Case Study

TAX 6025 Concepts of

Federal Income Tax

Gains or Losses from Dealings in Property

Instructor: Alexander Martini

Disclaimer

• The views expressed during this course are those of the instructor in his personal capacity and do not represent those of the IRS Office of Chief Counsel or the Internal Revenue Service.

Inclusion in Gross Income

• “Gains derived from dealings in property.” I.R.C. § 61(a)(3).

• Gain or loss (I.R.C. § 1001) • Gain is the amount realized less adjusted basis • Loss is the adjusted basis less amount realized • The entire gain or loss is recognized, except as otherwise provided

Definitions

• Amount realized (I.R.C. § 1001(b)) • the sum of any money received plus the fair market value of the

property (other than money) received

• Adjusted basis (I.R.C. § 1011(a)) • Basis, as adjusted

• Basis (I.R.C. § 1012(a)) • the cost of property, except as otherwise provided

• Adjustments (I.R.C. § 1016) • Increases and decreases

Property Acquired by Purchase

• Basis (I.R.C. § 1012(a)) • the cost of property, except as otherwise provided

• Cost includes all costs of acquisition: • Purchase price • Commissions paid • Closing/transaction costs • Delivery and/or installation

• Proceeds of a loan used for acquisition are included in cost basis

Property Acquired by Purchase

• Example 1 • Taxpayer purchases a residence. The contract price is $500,000.

Closing costs (excluding any currently deductible expenditures) total $15,000. • Taxpayer takes a cost basis of $515,000 in the residence.

• Example 2 • Taxpayer purchases a residence. The contract price is $500,000.

Closing costs total $15,000. Taxpayer pays $65,000 cash and takes a mortgage loan of $450,000. • Taxpayer takes a cost basis of $515,000 in the residence.

Adjustments to Basis

• Adjustments (I.R.C. § 1016) – • “Proper adjustment in respect of the property shall in all cases be

made- • for expenditures, receipts, losses, or other items, properly

chargeable to capital account . . . • … for exhaustion, wear and tear, obsolescence, amortization, and

depletion …”

• Adjustments can include increases or decreases • Improvements (increase) • Depreciation (decrease)

Adjustments to Basis

• Example 3 • Taxpayer purchases a residence and takes a cost basis of $515,000

in the residence. Two years later, Taxpayer replaces the roof and remodels the kitchen and bathrooms for a total cost of $150,000. • Taxpayer’s basis in the residence is adjusted upward (increased) by

$150,000.

• Example 4 • Taxpayer purchased a residence to be used as a rental property and

takes a costs basis of $515,000. Taxpayer deducts $20,000 in depreciation in the current year. • Taxpayer’s basis in the residence is adjusted downward (decreased) by

$20,000.

Realization

• Dispositions (sale, exchange, or other disposition) trigger realization: • Cash sales • Exchange of property for property or services • Transfer as payment or satisfaction of liability • Transfer of encumbered property

• Mere appreciation generally does not result in realization

Amount Realized on Disposition

• Amount realized (I.R.C. § 1001(b)) • the sum of any money received plus the fair market value of the

property (other than money) received

• Amount realized is reduced by costs of disposition: • Commissions paid • Closing/transaction costs

• Amounts can be realized without cash being received!

Amount Realized on Disposition

• Example 5 • Taxpayer sells a residence. The contract price is $500,000. Closing

costs total $10,000. The realtor commission is $15,000. • The amount realized on the sale of the residence is $475,000.

• Example 6 • Taxpayer sells a residence. The contract price is $500,000. Closing

costs total $10,000. The realtor commission is $15,000. $425,000 is paid by the closing agent to Taxpayer’s lender to satisfy the mortgage loan and Taxpayer receives a wire transfer of $50,000. • The amount realized on the sale of the residence is $475,000.

Amount Realized on Disposition

• Example 7 • Taxpayer wants Painter to paint Taxpayer’s house. Painter charges

$3,000, but Taxpayer is short on cash. Taxpayer signs over his car to Painter and Painter paints Taxpayer’s house. • The amount realized on the disposition of the car is $3,000.*

• Example 8 • Taxpayer is part of a barter club. Taxpayer exchanges gold jewelry

worth $5,000 with Counterpart and receives a painting. • Taxpayer’s amount realized on the exchange of the jewelry is $5,000. • Counterpart’s amount realized on the exchange of the painting is

$5,000.*

Gain or Loss on Disposition

• Gain or loss (I.R.C. § 1001) • Gain is the amount realized less adjusted basis • Loss is the adjusted basis less amount realized

Amount realized - Adjusted basis Gain or (Loss)

Gain or Loss on Disposition

• Example 9 • Taxpayer is part of a barter club. Taxpayer exchanges gold jewelry

worth $5,000 with Counterpart and receives a painting. Taxpayer purchased the jewelry two years before for $4,000. • The amount realized on the disposition of the jewelry is $5,000. • The adjusted basis in the jewelry is $4,000. • The gain on the exchange is $1,000.

$5,000 - $4,000

$1,000

Gain or Loss on Disposition

• Example 10 • Taxpayer signs over his car worth $3,000 to Painter and Painter

paints Taxpayer’s house. Taxpayer purchased the car 10 years before for $24,000 and used it solely for personal use. • The amount realized on the disposition of the car is $3,000. • The adjusted basis in the car is $24,000. • The loss on the disposition of the car is $21,000.

$3,000 - $24,000 ($21,000)

International Freighting Corporation v. Commissioner,

135 F.2d 310 (2d Cir. 1943)

• Corporation distributes stock to employees under bonus plan • Fair market value of $24,000 • Basis of $16,000

• Questions: • Is there a disposition? • What is the amount realized? • What is the gain or loss to the corporation? • Is the gain or loss recognized? • Is there any other tax consequence to the corporation?16

Property Acquired from a Decedent I.R.C. § 1014

• No gross income to the recipient* • Recipient takes basis equal to fair market value at date of death

(or alternative valuation date, if elected) • Step-up or step-down

Property Acquired from a Decedent I.R.C. § 1014

• Example 11 • Taxpayer inherits stock from his recently deceased grandmother.

She purchased it forty years ago for $5,000. It was worth $150,000 on the date of her death. • Taxpayer’s stepped up basis in the stock is $150,000.

• Example 12 • Taxpayer inherits a residence from her recently deceased

grandfather. He purchased it four years ago for $500,000. It was worth $450,000 on the date of his death. • Taxpayer’s stepped down basis in the residence is $450,000.

Property Acquired by Gift I.R.C. § 1015

• Transferred basis • Except if the basis is greater than the fair market value of the

property at the time of the gift (built-in loss potential), then: • for the purpose of determining loss, the basis is the fair market

value at the time of the gift • Rule creates two different potential bases on subsequent

disposition

Problems Page 128

1.Donor gave Donee property under circumstances that required no payment of gift tax. What gain or loss to Donee on the subsequent sale of the property if: (a)The property had cost Donor $20,000, had a $30,000 fair market value at the time of the gift, and Donee sold it for:

(1)$35,000? (2)$15,000? (3)$25,000?

(b)The property had cost Donor $30,000, had a $20,000 fair market value at the time of the gift, and Donee sold it for:

(1)$35,000? (2)$15,000? (3)$24,000? 20

Problem Page 134

1.In the current year, Giver holds two blocks of identical stock, both worth $1,000,000. Giver purchased the first block years ago for $50,000 and the second block more recently for $950,000. Giver plans to make an inter vivos gift of one block and retain the second until death. Which block of stock should Giver transfer inter vivos and why?

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Property Transferred Between Spouses or Incident to Divorce

I.R.C. § 1041

• No gain or loss to transferor • Transferee recognizes no gain or loss • Transferee takes transferred basis (the same as it was in the

hands of the transferor)

Problems Page 131

Andre purchased some land ten years ago for $40,000 cash. The property appreciated to $70,000 at which time Andre sold it to his wife Steffi for $70,000 cash, its fair market value.

(a)What are the income tax consequences to Andre? (b)What is Steffi’s basis in the property? (c)What gain to Steffi if she immediately resells the property? (d)What results in (a)–(c), above, if the property had declined in value to $30,000 and Andre sold it to Steffi for $30,000?

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Amount Realized – Nonrecourse Liabilities

• Amounts realized can take many forms, including: • Discharge of liabilities • Assumption by another • Transfer of encumbered property

• Crane v. Commissioner, 331 U.S. 1 (1947) • Fair market value exceeds nonrecourse liability

• Commissioner v. Tufts, 461 U.S. 300 (1983) • Nonrecourse liability exceeds fair market value

Gain or Loss / Discharge of Indebtedness

• Nonrecourse liability • Amount realized equals the nonrecourse liability plus any money

received plus the fair market value of other property received • Gain or loss computed based on the difference between amount

realized and adjusted basis (fair market value irrelevant)

• Recourse liability • Property transaction • Gain or loss equals amount realized (fair market value) over adjusted

basis (amount of liability is irrelevant) • Loan transaction • Remaining liability treated as COD income if discharged

Gain or Loss / Discharge of Indebtedness

• Taxpayer acquired property for $100,000, entirely paid from the proceeds of a mortgage encumbering the property. Five years later, the property is worth $60,000 and the balance of the loan is $80,000. Taxpayer transfers the property to lender. No adjustments to basis during holding period.

• Nonrecourse liability • Amount realized ($80,000 liability) less basis ($100,000) equals loss of

$20,000

• Recourse liability • Amount realized ($60,000 FMV) less basis ($100,000) equals loss of

$40,000 • If discharge occurs, COD income is $20,000 ($80,000 liability less

$60,000 FMV)