Property Transactions Start with the Code From ways and means in house Finance in the Senate. Section 1(h) (§ 1 is tax on individuals) Section 11 is tax on corporations. If C corp, Tax rate the same if it is ordinary income or capital gains. But prefer capital gains because can be rolled forward (no pass-through rules, just gains against losses). Carry back losses three years first, then roll them five years forward. Must use oldest losses first. And can restate previous years taxes and file for a refund. All carried forward losses are treated as STCL. Then go to the Secretary of the Treasury Regs (1) Interpretive Regs (power delegated by congress). Have force and effect of law unless in contradiction with the statute. (2) Legislative Regs -(3) Statutory Reenactment Doctrine (not on test): If you have a reg, from the time the reg is enacted when the statute is amended, then the regulation still stands unless the statute addresses the reg. Courts presume congress new about the reg. IRS Revenue Rulings: Can write in with a particular question. IRS will promulgate a ruling on that question that will clarify the point in question. Numbered 2006-1, 2006-2 etc. These rulings can be relied on as the view of the IRS, but it is not law. You can disagree and disregard it. But if you do the IRS will take a different position. Can come in the form of private letter rulings, which are specific to the person asking the question. It is persuasive however. Listed (PLR) (Year) (Number in that Year) Then go to Case Law: Litigated in Tax Court, Federal Circuit Court, Audit: After an audit they may send a statutory note of deficiency (aka 90 day letter). If they don’t send they can never assess a tax. They must send before SOL expires (3 years after the return is filed). Tax Court: Judge trial. Judge will issue an opinion. 105 T.C. 283 (2006). Golson Rule: Tax court will state it’s own rule, but if a circuit court rules differently, then the Tax court will follow that rule in that circuit. What happens when a circuit court judge finds differently that the Tax court. Tax court is not overruled because it is a court of national jurisdiction. GROSS INCOME There is no equity in the internal revenue code. If there is not an exemption on point then it is included in gross income under Glenshaw Glass economic accretion under § 61(a). Deductions are a matter of legislative grace. Losses are from: Trade or Business, transactions entered into for profit, Majority of class comes from § 61(3) § 61(3) Adjusted Gross Income: (GI – Above the line deductions). (1) Deductions under §62 are above the line. Don’t have to be itemized so can still take the standard deductions. (a) Losses from dealings in property are above the line. (2) Want a lower AGI so that below the line deductions don’t get phased out. (3) The first 2% of miscellaneous itemized deductions are non-deductible. Deductions start in § 161. Alternative Minimum Tax: Start with ADJ Gross income, and then get a few deductions, then apply 28% to that, and pay the greater of that or what you owe under the normal calculation method. Congress decided that certain deductions were not allowable. § 1001: AR – Adj. Basis = Gain. AR = How much did you get? Adj. Basis = How much did you pay adjusted for improvements and depreciation. Different Capital Gains Rates: (Work on this) 5% 15% 25% 28% Dealing with how capital gains are taxed: Income taxable at capital gains rates is deducted from ordinary gross income so that it is not double taxed (It should be included in the original gross income calculation). Dealing with how capital losses affect taxes: Example: GI = 220K + 4K LTCG +1K STCG = 225k Adj. GI = 226k – 2k LTCL (§ 623?) The Rules: Ord. Income + ST Cap Gains – ST Cap Loss = Income taxable at Ordinary rates Net Capital Gains = Income taxable at capital gains rate. Net Capital Loss = Roll forward or pass through rules (Losses are allowed only to the extent of gains + $3k [§162 to 165 to § 1212]). LTCG -LTCL =NLTCG/L STCG -STCL =NSTCG/L NLTCG = NLTCG-NSTCL = Net Capital Gains taxed at 15% NLTCL is passed through at 3k a year, but only after NSTCL is used up, and the balance rolled forward as LTCL. NSTCG is taxed at ordinary income rates. NSTCL left above that used in reducing NLTCG in the NCG calculation process is passed through at up to 3k a year and balance rolled forward as STCL. NSTCL passed through before NLTCL. If there is less than 3k to pass-through, then can pass-through NLTCL. All NSTCL and NLTCL passed through is treated as becoming LTCL for the next computation period. (1) Generally. If there is an amount that has to be rolled forward, it is treated as Long Term Capital Loss carryover. Specifically: (2)If there is an amount of loss allowed to be passed through (3k), we treat it as a short term capital gain. (3) We then take the Net Long Term Capital Loss (carried forward) and subtract the Net Short Term Capital Gain and you get the Net Long Term Capital Loss Carried forward. Dealing with an actual sale of property: **Any Depreciation taken has to be recaptured (§ 1250 gain) at 25%. **Collectibles (art and paintings): Taxable at 28%. (1) If a taxpayer has a net capital gain, subtract the net capital gain from GI (so no double taxation). The resulting number is the Adj. GI subject to ordinary deductions. (2) Subtract out from Net Capital Gains the unrecaptured gain and the collectible gains. Break them out into their own categories. (3) Then look at the broken out categories and Net Capital Gains after subtractions and apply the different capital gains tax rates (15% on NCG, 25% on depreciation recapture, 28% on art & collectibles). Dealing with Corporations and Capital Gains: If C corp, Tax rate the same if it is ordinary income or capital gains. But prefer capital gains because can be rolled forward (no pass-through rules, just gains against losses). (1) Carry back losses three years first, then roll them five years forward. (2) Must use oldest losses first. (3) And can restate previous years taxes and file for a refund. (4) All carried forward losses are treated as STCL. AMOUNT REALIZED Gross Income: Glenshaw Glass: 1) Accretion to wealth 2) Clearly Realized 3) That taxpayer has dominion and control over. Exception: Unsolicited gifts not intended to bestow a benefit. Exception to Exception: When the unsolicited gift or prize is given to a charity it becomes clearly realized so there is income and a deduction. Imputed Income: Old Colony Trust Case: Company agrees to pay income tax on CEO. Is payment of CEO’s taxes additional income: Yes. Discharge of a debt by a 3rd party is income as if received. But the government chooses not to tax on the tax, even thought they could. CEO argued: (1) No dominion or control. (2) Tax on a Tax in perpetuity. Calculation: After Tax 100 /(1-Tax Rate). Arms Length Transactions: Everything presumed as given in an arms length transaction. Will impute income on any rate below applicable federal rate. Gifts for the benefit of the giver = (promotional items, cars in the opera giveaway). Not a taxable event under __________________. Treasure Trove Doyle vs. Mitchell Bros. Gain is sale price less cost. Under § 61 Gross Income is Gain. § 1001-1(a) Gain from Dealings in Property. If not like kind then income. Amount Realized: Sum of money received plus fair market value of property received (“Services, relief of debt, contractual rights to be paid”). When is it included in income: (1) When computing income realized, use the accounting method by which the books are kept. There is the long term contract method in which you can defer income based on the percentage of completion. (2) §446(b) Exceptions: If no method has been regularly used by the tax payer, or the method used does not clearly reflect income, then the secretary shall decide what method is used. (3) §451(1) Cash Method: Cash or equivalent actually or constructively received by the taxpayer in the taxable year. (4) Reg 151-2 Although the income is not actually reduced to tax payers possession, it is constructively received during the taxable year in which it is credited to his account and set apart for him, or otherwise made available so he could draw on it any time. Even if have a legal right to it. a. Said differently: Made available, set aside, and can be drawn on. b. Mailbox rule: When received. c. Dividends: Not taxed until received. Accrual Method: When all events occur that fix the right to income and the amount of income can be determined with reasonable certainty. Aka “the all events test” all events must occur before the right occurs. SALES AND EXCHANGES PROBLEM II Important concepts: (A) open vs. closed transaction. a. Open is on going (or can’t be valued) b. Closed is done and can be valued. (1) Cash Basis: Three Methods (1) Open (cash) Western Oaks case a. Don’t include any gain until paid b. Note must be worth less than face (2) Closed Warren Jones Case (if FMV less than face) a. Note must be worth less than face. (3) Closed Tres. Reg §7701-(1)(G) (prob. Right answer). a. No difference between cash and accrual methods here. Open Transaction Cash Equivalence Facts Rule: (1) Can recover basis of a note first in accounting then gain after note. (2) The note must be same as cash, i.e. cannot trade at a significant discount, i.e. All payments up to basis amount are recovery of basis, then payments going forward after that are LTCG. Analysis: If a note is truly the equivalence of cash, then the total amount can be realized. If not is not equivalent to cash, then transaction cannot be totally realized. Must be discounted. Closed: Sum of money received plus fmv of property received so $2k+6k fmv on notes. a. AR = 8k b. AB = 4k c. ARec = 4k LTCG in year 0 + $500 a year for the next 4 years in LTCG when the payment is received. Closed: 9th Circuit Warren Jones Case: Installment Sale Contracts. This is regarding notes where the interest rate is so low it’s FMV is less than it’s face value. There is income in the year the installment’s booked because they have a FMV that the coupon payments could be sold for. So more income booked up front and less on back end. Can only use ascertainable FMV. If not ascertainable then:…Only in rare and extraordinary cases will property be taken to have no FMV. If there is no ascertainable FMV in this scenario then, we have 2k in gain realized each year, reducing the basis each year by 2k, so no income until year 3. Ex. Basis = FMV of note. 6k FMV of 4yr note with an 8k face. Therefore each payment is ¾ applied to recovering basis of 6k, ¼ of each payment is LTCGain. Latest Regulations §1001-g (out after Warren Jones): As long as there is adequate interest, the FMV of a note is it’s face value. So income realized is the face value of the note. This has not been resolved yet. §1271: Payments on a note shall be treated as a sale or exchange (makes long term capital gains). Under general law prior this was ordinary income. INSTALLMENT ACCOUNTING METHOD: Idea: Spread the gain as the cash comes in. If any installment is to be paid in another tax year. The term installment method means that any income is recognized for any tax year is the proportion of the Gross Profit payments received to the Total Contract Price in that year. (aka the Gross Profit Ratio). Gross Profit = § 453-11 Selling Price – Adjusted Basis. Selling Price: Gross Selling price not adjusted for any mortgage or encumbrance. Basically allows to pay the tax as the cash comes in. Said differently: payment x (SP – AB = Gross Profit) /(SP – Qualified Debt = TkP.) Sales Price = 100 Basis = 40 Gross Profit = 60 Qualified Debt = 0 100-40=60 /100-0=100 = 6/10. = 60% is long term gain on each payment. **Basis reflects the amount a property is worth in after tax investment. CONTINGENT COMPENSATION ACCOUNTING: Can you report this on an open transaction basis (i.e. no gain until basis recovered)? If there is no ascertainable fair market value. Monkey’s case: Company principle liquidates company and claims movie residuals as payment for the stock cannot be valued therefore it is an open transaction and payment for the stock therefore capital gains. Rev Ruling 55: Films get valued all the time. Distributors know based on mathematical models. Film depreciated on the income forecast method. % made over % forecasted times the cost to produce. Dorsey vs. Commissioner: Bowling Alley transaction was an open transaction. Burnet v. Logan Court said that she had the right to restore the basis of the property. Said had not ascertainable market value. The consideration for the sale in cash and the promise to pay money was totally contingent on facts and circumstances which cannot be ascertained with any certainty. Therefore no ascertainable FMV. Therefore reporting will happen when the facts actually occur. THERE ARE NO CAPITAL CARRYBACKS IF OVERVALUE AN ASSET SO HAVE MORE GAIN THAN ACTUALLY GET!!!. Whenever get a contract right that is contingent and are a cash basis tax payer always cite Burnett v. logan and take an open position. Accrual basis taxpayer does not have to book income until all events fixed that incur right. Therefore takes only portion of the payment that accrues during the year. § 6166 :If you disclose your position on a return and it is adequately disclosed then cannot be penalized. DEPRECIATION RECAPTURE §1245 AR-AB needs to be characterized. So Amount above Basis is appreciation and amount below Basis is depreciation recapture. Different rates. You cannot report recapture income on the installment method. Rather it comes in in the year of sale § 453(i) Installment method P. 1085 of book. “In the case of any installment sale all recapture income shall be recognized in the year of sale” $25 realized on $100 sale as ordinary income, add to basis, rest carried as installments. 10 x (100*(40+25)65 = 35) /(100) When owe 70 on a 100 house. Paid 10, assumed 20 debt. Basis is 40. Seller tax consequences: 100-40 = 60 /100 – 20 = 80 = ¾ = .75 of income in year one ($10) is treated as depreciation recapture, Qualifying Indebtedness: Debt on the property put during its ownership that is used towards the ownership of the property that cannot exceed the basis of the property. Any qualifying indebtedness greater that basis is treated as a payment in the year of… (sale?) When someone has a liability in excess of basis use a wrap around note to defer tax going forward. New party comes in and takes a note on 100% and pays on it into escrow which pays existing note and the seller. United States vs. Davis (john?) In process of Divorce his wife gave up her dower rights (a non-community property right). i.e cannot disinherit a wife, who has a dower right for 1/3 of husbands assets on death. When Mr. Davis gave Ms. Davis a certificate of stock worth $100 he paid $40 for to release the dower rights, he had $60 in gain on disposition of debt. OVERRULLED BY § 1041 as transactions between husbands and wifes in a divorce is non-taxable for purposes of income tax law. KEENAN VS. COMMISSIONER A specific bequest is a transaction in which gain can be recognized. Dietrich vs. Commissioner Transfer of Gift Tax: Supreme Court cites Old Colony trust in that someone paying a liability of another is income to that another. § 672 Trust Rules BASIS § 1012 Basis of property shall be the cost of the property. Philadelphia Park Case Property Exchange: Basis is FMV of what is received. Must look at basis in conjunction with amount realized, otherwise symmetry of the system messed up. . See P. 212 in book. P.205 Adjustments to Basis: Adjust basis up for capital expenditures and down for depreciation. Post Acquisition Indebtedness: Not included in basis, unless put into a capital improvement. Contingency Expenses: If too contingent cannot be included in basis, rather add to basis at the time the cost is incurred. i.e. you want to depreciate an asset, but you don’t know what the price is, so you don’t know basis. Can’t calculate basis until the contingency occurs. Doyle vs. Mitchell Bros As a matter of con law cannot have income until recovered cost of goods. If invest $20 in inventory and fabricate an item then only have income over inventory cost. § 61-6 when part of a property is sold the basis must be equitably apportioned. Look to FMV of particular lots when purchased. In the case of a large lot purchase that is later subdivided and sold in parts, the IRS will re-evaluation the proportion of how the basis is allocated between the lots based on the FMV at the time each lot is sold. Inyo Land Case: When an easement is granted over a whole property. Arms Length Transactions: P. 211 – When people are at arms length and cash is on one side of the transaction that presumptively sets the market price. When purchasing assets of a corporation must have an allocation table of how consideration is allocated to equipment, land, goodwill, etc. Also good to have an allocation agreement when swapping properties. The government wants consistent positions. There is a case in CA that says you can agree to report consistent positions and if you breach you are liable for damages. If you purchase personal property then liable for sales tax and the board of equalization will want to see the allocation table. If not at arms length. If sell a property worth 100 to son for 50 that is 50 dollars of gift. Any property sold to a charity is subject to scrutiny, because they do not pay tax. If the mirror receipt of property requires it to be included in income, then the basis is the basis for tax. When you buy a stock from an option, the holding period starts from the day the option is exercised, not from the date the option is purchased. Can always sell the option (not the purchased asset). See Treas Regs § 83: When you exercise a compensatory option (for services rendered) you get taxed on exercise and pay ordinary income tax and any further increase in value is capital gain. All assuming the option is not too far in the money when granted. Rule of thumb is 50% of the value. No constructive receipt because if exercise are giving up the free look so there are economic restrictions. As opposed to a purchase option where nothing realized until asset purchased is sold. Basis and Options: The basis is the purchase price at the time the asset is purchased + the cost of the option. Said differently, option price + exercise price. Amount Realized: Sum of cash + FMV of property + (Forgiveness of debt?) at time property is converted into something materially different than in kind. Exceptions: (1) Scholarships for school are not taxable. (2) Consumer Utility surplus is not income. (i.e. buying something on sale does not impute an amount realized at the usual greater price. When dealing with Non-Recourse Notes (under Crane and International Freighting): When a non-recourse note is transferred to another as part of a purchase /sale transaction, we know the FMV of the mortgages is their face value as long as the FMV of the property is greater than the note (which is shown by how much total consideration is being paid for it). Problem Set II C.4 P. 1261 third paragraph. Because we have a non-recourse debt we have an interesting tax issue. Because there was no tax when the money was borrowed, if it is not all paid back (forgiven or not paid because non-recourse) then it is time to see gain under glenshaw glass and we will tax you on the difference. Recourse vs. Non-Recourse Debt Crane and Tufts. Recourse Note: §1001-1 & 1001-2 AR is price at time of sale or disposition. Has nothing to do with the debt. If the creditor forgives or gives up on collecting a debt and takes the collateral back, then the AR is the FMV of the property and there is income from the forgiveness of debt. Non-Recourse Note: When sold for less than note: FMV is irrelavent, rather the amount of the note is the amount realized. If the Non-Recourse Note is part of a purchase price, then it is included in Basis. Even if there is some possibility we are not going to pay it back. Character of Income: Always ordinary income. Not capital asset, because not disposed by sale or exchange. Specific Rules § 108 Only taxed to extent solvent Not taxed in bankruptcy Sale Lease Back Tax Shelter Buy yourself a property for 100% financing on a non-recourse note Lease it to an entity you control for the same amount as the debt service cost. Take an accelerated depreciation schedule (say, half the time of the note) Sell the property halfway into the note’s term. Pay capital gains on the depreciation recapture, but already saved more on taxes (especially in terms of time value of money) than it costs. Ex. 3/8/06 Class: Gift vs. Taxable Income Intent is deciding factor. Is there quid pro quo. Intangible enjoyment (a meal, enjoyment from a hockey game) vs. tangible property. Former not taxable, latter taxable. § 1231 Assets. Assets held in a trade or business. Any gain is long term capital gain and any losses are ordinary losses. Problem: Purchase 100,000 Land 850,000 Building non-recourse note 770,000 is depreciated value 700,000 is mkt value Property is transferred to another person for assumption of debt. What is amount realized to transferor? AR 850,000 (tufts foregiveness of a non-recourse note) AB 770,000 Gain: 80,000 (all depreciation recapture at 25%). Modification: Bank forcloses: Two transactions, a sale and a loan repayment. Trick of the trade: Transfer property to a corporation before selling it. This triggers both a realization to the individual seller of the mkt value (850k), and a covenant to repay the bank. Then would enter into a short pay agreement with the bank and sell the property through the corporation, with a basis of 850k and all gains are long term capital gains. (Would I want to sell the property to the corporation for my adjusted basis? Is that a true arms length transaction? Is it part gift? Do corporations always take capital gains on sale of capital property?) HYPOTHETICALS – DUE DILIGENCE Know Phase 1 and Phase 2 process, and the exemption under CERCLA for environmental damage. Go to time of the test. CA – Regional water control board: Policy – if they discover the person responsible for groundwater contamination, the policy is not to sue downstream owners 4) Buyers Phase 1 discloses underground fuel tanks in an area now landscaped. It is uncertain if the tanks were removed. a. Answer: (1) Where are we on the timeline? Do we have time left to do a phase 2? Do we need to give notice of a contingency removal with a condition that the tank be looked into? (2) Do intrusive phase 2 testing. Perhaps amend the agreement or enter into a side agreement to look into the tank problem. You then want the government to say there is no CERCLA liability (get letter). 5) Buyers Phase one shows property (4 story office building) in methane hazard zone due to a methane hazard property next door. a. Answer: Methane hazard zone is not big deal, except that need to build buildings to vent actively and passively. Phase 1 will disclose in a methane zone. Can disapprove as buyer has no right to cure and walk away, but this is an inspection issue. This goes into environmental and physical inspection issues (we are looking for a building that is properly vented, which can be cured) 6) Buyer wants to convert that top two floors to apartments. Zoning does not allow, except with variance. a. Answer: Where are we on the timeline? Are we going to be able to get a variance? Look at zoning to see if conditional or prohibition on apartments. Give seller notice that approving contingency subject to getting a conditional use permit prior to closing or a zone change, all prior to closing or closing being extended b. 7) Contract with the wrong seller (same people, wrong entity name). Make sure that the party that is on title as the fee owner is actually the seller in the contract. 8) Buyers PTR lists several exceptions: a. Easement for underground gas line held by gas company i. Look to see where the easement is on the property, to see if benign or not. ii. Judgement lien against seller for Patty Plaintiff. Have seller pay before take title. Letter goes: I approve subject to all monetary encumbrances being paid prior to closing such that there are no liens on title at the time of transfer. iii. Seller as Trustor Chicago Title as Beneficiary. If there is a deed of trust on a property that shows a loan was borrowed. Bank is called and asked how much is owed as of closing date. Bank will quote how much owed to pay off deed of trust at closing. Deed of trust puts property in a 3rd party, it is a legal fiction, but an important one. Bank then will reconvey the deed of trust to seller who has clean title to pass to buyer. iv. CC&R’s with racial and religious covenants. Racial and religious no longer valid. Read the end first to see when expires. 1) 13) Seller gets offer to lease a portion of the property for installation of a cellular antenna for $5k a month for 20 years. Seller thinks it is a good idea. What should be done. a. Answer: This is a material change to the property, so buyer has approval or could get out of the contract. Buyer may not unreasonably withhold approval. Should write in that unreasonable to refuse a rent within 5% variance of the market rent. 14) Property is discovered to have asbestos after Phase 1. But it after due diligence period. Buyer stuck. 15) Buyer is unable to close June 1st, but can close morning of June 2nd. Seller wants to cancel and keep the earnest money. If time is of the essence, then too bad, except there is a clause in § 8.8 that says that the closing must take place “as soon as possible after closing date if does not close on time. If there is a party in default, then other party can give notice and a 5 business day period begins, and if not closed within, then contract may be cancelled. BASIS IN GIFT AND PARTIAL GIFT TRANSACTIONS: P. 26 of problem booklet: Juan gave his daughter Carla 1000 shares of stock he had originally purchased for 60k. FMV at transfer is 80k. How much gain does Carla have if she sells the stock for 120k? Original Basis: 60k. 120k Amount Realized Carla Basis: 60k from carryover. (See carryover basis rules, about if donor basis is less than FMV or greater than FMV). Amount Recognized: 60k. (120-60). What if Juan’s basis was 100K? Same. What if Carla sold for 70K? Go to EXCEPTION: FMV becomes basis for purpose of calculating the loss. So 10K loss. § 1223-2 If someone’s basis is determined in whole or in part by anyone else’s basis, then they get to tack holding periods. In characterizing the gain, we need to determine the holding period. Here, we can tack holding periods. Note: Don’t fall into the trap that short term capital gains are ordinary income. Basis for Computing Loss: Donor AB = 100K. Gives to Donar. Donars AB for computing gain is therefore 100K. But donor sells for 90K. So Basis for Computing Loss Applies which is FMV at time of transfer. Exceptions: If sold for anywhere between the FMV at the time of transfer and the Donor’s AB carryover AB (which is greater than FMV), no gain or loss. Said Differently: If the FMV at the time of transfer is the selling price and is less than Donor’s AB, then no gain or Loss. Tip: Don’t give away depreciated property. Part Sale /Part Gift: Basis is the greater of the amount paid or the donor’s basis. No losses allowed on a part sale part gift. § 267 disallows losses between any related people (descended or ancestors and siblings). Basis on Death: (1) FMV of Property at date of decedents death if the property is in the decedents estate. § 1014(a)(1). Assumed to be the value quoted in estate tax return. This means can acquire by will, JT, etc. 10 Exceptions: §2036 and 2038 “if retain the right to beneficial enjoyment or stock voting rights during life it is taxable” “If have right to revoke a trust” included in tax. (2) Estate Tax Marital Deduction: If property passes to a spouse, treated as one, so no tax burden. If T acquired land on 3.1.1986 and the basis Joint tenancy: If owned in JT all part of estate, unless it is a husband and wife, then ½ included in state. Community Property: The whole property steps up to the FMV on death of one spouse. Rev Ruling 92-37. § 1014(a)(6). “In case of decendents property which represents the surviving spouses ½ share of the property under community property shall be considered as acquired from decendent.” Tip: Take title as community property with rights of survivorship. Capital Losses: Capital Gains requires three elements: (1) (2) (3) Sale or Exchange Requirement: Commissioner vs. Fairbanks. Held that this is much more restricted than “disposition.” (a) Cancellation or extinguishment of a debt is not a sale or exchange. (b) Always make it a sale or exchange when dealing with contract extinguishment so it can be capital gains. What you need for a sale or exchange: (1) Complete disposition of the property. Cannot keep any interest in the property. (2) Property Must Exist Afterwards (especially when dealing with notes and contracts and other transferable interests). a. § 1234(a) Modifies the common law above: Gain attributable to the cancellation, lapse or termination of a right or other obligation … shall be treated as a capital asset. (3) Consideration for the transfer = a sum that can be fixed. Cannot be a nonrecoours loan because there is no risk shifting and the price may never be paid. Cannot retain any of the upside either. Exception: The right to ordinary income is not a capital asset. Service Profits Interest in Partnership: Rev. Ruling: 93-21. B puts money into a partnership and A provides services. The value of A’s interest is the value of his portion of the partnership if it is liquidated. How to take a fee and make it capital gains: (Do it through a partnership). Hedge Fund Managers: Don’t get an interest in capital, just an interest in profits. Get 20% of profits after return of capital accounts (key) and it is long term capital gains to Fund Manager if the asset was held by the partnership meets capital gains criteria, because income is determined and characterized at the partnership level. Must provide that first distributions go on an amount equal to taxes owed to both parties to protect the service provider. Clay Brown Case: A sale Lease Back Scenario (That can’t be done anymore): Clay Brown owned a corporation that owned a saw mill. A charity approached him to buy the saw mill. He agreed to sell it for $500 down and gets a note for 1.3M. 10 Years interest free. No imputed interest rules at the time. Charity liquidates the purchased company so all assets in the company. Clay Brown starts a new company and leases all the assets previously sold under the new company. The lease payments were 80% of the profits to the charity. The charity then paid 72% of 100% of the profits to him as per the payment provisions on the note. The 80% of profits paid to Charity were deductible, so saved on corporations tax bill (call it 50%). The 80% to Charity tax free because 501(c)(3). Then the 72% paid from Charity to Clay was capital gains (Because they were paying on the note they owed him on a sale so it was capital gains). IRS attacked because they say Clay kept all the risk because the note might never be paid and that’s not a sale. Shut down today because Charities cannot run a business unrelated to the charitable exemption. However, there is a current exemption for rents and debt financed property. But it is done on a prorate basis with respect to amount financed, so the clay scenario would have all money taxable at the Charity level. Summary: A sale is a sale if the price is reasonable and no reversionary interest is reserved. CA Landlord Tenant: IRC § 1241 cancellation of a lease. A lease can be an asset subject to a sale or exchange if all rights with no reversionary interest is sold. §1234(a) (stop commodities trading arbitrage) & §1271 payments on maturity of debt creates a sale or exchange. Futures Contracts: Farmers want to deliver grain in July and say will take $3 a bushel, so enters into a futures contract with a trader who guarantees that payment, trader then trades them on an exchange. Can buy a contract that says “in july I will take possession of X bushels of corn at a certain price.” Saved distributors from having to store too much in grain elevators. § 165(g) Losses from worthlessness of stock or securities (qualified debt instruments too) is considered a sale or exchange. § 166(e) Bad debt deductions for non-qualified debt instruments. (not in coupon form or not registered). § 1244 Losses on a small business corporations stock up to $50K is an ordinary loss. You must be an original investor and the business must generate less than a certain threshold in gross receipts. Racine Tip: if repping an investor, get more than one to pool interest and form an LLC to hold stock in the .com company. When the .com is worthless, abandon the LLC interest and take an ordinary loss. Problem Set IV A(d). Arrowsmith v. Commissioner: When a capital gain is had in one year, but a payback happens in a subsequent year for a defect, the payback would normally be ordinary loss because no sale or exchange. Generally each year stands along. However this case provides an exception. Rule: (the Arrowsmith Doctrine) If can look at one thing as a single integrated transaction (same parties same item), the character in the first year carries forward to transactions in subsequent years. Then what happens when income is reported based on claim of right (but not possession yet)? § 1341 ameliorates. Can redo previous years taxes or take refundable credit in current year. No interest however. DEFINITION OF CAPITAL ASSET: Property held by a tax payer whether or not in a trade or business, other than certain exceptions: -Any capital asset held less than 1 year give you short term capital gains. Short term capital gain is not ordinary income – except taxes at the same rate. Exceptions: (§ 1231 does not apply to these) (a) Inventory (b) Property held by taxpayer primarily for resale to customers in the ordinary course of business. (i.e. non fungible items i.e. not inventory, i.e. stock brokers /securities dealers or real estate held for sale. (c) Any kind of copyrightable property (by the author?). (Software). a. Exception: When selling a copyright and not in the business of selling copyrights. (i.e. MGM catalogue sale is cap gains). b. Patents are capital assets. i. §1235. Can depreciate a patent and there is no recapture. Sale of a patent is considered LTCG. No holding period requirement. Doesn’t matter what the royalty basis is. But must sell all substantial rights. c. Master Negatives (some cases say capital asset). d. What about Trademarks? (d) Note or Memorandum (Eisenhower’s presidential papers) (e) CAN HOWEVER: Sell stock in a corporation that has non-capital assets such as copyrights. Corn Products and Arkansas Best. See Handout. See Book P. 1158 and 1159. Francis the Talking Mule. Ordinary income on picture rights to a character being sold, even though not copyrightable. §1231 BUSINESS EXCEPTION: §1231 Property (depreciable property held in a trade or business): Any gain recognized from the sale or exchange of property used in a trade or business or transaction entered into for profit. (1) §1231(b) Sale or Exchange OF “Prop used for Business” a. “Used in Business” means §1221(2) property held for more than 1 year (depreciable property held for more than 1 year), which is not: i. Inventory ii. Held for sale in trade or business iii. Not publication 1. Does not mean timber, gold, iron ore, livestock other than cattle. (2) §1231(c) Casualty or Condemnation of Property used in Business or for profit (basically §1231 applies to capital assets that are casualty or condemned). a. Fire, Storm, Act of God. b. Causality Losses > Causality Gains (Insurance) is ordinary income. (3) Garden Variety capitals assets held for more than 1 year. Netting Process: **§1231 Gain > §1231 Loss, all items LTCG **§1231 Gain =< §1231 Loss all items: § 1231 does not apply and losses are ordinary. § 1245 Depreciation Recapture at ordinary income rates for depreciable personal property (and certain real property that is functionally equivalent to personal property): Taxed at ordinary income rates. Lower of Recomputed Basis or Amount Realized if disposed by sale, or FMV if disposed any other way, divided by the Adjusted Basis = Ordinary Income. Recomputed Basis is: AB + depreciation taken by any parties (so moves with transfer of property), even when property transferred under 1031. This almost always = purchase price. Basically, amount between the Adjusted basis and purchase price is §1245 gain at ordinary rates. The amount over purchase price is 1231 gain at capital gains rates. The policy is to not create arbitrage when asset sold for less than purchase price and depreciation has been taken. §1245 gain is recognized no matter what, even if there is another exemption on point outside of §1245. §1245(b) has the exceptions: (1) Gift (2) Death (3) Certain tax free exchanges, including 1031 like kind exchanges (this defers the 1245 gain from being recognized on transfer). §1250 (Un-recaptured 1250 gain –straight line on real property) is what I know as depreciation recapture (recapture of amount depreciated from original basis or amount realized, whichever is less. Personal assets: §165(c) In the case of an individual can only take loses incurred in a trade or business or entered into for profit or as provided for in H (not entered into for profit by loss from act of god). 165(h) Casualty Losses for personal items (not real estate?): (a) Can’t take 1st $100 of losses. (b) Can’t take netted casualty losses (greater than casualty gains) greater than 10% of adjusted gross income (except Hurricane Katrina). PROCEDURE: Look for casualty’s: (1) Net Casualties (2) Bring Casualty Gain into larger LTCG picture (3) If Losses Exceed Gains then Ordinary Loss: Abandonment: Can abandon a film by giving up copyright and have an ordinary loss. PROBLEMS: B(c): (i) 165(h) loss (ii) 1231 does not apply because of abandon. Ordinary Loss. (iii) 1231(b) Gain ADDITIONAL CHARACTERIZATION RULES: §1239 – Gain from sale of depreciable property between certain related taxpayers. When selling to an entity controlled at least 50% by seller, it is ordinary income (unless § 1221 applies and the corp cannot depreciate the property because it is inventory and held for development). BROKERS & DEALERS § 1221 (Ordinary gain and loss) A dealer is a guy who holds property: (1) Primarily For Sale (defined as of first importance) (2) To Customers (3) In ordinary course of business Element 1, “held for sale” Everyone sells, so how do we distinguish? If you sell “a lot” and actively then in business. If you sell occasionally probably not in business. Byron Case Capital gains treatment given to flipper who sold 22 parcels of Real Property, but did not keep an office or make improvement. Greer Case: A guy leased one piece of property and the court held it constitutes a trade or business because he was there maintaining it a lot, shoveling snow etc. Stocks and Bonds: If you manage stocks and bonds for own account can never have ordinary income because do not have Customers. Hedging Bets are different. … ??? Dealers are companies like K&B Homes. The big fight is when subdividing for people who do not do often. Buy farm land near a town that’s growing fast make money on crops, then subdivide and sell off when the town grows out. Suburban Realty P. 158. (5th Circuit). When profits have arisen from the ordinary activity of a business on one hand and appreciation on the other, before we can arrive. Suburban located in Houston. Between 1939 and 1971 made 244 individual parcels of real estate sales. At least 1 a year. Then decided to liquidate the remaining property. Did not solicit buyers, did not improve or develop, did not do much. **Where they dealers? Continuously engaged in holding and selling real estate, nothing else. Developed 5-11 part test to determine if the property was held primarily for sale to customers in the ordinary course of business. So ask: (1) Was the taxpayer in business? (2) What was the business (3) Was the property sold in the ordinary course of business? (really a frequency question). (4) Was the sale a departure from the norm? (1) Determine Original Intent (investment vs. … (2) Soliciting and advertising for sale (Like KB homes) (3) Extent of development and improvements. (standing alone some degree of development is not inconsistent with capital gains treatment). Being Practical (how to answer a client): Capitalize S-crop with 100K, then sell the personally owned property to a the related entity for a note. Then the S-corp does the development (with the higher basis because of the purchase price. The client get’s capital gains, and the S-corp passthrough is oridinary, but the original purchase price is protected as capital gains. Corporation is a dealer (as a development corp) and can’t depreciate the property (because it is inventory) so § 1239 does not apply. Is being deemed a real estate professional endangering the capital gains treatment? File tax put off paperwork. Problem C(d): Trader Scenario (Not subject to AMT because trading is the ordinary course of business. A trader must be a market maker or a “Bear Sterns” can deduct all expenses but gains and losses are capital, home traders don’t have customers (i.e. don’t know who customers are) so don’t qualify. Corn Products Case: Company decided to buy Corn Futures to insure supply. Court Ruled the buying and selling of these commodities was an integral part of the business, so therefore not characterized as capital gains. To hold otherwise would allow a taxpayer to transmute ordinary gains into capital gains at will. i.e. on a futres contract, the price goes up you sell the K for a capital gain if the price goes down, take delivery and sell as inventory and take ordinary loss. Western Wine Case: Stock purchased in wine company entitled owner to purchase wine. When stock sold at loss owners said it was an ordinary loss because they only bought the stock to ensure supply. Case on P.1155 Addresses machines that are leased as a business and then sold. How do the leases and sales get characterized? Company claimed just disposing of the property. Court held that there was still useful life to the machines when sold, therefore the company was in the business of selling too. Rule: (4) If in business of leasing and sell equipment at end of useful life to company, then the sale not in course of business and may be characterized as capital gains. (5) If sell with useful life left, then will be held to be in two business. Or is sell the leftovers from a manufacturing process (on a regular basis), will be held to be in two business. One sales and one leasing. Both are characterized as ordinary income. See Rev. Ruling 75-544 Sports Franchises (good tax shelter because players K’s are depreciable over a few years). Contracts were then never sold so there was no depreciation recapture. Even in a trade, there was not like kind exchange. They passed § 1256 to say at most 50% can be allocated to players when purchasing a sports Franchise. KNOW ALL OF §1221 FOR TEST!!! § 1221(a)(7) Gains and Losses under hedging transactions unless specifically identified (ordinary income) as something else are capital gains. P. 1160 Tres. Reg 1221-2(a) ???? Problem IV D (a) §1202 (Sale of small business stock). Deduction of 50% of the gain. Stock in a c-corp that qualifies as a small business organization acquired after 1993. $50M of basis in assets or less. Stock must be acquired in original issuance. C-corp must also be an active trade or business over it’s life. Exclusion for lawyers, accountants, actors, banks. More than 10% of the assets cannot be in Real Estate. Computer software royalties are active. Holding period 5 years. Next Non-Recognition Exchanges under § 1031. Read all regs and Skip 1031(a)-2t and all regs under 1031(j). Read McDaniel 1033-1059. 1031 EXCHANGES Elements: (1) Exchange (2) Held for investment or in trade /business a. What is duration for “held” i. Answer: Cannot have intent to sell immediately. There is a big presumption against someone who flips. (3) Property exchanged for must be held in a trade or business or for profit, and (4) Must be like kind. a. §1031(a)-(1)(b) – In reference to the nature and character of property, not to its extent or quality. i.e. land is land (if it’s a leasehold must be more than 30 years). Personal property must be of the same service code as the property exchanged for. Defined by IRS. b. Does not apply to: i. Anything held for sale, including inventory. ii. Securities or Debt or choses in action, or iii. Interest in a Partnership. 1. Step transaction doctrine applies. Cannot start with an interest in a partnership, liquidate and end in a partnership. 2. However, Partnership A and Partnership B can swap interests. 3. Can’t offset cash boot with liability boot. c. No Gain OR loss is recognized d. Do not sell property, take cash and reinvest. (5) Any property that is not of like kind (such as cash) is boot. a. Boot is recognizable., but b. You recognize the lesser of boot or gain. c. S 1031(d) Computing Basis in an Exchange The basis shall be the same as the property exchanged decreased by the amount of any money received, increased or decreased by recognized gain or loss. Example D-2 Old AB + Amounts paid (including liabilities assumed, cash paid, FMV of non-like kind property). -Amounts received.(Liabilities Relieved, FMV or property received or not given up) + Gain Recognized -Loss recognized = New AB Another way: What would gain have been in a sale. The potential gain should be the same after an exchange. 3 Corner Exchange: X-> Y -> Z double escrow. 4+ Corner Exchange Third party escrow agent takes title and money and re-doles out. Modern Accommodator Transactions: 45 days to identify property with accommodator. Can identify 3 properties without regard to value, if more cannot be more than 200% of value. Have lesser of 180 days from the day the tax return is due to close the exchange. TMS Case: All I need to know about depreciation for Final: § 1016 Basis is reduced by the depreciation allowed or allowable. 3 hours, 3 math questions. Open book open note. 4 thoughts: be scrupulously honest never make a promise you can’t keep keep all promises don’t take self to seriously.