CHAPTER 16



CHAPTER 14

PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES

§ 1231, AND RECAPTURE PROVISIONS

SOLUTIONS TO PROBLEM MATERIALS

| | | | |Status: | | Q/P |

|Question/ | | | |Present | | in Prior |

|Problem | |Topic | |Edition | |Edition |

| | | | | | |

|1 | |Issue ID | |Unchanged |2 |

|2 | |Definition of capital assets | |New | |

|3 | |Nonbusiness bad debts | |New | |

|4 | |Worthless securities | |New | |

|5 | |Issue ID | |Unchanged |6 |

|6 | |Patents | |Unchanged |7 |

|7 | |Lease cancellation | |New | |

|8 | |Issue ID | |Unchanged |10 |

|9 | |Issue ID | |Unchanged |11 |

|10 | |Capital loss carryovers | |Unchanged |12 |

|11 | |Section 1231 holding period | |New | |

|12 | |Section 1231 assets | |New | |

|13 | |Casualties and § 1231 | |New | |

|14 | |Issue ID | |New | |

|15 | |Issue ID | |Unchanged |14 |

|16 | |Section 1231: realized versus recognized | |Unchanged |15 |

|17 | |Section 1231: business use property condemnation | |Unchanged |16 |

|18 | |Issue ID | |Unchanged |17 |

|19 | |Section 1231 gain from disposition with § 1245 depreciation recapture | |Unchanged |18 |

|20 | |Issue ID | |Unchanged |19 |

|21 | |Section 1245 recapture and short-term holding period | |Unchanged |20 |

|22 | |Section 1245 recapture and nonresidential real estate | |Unchanged |21 |

|23 | |Issue ID | |Unchanged |22 |

|24 | |Section 1250 and residential real estate | |Unchanged |23 |

|25 | |Section 1250 recapture | |Unchanged |24 |

|26 | |Recapture and holding period | |Unchanged |25 |

|27 | |Residential rental housing | |Unchanged |26 |

|28 | |Unrecaptured § 1250 gain | |Unchanged |27 |

|29 | |Depreciation recapture and gifts | |Unchanged |28 |

|30 | |Depreciation recapture and death | |Unchanged |29 |

|31 | |Depreciation recapture for corporation: property distributions | |Unchanged |30 |

|32 | |Related party transactions | |Unchanged |31 |

|33 | |Capital assets | |Modified |32 |

|34 | |Capital assets | |Unchanged |33 |

|35 | |Capital assets | |Unchanged |34 |

|* 36 | |Section 1237 treatment | |Modified |35 |

|37 | |Nonbusiness bad debt and worthless securities, § 1244 stock | |Modified |36 |

|38 | |Options | |New | |

|39 | |Patents | |Unchanged |38 |

|40 | |Franchises | |Unchanged |39 |

|41 | |Lease cancellation | |Unchanged |40 |

|42 | |Gifts and holding period | |New | |

|43 | |Short sale | |New | |

|* 44 | |Net capital gain | |Unchanged |42 |

|* 45 | |Net capital gain | |Unchanged |43 |

|46 | |Capital asset, holding period, and basis | |New | |

|* 47 | |Capital loss carryover and negative taxable income | |New | |

|* 48 | |Net capital gain and alternative tax | |New | |

|49 | |Net capital gain and alternative tax | |Modified |44 |

|50 | |Corporate net capital loss and carryover | |Unchanged |45 |

|51 | |Covenant not to compete versus goodwill | |Unchanged |46 |

|52 | |Section 1231 computation and farm assets | |Unchanged |47 |

|53 | |Section 1231 nonpersonal use property casualty | |Unchanged |48 |

|54 | |Section 1231 lookback | |Unchanged |49 |

|55 | |Section 1231 gain and loss planning | |Unchanged |50 |

|56 | |Section 1245 recapture | |Unchanged |51 |

|57 | |Section 1245 recapture and § 1231 lookback | |Unchanged |52 |

|58 | |Section 1231 gain, § 1250 recapture, and unrecaptured § 1250 gain | |Unchanged |53 |

|59 | |Comprehensive §§ 1231, 1245, and 1250 | |Unchanged |55 |

|60 | |Sections 1245 and 1250 recapture, § 1231 gain, and unrecaptured § 1250 gain | |Unchanged |56 |

|61 | |Section 1245 and gifts | |Unchanged |58 |

|62 | |Section 1245 and inheritances | |New | |

|63 | |Section 1245 and charitable contributions | |New | |

|64 | |Section 1245 and installment sales | |New | |

|65 | |Section 1245 and property distributions | |New | |

|66 | |Section 1239 (related taxpayers) | |New | |

|67 | |Sections 1245 and 1231 gain and sales price allocation | |Unchanged |60 |

|* 68 | |Cumulative | |Modified |61 |

|69 | |Cumulative | |Unchanged |62 |

| | | | |Status | | |

|Research | | | |Present | | |

|Problem | |Topic | |Edition | | |

| | | | | | |

|1 | |Basis determination when selling stock | |Unchanged | |

|2 | |Section 1245 recapture | |Unchanged | |

|3 | |Internet activity | |New | |

| | | | | | |

*The solution to this problem is available on a transparency master.

CHECK FIGURES

34. $173,000 ordinary income.

35. Designate stock as an investment.

36. $3,000 ordinary gain; $225,000 long-term capital gain.

37.a. $3,700 short-term capital loss; $12,000 long-term capital loss; $30,000 ordinary loss.

37.b. $32,000.

37.c. $700 short-term capital loss carryover; $12,000 long-term capital loss carryover.

38. $3,000,000 long-term capital gain.

39. Sell the patent now and have $40,000 per year of long-term capital gain for 10 years.

40. Freys treats all payments as ordinary; Reynaldo may amortize $60,000 over 15 years and deduct the $30,000 currently.

42. $1,000 short-term capital loss.

43.a. $500 short-term capital loss.

43.b. May 2, 2004.

43.c. $200 short-term capital gain.

44. $13,000 net capital gain.

45. $1,000 long-term capital loss.

47. $3,850 long-term capital loss carryover.

48. $65,020 taxable income and $12,396 tax using the alternative method.

49. $13,425 tax using the alternative method.

50. $455,000 taxable income; $45,000 STCL carryover.

52. AGI $62,450.

53. $13,000 net § 1231 gain.

54. 2003 $30,000 ordinary gain; 2004 $30,000 ordinary gain, $9,000 LTCG.

55. Sell the § 1231 gain asset this year and the § 1231 loss asset next year.

56.a. Rack $60,000 ordinary gain, $35,000 § 1231 gain; forklift $7,000 § 1231 loss; bin $7,000 ordinary gain.

56.b. $23,000 capital gain and $5,000 ordinary income.

57.a. Rack $5,000 ordinary gain; forklift $7,000 § 1231 loss; bin $3,000 § 1231 loss.

57.b. $0 capital gain.

58.a. $41,032 cost recovery; $358,968 adjusted basis of building.

58.b. $11,032 § 1231 gain.

59.b. AGI $461,108.

60.a. $9,300 § 1250 gain; $61,700 § 1231 gain.

60.b. $71,000 § 1245 gain.

61. $19,000 ordinary gain.

62. $1,000 ordinary gain.

63. No recognized gain or loss; $38,000 charitable contribution.

64. The entire $453,000 gain is ordinary income due to § 1245 depreciation recapture.

65. Brown has $4,500 § 1245 ordinary income; Emily has a $4,500 qualifying dividend.

66. The corporation’s gain is all ordinary income due to § 1239. Eli’s basis is $45,000.

67. $45,000 ordinary income.

68. $1,236 refund for 2003.

69. AGI is $272,982; taxable income is $256,206; tax refund is $4,383.

DISCUSSION QUESTIONS

1. Meredith has a zero tax basis for the supplies because she has already deducted their cost. Therefore, she has a gain of $1,000 from selling them. The supplies are not a capital asset because § 1221 specifically defines supplies as not a capital asset. Meredith has an ordinary gain from disposition of the supplies. p. 14-4

2. James is in the business of selling antique toy trains. Therefore, the toy trains are inventory and not a capital asset. The person who sold the trains at the garage sale held them as either a personal use asset or an investment asset. In either situation, the assets were capital assets. p. 14-4

3. Natasha is probably not in the trade or business of making loans. Therefore, she has made a loan in connection with an investment activity since she clearly intended to receive repayment of the loan plus interest. In the year the loan is worthless, she has a nonbusiness bad debt for the $4,000 principal of the loan. The $4,000 is treated as a short-term capital loss. p. 14-8

4. Anwar has a loss on a worthless security held for investment. The date of worthlessness is deemed to be the last day of the taxable year. However, since that is still in the same year he purchased the bonds, he did not hold them more than one year and he has a short-term capital loss of $12,000. p. 14-9

5. Mubsin was the grantee of the option and, since he exercised the option, the $10,000 option price is added to the $112,000 cost of the property to determine Mubsin’s adjusted basis for the property. The property is not a capital asset because Mubsin will hold it for use as rental property. He would have to determine how much of this basis is allocable to the land and how much is allocable to the building to determine his basis for depreciation. p. 14-11

6. Since Charles is a holder, the patent has not been reduced to practice, and he has given up all substantial rights in the patent, the $37,000 gain ($40,000 amount realized – $3,000 adjusted basis) is automatically a long-term capital gain. pp. 14-11 to 14-13

7. The lease was a personal use asset for the student and, therefore, a capital asset. However, the payment was in lieu of rent, a non-deductible personal expense of the student. Therefore, the payment is not a capital loss. Lease cancellation payments received are treated as an exchange for the lessee, but not lease cancellation payments made. p. 14-15

8. A former owner’s holding period is tacked on to the present owner’s holding period if the transaction is nontaxable and the former owner’s basis carries over to the present owner. Here, the value of the property was less than Juan’s (the donor) basis at the time of the gift. Miguel’s (the donee) holding period will not be known until Miguel sells the property. If Miguel sells the property for more than Juan’s basis, Juan’s holding period will tack on to Miguel’s. If Miguel sells the property for less than its fair market value at the date of gift ($7,000), Miguel’s holding period will start at the date of the gift.

p. 14-16 and Examples 24 and 25

9. Byron should sell enough stock to generate a $10,000 long-term capital gain. This will reduce his 2004 net capital loss to $3,000 and that $3,000 will be a for AGI capital loss deduction. pp. 14-26 to 14-27

10. The corporation may not reduce its 2004 taxable income by the net short-term capital loss. The corporation may carry over (three years back and five years forward) the loss and offset it against capital gains of the carryover year(s). p. 14-29

11. Until a potential § 1231 asset has been held more than one year, it is an ordinary asset because potential § 1231 assets do not qualify as capital assets and ordinary asset is the “default” category. p. 14-32

12. The taxpayer is in the racehorse business and the racehorse is a depreciable asset of that business. Since the racehorse has been held 24 months or longer, it is a § 1231 asset. p. 14-32

13. Personal use property is a capital asset. When personal use property casualty gains exceed personal use property casualty losses, the excess gain is treated as a capital gain. p. 14-33

14. If there is a net § 1231 gain of $45,000, some or all of the gain may be treated as ordinary income to the extent of § 1231 lookback losses. p. 14-35 and Concept Summary 14-6

15. The tax issues that Sally must properly handle are:

• Should the two casualty items be netted against one another?

• If the items are netted, what type of gain or loss results from the netting?

• How are the results of the netting integrated with Sally’s other gains and losses (if any)?

• Should Sally postpone the gain by reinvesting in similar property?

pp. 14-35, 14-36, and Chapter 13

16. Section 1231 has no effect on whether or not realized gain or loss is recognized. Instead, § 1231 merely dictates how such recognized gain or loss is classified (ordinary, capital, or § 1231) under certain conditions. p. 14-33

17. Since the property was used in a trade or business and held more than a year, it was a § 1231 asset. Disposition by condemnation (unlike disposition by casualty or theft) is not subject to any special netting rules. The loss is a § 1231 loss initially. Personal use property condemnation gains and losses are not subject to the § 1231 rules, but the property here was business use property. p. 14-33

18. The factors that will influence whether any of the 2004 net § 1231 is treated as long-term capital gain are:

• What is the amount of the 2001 net § 1231 loss?

• What is the amount of the 2002 net § 1231 gain, and after reducing the 2001 net § 1231 loss by the 2002 net § 1231 gain, does any of the 2001 net § 1231 loss remain?

• If any of the 2001 net § 1231 loss remains, what is the amount of the 2003 net § 1231 gain, and after reducing the remaining 2001 net § 1231 loss by the 2003 net § 1231 gain, does any of the 2001 net § 1231 loss remain?

• If any of the 2001 net § 1231 loss remains, what is the amount of the 2004 net § 1231 gain?

• After reducing the 2004 net § 1231 gain by the remaining 2001 net § 1231 loss, does any of the 2004 net § 1231 gain remain?

pp. 14-33 to 14-35

19. The machine would have to be sold for more than the amount that was paid for it. p. 14-38

20. To properly handle this transaction, Sylvia must determine the following:

• The tax status of the property (§ 1231 asset, capital asset, or ordinary asset).

• The applicability of § 1245 depreciation recapture.

• The outcome of the § 1231 netting process.

Both assets are § 1231 assets. Section 1245 depreciation recapture causes the entire gain of $2,510 ($40,000 – $37,490) to be taxed as ordinary income since the selling price does not exceed the $100,000 original cost of the asset. Since the loss of $14,490 ($23,000 – $37,490) on the other asset is the only § 1231 gain or loss, there is a net loss of $14,490 that is treated as an ordinary loss. Consequently, Sylvia is partially correct, the $2,510 gain from one of the items does offset the $14,490 loss from the other item. However, these transactions are reported separately from her 2004 business income. The $11,980 net loss is deductible for adjusted gross income on her 2004 tax return. pp. 14-30, 14-35, and 14-38

21. Section 1245 depreciation recapture generally applies to § 1231 assets; in this case depreciable equipment held more than one year. This asset was held one year or less; so it was an ordinary asset rather than a § 1231 asset. Since the asset is ordinary, the gain from disposition is also ordinary and § 1245 does not apply. pp. 14-30 and 14-38

22. All of the gain is subject to § 1245 depreciation recapture because nonresidential real estate acquired after 1980 and before 1987 for which accelerated depreciation was used is subject to § 1245 depreciation recapture. p. 14-40

23. The unrecaptured § 1250 gain is related to the depreciation taken on the property and requires that the property be sold at a recognized gain. The greater the portion of the sales price that relates to the land, rather than to the building, the smaller the recognized gain from disposition of the building will be. The issues raised include the following:

• The original cost of the land and the building.

• The portion of the sales price related to the land and to the building.

• The depreciation taken on the building.

p. 14-45

24. Section 1250 depreciation recapture would not apply to an asset acquired in 2000 because straight-line depreciation would have to be used for the building. Section 1250 depreciation recapture only applies when there is an excess of accelerated depreciation over straight-line depreciation. However, a portion of the recognized gain from disposition of the building may be taxed at a maximum of 25% because of the unrecaptured § 1250 gain rules. pp. 14-42 and 14-43

25. The amount in the 2003 additional depreciation column is negative because the straight-line depreciation exceeded the accelerated depreciation. As the holding period of the depreciable property gets longer, yearly straight-line depreciation of the original cost begins to exceed yearly declining balance depreciation. p. 14-43

26. The gain would be an ordinary gain due to § 1250. All depreciation is recaptured if the property is purchased and disposed of in one year or less. p. 14-42

27. Property qualifies as residential rental housing only if at least 80 percent of the gross rental income is rental income from dwelling units. p. 14-43

28. Abigail’s maximum unrecaptured § 1250 gain is the amount of the depreciation she took on the real estate. If the $45,000 recognized gain is less than the depreciation taken, that would be the maximum. She would have no § 1250 depreciation recapture because she acquired the real estate after 1986. Therefore, only straight-line depreciation was taken on the property. pp. 14-44 to 14-46

29. The § 1245 depreciation recapture potential carries over to the donee. p. 14-46

30. The § 1245 depreciation recapture potential does not carry over to the beneficiary. p. 14-46

31. The distribution of the truck is a taxable transaction for the corporation. All of the gain is § 1245 gain because the truck is a § 1231 asset and the fair market value is less than the original cost. p. 14-48

32. The distribution of the truck is a taxable transaction for the corporation. All of the gain is ordinary gain due to § 1239 because the shareholder is a related taxpayer and will use the truck in a business. Therefore, the truck is depreciable by the shareholder and § 1239 makes all the gain of the transferor ordinary gain. p. 14-48

PROBLEMS

33. All the assets are capital assets because they do not fit any of the items listed in § 1221 as not capital assets. The antique truck is a “collectible.” Therefore, the $12,000 loss ($35,000 sale price – $47,000 basis) is a long-term capital loss that would first be netted against any 28% long-term capital gain. The Blue Growth Fund $11,000 gain ($23,000 sale price – $12,000 basis) is a long-term capital gain that is potentially taxable at 5% and/or 15%. The Orange Bonds are sold for a $7,250 gain ($42,000 proceeds – $750 interest income – $34,000 basis). The gain is a long-term capital gain potentially taxable at 5% and/or 15%. The sale of the Green stock results in a $2,000 ($11,000 sale price – $13,000 basis) short-term capital loss because the stock was held one year or less. The $750 interest income is includible in Eric’s gross income. pp. 14-4 and 14-21 to 14-24

34. Sara is in the trade or business of being an artist. Her artworks are not capital assets, but are ordinary assets instead. Since she has a zero tax basis for the art that was sold, her ordinary income is $173,000. p. 14-5

35. By the close of business on the day Brenda purchases the shares, she must designate them as held for investment. The $55 ($200 – $145) per share gain would be long-term capital gain if she sells the shares after holding them more than a year.

Willis, Hoffman, Maloney, and Raabe, CPAs

5191 Natorp Boulevard

Mason, OH 45040

March 17, 2005

Ms. Brenda Reynolds

200 Morningside Drive

Hattiesburg, MS 39406

Dear Ms. Reynolds:

The purpose of this letter is to discuss the rules for purchases of stock by a securities dealer such as yourself. Your co-workers are incorrect that a securities dealer may never have a long-term capital gain from the sale of stock. The tax law allows you to designate stock you purchase as being held for investment. You must make this designation by the end of the business day on which the stock is acquired. I suggest you check with your supervisor on how this “designation” is normally done at your firm. I am sure it is a relatively simple procedure.

As long as you continue to hold the designated shares for investment until you sell them, the shares will be a capital asset. When you sell them at $200 per share, your $55 per share gain will be long-term capital gain if you have held the shares for more than one year.

Thank you for the opportunity to be of service. Please telephone me if you have additional questions.

Sincerely,

Michelle Brown, CPA

Partner

p. 14-7

36. Because Gerald has sold more than five lots, he has potential ordinary income equal to 5% of the selling price of each lot. Gerald has a total recognized gain of $228,000. This is classified as $3,000 ordinary gain and $225,000 long-term capital gain. The computations are shown below:

Selling price (10 X $30,000) $300,000

Less: selling expenses ($300,000 X 4%) (12,000)

Amount realized $288,000

Basis (10 X $6,000) (60,000)

Realized and recognized gain $228,000

Classification of recognized gain:

Ordinary income

5% of selling price (5% X $300,000) $ 15,000

Less: selling expenses (12,000)

Ordinary gain 3,000

Capital gain ($228,000 – $3,000) $225,000

pp. 14-7, 14-8, and Example 9

37. a. When Sue made the loan to a friend, she had a nonbusiness receivable. When the loan is not repaid, she has a $3,700 nonbusiness bad debt assuming the debt is a bona-fide debt. The $3,700 is treated as a short-term capital loss, no matter how long Sue held the loan. Whether the receivable was a capital asset and whether its holding period was long or short-term are not relevant because the Code defines the loss as a short-term capital loss.

Sue also is the holder of a worthless bond. The bond is deemed to have become worthless on the last day of 2004—the year in which it became worthless. Sue’s holding period for the bond is long-term because the time period from November 10, 2003 through December 31, 2004 is more than one year. The $12,000 loss on the bond is a long-term capital loss. The $30,000 loss on the disposition of the § 1244 stock is an ordinary loss. The loss is a deduction for adjusted gross income.

b. Sue’s adjusted gross income is $32,000 [$65,000 – $3,000 (capital loss deduction) – $30,000 (§ 1244 ordinary loss deduction)].

c. Since short-term capital losses are used first to make up the capital loss deduction, Sue has a $700 ($3,700 – $3,000) short-term capital loss carryforward and a $12,000 long-term capital loss carryforward.

pp. 14-8, 14-9, 14-21, 14-27, and 14-28

38. The land was a capital asset for Celia because she held it for investment. The $120,000 paid to Frank is added to her basis for the land because she made this payment to clear the title to the land prior to selling it. She has $3,000,000 ($4,120,000 amount realized – $1,120,000 adjusted basis) of long-term capital gain from disposition of the land. pp. 14-4, 14-10, and 14-11

39. If Mateen sells the patent for $400,000, he has automatic long-term capital gain because he is a “holder.” He is the inventor, the patent has not yet been reduced to practice, and he will have sold all substantial rights to the patent. His maximum long-term capital gain tax rate is 15%. He will receive $40,000 per year for the next 10 years and could use the installment sale method (see Chapter 16) to recognize the gain as the sale proceeds are received. However, he will be taking a risk that the payments will actually be received and should consider the time value of money in analyzing this alternative.

If Mateen contributes the patent to a new business and receives shares of stock of that business, he has made a nontaxable exchange under § 351. He will not be currently taxed on the exchange, but is taking the risk that the business will be profitable and he will be able to sell the shares of stock later at a gain equal to or greater than what he could receive in cash over the next ten years. Once he has held the company’s shares of stock for more than one year, he would have long-term capital gain treatment from disposition of the shares of stock. Without much more information (such as the credit worthiness of the investors, the income potential from manufacturing and selling the process, etc.), it is not possible to make an informed decision either way at this time. pp. 14-11 to 14-13 and 14-17

40. Freys, Inc. has retained significant powers and rights in the franchise agreement. Therefore, Freys has not made a sale or exchange, but has created a license to use its trademarks, trade name, and mode of operation. Section 1253 requires that Freys treat the $60,000 lump-sum noncontingent payment and the $30,000 contingent payment as ordinary income. Reynaldo may amortize the $60,000 noncontingent payment over 15 years. The amortization is treated as a business expense. Reynaldo may currently deduct the $30,000 contingent payment as a business expense. pp. 14-13 and 14-14

41. The tax factors Irene should consider are: (1) whether or not she has an asset; (2) the tax basis for the asset; (3) the tax status (ordinary, capital, or § 1231) of the asset; (4) the amount of the gain or loss from disposition of the asset; (5) the holding period for the asset; and (6) the nature of gain or loss from disposition of the asset. Irene has an asset—the lease on her apartment. The asset is a capital asset because all personal use activity assets are capital assets. Irene has no tax basis for the lease because she did not pay anything for it. (Her monthly lease payments are nondeductible personal use activity expenses.) Her holding period for the lease is one year or less. Consequently, she will have a $1,000 short-term capital gain if she accepts the lease cancellation payment. p. 14-15

42. Since the fair market value of the shares at the date of the gift is less than the grandfather’s basis for the shares and Helmut sells the shares for less than this amount, the holding period begins on the date of the gift and the value of the shares at the date of the gift is used as Helmut’s basis for the shares. Consequently, he has a $1,000 ($8,000 value in May 2004 – $7,000 August 2004 sale price) short-term capital loss. Example 25

43. Dennis has engaged in a short sale against the box because although he did not own substantially identical property on the short sale date (January 15, 2004), he did acquire substantially identical property before the end of the short sale year (on April 1, 2004). However, since he closed the short sale by the end of the year of the short sale (2004), the deemed closing rules do not apply. Also, since Dennis did not own substantially identical stock at the date of the short sale, any gain or loss from closing the short sale is short-term.

a. The price of the shares rose after Dennis made the short sale. He lost $5 per share for a total of $500 short-term capital loss from closing the short sale.

b. The holding period for the remaining 100 shares begins with the closing date of the short sale (May 2, 2004). Because the remaining shares were acquired after the short sale date (January 15, 2004), they have a holding period which commences with the earlier of the closing date of the short sale or the sale date of the remaining shares.

c. Dennis has a $2 per share gain (total of $200) when he sells the remaining shares on January 20, 2005. This gain is short-term because the holding period did not start until the short sale closing date (May 2, 2004). Dennis must hold the stock more than one year to receive long-term treatment.

pp. 14-16 to 14-20 and Concept Summary 14-3

44. Net long-term capital gain ($22,000 – $5,000 long-term loss) $17,000  

Net short-term capital loss ($19,000 – $23,000) (4,000) 

Net capital gain $13,000  

Willis, Hoffman, Maloney, and Raabe, CPAs

5191 Natorp Boulevard

Mason, OH 45040

March 17, 2005

Ms. Elaine Case

300 Ireland Avenue

Shepherdstown, WV 25443

Dear Ms. Case:

The purpose of this letter is to discuss the result of your stock transactions for 2004. You had $17,000 (net) of long-term capital gains and $4,000 (net) of short-term capital losses. Subtracting the $4,000 of losses from the $17,000 of gains resulted in a $13,000 net long-term capital gain.

The $13,000 net long-term capital gain and the details of your stock transactions will be reported on the Schedule D attached to your Form 1040. The $13,000 net capital gain qualifies for the alternative tax and will be taxed at a 15% rate rather than at your marginal tax rate of 35%.

Thank you for the opportunity to be of service. Please telephone me if you have additional questions.

Sincerely,

Michelle Brown, CPA

Partner

pp. 14-21 and 14-22

45. The $18,000 loss on the sale of the personal residence is not deductible because it is a loss on the sale or exchange of a personal use asset. The patent is subject to automatic long-term capital treatment because it was purchased from the individual creator by an unrelated party, the invention had not yet been reduced to practice, and when Betty sold it, she transferred all rights to the patent. Thus, under § 1235, the $1,000 ($8,000 cost – $7,000 sales price) loss on her sale of the patent is a long-term capital loss.

Patent LTCL ($ 1,000) 

2004 stock LTCL (3,000) 

2003 LTCL carryover (12,000) 

Net LTCL ($16,000) 

STCG $21,000

STCL (6,000)

Net STCG $15,000

Net LTCL ($16,000 – $15,000) ($ 1,000)

Of the $1,000 net LTCL, $1,000 is deductible for AGI.

Willis, Hoffman, Maloney, and Raabe, CPAs

5191 Natorp Boulevard

Mason, OH 45040

March 17, 2005

Ms. Betty Jarow

1120 West Street

Ashland, OR 97520

Dear Ms. Jarow:

This letter is in response to your request for an explanation of the tax treatment of the sale of your residence. As you know, the residence was sold for less than your cost. Thus, you had an $18,000 tax loss on the residence sale. Unfortunately, the tax law does not allow that loss to be deducted on your tax return because the home was a personal use asset. The only type of loss deductible on personal use assets is a casualty loss.

Thank you for the opportunity to be of service. Please telephone me if you have additional questions.

Sincerely,

Steve Warren, CPA

Partner

pp. 14-4, 14-11 to 14-13, and 14-21 to 14-24

46. The tax factors Bridgette has to consider include: (1) the tax status of the dolls, (2) the tax basis for the dolls, (3) the holding period for the dolls, and (4) whether the dolls are “collectibles.” The tax status of the dolls is clearly capital asset because they were either personal use assets or investment assets. The tax basis of the dolls will be very hard to determine because Bridgette has owned many of them for a long time and/or they were received as gifts. However, the tax basis must be established somehow or she will have to treat them as having no tax basis and the entire $45,000 sale proceeds will be treated as a gain. In addition, some of the dolls may have been disposed of at a loss and, if the dolls are personal use assets, the loss is non-deductible. The gain is all long-term capital gain because all the dolls sold were held for more than one year. If the dolls are collectibles, the alternative tax rate on the long-term capital gain is 28%. If they are not collectibles, the alternative tax rate on the long-term capital gain is 5%/15%. Most of the dolls are probably not collectibles. Although Bridgette (and the buyer) certainly feel that the dolls are beautiful, they are not a “work of art” or “historical objects”—although some of them may be. p. 14-24

47. Ruth has a $3,850 long-term capital loss carryover. When a taxpayer has negative taxable income and a capital loss deduction has been taken, a special computation of the capital loss carryover is required. Specifically, the capital loss carryover is the net capital loss minus the lesser of: (1) the capital loss deduction claimed on the return or (2) the negative taxable income increased by the capital loss deduction claimed on the return and the personal and dependency exemption deduction. For (2), the negative taxable income number is treated as a negative number, but the capital loss deduction and the exemption deduction are treated as positive numbers. If after the capital loss deduction and the exemption deduction are added back there is still negative taxable income, then none of the capital loss deduction benefited the taxpayer and all of the net capital loss carries over. However, if taxable income before the personal and dependency exemption deduction is positive or zero, the full capital loss deduction benefited the taxpayer and the capital loss carryover is not affected. Ruth has $1,850 negative taxable income before personal and dependency exemptions [$8,300 (gross income) – $3,000 (capital loss deduction) – $7,150 (head of household standard deduction) = ($1,850)]. After the $9,300 ($3,100 X 3) deduction for personal and dependency exemptions, Ruth has negative taxable income of $11,150.

Ruth’s net long-term capital loss $5,000

Less: The lesser of

(1) Capital loss deduction $ 3,000

(2) Negative taxable income ($11,150)

Add: capital loss deduction 3,000

Add: exemption deduction (3 X $3,100) 9,300

Total $ 1,150

Lesser amount of (1) or (2) (1,150)

Ruth’s long-term capital loss carryover $3,850

p. 14-27

48. Roy has $65,020 of taxable income ($65,000 wages + $2,000 interest income + $1,300 qualified dividend income + $4,670 net long-term capital gain – $4,850 single standard deduction – $3,100 personal exemption). The qualified dividend income is added to the net long-term capital gain for purposes of the 5%/15% alternative tax calculation. The 15% alternative rate applies because Roy’s other taxable income puts him above the regular 15% bracket. The tax on the taxable income is $12,396 computed as shown below.

Tax on $59,050 ordinary taxable income $11,500

($65,020 TI – $1,300 QDI – $4,670 LTCG)

15% tax on QDI ($1,300) + LTCG ($4,670) 896

Total tax using the alternative tax calculation $12,396

Regular tax on $65,020 TI (12,993)

Tax savings from alternative tax computation $ 597

pp. 14-24 and 14-25

49. Janine and Bill’s taxable income without the long-term capital gain is $69,000 ($87,000 – $5,000 – $13,000). The short-term capital gain of $2,100 is taxed at regular tax rates. The married filing jointly tax on $69,000 is $10,725 {[($69,000 – $58,100) X .25] + $8,000}. The couple is no longer in the 15% bracket; so their $18,000 long-term capital gain is taxed at 15% rather than 5%. The tax on the long-term capital gains of $18,000 ($5,000 + $13,000) is $2,700 ($18,000 X .15). The total tax on taxable income is $13,425 ($10,725 + $2,700). pp. 14-20 to 14-22

50. Mauve, Inc. cannot reduce its operating taxable income by the $45,000 long-term capital loss. Mauve’s taxable income is $455,000 and it has a $45,000 short-term capital loss carryover because all corporate net capital losses carry over as short term. p. 14-29

51. The process that Hsui is selling is an intangible asset with a zero tax basis to Hsui. It is in the nature of goodwill and is probably a capital asset. If the process is copyrighted, it is not a capital asset. A copyright is specifically defined as not being a capital asset by § 1221. If the process is patented, the payment might automatically be long-term capital gain under § 1235. But the process is not patented. The specific exclusions from capital asset status of § 1221 do not seem to include this situation. Therefore, the conclusion is that the process is a capital asset. The covenant not to compete payments are ordinary income to Hsui as they are received and will be taxed at ordinary income rates. Consequently, Hsui should take the $850,000 for the process, treat it as long-term capital gain, and pay tax on it of 15%. The $45,000 per year should be taken as a covenant not to compete payment and be treated as ordinary income when it is received. For the acquirer, both payments are § 197 intangible assets that have to be capitalized and amortized over 15 years. pp. 14-4, 14-5, 14-11 to 14-13, 14-51, and 14-52

52. Cattle and horses must be held 24 months or more to qualify as § 1231 assets. Since the cow was held only 15 months, it is an ordinary asset and the $7,000 gain ($25,000 sales price – $18,000 adjusted basis) is an ordinary gain. The workhorse was held 66 months, so it is a § 1231 asset. The $650 gain ($1,000 sales price – $350 adjusted basis) is a § 1231 gain. Since there is only a § 1231 gain for the year, the net § 1231 gain is $650 and that gain is treated as an ordinary gain because the $2,000 of prior nonrecaptured losses causes application of the § 1231 lookback rule. None of the $650 net § 1231 gain is treated as a long-term capital gain; so the $200 long-term capital loss is deductible for AGI.

Section 1231 gain from sale of horse (treated as an ordinary gain) $ 650

Long-term capital loss from corporate stock sale (200)

Ordinary gain from sale of milk cow 7,000

Other adjusted gross income 55,000

Adjusted gross income $62,450

Concept Summary 14-6

53. Kwan has had two nonpersonal use property casualties. The $20,000 gain is netted against the $7,000 loss and results in a $13,000 net gain. The $13,000 net gain is treated as a § 1231 gain. Since there are no other property transaction gains or losses, and because Kwan has no lookback losses, he has a $13,000 net § 1231 gain for the year. That gain is treated as a long-term capital gain since both assets had been held more than 12 months when the flood occurred. p. 14-33 and Concept Summary 14-6

Willis, Hoffman, Maloney, and Raabe, CPAs

5191 Natorp Boulevard

Mason, OH 45040

November 23, 2004

Mr. Kwan Lee

2367 Meridian Road

Hannibal Point, MO 34901

Dear Mr. Lee:

Thank you for the opportunity to discuss the tax effect of the two casualties you suffered this year. Both the painting and the vase were assets you were holding for investment. The painting casualty resulted in a $20,000 gain because it was insured. The vase casualty resulted in a $7,000 loss because it was not insured.

The $20,000 gain is netted against the $7,000 loss and results in a $13,000 net gain. The $13,000 net gain is treated as a "§ 1231 gain" – a special type of gain for tax purposes. Since there are no other property transaction gains or losses this year, and because you had no § 1231 losses in prior years, the $13,000 net § 1231 gain for the year is treated as a long-term capital gain. That gain is eligible for a tax rate of no more than 15%.

If you have any questions concerning these transactions or other tax matters, please feel free to telephone me. Thank you.

Sincerely,

Sheila Dailey, CPA

Partner

p. 14-33

54. Net § 1231 gains must jump a final hurdle before being netted with capital transactions. The net § 1231 gain must exceed the sum of nonrecaptured net § 1231 losses recognized in the five most recent preceding years. The years 1999 through 2001 have a combined nonrecaptured net § 1231 loss of $101,000. The $101,000 nonrecaptured § 1231 loss is partially absorbed by the 2002 $41,000 § 1231 gain and the 2003 $30,000 § 1231 gain. Thus, $30,000 of the nonrecaptured § 1231 loss remains for offset against the 2004 $39,000 § 1231 gain.

Net Sec.  Before Lookback:

1231 Loss Current Year Long-Term

Subject to Net Sec. Ordinary Capital

 Recapture   1231 Gain Income     Gain  

1999 - 2001 ($101,000) 

2002 41,000 $ 41,000 $ 41,000 $ -0-

Remaining potential recapture ($ 60,000) 

2003 30,000 30,000 30,000 -0-

Remaining potential recapture ($ 30,000) 

2004 30,000 39,000 30,000 9,000

Totals $ -0- $110,000 $101,000 $9,000

pp. 14-35 and 14-36

55. Yoshida should sell the §  1231 gain asset this year and the § 1231 loss asset next year. This year, Yoshida would have $40,000 net § 1231 gain; there would be no lookback nonrecaptured § 1231 loss; the net § 1231 gain would be treated as a long-term capital gain, and the $25,000 short-term capital loss carryover would be offset against this capital gain. For this year, Yoshida would have a $15,000 net long-term capital gain which would be taxed at a maximum rate of 15%. Next year, Yoshida could sell the § 1231 loss asset; the $30,000 loss would generate a net § 1231 loss, and that loss would be an ordinary loss deductible for AGI. By selling the § 1231 gain asset the year before the § 1231 loss asset, Yoshida avoids having the § 1231 loss “taint” the § 1231 gain, converting that gain into ordinary gain. pp. 14-35, 14-36, and Example 76

56. a. Green has $67,000 ($60,000 + $7,000) of ordinary income due to § 1245 recapture and $28,000 ($35,000 – $7,000) of net § 1231 gain.

| |Asset |Sold For |Less Adjusted Basis |Gain or Loss |Character |

| |Rack | $135,000 |$40,000 ($100,000 – $60,000) | $95,000 |$60,000 ordinary |

| | | | | |income due to § 1245|

| | | | | |recapture; $35,000 |

| | | | | |§ 1231 gain |

| |Forklift | $5,000 |$12,000 ($35,000 – | ($7,000) |§ 1231 loss |

| | | |$23,000) | | |

| |Bin | $60,000 |$53,000 ($87,000 – | $7,000 |All ordinary income |

| | | |$34,000) | |due to § 1245 |

| | | | | |recapture |

b. Green has a $28,000 net § 1231 gain, but only $23,000 is treated as capital gain because the $5,000 of nonrecaptured prior years § 1231 loss causes $5,000 of the current year net § 1231 gain to be treated as ordinary income.

pp. 14-32 and 14-38 to 14-40

57 a. Magenta has $5,000 of ordinary income due to § 1245 recapture and $10,000 of § 1231 loss.

| |Asset |Sold For |Less Adjusted Basis |Gain or Loss |Character |

| |Rack | $55,000 |$50,000 ($110,000 – $60,000) | $5,000 |All ordinary income |

| | | | | |due to § 1245 |

| | | | | |recapture |

| |Forklift | $15,000 |$22,000 ($45,000 – | ($7,000) |§ 1231 loss |

| | | |$23,000) | | |

| |Bin | $60,000 |$63,000 ($97,000 – | ($3,000) |§ 1231 loss |

| | | |$34,000) | | |

b. Since Magenta has a $10,000 net § 1231 loss, there is no gain to be treated as capital gain. The $5,000 § 1245 depreciation recapture gain is treated as ordinary income and the $10,000 net § 1231 loss is treated as an ordinary loss deduction for AGI.

pp. 14-38 to 14-40

58. a. Store cost $400,000

2000 cost recovery rate .01391

2001 cost recovery rate .02564

2002 cost recovery rate .02564

2003 cost recovery rate .02564

2004 cost recovery rate (.02564 X 5.5/12) .01175

Total recovery rate X .10258

Total cost recovery $ 41,032

Adjusted basis ($400,000 – $41,032) of building $358,968

b. Selling price $470,000

Adjusted basis ($358,968 + $100,000) (458,968)

Recognized gain $ 11,032

Since the store was real estate used in business, it is a § 1231 asset. None of the gain is § 1250 gain because only straight-line cost recovery was used. Therefore, all of the gain is § 1231 gain. However, all of the $11,032 § 1231 gain is unrecaptured § 1250 gain because the gain is less than the depreciation taken of $41,032. pp. 14-42 to 14-46

59. a. Land:

Condemnation proceeds $25,000

Allocable basis (40,000)

Realized and recognized § 1231 loss ($15,000)

Truck:

Depreciation taken: $3,491 ($6,000 – $2,509).

Adjusted basis: $2,509.

Realized gain: $3,500 – $2,509 = $991.

Recognized gain: $991 ordinary income under § 1245.

Rowing machine:

Realized and recognized gain = Amount realized – Adjusted basis of

machine on date of sale = $3,900 – $0 = $3,900.

Section 1245 recapture = Amount of depreciation claimed ($5,200) or gain

recognized ($3,900), whichever is less = $3,900.

Apartment building:

Realized gain = Amount realized – Adjusted basis = $200,000 – $124,783 =

$75,217.

Section 1231 gain recognized = $75,217. No § 1250 recapture is recognized because the taxpayer used the straight-line method of depreciation. Of the $75,217 § 1231 gain, $25,217 is unrecaptured § 1250 gain because the depreciation taken of $25,217 ($150,000 cost – $124,783 basis) is less than the $75,217 recognized gain.

Yacht:

Personal casualty loss (without regard to the 10% of AGI limitation) = Fair market value at date of theft – Insurance proceeds – Floor = $20,000 – $12,500 – $100 = $7,400.

Auto:

Realized loss = Amount realized – Adjusted basis = $9,600 – $20,800 = $11,200. The loss relates to a personal use asset. Therefore, it is not recognized.

Trampoline:

$6,000 business casualty loss is deductible for AGI. The casualty loss is measured by the adjusted basis of the property at the time of the theft. There is no $100 or 10% of AGI floor for a business casualty.

Section Section

Recognized 1245 Casualty and 1231

b. Item Gain/Loss Recapture Theft Loss    Gain  

Land ($15,000) ($15,000)

Truck 991 $ 991

Rowing machine 3,900 3,900

Building 75,217 75,217

Yacht (7,400)  ($7,400)

Auto -0-

Trampoline (6,000)       (6,000)          

$4,891 $60,217

Ordinary $6,000 Net   Gain:   

income   business loss Receives

for AGI; LTCG  

  No Net treatment

personal loss **

from AGI*

Adjusted gross income computation:

Other sources $402,000

Ordinary income from depreciation recapture, as above 4,891

Long-term capital gain, as above 60,217

Business casualty loss, as above (6,000) 

Adjusted gross income $461,108

*None of the personal use activity property casualty loss is deductible from AGI because 10% of the $461,108 AGI is greater than the casualty loss of $7,400.

**Of the $60,217 § 1231 gain, $25,217 is unrecaptured § 1250 gain because according to the 2003 Form 1040, Schedule D instructions, if the net § 1231 gain is greater than the potential unrecaptured § 1250 gain, all of the unrecaptured § 1250 gain is in the § 1231 gain that is carried from Form 4797 to line 11 of the 2003 Form 1040 Schedule D. Thus, the $60,217 § 1231 gain is comprised of $25,217 of unrecaptured § 1250 gain and $35,000 of 5%/15% gain. References are to the 2003 tax forms because the 2004 forms were not yet available.

pp. 14-33 to 14-35 and 14-37 to 14-46

60. a. If the property is residential real property, the § 1250 recapture rules apply and

some of the gain is § 1231 gain.

Selling price $89,000

Adjusted basis (18,000)

Recognized gain $71,000

Less: Gain recaptured by § 1250 ($100,000 – $18,000 = $82,000

accelerated depreciation; $82,000 – $72,700 straight-line

cost recovery = additional depreciation) (9,300)

§ 1231 gain $61,700

Of the $61,700 § 1231 gain, $61,700 is unrecaptured § 1250 gain because the $82,000 of depreciation taken less the $9,300 § 1250 depreciation recapture is greater than the § 1231 gain.

b. If the property is nonresidential real property, all the depreciation is subject to

recapture under § 1245.

Selling price $89,000

Adjusted basis (18,000)

Recognized gain (all § 1245 gain because the gain is less than the $71,000

$82,000 depreciation taken)

c. Willis, Hoffman, Maloney, and Raabe, CPAs

5191 Natorp Boulevard

Mason, OH 45040

March 17, 2004

Ms. Cora Hassant

2345 Westridge Street #23

Homer, MT 67342

Dear Ms. Hassant:

The purpose of this letter is to answer the tax question which we discussed last week. Below you will find the specific question restated and the answer to it.

Question: What difference is there between the recapture rules for residential rental real estate acquired in 1986 as opposed to residential rental real estate acquired in 1987 and thereafter?

Answer: Residential rental real estate acquired in 1986 was eligible for accelerated depreciation. If accelerated depreciation was used, the gain upon disposition of the property may be partially taxable as ordinary income due to a special tax rule called "§ 1250 recapture." Residential rental real estate acquired in 1987 (and later years) is not eligible for accelerated depreciation. Therefore, there is no depreciation recapture applicable to the gain from disposition of such property. All of the gain is potentially taxable as capital gain.

Thank you for your inquiry. If we can be of any further service, please contact us.

Sincerely,

Walter Smith, CPA

Tax Partner

pp. 14-42 to 14-44

61. Terry takes the father’s basis for the equipment and there is a carryover of the father’s $55,000 ($100,000 cost – $45,000 adjusted basis) § 1245 depreciation recapture potential. Terry’s adjusted basis at the date of sale is $33,000 ($45,000 adjusted basis at date of gift – $12,000 depreciation). His recognized gain is $19,000 ($52,000 amount realized – $33,000 adjusted basis). All of the gain is ordinary gain due to § 1245 depreciation recapture because the gain does not exceed the combined $67,000 ($55,000 taken by the father + $12,000 by Terry) depreciation taken. p. 14-46

62. Terry has a basis of $63,000 (fair market value at the date of the father’s death) for the equipment. His adjusted basis is $51,000 ($63,000 original basis – $12,000 depreciation) at the time of the sale. His recognized $1,000 gain ($52,000 amount realized – $51,000 adjusted basis) is all ordinary gain due to § 1245 depreciation recapture since the gain does not exceed the depreciation taken on the equipment. p. 14-46

63. At the time of the charitable contribution, Terry has $62,000 of § 1245 depreciation recapture potential on the equipment. Since a charitable contribution is not a sale or exchange, there is no recognized gain or loss from the contribution. However, the charitable contribution deduction is reduced by any ordinary income due to depreciation recapture if the property was sold. If the property were sold, the ordinary gain would have been $14,000 [$52,000 fair market value at contribution – ($100,000 cost – $62,000 depreciation taken)]. Therefore, the charitable contribution is $38,000 ($52,000 fair market value – $14,000 depreciation recapture potential). pp. 14-46 and 14-47

64. The sale price ($453,000) equals the gain from the sale because the machine had a zero tax basis. Even though the machine was sold on the installment basis, the entire gain is taxable in 2004 because all of the gain is § 1245 gain. Section 1245 depreciation recapture is all taxable in the year of the installment sale. p. 14-48

65. Brown has a taxable disposition of the machine. The gain equals the machine’s $4,500 value because the machine had a zero tax basis. The entire gain is ordinary income due to § 1245 depreciation recapture. Emily has a $4,500 qualifying dividend eligible for the 5%/15% alternative tax rate because the corporation had earnings and profits exceeding the amount of the dividend. p. 14-48

66. Since Eli is a related taxpayer to the corporation and Eli will use the machine purchased from the corporation in a business activity, the machine will be depreciable for Eli. Consequently, § 1239 treats the corporation’s gain as ordinary income. Eli’s basis for the machine is the cost of $45,000. p. 14-48

67. The key to this problem is that all equipment depreciation taken is subject to recapture as ordinary income due to § 1245. However, if the equipment is sold for more than was paid for it, the excess of the selling price over the original cost is § 1231 gain. There appears to be three ways to allocate the purchase price:

(1) Subtract the $100,000 total adjusted basis from the $300,000 selling price to yield a $200,000 gain. Since total depreciation on the three assets exceeds $200,000, all of the gain is § 1245 gain.

(2) Allocate the $300,000 selling price to each asset based on its relative original cost. For instance, the driller would be sold for $37,113 ($120,000/$970,000 X $300,000). The gains and losses using this approach are shown below.

Asset Alloc. S.P. Adj. Basis Gain

Skidder $ 71,134 $ 40,000 $ 31,134

Driller 37,113 60,000 (22,887)

Platform 191,753 -0- 191,753

Totals $300,000 $100,000 $200,000

The $31,134 gain would all be § 1245 gain because the skidder cost $230,000 and was “sold” for $71,134. The $22,887 loss on the driller would be a § 1231 loss. The $191,753 gain on the platform would all be § 1245 gain because it cost $620,000 and was “sold” for $191,753.

(3) Allocate the $300,000 selling price to each asset based on its relative adjusted basis. For instance, the driller would be sold for $180,000 ($60,000/$100,000 X $300,000). The gains using this approach are shown below.

Asset Alloc. S.P. Adj. Basis Gain

Skidder $120,000 $ 40,000 $ 80,000

Driller 180,000 60,000 120,000

Platform -0- -0- -0-

Totals $300,000 $100,000 $200,000

The $80,000 skidder gain would all be § 1245 gain because the skidder cost $230,000 and was “sold” for $120,000. The $120,000 gain on the driller would be a $60,000 § 1245 gain (equals depreciation taken) and $60,000 § 1231 gain (equals excess of sale price over original cost of $120,000). The sale of the platform would generate no gain or loss because it was “sold” for nothing and the adjusted basis was $0. p. 14-41

CUMULATIVE PROBLEMS

68. Gross income:

Schedule C income $30,000

Interest income (Note 1) 600

Dividend income (Note 2) 440

Alimony received 5,000

Net long-term capital gain (Note 3) 2,880

$38,920

Deductions for adjusted gross income:

50% of self-employment tax (Note 4) $2,120

100% of health insurance premiums (Note 5) 3,000

(5,120)

Adjusted gross income $33,800

Less: Itemized deductions

Medical expenses (Note 6) $ -0-

State income tax 1,830

Real estate tax 3,230

Home mortgage interest 8,137

Charitable contributions 940 (14,137)

Less: Personal exemption and dependency deductions (2 X $3,050) (6,100)

Taxable income $13,563

Tax on taxable income (Note 7) $ 1,200

Self-employment tax (Note 4) 4,239

Child care credit (Note 8) (675)

Child tax credit (Note 9) (525)

Estimated tax payments (5,000)

Refundable child credit (475)

Net tax payable (or refund due) ($ 1,236)

See the tax return solution beginning on p. 14-27 of the Solutions Manual.

Notes

(1) The $800 of interest income from the State of Ohio bonds is excludible from gross income.

(2) The $440 of dividends is comprised of: Blue $30 (10 shares X $3), Green $30 (30 shares X $1), Purple $30 (15 shares X $2), Yellow $100 (100 shares X $1), White $100 (100 shares X $1), and Amber $150 (75 shares X $2). The entire $440 is qualified dividend income eligible for the 5%/15% alternative tax.

3) There is a $515 short-term capital loss and a $3,395 long-term capital gain. These net to a $2,880 long-term capital gain. All of this gain is 5%/15% gain.

Short-term: Blue [(10 shares X $72) – (10 shares X $80) = $80 loss] + Purple [(15 shares X $33) – (15 shares X $62) = $435 loss] = $515 short-term loss.

Long-term: Green [(30 shares X $47) – (30 shares X $33) = $420 gain] + Yellow [(100 shares X $46) – (100 shares X $18) = $2,800 gain] + Gold [(35 shares X $12) – (35 shares X $7) = $175 gain] = $3,395 long-term gain.

(4) The self-employment tax is $30,000 Schedule C net income X .9235 X .153 = $4,239. Half of the $4,239 or $2,120 is deductible as a for AGI deduction.

(5) The for AGI deduction for Sue’s health insurance deduction is $3,000 ($3,000 premiums X 100%).

(6) The total medical expenses are the $1,786 unreimbursed medical expenses for Sue and Kania. This amount must be reduced by 7.5% of AGI.

Medical expenses $1,786

7.5% of AGI (7.5% X $33,800) (2,535)

Deductible medical expenses $ -0-

(7) Sue qualifies for head of household filing status. Of the $13,563 of taxable income, $3,320 ($2,880 of net long-term capital gain and the $440 of qualifying dividend income) is taxed at 5% since taxable income does not exceed $38,050, the point at which Sue is no longer in the 15% regular tax rate bracket.

Tax on $10,243 ($13,563 – $3,320) regular taxable income $1,034

Tax on $3,320 @ .05 166

Total tax using the alternative tax computation $1,200

Total tax on $13,563 taxable income (1,536)

Tax savings from alternative tax computation $ 336

8) The annual maximum of qualifying expenses for the child care credit is $3,000 with one eligible child. Since Sue has $33,800 of AGI, her credit percentage is 25%; so she receives a credit of $675 ($2,700 X .25).

(9) Sue’s 10-year old dependent son entitles her to a $1,000 child tax credit. Sue qualifies to use $525 of the $1,000 child credit against her tax on taxable income, reducing the tax to zero. The balance of the $1,000 child credit creates a refundable child credit of $475. See the computations below.

Tax on taxable income (Note 7) $1,200

Dependent care credit (675)

Remaining income tax liability $ 525

Child credit $1,000

Portion needed to reduce income tax to zero (525)

Remaining child credit $ 475

Lower of $475 or $1,738 [($30,000 earned income –

$2,120 – $10,500) X .1] = refundable child credit $ 475

69. Justin qualifies as a head of household. He has $272,982 of adjusted gross income, $256,206 of taxable income, $55,617 of Federal income tax on that taxable income, and would have a net tax refund of $4,383. The computations appear below and are followed by the completed 2003 Form 1040 and its Schedules A, B, D, and E, and Forms 4562 and 4797.

|Wages | |$ 87,000 |

|Interest income—Blue | |5,000 |

|Interest income—State Bank | |3,000 |

|Rent income—Building 1 (Note 1) | |8,455 |

|Rent income—Building 2 (Note 2) | |13,755 |

|Rent income—Building 3 (Note 3) | |22,474 |

|Equipment sale ordinary income (Note 4) | |14,000 |

|Net long-term capital gain (Notes 5 and 6) | | 122,298 |

|Total income | |$275,982 |

|IRA deduction | | (3,000) |

|Adjusted gross income | |$272,982 |

|Itemized deductions: State income taxes |$ 4,300 | |

| Real estate taxes |5,600 | |

| Home mortgage interest |8,900 | |

| Charitable contributions |760 | |

|Phase out |(4,004) | |

|Total itemized deductions (Note 7) | |(15,556) |

|Taxable income before exemption deduction | |$257,426 |

|Exemption deduction (Note 8) | | (1,220) |

|Taxable income | |$256,206 |

|Tax on taxable income (Note 9) | |$ 55,617 |

|Child tax credit (phased out) | | (-0-) |

|Net tax due after credits | |$ 55,617 |

|Federal income tax withholding |$15,000 | |

|Federal estimated tax payments | 45,000 | |

|Total Federal income tax payments | | (60,000) |

|Net refund due | | ($ 4,383) |

| | | |

|See the tax return solution on p. 14-37 of the Solutions Manual. | | |

|Note 1: Rent revenue—building 1 | |$30,000 |

| Repairs |($ 4,000) | |

| Interest |(12,000) | |

| Miscellaneous |(1,000) | |

| Depreciation ($125,000 X .03636) | (4,545) | |

| Total expenses | |(21,545) |

| Net income | |$ 8,455 |

|Note 2: Rent revenue—building 2 | |$47,000 |

| Repairs |($ 5,000) | |

| Interest |(17,000) | |

| Miscellaneous |(2,300) | |

| Depreciation ($246,000 X .03636) | (8,945) | |

| Total expenses | |(33,245) |

| Net income | |$13,755 |

| | | |

|Note 3: Rent revenue—building 3 | |$88,000 |

| Repairs |($ 8,000) | |

| Interest |(37,000) | |

| Miscellaneous |(7,800) | |

|Depreciation ($400,000 X .03636 X 10.5/12) | | |

|(Sold after 10.5 months of 2003) |(12,726) | |

| Total expenses | |(65,526) |

| Net income | |$22,474 |

| |

|Note 4: $14,000 equipment sale price – $0 adjusted basis = $14,000 § 1245 ordinary gain because $25,000 of depreciation was taken on the |

|property. |

| |

|Note 5: $450,000 building 3 sale price – ($400,000 cost – $57,572 pre-2003 depreciation – $12,726 2003 depreciation) = $120,298 § 1231 gain. |

|$70,298 of the gain is potential 25% gain (equals depreciation taken) and the $50,000 balance of the gain is potential 5%/15% gain. |

| |

|Note 6: $2,000 capital gain distribution + $120,298 § 1231 gain treated as a long-term capital gain = $122,298 net long-term capital gain. |

|$52,000 is potential 5%/15% gain and $70,298 is potential 25% gain. |

|Note 7: The itemized deduction reduction applies since AGI exceeds $139,500. Itemized deductions total $19,560, but only $15,556 {$19,560 – |

|[($272,982 – $139,500) X .03]} is deductible. |

|Note 8: Since AGI exceeds $174,400, the personal and dependency exemption deduction is subject to a phaseout. The $6,100 (2 X $3,050) |

|deduction is reduced to $1,220. $272,982 AGI – $174,400 head of household phaseout threshold = $98,582; $98,582/$2,500 = 39.4328; rounded up|

|to 40; 40 X 2% = 80% phaseout; $6,100 – ($6,100 X .80) = $1,220. |

| |

|Note 9: The alternative tax on taxable income yields a lower tax because of the net long-term capital gains. The tax is $55,617. This is |

|the sum of the tax on ordinary taxable income of $133,908 [($256,206 TI – $122,298 net LTCG) = $30,242]; the tax on the 25% gain portion of |

|the $122,298 net LTCG [($70,298 X .25) = $17,575]; and the tax on the 15% gain portion of the net LTCG [($52,000 X .15) = $ 7,800]. |

|Note to Instructor: The alternative minimum tax is ignored in this solution. |

The answers to the Research Problems are incorporated into the 2005 Comprehensive Volume of the Instructor’s Guide with Lecture Notes to Accompany WEST FEDERAL TAXATION: COMPREHENSIVE VOLUME.

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