Solutions to Chapter 7 Problem Assignments

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1 134 Solutions Manual for Taxation for Decision Makers Solutions to Chapter 7 Problem Assignments Check Your Understanding 1. Asset Classification How are assets classified to determine their tax treatment on disposition? What are other ways to classify assets? What events qualify as asset dispositions? Solution: Assets are first classified as business, personal-use, or investment assets; then they are classified as capital assets, Section 1231 assets, and ordinary income assets to determine their tax treatment. Assets may also be classified as realty or personalty and tangible or intangible. Sales, exchanges, involuntary conversions, and abandonments all qualify as asset dispositions. 2. Amount Realized How is the amount realized on a sale or exchange determined? Solution: The amount realized on a sale or exchange is the sum of the cash received, the fair market value of property received, and the liabilities assumed by the buyer less the sum of the seller s selling expenses and the liabilities of the buyer assumed by the seller. 3. Realized vs. Recognized Gain Explain the difference between a realized gain and a recognized gain? Solution: A realized gain is the excess of the amount realized on a sale or exchange over the basis of the property sold or exchanged. The recognized gain is the amount of this realized gain that will be treated as income and subject to tax on the seller s income tax return. 4. Asset Classification What type of assets are Section 1231 assets? What type of assets are capital assets? What type of assets are ordinary income assets? Give several examples of each type of asset. Solution: Section 1231 assets are depreciable realty and personalty used in a trade or business, nondepreciable trade or business realty (and long-term capital gain property held for the production of income that is involuntarily converted). These assets must have been held for more than one year, however. Section 1231 assets include machinery and equipment, office furniture and fixtures, and rental real estate. Capital assets include most investment properties and personal-use assets. They exclude inventory, real and depreciable property used in a trade or business, and accounts and notes receivable from the sale of inventory in the ordinary course of business. Capital assets include investment stocks and bonds and other investment property, personal residences, and personal property items such as furs, jewelry, autos, and clothing. Ordinary assets include inventory, stock in trade, and accounts and notes receivable from inventory sales in the ordinary course of business. In addition, any asset that cannot be classified as a capital or Section 1231 asset must be an ordinary asset. Also assets used in a business but held for one year or less are ordinary income assets.

2 Chapter 7: Property Dispositions Recapture Why do taxpayers have to recapture depreciation on depreciable assets sold at a gain? To which assets do the Section 1245 and 1250 recapture provisions apply? Solution: Taxpayers deduct depreciation expenses against ordinary income resulting in a tax savings equal to the depreciation expense times the ordinary income marginal tax rate. Without recapture, all of the gain that is realized and recognized on the disposition of a depreciable asset would be Section 1231 gain and could receive favorable tax treatment as long-term capital gain. To ensure that all or part of the gain that results from the basis reduction for depreciation is taxed at ordinary income rates, depreciation recapture was instituted. Section 1245 full recapture and Section 1250 partial recapture apply to depreciable property (including property on which Section 179 expensing was claimed) that has been disposed of at a gain (it does not apply to losses). Section 1245 property includes all depreciable personalty and Section 1250 applies to certain depreciable realty. 6. Section 1231 Look-Back Explain the look-back procedure for Section 1231 assets. Why did this particular provision evolve? Solution: The Section 1231 look-back procedure which requires all or a portion of Section 1231 gain to be taxed as ordinary income applies to the gain on Section 1231 assets to the extent the taxpayer deducted Section 1231 losses against ordinary income during the five preceding tax years (referred to as unrecaptured Section 1231 losses). Taxpayers became adept at realizing Section 1231 losses in some years, deducting them from ordinary income, and Section 1231 gains in other years, benefiting from taxation at capital gains rates. The look-back procedure was designed to prevent this game. 7. Section 291 Recapture What is Section 291 recapture? Compare this to unrecaptured Section 1250 gains. Solution: Section 291, applicable to corporations, requires corporations to recapture (tax as ordinary income) an additional amount of Section 1231 gain beyond the recapture amount required by the Section 1250 recapture rules. This recapture applies even if there is no required Section 1250 recapture on the realty sold and simply converts part of the Section 1231 gain realized to ordinary income. Section 291 recapture is 20% of the excess of Section 1245 recapture (as if Section 1245 recapture applied) over the Section 1250 recapture. This corporate recapture rule eliminates some of the capital gains that would otherwise be available to offset capital losses as corporations can only offset capital losses with capital gains. Unrecaptured Section 1250 gains apply to individual taxpayers. This provision applies a maximum 25% tax rate to gains on the sale of realty that would be a Section 1250 gain if all prior depreciation were recaptured (similar to the rules for Section 1245 recapture). These capital gains would usually be taxed at a 15% capital gains tax rate otherwise.

3 136 Solutions Manual for Taxation for Decision Makers 8. Section 1231 Netting How are net losses treated in the Section 1231 netting process? How is a net Section 1231 gain taxed? Solution: Net Section 1231 losses that are the result of the Section 1231 netting process are deductible from ordinary income of both corporations and individuals. When there is a net Section 1231 gain, the taxpayer must first recapture as ordinary income any unrecaptured Section 1231 losses in the previous five years. The remaining net Section 1231 gain enters the capital asset netting process and can offset capital losses. If the taxpayer has no capital gains or losses, the net Section 1231 gain is included in the taxpayer s income for taxation. In this case, the net Section 1231 gains of corporations are taxed as ordinary income, but the net Section 1231 gains of individuals are taxed as long-term capital gains subject to a maximum 15% capital gains tax rate. 9. Capital Assets How are capital assets classified as short term and long term? How are long-term gains and losses and short-term gains and losses treated in the capital asset netting process? Solution: A long-term capital asset is one that is held for more than one year. A short-term capital asset is one that does not meet the holding period for a long-term capital asset (that is, is held for one year or less). Long-term capital gains and losses are first separated from short-term capital gains and losses. The long-term gains and losses are netted against each other and the short-term gains and losses are netted against each other separately. If the result is a short-term gain (loss) and a long-term loss (gain), these are then netted against each other with the resulting number taking the character of the largest element. The netting process continues subtracting losses from gains until there are only gains or only losses remaining. The net gain(s) or net loss(es) are then taxed according to the type of taxpayer. 10. Capital Gains How are net short-term capital gains of individuals treated? How are net short-term capital gains of corporations treated? Solution: The net short-term capital gains of both individuals and corporations are included in income and taxed at ordinary income rates. 11. Capital Losses How are net capital losses of individuals treated for tax purposes? How are net capital losses of corporations treated for tax purposes? Solution: An individual may deduct a maximum of $3,000 of capital losses annually against ordinary income. Short-term capital losses are deducted before long-term losses up to the $3,000 maximum. The remaining losses must be carried forward (and they retain their character as short-term or long-term) indefinitely until fully deducted. The losses that are carried forward enter the capital asset netting process in the carryover year and, thus, may also offset capital gains realized in that year. In

4 Chapter 7: Property Dispositions 137 future years in which the capital losses exceed capital gains, the excess losses continue to offset ordinary income at the rate of $3,000 per year. The net capital losses of corporations can only be carried back three years and then forward up to five years to offset capital gains in the carryover years. They are not permitted to deduct the net losses against ordinary income. The losses carried over are all assumed to be short-term capital losses and they enter the capital asset netting process in the carry-over year. Any unused losses remaining at the end of the five-year carryforward period are lost. 12. Capital Gains Tax Rates What tax rates apply to long-term capital gains, gains on collectibles, and unrecaptured Section 1250 gains for individuals? Solution: The general maximum tax rate for long-term capital gains for individuals is 15%. The maximum tax rate for gains on collectibles is 28% and the maximum tax rate for unrecaptured Section 1250 gains is 25%. These tax rates may be modified if the individual s marginal tax rate on ordinary income is less than these rates. If the individual s marginal tax rate does not exceed 15%, then the 25% and 28% assets are taxed at the 15% rate; the 15% assets are taxed at 5%. The amount taxed at these lower rates cannot exceed the room remaining in the 15% tax bracket, however. 13. Capital Gains Tax Rates If an individual taxpayer is in the 15 percent tax bracket, what is the maximum tax rate that applies to a. the initial dollar of gain on a capital asset held for two years? b. the long-term gain on collectibles? c. unrecaptured Section 1250 gain? Solution: a. 5%. b. 15% c. 15%. 14. Section 1244 Stock What is the significance of having stock qualify as Section 1244 stock? Solution: Up to $50,000 of the loss ($100,000 for married filing jointly) on the sale of Section 1244 stock in any year may be treated as an ordinary loss rather than as a capital loss. Any loss in excess of this limit is capital loss. This provision only applies to individuals or partnerships that are the original owners of the stock. 15. Qualified Small Business Stock Why could it be very advantageous to have a substantial investment in stock in a qualified small business corporation? Solution: A noncorporate taxpayer that realizes a gain on the sale of stock in a qualified small business may exclude 50% of the gain (subject to very generous limits) from taxation.

5 138 Solutions Manual for Taxation for Decision Makers 16. Personal Residences What are the ownership and use tests for excluding the maximum gain on the sale of a personal residence? Under what circumstances may the owner of a personal residence exclude gain if the required ownership and use tests are not met? Solution: The personal residence must be the primary residence of the taxpayer; the taxpayer or the taxpayer s spouse must have owned the residence for at least two of the five previous tax years; and the taxpayer (and the taxpayer s spouse, if married) must have occupied the home for at least two of the last five years. If both spouses qualify, up to $500,000 of gain is excluded. If only one spouse meets the use test, then the qualifying spouse can exclude up to $250,000 gain. Normally, this exclusion can be claimed only once every two years. If, however, the taxpayer(s) does not meet the ownership or use tests at the time of the sale and the sale of the residence is due to a change in health, employment, or other circumstance beyond the taxpayer s control, a portion of the gain may be excluded. Other circumstances include death of a spouse or co-owner, divorce, unemployment, disasters, and involuntary conversion of the residence. Crunch the Numbers 17. Realized Gain or Loss Charlie sold Whiteacre for $40,000 cash and the buyer assumed Charlie s $19,000 mortgage on the property. Charlie paid a realtor commission of $2,000 on the sale. What is his realized gain or loss if Whiteacre has an adjusted basis of a. $47,000? b. $67,000? Solution: a. ($40,000 + $19,000 - $2,000) - $47,000 = $10,000 realized gain. b. ($40,000 + $19,000 - $2,000) - $67,000 = $10,000 realized loss 18. Determination and Character of Gains and Losses Allan received $5,000 cash and an auto worth $15,000 in exchange for a lot that was encumbered by a $13,000 liability that the buyer assumed. a. What is the amount realized on this sale? b. If Allan had a basis of $34,000 in the land, what is his gain or loss on the sale? c. If Allen has owned the land for five years as an investment, what is the character of the gain or loss? d. How would your answer to (c) change if the land had been used by Allan s business as a parking lot? Solution: a. $5,000 + $15,000 + $13,000 = $33,000 amount realized. b. $33,000 - $34,000 = $1,000 loss c. Long-term capital loss. d. If the property had been used in a business, it would be Section 1231 property and it would be a Section 1231 loss. 19. Determination and Character of Gain Corgill Corporation sold some property that it had used for storing old equipment. Corgill owned the property for seven years and it had a basis of $234,000. Corgill received $50,000

6 Chapter 7: Property Dispositions 139 cash and a note for $100,000 and the purchaser assumed Corgill s $150,000 mortgage on the property. Corgill also paid a realtor s fee of $15,000 and other selling expenses of $2,000. a. What is Corgill s gain or loss on the sale and what is its character? b. If the property had been land that Corgill held as an investment, how would your answer change? Solution: a. $50,000 + $100,000 + $150,000 - $15,000 - $2,000 - $234,000 = $49,000 Section 1231 gain. b. As an investment, the gain would be long-term capital gain. 20. Determination and Character of Gain Bernadette sold her home. She received cash of $40,000, the buyer assumed her mortgage of $180,000, and she paid closing costs of $2,300 and a broker s commission of $7,000. a. What is the amount realized on the sale? b. If she has a basis in the home of $138,000, what is her gain or loss on the sale? c. What is the character of the gain or loss? d. How would your answer to (c) change if Bernadette sold a building used by her sole proprietorship rather than her personal residence? Solution: a. $40,000 + $180,000 - $2,300 - $7,000 = $210,700 amount realized. b. $210,700 - $138,000 = $72,700 gain. c. Long-term capital gain. If she owned and used the house as her principal residence for at least two of the previous five years, she could qualify to exclude the gain. d. If used in a sole proprietorship, the gain on the building s sale would be Section 1231 gain. If she claimed any depreciation on the building, the portion of gain attributable to depreciation would be taxed as unrecaptured Section 1250 gain (subject to a 25% maximum tax rate). 21. Determination and Character of Gains and Losses DDF Corporation sold land it had used for parking and storage for 20 years for $575,000. Its basis in the land was $68,000. It also sold some manufacturing equipment for $125,000 that it replaced with more modern equipment. The equipment sold had a basis of $760,000. a. What is the amount and character of DDF s gains or losses on these sales? b. If DDF has no other property transactions, how is the net gain or loss treated? Solution: a. DDF has $507,000 ($575,000 - $68,000) Section 1231 gain on the land sale. It has a $635,000 ($125,000 - $760,000) Section 1231 loss on the sale of the equipment. b. The $635,000 loss is netted against the $507,000 gain. The result is a $128,000 net Section 1231 loss that is deducted against DDF Corporation s ordinary income. 22. Determination and Character of Gain Barry Corporation sold a machine used in its business for two years for $27,000. The machine originally cost $24,000 and it had an adjusted basis at the time of the sale of $17,000. What is the amount and type of gain realized on the sale? Solution: $27,000 - $17,000 = $10,000 total gain. $7,000 ($24,000 - $17,000) of the gain is taxed as ordinary income due to Section 1245 recapture; the remaining $3,000 gain is Section 1231 gain.

7 140 Solutions Manual for Taxation for Decision Makers 23. Determination and Character of Gains and Losses The Grid Corporation owns a bank of boring machines. They regularly replace two machines each year. In the current year, the company sold Machine 8 for $12,000. It was purchased six years earlier for $40,000 and its adjusted basis was $14,000. Machine 6 was sold for $24,000. It was purchased four years ago for $45,000 and had an adjusted basis of $19,000. a. How much gain or loss is realized on each asset? b. What is the character of the gain or loss? c. If the company disposed of no other assets during the year, how are the results of these sales treated for tax purposes? Solution: a. Machine 8: $12,000 $14,000 = $2,000 loss realized. Machine 6: $24,000 - $19,000 = $5,000 gain realized. b. The machines are Section 1231 property. The loss on Machine 8 is a Section 1231 loss; the gain on Machine 6 is ordinary income due to Section 1245 recapture because the gain is less than the prior depreciation deductions ($45,000 - $19,000 = $26,000 accumulated depreciation). c. The $2,000 loss is deducted directly from ordinary income; the $5,000 Section 1245 recapture is included directly in ordinary income. 24. Determination and Character of Gains and Losses Jonas acquired a building in 1992 for $650,000. He sold it in the current year for $680,000 when its adjusted basis was $500,000. What is the amount and type of gain or loss realized on the sale a. if the building is a factory? b. if the building is an apartment complex? c. if the seller is a corporation? Solution: a. $680,000 - $500,000 = $180,000 Section 1231 gain. b. $680,000 - $500,000 = $180,000 Section 1231 gain. c. Section 291 recapture: $150,000 x 20% = $30,000; the remaining $150,000 ($180,000 - $30,000) of gain is Section 1231 gain. 25. Determination and Character of Gains and Losses Barbara sold two assets during year 5. How much and what kind of gain or loss does she have from each sale? a. On February 25 of year 5, she sold 200 shares of XYZ stock for $19,000. She bought that stock for $16,000 on February 23 of year 4. b. On July 20 of year 5, she sold an antique automobile for $30,000. She purchased the automobile for $31,000 on July 21 of year 4. Solution: a. $19,000 $16,000 = $3,000 long-term capital gain. b. $30,000 $31,000 = $1,000 short-term capital loss. 26. Section 1231 Recapture Barbara had the following Section 1231 gains and losses over the past four years:

8 Chapter 7: Property Dispositions 141 Year Section 1231 gain (loss) 1 $50,000 2 (45,000) 3 $20,000 4 $15,000 a. How will Barbara treat the $15,000 gain in year 4? b. Is there any unrecaptured Section 1231 loss remaining? Solution: a. The $15,000 of Section 1231 gain must be recaptured as ordinary income as Barbara deducted a $45,000 Section 1231 loss in year 2, only $20,000 of which was recaptured in year 3. b. There is $10,000 ($45,000 - $20,000 - $15,000) unrecaptured loss remaining after year Section 1245 Recapture Performance Industries sold three pieces of equipment on March 1, year 6. Data on these disposals are as follows: Machine Cost Date Acquired Depreciation Selling Price 1 $45,000 April 24, year 2 $35,000 $19,000 2 $105,000 May 2, year 1 $90,000 $24,000 3 $63,000 June 4, year 4 $12,000 $55,000 a. What is the amount and character of the gain or loss on each of these machines? b. How would your answer change if Performance had $6,000 of Section 1231 losses in year 3? Solution: a. Machine #1: $19,000 ($45,000 - $35,000) = $9,000 Section 1245 recapture. Machine #2: $24,000 ($105,000 $90,000) = $9,000 Section 1245 recapture. Machine #3: $55,000 ($63,000 - $12,000) = $4,000 Section 1245 recapture. b. The character of the gains would not change, because all of the gains must be included in ordinary income due to recapture. 28. Recapture The Angel Corporation acquired an office building for $600,000 in The corporation claimed $80,000 of cost recovery deductions before it sold the building for $700,000. a. What is the amount and type of gain or loss that Angel Corporation must recognize on the sale of the building? b. Would your answer change if Angel were a sole proprietorship? c. Would your answer change if Angel Corporation incurred $43,000 of Section 1231 losses in the prior year? Solution: a. $700,000 ($600,000 - $80,000) = $180,000 total gain. Only $80,000 of this gain is subject to Section 291 recapture, however, as that is the limit of Section 1245 recapture if that provision applied. Thus, the Section 291 recapture = 20% x $80,000 = $16,000. The corporation recognizes $16,000 of ordinary income due to Section 291 and the remaining $164,000 ($180,000 $16,000) is Section 1231 gain. b. If Angel were a sole proprietorship, there would be no Section 291 recapture.

9 142 Solutions Manual for Taxation for Decision Makers The entire $180,000 gain would be Section 1231 gain; however, the $80,000 unrecaptured Section 1250 gain would be subject to the 25% capital gains tax rate when included in the sole proprietor s tax return. c. If Angel Corporation has $43,000 of Section 1231 losses in the prior year, $43,000 of the $164,000 Section 1231 gain would be recaptured (under the lookback rules) and included in ordinary income (along with the $16,000 Section 291 recapture). Only the remaining $121,000 ($180,000 - $16,000 - $43,000) is Section 1231 gain. 29. Capital Gains and Losses Determine the amount of the capital gain or loss in each of the following transactions and state whether the gain or loss is long term or short term. a. 100 shares of Bilco stock bought for $8,000 on January 22 of year 3 and sold for $10,000 on January 22 of year 4. b. 20 acres of investment land bought for $8,000 on January 31 of year 3 and sold for $7,000 on February 2 of year 4. c. 150 shares of Dantron stock bought for $15,000 on April 1 of year 3 and sold for $17,000 on May 28 of year 5. Solution: a. $10,000 $8,000 = $2,000 short-term capital gain (held only one year). b. $7,000 - $8,000 = $1,000 long-term capital loss. c. $17,000 - $15,000 = $2,000 long-term capital gain. 30. Capital Asset Netting Determine the net capital gain or loss if the taxpayer has: a. a long-term capital gain of $500, a long-term capital loss of $300, a short-term capital gain of $1,900, and a short-term capital loss of $2,700? b. a long-term capital gain of $700, a long-term capital loss of $400, a short-term capital gain of $1,500, and a short-term capital loss of $1,100? Solution: a. $500 LTCG -$300 LTCL = $200 net long-term capital gain. $1,900 STCG - $2,700 STCL = $800 net short-term capital loss. $200 net LTCG - $800 net STCL = $600 net short-term capital loss. b. $700 LTCG $400 LTCL = $300 net long-term capital gain; $1,500 STCG - $1,100 STCL = $400 short-term capital gain No further netting is required as the short-and long-term netting both yield net gains. 31. Capital Asset Netting Bill had the following gains and losses on asset sales: $500 gain on stock held 11 months; $1,900 loss on gold coins held 2 years; $1,200 gain on antique toys held three years; and a $300 loss on investment land held six months. Determine Bill's net capital gain or loss and explain how it is treated for tax purposes. Solution: $500 gain is STCG; $1,900 loss is LTCL; $1,200 gain is LTCG; $300 loss is STCL. $500 STCG - $300 STCL = $200 net STCG; $1,200 LTCG - $1,900 LTCL = $700 net LTCL. The net $200 STCG and the net $700 LTCL are now netted and the final result is a $500 LTCL ($700 net LTCL - $200 net STCG). Bill can deduct the entire $500 LTCL against ordinary income, as it does not exceed the $3,000 maximum allowed as a capital loss deduction for individuals.

10 Chapter 7: Property Dispositions Capital Asset Netting Sharon has salary income of $68,000, a net short-term capital gain of $15,000, and a net long-term capital loss of $24,000. What is Sharon s adjusted gross income if she has no other income items? Solution: Netting the $15,000 STCG with the $24,000 LTCL results in a $9,000 LTCL. Sharon can deduct only $3,000 of this capital loss in the current year; thus, her adjusted gross income is $65,000 ($68,000 - $3,000). 33. Capital Asset Netting and Loss Carryover Determine the amount and type of capital loss deduction, the carryover to the next year, and the taxable income before any other deductions in each case for an individual taxpayer: Ordinary Short-term Short-term Long-term Long-term Taxable Income Capital Gain Capital Loss Capital Gain Capital Loss a. $15,000 0 $2,600 0 $2,800 b. $12,000 $500 $300 $200 $2,300 c. $13,000 0 $3,500 $11,800 $1,600 Solution: a. There are $5,400 ($2,600 + $2,800) of capital losses in total; the $2,600 STCL is deducted in full and $400 of the $2,800 LTCL is deducted. The remaining $2,400 LTCL may be carried forward. Taxable income is $12,000 ($15,000 - $3,000). b. There is a net $200 STCG ($500 - $300) and a net $2,100 LTCL ($200 - $2,300). Netting these results in a $1,900 LTCL ($2,100 - $200) which may be deducted in full. There is no carryover. Taxable income is $10,100 ($12,000 - $1,900). c. There is a net $10,200 LTCG ($11,800 $1,600); this is netted with the $3,500 STCL resulting in a $6,700 LTCG ($10,200 - $3,500). The taxpayer includes the $6,700 LTCG in taxable income but it will be subject to one of the alternative capital gains tax rates based on the type of gain. Taxable income is $19,700 ($13,000 + $6,700) Capital Asset Netting and Loss Carryover Chester provides you with the following income information for years 1 and 2, exclusive of capital loss carryovers: Short-term Capital Gain Short-term Capital Loss Long-term Capital Gain Long-term Capital Loss Year 1 0 $2,400 $400 $3,500 Year 2 $500 $700 $900 $1,000 Determine the amount and type of capital loss deduction each year, if any, and the carryover to the following year. Solution: In year 1, Chester has a $3,100 net LTCL ($3,500 - $400) and a $2,400 STCL. He first deducts the $2,400 STCL and then deducts $600 of the net LTCL (for a total deduction of $3,000) from ordinary income. He has a $2,500 STCL ($3,100 - $600) carryover year 2. In year 2, he has a $2,700 net STCL ($500 gain - $700 loss - $2,500 loss carryover); he also has a net $100 LTCL ($1,000 - $900) for total capital losses of

11 144 Solutions Manual for Taxation for Decision Makers $2,800 ($2,700 + $100), which he can deduct entirely in year 2 from ordinary income. Thus, there is no carryover to year Capital Asset and Section 1231 Netting An individual taxpayer has the following gains and losses from property transactions. What is the effect on the taxpayer's taxable income? $ 4,000 Long-term capital gain 7,000 Long-term capital loss 10,000 Section 1231 gain 6,000 Section 1231 loss 3,000 Short-term capital gain 6,000 Short-term capital loss Solution: Step 1. Net the $10,000 Section 1231 gain with the $6,000 Section 1231 loss; the result is a net Section 1231 gain of $4,000. Step 2. Net the $4,000 Section 1231 gain with the long-term capital gains and losses; the result is a net $1,000 long-term capital gain ($4,000 + $4,000 - $7,000). Step 3. The $3,000 short-term capital gain is netted with the $6,000 short-term capital loss; the result is a net $3,000 short-term capital loss. Step 4. The $3,000 STCL and $1,000 LTCG are netted; the result is a $2,000 STCL. This loss is deducted from the taxpayer s other income, reducing taxable income by $2, Multiple Property Transactions Juno Corporation had ordinary taxable income of $127,000 in the current year before consideration of any of the following property transactions. It sold two blocks of stock held for investment. One yielded a short-term capital gain of $8,000 and the other a long-term capital loss of $14,000. In addition, Juno sold four pieces of machinery for $30,000. It purchased the machines three years ago for $80,000 and claimed $35,000 of depreciation deductions. Juno also sold a building for $400,000 that it had purchased in 1990 for $390,000. The depreciation deductions up to the date of sale for the building were $108,000. Determine Juno Corporation s taxable income for the current year. Solution: Juno s taxable income is $224,000. The machines and building are Section 1231 properties. Machines: $30,000 ($80,000 $35,000) = $15,000 Section 1231 loss. Building: $400,000 ($390,000 - $108,000) = $118,000 total gain. Because Juno is a corporation, Section 291 recapture must be determined: $108,000 x 20% = $21,600 Section 291 recapture income. Total gain of $118,000 - $21,600 Section 291 recapture = $96,400 Section 1231 gain. (Section 291 applies to only $108,000 of the gain, the amount of prior depreciation deductions.) This Section 1231 gain is netted with the $15,000 Section 1231 loss on the machines for a net Section 1231 gain of $81,400 ($96,400 $15,000) and is treated as a long-term capital gain. Capital gains: The $81,400 Section 1231 gain is netted with the $14,000 long-term capital loss for a net $67,400 LTCG.

12 Chapter 7: Property Dispositions 145 Juno s taxable income: $127,000 ordinary income + $21,600 ordinary income due to Section 291 recapture + $67,400 long-term capital gain + $8,000 short-term capital gain = $224, Qualified Small Business Stock On October 1, 1996, Daniel bought some qualified small business stock for $2,000,000. In the current year, he sells that stock for $25,000,000. How much and what kind of gain or loss does he have? Solution: Daniel has a gain of $23,000,000. He can exclude one-half of his gain subject to the limitation of the greater of $10,000,000 or 10 times his stock basis. One-half the gain is $11,500,000. Although this is greater than $10,000,000, it is less than 10 times the stock basis of $20,000,000. Thus, his exclusion is $11,500,000 and he will have a taxable long-term capital gain on the remaining $11,500,000 gain. 38. Section 1244 Stock Vanessa bought 2,000 shares of Barbco stock when the company was formed for $107,000. The company had $900,000 of total capital upon formation; thus, it qualified as Section 1244 stock. Vanessa sold the stock three years later for $3,000. If Vanessa is single, how much and what kind of gain or loss does she have? Solution: Vanessa has a total loss on the Section 1244 stock of $104,000 ($3,000 $107,000). She can treat $50,000 of the loss as an ordinary loss, deductible from ordinary income. The remaining $54,000 loss is a long-term capital loss. She can deduct $3,000 this year as a capital loss giving her a total deduction of $53,000 in the current year. The remaining $51,000 of the long-term capital loss can only be carried forward and deducted at a rate of $3,000 per year after offsetting other net capital gains in future years. 39. Mixed-Use Asset Wilma did secretarial work out of her home. She purchased her own computer that she used for 2,250 hours during the year; her children, however, also used the computer for their homework for a total of 250 hours. She paid $4,000 for the computer and had claimed $2,200 of depreciation on it when she sold it for $1,100. What is the amount and type of her gain or loss realized on the sale of the computer? Solution: This is a mixed-use asset and the business and personal portions must be separated. Business-use portion: 2,250/(2, ) = 90% business use. Purchase price = 90% x $4,000 = $3,600. Adjusted basis at sale = $3,600 - $2,200 depreciation = $1,400. (90% x $1,100) - $1,400 = $410 Section 1231 loss on sale of business portion. Personal-use portion: 10% personal use: (10% x $1,100) (10% x $4,000) = $290 nondeductible personal loss on this portion of the computer. 40. Sale of Personal Residence Tina and Tony, a married couple, have owned and lived in their house for 20 years. They want to sell it now and move to a smaller place. They purchased the home for $56,000 and

13 146 Solutions Manual for Taxation for Decision Makers put $30,000 of improvements into the home over the years. If they sell the house for $387,000, what is their realized and recognized gain? Solution: Their realized gain = $301,000 [$387,000 ($56,000 + $30,000)]. Under Section 121 they can exclude up to $500,000 of gain from taxation; thus, they have no recognized gain. 41. Sale of Personal Residence Carlotta moved into a smaller home nine months ago, after her husband died. She sold the home that they had lived in together for fifteen years and elected Section 121 so she would not have to recognize the $150,000 of gain on that home. She then purchased the smaller home for $210,000. She is unhappy in the neighborhood after living there for 10 months and wants to move again. If she sells the home for $235,000, what is her realized and recognized gain? How would your answer change if Carlotta were forced to move into a nursing home because of her health? Solution: Carlotta s realized and recognized gain is $25,000 ($235,000 - $210,000). She is permitted to elect Section 121 only once every two years except in special circumstances that do not apply if she is only moving for her convenience. If Carlotta moves into a nursing home because of her health and that is the reason she sells the home, she may exclude a portion of the gain based on the time lived in the second home. She would be able to exclude up to 10/24 x $250,000 or $104,167 of gain. Thus, she would not have to recognize any of her $25,000 realized gain. 42. Related Party Transaction Marilyn owned 500 shares of Ibis stock that she purchased several years ago for $25,000. This year, she sold 200 of the shares to her brother for $7,000, its fair market value, when she wanted money for some plastic surgery. Determine Marilyn s realized and recognized gain or loss on the sale and her basis in the 300 shares remaining. Determine her brother s basis in the purchased stock and his realized and recognized gain or loss if he sells the shares for $12,000 the following year. Solution: Marilyn s basis in the shares sold = $10,000 [(200/500) $25,000]. She has a realized loss of $3,000 ($7,000 - $10,000) but she can recognize none of it because the sale was to her brother. Her basis in her remaining 300 shares is $15,000 ($25,000 - $10,000 sold). Her brother s basis in the shares he purchased is the purchase price of $7,000. When he sells the stock for $12,000, he has a $5,000 gain ($12,000 - $7,000). He only has to recognize $2,000 of the gain, however, as he can offset his sister s unrecognized $3,000 loss against his $5,000 gain. 43. Related Party Transaction William bought 1,000 shares of Bevo stock three years ago for $100 per share. This year he has a $20,000 short-term capital gain from the sale of his shares of an initial public offering of GBD Company stock. To offset the gain, William sells his shares of Bevo to his grandfather for $80,000, its current fair market value. The next month, William s grandfather sells the stock for $85,000 to his neighbor. Determine William s realized and recognized gain or loss on the sale of Bevo stock. Determine the grandfather s basis in the stock purchased

14 Chapter 7: Property Dispositions 147 from William and his realized and recognized gain or loss when he sells the stock to his neighbor. Solution: William s realized loss on the sale is $20,000 [$80,000 - ($100 x 1,000)]. William cannot recognize any of the loss because the sale was to his grandfather. The grandfather takes the $80,000 cost as his basis in the stock purchased. When the grandfather sells the stock for a $5,000 gain ($85,000 - $80,000 basis), he recognizes none of it. He offsets the $5,000 gain with $5,000 of William s unrecognized loss. The remaining $15,000 loss on William s stock is simply lost and provides no one any tax benefit. 44. Comprehensive Problem for Chapters 6 and 7 Sam Johnson started a small machine shop, Machines, Inc., in his garage and incorporated it in March of 2001 as a calendar-year corporation. At that time, he began using his personal computer and tools solely for the business as part of his contribution to the corporation. The computer cost $2,700 but had a fair market value of only $900 at conversion and the tools, which had cost $1,500, were valued at $1,100. During 2001, Machines, Inc. purchased two machines: Machine A, purchased on May 2, cost $24,000; Machine B, purchased on June 5, cost $40,000. The corporation expensed Machine A under Section 179. The computer, tools and Machine B were depreciated using accelerated MACRS depreciation. The corporation did not take any depreciation on the garage nor did Sam charge the business rent because the business moved to a building the business purchased for $125,000 on January 5, On January 20, 2002, Machines purchased $4,000 of office furniture and on July 7, it purchased Machine C for $48,000. It depreciated these assets under MACRS but did not use either Section 179 expensing or bonus depreciation. Machines acquired no new assets in On February 4, 2004, Machines bought a new computer system for $5,100. It sold the old computer the same day for $300. On March 15, it sold Machine A for $6,000 and purchased a more versatile machine for $58,000. On August 15, Machines sold bonds it had purchased with $9,800 of the cash Sam had originally contributed to the corporation for $10,400 to pay creditors. The business takes the maximum allowable depreciation deduction on assets purchased in 2004 but does not use Section 179 expensing. a. Determine Machines, Inc.'s depreciation expense deductions for 2001 through b. Determine the realized and recognized gains or losses on the property transactions in Solution: a. Depreciation deductions for years 2001 through 2004: Asset Life Basis Computer 5 yrs. $ 900 $ 180 $ 288 $ 173 $ 52 Tools 5 yrs. 1, Machine A 7 yrs. 24,000 24,000 Machine B 7 yrs. 40,000 5,716 9,796 6,996 4,996 Building 39 yrs. 125,000 3,076 3,205 3,205 Off. Furniture 7 yrs. 4, Machine C 7 yrs. 48,000 6,859 11,755 8,395 New Computer 5 yrs. 5,100 3,060 New Machine 7 yrs. 58,000 33,144 Total $30,116 $20,943 $23,320 $53,679

15 148 Solutions Manual for Taxation for Decision Makers Depreciation for all personalty is calculated using the half-year averaging convention. A half-year s depreciation is taken in the year of disposition for the computer. In 2004, 50 percent bonus depreciation is claimed for the new computer and new machine before computing regular MACRS depreciation. b. $6,000 Section 1245 ordinary income is recognized on the disposal of Machine A and $600 long-term capital gain is recognized on the bonds. No gain or loss is recognized on the disposition of the computer. The computer s basis at disposition is $207 ($900 - $693 depreciation) for loss and $2,007 ($2,700 cost - $693 depreciation) for gain. Because it is sold for a price ($300) between basis for gain and basis for loss, the basis is set equal to the selling price resulting in no recognized gain or loss. Machine A s basis was reduced to zero by Section 179 expensing. Therefore, the entire $6,000 sales proceeds will be recaptured as ordinary income under Section Bonds: $10,400 - $9,800 basis = $600 long-term capital gain The realized gains on the machine and the bonds are recognized. Think Outside the Text These questions require answers that are beyond the material that is covered in this chapter. 45. Personal Asset Converted to Business Use Beth had been using an automobile for personal purposes. In year 2, when she started a business, she began to use the car exclusively for this business at a time when it was worth $12,000. She had purchased the auto in year 1 for $16,000. a. Assuming that she takes $3,000 of depreciation on the auto and then sells it, how much gain or loss does she have and what is its character if the amount realized is $8,000? b. How would your answer change if she realizes $14,000? Solution: a. When personal property is converted to business use and then depreciated, dual depreciation schedules should be kept one based on the asset s original cost, the other on the fair market value, if lower because a different basis may be used to determine gain than for loss. Her adjusted basis for loss is $9,000 (the $12,000 fair market value at conversion less the $3,000 depreciation). When the auto is sold for $8,000, she has a $1,000 Section 1231 loss ($8,000 - $9,000 basis). b. Her adjusted basis for gain is $13,000 ($16,000 purchase price - $3,000 depreciation). If the auto is sold for $14,000, she would have $1,000 gain ($14,000 - $13,000 basis). The gain would be taxed as ordinary income due to Section 1245 recapture. 46. Gains and Losses on Stock Transactions Mary had the following transactions involving BMN stock:

16 Chapter 7: Property Dispositions 149 Shares Shares Price Total Date Purchased Sold Per Share Price July 2, year $5.00 $ 750 April 9, year ,500 May 4, year ,400 November 5, year ,300 April 12, year a. Determine Mary s gain or loss on each sale, assuming the shares are not specifically identified. b. Determine Mary s gain or loss on the second sale if she specifically identifies the shares as coming from the November 5 year 3 purchase. Solution: a. If specific identification is not used, the shares sold are identified using the firstin, first-out method to determine which shares are sold. May 4, year 3 sale: $1,400 [(150 x $5) + (50 x $6)] = $350 gain. April 12, year 4 sale: $600 (150 x $6) = $300 loss b. $600 (150 x 6.50) = $375 loss. 47. Capital Asset Netting If the netting process for capital gains really has no impact on corporations, why do you think it still remains as part of the tax law? Suggested Solution: The most likely reason that the netting process remains for corporations is that at some time in the future Congress could reinstate some form of preferential treatment for corporate capital gains. Preferential treatment for corporations capital gains was dropped when corporate tax rates were reduced significantly; if these rates are increased in the future, preferential treatment for capital gains could easily be reintroduced. 48. Multiple Capital Gain Rates Why do you think Congress requires capital assets held by individuals to be taxed at three different maximum tax rates? Do you believe Congress is justified by these reasons in adding this layer of complexity to determining the tax on capital gains? Suggested Solution: Congress generally encourages persons to invest in capital assets and has had preferential tax treatment for capital assets for many years. The higher rates on certain capital assets reduce the value of the preferential rates and raises additional revenue for the treasury. Possible reasons collectibles were chosen for the higher rate is that they are not income producing assets except through appreciation and many of these assets provide some degree of personal enjoyment to their owners. The lower rate for investments in productive assets (The proceeds of stock and bond investments can be invested in plant and equipment.) encourages that form of investing rather than investing purely for appreciation. The 25 percent rate applies only to realty on which depreciation has previously been taken. As depreciation deductions may have reduced ordinary income taxed at rates even higher than 25 percent, a higher rate for the gain on the sale takes the place of reinstating the complex Section 1250 recapture rules.

17 150 Solutions Manual for Taxation for Decision Makers The general feeling of the majority of taxpayers and tax professionals is that our tax laws are far too complex in general. One only has to try to complete the alternative tax calculation for capital gains to recognize the complexity that this three-tier treatment introduced into the tax laws. Whether it is too complex is a value judgment. 49. Personal Residence Gain Exclusion What are the policy reasons for allowing a portion of the gain on a personal residence to escape taxation? Suggested Solution: Just as the interest rate deduction for mortgage interest encourages home ownership, the ability to invest in a personal residence and exclude gain on a future sale encourages persons to make this type of investment. In addition, most persons who do sell a home purchase another residence. Taxing gain on the sale of the first residence would reduce the taxpayer s ability to purchase a comparable residence at the same price at which the old one was sold due to the tax payment. The old Section 1031 gain deferral required the taxpayer to purchase a more expensive residence to exclude any gain. This encouraged taxpayers to move up. Having to pay taxes defeats encouraging taxpayers to move up. The exemption also allows older persons who wish or need to move out of their home and into a more comfortable environment to do so without tax penalty. Many older persons primary investment is in their home and their equity is looked at as their retirement nest egg. Homes in general are purchased with after-tax income (although mortgage interest on most homes is deductible); thus, this allows the gain to be exempt from tax similar to allowing an exemption for retirement funds set aside with after-tax income (for example, the Roth IRA). Identify the Issues Identify the issues or problems suggested by the following situations. State each issue as a question. 50. Worthless Stock Kwan Lu bought 100 shares of Duchco stock on July 25, year 3 for $1,000. The company declared bankruptcy on July 8 of year 5, and his stock became worthless. Solution: What is Kwan Lu s loss on the stock and how and when will he be able to deduct it? 51. Character of Gain The Gallagher Farms has been in business for a number of years. During the peak planting and harvesting season, it hired a number of temporary workers. To house the temporary workers, it built three buildings that were essentially dormitories that had bathing and sleeping facilities. It provided meals in a central kitchen with an attached dining area. The dormitories were built in 1983 and depreciated under ACRS accelerated methods. Recently, the state declared that the buildings were inadequate for the workers. Gallagher Farms has decided to sell the buildings and the portion of the land on which they sit. It expects to have a $100,000 gain on the land and a $75,000 gain on the sale of the buildings. Solution: What will be Gallagher Farms amount and character of the gains realized on the sale of the dormitories and the land? How will these be taxed?

18 Chapter 7: Property Dispositions Asset Sales Martco, a manufacturer and seller of eyeglasses and contact lenses, purchased all of the stock of Fetco, a manufacturer of hearing aids. Management of Martco quickly had second thoughts about keeping Fetco in business and liquidated the company. Martco was unsuccessful selling the hearing aids to customers, although a few small lots were sold to a several retail outlets before the balance was sold to one distributor at $100,000 profit. Solution: How will Martco be taxed on the sales of the various hearing aids: those sold to customers, the first lots sold to retail outlets, and the second bulk sale to a distributor? 53. Sale of Personal Residence Geralyn and Marco sold their home and moved into a smaller home. They used their Section 121 election to exclude their $20,000 gain on the sale of the larger home. Six months after they moved into the smaller home, Geralyn died. Two months later Marco had a stroke and was in the hospital for one month and in a rehabilitation center for another seven months. At the end of that time, Marco moved back to his home. Three months later, he put the home up for sale and sold it within one month at a gain of $185,000 and moved out. Solution: What is the length of time Marco is considered to have occupied the smaller home? How will he treat the gain that he realizes on the sale of this home? Develop Research Skills Solutions to research problems are included in the Instructor s Manual. Search the Internet 57. Capital Gains Rates Locate at least one article that comments on the complexity of the capital gains laws for individuals, particularly the varying rates that apply. Summarize the comments and provide a citation for your article. Solution: Articles and citations will vary. 58. Capital Gain Schedules Locate the Schedule D and the accompanying instructions for both an individual and a corporation on the IRS Web site, Compare the length of the two forms and the instructions as they appear on the Web site. Summarize your findings. Solution: The Schedule D that accompanies an individual s Form 1040 is 2 pages long. The instructions for this schedule are 11 pages long. The Schedule D that accompanies a corporation s Form 1120 is 1 page long and it is packaged in 4 pages with 3 pages of instructions. The instructions and form are combined unlike the separate form and instructions for individuals. 59. Form 4797 Go to the IRS Web site ( and print Form 4797: Sales of Business Property. Complete Form 4797 for the following asset sales of machinery on December 20, year 6:

19 152 Solutions Manual for Taxation for Decision Makers Asset Cost Date Acquired Cost Recovery Selling Price A $45,000 April 24, year 2 $25,000 $25,000 B $75,000 March 5, year 1 $67,000 $18,000 C $63,000 June 18, year 4 $21,000 $51,000 D $87,000 Nov.10, year 5 $18,000 $93,000 Solution: A filled-in Form 4797 is included at the end of the solutions for this chapter. 60. Schedule D for Form 1040 Go to the IRS Web site ( and print the Schedule D for Form Compute the net effect of the following asset sales on Gineen Tibeau s taxable income using Schedule D: a. 100 shares of ABC stock; original cost = $4,000; selling price = $6,000 b. $5,000 in CDF bonds; original cost = $5,100; selling price = $4,950 c. Original Dali drawing; cost = $23,000; selling price = $31,000 d. 200 shares of GHI stock; original cost = $8,000; selling price = $6,400 e. 5,000 shares of XYZ stock; original cost = $20,000; selling price = $12,000 All assets except the CDF bonds have been held for more than one year. Solution: A filled-in Schedule D is included at the end of the solutions for this chapter. 61. Sale of Personal Residence Using the IRS Web site, locate the information and instructions on reporting the sale of a personal residence. Write a summary of what the taxpayer needs to do to elect Section 121 gain exclusion and how the sale is reported? Solution: These instructions can be found in two places. The Schedule D for individuals contains the basic instructions for determining any recognized gain and filing instructions. Publication 523 is a more extensive publication that provides the same information. If the taxpayer s entire realized gain on the sale of a personal residence is excluded from taxation, then the taxpayer does not report any information regarding the sale on his or her tax return. If the taxpayer has gain that is not excluded or elects not to exclude the gain, the gain is reported on Schedule D. Develop Planning Skills 62. Selling Decision Natalie expects to be in the 35 percent tax bracket with respect to her ordinary income for this year. So far this year she has a $5,000 short-term capital loss. As of June 1, she is holding 1,000 shares of Dritco stock purchased on June 15 of last year for $15,000. The market value as of May 21 is $27,000. Lately the value of the stock has been decreasing and Natalie feels it may go down by $1,000 or so in the next month and probably stabilize thereafter. Advise Natalie as to the various courses of action she might take. Solution: If Natalie elects to hold on to her Dritco stock, she will only be able to deduct $3,000 of her $5,000 capital loss. This will reduce her taxes by $1,050 ($3,000 x 35%). Currently, she has a $12,000 unrealized gain on her Dritco stock, which is equal to a gain of $12.00 per share. She has three potential courses of action: a.

20 Chapter 7: Property Dispositions 153 Sell all the stock now; b. Sell all the stock after June 15. c. Sell enough stock now to allow her to offset all $3,000 of her loss and sell the remaining stock next year. a. Sell all now: $27,000 - $15,000 = $12,000 short-term capital gain; the tax on the net gain of $7,000 net STCG ($12,000 STCG - $5,000 STCL) is $2,450 ($7,000 x 35%). Her net cash flow is $24,550 ($27,000 - $2,450). b. Sell all after June 15: $26,000 - $15,000 = $11,000 long-term capital gain; tax on the net gain of $6,000 ($11,000 LTCG - $5,000 STCL) is $900 ($6,000 x 15%). Her net cash flow is $25,100 ($26,000 - $900). c. Sell some stock now: Selling 167 shares now yields a gain of $2,004 [167 x ($27 - $15)]. She will have a net short-term capital loss of $2, 996 ($5,000 STCL - $2,004 STCG) that will reduce her taxes by $1,049 ($2,996 x.35). If she sells the remaining shares next year, she will have a $9,163 gain [833 x ($26 - $15)] which will result in a tax of $1,374 ($9,163 x15%). Her cash flow without considering the time value of the money would be $4,509 (167 x $27) + $1,049 + $21,658 (833 x $26) - $1,374 = $25,842. If, however, we use a 6 percent discount factor for the sale and taxes in the next year, the net cash flow is reduced to $24,686 [$4,509 + $1, ($21,658 - $1,374)]. Considering the time value of money, Natalie s best decision would be to sell all of the stock sometime after June 15 to take advantage of the long-term capital gain rates. Alternatively, if her discount rate is much lower than 6 percent, the last alternative could be used, but any additional drop is the stock price could alter that. 63. Timing of Sale George has a short-term capital loss of $42,000 this year. His brother wants to buy a piece of land that George has owned as an investment for $60,000. The land s basis is only $20,000. George also knows that the land is appreciating in value every year, and he is not sure he should sell it now. He thinks if he holds on to the land for three more years, he will be able to sell it for $66,000 net of expenses. If George s combined state and federal tax rate is 40 percent and he uses a 6 percent discount rate for all decisions, should he sell the land now? Solution: If he sells the land now, he will have a long-term capital gain of $40,000. This will offset all but $2,000 of the short-term capital loss. He will be able to deduct this remaining loss and reduce other taxes by $800 ($2,000 x 40%). His total cash flow is $60,800 ($60,000 + $800). If he waits three more years, he will only be able to deduct $3,000 of his shortterm capital loss in the current and next two succeeding years. This will reduce his taxes in each of those years by $1,200 ($3,000 x 40%). In the 4th year, he will have a $46,000 ($66,000 - $20,000) long-term capital gain on the sale. His remaining short-term capital loss of $33,000 ($42,000 - $9,000) will offset all but $13,000 of this gain. He will pay a federal capital gains tax of $1,950 ($13,000 x 15% assuming the 15% rate remains in effect until then) plus a state tax on this gain reducing his net proceeds to no more than $64,050 ($66,000 - $1,950). The net present value of the proceeds over the current and the next three years is: $1,200 (current tax savings) + $1,200 (.943) + $1,200 (.89) + $64,050 (.84) = $1,200 + $1,132 + $1,068 + $53,802 = $57,202 less the present value of any state tax.