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Chapter 16
PROPERTY TRANSACTIONS:CAPITAL GAINS AND LOSSES
LEARNING OBJECTIVES
Upon completion of this chapter you will be able to:
" Define a capital asset and use this definition
to distinguish capital assets from other types
of property
" Explain the holding period rules for
classifying a capital asset transaction as either
short-term or long-term
" Apply the capital gain and loss netting
process to a taxpayer’s capital asset
transactions
" Understand the differences in tax treatment of
an individual’s capital gains and losses
" Explain the differences in tax treatment of the
capital gains and losses of a corporate
taxpayer versus those of an individual
taxpayer
" Identify various transactions to which capital
gain or loss treatment has been extended
" Discuss the tax treatment of investments in
corporate bonds and other forms of
indebtedness
16–1
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The final piece of the property transaction puzzle concerns the treatment of the
taxpayer’s gains and losses. In the infancy of the tax law, solving this puzzle was
relatively easy. Taxpayers who sold or otherwise disposed of property needed only to
determine their gain or loss realized and how much, if any, they had to recognize. The
actual treatment of the gain or loss recognized—or more precisely, the rate at which it
was taxed—was identical to that for other types of income. The simplicity of treating all
income and loss the same was short-lived, however, lasting a mere eight years, from
1913 to 1921. Since 1921, the taxation of property transactions has been complicated by
the additional need to determine not only the amount of the taxpayer’s gain but also its
character. Virtually all of this complication can be traced to one source: Congress’s desire
to provide some type of preferential treatment for capital gains.
Whether capital gains should be taxed more leniently than wages and other types of
income is the subject of what seems to be a never-ending debate. When the first income
tax statute was enacted, there was nothing in the definition of income to indicate that
gains on dealings in property were taxable. Seizing on the omission, taxpayers relied on
somewhat abstract tax theory and ingeniously argued that a gain on a sale of property
(e.g., a citrus grove) was not the same as income derived from such property (e.g., sale
of the fruit) and should not be taxed at all. Moreover, taxpayers who sold property and
reinvested in similar property argued that they had not altered their economic position
and that taxation was therefore not appropriate. While detractors cried ‘‘nonsense!’’
champions of favorable treatment offered additional justification, explaining that capital
gain is often artificial, merely reflecting increases in the general price level. Perhaps the
most defensible argument can be found in the Ways and Means Committee Report that
16–2 PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES
CHAPTER OUTLINE
General Requirements for Capital Gain 16-4
Capital Assets 16-4
Definition of a Capital Asset 16-4
Inventory 16-5
Disposition of a Business 16-6
Sale or Exchange Requirement 16-7
Worthless and Abandoned Property 16-7
Certain Casualties and Thefts 16-9
Other Transactions 16-9
Holding Period 16-10
Stock Exchange Transactions 16-10
Special Rules and Exceptions 16-11
Treatment of Capital Gains and Losses 16-13
The Process in General 16-13
Netting Process 16-14
Dividends Taxed at Capital Gain
Rates 16-18
Corporate Taxpayers 16-19
Calculating the Tax 16-20
Reporting Capital Gains and
Losses 16-24
Capital Gain Treatment Extended
to Certain Transactions 16-25
Patents 16-25
Lease Cancellation Payments 16-26
Incentives for Investments in Small
Businesses 16-26
Lo on S
§ 1244
Qualified Small Business Stock
(§ 1202 Stock) 16-27
Rollover of Gain on Certain Publicly
Traded Securities 16-30
Dealers and Developers 16-30
Dealers in Securities 16-30
Subdivided Real Estate 16-31
Other Related Provisions 16-32
Nonbusiness Bad Debts 16-32
Franchise Agreements, Trademarks,
and Trade Names 16-32
Short Sales 16-33
Options 16-34
Corporate Bonds and Other Indebtedness 16-36
Original Issue Discount 16-37
Market Discount 16-39
Conversion Transactions 16-40
Bond Premium 16-40
Tax Planning Considerations 16-41
Timing of Capital Asset Transactions 16-41
Section 1244 Stock 16-42
Problem Materials 16-42
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accompanied the Revenue Act of 1921. As the following quotation shows, Congress
believed that the progressive nature of the tax rates was unduly harsh on capital gains,
particularly when the rate (at that time) could be as high as 77 percent.
The sale of . . . capital assets is now seriously retarded by the fact that gains and profits
earned over a series of years are under present law taxed as a lump sum (and the amount
of surtax greatly enhanced thereby) in the year in which the profit is realized. Many of
such sales . . . have been blocked by this feature of the present law. In order to permit
such transactions to go forward without fear of a prohibitive tax, the proposed bill . . .adds a new section [providing a lower rate for gains from the sale or dispositions of
capital assets].1
Although the top rate is currently much lower than it has been historically, the
bunching effect is still cited as one of the major justifications for lower rates for capital
gains. Proponents also reason that taxing capital gains at low rates encourages taxpayers
to make riskier investments and also helps stimulate the economy by encouraging the
mobility of capital. Without such rules, taxpayers, they believe, would tend to retain
rather than sell their assets.
Of course, opponents of special treatment are equally vocal in their objections to
the benefits extended capital gains. They reject the proposition that capital gain should
not be taxed. They maintain that income is income regardless of its form. Opponents
also doubt the stimulus value of preferential treatment and complain about the uneven
playing field that such treatment creates. Finally, opponents offer one argument for
which there is no denial. As will become all too clear in this and the following chapter,
the special treatment reserved for capital gains and losses creates an inordinate amount
of complexity in the tax law.
Despite the various objections, Congress has generally sided with those in favor of
preferential treatment. But, as history shows, there is little agreement on exactly what
that treatment should be. From 1922 to 1933, taxpayers were given the option of paying
a flat 12.5 percent tax on their capital gains and the normal rate on ordinary income.
From 1934 to 1937, the treatment was altered to allow an exclusion for capital gains
ranging from 20 to 80 percent, depending on how long the asset was held. After some
tinkering with the exclusion in 1938, Congress moved again in 1942. This time it
replaced the exclusion with a deduction equal to 50 percent of the gain. The 50 percent
deduction—increased in 1978 to 60 percent—made capital gains the most popular game
in town for almost 45 years. In 1986, however, Congress had a complete change of
heart. After lowering the top rate on ordinary income to 28 percent, it apparently
believed that special treatment for capital gains was no longer needed. Accordingly,
favorable capital gain treatment was repealed. This period of low rates, however,
proved to be only temporary, as Congress raised the top rate to 31 percent in 1991 and
39.6 percent in 1993. The increase prompted Congress to resurrect favorable treatment
for capital gains, in this case providing that the gains of an individual would be taxed at
a maximum rate not to exceed 28 percent. In 2003, Congress decided, once again, to
improve the tax advantage extended to capital gains. Under the new rules, capital gains
qualifying for special treatment can be taxed at one of four different rates (28 percent,
25 percent, 15 percent, or 5 percent).
The current rates applying to capital gains, like their predecessors, can produce sub-
stantial savings. The table below illustrates the benefit of the 15 percent capital gains rate
(5 percent for taxpayers in the 10 percent or 15 percent brackets).
1 House Rep. No. 350, 67th Cong. 1st Sess., pp. 10–11, as quoted in Seidman, Legislative History of the
Income Tax Laws, 1938–1961, 813 (1938).
16–3GENERAL REQUIREMENTS FOR CAPITAL GAIN
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OrdinaryRate
Capital GainsRate
DifferentialRate
PercentageSavings
35.0% 15.% 20.0% 57.14%
33.0 15 18.0 54.55
28.0 15 13.0 46.43
25.0 15 10.0 40.00
15.0 5 10.0 66.67
10.0 5 5.0 50.00
As should be apparent capital gain treatment is clearly desirable. But as the remainder of
this chapter explains, this favorable treatment is not extended to just any gain. The taxpayer
must jump through a few hoops, turn a couple of cartwheels, and clear innumerable hurdles
before he or she reaches the pot of gold at the end of the capital gains rainbow.
GENERAL REQUIREMENTS FOR CAPITAL GAIN
A gain or loss is considered a capital gain or loss and receives special treatment only
if each of several elements is present. The asset being transferred must be a capital assetand the disposition must constitute a sale or exchange. In addition, the exact treatment of
any net gain or loss can be determined only after taking into consideration the holdingperiod of the property transferred. Each of these elements is discussed below.
CAPITAL ASSETS
DEFINITION OF A CAPITAL ASSET
In order for a taxpayer to have a capital gain or loss, the Code generally requires a sale
or exchange of a capital asset. Obviously, the definition of a capital asset is crucial. Sales
involving property that qualifies as a capital asset are eligible for a reduced tax rate while
sales of assets that have not been so blessed may not be as lucky.
The Internal Revenue Code takes a roundabout approach in defining a capital asset.
Instead of defining what a capital asset is, the Code identifies what is not a capital asset.
Under § 1221, all assets are considered capital assets unless they fall into one of five
excluded classes. The following are not capital assets:
1. Inventory or property held primarily for sale to customers in the ordinary course
of a trade or business
2. Accounts and notes receivable acquired in the ordinary course of a trade or
business for services rendered or from the sale of inventory
3. Depreciable property and land used in a trade or business
4. Copyrights, literary, musical, or artistic compositions, letters or memoranda, or
similar property held by the creator, or letters or memoranda held by the person
for whom the property was created; in addition, such property held by a taxpayer
whose basis is determined by reference to the creator’s basis (e.g., acquired by
gift), or held by the person for whom it was created
5. Publications of the United States Government that are received from the
Government by any means other than purchase at the price at which they are
offered to the public, and which are held by the taxpayer who received the publi-
cation or by a transferee whose basis is found with reference to the original
recipient’s basis (e.g., acquired by gift)
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Before looking at some of these categories, one should appreciate the statutory scheme
and the rationale behind it.
As noted above, the Code starts with the very broad premise that all property held
by the taxpayer is a capital asset. Thus the sale of a home, car, jewelry, clothing, stocks,
bonds, inventory, and plant, property, and equipment used in a trade or business would
produce, at least initially, capital gain or loss since all assets are by default capital
assets. However, § 1221 goes on to alter this general rule with several significant
exceptions. It specifically excludes from capital asset status inventory, property held for
resale, receivables related to the sales of services and inventory, and certain literary
properties. As may be apparent, the purpose of these exclusions, as the Supreme Court
has said, ‘‘is to differentiate between the �profits and losses arising from the everyday
operation of business� on the one hand . . . and �the realization of appreciation in value
accrued over a substantial period of time� on the other.’’2 In essence, the statute is drawn
to deny capital gain treatment for income from regular business operations. Income that
is derived from the taxpayer’s routine personal efforts and services is treated as ordinary
income and in effect receives the same treatment as wages, interest, and all other types
of income. In contrast, capital gain, at least in the general sense, is limited to gains from
the sale of investment property.
Based on the above analysis, it might seem strange that § 1221 also excludes from
capital asset status a class of assets that most people would consider capital assets: the
fixed assets of a business (depreciable property and land used in a business). Although it
is true that these assets are not ‘‘pure’’ capital assets, as will be seen in Chapter 17, these
assets can, if certain tests are met, sneak in the back door and receive capital gain treatment.
Also observe that this rule does not exclude intangibles from capital asset treatment even
though they may be amortizable. For example, goodwill is a capital asset even though it
may be amortized.
One final note: it should be emphasized that the classification of an asset as a capi-
tal asset may affect more than the character of the gain or loss on its sale. For example,
the amount of a charitable contribution deduction also may be affected in certain instan-
ces. Recall that the deduction for charitable contributions of appreciated capital gain
property is generally based on fair market value, but is limited to a percentage of
adjusted gross income.3
INVENTORY
The inventory exception has been the subject of much litigation and controversy.
Whether property is held primarily for sale is a question of fact. The Supreme Court
decided in Malat v. Riddell4 that the word ‘‘primarily’’ should be interpreted as used in
an ordinary, everyday sense, and as such, means ‘‘principally’’ or of ‘‘first importance.’’
As a practical matter, such interpretations provide little guidance. In many cases, it
simply boils down to whether the court views the taxpayer as a ‘‘dealer’’ in the
particular property or merely an investor. Unfortunately, the line of demarcation is far
from clear.
The determination of whether an item is inventory or not frequently arises in the
area of sales of real property. In determining whether a taxpayer holds real estate, or a
particular tract of real estate, primarily for sale, the courts seem to place the greatest
emphasis on the frequency, continuity, and volume of sales.5 Other important factors
2 Malat v. Riddell, 66-1 USTC {9317, 17 AFTR2d 604, 383 U.S. 569 (USSC, 1966).
3 See § 170(e)(1) and Chapter 11 for a discussion of these charitable contribution limitations.
4 Supra, Footnote 2.
5 See, for example, Houston Endowment, Inc. v. U.S., 79-2 USTC {9690, 44 AFTR2d 79-6074, 606 F.2d 77
(CA-5, 1979) and Reese v. Comm., 80-1 USTC {9350, 45 AFTR2d 80-1248, 615 F.2d 226 (CA-5, 1980).
16–5CAPITAL ASSETS
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considered by the courts are subdivision and improvement,6 solicitation and advertising,7
purpose and manner of acquisition,8 and reason for and method of sale.9
DISPOSITION OF A BUSINESS
The treatment of the sale of a business depends on the form in which the business is
operated and the nature of the sale. If the business is operated as a sole proprietorship,
the sale of the proprietorship business is not, as one taxpayer argued, a sale of a single
integrated capital asset.10 Rather, it is treated as a separate sale of each of the assets of
the business. Accordingly, the sales price must be allocated among the various assets
and gains and losses determined for each individual asset. Any gain or loss arising from
the sale of inventory items and receivables would be treated separately as ordinary gains
and losses. Gains and losses from the sale of depreciable property and land used in the
business would be subject to special treatment discussed in Chapter 17 and may qualify
for capital gain treatment. Finally, gains and losses from capital assets would of course
be treated as capital gains and losses.
If the business is operated in the form of a corporation or partnership, the sale could
take one of two forms: (1) a sale of the owner’s interest (e.g., the owner’s stock or
interest in the partnership) or (2) a sale of all the assets by the entity followed by a
distribution of the sales proceeds to the owner. An owner’s interest—stock or an interest
in a partnership—is a capital asset. Consequently, a sale of such interest normally
produces capital gain or capital loss (although there are some important exceptions for
sales of a partnership interest). On the other hand, a sale of assets by the entity would be
treated in the same manner as the sale of a sole proprietorship, a sale of each individual
asset.
3 CHECK YOUR KNOWLEDGE
Review Question 1. Lois Price operates an office supply store, Office Discount, and
owns the property listed below. Indicate whether each of the following assets is a capital
asset. Respond yes or no.
a. Refrigerator in her home used solely for personal useb. The building that houses her businessc. A picture given to her by a well-known artistd. 100 shares of Chrysler Corporation stock held as an investmente. Furniture in her officef. A book of poems she has writteng. The portion of her home used as a qualifying home officeh. 1,000 boxes of 3½-inch floppy disksi. Goodwill of the business
The following are capital assets: (a), (d), and (i). All assets are capital assets except
inventory (item h), real or depreciable property used in a trade or business (items b, e, g),
literary or artistic compositions held by the creator (item f ), or property received by
6 See, for example, Houston Endowment, Inc., and Biedenharn Realty Co., Inc. v. U.S., 76-1 USTC {9194,37 AFTR2d 76-679, 526 F.2d 409 (CA-5, 1976).
7 See, for example, Houston Endowment, Inc.
8 See, for example, Scheuber v. Comm., 67-1 USTC {9219, 19 AFTR2d 639, 371 F.2d 996 (CA-7, 1967), and
Biedenharn Realty Co., Inc. v. U.S.
9 See, for example, Voss v. U.S., 64-1 USTC 9290, 13 AFTR2d 834, 329 F.2d 164 (CA-7, 1964).
10 Williams v. McCowan, 46-1 USTC {9120, 34 AFTR 615, 152 F.2d 570 (CA-2, 1945); Rev. Rul. 55-79,
1955-1 C.B. 370.
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gift from the creator (item c). Note that the Code does not exclude intangible assets from
capital assets status. Such assets as goodwill are treated as capital assets.
Review Question 2. Slam-Dunk Corporation manufactures collapsible basketball
rims in Houston, Texas. Because of its tremendous growth, Mr. Slam and Ms. Dunk, the
owners of the company, brought in a highly skilled executive to manage it, the famous
Sam Jam. As part of the employment agreement, the company agreed to buy Sam’s house
if it should terminate his contract. As you might expect, Slam and Dunk did not get along
with Sam and his creative management techniques. Consequently, the corporation
dismissed Sam after two years and purchased his house at Sam’s original cost of
$300,000. Needing the cash, the corporation decided to unload the house immediately.
Unfortunately, in the depressed housing market of Houston, the corporation sold the
house for only $200,000. Explain the tax problems associated with the sale by the
corporation. What important issue must be resolved and why?
In this situation, the corporation has realized a loss of $100,000. The critical issue is deter-
mining whether the loss is an ordinary or capital loss. The treatment, as explained below,
is quite different. If the loss is ordinary, the corporation may deduct the entire loss in com-
puting taxable income. In contrast, if the loss is a capital loss, the corporation can deduct
the loss only to the extent of any capital gains that it has during the year or a three-year
carryback and five-year carryforward period. The determination turns on the definition of
a capital asset.
SALE OR EXCHANGE REQUIREMENT
Before capital gain or loss treatment applies, the property must be disposed of in a
‘‘sale or exchange.’’ In most cases, determining whether a sale or exchange has occurred
is not difficult. The requirement is met by most routine transactions and as a practical
matter is often overlooked. Nevertheless, there are a number of situations when a sale or
exchange does not actually occur but the Code steps in and creates one, thus converting
what might have been ordinary income or loss to capital gain or capital loss. Several of
these are considered below.
WORTHLESS AND ABANDONED PROPERTY
When misfortune strikes, leaving the taxpayer with worthless property, the taxpayer
normally has a loss equal to the adjusted basis of the property. Note, however, that the loss
in these situations does not technically arise from a sale or exchange, leaving the taxpayer
to wonder how the loss is to be treated.
Worthless Securities. The Code has addressed this problem with respect to
worthless securities (e.g., stocks and bonds). In the event that a qualifying security
becomes worthless at any time during the taxable year, the resulting loss is treated as
having arisen from the sale or exchange of a capital asset on the last day of the taxable
year.11 Losses from worthlessness are then treated as either short-term or long-term
capital losses depending on the taxpayer’s holding period.
Example 1. After receiving a hot tip, N bought 200 shares of Shag Carpets Inc. for
$2,000 on November 1, 2005. Just three months later, on February 1, 2006,
N received a shocking notice that the company had declared bankruptcy and her
investment was worthless. Because of the worthlessness, N is treated as having sold
11 § 165(g).
16–7SALE OR EXCHANGE REQUIREMENT
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the stock for nothing on the last day of her taxable year, December 31, 2006.
Because the sale is deemed to occur on December 31, 2006 (and not February 1),
N is treated as if she actually held the stock for more than a year. As a result, she
reports a $2,000 long-term capital loss.
The sale or exchange fiction applies only to qualifying securities. To qualify, the
security must be (1) a capital asset and (2) a security as defined by the Code. Under
§ 165, the term security means stock, stock rights, and bonds, notes, or other forms of
indebtedness issued by a corporation or the government. When these rules do not apply
(e.g., property other than securities), the taxpayer suffers an ordinary loss. Whether a
security actually becomes worthless during a given year is a question of fact, and the
burden of proof is on the taxpayer to show that the security became worthless during
the year in question.12
Worthless Securities in Affiliated Corporations. The basic rule for worthless
securities is modified for a corporate taxpayer’s investment in securities of an affiliated
corporation. If securities of an affiliated corporation become worthless, the loss is
treated as an ordinary loss and the limitations that normally apply if the loss were a
capital loss are avoided.13 A corporation is considered affiliated to a parent corporation if
the parent owns at least 80 percent of the voting power of all classes of stock and at least
80 percent of each class of nonvoting stock of the affiliated corporation. In addition, to
be treated as an affiliated corporation for purposes of the worthless security provisions,
the defunct corporation must have been truly an operating company. This test is met if
the corporation has less than 10 percent of the aggregate of its gross receipts from
passive sources such as rents, royalties, dividends, annuities, and gains from sales or
exchanges of stock and securities. This condition prohibits ordinary loss treatment for
what are really investments.
Example 2. Toy Palace Corporation is the parent corporation for more than 100
subsidiary corporations that operate toy stores all over the country. Each subsidiary
is 100 percent owned by Toy Palace. This year the store in Chicago, TPC Inc.,
declared bankruptcy. As a result, Toy Palace’s investment in TPC stock of
$1 million became totally worthless. Toy Palace is allowed to treat the $1 million
loss as an ordinary loss since TPC was an affiliated corporation (i.e., Toy Palace
owned at least 80 percent of TPC’s stock and TPC was an operating corporation).
Observe that without this special rule, Toy Palace would have a $1 million capital
loss that it could deduct only if it had capital gains currently or within the three-year
carryback or five-year carryforward period.
Abandoned Property. While the law creates a sale or exchange for worthless
securities, it takes a different approach for abandoned business or investment property.
When worthless property (other than stocks and securities) is abandoned, the abandon-
ment is not considered a sale or exchange.14 Consequently, any loss arising from an
abandonment is treated as an ordinary loss rather than a capital loss, a much more
propitious result. Note, however, that the loss is deductible only if the taxpayer can
demonstrate that the business or investment property has been truly abandoned and not
simply taken out of service temporarily.
12 Young v. Comm., 41-2 USTC {9744, 28 AFTR 365, 123 F.2d 597 (CA-2, 1941). Code § 6511(d) extends the
statute of limitations from three years to seven years because of the difficulty of determining the specific tax
year in which stock becomes worthless.
13 § 165(g)(3).
14 Reg. §§ 1.165-2 and 1.167(a)-8.
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CERTAIN CASUALTIES AND THEFTS
Still another exception to the sale or exchange requirement involves excess casualty
and theft gains from the involuntary conversion of personal use assets. As discussed in
Chapter 10, § 165(h) provides that if personal casualty or theft gains exceed personal
casualty or theft losses for any taxable year, each such gain and loss must be treated as a
gain or loss from the sale or exchange of a capital asset. Each separate casualty or theft
loss must be reduced by $100 before being netted with the personal casualty or theft gains.
Example 3. T had three separate casualties involving personal-use assets during the year:
Fair Market Value
Casualty PropertyAdjustedBasis
BeforeCasualty
AfterCasualty
1. Accident Personal car $12,000 $ 8,500 $ 6,000
2. Robbery Jewelry 1,000 4,000 0
3. Hurricane Residence 60,000 80,000 58,000
T received insurance reimbursements as follows: (1) $900 for repair of the car;
(2) $3,200 for the theft of her jewelry; and (3) $21,500 for the damages to her home.
Assuming T does not elect (under § 1033) to purchase replacement jewelry, her
personal casualty gain exceeds her personal casualty losses by $300, computed as
follows:
1. The loss for the car is $1,500 [(lesser of $2,500 decline in value or the $12,000
adjusted basis ¼ $2,500) � $900 insurance recovery � $100 floor].
2. The gain for the jewelry is $2,200 ($3,200 insurance recovery � $1,000 adjusted
basis).
3. The loss from the residence is $400 [(lesser of $22,000 decline in value or the
$60,000 adjusted basis ¼ $22,000)� $21,500 insurance recovery � $100 floor].
T must report each separate gain and loss as a gain or loss from the sale or exchange
of a capital asset. The classification of each gain and loss as short-term or long-term
depends on the holding period of each asset.
It is important to note that this exception does not apply if the personal casualty losses
exceed the gains. In such case, the net loss, subject to the 10 percent limitation, is
deductible from A.G.I. Recall, however, that casualty and theft losses are among those
itemized deductions that are not subject to the 3 percent cutback rule imposed on high-
income taxpayers. (See Chapter 11 for a discussion of this cutback rule.)
Example 4. Assume the same facts in Example 3 except the insurance recovery
from the hurricane damage to the residence was only $11,500. In this case, the loss
from the hurricane is $10,400 ($22,000 � $11,500 � $100), and the personal
casualty losses exceed the gain by $9,700 ($1,500 þ $10,400 � $2,200). T must
treat the $9,700 net loss as an itemized deduction subject to the 10% of A.G.I.
limitation, but not subject to the 3% cutback rule.
OTHER TRANSACTIONS
There are still other situations where the sale or exchange requirement is an
important consideration. For example, foreclosure, condemnation, and other involuntary
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events are treated as sales even though they may not qualify as such for state law
purposes. Similarly, as discussed in greater detail later in this chapter, the collection of
the face value of a corporate bond (i.e., bond redemption) at maturity is treated as a sale
or exchange.
HOLDING PERIOD
The exact treatment of a capital gain or loss depends primarily on how long the
taxpayer held the asset or what is technically referred to as the taxpayer’s holdingperiod. The holding period is a critical element in determining which of the various tax
rates will apply. As might be expected, the longer the holding period is, the lower the
applicable tax rate will be. A short term gain or loss is one resulting from the sale or
disposition of an asset held one year or less.15 A long-term gain or loss occurs when an
asset is held for more than one year.
In computing the holding period, the day of acquisition is not counted but the day of
sale is. The holding period is based on calendar months and fractions of calendar months,
rather than on the number of days.16 The fact that different months contain different
numbers of days (i.e., 28, 30, or 31) is disregarded.
Example 5. P purchased 10 shares of EX, Inc. on March 16, 2006. Her gain or loss
on the sale is short-term if the stock is sold on or before March 16, 2007 but long-term
if sold on or after March 17, 2007.
Example 6. T purchased 100 shares of FMC Corp. stock on February 28, 2006. His
gain or loss will be long-term if he sells the stock on or after March 1, 2007.
The holding period runs from the time property is acquired until the time of its
disposition. Property is generally considered acquired or disposed of when title passes
from one party to another. State law usually controls the passage of title and must be
consulted when questions arise.
STOCK EXCHANGE TRANSACTIONS
The holding period for securities traded on a stock exchange is determined in the
same manner as for other property. The trade dates, rather than the settlement dates, are
used as the dates of acquisition and sale.
Generally, both cash and accrual basis taxpayers must report (recognize) gains and
losses on stock or security sales in the tax year of the trade, even though cash payment
(settlement) may not be received until the following year. This requirement is imposed
because the installment method of reporting gains is not allowed for sales of stock or
securities that are traded on an established securities market.17
Example 7. C, a cash basis calendar year taxpayer, sold 300 shares of ARA stock at
a gain of $5,000 on December 29, 2006. The settlement date was January 3, 2007.
C must report the gain in 2006 (the year of trade).
15 § 1222.
16 Rev. Rul. 66-7, 1966-1 C.B.188.
17 § 453(k)(2). See Chapter 14 for a detailed discussion of the installment sale method.
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SPECIAL RULES AND EXCEPTIONS
Section 1223 contains a number of special provisions that must be used for
determining the holding period of certain properties. The rules address the holding period
of property acquired (1) in a tax-deferred exchange; (2) by gift; (3) by inheritance; (4) in a
wash sale; (5) as a stock dividend; or (6) by exercising stock rights or options.
Property Acquired in Tax-Deferred Transaction. The holding period of property
received in an exchange includes the holding period of the property given up in the
exchange if the basis of the property is determined by reference, in whole or in part, to the
basis in that property given up (e.g., a substituted basis in a like-kind exchange).18 This
rule applies only if the property exchanged is a capital asset or a § 1231 asset (e.g., real or
depreciable property used in a trade or business) at the time of the exchange. For this
purpose, an involuntary conversion–where the taxpayer normally purchases replacement
property for that which was involuntarily converted—is treated as an exchange.19
As suggested above, this rule commonly can be found operating when there is a like-
kind exchange. For example, if a taxpayer purchased land on May 16, 1981 and swapped
it for other land in 2006, the taxpayer’s holding period for the new land would begin in
1981 since the basis of the new land is the same as the old land, $50,000, (i.e., the basis of
the new land was ‘‘determined by reference’’ to the property given up). Normally, if any
gain or loss is deferred, the holding period of the replacement property includes the
holding period of the property that was converted or exchanged.
Example 8. In 2005, the city of Milwaukee condemned 10 acres of M’s farm land
(a § 1231 asset) in order to build an exit for an interstate highway. M had acquired the
land on May 1, 1993 for $20,000. M received $120,000 for the land and therefore
realized a gain of $100,000. On July 7, 2007 M replaced the property by purchasing
new land for $120,000. As a result, he was able to defer all of the realized gain,
producing a basis for the new property of $20,000 ($120,000 cost less $100,000
deferred gain). Since an involuntary conversion is treated as an exchange, M’s
holding period begins on the date that he acquired the original property, May 1, 1993.
Property Acquired by Gift. Another exception provides that if a taxpayer’s basis in
property is the same basis as another taxpayer had in that property, in whole or in part, the
holding period will include that of the other person.20 Therefore, the holding period of
property acquired by gift generally will include the holding period of the donor. This will
not be true, however, if the property is sold at a loss and the basis in the property for
determining the loss is fair market value on the date of the gift.
Example 9. G received a gold necklace from her elderly grandmother as a birthday
gift on August 31, 2006. The necklace was worth $5,200 at that time and had a basis
to the grandmother of $1,300. Grandmother had bought the necklace in 1976.
Contrary to her grandmother’s wishes, G sold the family heirloom for $5,000 on
December 13, 2006. G will recognize a gain of $3,700 ($5,000 � $1,300). Her
holding period will begin in 1976 since her $1,300 basis is determined (under
§ 1015) by reference to her grandmother’s basis, and her holding period includes the
time the necklace was held by her grandmother.
18 § 1223(1).
19 § 1223(1)(A).
20 § 1223(2).
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Example 10. If G’s grandmother had a basis in the necklace of $6,000, G’s basis for
determining loss would be $5,200, the fair market value at the date of the gift
(see discussion in Chapter 14). Because G’s basis is not determined by reference to
her grandmother’s basis, the grandmother’s holding period is not added to G’s
holding period. Since G only held the necklace for three months, she will have a
$200 short-term capital loss ($5,200 basis � $5,000 sales price).
Property Acquired From a Decedent. A special rule is provided for the holding
period of property acquired from a decedent. The holding period formally begins on the
date of death. However, the Code provides that, if the heir’s basis in the property is its fair
market value under § 1014 and the property is subsequently sold after the decedent’s
death, the property is deemed to have a long-term holding period.21
Example 11. P sold 50 shares of Xero Corp. stock for $11,200 on July 27, 2006.
The stock was inherited from P’s uncle who died on May 16, 2006, and it was
included in the uncle’s Federal estate tax return at a fair market value of $12,000.
Since P’s basis in the stock ($12,000) is determined under § 1014, the $800 loss on
the sale will be a capital loss from property deemed to be held more than
12 months. This would be the case even if P’s uncle had purchased the stock within
days of his death. The decedent’s prior holding period is irrelevant.
Other Holding Period Rules. There are various other provisions that contain special
rules for determining holding periods. The holding period of stock acquired in a transac-
tion in which a loss was disallowed under the ‘‘wash sale’’ provisions (§ 1091) is added
to the holding period of the replacement stock.22 Also, when a shareholder receives stock
dividends or stock rights as a result of owning stock in a corporation, the holding period
of the stock or stock rights includes the holding period of the stock already owned in the
corporation.23 The holding period of any stock acquired by exercising stock rights,
however, begins on the date of exercise.24
The holding period of property acquired by exercise of an option begins on the day
after the option is exercised.25 If a taxpayer sells the property acquired by option within
one year after exercising the option, then he or she will have a short-term gain or loss.
Example 12. N owned an option to purchase ten acres of land. She had owned the
option more than one year when she exercised it and purchased the property. Her
holding period for the property begins on the day after she exercises the option. Had
she sold the option, her gain or loss would have been long-term. If she had sold the
property immediately, her gain or loss would have been short-term.
The holding period of a commodity acquired in satisfaction of a commodity futures
contract includes the holding period of the futures contract. However, the futures contract
must have been a capital asset in the hands of the taxpayer.26
21 § 1223(11).
22 § 1223(4); Reg. § 1.1223-1(d).
23 § 1223(5); Reg. § 1.1223-1(e).
24 § 1223(6); Reg. § 1.1223-1(f).
25 See, for example, Helvering v. San Joaquin Fruit & Inv. Co., 36-1 USTC {9144, 17 AFTR 470, 297 U.S. 496
(USSC, 1936), and E.T. Weir, 49-1 USTC {9190, 37 AFTR 1022, 173 F.2d 222 (CA-3, 1949).
26 § 1223(8); Reg. § 1.1223-1(h).
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TREATMENT OF CAPITAL GAINS AND LOSSES
The Taxpayer Relief Act of 1997 and the amendments of the Jobs and Growth Tax
Relief Reconciliation Act of 2003 significantly cut the tax rates on capital gains but not
without introducing an inordinate amount of complexity. The adventure begins below.
THE PROCESS IN GENERAL
The first step in determining the treatment of a taxpayer’s capital gain or loss is
identifying the applicable holding period. Once the holding period is determined, the gain
or loss can normally be assigned to an appropriate group to determine its taxation.
Historically, there have only been two groups: short-term and long-term. However,
beginning in 1997, the law made the classification process a bit more cumbersome,
producing the following groups for individual taxpayers.
" Short-Term group. Gains and losses from properties held not more than one year
" Long-Term group. Generally gains and losses from properties held more than
one year. However, individual taxpayers must subdivide the long-term group into
additional subgroups according to the rate at which they are to be taxed. The long-
term group includes:
1. The 28% group
" Capital gains and losses from collectibles (e.g., works of art, antiques, gold
and silver bullion, etc.)27
" Capital gains from qualified small business stock (taxable portion of
§ 1202 gains discussed below)
2. The 25% group.
" Capital gains (and only gains) from the sales of depreciable real estate
(e.g., office buildings, warehouses, apartment buildings) that are held for
more than 12 months but only to the extent of any unrecaptured straight-
line depreciation on such property (25CG). (See Chapter 17 for discussion
of depreciation recapture.)
3. The 15% group
" Capital gains and losses from the dispositions of other assets held more
than 12 months (15CG and 15CL).
The effect of the new rules is to require taxpayers to assign their capital gains and
losses into one of four different groups and net the amounts to determine the net gain or
loss in each group as shown below.
Short-Term Long-Term
Holding period (months) � 12 Collectibles & § 1202 stock > 12 Realty > 12 > 12A
Ordinary 28% 25% 15%
Gains $xx,xxx) $x,xxx) Gains only $xx,xxx)
Losses (xxx) (x,xxx) — (x,xxx)
Net gain or loss ????) ????) Gain only ????)
27 § 1(h)(1)(C) and (h)(4).
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As a practical matter, the capital gains of most individuals arise from the sales of stocks
and bonds and mutual fund transactions. Rarely do individuals have gains from
collectibles, § 1202 stock, or depreciable realty. Consequently, for most individuals, the
classification and netting process will indeed be much easier.
NETTING PROCESS
Generalizations about the treatment of capital gains and losses are difficult because
the actual treatment can be determined only after the various groups (i.e., the four groups
above) are combined, or netted, to determine the overall net gain or loss during the year.
This process is described below.28
Netting Within Groups. The first step in the netting process is to combine the gains
and losses within each group to produce one of the following:
1. Net short-term capital gain or net short-term capital loss (NSTCG or NSTCL).
2. Net 28% capital gain or net 28% capital loss (N28CG or N28CL).
3. Net 15% capital gain or net 15% capital loss (N15CG or N15CL).
Note that the first step requires no netting in the 25% group since this group initially con-
tains only gains.
Netting Between Groups. The second step requires the combination of the net
capital loss positions in any particular group against any net capital gain positions. The
treatment of these different groups is explained below.
1. Short-Term Capital Gains and Losses. A NSTCG receives no special treatment
and is taxed as ordinary income. If a NSTCL results, it may be used to offset net
gains of the long-term group in the following order: (1) the net 28% gains;
(2) any 25% gains; and (3) the net 15% gain. Any remaining NSTCL not
absorbed by the capital gains in the groups above is deductible subject to
limitations on the deduction of capital losses discussed below.
2. 28% Group. A N28CG is taxed at a maximum 28%.29 Any net loss in the 28%
group (N28CL) is applied in the following order: (1) 25% gains; (2) net 15%
gain; and (3) NSTCG. Any remaining N28CL that is not absorbed is deductible
subject to limitations on the deduction of capital losses discussed below.
3. 25% Group. The 25% group generally includes only capital gains from the sales
of depreciable real estate held for more than 12 months. Such gains are generally
only included to the extent of any unrecaptured straight-line depreciation on such
property. The net 25% capital gain (N25CG) is taxed at a maximum rate of
25%.30 Note that there can be no net loss in the 25% group.
4. 15% Group. A N15CG is taxed at a maximum of 15%. However, if the taxpayer’s
tax bracket (determined by including the N15CG) is only 10 or 15%, the net gain
falling into these brackets is taxed at 5%.31 Any N15CL is applied in the
following order: (1) the net 28% gains; (2) any 25% gains; and (3) any NSTCGs.
28 § 1(h)(1).
29 § 1(h)(1)(C).
30 § 1(h)(1)(B).
31 § 1(h)(1)(D) and (E).
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Any remaining N15CL not absorbed is deductible subject to limitations on the
deduction of capital losses discussed below.
It should be noted that the three long-term groups (the 28%, 25% and 15% groups) are
always netted together before taking into accounting any short-term items. Also observe
that Congress has generally given taxpayers the best possible treatment of net capital
losses in that a NSTCL offsets the net capital gain from the highest taxed group, then the
next highest taxed and so on.
Example 13. During the year, T, who is in the 35 percent tax bracket, reported the
following capital gains and losses.
Long-Term
Short-Term 28% 15%
Gains $10,000 $5,000 $8,000
Losses (4,000) (1,000) (1,000)
Net $ 6,000 $4,000 $7,000
In this case, T first nets the items within each group. She nets the $10,000 STCG and
$4,000 STCL to arrive at a NSTCG of $6,000; she nets a $5,000 28CG and a $1,000
28CL to produce a N28CG of $4,000; and she adds the $8,000 15CG and the $1,000
15CL resulting in a N15CG of $7,000. No further netting of these groups can occur
since they each group contains a positive amount. T’s NSTCG of $6,000 will receive
no special treatment and is taxed as ordinary income. T’s N28CG is taxed at 28%
while her N15CG is taxed at 15%.
Example 14. This year, L, who is in the 28% tax bracket, reported the following
capital gains and losses.
Long-Term
Short-Term 28% 15%
Gains $10,000 $5,000 $8,000
Losses (15,000) (1,000) (1,000)
Net ($5,000) $4,000 $7,000
Netting 5,000 (4,000) (1,000)
Net $ 0 $ 0 $6,000
Here L has a NSTCL of $5,000 which is netted first against N28CG of $4,000,
reducing it to zero. The remaining NSTCL of $1,000 would next be offset against
N25CG, if any. In this case, there is no N25CG, therefore the remaining NSTCL of
$1,000 is offset against the N15CG of $7,000, reducing it to $6,000 which would be
taxed at a rate of 15%.
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Example 15. This year, X, who is in the 35% tax bracket, reported the following
capital gains and losses
Long-Term
Short-Term 28% 25% 15%
Gains $14,000 $1,000 $1,000 $6,000
Losses (4,000) (9,000) — (1,000)
Net $10,000 ($8,000) $1,000 $5,000
Netting (2,000) 8,000 (1,000) (5,000)
Net $ 8,000 $ 0 $ 0 $ 0
Here X has a N28CL of $8,000 which is netted first against the 25CGs of $1,000,
reducing this group to zero. X next uses the remaining $7,000 N28CL to offset his
$5,000 N15CG, reducing it to zero. The remaining N28CL of $2,000 ($7,000 �$5,000) is offset against NSTCG, producing a NSTCG of $8,000 which will be
treated as ordinary income. Note that the effect of the rules is to net the long-term
groups before considering any short-term items. Absent these rules, X would prefer to
use the N28CL loss against the NSTCG which would leave $5,000 to be taxed at 15%
and $2,000 to be taxed as ordinary income, a far more beneficial result. X must net
the long-term groups first.
Treatment of Capital Losses. While capital gains receive favorable treatment, such
is not the case with capital losses. As can be seen above, capital losses are first netted
with capital gains within the same group (rather than reducing ordinary income). A net
capital loss from a particular group can then be combined with net capital gains from
the other groups as explained above. If after netting all of the groups together, the
taxpayer has an overall net capital loss, the loss is deductible against ordinary income.
This deduction is limited to the lesser of (1) $3,000 ($1,500 in the case of a married
individual filing a separate return) or (2) the net capital loss. In either case, the capital
loss deduction cannot exceed taxable income before the deduction.32 The deductible
capital loss is a deduction for adjusted gross income. Any losses in excess of the annual
$3,000 limitation are carried forward to the following year where they are treated as if
they actually occurred in such year. In effect, an unused capital loss can be carried over
for an indefinite period.33 However, should the taxpayer die, any unused capital loss is
normally lost.
If the netting process results in a NSTCL and either a N28CL or N15CL or both, the
NSTCL is applied first toward the maximum $3,000 limit. For example, if the taxpayer
has a NSTCL of $5,000 and a N15CL of $4,000, the NSTCL is used first. Any NSTCL
in excess of the $3,000 limit along with any other unused losses may be carried forward
to subsequent years indefinitely. In this case, the NSTCL carryover retains its character
to be treated just as if it had occurred in the subsequent year. The N15CL or N28CL are
both carried over as N28CLs. In other words, any long-term capital loss carryover is
carried over as a 28CL. In the example above, $3,000 of the $5,000 NSTCL would be
used first against ordinary income and the $2,000 remaining would be carried over as a
STCL while the $4,000 N15CL would be carried over as a 28CL. In the absence of a
NSTCL or, if after deducting any existing NSTCL, the taxpayer has not reached the an-
nual $3,000 limit for the capital loss deduction, the taxpayer uses any other net capital
losses (e.g., the excess of N15CL over N28CG and N25CG or the excess of N28CL
32 § 1212(b).
33 Reg. § 1.211-1(b)(4)(i).
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over 25 CG and N15CG) to reduce ordinary income up to the $3,000 limit.34 In this
regard, the order in which the remaining net capital losses are used is irrelevant since
any remaining losses (i.e., the long-term losses) are carried over as a N28CL which is
treated as if it occurred in the subsequent year.
Example 16. During the year, B reported the capital gains and losses revealed below.
B’s only other taxable income included his salary of $50,000. He had no other
deductions for A.G.I. The combination of gains, losses, and ordinary income is shown
in the following table.
Long-Term
Short-Term 28% 15%
Gains $10,000 $5,000 $9,000
Losses (18,000) (7,000) (6,000)
Net ($ 8,000) ($2,000) $3,000
Netting (long-term against long-term) 2,000 (2,000)
$ 0 $1,000
Netting (long-term against short-term) 1,000 (1,000)
($ 7,000) $ 0
Deduction 3,000
Carryover ($ 4,000)
B first nets the long-term items, that is, the N28CL of $2,000 is netted against the
N15CG of $3,000. This produces a N15CG of $1,000 ($3,000 � $2,000). B then
combines the $8,000 NSTCL and the remaining N15CG of $1,000, leaving a NSTCL
of $7,000. In determining his A.G.I., B may deduct only $3,000 of the NSTCL.
Therefore his A.G.I. is $47,000 ($50,000 � $3,000). The unused NSTCL of $4,000
($7,000� $3,000) is carried forward to future years as a STCL where it is treated as if
it arose in the subsequent year.
Example 17. This year, Q reported the capital gains and losses as shown below. He
had no other deductions for A.G.I. The combination of gains, losses, and ordinary
income is revealed in the following table.
Long-Term
Short-Term 28% 15%
Gains $1,000 $5,000 $4,000
Losses (2,000) (3,000) (9,000)
Net ($1,000) $2,000 ($5,000)
Netting (long-term against long-term) 0 (2,000) 2,000
Net ($1,000) $ 0 ($3,000)
Deduction 1,000 2,000
Carryover $ 0 ($1,000)
Here Q has a NSTCL of $1,000 and a net $5,000 N15CL. He first combines the long-
term groups, using $2,000 of the $5,000 N15CL to offset the N28CG of $2,000,
reducing it to zero. The remaining $3,000 normally would be netted against 25CG if
34 § 1211(a).
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there were any. No further netting is allowed. Therefore, J first uses the NSTCL of
$1,000 and then $2,000 of the $3,000 N15CG remaining toward the $3,000 offset
against ordinary income. The remaining N15CL of $1,000 is carried over and is
treated as a 28CL. It should be emphasized that the N15CL of $1,000 does not retain
its character but becomes a capital loss in the 28% group. Note that the carryover rule
is quite favorable. If next year J had $1,000 of N28CG and $1,000 of N15CG, the
carryover would wipe out the N28CG, leaving the most favorable gain to be taxed.
Example 18. W’s records for 2005 and 2006 revealed substantial ordinary income
and the following capital gains and losses.
Long-Term
Short-Term 28% 15%
2005 gains $ 1,000 $ 5,000 $ 4,000
2005 losses (2,000) (9,000) (9,000)
$ (1,000) $ (4,000) $ (5,000)
2006 $10,000 $12,000 $15,000
In 2005, there can be no further netting. Therefore, W first uses the NSTCL of
$1,000 against ordinary income and then uses $2,000 of the $9,000 in long-term
losses, leaving a long-term capital loss carryover of $7,000. Note that it makes no
difference which long-term loss is used (i.e., the 28% loss or the 15% loss) since all
long-term capital loss carryovers are treated as 28CLs.
In 2006, W treats the $7,000 long-term capital loss carryover as a N28CL. As a
result, W would report a N28CG of $5,000 ($12,000 � the $7,000 loss carryover),
N15CG of $15,000 and a NSTCG of $10,000.
DIVIDENDS TAXED AT CAPITAL GAIN RATES
In negotiations related to the Jobs and Growth Tax Relief Reconciliation Act of 2003,
Congress and the Bush administration considered a number of alternative statutory
schemes to reduce or eliminate the double taxation of corporate dividends. Somewhat as a
surprise, apparently in the interest of simplification, the 2003 Act allows noncorporate
taxpayers to treat qualifying dividends similarly to long-term capital gains when
calculating their tax. The dividends are now taxed at the reduced 15 percent capital gain
rate (5 percent for lower bracket taxpayers) and appears to reduce significantly the toll of
the double tax.
The new law provides that most dividends received after 2002 will be subject to the
revised capital gains rates35: 15 percent generally and 5 percent for dividends that would
otherwise be taxed at an ordinary rate of 15 percent or lower. The qualifying dividend is
added to the net capital gain and is not subject to the capital gain and loss netting process.
As a result, the dividends are subject to capital gains treatment regardless of whether the
taxpayer has other capital gains or losses.36
Qualified dividends are dividends from domestic corporations and qualified
foreign corporations.37 Qualified foreign corporations are those that are incorporated in
35 § 1(h)(11).
36 Like other long-term capital gains, dividends qualifying for capital gain treatment are not investment income
for purposes of the investment interest limitation. However, a taxpayer can elect to treat the dividends as
investment income and forego the capital gain treatment. See § 1(h)(11)(D)(i).
37 § 1(h)(11)(B).
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possessions of the United States, those subject to a treaty with the U.S. (involving the
exchange of tax information by the governments) and others, the stocks of which are
traded on a U.S. stock exchange (certain foreign corporations that are not subject to U.S.
tax are not included).
CORPORATE TAXPAYERS
The capital gains and losses of corporate taxpayers are treated a bit differently from
those of individual taxpayers. Corporations separate all of their capital gains and losses
into only two groups: short-term and long-term (holding period of more than one year).
Unlike individuals, there is no further subdividing of the long-term group. Items within
the groups are then netted, producing one of the following: NLTCG, NLTCL, NSTCG
or NSTCL. If the taxpayer has a NSTCG and a NLTCG, no further netting is allowed.
However, if the taxpayer has either a NSTCL and NLTCG or a NSTCG and a NLTCL,
these results can be combined to produce a final position. This can be illustrated as
follows:
Short-Term Long-Term Result
Holding period (months) � 12 >12
Gains $xx,xxx) $xx,xxx)
Losses (xxx) (x,xxx)
Net gain or loss ???? ????
Possibilities NSTCG NLTCG No further netting
NSTCG NLTCL NLTCL or NSTCG
NSTCL NLTCG NSTCL or NLTCG
NSTCL NLTCL No further netting
A corporate taxpayer receives no special treatment for either a NSTCG or NLTCG. They
are treated just like ordinary income. If after netting, the corporation has a NSTCL or a
NLTCL, such losses receive special treatment. Unlike an individual taxpayer, a corpora-
tion is not allowed to offset capital losses against ordinary income. A corporate taxpayer’s
capital losses can be used only to reduce its capital gains.38 Any excess losses are first
carried back to the three preceding years as short-term capital losses and offset against
any net short-term capital gains and then any net long-term capital gains. Absent any
capital gains in the three prior years, or if the loss carried back exceeds any capital gains,
the excess may be carried forward for five years.39
Example 19. An examination of C Corporation’s records for 2006 revealed
$200,000 of net ordinary taxable income, a long-term capital loss of $9,000 and a
short-term capital gain of $2,000. The corporation nets the loss against the gain to
produce a NLTCL of $7,000. The corporation cannot offset the loss against
ordinary income and, therefore, reports $200,000 of taxable income (undiminished
by the NLTCL). Instead the NLTCL is carried back to the third prior year, 2003, as
a STCL where it can be used to first offset any NSTCG and then any NLTCG. If
there are no capital gains in 2003, the corporation would carryover the loss, now a
STCL of $7,000, to 2004 to use against capital gains. This process would continue
until the loss is entirely used or it expires at the end of 2011. Note that when the
loss is used in prior years, a refund can be obtained.
38 § 1212(a).
39 Ibid.
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CALCULATING THE TAX
Section 1(h) provides a special tax calculation to ensure that an individual’s capital
gains will not be taxed at a rate greater than the applicable preferred rate (i.e., in 2005 the
28%, 25%, 15%, 10% or 5% rate). This calculation can only reduce the tax, not increase it.
Example 20. H and W are married. For 2006, their sole source of income was a
15CG of $79,000 from the sale of assets held five years. Their taxable income is
computed as follows:
15CG $79,000
Standard deduction (10,300)
Exemption deduction (6,600)
Taxable income $62,100
The 10% and 15% bracket for taxpayers filing jointly in 2006 runs to $61,300 at
which point any dollar of income in excess of that amount is taxed at 25%. Since all
of the couple’s income is from capital gain, however, none of it is taxed at the 15%
or 25% brackets. The effect of the special capital gains calculation is to tax the
portion of the N15CG that falls into the 10% and 15% bracket at a 5% rate and the
portion that falls into the 25% bracket at 15%. Therefore, $61,300 of the N15CG is
taxed at 5% and the remaining $2,900 is taxed at 15%. The total tax is $3,200
[($61,300 � 5%) þ ($2,900 � 15%)].
It may be clear from the above example that whenever an individual’s ordinary
taxable income exceeds the amount that would be taxed at 10 or 15 percent (e.g., $61,300
in 2006 for a joint return), none of the N15CG is taxed at 5 percent. In such case, the
taxpayer computes the tax liability by first calculating the regular tax on ordinary taxable
income and adding to that a tax of 15 percent on the N15CG. On the other hand, if
ordinary taxable income does not exceed the amount that is taxed at 10 or 15 percent, a
portion of the N15CG is taxed at the 5 percent rate until the 10 and 15 percent brackets
are exhausted. A similar approach applies for N25CGs and N28CGs.
Before proceeding, it is important to understand some statutory terms. The first term
is net capital gain—the excess of the net long-term capital gain over the net short-term
capital loss for a year. If there is no net short-term capital loss, the net capital gain is
simply the net gain from the 15 percent group, the 25 percent group, and the 28 percent
group combined. If there is a short-term loss, it is the excess of the combined long-term
gains minus the net short-term capital loss. The second term is adjusted net capitalgain—the net capital gain reduced (but not below zero) by the 25 percent gain and the
net 28 percent gain (reduced by any net short-term capital loss).
The actual steps to compute the capital gains tax are built into Schedule D of Form
1040. They are also summarized in Exhibit 16-1.
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EXHIBIT 16-1
Tax Computation Involving Capital Gains
Step 1. Calculate the regular income tax using the regular rates on the taxpayer’s taxable income
Step 2. Determine the tax on the ordinary income
a. Select the greater of—" Ordinary taxable income (taxable income � net capital gain), or" The lesser of—
" The maximum amount that would be taxed at 15 percent, or" Taxable income� the adjusted net capital gain
b. Compute the regular income tax on this amount
Step 3. Determine the tax on the net capital gain by adding the following together
a. Tax on 5 Percent Gains—5 percent of the portion of the adjusted net capital gain that
would have been taxed at 10 or 15 percent when added to ordinary income [i.e., the
lesser of (1) the adjusted net capital gain or (2) the maximum amount that would
normally be taxed at 10 or 15 percent minus the amount of ordinary income].
b. Tax on 15 Percent Gains—15 percent of (the adjusted net capital gain minus any
5 percent gains).
c. Tax on 25 Percent Gains—The lesser of" 25 percent of the 25 percent gains, or" If less, (1) 10 or 15 percent (respectively) of the amount of the 25 percent gains
that, when added to ordinary income and any 5 percent gains, would be taxed at
10 or 15 percent*, plus (2) 25 percent of any remaining 25 percent gains.
d. Tax on 28 Percent Gains—The lesser of" 28 percent of the 28 percent gains, or" If less, (1) 10 or 15 percent (respectively) of the amount of the 28 percent gains
that, when added to ordinary income, any 5 percent gains, and any 25 percent
gains, would be taxed at 10 or 15 percent**, plus (2) 28 percent of any remaining
28 percent gains.
Step 4. Add the tax on the ordinary income (Step 2) to the tax on the net capital gain (Step 3) to
get the total capital gains tax.
Step 5. The final tax is the lesser of the taxes computed in Step 1 and Step 4.
*This is the amount that would otherwise be taxed at 10 or 15 percent when added to ordinary income and
any 5 percent gains (or stated differently, it is the maximum amount that would be taxed at 10 or 15 percent
minus the amount of ordinary income and the amount of 5 percent gains).
**This is the amount that would otherwise be taxed at 10 or 15 percent when added to ordinary income, any
5 percent gains, and any 25 percent gains (or, stated differently, it is the maximum amount that would be
taxed at 15 percent minus the amount of ordinary income and the amount of 5 percent gains).
16–21TREATMENT OF CAPITAL GAINS AND LOSSES
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Example 21. J and K are married and file a joint return for 2006. They have taxable
income of $76,300, including a N15CG of $15,000. Thus they have ordinary taxable
income of $61,300. Their tax is computed as follows:
Step 1: Regular tax on $76,300 ¼ $12,190
Regular tax on $76,300:Tax on $61,300 (10% and 15% brackets) $ 8,440Plus: Tax on excess at 25%
[($76,300 � $61,300)� 25%] þ3,750
Equals: Total tax $12,190
Step 2a: Ordinary income ¼ $61,300 ($76,300� $15,000)Step 2b: Regular tax on ordinary income of $61,300 ¼ $8,440
Regular tax on $61,300 . . . . . . . . . . . . . . . . . . . . $8,440
Step 3: Tax on the net capital gain ¼ $2,250
a. Tax on 5% Gains ¼ 5% of zero (All of the net capital gain would
have been taxed at a rate exceeding 15% since V’s ordinary
income plus 25% gains and 28% gains equaled or exceeded
$61,300—the limit of the 15% bracket)
b. Tax on 15% Gains¼ 15% � $15,000 ¼ $2,250
c. Tax on 25% Gains ¼ 25% of zero
d. Tax on 28% Gains¼ 28% of zero
Step 4: Total capital gains tax ¼ $10,690 ($8,440þ $2,250)
Step 5: The final tax is $10,690. The savings is $1,500 ($12,190 � $10,690).
Note that this $1,500 is the 10% difference (25% � 15%) on the
$15,000 gain.
Example 22. V is single for 2006 and has taxable income for the year of $100,000
including the following:
Loss from stock held 11 months ($2,000)
Gain from gold bullion held 3 years 3,000
Gain from land held 9 years 16,000
Loss from stock held 2 years (3,000)
V would summarize his gains and losses as follows:
Long-Term
Short-Term 28% 15%
($2,000) $3,000 $16,000
— — (3,000)
($2,000) $3,000 $13,000
Netting 2,000 (2,000) —
$ 0 $1,000 $13,000
16–22 PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES
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The loss is a STCL since it was held for not more than a year. The gain on the sale of
the gold bullion is treated as a 28CG since it is a collectible. Collectibles are treated
as 28CGs even though they may have been held more than 12 months. The gain and
loss from the land and stock are both classified as 15% items since they were held
more than 12 months. Thus V’s overall capital gain is $14,000, consisting of a
N28CG of $1,000 and a N15CG of $13,000. V’s tax is computed as follows.
Step 1: Regular tax on $100,000¼ $22,332
Tax on $74,200 (10%, 15% and 25% bracket) $15,108
Plus: Tax on excess at 28% [($100,000� $74,200) � 28%] 7,224
Equals: Total tax $22,332
Step 2a: Ordinary income ¼ $86,000 ($100,000 � $14,000)Step 2b: Regular tax on ordinary income of $86,000 ¼ $18,412
Tax on $74,200 $15,108
Plus: Tax on excess at 28% [($86,000� $74,200)� 28%] 3,304
Equals: Total tax $18,412
Step 3: Tax on the net capital gain¼ $2,230 ($280þ $1,950)
a. Tax on 5% Gains ¼ 5% of zero (All of the net capital gain would have
been taxed at a rate exceeding 15% since V’s ordinary income
exceeded $30,650—the limit of the 15% bracket)
b. Tax on 15% Gains¼ 15% � $13,000 ¼ $1,950
c. Tax on 25% Gains¼ 25% of zero
d. Tax on 28% Gains¼ 28% � $1,000¼ $280
Step 4: Total capital gains tax¼ $20,642 ($18,412þ $2,230)
Step 5: The final tax is $20,817 (the lesser of Step 1 or Step 4). The difference
between the regular tax and the capital gains tax is $1,690 ($22,332 �$20,642). Note that this $1,690 is the 13% difference (28% � 15%) on
$13,000 (13%� $13,000¼ $1,690).
Example 23. Same as Example 21, except V’s total taxable income is $35,000.
Step 1: Regular tax on $35,000¼ $5,308
Tax on $30,650 $4,220
Plus: Tax on excess at 25% [($35,000� $30,650)� 25%] 1,088
Equals: Total tax $5,308
Step 2a: Ordinary income ¼ $21,000 ($35,000� $14,000)
Step 2b: Regular tax on $21,000¼ $2,773 ($7,550� 10% þ $13,450 � 15%)
Step 3: Tax on the net capital gain¼ $1,235 ($483þ $502þ $250)
a. Tax on 5% Gains ¼ $483 [$9,650 � 5%—The N15CG is taxed at 5%
to the extent the limit on the 15% tax bracket exceeds the ordinary
income ($30,650� $21,000 ¼ $9,650)]
16–23TREATMENT OF CAPITAL GAINS AND LOSSES
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b. Tax on 15% Gains ¼ $502 [($13,000 � $9,650 ¼ $3,350) � 15%—The
adjusted net capital gain reduced by the portion taxed at 5% multiplied
by 15%]c. Tax on 25% Gains ¼ 25% of zerod. Tax on 28% Gains ¼ 25% � $1,000 ¼ $250 [Since ordinary income plus
the 5% gains, 15% gains, and 25% gains are more than the limit on the
15% tax bracket ($21,000 þ $8,050 þ $4,950 > $30,650) but less than
the top of the 25% bracket amounts, the 28% gains are taxed at 25%.]
Step 4: Total capital gains tax¼ $4,008 ($2,773þ $1,235)
Step 5: The final tax is $4,008 (the lesser of Step 1 or Step 4). The difference between
the regular tax and the capital gains tax is $1,300 ($5,308 � $4,008). Note
that this $1,300 is the sum of the 10% difference (15% � 5%) on $9,650 and
the 10% difference (25%� 15%) on $3,350 [10%� $9,650þ 10%� $2,350¼$1,300], but there is no difference on the 28% gain that was taxed at the
ordinary income rate.
REPORTING CAPITAL GAINS AND LOSSES
Individual taxpayers report any capital gains or losses on Schedule D of Form 1040.40
This form is designed to facilitate the netting process, with one part used for reporting
short-term gains and losses and another part used to report long-term transactions. A third
part of the form is available for the second step of the netting process in the event the
taxpayer has either NSTCGs and NLTCLs or NLTCGs and NSTCLs.
Regular corporations must report capital gains and losses on Schedule D of Form
1120 in much the same manner as individual taxpayers. Partnerships and S corporations
must also report capital gains and losses on a separate schedule (Schedule D of Form
1065 for partnerships and Schedule D of Form 1120S for S corporations). However,
these conduit entities are limited to the first step of the netting process. Each owner
(partner or S corporation shareholder) must include his or her share of the results from
the entity with the appropriate capital transactions being netted on the owner’s Schedule
D, Form 1040.
3 CHECK YOUR KNOWLEDGE
Review Question 1. For 2006 Ms. Reyes earned a salary of $70,000 from her job
as an art curator. In addition, she sold stock, realizing the following capital gains and
losses:
15CG $10,000
15CL (7,000)
STCL (11,000)
In 2006 she changed jobs, becoming a tax accountant and earning a salary of $300,000. In
addition, she realized a 15CG of $12,000.
Compute Ms. Reyes’s adjusted gross income for 2006 and 2007 and indicate the amount,
if any, that is eligible for preferential treatment as long-term capital gain.
40 See Appendix for a sample of this form.
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Her adjusted gross incomes for 2006 and 2007 are $67,000 and $307,000, respectively.
After netting her capital gains and losses in 2006, Ms. Reyes has a net capital loss of
$8,000, all of which is short-term. The deduction for capital losses of an individual is
generally limited to $3,000. As a result, her adjusted gross income is $67,000 ($70,000 �$3,000). She is entitled to carry over the remainder of her short-term loss of $5,000. In
2007, she nets the $5,000 short-term capital loss against her $12,000 15CG to produce a
N15CG of $7,000. The $7,000 is combined with her other $300,000 of salary income to
produce an adjusted gross income of $307,000. Of this amount, her N15CG of $7,000 is
taxed at a preferred rate of 15 percent.
Review Question 2. True-False. This year Mr. and Mrs. Simpson retired. The
couple’s only income was a capital gain from the sale of stock held three years.
Assuming the Simpsons file a joint return, all $100,000 of their taxable income is taxed at
a rate of 15 percent.
False. The tax computation operates to ensure that the 15CG is taxed at 5 percent to the
extent that ordinary income does not absorb the 10 and 15 percent brackets. For 2006 the
15 percent bracket for a joint return extends to taxable income of $61,300. Therefore,
$61,300 is taxed at a 5 percent rate and the remaining $41,900 is taxed at a 15 percent
rate.
The Simpsons should have considered making the sales in two separate years (perhaps
2006 and 2007) if they have no other income in either year. That would allow them to
double the benefit of the 5 percent rate.
Review Question 3. True-False. An individual taxpayer is generally entitled to
deduct any capital loss recognized during the current year to the extent of any capital
gains recognized plus $3,000. Any capital loss in excess of this amount retains its charac-
ter and may be used in subsequent years until it is exhausted.
True.
CAPITAL GAIN TREATMENT EXTENDEDTO CERTAIN TRANSACTIONS
The Internal Revenue Code contains several special provisions related to capital asset
treatment. In some instances the concept of capital asset is expanded and in others it is
limited. Some of the provisions merely clarify the tax treatment of certain transactions.
PATENTS
Section 1235 provides that certain transfers of patents shall be treated as transfers of
capital assets held for more than one year. This virtually assures that a long-term capital
gain will result if the patent is transferred in a taxable transaction, because the patent will
have little, if any, basis since the costs of creating it are usually deducted under §174
(research and experimental expenditures) in the tax year in which such costs are incurred.
Any transfer, other than by gift, inheritance, or devise, will qualify as long as allsubstantial rights to the patent are transferred. All substantial rights have been described
as all rights that have value at the time of the transfer. For example, the transfer must not
limit the geographical coverage within the country of issuance or limit the time
application to less than the remaining term of the patent.41
41 Reg. § 1.1235-2(b).
16–25CAPITAL GAIN TREATMENT EXTENDED TO CERTAIN TRANSACTIONS
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The transferor must be a holder as defined in § 1235(b). The term holder refers to
the creator of the patented property or to an individual who purchased such property
from its creator if such individual is neither the employer of the creator nor related to
such creator.42
The sale of a patent will qualify for § 1235 treatment even if payments are made
over a period that ends when the purchaser’s use of the patent ceases or if payments are
contingent on the productivity, use, or disposition of the patent.43 It also is important to
note that §§ 483 and 1274, which require interest to be imputed on certain sales
contracts, do not apply to amounts received in exchange for patents qualifying under
§ 1235 that are contingent on the productivity, use, or disposition of the patent
transferred.44
Example 24. K, a successful inventor, sold a patent (in which she had a basis of zero)
to Bell Corp. The sale agreement called for K to receive a percentage of the sales of
the property covered by the patent. All of K’s payments received in consideration for
this patent will be long-term capital gain regardless of her holding period.
LEASE CANCELLATION PAYMENTS
Section 1241 allows the treatment of payments received in cancellation of a lease or
in cancellation of a distributorship agreement as having been received in a sale or
exchange. Therefore, the gains or losses will be treated as capital gains or losses if the
underlying assets are capital assets.45
INCENTIVES FOR INVESTMENTS IN SMALL BUSINESSES
Congress has frequently provided incentives for investment in general or for specific
investments. The Subchapter S election, for example, was intended to remove any impediment
for small business owners who were not incorporating because they believed there was a
double tax on corporate profits. Other incentives provide special treatment upon the disposition
of certain business interests. The following sections deal with various prominent examples.
LOSSES ON SMALL BUSINESS STOCK: § 1244
Losses on dispositions (e.g., sale or worthlessness) of corporate stock are generally
classified as capital losses. For a year in which a taxpayer has no capital gains, the deduc-
tion for capital losses would be limited to $3,000 annually. In contrast, a loss on the dispo-
sition of a sole proprietorship would be recognized upon the disposition of the assets used
in the business. Losses on the sale of many (if not most) of the assets would be treated as
ordinary losses, thereby avoiding (or partially avoiding) the $3,000 limit. Similarly,
proper planning could result in ordinary loss treatment upon the disposition of interests in
businesses operated in the partnership form.
Without special rules, the limitation on deductions for capital losses might
discourage investment in new corporations. For example, if an individual invested
$90,000 in stock of a new corporate venture, deductions for any loss from the
investment, absent offsetting gains, would be limited to $3,000 annually.46 Thus, where
42 For definition of ‘‘relative,’’ see § 1235(d).
43 § 1235(a).
44 §§ 483(d)(4) and 1274(c)(4)(E). See Chapter 14 for a discussion of the imputed interest rules.
45 See Chapter 17 for treatment if the asset is a § 1231 asset.
46 A taxpayer can offset any capital losses against capital gains, if any.
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the stock becomes worthless it could take the investor as long as 30 years to recover the
investment. This restriction on losses also is inconsistent with the treatment of losses
resulting from investments by an individual in his or her sole proprietorship or in a
partnership. In the case of a sole proprietorship or a partnership, losses generally may be
used to offset the taxpayer’s other income without limitation. For example, assume a
sole proprietor sank $150,000 into a purchase of pet rocks that he ultimately sold for
only $100,000. In such case, he would have an ordinary loss of $50,000, all of which
could be used to offset other ordinary income. Assume the same individual invested
$150,000 in a corporation that had the same luck. If the taxpayer could at best sell the
stock for $100,000, he would realize a capital loss of $50,000. Obviously the sole
proprietor is in a much better position. To eliminate these problems and encourage
taxpayers to invest in small corporations, Congress enacted § 1244 in 1958.
Under § 1244, losses on ‘‘Section 1244 stock’’ generally are treated as ordinary
rather than capital losses.47 Ordinary loss treatment normally is available only toindividuals who are the original holders of the stock. If these individuals sell the stock at
a loss or the stock becomes worthless, they may deduct up to $50,000 annually as an
ordinary loss. Taxpayers who file a joint return may deduct up to $100,000 regardless of
how the stock is owned (e.g., separately or jointly). When the loss in any one year
exceeds the $50,000 or $100,000 limitation, the excess is considered a capital loss.
Example 25. T, married, is one of the original purchasers of RST Corporation’s
stock, which qualifies as § 1244 stock. She separately purchased the stock two years
ago for $150,000. During the year, she sold all of the stock for $30,000, resulting in
a $120,000 loss. On a joint return for the current year, she may deduct $100,000 as an
ordinary loss. The portion of the loss exceeding the limitation, $20,000 ($120,000 �$100,000), is treated as a long-term capital loss.
Stock issued by a corporation (including preferred stock issued after July 18, 1984)
qualifies as § 1244 stock only if the issuing corporation meets certain requirements. The
most important condition is that the corporation’s total capitalization (amounts received
for stock issued, contributions to capital, and paid-in surplus) must not exceed
$1 million at the time the stock is issued.48 This requirement effectively limits § 1244
treatment to those individuals who originally invest the first $1 million in money and
property in the corporation.
Example 26. In 2003 F provided the initial capitalization for MNO Corporation by
purchasing 700 shares at a cost of $1,000 a share for a total cost of $700,000. In
2006 G purchased 500 shares at a cost of $1,000 per share or a total of $500,000.
All of F’s shares otherwise qualify as § 1244 stock. Only 300 of G’s new shares
qualify for § 1244 treatment, however, since 200 of the 500 purchased caused the
corporation’s total capitalization to exceed $1 million.
QUALIFIED SMALL BUSINESS STOCK (§ 1202 STOCK)
As part of the Revenue Reconciliation Act of 1993, Congress created a new tax
incentive to stimulate investment in small business. By virtue of this special rule,
individuals who start their own C corporations or who are original investors in
C corporations (e.g., initial public offerings) may be richly rewarded for taking the risk of
investing in such enterprises.
47 § 1244(a).
48 § 1244(c)(3)(A).
16–27INCENTIVES FOR INVESTMENTS IN SMALL BUSINESSES
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Fifty Percent Exclusion. Under § 1202, noncorporate investors (i.e., individuals,
partnerships, estates, and trusts) are allowed to exclude 50 percent of the gain on the
sale of qualified small business stock (QSB stock or § 1202 stock) held for more than
five years.49 The balance of this gain is treated as a 28 percent gain. The effect of this
provision is to impose a maximum tax of 14 percent (50% � 28% maximum capital
gain rate) on the gains from such investments,50 a far lower rate than the 35 percent that
may apply to other types of income received by the taxpayer.
Example 27. On October 31, 1999 N purchased 1,000 shares of Boston Cod
Corporation for $10,000. The stock was part of an initial public offering of the
company’s stock that was designed to raise $30 million to open another 200 fast fish
restaurants. On December 20, 2006 N sold all of her shares for $50,000. As a result,
she realized a capital gain of $40,000, her only gain or loss during the year. Since N
was one of the original investors and the stock qualified as § 1202 stock at the time
of its issue (assets at that time were less than $50 million), she is entitled to exclude
50 percent of her gain, or $20,000. The maximum tax on the $20,000 gain is $5,600
($20,000� 28%).
In determining net capital gain and capital losses, the taxpayer does not consider
any gain excluded on the sale of § 1202 stock.
Example 28. Assume the same facts as above, but assume that in addition to the
$40,000 gain on § 1202 stock, N also has other long-term capital gains of $10,000 and
short-term capital losses of $5,000. N first applies the 50% exclusion and then nets the
remainder with the other capital gains and losses. Therefore, N’s net capital gain for
the year is $25,000 [($40,000 � $20,000 ¼ $20,000)þ $10,000 � $5,000].
Example 29. Assume N has a gain on § 1202 stock of $40,000 and a short-term
capital loss of $23,000. N first applies the 50% exclusion and then nets the
remaining gain with the capital loss. As a result, N has a net capital loss of $3,000
($20,000� $23,000).
Rollover Provision. An individual who realizes a gain on the sale of QSB stock
held for more than six months can defer recognition of the gain by reinvesting in other
QSB stock within 60 days of the sale. Note that the stock qualifies for the rollover
provision if it is held more than six months (not five years). The individual must
recognize gain to the extent that the amount reinvested is less than the sales price of the
original stock. If the taxpayer uses the rollover provision, the basis in the newly
acquired QSB stock is reduced by the deferred gain. The holding period of the new QSB
stock includes the holding period of the old QSB stock.
Example 30. D purchased Netbrowser stock two years, for $10,000. The stock quali-
fied as § 1202 stock. After rising dramatically, the stock started to fall so D sold it for
$14,000 before he lost all of his profit. He realized a $4,000 gain on the sale.
D wanted to preserve the special treatment for § 1202 stock so 45 days after the sale,
he reinvested in MMX Inc., another issue of § 1202 stock, for $15,000. D recognizes
no gain on the sale since his holding period of two years exceeded the required six
months and he reinvested all $10,000 received from the sale of § 1202 stock. His
basis in the replacement stock is $11,000 ($15,000 � $4,000) and the two-year
49 Special rules apply for computing the exclusion on the sale of stock in a specialized small business invest-
ment company (see following discussion).
50 § 1h. Recall that the § 1202 gain on the sale of qualified small business stock is excluded from the adjusted
net capital gain. Therefore, the 15 percent rate does not apply.
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holding period of the old stock attaches to the new. Had D reinvested only $13,000,
he would have recognized a gain of $1,000 ($14,000 � $13,000) and have a basis in
the replacement stock of $10,000 ($13,000 � deferred gain of $3,000). Note that this
rollover provision enables the taxpayer to move in and out of positions in QSB stock
so long as QSB is repurchased.
§ 1202 Requirements. Stock qualifies as § 1202 stock if it is issued after August 10,
1993 and meets a long list of requirements.
1. At the time the stock is issued, the corporation issuing the stock must be a
qualified small business. A corporation is a qualified small business if" The corporation is a domestic C corporation
" The corporation’s gross assets do not exceed $50 million at the time the stock
was issued (i.e., cash plus the fair market value of contributed property
measured at the time of contribution plus the adjusted basis of other assets)
2. The seller is the original owner of the stock (i.e., the stock was acquired directly
from the corporation or through an underwriter at its original issue)
3. During substantially all of the seller’s holding period of the stock, the corporation
was engaged in an active trade or business other than the following:" A business involving the performance of providing services in the fields of
health, law, engineering, architecture, accounting, actuarial science, performing
arts, consulting, athletics, financial services, brokerage services, or any other
business where the principal asset is the reputation or skill of one or more of its
employees
" Banking, insurance, financing, leasing, or investing
" Farming
" Businesses involving the production or extraction of products eligible for
depletion
" Business of operating a hotel, motel, or restaurant
4. The corporation generally cannot own" Real property with a value that exceeds 10 percent of its total assets unless
such property is used in the active conduct of a trade or business (e.g., rental
real estate is not an active trade or business)
" Portfolio stock or securities with a value that exceeds 10 percent of the
corporation’s total assets in excess of its liabilities
Note that the active trade or business requirement and the prohibition on real estate
holdings severely limit the exclusion. These conditions effectively grant the exclusion to
corporations engaged in manufacturing, retailing, or wholesaling businesses.
The new provision also imposes a restriction, albeit a liberal one, on the amount of
gain eligible to be excluded on the sale of a particular corporation’s stock. The
maximum amount of gain that may be excluded on the sale of one corporation’s stock is
the larger of
1. $10 million, reduced by previously excluded gain on the sale of such
corporation’s stock; or
2. 10 times the adjusted basis of all qualified stock of the corporation that the
taxpayer sold during the tax year.
16–29INCENTIVES FOR INVESTMENTS IN SMALL BUSINESSES
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Chapter 17
PROPERTY TRANSACTIONS:DISPOSITIONS OF TRADE OR
BUSINESS PROPERTY
LEARNING OBJECTIVES
CHAPTER OUTLINE
Introduction 17-2
Section 1231 17-2
Historical Perspective 17-2
Section 1231 Property 17-3
Other § 1231 Property 17-4
Section 1231 Netting Process 17-7
Look-Back Rule 17-11
Applicability of Lower Rates 17-12
Depreciation Recapture 17-15
Historical Perspective 17-15
When Applicable 17-16
Types of Depreciation Recapture 17-16
Full Recapture—§ 1245 17-16
Partial Recapture—§ 1250 17-19
Additional Recapture—Corporations 17-28
Other Recapture Provisions 17-34
Related Business Issues 17-36
Installment Sales of Trade or
Business Property 17-36
Intangible Business Assets 17-37
Dispositions of Business Assets
and the Self-Employment Tax 17-37
Tax Planning Considerations 17-37
Timing of Sales and Other
Dispositions 17-37
Selecting Depreciation Methods 17-38
Installment Sales 17-39
Sales of Businesses 17-39
Dispositions of Business Assets and
the Self-Employment Tax 17-39
Problem Materials 17-40
Upon completion of this chapter you will be able to:
" Trace the historical development of the
special tax treatment allowed for dispositions
of trade or business property
" Apply the § 1231 gain and loss netting
process to a taxpayer’s § 1231 asset
transactions
" Determine the tax treatment of § 1231 gains
and losses
" Explain the purpose of the depreciation
recapture rules
" Compute depreciation recapture under
§§ 1245 and 1250
" Explain the additional recapture rule
applicable only to corporate taxpayers
" Identify tax planning opportunities related to
sales or other dispositions of trade or business
property
17–1
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INTRODUCTION
As is no doubt clear by now, the treatment of property transactions is a complex story
that seeks to answer three questions: (1) What is the gain or loss realized? (2) How much
is recognized? and (3) What is its character? This chapter, the final act in the property
transaction trilogy, addresses the problems in determining the character of gains or losses
on the dispositions of property used in a trade or business.
In an uncomplicated world, it might seem logical to assume that gains or losses from
property dispositions—be it stock, equipment, buildings, or whatever—would be treated
just like any other type of income or deduction. But, as shown in the previous chapter,
treating all items alike apparently was not part of the grand plan. Congress forever
changed the process with the institution of preferential treatment for capital gains in 1921.
Since that time taxpayers have been required to determine not only the gain or loss
realized and recognized but also whether a disposition involved a capital asset. It is
important to understand that these rules did not simply tip the scales in favor of capital
gain. In the interest of fairness and equity, they also established a less than friendly
environment for capital losses. The limitations on the deductibility of capital losses is
clearly a major disadvantage, particularly considering that ordinary losses are fully
deductible. The end result of Congress’s handiwork was the creation of a system in which
the preferred result is capital gain treatment for gains and ordinary treatment for losses.
This chapter contains the saga of what happens when Congress attempts to provide
taxpayers with the best of both worlds.
SECTION 1231
The road to tax heaven—capital gain and ordinary loss—begins at § 1231 (in tax
parlance properly pronounced as ‘‘twelve thirty-one’’). While § 1231 can be a completely
bewildering provision, its basic operation is relatively simple. At the close of the taxable
year, the taxpayer nets all gains and losses from so-called § 1231 property (e.g., land and
depreciable property used in a trade or business). If there is a net gain, it is treated as a
long-term capital gain. If there is a net loss, it is treated as an ordinary loss. In short,
§ 1231 allows taxpayers to have their cake and eat it, too. Unfortunately, this is
accomplished only with a great deal of complexity, much of which makes sense only if
the historical events that shaped § 1231 are considered.
HISTORICAL PERSPECTIVE
At first glance, it seems that the productive assets of a business—its property, plant,
and equipment—would be perfect candidates for capital gain treatment and would
therefore be considered capital assets. Indeed, that was exactly the case initially. From
1921 to 1938, real or depreciable property used in business was in fact treated as a
capital asset. At that time, the classification of such property as a capital asset seemed
not only appropriate but desirable—particularly as the economy grew during the early
1920s and taxpayers were realizing gains. However, the opposite became true with the
onset of the Great Depression. As the economy deteriorated, businesses that had
purchased assets at inflated prices during the booming 1920s found themselves selling
such properties at huge losses during the depression-plagued 1930s. To make matters
worse, the tax law treated such losses as capital losses, severely limiting their deduction.
But Congress apparently had a sympathetic ear for these concerns. Hoping that a change
would help stimulate the economy, Congress enacted legislation that removed business
properties from the list of capital assets. The legislative history to the Revenue Act of
1938 provides some insight into Congressional thinking, explaining that ‘‘corporations
will not, as formerly, be deterred from disposing of partially obsolescent property,
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such as machinery or equipment, because of the limitations imposed . . . upon the
deduction of capital losses.’’1 With the 1938 changes in place, business got the ordinary
loss treatment it wanted but at the same time was saddled with ordinary income
treatments for its gains.
Although these rules worked well during the Depression years as businesses were
reporting losses, they produced some unduly harsh results once the country moved to a
wartime economy. By 1942 the build-up for World War II had the economy humming
and inflation had once again set in. Businesses that earlier had sold assets for 10 cents on
the dollar now found themselves realizing gains. Of course, under the 1938 changes these
gains no longer benefited from preferential treatment but were taxed at extraordinarily
high tax rates (88 percent for individuals and 40 percent for corporations). The shipping
industry was particularly hard hit by the new treatment. Shippers not only had gains as the
enemy destroyed their insured ships but also profited when they were forced to sell their
property to the government for use in the war. Other businesses that had their factories
and equipment condemned and requisitioned also felt the sting of higher ordinary rates.
Although these companies could have deferred their gains had they replaced the property
under the involuntary conversion rules of § 1033, qualified reinvestment property was in
short supply, making § 1033 virtually useless. Understanding the plight of business,
Congress once again came to the rescue. In 1942 Congress enacted legislation generally
reinstating capital gain treatment but preserving ordinary loss treatment.
The changes in 1942 stemmed primarily from a need to provide relief for those whose
property was condemned for the war effort. But in the end they went much further. For
consistency, capital gain treatment was extended not only to condemnations of a business
property but to other types of involuntary conversions as well. Under the new rules, casu-
alty and theft gains from business property and capital assets also received capital gain
treatment. In addition, the new legislation unexpectedly extended capital gain treatment
to regular sales of property, plant, and equipment. Apparently, Congress felt that capital
gain treatment was also appropriate for taxpayers who were selling out in anticipation of
condemnation or simply because wartime conditions had made operations difficult. While
Congress thought capital gain treatment was warranted for these gains, it also knew that
other businesses had not profited from the war and were still suffering losses from their
property transactions. Accordingly, it acted to preserve ordinary loss treatment. The end
result of these maneuvers was the enactment of § 1231, an extremely complex provision that
provides taxpayers with the best of all possible tax worlds: capital gain and ordinary loss.
The product of Congressional tinkering in 1942 still remains today. To summarize, real
and depreciable property used in a trade or business is specifically denied capital asset
status. But this does not necessarily mean that such property will be denied capital gain treat-
ment. As explained at the outset, § 1231 generally extends capital gain treatment to gains
and losses from these assets if the taxpayer realizes a net gain from all § 1231 transactions.
On the other hand, if there is a net loss, ordinary loss treatment applies. But this summary
lacks a great deal of precision. The specific rules of § 1231 are described below.
SECTION 1231 PROPERTY
The special treatment of § 1231 is generally granted only to certain transactions
involving assets normally referred to as § 1231 property.2 Section 1231 property
includes a variety of assets, but among them the most important is real or depreciableproperty that is used in the taxpayer’s trade or business and that is held for more than
1 House Ways and Means Committee, H.R. Rep. 1860, 75th Cong., 3d Sess. (1938).
2 As explained below, § 1231 also applies to involuntary conversions of pure capital assets held more than one
year that are used in a trade or business or held for investment. Involuntary conversions by theft or casualty
of personal assets are not included under § 1231 but are subject to a special computation.
17–3SECTION 1231
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one year.3 This definition takes in most items commonly identified as a business’s fixed
assets, normally referred to as its property, plant, and equipment. For example, the
reach of § 1231 includes depreciable personal property used in business, such as
machinery, equipment, office furniture, and business automobiles. Similarly, realty used
in a business, such as office buildings, warehouses, factories, and farmland, is also
considered § 1231 property.
The Code specifically excludes the following assets from § 1231 treatment:
1. Property held primarily for sale to customers in the ordinary course of a trade or
business, or includible in inventory, if on hand at the close of the tax year;
2. A copyright; a literary, musical, or artistic composition; a letter or memorandum;
or similar property held by a taxpayer whose personal efforts created such prop-
erty or by certain other persons; or
3. A publication of the United States Government received from the government
other than by purchase at the price at which the publication is offered to the gen-
eral public.4
Note that the excluded assets are also excluded from the definition of a capital asset. As a
result, gains or losses on the disposition of inventory, property held primarily for resale,
literary compositions, and certain government publications always yield ordinary income
or ordinary loss.
One of the critical conditions for § 1231 treatment requires that the property be used
in a trade or business. Although this test normally presents little difficulty, from time to
time it has created problems, particularly for those with rental property. As an illustration,
consider the common situation of a taxpayer who sells rental property such as a house,
duplex, or apartment complex. Is the property sold a capital asset or § 1231 property? If a
taxpayer sells rental property at a gain, the gain would normally receive capital gain
treatment regardless of whether the property is a capital asset or § 1231 property. On the
other hand, if the taxpayer sells the rental property at a loss, § 1231 treatment is usually
far more desirable. Although the Code does not provide any clear guidance on the issue,
the courts have generally held that property used for rental purposes is considered as used
in a trade or business and is therefore eligible for § 1231 treatment.5
OTHER § 1231 PROPERTY
From time to time, Congress has been convinced that particular industries deserve
special tax relief. As a result, it has added a number of other properties to the § 1231
basket. Those eligible for capital gain and ordinary loss are
1. Timber, coal, and iron ore to which § 631 applies;6
2. Unharvested crops on land used in a trade or business and held for more than one
year;7 and
3. Certain livestock.8
3 The holding period is determined in the same manner as it is for capital assets. See § 1223 discussed in
Chapter 16.
4 § 1231(b)(1).
5 See, for example, Mary Crawford, 16 T.C. 678 (1951) A. 1951-2 C.B. 2, and Gilford v. Comm., 53-1 USTC
{9201, 43 AFTR 221, 201 F.2d 735 (CA-2, 1953).
6 § 1231(b)(2).
7 § 1231(b)(4).
8 § 1231(b)(3).
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Timber. Under § 631, the mere cutting of timber by the owner of the timber, or by a
person who has the right to cut the timber and has held the timber or right more than one
year, is to be treated, at his or her election, as a sale or exchange of the timber that is cut
during the year. The timber must be cut for sale or for use in the taxpayer’s trade or
business. In such case, the taxpayer would report a § 1231 gain or loss and potentially
receive capital gain treatment for what otherwise might be considered the taxpayer’s
inventory—a very favorable result. It may appear that the timber industry has secured an
unfair advantage, but timber’s eligibility is arguably justified on the grounds that the
value of timber normally accrues incrementally as it grows over a long period of time.
The amount of gain or loss on the ‘‘sale’’ of the timber is the fair market value of the
timber on the first day of the taxable year minus the timber’s adjusted basis for depletion.
For all subsequent purposes (i.e., the sale of the cut timber), the fair market value of the
timber as of the beginning of the year will be treated as the cost of the timber. The term
timber not only includes trees used for lumber and other wood products, but also includes
evergreen trees that are more than six years old when cut and are sold for ornamental
purposes (e.g., Christmas trees).9
Example 1. B owned standing timber that he had purchased for $250,000 three years
earlier. The timber was cut and sold to a lumber mill for $410,000 during 2006. The
fair market value of the standing timber as of January 1, 2006 was $320,000. B has a
§ 1231 gain of $70,000 if he makes an election under § 631 ($320,000 fair market
value of the timber on the first day of the taxable year less its $250,000 adjusted basis
for depletion). The remainder of his gain on the actual sale of the timber, $90,000
($410,000 selling price � $320,000 new ‘‘cost’’ of the timber), is ordinary income.
Any expenses incurred by B in cutting the timber would be deductible as ordinary
deductions.
An election under § 631 with respect to timber is binding on all timber owned by the
taxpayer during the year of the election and in all subsequent years. The IRS may permit
revocation of such election because of significant hardship. However, once the election is
revoked, IRS consent must be obtained to make a new election.10
Section 631 also applies to the sale of timber under a contract providing a retained
economic interest (i.e., a taxpayer sells the timber, but keeps the right to receive a royalty
from its later sale) for the taxpayer in the timber. In such a case, the transfer is considered
a sale or exchange. The gain or loss is recognized on the date the timber is cut, or when
payment is received, if earlier, at the election of the taxpayer.11
Coal and Iron Ore. When an owner disposes of coal or domestic iron ore under a
contract that calls for a retained economic interest in the property, the disposition is
treated as a sale or exchange of the coal or iron ore. The date the coal or ore is mined is
considered the date of sale and since the property is § 1231 property, the gain or loss will
be treated under § 1231.12
The taxpayer may not be a co-adventurer, partner, or principal in the mining of the
coal or iron ore. Furthermore, the coal or iron ore may not be sold to certain related
taxpayers.13
9 § 631(a).
10 Ibid.
11 § 631(b).
12 § 631(c).
13 §§ 631(c)(1) and (2).
17–5SECTION 1231
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Unharvested Crops. Section 1231 also addresses the special situation where a
farmer sells land with unharvested crops sitting upon the land. In this case, it seems logical
that the farmer should allocate the sales price between the crops and the land to ensure
ordinary income or loss for the sale of the farmer’s inventory and capital gain or ordinary
loss on the sale of the land. While this may be the theoretically correct result, Congress
wanted to eliminate potential controversy over the allocation. Accordingly, for
administrative convenience it brought the entire transaction into the § 1231 fold in 1951.
Currently, whenever land used in a trade or business and unharvested crops on that land
are sold at the same time to the same buyer, the gain or loss is subject to § 1231 treatment
as long as the land has been held for more than a year.14 It is worth noting that the benefits
of § 1231 were not extended to farmers free of charge. At the same time, Congress
eliminated the current deduction for production expenses. The law now provides that any
expenses related to the production of crops cannot be deducted currently but must be
capitalized as part of the basis of the crops.15 Such treatment, in a year when land and
crops are sold, reduces the farmer’s capital gain on the sale rather than any other ordinary
income.
Example 2. F sold 100 acres of land that she used in her farming business just days
before the corn on the land was harvested. For the ‘‘package’’ deal, she received
$600,000, including an estimated $70,000 for the unharvested crops that she figured
had cost her $20,000 to produce. F had purchased the land many years ago for
$200,000. In determining the character of her gain, F is not required to allocate the
sales price between the crops and the land since she sold both at the same time to
the same buyer, therefore qualifying for § 1231 treatment. As a result, she reports a
§ 1231 gain of $380,000 computed as follows:
Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000
Adjusted basis ($200,000þ $20,000). . . . . . . . . . . � 220,000
§ 1231 gain. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $380,000
Note that in the year of the sale F has effectively turned the $50,000 ($70,000 �$20,000) profit from the sale of her crops from ordinary income into potential capital
gain.
Livestock. As a general proposition, livestock that are used for breeding and other
purposes are depreciable assets much like machinery and equipment and therefore qualify
for § 1231 treatment. In many situations, however, livestock is used for these purposes for
only a short period of time and then sold. If this is the farmer’s or rancher’s normal
practice, the IRS is inclined to argue that the animals are held primarily for resale, in
which case the law specifically denies § 1231 treatment. To help end this controversy,
Congress specifically made all livestock (other than poultry) used for draft, breeding,
dairy, or sporting purposes eligible for § 1231 treatment as long as they are held for over
a year.16 In the case of cattle and horses, however, the holding period is extended to
two years. Note that this treatment is extremely beneficial since the taxpayer effectively
gets capital gain from animals pulled out of the breeding process and sold. Moreover, the
farmer or rancher is allowed to deduct the costs of raising such animals currently against
ordinary income. The extension of the holding period for cattle and horses was in part, an
attempt to cut back on the benefits of this favorable treatment.
14 § 1231(b)(4).
15 § 268.
16 § 1231(b)(3).
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SECTION 1231 NETTING PROCESS
The treatment of § 1231 gains or losses ultimately depends on the outcome of a
netting process that is far more complicated than outlined earlier.17 As can be seen from
the flowchart in Exhibit 17-1, the taxpayer must first identify all of the gains and losses
that enter into the netting process. As might be expected, these include gains and losses
from what has been described above as § 1231 property. In addition, the § 1231
hodgepodge includes involuntary conversions of certain capital assets. Surprisingly,
gains or losses recognized from casualties, thefts, or condemnations of capital assets that
are used in a trade or business or held for investment are part of the § 1231 netting
process. Involuntary conversions of capital assets that are held for personal use are not
considered under § 1231 but are subject to special rules.
After identifying all of the § 1231 transactions, the taxpayer must segregate the
§ 1231 gains and losses arising from casualty and theft from those attributable to sale,
exchange, and condemnation. The end result is that there are two sets of § 1231
transactions:
1. Involuntary conversions due to casualty and theft of" § 1231 property
" Real and depreciable property used in business and held more than one
year
" Timber, coal, iron ore, unharvested crops, and livestock" Capital assets
" Used in a trade or business or held for investment in connection with
business and held more than one year
2. Sales and exchanges of" § 1231 property
" Real and depreciable property used in business
" Timber, coal, iron ore, unharvested crops and livestock
Involuntary conversion due to condemnation of" § 1231 property
" Real and depreciable property used in business and held more than one
year
" Timber, coal, iron ore, unharvested crops, and livestock" Capital assets
" Used in a trade or business or held for investment in connection with
business and held more than one year
17 § 1231(a).
17–7SECTION 1231
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Within each of these two categories, each gain and loss must be assigned to one of the
three potential long-term capital gain groups and netted just as if they had been 28%, 25%
or 15% capital gains or losses (see Chapter 16). This means that each § 1231 gain or loss
is assigned to one of the following three categories: (1) 15% group for § 1231 gains and
losses (15G or 15L); (2) 25% group for unrecaptured § 1250 depreciation related to gains
from § 1231 assets (25G discussed below); and (3) 28% group for gains and losses from
collectibles (28G or 28L). Once all of the appropriate transactions have been poured into
the § 1231 process, the netting process can begin. There are three steps.
1. First, all of the gains and losses in the first category of § 1231 transactions
(casualties and thefts) are netted. Specifically, gains and losses within the 15%
and 28% groups are netted to arrive at one of the following: (1) a net gain or loss
on 15% § 1231 assets (N15G or N15L); and (2) a net gain or loss on 28% § 1231
assets (N28G or N28L). Any net loss positions are then combined with the net
EXHIBIT 17-1
Section 1231 Netting Process
Casualty and theft gains*and losses from §1231assets and specified
capital assets
Gains* and losses from sales orexchanges of § 1231 assets
and specified involuntaryconversions
Net(Step 1)
IfLoss
IfGain
Net(Step 2)
IfLoss
IfGain
IfYes
IfNo
Treat gains and lossesseparately: gains are
ordinary income: businesslosses are deductions
for A.G.I.: otherlosses are deductions
from A.G.I.
Treat net resultas an ordinary
deduction
Look-Back Rule:Did the taxpayerdeduct any net
§ 1231 losses inthe last five
taxable years?
Treat entirenet gain as a15% or 28%capital gain
Treat as ordinary incomethe lesser of
(1) unrecaptured § 1231losses, or (2) the currentyear’s net gain. Treat any
excess § 1231 gain as 15%or 28% capital gain
* Gains remaining after reduction for any depreciation recapture
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gain positions using the rules discussed for netting the three groups for capital
asset transactions:
" A N28L first offsets 25G, then N15G.
" A N15L first offsets a N28G, then 25G.
" There can be no net loss in the 25G group since this group contains only gains.
This netting process is summarized as follows:
Section 1231 Gains and Losses from Casualty andTheft
CollectiblesUnrecapturedDepreciation Other
28% 25% 15%
Gains . . . . . . . . . . . . . . . . . . . . . . . . $x,xxx). Gains only $xx,xxx)
Losses . . . . . . . . . . . . . . . . . . . . . . . (x,xxx) – X(x,xxx)
Net gain or loss . . . . . . . . . . . . . . . . ???? Gain only Xz????)
Possibilities:
1. . . . . . . . . . . . . . . . . . . . . . . . . . N28G 25G N15G
2. . . . . . . . . . . . . . . . . . . . . . . . . . N28G 25G N15L
3. . . . . . . . . . . . . . . . . . . . . . . . . . N28L 25G N15G
4. . . . . . . . . . . . . . . . . . . . . . . . . . N28L 25G N15L
If the netting process results in a net gain position(s) (e.g., a N28G, N25G, and a N15G)
the net gains from casualties and thefts become § 1231 gains and become part of the
second category of other § 1231 transactions (each assigned to either the 28%, 25%, or
15% groups).
Example 3. During the year, T, who is in the 35% tax bracket, reported the following
§ 1231 gains and losses from casualties of § 1231 assets (including casualties of
capital assets used in a trade or business) and netted them as shown below.
Section 1231 Gains and Losses
CollectiblesUnrecapturedDepreciation Other
28% 25% 15%
Gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000 $4,000 $2,000
Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . (4,000) — (7,000)
Net gain or loss . . . . . . . . . . . . . . . . . . . . $ 6,000 $4,000 ($5,000)
Netting . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,000) — 5,000
To Section 1231 Other . . . . . . . . . . . . . . $ 1,000 $4,000 $ 0
In this case, T has a N28G of $1,000 and a N25G of $4,000. Since the end results are
net gains, each of these net gains is assigned to its appropriate group in the second cat-
egory of other § 1231 transactions.
If a net loss results, the casualty and theft gains and losses are removed from the
§ 1231 process and treated separately. The gains are treated as ordinary income, and
the losses on business use assets are deductible for A.G.I. Any other casualty and theft
losses are deductible from A.G.I.
17–9SECTION 1231
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2. The second step of the process is to combine any net casualty or theft gains from
the first step with the gains or losses in the second set of § 1231 transactions. In
this regard, the net casualty and theft gains must be assigned to the appropriate
group (15%, 25%, or 28% group) in the second category of § 1231 transactions
(sales and exchanges of § 1231 assets and certain condemnations). For example,
if the taxpayer had a net 15% gain from § 1231 casualties, this gain would
become a 15% gain in the second category of § 1231 transactions. These
transactions are then netted just as if they had been 28%, 25%, or 15% capital
gains or losses to determine if there is a net gain or loss.
3. The third and final step in the § 1231 netting process is to characterize the gain or
loss resulting from netting the transactions in the second step. If the net result is a
loss, the net loss is treated as an ordinary deduction for adjusted gross income. It
is not treated as a capital loss. If the net result is a gain (e.g., a N25G and a
N15G), these gains are normally treated as capital gains and become part of the
capital gain and loss netting process.
The § 1231 netting process is illustrated in Exhibit 17-1 and the following examples.
Example 4. During the current year, D sold real estate used in her business for
$45,000. She had purchased the property several years ago for $36,000. D also sold a
business car (held for more than 15 months) at a loss of $1,200. D’s gain on the real
estate is computed as follows:
Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . $45,000
Less: Adjusted basis . . . . . . . . . . . . . . . . . . . . . (36,000)
Gain realized and recognized . . . . . . . . . . . . . $ 9,000
D nets the gain and loss as follows:
15% Gain from sale of § 1231 asset . . . . . . . . $ 9,000
15% Loss from sale of § 1231 asset . . . . . . . . (1,200)
Net 15% § 1231 gain for year . . . . . . . . . . . . . . $ 7,800
D’s net 15% § 1231 gain of $7,800 is treated as a 15% capital gain. If she had other
capital gains or losses during the year, they will be subject to the capital gain and loss
netting process discussed in Chapter 16.
Example 5. During the year R, a sole proprietor, sold a business computer for
$32,000. His basis at the time of the sale was $44,000. He also sold land used in his
business at a gain of $1,400 and had an uninsured theft loss of works of art used to
decorate his business offices (i.e., capital assets held in connection with a trade or
business). R had purchased the artwork for $1,500 and it was valued at $5,000 before
the burglary. All of the assets were acquired more than 12 months ago.
R nets his gains and losses as follows:
Step 1: The net loss from the casualty is $1,500 (adjusted basis). Since R has a net
15% casualty loss, it is not treated as a § 1231 loss. Instead, the loss is
treated as an ordinary loss (which is fully deductible for A.G.I. since the art
works were business property).
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Step 2: Combine gains and losses from sales of § 1231 assets:
15% loss from sale of business computer. . . . . . ($12,000)
15% gain from sale of business land . . . . . . . . . . 1,400
Net § 1231 loss for year . . . . . . . . . . . . . . . . . . . . ($10,600)
Step 3: A net § 1231 loss is treated as an ordinary deduction. Thus, R’s $10,600 loss
can be used to offset other ordinary income.
Note that the theft loss of the works of art is included in the first step of the netting
process even though these items are capital assets. This loss would have offset, dollar
for dollar, any casualty or theft gains (net of depreciation recapture) from § 1231
assets as well as any casualty or theft gains from other capital assets held in
connection with R’s business. Also note that the current year’s deductible § 1231 loss
may result in a change in the character of any net § 1231 gains in the next five years
due to the look-back rule.
LOOK-BACK RULE
For many years, taxpayers took advantage of the § 1231 netting process. For example,
assume a taxpayer in the 35 percent tax bracket currently owns two § 1231 assets, both
held for 15 months. One asset has a built-in gain of $3,000 and the other has a built-in loss
of $2,000. If both assets are sold during the year, the loss offsets the gain and the taxpayer
pays a capital gain tax of $150 [($3,000 � $2,000 ¼ $1,000) � 15%]. If the taxpayer had
sold the assets in different years, the loss would not have reduced the gain, and the tax
after both transactions would have been $450 in one year ($3,000 � 15%) and $700
($2,000 � 35%) of savings in the other year, for a net tax savings of $250 ($700 � $450).
As might be imagined, taxpayers carefully planned their transactions to maximize their
tax savings.
In an effort to prevent taxpayers from cleverly timing their § 1231 gains and losses to
ensure that § 1231 losses reduced ordinary income and not potential capital gain,
Congress enacted the so-called look-back rule in 1984. Under this rule, a taxpayer with a
net § 1231 gain in the current year must report the gain as ordinary income to the extent of
any unrecaptured net § 1231 losses reported in the past five taxable years.18 In recapturing
the § 1231 gains, recapture occurs in the following order: 28% gains, 25% gains, and 15%
gains. Unrecaptured net § 1231 losses are simply the net § 1231 losses that have occurred
during the past five years that have not been previously recaptured (i.e., the excess of net
§ 1231 losses of the five preceding years over the amount of such loss that has been
recaptured in the five prior years).
Example 6. Assume the same facts in Example 5 and that R’s 2006 net § 1231 loss
of $10,600 is the only loss he has deducted in the past five years. In 2007 R has a net
15% § 1231 gain of $15,000. R is subject to the look-back rule since in the prior year
he reported a § 1231 loss of $10,600 that has not been recaptured. He must report
$10,600 of ordinary income and $4,400 of net 15% § 1231 gain. Should R have a
§ 1231 gain in the following year, he will not be subject to the look-back rule since he
has recaptured all prior year’s net § 1231 losses.
18 § 1231(c).
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APPLICABILITY OF LOWER RATES
Five potential tax rates apply to long-term capital gains; six, to ordinary income,
which includes short-term capital gains. How can the calculation of the capital gains tax,
including any § 1231 gain, be completed in such a way as to arrive at a single right
answer?
Caution must be exercised so as to complete the netting process in the prescribed
order, as elaborated so far in this chapter and in Chapter 16.
" The first step is to complete the § 1231 netting process.
� If there is a net § 1231 loss, that loss must be treated as an ordinary loss and it
is left out of the capital gain and loss netting process entirely.
� If there is a net § 1231 gain, it is treated as a long-term capital gain and is
entered into the capital gain and loss netting process in the next step. In order
to do this, a determination must be made as to which part of the gain, if any, is
25% gain, and which part, if any, is 15% gain.
" Netting of capital gains and losses occurs in each of the various groups of assets.
� Short-term gains are netted against short-term losses and long-term gains are
netted against long-term losses.
� Within the long-term netting process, gains and losses are further broken down
in the various sub-groups with 15% gains and losses, and 28% gains and losses
being netted. Since there are no 25% losses, the 25% gains are not reduced.
� The net gains and losses from these three groups are netted against one another
as prescribed in Chapter 16 (e.g., 28% losses are first offset against 25% gains,
then 15% gains, and 15% losses are first offset against 28% gains, then 25%
gains.
" Short-term gains and losses are netted/combined with long-term gains and losses.
Short-term losses are first netted against 28% gains, then 25% gains, and finally
15% gains. Net long-term losses are netted against short-term gains.
" The net results are subject to the capital gain tax.
� Short-term gains are treated like ordinary income
� Long-term gains are subject to tax at the appropriate specified capital gains
rates (5%, 10%, 15%, 25%, and 28%)
� Losses are subject to the $3,000 annual limit with the excess being carried
forward.
Numerous possibilities exist, therefore, for any net § 1231 gain. Perhaps, the gain would
be offset by capital losses, receiving no favorable treatment at all. However, if the § 1231
gain survives the netting process to be included in a net capital gain, it is subject to the
preferred rates right along with any other long-term capital gains with surviving
unrecaptured § 1250 gain being treated as 25% gain and any other surviving gain treated
as 15% gain.
3 CHECK YOUR KNOWLEDGE
Review Question 1. Indicate whether the following gains and losses are § 1231
gains or losses or capital gains and losses or neither. Make your determination prior to the
§ 1231 netting process and assume any holding period requirement has been met.
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a. Gain on the sale of General Motors stock held as a temporary investment
by Consolidated Brands Corporation.
b. Gain on the sale of a four-unit apartment complex owned by Lorena Smith.
This was her only rental property.
c. Loss on the sale of welding machinery used by Arco Welding in its
business.
d. Loss on theft of welding machinery used by Arco Welding in its business.
e. Gain on sale of diamond bracelet by Nancy Jones.
f. Income from sale of electric razors by Razor Corporation, which manufac-
tures them.
g. Gain on condemnation of land on which Tonya Smith’s personal residence
is built.
h. Gain on condemnation of land owned by Tonya Smith’s business.
i. Loss on sale of personal automobile.
Answer. The § 1231 hodgepodge contains not only gains and losses from § 1231 property
but also those from involuntary conversions by casualty, theft, or condemnation of capital
assets that are used in a trade or business or held as an investment in connection with a
trade or business.
a. The sale of the GM stock is not included in the § 1231 pot since it is a sale
of a capital asset and not an involuntary conversion.b. The rental property is generally considered property used in a trade or busi-
ness and thus § 1231 property even if the owner owns only a single
property.c. The welding machinery is depreciable property used in a business and is
therefore considered § 1231 property.d. The theft of the welding machinery is also a § 1231 transaction. Note,
however, that in processing the § 1231 gains and losses, the casualties must
be segregated from the sales.e. The sale of the diamond bracelet produces capital gain since it is a pure
capital asset and not trade or business property.f. The razors are inventory and are therefore neither capital assets nor § 1231
property.g. The condemnation of the land near the residence is considered a personal
involuntary conversion gain. Since the land is not held in connection with a
trade or business, it does not qualify as § 1231 property, but it is a capital
asset.h. The condemnation of the land held for business does enter into the § 1231
hodgepodge as a regular § 1231 gain.i. Although the personal automobile is a capital asset, no loss is allowed from
the sale.
Review Question 2. During his senior year at the University of Virginia, Bill decided
that he never wanted to leave Charlottesville. After some thought, he opened his own
hamburger joint, Billy’s Burgers. That was 20 years ago and Bill has had great success,
owning a number of businesses all over Virginia and North Carolina. Not believing in
corporations, Bill and his wife, Betty, operate all of these as partnerships.
a. Information from the partnerships and his own personal records revealed the
following transactions during the current year:
1. Sale of one of 50 apartment buildings that one of their partnerships owns:
$50,000 gain (ignore depreciation)
2. Sale of restaurant equipment: $20,000 loss
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Assuming both assets have been held for several years, how should Bill and
Betty report these transactions on their current year return?
Answer. Under § 1231, the taxpayer generally nets gains and losses from the sale of
§ 1231 property. If a net gain results, the gain is treated as a long-term capital gain, while a
net loss is treated as an ordinary loss. For this purpose, § 1231 property generally includes
real or depreciable property used in a trade or business. In this case, both the apartment
complex and the restaurant equipment are § 1231 property and both are in the 15 percent
group. As a result, the couple should net the gain and loss and report a 15 percent capital
gain of $30,000.
b. The couple’s records for the following year revealed several gains and losses:
1. Office building burned down: $20,000 loss
2. Crane for bungee jumping business stolen: $35,000 gain (assume no depre-
ciation had been claimed)
3. Parking lot sold: $14,000 loss
4. Exxon stock sold: long-term capital loss of $10,000
5. Condemnation of Greensboro land held for use in the business: $15,000
gain.
Assuming each of the assets was held for several years, determine how much
15 percent capital gain or loss as well as the amount of ordinary income or loss
that Bill and Betty will report for the year.
Answer. The § 1231 netting process requires the taxpayer to separate § 1231 casualty
gains and losses from other § 1231 transactions (sometimes referred to as regular § 1231
items). The casualty loss on the office building and the casualty gain on the crane are both
considered § 1231 15 percent casualties since they involve § 1231 property (i.e., real or
depreciable property used in business). Note that the condemnation—even though it is an
involuntary conversion—is not treated as a § 1231 casualty. The casualty items are netted
to determine whether there is a net gain or loss. Here, there is a net casualty 15 percent
gain of $15,000 ($35,000 � $20,000). This net gain is then combined with any ‘‘regular’’
§ 1231 items, in this case the $14,000 loss on the sale of the parking lot (real property
used in a business) and the $15,000 gain on the condemnation of the land (a capital asset).
Note that both ‘‘regular’’ § 1231 items are also in the 15 percent group. After netting
these items, the partnership has a net gain of $16,000. This $16,000 net § 1231 gain is
treated as a 15 percent capital gain and is combined with $10,000 15 percent capital loss
on the sale of the stock. The end result is a $6,000 15 percent capital gain. This process
can be summarized as follows (see also Exhibit 17-3):
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c. Same as in (b), except Bill and Betty reported a net § 1231 loss of $3,000 in the
previous year.
Answer. In this case, the look-back rule applies, causing $3,000 of the net 15 percent
§ 1231 gain to be treated as ordinary income. As a result, the couple’s 15 percent capital
gain from the § 1231 netting process is $13,000 and their net 15 percent capital gain is
only $3,000.
DEPRECIATION RECAPTURE
HISTORICAL PERSPECTIVE
For many years, taxpayers have taken advantage of the interaction of § 1231 and the
depreciation rules to secure significant tax savings. Prior to 1962 there were no
substantial statutory restrictions on the depreciation methods that could be adopted.
Consequently, a taxpayer could quickly recover the basis of a depreciable asset by
selecting a rapid depreciation method such as declining balance and using a short useful
life. If the property’s value did not decline as quickly as its basis was being reduced by
depreciation deductions, a gain was ensured if the property was disposed of at a later date.
The end result could be quite beneficial.
Example 7. During the current year T purchased equipment for $1 million. After
two years, T, using favorable depreciation rules, had claimed and deducted
$600,000 of depreciation, leaving a basis of $400,000. Assume that the property did
not truly depreciate in value and T was able to sell it in the third year for its original
cost of $1 million. In such case T would report a gain of $600,000 ($1,000,000 �$400,000). Except for time value of money considerations, it appears that the
$600,000 gain and the $600,000 of depreciation are simply a wash. However, the
depreciation reduced ordinary income that would be taxed at ordinary rates while
the gain would be a § 1231 gain and taxed at capital gain rates. As an illustration of
the savings that could be achieved, assume that the law at this time provided for a
top capital gain rate of 20% and the taxpayer’s ordinary income was taxed at a 40%.
In this case the depreciation would offset ordinary income and provide tax savings
of $240,000, but the $600,000 gain on the sale would be treated as a capital gain
and produce a tax of only $120,000. Thus, even though the taxpayer has had no
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economic gain or loss with respect to the property—he bought and sold the
equipment for $1,000,000—he was able to secure a tax benefit of $120,000
($240,000 � $120,000).
The above example clearly illustrates how taxpayers used rapid depreciation and the
favorable treatment of § 1231 gains to effectively convert ordinary income into capital
gain. In fact, this strategy—deferring taxes with quick depreciation write-offs at ordinary
rates and giving them back later at capital gains rates—was the foundation of many tax
shelter schemes.
Legislation to limit these benefits came in a number of forms, but the most important
was the enactment of the so-called depreciation recapture rules. These rules strike right at
the heart of the problem, generally treating all or some portion of any gain recognized as
ordinary income, based on the amount of depreciation previously deducted. Thus, in the
above example, the taxpayer’s $600,000 gain, which was initially characterized as a
§ 1231 gain, is treated as ordinary income because of the $600,000 of depreciation
previously claimed. In this way, all of the tax savings initially given away by virtue of the
ordinary depreciation deductions are recaptured. Unfortunately, much like § 1231 in
general, the recapture rules can become quite complex. The operations of the specific
provisions are discussed below.
WHEN APPLICABLE
Before specific recapture rules are examined, there are two very important points to
keep in mind. First, depreciable assets held for one year or less do not qualify for § 1231
treatment. Thus, any gain from the disposition of such assets is always reported as
ordinary income. Second, the depreciation recapture rules do not apply if property is
disposed of at a loss. Remember that losses from the sale or exchange of depreciable
assets are treated as § 1231 losses if the property is held more than a year. In addition,
casualty or theft losses of such property are included in the § 1231 netting process. Any
loss from a depreciable asset held one year or less is an ordinary loss regardless of
whether it was sold, exchanged, stolen, or destroyed.
TYPES OF DEPRECIATION RECAPTURE
There are essentially three depreciation recapture provisions in the Code. These are
1. Section 1245 Recapture—commonly called the full recapture rule, and
applicable primarily to depreciable personalty (rather than realty)
2. Section 1250 Recapture—commonly called the partial recapture rule, and
applicable to most depreciable realty if a method of depreciation other than
straight-line was used
3. Section 291 Recapture—commonly called the additional recapture rule, and
applicable only to corporate taxpayers
Each of these recapture rules is discussed below.
FULL RECAPTURE—§ 1245
The recapture concept was first introduced with the enactment of § 1245 by the
Revenue Act of 1962. Section 1245 generally requires any gain recognized to be
reported as ordinary income to the extent of any depreciation allowed on § 1245
property after 1961.
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Definition of § 1245 Property. The recapture of depreciation under § 1245 applies
only to § 1245 property, normally depreciable personal property.19 Because the definition
of personal property itself is so broad, § 1245 generally covers a wide variety of
depreciable assets such as:
" Machinery and equipment used in production of goods and services" Office furniture and equipment" Automobiles, vans, trucks, and other transportation equipment" Livestock used for breeding or production" Intangibles such as patents, copyrights, trademarks, and goodwill that have been
amortized under § 197 or otherwise.
Essentially the amortization is treated the same as depreciation, just like any portion of
the cost of a depreciable asset that is expensed under § 179 is treated as depreciation
allowed.20 It is important to understand that § 1245 applies only if the property is
depreciable or amortizable. Consequently, it pertains only to property that is used in a
trade or business and property held for the production of income. For example, livestock
that are considered inventory are not subject to depreciation and are therefore not
§ 1245 property, although any gain or loss from the disposition of inventory is ordinary
income.
Although the above definition is usually sufficient, § 1245 property actually includes
a number of other assets besides depreciable personalty, including the following:21
1. Property used as an integral part of manufacturing, production, or extraction, or
in furnishing transportation, communications, electrical energy, gas, water, or
sewage disposal services.
a. However, any portion of a building or its structural components is not
included.b. A research facility or a facility for the bulk storage of commodities related to
an activity listed above is included.
2. A single-purpose agricultural or horticultural structure (e.g., greenhouses).
3. A storage structure used in connection with the distribution of petroleum or any
primary product of petroleum (e.g., oil tank).
4. Any railroad grading or tunnel bore.
5. Certain other property that is subject to a special provision allowing current
deductibility or rapid amortization (e.g., pollution control facilities and railroad
rolling stock).
Operation of § 1245. Section 1245 generally requires any gain recognized to be
treated as ordinary income to the extent of any depreciation allowed.22 To state the rule in
another way: any gain on the disposition of § 1245 property is ordinary income to the
extent of the lesser of the gain recognized or the § 1245 recapture potential, generally
the depreciation claimed and deducted. Although both statements say the same thing,
19 § 1245(a)(3).
20 See § 197(f)(7) for intangibles and § 1245(a)(3)(D) for expensed property and certain other properties
subject to unique expensing rules.
21 The definition parallels that of § 38 property, which qualified for the investment tax credit. § 48(a)(1).
22 § 1245(a).
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the latter helps focus attention on two points and eliminates some misconceptions. First,
a taxpayer is never required to report more income than the amount of gain realized
regardless of the amount of depreciation claimed and deducted (i.e., regardless of the
amount of recapture potential). For example, if the taxpayer realizes a gain of $10,000
and has deducted depreciation of $15,000, the taxpayer reports only $10,000 of income,
all of which would be ordinary. Note that the depreciation recapture rules do not affect
the amount of gain or loss, only the character of any gain to be recognized. Second,
using the term recapture potential helps emphasize that sometimes the amount that must
be recaptured may include more than mere depreciation.
Section 1245 recapture potential includes all depreciation or amortization allowed
(or allowable) with respect to a given property—regardless of the method of depreciation
used. This is why § 1245 is often called the full recapture rule. Recapture potential also
includes adjustments to basis related to items that are expensed (e.g., under § 179 expense
election) or where tax credits have been allowed under various sections of the Code.23
To summarize, determining the character of gain on the disposition of § 1245
property is generally a two-step process:
1. The gain is ordinary income to the extent of the lesser of the gain recognized or
the § 1245 recapture potential (all depreciation allowed or allowable).
2. Any recognized gain in excess of the recapture potential retains its original char-
acter, usually § 1231 gain.
Recall that there is no § 1245 depreciation recapture when a property is sold at a loss, so
any loss is normally a § 1231 loss.
Example 8. T owned a printing press that he used in his business. Its cost was $6,800
and T deducted depreciation in the amount of $3,200 during the three years he owned
the press. T sold the press for $4,000 and his realized and recognized gain is $400
($4,000 sales price � $3,600 adjusted basis). T’s recapture potential is $3,200, the
amount of depreciation taken on the property. Thus, the entire $400 gain is ordinary
income under § 1245.
Example 9. Assume the same facts as in Example 8, except that T sold his press for
$7,000. In this case, T’s realized and recognized gain would be $3,400 ($7,000 �$3,600). The ordinary income portion under § 1245 would be $3,200 (the amount of
the recapture potential), and the remaining $200 of the gain is a § 1231 gain. Note that
in order for any § 1231 gain to occur, the property must be sold for more than its
original cost since all of the depreciation is treated as ordinary income.
Example 10. Assume the same facts as in Example 8, except that the printing press is
sold for $3,000 instead of $4,000. In this case, T has a loss from the sale of $600
($3,000 � $3,600 adjusted basis). Because there is a loss, there is no depreciation
recapture. All of T’s loss is a § 1231 loss.
Exceptions and Limitations. In many ways, § 1245 operates much like the
proverbial troll under the bridge. It sits ready to spring on its victim whenever the proper
moment arises. Section 1245 generally applies whenever there is a transfer of property.
However, § 1245 does identify certain situations where it does not apply, most of which
23 See § 1245(a)(2) for a listing of these adjustments and their related Code sections, including the basis
adjustment related to the earned portion of any investment credit.
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are nontaxable events. For example, there is no recapture on a transfer by gift or bequest
since both of these are nontaxable transfers.24
In involuntary conversions and like-kind exchanges, the depreciation recapture under
§ 1245 is limited to the gain recognized.25 Similarly, in nontaxable business adjustments
such as the formation of partnerships, transfers to controlled corporations, and certain
corporate reorganizations, § 1245 recapture is limited to the gain recognized under the
controlling provisions.26 In any situation where recapture is not triggered, it is generally
not lost but carried over in some fashion.
PARTIAL RECAPTURE—§ 1250
As originally enacted in 1961, the concept of recapture as set forth in § 1245
generally applied only to personalty. Gains derived from dealing in realty were not
subject to recapture. In 1963, however, Congress eliminated this omission by enacting
§ 1250, a special recapture provision that applied to most buildings. Since that time
§ 1245 has generally been associated with depreciation recapture for personal property
while § 1250 served that role for buildings. Although the two provisions are similar,
§ 1250 is far less damaging. Specifically, § 1250 calls for the recapture of only a
portion of any accelerated depreciation allowed with respect to § 1250 property. Note
that while §§ 1250 and 1245 are essentially the same—they both convert potential
capital gain into ordinary income—§ 1250 differs from § 1245 in several important
ways: (1) it applies only if an accelerated method is used; (2) it does not require
recapture of all the depreciation deducted but only a portion—generally only the excessof accelerated depreciation over what straight-line would have been; and (3) it applies
to a different type of property, buildings and their components, rather than personal
property. Each of these aspects is considered below.
Section 1250 Property. Section 1250 property is generally any real property that is
depreciable and is not covered by § 1245.27 For the most part, § 1250 applies to all of the
common forms of real estate such as office buildings, warehouses, apartment complexes,
and low-income housing. As explained earlier, however, nonresidential real estate (e.g.,
warehouse and office buildings) placed in service after 1980 and before 1987 for which
an accelerated method was used is covered by the full recapture rule of § 1245.28
Depreciation of Real Property. Section 1250 applies only if an accelerated method
of depreciation is used. If the straight-line depreciation method is used, § 1250 does not
apply and there is no depreciation recapture for noncorporate taxpayers.29 For this reason,
a critical first step in determining the relevance of § 1250 is determining how the taxpayer
has depreciated the realty.
For many years, taxpayers could choose to use either an accelerated or straight-line
method to compute depreciation for realty. This was an extremely important decision,
for it affected not only the amount of depreciation the taxpayer claimed but also the
24 §§ 1245(b)(1) and (2). Recapture of depreciation under § 1245 is required, however, to the extent § 691
applies (relating to income in respect to a decedent).
25 § 1245(b)(4).
26 § 1245(b)(3). See Chapter 19 for further discussion of nontaxable business adjustments.
27 § 1250(c).
28 It is important to note, however, that such properties are § 1250 property if the optional straight-line method is
used. § 1245(a)(5).
29 As explained within, corporate taxpayers are still required to recapture 20 percent of any straight-line depreci-
ation under § 291. Also, any unrecaptured straight-line depreciation is taxed at a maximum rate of
25 percent.
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character of any gain on a subsequent disposition of the property. For example, a taxpayer
could accelerate depreciation deductions but only at the possible expense of recapture.
Alternatively, the taxpayer could accept the slower-paced straight-line method and
avoid the § 1250 recapture rules. But the Tax Reform Act of 1986 ended this flexibility
and at the same time simplified the law. Taxpayers who place realty in service after1986 must use the straight-line method. As a result, § 1250 does not apply to property
acquired after 1986. However, much of the existing inventory of real property was
acquired before 1987 and may therefore be subject to § 1250, depending on the
depreciation method used.
Realty Placed in Service from 1981 through 1986. For real property acquired
between 1981 and the end of 1986, the taxpayer could either use the accelerated
depreciation method allowed under ACRS or elect an optional straight-line method. Of
course, a taxpayer would normally select the accelerated method. In fact, that was the
normal recommendation with respect to residential property. However, with respect to
nonresidential property, electing to use the accelerated method resulted in the property
that would normally be § 1250 property being classified as § 1245 property—subject to
full, rather than partial, recapture.
Realty Placed in Service before 1981. All depreciable real property acquired before
1981 is classified as § 1250 property. For such property acquired before 1981 (non-ACRS
property), taxpayers were required to estimate useful lives and salvage values. Although
various methods could be used, the annual deduction (during the first two-thirds of the
useful life) generally could not exceed that arrived at by using the following maximum
rates and methods:30
Maximum Allowable DeductionType of Property Method/Rate
New residential real estate Declining-balance using 200% of the straight-line rate
Used residential real estate:
If estimated useful life at least 20 years Declining-balance using 125% of the straight-line rate
If estimated useful life less than 20 years Straight-line
New nonresidential real estate Declining-balance using 150% of the straight-line rate
Used nonresidential real estate: Straight-line
Operation of § 1250. The two critical factors in determining the amount, if any, of
§ 1250 recapture are the gain realized and the amount of excess depreciation. Excess
depreciation refers to depreciation deductions in excess of that which would be deductible
using the straight-line method. For property held one year or less, all depreciation is
considered excess depreciation.31
As a general rule, § 1250 requires recapture of the excess depreciation, that is,
the excess of accelerated over straight-line. Consequently, even if the taxpayer uses an
accelerated method to compute the amount of depreciation deducted on the return,
the hypothetical amount of straight-line depreciation must still be computed in order
to determine the excess of accelerated over straight-line when the property is sold. In
determining the hypothetical amount of straight-line depreciation, the taxpayer uses
the same life and salvage value, if any, that were used in computing accelerated
depreciation.32 Because of this approach, a taxpayer who uses the straight-line method
30 § 167(j).
31 § 1250(b).
32 § 1250(b)(5).
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would have no excess depreciation and no recapture. Because the § 1250 recapture rule
applies only to any excess depreciation claimed by a taxpayer, it is sometimes referred
to as the partial recapture rule. However, it should be emphasized that beginning in
1997, the unrecaptured § 1250 depreciation (e.g., the straight-line depreciation) on
§ 1250 property held more than 12 months is subject to a special 25 percent tax rate
(assuming it survives the § 1231 netting process).
Determining the taxation of any gain recognized on the disposition of § 1250 property
is a three-step process:
1. The gain is ordinary income to the extent of the lesser of the gain recognized or
the § 1250 recapture potential (generally the excess depreciation allowed).33
2. Any recognized gain in excess of the recapture potential is usually treated as
§ 1231 gain.
3. Any gain recognized on § 1250 property held more than 12 months that is due to
depreciation that is not recaptured and which survives the applicable netting
processes is taxed at a maximum rate of 25 percent to the extent of any
unrecaptured depreciation. Any additional gain is generally 15 percent gain.
There is no § 1250 depreciation recapture when a property is sold at a loss, so any loss is
normally a § 1231 loss.
Unrecaptured § 1250 Gain. As may be apparent from step 3 above, under § 1250,
taxpayers are required to recapture depreciation only if an accelerated method is used to
depreciate the property. Consequently, individual taxpayers never recapture depreciation
on § 1250 property if the straight-line method is used. Without some special rule, any gain
attributable to straight-line depreciation for § 1250 property held more than 12 months
would normally qualify for taxation at a 15 percent rate. However, Congress felt this
treatment was too generous and created a special rule for unrecaptured § 1250 gain. The
unrecaptured § 1250 gain is the lesser of (1) the gain recognized, or (2) the depreciation
allowed after each (the gain recognized and the depreciation allowed) is reduced by any
§ 1250 recapture. The resulting amount will equal the amount of straight-line depreciation
that was claimed or would have been claimed had the straight-line method been used (or,
if less, the gain recognized minus the § 1250 recapture).
Example 11. About 10 years ago, F purchased some residential rental property for
$100,000. This year he sold the property for $110,000. He had claimed straight-line
depreciation of $30,000 over this time, resulting in a basis of $70,000 (do not attempt
to verify this amount). As a result, F recognized a gain of $40,000. Since the property
is realty and a straight-line depreciation method was used there is no § 1250
recapture. Consequently, the entire gain is a § 1231 gain. However, the § 1231 gain
will be treated as a 25% gain to the extent of any straight-line depreciation claimed.
Therefore, $30,000 of the gain is a 25% § 1231 gain while $10,000 is a 15% § 1231
gain (i.e., in the capital gain netting process these will be 15% and 25% long-term
gains, respectively). If F had sold the property for $90,000, he would have had a gain
of $20,000, all of which would have been a 25% gain (i.e., the lesser of the gain
realized, $20,000, or the unrecaptured straight-line depreciation, $30,000).
Example 12. Same facts and $110,000 sales price from Example 11 above, except
that F also has a $400 gain on the sale of K Corporation stock held 26 months. F is
33 See § 1250(a) and discussion following dealing with recapture of only a portion of the excess depreciation for
certain properties.
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single and has taxable income, excluding these transactions, of $76,000. F’s tax
would be computed as follows (using the 2006 tax rates for single taxpayers):
Regular tax on $76,000:
Tax on $74,200 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,108
Tax on excess at 28%
[($76,000 � $74,200¼ $1,800)� 28%] . . . . . . . . . . . . 1,504
$15,612
Tax on 15% gains (15%� $10,400) . . . . . . . . . . . . . . . . . . . . . . . 1,560
Tax on 25% gains (25%� $30,000) . . . . . . . . . . . . . . . . . . . . . . . 7,500
Total tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $24,672
Combined Results. The net gain from the disposition of § 1250 property can be
treated as ordinary income subject to the regular tax rate, 15 percent capital gain, and/or
25 percent capital gain (and rarely 28 percent capital gain). Each step in the netting and
tax calculation processes has been covered. 13 through Example 16 and ComprehensiveExample 18 illustrate how they work in combination.
Example 13. During the current year, L sold a small office building for $38,000. The
building had cost her $22,000 in 1980, and she had deducted depreciation of $12,000
using an accelerated method. Straight-line depreciation would have been $10,600. L’s
gain recognized on the sale is $28,000 ($38,000 amount realized � $10,000 adjusted
basis). Of that amount, $1,400 ($12,000 � $10,600 ¼ $1,400 excess depreciation) is
ordinary income under § 1250 and the remainder, $26,600, is § 1231 gain. Of the
$26,600 § 1231 gain, the unrecaptured depreciation of $10,600 is a 25% gain. The
$16,000 excess of the amount realized over the original basis is 15% gain.
Example 14. M purchased a rental duplex during 1986 for $60,000. He deducted
$36,500 depreciation using the 19-year realty ACRS tables. Depreciation using the
straight-line recovery percentages for 19-year realty would have resulted in total
depreciation of $31,440.
On January 3, 2006 M sold the property for $87,000. His gain is reported as
follows:
Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $87,000
Less: Adjusted basis
Cost. . . . . . . . . . . . . . . . . . . $60,000
Depreciation (accelerated) (36,500) (23,500)
Gain to be recognized. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $63,500
Accelerated depreciation claimed and deducted . . . . . . . . . . . . $36,500
Straight-line depreciation (hypothetical) . . . . . . . . . . . . . . . . . . . (31,440)
Excess depreciation subject to recapture . . . . . . . . . . . . . . . . . . $ 5,060
Character of gain: . . . . . . . . . . . .
Ordinary income (partial recapture) . . . . . . . . . . . . . . . . . . $ 5,060
§ 1231 gain subject to 25% rate . . . . . . . . . . . . . . . . . . . . . 31,440
§ 1231 gain subject to 15% rate . . . . . . . . . . . . . . . . . . . . . 27,000
Total gain recognized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $63,500
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Note that without a special rule, the gain not recaptured under § 1250 might be
subject to the 15% capital gains rate. However, the balance of the depreciation that
has not been recaptured $31,440 ($36,500 � $5,060) is carved out and is considered a
25% § 1231 gain. Also observe that the $31,440 of 25% § 1231 gain is the amount of
straight-line depreciation. The remaining gain (i.e., the amount above the original
cost) of $27,000 is a 15% § 1231 gain.
Example 15. Assume the same facts as in Example 14, except that M elected to
recover his basis in the duplex using the 19-year straight-line method. Consequently
she recognizes gain of $58,440 computed as follows:
Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $87,000
Less: Adjusted basis
Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,000
Depreciation (straight-line) . . . . . . . . . . . . . (31,440)
(28,560)
Gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(58,440)
None of the gain is subject to § 1250 recapture since M used straight-line depreciation
(a requirement after 1986). However, the amount representing the unrecaptured
depreciation (i.e., the straight-line depreciation) of $31,440 is considered a 25%
§ 1231 gain and the $27,000 balance is considered a 15% § 1231 gain.
Example 16. Assume the same facts as in Example 14, except that the property is an
office building rather than a duplex. In this case, because the property is nonresidential
real property and the accelerated method was used, the asset is treated as § 1245
property rather than § 1250 property. Thus, M is subject to full rather than partial
depreciation recapture. All of the $36,500 depreciation is recaptured and treated as
ordinary income. The balance of the gain, $27,000 is treated as a 15% § 1231 gain.
History of § 1250. Over the years, § 1250 has been changed frequently, with a
general trend toward an expanded scope. The rules explained above apply only to
depreciation allowed on nonresidential property after 1969 and residential property (other
than low-income housing) after 1975. Only a portion of any other excess depreciation on
§ 1250 property is included in the recapture potential. The following percentages are
applied to the gain realized in the transaction or the excess depreciation taken during the
particular period, whichever is less:
1. For all excess depreciation taken after 1963 and before 1970, 100 percent less 1
percent for each full month over 20 months the property is held.34 Any sales after
1979 would result in no recapture of pre-1970 excess depreciation since this
percentage, when calculated, is zero.
2. For all excess depreciation taken after 1969 and before 1976, as follows:
a. In the case of low-income housing, 100 percent less 1 percent for each full
month the property is held over 20 months.
b. In the case of other residential rental property (e.g., an apartment building)
and property that has been rehabilitated [for purposes of § 167(k)],
100 percent less 1 percent for each full month the property is held over
100 months.35
34 § 1250(a)(3).
35 § 1250(a)(2).
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All sales from this group of real property after August 1992 will have no recapture of
excess depreciation claimed before 1976.
3. For excess depreciation taken after 1975 on low-income housing and property
that has been rehabilitated [for purposes of § 167(k)], 100 percent less 1 percent
for each full month the property is held over 100 months.36
In summary, 100 percent of the excess depreciation allowed with respect to § 1250
property after 1975 is subject to recapture unless it falls into one of the above categories.
Any gain recognized to the extent of any unrecaptured depreciation will be considered
25% gain. The rules for the various categories are provided in § 1250(a).
Exceptions and Limitations under § 1250. Generally, the exceptions and
limitations that apply under § 1245 also apply under § 1250. Thus, gifts, inheritances,
and most nontaxable exchanges are allowed to occur without triggering recapture.37 This
exception is extended to any property to the extent it qualifies as a principal residence
and is subject to deferral of gain under § 1034 or nonrecognition of gain under § 121.38
In such nontaxable exchanges, the excess depreciation (that is not recaptured) taken prior
to the nontaxable exchange on the property transferred carries over to the property
received or purchased.39 Similarly, in the case of gifts and certain nontaxable transfers in
which the property is transferred to a new owner with a carryover basis, the excess
depreciation carries over to the new owner.40 In the case of inheritances in which basis to
the successor in interest is determined under § 1014, no carryover of excess depreciation
occurs.41
Certain like-kind exchanges and involuntary conversions may result in the recognition
of gain solely because of § 1250 if insufficient § 1250 property is acquired. Since not all
real property is depreciable, it is possible that the replacement property would not be
§ 1250 property and would still qualify for nonrecognition under the appropriate rules of
§§ 1033 or 1034. In such situations, gain will be recognized to the extent the amount that
would be recaptured exceeds the fair market value of the § 1250 property received
(property purchased in the case of an involuntary conversion).42
Example 17. D completed a like-kind exchange in the current year in which he trans-
ferred an apartment complex (§ 1250 property) for rural farmland (not § 1250
property). The apartment had cost D $175,000 in 1980 and depreciation of $89,000
has been taken under the 200% declining-balance method. D would have deducted
$62,000 under the straight-line method.
The farm land was worth $200,000 at the time of the exchange. There were no
improvements on the farm property. D’s realized gain on the exchange is $114,000
($200,000 amount realized � $86,000 adjusted basis in property given up). If there
had been no § 1250 recapture, then D would have had no recognized gain. Because
the property acquired was not § 1250 property, § 1250 supersedes (overrides) § 1031.
D has a recognized gain of $27,000 [($89,000 � $62,000), the amount of excess
depreciation], which is all ordinary income under § 1250.
36 § 1250(a)(1).
37 §§ 1250(d)(1) through (d)(4).
38 § 1250(d)(7).
39 Reg. §§ 1.1250-3(d)(5) and (h)(4).
40 Reg. §§ 1.1250-3(a), (c), and (f).
41 Reg. § 1.1250-3(b).
42 § 1250(d)(4)(C). A similar rule is provided for rollovers (deferral) of gains from low-income housing under §
1039 [see § 1250(d)(8)].
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Exhibit 17-2 provides an overview of the handling of sales and exchanges of business
property. Exhibit 17-3 provides a chart that may be useful in summarizing property
transactions. Note that for purposes of this Exhibit 17-3, no distinction is made between
15%, 25% and 28% § 1231 gains and losses or 15%, 25% and 28% capital gains and
losses. A comprehensive example of sales and exchanges of trade or business property is
presented below.
Example 18. Ted and Carol Smith sold the following assets during the current year:
DescriptionHoldingPeriod
SellingPrice
AdjustedBasis
RecognizedGain (Loss)
Land and building
(straight-line depreciation) 3 years $14,000 $9,000 $5,000
Cost, $13,000
Depreciation allowed, $4,000
Photocopier 14 months 2,600 2,000 600
Cost, $2,500
Depreciation allowed, $500
Business auto 2 years 1,800 1,920 (120)
Cost, $4,000
Depreciation allowed, $2,080
In determining the tax consequences of these sales, the Smiths must start with gains
and losses from § 1231 transactions. The ultimate treatment of the gains, the character
of the gain and any possible depreciation recapture must be considered.
" On the sale of the land and the building, there is no depreciation recapture for
the building since straight-line depreciation was used. However, there is
unrecaptured depreciation of $4,000 which is accounted for as a 25% § 1231
gain. The balance of the gain on the land and building, $1,000, is a 15% § 1231
gain.
EXHIBIT 17-2
Stepwise Approach to Sales or Exchange of Trade or
Business Property—An Overview
Step 1: Calculate any depreciation recapture on the disposition of § 1245 property and § 1250
property sold or exchanged at a taxable gain during the year.
Step 2: For any remaining gain (after recapture) on depreciable property held for more than one year,
add to other § 1231 gains and losses and complete the § 1231 netting process.
" The § 1231 gain must be broken down into the portions that qualify as 15%CG and
25%CG (and rarely 28%CG).
Step 3: Complete the netting process for capital assets, taking into consideration the net § 1231 gain,
if any.
" The § 1231 gain is combined with other long-term capital gains and losses (with
separate netting for 15%CG, 25%CG, and 28%CG. Then the long-term capital gain or
loss is combined with the short-term capital gain or loss.
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" On the sale of the photocopier, $500 of the § 1231 gain of $600 is recaptured
and treated as ordinary income. The balance of the gain, $100, is a 15%
§ 1231 gain.
" On the sale of the automobile, there is no recapture since it is sold at a loss.
The $120 loss is treated as a 15% § 1231 loss. This information can be
summarized as follows:
Section 1231 Gains and Losses
CollectiblesUnrecapturedDepreciation Other
28% 25% 15%
Land and building . . . . . . . . . . . . . . $0 $4,000
$1,000Photocopier . . . . . . . . . . . . . . . . . . .
100Automobile . . . . . . . . . . . . . . . . . . . .
(120)Capital gains from § 1231. . . . . . . . $0 $4,000
$ 980
In this situation, the Smiths net the various groups, resulting in net gains in each of
the groups as shown above. These amounts are then combined with the appropriate
capital gain groups to determine the final treatment. Note that if the Smiths had
unrecaptured § 1231 losses, they would first offset the 28% gains, then 25% gains,
and finally 15% gains. The information is summarized in Exhibit 17-3.
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Example 19. Assume that the Smiths, from the previous example, had the following
capital asset transactions during the same year:
DescriptionHoldingPeriod
SellingPrice
AdjustedBasis
Description ofGain or (Loss)
100 shares XY Corp. 4 months $ 3,200 $4,200 $(1,000) STCL
100 shares GB Corp. 3 years 3,200 4,600 (1,400) LTCL
1 acre vacant land 5 years 12,000 5,000 7,000 LTCG
EXHIBIT 17-3
Summary of Property Transactions
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Taking into consideration the § 1231 gains from Example 18, the Smith’s summarize
their transactions as follows.
Short-Term Capital Gains and Losses
CollectiblesUnrecapturedDepreciation Other
Ordinary 28% 25% 15%
Capital gains from § 1231. . . . . . . . $0 $4,000 $ 980
XY stock loss . . . . . . . . . . . . . . . . . . (1,000)
GB stock loss . . . . . . . . . . . . . . . . . . (1,400)
Vacant land gain . . . . . . . . . . . . . . . 7,000
$(1,000) $0 $4,000 $6,580
Netting . . . . . . . . . . . . . . . . . . . . . . . 1,000 (1,000)
Total . . . . . . . . . . . . . . . . . . . . . . . . . $ 0 $0 $3,000 $6,580
Ted and Carol Smith would report a $3,000 N25CG and a $6,580 N15CG.
A Form 4797 and Schedule D containing the information from Examples 18 and 19are included in Exhibit 17-4 which follows. In using the forms, it should be pointed out
that neither the Form 4797 nor Schedule D Parts I, II, and III (i.e., the form for reporting
capital gains and losses) require the taxpayer to distinguish 25% gains from 28% or 15%
gains. The 25% distinction comes into play only when the taxpayer computes the tax as
can be seen on Schedule D, Part IV, Lines 25 and 47. The tax is computed assuming the
taxpayers have taxable income of $126,830 (including the capital gains).
ADDITIONAL RECAPTURE—CORPORATIONS
Corporations generally compute the amount of § 1245 and § 1250 ordinary income
recapture on the sales of depreciable assets in the same manner as do individuals.
However, Congress added Code § 291 to the tax law in 1982 with the intent of reducing
the tax benefits of the accelerated cost recovery of depreciable § 1250 property
available to corporate taxpayers. For sales or other taxable dispositions of § 1250
property, corporations must treat as ordinary income 20 percent of any § 1231 gain
that would have been ordinary income if § 1245 rather than § 1250 had applied to
the transaction.43 The effect of this provision is to require the taxpayer to recapture
20 percent of any straight-line depreciation that has not been recaptured under some
other provision. Technically, the amount that is treated as ordinary income under § 291
is computed in the following manner:
Amount that would be treated as ordinary income under § 1245 . . . . . . . . . $xx,xxx)
Less: Amount that would be treated as ordinary income § 1250. . . . . . . (x,xxx)
Equals: Difference between recapture amounts . . . . . . . . . . . . . . . . . . . . . . $xx,xxx)
Times: Rate specified in § 291 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � 20%
Equals: Amount that is treated as ordinary income . . . . . . . . . . . . . . . . . . . . $xx,xxx)
43 § 291(a)(1).
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Example 20. This year K Corporation sold residential rental property for $500,000.
The property was purchased for $400,000 in 1986. Assume that K claimed ACRS
depreciation of $140,000 (i.e., do not attempt to verify this estimate). Straight-line
depreciation would have been $105,000. K Corporation’s depreciation recapture and
§ 1231 gain are computed as follows:
Step 1: Compute realized gain:
Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $500,000
Less: Adjusted basis
Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $400,000
ACRS depreciation . . . . . . . . . . . . . . . . . . . (140,000) (260,000)
Realized gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $240,000
Step 2: Compute excess depreciation:
Actual depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000
Straight-line depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (105,000)
Excess depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,000
Step 3: Compute § 1250 depreciation recapture:
Lesser of realized gain of $240,000
or
Excess depreciation of $35,000
§ 1250 depreciation recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,000
Step 4: Compute depreciation recapture if § 1245 applied:
Lesser of realized gain of $240,000
or
Actual depreciation of $140,000
Depreciation recapture if § 1245 applied . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000
Step 5: Compute § 291 ordinary income:
Depreciation recapture if § 1245 applied . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000
§ 1250 depreciation recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (35,000)
Excess recapture potential . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $105,000
Times: § 291 rate � 20%
§ 291 ordinary income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 21,000
Step 6: Characterize recognized gain:
§ 1250 depreciation recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,000
Plus: § 291 ordinary income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000
Ordinary income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 56,000
Realized gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $240,000
Less: Ordinary income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (56,000)
§ 1231 gain. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $184,000
Note that without the additional recapture required under § 291, K Corporation
would have reported a § 1231 gain of $205,000 ($240,000 total gain � $35,000
§ 1250 recapture). If the property had been subject to § 1245 recapture, K
Corporation would have only a $100,000 § 1231 gain ($240,000 � $140,000 § 1245
recapture). Section 291 requires that the corporation report 20% of this difference
($205,000 � $100,000 ¼ $105,000 � 20%), or $21,000, as additional recapture.
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Note that this is 20% of the straight-line depreciation that is normally not recaptured
on the disposition of nonresidential or residential real estate.
Example 21. Assume the same facts as in Example 20, except that the property is
an office building rather than residential realty and straight-line depreciation
was elected. An individual taxpayer would report the entire gain of $205,000
[$500,000 � ($400,000 basis � $105,000 straight-line depreciation)] as a § 1231
gain. However, the corporate taxpayer must recapture $21,000 (20% � $105,000
depreciation) as ordinary income under § 291. The remaining $184,000 ($205,000 �$21,000) would be a § 1231 gain.
OTHER RECAPTURE PROVISIONS
There are several other recapture provisions that exist. They include the recapture of
farmland expenditures,44 recapture of intangible drilling costs,45 and recapture of gain
from the disposition of § 126 property (relating to government cost-sharing program
payments for conservation purposes).46 Another type of recapture is investment credit
recapture.47 This is discussed in detail in Chapter 13.
3 CHECK YOUR KNOWLEDGE
Review Question 1. True-False. This year T sold equipment for $6,000 (cost
$15,000, depreciation $10,000), recognizing a gain of $1,000 ($6,000 � $5,000). To
ensure that all of the ordinary deductions obtained from depreciation are recaptured, T
must report ordinary income of $10,000 and a capital loss of $9,000, ultimately producing
net income of $1,000.
False. This novel approach may seem consistent with Congressional intent, but it is
incorrect. Under § 1245 any gain realized is treated as ordinary income to the extent of
any depreciation allowed. As a result, the entire $1,000 is ordinary income. It may be
useful to think of the depreciation recapture as an adjustment to the depreciation claimed.
Depreciation of $10,000 was claimed, but the value of the equipment dropped by $9,000
($15,000 cost � $6,000 sales price). T claimed an ordinary depreciation deduction of
$10,000, and recognized ordinary income of $1,000, for a net ordinary deduction of
$9,000.
Review Question 2. True-False. This year L sold a machine and recognized a small
gain. Assuming L claimed straight-line depreciation, there is no depreciation recapture.
False. The machine is § 1245 property since it is depreciable personalty. Under the full
recapture rule of § 1245, all depreciation is subject to recapture regardless of the method
used.
Review Question 3. Several years ago Harry purchased equipment at a cost of
$10,000. Over the past three years he claimed and deducted depreciation of $6,000.
Assuming that Harry sold the equipment for (1) $7,000, (2) $13,000, or (3) $1,000,
determine the amount of gain or loss realized and its character (i.e., ordinary income or
§ 1231 potential capital gain).
44 § 1252.
45 § 1254.
46 § 1255.
47 § 47.
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1 2 3
Amount realized. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,000 $13,000 $ 1,000
Adjusted basis ($10,000 � $6,000) . . . . . . . . . . . . . . . . . � 4,000 � 4,000 � 4,000
Gain (loss) recognized . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,000 $ 9,000 $(3,000)
The equipment is § 1245 property since it is depreciable personalty. As a result, the full
recapture rule operates and any gain recognized is ordinary income to the extent of any
depreciation deducted. In the first case, the entire $3,000 is ordinary income (the lesser
of the gain recognized, $3,000, or the recapture potential, $6,000). In the second
situation, $6,000 is ordinary income (the lesser of the gain recognized, $9,000, or the
recapture potential, $6,000) and $3,000 is § 1231 gain. In the final case, § 1245 does not
apply because the property is sold at a loss. Therefore, Harry has a § 1231 loss that is
potentially an ordinary loss. Its ultimate treatment depends on the outcome of the
§ 1231 netting process.
Review Question 4. True-False. In 1990 Sal purchased an office building to rent out.
This year she sold the building, recognizing a large gain. The entire gain is a
§ 1231 gain since there is no recapture under either § 1245 or § 1250.
True. The office build is § 1250 property. The recapture rules of § 1250 apply only
when the taxpayer uses an accelerated method, in which case the excess of accelerated
depreciation over straight-line is treated as ordinary income. However, since 1987
taxpayers have been required to use the straight-line method in computing depreciation
on real estate. As a result, § 1250 is inapplicable and Sal’s gain retains its original
§ 1231 character. Nevertheless, the gain will not be treated as a 15 percent gain to the
extent of any unrecaptured § 1250 depreciation (i.e., all of the straight-line depreciation)
but rather 25 percent gain.
Review Question 5. True-False. In 1992 Z Corporation purchased an office
building to rent out. This year the corporation sold the building, recognizing a large
gain. The entire gain is a § 1231 gain since there is no recapture under either § 1245 or
§ 1250.
False. There is no recapture under § or § 1250. However, under § 291, corporate
taxpayers are required to recapture up to 20 percent of any straight-line depreciation.
The 25 percent rate does not apply to corporate taxpayers.
Review Question 6. True-False. In 1984 the Rose Partnership purchased a new
office building to use as its headquarters. This year the partnership sold the building,
recognizing a gain of $100,000. The partnership claimed and deducted accelerated
depreciation of $40,000. Straight-line depreciation would have been $15,000. The
partnership will report ordinary income of $25,000 and § 1231 gain of $75,000.
False. This would be true if the building were § 1250 property, but § 1250 does not
apply. Nonresidential real estate such as this office building that was acquired from 1981
through 1986 is treated as § 1245 property and is subject to the full recapture rule if accelerated
depreciation was used. In this case, the taxpayer opted for accelerated depreciation, so $40,000
is ordinary income and the remaining $60,000 is a 15% § 1231 gain.
Review Question 7.
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