Case Study

TAX 6025 Concepts of Federal Income

Tax

Characterization of Gains & Losses

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.

Character of Income, Gains & Losses

• Ordinary income/gain • Ordinary loss • Short-term capital gain • Short-term capital loss • Long-term capital gain • Long-term capital loss • Section 1231 gain • Section 1231 loss

Compensation for services – Ordinary* Gross income derived from business- Ordinary* Interest- Ordinary Rents- Ordinary Royalties- Ordinary Dividends- Ordinary (but preferred rate for qualified dividends) Annuities- Ordinary Income from life insurance and endowment contracts- Ordinary Pensions- Ordinary Income from discharge of indebtedness- Ordinary

Gains and losses derived from dealings in property - ??? 4

I.R.C. § 61(a)

Incentives & Disincentives

• Incentives • Ordinary losses can offset ordinary income • Long-term capital gains receive preferential tax rates • Net Section 1231 gains are treated as capital gains • Net Section 1231 losses are treated as ordinary losses

• Disincentives • Ordinary income is generally taxed at progressive rates • Short-term capital gains are taxed at ordinary progressive rates • Capital losses are limited in deductibility

Character Decision Tree

Realization

• Recognition generally requires realization • Realization events include: • Sale or exchange • Other disposition

• International Freighting Corporation v. Commissioner, 135 F.2d 310 (2d Cir. 1943)

• Kenan v. Commissioner, 114 F.2d 217 (2d Cir. 1940)

Type of Disposition

• Capital gain and loss rules generally only apply to a “sale or exchange”

• “Other dispositions” generally result in ordinary income or loss • Except when other Code provisions change the treatment: • Deemed sale or exchange (capital) treatment for other dispositions • Deemed ordinary treatment for sale or exchange

• Kenan v. Commissioner, 114 F.2d 217 (2d Cir. 1940) • Hudson v. Commissioner, 20 T.C. 734 (1953)

Type of Asset

• Capital asset defined in the negative, i.e., everything except what is not a capital asset

• Capital asset is not: • Inventory (stock in trade, property held primary for sale to

customers in the ordinary course of a trade or business) • Depreciable property used in trade or business* • Real property used in trade or business* • Accounts or notes received in the ordinary course of trade or

business from services or sale of goods • Mauldin v. Commissioner, 195 F.2d 714 (10th Cir. 1952)

Holding Period

• Purchased property • Holding period begins the day after acquisition • Holding period includes date of disposition

• Other acquisitions of property • Tacked-on holding period for transferred or substituted basis

transactions (gifts, transfers between spouses or incident to divorce) • Special rule for property acquired from decedent (always long-

term)

• Long-term capital gain treatment • More than one year • Regular tax rates apply to short-term capital gain

Problem Page 719

1.Taxpayer, a cash method, calendar year taxpayer, engaged in the following transactions in shares of stock. (a)T bought 100 shares of stock on January 15 of year one at a cost of $50 per share. T sold them on January 16 of year two at $60 per share. (b)T bought 100 shares of stock on February 28 of year one at a cost of $50 per share. T sold them on February 29 of year two, a leap year, for $60 per share. (d)T told T’s broker to purchase 100 shares of stock on December 29 of year one at a time when its price was $50 per share. The stock was delivered to T on January 3 of year two when it was selling for $52 per share. T told T’s broker to sell the stock on December 30 of year two when it sold for $60 per share, and it was delivered to Buyer on January 4 of year three when it was selling for $63 per share. (f)T’s father bought 100 shares of stock on January 10 of year one at $30 per share. On March 10 of year one when they were worth $40 per share he gave them to T who sold them on January 15 of year two for $60 per share.11

Netting

1. Organize gains and losses into four buckets by term 2. Net short-term with short-term and long-term with long-term

Short-term capital gain Long-term capital gain – Short-term capital loss – Long-term capital loss Net ST capital gain or (loss) Net LT capital gain or (loss)

Netting

3. Net the short-term result with the long-term result

• Possibilities • Net long-term gain in excess of short-term losses (preferred rate) • Net short-term gain in excess of long-term losses (ordinary income) • Long-term gain and short-term gain (combination) • Net short-term losses in excess of long-term gains (deduction limited) • Net long-term losses in excess of short-term gains (deduction limited) • Long-term losses and short-term losses (deduction limited)

Problem Page 692

T, a single taxpayer, has a salary of $200,000 in the current year. T also has the following transactions all involving the sale of capital assets: (1) a gain of $15,000 on a “collectible” held for 2 years; and (2) a gain of $20,000 on stock held for 15 months.

Determine the amount of T’s net capital gain.

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Capital Losses

• Limits • Noncorporate taxpayers - $3,000 ($1,500 in the case of a married

individual filing a separate return)

• Carryovers and carrybacks • Noncorporate taxpayers – carryover • Losses retain character (short-term losses reduced first by amount

allowed)

Problem Page 698

Determine the amount of the taxpayer’s capital loss that is allowed as a deduction from ordinary income under § 1211(b)(1) or (2) and the amount and character of his capital loss carryover, if any, under § 1212(b).

Taxable Income LTCG LTCL STCG STCL 1. $10,000 $2,000 $6,000 $2,600 $1,000 2. $10,000 $2,000 $10,000 $2,000 $4,000

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Section 1231 Gains and Losses

• Section 1231 Property • Depreciable property used in trade or business, held more than one

year • Real property used in trade or business, held more than one year

• Treatment • Net Section 1231 gains treated as capital gain* • Net Section 1231 losses treated as ordinary losses

• Wasnok v. Commissioner, 30 T.C.M. 39 (1971)

Statutorily Created Exceptions

• Character • Capital asset treatment for non-capital asset • Ordinary income treatment for capital asset

• Dispositions • Capital asset treatment for “other disposition,” i.e., not a sale or

exchange

• Holding Period • Tacking of holding periods • Exceptions for long-term treatment

Substitute-for-Ordinary Income Doctrine

• Hort v. Commissioner, 313 U.S. 28 (1941) • Payment to landlord to cancel lease

• Metropolitan Bldg. Co. v. Comm’r, 282 F.2d 592 (9th Cir. 1960) • Payment to tenant to release rights under lease

• Watkins v. Commissioner, 447 F.3d 1269 (10th Cir. 2006) • Sale of rights to future lottery payments

Problem Page 732

1.Agent entered into a contract with a national insurance Company to manage its State office for a ten year period. After two years Company decides to discontinue its State operations and agrees to pay Agent $50,000 to terminate her contract. What result to Agent?

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Problem Page 733

3.Landlord L owns two contiguous parcels of land. L leases both parcels to Tenant T for $1,000 per month per parcel or a total of $24,000 per year; the rent is payable at the end of each year. The lease is for a 10 year period. Upon the following events, which occur more than one year after the lease is signed, what are the results: (a)To L if L sells the right to the rents on both parcels, prior to any rental payments being due or paid, to a third party for $200,000? (b)To L if T pays L $20,000 to cancel the leases on both parcels? (c)To T if L pays T $20,000 to cancel the leases on both parcels?

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Relevant Considerations

• Realization event • Sale or exchange • Other disposition

• Type of asset • Capital asset • Other asset or property

• Holding period • More than one year • One year or less

• Taken in account • Gains includible in gross income or excludable • Losses deductible or limited