held by a dealer, then
ordinary.
Holding Period. The holding period for worthless securities begins on the
day after the acquisition date and ends on the LAST DAY OF THE YEAR
in which the securities are deemed to be worthless.
Example
Purchase date
Worthless date
Holding period
beginning date?
Holding period
end. date?
Long-term or
Short-term?
12/31/x1
12/31/x2
1/1/x2
12/31/x2
Short-term
12/30/x1
1/1/x2
12/31/x1
12/31/x2
Long term
Chapter 12, Exhibit 13
CCH Federal Taxation Basic Principles
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Depreciation Recapture—Example 1
Example 1
FACTS:
1. A taxpayer has $2 million of gross income in year 1.
2. The taxpayer purchases a machine for $800,000 and depreciates it for
$500,000 in year 1.
3. The machine is sold in year 2 for $1 million.
4. The taxpayer’s capital gains rate is 20%; the ordinary tax rate is 40%.
(Actual tax brackets, actual MACRS depreciation computations, and
deductions “from” AGI are ignored for purposes of simplifying this
illustration.)
QUESTION:
Compare the results in years 1 and 2 with and without depreciation.
Chapter 12, Exhibit 14a
CCH Federal Taxation Basic Principles
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Depreciation Recapture—Example 1
Year 1
Tax “Benefit” from Depreciation Deduction
With
Depreciation
Gross Income
Without
Depreciation
$2,000
$2,000
$500
$0
$1,500
$2,000
Ordinary Tax Rate
40%
40%
Ordinary Income Tax
$600
$800
Depreciation, Year 1
Taxable Income
Tax Benefit from
Depreciation
Chapter 12, Exhibit 14b
200
($800 – $600); or ($500 x 40%)
CCH Federal Taxation Basic Principles
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Depreciation Recapture—Example 1
Year 2
Tax “Burden” from Depreciation Adjustment to Basis
With
Without
Depreciation
Depreciation
Sales Price
Cost of Machine
Less: Accumulated Depreciation
Adjusted Basis
Realized Gain
Capital Gain Tax Rate
Capital Gain Tax (Ignoring
Depreciation Recapture)
Tax Burden From Depreciation,
Absent Any Depreciation Recapture
Chapter 12, Exhibit 14c
$1,000
$1,000
$800
$500
$300
$700
$800
$0
$800
$200
20%
$140
20%
$40
$100
($140 – $40); or ($500 x 20%)
CCH Federal Taxation Basic Principles
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Depreciation Recapture—Example 1
Observation: Overall tax advantage from depreciation if
depreciation is not recaptured: $100 ($200 benefit in year 1,
minus $100 tax burden in year 2.)
Chapter 12, Exhibit 14d
CCH Federal Taxation Basic Principles
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Depreciation Recapture—Example 2
Rationale for Recapture Rules
The foregoing illustration demonstrates how unrecaptured
depreciation would create an overall tax advantage—this,
despite a reduced basis equivalent to the amount of
accumulated depreciation deductions. The overall advantage
was eliminated in the early 1960s with the enactment of the
depreciation recapture rules. The depreciation recapture
rules recharacterize capital gains as ordinary income to the
extent of all or a portion of accumulated depreciation. Using
the facts from Example 1, the following example shows how
the recapture rules work.
Chapter 12, Exhibit 15a
CCH Federal Taxation Basic Principles
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Depreciation Recapture—Example 2
Example 2
Year 2: Sale of the Machinery
Sales Price
$1,000
Cost of Machine
$800
Less: Accumulated Depreciation
$500
Adjusted Basis
$300
Realized Gain
$700
Chapter 12, Exhibit 15b
CCH Federal Taxation Basic Principles
52 of 92
Depreciation Recapture—Example 2
With
Depreciation Recapture
Without
Depreciation Recapture
Code Sec.
1245
(Ordinary)
Code Sec.
1231
(Capital)
(Capital)
Recharacterized Gain
$500
$200
$700
Ordinary/Capital Tax Rates
40%
20%
20%
Tax
$200
$40
$140
Total Tax
Additional taxes attributable to
Depreciation Recapture
Chapter 12, Exhibit 15c
$240
$140
$100
($240 – $140)
CCH Federal Taxation Basic Principles
53 of 92
Depreciation Recapture—Example 2
Observation: The $100 additional taxes offsets the $100 tax
advantage that would have resulted if depreciation had not
been recaptured.
Chapter 12, Exhibit 15d
CCH Federal Taxation Basic Principles
54 of 92
Business Asset Dispositions—
Template for Problem Solving
Category
#/Description
(1) Gains on
all depreciable
personal
property.
Chapter 12, Exhibit 16a
Code Sec.
1245
Depreciation
Recapture
(a)
Code Sec. 1250
Depreciation
Recapture
38.6% Basket
(Always
Ordinary
Income)
38.6% Basket
(Always Ordinary
Income)
Lesser of:
1. Accumulated
depreciation, or
2. Realized
gain.
N/A
Code Sec. 1231 Gain/Loss
(Send to 2nd Netting)
(b)
(c)
(d)
25% Basket
20% Basket
(for
(for any
unrecaptured remaining gain or
Code Sec. 1250
any loss)
Gain)
N/A
[Realized gain –
(a)]
CCH Federal Taxation Basic Principles
55 of 92
Business Asset Dispositions—
Template for Problem Solving
Category
#/Description
Code Sec. 1245
Depreciation
Recapture
Code Sec. 1250
Depreciation
Recapture
(a)
(b)
38.6% Basket
(Always Ordinary
Income)
Code Sec. 1231 Gain/Loss
(Send to 2nd Netting)
(c)
38.6% Basket
25% Basket
(For
(Always Ordinary
unrecaptured
Income)
Sec. 1250
Gain)
(2) Gains on nonresidential real
property acquired
1981-1986, with
ACRS
depreciation.
Chapter 12, Exhibit 16b
Lesser of:
1. Accumulated
depreciation, or
2. Realized gain.
N/A
CCH Federal Taxation Basic Principles
N/A
(d)
20% Basket
(For any
remaining
gain or any
loss)
[Realized
gain – (a)]
56 of 92
Business Asset Dispositions—
Template for Problem Solving
Category
#/Description
(3) Gains on
residential and nonresidential real
property acquired
after 1986.
Code Sec.
1245
Depreciation
Recapture
(a)
Code Sec. 1250
Depreciation
Recapture
Code Sec. 1231 Gain/Loss
(Send to 2nd Netting)
(b)
(c)
(d)
38.6%
Basket
(Always
Ordinary
Income)
38.6% Basket
(Always Ordinary
Income)
25% Basket
(For
unrecaptured
Code Sec. 1250
Gain)
20% Basket
(For any
remaining
gain or any
loss)
N/A
Lesser of:
1. Actual accumulated
depreciation – straightline accumulated
depreciation,* or
2. Realized gain
Lesser of:
1. Straight-line
accumulated
depreciation
2. Realized gain – (b)
[Realized gain
– (b) – (c)]
[Note that (b)
= 0]
* (always 0 for individuals since actual accumulated depreciation = straight-line accumulated depreciation)
Chapter 12, Exhibit 16c
CCH Federal Taxation Basic Principles
57 of 92
Business Asset Dispositions—
Template for Problem Solving
Category
#/Description
(4) Gains on
residential real
property
acquired 19811986, with
ACRS
depreciation.
Chapter 12, Exhibit 16d
Code Sec. 1245
Depreciation
Recapture
Code Sec. 1250
Depreciation
Recapture
(a)
(b)
38.6% Basket
(Always
Ordinary
Income)
38.6% Basket
(Always
Ordinary
Income)
N/A
Lesser of:
1.Actual accumulated
depreciation – straightline accumulated
depreciation; or
2. Realized gain
Code Sec. 1231 Gain/Loss
(Send to 2nd Netting)
(c)
(d)
25% Basket
20% Basket
(For
(For any
unrecaptured remaining gain or
Code Sec.
any loss)
1250 Gain)
Lesser of:
[Real gain – (b) –
1. Straight-line (c)]
accumulated
depreciation
2. Realized gain
– (b)
CCH Federal Taxation Basic Principles
58 of 92
Business Asset Dispositions—
Template for Problem Solving
Code Sec. 1245
Depreciation
Recapture
(a)
Category
#/Description
(5) Gains on
non-residential
real property
acquired 19811986, with
straight-line
depreciation.
Chapter 12, Exhibit 16e
38.6% Basket
(Always
Ordinary
Income)
N/A
Code Sec. 1250
Depreciation
Recapture
(b)
Code Sec. 1231 Gain/Loss
(Send to 2nd Netting)
(c)
(d)
25% Basket
20% Basket
(For unrecaptured (For any remaining
Code Sec. 1250
gain or any loss)
Gain)
Lesser of:
Lesser of:
[Real gain – (b) –
1. Actual accumulated 1. Straight-line
(c)]
depreciation –
accumulated
[Note that (b) = 0]
straight-line
depreciation
accumulated
2. Realized gain –
depreciation; or
(b).
2. Realized gain
38.6% Basket
(Always Ordinary
Income)
CCH Federal Taxation Basic Principles
59 of 92
Business Asset Dispositions—
Template for Problem Solving
Code Sec. 1245 Code Sec. 1250
Depreciation
Depreciation
Recapture
Recapture
(a)
(b)
Category
#/Description
(6) Gains on
amortizable
personal property
used in business
(e.g., patents,
copyrights,
leaseholds).
Chapter 12, Exhibit 16f
Code Sec. 1231 Gain/Loss
(Send to 2nd Netting)
(c)
(d)
20% Basket
(For any
remaining gain or
any loss)
38.6% Basket
(Always
Ordinary
Income)
38.6% Basket
(Always
Ordinary
Income)
25% Basket
(For
unrecaptured
Code Sec.
1250 Gain)
Lesser of:
1. Accumulated
amortization or
2. Realized gain
N/A
N/A
CCH Federal Taxation Basic Principles
[Real gain – (a)]
60 of 92
Business Asset Dispositions—
Template for Problem Solving
Category
#/Description
(7) All losses
on any longterm business
assets.
Chapter 12, Exhibit 16g
Code Sec.
1245
Depreciation
Recapture
Code Sec. 1250
Depreciation
Recapture
(a)
(b)
38.6% Basket
(Always
Ordinary
Income)
38.6% Basket
(Always Ordinary
Income)
N/A
N/A
Code Sec. 1231 Gain/Loss
(Send to 2nd Netting)
(c)
(d)
25% Basket
20% Basket
(For
(For any
unrecaptured remaining gain or
Code Sec. 1250
any loss)
Gain)
CCH Federal Taxation Basic Principles
N/A
100% losses are
Code Sec. 1231.
61 of 92
Business Asset Dispositions—
Template for Problem Solving
Category
#/Description
(8) G/L on
sale of shortterm business
assets.
Chapter 12, Exhibit 16h
Code Sec.
1245
Depreciation
Recapture
Code Sec. 1250
Depreciation
Recapture
(a)
(b)
38.6% Basket
(Always
Ordinary
Income)
38.6% Basket
(Always Ordinary
Income)
Code Sec. 1231 Gain/Loss
(Send to 2nd Netting)
(c)
(d)
25% Basket
20% Basket
(For
(For any
unrecaptured remaining gain or
Code Sec. 1250
any loss)
Gain)
100% ordinary. (Short-term gains or losses on business property are
neither Code Sec. 1231, 1245, nor 1250.)
CCH Federal Taxation Basic Principles
62 of 92
Business Asset Dispositions—Example 1
FACTS:
David, a 38.6% taxpayer, purchases a building in 1988 for
$390,000. He takes $90,000 of depreciation using the
straight-line method. On October 15, 20x1, he sells the
building for $440,000.
QUESTION:
How much taxes are attributable to the sale?
Chapter 12, Exhibit 17a
CCH Federal Taxation Basic Principles
63 of 92
Business Asset Dispositions—Example 1
Computation of Taxes on Code Sec. 1250 and Code Sec. 1231 Gains
Code Sec. 1245
Depreciation
Recapture
Code Sec. 1250
Depreciation
Recapture
(a)
(b)
(c)
38.6% Basket
(Always Ordinary
Income)
25% Basket
(for unrecaptured
Code Sec. 1250
Gain)
20% Basket
(for any
remaining
gain or any
loss)
Lesser of:
1. Actual accumulated
depreciation – straightline accumulated
depreciation,* or
2. Realized gain
Lesser of:
1. Straight-line
accumulated
depreciation
2. Realized gain –
[Realized gain
– (b) – (c)]
Category #/
Type of Gain
# 3/Gains on
residential and
non-residential
real property
acquired after
1986.
N/A
Code Sec. 1231 Gain/Loss
(Sent to 2nd Netting)
(d)
[Note that (b)
= 0]
(b).
* (always 0 for individuals since actual accumulated depreciation = straight-line accumulated depreciation)
Chapter 12, Exhibit 17b
CCH Federal Taxation Basic Principles
64 of 92
Business Asset Dispositions—Example 1
Computation of Taxes on Code Sec. 1250 and Code Sec. 1231 Gains
Category #/
Type of Gain
Computation of realized gain:
Sale Price…. ……...$440,000
Cost ……….………$390,000
Straight-line depr...... $90,000
Adjusted basis……..$300,000
Realized gain……...$140,000
Tax rates
Tax amount ($32,500 total)
Chapter 12, Exhibit 17c
Code Sec.
1245
Depreciation
Recapture
Code Sec. 1250
Depreciation
Recapture
(a)
(b)
(c)
(d)
38.6% Basket
(Always
Ordinary
Income)
25% Basket
(for unrecaptured
Code Sec. 1250
Gain)
20% Basket
(for any
remaining gain
or any loss)
$0
The lesser of :
1. 0 = $90,000 –
$90,000
2. $140,000
Code Sec. 1231 Gain/Loss
(Sent to 2nd Netting)
$90,000
Lesser of
1. $90,000, or
2. $140,000 – 0
$50,000
[$140,000 – 0 –
$90,000]
38.6%
25%
20%
0
$22,500
$10,000
CCH Federal Taxation Basic Principles
65 of 92
Business Asset Dispositions—Example 2
FACTS:
Conor, a 38.6% taxpayer, purchased an apartment building in
1986 for $390,000. He had taken $99,000 of ACRS
depreciation. Straight-line depreciation would have been
$90,000. On October 15, 19x1, he sells the building for
$440,000.
QUESTION:
What are his taxes on the transaction?
Chapter 12, Exhibit 18a
CCH Federal Taxation Basic Principles
66 of 92
Business Asset Dispositions—Example 2
Computation of Taxes on Code Sec. 1250 and Code Sec. 1231 Gains
Code Sec.
1245
Depreciation
Recapture
Code Sec. 1250
Depreciation
Recapture
(a)
(b)
Category #/
Type of Gain
# 4 /Gains on residential
real property acquired
1981-1986, with ACRS
depreciation.
Chapter 12, Exhibit 18b
38.6% Basket
(Always Ordinary
Income)
N/A
Lesser of:
1. Actual accumulated
depreciation – straightline accumulated
depreciation; or
2. Realized gain
CCH Federal Taxation Basic Principles
Code Sec. 1231 Gain/Loss
(Send to 2nd Netting)
(c)
25% Basket
(For unrecaptured
Code Sec. 1250
Gain)
Lesser of:
1. Straight-line
accumulated
depreciation
2. Realized gain –
(b).
(d)
20% Basket
(For any
remaining
gain or any
loss)
[Real gain –
(b) – (c)]
67 of 92
Business Asset Dispositions—Example 2
Computation of Taxes on Code Sec. 1250 and Code Sec. 1231 Gains
Code Sec. 1250
Code Sec.
Depreciation
1245
Recapture
Depreciation
Recapture
(a)
Code Sec. 1231 Gain/Loss
(Send to 2nd Netting)
(b)
(c)
(d)
Category #/
Type of Gain
38.6% Basket
(Always Ordinary
Income)
Computation of realized gain:
Sale Price…….....…$440,000
Cost ………….....…$390,000
ACRS depr................ $99,000
Adjusted basis .. ......$291,000
Realized gain …......$149,000
$9,000
The lesser of :
1. $9,000 =
$99,000 –
$90,000
2. $149,000
25% Basket
(For unrecaptured
Code Sec. 1250
Gain)
$90,000
Lesser of
1. $90,000, or
2. $149,000 –
$9,000
20% Basket
(For any
remaining gain
or any loss)
$50,000
[$149,000 –
$9,000 –
$90,000]
Rate baskets
38.6%
25%
20%
Tax amount ($36,064 total)
$3,474
$22,500
$10,000
Chapter 12, Exhibit 18c
CCH Federal Taxation Basic Principles
68 of 92
The First Netting—Capital Gains and Losses
Offset Gains and Losses Within Each Basket
Offset capital gains and losses within each basket (i.e., the
10%, 15%, 20%, and 28% baskets). (The 25% basket is not
listed here because it holds only gains, never losses. Why no
losses? Because the 25% basket applies only to that portion
of Code Sec. 1231 gain attributable to unrecaptured Code
Sec. 1250 depreciation.)
Chapter 12, Exhibit 19a
CCH Federal Taxation Basic Principles
69 of 92
The First Netting—Capital Gains and Losses
Offset Gains and Losses from Separate Baskets
If, after step 1, there are opposites (i.e., one or more baskets
has a net gain and one or more a net loss), then the gains and
losses must be further offset. The pecking order in selecting
“net gain” and “net loss” baskets to offset is as follows.
Chapter 12, Exhibit 19b
CCH Federal Taxation Basic Principles
70 of 92
The First Netting—Capital Gains and Losses
Pecking Order of Baskets Selected For The First Netting
“Net gain baskets” to be offset against “net Start with short-term capital gains (might
loss baskets”
be as high as the 38.6% bracket), then
long-term capital gains beginning with the
highest-rate baskets holding net gains (i.e.,
28%, then 20%, then 15%, then 10%).
“Net loss baskets” to be offset against “net Start with short-term capital losses (might
gain baskets”
be as high as the 38.6% bracket), then
long-term capital losses beginning with the
highest-rate baskets holding net losses (i.e.,
28%, then 20%, then 15%, then 10%).
Chapter 12, Exhibit 19c
CCH Federal Taxation Basic Principles
71 of 92
The First Netting—Example 1
FACTS: Fred reports the following gains and losses:
Holding Period
Basket
Amount
Long-Term
15%
$2,000 gain
Long-Term
20%
$7,000 gain; ($4,000) loss
Long-Term
28%
$1,000 gain
Short-Term
38.6%
$4,000 gain; ($7,000) loss
QUESTION: How is the first netting performed?
Chapter 12, Exhibit 20a
CCH Federal Taxation Basic Principles
72 of 92
The First Netting—Example 1
Two-Step Solution
STEP 1: Offset Gains and Losses Within Each Basket
Basket
Result after 1st Netting
15%
Net Amount Within
Each Basket
$2,000 gain
$2,000 LTCG at 15%*
20%
$3,000 net gain
$1,000 LTCG at 20%*
28%
$1,000 gain
$0
38.6%
($3,000) net loss
$0
* These rates are only relevant if the Long-Term Capital Gains survive the 2nd netting.
Chapter 12, Exhibit 20b
CCH Federal Taxation Basic Principles
73 of 92
The First Netting—Example 1
Two-Step Solution
STEP 2: Offset Gains and Losses From Separate Baskets
The $3,000 net loss from the 38.6% basket is first used to
offset the $1,000 gain from the 28% basket; then $2,000 of
the $3,000 net gain from the 20% basket. The result of the 1st
netting is a $1,000 long-term capital gain subject to a 20%
rate and a $2,000 long-term capital gain subject to a 15% rate
(if they survive the second netting).
Chapter 12, Exhibit 20c
CCH Federal Taxation Basic Principles
74 of 92
The First Netting—Example 2
FACTS: Wilma reports the following gains and losses:
Holding Period
Basket
Amount
Long-Term
10%
($6,000) loss
Long-Term
20%
$4,000 gain; ($7,000) loss
Long-Term
28%
$4,000 gain
Short-Term
38.6%
$7,000 gain; ($3,000) loss
QUESTION: How is the first netting performed?
Chapter 12, Exhibit 21a
CCH Federal Taxation Basic Principles
75 of 92
The First Netting—Example 2
Two-Step Solution
STEP 1: Offset Gains and Losses Within Each Basket
Basket
Result after 1st Netting
10%
Net Amount Within
Each Basket
($6,000) loss
20%
28%
($3,000) net loss
$4,000 gain
($1,000) long-term capital
loss subject to ordinary
loss treatment if it survives
the second netting
0 net loss
0 net gain
38.6%
$4,000 net gain
0 net gain
Chapter 12, Exhibit 21b
CCH Federal Taxation Basic Principles
76 of 92
The First Netting—Example 2
Two-Step Solution
STEP 2: Offset Gains and Losses From Separate Baskets
The $4,000 net gain from the 38.6% basket is first netted
against the ($3,000) loss from the 20% basket, then against
($1,000) of the ($6,000) loss from the 10% basket. Next, the
$4,000 gain from the 28% basket is netted against ($4,000) of
the remaining ($5,000) loss from the 10% basket. The result
of the 1st netting is a ($1,000) long-term capital loss within the
10% basket. This long-term capital loss, as with all long- and
short-term capital losses not exceeding $3,000, is treated as an
ordinary loss if it survives the 2nd netting.
Chapter 12, Exhibit 21c
CCH Federal Taxation Basic Principles
77 of 92
The First Netting—Personal-Use Casualty/Theft
Gains/Losses
Combine casualty/theft gains and losses less $100 per event, on
personal-use property.

If a net gain, both gains and losses are capital. Transfer the net gain
to the second netting. Recall that the losses had been reduced by
$100 per event but NOT by the 10% AGI floor.

If a net loss, the net amount is treated as an ordinary itemized
deduction, having been reduced by $100 per event AND to be further
reduced by the 10% AGI floor. (No need to transfer to the second
netting; rather, report on Schedule A.)
Chapter 12, Exhibit 22
CCH Federal Taxation Basic Principles
78 of 92
The First Netting—Business/Investment Use
Casualty/Theft Gains/Losses
Combine casualty/theft gains and losses on business and PI property
held long-term. (If the holding period is short-term, the gain or losses
get ordinary treatment and are NOT part of the netting process.)

If a net gain, then treat the net amount as a Code Sec. 1231 gain and
transfer it to the second netting.

If a net loss, then treat the net amount as an ordinary deduction for
AGI. (No need to transfer to the second netting; rather, report on
Schedule C.)
Chapter 12, Exhibit 23
CCH Federal Taxation Basic Principles
79 of 92
The First Netting—Personal-Use Condemnation
Gains/Losses
Long-term gains receive capital treatment; short-term gains
receive ordinary treatment; losses are not deductible.
Transfer any personal-use condemnation long-term gains to
the second netting.
Chapter 12, Exhibit 24
CCH Federal Taxation Basic Principles
80 of 92
The First Netting—Business/Investment-Use
Condemnation Gains/Losses
Long-term gains and losses BOTH get Code Sec. 1231
treatment. (Code Sec. 1231 gains get capital tax rates;
Code Sec. 1231 losses are deductible at ordinary tax rates.
Also, note the difference in tax treatment for (1)
business/investment casualty/theft net losses and (2)
business/investment condemnation losses. Transfer the
Code Sec. 1231 condemnation gains and losses to the
second netting.)
Chapter 12, Exhibit 25
CCH Federal Taxation Basic Principles
81 of 92
The First Netting—Long-Term Business Assets
Upon the sale of a long-term business asset, any gain
remaining after Code Sec. 1245 or Code Sec. 1250
depreciation recapture is a Code Sec. 1231 gain. Any loss is
a Code Sec. 1231 loss. Transfer both Code Sec. 1231 gains
and losses to the second netting.
(Note that gains or losses on the sale of short-term business
assets are always ordinary. No need to transfer to the second
netting.)
Chapter 12, Exhibit 26
CCH Federal Taxation Basic Principles
82 of 92
The First Netting—Recap
Capital Gains and Losses
Code Sec. 1231
Description
10%
20%
25%
Capital gains
& losses
Personal
casualty net
gain
15%
20%
28%
Net gain
“38.6%”
Gains or losses
Net gain
Net losses, from AGI,
reduced $100 per event
& 10% AGI (if net loss)
Net losses, for
AGI
Net gain
Personal-use
condemnation
gains & losses
Net totals for
2nd Netting
10%
Short-term
Gains or losses
Bus./inv.
Casualty net
gain
Bus./inv.
Condemnation
G/L
L-T business
asset G/L
Long-term
(This column is
not part of the
netting process.)
Always Ordinary
Income
Gains (losses not deductible)
Gains (losses
not deductible)
Gains and losses
Code Sec. 1245 and
1250 recaptured as
ordinary income
Gains, net of depr.
Recap.; losses
Net Gain or Loss
10%
Chapter 12, Exhibit 27
20%
25%
Net Gain or Loss
10%
15%
20%
Net gain or loss
“38.6%”
28%
CCH Federal Taxation Basic Principles
N/A for netting
83 of 92
The Second Netting—Examples
QUESTION: For each independent set of gains and losses below, determine the tax treatment after
the second netting.
Rate Basket for
Rate Basket for Capital Gains and Losses
Code Sec. 1231 G/L’s
Problem
#1
Gains
(Losses)
Solution
Long-Term
Short-Term
20%
25%
20%
28%
($7,000)
$3,000
$7,000
($3,000)
($4,000), i.e.,
($3,000) is offset
against the “25%
Code Sec. 1231
basket”
(Code Sec. 1231
losses may not be
offset against
capital gains)
Chapter 12, Exhibit 28a
$4,000, i.e.,
$3,000 offsets the
“28% LTCL
basket”
(Capital gains may
not be offset
against Code Sec.
1231 losses)
CCH Federal Taxation Basic Principles
84 of 92
The Second Netting—Examples
QUESTION: For each independent set of gains and losses below, determine the tax treatment after
the second netting.
Rate Basket for
Rate Basket for Capital Gains and Losses
Code Sec. 1231 G/L’s
Long-Term
Short-Term
Problem
#2
20%
25%
20%
28%
Gains
(Losses)
($7,000)
$3,000
($18,000)
$3,000
Solution
($4,000)
ordinary loss
deduction
0
0
Chapter 12, Exhibit 28b
CCH Federal Taxation Basic Principles
$21,000
$6,000 net STCG,
taxed at ordinary rate
85 of 92
The Second Netting—Examples
QUESTION: For each independent set of gains and losses below, determine the tax treatment after
the second netting.
Rate Basket for
Rate Basket for Capital Gains and Losses
Code Sec. 1231 G/L’s
Long-Term
Short-Term
Problem
#3
20%
25%
20%
28%
Gains
(Losses)
($7,000)
$3,000
$19,000
$3,000
Solution
($4,000)
ordinary loss
deduction
0
0
0
Chapter 12, Exhibit 28c
CCH Federal Taxation Basic Principles
($27,000)
 ($3,000) ordin.
loss deduction;
 ($2,000) STCL
carryover
86 of 92
The Second Netting—Examples
QUESTION: For each independent set of gains and losses below, determine the tax treatment after
the second netting.
Rate Basket for
Rate Basket for Capital Gains and Losses
Code Sec. 1231 G/L’s
Long-Term
Short-Term
Problem
#4
20%
25%
20%
28%
Gains
(Losses)
$7,000
($3,000)
$18,000
($3,000)
($21,000)
Solution
0
(Code Sec.
1231 gains
offset capital
losses, first
from the
highest LTCL
basket, then
from STCLs!)
0
0
0
($2,000) ordinary
loss deduction
($21,000 - $19,000)
($19,000 = $18,000
+ $4,000 - $3,000)
Chapter 12, Exhibit 28d
CCH Federal Taxation Basic Principles
87 of 92
The Second Netting—Recap of the Rules
To complete the second netting, follow these steps:
1. Net each category by totaling the columns.
2. If the long-term capital column still shows a gain after offsetting any net shortterm capital losses (STCLs) treat the net amount as a net long-term capital gain
(LTCG) subject to a maximum 10%, 15%, 20%, or 28% tax rate, depending on
which basket survives the netting.
3. If the short-term capital column still shows a gain after offsetting any net LTCLs,
treat the net amount as a net STCG subject to the ordinary marginal tax rate.
4. If the Code Sec. 1231 column total shows a net loss, treat the net amount as an
ordinary loss, deductible for AGI, without the $3,000 limitation. Do not offset it
against net long-term or short-term capital gains.
5. If the Code Sec. 1231 column total shows a net gain:
Treat as ordinary income to the extent of Code Sec. 1231 net losses for the
previous five years that have not been recaptured. (Refer to the example
regarding 5-Year Look-Back Rules in the following slide.)
Chapter 12, Exhibit 29a
CCH Federal Taxation Basic Principles
88 of 92
The Second Netting—Recap of the Rules
Example on the 5-Year Look-Back Rules
QUESTION: Given the following facts, how much of the Code Sec. 1231 gains in 20x3
and 20x6 should be recharacterized as ordinary income?
20x1
20x2
20x3
20x4
20x5
20x6
Code Sec. 1231 G/L before (10,000) (20,000)
40,000 (10,000) (30,000) 50,000
look-back
Recharacterized as
ordinary income






10,000

20,000

30,000
10,000

30,000

40,000
Surviving Code Sec. 1231
10,000
10,000
gain treated as L-T capital
gain
(b) If any Code Sec. 1231 gain survives, offset it against any net LTCLs, starting with the
highest baskets containing LTCLs.
(c) If a Code Sec. 1231 gain still survives, offset it against any net STCLs.
(d) If yet a Code Sec. 1231 gain survives, treat it as a long-term capital gain, subject to a
maximum 25% tax rate.
Chapter 12, Exhibit 29b
CCH Federal Taxation Basic Principles
89 of 92
The Second Netting—Recap of the Rules
If LTCLs or STCLs survive after netting with Code Sec.
1231 gains, first treat STCLs as ordinary losses, limited to
$3,000. If any part of the $3,000 remains, treat any LTCLs
as ordinary to the extent of the remainder (starting with the
highest basket). Unused STCLs and LTCLs are carried
forward indefinitely.
Chapter 12, Exhibit 29c
CCH Federal Taxation Basic Principles
90 of 92
Applying the $3,000 Capital Loss Limitation
Only $3,000 may be deducted each year for the aggregate
of “net” short-term and “net” long-term capital losses.
Short-term capital losses (STCLs) are used up first, then
long-term capital losses (LTCLs) beginning with the
highest LTCL “baskets.” Note that STCLs and LTCLs get
“ordinary” treatment to the extent of the $3,000 deduction
noted above. Any remaining capital losses (i.e., in excess
of $3,000) are carried over. However, also note that STCLs
and LTCLs on the sale of personal use property such as a
principal residence or a car used for commuting, are
NEVER deductible, and NEVER carried forward!
Chapter 12, Exhibit 30a
CCH Federal Taxation Basic Principles
91 of 92
Applying the $3,000 Capital Loss Limitation
Pecking Order of Loss “Baskets”
Deductible against ordinary income, limited to:
(a)
Short-Term Capital Losses
$3,000
(b)
LTCLs, 28% Basket
$3,000 – (a)
(c)
LTCLs, 20% Basket
$3,000 – (a) – (b)
(d)
LTCLs, 15% Basket
$3,000 – (a) – (b) – (c)
(e)
LTCLs, 10% Basket
$3,000 – (a) – (b) – (c) – (d)
Note that there is no 25% basket for losses since this basket applies only to the portion
of Code Sec. 1231 gain attributable to unrecaptured Code Sec. 1250 depreciation.
Chapter 12, Exhibit 30b
CCH Federal Taxation Basic Principles
92 of 92