Capital Gains And Losses

October 24, 2024

8611 / What is the deduction for depreciation?

<div class="Section1">Depreciation is a deduction that permits recovery, over a period of time, of capital invested in tangible property used in a trade or business or held for the production of income.<a href="#_ftn1" name="_ftnref1">1</a> It is a deduction taken in arriving at adjusted gross income.<a href="#_ftn2" name="_ftnref2">2</a><div class="Section1"> Only property that has a limited useful life may be depreciated. Land does not have a limited life and, therefore, cannot be depreciated. However, the improvements on land can be depreciated. Inventory and stock in trade are not depreciable.<a href="#_ftn3" name="_ftnref3">3</a> A taxpayer who purchases a term interest in property cannot amortize or depreciate the cost of the property during any period in which the remainder interest is held by a related person.<a href="#_ftn4" name="_ftnref4">4</a> On the other hand, life tenants and beneficiaries of estates and trusts may be allowed the regular depreciation deduction if the property is depreciable property.<a href="#_ftn5" name="_ftnref5">5</a> The method used to determine the rate of depreciation depends on when the property was placed into service. Property is “placed into service” when it is first placed in a condition or state of readiness and availability for a specifically assigned function for use in a trade or business, for the production of income, or in a tax-exempt or personal activity.<a href="#_ftn6" name="_ftnref6">6</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a> for a discussion of the bonus depreciation rules that apply post-tax reform. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC §§ 167(a), 168(a), as amended by ATRA and Pub. Law No. 115-97 (the 2017 reform legislation). <a href="#_ftnref2" name="_ftn2">2</a>.  IRC §§ 62(a)(1), 62(a)(4). <a href="#_ftnref3" name="_ftn3">3</a>.  Treas. Reg. § 1.167(a)-2. <a href="#_ftnref4" name="_ftn4">4</a>.  IRC § 167(e). <a href="#_ftnref5" name="_ftn5">5</a>.  IRC § 167(d). <a href="#_ftnref6" name="_ftn6">6</a>.  Prop. Treas. Reg. § 1.168-2(l)(2). </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.</div> <div class="Section1"> 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> <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>

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. Payments made in lieu of dividends (“substitute payments”) are not eligible for the lower rates applicable to qualified dividends.</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></div> <div class="Section1"> The Code defines a “capital asset” by exclusion. For purposes of determining whether a certain type of property is a capital asset, the following types of property are excluded: <blockquote>(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></blockquote> </div> <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>

March 13, 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: <blockquote>(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.</blockquote> 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. <blockquote>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:</blockquote> <table border="1" align="center"> <tbody> <tr> <td width="109"></td> <td style="text-align: center;" width="124">Long-Term Capital G/L</td> <td style="text-align: center;" width="124">Short-Term Capital G/L</td> <td style="text-align: center;" width="124">IRC 1231 Business Assets</td> </tr> <tr> <td width="109">500 shares of stock</td> <td style="text-align: center;" width="124">1,500</td> <td width="124"></td> <td width="124"></td> </tr> <tr> <td width="109">200 shares of stock</td> <td width="124"></td> <td style="text-align: center;" width="124">300</td> <td width="124"></td> </tr> <tr> <td width="109">oriental rug*</td> <td style="text-align: center;" width="124">—</td> <td style="text-align: center;" width="124">—</td> <td style="text-align: center;" width="124">—</td> </tr> <tr> <td width="109">rental property</td> <td width="124"></td> <td style="text-align: center;" width="124">(5,000)</td> <td width="124"></td> </tr> <tr> <td width="109">computer</td> <td width="124"></td> <td width="124"></td> <td style="text-align: center;" width="124">(1,200)</td> </tr> <tr> <td width="109">law books</td> <td width="124"></td> <td width="124"></td> <td style="text-align: center;" width="124">200</td> </tr> <tr> <td width="109">Net totals</td> <td style="text-align: center;" width="124">1,500</td> <td style="text-align: center;" width="124">(4,700)</td> <td style="text-align: center;" width="124">(1,000)</td> </tr> <tr> <td colspan="4" width="482">* 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">1</a>.  IRC § 1(h)(1), as amended by ATRA; Notice 97-59, 1997-2 CB 309. <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 1211(b). <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 165. </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><div class="Section1"> 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: <blockquote>(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.</blockquote> 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><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

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.”<div></div><div>In the course of a taxpayer’s ownership of property, basis can be increased or it can be decreased.</div><div class="Section1"> Capital Improvement <blockquote>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.</blockquote> 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 not depreciable) 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> <blockquote>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).</blockquote> </div><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.</div> <div class="Section1"> 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. <blockquote>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.</blockquote> 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> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. See, e.g., Wood v. Commissioner, 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>

March 13, 2024

8630 / Are there any special rules that apply in determining whether the sale of a patent gives rise to capital gains treatment?

<div class="Section1">Editor’s Note The 2017 tax reform legislation provides that gain or loss from the disposition of a self-created patent, invention, model or design, or secret formula or process will be taxed as ordinary income or loss for tax years beginning after 2017. The election to treat musical compositions and copyrights in music as capital assets was not changed.<a href="#_ftn1" name="_ftnref1">1</a></div> <div class="Section1"> Unlike typical asset sales, if the sale or exchange of a patent meets certain requirements, the sale will automatically qualify for long-term capital gains treatment regardless of the transferor’s holding period and whether or not the patent would have been classified as a capital asset in the hands of the holder who transfers the patent.<a href="#_ftn2" name="_ftnref2">2</a> Sale of a patent will qualify for long-term capital gains treatment if the holder of the patent transfers either “all substantial rights” in the patent or an undivided interest in the patent. The phrase “all substantial rights” is defined in the regulations to mean all rights in the patent that have value at the time the rights to the patent are transferred, whether or not the holder of the patent is the owner of those rights.<a href="#_ftn3" name="_ftnref3">3</a> The holder does not transfer all substantial rights in the patent if the rights to the patent are: <blockquote>(1) limited geographically within the country; (2) confined to a period of time that is less than the entire remaining life of the patent; (3) limited to a grant of rights, in fields of use within trades or industries, which are less than all the rights covered by the patent that exist and have value at the time of the transfer; or (4) limited to a grant of rights that does not give the transferee rights to all the claims and inventions covered by the patent that exist and have value at the time of sale.<a href="#_ftn4" name="_ftnref4">4</a></blockquote> Conversely, the holder does not lose long-term capital gain treatment by retaining rights that are not considered substantial. The regulations provide that, depending upon all of the facts and circumstances of the transaction as a whole, the holder may retain the right to prohibit sub-licensing or sub-assignment by the transferee and may also fail to convey the right to use or sell the property that is the subject of the patent.<a href="#_ftn5" name="_ftnref5">5</a> The holder transfers an “undivided interest” in a patent when the holder transfers the same fractional share of every substantial right in the patent. A sale of the right to income from a patent, for example, does not constitute the sale of an undivided interest in the patent.<a href="#_ftn6" name="_ftnref6">6</a> This treatment is not available to all patent holders, however. The term “holder” is defined in IRC Section 1235 to include only (1) the original inventor of the property subject to the patent and (2) an individual who obtained his rights in the patent in exchange for money or other property before the property subject to the patent was actually put to use if that individual is neither (i) the inventor’s employer or (ii) related to the inventor.<a href="#_ftn7" name="_ftnref7">7</a> <hr /> Planning Point: Due to the limited definition of “holder” under the patent laws, if an employer maintains the rights to patents on property invented by its employees, the employer will not be eligible for this special capital gains treatment upon sale of the patent. <hr /> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 1221(a)(3). <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 1235(a). <a href="#_ftnref3" name="_ftn3">3</a>. Treas. Reg. § 1.1235-2(b)(1). <a href="#_ftnref4" name="_ftn4">4</a>. Treas. Reg. § 1.1235-2(b)(2). <a href="#_ftnref5" name="_ftn5">5</a>. Treas. Reg. § 1.1235-2(b)(3). <a href="#_ftnref6" name="_ftn6">6</a>. Treas. Reg. § 1.1235-2(c). <a href="#_ftnref7" name="_ftn7">7</a>. IRC § 1235(b). </div>