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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
D. What are consequences of Passive Loss Rules? Once you
determine that you are subject to the passive loss rules, what are
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,
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
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
2. Rehabilitations of Historic Properties- are also exempt
3. Rehabilitation of Low Income Housing- an interest in a
project designed to rehabilitate low income housing is also exempt
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
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
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
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
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
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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