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Chapter 16

PROPERTY TRANSACTIONS:CAPITAL GAINS AND LOSSES

LEARNING OBJECTIVES

Upon completion of this chapter you will be able to:

" Define a capital asset and use this definition

to distinguish capital assets from other types

of property

" Explain the holding period rules for

classifying a capital asset transaction as either

short-term or long-term

" Apply the capital gain and loss netting

process to a taxpayer’s capital asset

transactions

" Understand the differences in tax treatment of

an individual’s capital gains and losses

" Explain the differences in tax treatment of the

capital gains and losses of a corporate

taxpayer versus those of an individual

taxpayer

" Identify various transactions to which capital

gain or loss treatment has been extended

" Discuss the tax treatment of investments in

corporate bonds and other forms of

indebtedness

16–1


The final piece of the property transaction puzzle concerns the treatment of the

taxpayer’s gains and losses. In the infancy of the tax law, solving this puzzle was

relatively easy. Taxpayers who sold or otherwise disposed of property needed only to

determine their gain or loss realized and how much, if any, they had to recognize. The

actual treatment of the gain or loss recognized—or more precisely, the rate at which it

was taxed—was identical to that for other types of income. The simplicity of treating all

income and loss the same was short-lived, however, lasting a mere eight years, from

1913 to 1921. Since 1921, the taxation of property transactions has been complicated by

the additional need to determine not only the amount of the taxpayer’s gain but also its

character. Virtually all of this complication can be traced to one source: Congress’s desire

to provide some type of preferential treatment for capital gains.

Whether capital gains should be taxed more leniently than wages and other types of

income is the subject of what seems to be a never-ending debate. When the first income

tax statute was enacted, there was nothing in the definition of income to indicate that

gains on dealings in property were taxable. Seizing on the omission, taxpayers relied on

somewhat abstract tax theory and ingeniously argued that a gain on a sale of property

(e.g., a citrus grove) was not the same as income derived from such property (e.g., sale

of the fruit) and should not be taxed at all. Moreover, taxpayers who sold property and

reinvested in similar property argued that they had not altered their economic position

and that taxation was therefore not appropriate. While detractors cried ‘‘nonsense!’’

champions of favorable treatment offered additional justification, explaining that capital

gain is often artificial, merely reflecting increases in the general price level. Perhaps the

most defensible argument can be found in the Ways and Means Committee Report that

16–2 PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES

CHAPTER OUTLINE

General Requirements for Capital Gain 16-4

Capital Assets 16-4

Definition of a Capital Asset 16-4

Inventory 16-5

Disposition of a Business 16-6

Sale or Exchange Requirement 16-7

Worthless and Abandoned Property 16-7

Certain Casualties and Thefts 16-9

Other Transactions 16-9

Holding Period 16-10

Stock Exchange Transactions 16-10

Special Rules and Exceptions 16-11

Treatment of Capital Gains and Losses 16-13

The Process in General 16-13

Netting Process 16-14

Dividends Taxed at Capital Gain

Rates 16-18

Corporate Taxpayers 16-19

Calculating the Tax 16-20

Reporting Capital Gains and

Losses 16-24

Capital Gain Treatment Extended

to Certain Transactions 16-25

Patents 16-25

Lease Cancellation Payments 16-26

Incentives for Investments in Small

Businesses 16-26

Lo on S

§ 1244

Qualified Small Business Stock

(§ 1202 Stock) 16-27

Rollover of Gain on Certain Publicly

Traded Securities 16-30

Dealers and Developers 16-30

Dealers in Securities 16-30

Subdivided Real Estate 16-31

Other Related Provisions 16-32

Nonbusiness Bad Debts 16-32

Franchise Agreements, Trademarks,

and Trade Names 16-32

Short Sales 16-33

Options 16-34

Corporate Bonds and Other Indebtedness 16-36

Original Issue Discount 16-37

Market Discount 16-39

Conversion Transactions 16-40

Bond Premium 16-40

Tax Planning Considerations 16-41

Timing of Capital Asset Transactions 16-41

Section 1244 Stock 16-42

Problem Materials 16-42

Steve

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accompanied the Revenue Act of 1921. As the following quotation shows, Congress

believed that the progressive nature of the tax rates was unduly harsh on capital gains,

particularly when the rate (at that time) could be as high as 77 percent.

The sale of . . . capital assets is now seriously retarded by the fact that gains and profits

earned over a series of years are under present law taxed as a lump sum (and the amount

of surtax greatly enhanced thereby) in the year in which the profit is realized. Many of

such sales . . . have been blocked by this feature of the present law. In order to permit

such transactions to go forward without fear of a prohibitive tax, the proposed bill . . .adds a new section [providing a lower rate for gains from the sale or dispositions of

capital assets].1

Although the top rate is currently much lower than it has been historically, the

bunching effect is still cited as one of the major justifications for lower rates for capital

gains. Proponents also reason that taxing capital gains at low rates encourages taxpayers

to make riskier investments and also helps stimulate the economy by encouraging the

mobility of capital. Without such rules, taxpayers, they believe, would tend to retain

rather than sell their assets.

Of course, opponents of special treatment are equally vocal in their objections to

the benefits extended capital gains. They reject the proposition that capital gain should

not be taxed. They maintain that income is income regardless of its form. Opponents

also doubt the stimulus value of preferential treatment and complain about the uneven

playing field that such treatment creates. Finally, opponents offer one argument for

which there is no denial. As will become all too clear in this and the following chapter,

the special treatment reserved for capital gains and losses creates an inordinate amount

of complexity in the tax law.

Despite the various objections, Congress has generally sided with those in favor of

preferential treatment. But, as history shows, there is little agreement on exactly what

that treatment should be. From 1922 to 1933, taxpayers were given the option of paying

a flat 12.5 percent tax on their capital gains and the normal rate on ordinary income.

From 1934 to 1937, the treatment was altered to allow an exclusion for capital gains

ranging from 20 to 80 percent, depending on how long the asset was held. After some

tinkering with the exclusion in 1938, Congress moved again in 1942. This time it

replaced the exclusion with a deduction equal to 50 percent of the gain. The 50 percent

deduction—increased in 1978 to 60 percent—made capital gains the most popular game

in town for almost 45 years. In 1986, however, Congress had a complete change of

heart. After lowering the top rate on ordinary income to 28 percent, it apparently

believed that special treatment for capital gains was no longer needed. Accordingly,

favorable capital gain treatment was repealed. This period of low rates, however,

proved to be only temporary, as Congress raised the top rate to 31 percent in 1991 and

39.6 percent in 1993. The increase prompted Congress to resurrect favorable treatment

for capital gains, in this case providing that the gains of an individual would be taxed at

a maximum rate not to exceed 28 percent. In 2003, Congress decided, once again, to

improve the tax advantage extended to capital gains. Under the new rules, capital gains

qualifying for special treatment can be taxed at one of four different rates (28 percent,

25 percent, 15 percent, or 5 percent).

The current rates applying to capital gains, like their predecessors, can produce sub-

stantial savings. The table below illustrates the benefit of the 15 percent capital gains rate

(5 percent for taxpayers in the 10 percent or 15 percent brackets).

1 House Rep. No. 350, 67th Cong. 1st Sess., pp. 10–11, as quoted in Seidman, Legislative History of the

Income Tax Laws, 1938–1961, 813 (1938).

16–3GENERAL REQUIREMENTS FOR CAPITAL GAIN


OrdinaryRate

Capital GainsRate

DifferentialRate

PercentageSavings

35.0% 15.% 20.0% 57.14%

33.0 15 18.0 54.55

28.0 15 13.0 46.43

25.0 15 10.0 40.00

15.0 5 10.0 66.67

10.0 5 5.0 50.00

As should be apparent capital gain treatment is clearly desirable. But as the remainder of

this chapter explains, this favorable treatment is not extended to just any gain. The taxpayer

must jump through a few hoops, turn a couple of cartwheels, and clear innumerable hurdles

before he or she reaches the pot of gold at the end of the capital gains rainbow.

GENERAL REQUIREMENTS FOR CAPITAL GAIN

A gain or loss is considered a capital gain or loss and receives special treatment only

if each of several elements is present. The asset being transferred must be a capital assetand the disposition must constitute a sale or exchange. In addition, the exact treatment of

any net gain or loss can be determined only after taking into consideration the holdingperiod of the property transferred. Each of these elements is discussed below.

CAPITAL ASSETS

DEFINITION OF A CAPITAL ASSET

In order for a taxpayer to have a capital gain or loss, the Code generally requires a sale

or exchange of a capital asset. Obviously, the definition of a capital asset is crucial. Sales

involving property that qualifies as a capital asset are eligible for a reduced tax rate while

sales of assets that have not been so blessed may not be as lucky.

The Internal Revenue Code takes a roundabout approach in defining a capital asset.

Instead of defining what a capital asset is, the Code identifies what is not a capital asset.

Under § 1221, all assets are considered capital assets unless they fall into one of five

excluded classes. The following are not capital assets:

1. Inventory or property held primarily for sale to customers in the ordinary course

of a trade or business

2. Accounts and notes receivable acquired in the ordinary course of a trade or

business for services rendered or from the sale of inventory

3. Depreciable property and land used in a trade or business

4. Copyrights, literary, musical, or artistic compositions, letters or memoranda, or

similar property held by the creator, or letters or memoranda held by the person

for whom the property was created; in addition, such property held by a taxpayer

whose basis is determined by reference to the creator’s basis (e.g., acquired by

gift), or held by the person for whom it was created

5. Publications of the United States Government that are received from the

Government by any means other than purchase at the price at which they are

offered to the public, and which are held by the taxpayer who received the publi-

cation or by a transferee whose basis is found with reference to the original

recipient’s basis (e.g., acquired by gift)



Before looking at some of these categories, one should appreciate the statutory scheme

and the rationale behind it.

As noted above, the Code starts with the very broad premise that all property held

by the taxpayer is a capital asset. Thus the sale of a home, car, jewelry, clothing, stocks,

bonds, inventory, and plant, property, and equipment used in a trade or business would

produce, at least initially, capital gain or loss since all assets are by default capital

assets. However, § 1221 goes on to alter this general rule with several significant

exceptions. It specifically excludes from capital asset status inventory, property held for

resale, receivables related to the sales of services and inventory, and certain literary

properties. As may be apparent, the purpose of these exclusions, as the Supreme Court

has said, ‘‘is to differentiate between the �profits and losses arising from the everyday

operation of business� on the one hand . . . and �the realization of appreciation in value

accrued over a substantial period of time� on the other.’’2 In essence, the statute is drawn

to deny capital gain treatment for income from regular business operations. Income that

is derived from the taxpayer’s routine personal efforts and services is treated as ordinary

income and in effect receives the same treatment as wages, interest, and all other types

of income. In contrast, capital gain, at least in the general sense, is limited to gains from

the sale of investment property.

Based on the above analysis, it might seem strange that § 1221 also excludes from

capital asset status a class of assets that most people would consider capital assets: the

fixed assets of a business (depreciable property and land used in a business). Although it

is true that these assets are not ‘‘pure’’ capital assets, as will be seen in Chapter 17, these

assets can, if certain tests are met, sneak in the back door and receive capital gain treatment.

Also observe that this rule does not exclude intangibles from capital asset treatment even

though they may be amortizable. For example, goodwill is a capital asset even though it

may be amortized.

One final note: it should be emphasized that the classification of an asset as a capi-

tal asset may affect more than the character of the gain or loss on its sale. For example,

the amount of a charitable contribution deduction also may be affected in certain instan-

ces. Recall that the deduction for charitable contributions of appreciated capital gain

property is generally based on fair market value, but is limited to a percentage of

adjusted gross income.3

INVENTORY

The inventory exception has been the subject of much litigation and controversy.

Whether property is held primarily for sale is a question of fact. The Supreme Court

decided in Malat v. Riddell4 that the word ‘‘primarily’’ should be interpreted as used in

an ordinary, everyday sense, and as such, means ‘‘principally’’ or of ‘‘first importance.’’

As a practical matter, such interpretations provide little guidance. In many cases, it

simply boils down to whether the court views the taxpayer as a ‘‘dealer’’ in the

particular property or merely an investor. Unfortunately, the line of demarcation is far

from clear.

The determination of whether an item is inventory or not frequently arises in the

area of sales of real property. In determining whether a taxpayer holds real estate, or a

particular tract of real estate, primarily for sale, the courts seem to place the greatest

emphasis on the frequency, continuity, and volume of sales.5 Other important factors

2 Malat v. Riddell, 66-1 USTC {9317, 17 AFTR2d 604, 383 U.S. 569 (USSC, 1966).

3 See § 170(e)(1) and Chapter 11 for a discussion of these charitable contribution limitations.

4 Supra, Footnote 2.

5 See, for example, Houston Endowment, Inc. v. U.S., 79-2 USTC {9690, 44 AFTR2d 79-6074, 606 F.2d 77

(CA-5, 1979) and Reese v. Comm., 80-1 USTC {9350, 45 AFTR2d 80-1248, 615 F.2d 226 (CA-5, 1980).

16–5CAPITAL ASSETS


considered by the courts are subdivision and improvement,6 solicitation and advertising,7

purpose and manner of acquisition,8 and reason for and method of sale.9

DISPOSITION OF A BUSINESS

The treatment of the sale of a business depends on the form in which the business is

operated and the nature of the sale. If the business is operated as a sole proprietorship,

the sale of the proprietorship business is not, as one taxpayer argued, a sale of a single

integrated capital asset.10 Rather, it is treated as a separate sale of each of the assets of

the business. Accordingly, the sales price must be allocated among the various assets

and gains and losses determined for each individual asset. Any gain or loss arising from

the sale of inventory items and receivables would be treated separately as ordinary gains

and losses. Gains and losses from the sale of depreciable property and land used in the

business would be subject to special treatment discussed in Chapter 17 and may qualify

for capital gain treatment. Finally, gains and losses from capital assets would of course

be treated as capital gains and losses.

If the business is operated in the form of a corporation or partnership, the sale could

take one of two forms: (1) a sale of the owner’s interest (e.g., the owner’s stock or

interest in the partnership) or (2) a sale of all the assets by the entity followed by a

distribution of the sales proceeds to the owner. An owner’s interest—stock or an interest

in a partnership—is a capital asset. Consequently, a sale of such interest normally

produces capital gain or capital loss (although there are some important exceptions for

sales of a partnership interest). On the other hand, a sale of assets by the entity would be

treated in the same manner as the sale of a sole proprietorship, a sale of each individual

asset.

3 CHECK YOUR KNOWLEDGE

Review Question 1. Lois Price operates an office supply store, Office Discount, and

owns the property listed below. Indicate whether each of the following assets is a capital

asset. Respond yes or no.

a. Refrigerator in her home used solely for personal useb. The building that houses her businessc. A picture given to her by a well-known artistd. 100 shares of Chrysler Corporation stock held as an investmente. Furniture in her officef. A book of poems she has writteng. The portion of her home used as a qualifying home officeh. 1,000 boxes of 3½-inch floppy disksi. Goodwill of the business

The following are capital assets: (a), (d), and (i). All assets are capital assets except

inventory (item h), real or depreciable property used in a trade or business (items b, e, g),

literary or artistic compositions held by the creator (item f ), or property received by

6 See, for example, Houston Endowment, Inc., and Biedenharn Realty Co., Inc. v. U.S., 76-1 USTC {9194,37 AFTR2d 76-679, 526 F.2d 409 (CA-5, 1976).

7 See, for example, Houston Endowment, Inc.

8 See, for example, Scheuber v. Comm., 67-1 USTC {9219, 19 AFTR2d 639, 371 F.2d 996 (CA-7, 1967), and

Biedenharn Realty Co., Inc. v. U.S.

9 See, for example, Voss v. U.S., 64-1 USTC 9290, 13 AFTR2d 834, 329 F.2d 164 (CA-7, 1964).

10 Williams v. McCowan, 46-1 USTC {9120, 34 AFTR 615, 152 F.2d 570 (CA-2, 1945); Rev. Rul. 55-79,

1955-1 C.B. 370.



gift from the creator (item c). Note that the Code does not exclude intangible assets from

capital assets status. Such assets as goodwill are treated as capital assets.

Review Question 2. Slam-Dunk Corporation manufactures collapsible basketball

rims in Houston, Texas. Because of its tremendous growth, Mr. Slam and Ms. Dunk, the

owners of the company, brought in a highly skilled executive to manage it, the famous

Sam Jam. As part of the employment agreement, the company agreed to buy Sam’s house

if it should terminate his contract. As you might expect, Slam and Dunk did not get along

with Sam and his creative management techniques. Consequently, the corporation

dismissed Sam after two years and purchased his house at Sam’s original cost of

$300,000. Needing the cash, the corporation decided to unload the house immediately.

Unfortunately, in the depressed housing market of Houston, the corporation sold the

house for only $200,000. Explain the tax problems associated with the sale by the

corporation. What important issue must be resolved and why?

In this situation, the corporation has realized a loss of $100,000. The critical issue is deter-

mining whether the loss is an ordinary or capital loss. The treatment, as explained below,

is quite different. If the loss is ordinary, the corporation may deduct the entire loss in com-

puting taxable income. In contrast, if the loss is a capital loss, the corporation can deduct

the loss only to the extent of any capital gains that it has during the year or a three-year

carryback and five-year carryforward period. The determination turns on the definition of

a capital asset.

SALE OR EXCHANGE REQUIREMENT

Before capital gain or loss treatment applies, the property must be disposed of in a

‘‘sale or exchange.’’ In most cases, determining whether a sale or exchange has occurred

is not difficult. The requirement is met by most routine transactions and as a practical

matter is often overlooked. Nevertheless, there are a number of situations when a sale or

exchange does not actually occur but the Code steps in and creates one, thus converting

what might have been ordinary income or loss to capital gain or capital loss. Several of

these are considered below.

WORTHLESS AND ABANDONED PROPERTY

When misfortune strikes, leaving the taxpayer with worthless property, the taxpayer

normally has a loss equal to the adjusted basis of the property. Note, however, that the loss

in these situations does not technically arise from a sale or exchange, leaving the taxpayer

to wonder how the loss is to be treated.

Worthless Securities. The Code has addressed this problem with respect to

worthless securities (e.g., stocks and bonds). In the event that a qualifying security

becomes worthless at any time during the taxable year, the resulting loss is treated as

having arisen from the sale or exchange of a capital asset on the last day of the taxable

year.11 Losses from worthlessness are then treated as either short-term or long-term

capital losses depending on the taxpayer’s holding period.

Example 1. After receiving a hot tip, N bought 200 shares of Shag Carpets Inc. for

$2,000 on November 1, 2005. Just three months later, on February 1, 2006,

N received a shocking notice that the company had declared bankruptcy and her

investment was worthless. Because of the worthlessness, N is treated as having sold

11 § 165(g).

16–7SALE OR EXCHANGE REQUIREMENT


the stock for nothing on the last day of her taxable year, December 31, 2006.

Because the sale is deemed to occur on December 31, 2006 (and not February 1),

N is treated as if she actually held the stock for more than a year. As a result, she

reports a $2,000 long-term capital loss.

The sale or exchange fiction applies only to qualifying securities. To qualify, the

security must be (1) a capital asset and (2) a security as defined by the Code. Under

§ 165, the term security means stock, stock rights, and bonds, notes, or other forms of

indebtedness issued by a corporation or the government. When these rules do not apply

(e.g., property other than securities), the taxpayer suffers an ordinary loss. Whether a

security actually becomes worthless during a given year is a question of fact, and the

burden of proof is on the taxpayer to show that the security became worthless during

the year in question.12

Worthless Securities in Affiliated Corporations. The basic rule for worthless

securities is modified for a corporate taxpayer’s investment in securities of an affiliated

corporation. If securities of an affiliated corporation become worthless, the loss is

treated as an ordinary loss and the limitations that normally apply if the loss were a

capital loss are avoided.13 A corporation is considered affiliated to a parent corporation if

the parent owns at least 80 percent of the voting power of all classes of stock and at least

80 percent of each class of nonvoting stock of the affiliated corporation. In addition, to

be treated as an affiliated corporation for purposes of the worthless security provisions,

the defunct corporation must have been truly an operating company. This test is met if

the corporation has less than 10 percent of the aggregate of its gross receipts from

passive sources such as rents, royalties, dividends, annuities, and gains from sales or

exchanges of stock and securities. This condition prohibits ordinary loss treatment for

what are really investments.

Example 2. Toy Palace Corporation is the parent corporation for more than 100

subsidiary corporations that operate toy stores all over the country. Each subsidiary

is 100 percent owned by Toy Palace. This year the store in Chicago, TPC Inc.,

declared bankruptcy. As a result, Toy Palace’s investment in TPC stock of

$1 million became totally worthless. Toy Palace is allowed to treat the $1 million

loss as an ordinary loss since TPC was an affiliated corporation (i.e., Toy Palace

owned at least 80 percent of TPC’s stock and TPC was an operating corporation).

Observe that without this special rule, Toy Palace would have a $1 million capital

loss that it could deduct only if it had capital gains currently or within the three-year

carryback or five-year carryforward period.

Abandoned Property. While the law creates a sale or exchange for worthless

securities, it takes a different approach for abandoned business or investment property.

When worthless property (other than stocks and securities) is abandoned, the abandon-

ment is not considered a sale or exchange.14 Consequently, any loss arising from an

abandonment is treated as an ordinary loss rather than a capital loss, a much more

propitious result. Note, however, that the loss is deductible only if the taxpayer can

demonstrate that the business or investment property has been truly abandoned and not

simply taken out of service temporarily.

12 Young v. Comm., 41-2 USTC {9744, 28 AFTR 365, 123 F.2d 597 (CA-2, 1941). Code § 6511(d) extends the

statute of limitations from three years to seven years because of the difficulty of determining the specific tax

year in which stock becomes worthless.

13 § 165(g)(3).

14 Reg. §§ 1.165-2 and 1.167(a)-8.



CERTAIN CASUALTIES AND THEFTS

Still another exception to the sale or exchange requirement involves excess casualty

and theft gains from the involuntary conversion of personal use assets. As discussed in

Chapter 10, § 165(h) provides that if personal casualty or theft gains exceed personal

casualty or theft losses for any taxable year, each such gain and loss must be treated as a

gain or loss from the sale or exchange of a capital asset. Each separate casualty or theft

loss must be reduced by $100 before being netted with the personal casualty or theft gains.

Example 3. T had three separate casualties involving personal-use assets during the year:

Fair Market Value

Casualty PropertyAdjustedBasis

BeforeCasualty

AfterCasualty

1. Accident Personal car $12,000 $ 8,500 $ 6,000

2. Robbery Jewelry 1,000 4,000 0

3. Hurricane Residence 60,000 80,000 58,000

T received insurance reimbursements as follows: (1) $900 for repair of the car;

(2) $3,200 for the theft of her jewelry; and (3) $21,500 for the damages to her home.

Assuming T does not elect (under § 1033) to purchase replacement jewelry, her

personal casualty gain exceeds her personal casualty losses by $300, computed as

follows:

1. The loss for the car is $1,500 [(lesser of $2,500 decline in value or the $12,000

adjusted basis ¼ $2,500) � $900 insurance recovery � $100 floor].

2. The gain for the jewelry is $2,200 ($3,200 insurance recovery � $1,000 adjusted

basis).

3. The loss from the residence is $400 [(lesser of $22,000 decline in value or the

$60,000 adjusted basis ¼ $22,000)� $21,500 insurance recovery � $100 floor].

T must report each separate gain and loss as a gain or loss from the sale or exchange

of a capital asset. The classification of each gain and loss as short-term or long-term

depends on the holding period of each asset.

It is important to note that this exception does not apply if the personal casualty losses

exceed the gains. In such case, the net loss, subject to the 10 percent limitation, is

deductible from A.G.I. Recall, however, that casualty and theft losses are among those

itemized deductions that are not subject to the 3 percent cutback rule imposed on high-

income taxpayers. (See Chapter 11 for a discussion of this cutback rule.)

Example 4. Assume the same facts in Example 3 except the insurance recovery

from the hurricane damage to the residence was only $11,500. In this case, the loss

from the hurricane is $10,400 ($22,000 � $11,500 � $100), and the personal

casualty losses exceed the gain by $9,700 ($1,500 þ $10,400 � $2,200). T must

treat the $9,700 net loss as an itemized deduction subject to the 10% of A.G.I.

limitation, but not subject to the 3% cutback rule.

OTHER TRANSACTIONS

There are still other situations where the sale or exchange requirement is an

important consideration. For example, foreclosure, condemnation, and other involuntary

16–9SALE OR EXCHANGE REQUIREMENT


events are treated as sales even though they may not qualify as such for state law

purposes. Similarly, as discussed in greater detail later in this chapter, the collection of

the face value of a corporate bond (i.e., bond redemption) at maturity is treated as a sale

or exchange.

HOLDING PERIOD

The exact treatment of a capital gain or loss depends primarily on how long the

taxpayer held the asset or what is technically referred to as the taxpayer’s holdingperiod. The holding period is a critical element in determining which of the various tax

rates will apply. As might be expected, the longer the holding period is, the lower the

applicable tax rate will be. A short term gain or loss is one resulting from the sale or

disposition of an asset held one year or less.15 A long-term gain or loss occurs when an

asset is held for more than one year.

In computing the holding period, the day of acquisition is not counted but the day of

sale is. The holding period is based on calendar months and fractions of calendar months,

rather than on the number of days.16 The fact that different months contain different

numbers of days (i.e., 28, 30, or 31) is disregarded.

Example 5. P purchased 10 shares of EX, Inc. on March 16, 2006. Her gain or loss

on the sale is short-term if the stock is sold on or before March 16, 2007 but long-term

if sold on or after March 17, 2007.

Example 6. T purchased 100 shares of FMC Corp. stock on February 28, 2006. His

gain or loss will be long-term if he sells the stock on or after March 1, 2007.

The holding period runs from the time property is acquired until the time of its

disposition. Property is generally considered acquired or disposed of when title passes

from one party to another. State law usually controls the passage of title and must be

consulted when questions arise.

STOCK EXCHANGE TRANSACTIONS

The holding period for securities traded on a stock exchange is determined in the

same manner as for other property. The trade dates, rather than the settlement dates, are

used as the dates of acquisition and sale.

Generally, both cash and accrual basis taxpayers must report (recognize) gains and

losses on stock or security sales in the tax year of the trade, even though cash payment

(settlement) may not be received until the following year. This requirement is imposed

because the installment method of reporting gains is not allowed for sales of stock or

securities that are traded on an established securities market.17

Example 7. C, a cash basis calendar year taxpayer, sold 300 shares of ARA stock at

a gain of $5,000 on December 29, 2006. The settlement date was January 3, 2007.

C must report the gain in 2006 (the year of trade).

15 § 1222.

16 Rev. Rul. 66-7, 1966-1 C.B.188.

17 § 453(k)(2). See Chapter 14 for a detailed discussion of the installment sale method.



SPECIAL RULES AND EXCEPTIONS

Section 1223 contains a number of special provisions that must be used for

determining the holding period of certain properties. The rules address the holding period

of property acquired (1) in a tax-deferred exchange; (2) by gift; (3) by inheritance; (4) in a

wash sale; (5) as a stock dividend; or (6) by exercising stock rights or options.

Property Acquired in Tax-Deferred Transaction. The holding period of property

received in an exchange includes the holding period of the property given up in the

exchange if the basis of the property is determined by reference, in whole or in part, to the

basis in that property given up (e.g., a substituted basis in a like-kind exchange).18 This

rule applies only if the property exchanged is a capital asset or a § 1231 asset (e.g., real or

depreciable property used in a trade or business) at the time of the exchange. For this

purpose, an involuntary conversion–where the taxpayer normally purchases replacement

property for that which was involuntarily converted—is treated as an exchange.19

As suggested above, this rule commonly can be found operating when there is a like-

kind exchange. For example, if a taxpayer purchased land on May 16, 1981 and swapped

it for other land in 2006, the taxpayer’s holding period for the new land would begin in

1981 since the basis of the new land is the same as the old land, $50,000, (i.e., the basis of

the new land was ‘‘determined by reference’’ to the property given up). Normally, if any

gain or loss is deferred, the holding period of the replacement property includes the

holding period of the property that was converted or exchanged.

Example 8. In 2005, the city of Milwaukee condemned 10 acres of M’s farm land

(a § 1231 asset) in order to build an exit for an interstate highway. M had acquired the

land on May 1, 1993 for $20,000. M received $120,000 for the land and therefore

realized a gain of $100,000. On July 7, 2007 M replaced the property by purchasing

new land for $120,000. As a result, he was able to defer all of the realized gain,

producing a basis for the new property of $20,000 ($120,000 cost less $100,000

deferred gain). Since an involuntary conversion is treated as an exchange, M’s

holding period begins on the date that he acquired the original property, May 1, 1993.

Property Acquired by Gift. Another exception provides that if a taxpayer’s basis in

property is the same basis as another taxpayer had in that property, in whole or in part, the

holding period will include that of the other person.20 Therefore, the holding period of

property acquired by gift generally will include the holding period of the donor. This will

not be true, however, if the property is sold at a loss and the basis in the property for

determining the loss is fair market value on the date of the gift.

Example 9. G received a gold necklace from her elderly grandmother as a birthday

gift on August 31, 2006. The necklace was worth $5,200 at that time and had a basis

to the grandmother of $1,300. Grandmother had bought the necklace in 1976.

Contrary to her grandmother’s wishes, G sold the family heirloom for $5,000 on

December 13, 2006. G will recognize a gain of $3,700 ($5,000 � $1,300). Her

holding period will begin in 1976 since her $1,300 basis is determined (under

§ 1015) by reference to her grandmother’s basis, and her holding period includes the

time the necklace was held by her grandmother.

18 § 1223(1).

19 § 1223(1)(A).

20 § 1223(2).

16–11HOLDING PERIOD


Example 10. If G’s grandmother had a basis in the necklace of $6,000, G’s basis for

determining loss would be $5,200, the fair market value at the date of the gift

(see discussion in Chapter 14). Because G’s basis is not determined by reference to

her grandmother’s basis, the grandmother’s holding period is not added to G’s

holding period. Since G only held the necklace for three months, she will have a

$200 short-term capital loss ($5,200 basis � $5,000 sales price).

Property Acquired From a Decedent. A special rule is provided for the holding

period of property acquired from a decedent. The holding period formally begins on the

date of death. However, the Code provides that, if the heir’s basis in the property is its fair

market value under § 1014 and the property is subsequently sold after the decedent’s

death, the property is deemed to have a long-term holding period.21

Example 11. P sold 50 shares of Xero Corp. stock for $11,200 on July 27, 2006.

The stock was inherited from P’s uncle who died on May 16, 2006, and it was

included in the uncle’s Federal estate tax return at a fair market value of $12,000.

Since P’s basis in the stock ($12,000) is determined under § 1014, the $800 loss on

the sale will be a capital loss from property deemed to be held more than

12 months. This would be the case even if P’s uncle had purchased the stock within

days of his death. The decedent’s prior holding period is irrelevant.

Other Holding Period Rules. There are various other provisions that contain special

rules for determining holding periods. The holding period of stock acquired in a transac-

tion in which a loss was disallowed under the ‘‘wash sale’’ provisions (§ 1091) is added

to the holding period of the replacement stock.22 Also, when a shareholder receives stock

dividends or stock rights as a result of owning stock in a corporation, the holding period

of the stock or stock rights includes the holding period of the stock already owned in the

corporation.23 The holding period of any stock acquired by exercising stock rights,

however, begins on the date of exercise.24

The holding period of property acquired by exercise of an option begins on the day

after the option is exercised.25 If a taxpayer sells the property acquired by option within

one year after exercising the option, then he or she will have a short-term gain or loss.

Example 12. N owned an option to purchase ten acres of land. She had owned the

option more than one year when she exercised it and purchased the property. Her

holding period for the property begins on the day after she exercises the option. Had

she sold the option, her gain or loss would have been long-term. If she had sold the

property immediately, her gain or loss would have been short-term.

The holding period of a commodity acquired in satisfaction of a commodity futures

contract includes the holding period of the futures contract. However, the futures contract

must have been a capital asset in the hands of the taxpayer.26

21 § 1223(11).

22 § 1223(4); Reg. § 1.1223-1(d).

23 § 1223(5); Reg. § 1.1223-1(e).

24 § 1223(6); Reg. § 1.1223-1(f).

25 See, for example, Helvering v. San Joaquin Fruit & Inv. Co., 36-1 USTC {9144, 17 AFTR 470, 297 U.S. 496

(USSC, 1936), and E.T. Weir, 49-1 USTC {9190, 37 AFTR 1022, 173 F.2d 222 (CA-3, 1949).

26 § 1223(8); Reg. § 1.1223-1(h).



TREATMENT OF CAPITAL GAINS AND LOSSES

The Taxpayer Relief Act of 1997 and the amendments of the Jobs and Growth Tax

Relief Reconciliation Act of 2003 significantly cut the tax rates on capital gains but not

without introducing an inordinate amount of complexity. The adventure begins below.

THE PROCESS IN GENERAL

The first step in determining the treatment of a taxpayer’s capital gain or loss is

identifying the applicable holding period. Once the holding period is determined, the gain

or loss can normally be assigned to an appropriate group to determine its taxation.

Historically, there have only been two groups: short-term and long-term. However,

beginning in 1997, the law made the classification process a bit more cumbersome,

producing the following groups for individual taxpayers.

" Short-Term group. Gains and losses from properties held not more than one year

" Long-Term group. Generally gains and losses from properties held more than

one year. However, individual taxpayers must subdivide the long-term group into

additional subgroups according to the rate at which they are to be taxed. The long-

term group includes:

1. The 28% group

" Capital gains and losses from collectibles (e.g., works of art, antiques, gold

and silver bullion, etc.)27

" Capital gains from qualified small business stock (taxable portion of

§ 1202 gains discussed below)

2. The 25% group.

" Capital gains (and only gains) from the sales of depreciable real estate

(e.g., office buildings, warehouses, apartment buildings) that are held for

more than 12 months but only to the extent of any unrecaptured straight-

line depreciation on such property (25CG). (See Chapter 17 for discussion

of depreciation recapture.)

3. The 15% group

" Capital gains and losses from the dispositions of other assets held more

than 12 months (15CG and 15CL).

The effect of the new rules is to require taxpayers to assign their capital gains and

losses into one of four different groups and net the amounts to determine the net gain or

loss in each group as shown below.

Short-Term Long-Term

Holding period (months) � 12 Collectibles & § 1202 stock > 12 Realty > 12 > 12A

Ordinary 28% 25% 15%

Gains $xx,xxx) $x,xxx) Gains only $xx,xxx)

Losses (xxx) (x,xxx) — (x,xxx)

Net gain or loss ????) ????) Gain only ????)

27 § 1(h)(1)(C) and (h)(4).

16–13TREATMENT OF CAPITAL GAINS AND LOSSES


As a practical matter, the capital gains of most individuals arise from the sales of stocks

and bonds and mutual fund transactions. Rarely do individuals have gains from

collectibles, § 1202 stock, or depreciable realty. Consequently, for most individuals, the

classification and netting process will indeed be much easier.

NETTING PROCESS

Generalizations about the treatment of capital gains and losses are difficult because

the actual treatment can be determined only after the various groups (i.e., the four groups

above) are combined, or netted, to determine the overall net gain or loss during the year.

This process is described below.28

Netting Within Groups. The first step in the netting process is to combine the gains

and losses within each group to produce one of the following:

1. Net short-term capital gain or net short-term capital loss (NSTCG or NSTCL).

2. Net 28% capital gain or net 28% capital loss (N28CG or N28CL).

3. Net 15% capital gain or net 15% capital loss (N15CG or N15CL).

Note that the first step requires no netting in the 25% group since this group initially con-

tains only gains.

Netting Between Groups. The second step requires the combination of the net

capital loss positions in any particular group against any net capital gain positions. The

treatment of these different groups is explained below.

1. Short-Term Capital Gains and Losses. A NSTCG receives no special treatment

and is taxed as ordinary income. If a NSTCL results, it may be used to offset net

gains of the long-term group in the following order: (1) the net 28% gains;

(2) any 25% gains; and (3) the net 15% gain. Any remaining NSTCL not

absorbed by the capital gains in the groups above is deductible subject to

limitations on the deduction of capital losses discussed below.

2. 28% Group. A N28CG is taxed at a maximum 28%.29 Any net loss in the 28%

group (N28CL) is applied in the following order: (1) 25% gains; (2) net 15%

gain; and (3) NSTCG. Any remaining N28CL that is not absorbed is deductible

subject to limitations on the deduction of capital losses discussed below.

3. 25% Group. The 25% group generally includes only capital gains from the sales

of depreciable real estate held for more than 12 months. Such gains are generally

only included to the extent of any unrecaptured straight-line depreciation on such

property. The net 25% capital gain (N25CG) is taxed at a maximum rate of

25%.30 Note that there can be no net loss in the 25% group.

4. 15% Group. A N15CG is taxed at a maximum of 15%. However, if the taxpayer’s

tax bracket (determined by including the N15CG) is only 10 or 15%, the net gain

falling into these brackets is taxed at 5%.31 Any N15CL is applied in the

following order: (1) the net 28% gains; (2) any 25% gains; and (3) any NSTCGs.

28 § 1(h)(1).

29 § 1(h)(1)(C).

30 § 1(h)(1)(B).

31 § 1(h)(1)(D) and (E).



Any remaining N15CL not absorbed is deductible subject to limitations on the

deduction of capital losses discussed below.

It should be noted that the three long-term groups (the 28%, 25% and 15% groups) are

always netted together before taking into accounting any short-term items. Also observe

that Congress has generally given taxpayers the best possible treatment of net capital

losses in that a NSTCL offsets the net capital gain from the highest taxed group, then the

next highest taxed and so on.

Example 13. During the year, T, who is in the 35 percent tax bracket, reported the

following capital gains and losses.

Long-Term

Short-Term 28% 15%

Gains $10,000 $5,000 $8,000

Losses (4,000) (1,000) (1,000)

Net $ 6,000 $4,000 $7,000

In this case, T first nets the items within each group. She nets the $10,000 STCG and

$4,000 STCL to arrive at a NSTCG of $6,000; she nets a $5,000 28CG and a $1,000

28CL to produce a N28CG of $4,000; and she adds the $8,000 15CG and the $1,000

15CL resulting in a N15CG of $7,000. No further netting of these groups can occur

since they each group contains a positive amount. T’s NSTCG of $6,000 will receive

no special treatment and is taxed as ordinary income. T’s N28CG is taxed at 28%

while her N15CG is taxed at 15%.

Example 14. This year, L, who is in the 28% tax bracket, reported the following

capital gains and losses.

Long-Term

Short-Term 28% 15%

Gains $10,000 $5,000 $8,000

Losses (15,000) (1,000) (1,000)

Net ($5,000) $4,000 $7,000

Netting 5,000 (4,000) (1,000)

Net $ 0 $ 0 $6,000

Here L has a NSTCL of $5,000 which is netted first against N28CG of $4,000,

reducing it to zero. The remaining NSTCL of $1,000 would next be offset against

N25CG, if any. In this case, there is no N25CG, therefore the remaining NSTCL of

$1,000 is offset against the N15CG of $7,000, reducing it to $6,000 which would be

taxed at a rate of 15%.



Example 15. This year, X, who is in the 35% tax bracket, reported the following

capital gains and losses

Long-Term

Short-Term 28% 25% 15%

Gains $14,000 $1,000 $1,000 $6,000

Losses (4,000) (9,000) — (1,000)

Net $10,000 ($8,000) $1,000 $5,000

Netting (2,000) 8,000 (1,000) (5,000)

Net $ 8,000 $ 0 $ 0 $ 0

Here X has a N28CL of $8,000 which is netted first against the 25CGs of $1,000,

reducing this group to zero. X next uses the remaining $7,000 N28CL to offset his

$5,000 N15CG, reducing it to zero. The remaining N28CL of $2,000 ($7,000 �$5,000) is offset against NSTCG, producing a NSTCG of $8,000 which will be

treated as ordinary income. Note that the effect of the rules is to net the long-term

groups before considering any short-term items. Absent these rules, X would prefer to

use the N28CL loss against the NSTCG which would leave $5,000 to be taxed at 15%

and $2,000 to be taxed as ordinary income, a far more beneficial result. X must net

the long-term groups first.

Treatment of Capital Losses. While capital gains receive favorable treatment, such

is not the case with capital losses. As can be seen above, capital losses are first netted

with capital gains within the same group (rather than reducing ordinary income). A net

capital loss from a particular group can then be combined with net capital gains from

the other groups as explained above. If after netting all of the groups together, the

taxpayer has an overall net capital loss, the loss is deductible against ordinary income.

This deduction is limited to the lesser of (1) $3,000 ($1,500 in the case of a married

individual filing a separate return) or (2) the net capital loss. In either case, the capital

loss deduction cannot exceed taxable income before the deduction.32 The deductible

capital loss is a deduction for adjusted gross income. Any losses in excess of the annual

$3,000 limitation are carried forward to the following year where they are treated as if

they actually occurred in such year. In effect, an unused capital loss can be carried over

for an indefinite period.33 However, should the taxpayer die, any unused capital loss is

normally lost.

If the netting process results in a NSTCL and either a N28CL or N15CL or both, the

NSTCL is applied first toward the maximum $3,000 limit. For example, if the taxpayer

has a NSTCL of $5,000 and a N15CL of $4,000, the NSTCL is used first. Any NSTCL

in excess of the $3,000 limit along with any other unused losses may be carried forward

to subsequent years indefinitely. In this case, the NSTCL carryover retains its character

to be treated just as if it had occurred in the subsequent year. The N15CL or N28CL are

both carried over as N28CLs. In other words, any long-term capital loss carryover is

carried over as a 28CL. In the example above, $3,000 of the $5,000 NSTCL would be

used first against ordinary income and the $2,000 remaining would be carried over as a

STCL while the $4,000 N15CL would be carried over as a 28CL. In the absence of a

NSTCL or, if after deducting any existing NSTCL, the taxpayer has not reached the an-

nual $3,000 limit for the capital loss deduction, the taxpayer uses any other net capital

losses (e.g., the excess of N15CL over N28CG and N25CG or the excess of N28CL

32 § 1212(b).

33 Reg. § 1.211-1(b)(4)(i).



over 25 CG and N15CG) to reduce ordinary income up to the $3,000 limit.34 In this

regard, the order in which the remaining net capital losses are used is irrelevant since

any remaining losses (i.e., the long-term losses) are carried over as a N28CL which is

treated as if it occurred in the subsequent year.

Example 16. During the year, B reported the capital gains and losses revealed below.

B’s only other taxable income included his salary of $50,000. He had no other

deductions for A.G.I. The combination of gains, losses, and ordinary income is shown

in the following table.

Long-Term

Short-Term 28% 15%

Gains $10,000 $5,000 $9,000

Losses (18,000) (7,000) (6,000)

Net ($ 8,000) ($2,000) $3,000

Netting (long-term against long-term) 2,000 (2,000)

$ 0 $1,000

Netting (long-term against short-term) 1,000 (1,000)

($ 7,000) $ 0

Deduction 3,000

Carryover ($ 4,000)

B first nets the long-term items, that is, the N28CL of $2,000 is netted against the

N15CG of $3,000. This produces a N15CG of $1,000 ($3,000 � $2,000). B then

combines the $8,000 NSTCL and the remaining N15CG of $1,000, leaving a NSTCL

of $7,000. In determining his A.G.I., B may deduct only $3,000 of the NSTCL.

Therefore his A.G.I. is $47,000 ($50,000 � $3,000). The unused NSTCL of $4,000

($7,000� $3,000) is carried forward to future years as a STCL where it is treated as if

it arose in the subsequent year.

Example 17. This year, Q reported the capital gains and losses as shown below. He

had no other deductions for A.G.I. The combination of gains, losses, and ordinary

income is revealed in the following table.

Long-Term

Short-Term 28% 15%

Gains $1,000 $5,000 $4,000

Losses (2,000) (3,000) (9,000)

Net ($1,000) $2,000 ($5,000)

Netting (long-term against long-term) 0 (2,000) 2,000

Net ($1,000) $ 0 ($3,000)

Deduction 1,000 2,000

Carryover $ 0 ($1,000)

Here Q has a NSTCL of $1,000 and a net $5,000 N15CL. He first combines the long-

term groups, using $2,000 of the $5,000 N15CL to offset the N28CG of $2,000,

reducing it to zero. The remaining $3,000 normally would be netted against 25CG if

34 § 1211(a).



there were any. No further netting is allowed. Therefore, J first uses the NSTCL of

$1,000 and then $2,000 of the $3,000 N15CG remaining toward the $3,000 offset

against ordinary income. The remaining N15CL of $1,000 is carried over and is

treated as a 28CL. It should be emphasized that the N15CL of $1,000 does not retain

its character but becomes a capital loss in the 28% group. Note that the carryover rule

is quite favorable. If next year J had $1,000 of N28CG and $1,000 of N15CG, the

carryover would wipe out the N28CG, leaving the most favorable gain to be taxed.

Example 18. W’s records for 2005 and 2006 revealed substantial ordinary income

and the following capital gains and losses.

Long-Term

Short-Term 28% 15%

2005 gains $ 1,000 $ 5,000 $ 4,000

2005 losses (2,000) (9,000) (9,000)

$ (1,000) $ (4,000) $ (5,000)

2006 $10,000 $12,000 $15,000

In 2005, there can be no further netting. Therefore, W first uses the NSTCL of

$1,000 against ordinary income and then uses $2,000 of the $9,000 in long-term

losses, leaving a long-term capital loss carryover of $7,000. Note that it makes no

difference which long-term loss is used (i.e., the 28% loss or the 15% loss) since all

long-term capital loss carryovers are treated as 28CLs.

In 2006, W treats the $7,000 long-term capital loss carryover as a N28CL. As a

result, W would report a N28CG of $5,000 ($12,000 � the $7,000 loss carryover),

N15CG of $15,000 and a NSTCG of $10,000.

DIVIDENDS TAXED AT CAPITAL GAIN RATES

In negotiations related to the Jobs and Growth Tax Relief Reconciliation Act of 2003,

Congress and the Bush administration considered a number of alternative statutory

schemes to reduce or eliminate the double taxation of corporate dividends. Somewhat as a

surprise, apparently in the interest of simplification, the 2003 Act allows noncorporate

taxpayers to treat qualifying dividends similarly to long-term capital gains when

calculating their tax. The dividends are now taxed at the reduced 15 percent capital gain

rate (5 percent for lower bracket taxpayers) and appears to reduce significantly the toll of

the double tax.

The new law provides that most dividends received after 2002 will be subject to the

revised capital gains rates35: 15 percent generally and 5 percent for dividends that would

otherwise be taxed at an ordinary rate of 15 percent or lower. The qualifying dividend is

added to the net capital gain and is not subject to the capital gain and loss netting process.

As a result, the dividends are subject to capital gains treatment regardless of whether the

taxpayer has other capital gains or losses.36

Qualified dividends are dividends from domestic corporations and qualified

foreign corporations.37 Qualified foreign corporations are those that are incorporated in

35 § 1(h)(11).

36 Like other long-term capital gains, dividends qualifying for capital gain treatment are not investment income

for purposes of the investment interest limitation. However, a taxpayer can elect to treat the dividends as

investment income and forego the capital gain treatment. See § 1(h)(11)(D)(i).

37 § 1(h)(11)(B).



possessions of the United States, those subject to a treaty with the U.S. (involving the

exchange of tax information by the governments) and others, the stocks of which are

traded on a U.S. stock exchange (certain foreign corporations that are not subject to U.S.

tax are not included).

CORPORATE TAXPAYERS

The capital gains and losses of corporate taxpayers are treated a bit differently from

those of individual taxpayers. Corporations separate all of their capital gains and losses

into only two groups: short-term and long-term (holding period of more than one year).

Unlike individuals, there is no further subdividing of the long-term group. Items within

the groups are then netted, producing one of the following: NLTCG, NLTCL, NSTCG

or NSTCL. If the taxpayer has a NSTCG and a NLTCG, no further netting is allowed.

However, if the taxpayer has either a NSTCL and NLTCG or a NSTCG and a NLTCL,

these results can be combined to produce a final position. This can be illustrated as

follows:

Short-Term Long-Term Result

Holding period (months) � 12 >12

Gains $xx,xxx) $xx,xxx)

Losses (xxx) (x,xxx)

Net gain or loss ???? ????

Possibilities NSTCG NLTCG No further netting

NSTCG NLTCL NLTCL or NSTCG

NSTCL NLTCG NSTCL or NLTCG

NSTCL NLTCL No further netting

A corporate taxpayer receives no special treatment for either a NSTCG or NLTCG. They

are treated just like ordinary income. If after netting, the corporation has a NSTCL or a

NLTCL, such losses receive special treatment. Unlike an individual taxpayer, a corpora-

tion is not allowed to offset capital losses against ordinary income. A corporate taxpayer’s

capital losses can be used only to reduce its capital gains.38 Any excess losses are first

carried back to the three preceding years as short-term capital losses and offset against

any net short-term capital gains and then any net long-term capital gains. Absent any

capital gains in the three prior years, or if the loss carried back exceeds any capital gains,

the excess may be carried forward for five years.39

Example 19. An examination of C Corporation’s records for 2006 revealed

$200,000 of net ordinary taxable income, a long-term capital loss of $9,000 and a

short-term capital gain of $2,000. The corporation nets the loss against the gain to

produce a NLTCL of $7,000. The corporation cannot offset the loss against

ordinary income and, therefore, reports $200,000 of taxable income (undiminished

by the NLTCL). Instead the NLTCL is carried back to the third prior year, 2003, as

a STCL where it can be used to first offset any NSTCG and then any NLTCG. If

there are no capital gains in 2003, the corporation would carryover the loss, now a

STCL of $7,000, to 2004 to use against capital gains. This process would continue

until the loss is entirely used or it expires at the end of 2011. Note that when the

loss is used in prior years, a refund can be obtained.

38 § 1212(a).

39 Ibid.



CALCULATING THE TAX

Section 1(h) provides a special tax calculation to ensure that an individual’s capital

gains will not be taxed at a rate greater than the applicable preferred rate (i.e., in 2005 the

28%, 25%, 15%, 10% or 5% rate). This calculation can only reduce the tax, not increase it.

Example 20. H and W are married. For 2006, their sole source of income was a

15CG of $79,000 from the sale of assets held five years. Their taxable income is

computed as follows:

15CG $79,000

Standard deduction (10,300)

Exemption deduction (6,600)

Taxable income $62,100

The 10% and 15% bracket for taxpayers filing jointly in 2006 runs to $61,300 at

which point any dollar of income in excess of that amount is taxed at 25%. Since all

of the couple’s income is from capital gain, however, none of it is taxed at the 15%

or 25% brackets. The effect of the special capital gains calculation is to tax the

portion of the N15CG that falls into the 10% and 15% bracket at a 5% rate and the

portion that falls into the 25% bracket at 15%. Therefore, $61,300 of the N15CG is

taxed at 5% and the remaining $2,900 is taxed at 15%. The total tax is $3,200

[($61,300 � 5%) þ ($2,900 � 15%)].

It may be clear from the above example that whenever an individual’s ordinary

taxable income exceeds the amount that would be taxed at 10 or 15 percent (e.g., $61,300

in 2006 for a joint return), none of the N15CG is taxed at 5 percent. In such case, the

taxpayer computes the tax liability by first calculating the regular tax on ordinary taxable

income and adding to that a tax of 15 percent on the N15CG. On the other hand, if

ordinary taxable income does not exceed the amount that is taxed at 10 or 15 percent, a

portion of the N15CG is taxed at the 5 percent rate until the 10 and 15 percent brackets

are exhausted. A similar approach applies for N25CGs and N28CGs.

Before proceeding, it is important to understand some statutory terms. The first term

is net capital gain—the excess of the net long-term capital gain over the net short-term

capital loss for a year. If there is no net short-term capital loss, the net capital gain is

simply the net gain from the 15 percent group, the 25 percent group, and the 28 percent

group combined. If there is a short-term loss, it is the excess of the combined long-term

gains minus the net short-term capital loss. The second term is adjusted net capitalgain—the net capital gain reduced (but not below zero) by the 25 percent gain and the

net 28 percent gain (reduced by any net short-term capital loss).

The actual steps to compute the capital gains tax are built into Schedule D of Form

1040. They are also summarized in Exhibit 16-1.



EXHIBIT 16-1

Tax Computation Involving Capital Gains

Step 1. Calculate the regular income tax using the regular rates on the taxpayer’s taxable income

Step 2. Determine the tax on the ordinary income

a. Select the greater of—" Ordinary taxable income (taxable income � net capital gain), or" The lesser of—

" The maximum amount that would be taxed at 15 percent, or" Taxable income� the adjusted net capital gain

b. Compute the regular income tax on this amount

Step 3. Determine the tax on the net capital gain by adding the following together

a. Tax on 5 Percent Gains—5 percent of the portion of the adjusted net capital gain that

would have been taxed at 10 or 15 percent when added to ordinary income [i.e., the

lesser of (1) the adjusted net capital gain or (2) the maximum amount that would

normally be taxed at 10 or 15 percent minus the amount of ordinary income].

b. Tax on 15 Percent Gains—15 percent of (the adjusted net capital gain minus any

5 percent gains).

c. Tax on 25 Percent Gains—The lesser of" 25 percent of the 25 percent gains, or" If less, (1) 10 or 15 percent (respectively) of the amount of the 25 percent gains

that, when added to ordinary income and any 5 percent gains, would be taxed at

10 or 15 percent*, plus (2) 25 percent of any remaining 25 percent gains.

d. Tax on 28 Percent Gains—The lesser of" 28 percent of the 28 percent gains, or" If less, (1) 10 or 15 percent (respectively) of the amount of the 28 percent gains

that, when added to ordinary income, any 5 percent gains, and any 25 percent

gains, would be taxed at 10 or 15 percent**, plus (2) 28 percent of any remaining

28 percent gains.

Step 4. Add the tax on the ordinary income (Step 2) to the tax on the net capital gain (Step 3) to

get the total capital gains tax.

Step 5. The final tax is the lesser of the taxes computed in Step 1 and Step 4.

*This is the amount that would otherwise be taxed at 10 or 15 percent when added to ordinary income and

any 5 percent gains (or stated differently, it is the maximum amount that would be taxed at 10 or 15 percent

minus the amount of ordinary income and the amount of 5 percent gains).

**This is the amount that would otherwise be taxed at 10 or 15 percent when added to ordinary income, any

5 percent gains, and any 25 percent gains (or, stated differently, it is the maximum amount that would be

taxed at 15 percent minus the amount of ordinary income and the amount of 5 percent gains).



Example 21. J and K are married and file a joint return for 2006. They have taxable

income of $76,300, including a N15CG of $15,000. Thus they have ordinary taxable

income of $61,300. Their tax is computed as follows:

Step 1: Regular tax on $76,300 ¼ $12,190

Regular tax on $76,300:Tax on $61,300 (10% and 15% brackets) $ 8,440Plus: Tax on excess at 25%

[($76,300 � $61,300)� 25%] þ3,750

Equals: Total tax $12,190

Step 2a: Ordinary income ¼ $61,300 ($76,300� $15,000)Step 2b: Regular tax on ordinary income of $61,300 ¼ $8,440

Regular tax on $61,300 . . . . . . . . . . . . . . . . . . . . $8,440

Step 3: Tax on the net capital gain ¼ $2,250

a. Tax on 5% Gains ¼ 5% of zero (All of the net capital gain would

have been taxed at a rate exceeding 15% since V’s ordinary

income plus 25% gains and 28% gains equaled or exceeded

$61,300—the limit of the 15% bracket)

b. Tax on 15% Gains¼ 15% � $15,000 ¼ $2,250

c. Tax on 25% Gains ¼ 25% of zero

d. Tax on 28% Gains¼ 28% of zero

Step 4: Total capital gains tax ¼ $10,690 ($8,440þ $2,250)

Step 5: The final tax is $10,690. The savings is $1,500 ($12,190 � $10,690).

Note that this $1,500 is the 10% difference (25% � 15%) on the

$15,000 gain.

Example 22. V is single for 2006 and has taxable income for the year of $100,000

including the following:

Loss from stock held 11 months ($2,000)

Gain from gold bullion held 3 years 3,000

Gain from land held 9 years 16,000

Loss from stock held 2 years (3,000)

V would summarize his gains and losses as follows:

Long-Term

Short-Term 28% 15%

($2,000) $3,000 $16,000

— — (3,000)

($2,000) $3,000 $13,000

Netting 2,000 (2,000) —

$ 0 $1,000 $13,000



The loss is a STCL since it was held for not more than a year. The gain on the sale of

the gold bullion is treated as a 28CG since it is a collectible. Collectibles are treated

as 28CGs even though they may have been held more than 12 months. The gain and

loss from the land and stock are both classified as 15% items since they were held

more than 12 months. Thus V’s overall capital gain is $14,000, consisting of a

N28CG of $1,000 and a N15CG of $13,000. V’s tax is computed as follows.

Step 1: Regular tax on $100,000¼ $22,332

Tax on $74,200 (10%, 15% and 25% bracket) $15,108

Plus: Tax on excess at 28% [($100,000� $74,200) � 28%] 7,224


Step 2a: Ordinary income ¼ $86,000 ($100,000 � $14,000)Step 2b: Regular tax on ordinary income of $86,000 ¼ $18,412

Tax on $74,200 $15,108

Plus: Tax on excess at 28% [($86,000� $74,200)� 28%] 3,304


Step 3: Tax on the net capital gain¼ $2,230 ($280þ $1,950)

a. Tax on 5% Gains ¼ 5% of zero (All of the net capital gain would have

been taxed at a rate exceeding 15% since V’s ordinary income

exceeded $30,650—the limit of the 15% bracket)

b. Tax on 15% Gains¼ 15% � $13,000 ¼ $1,950

c. Tax on 25% Gains¼ 25% of zero

d. Tax on 28% Gains¼ 28% � $1,000¼ $280

Step 4: Total capital gains tax¼ $20,642 ($18,412þ $2,230)

Step 5: The final tax is $20,817 (the lesser of Step 1 or Step 4). The difference

between the regular tax and the capital gains tax is $1,690 ($22,332 �$20,642). Note that this $1,690 is the 13% difference (28% � 15%) on

$13,000 (13%� $13,000¼ $1,690).

Example 23. Same as Example 21, except V’s total taxable income is $35,000.

Step 1: Regular tax on $35,000¼ $5,308

Tax on $30,650 $4,220

Plus: Tax on excess at 25% [($35,000� $30,650)� 25%] 1,088


Step 2a: Ordinary income ¼ $21,000 ($35,000� $14,000)

Step 2b: Regular tax on $21,000¼ $2,773 ($7,550� 10% þ $13,450 � 15%)

Step 3: Tax on the net capital gain¼ $1,235 ($483þ $502þ $250)

a. Tax on 5% Gains ¼ $483 [$9,650 � 5%—The N15CG is taxed at 5%

to the extent the limit on the 15% tax bracket exceeds the ordinary

income ($30,650� $21,000 ¼ $9,650)]



b. Tax on 15% Gains ¼ $502 [($13,000 � $9,650 ¼ $3,350) � 15%—The

adjusted net capital gain reduced by the portion taxed at 5% multiplied

by 15%]c. Tax on 25% Gains ¼ 25% of zerod. Tax on 28% Gains ¼ 25% � $1,000 ¼ $250 [Since ordinary income plus

the 5% gains, 15% gains, and 25% gains are more than the limit on the

15% tax bracket ($21,000 þ $8,050 þ $4,950 > $30,650) but less than

the top of the 25% bracket amounts, the 28% gains are taxed at 25%.]

Step 4: Total capital gains tax¼ $4,008 ($2,773þ $1,235)

Step 5: The final tax is $4,008 (the lesser of Step 1 or Step 4). The difference between

the regular tax and the capital gains tax is $1,300 ($5,308 � $4,008). Note

that this $1,300 is the sum of the 10% difference (15% � 5%) on $9,650 and

the 10% difference (25%� 15%) on $3,350 [10%� $9,650þ 10%� $2,350¼$1,300], but there is no difference on the 28% gain that was taxed at the

ordinary income rate.

REPORTING CAPITAL GAINS AND LOSSES

Individual taxpayers report any capital gains or losses on Schedule D of Form 1040.40

This form is designed to facilitate the netting process, with one part used for reporting

short-term gains and losses and another part used to report long-term transactions. A third

part of the form is available for the second step of the netting process in the event the

taxpayer has either NSTCGs and NLTCLs or NLTCGs and NSTCLs.

Regular corporations must report capital gains and losses on Schedule D of Form

1120 in much the same manner as individual taxpayers. Partnerships and S corporations

must also report capital gains and losses on a separate schedule (Schedule D of Form

1065 for partnerships and Schedule D of Form 1120S for S corporations). However,

these conduit entities are limited to the first step of the netting process. Each owner

(partner or S corporation shareholder) must include his or her share of the results from

the entity with the appropriate capital transactions being netted on the owner’s Schedule

D, Form 1040.


Review Question 1. For 2006 Ms. Reyes earned a salary of $70,000 from her job

as an art curator. In addition, she sold stock, realizing the following capital gains and

losses:

15CG $10,000

15CL (7,000)

STCL (11,000)

In 2006 she changed jobs, becoming a tax accountant and earning a salary of $300,000. In

addition, she realized a 15CG of $12,000.

Compute Ms. Reyes’s adjusted gross income for 2006 and 2007 and indicate the amount,

if any, that is eligible for preferential treatment as long-term capital gain.

40 See Appendix for a sample of this form.



Her adjusted gross incomes for 2006 and 2007 are $67,000 and $307,000, respectively.

After netting her capital gains and losses in 2006, Ms. Reyes has a net capital loss of

$8,000, all of which is short-term. The deduction for capital losses of an individual is

generally limited to $3,000. As a result, her adjusted gross income is $67,000 ($70,000 �$3,000). She is entitled to carry over the remainder of her short-term loss of $5,000. In

2007, she nets the $5,000 short-term capital loss against her $12,000 15CG to produce a

N15CG of $7,000. The $7,000 is combined with her other $300,000 of salary income to

produce an adjusted gross income of $307,000. Of this amount, her N15CG of $7,000 is

taxed at a preferred rate of 15 percent.

Review Question 2. True-False. This year Mr. and Mrs. Simpson retired. The

couple’s only income was a capital gain from the sale of stock held three years.

Assuming the Simpsons file a joint return, all $100,000 of their taxable income is taxed at

a rate of 15 percent.

False. The tax computation operates to ensure that the 15CG is taxed at 5 percent to the

extent that ordinary income does not absorb the 10 and 15 percent brackets. For 2006 the

15 percent bracket for a joint return extends to taxable income of $61,300. Therefore,

$61,300 is taxed at a 5 percent rate and the remaining $41,900 is taxed at a 15 percent

rate.

The Simpsons should have considered making the sales in two separate years (perhaps

2006 and 2007) if they have no other income in either year. That would allow them to

double the benefit of the 5 percent rate.

Review Question 3. True-False. An individual taxpayer is generally entitled to

deduct any capital loss recognized during the current year to the extent of any capital

gains recognized plus $3,000. Any capital loss in excess of this amount retains its charac-

ter and may be used in subsequent years until it is exhausted.

True.

CAPITAL GAIN TREATMENT EXTENDEDTO CERTAIN TRANSACTIONS

The Internal Revenue Code contains several special provisions related to capital asset

treatment. In some instances the concept of capital asset is expanded and in others it is

limited. Some of the provisions merely clarify the tax treatment of certain transactions.

PATENTS

Section 1235 provides that certain transfers of patents shall be treated as transfers of

capital assets held for more than one year. This virtually assures that a long-term capital

gain will result if the patent is transferred in a taxable transaction, because the patent will

have little, if any, basis since the costs of creating it are usually deducted under §174

(research and experimental expenditures) in the tax year in which such costs are incurred.

Any transfer, other than by gift, inheritance, or devise, will qualify as long as allsubstantial rights to the patent are transferred. All substantial rights have been described

as all rights that have value at the time of the transfer. For example, the transfer must not

limit the geographical coverage within the country of issuance or limit the time

application to less than the remaining term of the patent.41

41 Reg. § 1.1235-2(b).

16–25CAPITAL GAIN TREATMENT EXTENDED TO CERTAIN TRANSACTIONS


The transferor must be a holder as defined in § 1235(b). The term holder refers to

the creator of the patented property or to an individual who purchased such property

from its creator if such individual is neither the employer of the creator nor related to

such creator.42

The sale of a patent will qualify for § 1235 treatment even if payments are made

over a period that ends when the purchaser’s use of the patent ceases or if payments are

contingent on the productivity, use, or disposition of the patent.43 It also is important to

note that §§ 483 and 1274, which require interest to be imputed on certain sales

contracts, do not apply to amounts received in exchange for patents qualifying under

§ 1235 that are contingent on the productivity, use, or disposition of the patent

transferred.44

Example 24. K, a successful inventor, sold a patent (in which she had a basis of zero)

to Bell Corp. The sale agreement called for K to receive a percentage of the sales of

the property covered by the patent. All of K’s payments received in consideration for

this patent will be long-term capital gain regardless of her holding period.

LEASE CANCELLATION PAYMENTS

Section 1241 allows the treatment of payments received in cancellation of a lease or

in cancellation of a distributorship agreement as having been received in a sale or

exchange. Therefore, the gains or losses will be treated as capital gains or losses if the

underlying assets are capital assets.45

INCENTIVES FOR INVESTMENTS IN SMALL BUSINESSES

Congress has frequently provided incentives for investment in general or for specific

investments. The Subchapter S election, for example, was intended to remove any impediment

for small business owners who were not incorporating because they believed there was a

double tax on corporate profits. Other incentives provide special treatment upon the disposition

of certain business interests. The following sections deal with various prominent examples.

LOSSES ON SMALL BUSINESS STOCK: § 1244

Losses on dispositions (e.g., sale or worthlessness) of corporate stock are generally

classified as capital losses. For a year in which a taxpayer has no capital gains, the deduc-

tion for capital losses would be limited to $3,000 annually. In contrast, a loss on the dispo-

sition of a sole proprietorship would be recognized upon the disposition of the assets used

in the business. Losses on the sale of many (if not most) of the assets would be treated as

ordinary losses, thereby avoiding (or partially avoiding) the $3,000 limit. Similarly,

proper planning could result in ordinary loss treatment upon the disposition of interests in

businesses operated in the partnership form.

Without special rules, the limitation on deductions for capital losses might

discourage investment in new corporations. For example, if an individual invested

$90,000 in stock of a new corporate venture, deductions for any loss from the

investment, absent offsetting gains, would be limited to $3,000 annually.46 Thus, where

42 For definition of ‘‘relative,’’ see § 1235(d).

43 § 1235(a).

44 §§ 483(d)(4) and 1274(c)(4)(E). See Chapter 14 for a discussion of the imputed interest rules.

45 See Chapter 17 for treatment if the asset is a § 1231 asset.

46 A taxpayer can offset any capital losses against capital gains, if any.



the stock becomes worthless it could take the investor as long as 30 years to recover the

investment. This restriction on losses also is inconsistent with the treatment of losses

resulting from investments by an individual in his or her sole proprietorship or in a

partnership. In the case of a sole proprietorship or a partnership, losses generally may be

used to offset the taxpayer’s other income without limitation. For example, assume a

sole proprietor sank $150,000 into a purchase of pet rocks that he ultimately sold for

only $100,000. In such case, he would have an ordinary loss of $50,000, all of which

could be used to offset other ordinary income. Assume the same individual invested

$150,000 in a corporation that had the same luck. If the taxpayer could at best sell the

stock for $100,000, he would realize a capital loss of $50,000. Obviously the sole

proprietor is in a much better position. To eliminate these problems and encourage

taxpayers to invest in small corporations, Congress enacted § 1244 in 1958.

Under § 1244, losses on ‘‘Section 1244 stock’’ generally are treated as ordinary

rather than capital losses.47 Ordinary loss treatment normally is available only toindividuals who are the original holders of the stock. If these individuals sell the stock at

a loss or the stock becomes worthless, they may deduct up to $50,000 annually as an

ordinary loss. Taxpayers who file a joint return may deduct up to $100,000 regardless of

how the stock is owned (e.g., separately or jointly). When the loss in any one year

exceeds the $50,000 or $100,000 limitation, the excess is considered a capital loss.

Example 25. T, married, is one of the original purchasers of RST Corporation’s

stock, which qualifies as § 1244 stock. She separately purchased the stock two years

ago for $150,000. During the year, she sold all of the stock for $30,000, resulting in

a $120,000 loss. On a joint return for the current year, she may deduct $100,000 as an

ordinary loss. The portion of the loss exceeding the limitation, $20,000 ($120,000 �$100,000), is treated as a long-term capital loss.

Stock issued by a corporation (including preferred stock issued after July 18, 1984)

qualifies as § 1244 stock only if the issuing corporation meets certain requirements. The

most important condition is that the corporation’s total capitalization (amounts received

for stock issued, contributions to capital, and paid-in surplus) must not exceed

$1 million at the time the stock is issued.48 This requirement effectively limits § 1244

treatment to those individuals who originally invest the first $1 million in money and

property in the corporation.

Example 26. In 2003 F provided the initial capitalization for MNO Corporation by

purchasing 700 shares at a cost of $1,000 a share for a total cost of $700,000. In

2006 G purchased 500 shares at a cost of $1,000 per share or a total of $500,000.

All of F’s shares otherwise qualify as § 1244 stock. Only 300 of G’s new shares

qualify for § 1244 treatment, however, since 200 of the 500 purchased caused the

corporation’s total capitalization to exceed $1 million.

QUALIFIED SMALL BUSINESS STOCK (§ 1202 STOCK)

As part of the Revenue Reconciliation Act of 1993, Congress created a new tax

incentive to stimulate investment in small business. By virtue of this special rule,

individuals who start their own C corporations or who are original investors in

C corporations (e.g., initial public offerings) may be richly rewarded for taking the risk of

investing in such enterprises.

47 § 1244(a).

48 § 1244(c)(3)(A).

16–27INCENTIVES FOR INVESTMENTS IN SMALL BUSINESSES


Fifty Percent Exclusion. Under § 1202, noncorporate investors (i.e., individuals,

partnerships, estates, and trusts) are allowed to exclude 50 percent of the gain on the

sale of qualified small business stock (QSB stock or § 1202 stock) held for more than

five years.49 The balance of this gain is treated as a 28 percent gain. The effect of this

provision is to impose a maximum tax of 14 percent (50% � 28% maximum capital

gain rate) on the gains from such investments,50 a far lower rate than the 35 percent that

may apply to other types of income received by the taxpayer.

Example 27. On October 31, 1999 N purchased 1,000 shares of Boston Cod

Corporation for $10,000. The stock was part of an initial public offering of the

company’s stock that was designed to raise $30 million to open another 200 fast fish

restaurants. On December 20, 2006 N sold all of her shares for $50,000. As a result,

she realized a capital gain of $40,000, her only gain or loss during the year. Since N

was one of the original investors and the stock qualified as § 1202 stock at the time

of its issue (assets at that time were less than $50 million), she is entitled to exclude

50 percent of her gain, or $20,000. The maximum tax on the $20,000 gain is $5,600

($20,000� 28%).

In determining net capital gain and capital losses, the taxpayer does not consider

any gain excluded on the sale of § 1202 stock.

Example 28. Assume the same facts as above, but assume that in addition to the

$40,000 gain on § 1202 stock, N also has other long-term capital gains of $10,000 and

short-term capital losses of $5,000. N first applies the 50% exclusion and then nets the

remainder with the other capital gains and losses. Therefore, N’s net capital gain for

the year is $25,000 [($40,000 � $20,000 ¼ $20,000)þ $10,000 � $5,000].

Example 29. Assume N has a gain on § 1202 stock of $40,000 and a short-term

capital loss of $23,000. N first applies the 50% exclusion and then nets the

remaining gain with the capital loss. As a result, N has a net capital loss of $3,000

($20,000� $23,000).

Rollover Provision. An individual who realizes a gain on the sale of QSB stock

held for more than six months can defer recognition of the gain by reinvesting in other

QSB stock within 60 days of the sale. Note that the stock qualifies for the rollover

provision if it is held more than six months (not five years). The individual must

recognize gain to the extent that the amount reinvested is less than the sales price of the

original stock. If the taxpayer uses the rollover provision, the basis in the newly

acquired QSB stock is reduced by the deferred gain. The holding period of the new QSB

stock includes the holding period of the old QSB stock.

Example 30. D purchased Netbrowser stock two years, for $10,000. The stock quali-

fied as § 1202 stock. After rising dramatically, the stock started to fall so D sold it for

$14,000 before he lost all of his profit. He realized a $4,000 gain on the sale.

D wanted to preserve the special treatment for § 1202 stock so 45 days after the sale,

he reinvested in MMX Inc., another issue of § 1202 stock, for $15,000. D recognizes

no gain on the sale since his holding period of two years exceeded the required six

months and he reinvested all $10,000 received from the sale of § 1202 stock. His

basis in the replacement stock is $11,000 ($15,000 � $4,000) and the two-year

49 Special rules apply for computing the exclusion on the sale of stock in a specialized small business invest-

ment company (see following discussion).

50 § 1h. Recall that the § 1202 gain on the sale of qualified small business stock is excluded from the adjusted

net capital gain. Therefore, the 15 percent rate does not apply.



holding period of the old stock attaches to the new. Had D reinvested only $13,000,

he would have recognized a gain of $1,000 ($14,000 � $13,000) and have a basis in

the replacement stock of $10,000 ($13,000 � deferred gain of $3,000). Note that this

rollover provision enables the taxpayer to move in and out of positions in QSB stock

so long as QSB is repurchased.

§ 1202 Requirements. Stock qualifies as § 1202 stock if it is issued after August 10,

1993 and meets a long list of requirements.

1. At the time the stock is issued, the corporation issuing the stock must be a

qualified small business. A corporation is a qualified small business if" The corporation is a domestic C corporation

" The corporation’s gross assets do not exceed $50 million at the time the stock

was issued (i.e., cash plus the fair market value of contributed property

measured at the time of contribution plus the adjusted basis of other assets)

2. The seller is the original owner of the stock (i.e., the stock was acquired directly

from the corporation or through an underwriter at its original issue)

3. During substantially all of the seller’s holding period of the stock, the corporation

was engaged in an active trade or business other than the following:" A business involving the performance of providing services in the fields of

health, law, engineering, architecture, accounting, actuarial science, performing

arts, consulting, athletics, financial services, brokerage services, or any other

business where the principal asset is the reputation or skill of one or more of its

employees

" Banking, insurance, financing, leasing, or investing

" Farming

" Businesses involving the production or extraction of products eligible for

depletion

" Business of operating a hotel, motel, or restaurant

4. The corporation generally cannot own" Real property with a value that exceeds 10 percent of its total assets unless

such property is used in the active conduct of a trade or business (e.g., rental

real estate is not an active trade or business)

" Portfolio stock or securities with a value that exceeds 10 percent of the

corporation’s total assets in excess of its liabilities

Note that the active trade or business requirement and the prohibition on real estate

holdings severely limit the exclusion. These conditions effectively grant the exclusion to

corporations engaged in manufacturing, retailing, or wholesaling businesses.

The new provision also imposes a restriction, albeit a liberal one, on the amount of

gain eligible to be excluded on the sale of a particular corporation’s stock. The

maximum amount of gain that may be excluded on the sale of one corporation’s stock is

the larger of

1. $10 million, reduced by previously excluded gain on the sale of such

corporation’s stock; or

2. 10 times the adjusted basis of all qualified stock of the corporation that the

taxpayer sold during the tax year.

16–29INCENTIVES FOR INVESTMENTS IN SMALL BUSINESSES

Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3dDate: 9th March 2006 Time: 11:43 User ID: 40459

Chapter 17

PROPERTY TRANSACTIONS:DISPOSITIONS OF TRADE OR

BUSINESS PROPERTY

LEARNING OBJECTIVES

CHAPTER OUTLINE

Introduction 17-2

Section 1231 17-2

Historical Perspective 17-2

Section 1231 Property 17-3

Other § 1231 Property 17-4

Section 1231 Netting Process 17-7

Look-Back Rule 17-11

Applicability of Lower Rates 17-12

Depreciation Recapture 17-15

Historical Perspective 17-15

When Applicable 17-16

Types of Depreciation Recapture 17-16

Full Recapture—§ 1245 17-16

Partial Recapture—§ 1250 17-19

Additional Recapture—Corporations 17-28

Other Recapture Provisions 17-34

Related Business Issues 17-36

Installment Sales of Trade or

Business Property 17-36

Intangible Business Assets 17-37

Dispositions of Business Assets

and the Self-Employment Tax 17-37

Tax Planning Considerations 17-37

Timing of Sales and Other

Dispositions 17-37

Selecting Depreciation Methods 17-38

Installment Sales 17-39

Sales of Businesses 17-39

Dispositions of Business Assets and

the Self-Employment Tax 17-39

Problem Materials 17-40

Upon completion of this chapter you will be able to:

" Trace the historical development of the

special tax treatment allowed for dispositions

of trade or business property

" Apply the § 1231 gain and loss netting

process to a taxpayer’s § 1231 asset

transactions

" Determine the tax treatment of § 1231 gains

and losses

" Explain the purpose of the depreciation

recapture rules

" Compute depreciation recapture under

§§ 1245 and 1250

" Explain the additional recapture rule

applicable only to corporate taxpayers

" Identify tax planning opportunities related to

sales or other dispositions of trade or business

property

17–1


INTRODUCTION

As is no doubt clear by now, the treatment of property transactions is a complex story

that seeks to answer three questions: (1) What is the gain or loss realized? (2) How much

is recognized? and (3) What is its character? This chapter, the final act in the property

transaction trilogy, addresses the problems in determining the character of gains or losses

on the dispositions of property used in a trade or business.

In an uncomplicated world, it might seem logical to assume that gains or losses from

property dispositions—be it stock, equipment, buildings, or whatever—would be treated

just like any other type of income or deduction. But, as shown in the previous chapter,

treating all items alike apparently was not part of the grand plan. Congress forever

changed the process with the institution of preferential treatment for capital gains in 1921.

Since that time taxpayers have been required to determine not only the gain or loss

realized and recognized but also whether a disposition involved a capital asset. It is

important to understand that these rules did not simply tip the scales in favor of capital

gain. In the interest of fairness and equity, they also established a less than friendly

environment for capital losses. The limitations on the deductibility of capital losses is

clearly a major disadvantage, particularly considering that ordinary losses are fully

deductible. The end result of Congress’s handiwork was the creation of a system in which

the preferred result is capital gain treatment for gains and ordinary treatment for losses.

This chapter contains the saga of what happens when Congress attempts to provide

taxpayers with the best of both worlds.

SECTION 1231

The road to tax heaven—capital gain and ordinary loss—begins at § 1231 (in tax

parlance properly pronounced as ‘‘twelve thirty-one’’). While § 1231 can be a completely

bewildering provision, its basic operation is relatively simple. At the close of the taxable

year, the taxpayer nets all gains and losses from so-called § 1231 property (e.g., land and

depreciable property used in a trade or business). If there is a net gain, it is treated as a

long-term capital gain. If there is a net loss, it is treated as an ordinary loss. In short,

§ 1231 allows taxpayers to have their cake and eat it, too. Unfortunately, this is

accomplished only with a great deal of complexity, much of which makes sense only if

the historical events that shaped § 1231 are considered.

HISTORICAL PERSPECTIVE

At first glance, it seems that the productive assets of a business—its property, plant,

and equipment—would be perfect candidates for capital gain treatment and would

therefore be considered capital assets. Indeed, that was exactly the case initially. From

1921 to 1938, real or depreciable property used in business was in fact treated as a

capital asset. At that time, the classification of such property as a capital asset seemed

not only appropriate but desirable—particularly as the economy grew during the early

1920s and taxpayers were realizing gains. However, the opposite became true with the

onset of the Great Depression. As the economy deteriorated, businesses that had

purchased assets at inflated prices during the booming 1920s found themselves selling

such properties at huge losses during the depression-plagued 1930s. To make matters

worse, the tax law treated such losses as capital losses, severely limiting their deduction.

But Congress apparently had a sympathetic ear for these concerns. Hoping that a change

would help stimulate the economy, Congress enacted legislation that removed business

properties from the list of capital assets. The legislative history to the Revenue Act of

1938 provides some insight into Congressional thinking, explaining that ‘‘corporations

will not, as formerly, be deterred from disposing of partially obsolescent property,

17–2 PROPERTY TRANSACTIONS: DISPOSITIONS OF TRADE OR BUSINESS PROPERTY


such as machinery or equipment, because of the limitations imposed . . . upon the

deduction of capital losses.’’1 With the 1938 changes in place, business got the ordinary

loss treatment it wanted but at the same time was saddled with ordinary income

treatments for its gains.

Although these rules worked well during the Depression years as businesses were

reporting losses, they produced some unduly harsh results once the country moved to a

wartime economy. By 1942 the build-up for World War II had the economy humming

and inflation had once again set in. Businesses that earlier had sold assets for 10 cents on

the dollar now found themselves realizing gains. Of course, under the 1938 changes these

gains no longer benefited from preferential treatment but were taxed at extraordinarily

high tax rates (88 percent for individuals and 40 percent for corporations). The shipping

industry was particularly hard hit by the new treatment. Shippers not only had gains as the

enemy destroyed their insured ships but also profited when they were forced to sell their

property to the government for use in the war. Other businesses that had their factories

and equipment condemned and requisitioned also felt the sting of higher ordinary rates.

Although these companies could have deferred their gains had they replaced the property

under the involuntary conversion rules of § 1033, qualified reinvestment property was in

short supply, making § 1033 virtually useless. Understanding the plight of business,

Congress once again came to the rescue. In 1942 Congress enacted legislation generally

reinstating capital gain treatment but preserving ordinary loss treatment.

The changes in 1942 stemmed primarily from a need to provide relief for those whose

property was condemned for the war effort. But in the end they went much further. For

consistency, capital gain treatment was extended not only to condemnations of a business

property but to other types of involuntary conversions as well. Under the new rules, casu-

alty and theft gains from business property and capital assets also received capital gain

treatment. In addition, the new legislation unexpectedly extended capital gain treatment

to regular sales of property, plant, and equipment. Apparently, Congress felt that capital

gain treatment was also appropriate for taxpayers who were selling out in anticipation of

condemnation or simply because wartime conditions had made operations difficult. While

Congress thought capital gain treatment was warranted for these gains, it also knew that

other businesses had not profited from the war and were still suffering losses from their

property transactions. Accordingly, it acted to preserve ordinary loss treatment. The end

result of these maneuvers was the enactment of § 1231, an extremely complex provision that

provides taxpayers with the best of all possible tax worlds: capital gain and ordinary loss.

The product of Congressional tinkering in 1942 still remains today. To summarize, real

and depreciable property used in a trade or business is specifically denied capital asset

status. But this does not necessarily mean that such property will be denied capital gain treat-

ment. As explained at the outset, § 1231 generally extends capital gain treatment to gains

and losses from these assets if the taxpayer realizes a net gain from all § 1231 transactions.

On the other hand, if there is a net loss, ordinary loss treatment applies. But this summary

lacks a great deal of precision. The specific rules of § 1231 are described below.

SECTION 1231 PROPERTY

The special treatment of § 1231 is generally granted only to certain transactions

involving assets normally referred to as § 1231 property.2 Section 1231 property

includes a variety of assets, but among them the most important is real or depreciableproperty that is used in the taxpayer’s trade or business and that is held for more than

1 House Ways and Means Committee, H.R. Rep. 1860, 75th Cong., 3d Sess. (1938).

2 As explained below, § 1231 also applies to involuntary conversions of pure capital assets held more than one

year that are used in a trade or business or held for investment. Involuntary conversions by theft or casualty

of personal assets are not included under § 1231 but are subject to a special computation.

17–3SECTION 1231


one year.3 This definition takes in most items commonly identified as a business’s fixed

assets, normally referred to as its property, plant, and equipment. For example, the

reach of § 1231 includes depreciable personal property used in business, such as

machinery, equipment, office furniture, and business automobiles. Similarly, realty used

in a business, such as office buildings, warehouses, factories, and farmland, is also

considered § 1231 property.

The Code specifically excludes the following assets from § 1231 treatment:

1. Property held primarily for sale to customers in the ordinary course of a trade or

business, or includible in inventory, if on hand at the close of the tax year;

2. A copyright; a literary, musical, or artistic composition; a letter or memorandum;

or similar property held by a taxpayer whose personal efforts created such prop-

erty or by certain other persons; or

3. A publication of the United States Government received from the government

other than by purchase at the price at which the publication is offered to the gen-

eral public.4

Note that the excluded assets are also excluded from the definition of a capital asset. As a

result, gains or losses on the disposition of inventory, property held primarily for resale,

literary compositions, and certain government publications always yield ordinary income

or ordinary loss.

One of the critical conditions for § 1231 treatment requires that the property be used

in a trade or business. Although this test normally presents little difficulty, from time to

time it has created problems, particularly for those with rental property. As an illustration,

consider the common situation of a taxpayer who sells rental property such as a house,

duplex, or apartment complex. Is the property sold a capital asset or § 1231 property? If a

taxpayer sells rental property at a gain, the gain would normally receive capital gain

treatment regardless of whether the property is a capital asset or § 1231 property. On the

other hand, if the taxpayer sells the rental property at a loss, § 1231 treatment is usually

far more desirable. Although the Code does not provide any clear guidance on the issue,

the courts have generally held that property used for rental purposes is considered as used

in a trade or business and is therefore eligible for § 1231 treatment.5

OTHER § 1231 PROPERTY

From time to time, Congress has been convinced that particular industries deserve

special tax relief. As a result, it has added a number of other properties to the § 1231

basket. Those eligible for capital gain and ordinary loss are

1. Timber, coal, and iron ore to which § 631 applies;6

2. Unharvested crops on land used in a trade or business and held for more than one

year;7 and

3. Certain livestock.8

3 The holding period is determined in the same manner as it is for capital assets. See § 1223 discussed in

Chapter 16.

4 § 1231(b)(1).

5 See, for example, Mary Crawford, 16 T.C. 678 (1951) A. 1951-2 C.B. 2, and Gilford v. Comm., 53-1 USTC

{9201, 43 AFTR 221, 201 F.2d 735 (CA-2, 1953).

6 § 1231(b)(2).

7 § 1231(b)(4).

8 § 1231(b)(3).



Timber. Under § 631, the mere cutting of timber by the owner of the timber, or by a

person who has the right to cut the timber and has held the timber or right more than one

year, is to be treated, at his or her election, as a sale or exchange of the timber that is cut

during the year. The timber must be cut for sale or for use in the taxpayer’s trade or

business. In such case, the taxpayer would report a § 1231 gain or loss and potentially

receive capital gain treatment for what otherwise might be considered the taxpayer’s

inventory—a very favorable result. It may appear that the timber industry has secured an

unfair advantage, but timber’s eligibility is arguably justified on the grounds that the

value of timber normally accrues incrementally as it grows over a long period of time.

The amount of gain or loss on the ‘‘sale’’ of the timber is the fair market value of the

timber on the first day of the taxable year minus the timber’s adjusted basis for depletion.

For all subsequent purposes (i.e., the sale of the cut timber), the fair market value of the

timber as of the beginning of the year will be treated as the cost of the timber. The term

timber not only includes trees used for lumber and other wood products, but also includes

evergreen trees that are more than six years old when cut and are sold for ornamental

purposes (e.g., Christmas trees).9

Example 1. B owned standing timber that he had purchased for $250,000 three years

earlier. The timber was cut and sold to a lumber mill for $410,000 during 2006. The

fair market value of the standing timber as of January 1, 2006 was $320,000. B has a

§ 1231 gain of $70,000 if he makes an election under § 631 ($320,000 fair market

value of the timber on the first day of the taxable year less its $250,000 adjusted basis

for depletion). The remainder of his gain on the actual sale of the timber, $90,000

($410,000 selling price � $320,000 new ‘‘cost’’ of the timber), is ordinary income.

Any expenses incurred by B in cutting the timber would be deductible as ordinary

deductions.

An election under § 631 with respect to timber is binding on all timber owned by the

taxpayer during the year of the election and in all subsequent years. The IRS may permit

revocation of such election because of significant hardship. However, once the election is

revoked, IRS consent must be obtained to make a new election.10

Section 631 also applies to the sale of timber under a contract providing a retained

economic interest (i.e., a taxpayer sells the timber, but keeps the right to receive a royalty

from its later sale) for the taxpayer in the timber. In such a case, the transfer is considered

a sale or exchange. The gain or loss is recognized on the date the timber is cut, or when

payment is received, if earlier, at the election of the taxpayer.11

Coal and Iron Ore. When an owner disposes of coal or domestic iron ore under a

contract that calls for a retained economic interest in the property, the disposition is

treated as a sale or exchange of the coal or iron ore. The date the coal or ore is mined is

considered the date of sale and since the property is § 1231 property, the gain or loss will

be treated under § 1231.12

The taxpayer may not be a co-adventurer, partner, or principal in the mining of the

coal or iron ore. Furthermore, the coal or iron ore may not be sold to certain related

taxpayers.13

9 § 631(a).

10 Ibid.

11 § 631(b).

12 § 631(c).

13 §§ 631(c)(1) and (2).

17–5SECTION 1231


Unharvested Crops. Section 1231 also addresses the special situation where a

farmer sells land with unharvested crops sitting upon the land. In this case, it seems logical

that the farmer should allocate the sales price between the crops and the land to ensure

ordinary income or loss for the sale of the farmer’s inventory and capital gain or ordinary

loss on the sale of the land. While this may be the theoretically correct result, Congress

wanted to eliminate potential controversy over the allocation. Accordingly, for

administrative convenience it brought the entire transaction into the § 1231 fold in 1951.

Currently, whenever land used in a trade or business and unharvested crops on that land

are sold at the same time to the same buyer, the gain or loss is subject to § 1231 treatment

as long as the land has been held for more than a year.14 It is worth noting that the benefits

of § 1231 were not extended to farmers free of charge. At the same time, Congress

eliminated the current deduction for production expenses. The law now provides that any

expenses related to the production of crops cannot be deducted currently but must be

capitalized as part of the basis of the crops.15 Such treatment, in a year when land and

crops are sold, reduces the farmer’s capital gain on the sale rather than any other ordinary

income.

Example 2. F sold 100 acres of land that she used in her farming business just days

before the corn on the land was harvested. For the ‘‘package’’ deal, she received

$600,000, including an estimated $70,000 for the unharvested crops that she figured

had cost her $20,000 to produce. F had purchased the land many years ago for

$200,000. In determining the character of her gain, F is not required to allocate the

sales price between the crops and the land since she sold both at the same time to

the same buyer, therefore qualifying for § 1231 treatment. As a result, she reports a

§ 1231 gain of $380,000 computed as follows:

Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000

Adjusted basis ($200,000þ $20,000). . . . . . . . . . . � 220,000

§ 1231 gain. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $380,000

Note that in the year of the sale F has effectively turned the $50,000 ($70,000 �$20,000) profit from the sale of her crops from ordinary income into potential capital

gain.

Livestock. As a general proposition, livestock that are used for breeding and other

purposes are depreciable assets much like machinery and equipment and therefore qualify

for § 1231 treatment. In many situations, however, livestock is used for these purposes for

only a short period of time and then sold. If this is the farmer’s or rancher’s normal

practice, the IRS is inclined to argue that the animals are held primarily for resale, in

which case the law specifically denies § 1231 treatment. To help end this controversy,

Congress specifically made all livestock (other than poultry) used for draft, breeding,

dairy, or sporting purposes eligible for § 1231 treatment as long as they are held for over

a year.16 In the case of cattle and horses, however, the holding period is extended to

two years. Note that this treatment is extremely beneficial since the taxpayer effectively

gets capital gain from animals pulled out of the breeding process and sold. Moreover, the

farmer or rancher is allowed to deduct the costs of raising such animals currently against

ordinary income. The extension of the holding period for cattle and horses was in part, an

attempt to cut back on the benefits of this favorable treatment.

14 § 1231(b)(4).

15 § 268.

16 § 1231(b)(3).



SECTION 1231 NETTING PROCESS

The treatment of § 1231 gains or losses ultimately depends on the outcome of a

netting process that is far more complicated than outlined earlier.17 As can be seen from

the flowchart in Exhibit 17-1, the taxpayer must first identify all of the gains and losses

that enter into the netting process. As might be expected, these include gains and losses

from what has been described above as § 1231 property. In addition, the § 1231

hodgepodge includes involuntary conversions of certain capital assets. Surprisingly,

gains or losses recognized from casualties, thefts, or condemnations of capital assets that

are used in a trade or business or held for investment are part of the § 1231 netting

process. Involuntary conversions of capital assets that are held for personal use are not

considered under § 1231 but are subject to special rules.

After identifying all of the § 1231 transactions, the taxpayer must segregate the

§ 1231 gains and losses arising from casualty and theft from those attributable to sale,

exchange, and condemnation. The end result is that there are two sets of § 1231

transactions:

1. Involuntary conversions due to casualty and theft of" § 1231 property

" Real and depreciable property used in business and held more than one

year

" Timber, coal, iron ore, unharvested crops, and livestock" Capital assets

" Used in a trade or business or held for investment in connection with

business and held more than one year

2. Sales and exchanges of" § 1231 property

" Real and depreciable property used in business

" Timber, coal, iron ore, unharvested crops and livestock

Involuntary conversion due to condemnation of" § 1231 property

" Real and depreciable property used in business and held more than one

year

" Timber, coal, iron ore, unharvested crops, and livestock" Capital assets

" Used in a trade or business or held for investment in connection with

business and held more than one year

17 § 1231(a).

17–7SECTION 1231


Within each of these two categories, each gain and loss must be assigned to one of the

three potential long-term capital gain groups and netted just as if they had been 28%, 25%

or 15% capital gains or losses (see Chapter 16). This means that each § 1231 gain or loss

is assigned to one of the following three categories: (1) 15% group for § 1231 gains and

losses (15G or 15L); (2) 25% group for unrecaptured § 1250 depreciation related to gains

from § 1231 assets (25G discussed below); and (3) 28% group for gains and losses from

collectibles (28G or 28L). Once all of the appropriate transactions have been poured into

the § 1231 process, the netting process can begin. There are three steps.

1. First, all of the gains and losses in the first category of § 1231 transactions

(casualties and thefts) are netted. Specifically, gains and losses within the 15%

and 28% groups are netted to arrive at one of the following: (1) a net gain or loss

on 15% § 1231 assets (N15G or N15L); and (2) a net gain or loss on 28% § 1231

assets (N28G or N28L). Any net loss positions are then combined with the net

EXHIBIT 17-1

Section 1231 Netting Process

Casualty and theft gains*and losses from §1231assets and specified

capital assets

Gains* and losses from sales orexchanges of § 1231 assets

and specified involuntaryconversions

Net(Step 1)

IfLoss

IfGain

Net(Step 2)

IfLoss

IfGain

IfYes

IfNo

Treat gains and lossesseparately: gains are

ordinary income: businesslosses are deductions

for A.G.I.: otherlosses are deductions

from A.G.I.

Treat net resultas an ordinary

deduction

Look-Back Rule:Did the taxpayerdeduct any net

§ 1231 losses inthe last five

taxable years?

Treat entirenet gain as a15% or 28%capital gain

Treat as ordinary incomethe lesser of

(1) unrecaptured § 1231losses, or (2) the currentyear’s net gain. Treat any

excess § 1231 gain as 15%or 28% capital gain

* Gains remaining after reduction for any depreciation recapture



gain positions using the rules discussed for netting the three groups for capital

asset transactions:

" A N28L first offsets 25G, then N15G.

" A N15L first offsets a N28G, then 25G.

" There can be no net loss in the 25G group since this group contains only gains.

This netting process is summarized as follows:

Section 1231 Gains and Losses from Casualty andTheft

CollectiblesUnrecapturedDepreciation Other

28% 25% 15%

Gains . . . . . . . . . . . . . . . . . . . . . . . . $x,xxx). Gains only $xx,xxx)

Losses . . . . . . . . . . . . . . . . . . . . . . . (x,xxx) – X(x,xxx)

Net gain or loss . . . . . . . . . . . . . . . . ???? Gain only Xz????)

Possibilities:

1. . . . . . . . . . . . . . . . . . . . . . . . . . N28G 25G N15G

2. . . . . . . . . . . . . . . . . . . . . . . . . . N28G 25G N15L

3. . . . . . . . . . . . . . . . . . . . . . . . . . N28L 25G N15G

4. . . . . . . . . . . . . . . . . . . . . . . . . . N28L 25G N15L

If the netting process results in a net gain position(s) (e.g., a N28G, N25G, and a N15G)

the net gains from casualties and thefts become § 1231 gains and become part of the

second category of other § 1231 transactions (each assigned to either the 28%, 25%, or

15% groups).

Example 3. During the year, T, who is in the 35% tax bracket, reported the following

§ 1231 gains and losses from casualties of § 1231 assets (including casualties of

capital assets used in a trade or business) and netted them as shown below.

Section 1231 Gains and Losses


28% 25% 15%

Gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000 $4,000 $2,000

Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . (4,000) — (7,000)

Net gain or loss . . . . . . . . . . . . . . . . . . . . $ 6,000 $4,000 ($5,000)

Netting . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,000) — 5,000

To Section 1231 Other . . . . . . . . . . . . . . $ 1,000 $4,000 $ 0

In this case, T has a N28G of $1,000 and a N25G of $4,000. Since the end results are

net gains, each of these net gains is assigned to its appropriate group in the second cat-

egory of other § 1231 transactions.

If a net loss results, the casualty and theft gains and losses are removed from the

§ 1231 process and treated separately. The gains are treated as ordinary income, and

the losses on business use assets are deductible for A.G.I. Any other casualty and theft

losses are deductible from A.G.I.

17–9SECTION 1231


2. The second step of the process is to combine any net casualty or theft gains from

the first step with the gains or losses in the second set of § 1231 transactions. In

this regard, the net casualty and theft gains must be assigned to the appropriate

group (15%, 25%, or 28% group) in the second category of § 1231 transactions

(sales and exchanges of § 1231 assets and certain condemnations). For example,

if the taxpayer had a net 15% gain from § 1231 casualties, this gain would

become a 15% gain in the second category of § 1231 transactions. These

transactions are then netted just as if they had been 28%, 25%, or 15% capital

gains or losses to determine if there is a net gain or loss.

3. The third and final step in the § 1231 netting process is to characterize the gain or

loss resulting from netting the transactions in the second step. If the net result is a

loss, the net loss is treated as an ordinary deduction for adjusted gross income. It

is not treated as a capital loss. If the net result is a gain (e.g., a N25G and a

N15G), these gains are normally treated as capital gains and become part of the

capital gain and loss netting process.

The § 1231 netting process is illustrated in Exhibit 17-1 and the following examples.

Example 4. During the current year, D sold real estate used in her business for

$45,000. She had purchased the property several years ago for $36,000. D also sold a

business car (held for more than 15 months) at a loss of $1,200. D’s gain on the real

estate is computed as follows:

Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . $45,000

Less: Adjusted basis . . . . . . . . . . . . . . . . . . . . . (36,000)

Gain realized and recognized . . . . . . . . . . . . . $ 9,000

D nets the gain and loss as follows:

15% Gain from sale of § 1231 asset . . . . . . . . $ 9,000

15% Loss from sale of § 1231 asset . . . . . . . . (1,200)

Net 15% § 1231 gain for year . . . . . . . . . . . . . . $ 7,800

D’s net 15% § 1231 gain of $7,800 is treated as a 15% capital gain. If she had other

capital gains or losses during the year, they will be subject to the capital gain and loss

netting process discussed in Chapter 16.

Example 5. During the year R, a sole proprietor, sold a business computer for

$32,000. His basis at the time of the sale was $44,000. He also sold land used in his

business at a gain of $1,400 and had an uninsured theft loss of works of art used to

decorate his business offices (i.e., capital assets held in connection with a trade or

business). R had purchased the artwork for $1,500 and it was valued at $5,000 before

the burglary. All of the assets were acquired more than 12 months ago.

R nets his gains and losses as follows:

Step 1: The net loss from the casualty is $1,500 (adjusted basis). Since R has a net

15% casualty loss, it is not treated as a § 1231 loss. Instead, the loss is

treated as an ordinary loss (which is fully deductible for A.G.I. since the art

works were business property).



Step 2: Combine gains and losses from sales of § 1231 assets:

15% loss from sale of business computer. . . . . . ($12,000)

15% gain from sale of business land . . . . . . . . . . 1,400

Net § 1231 loss for year . . . . . . . . . . . . . . . . . . . . ($10,600)

Step 3: A net § 1231 loss is treated as an ordinary deduction. Thus, R’s $10,600 loss

can be used to offset other ordinary income.

Note that the theft loss of the works of art is included in the first step of the netting

process even though these items are capital assets. This loss would have offset, dollar

for dollar, any casualty or theft gains (net of depreciation recapture) from § 1231

assets as well as any casualty or theft gains from other capital assets held in

connection with R’s business. Also note that the current year’s deductible § 1231 loss

may result in a change in the character of any net § 1231 gains in the next five years

due to the look-back rule.

LOOK-BACK RULE

For many years, taxpayers took advantage of the § 1231 netting process. For example,

assume a taxpayer in the 35 percent tax bracket currently owns two § 1231 assets, both

held for 15 months. One asset has a built-in gain of $3,000 and the other has a built-in loss

of $2,000. If both assets are sold during the year, the loss offsets the gain and the taxpayer

pays a capital gain tax of $150 [($3,000 � $2,000 ¼ $1,000) � 15%]. If the taxpayer had

sold the assets in different years, the loss would not have reduced the gain, and the tax

after both transactions would have been $450 in one year ($3,000 � 15%) and $700

($2,000 � 35%) of savings in the other year, for a net tax savings of $250 ($700 � $450).

As might be imagined, taxpayers carefully planned their transactions to maximize their

tax savings.

In an effort to prevent taxpayers from cleverly timing their § 1231 gains and losses to

ensure that § 1231 losses reduced ordinary income and not potential capital gain,

Congress enacted the so-called look-back rule in 1984. Under this rule, a taxpayer with a

net § 1231 gain in the current year must report the gain as ordinary income to the extent of

any unrecaptured net § 1231 losses reported in the past five taxable years.18 In recapturing

the § 1231 gains, recapture occurs in the following order: 28% gains, 25% gains, and 15%

gains. Unrecaptured net § 1231 losses are simply the net § 1231 losses that have occurred

during the past five years that have not been previously recaptured (i.e., the excess of net

§ 1231 losses of the five preceding years over the amount of such loss that has been

recaptured in the five prior years).

Example 6. Assume the same facts in Example 5 and that R’s 2006 net § 1231 loss

of $10,600 is the only loss he has deducted in the past five years. In 2007 R has a net

15% § 1231 gain of $15,000. R is subject to the look-back rule since in the prior year

he reported a § 1231 loss of $10,600 that has not been recaptured. He must report

$10,600 of ordinary income and $4,400 of net 15% § 1231 gain. Should R have a

§ 1231 gain in the following year, he will not be subject to the look-back rule since he

has recaptured all prior year’s net § 1231 losses.

18 § 1231(c).

17–11SECTION 1231


APPLICABILITY OF LOWER RATES

Five potential tax rates apply to long-term capital gains; six, to ordinary income,

which includes short-term capital gains. How can the calculation of the capital gains tax,

including any § 1231 gain, be completed in such a way as to arrive at a single right

answer?

Caution must be exercised so as to complete the netting process in the prescribed

order, as elaborated so far in this chapter and in Chapter 16.

" The first step is to complete the § 1231 netting process.

� If there is a net § 1231 loss, that loss must be treated as an ordinary loss and it

is left out of the capital gain and loss netting process entirely.

� If there is a net § 1231 gain, it is treated as a long-term capital gain and is

entered into the capital gain and loss netting process in the next step. In order

to do this, a determination must be made as to which part of the gain, if any, is

25% gain, and which part, if any, is 15% gain.

" Netting of capital gains and losses occurs in each of the various groups of assets.

� Short-term gains are netted against short-term losses and long-term gains are

netted against long-term losses.

� Within the long-term netting process, gains and losses are further broken down

in the various sub-groups with 15% gains and losses, and 28% gains and losses

being netted. Since there are no 25% losses, the 25% gains are not reduced.

� The net gains and losses from these three groups are netted against one another

as prescribed in Chapter 16 (e.g., 28% losses are first offset against 25% gains,

then 15% gains, and 15% losses are first offset against 28% gains, then 25%

gains.

" Short-term gains and losses are netted/combined with long-term gains and losses.

Short-term losses are first netted against 28% gains, then 25% gains, and finally

15% gains. Net long-term losses are netted against short-term gains.

" The net results are subject to the capital gain tax.

� Short-term gains are treated like ordinary income

� Long-term gains are subject to tax at the appropriate specified capital gains

rates (5%, 10%, 15%, 25%, and 28%)

� Losses are subject to the $3,000 annual limit with the excess being carried

forward.

Numerous possibilities exist, therefore, for any net § 1231 gain. Perhaps, the gain would

be offset by capital losses, receiving no favorable treatment at all. However, if the § 1231

gain survives the netting process to be included in a net capital gain, it is subject to the

preferred rates right along with any other long-term capital gains with surviving

unrecaptured § 1250 gain being treated as 25% gain and any other surviving gain treated

as 15% gain.


Review Question 1. Indicate whether the following gains and losses are § 1231

gains or losses or capital gains and losses or neither. Make your determination prior to the

§ 1231 netting process and assume any holding period requirement has been met.



a. Gain on the sale of General Motors stock held as a temporary investment

by Consolidated Brands Corporation.

b. Gain on the sale of a four-unit apartment complex owned by Lorena Smith.

This was her only rental property.

c. Loss on the sale of welding machinery used by Arco Welding in its

business.

d. Loss on theft of welding machinery used by Arco Welding in its business.

e. Gain on sale of diamond bracelet by Nancy Jones.

f. Income from sale of electric razors by Razor Corporation, which manufac-

tures them.

g. Gain on condemnation of land on which Tonya Smith’s personal residence

is built.

h. Gain on condemnation of land owned by Tonya Smith’s business.

i. Loss on sale of personal automobile.

Answer. The § 1231 hodgepodge contains not only gains and losses from § 1231 property

but also those from involuntary conversions by casualty, theft, or condemnation of capital

assets that are used in a trade or business or held as an investment in connection with a

trade or business.

a. The sale of the GM stock is not included in the § 1231 pot since it is a sale

of a capital asset and not an involuntary conversion.b. The rental property is generally considered property used in a trade or busi-

ness and thus § 1231 property even if the owner owns only a single

property.c. The welding machinery is depreciable property used in a business and is

therefore considered § 1231 property.d. The theft of the welding machinery is also a § 1231 transaction. Note,

however, that in processing the § 1231 gains and losses, the casualties must

be segregated from the sales.e. The sale of the diamond bracelet produces capital gain since it is a pure

capital asset and not trade or business property.f. The razors are inventory and are therefore neither capital assets nor § 1231

property.g. The condemnation of the land near the residence is considered a personal

involuntary conversion gain. Since the land is not held in connection with a

trade or business, it does not qualify as § 1231 property, but it is a capital

asset.h. The condemnation of the land held for business does enter into the § 1231

hodgepodge as a regular § 1231 gain.i. Although the personal automobile is a capital asset, no loss is allowed from

the sale.

Review Question 2. During his senior year at the University of Virginia, Bill decided

that he never wanted to leave Charlottesville. After some thought, he opened his own

hamburger joint, Billy’s Burgers. That was 20 years ago and Bill has had great success,

owning a number of businesses all over Virginia and North Carolina. Not believing in

corporations, Bill and his wife, Betty, operate all of these as partnerships.

a. Information from the partnerships and his own personal records revealed the

following transactions during the current year:

1. Sale of one of 50 apartment buildings that one of their partnerships owns:

$50,000 gain (ignore depreciation)

2. Sale of restaurant equipment: $20,000 loss

17–13SECTION 1231


Assuming both assets have been held for several years, how should Bill and

Betty report these transactions on their current year return?

Answer. Under § 1231, the taxpayer generally nets gains and losses from the sale of

§ 1231 property. If a net gain results, the gain is treated as a long-term capital gain, while a

net loss is treated as an ordinary loss. For this purpose, § 1231 property generally includes

real or depreciable property used in a trade or business. In this case, both the apartment

complex and the restaurant equipment are § 1231 property and both are in the 15 percent

group. As a result, the couple should net the gain and loss and report a 15 percent capital

gain of $30,000.

b. The couple’s records for the following year revealed several gains and losses:

1. Office building burned down: $20,000 loss

2. Crane for bungee jumping business stolen: $35,000 gain (assume no depre-

ciation had been claimed)

3. Parking lot sold: $14,000 loss

4. Exxon stock sold: long-term capital loss of $10,000

5. Condemnation of Greensboro land held for use in the business: $15,000

gain.

Assuming each of the assets was held for several years, determine how much

15 percent capital gain or loss as well as the amount of ordinary income or loss

that Bill and Betty will report for the year.

Answer. The § 1231 netting process requires the taxpayer to separate § 1231 casualty

gains and losses from other § 1231 transactions (sometimes referred to as regular § 1231

items). The casualty loss on the office building and the casualty gain on the crane are both

considered § 1231 15 percent casualties since they involve § 1231 property (i.e., real or

depreciable property used in business). Note that the condemnation—even though it is an

involuntary conversion—is not treated as a § 1231 casualty. The casualty items are netted

to determine whether there is a net gain or loss. Here, there is a net casualty 15 percent

gain of $15,000 ($35,000 � $20,000). This net gain is then combined with any ‘‘regular’’

§ 1231 items, in this case the $14,000 loss on the sale of the parking lot (real property

used in a business) and the $15,000 gain on the condemnation of the land (a capital asset).

Note that both ‘‘regular’’ § 1231 items are also in the 15 percent group. After netting

these items, the partnership has a net gain of $16,000. This $16,000 net § 1231 gain is

treated as a 15 percent capital gain and is combined with $10,000 15 percent capital loss

on the sale of the stock. The end result is a $6,000 15 percent capital gain. This process

can be summarized as follows (see also Exhibit 17-3):



c. Same as in (b), except Bill and Betty reported a net § 1231 loss of $3,000 in the

previous year.

Answer. In this case, the look-back rule applies, causing $3,000 of the net 15 percent

§ 1231 gain to be treated as ordinary income. As a result, the couple’s 15 percent capital

gain from the § 1231 netting process is $13,000 and their net 15 percent capital gain is

only $3,000.

DEPRECIATION RECAPTURE

HISTORICAL PERSPECTIVE

For many years, taxpayers have taken advantage of the interaction of § 1231 and the

depreciation rules to secure significant tax savings. Prior to 1962 there were no

substantial statutory restrictions on the depreciation methods that could be adopted.

Consequently, a taxpayer could quickly recover the basis of a depreciable asset by

selecting a rapid depreciation method such as declining balance and using a short useful

life. If the property’s value did not decline as quickly as its basis was being reduced by

depreciation deductions, a gain was ensured if the property was disposed of at a later date.

The end result could be quite beneficial.

Example 7. During the current year T purchased equipment for $1 million. After

two years, T, using favorable depreciation rules, had claimed and deducted

$600,000 of depreciation, leaving a basis of $400,000. Assume that the property did

not truly depreciate in value and T was able to sell it in the third year for its original

cost of $1 million. In such case T would report a gain of $600,000 ($1,000,000 �$400,000). Except for time value of money considerations, it appears that the

$600,000 gain and the $600,000 of depreciation are simply a wash. However, the

depreciation reduced ordinary income that would be taxed at ordinary rates while

the gain would be a § 1231 gain and taxed at capital gain rates. As an illustration of

the savings that could be achieved, assume that the law at this time provided for a

top capital gain rate of 20% and the taxpayer’s ordinary income was taxed at a 40%.

In this case the depreciation would offset ordinary income and provide tax savings

of $240,000, but the $600,000 gain on the sale would be treated as a capital gain

and produce a tax of only $120,000. Thus, even though the taxpayer has had no

17–15DEPRECIATION RECAPTURE


economic gain or loss with respect to the property—he bought and sold the

equipment for $1,000,000—he was able to secure a tax benefit of $120,000

($240,000 � $120,000).

The above example clearly illustrates how taxpayers used rapid depreciation and the

favorable treatment of § 1231 gains to effectively convert ordinary income into capital

gain. In fact, this strategy—deferring taxes with quick depreciation write-offs at ordinary

rates and giving them back later at capital gains rates—was the foundation of many tax

shelter schemes.

Legislation to limit these benefits came in a number of forms, but the most important

was the enactment of the so-called depreciation recapture rules. These rules strike right at

the heart of the problem, generally treating all or some portion of any gain recognized as

ordinary income, based on the amount of depreciation previously deducted. Thus, in the

above example, the taxpayer’s $600,000 gain, which was initially characterized as a

§ 1231 gain, is treated as ordinary income because of the $600,000 of depreciation

previously claimed. In this way, all of the tax savings initially given away by virtue of the

ordinary depreciation deductions are recaptured. Unfortunately, much like § 1231 in

general, the recapture rules can become quite complex. The operations of the specific

provisions are discussed below.

WHEN APPLICABLE

Before specific recapture rules are examined, there are two very important points to

keep in mind. First, depreciable assets held for one year or less do not qualify for § 1231

treatment. Thus, any gain from the disposition of such assets is always reported as

ordinary income. Second, the depreciation recapture rules do not apply if property is

disposed of at a loss. Remember that losses from the sale or exchange of depreciable

assets are treated as § 1231 losses if the property is held more than a year. In addition,

casualty or theft losses of such property are included in the § 1231 netting process. Any

loss from a depreciable asset held one year or less is an ordinary loss regardless of

whether it was sold, exchanged, stolen, or destroyed.

TYPES OF DEPRECIATION RECAPTURE

There are essentially three depreciation recapture provisions in the Code. These are

1. Section 1245 Recapture—commonly called the full recapture rule, and

applicable primarily to depreciable personalty (rather than realty)

2. Section 1250 Recapture—commonly called the partial recapture rule, and

applicable to most depreciable realty if a method of depreciation other than

straight-line was used

3. Section 291 Recapture—commonly called the additional recapture rule, and

applicable only to corporate taxpayers

Each of these recapture rules is discussed below.

FULL RECAPTURE—§ 1245

The recapture concept was first introduced with the enactment of § 1245 by the

Revenue Act of 1962. Section 1245 generally requires any gain recognized to be

reported as ordinary income to the extent of any depreciation allowed on § 1245

property after 1961.



Definition of § 1245 Property. The recapture of depreciation under § 1245 applies

only to § 1245 property, normally depreciable personal property.19 Because the definition

of personal property itself is so broad, § 1245 generally covers a wide variety of

depreciable assets such as:

" Machinery and equipment used in production of goods and services" Office furniture and equipment" Automobiles, vans, trucks, and other transportation equipment" Livestock used for breeding or production" Intangibles such as patents, copyrights, trademarks, and goodwill that have been

amortized under § 197 or otherwise.

Essentially the amortization is treated the same as depreciation, just like any portion of

the cost of a depreciable asset that is expensed under § 179 is treated as depreciation

allowed.20 It is important to understand that § 1245 applies only if the property is

depreciable or amortizable. Consequently, it pertains only to property that is used in a

trade or business and property held for the production of income. For example, livestock

that are considered inventory are not subject to depreciation and are therefore not

§ 1245 property, although any gain or loss from the disposition of inventory is ordinary

income.

Although the above definition is usually sufficient, § 1245 property actually includes

a number of other assets besides depreciable personalty, including the following:21

1. Property used as an integral part of manufacturing, production, or extraction, or

in furnishing transportation, communications, electrical energy, gas, water, or

sewage disposal services.

a. However, any portion of a building or its structural components is not

included.b. A research facility or a facility for the bulk storage of commodities related to

an activity listed above is included.

2. A single-purpose agricultural or horticultural structure (e.g., greenhouses).

3. A storage structure used in connection with the distribution of petroleum or any

primary product of petroleum (e.g., oil tank).

4. Any railroad grading or tunnel bore.

5. Certain other property that is subject to a special provision allowing current

deductibility or rapid amortization (e.g., pollution control facilities and railroad

rolling stock).

Operation of § 1245. Section 1245 generally requires any gain recognized to be

treated as ordinary income to the extent of any depreciation allowed.22 To state the rule in

another way: any gain on the disposition of § 1245 property is ordinary income to the

extent of the lesser of the gain recognized or the § 1245 recapture potential, generally

the depreciation claimed and deducted. Although both statements say the same thing,

19 § 1245(a)(3).

20 See § 197(f)(7) for intangibles and § 1245(a)(3)(D) for expensed property and certain other properties

subject to unique expensing rules.

21 The definition parallels that of § 38 property, which qualified for the investment tax credit. § 48(a)(1).

22 § 1245(a).



the latter helps focus attention on two points and eliminates some misconceptions. First,

a taxpayer is never required to report more income than the amount of gain realized

regardless of the amount of depreciation claimed and deducted (i.e., regardless of the

amount of recapture potential). For example, if the taxpayer realizes a gain of $10,000

and has deducted depreciation of $15,000, the taxpayer reports only $10,000 of income,

all of which would be ordinary. Note that the depreciation recapture rules do not affect

the amount of gain or loss, only the character of any gain to be recognized. Second,

using the term recapture potential helps emphasize that sometimes the amount that must

be recaptured may include more than mere depreciation.

Section 1245 recapture potential includes all depreciation or amortization allowed

(or allowable) with respect to a given property—regardless of the method of depreciation

used. This is why § 1245 is often called the full recapture rule. Recapture potential also

includes adjustments to basis related to items that are expensed (e.g., under § 179 expense

election) or where tax credits have been allowed under various sections of the Code.23

To summarize, determining the character of gain on the disposition of § 1245

property is generally a two-step process:

1. The gain is ordinary income to the extent of the lesser of the gain recognized or

the § 1245 recapture potential (all depreciation allowed or allowable).

2. Any recognized gain in excess of the recapture potential retains its original char-

acter, usually § 1231 gain.

Recall that there is no § 1245 depreciation recapture when a property is sold at a loss, so

any loss is normally a § 1231 loss.

Example 8. T owned a printing press that he used in his business. Its cost was $6,800

and T deducted depreciation in the amount of $3,200 during the three years he owned

the press. T sold the press for $4,000 and his realized and recognized gain is $400

($4,000 sales price � $3,600 adjusted basis). T’s recapture potential is $3,200, the

amount of depreciation taken on the property. Thus, the entire $400 gain is ordinary

income under § 1245.

Example 9. Assume the same facts as in Example 8, except that T sold his press for

$7,000. In this case, T’s realized and recognized gain would be $3,400 ($7,000 �$3,600). The ordinary income portion under § 1245 would be $3,200 (the amount of

the recapture potential), and the remaining $200 of the gain is a § 1231 gain. Note that

in order for any § 1231 gain to occur, the property must be sold for more than its

original cost since all of the depreciation is treated as ordinary income.

Example 10. Assume the same facts as in Example 8, except that the printing press is

sold for $3,000 instead of $4,000. In this case, T has a loss from the sale of $600

($3,000 � $3,600 adjusted basis). Because there is a loss, there is no depreciation

recapture. All of T’s loss is a § 1231 loss.

Exceptions and Limitations. In many ways, § 1245 operates much like the

proverbial troll under the bridge. It sits ready to spring on its victim whenever the proper

moment arises. Section 1245 generally applies whenever there is a transfer of property.

However, § 1245 does identify certain situations where it does not apply, most of which

23 See § 1245(a)(2) for a listing of these adjustments and their related Code sections, including the basis

adjustment related to the earned portion of any investment credit.



are nontaxable events. For example, there is no recapture on a transfer by gift or bequest

since both of these are nontaxable transfers.24

In involuntary conversions and like-kind exchanges, the depreciation recapture under

§ 1245 is limited to the gain recognized.25 Similarly, in nontaxable business adjustments

such as the formation of partnerships, transfers to controlled corporations, and certain

corporate reorganizations, § 1245 recapture is limited to the gain recognized under the

controlling provisions.26 In any situation where recapture is not triggered, it is generally

not lost but carried over in some fashion.

PARTIAL RECAPTURE—§ 1250

As originally enacted in 1961, the concept of recapture as set forth in § 1245

generally applied only to personalty. Gains derived from dealing in realty were not

subject to recapture. In 1963, however, Congress eliminated this omission by enacting

§ 1250, a special recapture provision that applied to most buildings. Since that time

§ 1245 has generally been associated with depreciation recapture for personal property

while § 1250 served that role for buildings. Although the two provisions are similar,

§ 1250 is far less damaging. Specifically, § 1250 calls for the recapture of only a

portion of any accelerated depreciation allowed with respect to § 1250 property. Note

that while §§ 1250 and 1245 are essentially the same—they both convert potential

capital gain into ordinary income—§ 1250 differs from § 1245 in several important

ways: (1) it applies only if an accelerated method is used; (2) it does not require

recapture of all the depreciation deducted but only a portion—generally only the excessof accelerated depreciation over what straight-line would have been; and (3) it applies

to a different type of property, buildings and their components, rather than personal

property. Each of these aspects is considered below.

Section 1250 Property. Section 1250 property is generally any real property that is

depreciable and is not covered by § 1245.27 For the most part, § 1250 applies to all of the

common forms of real estate such as office buildings, warehouses, apartment complexes,

and low-income housing. As explained earlier, however, nonresidential real estate (e.g.,

warehouse and office buildings) placed in service after 1980 and before 1987 for which

an accelerated method was used is covered by the full recapture rule of § 1245.28

Depreciation of Real Property. Section 1250 applies only if an accelerated method

of depreciation is used. If the straight-line depreciation method is used, § 1250 does not

apply and there is no depreciation recapture for noncorporate taxpayers.29 For this reason,

a critical first step in determining the relevance of § 1250 is determining how the taxpayer

has depreciated the realty.

For many years, taxpayers could choose to use either an accelerated or straight-line

method to compute depreciation for realty. This was an extremely important decision,

for it affected not only the amount of depreciation the taxpayer claimed but also the

24 §§ 1245(b)(1) and (2). Recapture of depreciation under § 1245 is required, however, to the extent § 691

applies (relating to income in respect to a decedent).

25 § 1245(b)(4).

26 § 1245(b)(3). See Chapter 19 for further discussion of nontaxable business adjustments.

27 § 1250(c).

28 It is important to note, however, that such properties are § 1250 property if the optional straight-line method is

used. § 1245(a)(5).

29 As explained within, corporate taxpayers are still required to recapture 20 percent of any straight-line depreci-

ation under § 291. Also, any unrecaptured straight-line depreciation is taxed at a maximum rate of

25 percent.



character of any gain on a subsequent disposition of the property. For example, a taxpayer

could accelerate depreciation deductions but only at the possible expense of recapture.

Alternatively, the taxpayer could accept the slower-paced straight-line method and

avoid the § 1250 recapture rules. But the Tax Reform Act of 1986 ended this flexibility

and at the same time simplified the law. Taxpayers who place realty in service after1986 must use the straight-line method. As a result, § 1250 does not apply to property

acquired after 1986. However, much of the existing inventory of real property was

acquired before 1987 and may therefore be subject to § 1250, depending on the

depreciation method used.

Realty Placed in Service from 1981 through 1986. For real property acquired

between 1981 and the end of 1986, the taxpayer could either use the accelerated

depreciation method allowed under ACRS or elect an optional straight-line method. Of

course, a taxpayer would normally select the accelerated method. In fact, that was the

normal recommendation with respect to residential property. However, with respect to

nonresidential property, electing to use the accelerated method resulted in the property

that would normally be § 1250 property being classified as § 1245 property—subject to

full, rather than partial, recapture.

Realty Placed in Service before 1981. All depreciable real property acquired before

1981 is classified as § 1250 property. For such property acquired before 1981 (non-ACRS

property), taxpayers were required to estimate useful lives and salvage values. Although

various methods could be used, the annual deduction (during the first two-thirds of the

useful life) generally could not exceed that arrived at by using the following maximum

rates and methods:30

Maximum Allowable DeductionType of Property Method/Rate

New residential real estate Declining-balance using 200% of the straight-line rate

Used residential real estate:

If estimated useful life at least 20 years Declining-balance using 125% of the straight-line rate

If estimated useful life less than 20 years Straight-line

New nonresidential real estate Declining-balance using 150% of the straight-line rate

Used nonresidential real estate: Straight-line

Operation of § 1250. The two critical factors in determining the amount, if any, of

§ 1250 recapture are the gain realized and the amount of excess depreciation. Excess

depreciation refers to depreciation deductions in excess of that which would be deductible

using the straight-line method. For property held one year or less, all depreciation is

considered excess depreciation.31

As a general rule, § 1250 requires recapture of the excess depreciation, that is,

the excess of accelerated over straight-line. Consequently, even if the taxpayer uses an

accelerated method to compute the amount of depreciation deducted on the return,

the hypothetical amount of straight-line depreciation must still be computed in order

to determine the excess of accelerated over straight-line when the property is sold. In

determining the hypothetical amount of straight-line depreciation, the taxpayer uses

the same life and salvage value, if any, that were used in computing accelerated

depreciation.32 Because of this approach, a taxpayer who uses the straight-line method

30 § 167(j).

31 § 1250(b).

32 § 1250(b)(5).



would have no excess depreciation and no recapture. Because the § 1250 recapture rule

applies only to any excess depreciation claimed by a taxpayer, it is sometimes referred

to as the partial recapture rule. However, it should be emphasized that beginning in

1997, the unrecaptured § 1250 depreciation (e.g., the straight-line depreciation) on

§ 1250 property held more than 12 months is subject to a special 25 percent tax rate

(assuming it survives the § 1231 netting process).

Determining the taxation of any gain recognized on the disposition of § 1250 property

is a three-step process:

1. The gain is ordinary income to the extent of the lesser of the gain recognized or

the § 1250 recapture potential (generally the excess depreciation allowed).33

2. Any recognized gain in excess of the recapture potential is usually treated as

§ 1231 gain.

3. Any gain recognized on § 1250 property held more than 12 months that is due to

depreciation that is not recaptured and which survives the applicable netting

processes is taxed at a maximum rate of 25 percent to the extent of any

unrecaptured depreciation. Any additional gain is generally 15 percent gain.

There is no § 1250 depreciation recapture when a property is sold at a loss, so any loss is

normally a § 1231 loss.

Unrecaptured § 1250 Gain. As may be apparent from step 3 above, under § 1250,

taxpayers are required to recapture depreciation only if an accelerated method is used to

depreciate the property. Consequently, individual taxpayers never recapture depreciation

on § 1250 property if the straight-line method is used. Without some special rule, any gain

attributable to straight-line depreciation for § 1250 property held more than 12 months

would normally qualify for taxation at a 15 percent rate. However, Congress felt this

treatment was too generous and created a special rule for unrecaptured § 1250 gain. The

unrecaptured § 1250 gain is the lesser of (1) the gain recognized, or (2) the depreciation

allowed after each (the gain recognized and the depreciation allowed) is reduced by any

§ 1250 recapture. The resulting amount will equal the amount of straight-line depreciation

that was claimed or would have been claimed had the straight-line method been used (or,

if less, the gain recognized minus the § 1250 recapture).

Example 11. About 10 years ago, F purchased some residential rental property for

$100,000. This year he sold the property for $110,000. He had claimed straight-line

depreciation of $30,000 over this time, resulting in a basis of $70,000 (do not attempt

to verify this amount). As a result, F recognized a gain of $40,000. Since the property

is realty and a straight-line depreciation method was used there is no § 1250

recapture. Consequently, the entire gain is a § 1231 gain. However, the § 1231 gain

will be treated as a 25% gain to the extent of any straight-line depreciation claimed.

Therefore, $30,000 of the gain is a 25% § 1231 gain while $10,000 is a 15% § 1231

gain (i.e., in the capital gain netting process these will be 15% and 25% long-term

gains, respectively). If F had sold the property for $90,000, he would have had a gain

of $20,000, all of which would have been a 25% gain (i.e., the lesser of the gain

realized, $20,000, or the unrecaptured straight-line depreciation, $30,000).

Example 12. Same facts and $110,000 sales price from Example 11 above, except

that F also has a $400 gain on the sale of K Corporation stock held 26 months. F is

33 See § 1250(a) and discussion following dealing with recapture of only a portion of the excess depreciation for

certain properties.



single and has taxable income, excluding these transactions, of $76,000. F’s tax

would be computed as follows (using the 2006 tax rates for single taxpayers):

Regular tax on $76,000:

Tax on $74,200 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,108

Tax on excess at 28%

[($76,000 � $74,200¼ $1,800)� 28%] . . . . . . . . . . . . 1,504

$15,612

Tax on 15% gains (15%� $10,400) . . . . . . . . . . . . . . . . . . . . . . . 1,560

Tax on 25% gains (25%� $30,000) . . . . . . . . . . . . . . . . . . . . . . . 7,500

Total tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $24,672

Combined Results. The net gain from the disposition of § 1250 property can be

treated as ordinary income subject to the regular tax rate, 15 percent capital gain, and/or

25 percent capital gain (and rarely 28 percent capital gain). Each step in the netting and

tax calculation processes has been covered. 13 through Example 16 and ComprehensiveExample 18 illustrate how they work in combination.

Example 13. During the current year, L sold a small office building for $38,000. The

building had cost her $22,000 in 1980, and she had deducted depreciation of $12,000

using an accelerated method. Straight-line depreciation would have been $10,600. L’s

gain recognized on the sale is $28,000 ($38,000 amount realized � $10,000 adjusted

basis). Of that amount, $1,400 ($12,000 � $10,600 ¼ $1,400 excess depreciation) is

ordinary income under § 1250 and the remainder, $26,600, is § 1231 gain. Of the

$26,600 § 1231 gain, the unrecaptured depreciation of $10,600 is a 25% gain. The

$16,000 excess of the amount realized over the original basis is 15% gain.

Example 14. M purchased a rental duplex during 1986 for $60,000. He deducted

$36,500 depreciation using the 19-year realty ACRS tables. Depreciation using the

straight-line recovery percentages for 19-year realty would have resulted in total

depreciation of $31,440.

On January 3, 2006 M sold the property for $87,000. His gain is reported as

follows:

Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $87,000

Less: Adjusted basis

Cost. . . . . . . . . . . . . . . . . . . $60,000

Depreciation (accelerated) (36,500) (23,500)

Gain to be recognized. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $63,500

Accelerated depreciation claimed and deducted . . . . . . . . . . . . $36,500

Straight-line depreciation (hypothetical) . . . . . . . . . . . . . . . . . . . (31,440)

Excess depreciation subject to recapture . . . . . . . . . . . . . . . . . . $ 5,060

Character of gain: . . . . . . . . . . . .

Ordinary income (partial recapture) . . . . . . . . . . . . . . . . . . $ 5,060

§ 1231 gain subject to 25% rate . . . . . . . . . . . . . . . . . . . . . 31,440

§ 1231 gain subject to 15% rate . . . . . . . . . . . . . . . . . . . . . 27,000

Total gain recognized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $63,500



Note that without a special rule, the gain not recaptured under § 1250 might be

subject to the 15% capital gains rate. However, the balance of the depreciation that

has not been recaptured $31,440 ($36,500 � $5,060) is carved out and is considered a

25% § 1231 gain. Also observe that the $31,440 of 25% § 1231 gain is the amount of

straight-line depreciation. The remaining gain (i.e., the amount above the original

cost) of $27,000 is a 15% § 1231 gain.

Example 15. Assume the same facts as in Example 14, except that M elected to

recover his basis in the duplex using the 19-year straight-line method. Consequently

she recognizes gain of $58,440 computed as follows:

Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $87,000


Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,000

Depreciation (straight-line) . . . . . . . . . . . . . (31,440)

(28,560)

Gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(58,440)

None of the gain is subject to § 1250 recapture since M used straight-line depreciation

(a requirement after 1986). However, the amount representing the unrecaptured

depreciation (i.e., the straight-line depreciation) of $31,440 is considered a 25%

§ 1231 gain and the $27,000 balance is considered a 15% § 1231 gain.

Example 16. Assume the same facts as in Example 14, except that the property is an

office building rather than a duplex. In this case, because the property is nonresidential

real property and the accelerated method was used, the asset is treated as § 1245

property rather than § 1250 property. Thus, M is subject to full rather than partial

depreciation recapture. All of the $36,500 depreciation is recaptured and treated as

ordinary income. The balance of the gain, $27,000 is treated as a 15% § 1231 gain.

History of § 1250. Over the years, § 1250 has been changed frequently, with a

general trend toward an expanded scope. The rules explained above apply only to

depreciation allowed on nonresidential property after 1969 and residential property (other

than low-income housing) after 1975. Only a portion of any other excess depreciation on

§ 1250 property is included in the recapture potential. The following percentages are

applied to the gain realized in the transaction or the excess depreciation taken during the

particular period, whichever is less:

1. For all excess depreciation taken after 1963 and before 1970, 100 percent less 1

percent for each full month over 20 months the property is held.34 Any sales after

1979 would result in no recapture of pre-1970 excess depreciation since this

percentage, when calculated, is zero.

2. For all excess depreciation taken after 1969 and before 1976, as follows:

a. In the case of low-income housing, 100 percent less 1 percent for each full

month the property is held over 20 months.

b. In the case of other residential rental property (e.g., an apartment building)

and property that has been rehabilitated [for purposes of § 167(k)],

100 percent less 1 percent for each full month the property is held over

100 months.35

34 § 1250(a)(3).

35 § 1250(a)(2).



All sales from this group of real property after August 1992 will have no recapture of

excess depreciation claimed before 1976.

3. For excess depreciation taken after 1975 on low-income housing and property

that has been rehabilitated [for purposes of § 167(k)], 100 percent less 1 percent

for each full month the property is held over 100 months.36

In summary, 100 percent of the excess depreciation allowed with respect to § 1250

property after 1975 is subject to recapture unless it falls into one of the above categories.

Any gain recognized to the extent of any unrecaptured depreciation will be considered

25% gain. The rules for the various categories are provided in § 1250(a).

Exceptions and Limitations under § 1250. Generally, the exceptions and

limitations that apply under § 1245 also apply under § 1250. Thus, gifts, inheritances,

and most nontaxable exchanges are allowed to occur without triggering recapture.37 This

exception is extended to any property to the extent it qualifies as a principal residence

and is subject to deferral of gain under § 1034 or nonrecognition of gain under § 121.38

In such nontaxable exchanges, the excess depreciation (that is not recaptured) taken prior

to the nontaxable exchange on the property transferred carries over to the property

received or purchased.39 Similarly, in the case of gifts and certain nontaxable transfers in

which the property is transferred to a new owner with a carryover basis, the excess

depreciation carries over to the new owner.40 In the case of inheritances in which basis to

the successor in interest is determined under § 1014, no carryover of excess depreciation

occurs.41

Certain like-kind exchanges and involuntary conversions may result in the recognition

of gain solely because of § 1250 if insufficient § 1250 property is acquired. Since not all

real property is depreciable, it is possible that the replacement property would not be

§ 1250 property and would still qualify for nonrecognition under the appropriate rules of

§§ 1033 or 1034. In such situations, gain will be recognized to the extent the amount that

would be recaptured exceeds the fair market value of the § 1250 property received

(property purchased in the case of an involuntary conversion).42

Example 17. D completed a like-kind exchange in the current year in which he trans-

ferred an apartment complex (§ 1250 property) for rural farmland (not § 1250

property). The apartment had cost D $175,000 in 1980 and depreciation of $89,000

has been taken under the 200% declining-balance method. D would have deducted

$62,000 under the straight-line method.

The farm land was worth $200,000 at the time of the exchange. There were no

improvements on the farm property. D’s realized gain on the exchange is $114,000

($200,000 amount realized � $86,000 adjusted basis in property given up). If there

had been no § 1250 recapture, then D would have had no recognized gain. Because

the property acquired was not § 1250 property, § 1250 supersedes (overrides) § 1031.

D has a recognized gain of $27,000 [($89,000 � $62,000), the amount of excess

depreciation], which is all ordinary income under § 1250.

36 § 1250(a)(1).

37 §§ 1250(d)(1) through (d)(4).

38 § 1250(d)(7).

39 Reg. §§ 1.1250-3(d)(5) and (h)(4).

40 Reg. §§ 1.1250-3(a), (c), and (f).

41 Reg. § 1.1250-3(b).

42 § 1250(d)(4)(C). A similar rule is provided for rollovers (deferral) of gains from low-income housing under §

1039 [see § 1250(d)(8)].



Exhibit 17-2 provides an overview of the handling of sales and exchanges of business

property. Exhibit 17-3 provides a chart that may be useful in summarizing property

transactions. Note that for purposes of this Exhibit 17-3, no distinction is made between

15%, 25% and 28% § 1231 gains and losses or 15%, 25% and 28% capital gains and

losses. A comprehensive example of sales and exchanges of trade or business property is

presented below.

Example 18. Ted and Carol Smith sold the following assets during the current year:

DescriptionHoldingPeriod

SellingPrice

AdjustedBasis

RecognizedGain (Loss)

Land and building

(straight-line depreciation) 3 years $14,000 $9,000 $5,000

Cost, $13,000

Depreciation allowed, $4,000

Photocopier 14 months 2,600 2,000 600

Cost, $2,500

Depreciation allowed, $500

Business auto 2 years 1,800 1,920 (120)

Cost, $4,000

Depreciation allowed, $2,080

In determining the tax consequences of these sales, the Smiths must start with gains

and losses from § 1231 transactions. The ultimate treatment of the gains, the character

of the gain and any possible depreciation recapture must be considered.

" On the sale of the land and the building, there is no depreciation recapture for

the building since straight-line depreciation was used. However, there is

unrecaptured depreciation of $4,000 which is accounted for as a 25% § 1231

gain. The balance of the gain on the land and building, $1,000, is a 15% § 1231

gain.

EXHIBIT 17-2

Stepwise Approach to Sales or Exchange of Trade or

Business Property—An Overview

Step 1: Calculate any depreciation recapture on the disposition of § 1245 property and § 1250

property sold or exchanged at a taxable gain during the year.

Step 2: For any remaining gain (after recapture) on depreciable property held for more than one year,

add to other § 1231 gains and losses and complete the § 1231 netting process.

" The § 1231 gain must be broken down into the portions that qualify as 15%CG and

25%CG (and rarely 28%CG).

Step 3: Complete the netting process for capital assets, taking into consideration the net § 1231 gain,

if any.

" The § 1231 gain is combined with other long-term capital gains and losses (with

separate netting for 15%CG, 25%CG, and 28%CG. Then the long-term capital gain or

loss is combined with the short-term capital gain or loss.



" On the sale of the photocopier, $500 of the § 1231 gain of $600 is recaptured

and treated as ordinary income. The balance of the gain, $100, is a 15%

§ 1231 gain.

" On the sale of the automobile, there is no recapture since it is sold at a loss.

The $120 loss is treated as a 15% § 1231 loss. This information can be

summarized as follows:

Section 1231 Gains and Losses


28% 25% 15%

Land and building . . . . . . . . . . . . . . $0 $4,000

$1,000Photocopier . . . . . . . . . . . . . . . . . . .

100Automobile . . . . . . . . . . . . . . . . . . . .

(120)Capital gains from § 1231. . . . . . . . $0 $4,000

$ 980

In this situation, the Smiths net the various groups, resulting in net gains in each of

the groups as shown above. These amounts are then combined with the appropriate

capital gain groups to determine the final treatment. Note that if the Smiths had

unrecaptured § 1231 losses, they would first offset the 28% gains, then 25% gains,

and finally 15% gains. The information is summarized in Exhibit 17-3.



Example 19. Assume that the Smiths, from the previous example, had the following

capital asset transactions during the same year:

DescriptionHoldingPeriod

SellingPrice

AdjustedBasis

Description ofGain or (Loss)

100 shares XY Corp. 4 months $ 3,200 $4,200 $(1,000) STCL

100 shares GB Corp. 3 years 3,200 4,600 (1,400) LTCL

1 acre vacant land 5 years 12,000 5,000 7,000 LTCG

EXHIBIT 17-3

Summary of Property Transactions



Taking into consideration the § 1231 gains from Example 18, the Smith’s summarize

their transactions as follows.

Short-Term Capital Gains and Losses


Ordinary 28% 25% 15%

Capital gains from § 1231. . . . . . . . $0 $4,000 $ 980

XY stock loss . . . . . . . . . . . . . . . . . . (1,000)

GB stock loss . . . . . . . . . . . . . . . . . . (1,400)

Vacant land gain . . . . . . . . . . . . . . . 7,000

$(1,000) $0 $4,000 $6,580

Netting . . . . . . . . . . . . . . . . . . . . . . . 1,000 (1,000)

Total . . . . . . . . . . . . . . . . . . . . . . . . . $ 0 $0 $3,000 $6,580

Ted and Carol Smith would report a $3,000 N25CG and a $6,580 N15CG.

A Form 4797 and Schedule D containing the information from Examples 18 and 19are included in Exhibit 17-4 which follows. In using the forms, it should be pointed out

that neither the Form 4797 nor Schedule D Parts I, II, and III (i.e., the form for reporting

capital gains and losses) require the taxpayer to distinguish 25% gains from 28% or 15%

gains. The 25% distinction comes into play only when the taxpayer computes the tax as

can be seen on Schedule D, Part IV, Lines 25 and 47. The tax is computed assuming the

taxpayers have taxable income of $126,830 (including the capital gains).

ADDITIONAL RECAPTURE—CORPORATIONS

Corporations generally compute the amount of § 1245 and § 1250 ordinary income

recapture on the sales of depreciable assets in the same manner as do individuals.

However, Congress added Code § 291 to the tax law in 1982 with the intent of reducing

the tax benefits of the accelerated cost recovery of depreciable § 1250 property

available to corporate taxpayers. For sales or other taxable dispositions of § 1250

property, corporations must treat as ordinary income 20 percent of any § 1231 gain

that would have been ordinary income if § 1245 rather than § 1250 had applied to

the transaction.43 The effect of this provision is to require the taxpayer to recapture

20 percent of any straight-line depreciation that has not been recaptured under some

other provision. Technically, the amount that is treated as ordinary income under § 291

is computed in the following manner:

Amount that would be treated as ordinary income under § 1245 . . . . . . . . . $xx,xxx)

Less: Amount that would be treated as ordinary income § 1250. . . . . . . (x,xxx)

Equals: Difference between recapture amounts . . . . . . . . . . . . . . . . . . . . . . $xx,xxx)

Times: Rate specified in § 291 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . � 20%

Equals: Amount that is treated as ordinary income . . . . . . . . . . . . . . . . . . . . $xx,xxx)

43 § 291(a)(1).



Example 20. This year K Corporation sold residential rental property for $500,000.

The property was purchased for $400,000 in 1986. Assume that K claimed ACRS

depreciation of $140,000 (i.e., do not attempt to verify this estimate). Straight-line

depreciation would have been $105,000. K Corporation’s depreciation recapture and

§ 1231 gain are computed as follows:

Step 1: Compute realized gain:

Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $500,000


Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $400,000

ACRS depreciation . . . . . . . . . . . . . . . . . . . (140,000) (260,000)

Realized gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $240,000

Step 2: Compute excess depreciation:

Actual depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000

Straight-line depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (105,000)

Excess depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,000

Step 3: Compute § 1250 depreciation recapture:

Lesser of realized gain of $240,000

or

Excess depreciation of $35,000

§ 1250 depreciation recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,000

Step 4: Compute depreciation recapture if § 1245 applied:

Lesser of realized gain of $240,000

or

Actual depreciation of $140,000

Depreciation recapture if § 1245 applied . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000

Step 5: Compute § 291 ordinary income:

Depreciation recapture if § 1245 applied . . . . . . . . . . . . . . . . . . . . . . . . . . $140,000

§ 1250 depreciation recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (35,000)

Excess recapture potential . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $105,000

Times: § 291 rate � 20%

§ 291 ordinary income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 21,000

Step 6: Characterize recognized gain:

§ 1250 depreciation recapture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,000

Plus: § 291 ordinary income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000

Ordinary income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 56,000

Realized gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $240,000

Less: Ordinary income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (56,000)

§ 1231 gain. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $184,000

Note that without the additional recapture required under § 291, K Corporation

would have reported a § 1231 gain of $205,000 ($240,000 total gain � $35,000

§ 1250 recapture). If the property had been subject to § 1245 recapture, K

Corporation would have only a $100,000 § 1231 gain ($240,000 � $140,000 § 1245

recapture). Section 291 requires that the corporation report 20% of this difference

($205,000 � $100,000 ¼ $105,000 � 20%), or $21,000, as additional recapture.



Note that this is 20% of the straight-line depreciation that is normally not recaptured

on the disposition of nonresidential or residential real estate.

Example 21. Assume the same facts as in Example 20, except that the property is

an office building rather than residential realty and straight-line depreciation

was elected. An individual taxpayer would report the entire gain of $205,000

[$500,000 � ($400,000 basis � $105,000 straight-line depreciation)] as a § 1231

gain. However, the corporate taxpayer must recapture $21,000 (20% � $105,000

depreciation) as ordinary income under § 291. The remaining $184,000 ($205,000 �$21,000) would be a § 1231 gain.

OTHER RECAPTURE PROVISIONS

There are several other recapture provisions that exist. They include the recapture of

farmland expenditures,44 recapture of intangible drilling costs,45 and recapture of gain

from the disposition of § 126 property (relating to government cost-sharing program

payments for conservation purposes).46 Another type of recapture is investment credit

recapture.47 This is discussed in detail in Chapter 13.


Review Question 1. True-False. This year T sold equipment for $6,000 (cost

$15,000, depreciation $10,000), recognizing a gain of $1,000 ($6,000 � $5,000). To

ensure that all of the ordinary deductions obtained from depreciation are recaptured, T

must report ordinary income of $10,000 and a capital loss of $9,000, ultimately producing

net income of $1,000.

False. This novel approach may seem consistent with Congressional intent, but it is

incorrect. Under § 1245 any gain realized is treated as ordinary income to the extent of

any depreciation allowed. As a result, the entire $1,000 is ordinary income. It may be

useful to think of the depreciation recapture as an adjustment to the depreciation claimed.

Depreciation of $10,000 was claimed, but the value of the equipment dropped by $9,000

($15,000 cost � $6,000 sales price). T claimed an ordinary depreciation deduction of

$10,000, and recognized ordinary income of $1,000, for a net ordinary deduction of

$9,000.

Review Question 2. True-False. This year L sold a machine and recognized a small

gain. Assuming L claimed straight-line depreciation, there is no depreciation recapture.

False. The machine is § 1245 property since it is depreciable personalty. Under the full

recapture rule of § 1245, all depreciation is subject to recapture regardless of the method

used.

Review Question 3. Several years ago Harry purchased equipment at a cost of

$10,000. Over the past three years he claimed and deducted depreciation of $6,000.

Assuming that Harry sold the equipment for (1) $7,000, (2) $13,000, or (3) $1,000,

determine the amount of gain or loss realized and its character (i.e., ordinary income or

§ 1231 potential capital gain).

44 § 1252.

45 § 1254.

46 § 1255.

47 § 47.



1 2 3

Amount realized. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,000 $13,000 $ 1,000

Adjusted basis ($10,000 � $6,000) . . . . . . . . . . . . . . . . . � 4,000 � 4,000 � 4,000

Gain (loss) recognized . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,000 $ 9,000 $(3,000)

The equipment is § 1245 property since it is depreciable personalty. As a result, the full

recapture rule operates and any gain recognized is ordinary income to the extent of any

depreciation deducted. In the first case, the entire $3,000 is ordinary income (the lesser

of the gain recognized, $3,000, or the recapture potential, $6,000). In the second

situation, $6,000 is ordinary income (the lesser of the gain recognized, $9,000, or the

recapture potential, $6,000) and $3,000 is § 1231 gain. In the final case, § 1245 does not

apply because the property is sold at a loss. Therefore, Harry has a § 1231 loss that is

potentially an ordinary loss. Its ultimate treatment depends on the outcome of the

§ 1231 netting process.

Review Question 4. True-False. In 1990 Sal purchased an office building to rent out.

This year she sold the building, recognizing a large gain. The entire gain is a

§ 1231 gain since there is no recapture under either § 1245 or § 1250.

True. The office build is § 1250 property. The recapture rules of § 1250 apply only

when the taxpayer uses an accelerated method, in which case the excess of accelerated

depreciation over straight-line is treated as ordinary income. However, since 1987

taxpayers have been required to use the straight-line method in computing depreciation

on real estate. As a result, § 1250 is inapplicable and Sal’s gain retains its original

§ 1231 character. Nevertheless, the gain will not be treated as a 15 percent gain to the

extent of any unrecaptured § 1250 depreciation (i.e., all of the straight-line depreciation)

but rather 25 percent gain.

Review Question 5. True-False. In 1992 Z Corporation purchased an office

building to rent out. This year the corporation sold the building, recognizing a large

gain. The entire gain is a § 1231 gain since there is no recapture under either § 1245 or

§ 1250.

False. There is no recapture under § or § 1250. However, under § 291, corporate

taxpayers are required to recapture up to 20 percent of any straight-line depreciation.

The 25 percent rate does not apply to corporate taxpayers.

Review Question 6. True-False. In 1984 the Rose Partnership purchased a new

office building to use as its headquarters. This year the partnership sold the building,

recognizing a gain of $100,000. The partnership claimed and deducted accelerated

depreciation of $40,000. Straight-line depreciation would have been $15,000. The

partnership will report ordinary income of $25,000 and § 1231 gain of $75,000.

False. This would be true if the building were § 1250 property, but § 1250 does not

apply. Nonresidential real estate such as this office building that was acquired from 1981

through 1986 is treated as § 1245 property and is subject to the full recapture rule if accelerated

depreciation was used. In this case, the taxpayer opted for accelerated depreciation, so $40,000

is ordinary income and the remaining $60,000 is a 15% § 1231 gain.

Review Question 7.


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