the tax nucleus of gains and losses

The Tax Nucleus of Gains and LossesAuthor(s): Kevin M. MisiewiczSource: The Accounting Review, Vol. 53, No. 4 (Oct., 1978), pp. 979-984Published by: American Accounting AssociationStable URL: http://www.jstor.org/stable/246306 .

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THE ACCOUNTING REVIEW Vol. LIII, No. 4 October 1978

The Tax Nucleus of Gains and Losses

Kevin M. Misiewicz

ABSTRACT: Much of the complexity of our federal income tax laws is due to the intricate treatment of gains and losses upon dispositions of property. Flow charts and examples are employed here to delineate the tax nucleus of this area. They can be used to increase the comprehension of students, the efficiency and effectiveness of services provided by tax professionals, and the quality of tax decisions by lawmakers.

A large contribution to the complexity of our current federal income tax system is made by the provi-

sions concerning gains and losses incurred upon the disposition of property. In many cases this complexity leads to difficulty in applying the law to specific fact situations in tax compliance and tax planning. In others, it encourages incor- rect treatment due to negligence or ignorance. Consequently, it seems de- sirable to try to depict this important area to enhance the effectiveness of the efforts of educators, students, tax prac- titioners and lawmakers.

THE LAW

The provisions of the Internal Revenue Code which most directly involve gains and losses incurred by the disposition of assets are found in Subchapter 0 which is titled "Gain or Loss on Disposition of Property" and Subchapter P on "Capital Gains and Losses." They encompass Sections 1001 through 1254. Although even a cursory look at these provisions indicates a large number of special rules to be applied in very specific circum- stances, a basic pattern or nucleus also reveals itself. This nucleus is depicted by the combination of Figures 1, 2, and 3. Although the tax practitioner must still be aware of special rules, the nucleus information covers the majority of cases

and it provides a base for application of the narrower rules.

Figure 1 shows the alternative tax treatments available when property is disposed of resulting in realized gain or loss. Non-taxable exchanges, sales, taxable exchanges and involuntary conversions can result in no gain or loss recognized or either of two tax algorithms for gain or loss recognition.

The common property dispositions involve sale, taxable exchange, or involuntary conversion. Figure 2 traces the treatment to be accorded a common sale or taxable exchange eventually merging with the treatment of involuntary conversions shown in Figure 3.

EXAMPLE APPLICATIONS TO FACT SITUATIONS

An effective way to gain an understand- ing of this nucleus of gains and losses is to work through some examples of property disposition combinations.

The author gratefully acknowledges the comments of Anna C. Fowler, John L. Kramer and Theodore R. Saldin.

Kevin M. Misiewicz is Visiting Associ- ate Professor of Accountancy, University of Notre Dame, on leave from The Univer- sity of Texas at Austin.

Manuscript received November, 1977. Revision received January, 1978. Accepted February, 1978.

979



980 The Accounting Review, October 1978

FIGURE 1

NUCLEUS TREATMENT OF PROPERTY DISPOSITIONS WITH REALIZED GAIN OR Loss

Loss or Gain > Boot' No Recognized , Gain or Loss

Non-taxable Exchange'

Gain < Boot4/

Wash Salve'

Realized Gain or Sale or Taxable Exchange2 Installment Sale6 Loss IsaletSe'Recognized Gain or

Loss on Sale or Taxable Exchange

Other of Property7

Gain

| ~~~~~~~~Conversion into Similar Property l Loss Recognized Gain

,or Loss from Involuntary Conversion'.. Involuntary

.Conversion Into Dissimilar Property or Money Conversion'

'Sections 1031, 1032, and 1034-1040. Section 1091. 2 Section 61. 6 Section 453. 3 Section 1033. To Figure 2. 4 Section 1031. 8 To Figure 3.

Example 1: Assume a taxpayer only disposes of one item of property during the year- a share of corporate stock. It was pur- chased two years ago and sold for a $50 gain. Taking the $50 realized gain to Figure 1, this is a "sale or taxable exchange." Since it is not a "wash sale" nor an "installment sale," it is "other" and, therefore, a $50 "recognized gain or loss on sale or taxable exchange of property." This leads to Figure 2 where the transaction conditions are "capital asset," "gain," and "held more than one year." "Total gains and losses" is a net gain. Thus, we have net long-term capital gain of $50. Since "net long- term capital gain" ($50) is greater than "net short-term capital loss" ($0), we may apply the "capital gain deduction and/or alternative tax" to this $50 gain

which goes into ''gross income."

Example 2: Assume the taxpayer had also sold a family car at a $200 loss. Figure I indicates this is a $200 "recognized gain or loss on sale or taxable exchange of property." The Figure 2 transaction conditions for the auto would be "capital asset," "loss," and "personal purpose property." Therefore, the loss would be "not deductible."

Example 3: Assume the taxpayer had also sold a section of land bought as an invest- ment. The land which had been owned for eight months was sold for a $125 loss. Figure 1 shows a "recognized gain or loss on sale or taxable exchange of property" amounting to $25. The transaction conditions on Figure 2 for



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the land would be "capital asset," "loss," "income-producing purpose asset," and "held less than or equal to one year." This produces a "net short- term capital loss" of $125 which would be greater than the $50 "net long-term capital gain" from Example 1. The result would be a $75 "capital loss deduction" for adjusted gross income.

Example 4: Assume the taxpayer additionally had a $150 gain due to a taxable exchange involving a business desk which had been owned for four years. The desk had accumulated depreciation of $100 on a straight line basis. On Figure 1 this would produce a $150 "recognized gain or loss on sale or taxable exchange of property." The transaction conditions for the desk on Figure 2 would be ''non-capital asset,'' ''gain," "'held greater than one year," "real or depreciable property used in a trade or business," and "other property." The result would be "depreciation recapture" of $100 going directly into "gross income" and "net of recapture" of $50. This $50 would be "net gain for year" and, thus, be combined with the $50 gain from Example 1 to give a "net long-term capital gain" of $100. "Net short-term capital loss" of $125 (from Example 3) exceeds this "net long- term capital gain" by $25. This $25 would be a "capital loss deduction" for adjusted gross income.

Example 5: Assume the taxpayer had a loss of $500 due to a flood in a 10-year-old business building which had been originally constructed by the taxpayer. Straight line depreciation of $10,000 had been previously deducted. The Figure 1 cap- tions "involuntary conversion" and ''conversion into dissimilar property or money" apply. Thus, the $500 is

"recognized gain or loss from involuntary conversion." The transaction conditions for the building using Figure 3 would be "real or depreciable property used in a trade or business," "held greater than one year," "building or its structural components," "net of recapture" amounting to $500, and "net loss for year." This results in "losses" under "deductions for and/or from adjusted gross income," in this case, an ordinary deduction for adjusted gross income of $500.

Example 6: Assume the taxpayer had a gain of $600 from storm damage to a house which had been owned for three years. Figure 1 takes us through "involuntary conversion" and "conversion into dissimilar property or money" to "recognized gain or loss from involuntary conversion." The transaction conditions on Figure 3 for the house would be "capital asset" and "held greater than one year." This $600 gain and the $500 loss from Example 5 would be combined in "total gains and losses" producing a "net gain for the year" and "net gain from involuntary conversions' of $100 which would be combined in "total gains and losses" on Figure 2 with the Example 4 gain of $50 resulting in a "net gain for year" of $150. This $150 would be added in "total gains and losses" to the $50 gain from Example 1 to produce a $200 "net long-term capital gain." The Example 3 "net short-term capital loss" is $125. Thus, we have "net long-term capital gain" greater than "net short-term capital loss" by $75 which is eligible for the "capital gain deduction and/or alternative tax."

Thus, if all of the example transactions occur, we have: Ordinary gross income-$ 100 Example 4




Long-term capital gain-$ 75 Examples 1, 3, 4, 5 and 6

Non-deductible loss -$200 Example 2

EDUCATIONAL APPLICATION

These flow charts can be used peda- gogically to increase the comprehension of students in a tax area susceptible to confusion and low test scores. Educators will want to apply them as befits the needs of their particular students. Some may prefer to distribute them but not discuss them specifically. Others may want to use them for transparencies which can be revealed gradually as law segments are

covered in a lecture. Another possibility is to use them for lecture purposes and have problems assigned for the next class. In that next class, the homework can be discussed by distributing this article with charts to students, displaying transparencies, and using them to work the problems. Additional problems may be assigned for a subsequent class to require the students to apply the flow charts in order to resolve any questions they might have and to reinforce their previous efforts. Permitting use of the flow charts during exams may also be appropriate especially in tax classes for non-accounting majors.



the tax nucleus of gains and losses

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