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Chapter 14 Property Transactions: Determination of Gain or Loss and Basis Considerations Individual Income Chapter 14 Property Transactions: Determination of Gain or Loss and Basis Considerations Individual Income Taxes © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1

The Big Picture (slide 1 of 3) • Alice owns a house that she The Big Picture (slide 1 of 3) • Alice owns a house that she received from her mother 7 months ago. – Her mother’s cost for the house was $275, 000. • Alice is considering selling the house to her favorite nephew, Dan, for $275, 000. – Alice anticipates she will have no gain or loss on the transaction. 2

The Big Picture (slide 2 of 3) • She comes to you for advice. The Big Picture (slide 2 of 3) • She comes to you for advice. As Alice’s tax adviser, you need answers to the following questions: – You are aware that Alice’s mother died around the time Alice indicates she received the house from her mother. • Did Alice receive the house by gift prior to her mother’s death? – If so, what was the mother’s adjusted basis? • Did Alice instead inherit the house from her mother? – If so, what was the fair market value of the house on the date of her mother’s death? – Has the house been Alice’s principal residence during the period she has owned it? – Was it her principal residence before she received it from her mother? – How long did Alice’s mother own the house? – What is the fair market value of the house? – Does Alice intend for the transaction with Dan to be a sale or part sale and part gift? – What does Alice intend to do with the sale proceeds? 3

The Big Picture (slide 3 of 3) • Alice would also like to know The Big Picture (slide 3 of 3) • Alice would also like to know the tax consequences of selling her car – She paid $22, 000 for the car 4 months ago and has used it exclusively for personal use. – Based on the ‘‘Blue Book’’ value, she anticipates that she can sell it for $20, 000 to $23, 000. • In addition, earlier this year Alice sold some stock at a realized loss and subsequently repurchased some shares of the same stock. • She has also asked you about the tax consequences of these transactions. • Once you have more information, you can advise Alice on the tax consequences of these various transactions. – Read the chapter and formulate your response. 4

Determination of Gain or Loss (slide 1 of 7) • Realized gain or loss Determination of Gain or Loss (slide 1 of 7) • Realized gain or loss – Difference between amount realized from sale or other disposition of the asset and its adjusted basis – Sale or other disposition • Includes trade-ins, casualties, condemnations, thefts, bond retirements 5

Determination of Gain or Loss (slide 2 of 7) • Amount realized from disposition Determination of Gain or Loss (slide 2 of 7) • Amount realized from disposition – Total consideration received, including cash, FMV of property received, mortgages/loans transferred to buyer • Fair market value (FMV): Value of asset determined by arms-length transaction, i. e. , amount set by transaction between willing buyer and seller with neither obligated to enter into transaction – Reduced by any selling expenses 6

Determination of Gain or Loss (slide 3 of 7) • Adjusted basis – Original Determination of Gain or Loss (slide 3 of 7) • Adjusted basis – Original cost (or other adjusted basis) plus capital additions less capital recoveries 7

Determination of Gain or Loss (slide 4 of 7) • Capital additions – Cost Determination of Gain or Loss (slide 4 of 7) • Capital additions – Cost of improvements and betterments to the property that are capital in nature and not currently deductible 8

Determination of Gain or Loss (slide 5 of 7) • Capital recoveries – Amount Determination of Gain or Loss (slide 5 of 7) • Capital recoveries – Amount of basis recovered through: • • • Depreciation or cost recovery allowances Casualty and theft losses (and insurance proceeds) Certain corporate distributions Amortizable bond premium Easements 9

Determination of Gain or Loss (slide 6 of 7) • Recognized gain or loss Determination of Gain or Loss (slide 6 of 7) • Recognized gain or loss – Amount of realized gain (loss) that is included in (deducted from) gross income 10

Determination of Gain or Loss (slide 7 of 7) • Realized gains and losses Determination of Gain or Loss (slide 7 of 7) • Realized gains and losses are not always recognized – Realized gains may be deferred or excluded – Realized losses may be deferred or disallowed • Realized losses from the sale, exchange, or condemnation of personal use assets (e. g. , a personal residence) are not recognized for tax purposes – Exception - casualty or theft losses from personal use assets • In contrast, any gain realized from the sale or other disposition of personal use assets is, generally, fully taxable 11

Determination of Gain or Loss (slide 7 of 7) • Realized gains and losses Determination of Gain or Loss (slide 7 of 7) • Realized gains and losses are not always recognized – Realized gains may be deferred or excluded – Realized losses may be deferred or disallowed • Realized losses from the sale, exchange, or condemnation of personal use assets (e. g. , a personal residence) are not recognized for tax purposes – Exception - casualty or theft losses from personal use assets • In contrast, any gain realized from the sale or other disposition of personal use assets is, generally, fully taxable 12

The Big Picture - Example 7 Gain On Sale of Personal Use Assets • The Big Picture - Example 7 Gain On Sale of Personal Use Assets • Return to the facts of The Big Picture on p. 14 -1. • Assume Alice sells the car, which she has held exclusively for personal use, for $23, 000. – Recall that her adjusted basis of the car is $22, 000. • Alice has a realized and recognized gain of $1, 000. 13

The Big Picture - Example 8 Loss On Sale of Personal Use Assets • The Big Picture - Example 8 Loss On Sale of Personal Use Assets • Return to the facts of The Big Picture on p. 14 -1. • Assume Alice sells the car in Example 7 for $20, 000. – She has a realized loss of $2, 000, but the loss is not recognized. 14

Recovery of Capital Doctrine • Taxpayer is entitled to recover cost or other original Recovery of Capital Doctrine • Taxpayer is entitled to recover cost or other original basis of property acquired and is not taxed on that amount • To extent receive only investment back upon disposition of an asset, taxpayer has no gain 15

Basis Considerations (slide 1 of 6) • Original basis of an asset is generally Basis Considerations (slide 1 of 6) • Original basis of an asset is generally its cost • Bargain purchase assets have a basis equal to their FMV – Bargain amount may be income to purchaser (e. g. , employee = compensation; shareholder = dividend) 16

Basis Considerations (slide 2 of 6) • Identification problems – Security sales where specific Basis Considerations (slide 2 of 6) • Identification problems – Security sales where specific identification not possible, use FIFO to compute basis 17

Basis Considerations (slide 3 of 6) • Allocation problems: lump-sum purchase – Must allocate Basis Considerations (slide 3 of 6) • Allocation problems: lump-sum purchase – Must allocate basis to each asset obtained – Allocation usually based on relative FMV of assets 18

Basis Considerations (slide 4 of 6) • Allocation problems: Going concern purchase – Assign Basis Considerations (slide 4 of 6) • Allocation problems: Going concern purchase – Assign purchase price to assets (excluding goodwill) to extent of their total FMV – Then allocate among assets based on FMV – Residual amount is goodwill • Goodwill is an amortizable § 197 asset – Allocation applies to both purchaser and seller 19

Basis Considerations (slide 5 of 6) • Allocation problems: Nontaxable stock dividends – Basis Basis Considerations (slide 5 of 6) • Allocation problems: Nontaxable stock dividends – Basis of original shares is allocated over the original and new shares • Based on number of shares (common on common), or • Based on relative FMV (preferred on common) – Holding period includes the holding period of the original shares 20

Basis Considerations (slide 6 of 6) • Allocation problems: Nontaxable stock rights – Basis Basis Considerations (slide 6 of 6) • Allocation problems: Nontaxable stock rights – Basis in rights is zero unless taxpayer is required or elects to allocate basis from stock • Required to allocate if FMV of rights is at least 15% of the FMV of the stock • Allocation is based on relative FMV of rights and stock – Holding period includes holding period of the stock on which the rights were distributed • However, if the rights are exercised, holding period of newly acquired stock begins with date the rights are exercised 21

Gift Basis (slide 1 of 9) • Gift property may have a dual basis, Gift Basis (slide 1 of 9) • Gift property may have a dual basis, i. e. , basis for gain and loss may differ • Basis is dependent on relationship between FMV at date of gift and donor’s adjusted basis 22

Gift Basis (slide 2 of 8) • Gift property may have a dual basis, Gift Basis (slide 2 of 8) • Gift property may have a dual basis, i. e. , basis for gain and loss may differ • Basis is dependent on relationship between FMV at date of gift and donor’s adjusted basis 23

Gift Basis (slide 3 of 9) • Gift basis for subsequent gain – When Gift Basis (slide 3 of 9) • Gift basis for subsequent gain – When a gifted asset is disposed of by the donee, the basis for calculating any gain is the donor’s adjusted basis (carryover basis) – This basis is called the “gain basis” • Gain basis may be increased if donor incurred gift tax on gift – Holding period for donee includes that of donor 24

Gift Basis (slide 4 of 9) • Gift basis for subsequent loss – When Gift Basis (slide 4 of 9) • Gift basis for subsequent loss – When a gifted asset is disposed of by a donee, the basis for calculating any loss is the lesser of FMV at the date of gift or the donor’s adjusted basis – This basis is called the “loss basis” – If dual basis and sold for loss, holding period for donee starts on date of gift 25

Gift Basis (slide 5 of 9) • Gift basis when no gain or loss Gift Basis (slide 5 of 9) • Gift basis when no gain or loss – If a dual basis exists and the amount realized from the disposition of a gifted asset falls between the gain basis and the loss basis • No gain or loss is realized – Holding period for donee is not needed since there is no gain or loss 26

Gift Basis (slide 6 of 9) • Example of gift basis determination – Alex Gift Basis (slide 6 of 9) • Example of gift basis determination – Alex received a gift from Beth on June 15 this year – FMV of asset on June 15 was $8, 000 – Beth bought the asset on May 5, 1985 for $10, 000 27

Gift Basis (slide 7 of 9) • Example of gift basis determination (cont’d) – Gift Basis (slide 7 of 9) • Example of gift basis determination (cont’d) – If Alex sells the asset for $11, 000, there is a $1, 000 gain ($11, 000 – $10, 000) – If Alex sells the asset for $7, 000, there is a $1, 000 loss ($7, 000 – $8, 000) – If Alex sells the asset for $9, 000, there is no gain or loss ($9, 000 – $9, 000) 28

Gift Basis (slide 8 of 9) • Adjustment for gift taxes – The proportion Gift Basis (slide 8 of 9) • Adjustment for gift taxes – The proportion of gift tax paid (on gifts after 1976) by the donor on appreciation of asset can be added to basis of donee – The donee's basis is equal to: Donor’s basis + [(unrealized appreciation/taxable gift) × gift tax] 29

Gift Basis (slide 9 of 9) • Example of gift tax: – Cathy received Gift Basis (slide 9 of 9) • Example of gift tax: – Cathy received a gift from Darren on June 15 of this year – FMV on June 15 was $34, 000 – Darren had a basis in the asset of $29, 000 – Darren paid gift tax of $800 – Cathy’s basis in the gifted property is $29, 200 [$29, 000 + ($5, 000/($34, 000 – $14, 000) × $800)] 30

Property Acquired from a Decedent (slide 1 of 7) • Generally, beneficiary’s basis in Property Acquired from a Decedent (slide 1 of 7) • Generally, beneficiary’s basis in inherited assets will be the FMV of the asset at decedent’s date of death – Exception: If the executor/administrator of estate elects alternate valuation date, basis is FMV on such date • Inherited property is always treated as longterm property 31

Property Acquired from a Decedent (slide 2 of 7) • Inherited property valuation date Property Acquired from a Decedent (slide 2 of 7) • Inherited property valuation date – Date assets valued for estate tax is either: • Date of decedent’s death, which is called the primary valuation date (PVD), or • 6 months after date of decedent’s death, which is called the alternate valuation date (AVD) – Can only be elected if both the value of gross estate and the estate tax liability are lower than if PVD was used 32

Property Acquired from a Decedent (slide 3 of 7) • Inherited property valuation date Property Acquired from a Decedent (slide 3 of 7) • Inherited property valuation date – When PVD is used, beneficiary’s basis will be the FMV at date of decedent’s death – When AVD is used, beneficiary’s basis will be the FMV at the earliest of: • Date asset is distributed from estate, or • 6 months after date of decedent’s death 33

Property Acquired from a Decedent (slide 4 of 7) • Example of inherited property Property Acquired from a Decedent (slide 4 of 7) • Example of inherited property valuation: – At Rex’s date of death, April 30 of this year, his assets had an adjusted basis of $200, 000, and a FMV of $700, 000 • PVD selected and assets distributed June 30; beneficiary’s basis is $700, 000 34

Property Acquired from a Decedent (slide 5 of 7) • Example of inherited property Property Acquired from a Decedent (slide 5 of 7) • Example of inherited property valuation (cont’d) – October 30 this year (six months after date of Rex’s death), the assets had a FMV of $650, 000 • AVD selected and assets distributed November 10; beneficiary’s basis is $650, 000 • AVD selected and assets distributed June 30 when FMV of assets is $670, 000; beneficiary’s basis is $670, 000 35

Property Acquired from a Decedent (slide 6 of 7) • Deathbed gifts – Property Property Acquired from a Decedent (slide 6 of 7) • Deathbed gifts – Property inherited by taxpayer (or spouse) which was both appreciated and gifted by same taxpayer to decedent within 1 year of decedent's death – Beneficiary’s basis in property is carryover of decedent’s basis (not date of death FMV) – Generally the same basis taxpayer had on date of gift 36

Property Acquired from a Decedent (slide 7 of 7) • Survivor’s share of community Property Acquired from a Decedent (slide 7 of 7) • Survivor’s share of community property – Both decedent’s share and surviving spouse’s share of community property receives basis of FMV on date of death • Surviving spouse’s share deemed to be acquired from decedent • Survivor’s share in common law state – Only 1/2 of jointly held property of spouses is included in the estate • In such a case, no adjustment of the basis is permitted for the excluded property interest (the surviving spouse’s share) 37

The Big Picture - Example 19 Property Acquired From A Decedent • Return to The Big Picture - Example 19 Property Acquired From A Decedent • Return to the facts of The Big Picture on p. 14 -1. • In 2014, Alice inherited her mother’s house. – At the date of death, the mother’s adjusted basis for the house was $275, 000. – The house’s fair market value at the date of death was $475, 000. – The alternate valuation date was not elected. – Alice’s basis for income tax purposes is $475, 000. • This is commonly referred to as a stepped-up basis. 38

The Big Picture - Example 20 Property Acquired From A Decedent • Return to The Big Picture - Example 20 Property Acquired From A Decedent • Return to the facts of The Big Picture on p. 14 -1. • Assume the same facts as in Example 19, except the house’s fair market value at the date of the mother’s death was $260, 000. • Alice’s basis for income tax purposes is $260, 000. – This is commonly referred to as a stepped-down basis. 39

Disallowed Losses (slide 1 of 5) • Related parties (§ 267) – Losses on Disallowed Losses (slide 1 of 5) • Related parties (§ 267) – Losses on sale of assets between related parties are disallowed – For income-producing or business property, any loss disallowed can be used to reduce gain recognition on subsequent disposition of asset to unrelated party • Only available to original transferee • Not available for sales of personal use assets 40

Disallowed Losses (slide 2 of 5) • Related parties include: – Family members, – Disallowed Losses (slide 2 of 5) • Related parties include: – Family members, – Corporation and a shareholder who owns greater than 50% (directly or indirectly) of the corporation, and – Partnership and a partner who owns greater than 50% (directly or indirectly) of the partnership 41

Disallowed Losses (slide 3 of 5) • Wash sales – Losses from wash sales Disallowed Losses (slide 3 of 5) • Wash sales – Losses from wash sales are disallowed – Wash sale occurs when taxpayer disposes of stock or securities at loss and acquires substantially identical stock or securities within 30 days before or after the date of the loss sale 42

Disallowed Losses (slide 4 of 5) • Wash sales – Disallowed loss is added Disallowed Losses (slide 4 of 5) • Wash sales – Disallowed loss is added to the basis of the substantially identical stock or securities that caused the disallowance – Does not apply to gains realized on disposition of securities 43

Disallowed Losses (slide 5 of 5) • Personal use assets – Loss on the Disallowed Losses (slide 5 of 5) • Personal use assets – Loss on the disposition of personal use assets is disallowed – Personal use asset loss cannot be converted into a business (or production of income) use deductible loss • Original loss basis for an asset converted is the lower of personal use basis or FMV at date of conversion • Cost recovery basis similarly limited 44

The Big Picture - Example 25 Wash Sale • Return to the facts of The Big Picture - Example 25 Wash Sale • Return to the facts of The Big Picture on p. 14 -1. • Alice owned 100 shares of Green Corporation stock (adjusted basis of $20, 000). – She sold 50 shares for $8, 000. – Ten days later, she purchased 50 shares of the same stock for $7, 000. • Alice’s realized loss of $2, 000 ($8, 000 amount realized $10, 000 adjusted basis) is not recognized because it resulted from a wash sale. • Alice’s basis in the newly acquired stock is $9, 000 ($7, 000 purchase price + $2, 000 unrecognized loss from the wash sale). 45

Refocus On The Big Picture (slide 1 of 4) • Alice inherited the house Refocus On The Big Picture (slide 1 of 4) • Alice inherited the house from her mother. – The fair market value of the house at the date of her mother’s death was $475, 000. – An appraisal indicates that the house currently is worth $485, 000. • Alice’s mother lived in the house for 38 years. – Her adjusted basis for the house was $275, 000. – As a child, Alice lived in the house for 10 years, but she has not lived there in 25 years. – The house has been vacant during the 7 months Alice has owned it. 46

Refocus On The Big Picture (slide 2 of 4) • Alice has been trying Refocus On The Big Picture (slide 2 of 4) • Alice has been trying to decide whether she should sell the house for its fair market value or sell it to her nephew for $275, 000. – Alice has suggested a $275, 000 price for the sale to Dan • She believes she will have no gain or loss at this price. • You advise Alice that her adjusted basis for the house is the $475, 000 fair market value on the date of her mother’s death. 47

Refocus On The Big Picture (slide 3 of 4) • If Alice sells the Refocus On The Big Picture (slide 3 of 4) • If Alice sells the house for $485, 000, she would have a recognized gain of $10, 000 Amount realized Adjusted basis Recognized Gain $485, 000 475, 000 $10, 000 • The gain would be long-term capital gain. 48

Refocus On The Big Picture (slide 4 of 4) • If, instead, Alice sells Refocus On The Big Picture (slide 4 of 4) • If, instead, Alice sells the house to her nephew for $275, 000, she will have a part sale and part gift. The realized gain on the sale of $5, 670 is recognized as long-term capital gain. Amount realized Less: Adjusted basis Realized gain Recognized gain $ 275, 000 * (269, 330) $ 5, 670 *[($275, 000/$485, 000) X $475, 000] = $269, 330 • Alice is then deemed to have made a gift to Dan of $210, 000 ($485, 000 - $275, 000). • With this information, Alice can make an informed selection between the two options. 49

If you have any comments or suggestions concerning this Power. Point Presentation for South-Western If you have any comments or suggestions concerning this Power. Point Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA [email protected] edu SUNY Oneonta © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 50