1. Chapter 16
Property Transactions:
Capital Gains and Losses
Individual Income Taxes
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1

2. The Big Picture (slide 1 of 3)
• Maurice has come to you for tax advice
regarding his investments.
– He inherited $500,000 from his Uncle Joe and,
following the advice of a financial adviser, made
the following investments 9 months ago.
• $200,000 in the stock of Purple, a publicly
held bank that does not pay dividends.
– At one time, the stock had appreciated to
$300,000, but now it is worth only $210,000.
• Maurice is considering unloading this stock.
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3. The Big Picture (slide 2 of 3)
• $50,000 for a 50% interest in a patent that Kevin, an
unemployed inventor, had obtained for a special battery he had
developed to power ‘‘green’’ cars.
– To date, Kevin has been unable to market the battery to an auto
manufacturer or supplier.
• $50,000 in tax-exempt bonds.
– The interest rate is only 3%.
– Maurice is considering moving this money into taxable bonds that pay
3.5%.
• $100,000 to purchase a franchise from Orange, Inc.
• $100,000 for a 10% limited partnership interest in a real estate
development.
– Lots in the development are selling well.
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4. The Big Picture (slide 3 of 3)
• Maurice read an article that talked about the
beneficial tax rates for capital assets and dividends.
– He really liked the part about ‘‘costless’’ capital gains,
although he did not understand it.
• Maurice has retained his job as a toll booth operator
at the municipal airport.
– His annual compensation is $35,000.
• Respond to Maurice’s inquiries.
– Read the chapter and formulate your response.
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5. Taxation of Capital
Gains and Losses
• Capital gains and losses must be separated
from other types of gains and losses for two
reasons:
– Long-term capital gains may be taxed at a lower
rate than ordinary gains
– A net capital loss is only deductible up to $3,000
per year
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6. Proper Classification of
Gains and Losses
• Depends on three characteristics:
– The tax status of the property
• Capital asset, §1231 asset, or ordinary asset
– The manner of the property’s disposition
• By sale, exchange, casualty, theft, or condemnation
– The holding period of the property
• Short term and long term
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7. Capital Assets
(slide 1 of 6)
• §1221 defines capital assets as everything
except:
– Inventory (stock in trade)
– Notes and accounts receivables acquired from the
sale of inventory or performance of services
– Realty and depreciable property used in a trade or
business (§1231 assets)
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8. Capital Assets
(slide 2 of 6)
• §1221 defines capital assets as everything except
(cont’d):
– Certain copyrights; literary, musical, or artistic
compositions; or letters, memoranda, or similar property
• Taxpayers may elect to treat a sale or exchange of certain musical
compositions or copyrights in musical works as the disposition of a
capital asset
– Certain publications of U.S. government
– Supplies of a type regularly used or consumed in the
ordinary course of a business
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9. Capital Assets
(slide 3 of 6)
• Thus, capital assets usually include:
– Assets held for investment (e.g., stocks, bonds,
land)
– Personal use assets (e.g., residence, car)
– Miscellaneous assets selected by Congress
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10. Capital Assets
(slide 4 of 6)
• Dealers in securities
– In general, securities are the inventory of securities
dealers, thus ordinary assets
– However, a dealer can identify securities as an
investment and receive capital gain treatment
• Clear identification must be made on the day of
acquisition
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11. Capital Assets
(slide 5 of 6)
• Real property subdivided for sale
– Taxpayer may receive capital gain treatment on the
subdivision of real estate if the following requirements are
met:
• Taxpayer is not a corporation
• Taxpayer is not a real estate dealer
• No substantial improvements made to the lots
• Taxpayer held the lots for at least 5 years
• Capital gain treatment occurs until the year in which the 6th lot is
sold
– Then up to 5% of the revenue from lot sales is potential ordinary
income
– That potential ordinary income is offset by any selling expenses from
the lot sales
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12. Capital Assets
(slide 6 of 6)
• Nonbusiness bad debts
– A nonbusiness bad debt is treated as a short-term
capital loss in the year it becomes completely
worthless
• Even if outstanding for more than one year
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13. Sale or Exchange
• Recognition of capital gains and losses
generally requires a sale or exchange of assets
• Sale or exchange is not defined in the Code
• There are some exceptions to the sale or
exchange requirement
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14. Sale or Exchange–Worthless Securities and
§ 1244 Stock (slide 1 of 2)
• A security that becomes worthless creates a
deductible capital loss without being sold or
exchanged
– The Code sets an artificial sale date for the securities on the
last day of the year in which worthlessness occurs
• Section 1244 allows an ordinary deduction on
disposition of stock at a loss
– The stock must be that of a small business company
– The ordinary deduction is limited to $50,000 ($100,000 for
married individuals filing jointly) per year
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15. Sale or Exchange–Worthless Securities
(slide 2 of 2)
• Worthless securities example:
– Calendar year taxpayer purchased stock on
December 5, 2011
– The stock becomes worthless on April 5, 2012
– The loss is deemed to have occurred on December
31, 2012
• The result is a long-term capital loss
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16. Sale or Exchange
Retirement of Corporate Obligations
• Collection of the redemption value of
corporate obligations (e.g., bonds payable) is
treated as a sale or exchange and may result in
a capital gain or loss
– OID amortization increases basis and reduces gain
on disposition or retirement
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17. Sale or Exchange–Options
(slide 1 of 2)
• For the grantee of the option, if the property subject
to the option is (or would be) a capital asset in the
hands of the grantee
– Sale of an option results in capital gain or loss
– Lapse of an option is considered a sale or exchange
resulting in a capital loss
• For the grantor of an option, the lapse creates
– Short-term capital gain, if the option was on stocks,
securities, commodities or commodity futures
– Otherwise, ordinary income
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18. Sale or Exchange–Options
(slide 2 of 2)
• Exercise of an option by a grantee
– Increases the gain (or reduces the loss) to the
grantor from the sale of the property
– Gain is ordinary or capital depending on the tax
status of the property
• Grantee adds the cost of the option to the basis
of the property acquired
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19. Sale or Exchange–Patents
• When all substantial rights to a patent are
transferred by a holder to another, the transfer
produces long-term capital gain or loss
– The holder of a patent must be an individual,
usually the creator, or an individual who purchases
the patent from the creator before the patented
invention is reduced to practice
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20. The Big Picture - Example 14
Patents (slide 1 of 2)
• Return to the facts of The Big Picture on p. 16-1.
• Kevin transfers his 50% rights in the battery
patent to the Green Battery Co.
– In exchange, he receives $1 million plus $.50 for
each battery sold.
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21. The Big Picture - Example 14
Patents (slide 2 of 2)
• Assuming Kevin has transferred all substantial rights,
Kevin automatically has a long-term capital gain.
– Both his share of the $1 million lump-sum payment and the
$.50 per battery royalty qualify (less his basis in the
patent).
– Kevin also had an automatic long-term capital gain when
he sold 50% of his rights in the patent to Maurice.
• Whether Maurice gets long-term capital gain
treatment on the transfer to Green Battery will depend
on whether he is a holder (see the discussion below in
Example 15).
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22. The Big Picture - Example 15
Holder Of A Patent (slide 1 of 2)
• Return to the facts of The Big Picture on p. 16-1 and
continuing with the facts of Example 14
• Kevin is clearly a holder of the patent
– He is the inventor and was not an employee when
he invented the battery.
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23. The Big Picture - Example 15
Holder Of A Patent (slide 2 of 2)
• When Maurice purchased a 50% interest in the patent, he
became a holder if the patent had not yet been reduced to
practice.
– Since the patent was not being manufactured at the time of the
purchase, it had not been reduced to practice.
• Consequently, Maurice is also a holder.
– He has an automatic long-term capital gain or loss if he transfers his
50% interest to Green Battery Co.
• Maurice’s basis for his share of the patent is $50,000, and his
share of the proceeds is $1 million plus $.50 for each battery
sold.
• Thus, Maurice has a long-term capital gain even though he has
not held his interest in the patent for more than one year.
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24. Sale or Exchange–Franchises, Trademarks, and
Trade Names (slide 1 of 3)
• The licensing of franchises, trade names,
trademarks, and other intangibles is generally
not considered a sale or exchange of a capital
asset
– Therefore, ordinary income results to transferor
• Exception: Capital gain (loss) may result if the
transferor does not retain any significant power, right,
or continuing interest
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25. Sale or Exchange–Franchises, Trademarks, and
Trade Names (slide 2 of 3)
• Significant powers, rights, or continuing
interests include:
– Control over assignment
– Quality of products and services
– Sale or advertising of other products or services
– The right to require that substantially all supplies
and equipment be purchased from the transferor
– The right to terminate the franchise at will, and
– The right to substantial contingent payments
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26. Sale or Exchange–Franchises, Trademarks, and
Trade Names (slide 3 of 3)
• Noncontingent payments are ordinary income
to the transferor
– The franchisee capitalizes the payments and
amortizes them over 15 years
• Contingent payments are ordinary income for
the franchisor and an ordinary deduction for
the franchisee
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27. The Big Picture - Example 16
Sale of Franchise
• Return to the facts of The Big Picture on p. 16-1
• Maurice sells for $210,000 to Mauve, Inc., the
franchise purchased from Orange, Inc., nine months
ago.
– The $210,000 received by Maurice is not contingent, and
all significant powers, rights, and continuing interests are
transferred.
– The $110,000 gain ($210,000 proceeds − $100,000
adjusted basis) is a short-term capital gain because Maurice
has held the franchise for only nine months.
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28. Sale or Exchange
Lease Cancellation Payments
• Lessee treatment
– Treated as received in exchange for underlying leased
property
• Capital gain results if asset leased was a capital asset (e.g., personal
use )
• Ordinary income results if asset leased was an ordinary asset (e.g.,
used in lessee’s business and lease has existed for one year or less
when canceled)
• Lease could be a § 1231 asset if the property is used in lessee’s
trade or business and the lease has existed for > a year when it is
canceled
• Lessor treatment
– Payments received are ordinary income (rents)
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29. Holding Period
(slide 1 of 3)
• Short-term
– Asset held for 1 year or less
• Long-term
– Asset held for more than 1 year
• Holding period starts on the day after the
property is acquired and includes the day of
disposition
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30. Holding Period
(slide 2 of 3)
• Nontaxable Exchanges
– Holding period of property received includes holding period of former
asset if a capital or §1231 asset
• Transactions involving a carryover basis
– Former owner’s holding period tacks on to present owner’s holding
period if a nontaxable transaction and basis carries over
• Certain disallowed loss transactions
– Under several Code provisions, realized losses are disallowed.
– When a loss is disallowed, there is no carryover of holding period.
• e.g., Related party losses, sale or exchange of personal use assets
• Inherited property is always treated as long term no matter
how long it is held by the heir
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31. Holding Period
(slide 3 of 3)
• Short sales
– Taxpayer sells borrowed securities and then repays the
lender with substantially identical securities
– Gain or loss is not recognized until the short sale is closed
– Generally, the holding period for a short sale is determined
by how long the property used for repayment is held
• If substantially identical property (e.g., other shares of the same
stock) is held by the taxpayer, the short-term or long-term character
of the short sale gain or loss may be affected
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32. The Big Picture - Example 21
Holding Period
• Return to the facts of The Big Picture on p. 16-1
• Assume that Maurice purchased the Purple
stock on January 15, 2011.
– If he sells it on January 16, 2012, Maurice’s
holding period is more than one year.
– If instead Maurice sells the stock on January 15,
2012, the holding period is exactly one year, and
the gain or loss is short term.
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33. Tax Treatment of Capital
Gains and Losses (slide 1 of 7)
• Noncorporate taxpayers
– Capital gains and losses must be netted by holding
period
• Short-term capital gains and losses are netted
• Long-term capital gains and losses are netted
• If possible, long-term gains or losses are then netted
with short-term gains or losses
– If the result is a loss:
– The capital loss deduction is limited to a maximum deduction
of $3,000
– Unused amounts retain their character and carryforward
indefinitely
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34. Tax Treatment of Capital
Gains and Losses (slide 2 of 7)
• Noncorporate taxpayers (cont’d)
– If net from capital transactions is a gain, tax
treatment depends on holding period
• Short-term (assets held 12 months or less)
– Taxed at ordinary income tax rates
• Long-term (assets held more than 12 months)
– An alternative tax calculation is available using preferential
tax rates
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35. Tax Treatment of Capital
Gains and Losses (slide 3 of 7)
• Noncorporate taxpayers (cont’d)
– Net long-term capital gain is eligible for one or
more of four alternative tax rates: 0%, 15%, 25%,
and 28%
• The 25% rate applies to unrecaptured §1250 gain and is
related to gain from disposition of §1231 assets
• The 28% rate applies to collectibles
• The 0%/15% rates apply to any remaining net long-term
capital gain
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36. Tax Treatment of Capital
Gains and Losses (slide 4 of 7)
Income Layers for Alternative Tax on Capital Gain Computation
*May include qualified dividend income
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37. Tax Treatment of Capital
Gains and Losses (slide 5 of 7)
• Collectibles, even though they are held long term, are
subject to a 28% alternative tax rate
• Collectibles include any:
– Work of art
– Rug or antique
– Metal or gem
– Stamp
– Alcoholic beverage
– Historical objects (documents, clothes, etc.)
– Most coins
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38. Tax Treatment of Capital
Gains and Losses (slide 6 of 7)
• Qualified dividend income paid from current or acc.
E & P is eligible for the 0%/15% long-term capital
gain rates
– After determining net capital gain or loss, qualified
dividend income is added to the net long-term capital gain
portion of the net capital gain and is taxed as 0%/15% gain
• If there is a net capital loss, it is still deductible for AGI
– Limited to $3,000 per year with the remainder of the loss carrying
over
• In this case, the qualified dividend income is still eligible to be
treated as 0%/15% gain in the alternative tax calculation
– It is not offset by the net capital loss
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39. Tax Treatment of Capital
Gains and Losses (slide 7 of 7)
• The alternative tax on net capital gain applies only if
taxable income includes some net long-term capital
gain
– Net capital gain may be made up of various rate layers
• For each layer, compare the regular tax rate with the alternative tax
rate on that portion of the net capital gain
• The layers are taxed in the following order: 25% gain, 28% gain,
the 0% portion of the 0%/15% gain, and then the 15% portion of
the 0%/15% gain
• This allows the taxpayer to receive the lower of the regular tax or
the alternative tax on each layer of net capital gain
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40. The Big Picture - Example 37
Qualified Dividend Income
• Return to the facts of The Big Picture on p. 16-1
• After holding the Purple stock for 10 months,
Maurice receives $350 of dividends.
– If Purple is a domestic or qualifying foreign
corporation, these are qualified dividends eligible
for the 0%/15% tax rate.
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41. Tax Treatment of Capital
Gains and Losses - Corporate Taxpayers
• Differences in corporate capital treatment
– There is a NCG alternative tax rate of 35 %
• Since the max corporate tax rate is 35 %, the alternative
tax is not beneficial
– Net capital losses can only offset capital gains (i.e.,
no $3,000 deduction in excess of capital gains)
– Net capital losses are carried back 3 years and
carried forward 5 years as short-term losses
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42. Refocus On The Big Picture (slide 1 of 3)
• Maurice is correct that certain capital gains and
dividends are eligible for preferential tax treatment
– Tax rates of 0% or 15% may apply rather than regular tax
rates.
• You then discuss the potential tax consequences of
each of his investments.
– Purple stock - To qualify for the beneficial tax rate, the
holding period for the stock must be longer than one year.
• From a tax perspective, Maurice should retain his stock investment
for at least an additional three months and a day.
• To be eligible for the ‘‘costless’’ capital gains, his taxable income
should not exceed $35,350 for 2012.
• The dividends received on the Purple stock are “qualified
dividends” eligible for the 0%/15% alternative tax rate.
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43. Refocus On The Big Picture (slide 2 of 3)
• Patent - Since he is a ‘‘holder’’ of the patent, it will
qualify for the beneficial capital gain rate regardless
of the holding period if the patent should produce
income in excess of his $50,000 investment.
– However, if he loses money on the investment, he will be
able to deduct only $3,000 of the loss per year (assuming
no other capital gains).
• Tax-exempt bonds.
– The after-tax return on the taxable bonds would be less
than the 3% on the tax-exempt bonds.
– In addition, the interest on the taxable bonds would
increase his taxable income, possibly moving it out of the
desired 15% marginal tax rate into the 25% marginal tax
rate.
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44. Refocus On The Big Picture (slide 3 of 3)
• Franchise rights.
– The franchise rights purchased from Orange, Inc., probably require the
payment of a franchise fee based upon sales in the franchise business.
– Maurice should either start such a business or sell the franchise rights.
• Partnership interest.
– The tax treatment related to his partnership interest depends on whether
he is reporting
• His share of profits or losses
– Ordinary income or ordinary loss, or
• Recognized gain or loss from the sale of his partnership interest
– Capital gain or capital loss.
• You conclude your tax advice to Maurice by telling him that
his investments should make economic sense.
– There are no 100% tax rates.
– For example, disposing of the bank stock in the current market could
be the wise thing to do.
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45. If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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