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I. Gross Income (sec 61).
A. Definition- All income from whatever source derived including but not limited to: (15 items listed in code including compensation for services rendered, etc.
B. IRC Does Not elaborate, but following cases do: 1. Glenshaw Glass v. Commissioner, 1955 S.Ct. Issue here was, are punitive damages collected in law suit taxable as income? Supreme Court said yes since sec 61 says any income derived from whatever source. Simply getting the income, even from windfall, is enough. 2. Court reasoned in Glenshaw that Congress has constitutional power to tax income as it sees fit. 3. What Does Word Income Mean? Cesarini case, 1969, was case where TP bought piano and years later, found $4,000 in it. Issue presented was, did TP have taxable income in the year the money was discovered in the piano? This case presented procedural issue of where to take this case when it was not settled between TP and IRS. Fed tax procedural law permits TP to sue in any of three different courts of original jurisdiction: 1, U.S. District court or 2, Claims Court in Washington, D.C., has jurisdiction over any actions against fed government for money, or finally, tax court. Tax court is different from the others since only those who have not yet paid their tax can sue here and not pay until matter is resolved here. The district court and claims court are for controversies where TP has already paid and wants his money back.Another procedural matter before going on to Cesarini is the Statutory Notice of Deficiency which the IRS issues when it believes taxes are owed. TP has 90 days to react to such notice and can file a petition with the U.S. Tax Court to have his day in court. The petition must be filed within the 90 days and then is automatically assigned to tax court and IRS cannot collect taxes until court matter is resolved. If TP allows 90 days to lapse, then he has lost the opportunity to go to the U.S. Tax Court and then must pay the amount in controversy and sue elsewhere.
Cesarini paid the amount in question first and then filed for a refund vis-a-vis an amended return which was rejected. Since constitution prohibits Congress from directly taxing property but, via the 16th Amendment, allows income taxation which is not required to be "apportioned among the several states," question in Cesarini becomes, is the cash found in the piano just property that also cannot be taxed? Court said no, because cash is not property in and of itself, but rather is a medium of exchange which makes the discovery of the cash a taxable event. There must be an event or transaction with respect to the property, such as a sale or exchange to produce gross income. If Cesarini found a valuable painting in the piano instead of the cash, the value of the painting is not taxable since it is still property and no realization event has occurred to render the value of the painting gross income. 4. Timing of Recognition of Income- Second issue in Cesarini was when is the found money considered income for tax purposes? In the year the piano was purchased or later when the money was discovered? Court looked to Ohio state law since there is no fed law on property and concluded that the found money was income when they discovered it and not when they bought the piano. The statute of limitations would have closed tax period on this money if Cesarini succeeded in his argument that the money was taxable in the year they purchased the piano if it had to be taxed at all since this would have barred recovery for Fed. Ohio law on this point states that treasure trove is titled to owner in the year it is reduced to undisputed possession.
C. Definition- From Glenshaw Glass and Cesarini we see that income is an accession to wealth and is taxable as gross income only if it results from a realization event. EXAMPLE: Man discovers 1,000 barrels of oil buried under his newly acquired land. The oil is an accession to wealth but until it is sold, it is not realized income for tax purposes. EXAMPLE2: Man walking along finds diamond engagement ring that he brings to jeweler who appraises its worth at $2,000. The value of the ring is taxable when it is found because it was found and cannot be tied to any purchase. finding the ring in and of itself was a realization event that made the finder $2,000 richer. This is different than the man who buys land and then discovers barrels of oil on it. Again, the congress has the power to tax this realized accession to wealth (finding the ring) but does not have the power to tax actual property directly since this type of tax is prohibited by constitution which does not allow direct taxation because it cannot be apportioned among the several states (proportionately).
II. Deductions or Offsets.
1. Definition- Exclusions are items that are clearly items of gross income under sec 61, but are items which the congress does not want to tax. By choice, the congress excludes various sources of income.
2. Gifts (sec 102)- under 102, property acquired by gift is generally excluded from income. Court has held that excludable gifts must be between family members where affection, love, etc are motivations and not between business person rewarding another business person for one sending the other business for example. A gift for 102 purposes must be a transfer of property made in a detached and dis- interested generosity out of love and affection or similar motivations.
3. Gifts by Bequest (sec 102A)- are excluded from income but, if claim against estate yields inheritance by law, this will be viewed as contract benefit which is gross income for tax purposes and not excluded under 102 on face of it, but court will go beyond plain meaning of words in IRC to see what was the intent of congress in adopting various pro- visions and in so doing, will analyze a TP's transaction from a point of view of substance over form. The mere legal form of the transaction will not necessarily control. Most significant for court is what is really taking place. In case where bequest might be made to lawyer in lieu of payment during testator's life, even if strictly speaking, the conditions of 102A are met to exclude bequest gift as gross income, the court would find that this gift is really for services rendered and thus taxable as gross income masquerading as testamentary gift.
5. Employer/Employee (sec 132)- this section, in general,
provides a fringe benefit is taxable unless it meets one of four
tests provided in the code:
a. If it is a no-additional cost service fringe benefit then it is not taxable. This is intended to exempt typical fringe benefit like the case where an airline employee is provided stand- by free flights. This is a benefit that is of no additional cost to the employer and thus is exempted from sec 132. While strictly speaking, this type of benefit is income in that it is an accession to wealth, it is to administratively difficult to keep records like this and is generally of little actual value to employee and so is not taxed. If providing the benefit to the employee is something that is related to what the company is in business for and providing this free benefit does not cost the company any substantial additional amount then the fringe benefit is exempt.
b. A qualified employee discount is not taxable. This is usually where company offers discount on the specific product it sells to its own employees, but there are some restrictions indicated in section 132.
c. A working condition fringe is not taxable. If the fringe benefit is directly related to the performance of the job, then it is exempt. Free parking spots, payment for trade publications are examples of this.
d. a diminimous fringe benefit is not taxable. If the amount involved is so small in terms of benefit, that it would be burdensome record keeping for the employer to keep track of, then it is deemed diminimous and thus exempt. An example might include an employee using the company Xerox machine to copy personal documents. While this copying of documents for the employee's benefit is taxable, it is so small as to make it worthless for record keeping and thus tax purposes.
NOTE: The intent of sec 132 seems to be to take the fairly nominal non-cash benefits provided in the workplace and make them non-taxable.
6. Company Provided Cafeteria Plans (sec 125)- this refers not to the eating rooms, but rather the flexible compensation plan that companies can provide with respect to medical and child care costs, for example, to an employee. A company that adopts a qualified cafeteria plan under sec 125 can permit an employee to take a certain dollar amount of his cash compensation and hold on to it and then the company will use that money to pay for personal medical and child care and similar related expenses that the employee has. This makes the cash that would otherwise be paid to the employee non-taxable and thus provides a valuable pre-tax payment of personal expenses.
7. Personal Injury Awards (sec 104A2)- this section provides that gross income does not include the amount of any damages received, whether by suit or agreement, and whether as lump sums or periodic payments, on account of personal injuries or sickness. This is a significant exemption The policy reason behind 104A2 is that congress's intent is that the injured party has suffered enough and the damage award is an attempt to get the injured party back on his feet so to speak and any taxes on such an award would add insult to injury and is therefore exempt. Romer v Commissioner, 1983 9th circuit appeals case is important here. Romer involved an insurance agent who applied for agency license to be able to sell policies for the Penn Mutual Insurance Company. Penn Mutual turned down Romer because of mistaken faulty credit report on Romer who actually had a fine credit record. Romer filed a defamation action against credit bureau saying they injured his reputation and made it impossible for him to become an agent for Penn Mutual and so valuable business was lost. The court here awarded the agent $40,000 in compensatory damages and $250,000 in punitive damages. The amount received by TP was ultimately deemed the result of emotional distress, and like physical injury, the amount was deemed non-taxable under sec 104A2. The court here said the proper focus of attention was not whether the injury was physical to the body or simply emotional, but rather whether the injury was personal as opposed to non- personal in nature. Secondly, the IRS argued here that the wrong was defamation and that the injuries suffered by Romer taxpayer were primarily for lost profits of his business and not injuries to his person. The court focused not on the cause of action, but rather the remedy. The damages, according to the court, were awarded to compensate Romer not only for his business losses but also for his personal (emotional) injuries. Looking to local law, in this case California law, the court said that defamation was a personal injury type tort and must be for personal injury for purposes of the tax exclusion in 104A2. This analysis for the first time, looks at the cause of action and need not go further. The remedy here was not the relevant focus of attention. Punitive damages in cases of personal injury are taxable pursuant to 1989 tax amendments unless they are awarded in cases of physical injury only, and not emotional injury. This amendment only applies to punitive damages.
III. Tax Basis Rules.
A. Definition- generally, basis refers to cost to TP for property, or selling price of property.
1. Sec 1001- provides that a TP who sells his property determines gain or loss by comparing the difference between the amount realized on such sale less the the adjusted basis the TP has in that property. 2. HYPO: TP buys property in 1980 for $10,000 and then sells that property in 1988 for $30,000. His adjusted basis is $10,000 so his gain is $20,000. 3. Exchange of Property- In 1980, TP buys land for $10,000 and five years later, he swaps or exchanges his land for classic auto worth the same $30,000 that his land is worth. Two years later TP sells his auto for $35,000. TP had a taxable event when he swapped his land for the car of the same value in the amount of $20,000 which is the selling price of the car less his basis in the land he swapped for it. Now, his adjusted basis in the auto is $30,000, so when he sells it for $35,000, his taxable gain is $5,000.
B. Basis for tax purposes depends upon the way that TP acquired the property.
1. Straight Purchase- sec 1012 says that basis of property acquired by purchase is simply its cost. Basis is adjusted upward when TP makes capital improvements such as putting on a building addition or building a plant on a piece of land. The cost of the building is added to the land to get an adjusted basis. Basis is adjusted downward if portions of property are sold off. Depreciation (see below) also adjusts basis downward.
2. Exchange- the basis of property acquired in a taxable exchange is equal to the fair market value of the property received in the exchange.
3. Gift- sec 1015 says property acquired by gift has a basis to donee equal to the cost to the donor. This is called a carry over basis. The donee steps into the shoes of the donor. If property is sub- sequently sold by the donee at a loss, then a special rule applies in sec 1015.
4. Inheritance- sec 1014 provides that the fair market value of the property on the date of decedent's death is its basis for tax purposes. Practically speaking, this is a more generous rule than the gift rule since the TP heir gets a stepped up basis which is almost certain to be higher than the basis in a gift transaction where the basis is equal to the donor's basis or cost.
5. Rationale- of congress in distinguishing between gift and inheritance with respect to basis may be that allowing a stepped up basis for inherited property is administratively easier to do than is the case with carry over basis for ordinary gifts. If inherited property had to use the carry over basis it would be nearly impossible to determine cost or basis in what could be very old property.
C. What is Basis in Joint Property? Joint tenancy with right of survivorship, tenancy in common, tenancy by the entirety and community property are those joint ownership possibilities.
1. Joint tenancy with Right of Survivorship- assume husband and wife buy property for $1,000. A year later, wife dies and property is now worth $3,000. One year later, husband sells property for $6,000. Husband has initial basis of $500 at time of purchase. Then, when wife dies, he inherits by law, her half and now has to add $1,500 to basis of $500 for total new basis of $2,000. When he sells the land for $6,000, he realizes a gain of $4,000.
2. Tenancy in Common- if property is held this way, and the person who dies leaves her half to the other tenant in common, then the same rules as in joint tenancy with right of survivorship apply.
3. Community Property- sec 1014B6 has peculiar rule here that says that the survivor who acquires ownership of community property gets a basis equal to the entire fair market value of that property on the death of the first community property owner. In community property states, the survivor gets a full step up in basis where in common law states, the survivor gets only a half step up in basis in cases of joint tenancy.
4. IRC Sec 1041- provides that no gain or loss shall be recognized on a transfer of property from an individual to his spouse or former spouse if the transfer is incident to divorce. Sec 1041 also says that the transfer is treated as if it were a gift for tax law purposes with the effect being that the recipient takes over the transforor's basis in the property. EXAMPLE: If husband and wife enter into a transaction between themselves like a wife selling her business to her husband for its fair market value, she would have no gain or loss under sec 1041, but her husband would have to take the basis of the business which is the price his wife originally paid along with whatever adjustments were made before the sale. This would mean the wife is not taxed on any gain but the husband is taxed bigtime if he ever sells or exchanges the business at a later date for any price over the original basis price to the wife.
IV. Other Domestic Relations Tax Law.
A. Alimony (sec 71)- Alimony is taxable to recipient spouse and deductible by payor spouse provided that the alimony meets certain specific requirements in the IRC.
1. It is Alimony for Tax PUrposes- if it is a cash payment under a decree or written agreement incident to a divorce or separation. Not property, but cash and it must be pursuant to written instrument or decree related to divorce.
2. The Instrument Qualifies Only- if it does not provide that the payments are not sec 71 alimony. If the paying spouse does not want the alimony to be taxed to the payee, then he needs to say in the instrument that the alimony is not sec 71 alimony.
3. Husband and Wife Cannot Be Living Together- to qualify alimony under sec 71.
4. Payments Under Sec 71 Must Cease Upon Death of Payee. If payments continue to recipient's estate, then they are not alimony under sec 71.
5. Front Loading Rule- congress requires that payments cannot be paid all up front and qualify as sec 71 alimony, rather, the payments must be spread out over at least three years.
B. Child Support (sec 152E)- says that custodial parent (parent who has child for more than 1/2 year) is entitled to the dependency deduction. There is no deduction for payments to child support from paying parent.
V. Assignment of Income (Who is Subject to Tax?).
A. Person Who Earns Must Pay Tax. The TP is the one who performs the service and cannot assign his income to others as this would have ultimate effect of avoiding taxes altogether or reducing marginal rate.
B. Abandoned Income is Not Taxable. If abandonment is unequivocal (no strings attached) then there is no tax. Example is game show winner who does not want to accept prize and thus need not pay any tax.
C. Property- HYPO: Spinster owns 20 unit apartment building and receives $500 per unit per month in rent. Spinster assigns the rental value for one month to her favorite niece instead of giving that niece a gift. Spinster then writes letter to one of her tenants and instructs such tenant to pay that month's rent to her niece instead of to her. Who pays tax on this $500 of income, the niece or the spinster aunt? The spinster must pay tax on the $500 even though she does not herself receive it because she has effective control over the apartments which produce the income and as such, any income produced by these apartments is her income. The only way the spinster could effectively transfer taxability for all or a portion of the rents from the apartments is to transfer ownership in all or part of the property. The spinster could actually transfer in writing 1/20 of the building for one month only to her niece to assign the income and its tax to her niece.
NOTE: Justice Holmes- "If someone owns a tree, to transfer taxability with respect to the fruits of that tree, you must transfer more than just the fruit. All or part of the tree itself must be transferred".
D. Capital Gain Can Be Transferred- only if the transfer of property occurs before there is a meeting of the minds on an agreement to sell the property to a buyer which results in some kind of gain. EXAMPLE: Owner of gas station cannot transfer or decide to give half of the station to her kids after an agreement has been reached to sell the station to a buyer. A transfer of ownership in part or whole by gift or otherwise before an agreement to sell to another could effectively transfer the income from any gain made on the sale.
E. Negative Taxable Income- results where TP has particular taxable year where there are more deductions than there is income. Individuals cannot generally carry back or forward any deductions. TP can maneuver year in which income is taxable and this is not deemed income assignment. EXAMPLE: Father can contract at arm's length with his son whereby the son will pay this year for the right to receive his father's dividends from stock in the following year. This can have the effect of bringing income from the future to the present if the present year is one where you will have many deductions and thus room for more income at lower taxation than you might have in the following year when you may have fewer deductions and higher income and thus a higher bracket and higher overall tax bill. This example is not really an assignment case but a timing case.
NOTE: Learned Hand- "Anyone may so arrange his affairs that his taxes shall be as low as possible. He is not bound to choose that pattern which will best pay the treasury. There is not even a patriotic duty to increase one's taxes". The taxpayer may arrange his transactions in such a way as to save income taxes so long as the transaction as structured has substance to it. It does not matter if the reason an arm's length contract was entered into in the first place was to avoid taxes; this is perfectly acceptable, but the transaction must have substance. The transaction cannot be purely a formalistic tax avoidance scheme.
F. Grantor Trust Provisions of IRC- sections 671 thru 679.Who is taxed when it comes to income received from trusts? It depends upon upon the strings or controls that are retained by the grantor.
EXAMPLE: Grantor transfers property in trust with income payable to his daughter for life with remainder to his daughter's children. The income of such a trust will be taxed to beneficiaries. If the father retains certain kinds of controls, sec 671 says income will be taxed to grantor and not to beneficiary. What sticks are kept by the grantor when he transfers property in trust that are going to taint that trust in a tax sense so that all of the income or a portion of that income will be taxed?
1. Power to Revoke a Trust- Sec 676 says that when a grantor sets up a trust and retains the power to revoke it at any time, the grantor will be taxed on that income regardless of whether or not the grantor revokes or not. The Revocable living trust does not create any income tax advantage to the grantor because any income from such a trust is still taxed to the grantor and not to the beneficiaries.
2. Power to Enjoy Income- sec 677 says that when a grantor retains power to enjoy income from the trust and the income of the trust is used for the advantage of the grantor, then the income from such a trust is taxed to the grantor. EXAMPLE: Father who sets up trust to provide education (tuition) for his sons cannot assign the income from the trust to his sons in this way since he already, either expressed or implied in fact, has a contractual duty to provide education for his children. Income from a trust of this type will be taxed to the grantor.
3. Reversionary Interest Trust- sec 673 says that if grantor has reversionary interest that at the inception of the trust is greater than 5 percent of the value of the total trust, then the grantor will be taxed on the income on that trust from that point on.
VI. Business Deductions.
A. Sec 162- provides that there should be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Necessary means appropriate and helpful to a TP's business. Ordinary need not be habitual or repeated and can be only once in a lifetime. In Welsh(sp?) v. Helvering(sp?), where welsh(sp?) tried to deduct payments he made to clear up a former employer's debt, the court said TP legitimately considered his non-obligatory payments for another's debt to be necessary (to restore his business reputation) but such payments were not ordinary as it is not ordinary to pay another's debts. Perhaps Court should have considered his payments ordinary since another business man similarly situated would probably have done the same thing, but the court did not find Welsh's(sp?) repayments of his boss's debts ordinary. Court further considered TP's payments to be not ordinary expenses but capital outlays.
B. Expenses vs. Capital OUtlays or Expenditures- 162 deductions are only for business expenses and not capital expenditures. An expense item is generally a payment made for something beneficial to a company within a period of one year or less. A capital Outlay is beneficial for a period greater than one year. EXAMPLES: Salaries paid out to employees are expenses while building a new office complex is a capital expenditure which will confer benefit lasting more than one year.
C. Depreciation- is proportionate deduction of capital expenditure costs over a period of time (life of capital asset purchased). NOTE: In Welsh(sp?), TP was buying his reputation by paying back his employer's debt and this is capital outlay since it confers benefit lasting beyond a year and so does not fall under 162.
D. For Capital Expenditures- look to depreciation sections of the code, 167 and 168.
1. Intangible Asset- like purchasing good will, etc, is depreciated over determinable useful life. If the intangible asset will benefit the company for an indefinite period, then it cannot be written off until the item becomes worthless.
2. Tangible Assets- are depreciated over fixed determinable life of asset. What about repairs to buildings or other assets? Look at nature of repair or improvement. If the repair or improvement is simply maintaining the status quo, then it will be treated as a deductible expense but if it creates something new, then it will have to be depreciated. EXAMPLE: A meat packing house that needs to repair a basement wall in order to keep curing meat is really just making a deductible repair under 162 and not making a capital outlay that must be depreciated as a new or different asset like a whole new building or foundation. EXAMPLE2: simply repairing shingles on a roof is a deductible expense but building a whole new roof is probably a capital expenditure that must be depreciated. EXAMPLE3: you cannot deduct as an expense your law school tuition since it will last more than a year and you also cannot depreciate it over the working life of your career either since this is intangible and so must have a determinable life in which to depreciate its cost and the length of a law career is not determinable. A practicing lawyer who takes a CLE course can deduct this expense since he is merely maintaining his business like repairing a roof.
E. What is a Trade or Business? Look to the relationship between the TP and clients, customers, third parties. How much time is spent on business activity that TP is trying to deduct expenses for? Later gambling case adds that it is not whether you have clientele or not, but whether or not there is continuity and regularity in TP's involvement in the activity.
F. Individual Deductions- under sec 212 allow as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year for the production of income or collection of income for the management conservation or maintenance of property held for the production of income or in connection with the determination, collection, or refund of any tax. Where sec 212 allows deductions for maintaining your investment portfolio for example, sec 162 does not since that section requires that the expense be a business expense.
NOTE: 212 deductions fit into the miscellaneous deductions category and not the business deductions category of sec 162 and 212 deductions must exceed 2.5 percent of adjusted gross income so 162 deductions are preferred if possible.
G. Legal Fees- are they deductible? Look to see first if you can categorize the activity involved as either 162 business activity or 212 investment activity or is it a 262 personal activity? It must be either business or investment related to be deductible as personal expenses are not deductible. Secondly, once you determine that it falls under 162 or 212, you ask if it is an expense or capital outlay? If it is an expense then you can currently deduct it. If it is a capital outlay, then you can depreciate it over time. EXAMPLES: legal fees incurred in battle over title to stock ownership for example is 212 related but is not deductible since it concerns value (title) lasting more than one year. EXAMPLE2: TP paid into proxy fund to get a change in corporate management that was intended to yield higher dividends which is 212 related and deductible since it was expense conferring value lasting less than a year. EXAMPLE3: TP is involved in a divorce and incurred legal fees defending a prenuptual agreement and this is personal in nature and potentially not deductible as such. This last hypo could work out differently if you consider that his legal fees were all about conserving property as in 212 investment type deductions. Ultimately, though marriage contract is most likely deemed personal 262 type contract that is not deductible vis-a-vis related legal fees.
VII. Passive Loss Rules & Interest Expense LImitation Rules. (IRC Sec 469).
A. HYPO: Wife receives $50,000 from brokerage fees as her taxable income for 1988. Her husband is a newly admitted attorney and in his first solo year lost $50,000 from his law practice (he collected $10,000 in fees for that year and his expenses were $60,000). Filing jointly, this couple has a 0 adjusted income and need go no further, no taxes are due. If this same husband and wife buy a ski lodge that they don't run but own as a kind of passive activity, if they lose $100,000 or whatever during the year, they used to be able to offset this against their incomes for tax purposes but after 1986 tax reform they cannot and this is the crux of the passive loss rules.
1. First, is it a Passive Trade or Business?- you must determine if it is a passive trade or business before sec 469 is implicated.
2. Next, Is the Activity Passive?- you need to not only determine whether it is a trade or business (use same analysis as in 162) but also whether the activity is passive because if the conduct of the business is active (involvement by owner is significant) then it is not passive and TP can deduct the loss. Code says you look to see if the participation in the business by TP is material. Regs say if TP's involvement is more than 500 hours per year, then his involvement is material and losses will be therefore deductible.
B. Owner's Interest in Activity as Limited Partner- if the owner's interest in the activity is as a limited partner, then it is per se deemed to be a passive activity.
C. If Activity is Rental One- for example, renting apartments or condominium space where income is derived, then it is deemed automatically to be passive activity regardless of the amount of time spent by TP in this type of activity. Renting services like motel space or maid services, etc, are not deemed to be services for this passive loss area, but rather are deemed to be regular business activity.
D. What are consequences of Passive Loss Rules? Once you determine that you are subject to the passive loss rules, what are the consequences?
1. If Activity Generates Profit- then it is taxable.
2. If Activity Generates a Loss- then cannot be offset against other, non-passive income, i.e., money you make from your job, etc...
3. Passive Loss is Deferred- if there is a passive loss incurred in a given year, it is not lost altogether but rather is deferred until you have a passive gain in income. EXAMPLE: You incur a passive loss on your ski lodge in 1989 of $100,000 and then profit $100,000 in 1990. You can carry over the passive loss from 1989 and offset it against your passive gain in 1990 and pay no tax on your gain in 1990.
4. Passive Loss Limitation Rules Viewed in Totality- EXAMPLE: If couple from above hypo has other passive activities that are generating income other than the ski lodge, you combine them all together. If you end up having a net loss from all passive activities combined, then you are still subject to the passive loss limitations.
5. Disposing of Passive Activity- when you sell your passive activity (totally, not in part), then you can take the carry over loss. At this final sale of such passive activities, you can deduct any losses against your other incomes of all types.
E. Exceptions to Passive Loss Rules.
1. Working Interests In Oil or Gas Wells- are exempt under sec 469.
2. Rehabilitations of Historic Properties- are also exempt under 469.
3. Rehabilitation of Low Income Housing- an interest in a project designed to rehabilitate low income housing is also exempt under 469.
4. Rental Real Estate Activity- as stated above is automatically deemed passive but one can deduct up to $25,000 of total losses from rental real estate is such losses were incurred in one year and only if TP has active involvement in renting such rental real estate and TP must not be high income taxpayer. Active participation under this exception to the passive loss rules can even include simply hiring a manager to manage your rental property. The income level for this exception is measured by the AGI (adjusted gross income) and cannot exceed $100,000 in a given year for the TP to qualify for this exception. A TP who wants to use this exception for rental property income who also makes more than $100,000 per year can do so but according to the schedule outlined in sec 469.
F. Limitation of Deduction for Interest Expense.
1. Trade or Business Activity In Which There is Material Participation- Interest paid on loans incurred in this type of business is fully deductible without limitation.
2. Trade or Business In Which There is Passive Activity- Interest expenses related to such passive activities is still subject to the passive loss rules.
3. Qualified Principle and 2nd Home Interest- Interest on
mortgages are fully deductible up to $1,000,000 cost of
a. Up to $100,000 of Home Equity Indebtedness- may be incurred for personal and educational purchases and all interest will be deductible.
4. All Other Consumer Interest- auto loans, credit card loans, etc are not deductible.
5. Investment Portfolio Related Interest- 212 type activities that incur interest such as margin account interest (borrowing from the broker) or borrowing to buy vacant or unproductive land is deductible only to the extent of net investment income (so this type of investment related property must produce an income from which to deduct under this rule). You can carry over any losses in this category indefinitely.
VIII. Capital Gains & Losses.
A. Amount Realized Less Adjusted Basis- is either a capital gain or a capital loss.
B. Special Treatment- Capital gains are given special treatment by congress to encourage investment in capital assets, i.e., stocks and bonds.
C. Capital Gains are Not Indexed- capital gain is measured in absolute terms and not indexed to inflation. EXAMPLE: You invest in a capital asset for $20,000 and then sell it for $100,000 20 years later and your capital gain is $80,000 with no discount for how inflation has eroded the value of money during the period of ownership. Capital gains are taxed at 28 percent.
D. Capital Losses Are Limited to $3,000- annually as offsets against other ordinary income. EXAMPLE: tp bought stock for $10,000 and then sells it for $2,000. This $8,000 loss on the stock asset cannot be taken in full but only $3,000 of it may be deducted against other income (sec 1211). The difference of $5,000 isn't lost forever, rather it carries over. It carries over in the subsequent year until it is used up.
1. The Carry Over Is Used Up- if the TP has a capital gain in the subsequent year where the capital loss can be used to the full extent against a capital gain. If TP still has more loss than capital gain in that subsequent year, he may use it against his other ordinary income up to another $3,000.
E. Capital Asset Defined in Sec 1221- Capital asset means property held by TP whether or not connected by a a trade or business, but does not include the following:
1. Inventory- stock in trade in TP's business is inventory and not considered capital asset.
2. Depreciable Property Used in Trade or Business- is not considered capital asset, IRC Sec 1231 says any gains net on the sale of depreciable property have capital gain treatment if there is in fact a capital gain. If there is a loss when depreciable property used in a trade or business is sold, then the loss will be considered ordinary loss. This is the best of both worlds: gain on depreciable property is capital gain while loss is ordinary loss. EXAMPLE: TP has commercial building which he sells at a loss and then is allowed to fully deduct such loss not subject to the capital loss limitation of only $3,000 per year against ordinary income and all because the building is depreciable.
3. Copyrights in Literary, Musical and Artistic Compositions- intellectual property such as this is not deemed to be capital asset. This is ordinary asset since congress did not want to give preferential treatment to that person who produces income by writing books, or songs over those who perform other services in a non-artistic setting like law or medicine.
F. Important Cases.
1. Corn Products Case (1955 S.Ct.)- How do you treat commodity futures contracts? Is such contract a capital asset or not? Court said it was not capital but rather an ordinary asset.
2. Arkansas Best (1988 S.Ct.)- Court here said that it did not mean in the Corn Products decision to extend those assets which were not capital assets and said Corn Products had a very narrow extension of what types of property would be ordinary assets. Corn Products was akin to inventory and clearly not a capital asset and this marks the outer boundary of how far the court will go in extending ordinary assets.
G. Swapping or Exchanging Under Sec 1231- If like kind property is exchanged for like kind property, then this exchange is not a taxable event. This sec 1231 only applies to depreciable property used in a trade or business and vacant land but not to inventory, etc...Courts have defined "like kind" very liberally and now permits swapping a commercial office building for example, for a commercial apartment building. Now, in effect, the TP can exchange real property for real property but not realty for personalty. If there are two independent transactions, then sec 1231 does not apply. EXAMPLE: If TP sells his building for cash and then the next day he buys another building or some vacant land, then this is not a non-taxable event under Sec 1231. Today, a TP must identify or find the replacement property within 45 days of the transfer of ownership of his original property that he sold and secondly, must close the deal for the replacement property within 180 days of the sale of the first. 45 days to find replacement property and a total of 180 days to close on the new property.
H. Gain in the Sale of Personal Residence (Sec 1034)- HYPO: tp buys residence for $100,000 in 1984 and then sells it for $500,000 ten years later. This section permits TP up to 2 years to find new property and close on it to avoid gain and tax on sale of first house.
I. Sale of Principle Residence by TP Over Age 55- Sec 121 lets TP take advantage of sec 1034 by buying a replacement residence equal to or greater in value than the one first sold, but does not limit such TP as does 1034 and allows such TP a once in a lifetime opportunity to buy down without tax penalty up to $125,000. EXAMPLE: TP who is age 60 sells his house for $200,000 and buys a new house for only $100,000. Ordinarily he would be taxed on any gain from the first house up to the difference between the gain on the first house and the price of the second but under this sec 121, the senior citizen TP has one chance in his lifetime to take advantage of this section of the code and buy down without tax implication up to $125,000 in value. This shows Congress' intent to protect senior citizens by allowing them to move down in property size as their children marry and leave home without penalizing the senior citizen TP who makes such a residence adjustment.
NOTE: Section 1031applies to business or investment related property and requires an exchange while Section 1034 does not require exchange but rather permits two separate transactions subject to specific limitations indicated above.
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