Real Estate Land Taxes Ordinary Income Long Term Investment

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Real Estate Land Taxes Ordinary Income Long Term Investment Powered By Docstoc
					                                        Income Tax
                                         Prof. Roin

I.   Structural Overview: The Tax Rate Schedule
     A. Basics
         1. Tax rates are listed in § 1.
         2. Mechanical Steps to Compute Tax (also in HO 1)
            a. Calculate gross income (§ 61)
            b. Subtract above the line deductions (§ 62) = adjusted gross income.
            c. Subtract either standard deduction or below the line deductions (§ 63), as
                adjusted by the phaseout provisions (§§ 67, 68)
            d. Subtract personal exemptions (§ 151), also adjusted by phaseouts.
            e. Apply tax rate schedule to taxable income.[Excluding capital gains, which are
                calculated separately.]
         3. Tax Rate schedule is progressive because we think people who earn more ought
            to pay proportionally more to the federal government.
     B. Marginality
         1. Rates are complicated [5,535 + 28% of excess over 36,900] so that people will not
            lose money when they get ―pushed into a higher tax bracket.‖
         2. Under the marginal system, each slice of income is taxed at its own rate.
         3. Still, if rates are too high, it will discourage work: ―I’d rather watch TV than earn
            50¢ on the $.‖
     C. Hidden Rates
         1. IRS can generate more revenue either by raising rates or adjusting basis.
         2. Post-1986, Congress has primarily raised revenue by phasing out deductions.
         3. Rationale for Deductions
            a. Think not everyone w/ the same gross income in the same economic position.
            b. Example: Difference b/n law firm associate and small business owner
         4. In cases where deductions are disallowed for expenses only b/c gross income has
            increased, has effect of increasing a person’s marginal tax rate. See HO 2B and
            Problem 1-3 (statutory rate of 36% goes up to 42.2% with phaseouts).
         5. Rationale for Phaseout of Deductions
            a. Only want to co-pay some expenses (like medical) for those w/ lower income.
            b. Can play political games and hide tax increases.
     D. Married People
         1. Congress has provided different tax rates for married and single individuals.
         2. Problem Set 1: Two equal wage-earners will increase their tax burden if they
            marry (―Marriage Penalty‖), but if the husband earns all the income, the tax
            system confers a ―Marriage Bonus.‖
            a. Many Congressmen want to give tax break to traditional families.
            b. But this undercuts traditional marriage in 2 wage-earner households
         3. A few possible solutions, but none of them good
            a. Widen the rate brackets so marriage rates are just double the individual rates
                i.        Big loss of revenue
                ii.       Phaseouts also harm married couples and would be unaffected
            b. Double brackets in phaseouts too (Huge Revenue Drain)
             c. Award a flat second-earner deduction
             d. Give taxpayers the option of filing under a single rate structure (Drain)
II.   Income
      A. Receipt (Realization Problems)
         1. § 61: Gross income ―means all income from whatever source derived.‖
             a. Only counted as income ―to the recipients.‖ § 1.61-2.
             b. If you are viewed as having received a certain benefit, it is income.
         2. Old Colony
             a. Facts: Wood has income taxes of $681K paid for by his company. That $681K
                is income, and Wood owes tax on that too.
             b. Same result if American Woolen gave 681K to Wood’s 12 year old daughter,
                or paid for his 18 year old daughter’s college education.
             c. But result would be different if education paid through National Merit
                Scholarship funded by the company.
             d. Also different if company donates 681K to the Art Institute where Wood
                serves on the Board. [Note: Even w/ charitable deductions, Wood would be
                taxed more if he donated himself b/c of phaseouts.]
         3. Principles for Analysis of Receipt
             a. Certainty: less chance of gaming the system with National Merit.
             b. Benefit: Long-term prestige from donation so at least some purpose
             c. BL: Different tax treatment depending on whether Wood receives the money.
         4. Timing: When is Income Received? (Drescher)
             a. Court requires Drescher to include $5000 employer uses to buy an annuity in
                his income the year purchased.
                i.      T: I won’t receive income for 19 years; should pay then.
                ii.     Importance of deferral based on TVOM (and here also b/c Drescher
                        may be in lower tax bracket in 19 years earning less income.)
                iii.    If let T do this, vicious cycle of HO 3 occurs w/ T and employer
                        colluding so both pay lower taxes by shifting compensation to non-
                        taxable forms. IRS loses revenue or taxes those who can’t take
                        advantage of annuities.
             b. Rule: Taxable on any cash or property you receive. Since annuity is tangible
                property with certain value, it is taxed when Drescher receives it.
      B. Fringe Benefits
         1. Valuation Problems
             a. Undertaxing  same as Drescher (HO 3); fear if we let you deduct a business
                lunch, employers will start paying you with more lunches and less salary.
             b. Overtaxing  If Benaglia must have his hotel manager work in his hotel, then
                he has no all-cash alternative and will have to pay more cash to get an
                employee. Don’t want tax system to force people sensibly providing meals
                and lodging to move away from that for tax reasons.
             c. BL: Don’t want to change taxpayer behavior through under or overtaxation.
         2. Meals & Lodging
             a. Tax can’t be based on reporting subjective value b/c people will underreport.
             b. Benaglia: Are benefits provided for the ―convenience of the employer‖ or as a
                form of compensation?

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           i.    Unclear whether necessary for Benaglia to live at hotel (or just near)
           ii.   NY law firm could provide associates w/ Mid-Town apartments. Too
                 manipulable a test
      c. Statutory Solution: § 119
         i.      Meals/lodging must be directly furnished by employer on the
                 employer’s premises. Kowalski.
         ii.     If meal, must be for convenience of employers
         iii.    If lodging, must be a condition of employment.
         iv.     While firm could still provide a restaurant or hotel, it seems unlikely.
      d. BL: Once tax benefit is accidentally created it’s hard to yank. A person’s taxes
         will suddenly go up as their compensation drops. HO #3-3. So just contain.
   3. Other Fringe Benefits [§ 132]
      a. General rules.
         i.      Discount must be less than or equal to 20% if service or the gross
                 profit percentage if property.
         ii.     Retirees, widows, spouses, and dependents also qualify as employees,
                 as do parents for air transportation only.
         iii.    Nondiscrimination rule: Fringe benefit can’t go only to highly
                 compensated employees. But toothless if discount is on a Mercedes.
         iv.     Discount must be in your line-of-business, so a Hilton employee can’t
                 get a benefit from TWA even if both are owned by same
                 conglomerate. But a conglomerate exec could get both.
         v.      Only OK to the extent you provide good or service to the public.
      b. No additional cost services like airline tickets are not income.
      c. Can’t get discounts on things like marketable securities that are almost cash.
C. Income v. Capital Recovery
   1. General Treatment
      a. § 61(a)(3): Income includes wages + gains derived from property.
      b. Gain = Amount Realized – Basis. § 1001(a).
         i.      Amount Realized = Cash Received + FMV of other property received.
                 § 1001(b).
         ii.     Adjusted Basis[§ 1011(a)] = Cost[§ 1012] adjusted by § 1016.
      c. Example: One year Mary earns $400, buys a cow for $150, and sells the cow
         for $250. Her income is 400 + (250 – 150) = 500.
   2. Disposal in Units Different from Those Purchased
      a. Treas. Reg. § 1.61-6(a): When a taxpayer disposes of only part of a property,
         he must allocate basis b/n the amount sold and that retained based on relative
         fair market value.
      b. Example: Mary buys a cow for $150. This year she sells ½ the cow for $100.
         Next year she sells ½ the cow for $110. In Yr. 1 she gains (100 – 75) = 25. In
         Yr. 2 she gains (100 – 75) = 35.
      c. Often big difficulties in appraisal: Mary buys 40 acres for $150 and sells 20
         acres that are rocky for $100. If she allocates 1/3 of the value to the property,
         her gain is 50. If she allocates ¼, her gain is 62.50. By allocating more, she
         can defer TVOM on $12.50.
   3. Treated as Capital Recovery Only

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       a. City uses eminent domain to change river and pays T $49,000. T may allocate
          the entire award to reducing basis of land and none to easement it has gained.
          Inaja Land Co.
       b. Rationale: FMV difficult to determine and circumstance unlikely to recur.
       c. T gets huge TVOM benefit. Inaja a unique case; always distinguished.
   4. Treated as Income Only
       a. Despite sympathies of the Great Depression, prepaid leases must be treated as
          income b/c substitute for future income that would ordinarily be received.
          Cannot be used to offset basis. Hort.
       b. Any money received from a trust must be treated as income and cannot be
          used to reduce the basis of the trust. Irwin.
       c. No allocation allowed here b/c taxpayers could manipulate and not realize tax
          by not selling building or trust. TVOM. Contrast Inaja where the situation is
          fact-based on state action of eminent domain unlikely to recur.
D. Gifts
   1. General Rule: Gifts not included in gross income. § 102(a).
   2. Limitations
       a. Allowing employers to give employees ―gifts’ instead of ―compensation‖
          could lead to big rate arbitrage problems, as discussed in HO #6.
          i.      If parties taxed at different rates, the employer can give a greater
                  benefit at a lower cost.
          ii.     Even a limitation on deductibility may still allow some tax arbitrage if
                  employee’s marginal rate is higher than employer’s rate.
          iii.    BL: Gifts just another form of tax-free benefit where IRS must look
                  out for collusion and arbitrage. Back to Benaglia.
       b. Court initially imposes a ―fact-specific‖ approach based on donor’s intent that
          proves totally unworkable. Duberstein.
       c. § 274(b): Business gifts are deductible by the business only up to $25/year.
       d. § 102(c): Any amount transferred from employer to employee is not a gift.
          The employee must include in income (unless de minimis under § 132).
   3. Basis Rules [§ 1015]
       a. § 1015(a): Normally, the donee’s basis in gifted property will be the basis in
          the hands of the last owner who did not acquire the property by gift. PS # 3.
       b. However, if this basis is greater than FMV of property at time of gift, then for
          purpose of determining loss, the basis will be the FMV of property at time of
          gift.
       c. If FMV at transfer < Donee’s Sale Price < Donor’s Basis, no gain or loss is
          recognized. See PS # 3.
       d. Because of these rules, you should never give away depreciated property.
          Instead sell it, claim the loss, and gift the cash.
       e. Compare § 1014: The basis for property transferred at death is always the
          FMV at the date of death.
          i.      Usually this will lead to ―stepped-up basis‖ that won’t be taxed.
          ii.     If property depreciated, there will be ―stepped-down basis,‖ so people
                  usually try to sell these assets before death and avoid disappearing loss



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           iii.    Don’t allow this stepped-up basis for gifts. Taft. Rationale: People
                   would gift property anytime it appreciates to avoid tax consequences.
                   This is too big a loophole.
          iv.      Alternate solution: Treat a gift as a realization event. This would have
                   really hurt taxpayers though on TVOM.
          v.       Congress tried replacing § 1014 w/ a § 1015 rule, but it was repealed
                   b/c often impractical to figure out what the original property basis was.
      f. Nonstatutory Basis (Clark)
          i.       Sometimes courts will find a nonstatutory basis that wasn’t purchased,
                   inherited, or gifted.
          ii.      Example: An accountant error causes  to overpay IRS by $ 19,000.
                   Accountant gives  that amount. Court treats as recovery of capital.
          iii.     Inconsistent that you can exclude from income but can’t take a loss
                   deduction if your accountant won’t reimburse you. Same problem
                   arises with personal injury awards.
          iv.      BL: Allow weird quasi-basis to sympathetic taxpayers sometimes.
   4. Gifts of Divided Interests [§ 102(b)]
      a. What happens when you leave a trust to your grandchild and allow your son to
          draw interest until the grandchild turns 21?
      b. Annual trust income taxable to son, while grandchild will receive gift under
          normal § 102 rules.
E. Cancellation of Indebtedness Income
   1. General Mechanics
      a. Loans are not included in income b/c subject to obligation to repay.
      b. But if the obligation is cancelled, there is income at that time. § 61(a)(12).
      c. Example: Borrow $30,000 from bank. 4 years later bank forgives loan. You
          have $30,000 gain in Year 4.
      d. Example2: Sell $1 million in bonds. Buy bonds back for $862,000. Company
          recognizes taxable gain of $138,000. Kirby Lumber.
   2. Purchase Price Adjustments [§ 108(e)(5)]
      a. If you purchase property and later haggle and get a reduced price, that may be
          treated as a purchase price adjustment and not income.
      b. Example: Joan borrows $15,000 to take a trip around the world and has an
          awful time. She convinces the tour company to refund $10,000. That is not
          income, although it would be if she borrowed the money from the bank.
      c. Example2 (Zarin): Taxpayer with huge gambling debts held to be haggling
          over actual price of chips and not recognizing discharge of actual debt.
      d. May also apply if parties are very closely related such as loan companies
          associated with or referred from car dealers. PS # 4-1.
   3. Insolvent Debtors (PS #4)
      a. Any discharge of debt when T is insolvent is excludable from income.
      b. Any successor corporation cannot use a net operating loss (NOL) unless it
          first absorbs all of the DOI income.
F. Transfer of Property Subject to Debt
   1. Loans as Basis


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     a. Funds borrowed by T and invested in property (i.e. mortgages) are treated as
        part of the cost of property and part of basis.
     b. Basis in a house is $100,000 if
        i.       I buy it with $100,000 cash
        ii.      I buy it with $100,000 I borrow from the bank
        iii.     I buy it with $100,000 I borrow from the seller
        iv.      I assume the seller’s $100,000 mortgage.
        v.       I buy it with $100,000 of nonrecourse debt (lender can only get the
                 property if I default and can’t touch my other assets).
     c. Limitation: If I borrow money secured by property (my house) and invest it in
        another asset (my boat), the money is allocated to basis of boat, not house.
        Woodsam.
     d. If we didn’t include loan proceeds in basis, then every loan repayment would
        require basis and depreciation adjustments. See Crane.
2.   Loans as Amount Realized
     a. When disposing of property, Amount Realized = Cash Received + Mortgages
        Assumed by the Other Party. Treas. Reg. § 1.1001-2(a)(1).
     b. Example: I sell property w/$60,000 mortgage to J, who pays $40,000 and
        assumes the mortgage. Amount Realized = $100,000.
3.   The Ambiguity Problem
     a. When interest rates rise, the economic burden of lower interest rate debt falls,
        but DOI income can screw things up.
     b. Example: T buys house for $100,000 w/ mortgage at 6% interest. The rate
        rises to 10%. T would be willing to pay $70,000 to pay upfront. But if he
        does, he will have $30,000 in DOI income.
     c. Possible Solution1: Sell house to J for $30,000 cash + assumption of debt.
        Now T has $30,000 gain, but no tax on first $250,000 gain from residence,
        and even if business instead, it would be taxed at low capital gains rate.
     d. J will now have basis of $130,000.
4.   Recourse Loans
     a. Treas. Reg. § 1.1001-2(a)(2) specifically disallows Possible Solution 1;
        instead T must bifurcate the transaction. Amount realized would be FMV of
        the property, and T would have DOI income to the extent that such value was
        less than face amount of the recourse debt. Check this somewhere.
     b. BL: Recourse loans bifurcated into sale of property and DOI income.
     c. By and large though, Treasury doesn’t try to figure out value of assumed loans
5.   Nonrecourse Loans (Tufts)
     a. What happens when T disposes of property subject to a nonrecourse
        mortgage? Suppose T takes out a $1.85 million nonrecourse loan secured by
        the property, which falls in value to $1.4 million, and in which (through
        depreciation deductions) T now has a basis of $1.45 million.
     b. T’s position: Amount realized = FMV of property = $1.4 million. Loss
        [Amount Realized – Basis] = $50,000
     c. Tax purist position: T is right, but in addition, T has realized DOI income of
        $450,000 b/c he paid of a $1.85 million debt w/ a $1.4 million property.



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             d. BLL (Tufts): Amount realized = (Cash + Mortgages Assumed) = $1.85
                  million. Gain = Amount realized – Basis = $1.85 - $1.45 = $400,000
             i.        Court deems FMV of the property in question irrelevant.
             ii.       Court basically mashes two transactions together. While purely a loss, this
                       still ends up resulting in a net cash flow gain b/c of TVOM and b/c
                       transaction taxed at capital gains rate. Gets a bit of a break for T, but not
                       as high as he wanted.
             iii.      Matters because the higher your initial basis in nonrecourse debt, the
                       higher your potential depreciation deductions. (Tax shelter options).
             e. However, if we applied the recourse loan rule to nonrecourse debt, it would
                  change the value of debt/gain every time the property value goes down, which
                  is just administratively infeasible.
          6. Basis of Recipient on Transfer
             a. Usually assumed basis is Value of Mortgages Received.
             b. Occasionally use FMV (Pleasant Hill Summit) or zero (Estate of Franklin) if
                  the value of the property has dropped drastically and we think this is a tax
                  shelter case and debt unlikely to be repaid. See HO #5 and Notes 1/29/1.
             c. If given this lower basis and property declines further in value, amount
                  realized should be limited to this lower basis since this is ―cost.‖
             d. Wouldn’t be totally irrational to take property whose value is less than that of
                  its mortgages if debt is nonrecourse. If doesn’t appreciate, you can just default
                  and bank eats the loss. Reason Pleasant Hill Summit makes sense.
          7. Gifts
             a. What do you do when you give somebody mortgaged property as a gift or
                  require them to pay your gift tax? Recharacterize as part gift and part sale.
             b. Rule for Charities and ―Right Answer‖ § 1011(b)
                  i.        Allocate on a percentage basis b/n gift and sale.
                  ii.       Example: Man gives church a $250 piece of property in which he has a
                            $100 basis subject to $200 gift tax liability. Treated as selling 4/5 of
                            the property (w/basis of $80) for $200 and giving $50 gift (w/basis of
                            $20). Therefore, Man has a gain of $120.
                  iii.      Church’s Carryover Basis = Donor’s Basis in Gift + Sale Price = $20
                            + $200 = $220
             c. Rule of Diedrich
                  i.        Treated as selling the whole property for amount discharged.
                  ii.       Example: Amount Realized – Basis = Gain. Here $200 - $100 = $100.
                  iii.      Son’s Basis = Sale Price(Gift Tax/Amount Realized) = $200 {or
                            Donor’s Basis, whichever is greater}.
                  iv.       Follows regulations from § 1.1015-4, but lets you defer $20 in taxes.
                  v.        If the property is mortgaged for less than the basis, you can’t
                            manufacture a loss. See § 1.1015
III.   Timing Issues
       A. Realization
          1. Gains and losses only determined when property is sold to a third party for cash.
          2. Rationale
             a. Difficulty of determining value of property w/out sale.

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      b. Fear ―forced liquidation‖ of assets.
   3. But don’t want people going back to barter to avoid taxes.
   4. Cases & Trends
      a. In Eisner, the court found that a 2:1 stock dividend was not a realization event
          because there was no severance of the asset.
      b. But in Helvering, the court holds that a building attached to the land might
          have been severable and a new building on land is realized when the tenant
          defaults. Basically overrules Eisner.
      c. In Cottage Savings the court turns formalist again and finds a realization when
          nearly identical assets are exchanged by S&Ls. The property differences were
          enough to be considered ―materially different‖ for § 1001(a).
      d. BL: Courts are inconsistent, so you have to just follow statutes. When courts
          try to loosen realization, Congress usually passes nonrecognition statutes.
B. Nonrecognition Rules
   1. Key Elements of All Nonrecognition Rules
      a. Taxpayer can ignore gains that are realized.
      b. Basis is preserved.
   2. § 305(a)/§ 307
      a. Macomber codified: GI does not include a stock distribution to shareholders.
      b. § 307(a): Basis of old stock is allocated proportionally b/n new and old stock.
   3. § 109/§ 1019
      a. Reverses Helvering: At the time of lease termination, income does not include
          the value derived from any building improvements on the land.
      b. § 1019: No basis adjustment allowed at lease termination.
   4. § 1031
      a. There is no gain if property exchanged for property of like kind.
          i.       Can’t sell for cash. Structure transaction as a trade even if 3-cornered
          ii.      Properties exchanged must be ―trade, business, or investment
                   property.‖ No recreation sites.
          iii.     ―Like kind‖ based on type of asset rather than common sense or use in
                   business (gold and silver not like kind; computers and printers are).
          iv.      Cannot exchange stocks, bonds, or notes as like kind property.
          v.       Any real estate (apt. building for undeveloped land) is like property.
          vi.      Numerous miscellaneous limitations: livestock only if of the same sex.
          vii.     If exchange with a related person and they dispose of the property
                   within a certain time, loses nonrecognition advantages. § 1031(f)(1)(C)
                   Easily circumvented w/third party brokers.
      b. Allows taxpayers to get property they want and defer taxation. Big benefit.
      c. Straightforward exchange: Basis is simply preserved; tax deferred.
      d. Trading Up
          i.       If give away property and cash for like property, no tax is recognized
          ii.      If give away property, cash, and other property (hay) for like property,
                   must recognize the gain on the other property.
          iii.     Basis = Carryover Basis (i.e., basis in old property) + Cost [Cash &
                   Unlike Property Received].
      e. Trading Down

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                 i.     If receive like property and unlike property (cash or unlike property),
                        the gain recognized = the lesser of (1) Unlike Property Received, or
                        (2) Amount Realized under normal principles.
                ii.     § 1031(d): Basis = (Carryover Basis of Property) – (Amount of $
                        Received) + (Gain Recognized) – (Loss Recognized).
                iii.    If received unlike property, must allocate to unlike property as basis its
                        FMV on date of exchange. Remaining basis is allocated to like
                        property received.
         5. Nonrecognition of Tax Losses
             a. Also cannot recognize tax losses if there is no realization event. See Rev.
                Ruling 84-145 (worthless airline routes in age of deregulation).
             b. But in Jordan Marsh a fixed-price lease w/obligation to renegotiate in 30 years
                is held to be enough to permit recognition of a loss b/c landlord not tenant will
                benefit from any increase in value in the next thirty years.
             c. Similarly could sell worthless air rights for $0 or quitclaim to government.
IV.   Exclusions from Income
      A. Imputed Income
         1. Generally
             a. The income tax only taxes transactions.
             b. Rationale #1: Very hard to value imputed income
             c. Rationale #2: Liquidity. If income not received in cash, people might have to
                sell assets to pay taxes.
             d. Therefore some financial benefits to people are never taxed.
         2. Home Ownership and the Mortgage Interest Deduction
             a. HO #11: A person who buys his house w/bank account does not have to pay
                rental income, so better off after taxes.
             b. To allow even people w/out bank accounts to take advantage of this, Congress
                allows deduction of home interest mortgage payments. § 163(a)
             c. Problems
                i.      Some fairness issues, but A could buy a house. Hardly hidden tax fact.
                ii.     Long term effect: Investment in housing will increase relative to other
                        forms of investment. Far more Americans own their homes.
                iii.    Real estate prices go way up. This makes it impossible for Congress to
                        repeal. Just like reliance in taxing fringe benefits.
                iv.     But it would be very hard to place a ―rental‖ value on homes. Hard
                        enough w/ property taxes.
             d. We do tax home loans w/ below-market interest rates. § 7872.
             e. Have contained this to homes by disallowing deductions on other personal
                interest loans. § 163(h).
                i.      Example: Car loans. Taxpayer C has same liability as A.
                ii.     But B still has less taxable income b/c no interest or dividend
                        payments. Therefore the rich benefit more than the middle class.
         3. Services
             a. If L pays A to draft plans, and A pays L to draw up a will, both are taxed.
             b. If L draws up a will in exchange for plans, both taxed on the barter exchange.



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      c. If L draft his own plans and A writes his own will, neither is taxed although
          the benefit to them is the same.
   4. The Marriage Penalty
      a. Many two wage-earner couples are faced with a huge tax burden. PS #7: If
          Wife B works outside to earn $20,000 but has $20,000 in housekeeping and
          child care expenses, the family is $5600 worse off.
      b. Part of the problem is the marriage penalty in the rate structure. Allowing
          husband and wife to file separately reduces difference to $4924. But the big
          problem is excluding the imputed household income of Wife A.
      c. Solutions?
          i.       Could allow a housekeeping expenses deduction (like § 163), but
                   people might deduct unreasonable amounts, and some people just live
                   in dirty houses or send their children to substandard day care.
          ii.      Could tax Wife A’s income. But valuation/political problems
      d. May want women to stay home, but also implicates welfare/alimony policies.
      e. Since the tax system can’t deal with the problem, it has ignored it.
B. Tax Expenditures
   1. Congress sometimes uses tax system to deliver benefits.
   2. Problems
      a. Offends tax purists
      b. Sometimes unintentionally benefits other people.
      c. Benefits might be delivered better through spending programs.
C. Tax-Free Municipal Bonds
   1. Path of a Subsidy: § 103(a)
      a. § 103: Gross income does not include any income from state or local bonds.
      b. If in 40% tax bracket, you can invest $1000 in a 10% GM bond or a 6% IN
          bond. Either way you will get $60 [6% return] after taxes.
      c. But IN benefits b/c it can borrow money at 6% interest instead of 10%. Same
          as if the federal government gave IN $40.
   2. Benefits
      a. Intended and complete: Even more than fringe benefits, all benefit goes to IN.
      b. Transparent: Nobody would buy a 6% state bond if not for clear § 103 rule.
      c. Makes sense: Project funded by bonds must still sell its creditworthiness to
          outside investors. They are more knowledgeable than federal bureaucrats.
   3. Obstructions
      a. Tax Arbitrage Bonds: IN issues bonds at 6% and uses proceeds to invest in
          GM bonds at 10%. Since IN not taxed, it can pay off bondholders and get
          even more money than government intended.
      b. Industrial Revenue Bonds: IN issues bonds at 6% and offers the money to GM
          to build a plant. All corporate debt becomes municipal debt and GM brings
          even more money into IN.
      c. So many bonds you run out of investors in 40% tax bracket.
          i.       Now must offer bonds w/ 7.2% interest for the 28% tax bracket.
          ii.      But this gives tax break to the 40% [rich] taxpayer. Now government
                   foregoes $40: $28 go to the state; $12 to the rich taxpayer.
   4. Solution: § 103(b) and Beyond

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            a. Eliminates tax arbitrage bonds entirely and many industrial revenue bonds.
            b. Caps volume of total bonds state/local governments can issue.
            c. But these bonds still attractive to 33% taxpayers. Some advantage to the rich.
            d. Municipal bonds still rather risky. Not necessarily blue-chip.
            e. Other proposed solutions
               i.       Allow interest deductions like mortgage interest deduction to turn all
                        investors into ―40% taxpayers.‖
               ii.      Replace § 103 w/ direct state subsidy. States hate this idea.
V.   Deductions
     A. Introduction
        1. Upside Down Subsidy Effect
            a. Policy Question: What income should the tax system ignore and not tax?
            b. If a rich taxpayer and poor taxpayer receive the same monetary deduction, it
               will wipe out more tax for the person with higher income.
               i.       If subsidy, why hand out a bigger subsidy to less pitiful people?
               ii.      But is a medical expense really a subsidy? Maybe we should compare
                        a rich person w/$20,000 in medical bills to a rich person w/out those
                        bills.
            c. Possible Solutions not widely used include refundable tax credits like the
               Earned Income Tax Credit, which is essentially a wage subsidy.
            d. Congress’ solution: Impose floors on deductions [§ 67] and phase them out at
               high income levels [§ 68] to make tax savings closer for rich and poor.
        2. Above the Line v. Below the Line
            a. Above the Line Deductions are listed in § 62. Everything else is below the
               line under § 63. Above the Line better (W wants to make charitable
               contributions Above the Line Deductions).
            b. Below the Line can be replaced by the standard deduction, which is claimed
               by 80% of taxpayers.
        3. Phaseout Provisions Applying to Below the Line Deductions
            a. § 67 Floor: Deductions allowed only to extent they exceed 2% of AGI.
            b. § 68 Phaseout: If earn six figures, reduce deduction by the lesser of (i) 3% of
               [AGI - $100,000] or (ii) 80%.
        4. Examples: PS #8
            a. Meal and hotel reimbursements are above the line. § 62(a)(2)(A), but those
               merely reported by taxpayer are below the line and subject to 2% floor.
               i.       Maybe think employer will better monitor and minimize costs. He
                        can’t fully deduct under § 274(n).
               ii.      But we also allow sole proprietor to deduct above the line, and here
                        he’s wearing 2 hats and more likely to gild.
               iii.     And employers may have incentives to lower taxes through arbitrage.
               iv.      Congress always generous to sole proprietors so unsurprising.
            b. Trade and business deductions are above the line. § 62(a)(1); § 162. But
               deductions for investments or collection of income below the line, § 212,
               unless attributable to rents or royalties. § 62(a)(4).
            c. Investors in real estate get better tax treatment than dotcom investors.
            d. Explanations for Phaseouts

                                             11
          i.      Congress attempting to accomplish substitute taxation like in Benaglia.
          ii.     Cynical: Congress wants to raise revenue w/out raising tax rates.
B. Business/Personal Borderline
   1. § 183
      a. If not engaging in activity for profit, you may not deduct your losses except to
          offset gross income derived from the activity.
      b. Combats ―hobby farmers‖: people who spend money on entertainment and try
          to claim a deduction for it. Essentially trying to tax psychic income.
      c. Tests for Determining Activity
          i.      Presumed for profit if profit generated in 3 of last 5 years. § 183(d).
          ii.     If not, apply multifactor test to see if T has ―bona fide expectation of
                  realizing a profit.‖
          iii.    Profit need not be near-term as long as working hard and don’t seem to
                  be deriving any pleasure from the activity. Nickerson.
      d. Even if you do derive some income from a § 183 activity (but a net loss), you
          won’t be fully compensated b/c still subject to 2% floor and § 68 phaseout.
   2. § 274
      a. Fear T will characterize personal expenses as part of profit-oriented activity.
      b. Let employer deduct T’s wages b/c we know T is reporting them as income.
          But if employer deducts T’s business lunch every day, we doubt T reports.
          Moss. So § 274 allows substitute taxation on business meals, gifts, etc. See,
          e.g. §274(b)
          i.      If too much substitute taxation, we will disfavor certain business
                  expenditures and certain industries. Back to Benaglia.
          ii.     If too little, we unduly encourage some business expenditures.
          iii.    Congress constantly tinkers with these rules to deal w/ problems.
      c. Beefs up the ―Business Nexus‖ Test
          i.      No deduction allowed unless ―directly related to or associated w/ bona
                  fide business discussion.‖
          ii.     But can still deduct lawyer retreat even if mostly pleasure; a spouse’s
                  meal if designed to make a client’s spouse feel ―comfortable‖; season
                  tickets used by firm associates if it ―helps firm morale.‖
      d. Specific Disallowances
          i.      No business gifts of more than $25. § 274(b).
          ii.     Only deduct half of meal and entertainment expenses. § 274(n).
          iii.    No extravagant entertainment like skyboxes, § 274(l) or luxury water
                  transportation, § 274(m).
      e. Substantiation Requirement: Must have receipt; explain business purpose.
      f. Below the line: Still subject to §§ 67-68.
          i.      Underinclusive: Sole proprietor w/ big HO #3 incentives can deduct
                  above the line.
          ii.     Overinclusive: Less deduction who generate no personal satisfaction.
C. Capital Recovery
   1. § 263
      a. Disallows deductions for capital expenditures in year of expense but allows
          them later through depreciation, amortization, or sale of asset.

                                        12
     b. Mainly a TVOM/tax deferral question from Drescher.
     c. Example: T buys $150 tractor. Must capitalize and depreciate.
2.   Matching Theory: If you can match up what you bought and sold, capitalize.
3.   Purchase v. Self-Construction Problem
     a. Rule of Encyclopedia Britannica
        i.       Company that wrote its own manuscripts could treat as expenses.
        ii.      But when it switches to paying for manuscripts, must capitalize.
        iii.     Rule told T that if you make facts messy enough you can deduct
                 instead of capitalize. Too administratively difficult for IRS.
     b. § 263A: large enterprises must capitalize cost of self-constructed assets.
        i.       Rationale: T already does this for business planning reasons.
        ii.      Eliminates cushy treatment for EB’s in-house manuscripts.
     c. Still, one who buys an asset can depreciate it, while one who leases must now
        capitalize and have it added to basis. Never recover until sell the product into
        that asset. See Crane Hypos on 2/12.
     d. Must capitalize even intangibles that don’t create identifiable assets like
        investment banking fees. INDOPCO.
        i.       But if no identifiable asset, you can’t ever depreciate it.
        ii.      Must simply add to basis of something; may never get a deduction.
4.   Repair & Maintenance Expenses
     a. Unexpected repairs generally allowed as expenses. Midland Empire Packing.
        i.       If law changes and may add value, as with fire sprinklers, often
                 disallow. Hotel Sulgrave.
        ii.      This is in stark contrast to the realization doctrine in § 1031 and Jordan
                 Marsh, where loss cannot be recognized until sale.
        iii.     Comparable to negligent accountant in Clark: Court sympathies allow
                 it to reach very T-friendly result.
     b. Expected (Wear & Tear/HO #14)
        i.       Perfect system would create a separate expense account for each
                 component part of an asset and depreciate each component. But
                 administratively this solution is not viable.
        ii.      Inability to predict future repair costs means we can’t expense over
                 entire life as we should either.
        iii.     Net result: Usually depreciate buildings over entire expected life (T-
                 unfriendly) and expense repairs (T-friendly).
        iv.      Another big option: Accelerate depreciation and capitalize all repair
                 costs. May partially explain why depreciation so overstated.
        v.       BL: Repair deduction takes the place of depreciation.
     c. Example: Can airline deduct an FAA-required overhaul of a jet engine?
     d. An alteration that increases value of asset or extends its useful life must be
        capitalized.
5.   Depreciation [§ 168]
     a. Theory & Design of Depreciation Formula
        i.       If we permit expensing of all business deductions, people will
                 recognize huge tax losses in early years that don’t really match
                 economic losses.

                                      13
           ii.    But if we require realization, T will make needless purchase and sale
                  transactions = depreciation w/ huge administrative costs.
          iii.    Therefore, Congress lets T claim depreciation deductions and at the
                  same time reduce the basis of assets to reflect actual value.
          iv.     Has become a policy tool to spur investment and deliver subsidies to
                  businesses who invest in capitalized business assets.
      b. Components of the Depreciation Formula
          i.      Salvage Value: Too administratively difficult to figure this out, so we
                  let T depreciate all the way from original basis to zero.
          ii.     Formula for Allocating Deductions Over Useful Life
               a) Straight-line would have a constant rate over useful life.
               b) Under double-declining balance method (HO #15), taxpayer doubles
                  straight-line percentage and multiplies that by basis or uses straight-
                  line, whichever is larger.
          iii.    Useful life: Under § 168 can depreciate over accelerated time frame.
      c. Goodwill and other intangible assets are not depreciated, but are amortized on
          a straight-line basis over 15 years. § 197.
   6. Consumption Tax?
      a. HO #16: If depreciation schedule is super-compressed we eventually read §
          263 out of the Code, and have something similar to a consumption tax.
      b. Can also create a consumption tax simply by allowing a deduction for all
          savings and investment.
      c. Case 3A/3B: Unclear what would happen. Perhaps people would use their
          $100 to buy $143 machines instead of $100 machines and spur investment, or
          perhaps they would continue to buy $100 machines and use the extra $43 to
          buy Japanese DVD players, doing nothing for our economy.
      d. 1981: Tax Act rapidly accelerated depreciation and added an investment tax
          credit to create economic equivalent of expensing.
          i.      Turned out to be very revenue depleting.
          ii.     Tax looked bad politically
          iii.    20% of the savings went to lawyers and investment bankers.
      e. Current proposals are more direct by looking at rate of tax and consumption
          rather than at the deduction stage.
D. Tax Shelters
   1. In General
      a. Tax Shelter—combining 2 transactions that net out but create favorable tax
          treatment.
      b. A few ―tax shelters‖ are legal, such as using the mortgage interest deduction
          to substitute imputed income from home ownership for taxable wages.
      c. In general though, Congress tries to shut these loopholes down by eliminating
          possible arbitrage while keeping original tax advantages in place.
   2. Municipal Bonds (HO #17-1)
      a. By investing in tax-exempt bonds instead of industrial bonds, T1 can save
          $5000 in taxes as part of the misdirected subsidy.
      b. T2 could do the same thing by borrowing $1 million, investing it in tax-free
          bonds, and deducting the interest payments through § 163(a).

                                       14
   c. § 265(a)(2): ―No deduction shall be allowed for interest on indebtedness
       incurred or continued to purchase or carry obligations the interest on which is
       wholly exempt from…taxes.‖
   d. So T2 can’t do this, but T1 still can. And T2 can do this with mortgage
       interest deduction. Plus might want people to do this to subsidize states.
3. Interest Deductions (Knetsch)
   a. T2 borrows money at 3.5% to invest in annuity w/ 2.5% interest.
   b. When taxed at 90%, T2 is able to deduct his 3.5% interest payment and offset
       tons of taxes. He is also able to withdraw the 2.5% from the annuity and add it
       to income, offsetting his interest payment and giving positive cash flow.
   c. In final year of annuity, T2 would realize big cancellation of indebtedness
       income. But by then rates may have gone down and in any event, T2 wins out
       b/c of TVOM. BL: Deferral gains make up for current losses.
   d. § 264(a)(2): ―No deduction shall be allowed for any amount paid or accrued
       on indebtedness incurred or continued to purchase or carry a single premium
       life insurance, endowment, or annuity contract.‖
   e. In Knetsch, IRS argues this is a ―sham transaction.‖ True, but if he had
       borrowed from a bank, could have done pre-§ 264.
   f. Real problem: We want people to build up annuities for old age/retirement,
       but when clear people aren’t doing that, Congress gets mad and tries to close
       off tax shelters.
4. Growth Stock
   a. T1’s of this world prefer to invest in stocks to bonds b/c they will realize
       capital gains, which are taxed at a lower rate.
   b. T2 might try to borrow $100,000 to take advantage of this, and could if he
       could deduct his interest payment. $12,000 better off than bond investment.
   c. § 163(a),(d)
       i.       Can claim interest deduction, but only to offset net investment income.
       ii.      If you have none, carried forward until you have some.
       iii.     Only applies to interest incurred to purchase investment assets.
   d. Result (HO #18): Can deduct interest payments only when sells the stock in
       Yr. 6. § 163(d)(4)(B)(iii).
       i.       Comes out with no net return and a loss on TVOM.
       ii.      Could also in Yr. 6 recognize capital gains of $12,000 [20% tax] and
                continue to carry forward the $60,000 interest deduction.
5. Real Estate Depreciation (Estate of Franklin; HO #19)
   a. Buy property for highly inflated price with nonrecourse loan from the seller.
       Then rent property back to the seller for interest payments (―leaseback‖)
   b. Then depreciate off the highly inflated basis to realize huge losses.
   c. When note comes due, default. Huge cancellation of indebtedness income.
       i.       Would be a loss, except in real estate taxed at capital gains rate.
       ii.      Plus TVOM advantages. Really a lot like Tufts.
       iii.     Seller benefits too through an up-front cash payment (less taxes).
       iv.      1981 Act was designed to allow some of these ―sale of tax benefits‖
                through sale-leaseback arrangements, but here just inflated prices.



                                    15
      d. In Franklin, court disallows b/c price is so inflated. Contrast Jordan Marsh,
          which is allowed b/c the sale and leaseback seem more real.
      e. BL: Court won’t allow gross overvaluations. Wants a depreciation subsidy for
          real investments, not pretend ones.
      f. This solution is too impractical to last long-term. Expensive for IRS to litigate
          so only really egregious overvaluation gets caught.
   6. Solutions
      a. § 465: Make nonrecourse seller-financed debt unavailable.
          i.      § 465(c)(3): Applies to any post-1978 trade or business activity.
          ii.     § 465(a): Can only claim a tax loss to the extent ―at risk‖—cash paid +
                  FMV or any property pledged other than that at issue.
          iii.    In HO #19, only loss allowable would be $50,000 cash payment.
          iv.     If loss exceeds amount at risk, carried over just like in § 163(d).
          v.      Only way to increase amount at risk is to put up more cash or get a
                  recourse loan, which nobody would do w/ overvalued property.
          vi.     Nonrecourse OK if issued by third party unrelated to transaction, plus
                  a few other funny exceptions/details.
      b. § 469: Passive activity losses disallowed for individuals/small corporations
          i.      passive activity—trade or business in which T not materially involved.
               a) Rental is always a passive activity. Sale-leaseback eliminated.
               b) If you earn < $150,000, you can deduct up to $25,000 in passive
                  activity losses (so you can rent your cottage).
               c) ―Material participation‖ defined in Treas. Regs.
          ii.     Losses carried forward just like §§ 465/163(d) until activity either
                  generates income or is disposed of.
          iii.    Rationale: Totally eliminate sale-leaseback arrangement so tax benefit
                  can only go to people who own and materially use their property.
      c. Large corporations not subject to § 469.
      d. Deeper analysis of these issues in PS #9.
      e. One final solution of sorts is the Alternative Minimum Tax. § 55.
E. Personal Deductions
   1. In General
      a. § 262: No deductions allowed for personal or family expenses.
      b. Without this rule we would essentially tax savings instead of income, which
          means nobody would save and there would be no tax revenue.
      c. But in a few circumstances, Congress violates the rule by allowing PD.
      d. Sometimes these deductions eliminated entirely through the AMT.
   2. Casualty Losses [§ 165]
      a. Amount (Max’s Boat Hypos).
          i.      Deduction is limited to basis of the boat or FMV, whichever is lower.
                  § 165(b).
          ii.     There is a $100 floor. § 165(h).
          iii.    Can only claim loss to extent it exceeds 10% of AGI. § 165(h)(2).
      b. What is a Casualty?
          i.      § 165(c)(3): Loss must arise from fire, storm, shipwreck, or other
                  casualty, or from theft.

                                        16
           ii.     Event must be sudden and unexpected. Drought, termites not sudden.
           iii.    Can’t deduct for ordinary losses through negligence. Dyer.
           iv.     Also can’t deduct if contrary to state public policy, like home arsonist
                   in Blackman.
      c. Effect on Insurance
          i.       High bracket taxpayers get a fair amount of free insurance.
          ii.      Anecdotal proof that rich drastically underinsure their possessions.
          iii.     Cannot deduct your loss to extent you are insured.
   3. Medical Expenses [§ 213]
      a. Statutory Language: Can deduct medical care ―for the diagnosis, cure,
          mitigation, treatment, or prevention of disease, or for the purpose of affecting
          any structure or function of the body.‖ § 213(d), if > 7.5% of AGI.
      b. Interpretation
          i.       Broad definition obviously must be limited.
          ii.      Don’t allow medical deductions for lawn care, but do is you get an
                   asthma attack while mowing. Taylor.
          iii.     Don’t allow to send kids to boarding school, but do allow to send mom
                   to a sanitarium. Ochs. Basically think the husband is the one really
                   benefiting from boarding school, not the sick wife.
      c. Insurance Provisions
          i.       If your employer gives you insurance, you can exclude health benefits
                   from GI and your employer gets a deduction. § 106.
          ii.      Also currently phasing in deductions of 80% of premiums for self-
                   employed who buy insurance.
          iii.     Rationale: Encourage employers to provide health benefits.
   4. Biggest Criticism: Product of unwarranted sympathy; T should just get insurance.
F. Charitable Contributions
   1. Justification
      a. Subsidy for ―good‖ organizations through gov’t co-payments. Unclear what
          elasticity of this is, but may find out if Bush repeals the estate tax.
      b. Direct Democracy: Let taxpayers rather than Congress prioritize which
          charities get the benefits of gov’t largesse.
          i.       People like writing checks to charities rather than gov’t
          ii.      People have different preferences than Congress (but we dislike some
                   of those preferences).
          iii.     Allows funding of religious institutions (But what about 1 Am?)
          iv.      Limits governmental interference in charities (But not really. BJU).
   2. Limits?
      a. No more than 50% of AGI.
      b. § 170(c)(2)(B): Definition of ―charity‖ includes common law requirement that
          organization can’t act contrary to public policy. Bob Jones Univ.
      c. Court lets IRS, rather than Congress, decide what is contrary to public policy.
      d. IRS also monitors to see whether you are setting up a ―sham church‖ for tax
          shelter purposes. All kinds of Scientology problems.
      e. Direct Mail Fronts: Charity can spend 99% of proceeds on direct mailings.



                                        17
         3. Upside Down Subsidy: When poor person donates $1, gov’t donates 15 cents;
             when rich person donates $1, gov’t donates 39.6 cents.
         4. Transfer of Property Subject to Capital Gains
             a. § 170(e)(1): For donated ordinary and short-term capital gain property, plus
                 donations to private foundations, you can only deduct the basis.
             b. But for transfers of long-term capital gain property, if we only let you deduct
                 basis, everybody would sell property to realize gains and donate proceeds. See
                 HO #21. Charities sometimes want property, so rule changes.
             c. New rule, § 170(a), lets you deduct FMV.
                 i.      Now get tax benefit when you donate appreciated property
                 ii.     Also problem of highly inflated FMV, especially w/ artwork. Huge
                         problems including w/ the Smithsonian.
             d. Service/Congress crackdown
                 i.      § 6662: Extra punitive penalty tax of 20% of gross understatements.
                 ii.     Extra substantiation requirements: Valuation by independent expert.
                 iii.    § 68: Phase out of charitable deduction (up to 80% for the very
                         wealthy). Now people who make out like bandits under the provision
                         are the upper middle class instead of the wealthy.
         5. What is a Donation?
             a. If intend to get a ―clear benefit‖ from your donation, like gov’t will improve
                 land near your property, increasing its value, no deduction. Ottawa Silica.
             b. IRS doesn’t push too hard if all you get in return is publicity (e.g., give to
                 child’s school or put name on a building).
VI.   Capital Gains
      A. Introduction
         1. Not all capitalized assets w/ basis are capital assets.
         2. Net capital gains treated favorably and taxed at a lower marginal rate (10-28%).
         3. Net capital losses treated unfavoarbly.
             a. Individual can only deduct first $3000 against ordinary income. Rest carried
                 forward until death.
             b. Corporations can only deduct capital losses against capital gains and can only
                 carry forward for 8 years.
         4. Result: Upside and downside of capital investment both exaggerated.
         5. Rationale(?)
             a. Prevent ―bunching‖ of accrued property appreciation (forced into higher tax
                 bracket by taxing all of gain in one year).
             b. Assure or foster the mobility of invested capital (avoid lock-in).
         6. Computing Net Capital Gain/Net Capital Loss
             a. Identify all capital transactions as either ST (<1 yr.) or LT (> 1yr.)
             b. Net all transactions within each category against each other.
             c. Net STCG becomes ordinary income.
             d. Net Capital Gain = Net LTCG – Net STCL. If this is a negative number, it is
                 actually a net capital loss subject to the limits discussed above.
         7. Computations of capital gains are amazingly complicated. See HO #22;
             Chirelstein 331.
      B. Capital Assets

                                             18
   1. Default Rule [§ 1221]
      a. Capital gains treatment only occurs when you sell a capital asset.
      b. All property is a capital asset unless included in one of the § 1221(a)
          exceptions.
   2. Inventory Exception [§ 1221(a)(1)]
      a. ―Stock in trade,‖ ―inventory,‖ and ―property held by the taxpayer primarily for
          sale to customers‖ are not capital assets.
      b. Not defined by type of property but by its relation to the person holding it. A
          securities dealer who makes money off commissions would hold the securities
          as an ordinary asset; a trader, who makes money off extraneous price changes,
          has a capital asset. Van Suetendael.
      c. Rationale: A hat merchant will try to sell as many hats as possible, but a hat
          speculator will try to selectively realize gains and losses, giving him too much
          chance of tax avoidance.
      d. Generally, if a landowners subdivides property and sells it off, it is in the
          business of selling real estate (so OI). Biedenharn Realty Co.
          i.       Investment intent can change over time.
          ii.      Solution: Sell in chunk to a wholly-owned development subsidy.
   3. Business Property [§ 1221(a)(2)]
      a. ―Property, used in trade or business which is subject to depreciation‖
      b. Under § 1231, gains are treated as capital gains, but losses are treated as
          ordinary losses. T gets best of both worlds.
      c. Problem: W/ accelerated depreciation much 1231 property now has an
          artificially low basis and T could gain windfall capital gains treatment
      d. Solution: 1245 Recapture. W/ depreciable business property, any gain up to
          the amount previously depreciated is ordinary income. Only above that is
          capital gain.
      e. Example: Property bought at 100 w/ current basis of 44 sold for 80. Realize
          36 in ordinary income. If sold for 110, 56 in OI, 10 in capital gain.
      f. But w/ ―real property‖ 1231 still applies. If item sold above was real property,
          T would realize 36 or 66—all in capital gain.
C. Hedging Transactions
   1. Taxpayers enter futures contracts to minimize possibility of gain/loss on a
      transaction.
      a. Contract to buy at future price.
      b. But economically indifferent whether you then take delivery or sell futures
          contract and buy on spot market.
      c. But if you can sell futures contract for a capital gain, people would do that
          when price goes up but take delivery when price goes down. Whipsaw.
   2. Judicial Gloss
      a. In Corn Products, Court disallows this by declaring that if a hedging contract
          appears ―integral to the business‖ you must take ordinary income treatment.
      b. But this leads to T claiming ordinary loss treatment on items purchased for his
          business that clearly look capital. So in Arkansas Best, Court narrows Corn
          Products to inventory exception. If not inventory, must treat as capital.



                                        19
      c. Problem: Some T like airlines and Quaker Oats had come to rely on the
          exception and now afraid they will generate huge capital losses.
   3. Congressional Response
      a. § 1221(a)(7): Now allowed to identify a hedging transaction on day it is made
          as subject to ordinary income treatment.
      b. But this still leads to the Corn Products whipsaw: Don’t identify so it is
          capital, but then take delivery anyway if it would be a loss.
   4. Underlying Problem: Some of the income being generated by merchants is based
      on extraneous price changes. People normally don’t separate this out, but will if
      there are tax advantages.
D. Substitutes for Ordinary Income
   1. Leases (Hort)
      a. If a lessor buys back a lease from a tenant, he does not realize a loss on the
          deal b/c the loss of rental payments is offset by a gain in his reversionary
          interest, which he may be able to rent again at a higher rate.
      b. The lessor also must treat the lump sum payment as ordinary income b/c
          under § 1221(a)(1) a lease is inventory to one who rents building.
      c. However, if a tenant sells a lease, the lease is not inventory, it is property and
          therefore a capital asset not falling under any exception. It might even be trade
          or business property subject to 1231 treatment.
   2. Contracts (Ferrer)
      a. Producer buys for one lump sum an actor’s services to act in a movie (clear
          ordinary income) and his rights under a contract.
      b. Court says contract composed of both services and some rights that rise to the
          level of property and can be treated as capital, but by far the biggest chunk is
          services.
      c. Don’t normally do this, because too messy.
      d. Hard to get clean, simple rules to do what we intend, just like in the rest of
          tax. So we settle for the ―Rule of Second Best.‖




                                        20

				
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