IV. Federal Taxation of Property Transactions (12% - 16%)
A. Types of Assets
Current assets are cash and other assets expected to be converted to cash, sold, or consumed either in a year
or in the operating cycle (whichever is shorter), without disturbing the normal operations of a business. These
assets are continually turned over in the course of a business during normal business activity. There are 5 major
items included into current assets:
1. Cash and cash equivalents — it is the most liquid asset, which includes currency, deposit accounts,
and negotiable instruments (e.g., money orders, cheque, bank drafts).
2. Short-term investments — include securities bought and held for sale in the near future to generate
income on short-term price differences (trading securities).
3. Receivables — usually reported as net of allowance for uncollectable accounts.
4. Inventory — trading these assets is a normal business of a company. The inventory value reported on
the balance sheet is usually the historical cost or fair market value, whichever is lower. This is known as
the "lower of cost or market" rule.
5. Prepaid expenses — these are expenses paid in cash and recorded as assets before they are used or
consumed (a common example is insurance). See also adjusting entries.
Securities that can be converted into cash quickly at a reasonable price
The phrase net current assets (also called working capital) is often used and refers to the total of current assets
less the total of current liabilities.
Often referred to simply as "investments". Long-term investments are to be held for many years and are not
intended to be disposed of in the near future. This group usually consists of three types of investments:
1. Investments in securities such as bonds, common stock, or long-term notes.
2. Investments in fixed assets not used in operations (e.g., land held for sale).
3. Investments in special funds (e.g. sinking funds or pension funds).
Different forms of insurance may also be treated as long term investments.
Also referred to as PPE (property, plant, and equipment), these are purchased for continued and long-term use
in earning profit in a business. This group includes as an asset land, buildings,machinery, furniture, tools, and
certain wasting resources e.g., timberland and minerals. They are written off against profits over their
anticipated life by charging depreciation expenses (with exception of land assets). Accumulated depreciation is
shown in the face of the balance sheet or in the notes.
These are also called capital assets in management accounting.
Intangible assets lack of physical substance and usually are very hard to evaluate. They
include patents, copyrights, franchises, goodwill, trademarks, trade names, etc. These assets are (according to
US GAAP) amortized to expense over 5 to 40 years with the exception of goodwill.
Websites are treated differently in different countries and may fall under either tangible or intangible assets.
Tangible assets are those that have a physical substance and can be touched, such
as currencies, buildings, real estate, vehicles, inventories, equipment, and precious metals.
B. Basis and Holding Periods of Assets
Basis (or cost basis), as used in United States tax law, is the original cost of property, adjusted for factors such
as depreciation. When property is sold, the taxpayer pays/(saves) taxes on a capital gain/(loss) that equals the
amount realized on the sale minus the sold property's basis.
The taxpayer deserves a tax-free "recovery" of the cost of acquiring a capital asset, because this cost is
analogous to a "business expense" used to acquire income. This recovery is postponed to the year of
disposition because of a further analogy to the accrual accounting principle of matching expenses to revenues:
disposing of property will deprive the taxpayer of a valuable asset, leaving a "hole" that should be filled by some
form of tax-free recovery. The size of this "hole" is set to equal that asset's original cost, but doing so is not
logically necessary; rather, it arises from the administrative decision to levy income tax on asset appreciation at
the moment of sale, rather than as it appreciates (in which case, basis would equal amount realized and there
would be no tax at disposition -- since appreciation taxes were levied by constant assessments).
IRS Publication 551 contains the IRS's definition of basis: "Basis is the amount of your investment in property for
tax purposes. Use the basis of property to figure depreciation, amortization, depletion, and casualty losses. Also
use it to figure gain or loss on the sale or other disposition of property."
For federal income taxation purposes, determining basis depends on how the asset in question was acquired.
Assets acquired by purchase or contract: For assets purchased or acquired contractually, the basis equals
the purchase price. See IRC (Internal Revenue Code) § 1012.
Assets acquired by gift or trust: The general rule is that assets acquired by gift or trust receive transferred
basis (also called carryover basis). See IRC § 1015. Put simply, gifted assets retain the donor's basis. This
means that the value of the asset at the time of transfer is irrelevant to computing the donee's new basis. The
general rule does not apply, however, if at the time of transfer the donor's adjusted basis in the property
exceeds its fair market value and the recipient disposes of the property at a loss. In this situation the asset's
basis is its fair market value at the time of transfer. See Treas. Reg. § 1.1015-1(a)(1).
Assets acquired by inheritance: Assets acquired by inheritance receive stepped-up basis, meaning the fair
market value of the asset at the time of the decedent's death. See IRC § 1014. This provision shields the
appreciation in value of the asset during the life of the decedent from any income taxation whatsoever.
Adjusted basis: An asset's basis can increase or decrease depending on changes that occur throughout its
lifetime. For this reason, IRC § 1001(a) provides that computing gain requires determining the amount realized
from the sale or disposition of property minus the adjusted basis. Capital improvements (such as adding a
deck to your house) increase the asset's basis while depreciation deductions (statutory deductions that
reduce the taxpayer's taxable income for a given year) diminish the asset's basis. Another way of viewing
adjusted basis is to think of the asset as a saving's account, with capital improvements representing deposits
and depreciation deductions representing withdrawals.
Mutual Fund Basis Methods
For mutual funds, there are 4 basis methods approved by the IRS, detailed in Publication 564:
Cost basis methods:
Specific share identification
First-in, first-out (FIFO)
Average basis methods:
Average cost single category (ACSC)
Average cost double category (ACDC)
Evaluation of methods
Specific share identification is the most record and labor intensive, as one must track all purchases and sales
and specify which share was sold on which date. It almost always allows the lowest tax bill, however, as one
has discretion on which gains to realize.
FIFO is the default method used if no other is specified, and generally results in the highest tax bill, as it sells
oldest (hence generally most appreciated) shares first.
Average cost single category is widely used by mutual funds, as it is the simplest in terms of record keeping
(only total basis need be tracked) and sale (no specifying required), and results in moderate tax.
C. Cost Recovery (Depreciation, Depletion, and Amortization)
Depreciation refers to two very different but related concepts:
1. the decline in value of assets (fair value depreciation), and
2. the allocation of the cost of assets to periods in which the assets are used (depreciation with
the matching principle).
The former affects values of businesses and entities. The latter affects net income. Generally the cost is
allocated, as depreciation expense, among the periods in which the asset is expected to be used.
Such expense is recognized by businesses for financial reporting and tax purposes. Methods of computing
depreciation may vary by asset for the same business. Methods and lives may be specified in accounting and/or
tax rules in a country. Several standard methods of computing depreciation expense may be used, including
fixed percentage, straight line, and declining balance methods. Depreciation expense generally begins when the
asset is placed in service. Example: a depreciation expense of 100 per year for 5 years may be recognized for
an asset costing 500.
In economics, depreciation is the gradual and permanent decrease in the economic value of the capital stock of
a firm, nation or other entity, either through physical depreciation, obsolescence or changes in the demand for
the services of the capital in question. If capital stock is C0 at the beginning of a period, investment is I and
depreciation D, the capital stock at the end of the period, C1, isC0 + I – D
In determining the profits (net income) from an activity, the receipts from the activity must be reduced by
appropriate costs. One such cost is the cost of assets used but not currently consumed in the activity. Such
costs must be allocated to the period of use. The cost of an asset so allocated is the difference between the
amount paid for the asset and the amount expected to be received upon its disposition. Depreciation is any
method of allocating such net cost to those periods expected to benefit from use of the asset. The asset is
referred to as a depreciable asset. Depreciation is a method of allocation, not valuation.
Any business or income producing activity using tangible assets may incur costs related to those assets. Where
the assets produce benefit in future periods, the costs must be deferred rather than treated as a current
expense. The business then records depreciation expense as an allocation of such costs for financial reporting.
The costs are allocated in a rational and systematic manner as depreciation expense to each period in which
the asset is used, beginning when the asset is placed in service. Generally this involves four criteria:
cost of the asset,
expected salvage value, also known as residual value of the asset,
estimated useful life of the asset, and
a method of apportioning the cost over such life.
Cost generally is the amount paid for the asset, including all costs related to acquisition. In some countries or for
some purposes, salvage value may be ignored. The rules of some countries specify lives and methods to be
used for particular types of assets. However, in most countries the life is based on business experience, and the
method may be chosen from one of several acceptable methods.
When a depreciable asset is sold, the business recognizes gain or loss based on net basis of the asset. This net
basis is cost less depreciation.
Accounting rules also require that an impairment charge or expense be recognized if the value of assets
declines unexpectedly. Such charges are usually nonrecurring, and may relate to any type of asset.
Depletion and amortization
Depletion and amortization are similar concepts for mineral assets (including oil) and intangible assets,
Depletion is an accounting concept used most often in mining, timber, petroleum, or other similar industries.
The depletion deduction allows an owner or operator to account for the reduction of a product's reserves.
Depletion is similar to depreciation in that, it is a cost recovery system for accounting and tax reporting. For tax
purposes, there are two types of depletion; cost depletion and percentage depletion.
For mineral property, you generally must use the method that gives you the larger deduction. For standing
timber, you must use cost depletion.
According to the IRS Newswire, over 50 percent of oil and gas extraction businesses use cost depletion to figure
their depletion deduction. Mineral property includes oil and gas wells, mines, and other natural deposits
(including geothermal deposits). For this purpose, the term “property” means each separate interest businesses
own in each mineral deposit in each separate tract or parcel of land. Businesses can treat two or more separate
interests as one property or as separate properties.
Amortization (or amortisation) is the process of decreasing, or accounting for, an amount over a period. The
word comes from Middle English amortisen to kill, alienate in mortmain, from Anglo-French amorteser, alteration
of amortir, from Vulgar Latin admortire to kill, from Latin ad- + mort-, mors death.
When used in the context of a home purchase, amortization is the process by which your loan principal
decreases over the life of your loan. With each mortgage payment that you make, a portion of your payment is
applied towards reducing your principal and another portion of your payment is applied towards paying the
interest on the loan. An amortization table shows this ratio of principal and interest and demonstrates how your
loan's principal amount decreases over time.
Amortization is generally known as depreciation of intangible assets of a firm.
D. Taxable and Nontaxable Sales and Exchanges
E. Amount and Character of Gains and Losses, and Netting Process
F. Related Party Transactions
G. Estate and Gift Taxation
1. Transfers subject to the gift tax
A gift tax is a tax imposed on the gratuitous transfer of ownership of property.
When a taxable gift in the form of cash, stocks, real estate, or other tangible or intangible property is made the
tax is usually imposed on the donor (the giver) unless there is a retention of an interest which delays completion
of the gift. A transfer is completely gratuitous where the donor receives nothing of value in exchange for the
gifted property. A transfer is gratuitous in part where the donor receives some value but the value of the property
received by the donor is substantially less than the value of the property given by the donor. In this case, the
amount of the gift is the difference.
In the United States, the gift tax is governed by Chapter 12, Subtitle B of the Internal Revenue Code. The tax is
imposed by section 2501 of the Code.
Generally, if an interest in property is transferred during the giver's lifetime (often called an inter vivos gift) then
the gift or transfer would not be subject to the estate tax. In 1976, Congress unified the gift and estate taxes
limiting the giver’s ability to circumvent the estate tax by gifting during his or her lifetime. Notwithstanding, there
remain differences between estate and gift taxes such as the effective tax rate, the amount of the credit
available against tax, and the basis of the received property. There are also types of gifts which will be included
in a person's estate such as certain gifts made within the three year window before death and gifts in which the
donor retains an interest, such as gifts of remainder interests that are not either qualified remainder trusts or
charitable remainder trusts. The remainder interest gift tax rules apply the gift tax on the entire value of the trust
by assigning a zero value to the interest retained by the donor.
2. Annual exclusion and gift tax deductions
Generally, the following gifts are not taxable gifts:
Gifts that are not more than the annual exclusion for the calendar year
Gifts to a political organization for its use
Gifts to charities
Gifts to one's (US taxpayer) spouse
Tuition or medical expenses one pays directly to a medical or educational institution for someone
Gift tax exemptions
There are two levels of exemption from the gift tax. First, transfers of a present interest up to $13,000 per
person per year (as of 2011) are not subject to the tax ("present interest" is defined as: when the recipient of the
gift can "immediately and without restriction use, possess, or enjoy the gifted property", if it's not this "present
interest" then it's a "future interest" and therefore the annual exclusion amount of $13,000 (2011) is NOT
available to use as a deduction from the gift). An individual can make gifts up to this amount to as many people
as he/she wishes each year. A married couple can pool their individual gift exemptions to make gifts worth up to
$26,000 per recipient per year without incurring any gift tax. For 2011 and 2012, the lifetime gift tax exemption is
$5,000,000, which is the same as the federal estate tax exemption. The lifetime gift tax exemption is tied directly
to the federal estate tax exemption such that if you gift away any amount of your lifetime gift tax exemption, then
this amount will be subtracted from your estate tax exemption after you die.
If an individual or couple makes gifts of more than the limit, gift tax is incurred. The individual or couple has the
option of paying the gift taxes that year, or to use some of the "unified credit" that would otherwise reduce the
estate tax. In some situations it may be advisable to pay the tax in advance to reduce the size of the estate.
In many instances, however, an estate planning strategy is to give the maximum amount possible to as many
people as possible to reduce the size of the estate.
Furthermore, transfers (whether by bequest, gift, or inheritance) in excess of $1 million may be subject to
a generation-skipping transfer tax if certain other criteria are met.
Tax deductibility for gifts
Pursuant to 26 U.S.C. § 102(a), property acquired by gift, bequest, devise, or inheritance is not included in gross
income and thus a taxpayer does not have to include the value of the property when filing an income tax return.
Although many items might appear to be gift, courts have held that the most critical factor is the transferor's
intent. Bogardus v. Commissioner, 302 U.S. 34, 43, 58 S.Ct. 61, 65, 82 L.Ed. 32. (1937). The transferor must
demonstrate a "detached and disinterested generosity" when giving the gift to actually exclude the value of the
gift from the taxpayer's gross income.Commissioner of Internal Revenue v. LoBue, 352 U.S. 243, 246, 76 S.Ct.
800, 803, 100 L.Ed. 1142 (1956). Unfortunately, the court's articulation of what exactly satisfies a "detached and
disinterested generosity" leaves much to be desired.
Some situations are clearer, however.
1. "Gifts" received at promotional events are not excluded from taxation:
For example, Oprah's seemingly good deed of giving new cars to her audience does not satisfy this definition
because of Oprah's interest in the promotional value that this event causes for her television show.
1. "Gifts" received from employers that benefit employees are not excluded from taxation:
26 U.S.C. § 102(c) clearly states that employers cannot exclude as a gift anything transferred to an employee
that benefits the employee. Consequently, an employer cannot gift an employee's salary to avoid taxation.
In addition, policy reasons for the gift exclusion from gross income are unclear. It is said that no justification
exists. It is also said that the exclusion is for administrative reasons, both for taxpayers and for the IRS. Without
the exclusion taxpayers would have to keep track of all their gifts, including nominal ones, during the year, and
this would create additional oversight problems for the IRS.
3. Determination of taxable estate
The estate tax in the United States is a tax imposed on the transfer of the "taxable estate" of a deceased
person, whether such property is transferred via a will, according to the state laws of intestacy or otherwise
made as an incident of the death of the owner, such as a transfer of property from an intestate estate or trust, or
the payment of certain life insurance benefits or financial account sums to beneficiaries. The estate tax is one
part of the Unified Gift and Estate Tax system in the United States. The other part of the system, the gift tax,
imposes a tax on transfers of property during a person's life; the gift tax prevents avoidance of the estate tax
should a person want to give away his/her estate.
In addition to the federal government, many states also impose an estate tax, with the state version called either
an estate tax or an inheritance tax. Since the 1990s, opponents of the tax have used the pejorative term, "death
tax." The equivalent tax in the United Kingdom has always been referred to as "inheritance tax".
If an asset is left to a (Federally recognized) spouse or a charitable organization, the tax usually does not apply.
For deaths occurring in 2011, up to $5,000,000 can be passed from an individual (for married couples, the
applicable amount is $10,000,000) upon his or her death without incurring estate tax.
4. Marital deduction
Marital deduction is a type of tax law that allows a person to give assets to his or her spouse with reduced or
no tax imposed upon the transfer. Some marital deduction laws even apply to transfers made postmortem.
Spouses can transfer property between them tax free and ex-spouses can do that according to divorce decree.
For U.S. estate and gift tax purposes, there is no tax on transfers between spouses, whether during lifetime or at
death. There is no limit on the amount that may be transferred. However, there are two important exceptions.
The federal gift tax marital deduction is only available if the donee spouse (the person receiving the gift) is
a U.S. citizen. The federal estate tax marital deduction is available for bequests at death to a surviving spouse,
whether or not he or she is a U.S. citizen. However, if the survivor is not a U.S. citizen, the bequest must take
the form of a specialized type of trust known as a Qualified Domestic Trust.
5. Unified credit
Credits against tax
There are several credits against the tentative tax, the most important of which is a "unified credit" which can be
thought of as providing for an "exemption equivalent" or exempted value with respect to the sum of the taxable
estate and the taxable gifts during lifetime.
For a person dying during 2006, 2007, or 2008, the "applicable exclusion amount" is $2,000,000, so if the sum
of the taxable estate plus the "adjusted taxable gifts" made during lifetime equals $2,000,000 or less, there is no
federal estate tax to pay. According to the Economic Growth and Tax Relief Reconciliation Act of 2001, the
applicable exclusion increased to $3,500,000 in 2009, the estate tax was repealed for estates of decedents
dying in 2010, but then the Act "sunsets" in 2011 and the estate tax was to reappear with an applicable
exclusion amount of only $1,000,000. However, On December 16, 2010, Congress passed the Tax Relief,
Unemployment Insurance Reauthorization, and Job Creation Act of 2010, which was signed into law by
President Barack Obama on December 17, 2010. The 2010 Act changed, among other things, the rate structure
for estates of decedents dying after December 31, 2009, subject to certain exceptions. It also served to reunify
the estate tax credit (aka exemption equivalent) with the federal gift tax credit (aka exemption equivalent). The
gift tax exemption is now equal to $5,000,000.
The 2010 Act also provided portability to the credit, allowing a surviving spouse to use that portion of the pre-
deceased spouses credit that was not previously used (i.e. Husband dies and used $3 million of his credit. At his
wife's death, she can use her $5 million credit plus the remaining $2 million of her husband's).
If the estate includes property that was inherited from someone else within the preceding 10 years, and there
was estate tax paid on that property, there may also be a credit for property previously taxed.
Before 2005, there was also a credit for non-federal estate taxes, but that credit was phased out by
the Economic Growth and Tax Relief Reconciliation Act of 2001.