TAXATION OF PROPERTY TRANSACTIONS – RACINE (Spring 06) Income (Glenshaw Glass Test) – Net accession to wealth, that is clearly realized, over which the taxpayer has complete dominion and control. Unsolicited books from publishers are not income. This is because the benefit is more for the publisher. If you buy box and find ring inside, then that is income. But, if you buy box and it appreciates then that is not income. It is not income if a tenant defaults and leaves an improvement on the property, unless it was intended as rent. A prize is income -- Report income in the year taxpayer actually or constructively receives cash or cash equivalent. Income must be credited to your account, set apart for you, and made available so you can draw upon it at any time. Gross Income = Salary + gains from dealings in property, or § 61 – All income from whatever source derived. Long term capital gain – Gains from a 1) sale or exchange of a 2) capital asset 3) held for more than one year. What is a gain? A gain is the amount realized minus the adjusted basis. Amount realized equals money received from a sale or disposition, plus FMV of property received plus monies worth of services received plus any liabilities relinquished. Keep in mind must be a net accession to wealth, that is clearly realized, over which the taxpayer has complete dominion and control. Eg. Buy piano and find diamond ring, v. find out that it is a Steinway. What is a sale of exchange? If you convert property to cash or other property materially different from that property, then you have disposition. Also must be a complete disposition in that you retain none of the benefits (but you can retain the burden). Common law requires the item to exist before and after (can not be cancellation or termination or contract rights). Note: If you sell a stock or something and then buy it back within 30 days, section 1091 says you do not get to recognize the loss, it just carries over. There is no converse rule for gains. o Examples of Sale or Exchange: Destroyed by fire is not sale or exchange you still own it. Abandonment is not sale or exchange because no consideration. Condemnation is considered a sale or exchange because the govt doesn’t steal. Bank taking property is sale or exchange. o What is materially different? Materially different if the respective possessors enjoy legal entitlements that are different in kind or in extent. Really just means different rights and different obligations. EXAMPLES – Even if a company changes its state of incorporations, and swaps out it’s stock, that is considered a disposition. If two banks swap mortgages then that is a disposition because different borrowers.
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Two companies swapping bushels of wheat is not considered a disposition because wheat is fungible. What is a capital asset? § 1221 – All property are capital assets unless specifically excluded. What is excluded? o Stock in trade, aka inventory or property held primarily for sale to customers in the ordinary course of a trade or business is excluded. o Real or personal property that is used in a trade or business that can be depreciated is excluded. o Copyrightable property that is made by the taxpayer is not a capital asset. o Accounts and notes receivable. o Supplies that are consumed by the business.
§ 1271 – Amount received on retirement of a debt instrument shall be considered amounts received for sale or exchange. Basically when you sell property and get a note in return, when that note is paid we consider that part of the sale or exchange of the property, even though technically someone paying off a note is not a sale or exchange. DEALER PROPERTY – What property is excluded from § 1221 under the first exclusion (aka dealer property). This is property that is held 1) primarily for sale, 2) to customers, 3) in the ordinary course of a trade or business. If you hold real estate for many years it will qualify under 1221 as a capital asset because you are holing primarily for investment. But, if you subdivide and sell to multiple customers, then more of a argument can be made that the property is dealer property and you should not qualify for capital treatment. Stocks – An individual who buys and sells stocks regularly will be considered in the trade or business, but the stocks are capital assets under 1221 because they are not held for sale to customers. They are just sold on the open market. Futures – Corn Products case said that if the buying and selling of futures is integrally related part of a company’s underlying business, then the futures will not be treated as capital assets. Short Sales – § 1233 says that all short sales of property will be treated as sales or exchanges of capital assets. However there is an exception for hedging transactions (transactions which are to be regarded as insurance). Gains and losses therefrom are ordinary. Liquidation v. Dual Purpose – If a company is in the business of leasing property and then sells some of that property, the gain or loss from sale is characterized based on whether the transaction is considered a liquidation or a sale in the ordinary course of business (aka the company has a dual purpose, to lease and sell). If the company only sells the property after its useful life (to the business), then the sale will be considered a liquidation and the gains and losses capital. Otherwise, for a dual purposes company the gains and losses are ordinary. § 1234 – Gain or loss attributable to the cancellation, lapse, expiration or other termination of a contract right that is linked to property that is considered a capital asset, will be treated as a capital gain or loss.
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§ 1231 Property – Any real property used in a trade or business held for more than 1 year, or any depreciable personal property used in a trade or business held for more than 1 year is considered 1231 property. This property is not a capital asset. § 1235 (Patents) – Transfer of a patent is a sale or exchange of a long term capital asset regardless of holding period as long as you are a holder and sell all substantial rights. If the patent does not qualify as 1235 then it is a 1231 asset if held for more than a year. Goodwill – Goodwill is not excluded from section 1221, thus it is a capital asset. § 165(c) -- basically only 3 types of losses from disposition of property are recognized i. Related to trade or business ii. Related to investment activity (activity for profit, personal residence and/or beach home is not investment activity) iii. Un-reimbursed casualty or theft loss 165(h) – Look at all casualty gains and losses of personal use (not business) property. If losses exceed gains then treat all of them as either ordinary gains or ordinary losses. If gains exceed losses treat all of them as sales/exchanges of capital assets. Go back and look at each casualty and classify it as one of the following: Long term capital gain, long term capital loss, short term capital gain, short term capital loss. UNRECAPTURED DEPRECIATION – Un-recaptured depreciation gains will be taxed at either ordinary income rates or at 25%. If the property in question is real property subject to § 1250 then it will be recaptured at 25%. If the property is § 1245 property (mostly machinery and equipment and other personal property) then it will be recaptured at ordinary income rates. THE TIER GAME Tier 2 – Casualty of 1231(b) property and casualties of capital assets held for more than one year and held in a trade or business or for profit. It does not apply to property that has been held for one year or less or to any personal (not in trade or business) property. Net these first. If a loss then all gains and losses are ordinary and done with these. If these are a net gain, then move them up to tier 1 and continue. Tier 1 – Tier 1 is the hodgepot. This consists of (1) anything moved up from tier 2, and (2) sales or exchanges or condemnation of 1231(b) and (3) condemnation of capital assets held for more than one year in connection with a trade or business or for profit. Net all Tier 1 gains and losses. If gains exceed losses treat all gains and losses as long term capital. If losses exceed gains treat all gains and losses as ordinary. If a gain or loss does not qualify in 165(h) or in any of the Tiers. Then look to see if it is a capital gain or loss based on § 1221, or then it is just ordinary. SINGLE INTEGRATED TRANSACTIONS – Where there is a single integrated transaction that takes place over multiple years, the character of the initial transaction will dictate the character of the subsequent ones. This is the situation where guy sells property and gets a long term capital
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gain. Then years later is sued because he charged too much and gives back some money. Giving back that money is also going to be treated as a long term capital loss. Gains from collectables are taxed at 28%. Un-recaptured § 1250 gain is taxed at 25%. This is when you take too much depreciation on your real property. § 11 – This is where the tax on corporation is. Tax is 15% on first $50,000, 25% on the amount between 50 and 75K, 34% on 75K up to 10 million, 35% on any amount above 10 million. o Corporations do not get any special tax treatment for long term capital gains. It is all taxed as income. o If there is a net long term capital loss in a given year the corporation does not get to deduct from business income, but they can carry it back 3 years or forward 5 years in an attempt to offset other long term capital gains. The short term works exactly the same. There is no difference, they are netted against each other. 1031 EXCHANGE – Deferment of gain or loss. Realized gain or loss that is not recognized in a given tax year. 1. Elements Exchange of property Held in a trade or business or for investment (but remember this specifically excludes inventory or other property that is held primarily for sale) And the property exchanged for must be like kind and also held in a trade or business or for investment. Watch for pre-arranged plan to trade and sell. No good because after exchange must plan on being held. o Like kind property is in reference to the nature and character of the property. Farmland for a commercial building is ok. Land for Land is ok. A truck for a truck is ok. Machinery for machinery is ok. But gold bullion for a $20 silver coin is not ok. A fee simple for a leasehold is ok as long as the leasehold is over 30 years. 2. Boot – Anything received in the exchange that is not like-kind property will be considered boot. There are two types of boot, cash boot (cash or property like cars) and mortgage boot. Net the boot and if negative then consider it a complete exchange. But remember, if there is positive cash boot then you must recognize that cash, you can not net a negative mortgage boot against a positive cash boot. You can net a negative cash boot with a positive mortgage boot. 3. How much gain deferred and how much gain recognized? You recognize the lesser of gain or boot. 4. This section (1031) does not apply to stocks, bonds, or any property that is held primarily for sale (aka inventory). Also can not exchange notes or interests in a partnership. 5. Watch out for sham sale. When two parties sell their property to each other, that is really just an exchange.
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Realized Gain AR (FMV of property received + cash received + monies worth of services received + liabilities relinquished) – AB (Basis of property given up + new liability assumed + cash paid + FMV of non-like kind property given up)
Recognized Gain Recognize the lesser of boot or gain. What ever gain is not recognized should be carried over.
New Basis OLD AB + Amounts Paid other than exchange property (liabilities assumed, cash paid, FMV of non-like kind property given up) – Amounts Received other than exchange property (liabilities relieved, cash received, FMV of nonlike kind property received) + Gain Recognized – Loss Recognized = New AB
TAX on TAX After tax amount/(1-tax rate) If salary is $50,000 and company is going to pay tax amount on your behalf, then they need to give you $50,000/(1-tax rate) PROBLEM SET II 1. CASH ACCOUNTING METHOD – Taxpayer has property with a basis of $4000. He sells the property and receives $2000 cash in year 1. He also receives 4 promissory notes each with a face value of $2000, and each of which pays off in a subsequent year (years 2, 3, 4, and 5). The FMV of the notes in the current year are each $1500. A cash accounting method taxpayer will report an amount realized of $8000 in year 1. This consists of $2000 in cash and $6000 in notes (4 x $1500 FMV). The total gain in year 1 is $4000 (AR-AB). In years 2, 3, 4, and 5, the taxpayer will get paid off the $2000 from the notes and will report $500 AR in each year (because he already reported $1500 amount realized of the note in year 1). Above is how the 9 th circuit (Warren Jones) applies the rules, but according to the Regulations, a note that pays interest at or above the AFR (applicable federal rate) will have a FMV equal to the face value. For purposes of our class all notes pay a rate equal or above the AFR. In this case the AR in year 1 is $10,000. Gain is $6000, end of story. If the notes had no FMV (only in rare and extraordinary circumstances property will have not FMV) then the taxpayer would report an amount realized of $2000 in each year, 1, 2, 3, 4 and 5. After years 1 and 2 there will be no gain because the basis is $4000. The $2000 in years 3, 4 and 5 will all be gain.
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Report income in the year taxpayer actually or constructively receives cash or cash equivalent. Income must be credited to your account, set apart for you, and made available so you can draw upon it at any time.
2. ACCRUAL METHOD (If you are selling inventory, then you are required to use the accrual method of accounting) – The accrual method basically is the same as the Regulations for the cash method (see bullet point above). But keep in mind that all events that fix the right to income must occur and the amount of income must be able to be ascertained with accuracy. For a sale, this test is generally met but, if the property is leased then the test is not met because all events that fix the landlord’s right to income have not occurred. The landlord must continue to provide the premises. Under the accrual method the taxpayer would recognize $10,000 in year 1. Gain would be $6,000. If you are selling goods then once the good is sold, even if the buyer still owes the money, under the accrual method you book the income. Under the cash method you book the income when actually received. 3. INSTALLMENT METHOD – Use this method when there is an installment sale. This is any kind of sale where one payment is received after the taxable year in which the sale occurred. Gross Profit Ratio is Gross Profit / Total Contract Price. Gross profit = sales price minus adjusted basis. Total contract price = sales price minus qualified debt. Qualified debt is capped at the adjusted basis. Find your gain to total cash ratio. Here it is 60%, 6000 / 10000. Then report 60% of each installment as gain, so each 2000 receipt will result in 1200 gain. 5 of those give you a total of 6000 gain. Recapture can not be paid on the installment method, the govt. wants the check for the recapture right away. OPEN TRANSACTIONS – These are obligations or notes that the taxpayer will argue are not equivalent of cash. They are uncertain in value. Also when a note is crappy. In the problem the taxpayer got $2000 cash up front plus a percentage of profits in subsequent years. That percentage of profits is considered uncertain. A. Cash Accounting Method – Under the cash method you recognize the amount realized when you actually get paid. Treat the problem similarly to the situation above where the notes had no FMV. In the problem the taxpayer received $2000 cash in year one. That would be all realized but no gain because basis is $4000. In year 2 he gets $1000 and again that is realized but there is no gain. In year 3 he gets $1500, that is all realized and $500 of it is gain because the basis has been surpassed. Any money received in subsequent will be realized and recognized in those years as gain. B. Accrual Accounting Method – Treat the exact same as cash method because income is recognized and realized when all events that fix the right to it have occurred. In this problem the right to income only occurs after the company makes profits. So that right fully vests in each given year. STOCK SWAP of Unequal Value: Mark owns LU stock worth 2000, Scott owns GOOG stock worth 7000. They swap the stock. Mark’s amount realized is 7000 and gain is calculated according to his basis in LU. His basis in LU was 1000 thus his gain is 6000 in the transaction. His new basis for GOOG stock is 7000.
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OPTIONS If you buy an option for $1000 to purchase property or stock at $10,000 and then exercise that option the basis is $11,000. The holding period for the property or stock starts the day of purchase of the property, not the option. If your employer gives you stock for services rendered, then you have income of the FMV of the stock at the time received. That value is now your basis in the stock. If your employer, in exchange for services rendered, gives you a stock option that will entitle you to purchase stock for $10,000 then you have no income at the point of receipt of the option. If the price of stock goes up to $15,000 and you exercise the option, then at the point of exercision you are immediately have income of $5,000. This is taxed at ordinary income rates. Your basis in the stock will be $15,000 (cost + income). EFFECT OF INDEBTEDNESS Golden Rule – Basis is not affected by debt. Depreciation reduces basis. But land can never be depreciated, only buildings or equipment, etc. Recourse Mortgage situation: FMV of property is $100, the debt on the property is $140. If the bank forecloses on the property then the taxpayer receives a benefit of 100 by virtue of the bank reducing the amount owed. The taxpayer still owes $40 to the bank. In this situation, the AR is $100 (equal to the FMV). If the bank discharges that additional $40 debt then that is income (taxed at ordinary income rates) from the discharge of indebtedness that is separate from the property transaction. Non-Recourse Mortgage situation: FMV of property is $100, the debt on the property is $140. If the bank forecloses on the property then the taxpayer receives a benefit of $140 by virtue of the fact that he now owes $0 to the bank where he used to owe $140. In this situation the AR is $140. SCATTERED LOTS To find the basis of scattered lots you need the total basis of all the lots. First find the total price if all the lots were to be sold and then find each individual lot’s percentage of the total sales price. Apply that percentage to the total basis and that will give you the basis of the individual lot. BASIS – GIFTS, TRANSFERS AT DEATH AND HOLDING PERIOD A. General Rule -- Carry-Over-Basis: When a DE receives property as a gift, the basis is the DR’s adjusted basis. Burden is on taxpayer to prove the donor’s basis, otherwise it is 0. B. Special Loss Rule -- If at the time of the gift the FMV is less than the donor’s adjusted basis, when used for determining a loss the donee’s adjusted basis is the FMV. 1. Watch for trap area where there will be no gain or loss -- Reg. §1.1015-1(a)(2) C. Gift tax paid adjustment -- §1015(d) 1. Gifts given before 1977 -- You add the gift tax paid to the AB to get the gift tax adjusted basis, as long as that number does not exceed the FMV at the time the gift was made. This rule only applies to gifts made before 1977.
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2. Gifts given after 1976 – solve the equation for x and then add x to the basis POST 1976 EQUATION Net Appreciation (in donor’s hands) Amount of Gift at time given (FMV of Gift); In part = Amount of sale part gift situation use only the value of the gift Gift Tax Paid portion here 3. Popovich Rule -- No matter when the gift was made, if at the time of the gift the FMV of the property is less than or equal to the donor’s AB, there will be no gift tax paid adjustment. D. Part Sale + Part Gift (treated as a sale at bargain price) 1. If the transferor received as consideration an amount greater than adjusted basis then there is a gain, but if he receives an amount less than his adjusted basis then there is no loss 2. The transferee’s basis is going to be the greater of what was paid, or the gift calculated basis. E. Tacking -- § 1223(2) – When there is a transfer and the transferee gets a carry-over basis then he can tack on the ownership period of the transferor. Watch out for part sale/part gift, and full gift where property depreciated in the transferor’s hands. X Ask about problem III, B. F. Part Sale / Part Gift to Tax Exempt organization (charitable) – § 1011(b) says that we treat it as a sale of a portion of the property. Use as the basis only the same ratio as the AR/FMV. Eg. If you buy something for $40, and its FMV is $200. You sell to a charity for $50 (part sale part gift). Instead of the normal $10 gain, in this situation it is treated as if only ¼ of the property is sold and the rest is gifted. Therefore the basis in ¼ of the property is $10 and the AR is still $50. So, the gain is $40. The other $150 is treated as a charitable contribution but that is neither here nor there. PROPERTY FROM A DECEDENT G. Property acquired from a decedent -- General Rule – Property acquired from a decedent will take the FMV on the date of death as a basis. H. Tacking property acquired from a decedent -- When you receive property from a decedent, automatically receive long term treatment. Does not matter how long anyone held it STEP UP IN BASIS I. Joint Tenants – When one tenant dies the other tenant gets their interest and that portion is stepped up in basis to the FMV at the time of death. However, the portion held by the surviving joint tenant is not stepped up in basis. This creates a situation where the surviving joint tenant has portions of the property with different bases. 2. Community Property – When spouse dies he may give his ½ to anyone, but there is a double step up in basis, the given property is obviously deemed to have a basis of the FMV at the time of death, but the surviving spouse’s property will also get the basis of FMV at the time of death.
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