Assignment 8 — Capital gains and losses

¶801 Introduction

  • Recognized gain on sale or exchange of property is taxable; recognized loss may be deductible.

  • FIRST decision: Is the property a Capital Asset or an Ordinary / Non-capital Asset?

    • Ordinary income/loss: wages, business income/loss, gains on non-capital assets.

    • Capital gain/loss: arises from sale or exchange of capital assets.

  • Key takeaway

    • Tax treatment of gain or loss hinges on whether the underlying property is capital or ordinary.

¶802 What are Capital Assets?

  • General definition

    • Assets held for personal use or for investment.

    • Ordinary assets = business inventory or property held primarily for sale in ordinary course.

  • Example 1 (Furniture manufacturer)

    • Sold personal automobile, personal residence, 100 shares of X Corp → capital assets.

    • Sold $250,000 of furniture (inventory) → ordinary assets.

  • Purpose-of-holding, not the form, governs classification.

    • Same government bond → capital asset for investor; ordinary asset for bond dealer.

  • Third category: Section 1231 assets (business property used in trade or business but not held for sale).

    • Example 2: Delivery truck & factory building used in business → §1231.

    • §1231 gains/losses sometimes capital, sometimes ordinary (discussed later).

  • Historical rate preference

    • 1990s: Long-term capital gains (LTCG) taxed ≤ 28 % vs ordinary top rate 39.6 %.

    • Subsequent reductions: 15 %, 0 % etc.

  • 2024 LTCG rates (without NIIT)

    • 0 %, 15 %, 20 % tiers based on taxable-income bands; see detailed tables for each filing status.

  • Additional 3.8 % Net Investment Income Tax (NIIT) for high-income taxpayers.

  • Key takeaways

    • Capital assets = personal or investment property; ordinary = inventory, etc.

    • LTCG rate depends on filing status & income.

¶803 Reason for Special Treatment of Capital Gains & Losses

  • Rationale for preferential LTCG rates

    • Lump-sum realization after years of appreciation could push taxpayer into higher bracket → hardship.

    • Encourages investment capital → economic growth.

    • Philosophical: appreciation is growth of the “tree,” not the “fruit.”

    • Inflation component of gain isn’t true income.

  • Counterbalance: Capital loss limitation.

    • Loss on personal-use property not deductible.

    • Example: Loss on personal fur coat → ignored.

  • Key takeaways

    • Multiple economic & theoretical reasons for LTCG preference.

    • Personal-use property losses disallowed.

¶804 Treatment of Gains and Losses — In General

  • All recognized gains included in Gross Income (GI).

  • All deductible losses subtracted in computing Adjusted Gross Income (AGI).

  • Example (Robert Coleman)

    • Personal residence loss $14k non-deductible.

    • GI =30,000+4,500+600+2,000=37,100=30{,}000+4{,}500+600+2{,}000=37{,}100.

    • AGI =37,100−2,500=34,600=37{,}100-2{,}500=34{,}600.

  • Key takeaway

    • All recognized gains/losses affect GI/AGI except nondeductible personal-use losses.

¶805 Long-Term vs Short-Term Capital Gains/Losses

  • Holding period: > 12 months → long-term; ≤ 12 months → short-term.

  • Preference applies only to LTCG.

  • STCG presumed speculative; taxed as ordinary income.

  • Key takeaway

    • 12-month threshold distinguishes preferential vs ordinary rate treatment.

¶806 How Capital Gains Are Taxed

  • Rate timeline: 1997 (20 %/10 %), 2003 (15 %/5 %), 2009–12 (0 % for lowest brackets), 2013+ (20 % upper).

  • Collectibles LTCG capped at 28 %.

  • NIIT (3.8 %) steps

    1. Verify high-income threshold (MAGI).

    2. Compute excess MAGI.

    3. Compute net investment income (NII).

    4. Apply extNIIT=0.038×min⁡(excess MAGI,NII)ext{NIIT}=0.038\times\min(\text{excess MAGI},\text{NII}).

  • Unrecaptured §1250 gain (depreciated real estate) max 25 %.

  • Reporting flow (Schedule D)

    1. Net ST gains vs ST losses → Net ST.

    2. Net LT gains vs LT losses → Net LT.

    3. Combine Net ST and Net LT to arrive at Net Capital Gain/Loss.

  • Example (Bell)

    • LT gain =1,500+2,500−1,250=2,750=1{,}500+2{,}500-1{,}250=2{,}750.

    • ST net loss =1,000−(500+1,250)=−750=1,000-(500+1,250)=-750.

    • Net capital gain =2,750−750=2,000=2,750-750=2,000 (long-term).

  • Key takeaway

    • Segregate ST and LT first; only net amounts interact.

¶807 Capital Losses & Carryover Rules

  • Ordinary losses: fully deductible without limit (e.g., Schedule C loss).

  • Capital loss limitation

    • If Net Capital Loss occurs, deduct up to 3,0003,000 (MFJ or single) or 1,5001,500 (MFS) against ordinary income.

    • Excess carries forward indefinitely.

  • Carryover mechanics

    • Unused loss retains character; offsets gains first, then up to 3,0003,000 ordinary.

  • Example (Jones)

    • 2024: 10k10k net loss ⇒ deduct 3k3k, carry 7k7k.

    • 2025: gains $5k, current losses $3.5k ⇒ combine with carryover, end-year loss 5.5k5.5k; deduct 3k3k, carry 2.5k2.5k.

  • Key takeaways

    • Annual ordinary deduction cap of 3k3k.

    • Couples filing jointly share a single 3k3k cap.

¶807A Capital Gains Exclusion — Qualified Small Business Stock (QSBS)

  • §1202: Non-corporate holders of QSBS held > 5 yrs may exclude part of gain.

    • 50 % for stock issued 1993-2009; 75 % (ARRA 2009), then 100 % for stock acquired ≥ 27 Sep 2010 (permanently extended 2015).

    • Exclusion limit: greater of 10 million10\text{ million} or 10×10\times adjusted basis in disposed stock.

  • QSBS qualifications

    • C-corp (not S-corp) with gross assets ≤ 50 million50\text{ million} at time of issuance.

    • ≥80 % of assets used actively; excludes service industries whose principal asset is employee skill (law, health, consulting, etc.).

  • Key takeaway

    • Potential 100 % exclusion of gain if requirements met and 5-year holding satisfied.

¶808 Section 1231 Assets — Gains & Losses on Business Property

  • Motivation: Limitations on capital losses unfair to business property.

  • §1231 assets (held > 1 yr):

    • Real property used in business.

    • Depreciable business property (machinery, vehicles, etc.).

    • Certain involuntary conversions (condemnation, casualty, theft) of business/income property.

  • Treatment logic

    • If aggregate §1231 gains > losses → all §1231 items treated as LTCG/LTCL.

    • If losses ≥ gains → all treated as ordinary.

  • Example 1 (gain scenario): Truck gain $300, machine loss $100 ⇒ net §1231 gain $200, therefore both treated as capital; combine with other LTCG.

  • Example 2 (loss scenario): Factory building loss $16k, no gains ⇒ ordinary loss fully deductible.

  • Key takeaways

    • “Netting” rule flips entire bucket to capital or ordinary based on totals.

¶810 Special Rule — Casualty & Theft Losses within §1231

  • Casualty/theft gains & losses from business or income property enter §1231 only if total casualty/theft gains ≥ losses.

  • If casualty/theft loss > gains ⇒ treat net casualty loss as ordinary; none of the casualty numbers enter §1231 computation.

  • Personal-use casualty/theft gains/losses (post-TCJA) do not enter §1231.

  • Key takeaway

    • Net casualty gain pushes items into §1231; net casualty loss bypasses §1231 and is ordinary.

¶811 Section 1231 & Farm Property

  • Farming = business ⇒ farm real estate & depreciable equipment qualify for §1231.

  • Unharvested crops qualify if land held > 1 yr and crop+land sold in one transaction.

  • Timber qualifies if held > 1 yr.

  • Livestock held for draft, breeding, dairy, sporting

    • Cattle & horses: holding period > 24 months.

    • Other livestock: > 12 months.

  • Key takeaway

    • Special livestock & crop provisions extend §1231 treatment to farming.

¶812 Related-Party Rules

  • §1231 treatment disallowed for sales of depreciable property between related parties:

    • Family: spouses, siblings, ancestors, lineal descendants.

    • Taxpayer with > 50 % ownership in corp/partnership, trust & beneficiary, etc.

  • Key takeaway

    • Related-party sale of depreciable property ⇒ ordinary result, not §1231.

¶813 Full Definition of Capital Assets (IRC §1221)

  • Default rule: All property = capital asset except eight categories:

    1. Inventory or property held for sale (stock-in-trade).

    2. Property includible in inventory.

    3. A/R or notes receivable from business sales/services.

    4. Depreciable property used in trade/business.

    5. Real property used in trade/business.

    6. Self-created copyrights, literary/artistic works, or those received from creator.

    7. Certain short-term government obligations.

    8. Franchise/trademark/trade name where seller retains significant rights.

  • Examples

    • Doctor’s $2,000 note for medical service = ordinary asset; $500 note for personal sculpture sale = capital asset.

    • Patent IS a capital asset; self-created copyright is not.

  • Goodwill in business sale → capital asset subject to amortization.

  • Key takeaway

    • Start with “everything is capital” then subtract statutory exceptions.

¶814 Holding Period Nuances

  • Count day after purchase thru date of sale.

  • Traded securities: “trade date” controls, not settlement.

  • Gift property

    • If recipient’s basis = donor’s basis (appreciated property) → tack on donor’s holding period.

    • If sale at loss and basis = FMV at gift date → holding period starts next day.

  • Inheritance → holding period long-term automatically (date of death start).

  • Like-kind (§1031) exchange, involuntary conversion: holding period of old asset carries to new.

  • Example: Office exchange on 12/25/23; new office sold 2/25/24 → long-term (use original 2/15/23 purchase date).

  • Key takeaway

    • Numerous tacking rules can transform nominal short-term ownership into long-term.

¶815 Wash Sales

  • Definition: Selling stock for a loss and acquiring substantially identical stock within ±30 days.

  • Consequences

    • Loss disallowed.

    • Disallowed loss added to basis of new shares.

    • Holding period of old shares tacked to new shares (loss scenario only).

  • Example: Sold 100 ABC for $2,000 (basis $5,000) on Feb 1; repurchased Feb 20 for $1,850 → Loss $3,000 disallowed; new basis =1,850+3,000=4,850=1,850+3,000=4,850.

  • Rule applies to purchases by taxpayer, spouse, or controlled corporation and to stock bought inside IRA.

  • Gains not affected.

  • Exceptions: Securities dealers & floor traders trading for own account.

  • Key takeaway

    • Wash sale disallows loss but economically shifts it to future sale via basis adjustment.

¶816 Digital Assets (Virtual Currency)

  • Starting 2014 IRS asks: did taxpayer receive, sell, exchange, or dispose of digital assets?

  • Digital assets include cryptocurrency, virtual currency, stablecoins, NFTs.

  • Merely holding assets without transactions → answer “No”.

  • When disposed/received

    • Report on Schedule D (capital), Form 709 (gifts), business schedules, etc.

    • Character depends on use: investment vs business inventory.

  • Key takeaway

    • Taxpayers must disclose digital-asset activity and report resulting income or gain/loss on appropriate forms.

Global Formulas & Limits (Quick Reference)

  • LTCG tax rates 2024: 0 %, 15 %, 20 %.

  • Collectibles LTCG rate: 28 %.

  • Unrecaptured §1250 gain: 25 %.

  • NIIT: 0.038×min⁡(NII,MAGI excess)0.038\times \min(\text{NII}, \text{MAGI excess}).

  • Capital loss ordinary deduction limit: 3,0003,000 (MFJ/S) or 1,5001,500 (MFS).

  • QSBS exclusion: up to max⁡(10 million,10×basis)\max(10\text{ million},10\times\text{basis}).