Chapter 14: Property Transaction: Capital Gains and Losses, 1231, and Recapture Provisions

What are the two reason that capital gains and losses must be separated from other gains and losses?

Capital gains and losses must be separated from other types of gains and losses for two reasons:
(1) Long-term capital gains may be taxed at a lower rate than ordinary gains
(2) A net capital loss is only deductible up to $3,000 per year

What three characteristics does proper classification of recognized gains and losses depend upon?

Proper classification of gains and losses depends on three characteristics:
(1) The tax status of the property
(Capital asset, �1231 asset, or ordinary asset)
(2) The manner of the property's disposition
(By sale, exchange, casualty, theft, or condemnatio

capital asset

Capital assets are not directly defined in the Code. 1221 defines capital assets as everything except:
*Inventory (stock in trade)
*Notes and accounts receivables acquired from the sale of inventory or performance of services
*Realty and depreciable prope

capital asset (continued)

*Dealers in securities
-In general, securities are the inventory of securities dealers, thus ordinary assets
-However, a dealer can identify securities as an investment and receive capital gain treatment
-Clear identification must be made on the day of ac

dealers in securities

a merchant (e.g. brokerage firm) that regularly engages in the purchase and resale of securities to customers.

Capital gain

The gain from the sale or exchange of a capital asset.

Capital loss

The loss from the sale or exchange of a capital asset.

Sale or exchange

A requirement for the recognition of capital gain or loss. Generally, the seller of property must receive money or relief from debt in order to have sold the property. An exchange involves the transfer of property for other property. Thus, collection of a

Does an involuntary conversion (casualty, theft, or condemnation) constitute a sale or exchange?

No. An involuntary conversion is not sale or exchange.

What does the recognition of capital gain or loss usually requires?

The recognition of capital gain or loss usually requires a sale or exchange of a capital asset.

Sale or Exchange-Worthless Securities and � 1244 Stock

*A security that becomes worthless creates a deductible capital loss without being sold or exchanged
- The Code sets an artificial sale date for the securities on the last day of the year in which worthlessness occurs
*Section 1244 allows an ordinary dedu

Sale or Exchange-Retirement of Corporate Obligations

*Collection of the redemption value of corporate obligations (e.g., bonds payable) is treated as a sale or exchange and may result in a capital gain or loss
-OID amortization increases basis and reduces gain on disposition or retirement

Original issue discount (OID)

The difference between the issue price of a debt obligation (e.g., a corporate bond) and the maturity value of the obligation when the issue price is less than the maturity value. OID represents interest and must be amortized over the life of the debt obl

Option

The sale or exchange of an option to buy or sell property results in capital gain or loss if the property is a capital asset. Generally, the closing of an option transaction results in short-term capital gain or loss to the writer of the call and the purc

Sale or Exchange-Options

*Exercise of an option by a grantee
-Increases the gain (or reduces the loss) to the grantor from the sale of the property
-Gain is ordinary or capital depending on the tax status of the property
*Grantee adds the cost of the option to the basis of the pr

Sale or Exchange-Patents

*When all substantial rights to a patent are transferred by a holder to another, the transfer automatically produces long-term capital gain or loss
-The holder of a patent must be an individual, usually the creator, or an individual who purchases the pate

Sale or Exchange-Franchises, Trademarks, and Trade Names

*Significant powers, rights, or continuing interests include:
-Control over assignment, quality of products and services
-Sale or advertising of other products or services
-The right to require that substantially all supplies and equipment be purchased fr

Sale or Exchange-Franchises, Trademarks, and Trade Names

*Noncontingent payments are ordinary income to the transferor
-The franchisee capitalizes the payments and amortizes them over 15 years
*Contingent payments are ordinary income for the franchisor and an ordinary deduction for the franchisee

Sale or Exchange-Lease Cancellation Payments

*Lessee treatment
-Treated as received in exchange for underlying leased property
(a) Capital gain results if asset leased was a capital asset (e.g., personal use )
(b) Ordinary income results if asset leased was an ordinary asset (e.g., used in lessee's

ordinary income

Recurring income earned by a taxpayer for a tax year; the type of income that people and businesses expect to earn. Ordinary income typically includes business profits, rent from property, interest on investments, and wages. Ordinary income receives no sp

features of holding period

*Short-term
-Asset held for 1 year or less
*Long-term
-Asset held for more than 1 year
*Holding period starts on the day after the property is acquired and includes the day of disposition

holding period

The period of time during which property has been held for income tax purposes. The holding period is significant in determining whether gain or loss from the sale or exchange of a capital asset is long term or short term.

holding period (continued)

*Nontaxable Exchanges
-Holding period of property received in like-kind exchange includes holding period of former asset if a capital or �1231 asset
*Transactions involving a carryover basis
-Former owner's holding period tacks on to present owner's holdi

short sales

A short sale occurs when a taxpayer sells borrowed property (usually stock) and repays the lender with substantially identical property either held on the date of the short sale or purchased after the sale. No gain or loss is recognized until the short sa

Tax Treatment of Capital Gains and Losses

*Noncorporate taxpayers
-Capital gains and losses must be netted by holding period
(a) Short-term capital gains and losses are netted
(b) Long-term capital gains and losses are netted
(c )If possible, long-term gains or losses are then netted with short-t