Property Transactions Outline

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Introduction to Property Transactions Class Notes I. Basis, Realization, and Recognition a. Problem 1 - Purchase and Sale: In Y1, A purchase unimproved land for $100 in cash. At the end of Y1, the land is worth $105. In Y10, A transfers the land to B in exchange for $80 in cash and stock worth $35. i. (a) When and in what amounts does A recognize gain with respect to the land? In Y1, A has no GI b/c there is no financial benefit/accession to wealth, meaning, there is no realization event. In Y1 A gets a cost basis of $100, b/c this is the amount that he paid for the property. At the end of Y1 is there any taxable event? No, A will have no taxable income on the increase in value on this land. Cottage Savings (pg. 89 see below). In Y10 there is a realization event. (1.1001-1(a)). A will recognize $15 because it first will recover its basis tax-free. Amount realized is $115. 1. 1012: cost basis is the purchase price in cash or other property. 2. Doyle: our income tax system taxes income, not the gross proceeds. This means that we need to keep track of the basis b/c this amount will be compared to amount realized for taxable gain purposes upon sale. 3. 61(a)(3): gains derived from dealings in property. 4. 1001(a): gain from sale or other disposition of property shall be the excess of the amount realized over the adjusted basis. a. Amount realized adjusted basis = gain 5. 1011: adjusted basis is the 1012 cost basis adjusted by the terms in 1016. 6. Tax-benefit of its basis more quickly may be achieved through depreciation mechanisms. 167, 168, 179. It cannot be land and it must be property used in a trade or business, or held for the production of income. 7. Cottage Savings: a. Tax liability is not accessed based on annual fluctuations in the TPs property, something more must happen. The tax consequences are deferred until the TP realizes the gain or loss. The realization requirement is implicit in 1001, which is based on administrative convenience. There must be a realization event to tax property ownership, meaning the tax system uses a transactional approach. b. Is there a constitutional requirement that we tax property in this manner? No, because Congress included 475 which taxes accumulation rather than realization. This section applies only to securities dealers and uses the mark to market approach. It requires securities dealers to recognize gain or loss based on annual fluctuations on the value of unsold securities. It is elective by traders. 8. 1.1001-1(a):the gain or loss realized from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or in extent, is treated as income or as loss sustained. The amount relized from a sale or other disposition of property is the sum of any money received plus the FMV of any property received.
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9. 1001(b): amount realized sum of money plus FMV of property received. 10. 1001(c): except as otherwise provided the amount of gain or loss realized shall be recognized (included as income). 11. Transactional approach benefits: A did not pay taxes in Y1-Y9 because the tax was deferred. The benefit is a time value of money issue. Practically speaking, A got to keep and invest the money that he accumulated each year since our system does not tax in that manner. Pgs. 71/71 look at this issue. The problem with our system is that it does not take into account inflation. 12.Preferential rates for long-term capital gains help out the situation for the TP in this problem, but once again it still does not take inflation into consideration. ii. (b) pgs. 8/71 Henry Simons perspective on income says that the change in value of property between its purchase and disposition should be taxable income. iii. (c) its a bad investment for A if the price inflation has doubled. This investment in this situation has not kept up with inflation. Therefore, A has lost purchasing power. 1. Our system compares things that have different values without taking those values into account. 2. One alternative to this problem was considered which would adjust basis based on inflation, which the code already does to a certain extent for: a. Tax rates and personal exemptions. b. Realization i. Includes sale or other disposition of property. Under 1001 TP can offset the basis against income. So when dealing with property interests it is conceivable that an issue can arise as to whether a significant change has occurred as to the sale. 1. Eisner v. Macomber: a. Facts: TP owns 2200 shares of corp. Corp. paid a 50% stock dividend to all of its SHs so TP received 1100 more shares of the stock. There was an idea that stock dividend should be included in income. However, the SC said that the SH had no realized any income in accordance with the 16th amendment b/c there was no income present in the transaction. b. Issue: Was there a realization event? c. Holding: No. d. Rationale: his ownership interest in the corporation didnt change as a result of the stock distribution. Every SH received the stock split so there was no change in position based on this. The SH received nothing out of the corporations assets and his proportionate ownership had not changed. i. Income includes a gain, profit, something of exchangeable value proceeding from the property being received by the TP for its separate use, benefit, and disposal.
ii. It is true that stock dividend may indicate that the SH/TP is richer, b/c usually it is as a result of accumulated earnings, but he hasnt received the income as yet. iii. This stock dividend more closely resembles accumulated earnings and not a cash dividends. iv. 305(a): generally stock dividends are not taxable events. v. 305(b): identifies situations where stock dividends may be taxable events, where the distribution is disproportionate in the sense that the SH who receives the distribution ownership changes. 2. Helvering v. Bruun a. We are not concerned with severance, which was part of the definition of realization in Eisner v. Macomber. c. Taxable Exchange i. Problem 1: Treas. Reg. 1.1001 says you have realization if there is an exchange of property for other property if the properties differ materially 1. Where does the banks cost basis arise? The basis in the note, when it originates the note, is the amount loaned. 2. What would cause the value of the notes to decrease? The prevailing interest rate is higher than the rate of the loans. When interest rates go up, the lower fixed rates on these notes become less valuable. a. Hypothetically if the bank just sold the notes, it would have to sell at a discount since they are not worth as much b/c the hypothetical buyer wants to make sure it will not lose too much. 3. The bank wants to get a tax deduction b/c of this loss so it arranges an exchange which will occur at a loss so there is a taxable event. 4. Cottage Savings: a. Issue 1: was there a disposition of property within the definition of realization under 1001. b. Holding: 1001 says there is a realization event only if the exchange is property that is materially different. i. Court agreed with the definition of realization set out in the regs. c. Issue 2: What must occur to have a material exchange? d. Holding: So, what is a material difference and was there one in the case? i. There must be different legal entitlements to be a material different. ii. In Cottage Savings, there were different obligors exchanged by the different S&Ls and that amounted to a change in legal entitlements. e. Outcome: the TP (cottage savings) could realize a loss on the exchange. 5. Recent changes to this approach: The $2.4 million dollar loss that is sustained produced an ordinary deduction that could be used by the bank without restriction b/c the notes held by the bank after the loan were not considered capital assets by virtue of an
exception of the definition of capital assets found in 1221(a)(4): notes receivable that arose from the services of the TP. This definition was interpreted by courts as if the bank lent money to someone and received a note in exchange, that was considered a service and that was under the 1221(a)(4) exception for notes receivable. In August the treasury proposed a regulation that says that such notes will no longer be viewed as issued/received for services. This type of exchange will still be a realization event, but if the notes are capital assets then the loss is a capital loss and there are restrictions on the deductibility of capital losses. a. For corporations, capital losses can only be deducted to offset capital gains. 1211. Any excess capital loss cannot be currently deducted but can be carried back three years and carried forward five years into the future to offset capital gains in those years.
ii. Problem 2: Tax consequences of this transaction to A and B

1. A owns X stock with cost basis of $200. B owns Y stock with cost basis of $300. A and B swap when X is worth $250 and Y is worth $260. 2. Approach to answer: a. Why does A get this benefit? (Is there a relationship here?). i. Does A work for B and the $10 is compensation, or maybe A is Bs daughter and so the transaction is a gift. Or, is there no relationship whatsoever (assume this is the case). b. Hypothetically, what if A paid cash for Bs stock and paid $250. What would be the tax consequences of this? Cash purchases in an arms-length relationship does not produce income under our system. c. Here, however, there is a realization event b/c the properties exchanged (cottage savings) differ materially. Therefore, we trigger the application of 1001(b). d. As tax consequences i. Amount realized = $260 (property received) ii. Adjusted basis= $200 iii. Realized and recognized gain = $60 iv. He will be taxed on the benefit of his bargain. v. As basis in the newly acquired stock: 1012 (cost basis) regs say cost is the amount paid in cash or in other property. Which should be the FMV of the property received. Therefore, As basis will be $260 in the shares he acquired. BOOK NOTES d. Gifts as Property: Transferred Basis i. Taft v. Bowers (1015) 1. Facts: TPs received gift of stock. Upon the sale the IRS taxed on the entire gain including the gain from the time it was in the donors hands, and therefore, using the donors basis. TP said 16th amendment does not allow IRS to tax in this way. 2. Issue: what basis does the donee get in stock received as a gift.
3. Holding: the donee receives the donors basis. ii. Basis rules for loss transactions 1. when the donee sells property at a loss, the donee uses the FMV at the time of the gift as their basis, rather than the donors basis as is the case when there is a gain. The purpose of this is to limit lossshifting. iii. 84: Gifts to Political Organizations 1. Transferor must recognize the gain when donating stock to a political organization. Then the political organization takes the FMV of the stock at the time of the donation as its basis. e. Transfer at Death (1014) i. Gains: Property devised at death receives a basis equal to the FMV at the time of the donors death. This means that the donee will never have to recognize the gain. ii. Losses: B/c the donee receives a basis equal to the FMV at the time of the donors death, the donee will not recognize the loss either. 1. Therefore, well informed TPs sell loss property prior to death. Class Notes: September 11, 2006 f. Continuation/Review of Last Class Taxable Exchange: i. Problem Two: As stock has a value of $250, and a basis of $200. Bs stock had a value of $260 and a basis of $300. This exchange was at arms length 1. Applying 1001(b): As gain is the amount realized (cash/property received= $260) minus adjusted basis = $60. Question becomes, what is the basis in the new stock to A and B. This leads to the conclusion that As basis should be $250, but this is problematic economically b/c upon the sale, A will be taxed twice. a. Regs. 1.1012 say cost is equal to the amount paid in cash or property. The term cost should not be applied literally but should be the FMV of the property received. Using this approach, you get a more reasonable conclusion b/c start to finish A has a gain of $60 b. New basis should equal= old basis plus gain. Here that amount equals $60. This prevents the TP from 2. Bs amount realized $250 (cash and property received in arms length transaction) minus adjusted basis $300 equals loss recognized of $50. New basis equals $250, b/c based on Philadelphia Park you take the basis equal the value of the property received. It also works out b/c if the basis is $300 and he recognizes a $50 loss that should reduce his basis to $250. ii. Authority: Philadelphia Park v US 1. Facts: Franchise right which was at issue had been obtained by the TP in an exchange transaction for a bridge. 2. Issue: what is the value of the property 3. Analysis: presents three approaches for determining basis for property received as part of a taxable exchange. Three rules applied in the following order: a. (1) The basis of property received in a taxable exchange is the FMV of that property (received.)
i. This is the approach used in the hypo, but this approach could not be used in the case b/c no one knew the value of the property received by the TP b. (apply if first cannot be used) (2) FMV of item received cannot be determined independently, then well assume that its FMV was equal to the property given up in the transaction (aka barter exchange transaction). c. (3) If you cant determine the FMV of either the property received or the property given up, then punt, treated as equal to the adjusted basis of the property given up in the transaction. iii. Problem 3: 1. 83(a): FMV minus amount paid. Therefore T had $60 of taxable income at the time of the transfer. a. What is Ts basis: Treas. Reg. 1.61-2(d)(2)(i) amount paid plus the amount included already. i. Here TP paid zero and included $60. Therefore the basis equals $60. ii. Rationale: This approach prevents double taxation. 2. What are the tax consequences to A? $40 gain is recognized in this income. 3. Treas Reg 1.1001-2: amount realized from a disposition of property includes the liability from which the TP is discharged as a result of the transfer. In other words, the claim that is satisfied is included in amount realized. iv. International Freighting 1. Facts: corporation had a bonus compensation plan for eees, under which, corporation transferred stock to its employees. The stock transferred, was stock in another corporation. The FMV of the stock was $25,000, and the basis was $16,000. IRS wants corp to realize the gain of $9000. 2. Issues: Was there an amount realized on the transfer of the stock? If there was, what was the amount realized? 3. Analysis: Amount realized equals cash and FMV of property received. Here there was no cash or property received. So the service asks the court to approach it like the services rendered by the employees was the exchange and the disposition of stock was in exchange for those services. So the Court applies the second rule from Philadelphia Park which is the barter exchange rule. Then the court assumes that the value on both sides of the exchange is equal and the amount realized equals $25,000. 4. US v. Davis (US): a. Incident to a divorce the husband transferred securities in exchange for the wife giving up marital rights received. b. Court applies the same Philadelphia Park rule. c. Barter exchange methodology is very similar even though 1041 makes this exact scenario non-taxable now. g. Gift i. Problem Three: A makes a gift to B of an undeveloped parcel of real property, Blackacre, that A had purchased several years ago for $500.
Determine the tax consequences to A and B in the following alternative situations: 1. (a) Is there a realization event? No. This is consistent with 1001 b/c there is no realization event. a. Exceptions to this rule: i. Part gift and part sale: When there is some consideration that is a realization event. See 1.10011(e): donor has to realize gain to the extent that amount realized exceeds adjusted basis. Loss cannot be recognized as a result of a part gift and part sale ii. Charitable Gifts: 1011(b) donor has to allocate between portion sold and portion given away. iii. Installment Sales (453B): Here the scenarios is the TP owns property which is sold to a buyer who doesnt pay immediately. The buyer delivers a note (IOU) evidencing promise to pay for the property in the future. Under 453B the seller, TP does not have to report the gain from the sale until payments of the sales price actually is paid. Where the seller/TP gives the buyers note to a third-party, before the buyer pays, 453B applies, and says that this gift is a taxable event as far as the donor is concerned. The underlying policy is to avoid the possibility of a shifting of the income tax consequences of the sale of the property after the TP has already made the sale. 2. What is Bs Basis? a. 1015(a) states that the donee will take the transfer basis in the property from A. The property will have the same basis in the hands of the donee as it had in the hands of the donor. b. Bs basis equals $500. c. Bs amount realized equals $1600. d. Bs gain recognized equals $1100. 3. What is the holding period? a. 1223: When you have a transferred basis situation, in computing the donees holding period, the donee can tack the donors holding period. So, even though B only held the property for three months he gets to tack the several years that A held the land. b. 1221: Therefore, upon the sale B will recognize the gain as a long term capital gain and receive 15% preferential rate. ii. Problem Three (a)(i) (1015(d)): permits an increase in basis for the donee, for a part of the gift tax that has been paid. 1. 1015(d)(6) equal to the gift tax paid multiplied by a fraction (net appreciation/amount of gift) a. net appreciation equals FMV of gift minus the donors adjusted basis in that property. 2. Textbook: pg. 222 3. $400 x (500/1000)= $200 iii. Part Three (b): Blackacre is worth $300 at the time of the gift. No gift tax is paid. Three months later, B sells Blackacre for, in the alternative, $200,
$800, or $500. Donee is taxed on the amount that is economically generated while in the donees hands. 1. Sale $200 (loss transaction) a. Amount Realized $200 minus b. Adjusted Basis $300 i. ****Special Basis Rule under 1015(a): use the FMV at the time of the gift, a loss scenario, if the value at the time of the gift exceeds the donors basis in the property. c. Loss = 200 300 = $100 i. The other amount of loss is a wash and no one gets it. 2. Sale $800 a. Amount Realized $800 b. Adjusted Basis $500 c. Gain $300 3. Sale $400: See Treas Reg. 1.1015-1(a)(ii) look at it both ways to determine whether there is a gain or loss a. Gain: AR $400 AB $500 (transferred basis) gain only exists to the extent that the amount realized exceeds the adjusted basis. i. G= 0 b. Loss: AR $400 AB $300 (loss basis1015(a)) loss only exists to the extent that adjusted basis exceeds amount realized. i. G=0 c. A cannot shift the loss onto B except when it is in his hands. At the same time A cannot shift the gain through this transaction. h. Transfers at Death i. Rules 1014: receipt by the beneficiary is generally excluded from GI under 102, but when we determine the beneficiarys basis, we have to follow the basis rules under this section. If the decedent dies before 2010, the beneficiary can usually apply 1014 and take a stepped up basis (which is equal to the FMV of the property as of the date of death or as of an alternate valuation date) at the time of the death. This is the value of the property at the time of the decedents death. 1. Underlying policy: traditionally this worked b/c these devises were subject to estate taxes and so the idea was that it should not tax this twice. It doesnt work well, however, b/c most estates are not subject to the estate tax b/c of the heightened exemption levels. 2. Alternative Valuation (2032): if an estate tax return is filed for the dcedent the executor of the estate can elect to value the estate for basis purposes, six months after death, except that if the election is made, property that was distributed by the estate or sold by the estate within the six month period will have a basis equal to the FMV at the time of sale or distribution. a. ****Election can only be made if it will decrease the value of the estate and the estate tax liability. i. For example: if the decedent dies with a large portfolio and the market bottoms out over the next six months the estate can make this election. ii. Problem 1:
1. Basis of the stock steps up from the $100 in the decedents hands to the $120 in the beneficiarys hands at the time of death. a. What is the gain? i. Only $20 is recognized gain because of the stepped up basis allowed in 1014. b. What is the character of this gain? i. 1223(9) allows the beneficiary to consider the property as having held it for more than one year. There is no tacking here, this is an automatic one-year holding period. c. Basis steps down for purposes of loss, LOOK AT THIS LATER. Class Notes: September 18, 2006 2. How might answer to Problem 1 above change if D had died in 2010 rather than this year? a. Inheritance basis rules are scheduled to change. b. Estate tax has been repealed for people who die in 2010 c. 1022 will use the following formula: i. Lesser of: 1. Adjusted basis of decedent; OR FMV at death d. In the case of loss property it would be a step down basis. e. 1022(b),(c) also provide for an increased basis for appreciated property. i. (C) possibility of $3million ii. $1.3 million step up for transfers to any decedent iii. (d)(2): any basis increase can provide an asset with a new basis that would increase the basis higher than the FMV at the time of the decedents death. iii. Problem 2: Lawyer billed a client $50 for services rendered, but died this year before collecting. The client pays the lawyers estate. Who, if anyone, is taxed on the $50? 1. If we applied the typical inheritance rules: The value of this service would take the stepped up basis of $50 which means that there would be no taxation b/c it would be FMV AB= 0 gain. The $50 which is essentially compensation would go untaxed. 2. If the lawyer was an accrual method TP, then the lawyer would have had to included the $50 as GI in his final income tax return and would be taxed as such. 3. 1014 eliminates this disparity, by saying the sections basis rule does not apply in regards to income in respect to a decedent under 691. a. 691(a): this section says items of GI that the decedent had a right to but which were not includible by the decedent shall be included in GI on receipt by: i. the estate; or whoever had the right to receive that item. b. Here, this compensation will become part of the estate. c. The significance of this scenario is that there is no basis step-up here. II. Cost Recovery and Recapture
a. Review: sale of property allows the seller to recover the cost tax-free in the sale
(1001). It allows the TP to compare the AB to the AR tax-free when there is sale or other disposition. In this situation, this tax-free recovery is only upon a sale. i. For certain assets it may be more appropriate to permit the TP to recover its basis for tax purposes prior to a sale or other disposition of other property. It may be better to permit the TP to match the cost of an asset against the income generated by that asset for the TP over its lifetime, this is the theory behind allowing TP to depreciate property. This creates a clear reflection of the TPs income for a given period. b. Problem 1: Theory and Stakes i. Q: Can the TP deduct the full amount in year one? 1. Code will permit an immediate deduction in connection with business expenses under 162, 212. 2. If matching is a goal, then there is little justification for a complete deduction for the cost of this machinery in year one. Particularly b/c we are told that this machinery will be in use in the TPs business over the next five years. 3. 263 prevents the TP from deducting the entire cost up-front, and requires the TP to capitalize this cost and create a basis, so that the tax benefits from this purchase will be deferred. 4. Regs: 2.263-2: includes expenditures for buildings, equipment, or similar property that has a useful life extending beyond the taxable year in which the cost was incurred. a. THESE REGS. ARE CURRENTLY PROPOSED TO BE REPLACED. b. PROPOSED REGS. STILL REQURIE TP TO CAPITALIZE THE COSTS TO ACQUIRE REAL PROPERTY HAVING A USEFUL LIFE. c. Also include a 12-month rule which says the cost of property which has a useful life of 12-months or less is generally not a capital expenditure and can be deducted. d. Answer: TP will have to capitalize and will not be able to deduct all of this year in One. ii. Q: Is T required to wait until the end of the equipments useful life before he is entitled to deduct the cost of this machinery? 1. No, b/c we want to match the expense used to produce income with the amount of the equipment used/exhausted in the year. 2. This is just an additional cost of doing business that should be applied against the GI of the TP. 3. This leads us to a mechanism, like depreciation, that depicts the gradual recovery of the TPs cost. 4. The problem is that there also needs to be a mechanism for adjusting the basis since 1001 is of no help since in these scenarios there is no realization event which under Eisner v. Maccomber is required. 5. What is the other goal of depreciation? a. Encourages capital investments, through the mechanism of accelerated depreciation. b. 168(k) illustrates this point most recently: was enacted directly after 9/11 which permitted TPs to immediately deduct 50% of the cost of certain new depreciable property purchased by the TP before 2005 as a means of economic stimulation.
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iii. Two goals of depreciation are: 1. income matching; and
2. economic stimulus iv. Two goals are inconsistent and creates rules that dont necessarily make sense together. v. Depreciation Methods 168(b) 1. Straight Line (SL) Method 168(b)(3): permits a TP to elect the SL method over the equipments recovery period. For example: machinery from the problem above has a 5-year recovery period. SL method permits the TP to deduct its basis evenly over the recovery period applicable to the asset. Each 12-month period recovery period for the asset would be allocated depreciation divided by the number of years a. Formula: Basis/(recovery period) = annual depreciation deduction i. $600,000/5= $120,000 (20%) ii. This amount, $120,000 is applied against the basis each year. b. Applicable Convention: 168(a)(3): i. Half-year convention (168(b)). It is pure fiction. This convention says that in computing the deduction, we are to assume that the TP began using the item at the midpoint in the first year. This prevents fact-finding. And the result is that in the first year that the DD applies, the TP can only deduct one-half of the applicable amount in that year. 1. Using our number, the actual DD in Y1 is $60,000 2. Y2, Y3, Y4, Y5 DD= $120,000 3. Y6= $60,000 2. Declining Balance Method (DBM) (Investment incentive method accelerates recovery in the beginning)(168(b)). a. Computes yearly depreciation by applying a constant rate to TPs adjusted basis. b. When using this method it is a multiple of the rate of what would have been used with respect to the straight line method. i. Double Declining Balance Method: You would double the rate that would have been used on the SL method. ii. Here, 5-year property is used for our proprety, and assuming that the year method applies the result is: 1. 40% X $600,000 X = $120,000 (Y1) 2. 40% X $480,000(AB)= $192,000 (Y2). c. 168(b)(1)(A): i. even if you use the double declining method, you have to switch to the SL method, in the first year that the SL would give you a bigger deduction than the DBM.
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ii. 1016(a)(2): AB is adjusted downward for deductions taken, to prevent a double tax benefit on a later disposition of the property. 3. Valuation of Assets in Depreciation: Neither method takes into consideration what the revaluation would be. Assets are presumed to be subject to a gradual loss in their value without regard for its actual value and the decrease is established by statute. (168) c. Problem II: Property Qualifying for Cost Recovery i. Is the particular asset depreciable? Section 167 is the operative provision that permits depreciation deductions: 1. Statutory construction: 167 operation/ 168 methodology ii. 167: There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear 1. of property used in the trade or business; or 2. of property held for the production of income. iii. Which of the following are depreciable? 1. (a): First, how do we view land? It is not depreciable b/c it is something we view as not wearing out (Treas. Reg. 1.167(a)-2). a. Here, it appears we are dealing with land that may be connected to b. Duda & Sons : The TP said here that they should be allowed to take a deduction for depletion. Court said NO, depletion is more like miners. As to a depreciation for land, the Court said this regulation is a bar, bright-line rule, for administrative reasons the regulation was intended to prevent disputes between the TP and the government in those types of instances. c. Rev. Rul. 2001-60 : this ruling deals with land preparation costs associated with drainage systems used in connection with modern golf courses. In this situation the service says that if the land prep cost is closely related to a depreciable cost, so that the land preparation replacement would coincide with the depreciation replacement, then the deduction for depreciation will be allowed. Cost that the TP incurs, preliminary to construction, those would be associated with the land and as a result would not be depreciable. d. Cost of landscaping near a building that would be destroyed by replacement of the building, will also be depreciable. Rev. Rul. 74-248 2. (b): A hole in the ground used as a garbage dump a. Airspace was a separate depreciable asset. The airspace was considered an intangible asset in the sense that the rights to the airspace could be transferred separate from the land and treat it as an intangible. b. Tangible asset: used in the business whose length can be determined with reasonable accuracy. 3. (c): painting hung in a doctors office, acquired and placed in service this year. a. Work of art didnt have a determinable useful life and therefore it couldnt be depreciated.
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makes this situation not as big of a deal today. This section was not in the code at the time of the Obstetricians case. c. Simons v. CIR: i. Issue: Is the cost depreciable in the violin bow, even though the bow will retain its value and will like appreciate even after you stop using it in your business; or, is it more like a work of art. ii. Holding: Both in 2nd circuit and Tax Court the courts held that paintings hung on a wall in the office are not subject to wear and tear, whereas here, the bows will be used and subject to wear and tear. iii. Test: Whether the property will suffer wear and tear, exhaust, or obsolescence? Therefore, determinable useful life is no longer an issue, at least according to this court, although the Service disagrees and did not acquiesce. iv. Here: The TP had not established the useful life of the bow. Now thats ok b/c ACRS will supply the recovery period for the asset, once we determine that the asset is subject to wear and tear. 4. (d): costs incurred in forming a corporation. ORGANIZATIONAL COST a. 248/709 (corporation/partnership): each create a hybrid between depreciation and immediate deduction. The statutes (248) says that corporations can elect to immediately deduct $5000 of its organizational costs for the year in which the corp. begins business; but, the maximum $5000 deduction is reduced dollar for dollar to the extent that the total organizational cost exceeds $50,000. i. Amortization of excess amount: The organizational costs that are not immediately deducted can be amortized, straight line, over a 15-year period, which starts in the month in which the corp. begins business. ii. Organizational Costs 248: 1. Treas. Reg. 1.248-1b: by laws, filing fees, incorporation fees. Does not include underwriters fees or costs incurred to transfer assets to the corporation. iv. Book Notes: (Geneva Drive-In Theater v. CIR, Rev. Rul 60-358, Associated Patentees v. CIR) 1. Geneva Drive-In v. CIR (TC/9th Cir) a. Issue: whether TP is entitled to take depreciation deductions for improvements made by the lessee of property acquired by petitioners. b. Holding: No, at least not in this case. i. TP did not suffer any economic loss as a result of the deterioration. Upon the termination of the lease, TPs interest ripened into a depreciable one.
b. 168 assigns recovery periods to tangible assets which
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ii. TPs interest was not a business or income-producing property until the lease terminated, that the TP suffered no economic loss, and that the TP did not pay a premium for the lease. 2. Rev. Rul. 60-358 a. Issue: what is the proper method for recovering the cost of leased or rented television films for federal income tax purposes. b. Holding: Use the income forecast method. i. Formula: Income from the films for the taxable year Forecasted total income to be derived from the films during their useful life (income less expense of distribution) X Cost of films which produced income during the taxable year (after adjustments for salvage value)
ii. If in subsequent years the values are overestimated or underestimated, then adjustments must be made. 3. Associated Patentees v. CIR a. Facts: TP was an association that sold to market/exploit patents, from its shareholders. SH sold to TP in exchange for 80% of the royalties from the patent, each year of the patent. b. Issue: how do you take depreciation deductions for patents? c. Holding: Allow the payment made to the shareholders for a portion of the cost of the patent. i. Court said this is an unusual situation b/c we dont know the future cost of the patent. ii. Court allowed TP to take deductions equal to the cost paid to the SHs for exhaustion. Class Notes: September 25, 2006 d. Problem II: Property Qualifying for Cost Recovery (continued) i. (e) What we assume from fair rental value is that the lease has no independent value for the TP. The TP isnt paying a premium for these rights. 1. The TP has an investment 2. TP can depreciate the building, and not the land. When the TP buys the land and the building how do we figure out which part is depreciable. We do this based on the FMV of each at the time of the sale. 3. 1.167(a)-5: the TP is required to allocate purchase between land and building, which is depreciable. ii. (f) Impact of a lessors right to obtain an improvement that was erected on the property by the lessee. 1. Under these facts, the rent that the lessee is paying to LL (A in this scenario) is for the land, but then the lessee constructs a building on the land. So any rent received by the lessor
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2. The building is depreciable, but the issue is who gets to take the deduction. Who has the depreciable interest? a. The lessee has the right to the deduction (Geneva Drive-in) 3. Geneva Drive-In a. Depreciable interest exists if the TP has made an investment in the item, and the TP would suffer economic loss resulting form that items deterioration. b. So under that standard, the lessee had the right to take the deduction. 4. If the lessee sold its leasehold interest it would get leass as time goes by. The lessee gets the deduction. 1.167(a)-4 5. What is the depreciation period? a. 39 years (168) b. If it is a rental period then it is 27.5 years. c. Regs say to use the 10-year period, but the code was changed after the regs so dont follow that. Instead, use the 39 year period from 168. 168(i)(8) trumps the regs for determining the useful life of the property. d. 168(i)(8) slows down the depreciation method for the lessee. 6. What is the useful life upon the termination of the lease a. Lessee could deduct its unrecovered cost at the end of the lease, assuming the lessor doesnt renew the lease. b. It is as though the lessee can recover the entire undepreciated amount, and is allowed to get the unrecovered basis. 7. Does the lessor get to depreciate after the lease ends? a. To take a depreciation deduction, there must be basis in the building. Does the lessor get basis when the property is reverted back? 8. Is there income when the lease ends and the lessor gets the land with the improvements. NO. 109. a. When the landlord has been able to exclude items from gross income, it cannot increase its basis in the property. This is 1019. b. This result means that the lessor will not get to depreciate the improvements b/c he will only get basis in the land which is not a depreciable asset. 9. 168(e)(3)(E), 168(b)(3) a. These provisions read together permit the depreciation of certain leasehold improvements to non residential real property to be taken straight line over 15 years. These provisions, however, are not applicable to the construction of a building. Only apply to improvements if the building had been in service for more than three years (like renovations). b. The 15-year deduction, only applies to improvements made before this year, made before 2006. iii. (g) FACTS: TP buys property from the original lessor, after the lessee has already made the improvements to the property and Ts purchase price ($877) is comprised of the $800 value of the land in the undeveloped state, plus the discounted value of the building in ten years ($77).
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1. Issue: This is different thatn (f) above, b/c now TP has a basis in the bulding, that is the $77. Can T depreciate the portion of its purchase price that is allocable to the improvement; Or does T have to wait until the 10-year lease is up to depreciate. During the ten year lease hes getting rental income from the land. 2. Answer: T would allocate $77 in the reversion interest to the building when he gets the building back. Then he can start taking depreciation deductions. 3. Geneva Drive-In: TP doesnt have any investment in the building that is wasting away during the lease term. a. According to this case the TP (LL) should wait to take deductions at the time when he is getting revenue from the building. 4. here, there are two costs a. Cost 1: Lessee pays the amount to erect the building b. Cost 2: Lessor pays for the value of the improvements on the land. So he should get to deduct this amount when he gets the land back. iv. (h) Facts: lease itself impacts the price someone would be willing to pay for the property. Assume alternatively: 1. The annual rent under the lease is $80 and the purchase price is $877 ($1000 less the present value of $20 per year for 10 years at 10 percent). a. Land is sold at a discount b/c of the long term lease which is less than the FMV of the property. b. What is potentially depreciable with respect to the $877 cost? i. To get to a depreciable interest for the new buyer, you have to ask what items of value did the buyer purchase? 1. Land 2. Existing lease (rights under the lease). a. What is this value? NEGATIVE. The land is worth less with the lease in place then the 1000 it would be worth if the lease were not in place. b. In effect, there is nothing to depreciate when it comes to the lease. 2. Alternatively, the annual rent under the lease is $120, and the purchase price is $1,122 ($1,000 plus the present value of $20 per year for 10 years at 10 percent) a. TP effectively bought the land for b. New owner does have an investment a contract right to receive $20 a year, premium rent over the next ten years. c. The present value of the right to receive is going to be $122. d. What can the TP do with the $122 over the term of the lease, as in, can it be depreciated or amortized? i. Well, the lease represents a wasting asset. The right to receive above market rent gradually disappears as each year goes by. So can TP right this off?
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ii. 167(c)(2) says that TP cannot right off these amounts. IT syas if property is acquired subject to a lease no portion of the basis shall be allocated to the leasehold interest. Entire basis is attributed to the underlying property subject to the lease. e. 167(c)(2) Property subject to a lease: When one acquires property subject to a lease, no portion of the basis goes to the lease right. Premium cannot be amortized. Professor Davidian thinks that this is a bit dubious. i. This is different than where someone buys existing leasehold in property. In the latter case, the leasehold is subject to amortization. e. Methods of Cost Recovery i. Intangibles: Things that lack physical existence, but have value for the taxpayers. This part deals with 197, 167 which deals with how to depreciate some of these assets. 168 does not apply to intangibles b/c by its terms that it applies to tangibles. 1. Prior Law: before 197 the government was conflicted on how to allow TPs to deal with intangibles, namely in the context of goodwill and going concern when purchasing a company. THe difficulty, was that the regs said that intangible assets could generally be subject to depreciation deductions, but the same reg. said that goodwill was not depreciable under 167. So when a business was being acquired through assets, the buyer would allocate purchase price among the assets including making an allocation for goodwill. Invariably the buyer would want the allocation for goodwill in purchase price to be very low b/c it new it could not take a deduction for the goodwill, whereas the allocation for tangible assets to be very high b/c it could deduct these quickly through depreciation. a. Example: If the acquisition involved good will and covenants not to compete, pre-197, the buyer would want a bigger part of the purchase price to go towards the covenant not to compete. Covenants was depreciable over the period of the covenant. b. The outcome was that there were difficult valuation issues. 2. 197: Current Law Congress came up with 197 to limit potential disputes over allocation and valuation. The basic premise is that well treat all acquired intangibles that fit within 197, the same. Particularly within a business acquisition context. We apply a 15year straightlines write-off starting in the month that the asset was purchased. 3. For those not governed by 197, well continue to use 167. SO 167 has a continuing role in determining amortization, concerning intangible assets that are not governed by 197. 4. Under 167 (look at the regs) a. 1.167(a)-3, so if that asset has a limited useful life it can be depreciated over that useful life. i. And, in limited circumstances 1.167(b), that paragraph may supply a 15-year straightline safe
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ii.
iii.
iv.
v. vi.
harbor for certain self-created intangibles that do not have a determinable useful life. (a) Goodwill or going concern 1. Goodwill is defined as the value of the business attributable to expectancy of customer patronage, etc. 2. Going Concern Value: Defined as the additional value that attaches to property b/c it is part of an on-going business activity. 3. Both of these assets were not depreciable prior to the enactment of 197 b/c they were determined to lack a useful life, under 167. 197 permits a straightline 15-year amortization starting in the month the asset is acquired. 4. 197(c) defines an intangible acquired by the TP in connection with a business or an income producing activity. 5. 197(c)(2) generally self-created intangibles are not allowed to be amortized. There are a couple of exceptions to this rule. 6. 197(d) has a laundry list of amortizable intangible items. Which includes: a. going concern, and good will. 7. Result: TP can amortize the cost of these items over 15-years, straightline, starting in September. 8. That means that TP is significantly aided. (b) Covenants not to compete 1. 197(d)(1)(E): only allows amortization of covenants not to compete is if it is acquired. If the covenant was entered into in an acquisition in a business. 2. Could also include the acquisition of stock of a business. So if the covenant is part of that acquisition then it can be amortized. 3. This means that the code is removing any allocation issue, at least in the acquisition issue, as between covenants not to compete, good will, and going concern. 4. What happens, when the covenant has now ended after five years, and there is still 10 years to go of amortization? a. 197(f)(1)(B) says you cannot take a loss with respect to a covenant not to compete governed by 197, until you dispose of the entire business that gave rise to the covenant. 5. Here with respect to the CNC, taxpayers are hurt b/c of 197 that they cannot. 6. Valuation matters from the sellers perspective b/c of character. (b)(i) Suppose it was acquired in some other context from acquisition of a business. How do we amortize from the payors perspective. Since it is not under 197 you can amortize but it is under 167. It would be amortized on its terms so it would be five years here. Rev. Rul. 68-636. There is no allocation issue here, which is probably the reason for the different rules. 197 was primarily intended in connection with acquisition of a business, but section 197 isnt entirely limited to business acquisitions. (c) Customer Lists: cost incurred to acquire such lists 1. This cost is treated as a 197 intangible item. 2. 197(d)(1)(C)(ii) (d) US Rights to a Movie 1. IS the cost of the acquisition, of the movie rights, within 197?
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a. Depends on whether it was an acquisition 2. 197(3)(4): excludes from 197 the cost of an interest in a film that was not part of the acquisition of the assets of a business. a. If the motion picture rights were acquired as part of an acquisition of a business, the 197(d)(1)(iii) treated as know how. 3. Suppose it was acquired separately, as a stand alone purchase, then 197 does not apply and you use the income forecast method. Apply 167 b/c 168(f)(3) says this is not a tangible asset. 167 would allow a depreciation deduction for intangible assets not covered by 197. 4. 1.167(a)-1: regs. call for depreciation in accordance with a reasonably consistent plan and not necessarily straightline. 5. So should we use straightline in this situation? Rev. RUl. 60-358 deals with amortization for movie films which says a write-off using the income forecast method is appropriate. Write-off will be based on the income that the movie produces. The cost would be recovered annually by applying a fraction to that cost. Fraction equals income derived by the TP from that item divided by the total estimated income to be derived over the items useful life. 167(g). This amount can be adjusted if the income changes substantially from year to year. a. 167(g): It provides for an eleven year recovery method. b. Provides that interest to be paid by TP if it turns out that deductions were taken too quickly for underestimating the denomination of the fraction. c. Also tells us that this method is only available with respect to movies, television films, recordings, book, patents, and copyrights. d. Not available with respect to property that is governed by 197. e. Proposed regs. 1.167(n)-1 1.167(n)-6. These regs. ignore salvage value. 6. If you are the TP here, are you happy about the availability of the income forecast method? Btw, you can also use the straight line method under 167. a. This is a great deal for TP: Out of the total estimated income for movies the bulk of it will be in the first year, so taking the deductions up front is GREAT FOR MOVIES. i. Enhances the speed in the early part of the recovery period. 7. 167(g)(8): 2006 amendment to 167 dealing with rights to musical compositions, including copyrights. a. IT says that with respect to acquisitions for musical compositions, the TP can elect to deduct straightline over five years, for expesnses in acquiring the composition, otherwise it can use 167. vii. (e) Cost to acquire a leasehold with ten years remaining on the lease 1. where TP pays lessee to acquire the lessees right to the property. 2. Is it governed by 197? No, it is precluded in (e)(5) from using the 15-year right off. So what happens?
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a. 1.162-11(a) the basis is recovered ratably (straightline) over the term of the lease. 3. For purposes of determining the term of the lease, you may have to take renewal periods into consideration. This is true of more than 25% of the price to acquire is attributable to the potential renewal periods in the lease, you have to take these periods into account. Class Notes: October 2, 2006 f. Review: Methods of Cost Recovery Continued i. Under 167, a straight line recovery may be used, over the assets useful life. ii. Some kinds of assets, may use the income forecast method. g. Question 2: i. Patent purchased for $100,000 with a useful life of ten years. Is this a 197 depreciable asset? It depends. 1. 197 only applies if purchased as part of an acquisition of the assets that constitute an assets deal. 2. If it is bought independently, then it is not depreciable under 197. 3. Assuming 197 applies, the asset is amortized over 15 years. a. If five years go by and the patent has lost half of its value, the patent is only worth $50,000. The TP has only amortized 1/3 of its cost, so at that point its AB is $66,666. Under 197(f)(7) amortization is treated the same way as depreciation. Now TP sells the patent right for $50,000 in cash. That would create a loss of $17,000. Will the TP be able to deduct that loss? i. 197(f)(1)(A): you probably cannot take this loss. ii. If the scenario is that the patent is purchased part of an asset acquisition where other intangibles were purchased (goodwill), you cannot take the loss, so what you do is add that loss onto the basis of the other intangible assets. iii. This all goes back to the anti-allocation goal of the code for assets that are intangible b/c of the notion that if you are within 197, it doesnt matter how you allocate b/c they will all be treated the same. 4. Now suppose it was purchased separately, then 197 would not apply b/c of 197(e)(4)(C). So what would happen? a. 167 would apply with respect to this asset. 1.165(a)-14 says that the basis of a separately acquired patent is generally depreciated ratably (straight line) over its remaining useful life or under the income forecast method. b. 197(c)(2) excludes self-created intangible from the 15-year write-off rule. 174 allows, however, a current deduction of all the expenses. 174(a) says that the TP can currently deduct all expenses incurred. h. Question 3: Same as (2) except that the purchase price is $40,000 plus Ts promise to pay the seller 40% of the annual net profits derived from the patent. What is Ts basis in the patent?
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How should T recover her cost. Assume this is part of an acquisition asset deal, which means that 197 applies. 1. The fixed portion will be amortized over 15-years, but the question becomes how will the contingent part be treated? a. 1.197-(2)(f)(2): Contingent amount is amortized ratably over the remainder of the period, beginning in the month when TPs basis increases as a result of contingent amount. If costs are paid afterwards, then you deduct currently (immediately.) ii. What if patent was acquired independently? (197(e) these types of patents arent under 197) How would the contingent be treated? This issue arose in Associated Patentees. 1. Associated Patentees: entire purchase price was contingent. Once those expenses arose, the IRS allowed the TP to deduct the contingent amounts currently, without the need to amortize them over a period of time. a. Rationale: a current deduction created a proper match between the income generated and the cost incurred by the TP related to that income. b. 1.167(a)-14: this is the codification of Associated Patentees, which relates to patents that arent 197 intangibles. If purchase price is payable annually as either a fixed amount per use or as a fixed percentage of revenues derived from use, then the deduction under 167 is equal to paid or incurred by TP during that year. Otherwise, the TPs basis in patent is deducted either straightline or by using the income forecast method. 2. Here, in this problem, we have both a fixed purchase price and a contingent amount. Prof. Davidian says the regulations still apply. The TP would be able to currently deduct the contingent amounts, and the fixed amount should be amortized straightline over the 10year remaining useful life. 3. Alternatively, the regs under 1.167 permit the TP to use the income forecast method, then an amendment that came in in 2004 167(g) (7) which deals with so-called participation and residuals. a. Residuals and participations: costs incurred in acquisition that vary in amount with the income earned by the property. b. Here, the portion of the purchase price is stated as a variable. c. TPs who use the income forecast method have two choices: i. Estimate at outset what they think theyll have to pay as a result of the contingency deal, include that estimate immediately as part of their cost basis and amortize that total cost including the estimate over the recovery period under 167(g) (where you only look at things for the first 11 years.) ii. Alternatively, the TP can deduct currently the participation and residuals in the year in which they are paid.
i. (a) y1 patent earns $25,000 and T pays the seller $10,000 as his share.
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i.
d. In terms of participation and residuals TP can elect to use the Associated Patentees Tangible Personal Property: Problem One i. 179 is quite helpful. TP can elect to currently expense up to $100,000 of the cost of the 179 property placed in service during 2006 by the TP. In addition this figure is subject to adjustments for inflation, so the annual maximum deduction for 2006 is $108,000 b/c of the effects of inflation. This provision is intended to encourage certain types of capital investment by smaller business. Which is clear in 179(b). ii. 179(b) limitation: the max. deduction will be phased out dollar for dollar to the extent that the TPs total cost of 179 property acquired during the year, exceeds $400,000. This amount is adjusted upwards for inflation so that in 2006 the phase out starts at $430,000. iii. Once your total 179 purchases equal or exceed $538,000 there is no benefit at all for $108,000. This shows that this is a targeted provision which in no way helps IBM or Microsoft. iv. Another limitation 179(b)(3): amount aht is expensed in a given year cannot exceed the TI of the TP derived from businesses in which the TP actively participates. This means you cannot use 179 to shelter nonbusiness income. v. 179 property includes: defined in 179(d) and is limited to: 1. tangible property to which 168 applies; and to certain computer software; and 2. must be 1245 property. a. 1245(a)(3) is basically new or used personal property, NONR/E, which is subject to depreciation deductions. 3. Must be for use in an active conduct of a trade or business; and 4. the property had to be acquired by purchase. a. 179(d)(2) excludes an acquisition of an asset that has a transferred or carryover basis. b. Also excludes assets where TPs basis is calculated under 1014. c. Property cannot be acquired from certain persons who are related to the TP. vi. (a) Here how much can he deduct? 1. $100,000 vii. (a) What if T borrows to buy the computer? 1. Should not make a difference. viii. (a) What if the computer cost $440,000 1. He can deduct $98,000 a. $440,000 430,000 = $10,000 which is the amount that the maximum deduction must be reduced by. ($108,000 $10,000). 2. This would leave him with a AB of $342,000 which can be deducted under 168. a. Proposed Regs. 1.168-2(d) ix. (b) Would it make a difference if T purchased from her brother? 1. No, b/c here the related parties provision only includes spouse, ancestors, and lineal descendants. 2. So here the TP can take the 179 deduction b/c brothers and sisters are not counted.
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x. (c) Compute depreciation deductions for the $100,000 computer on the most accelerated basis allowable assuming 179 is not elected. 1. 167 says the cost can be depreciated b/c it will wear out and it is used in TorB 2. 167(c) tells us that the $100,000 is the basis that can be depreciated. 3. 168 tells us how to compute the depreciation. a. Method b. Recovery period c. Convention 4. 168(c) - Recovery Period: statutory write-off periods, which places property into classes. These periods are for the most part predetermined periods by the government. The recovery period assigned to a particular asset, ay have little to do with the estimated time that the TP expects to use that asset. a. Here, the fact that the TP says he will only use the computer for three years is really irrelevant in computing the deductions. What is relevant is how the code classifies the asset. b. How do you determine the class life? 168(i) describes this as the class life assigned to the asset under a prior version of the depreciation statute. In other words, the services has assigned most assets a class life. These class lives are set out in Rev. Proc. 87-56. If the designated class life for that asset is more than four years but less than ten years, then that asset is five-year property. Even with that simplistic recovery assignment, ACRS is providing for an accelerated write-off by using a recovery period that is generally shorter than what the service thinks it should be. c. Here, the computer has a six-year class life so that means it is five-year property. You dont have to go to the Rev.Proc. b/c some assets are classified in the statute itself in 168(e) (3). 168(e)(3) states that there is a five-year recovery period for qualified technological equipment. 5. Applicable Depreciation Method a. Absent an election to use an alternative, the TP would use the method outlined in 168(b)(1) which calls for the TP to use the 200% declining method, but with a switch to straight line for the first year in which a straight line write-off would produce a larger deduction than the declining method when applied to the AB at the beginning that year. i. Or, switch to SL when straight line produces equal to or greater than the depreciation of declining method. b. Here, the rate is 40% (1/5 or 20% doubled for a five-year recovery period asset) which is applied against the AB. c. What is the role of salvage value here? i. No role. 168(b)(4). Treats the salvage value as zero. d. Under 1016(a)(2) the TPs basis figure goes down by the amount of deduction taken, but cannot be less than the amount of depreciation which is allowable to the TP under the code.
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i. allowable means that if for some reason TP forgoes a depreciation deduction, you still have to reduce your basis in the asset by the permitted amount allowable to you which forces the bus. TP to take the deduction even if they lack the bus. income in that year and to make full use of the depreciation deduction and to make use of carryback and carry forward provisions, like 172. 6. Applicable Convention 168(d) a. General rule is the half-year convention for non R/E, which means you treat all property placed in service as if it were actually placed in service in the midpoint of that year, regardless of when it was purchased. b. This means, HERE, the TP will only get of the depreciation amount in year one. 7. See Depreciation Schedules a. If you follow the language of the statute which says that you make the switch in the year that the straightline exceeds so that means you switch in year five. b. If you follow the rev. proc which says that you switch when the straight line is equal to or exceeds the double recovery youd switch in year four. c. Once you switch straight line, you must remain in year five. 8. The easier way: USE THE TABLES. Here the applicable table is NUMBER ONE. These tables include a switch to the straight line. Under the tables provided the percentage MUST be applied against the unadjusted basis of the property, as opposed to the adjusted basis. a. BRING THE TABLES IN TO THE FINAL EXAM. 9. In the exam remember that a class-life of seven years has a recovery period of five years. Also remember when to apply the half-year convention. Then finally, dont use the tables with an adjusted basis. The table percentages are applied to UNADJUSTED BASIS. xi. Problem 1(c) Continued 1. So Class Notes: October 9, 2006 xii. Problem 1(d) 1. once the mid-quarter applies, it will apply to all depreciable nonreal estate placed in service by the TP during that year. So not only the Dec. computer but also the June computer. 2. TP has backloaded its purchases of depreciable personal property in first year 3. So June computer is treated as being put in service on May 15 4. 40,000 X .4 X 5/8 5. Table 3 xiii. Problem 1(e): can T compute depreciation on a less accelerated basis? 1. Three methods in 168 which give the TP some flexibility if it is inclined to slow down its depreciation deductions. One or more
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j.
may be required for certain other calculations under the code. For example computing with respect to e&p for purposes of dividends. a. Method One: 168(g) Alternative Depreciation System as to any class of personal property placed in service during a given year, or with respect to any item of depreciable real property. i. The effect of this election is straighline. ii. The convention stays the same. iii. The recovery period generally becomes that assets class life (usually this is slightly longer than the ACRS method). iv. Except that: with respect to a computer, even under the alternative deprecation system, the right off period would generally stay at five-years 168(g)(3)(C). The annual straightline rate is 20% X 100,000 X (half-year). The depreciation is going to be $20,000 in every other year and then TP will get $10,000 in Y6. As a result, if TP has a choice, normally it will not elect for 168(g) alternative method. v. This method has to be used by corporations when they are computing e&p under 312(k)(3). b. Method Two: 168(b)(3)(D) starihgt line method, this is over the usual ACRS recovery period of the asset. Must be applied to all assets of a class (all five-year property). i. With computer, it will produce the same results as 168(g), but GENERALLY this election is typically a little faster than 168(g) b/c typically the 168(g) write-off is based on class lives, whereas 168b3D applies the class life method. c. Method Three: 168(b)(2)(C) this election does not apply to depreciable real property, meaning it gen. only applies to depreciable non-real estate. It can elect to use the 150% declining method with an ultimate switch to straight line. i. Recovery period is the typical ACRS (not class life). ii. Conventions are the same as always. iii. If we make this election to the qualified technological equipment, the TP would get to retain the five-year period. iv. MANDATORY USE: This method is used for non-real estate that has to be used for purposes computing TPs alternative minimum tax (AMT). UNLESS, you chose to use the alternative method (straight line). This method forces TP to slow down deductions. Problem 2: Assume 179 is not elected in problem 1(c) and depreciation is determined under 168 by the most accelerated method allowed. What is the amount and character of Ts gain or loss if, on June 1, of Y3, T sells the computer for $25,000. Alternatively, for $125,000? i. Original Basis $100,000 ii. Amount Realized $25,000 iii. Adjusted Basis (100,000 20,000 32,000 9600) 38,400
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iv.
v.
vi.
vii.
viii.
ix.
1. Issue: what convention do we use? We applied the mid-year convention on the way in so we have apply the half year convention on the way out. (d)(4)(A) both in acquisition and in disposition. So when this asset is sold on June 1, of Y3, it is treated as being sold at the midpoint of Y3, the TP will get. Loss: 13,400 (25,000 38,400) Character of the loss: Problem also looks at character of the loss: 1. Ordinary income and loss does not receive special treatment in the code. Capital gain may get preferential treatment, 15% max under 1(h). Capital losses can be deducted to the extent of capital gains and to the extent of excess capital losses can be offset against ordinary income to the extent of $3,000. 1221: defines capital asset 1. 1221(a): defines all assets as capital assets 2. 1221 excludes eight kinds of assets from the list of capital assets. a. (a)(2): does not include depreciable business property, as well as real property that was used in the TPs biz. i. As applied the computer would not be considered a 1221 capital asset. ii. However, disposition of those assets, if held more than one year, they get their own special treatment under another provision of the code. SECTION 1231. 1231: sales of property 1. Mechanically you look at all 1231 transaction during a given year and compute aggregate gains from 1231 trans., do the same for losses, and then there are two rules: a. If total gains exceed total losses all gains will be treated as longterm capital gains. i. This means that net gains from the year will be LTCG. As an individual this means that you will likely have preferential treatment. ii. Subject to an exception in 1231(c). b. If total 1231 losses exceed gains, all the losses from 1231 exchanges will be treated as ordinary losses. The result either way is usually a benefit for a non-corporate business TP. i. This means losses will not be restricted under 1211, which restricts capital losses. 2. If you are dealing with a taxable corporation, the application of 1231 is the same but the ultimate benefit to a taxable corporation is not as good b/c they do not get preferential capital gains rates. a. Losses: this is a benefit however for corporations b/c it will not be subject to 1211 limitations. Character of Loss here: 1. Depreciable biz asset held for more than one year, and if this represents the TPs only capital losses for the year, then this $13,400 is going to be an ordinary loss. Alternatively, if the TP sells the computer for $125,000 what is the tax consequence? 1. Now there is a gain $86,600. As before the computer is 1231 property that is held for more than year. If that was all we had to
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deal with than simply by applying 1231 we would anticipate that the entire gain would be a LTCG. However, there is another character issue (1245). 2. Only $25,000 is due to actual appreciation, in the value of the computer, from the time we bought the computer to the time of disposition. The remainder represents the depreciation we took. Effectively $25,000 represents true market appreciation and $61,600 represents the depreciation. To the extent that this gain arises from ordinary depreciation deductions that were taken by the TP in the past, the code takes the position that capital gain treatment on a later sale would be too generaous for the TP. In some sense the prior depreciation deduction were based on an unstated statutory assumption that the computer was losing value at a pace similar to the deductions. Here, however, the value went up. So the code will say that to the extent that it did not lose its value, the TP has to give back its depreciation deductions to a decrease in value through reporting ordinary income. TO the extent it applies, it will take priority over 1231. 3. Character of the gain: a. 1245 depreciation recapture: applies if 1245 property is disposed of by the TP. There are many 1245 property that are excepted from this rule (1245(b)). b. 1245(a)(3) property is depreciable personal property which is primarily non-real estate, subject to a couple of exceptions (which we dont care about). c. The computer is 1245 property b/c it is depreciable personal property. d. On the sale of the computer TP will have OI to the extent of the lesser of the recomputed basis or the AR from its sale exceeds the adjusted basis. e. 1245(a)(2): recomputed basis TPs AB in property plus all adjustements reflected in that AB figure on account of deprecitation and amortization deductions of the TP or any other person, including 179 deductions i. This just means your AB plus everything added back. ii. (a)(2)(B) if the TP can show the depreciation allowed, was less than the depreciation allowable, than the add back for recomputed basis purposes is only the actual deductions. f. Under these facts the recomputed basis is $100,000. i. 100,000 38,400 = 61,600 (ordinary income). ii. $25,000 = capital gain 1231 gain so it has to be compared to other 1231 income/losses throughout the year, but under these facts it appears to be the only 1231 property. g. Go through 1231 analysis before coming to this conclusion. h. Notice about 1245 it is simply a characterization provision, it doesnt create gain or loss. The portion of the gain that it does characterize gets taken out of what would be a normal 1231 analysis.
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Also notice that 1245 had no application in the prior part of the problem when the TP sold the computer at a loss b/c the AR was only $25,000. In the absence of the excess there is no 1245 trigger. k. Problem Three: Instead of selling the computer, on June 1 of Y3, T transfers it and all other assets used in her law practice to a newly organized professional corporation in exchange for all the corporations stock. THe computer was worth $125,000 when this transfer occurs. i. (a): The code is going to treat this as a continuation of the TPs investment in the computer rather than a closing out. The TP will not recognize gain on the exchange of the computer for the corporations stock (351). 1. Corporation will take the AB of the transferred property, under 362(a). This is the rule for gain. a. There is a special rule for loss property that is transferred. 2. No gain is recognized, the corporation simply takes a transferred basis. 3. 1245(b)(3) is going to remove the depreciation recapture possibility at the time of the exchange. Where the recipients basis is determined by reference to the transferors basis, then the recapture rules only apply to the extent the TP had to recognize gain in that 351 transaction. 4. If boot is received in addition to the corporations stock, then 351 says that the contributing SH has to recognize gain to the extent of the boot. 5. (b)(3) is saying if boot is received then 1245 will help to characterize it. ii. (b) 1. We also have 168(i)(7): in a 351 transfer the corporation will be treated the same as the transferor for depreciation pruposes with respect to so muchof its basis as does not exceed the transferors basis. a. In other words, to the extent the corp is taking over the contributing sh basis,t he corp. will continue to use the contributing sh basis, method, and whatever remains of the depreciation deductions. i. Or, aka, corporation steps into the shoes of the contributing shareholder. 2. Prorating Y3 is governed by proposed regs. 1.168-5(b)(4). For the depreciation attributable to the SHs basis in that asset (all here), the regs. provide that the available deduction be allocated between the contributing SH and the corporation on a monthly basis. a. SH gets deductions in months prior to the exchange. b. Corp gest deduction in months after. 3. The SH gets 5/12 4. Corp gets 7/12. 5. The allocation will affect the adjusted basis of the property at the time of its contribution. If SH gets depreciation of 20, 32, and 8 in the year of the transfer that is 60 to SH.. 6. Suppose the corporation took the computer with a basis greater than the SHs. How would this come up? This comes up when the
i.
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l.
corporation gives boot along with the stock. 362 says the corporations basis is increased by the gain recognized by the shareholder (boot) in the transaction. Under this scenario how would corporation depreciate the amount in excess of the SHs basis? Under proposed regs. 1.168-5(b)(7), it would be treated as a separate transaction with its own recovery period. iii. (c): corporation sells the computer for $70,000, what gain or loss will be recognized on the sale, and what will be the character of the gain or loss? 1. step one: what is the corporations AB a. $40,000 (AB when received 11,200 5760) b. Depreciation in Y4 = $5,760, Y4 half-year convention. c. AB - $23,040 2. step two: what is the gain? a. $70,000 23,040 = 46,960 3. step three: what is the recomputed basis? a. OI = (lesser of RB or AR) AB b. = lesser of $100,000 (RB) or 70,000 (AR) = 23,040 c. recomputed basis = $100,000 b/c 1245(a)(2) says the recomputed basis means to add back from the deductions of the TP or any other person, this would include the amount deducted by the SH before the exchange. d. 70,000 23,040= 46,960 (OI) 4. This shows that the depreciation recapture potential is preserved in the corporation b/c it takes into account, in recomputed basis, the amount of deductions taken by the SH before the exchange. 5. For the corporation this isnt that big of a deal b/c it doesnt get LTCG preferential treatment. 6. Where it could be significant is where you have a corporation that has a large amount of capital losses and is craving capital gains, then it wants capital gains in order to offset the capital losses and this type of situation would not help out the corporation. 7. Gift Treatment: If this was a gift, the results would be the same due to the transferred basis rules of 1015. 1245(b)(1). 1.168-5(f)(3) would apportion the depreciation deduction for the year of the gift itself just like we did it above. Also provides that the donee steps into the shoes of the donor. The proposed regulations fill in the gaps (168(i)(7) doesnt tell us this). If the donee disposes of property at a gain, on that sale, wed apply 1245 and the definition of recomputed basis in the way we did in problem 3 as well. Problem Four: Instead of selling the computer or incorporating her law practice, T dies on June 1 of Y3 when the computer is worth $75,000. Ts will leaves the computer to Ts son, S, who then uses it in a business that S owns and operates as a sole propertierships. i. (a): does 1245 affect this situation since there was 1245 recapture at the time of the death. 1245(b)(2) excepts transfers at death from the recapture rules. ii. (b): whats the sons basis in the computer? 1. 1014 gives the son a FMV at the time of death. a. FMV has nothing to do with prior depreciation deductions taken by the decedent. The significance is that when the son later sells the computer and we need to figure out his
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recomputed basis, his recomputed basis will not include prior depreciation deductions taken by the decedent. This is different from a 351/gift scenario where you have a transferred basis. As a result, theres no recapture potential passing form the decedent to the beneficiary whereas there is in 351/gift scenarios. This is in 1.1245-2(c)(1)(iv). Class Seven: October 16, 2006 m. Problem Four Continued i. Deductions: 1. Basis: $100,000 a. -20,000 b. -32,000 2. OI ii. Part(c): What depreciation deductions are allowed to T and S for Y3? 1. Apply the short taxable year when an individual TP dies and leaves property to someone. This is in 443, and in 1.443-1(a)(2). 2. Short taxable year 3. For purposes of depreciation for the decedent, proposed reg 1.1685(f)(4) says to apply the short taxable years, which are cited in 1.168-2(f)(1). Take the full year and multiple it by a fraction which amounts to the amount of full and partial months in that year divided by twelve. 4. Under our facts, an entire years depreciation allowance would have been 19,200 x 6/12 (full and partial months). Which gives the decedent a depreciation deduction of 9,600 5. Query: whether in the year of death, the death is viewed as a disposition of the computer by the descendant in which case we have to apply the applicable convention. This would mean that 9,600 would be halved again. Professor Davidian doesnt think that this was the intention so the decedent would get the full amount. 1.168-2(l) which says that a disposition for purposes of depreciation rules does not include a disposition made at death. 6. What about the sons basis? It should not use the normal rules from 351 and 1015 gifts b/c there is no carry-over or transferred basis here. It is a stepped up basis and therefore he starts at the FMV and it is like he starts over entirely, with a new period, convention, method. 7. Is 179 applicable for the son? 179 is only applicable for purchases. iii. Part (d): If S sells the computer on February 1 of Year 4 for $80,000, what is the amount and character of the gain or loss on the sale? 1. Amount Realized= 80,000 2. Adjusted Basis= 48,000 a. 75,000 (basis) i. 15,000 from year 3 ii. 12,000 from year 4 b. = 48,000 3. Gain = 32,000 4. We have to characterize the gain, according to 1245? a. OI= (lesser of RB or AR) AB
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i. (lesser of RB or 80,000) 48,000 ii. Son only adds back 27,000 b/c thats how we started with the son. Idiot thea you knew that. 1245-2c1 iii. So the lesser is 75,000 -48,000 1. = 27,000 iv. The remaining 5,000 is long term capital gain b/c you get the holding period of the parents. b. It is 1231 property. This is capital asset b/c it is depreciable property held in a business. 5. Result may change if we were dealing with a taxpayer dying after 2010. If you recall under 1022 if the decedent dies in 2010, then beneficiaries basis starts out equal to the decedents adjusted basis in the property at the time of death. Later sale by the beneficiary at a gain, there would be recapture, but now recomputed basis might well include the decedent. These things were reflected in ultimately determining the basis in the property. III. Real Property: Problem C a. B/c there is both land and property here, we need to allocate some part to the land and some to the building b/c only the building is depreciable. 1.167(a)-5 i. Basis 1. Land: 2. Building ii. Depreciation Approach 1. We cannot use 179: only applies to 1245 property 2. 168 is applicable and we have to know three things: a. method, period, and convention 3. Method: straight line 4. Period: we have to determine whether it is residential real or nonresidential a. residential real: any building if 80% or more of gross rental incomeis is from rental of dwelling units. A dwelling unit is a house or an apartment building but not a unit in a hotel. b. So this hotel is not residential real, it is non-residential real property. 5. Convention: mid-month a. Depreciation for the balance of that first taxable year. b. Real property not covered by the mid-quarter convention. c. Under our facts the TP will get 2.5 month in Y1, all of Y2, and 6.5 months in Y3. 6. Amount Realized a. 50,000 (AR) 25,000 (AB) = 25,000 (Gain) i. this will be longterm capital gain b/c it is 1231 property ii. no depreciation recapture to worry about. b. 400,000 (AR) 372,500(AB) = 27,500 (gain) 7. How do we deal with the recapture? When dealing with depreciable buildings we are dealing with 1250. a. 1250(a)(1) says that on the disposition of the building the OI= applicable % X (lesser of AD or Gain)
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b.
c. d. e.
i. as a general proposition the applicable percentage (above) will be 100% Additional depreciation is defined in 1250b1- if the property was held for more than one year, the additional deprecation s is the deprecation allowed on the buileidng in excess of straight line method. Since the building had to be derpceted on the straight line method, this means there is no excess of depreciation allowed over and above straight lines.) 100% X (0 or 27,500) So this means that 100% X (O) = ZERO If the TP had held property for one year or less than under 1250 the additional depreciation would have been the entire depreciation.
iii. Gain: 1. 27,500 is 1231 gain, all of it, b/c of above. 2. What is the characterization of this gain? 1(h) a. Will it be taxed at the best rate or is there some other rate. The other possible 1h1(D) that applies with something referred to unrecaptured 1250 gain which is defined in 1h(6) essentially as the longterm capital gain of the TP that would have been ordinary income if section 1250 applied to all of the depreciation taken on the building and not simply to the additional depreciation. b. Applying this: i. It would have been: 100% X (lesser of 17,500 or 27,500) ii. b/c 17,500 = all the depreciation iii. that means that 17,500 is treated as unrecaptured 1250 gain which does not qualify for the best preferential tax rate applicable to net capital gain. It is taxed at 25%. The other 10,000 along with the sale of the land, that would be the adjusted net capital gain and under 1(h), this qualifies for the best treatment under 1(h). b. THe only thing that would have changed would have been the recovery period which would have become 40 years, and the annual straight line recovery becomes 2%. This is the same, as would be applied with residential real property IV. UNIT III a. Effect of Financing on Basis i. In General: Problems Part A b. Book Notes: Part II i. Woodsam: Increasing your mortgage on a non-recourse loan is not a realization event for purposes of 1001 which would result in recognized gain. 1. There is no realized gain upon the subsequent borrowing.
Class Notes: November 6, 2006 V. Unit IV: Capital Gains
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a. Overview: i. We need to distinguish ordinary income/loss from capital gain/loss. Operative provisions on the ordinary side are in 64 and 65 which essentially say that any gain or loss from the sale or exchange of property is ordinary, unless the asset that youre involved with is either a capital asset or 1231 property. 1. 1231 property: ii. Capital Assets 1. 1221 Capital Assets Defined: All property is a capital asset, except for eight types of property that are specifically listed in the statute as not being capital assets. Property which is not capital property: a. Inventory (1221(a)(1)) 2. 1222 Definitions: a. Capital Gain: arising form the sale/exchange of a capital asset to the extent that the gain/loss is taken into account for tax purposes. i. Gain that must be recognized ii. Loss that is potentially deductible by TP. b. Longterm capital assets vs. Shortterm capital assets c. 1222(11): net capital gain derived from sales of capital assets, defined as the excess if any of TPs NLTCG NSTCL = net capital gains. iii. Impact of Netting (TAX RATES): 1. The distinction is important based on whether the TP is dealing with gain or losses in the given year. 2. Net Capital Gains Rates (1(h)): a. Tax preferences to non-corporate taxpayers who have net capital gain. b. Under the tax rates schedules that exist for individuals under 1(a)-1(d) amended by 1(i), tax rates can be as high as 35%, but that indivudal will not pay tax on its net capital gain on rates tahte exceed the rate limits that are in 1(h). c. On sale of most capital assets, the maximum rate applied to TPs capital gain derived from those sales will generally be 15% under 1(h)(1)(C). d. Unfortunately, special rules under 1(h) complicate things by applying different tax rates in certain situations. i. 1(h)(1)(E) 28% net capital gain for sale of collectibles, artwork, coins. ii. taxable gain derived by TP for the sale of small business stock that qualifies for a 50% exclusion from GI under 1202 of the statute. 1. this refers to stock of a c-copr that was issued directly to the TP after 1993 and that stock had to have been held by the TP for more than 5 years prior to its sale. The gain derived from sale will get a 50% exclusion if the corporation is qualifed under 1202. The 50% that is still going to be taxed will be taxed at a maximum rate of 28%, which really means that the tax rate is 14% which isnt a huge savings.
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e. Also a 25% rate for certain net capital gain for depreciable property. i. (h)(1)(D) applied to unrecaptured 1250 gain. Which is the gain from a sale of depreciable property that is not the recaptured amount. f. 5% ((h)(1)(D)) for taxpayers who have little or no taxable income but still have some net capital gain that would otherwise have been taxed at a maximum of 15%. i. This is so limited in application and so in the class were going to ignore this issue. ii. Just be aware that the 5% rate exists. iv. Mechanics 1. We have to compute the Taxable Income, including the TPs recognizable capital gains and taking into account the capital losses. Once we know the TI we will figure out the tax lialbity for the year. From the TI figure we will identify the next capital gain for a given year. Whatever is not capital gain will be the other category. a. **The only quirk is that in carving out from TI the Net Capital Gain, we will also include as part of Net Capital Gain, one type of ordinary income which is dividend income 1(h)(11) b/c of the rates applicable to dividend income. b. Once the distinction is made, we will apply the taxrate schedules to the other TI up to a maximum of 35%. c. Then we will apply the tax rates schedules for the net capital gain. d. This will produce a tax saving for those taxpayers who have net capital gain. 2. There is no rate preference for c-corporations capital gains. a. 1201(a) and 11 interplay b. 1201 will cap the rate on corporate net capital gains at 35% if the maximum rate of tax imposed on corporate taxpayers generally should ever exceed 35%, but at present the maximum tax rate generally applicable to c-corporations is currently 35% and so as a result there is no potential tax rate preference for corporations that have net capital gains. 3. On the loss side the significance of capital losses and oreinary losses is significant for indivudals and for corporations b/c there are special limiations on the amount of capital losses a TP can deduct in any given year and those limitations are applicable to both individuals and corporations who dont get the benefit on the gain side. Class Notes: November 13, 2006 b. Capital Gains- Overview i. No preference for capital gains generated by corporations which is the result of an interplay between 1201 and 11 c. Capital Loss vs. Ordinary Loss i. On the loss side the difference is significant for both corporations and individuals.
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ii. The significance is due to the limit on the amount of capital loss that a taxpayer can deduct in a given year. iii. Step one: determine if the loss is deductible by taxpayer, which is under 165. 1. 267: which disallows losses sustained by a seller of an asset when the sale is to a related party, as specified therein. a. Example: Father sells an asset to Son, 165 doesnt deal with this b/c the loss is not allowed under 265. 2. Under 165(a), losses are deductible. a. 165(c) governs losses for individuals and states: with respect to losses incurred on the sale of assets that produce a deduction for an individual taxpayer are limited to two situations. i. Losses incurred in the taxpayers business (loss from a business asset); or, ii. Losses incurred in a transaction entered into for profit (investment transaction). 1. Loss from a sale of stock will be allowed under 165(c) b. Losses that are purely personal are not deductible. i. Sale of personal residence at a loss is not deductible at all so we dont even care about if this is a capital gain or not. 3. 165(f): losses from capital assets sends TP to 1211 and 1212 which limit the current deductibility of losses on the sale or exchange of capital assets but have no application to ordinary losses. iv. Step Two: Loss limitations on individual taxpayers. 1. 1211(b) for individuals the limitations on deductible. 1211b provides that deductible losses are only allowed to the extent of gains derived on the sale of other capital assets. a. Loss limitation: You can use excess capital loss against ordinary income including dividend income subject to a maximum deduction against ordinary income of $3000. 2. 1212(b) Excess loss: a. losses in excess of $3000 can be carried forward indefinitely for individuals. v. Step Three: loss limitations on corporations 1. 1211(a) capital losses are only allowed to the extent of capital gains. a. There is no offset. 2. 1212(a) carry-back and carry-forward a. Carry-back: Unused capital losses of corporations can be carried back for three years for use against capital gains in those earlier year. b. Carry-forward: Any additional excess losses can be carried forward for up to five years. c. This means there is an expiration date on vi. Identifying a loss as a capital loss can have negative effects in terms of the taxpayers ability to get immediate tax benefits from the loss that has been generated.
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d. Mechanics of Net Capital Gain i. Tax rate preferences within 1(h) only apply if the taxpayer has net capital gain within the given year. ii. Net Capital Gain 1222(11): the excess of the net long-term capital gain for the taxable year over the net short-term capital loss for such year. 1. Dividend income doesnt fit into this definition under 1221(11) 2. This definition suggests that when a TP wants to compute its net capital gain from sales for the year, 3. Step one: TP has to separate its sales of long-term capital assets from sales of short-term capital assets. a. Holding Period: holding period determines whether something is a short-term or long-term asset. The definition of long-term and short-term is in 1222(1), (2), (3), and (4). 4. Step TwoNetting process: net out the short-term capital losses against capital gains and long-term capital gains from long-term capital losses. a. Net capital losses against capital gains for the year. This is doing nothing more than carrying out the rule of 1211 that you can deduct capital losses against capital gains. b. Long-term side it is more complicated b/c there is more than one category of long-term capital gain, 15%, 25%, and 28% category. c. At times we may have to focus on those subcategories, but in the first instance we dont have to do this. d. Netting process i. First net the long term against the long term and the short term against the short term 1. Example: a. TP has a NLTCG and NSTCL ii. Second, net the NSTCL against the NLTCG which is ok under the 1211. If the TP has net capital gain then he is on the road to preferential treatment, including dividned income. 5. Step Three 1(h)(11) if after netting you have net capital gain, including dividend, and then breaks that figure down into components, with each getting a different preference. a. 1(h)(3): adjusted net capital gain which is defined as the taxpayers net capital gain from the sales that remains after backing out unrecaptured 1250 gain, 28% gain, and dividend income. b. ANCG is good b/c it is taxed at a maximum tax rate of 15% i. Some might be taxed at 5%. c. Unrecaptured 1250 gain is taxed at a maximum of 25% under 1(h)(D) d. 1(h)(4) collectibles is taxed at a maximum of 28%
e. Problem one: T, an unmarried taxpayer, is in business for herself. This year, T

has $350,000 of taxable income without regard to the transactions listed below. The character of this $350,000 is entirely derived from ordinary income
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transactions (e.g., fees for services, sales of inventory, etc.). On June 1 of this year, T also engages in the sales transactions described in the questions below. For each question, where relevant, determine the amount of T's taxable income that will be subject to each of the tax rates set forth in 1(c), as amended by 1(i), and 1(h) [ignoring the inflation adjustments in 1(f)] as well as the amount of any loss carryovers. Do not bother computing Ts actual tax liability. i. (a) T has the following gains and losses from sales. In each case, Ts holding period for the asset sold is set forth below: 1. (i) T sold shares of IBM stock that T had held for investment for three years at a gain of $29,000; a. LTCG of $29,000 2. (ii) T also sold shares of AT&T stock that T had held for investment for two years at a loss of $3,000; a. T will have a LTCL of $3000 (1224(4)) b. Now T will have an adjusted net capital gain of $26,000. c. $26,000 will get the preferential treatment 3. (iii) T also sold shares of Microsoft stock that T had held for investment for ten months at a gain of $19,000; and a. T will have STCG of $19,000. This will be considered ordinary income b/c it is a capital asset which has been held for less then a year and therefore does not receive a preferential rate. 4. (iv)T also sold shares of Intel stock that T had held for investment for one month at a loss of $1,000 a. 1222(2) STCL of $1,000 b. $18,000 STCG adjusted capital gain. LTCG= 29,000 LTCL=3,000 NLTCG= 26,000 STCG= 19,000 STCL=1,000 NSTCG=18,000 5. Answer a. TI= 350,000 + 26,000 + 18,000 i. 394,000 b. Netting out i. NLTCG NSTCL ii. 26,000-0=26,000 c. ANCG i. You have to back everything out. ii. Here, however, there is nothing to back out b/c we only had 15% gain. d. What about the NSTCG? i. It is taxed at ordinary rates. So the 18,000 will be taxed at the 35% rate so this amount is just added to that bracket. e. For this TP we have a 20% differential between the $26,000 which is taxed at 15% and the 18,000 which is taxed at 35%. f. 18,000 rate is gain from assets that she hadnt held long enough.
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g. The tax rate preference is designed to encourage longer term investment. But keep in mind that long-term only means a year and a day.
ii. (b) Dividends and the interplay with capital gains rates: Introduces you to
1(h)(11): Assume the same facts as in part (a) above, except that T also received $1,000 of dividend income this year from the shares of each corporation. 1. This amount is not contributed to the capital gain calculation even though it gets preferential rates. 2. Since corporate dividends are distributions of corporate earnings and therefore since they dont result from a sale of any property by the shareholder, they are an illustration of ordinary income. 3. The receipt of dividend income also creates a form of doubletaxation b/c the corporation was taxed on its earnings and when those earnings are distributed to the shareholders, the shareholders are taxed on those earnings. 4. Now the term net capital gain as used in 1(h)(11) for rate purposes also will include qualified dividend income. a. 1(h)(3): qualified dividend income gets added into ANCG, meaning that it will qualify for the 15% preference. b. Beyond rate purposes, dividend income is still ordinary income, and it is not capital gain. It is only treated as capital gain for rate purposes. Therefore, capital losses cannot freely be used against dividend income that the TP may have. 5. Qualified dividend income can include dividends from domestic corporations and from foreign corporations. Minimum holding period: a. To be qualified dividend income there is a holding period requirement. Under 1(h)(11)(iii) says the preference is removed with respect to dividend income of the SH held the stock for 60 days or less during the 121 day period surrounding the day the shareholder became entitled to the dividend. i. You get this holding period by cross-referencing this with 246(c) b. That means that the Intel stock will not be qualified dividend income b/c of the holding period for qualified dividend income, and as a result there is no tax rate preference from the Intel stock. i. Rationale: the code is limiting the benefits for TP who bought stock in order to get a dividend only to turn around and sell the less valuable stock afterwards at a loss. ii. If the government gave the TP the dividend the preferential rate, she would only pay 15% on the dividend and as a result of the loss too, the net benefit is $200. c. 394,000 + $4000 = 398,000 d. So, $29,000 will be taxed at 15%
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e. Other income = $369,000
iii. (c) Limitation on deductibility of Losses: Assume the same facts as in
LTCG 29,000 STCL 40,000 NLTCL 11,000
part (a) above (but no dividends), except that the loss on the AT&T stock in (ii) was, alternatively, $40,000, or $60,000. 1. Step one: net capital losses against capital gains in the same groups a. LTCG against LTCL b. STCG against STCL 2. Complication of netting LTCG: a. This process can become more complicated b/c 1(h) creates multiple categories including 28%, 25%, and 15% on the long-term capital gain side. b. If you have LTCG and LTCL in different sub-categories (15, 25, 28% categories) normally what you do is to net in the same sub-category first i. LTCL vs. LTCG (15% group) ii. LTCL vs. LTCG (25% group) iii. LTCL vs. LTCG (28% group) c. May be a net-long-term loss and long-term gain from different categories. If one long-term group has a loss and another has a gain, you continue the netting and you do that by applying the net loss from a long-term sub-group against the long-term gain in the highest sub-group. i. If there is a net-loss in the 15% subgroup that is applied against net-gain a TP may have in first the 28% subgroup and then the 25% subgroup. ii. If there is still a net longterm loss for the period then and only then is that netted against any short-term gain. d. ALWAYS apply the ne e. If the Tp has a net short-term loss in the given period that amount can be used against the net longterm capital gains. First it is applied to offset long-term gains that it may have in its highest taxed long-term grouping, then the next longterm grouping, and then the lowest long-term grouping. f. 1(h)(4) is very clear on this point. g. Similarly, unused long-term capital losses that are carried forward to a later taxable year, retain their status as longterm capital losses in the later year, but when used in the later year, they first offset gains in its long-term group starting with the highest taxed group first. STCG 19,000 STCL 1,000 NSTCG 18,000 3. This will increase the Taxable income by $7,000 (18,000 -11,000) to 357,000 which will be taxed under the other category and taxed at those applicable rates. This is the result b/c he has no net capital gains which receive the preferential tax. a. We will have NLTCL of $31,000 and then we have to net the NSTCG of $18,000 so we have $13,000 remaining which equals the Net capital loss.
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b. So are only allowed to use the $3,000 as a loss and the remaining $10,000 is carried forward and applied against the highest group in the LTCG grouping. c. The remaining $347,000 is in the other category. 4. (i) How would your answer to part (c) above change if T sold the AT&T stock at a loss of $40,000 and T also sold a painting that T had been holding for investment for four years at a gain of $15,000? a. Here we have subcategories involved: the 28% grouping for collectibles. i. In 1(h)(4) includes net gain from collectibles and (h) (5) defines this from the sale of collectibles under 408(m) which includes a work of art. 29,000 LTCG 19,000 LTCL 30,000 STCL 1,000 NSTCG $18,000
15,000 LTCG (28%) n/a NLTCG 4,000
b. How do we tax the $4,000 i. Net capital gain = $4000 ii. ANCG = zero b/c you have to take out that amount which is the collectible. iv. (d) How would your answer to part (a) above have changed if, in addition to the stock sales described in part (a), T had also sold an undeveloped parcel of land that T had been using in her business over the past several years? The land was sold by T for $20,000 at a time when Ts basis in the land was $15,000. LTCG $5,000 (1250) LTCG, 29,000 STCG 19,000 STCL 1,000 NSTCG 18,000 1. Not a capital asset by virtue of 1221(a)(2) which excepts property which was used in the TPs biz and was depreciable or was real property. 2. This property will be treated under 1231 which requires that it be held for more than one year. Under these facts, it would appear that this is the TPs only 1231 property. Because all of the gain from the 1231 transaction exceeds the losses, the gain will be treated as capital gain. 3. This means that here 350,000 + 26,000 + 18,000 + $5000 = 399,000 a. $31,000 equals net capital gain b. The entire amount is Adjusted net capital gain (ANCG) c. Remember 1231(c): To the extent there are net 1231 losses during the five-year period the 1231 gain in the current year will be characterized as ordinary. d. The rule is designed to limit bunching 1231 loss transactions in an earlier year to produce an ordinary loss in that ordinary year while bunching all of the taxpayers gains in a later year in the hope of deriving a capital gain result. 4. (i) Alternatively, assume that Ts basis in the land at the time of sale had been $80,000.
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f.
a. Here the 1231 losses exceed the gains. That means that the net loss will be characterized as ordinary. b. Two significant aspects: i. Loss by being ordinary is not subject to the limits on deductibility that capital losses are. ii. Ordinary loss can first offset what is first higher tax ordinary income, as opposed to reducing capital gain. c. The result is that when you throw the capital loss into the mix ($60,000) you reduce the taxable income down to $334,000 i. 350,000 + 26,000 + 18,000 + <60,000> = 334,000 ii. $26,000 is NCG iii. $308,000 is in the other category. Questions #2 and #3 i. Book Notes: Definition of Capital Asset (pg. 1134-1162) 1. Suburban Realty Co. v. US a. Facts: Real Estate company sold some portion of its interest in 1700 acres of unimproved land and upon a refund claimed wanted to consider the gains from the sales as capital assets and therefore a capital gain. b. Issue: when profits have arisen from the ordinary operation of a business on the one hand and are also the realization of appreciation in value over a substantial period of time on the other, are these profits treated as ordinary income or capital gain? c. Analysis: Apply the following framework i. Was taxpayer engaged in a trade or business, and, if so, what business? 1. Suburban was in the r/e biz. ii. Was taxpayer holding the property primarily for sale in that business? 1. The primary purpose over time for holding the properties was for sale. This court traces the holding of the property rather than looking at the purpose at the time of the sale. iii. Were the sales contemplated by taxpayer ordinary in the course of that biz? 1. Although market forces were directly involved in the appreciation of the property held by Suburban, narrow construction of the term capital asset has been applied Cong. And the SC and therefore this will not be considered a capital asset. d. Holding: Suburbans gains will be considered ordinary income. 2. 1237 (Safe Harbor) a. provides capital gain treatment for individuals not otherwise holding real property for sale to customers who are engaged in minimal subdivision activities with respect to a tract held for investment for at least five years. b.
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Class Notes: November 20, 2006 g. Capital Gains (Question One continued) i. 1245 Depreciation Rules (e): How would your answer to part (a) above have changed if, in addition to the stock sales described in part (a), T had also sold some machinery that T had been using in her business over the past several years? The machinery had been purchased by T for $10,000 and T had properly taken $6,000 of depreciation deductions with respect to the machinery prior to its sale (no 179 election had been made by T). T sold the machinery for $15,000. 1. TI a. 350,000 OI b. 26,000 NLTCG c. 18,000 NSTCG d. 2. Depreciation recapture rules as a characterization element within the code and also reviewing the possibility that depreciation recapture when it applies under 1245 will serve to trump/override what otherwise might have been the gain under 1231. 3. Tp will sell this amount at a gain 4. 1245 formula: a. Total Gain of $11,000 (15,000(AR)-4,000(AB)) b. OI= (lesser of RB or AR) AB i. Recomputed Basis (RB) = $10,000 ii. AR= $15,000, so iii. 10,000 - $4,000 = $6000 iv. $6000 equals ordinary income c. Since she had an additional $5000 gain i. $5000 equals capital gain ii. Depreciable property used in her business, so this is 1231. iii. 1245 only trumps 1231 to the extent of the recapture amount. iv. $5000 additional gain from the sale is capital gain v. Then you have to net the 1231 gains and d. We have to consider 1231(c) look back rule, but we have no facts that would indicate that this amount is applicable. 5. This means she has another $11,000 of income to add to the amount from (a), $6000 is OI and $5000 is LTCG 6. This means she has a total of $405,000 income 7. $31,0000 of ANCG 8. 374,000 other income
ii. 1250 depreciation rules (f): How would your answer to part (a) above
have changed if, in addition to the stock sales described in part (a), T had also sold an office building that T had been using in her business over the past several years? Disregarding the land underlying the building, the office building had been purchased by T for $400,000. Prior to the sale, T had properly taken $20,000 of depreciation deductions with respect to the office building. Disregarding the underlying land, T sold the office building for $410,000.
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1. TP had an adjusted basis of 380,000 2. Gain is $30,000 3. 1250 recapture provision, but if the depreciable real property was held by TP for more than one year, 1250 will only cuase ordinary income to recapture to exist if the TPs depreciation on the building was in excess of depreciation using the straightline method. a. 1250 OI= Lesser of AD or gain b. gain was $30,000 c. TP had to use the straightline method, and as a result the AD was zero and since the OI is the lesser of AD or gain, the OI is gain. 4. If the $30,000 is not OI then it is 1231 real property used in the business so long as it was held for more than one year. 5. Since it is the only 1231 property in the year, and the 1231(c) look back rule isnt applicable then this amount will be long term capital gain. 6. TP has 424,000 total taxable income 7. The portion of that income that would be capital gain is $56,000 8. $368,000 - Everything else falls into the other taxable income categories. 9. Then we have to figure out the maximum tax rate applicable to the capital gain. 10.1(h)(1)(D) unrecaptured 1250 gain which is a defined term in 1(h)(6) and is essentially defined as the amount of LTCG that would have been OI if 1250 applied to all the depreciation that the TP took on that building and not just as it is determined under the 1250 (AD) rules. a. Under these facts all the depreciation was $20,000 (which we determined was not AD). b. So this amount goes into the unrecapture 1250 gain. And would be taxed at a maximum tax rate of 25%. 11.The remaining $36,000 is going to be ANCG 12.There is a possible limit on 1250 gain from 1231 transactions. a. 1250 gain with respect to 1231 property cannot exceed the TPs overall 1231 gain for the year. b. Meaning, if you have 1231 losses that are treated as capital losses those capital losses may serve to offset potential 25% gain. c. This is not applicable in this problem. iii. Transition: most of what weve looked has been on the assumption that were dealing with a capital asset, but were going to look at how to determine whether something is a capital asset VI. Defining Capital Assets a. Overview: i. 1221(a) In general - defines all property as capital assets: ii. 1221(a)(1)-(8): excepts eight categories that are not capital assest. 1. These eight exceptions have in common either a business nature or a services nature to them in terms of being excepted from the definition of capital asset that we start out with.
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2. 1221(a)(1): property held by the TP primarily for sale to customers in the ordinarcy course of the TPs business a. Example: inventory b. What the statute is attempting is to distinguish ordinary business profits from investment profits.
b. Question Two: In each of the following alternative situations, determine whether

the properties being sold are capital assets in Ts hands:
i. (a) 's full-time occupation is trading in securities. She spends her days
researching stocks and bonds, talking on the telephone with brokers, and keeping records of her trades. Last year, she made 253 purchases of stocks and bonds and 362 sales. In thinking about this question, consider particularly the cases described at page 1156 of the casebook. 1. Trader is someone who buys or sells stocks for his/her account. 2. Typically we expect securities trading as an investment activity, but on the other hand given the degree of involvement and number of trades this has become her business- her fulltime occupation. 3. Issue: Does this activity mean that the securities are ordinary assets and not capital assets? (McD. Pg. 1156) a. Traders who trade securities over stock exchanges for their own account is not regarded as selling to customers within the meaning of 1221(a)(1), and therefore it is not property held by the TP sold to customers. b. Rule: gains and losses for a trader will in most cases be capital, and trader will not be able to get ordinary losses. 4. (Pasted from original question) What is it about the nature of their activities that distinguishes "traders" in securities (who generally receive capital gain or loss treatment) from, say, retailers, e.g., the local grocer, whose inventory sales produce ordinary income? Compare the result under 475(f)(1) & (d)(3). a. The principal difference is the markets in which they operate. The retailer generates gains from sales by buying in one market (manufacturer/wholesaler) and selling in another market. Retailer makes money by acting as a middleman between the manufacturer and the ultimate buyer and as a result, the money it makes is essentially for lining up buyers for the manufacturers product. As a result, what the retialers earns starts to look like services. b. Dealers are also distinguished from traders in the same way as retailers. Often the gains from securities transactions are derived by acting as a middleman between the original issuer and the retail market. As a result, the dealer is viewed as selling to customers. i. See 1236- securities dealers gains and losses are ordinary (like retailer) unless the dealer properly identifies the particular security as being held for investment. c. Trader busy/sells over exchanges and so the traders profit depends on changes in the value of securities and is a
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function of the market rather than a function of the traders services on the other hand. i. Less compensatory nature in this business. ii. This may be why the trader generally gets capital gains/loss results. iii. Trader whose (475) business rises to the level of a trade or business may elect to treat it as OI. iv. 475(f): traders in securities (where it constitutes their business) can elect to use the mark to market approach to report gains or losses from securities without realization events. v. If the election is made, under 475(d)(3) gain/loss is reported as OI. d. Why would this election be made i. A day trader is not going to get LTCG b/c the trades are made every day and never held for a year. ii. By virtue of treating the losses as ordinary, they are not limited by the loss limitation rules in 1211/1212
ii. (b) Characterization of Real Estate Transactions:
T is always on the lookout for land to buy, usually holds about 40 tracts, is always willing to listen to offers to buy her land, and makes about six sales in an average year. Ten years ago, T bought an undeveloped tract of land with the intention of holding it for appreciation. The land was rented to a farmer, but the rents were barely sufficient to cover the real estate taxes and interest on a mortgage T took out to finance the purchase. This year, T sold this still-undeveloped tract of land at a substantial gain. 1. This is a question of fact. There is essentially no emphasis on the customers language from 1221. Any purchaser can be considered a customer. 2. Cases in the real estate area are all over the place and so we have to find a good argument as to why the gain should be treated as capital or not. 3. All you can hope to get here is sensitivity training b/c there is really no answer her. 4. Factual Spectrum: a. Ordinary Extreme: Professional developer: buys a tract of land, subdivides, builds homes, improves property and then sells those properties off in numerous sales transactions. Those transactions are clearly ordinary. b. Capital Extreme: Taxpayer who buys a single parcel of land lets it sit unchanged (no developmental activity) in the hope that it will appreciate in value. This will be a capital asset. c. Middleground: buys a single parcel, makes substantial improvements to it, but does not engage in too many sales. i. Or, no developmental activities 5. Here, no developmental activity, even though there are sales over the years. Will this parcel be within 1221(a)(1) and therefore excepted from capital asset treatment? Or will it be a capital asset? 6. Suburban Realty
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a. Facts: TP over the course of 30 years sold about 240 parcels of real estate some of which had been developed by the TP, but the TP had provided no development activities with respect to six sales which are covered by the opinion. b. Issue: Whether the TP can have capital gain treatment with respect to the sales of the six undeveloped parcel. The specific question is: do these property sales fit within 1221(a)(1) (see above)? i. If the answer is yes, these sales will be considered ordinary income. c. Holding: i. Apply the language of the statute by breaking it down into three steps (see pg. 1141) 1. Was TP engaged in a biz? 2. If so, was TP holding property primarily for sale in that biz? 3. Were the sales ordinary in the course of that business? ii. The frequency and substantiality is the most important factor in determining whether it will be considered a capital asset under the three factor test above. 1. frequency shows that the property was primarily for sale in that business. 2. Frequency shows that the sales were ordinary in that business. iii. Development is also important, but less so than frequency. iv. Solicitication and advertising efforts: 1. By the TP are also quite relevant to the analysis under this framework and tend to strenghthen the ordinary treatment of the sales. 2. On the other hand the absence of solicitation is not indiciative of capital asset treatment. d. Results: the sales produced ordinary income b/c the TP was within 1221(a)(1) primarily by looking at the frequency and substantiality of the sales over time. Court was able to look at this and say that the TP was in the real estate business, these sales were primarily for the business and were ordinary in that business. 7. In this question, in arguing for capital asset characterization, TP is benefiting from market values and not from development activities and should argue this point. a. This particular parcel, it was segregated from other assets held primarily for sale b/c this one was bought separately, rented to a farmer, etc. b. Based on Suburban Realty, the frequency/substantiality of real estate sales in total may be enough to characterize these sales as ordinary. c. TP made about six sales in the year, and the TP in Suburban realty sold about 7/8. The problem is that there is no
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brightline rule of when you turn from being a passive investor to being considered in the business of holding the real estate. iii. (c)Single Sale Transaction Characterization: T is a public school shop teacher. Last spring, he bought a residential lot. Over the summer, he and two other teachers, who worked as T's employees, built a house on the lot. T sold the house and lot in October. T has never done anything like this before, and although he sold the property at a profit, he has no definite plans for building any more houses. 1. here there is not frequent/substantial sales. 2. S&H (pg. 1150) where court concludes that one intended sale could be enough to say that the TP was in a business. a. One sale is not a safe harbor that will assure the TP of capital treatment. 3. Damaging facts: a. Extensive developmental activities undertaken in preparation for sale. b. These extensive activities would suggest that this is a business. i. This has a service nature to it. 4. We can probably conclude that this guy was in the real estate business and he was clearly holding the property for sale in this business. Therefore, the sale is ordinary. 5. TPs gain is likely to be ordinary. 6. Real estate cases do not turn on the sale to customers any buyer is viewed as a customer. c. Question 3 Treatment of Change in Purpose over time i. Facts: T owns a farm, acquired years ago for $50 and held for rental, which is located adjacent to an interchange on a recently completed segment of an interstate highway. T receives an offer to purchase the farm for $1,000. T's daughter, a real estate broker, advises: "You'll never get top dollar selling it as it is now. Let me dosome work with it. I'll get the zoning straightened out and put in some basic roads. If you spend $100 on these things, I can sell the property in two or three chunks--one to a shopping center developer and one or two to residential developers-and get at least $2,000 for the whole thing. My commission will be only the standard 6 percent." Advise T on the tax consequences of the daughter's plan. 1. The resulting gain here would likely be ordinary, although the law is not clear here. 2. In accordance with Surburban realty the developmental activities and improvements are likely to make it look like an ordinary sale. 3. On the other hand, we dont have frequent and substantial sales here so that might make it more like a capital sale. 4. The point is, the principal purpose for holding the property can change from holding from rental to holding for sale when the developmental activities began. a. The property doubles in value as a result of the developmental activity which is possibly a big deal. I guess. 5. Would it be possible for the taxpayer to bifurcate the transaction?
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a. Holding for rental purposes the property had gone up $950, then $100 for developmental activities, then another $900 after for the gain. b. So could only the $900 of gain as a result of the developments be considered ordinary income? c. This seems logical, but Davidian says that the case law takes an all or nothing approach in these cases. Cases look at what the primary purpose was at the time of the sale. d. Case law does not take a bifurcated approach. 6. It is likely that this sale will result in ordinary income. 7. In connection with this problem see pg.1154 discussing: 1237. 1237 provides a safe harbor for TP seeking a capital gain result if all the TP did with respect to the land was to engage in subdividing and selling activities. a. This section is unavailable to dealers in real property. b. This means that there will still be a factual issue as to whether the taxpayer is in fact a dealer in real estate. 8. On our facts, assuming the TP is not a dealer in real estate, the safe harbor can be applied if: 9. 1237 Safe harbor requirements: a. Land was not substantially improved; b. Land was not previously held for sale to customers in the ordinary coruse of the TPs biz. c. Property held by the TP for five years before sale. 10.Limitation of 1237 safeharbor: a. First five parcel sales generally will produce capital gain, but when the TP sells the sixth parcel from the tract of land, the TPs gain will be ordinary income up to 5% of the selling price of each parcel sold during that year and thereafter. 11.Difficulty for our TP in using 1237 safeharbor was the construction of the roads which under the 1237 safe harbor would be considered substantial development a. 1237(b)(3) i. Owned for ten years ii. Cant add substantial improvement costs to basis of property iii. Property without the roads would not have been marketable at prevailing prices for unimproved property. b. Application: i. This will probably not apply to our TP b/c he will fail the third element. ii. Therefore, as was said above, the sale will be an ordinary sale and not a capital sale. d. Question 4 Options(1234/1234A) i. On January 1 of year 1, B pays S $100 for an option to purchase a tract of undeveloped land for $1,000 at any time during year 1 or year 2. What are the tax consequences to the parties if, alternatively: 1. Property was probably worth $1100 at the time of the option ii. (a) B exercises the option during year 2; 1. Two issues:
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a. What are the tax consequences when the option was issued for the $100? b. What are the tax consequences of exercising the option in Y2? 2. Consequences of acquiring option a. B has acquired a property right, and has a $100 basis in the option right. b. That cost has to be capitalized. 1.263(a)-4d 3. Consequences to S of issuing the option. a. The $100 receipt for the option right is deferred until the option is exercised or when it expires. b. On Jan. 1, Y1 the receipt of $100 is not considered a disposition of property. See Rev. Rul. 58-234 i. Upon issuance of the option, S is seen as incurring a debt. 4. Consequence to B of exercising option a. When he exercises the option, B acquires the property and takes a basis of $1100. i. Contrast this with what happens in a 83 compensatory option where there may be income. This is not the case in an investment option. 5. Consequences to S of the exercise a. AR of $1100 b. Assuming S is in a gain posture, the character of the gain will be determined based on the underlying property. c. Here it is likely that it will be a capital gain b/c the property d. This is not determined under 1234. 6. 1234 deals with transactions involving option rights itself. iii. (b) B sells the option to A for $75 during year 1, and A exercises the option during year 2; or 1. B has a $25 loss as a result of the sale. 2. This would happen if the value of the underlying property has gone down. 3. The option loses value b/c of the loss in value of the underlying land. 4. The issue becomes, what is the character of Bs resulting loss? 1234 a. 1234(a): the character of Bs loss depends on what the character of the land would have been in Bs hands had he acquired it. i. If B was going to hold the land for investment the loss would be considered a capital loss. ii. The period of time that B held the option before he sold it will determine the holding period as to whether there is a long term or short term capital asset. 5. Tax consequences to A a. Cost basis of $1075 when he exercises the option. 6. Tax consequences to S? a. Same result as before b/c someone else already paid the full $100
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of year 2? 1. B has lost $100 b/c he gets nothing b/c the land lost value in the interim so that it would make no sense economically for B to exercise the option. 2. Presumably the land is worth less than $1100 3. 1234 says that a loss attributable to the filaure to exercise an option gets the same character as the land would have had if Bs hands had he acquired it. 4. This means it is probably a capital loss. 5. 1234(a)(2) expired optin ins treated as sold/exchanged by B on the date that it expired. 6. $100 LTCL. 7. Tax consequences to S a. When option lapses, Ss obligation is gone but S is ahead by $100. b. $100 of gain. c. What is the character of the gain? i. It is governed 1234A (see 1193) ii. Gain or loss attributable to the expiration of Ss obligation to B with respect to any property that is a capital asset for the TP shall be treated as gain or loss from the sale of a capital asset. iii. If the underlying land was a capital asset to S, then the gain that S derives from expiration of its obligation is treated as if it were a gain derived from a capital asset and therefore $100 of capital gain. iv. ***Ignore old reg 1.1234-1(b) which says that sale/exchange is treated as OI, this is not good law anymore. e. Characterization of Hedging Transactions i. Book Notes 1. Corn Products: held that gains recognized on disposition of futures contracts entered into to protect the taxpayers source of supplies were to be treated as ordinary gain because the gains were derived from ordinary business activities as an integral part of the business.. 2. Arkansas Best: SC limited Corn Products to its facts by interpreting Corn Products merely as a broad reading of the inventory exclusion of 1221(a)(1), meaning that the futures contracts in Corn Products were excluded from capital asset status only b/c the contracts were surrogates for the stored inventory of raw corn. a. Broad definition of the term capital asset explicitly makes irrelevant any consideration of the propertys connection with the taxpayers business. 3. 1221(a)(7) makes these doctrines irrelevant. Class Notes November 27, 2006 f. 5. T manufactures baseball bats. The principal raw material for the business is ash lumber. T has occasionally suffered losses when the prices for ash lumber unexpectedly rose. One of the means T uses to protect against these possible
iv. (c) B neither transfers nor exercises the option, which expires at the end
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losses is to purchase futures contracts in pine lumber. Pine futures are purchased because (1) no futures market in ash lumber exists and (2) the spot prices for pine and ash lumber tend to move in parallel. Since T has no desire to acquire a stock of pine lumber, the futures contracts are always closed out by cash settlements. i. Futures contract: is a contract to buy a specific commodity (ash lumber here) at a specified price on a future date. ii. For simplicity assume the futures contracts was in ash lumber and not pine lumber iii. Are these transactions hedging transactions which would make them excepted from the definition of a capital asset iv. Amended Question Five: Suppose at Jan. 1, 2006 and our TP has entered into a contract to deliver 100,000 baseball bats to major league baseball for the 2007 baseball season which begins in April 2007. Manufactured at $3/bat. Total contract for $300,000. B/c they are not due until 2007, taxpayer will not manufacture until later. T is having a short position in this scenario. Meaning, he is agreeing to sell something in the future that he doesnt currently have. Assuming to meet the demands of the contract, he is going to need 100,000 units of ash lumber, and presumably in setting the price for the finished goods at $3/bat, tp mustve taken into account the cost of the lumber. Therefore, assume on Jan. 1, 2006 ash lumber was selling at that point for $1/unit. He becomes nervous that the price of ash lumber might increase dramatically. If the cost of raw materials increases dramatically over that period, that increased cost, is going to decrease the taxpayerss anticipated profit. So, TP wants to lock-in his anticipated profit on the sale of bats to MLB. He could lock in his profit either by buying the 100,000 of ash lumber for its then current market price of $1/unit and warehousing the extra. (referred to as buying on the spot), but perhaps this is not an available alternative if the taxpayer does not have the money at that time, or maybe he doesnt want to spend the money at that time. OR, taxpayer could enter into contracts to purchase 100,000 units of ash lumber at a $1/unit, with closing and delivery to made at some point in the future. By entering into those contracts to buy, that is sometimes referred to as having a long position in those contracts b/c now the TP has a contractual right to the ash lumber in the future, but he also has an obligation to deliver the goods to MLB. As a result, the TP is both short and long with respect to 100,000 units of ash lumber. This is sometimes referred to as a business hedge where you have multiple positions in the same commodity in order to protect from future price changes that might otherwise eat into the taxpayers profits. From a business standpoint if price of lumber increases from Jan. 1, 2006- Feb. 1, 2007 (when tp needs lumber) to $2, how is he protected from having entered into the futures contracts? He is protected if he takes delivery of the underlying lumber at the price determined under the future contract. 1. The character of the profit will be ordinary b/c it is a profit made on inventory under 1221(a)(1). 2. ALTERNATIVELY, After the price had increased to $2 in Jan 1 2007, TP could go out and buy 100,000 units at $2 per unit, which would reduce the anticipated profits by $100,000 due to this price increase in the cost of each unit. So he will derive $100,000 less
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profit and that will reduce his ordinary income by $100,000, but in addition, the TP could sell its futures contracts rather than taking delivery of the contract, at a price that would reflect the fact that the buyer would be able to get 100,000 units at only $1/unit when Ash Lumber is selling in the market place for $2/unit. On the sale of the futures contracts, the TP could demand a price that would produce $100,000 of profit. Economically, the sale of the futures contracts offsets the loss on the sale of the baseball bats, so the net of the transaction is the same as what the TP thought hed get. 3. Tax consequences: a. TP has less ordinary income derived from the sale of those baseball bats. b. If the futures contracts that was sold was a capital asset, the TP would have a $100,000 of gain drevied from the sale of that futures contracts, but if it were a capital asset it would get the long term capital gains preferential treatment. c. This was the argument by the TP in Corn Products. i. If successful, the end result was that the T has same economic income as anticipated, but some if OI and some it capital. ii. SC said the futures contracts were not capital assets, and simply related to the every day business operations of the TP and therefore the futures contracts should be considered ordinary assets. 4. Arkansas Best, a. SC revisited corn productas and said that Corn Products stood for the proposition that heading trans that are part of the TPs inventory purchase system were ordinary assets b/c they are so close to inventory themselves. 5. This conclusion is picked up by the statute. a. 1221(a)(7) and 1.1221-2 i. Hedging transaction re not capital assets so long as Tp identifies as a hedge before the close of the day on which the trans was entered into. ii. must be identified as a hedge on the taxpayers buooks. iii. 1221(b)(2)(A)(i) defines a hedging transaction: 1. Entered into in the normal course primarily to manage the risk of price changes with respect to ordinary property which is held or to be held by the taxpayer. v. (a) Are the gains and losses on the futures contracts capital or ordinary under Corn Products & Arkansas Best? 1. The character of the result gain or loss is going to be ordinary. 2. provides that a hedging transaction is any transaction that a taxpayer enters into in the normal course of the taxpayers trade or business primarily 3. See Kleinfeld, on Kurtan- butter futures were used to hedge against price changes in cheese.
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Does the transaction qualify as a hedge under 1221(a)(7), (b)(2) and Reg. 1.1221-2(b), (c)(2) as a definitional matter? If so, what must T do mechanically to perfect qualification? Identification Rules. 1. If the disposition of future contracts produces a loss, it would want to argue that it is a hedging transaction and get the ordinary loss. 2. Suppose there is a true hedge but the TP has failed to identify it as a hedging transaction? a. Regs. must be adopted that properly characterize any gain or loss from the hedging transaction despite the failure to properly identify. b. The regs are more punitive as to the TP. In the situation of a failure to identify 1221-2(g) Transactions not identified i. Failure to identify will result in the transaction not being a heading transsctions ii. Exceptions: 1. Loss a. Side for inadvertent errors with respect to true hedging transactions and youre handgling the other heding transactions properly then the regs suggest your loss will be ordinary. b. inadvertent error is not defiend. 2. Anti-abuse rule a. Would characterize any resulting gain as ordinary in character if it is truly a hedging transction but for the failure to identify. vii. (c) Would your answer in (b) change if T expects to need 100 units of ash, but buys 1,000 units of pine futures? Over-hedging 1. This starts to look like an investment beyond your ordinary property needs. 2. This profit will have no relationship to the TP increase inventory cost. 3. Therefore, it is not entirely clear how this should turn out b/c the regs are not clear on what happens when there is an over-hedge. 4. The risk is that the TP will be treated as a speculator, as having made an investment in what might be the future value of pinelumber. a. 1.1221-(c)(4): speculation will not be considered a hedging transaction viii. (d) Assume that the purchase of pine futures in (c) above is held not to be a hedge, but T identified it as a hedge anyway. What are the consequences of the identification if these futures contracts are closed out at a gain? At a loss? Improper Identification Issues 1. 1221(b)(2)(B) calls for regs to be promulgated that will categorize the treatment of gain or loss from the transaction if not hedge and does not fit into exceptions then perhaps you should get a capital gain/loss. 2. 1.1221-(2)(g): punitive
vi. (b)
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a. Improper identification as a hedge when it is not then any later gain you realize from disposing of contract will be ordinary. b. This is a punishment regime for identifying it as a hedge when it is not, unless the TP can show inadvertent error, but as we said above this term has not been defiend. c. Regs also say (on the other hand) if you sustain a later loss on the disposition of the hedging trans the government can treat the transaction as a capital loss. d. This shows the punitive nature of the regs, which is that youll get a different result depending upon whether you have gain or loss. i. If it is gain, ultimately it will be ordinary ii. If it is loss, ultimately it will be capital. g. 6. X Corp. is in the business of cutting and milling ash lumber and owns a substantial acreage of standing mature ash trees. T acquired a significant percentage of X Corp.s stock in order to have a captive supply source for ash lumber and to end its problems with fluctuations in its ash lumber costs. X Corp. also owns several large stands of pine, which it regularly cuts and sells to home builders. If T ultimately sells the X Corp. stock at a loss (and assuming any necessary identification was made), will Ts ownership of the stock qualify as a hedging transaction? See Reg. 1.1221-2(d)(5). Characterization of Equity Purchases i. Arkansas Best: involves a sale of stock at a loss and an attempt to get ordinary loss treatment with respect to that sale. 1. This case is different. 2. Involved a diversified company that owned stock in a bank. When bank had financial difficulties, Tp bought more stock in order to keep it in business. Ultimately things went from bad to wrose. The TP sells the stock at a substantial loss. THe TP based on Corn Products argued that it had bought this stock for biz purposes to preserve the TP existing business reputation which would have suffered if the bank failed and the depositors lost their money. 3. Holding: loss was a capital loss, subject to 1211. a. Analysis: TPs biz motive in buying an asset is generally irrelevant in determining whether that asset was property within the general definition of an asset. b. The exceptions to capital asset treatment listed in 1221, are exclusive. i. In other words, there are not judicial exceptions and therefore, since the stock was property within 1221 and wasnt within any statutory exception then by nature it is a capital asset. ii. Therefore the loss was a capital loss. ii. Our facts are different than AB, where the bank stock sold at a loss had nothing to do with the TPs inventory. In contrast, here there may be a relationship between the stock and protection of the stock as a result of the ownership. Is this a managing risk factor? 1.1221-2(b). 1. Maybe those higher costs are offset by higher dividend income. Maybe the lower profits on the finished goods might be offset by increase gain on the sale of the stock.
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2. Potential offsetting relationship b/et higher inventory cost and gain from the stock is less direct than it is with respect to futures contracts b/c there may be many other tangential factors that will come into play b/f T gets increased dividend. 3. Therefore, this is really not a hedging situation. And youll end up with a capital loss. a. 1.1221-2(d)(5): except as otherwise provided purchase of an equity security is not a hedging transaction even if the transaction limits or reduces the taxpayers risk with respect to ordinary property. b. Purchase of equity security is not acquired primarily to manage risk c. When this reg was initially proposed it said you dont get ordinary treatment with respect to stock acquired to protect goodwill or biz reputation (Arkansas Best) and you also dont get ordinary treatment with respect to stock acquired to insure the availability of goods. d. TP ends up with capital loss treatement. h. 7. Motorola plans to build a new semiconductor manufacturing facility in Virginia at an anticipated cost of about $300 million. The project will get under way in about a year, and will take about 3 years to complete. The company will finance the project by issuing 15-year notes that are expected to carry an 8% interest rate, based on today's rates. Public sales of the debt will not begin for about 6 months. Motorola wishes to lock in the interest cost on the notes at today's rates and sells short $300 million of 15-year, 8% U.S. Treasury bonds at par. i. (a) How does the short sale of the Treasury bonds lock in today's rates with respect to the anticipated debt issue? [Hint: An obligation that pays $1,000 at the end of 15 years and $80 per year in the interim has a present value of $847.88 when discounted at 10% compounded annually, and a present value of $1,192.25 when discounted at 6% compounded annually.] See also notes 3 & 4 of the Kleinbard & Greenberg excerpt for equivalent transactions that might give Motorola the same protection as the short sale of the bonds themselves. i. Short Sale of Securities: in a typical short sale the TP sells an item that the TP doesnt presently own b/c the TP thinks that value of the particular item is going to increase. 1. To effect the short sale and make delivery: Borrows securities from broker and sells stock for cash. THe T incurs an obligation to broker to replace the securities with the broker at a future place in time. Generally speaking, to secure obligation to make good at some time in the future the broker will hold onto the cash proceeds until the TP meets its obligation. 2. If later on: Securities do drop in value, goal of TP, then the TP will go out and replace the securities at the lower price (current value) and then repay those securities to the broker who releases the cash that it has held onto until that time. 3. Difference between sales price from shrot sale and lower cost that TP now incurs to buy and replace securities with broker, that difference becomes the TP profit.
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4. If it doesnt work out the way the TP wants then the TP has to pay a premium to buy the securities that are necessary to repay the broker (cover) and as a result the TP would sustain an overall loss. 5. Either way there is a possibility of gain or loss until the TP later closes or covers by replacing the securities to the broker. 6. We dont know whether itll be a gain or loss until that later time when the replacement securities are purchased. 7. Generally speaking, realization of gain/loss from the short sale is deferred until the tax payer covers the short sale transaction. Until this point it is considered an open transaction. a. 1233-1(a) ii. Applying these ideas to our facts: It is engaging in the short sale to lock-in the 8% interest for the financing of the manufacturing facility. 1. Suppose that b/f Motorola issues its own debt, interst rates in the market rise to 10%. If that happens Motorola will not be able debt at 8% when the market rates are 10%. So in all likelihood Motorola will have to issue those notes with an interest rate of 10%. This means Motorolas interest cost is going to rise to $390,000,000. This means Motorolas interst cost will rise by $90,000,000 over the fifteen years at the 10% rate. a. The present value (cost) to Motorola is about $46,000,000. 2. Motorola would have to set aside $45 million to cover this amount. iii. At the same time, Motorola entered into a short sale, and in the interim the interest rates have increased, the value of those treasury bonds has decreased and now Motorola could purchase 8% treasury bonds to cover its short sale for less than their face amount (par value). AS a result it could reap a profit for the short sale. 1. In effect, M would be able to buy 8% treasury bonds at a discount from their face amount and the reason why is so that the overall return to the buyer of those notes would produce a market rate of return. 2. Thats why if interest rates go up, the value of a bond with a lower interest rate goes down. 3. Under the numbers in problem 7(a), Motorola could go into market buy $300,000,000 at 8% for about $240,000,000 and make about $60,000,000 and that profit offsets the increased interest cost that Motorola will have to pay on issuing its own debt at a higher rate. 4. Net interest cost will be the 10% stated interest rate that it has to apy on its own debt, less the profit it derived from covering the short sale, and the net effect should be an overall cost of 8% on an annual basis. iv. Converse applies if in the interim, interest rates drop to 6%. Short sale on Jan. 1, 2006, and on July 1, 2006 interest rates have fallen to 6%. Now it will issue its bonds for 6% interest rates. So its costs will be less than what it initially anticipated. It will be $18 million instead of 1. So now Motorola will have less interest cots. 2. At the same tiem b/c interest rates have fallen, the value of outstanding treasury bonds will have increased. 3. As a result it will cost M more than face amount (300 mill) to purchase the 8% treasury bonds to cover the short sale and so it will have to purchase them at a premium.
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4. As a result, M sustains a loss on covering the short sale and that loss economically offsets the interest savings that Motorola is realizing in issuing its own notes with a 6% coupon instead of a 8% coupon. 5. Motorolas total cost is 6% stated interest rate plus the loss it sustained from the short sale. Total loss should be about 8%. 6. M incurs approximately the overall cost that it anticipated with respect to borrowing cost. 7. This same idea is illustrated, in a different context, in the Fanny Mae Caes. v. Fanny May 1. After entering into the short sale transaction interest rates dropped significantly. As a result when FM covered it had to cover at a premium and sustained substantial losses and wanted ordinary loss treatment. Equally unsurprising, the government wanted capital loss treatment. 2. Holding: TP won in this situation and got its ordinary result. 3. **This case predates 1221(a)(7) and 1221(b)(2) j. (b) If Motorola's short sale results in a loss, does that short sale of Treasury bonds qualify as a hedging transaction under 1221(a)(7) and Reg. 1.1221-2? See also Reg. 1.446-4(e)(4). i. This scenario arises when after entering into the short sale transaction, interest rates in the market dropped and covers by purchasing 8% treasury bonds at a premium beyond the $300,000,000. ii. 1221(b)(2)(A)(ii): Defines interest rate hedge 1. Hedging trans is any trans entered into in the normal course of the tps business. 2. Is Ms transaction entered into with the connection with the manufacture facility in the normal course of the TPs biz? a. Statute is silent on this issue. b. In regs. 1221-2(c): normal course means was in furtherance of the TPs biz and it also says youd be ok under the normal course language even if the managing risk language relates to the expansion of an existing business. c. Transaction entered into in the normal course and has to be primarily to mange risk of interest rate changes with respect to borrowing made or to be made by the TP. 3. Therefore, M will fit with respect to its loss as a hedging transaction. a. Regs also say gain/loss from a short sale part of a hedign transaction is ordinary. iii. Expect an ordinary result here. iv. Remaining issue is one of timing. In the typical short sale transaction a loss from that short sale would be realized when the sale is covered. 1.1233-1(a). 1. BUT, in dealing with a hedging transaction and the gain/loss, there are special timing rules that exist 1.446-4(e)(4) ties the TP loss deduction to the period covered by the hedge. 2. To the term of Ms debt.
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3. What is doing is reflecting the fact that he loss sustained by TP is about the additional cost of borrowing. 4. The way you treat the loss as a decrease to the issue price of Motorolas debt. 5. Therefore, M is treated as issuing the debt for $250 million paying out $300 million in the end and paying 6% interest. Therefore there is a $50 million payment of OID. 6. You deduct over the 15 years, gradually. Is it relevant that the anticipated use of the proceeds of the debt issue is construction of a depreciable building, a 1231 asset, rather than the financing of inventory? 1. It does not matter. 2. Where the asset involved in the hedging trans becomes relevant is in (b)(2)(A)(i) is with respect to managing risk of prices changes to ordinary property. 3. When dealing with a hedge against interst costs that protion of the statute says nothing about the underlying property being ordinary property. a. Doesnt matter what youre using the proceeds of the loan to build when oyure realying on the protion that dealis with managing risk of itnerst rate changes. Class Notes: December 4, 2006 k. Problem 8 A owns 1000 shares of Microsoft stock that she purchased 10 years ago for $2,000 ($2 per share). The stock is currently worth $100,000. A believes that the stock may drop in value as a result of various antitrust suits that are pending against Microsoft. To protect herself from this possible loss, on November 15th of Year 1, A sells short 1000 shares of Microsoft, i.e., she borrows 1000 shares of Microsoft from her broker and sells the shares on the open market for $100,000. Whether the stock goes down in value (as A suspects it will) or the stock goes up in value, A expects to cover the loan with her broker by transferring her original 1000 Microsoft shares to the broker. On February 5th of Year 2, A delivers the 1000 shares (then worth $90,000) to her broker to cover (close) her Year 1 short sale. What are the tax consequences (including timing considerations) that arise for A as a result of the foregoing transactions? i. Issue: Timing issue, as in when does the TP recognize gain from this kind of short sale transaction. 1. not a character of the gain issue. ii. Short sale transaction. 1. Capital result iii. When will she have to recognize gain? 1. This is different b/c at time she enters into short sale, TP is already the owner of 1000 shares. 2. Short sale against the box. a. If this were treated for tax purposes in the same way we treat a typical short sale, then the tax consequence would be a deferral until the sale, 1.1233-1. 3. Here, the TP has achieved economically, an economic gain in the original Microsoft Shares, regardless of what happens subsequently in the market during the time the short sale remains open.
v. (c)
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a. Example: stock goes down in value to $90,000 (as predicted) she can cover the short sale by delivering the original shares to broker in repayment of her obligation to the broker for the borrowed securities use in the sale. Result is that she receives a gain of $98,000 b/c she has locked in the price of $100,000 on a basis of $2000. b. Alternatively, when the Microsoft stock drops in value after the short sale she could conceivably go into the market place, buy new Microsoft stock, and deliver that to the broker to cover the short sale, at which point she has derived a $10,000 gain (100,000 90,000) and then she sells the old for its then FMV of $90,000 at a gain of $88,000. c. If she guessed wrong and indeed Microsoft went up in value to $120,000 at that point she could use the original Microsoft stock, transfer it to the broker, she still locks in her profit of $98,000. 4. Should the sort sale against the box be enough to make the TP report the gain immediately, since she has locked it in at that short sale time? Or will there be a deferral? a. Under 1259 (no deferral under these facts): creates a constructive sale for gain purposes where a taxpayer has entered into a short sale against the box with respect to appreciated securities. i. Upon the short sale (making of the short sale), Nov. 1, the TP will be treated as having sold the original Microsoft shares for $100,000 and will have an immediate gain of $98,000 ii. Basis Rule: Treat TP as if she immediately repurchased the shares, taking a new basis in those original shares equal to their value at the time. 1. TP increase its basis in the original 1000 shares by the $98,000 gain recognized on the constructive sale. Going forward her basis will be $100,000. a. Basis bump is logical to prevent double taxation this 5. Tax consequences a. No excess of amount realized over adjusted basis of the property used to cover and therefore there will be no further gain upon delivering the shares to the broker. b. 1259(a)(2): calls for proper adjustment in the amount of gain or loss subsequently realized with respect to the appreciated position, proper adjustment for any gain recognized on the constructive sale. c. Exception: 1259(c)(3): no constructive sale if the TP actually closes the short sale by 30 days after the end of the taxable year and in addition the TP continues to hold the underlying stock for at least 60 days after that closure of the short sale takes place.
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l.
year to the next if the short sale turns out to look like something separate and distinct from the TPs original investment. i. If there is a separate transaction rather than a lockin they will be viewed as ii. Exception doesnt apply: 1. she doesnt close within 30 days; and 2. she used the old and cold stock to actually cover the short sale. 9. L is the owner of a tract of land on which a Building is situated. L executed a 50-year lease of the land and the Building to T. The annual rent (payable in monthly installments on the first day of each month) is $24,000 per year. T in turn subleased the Building to X for a 10 year term at an annual rental of $36,000 (payable monthly on the first day of each month). During the current year, the following alternative transactions occur. What is the character result for each transaction? i. Issue: Similar to Corn Products character upon a transfer of contract rights. When contractual rights are disposed of at a profit, what is the character of consulting gain. Are they capital asset. 1. Unlike Corn Products, however, these contracts are not hedging transactions, within 1221(b). ii. Tp wants Capital gains. iii. IRS position: Contract right scenarios that are not hedging, the Service usually makes this argument for getting OI treatment: 1. Consideration being received by the TP for the contract right was nothing more than a substitute for what wouldve been OI for the taxpayer if no transfer of the contract had taken place. 2. The contract right did not constitute property. Focusing on 1221(a): for purposes of this subtitle the term capital assets means property held by the TP. 3. Hort (1167): a. Facts: TP had inherited an office building in 1928. Prior to the time of the inheritance, in 1927 had agreed to lease part of the building to a tenant for 15 years at an annual rental of $25,000. Lease was commence in 1932. Term commences and the tenant stays on property for one year out of the fifteen year term, after which the tenant decides it wants to get out of the remaining 14 years. To get the TP to cancel, tenant pays $140,000 to cancel the remaining 14 year term. b. Issues: i. #1 Could TP offset basis in bldg against the $140,000 payment? ii. #2 To the extent that there was income, what was the character of that income? c. Analysis: i. If there was no cancellation, clearly there wouldve been income. Additionally, there would be no basis offset against the rent received, other than depreciation deductions.
d. Policy: Code is willing to tolerate a modest deferral from one
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4.
5.
6.
7.
8.
9.
received ($140,000) with no basis offset and that that income should be ordinary income. i. Rationale: This amount, $140,000, was a substitute for what wouldve been ordinary rent payments made by the lessee and should be treated as OI too. Suppose - As an alternative: suppose the TP sells the bldg., the TP is selling a future rental stream to be derived in the future. In a sense part of sale proceeds would be a substitute for what otherwise wouldve been future rental income by the TP. In that case, the TP will have capital gain treatment and the TP could offset the basis against the sale. Suppose: Lessee decides to stay, but the owner sells the building to a third-party, subject to the existing lease. Presumably under those facts, the seller (TP) is going to get more on the building for its sale with the favorable lease, then it would have had there not be this lessee. Seller is getting a premium that would probably have been around $140,000, the character of that resulting gain is capital. If this situation arises then you have to conclude the substitute for income logic in the SC Hort case, is not satisfactory. Implications of Hort a. He didnt transfer property for purposes of 1221, and that seems to be the only element that is different here. b. In a Hort situation, the property is the larger interest that the TP owns in the building. c. The leasehold interest of the owner/lessor, standing alone, is referred to as a horizontal carve out of the larger interest in the building. d. You are still retaining the underlying property to which the leasehold relates. e. When you receive cash or the lessor interest, youre not viewed as having conveyed property and therefore youre not conveying a capital asset and therefore it is not a capital gain. Also See, PG Lake In contrast, if TP conveys a vertical slice which arises when you dispose of an interest in every type of right that you have in the property. a. The ultimate carve out is the sale of everything with respect to the entire property. b. It also arises, however, when you transfer a percentage of all of my rights. That generally is viewed as a transfer of property and if the asset involved then that will trigger capital gain treatment and basis offset. c. If in the Hort case, the TP sold an undivided interest including in the Irving Trust lease, that would be considered a transfer of property d. You can see that distinction being applied in Metropolitan Building. Metropolitan Building
d. Holding: SC says TP should have OI equal to the payment
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subleases one block to Olympic and the sublease is for the entire term of Metros lease with the University. i. Two years before expiration Olympic wants to deal directly with the University b/c it wants to extend its lease on the property. Olympic pays $137,000 in cash to Metro, and in return Metro gives up its lease/rights with University with respect to the blocks that Metro uses. b. Issue: Character of the $137,000 receipt? c. Holding: looks a bit like Hort, but Court says it is different and gives Metropolitan capital gain treatment. Here, Court says this payment eliminated Metropolitans entire interest in the one block and therefore this was a disposition by Metropolitan of income producing property. This was a vertical carve out. i. Same result if University had paid Olympic. ii. Meaning, same treatment if third-party pays Metro for the one city block. d. 1241: amounts received by lessee for cancellation of a lease as received in exchange for that lease, thereby satisfying the sale or exchange requirement for capital asset treatment. 10.Letarra (Third Circuit) a. Facts: Difficulty of relying on a vertical carve out analysis in the contracts rights cases. Lottery winnings to be received in installments. Then the TP sell their rights to the remaining 17 payments for approximately $3.5 million. This seems like a vertical carve out b/c theyre disposing of all of their remaining rights after they make this sale. TP wanted LTCG treatment based on the vertical carve out caselaw precedent. b. Holding: payments was essentially a substitute for ordinary income b/c thats what it wouldve been had they just collected the installments. The court notes the flaws that exist in that type of analysis, so it points to the carve out analysis. i. Horizontal carve outs usually produce OI for the TP. ii. Vertical carve out doesnt always produce capital gain. You still have to look at the underlying asset that is being disposed of by the TP. If the underlying asset is a right to earn income then the result should be capital gain (Metropolitan Building). If, on the other hand, the right is to earned income, then the result should be OI, which was the finding here. c. Lottery winnings are ordinary income. iv. Question 9(a): X pays T $10,000 to cancel the unexpired portion of his sublease for the Building. T then relets the premises to Z for the unexpired portion of Xs term at the same rent. 1. This is the Hort Case, and so OI results. This is a horizontal carve out b/c after the cancellation T retains its lease.
a. Facts: University Leases 4 blocks to Metro Bldg. Metro,
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2. 1241: payments made to a lessee in cancellation of a lease would not be triggered b/c X is paying the lessor to get out of the lease. v. Question 9(b): L pays T $50,000 to cancel the unexpired portion of the long-term lease from L to T on the Building. 1. 1241: gives this exchange treatment, but not character. a. 1.1241-1(b): lessee would also get exchange result if the payment was for a partial cancellation that relates to a severable economic unit. i. Ex in regs.: Payment by L to T for L to take back a portion of the leased property. ii. Ex: A payment that would reduce the unexpired term of the lease. 2. This is a vertical carve out so T should get capital gain treatment. vi. Question (9)(b)(i): Suppose instead that X makes the above payment to T for the cancellation of Ts lease in order to eliminate T so that L can lease the Building directly to X. 1. This is Metropolitan Building. 2. This is vertical 3. This should produce capital gain treatment.
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ii. Problem 2: Tax consequences of this transaction to A and B

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iii. Two goals of depreciation are: 1. income matching; and

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b. 168 assigns recovery periods to tangible assets which

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Class Notes: November 6, 2006 V. Unit IV: Capital Gains

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e. Problem one: T, an unmarried taxpayer, is in business for herself. This year, T

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e. Other income = $369,000

iii. (c) Limitation on deductibility of Losses: Assume the same facts as in

LTCG 29,000 STCL 40,000 NLTCL 11,000

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15,000 LTCG (28%) n/a NLTCG 4,000

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b. Question Two: In each of the following alternative situations, determine whether

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ii. (b) Characterization of Real Estate Transactions:

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