Chapter 14 v2 - Income Taxation: Chapter 14 Section 1221...

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Unformatted text preview: Income Taxation: Chapter 14 Section 1221 Capital Assets 1 Primary IRC Sections Sec. 1221* Capital Asset defined Sec. 1222 Other terms relating to capital gains and losses Sec. 1223 Holding period of property * Students should remember this section # 2 Rationale for Favorable Treatment of CG Pro & Con Pro-preferential Treatment Con-preferential Treatment x Alleviates tax on inflation-produced x No real economic difference Alleviates No gains gains x Bunching of gains leads to higher Bunching taxes in a progressive rate system taxes x Encourages investment/ stimulates Encourages sales sales x World trade demands it x Political: principal way of gaining Political: wealth wealth between ordinary and capital gains gains x Preferential treatment produces Preferential administrative complexity administrative x Political: wealth redistribution Political: and horizontal equity problems; inequities inequities x In combination with other tax In provisions, preferential treatment for C.G. can lead to decisions being made for tax rather than for economic reasons economic 3 Section 1221: Capital Asset Defined All property is a capital asset except: x Stock­in­trade (inventory) x Depreciable property and real property used in T/B x Copyrights; literary, musical or artistic compositions; letters or memoranda; if held by: y TP who created it or y for letters, memoranda, etc., held by a TP for whom it was created or y a TP whose basis in such property is determined by the basis of a TP in the above x Trade accounts and notes receivable x US Gov’t publications acquired at less than public selling price 4 Requirements for CG or CL Treatment x Qualifying property (Sec. 1221) x Sale or x­chg. required EXCEPTIONS x Abandonment (no sale or x-chg) produces ordinary loss, if deductible x Worthless stock; treated as a sale or x-chg as of the last day of the taxable year in which they became worthless x Casualties or thefts of personal use assets, if gain is involved 5 Holding Period Rules Secs. 1223 & 1(h)(8) x Short Term: Held 12 months or less; taxed as ordinary income x Long Term: Held over 12 months; taxed at either 28%, 25%, or 15% (5% for TPs in 10% or 15% bracket)* 6 Tax Rates for Capital Assets for Individuals Maximum Tax Rate – Individual’s Marginal Rate — 28% Type of Asset in this Category – Gains on sale or disposition of short­ term capital assets. (Net remaining losses are deducted from ordinary income up to $3,000 per year or $1,500 for MFS.) — Long­term gains on y Collectibles (ex., coins,stamps, & art ˜ 25% work) y Qualified Small Business Stock y Self­Created Musical Works (TIPRA) ™ 15% / 5% ˜ Long­term gains on real estate sales or dispositions, including recapture ™ Other gains on sales or dispositions of long­term capital assets 7 Netting of CG & L for Individuals x Only NET long­term capital gains get favorable tax treatment (max. rates of 28%, 25%, or 15% / 5%*). x The three­step netting process: ‚ Group transactions by rate categories ƒ Net gains & losses on sale or disposition of capital assets within each of the 4 rate categories x Net short­term gains are taxed at the individual’s marginal rate ˜ Use net losses from any category to reduce gains in higher rate categories, except for STCG. x x Any remaining net loss is deductible up to $3,000 per year. Net short­term losses are deducted before long­term losses. *15% / 5% as of May 6, 2003 through December 31, 2007 (with the 15% rate continuing unchanged in 2008­2010 as well). 8 Example of Individual Netting: x JB, a TP in the 35% bracket, has the following Section 1221 transactions during the year: y Depreciation recapture on $17,000 sale of a rental house (25% category) y Sale of stock held ST Gain y Sale of a coin collection Gain $1,500 $1,300 y Sale of stock held LT Gain $4,000 y Sale of bonds held LT Loss ($22,000) y Sale of art painting Gain $3,000 x What is the tax effect of these transactions on JB? 9 Answer for Individual Netting Example: x Step 1: Group transactions into categories x Step 2: Net gains & losses within each category x Step 3: Net between groups, i.e., net losses from lower rate categories; reduce gain in higher rate categories; BUT, STCG are included in ordinary income and do not participate in this netting step. ST 28% 25% 15% Step 1 $1,500 Step 2 $1,500 $4,300 $17,000 $4,000 ($22,000) $4,300 $17,000 ($18,000) Step 3 Taxed at ord. inc. rate $0 [($18,000)+$4,300=($13,700)] $3,300 [($13,700)+$17,000=$3,300] $0 All loss has been absorbed by higher rate category gains. *Net result: JB is taxed on $3,300 at a 25% rate. 10 Thrust of IRC Section 1231: “The Best of Both Worlds” x Section 1231 applies to: x Depreciable Assets used in a T/B or for the production of income and held longer than 12 months x If such property is held 12 months or less, ordinary income treatment applies x Generally: x Gain will be taxed as LONG­TERM Capital Gain and Loss will be treated as Ordinary Loss. 11 ...
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