Federal Income Taxation Lecture 14 Step-up in basis” rule If a person dies holding an asset, the new basis of the recipient becomes the date of death value of the assets! This is a major consideration in estate planning! This applies as long as the appreciated asset is part of the taxpayer’s gross taxable estate. Therefore, when one puts an appreciated asset in a trust or similar device, it often makes sense to intentionally draft the trust so as to keep the asset in the taxpayer’s estate especially when the taxpayer does not have an estate large enough to be subject to estate tax. Federal Income Taxation Lecture 14

Federal Income Taxation Lecture 14 What is a Capital Asset? A capital asset is generally something one buys for investment and not to conduct business with. Examples of things that are NOT capital assets: Inventory held for sale in the normal course of business Property used in the taxpayer’s trade or business Some copyrights and other intellectual property rights held for things like literary, musical or artistic works Accounts receivable and notes acquired in the course of business “Hedge” transactions Supplies used by the taxpayer in the ordinary course of business Federal Income Taxation Lecture 14

Distinguishing Between a Capital Asset and a Business Property Sometimes a person is running a side business of buying and selling property but running it almost like a full time occupation. How would one then distinguish between a job and a series of investments? Factors that tend to lead to a conclusion that proceeds are ordinary income and not capital gains include: Frequent or numerous turnover Significant capital improvements in the property Brokerage activities Advertising Short term resale Importance of the activity relative to overall income of the taxpayer Stock trades and transactions, no matter how frequent, are always considered capital gains (or losses) Federal Income Taxation Lecture 14

Depreciable Property and Capital Gains Section 1231 presents a very favorable rule in many cases. This is especially relevant to corporations who are more likely to own many depreciable assets. The rule states that a taxpayer recognizes gains and losses within a given year from all capital assets that are depreciable and owned by the taxpayer (including things like selling the property and depreciation), If the gains are more, they can be treated as capital gains! If the losses are more, they can be treated as ordinary losses! However, if a taxpayer takes a loss (such as through depreciation) and counts it as an ordinary income deduction; and within 5 years recognizes a gain, that gain must be recognized as ordinary income to the extent of the deduction previously taken. Federal Income Taxation Lecture 14

Depreciation Recapture Rule If a taxpayer takes a loss through depreciation and Later sells that property for a profit (based on the new adjusted basis), Then, the amount previously depreciated (up to the amount of the capital gain) must be treated as ordinary income. Any capital gain in excess of the depreciation is a capital gain only. This rule does not generally apply to real estate. Although, as discussed earlier, a capital gain from real estate is subject to the 25% capital gains rate to the extent that it constitutes not-recaptured depreciation. Federal Income Taxation Lecture 14

Depreciation Recapture- Example Mike buys Blackacre, an investment property, in 1990 for $250,000. Over the course of the next 18 years, he takes $150,000 worth of depreciation deductions. In 2008, he sells the property for $200,000. How much income would he realize? Answer: $100,000 - all at the 25% rate as unrecaptured depreciation In 2008, he sells the property for $350,000. How much income would he realize? $150,000 at the 25% rate and $100,000 at the 15% rate. Federal Income Taxation Lecture 14

Substitutes for Ordinary Income If a “sale” or transaction is deemed to not really be a sale of an asset but rather an attempt to shift ordinary income into capital gain, it will be treated as ordinary income. For example, if one “sells” the right to collect rents from a building without actually selling the building, the amount received is income, not a capital gain. Also, if one sells a right to receive what would otherwise have been his/her income, that’s counted as ordinary income. E.g., “I’ll sell you the right to collect my salary.” However, the following can be capital gain although similar to income: Selling stock in a business you built yourself Selling all substantial rights to a patent Federal Income Taxation Lecture 14

Federal Income Taxation Lecture 14 Sale of a Business Sale of stock or business interests in a larger business, of course, is a capital gain/loss transaction. A sale of an unincorporated business is treated as a sale of its assets. Thus, even if the price is not the same as the sum total of the value of the assets, you have to look at it as though each asset in the business was sold for its pro rata percentage of the business’ value. Federal Income Taxation Lecture 14