Week Eleven

Chapter 8: Income from Asset Sales

Capital or ordinary?

Recurrent question: is a gain/loss "capital" or noncapital ("ordinary")? Matters because:

Defining the subject matter: "capital assets":

Sec. 1221(a) is the core definition -- and is at the heart of the problem

"In general --

For purposes of this subtitle, the term "capital asset" means property held by the taxpayer (whether or not connected with his trade or business), but does not include--

(1) stock in trade of the taxpayer ... , or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;

(2) property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business;

(3) a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property, held by ... (ed. the creator, the recipient, or one who takes on their basis, eg. by gift)

(4) accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of property described in paragraph (1);

(5) a publication of the United States Government (including the Congressional Record) which is received from the United States Government or any agency thereof, other than by purchase ....

(6) any commodities derivative financial instrument held by a commodities derivatives dealer, unless ... (ed. acquired for investment)

(7) any hedging transaction ... , or

(8) supplies ...."

Note further complications from Sec. 1231 for dispositions of plant and equipment: "business assets"

Many, many ad hoc rules elsewhere in tax code make particular transaction results capital or ordinary, and grant or deny "sale or exchange" treatment

Examples: Secs. 331, 341, 751

Parsing the language of 1221(a)

"property... except..."

So if something is "property", and isn't on the exception list, it's presumably a capital asset

(a)(1) Except inventory, etc.

There's a lot of case law here. Questions like:

Is a single transaction import and sale of art objects a trade/biz?

Are dispositions of rental cars or minor league baseball contracts the "ordinary course" of business?

When land is subdivided is it then held for sale to customers etc.?

(a)(2) Except depreciable assets and land used in business

Plant & equipment aren't capital assets (!) They become "1231 assets" if held > 1 year

Sec. 1231 operates to make losses ordinary (fully deductible) and gains capital (tax-favored) although in practice, there are complex limitations

Other "Sec. 1231 assets" [1231 (b)(2)-(4)]
  • Timber, coal, and iron ore
  • cattle and horses held more then 24 months
  • other livestock held more than 12 months
  • "Such term does not include poultry."
What about bees?

Are they "livestock"?

(a)(3) except copyrights and artistic works

Compare with Sec. 1235 giving automatic long term gains treatment to the sale of patent rights by the inventor & financial backers

Case: Chronical Publishing v CIR 97 T.C. 445 (1991), involving donation of newspaper "morgue" (clippings files) to Historical society

(a)(4) Except AR's from inventory or services

(a)(5) Except free gov't documents

Example: President Nixon's $300K backdated charitable deduction for official papers

(a)(6), (7) and (8) added in 1999 for clarification

What else on the borderline? Contract rights, etc.

Ferrer v. CIR, Bellamy v. CIR

Capital Gain and Loss Mechanics

Procedure (Schedule "D")

Classify each gain or loss as short-term or long-term, depending whether held more than one year. Note that holding period can tack on for gift or trade basis

Net short and long term transactions separately, to get a NSG/NSL and a NLG/ NLL

Then combine the results.

Capital loss limits

If there is an overall capital loss, a corporation carries it back 3 yrs forward 5 to offset net gains in those years.

An individual uses $3K of capital loss against other income (st is used first), and carries the excess forward indefinitely, keeping the character of -ST and of -LT losses. Treat as loss(es) arising in subsequent year

Capital gain benefits for individuals (not corporations!)

If the overall result is a gain ("capital gains net income"), then see if there is also a Net Long Gain. If not, just include the cgnY with other income

If there is an overall gain, the Net Long Gain (less net short loss if any) equals the "net capital gain" (NCG). Any Net Short Gain (less net long loss if any) will be taxed at regular rates, but a NCG will be given more favorable rates. Include cgnY in income , but use a special procedure for calculating tax on taxable income:

Calculate tax the regular way, and then calculate tax = (txblY-NCG) +20% * NCG. The lower amount is the tax. Sched D p 2 has the algorithm for calculations.

Made complex by special rates for certain kinds of capital gain (28% for collectibles, 25% for some gain on building sales, 18% for certain stock held 5 years) and by a 10% rate for capital gains otherwise in the 15% bracket.

Cui Bono? (Latin for "Who Benefits?")

source: IRS Statistics of Income, 99INPREL.EXE 7/25/01

And remember, the 20% maximum rate is more beneficial to a 39.6% bracket taxpayer (keep 80% instead of 60.4%) than a 28% bracket taxpayer (only raises amount kept from 72% to 80%)

Or, as the IRS' detailed study of 1998 returns (98INRATE.EXE) 7/12/01 gently stated:

"For 1998, some 15.8 million returns using the Schedule D capital gain tax computation generated $345.2 billion in tax. However, if long term capital gains had been taxed the same as ordinary income, the amount of income tax before credits (regular tax computation) for these same taxpayers would have been $396.6 billion. Therefore, the reduction in tax generation resulting from use of the Schedule D tax computation was $51.4 billion .... Most of these tax savings (60.8 percent) were reported by taxpayers in the $1,000,000 or more income-size class."

Put another way:

In 1998 there were 172,004 income millionaires with total income of $533 billion ( 0.1% of the people had 10% of all the income). 142,148 reported long gains of $222 billion -- almost half their income was long gains, and they had almost half of all the long gains. 60.8% of $51.4 billion is about $31 billion, an average tax savings of $220,000

But then again, taxes pay for civilization ...

The top 2% in 1999 showed $376 billion in "income tax after credits" or about 43% of the $874 billion total income tax.

And the 1998 income millionaires accounted for $148 billion in income tax -- about 18.2% of the total

Still, some might conclude (as in our Acct'g 804 class) that:

PROPERTY IS ROBBERY!

Sec. 1231 "Business Assets" and Special nettings

Purpose: ordinary losses and capital gains on casualties to, or sales of, plant & equipment

Casualty gains and losses: the "Firepot netting".

See Form 4797 p. 1 and 4684 p. 2. Also includes casualties to investment capital assets held long term (eg. theft of bonds)

If result is a net loss, its "ordinary" - non capital. If business property, transfer to Sched C/1120. If Individual investment loss, transfer to Sched A, not as a casualty, but as a "miscellaneous deduction not subject to 2% limit"

This was a technical correction in the 1998 Tax Act, made effective retroactively to 1984!

If result is a net gain, carry amount forward to a second testing

The Hotchpot netting

For g/l on sales of business assets, gov't. condemnation of business assets and of investment capital assets held long term (eg. gov't takes land for flood control dam), and any gain from the firepot.

Net it all out. If a loss, it's ordinary, if a gain, add it to the other long term gains and losses netted on Schedule D

After adjusting character of gain per a five year lookback rule.

So What Does the Flowchart look like?

Yikes! Is that all?

Depreciation recapture

Policy reason

The "Conversion loophole": ord deductions creating capital gains. Use of generous depreciation allowances for economic stimulus, plus Sec. 1231 hotchpot, created loophole. Depreciation offset ordinary income and reduced basis, but gain on sale (using that low basis) would be capital. Possibility of tax benefits w/o underlying economic income.

Sec. 1245 recapture

For equipment (and some ACRS buildings 1981-86), a partial override of Sec. 1231. Treat gain as ordinary (not 1231) to the extent of depreciation taken. See p. 2 of Form 4797

Sec. 1250 recapture

For buildings, treat gain as ordinary only to extent that accelerated depreciation taken exceeded what would have been taken under straight line.

Not an issue under MACRS (buildings are 27.5 yrs or 39 yrs., always straight line)

There are also some (old) tricky rules dealing with a phase-in of bldg recapture, and requiring corporations (where it usually doesn't make a difference -- no cap gains rate advantage now) to recapture 20% on buildings

"Nonrecaptured Sec. 1250 depreciation"

Added in 1997 in context of capital gains rate cut from 28% to 20% for individuals. A 25% capital gains rate on the amount of depreciation that would have been recaptured if building were 1245 property instead of 1250 property.

Yikes! Is that all?

Special rules for particular types of investment transactions

See IRS publication 550 for investment transactions

Sales without gains, losses without sales

short sales

Deemed realization on "short sales against the box"

related party sales and Sec. 267
wash sales and Sec. 1091. Loss denied on sale if replaced w/in 30 days before or after by "substantially similar" securities

Investor incentives

venture capital: 50% gains exclusion (28% rate on half the gain) for sales of certain small business stock

Sec. 1244 stock: a limited amount ($50K) of what would otherwise be a capital loss is treated as an ordinary loss

Rollovers of gain if qualified small biz stock sold and reinvested, or if public securities sold and SSBIC purchased, or if major owner sells to ESOP and buys publicly traded.

Incentive Zones as tax relief for poverty area investments

Derivatives

futures: Sec. 1256

Mark to market and 60% LT/40 ST rule, unless its a identified as a hedge at the time contract initiated

options.

Tradeable non-equity options generally marked to market at year end. Traded stock / and nontraded property options take character and timing from underlying transactions

straddles

Extremely complex rules (because straddles can have futures and options as components) that generally defer realized losses until the offsetting gains are realized

Pass thru's: dual holding periods

So where are the Loopholes?

Self-created property

Turn income from work into NCG from the sale of property by working to increase the value of a saleable capital asset

Home improvements ($250K gains exclusion every two years)

Incorporate, work to build up company value, underpay self, cash in by selling the stock or in a tax deferred merger

Corporate stock options

"Wrap" a capital asset around an ordinary income transaction

Stock and partnership interests are generally capital assets. A sale of the assets of a business carried on by an entity can also be structured as a sale of the equity in the entity.

Attempts to block this in the tax code are hugely complex and only partly effective:

Arbitrage: use the costs incurred to create capital gains as deductions against ordinary income

Margin interest to carry appreciating securities (note that margin interest deduction is limited to net investment income, not counting LT gain unless Tp waives the 20% rate)

Home mortgage interest expense

Depreciation allowances (funded by nonrecourse borrowed money) on rental property, with maximum 25% rate on "nonrecaptured Sec. 1250 depreciation" when sold.

Do well by doing good

The ability to deduct the FMV of certain LT capital gains property gifted to charity but never include the appreciation -- the difference between cost and FMV -- as income.

Footnote:

No. "...(B)ees are by implication excluded from the definition of 'livestock.' Section 1.1231-2 (a)(3), Income Tax Regs., includes only mammals, such as 'cattle, hogs, horses, mules, donkeys, sheep, goats, fur-bearing animals, and other mammals.' It specifically excludes 'poultry, chickens, turkeys, pigeons, geese, other birds, fish, frogs, reptiles, etc.' This impliedly excludes all lower forms of life. Bees are insects, and thus they are excluded." Charles A. Sykes v. Comm'r, 57 T.C. 618 (1972) <BACK>

Notes and outline (c) 2001-02 Robert H. Daniels