ACC 343 (Brink) - Miami University - Exam 2

Character

How a gain or loss is going to be treated (what tax rate will be applied to it)

What happens when we buy property (stock, partnership interest, car, house, etc.)

It creates basis in the property

basis

after-tax investment

Amount Realized =

Money received + FMV of property received + Liabilities received - Money or property given up - Liabilities assumed

What is amount realized?

What you received when you dispose of property (money, liability relief, FMV of property, etc.)

Gain (loss) Realized =

Amount Realized - Adjusted Basis

Loss:

adjusted basis > amount realized

Gain:

adjusted basis < amount realized

Gain (loss) Recognized =

Gain (loss) realized - Deferrals (exclusions)

What is the gain (loss) realized of the transaction?

The economics of the transaction (what did you receive - your investment in the property)

What is gain (loss) recognized of the transaction?

What is taxable

Deferral

defer recognizing the gain until some future point in time

Exclusion

gain is not subject to taxation

All realized gains must be recognized unless...

The Internal Revenue Code (IRC) expressly provides otherwise

No deduction is allowed for a realized loss unless...

The IRC expressly provides for it

Are personal-use property gains recognized?

YES

Are personal-use property losses recognized?

NO

What are examples of personal-use property?

Personal car, personal computer, personal house, etc.

Why do we need to know basis?

- Calculating taxable gain or loss (for property transactions)

- Calculating depreciation (if we buy a fixed asset, we utilize the basis amount to calculate depreciation)

For acquired property, what is the basis in the property?

The initial cost basis, transferred basis, or exchanged basis

Cost Basis

- FMV of property given up (i.e., cash)

- The "true" cost of whatever the asset is

- If there is something that reduces your actual cost in an asset, it also reduces your basis

Transferred basis

- Computed by reference to basis in the property in the hands of another

- Example: a gift

- Example: when a person transfers property to a corporation

Exchanged basis

- Computed by reference to basis in other property previously held

- Property converted from personal use to business use has a basis of the LOWER FMV of the property at the time of transfer or the adjusted basis at conversion

Property converted from personal use to business use has a basis of...

the LOWER FMV of the property at the time of transfer or the adjusted basis at conversion

Can personal-use loss general a loss on your tax return?

NO

Capitalized costs

Initial basis in purchased property is the cost of acquiring it and only capitalized costs are included

What can capital expenditure be made in?

Cash, cash equivalent, in property, with liability or by services

Common capitalized costs are:

- Purchase price

- Closing costs (i.e., commissions, sales taxes, titles insurance, attorney fees, etc.)

- Major improvements

- Appraisal fees, freight, installation, and testing

Gifts

When one individual gives another individual property without reciprocation

Is there tax on gifts or inheritances to the person receiving it?

For tax purposes, there is not tax on gifts or inheritances to the person receiving it

Tax is born on who for gift and estate tax?

The person who is gifting the property or the person who passed away

What kind of basis is the basis in received property (gifts or estate)?

Transferred basis

Gain property

- FMV > Donor's Basis

- Gone up in value in the donor's hands (gone up in value by the time it was given to you)

- Donee's basis = donor's basis

- Donor's carryover basis if later transferred at a gain

- Taxpayer friendly!

Is gain property taxpayer friendly?

YES

Loss property

- FMV < Donor's Basis

- Double Basis Rule

- Value of property goes down

- FMV at the date of gift if later transferred at a loss

What happens if the property is transferred between the FMV and donor's basis?

NO gain or loss is recognized (and basis is whatever you sold it for)

Inherited Property

- Property received from someone who has passed away

- Step up in basis to the FMV on date of death or valuation date (six months after date of death)

- Eliminates gain recognition for built-in gain property

Angel of Death Loophole

- Taxpayer friendly for the receiver of property because they do not have to recognize the built-in gain that the donor experienced

- Built-in loss property is better to sell (you can take the loss if it is not personal-use property)

Is it better to hold appreciated property or depreciation property inside a taxpayer's estate?

Appreciated property because depreciated property loses the tax loss forever. You should sell the depreciated property to use the loss to offset other types of property

Lump-sum assets

- Multiple assets purchased for a single, agreed upon lump sum

- This means you need to figure out how to allocate costs to each of the assets so that there is a basis on each of the assets

- When you buy things in a lump-sum purchase, you generally buy them for a discount

Why do you need to allocate costs to each of the assets in a lump-sum purchase?

so that there is a basis on each of the assets

Allocable costs (basis) =

(FMV of Asset / FMV of all assets) x Lump Sum Purchase Price

Three methods of allocating basis to each asset in lump-sum:

1. Transferor and transferee may agree upon allocation (Not regularly utilized in practice - often times transferor and transferee will disagree based on tax purposes)

2. Residual method may be used - Purchase price allocated up to FMV in order

3. Cash, Near-Cash, A/R, Ordinary Assets, Other Assets, Intangible, Goodwill

(Most utilized by businesses - based on liquidity)

Property for Services

- FMV of property received in exchange for services is income (compensation)

- You do labor, someone compensates you in property / form other than cash

What is the initial basis in the property for property for services?

- Initial basis in the property is the FMV on the date received

- Amount of compensation that is recorded

- Value of the property is income to the taxpayer and basis is the compensation that is recorded and paid tax on

The sale of restricted stock to employees is treated as what?

Income to the extent the FMV exceeds the purchase price

Capital Assets

- All property unless expressly excluded

- Congress uses an "exclusionary definition" - not a clean definition of what is a capital asset, but there is a clear definition of what is NOT a capital asset (it is property except expressly excluded)

- Generally taxed at a preferential rate (lower than MTR)

How are capital assets generally taxed?

at a preferential rate (lower than MTR)

What are capital asset examples?

- Stocks

- Bonds

- Commodities (unless dealer property)

- Generated goodwill

Holding period

- Begins the day after you buy an asset and includes the day that you sell the asset

Why is it important to think about how long we have had a capital asset?

To see if we owned the property long enough for preferential tax rates to be used

A long-term holding period is...

> a year

Net long-term capital gains are taxed at...

preferential rates

What is the main reason that long-term capital gains are taxed at preferential rates?

Congress is trying to incentivize certain behavior: long-term investment in capital assets

A short-term holding period...

<= 1 year

Net short term capital gains are taxed at...

ordinary rates

Do corporations have preferential tax rates for capital gains?

NO - only applicable to individuals, but they still may offset capital losses with capital gains (carryovers limited to 3 years back and 5 years forward)

Wash Sales

Sales with an intention to repurchase in the immediate future when the value of the stock goes back up

Why do wash sales occur?

To reap the benefit of the stock going back up in value

Wash Sales Rule

- Losses on sales of securities are not recognized if identical stock is purchased 30 days before or after the loss stock is sold

- Because your economic position has not changed, the loss is disallowed

- The disallowed loss is added to the basis of the newly purchased stock

- The holding period of the newly purchases stock includes the holding period of the old stock

Small Business Stock Provisions

- Up to $100,000 of loss realized of Sec. 1244 stock may be treated as ordinary loss

- Not subject to capital asset netting procedures and the $3,000 loss limit

- Taxpayer friendly to try to incentivize investors to invest in small business stock

Small Business Stock Exclusion (Sec. 1202) - Small business stock gains

- Taxpayers may exclude 50% depending on the purchase date of the gain from the sale of small business stock

- Stock must be held for 5 years or more

Section 1244 Stock

Small business stock

Why do we need basis? (two things)

1. When you dispose of property, you need to calculate gain or loss

2. When you buy / own a fixed asset, you need to know your after-tax investment in the asset so you can calculate depreciation and amortization

What does it mean to capitalize the cost of something

You put the cost of something on your balance sheet instead of expensing it on the income statement

From a tax standpoint would you rather capitalize or expense something now?

Expense something now - taxable income matters & not as focused on assets

From a financial accounting perspective, would you rather capitalize or expense something now?

Capitalize - want to show higher assets on balance sheet

Depreciation

- Allocating the cost of an asset over a period of time when expensing

- Used for long-life fixed assets used in a trade or business

Why do we expense over a period of time with depreciation?

Fixed assets are intended to be used for more than a year, so expenses should be spread out for more than a year

Financial accounting depreciation

- Goal is to allocate cost over the life of an asset

- The general method of depreciation is straight-line

- Evenly depreciates assets

Straight-line Depreciation =

(Asset Value - Salvage Value) / Useful Life

Tax depreciation

- Generally accelerates deductions to the early years of an asset's life in a systematic and rational manner

What does tax depreciation have embedded in the tax law?

Economic encouragement

When do you want to expense something from a a cash flow standpoint?

NOW: would rather expense something now for tax purposes to reduce your taxable income, which reduces your tax liability (rather have expenses now than in the future)

From an economic stimulus standpoint, what are taxpayers being encouraged to do by allowing expenses now opposed to spreading them out?

reinvest in the fixed asset

Difference between tax and financial depreciation

- Tax depreciation: generally accelerates deductions

- Financial depreciation: evenly depreciates the asset over its useful life

Which type of accounting depreciation allows managers / owners to decide how to depreciate assets (i.e., straight-line versus other methods) and define the useful life of an asset?

Financial accounting depreciation

asset depreciation range (ADR)

- IRS publishes a list of acceptable useful life ranges by asset type

- Government does not want managers to decide the useful life of an asset because they want to know (in a systematic manner) how much depreciation to expect from taxpayers

When taxpayers are depreciating a fixed asset, what do they have to think about? (2 things)

1. Methodology they are going to use (straight-line or something else?)

2. Over what useful life

Straight-line is used for what kind of property?

Real property

Real property

Land and everything permanently attached to it (like buildings)

Is land a depreciable asset?

NO

Declining Balance =

Adjusted Basis x (150% or 200% / Useful life)

Each year, what do you have to do for declining balance method?

recalculate the depreciation based on the 150% or 200% declining method

Declining balance method is used for what kind of property?

Personal property

Personal property

Any fixed asset other than real property used in a trade or business (computers, equipment, etc.)

What is the difference between personal property and personal-use property?

- Personal-use property is what you use in your personal lives (NO depreciation deduction)

- Personal property is what is used in trade or business or for production of income (depreciation deduction)

Listed property

- Automobiles and other fixed assets related to transportation

- There is both a personal and business nature to them

- IRS limits the depreciation deduction on listed property

What was the major tax reform in 1986 that modified the depreciation methodology used for tax purposes into what we are still using today?

Modified accelerated cost recovery system (MACRS) - applies to property placed in service in 1987 or later

MACRS

depreciation method that front-loads depreciation of personal property fixed assets into the early years of a life

With MACRS, what is the effect of front-loading the depreciation?

We are going to use the depreciation methods to create a great depreciation expense early and a smaller depreciation expense later in an asset's useful life

Under MACRS, real property is depreciated with...

Straight-line

With MACRS, what is ignored?

Salvage value - for tax accounting, salvage value is ignored / not taken into consideration, so the full basis of the asset is depreciated

200% declining balance used for...

PERSONAL PROPERTY:

3, 5, 7, and 10 year property (the shorter the life, 200%)

150% declining balance used for...

PERSONAL PROPERTY:

15 and 20 year property (greater than 10 years, 150%)

MACRS convention means...

1. In the year that you acquired property, how much depreciation are you taking?

2. In the year that you sell property, how much depreciation are you taking?

Why does the IRS + Congress allow taxpayers to take MACRS conventions?

From a record keeping standpoint, to simplify the tax reporting of depreciation and ability to keep track of depreciation schedules for fixed assets

Mid-year convention under MACRS

- APPLIES ONLY TO PERSONAL PROPERTY

- Treats assets as if they were placed in service at the midpoint of the year

What kind of property do the mid-year and mid-quarter conventions apply to?

personal property

Mid-quarter convention under MACRS

- APPLIES ONLY TO PERSONAL PROPERTY (when at least 40% of the personal property is purchased in the 4th quarter)

- Treats assets as if they were placed in service at the midpoint of the quarter