Capital Gains And Losses

June 24, 2024

8631 / What is the netting process used to determine whether the taxpayer has a capital gain or loss?

<div class="Section1">The complex rules applicable to capital gains taxation essentially establish four different types of capital assets. These groups of capital assets are: (1)     short-term capital assets, with no special tax rate; (2)     28 percent capital assets, generally consisting of collectibles gain or loss, and IRC Section 1202 gain; (3)     25 percent capital assets, consisting of assets that generate unrecaptured IRC Section 1250 gain; and (4)     all other long-term capital assets, which are taxed according to the taxpayer’s taxable income at 20 percent, 15 percent, or 0 percent. Within each group, gains and losses must be netted. Generally, if, as a result of this process, there is a net loss from asset-group “(1),” it is applied to reduce any net gain from groups “(2),” “(3),” or “(4),” in that order. If there is a net loss from group “(2),” it is applied to reduce any net gain from groups “(3)” or “(4),” in that order. If there is a net loss from group “(4),” it is applied to reduce any net gain from groups “(2)” or “(3),” in that order.<a href="#_ftn1" name="_ftnref1">1</a> If net capital losses result from the netting process described above, up to $3,000 ($1,500 in the case of married individuals filing separately) of losses can be deducted against ordinary income.<a href="#_ftn2" name="_ftnref2">2</a> Any losses that are deducted would be treated as reducing net loss from groups “(1),” “(2),” or “(4),” in that order. If there are net gains, such gains would generally be taxed as described above and discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8605">8605</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8606">8606</a>. If the taxpayer has capital gains and capital losses from investment property as well as gains and losses from Section 1231 business property (depreciable property used in a trade or business and held for more than one year), the latter gains and losses are netted against each other. If the netting results in a net gain, the gain is treated as if it were a long-term capital gain and included in the netting process for capital gains in group (4). On the other hand, if the netting results in a net loss from Section 1231 assets, this net loss is fully deductible as an ordinary loss and not subject to capital gain and loss netting. Example: Claire, an attorney, sold 500 shares of stock, recognizing a $1,500 long-term capital gain and 200 shares of stock recognizing a $300 short-term capital gain. In the same year she sold an oriental rug used in her home for the past 5 years at a loss of $700 and a rental property, owned for 9 months, for a short-term capital loss of $5,000. From her office she sold a computer system (a Section 1231 asset) at a loss of $1,200 and a set of law books (a Section 1231 asset) at a gain of $200. Both of these had been used in her practice for more than one year. Claire’s various gains and losses (“G/L”) must first be grouped according to the following column headings and a net total computed for each group: <table width="100%" align="center"> <tbody> <tr> <td width="28%"></td> <td style="text-align: center" width="23%">Long-Term Capital G/L</td> <td style="text-align: center" width="22%">Short-Term Capital G/L</td> <td style="text-align: center" width="25%">IRC 1231 Business Assets</td> </tr> <tr> <td width="28%">500 shares of stock</td> <td style="text-align: center" width="23%">1,500</td> <td style="text-align: center" width="22%"></td> <td style="text-align: center" width="25%"></td> </tr> <tr> <td width="28%">200 shares of stock</td> <td width="23%"></td> <td style="text-align: center" width="22%">300</td> <td width="25%"></td> </tr> <tr> <td width="28%">oriental rug *</td> <td style="text-align: center" width="23%">—</td> <td style="text-align: center" width="22%">—</td> <td style="text-align: center" width="25%">—</td> </tr> <tr> <td width="28%">rental property</td> <td style="text-align: center" width="23%"></td> <td style="text-align: center" width="22%">(5,000)</td> <td style="text-align: center" width="25%"></td> </tr> <tr> <td width="28%">computer</td> <td style="text-align: center" width="23%"></td> <td style="text-align: center" width="22%"></td> <td style="text-align: center" width="25%">(1,200)</td> </tr> <tr> <td width="28%">law books</td> <td style="text-align: center" width="23%"></td> <td style="text-align: center" width="22%"></td> <td style="text-align: center" width="25%">200</td> </tr> <tr> <td width="28%">Net totals</td> <td style="text-align: center" width="23%">1,500</td> <td style="text-align: center" width="22%">(4,700)</td> <td style="text-align: center" width="25%">(1,000)</td> </tr> <tr> <td colspan="4" width="100%">* No loss deduction is allowed for the oriental rug since it was held for personal use.<a href="#_ftn3" name="_ftnref3">3</a></td> </tr> </tbody> </table> Because the netting of the Section 1231 assets resulted in a net $1,000 loss, it is treated as a fully deductible ordinary loss and not subject to further netting. Netting short-term capital gain against short-term capital loss results in a net short-term capital loss of $4,700. That amount is netted against Claire’s net long-term gain of $1,500, resulting in a net short-term loss of $3,200. Only $3,000 worth of capital losses in excess of capital gains are deductible in any single tax year. The remaining $200 capital loss is carried forward to subsequent tax years subject to the same rules. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1" style="padding-right: 10px;">1</a>.IRC § 1(h)(1), as amended by ATRA; Notice 97-59, 1997-2 CB 309. <a href="#_ftnref2" name="_ftn2" style="padding-right: 10px;">2</a>.IRC § 1211(b). <a href="#_ftnref3" name="_ftn3" style="padding-right: 10px;">3</a>.IRC § 165. </div></div>

March 13, 2024

8633 / Is there a limitation to the amount of capital losses a taxpayer may deduct in a tax year? How are disallowed capital losses treated?

<div class="Section1">Unlike ordinary losses that are deductible against any type of income (ordinary or capital), capital losses are deductible against capital gains (long and short-term). However, a noncorporate taxpayer who has capital losses in excess of capital gains is entitled to deduct from ordinary income the lesser of (a) $3,000 ($1,500 for married taxpayers filing separately) or (b) the excess of the taxpayer’s net capital losses over gains.<a href="#_ftn1" name="_ftnref1">1</a> Any nondeductible losses may be carried forward indefinitely to subsequent tax years. Losses that are carried forward retain their character as either short-term or long-term in future years.Conversely, corporations are only permitted to recognize capital losses to the extent of capital gains with no exception.<a href="#_ftn2" name="_ftnref2">2</a> However, unlike noncorporate taxpayers who must carry forward nondeductible losses to subsequent tax years, corporations may carry disallowed capital losses back for three tax years (beginning with the earliest of the three) with any remaining nondeductible capital losses to be carried forward for five successive tax years (beginning with the earliest of the five).<a href="#_ftn3" name="_ftnref3">3</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.IRC § 1211(b). <a href="#_ftnref2" name="_ftn2">2</a>.IRC § 1211(a). <a href="#_ftnref3" name="_ftn3">3</a>.IRC § 1212(a). </div></div>

March 13, 2024

8632 / What is the tax significance of short-term capital gain?

<div class="Section1">Although as discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8631">8631</a> above, like long-term capital gain, short-term capital gain is netted against capital losses, net short-term capital gain is not subject to the preferential capital gains rates. Instead, such gain is taxed as ordinary income (up to 37 percent).</div>

March 13, 2024

8634 / What are the reporting requirements for capital gains and losses?

<div class="Section1">New boxes have been added to Form 1099-DIV to allow for the reporting of qualified dividends (Box 1b) and post-May 5, 2003 capital gain distributions (Box 2b). Likewise, new boxes have also been added to Form 1099-B for reporting post-May 5, 2003 profits or losses from regulated futures or currency contracts.<a href="#_ftn1" name="_ftnref1">1</a> Payments made in lieu of dividends (“substitute payments”) are not eligible for the lower rates applicable to qualified dividends.<div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.See Ann. 2003-55, 2003-38 IRB 597. </div></div>

March 13, 2024

8604 / What is a “capital asset”?

<div class="Section1">Generally, any property held as an investment is a capital asset, except that rental real estate is typically not a capital asset because it is treated as a trade or business asset.<a href="#_ftn1" name="_ftnref1">1</a>The Code defines a “capital asset” by exclusion. So for purposes of determining whether a certain type of property is a capital asset, the following types of property are excluded: (1) property (including inventory and stock in trade) held primarily for sale to customers; (2) real or depreciable property used in the taxpayer’s trade or business; (3) patents, inventions, models or designs (whether or not patented), a secret formula or process, copyrights and literary, musical, or artistic compositions (or similar properties) created by the taxpayer, or merely owned by him, if the taxpayer’s basis in the property is determined (other than by reason of IRC Section 1022, which governs the basis determination of inherited property) by reference to the creator’s tax basis; (4) letters, memoranda, and similar properties produced by or for the taxpayer, or owned by him if the taxpayer’s basis is determined by reference to the tax basis of the producer or recipient; (5) accounts or notes receivable acquired in the taxpayer’s trade or business for services rendered or sales of property described in (1), above; (6) certain publications of the United States government; (7) any commodities derivative financial instrument held by a commodities derivatives dealer; (8) any hedging instrument clearly identified as such by the required time; or (9) supplies of a type regularly used or consumed by the taxpayer in the ordinary course of the taxpayer’s trade or business.<a href="#_ftn2" name="_ftnref2">2</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.See IRS Pub. 544. <a href="#_ftnref2" name="_ftn2">2</a>.IRC § 1221; Treas. Reg. § 1.1221-1. </div></div>

March 13, 2024

8606 / How is net capital gain taxed?

<div class="Section1"> Net capital gain is the excess of net long-term capital gain for the taxable year over net short-term capital loss for such year.<a href="#_ftn1" name="_ftnref1">1</a> However, net capital gain for any taxable year is reduced (but not below zero) by any amount the taxpayer takes into account under the investment income exception to the investment interest deduction.<a href="#_ftn2" name="_ftnref2">2</a>If a taxpayer has net capital gain for any tax year, the IRC provides that the tax will not exceed the sum of the following six items: (A) the tax computed at regular rates (without regard to the rules for capital gain) on the greater of (i) taxable income reduced by the net capital gain, or (ii) the lesser of (I) the amount of taxable income taxed at the rates that apply if taxable income is below the relevant income threshold (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8605">8605</a>), or (II) taxable income reduced by the adjusted net capital gain; (B) 0 percent of the taxpayer’s adjusted net capital gain (or, if less, taxable income) that does not exceed the excess (if any) of (i) the amount of taxable income that would (without regard to this paragraph) be taxed at the rates that apply if taxable income is below the relevant income threshold (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8605">8605</a>) over (ii) the taxable income reduced by the adjusted net capital gain; (C) 15 percent of the lesser of (i) so much of the taxpayer’s adjusted net capital gain (or, if less, taxable income) as exceeds the amount on which a tax is determined under (B), above, or (ii) the excess of (I) the amount of taxable income which would be taxed at the rates that apply if taxable income is below the relevant income threshold (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8605">8605</a>) over (II) the sum of the amounts on which a tax is determined under (A) and (B), above; (D) 20 percent of the taxpayer’s adjusted net capital gain (or, if less, taxable income) in excess of the sum of the amounts on which tax is determined under (B) and (C), above; (E) 25 percent of the excess (if any) of (i) the unrecaptured IRC Section 1250 gain (or, if less, the net capital gain (determined without regard to qualified dividend income)), over (ii) the excess (if any) of (I) the sum of the amount on which tax is determined under (A) above, plus the net capital gain, over (II) taxable income (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8607">8607</a> for a discussion of unrecaptured IRC Section 1250 gain); and (F)28 percent of the amount of taxable income in excess of the sum of the amounts on which tax is determined under (A) through (D) above. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8607">8607</a> for a discussion of 28 percent gain. For most long-term capital gains, this complicated formula generally results in a maximum capital gains rate on adjusted net capital gain equal to 20 percent, 15 percent, or 0 percent, depending upon income level. Note that under the 2017 tax reform legislation, these thresholds no longer neatly align with the ordinary income tax brackets. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.IRC § 1222(11). <a href="#_ftnref2" name="_ftn2">2</a>.IRC §§ 163(d)(4)(B)(iii), 1(h)(2). </div></div>

March 13, 2024

8608 / What new rules have been developed in recent years to change the tax rates applicable to long-term capital gain?

<div class="Section1"> Congress has taken steps in recent years to reduce the rates applicable to long-term capital gains. As such, long-term capital gains recognized on or after May 6, 2003 are subject to lower tax rates today than has historically been the case. Under the 2017 tax reform legislation, those lower rates continue to apply, but the income thresholds that determine to whom those rates will apply have changed along with the changes to the individual income tax rates.Up until 2018, for taxpayers in the 25, 28, 33 and 35 percent ordinary income tax brackets, the rate on long-term capital gains was reduced from 20 percent to 15 percent in 2003 through 2012. For taxpayers in the 10 and 15 percent brackets, the rate on long-term capital gains was reduced from 10 percent to 5 percent in 2003 through 2007, and then to 0 percent in 2008 through 2012. As discussed below, these lower capital gain rates have been made permanent for tax years beginning after 2012.<a href="#_ftn1" name="_ftnref1">1</a> The American Taxpayer Relief Act of 2012 (“ATRA”) extended the 0 percent and 15 percent capital gain rates for most taxpayers and increased the rates for taxpayers in the highest income tax bracket. ATRA permanently increased the rate on long-term capital gains to 20 percent for taxpayers with taxable income that placed them in the highest 39.6 percent income tax rate bracket (for 2012017).<a href="#_ftn2" name="_ftnref2">2</a> The applicable threshold amounts were adjusted annually for inflation.<a href="#_ftn3" name="_ftnref3">3</a> For taxpayers in the 10 or 15 percent income tax brackets, the rate on long-term capital gains was set at 0 percent for 2012017. Taxpayers in the 25, 28, 33 and 35 percent tax brackets were taxed at 15 percent on long-term capital gains for 2012017.<a href="#_ftn4" name="_ftnref4">4</a> 2024 Long-Term Capital Gains Rates The 0 percent capital gains rate applies to joint filers who earn less than $94,050 (half of that amount for married taxpayers filing separately), heads of households who earn less than $63,000, single filers who earn less than $47,025, and trust and estates with less than $3,150 in income. <div class="Section1">The 15 percent rate applies to joint filers who earn more than $94,050 but less than $583,750 (half of that amount for married taxpayers filing separately), heads of households who earn more than $63,000 but less than $551,350, single filers who earn more than $47,025, but less than $518,900 and trust and estates with more than $3,150 but less than $15,450 in income.</div><div class="Section1"> The 20 percent rate applies to joint filers who earn more than $583,750 (half of that amount for married taxpayers filing separately), heads of households who earn more than $551,350, single filers who earn more than $518,900, and trusts and estates with more than $15,450 in income.<a href="#_ftn4" name="_ftnref4">5</a><a href="#_ftn1" name="_ftnref1"></a><a href="#_ftnref1" name="_ftn1"></a> <a href="#_ftnref1" name="_ftn1"></a> 2023 Long-Term Capital Gains Rates The 0 percent rate will apply to joint filers who earn less than $89,250 (half the amount for married taxpayers filing separately), heads of households who earn less than $59,750, single filers who earn less than $44,625, and trusts and estates with less than $3,000 in income. The 15 percent capital gains rate will apply to joint filers who earn more than $89,250 but less than $553,850 (half the amount for married taxpayers filing separately), heads of households who earn more than $59,750 but less than $523,050, single filers who earn more than $44,625 but less than $492,300, and trusts and estates with more than $3,000 but less than $14,650 in income. The 20 percent capital gains rate will apply to joint filers who earn more than $553,850 (half that amount for married taxpayers filing separately), heads of households who earn more than $523,050, single filers who earn more than $492,300, and trusts and estates with more than $14,650 in income.<a href="#_ftn5" name="_ftnref5">6</a> As of January 1, 2013, an investment income tax of 3.8 percent applies to certain investment-type income (including income received from capital gains). The investment income tax was not impacted by the 2017 tax reforms and applies for taxpayers whose annual adjusted gross income exceeds the investment income threshold amount ($250,000 for married taxpayers filing jointly, $125,000 for married taxpayers filing separately and $200,000 for all other taxpayers).<a href="#_ftn7" name="_ftnref7">7</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8637">8637</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8647">8647</a> for a detailed discussion of the investment income tax. The rates applicable for collectibles gain, IRC Section 1202 gain (i.e., qualified small business stock), and unrecaptured IRC Section 1250 gain remained unchanged. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8607">8607</a>.<a href="#_ftn8" name="_ftnref8">8</a> Repeal of qualified 5-year gain. For tax years beginning after December 31, 2000, if certain requirements were met, the maximum rates on “qualified 5-year gain” could be reduced to 8 percent and 18 percent (in place of 10 percent and 20 percent, respectively). Furthermore, a noncorporate taxpayer in the 25 percent bracket (or higher) who held a capital asset on January 1, 2001 could elect to treat the asset as if it had been sold and repurchased for its fair market value on January 1, 2001 (or on January 2, 2001 in the case of publicly traded stock). If a noncorporate taxpayer made this election, the holding period for the elected assets began after December 31, 2000, thereby making the asset eligible for the 18 percent rate if it was later sold after having been held by the taxpayer for more than five years from the date of the deemed sale and deemed reacquisition.<a href="#_ftn9" name="_ftnref9">9</a> Under JGTRRA 2003, the 5-year holding period requirement, and the 18 percent and 8 percent tax rates for qualified 5-year gain, were repealed. Though this repeal was scheduled to sunset along with the reduced rates on long-term capital gains, it was made permanent under ATRA. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.IRC § 1(h)(1), as amended by ATRA; TIPRA 2005 § 102, amending JGTRRA 2003 § 303. <a href="#_ftnref2" name="_ftn2">2</a>.Rev. Proc. 2017-58. <a href="#_ftnref3" name="_ftn3">3</a>.IRC §§ 1(i), 1(h), as amended by ATRA, §§ 101(b)(3)(C) and 102(b). <a href="#_ftnref4" name="_ftn4">4</a>.IRC § 1(h), as amended by ATRA, § 102. <a href="#_ftnref5" name="_ftn5">5</a> Rev. Proc. 2023-34. <a href="#_ftnref6" name="_ftn6">6</a> Rev. Proc. 2022-38. <a href="#_ftnref7" name="_ftn7">7</a>.IRC § 1411. <a href="#_ftnref8" name="_ftn8">8</a>.IRC § 1(h). <a href="#_ftnref9" name="_ftn9">9</a>.IRC §§ 1(h)(2), 1(h)(9), prior to amendment by JGTRRA 2003; JCWAA 2002 § 414(a) and CRTRA 2000 § 314(c), amending TRA ’97 § 311(e). </div></div>

March 13, 2024

8626 / Are there any special rules applicable in determining whether a gain or loss is long-term or short-term when a short sale is involved?

<div class="Section1"> Whether capital gain or loss on a short sale is long-term or short-term will ordinarily be determined by the seller’s holding period in the stock used to close the sale.<a href="#_ftn1" name="_ftnref1">1</a> For most purposes, the capital gain or loss is long-term if the holding period is more than one year. If the holding period is one year or less, the gain is short-term. (See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8625">8625</a> for a detailed discussion of the holding period requirement.)In a “short sale,” a seller agrees to sell stock to another at a fixed price on a future date. If the future date is more than a year from the date the taxpayer acquired the stock, he or she would be able to convert short-term capital gain (taxed at ordinary tax rates, i.e., up to 37 percent) to long-term capital gain (i.e., with rates of 0 percent, 15 percent or 20 percent). IRC Sections 1233 and 1259 are designed to prevent such abuse. Example: On March 1, 2023, Asher acquires stock for $200. On September 1, the fair market value of the stock is $300. To lock in the appreciation, Asher enters a short sale to close on April 1, 2024. Without IRC Sections 1233 and 1259, Asher would effectively convert a short-term holding period into a long-term holding period; and, thus, recognize long-term capital gain. To prevent individuals from using short sales to convert short-term gains to long-term gains or long-term losses to short-term losses, and to prevent the creation of artificial losses, the IRC and regulations provide special rules as follows: (1) If on the date the short sale is closed (see below), any “substantially identical property” has been held by the seller for a period of one year or less, any gain realized on property used to close the sale will, to the extent of the quantity of such substantially identical property, be short-term capital gain.<a href="#_ftn2" name="_ftnref2">2</a> This is true even though the stock actually used to close the short sale has been held by the seller for more than one year. This rule does not apply to losses realized on the property used to close the sale; (2) If any substantially identical property is acquired by the seller after the short sale and on or before the date the sale is closed, any gain realized on property used to close the sale will, to the extent of the quantity of such substantially identical property, be short-term capital gain.<a href="#_ftn3" name="_ftnref3">3</a> This is true regardless of how long the substantially identical property has been held, how long the stock used to close the short sale has been held, and how much time has elapsed between the short sale and the date the sale is closed. This rule does not apply to losses realized on the property used to close the sale; (3) The holding period of any substantially identical property held one year or less, or acquired after the short sale and on or before the date the short sale is closed will, to the extent of the quantity of stock sold short, be deemed to have begun on the date the sale is closed or the date such property is sold or otherwise disposed of, whichever is earlier. If the quantity of such substantially identical property held for one year or less or so acquired exceeds the quantity of stock sold short, the “renewed” holding period will normally be applied to individual units of such property in the order in which they were acquired (beginning with earliest acquisition), but only to so much of the property as does not exceed the quantity sold short. Any excess retains its original holding period.<a href="#_ftn4" name="_ftnref4">4</a> Where the short sale is entered into as part of an arbitrage operation in stocks or securities, this order of application is altered so that the “renewed” holding period will be applied first to substantially identical property acquired for arbitrage operations and held at the close of business on the day of the short sale and then in the order of acquisition as described in the previous sentence. The holding period of substantially identical property not acquired for arbitrage operations will be affected only to the extent that the quantity sold short exceeds the amount of substantially identical property acquired for arbitrage operations;<a href="#_ftn5" name="_ftnref5">5</a> (4)If on the date of a short sale any substantially identical property has been held by the seller for more than one year, any loss realized on property used to close the sale will, to the extent of the quantity of such substantially identical property, be long-term capital loss.<a href="#_ftn6" name="_ftnref6">6</a> This is true even though the stock actually used to close the short sale has been held by the seller for a year or less. This rule does not apply to gains realized on the property used to close the sale. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.Treas. Reg. § 1.1233-1(a)(3). See Bingham, 27 BTA 186 (1932), acq. 1933-1 CB 2. <a href="#_ftnref2" name="_ftn2">2</a>.IRC § 1233(b)(1); Treas. Reg. § 1.1233-1(c). <a href="#_ftnref3" name="_ftn3">3</a>.IRC § 1233(b)(1); Treas. Reg. § 1.1233-1(c). <a href="#_ftnref4" name="_ftn4">4</a>.IRC § 1233(b)(2); Treas. Reg. § 1.1233-1(c)(2). <a href="#_ftnref5" name="_ftn5">5</a>.IRC § 1233(f); Treas. Reg. § 1.1233-1(f). <a href="#_ftnref6" name="_ftn6">6</a>.IRC § 1233(d); Treas. Reg. § 1.1233-1(c)(4). </div></div>

March 13, 2024

8610 / How is tax basis adjusted and how does it impact the computation of capital gain or loss?

<div class="Section1">As discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8609">8609</a>, gain or loss is measured by determining whether the amount received in a sale or exchange of property was more or less than the taxpayer’s “basis.” If the amount received is more than basis, there is a taxable gain. Conversely, if basis is greater than the amount received there is a loss. However, during the period of a taxpayer’s ownership of property, certain adjustments to the original tax basis are required. Thus, tax basis, as adjusted, is referred to as “adjusted basis.”In the course of a taxpayer’s ownership of property, basis can be increased or it can be decreased. Capital Improvement Example: Asher purchases a 10 story office building for $500,000. Subsequently, Asher decides to add an 11th story to the building at a cost of $100,000. As a capital improvement, Asher’s original $500,000 basis is adjusted upward to $600,000<a href="#_ftn1" name="_ftnref1">1</a> and becomes the adjusted basis in the building. Depreciation Generally, depreciation is a means of deducting the cost of an asset over its useful life. For example, the cost of a commercial building (excluding land, which is nondepreciable) is depreciated over a useful life of 39 years.<a href="#_ftn2" name="_ftnref2">2</a> Based on a tax fiction, at the end of the 39 year depreciation period, the building will be completely “used up” and worth nothing. Therefore, every year, the basis of the building is adjusted downward by the amount of that year’s depreciation deduction.<a href="#_ftn3" name="_ftnref3">3</a> Example: Asher purchases a 10 story office building for $390,000.<a href="#_ftn4" name="_ftnref4">4</a> Because the building is depreciable over 39 years, Asher claims a $10,000 depreciation deduction each year. After nine years, Asher’s original basis is adjusted downward to $300,000 ($390,000 minus $90,000). At that time, if Asher were to sell the building for $400,000, he would have a taxable gain of $100,000 ($400,000 minus $300,000). <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.IRC § 1016(a)(1). <a href="#_ftnref2" name="_ftn2">2</a>.IRC § 168(c). <a href="#_ftnref3" name="_ftn3">3</a>.IRC § 1016(a)(2). <a href="#_ftnref4" name="_ftn4">4</a>.For purposes of this example, the amount of the purchase price attributable to the land is ignored. </div></div>

March 13, 2024

8628 / Can the redemption of a debt obligation result in capital gains treatment?

<div class="Section1">Redemption of a debt obligation can result in recognition of gain or loss in situations where the obligation was acquired at a premium or discount. The relevant issue for determining whether the retirement or satisfaction of the debt can result in a capital gain or loss is whether a sale or exchange has taken place. Historically, cases dealing with the subject have found that no sale or exchange takes place when the maker of a debt satisfies the obligations under the debt instrument.<a href="#_ftn1" name="_ftnref1">1</a> IRC Section 1271 was enacted to change this result in many situations involving the redemption of debt obligations.Under Section 1271, amounts received by the holder when the debt instrument is redeemed are treated as having been received in an exchange.<a href="#_ftn2" name="_ftnref2">2</a> Because of this, gain or loss realized upon redemption can qualify for capital gains treatment. However, some debt instruments contain “original issue discount” which is a type of interest. These include debt instruments in which the maturity price exceeds the purchase price. The difference is the interest component. Example: Asher purchases an original issue discount debt for $1,000 that matures two years later for $1,250. The difference between the maturity amount and the purchase amount, $250, is essentially interest. Original issue discount interest is reportable as ordinary income. Such ordinary income may be realized, however, in some transactions where there was an intention to call the obligation before maturity at the time the obligation was originally issued.<a href="#_ftn3" name="_ftnref3">3</a> If this is the case, any gain realized in the transaction must be treated as ordinary income to the extent that the amount of gain does not exceed the sum of (a) the original issue discount, reduced by (b) the portion of original issue discount previously included in the gross income of any holder of the obligation.<a href="#_ftn4" name="_ftnref4">4</a> The requirement that ordinary income be recognized does not apply to certain tax-exempt obligations and to holders who purchased the debt instrument at a premium.<a href="#_ftn5" name="_ftnref5">5</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.See, e.g., Wood v. Comm., 25 TC 468 (1955). <a href="#_ftnref2" name="_ftn2">2</a>.IRC § 1271(a)(1). <a href="#_ftnref3" name="_ftn3">3</a>.IRC § 1271(a)(2)(A). <a href="#_ftnref4" name="_ftn4">4</a>.IRC § 1271(a)(2). <a href="#_ftnref5" name="_ftn5">5</a>.IRC § 1271(a)(2)(B). </div></div>