2016 INCOME ITEMS AND PROPERTY TRANSACTIONS · The completion d ate on your answer sheet will be the date designated on your certificate. The latest recommended completion date is

2016 INCOME ITEMS AND PROPERTY TRANSACTIONSRecommended CPE Credit: 6 HRS [B]

PREPARED BY

CPElite T.M .

In a Class By Yourself T.M.

(800) 9500-CPE

P.O. BOX 1059, CLEMSON, SC 29633-1059 & P.O. BOX 721, WHITE ROCK, SC 29177-0721

INSTRUCTIONS

Read the content of this course on pages 1-69 and answer the review questions at the end of eachcourse section. Then read the quiz instructions on page i and the 30 quiz questions on pages 71-76.Select the best answer for each quiz question and record your answers either on the answer sheet onpage ii, or on-line at www.cpelite.com if you are an online test-taker.

COURSE COMPONENTS, CONTENT LEVEL, AND LEARNING OBJECTIVES

The components of this course include two basic topics – (1) selected income items and (2) propertytransactions. For the former, alimony, social security benefits, scholarships and fellowships, prizesand awards, the income tax benefit rule, and court awards are covered. The latter includes basiscomputation, gains and losses from property transactions, the sale of a principal residence, and like-kind exchanges. The table of contents on pages iii and iv provide a more detailed description of thecourse components. Also, where applicable, key terms are listed and defined at the beginning of thesection in which they are found. The content level of this course is basic. The learning objectivesof the course are provided at the beginning of each section (see part 1, sections A - F and part 2,sections A - D).

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2016

QUIZ INSTRUCTIONS

2016 INCOME ITEMS AND PROPERTY TRANSACTIONS

There are 30 multiple-choice questions at the end of the course. Choose the best answer based onthe limited facts of each question, and record your answer on the enclosed answer sheets. An extraanswer sheet below is enclosed for your personal records. The answer sheet to be turned in is on thenext page. To test on-line, go to www.cpelite.com and log in to your account page. If youraccount has not yet been created at our website, please contact us for assistance [email:[email protected]; phone or fax: 800-950-0273].

You must score 70% to receive continuing professional education credit for this course. You maytake the quiz two additional times without incurring additional expense.

If your zip code is below 56000, please return your completed answer sheet to CPElite, P. O. BoxT.M

721, White Rock, SC 29177-0721. If your zip code is above 55999, please return your completedanswer sheet to CPElite, P.O. Box 1059, Clemson, SC 29633-1059. After you successfullyT.M

complete the quiz, your quiz results, a complete set of solutions, and a certificate of completion willbe mailed to you within 10 working days of our receipt of your answer sheet. The completion dateon your answer sheet will be the date designated on your certificate. The latest recommendedcompletion date is within one year of purchase.

ANSWER SHEET FOR YOUR RECORDS

2016 INCOME ITEMS AND PROPERTY TRANSACTIONS6 HOURS OF CPE

(Based on 50 Minutes of Average Completion Time Per Hour)Delivery Method – Self Study

(Latest Recommended Completion Date: Within one year of purchase)

Please record your answers below and retain this copy for your records.

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We appreciate your business and hope that you were satisfied with the course.

COMPLETION DATE _____________________________________________


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2016

ANSWER SHEET TO BE SUBMITTED

2016 INCOME ITEMS AND PROPERTY TRANSACTIONS6 HOURS OF CPE

(Based on 50 Minutes of Average Completion Time Per Hour)Delivery Method – Self Study

(Latest Recommended Completion Date: Within one year of purchase)

To test on-line, go to www.cpelite.com and log in to your account page. If your account has not yetbeen created at our website, please contact us for assistance [email: [email protected]; phone orfax: 800-950-0273]. Otherwise, please record your answers below and mail your solutions to:

ZIP CODE BELOW 56000 ZIP CODE ABOVE 55999

CPElite CPElite T.M. T.M.

P.O. Box 721 P. O. Box 1059White Rock, SC 29177-0721 Clemson, SC 29633-1059

We appreciate your business and hope that you were satisfied with the course. Please express below yourcomments on course quality, other topics you would like, or our other products and services.

1. ________ 7. ________ 13. ________ 19. ________ 25. ________

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COURSE EVALUATION (Answer Yes, No, or N/A)

1. The stated learning objective was met. _______ 2. Handout or advance preparation materials were

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2016 INCOME ITEMS AND PROPERTY TRANSACTIONSRecommended CPE Credit: 6 HRS [B]

TABLE OF CONTENTS

PART 1 – SELECTED INCOME ITEMS

A. ALIMONY

A.1 Introduction 2A.2 Definition of Alimony 2A.3 Alimony Recapture 7A.4 Tax Planning For Alimony, Child Support, and Property Settlements 9

B. SOCIAL SECURITY BENEFITS

B.1 Definition of Social Security Benefits 13B.2 Calculation of Taxable Portion of Social Security Benefits 14

C. SCHOLARSHIPS AND FELLOWSHIPS

C.1 General Requirements for Exclusion 16C.2 Other Items Related to Scholarships or Fellowships 17

D. PRIZES AND AWARDS

D.1 Charitable Achievement Awards 20D.2 Employee Awards 21

E. INCOME UNDER THE TAX BENEFIT RULE

E.1 General Concepts 23E.2 Other Issues 25

F. COURT AWARDS, DAMAGES, AND BACK PAY

F.1 General Concepts 28F.2 Contingent Attorney Fees 30

PART 2 – PROPERTY TRANSACTIONS

A. COMPUTATION OF BASIS

A.1 General Rules 32A.2 Gift and Inherited Property 33A.3 Personal-Use Property Converted to Business/Rental Use 37A.4 Stock Splits and Stock Dividends 36A.5 Wash Sales 37

B. GAINS AND LOSSES FROM PROPERTY TRANSACTIONS

B.1 Asset Classification 40B.2 Capital Gains and Losses 41B.3 Steps in the Netting Process 43B.4 Special Loss Situations 46

iv

TABLE OF CONTENTS CONTINUED

C. GAIN EXCLUSION FOR SALE OF PRINCIPAL RESIDENCE

C.1 General Rules 49C.2 Ownership and Use Tests 50C.3 Partial Exclusion 53C.4 Principal Residence 57

D. LIKE-KIND EXCHANGES

D.1 Qualifications 61D.2 Tax Consequences of Exchanges Not Wholly Like-Kind 63D.3 Non-Simultaneous Exchanges 65

E. CONCLUDING REMARKS 69

INDEX 70

QUIZ QUESTIONS 71

ENDNOTES 77

ONGOING DEVELOPMENTS

CPElite CONTINUES TO MONITOR LEGISLATIVE, ADMINISTRATIVE, AND JUDICIALT.M.

DEVELOPMENTS AS THEY OCCUR, AND OUR COURSES ARE UPDATED AT LEASTANNUALLY TO REFLECT TAX LAW CHANGES.

ALL RIGHTS RESERVED. THE REPRODUCTION OR TRANSLATION OF THESEMATERIALS IS PROHIBITED WITHOUT THE WRITTEN PERMISSION OF CPElite.T.M.

1

2016 INCOME ITEMS AND PROPERTY TRANSACTIONS

The primary objectives of this course are to provide an explanation of (1) selected income

items affecting individual income taxpayers, including social security income, alimony, scholarships,

and court awards, and (2) common property transactions involving individual income taxpayers, such

as capital gains, sale of a personal residence, and like-kind exchanges. This course reflects

legislative changes made through the “Protecting Americans from Tax Hikes Act of 2015,” the

PATH Act, signed by President Obama on December 18, 2015.1

The level of knowledge expected to be imparted by this course is basic. Our courses

comply with the enhanced standards required of providers of continuing professional

education (the Statement of Standards for Continuing Professional Education (CPE)

Programs, issued jointly by the AICPA and NASBA) and the QAS requirements. Also, we

are an IRS-Approved Continuing Education Provider.

PART 1 – SELECTED INCOME ITEMS

A. ALIMONY

Key Terms in This Section

Alimony: The part of transfer payment to a former spouse under an agreement that is deductible bythe payor and includible in income by the recipient.

Property settlement: The part of transfer payment to a former spouse under an agreement thatrepresents the former spouse’s share of joint property. This payment is not deductible by the payornor includible in income by the recipient.

Child support: The part of transfer payment to a former spouse under an agreement that representsthe payor’s obligation to pay for the care of his or her children. This payment is not deductible bythe payor nor includible in income by the recipient.

Alimony recapture: The amount of alimony payment which is recharacterized as nonalimony as aresult of a reduction in alimony payments either in years 2 or 3 of the divorce agreement.

LEARNING OBJECTIVES:

1. Identify the requirements for characterizing payments as alimony.

2. Compute the alimony deduction when the divorce decree contains contingent payments.

2

3. Recognize the tax consequences alimony recapture compute the amount of alimonyrecapture.

A.1 Introduction

Generally payments under a divorce or separation instrument are classified as either alimony,

property settlement, and/or child support. Alimony payments are deductible by the payer as an

adjustment to income (line 31a of Form 1040) and are includible in income by the recipient (line2 3

11 of Form 1040). On the other hand, payments for property settlement and child support are not

deductible by the payer and are not includible in income by the recipient. Consequently, there is a

natural adverse interest between the two parties. All other things being equal, the recipient would

rather have the payments classified as property settlement or child support while the payer would

rather have the payments classified as alimony.

Even though property settlements and child support payments are not deductible or includible

in income, there are tax implications associated with these payments. This section of the course

reviews the definitions of alimony, property settlement, and child support, explores the tax

implications of the three types of payments, and offers some tax planning opportunities which are

available before the divorce or separation agreement is finalized.

A.2 Definition of Alimony

Alimony payments must be made pursuant to a written divorce or separation instrument.4

The instrument may be a decree of divorce or separate maintenance agreement, a written instrument

incident to such a decree, or a written separation agreement. Other requirements include the5

following:

1. payments must be made in cash;

2. the instrument must not designate the payment as not being alimony;

3. in the case of legal separation, the spouses may not be members of the samehousehold when the payment is made; and,

4. there must be no liability to make the payment after the death of the recipientspouse.6

3

In addition, the law specifically indicates that any payments pursuant to the instrument which

are payable for the children of the payer spouse are not includible in gross income. Currently, there7

is no minimum number of years over which alimony payments must be made. However, large

payments in the first two years may be subject to alimony recapture rules (Section A.3 below).

Example 1

Raymond and Julie have decided to separate. Pursuant to a written separationagreement, Raymond is obligated to pay Julie $18,000 a year for four years.Payments would cease in the event of death. Assume all four requirements describedabove are satisfied. The entire amount would be treated as alimony.

With respect to requirement 3 above, a home is deemed to be shared even if the spouses

physically separate themselves in the home. However, the taxpayers are not treated as members of

the same home if one is preparing to leave the home and leaves within one month of the date of the

payment.8

The Ewell case illustrates the importance of having a written divorce decree or separation9

instrument. The taxpayer separated from his wife and pursuant to a written list of expenses prepared

by his former wife, the taxpayer agreed to pay her $3,700 per month. The taxpayer argued that (1)

the written list of expenses, (2) his promise to pay the expenses, (3) letters exchanged between the

attorneys, and (4) written notations on the checks were tantamount to a written separation agreement

and the payments, therefore, were deductible as alimony. The Tax Court disagreed, indicating that

the letters exchanged between the attorneys signified negotiation rather than agreement. It also

observed that the combination of the four preceding items did not constitute a mutual assent or a

meeting of the minds since there were several proposals during this time period. Because there was

no written separation agreement, the Tax Court ruled that none of the payments qualified for the

alimony deduction.

What are the tax consequences of court-mandated past alimony payments? Are these

deductible in the year paid as alimony? This was an issue under a 2015 Tax Court case. Under a10

separation agreement between the taxpayer and his former wife, the taxpayer was required to pay

$735 per month in child support, but no spousal support. However, if he defaulted under his

4

separation agreement obligations, he would immediately become liable for $1,000 in monthly

spousal support. The spousal support obligation would continue until his former wife died, he died,

or he made 36 payments. Subsequently, there was a final divorce decree that incorporated the

separation agreement. The taxpayer defaulted on his separation agreement obligations, and he began

incurring spousal support obligations. His former wife filed a judgement for past due child support

of $16,500 plus $6,338 in interest, and $36,000 in past due spousal support plus $28,156 in interest.

She obtained a writ of garnishment of the taxpayer's wages.

During the 2010 tax year in question, the taxpayer had $50,606 garnished from his wages,

which included $11,256 in child support. He claimed a $39,350 alimony deduction on his federal

income tax return. The IRS disallowed the alimony deduction. The IRS argued that two of the four

Section 71(b)(1) alimony requirements were not met. One is that the payment is received by a

spouse under a divorce decree or a written separation instrument. The other is that there is no

liability to make the payment after the payee spouse's death, and there is no liability to make any

payment as a substitute for such payments after the payee spouse's death. The Tax Court stated that

under Section 71(b)(1)(D), the payor may not deduct payments as alimony unless he or she has no

liability to continue payments after the payee's death. It stated that liability for even one payment

after the payee's death causes none of the related payments to qualify as deductible alimony. It noted

that if the state court order is silent as to the existence of a post death obligation, the section's

requirements still may be met if the payments terminate upon the payee's death by operation of state

law. The court distinguished a fine line under the applicable state law (Colorado) between payments

made to satisfy future spousal support obligations from payments made to satisfy spousal support

in arrears. Future spousal support obligations terminate at the death of either spouse. By contrast,

an order enforcing spousal support in arrears becomes a final money judgment. The applicable

statute of limitations for such judgment payments is the general 20-year statute that applies to any

court order. The court stated that since the judgment was issued to his former wife in collecting past

due but unpaid spousal support, it was treated as a final money judgment against the taxpayer. It

5

stated that under Colorado law, liability for payment of a final money judgment is not affected by

the death of either the payor or the payee spouse. It ruled that the payments failed to qualify as

alimony under Section 71(b)(1)(D), and thus they were not deductible alimony under Section 215(a).

A.21 Payments Made After Death

As will be discussed in the planning section (Section A.4 below), it may be beneficial from

a tax standpoint to convert nonalimony payments to alimony payments by satisfying the above four

requirements. As noted in the 2015 Tax Court case discussed in the preceding paragraph, the fourth

requirement (payments cease upon the death of the recipient) may be the largest hurdle in obtaining

this result.

The traditional purpose of alimony is to fulfil the legal obligation to care for the spouse

during the spouse's lifetime. The fourth requirement is consistent with this traditional purpose. If

payments continue after the death of the former spouse, by implication the payments must represent

something else (for example, property settlement). In today's society, one spouse's legal obligation

to provide for the other spouse's support is steadily eroding away. Nevertheless, for payments to be

treated as alimony, requirement 4 must be met. If payments are required after the death of the

spouse, none of the payments qualify as alimony, including all the payments made before the death

of the spouse. If the recipient gives up the right to continued payments after death (in an attempt to

reclassify nonalimony payments as alimony to benefit both parties, as discussed in Section A.4

below), the recipient of the payment may be bearing all of the risk, particularly if the payment period

is fairly long. As discussed in Section A.4 below, this risk could be mitigated by purchasing life

insurance which, for younger parents, is fairly inexpensive.

What happens if the divorce decree is silent as to whether payments to the taxpayer’s former

spouse terminates on her death? Such was the case in Moore. As a result, the Tax Court had to11

look to state law (Indiana) to determine whether the payments would terminate if she died before all

of the payments were made. Because the Tax Court was not able to find any Indiana law that states

that maintenance payments automatically terminate on the death of the payee spouse, it ruled that

the fourth requirement was not satisfied and the payments could not be deducted as alimony.

6

A.22 Contingent Payments

The recipient and payer may try to circumvent requirement 4 by specifying contingent or

substitute payments to the children in the event of the recipient's death. If this is done, however, the

intended alimony payment will not be treated as such to the extent of the amount of the substitute

payment provided for in the agreement.

Example 2

Fred and Wilma obtain a divorce. Pursuant to the divorce decree, Fred mustpay Wilma $30,000 per year for a period of six years or until Wilma's death,whichever is earlier. The decree provides that in the event of Wilma's death withinthe first six years, $10,000 must be paid annually to a trust for Fred's children untilthey reach age 18.

It appears that Fred and Wilma have attempted to convert $10,000 per year ofchild support payments to alimony payments. This strategy will not work. $10,000of the payment is considered a substitute payment contingent upon the death ofWilma within the six-year period. As a result, $10,000 of the $30,000 payment willbe reclassified as child support, leaving $20,000 per year as alimony.12

Example 3

Under a divorce decree, Judy pays Jack $30,000 per year for 15 years or untildeath, which ever is earlier. If Jack dies before 15 years, the decree requires Judy topay to Jack's estate the difference between $450,000 and the total amount paid toJack during his lifetime.

This arrangement is a clear example of attempting to convert a propertysettlement to deductible alimony. In this case, none of the payments will constitutealimony even if Jack lives the entire 15 years.13

A.23 Meaning of Cash Payments

Cash payments include checks and money orders. However, they do not include liquid assets

such as marketable securities. Cash payments to a third party pursuant to a written agreement are

acceptable. Also, at the written request of the recipient spouse, cash payments to a third party will

qualify as alimony providing (1) the written request states that both spouses intend the payments to

be treated as alimony, and (2) the request is received from the payee's spouse before filing the return

for the year the payments are made. Examples of third party payments are payments for the former14

spouse's medical expenses, housing costs, taxes, and education costs. Premiums that are required

to be paid on the payer's life insurance policy qualify as alimony if the former spouse owns the

policy.15

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44444444444444444444444444444444444444444444444444444444444444TAX SAVER!! Although the second requirement allows the payee-spouse toreceive the request after year-end, it is prudent to obtain the request before third partypayments are made. This should help to avoid potential misunderstandings.

44444444444444444444444444444444444444444444444444444444444444

Voluntary payments to third parties do not qualify as alimony even if the spouses

"informally" have agreed to this arrangement as a means of reaching an amenable separation. A

written instrument which specifies the payer's obligation is required.

If the instrument requires the taxpayer to pay expenses for a home owned jointly by the

taxpayer and former spouse, some of the payments will be classified as alimony. For example, if the

taxpayer is required to pay the entire mortgage payment, one-half of the total payment will be

considered alimony.

A.3 Alimony Recapture

If alimony payments are terminated or significantly reduced in the first three years, alimony

recapture is likely to occur. If it does, the payer actually has to report income and the recipient claims

a deduction. In essence, the tax treatment of the alimony paid earlier is reversed in the year alimony

recapture occurs. The only way to assure alimony treatment for all of the payments is to have fairly

level payments in the first three years.

Alimony recapture is not determined until the end of the third year. The recapture, if any,

relates to "front loaded" payments in either Year 1 or Year 2. Year 2 alimony payments will result

in some recapture only to the extent they exceed Year 3 alimony payments by $15,000. Year 1

payments will be subject to some recapture only to the extent they exceed the average of the Year

2 payment and Year 3 payment by $15,000. For this purpose, the Year 2 payment is reduced by any

recapture from the Year 2 payment. As a result, alimony recapture relating to the Year 2 payment

must be determined before the Year 1 recapture amount can be determined.

Example 4

Myrna pays Phil the following amounts of alimony under their divorce decree:Year 1 - $60,000, Year 2 - $40,000, and Year 3 - $20,000. If payments in any yearhave declined by $15,000, alimony recapture will occur. In this case, paymentsdeclined by more than $15,000 in each year, so alimony recapture will result for theYear 1 and Year 2 payments.

8

Year 2 payment recapture is $5,000 (($40,000 - $20,000) - $15,000). Forpurposes of calculating Year 1 recapture, the Year 2 payment is reduced by the$5,000 recapture. The average of the adjusted Year 2 payment and Year 3 paymentis $27,500 (($35,000 + $20,000)/2). Thus, the Year 1 payment recapture is $17,500(($60,000 - $27,500) - $15,000). Total recapture in Year 3 is $22,500 ($5,000 +$17,500).

For the Year 3 taxable year, Myrna will have an alimony deduction of $20,000and alimony recapture income of $22,500. Phil will have the opposite result (analimony recapture deduction of $22,500 and alimony income of $20,000).16

44444444444444444444444444444444444444444444444444444444444444TAX SAVER!! Tax advisers involved with a divorce or separation instrumentshould ensure that payments do not decline by more than $15,000 for any of the firstthree years. Although some very good reason, e.g., job loss, may dictate such adecline, there may be more manageable situations where a temporary cash shortageis the reason for the payment decline. In these cases, short-term loans may be wise,especially if there is a significant tax rate difference between the payer and payee.

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Alimony recapture income is reported on line 11 of Form 1040. This is the line where

alimony received (income) normally is reported. If alimony recapture income is reported, the

taxpayer needs to cross out the word received and write recapture to the right. In addition, the

taxpayer needs to write the former spouse's last name and social security number on the dotted line.

If an alimony recapture deduction is reported, it is reported on line 31a of Form 1040 (labeled

"alimony paid"). Consistent with the above procedure for alimony recapture income, the word

"paid" is crossed out and replaced with "recapture". The last name and social security number of17

the former spouse also are reported on this line.

IRS Publication 504 (page 18 ) contains a worksheet to facilitate the calculation of alimony

recapture. The worksheet appears below with Example 4 information.

1. Alimony paid in 2nd year $40,000

2. Alimony paid in 3rd year $20,000

3. Floor 15,000

4. Add lines 2 and 3 35,0005. Subtract line 4 from line 1 $ 5,000

6. Alimony paid in 1st year 60,000

7. Adjusted alimony - year 2 (line 1-line 5) 35,000

8. Alimony paid in 3rd year 20,000

9

9. Add lines 7 and 8 55,000

10. Divide line 9 by 2 27,500

11. Floor 15,000

12. Add lines 10 and 11 42,500

13. Subtract line 12 from line 6 17,500

14. Recaptured alimony. Add lines 5 and 13 $22,500

A.4 Tax Planning For Alimony, Child Support, and Property Settlements

Although there are certain rules which must be followed to satisfy the definition of alimony,

the rules are not so rigid to prevent a portion of child support or property settlement payments to be

characterized as alimony. One might ask why the recipient would agree to the classification shift.

After all, isn't it better to receive nontaxable income instead of taxable income? The major reason

for the shift is the availability of tax benefits. The parties could negotiate the overall payments such

that an increase in the overall alimony payments would benefit both parties. The following example

illustrates this strategy.

Example 5

Dawn and Donald have decided to separate and are in the process of draftinga separation agreement. They have two children, ages 7 and 9, and agree that Dawnwill have custody of the children. They also agree to split their property equally.Their only points of contention concern the amount of alimony and child supportpayments that Donald will be paying Dawn. Dawn is currently unemployed, whileDonald is in the 33% tax bracket (including state income taxes).

Dawn does not want to pay the income tax associated with alimony andproposes $27,000 of child support for 10 years. If Dawn's option were chosen, herafter-tax benefit would be $27,000 and Donald's after-tax cost would also equal$27,000 since there would be no tax benefit from paying child support.

After analyzing the tax implications, Donald proposes to offer $35,000 peryear and have the payment classified as alimony. Assume this offer is accepted andDawn files as head of household and pays an average tax of 15% on income (afterconsidering exemptions, the standard deduction, and a portion of the income taxedat the 10%, 15%, and 25% marginal tax rates).

At first this might seem strange for Donald to propose an $8,000 increase inhis annual cash outlay. However, because the payment is deductible, Donald's after-tax cost would be only $23,450 ($35,000 x 67%). This actually would save him$3,550 ($27,000 - $23,450) per year in net cash after-tax savings. Dawn's after-taxbenefit is $29,750 ($35,000 x 85%). Thus, her overall benefit from the originalproposal would increase by $2,750 per year ($29,750 - $27,000). In total, the

10

combined annual benefit is $6,300. The government loses $6,300 of tax revenue,which is the difference in their tax rates (18%) times the amount of alimony($35,000). Over a ten-year period, the combined tax savings is $63,000.

Recall that to be classified as alimony, payments must not continue after the death of the

payee. Thus, the payee may be taking too much risk in order to obtain tax savings, particularly if a

portion of the property settlement has been shifted to alimony. Sometimes the risk may not be too

severe. If the recipient is fairly young and in good health, life insurance could be purchased at

reasonable rates. During the negotiation process, the recipient may demand extra payments to cover

the annual insurance payments. In other cases, the payer may continue to support the children out

of moral or perhaps legal reasons.

Example 6

Refer to the facts of Example 5. Assume Dawn dies after three years ofpayments. At this time, the children will be ages 10 and 12. Under this scenario, itis possible that Donald will obtain legal custody of the children. Thus, whether theoriginal payments were classified as alimony or child support would not make muchdifference after Dawn's death (as far as the support for the children is concerned,since Donald would be legally obligated to care for the children).

A.41 Splitting Up the Property Fairly

As mentioned previously, generally property settlements are not a taxable transaction. In line

with this result, the recipient's basis in the property received equals the basis of the property before

the settlement. Thus, when dividing up the property, the taxpayer needs to be aware of the bases of

the properties and should not agree to receive all of the appreciated assets without being

appropriately compensated.

Example 7

Mary and John file a separation agreement. The personal effects (furniture,clothing, television, stereo, etc.) are divided equally. All that remains are 1,000shares of ABC stock and 500 shares of XYZ stock. Each stock is valued at $20,000.ABC stock was purchased 20 years ago at a cost of $4,000. XYZ stock waspurchased for $30,000. John feels that the ABC stock has more potential, so he asksMary if he can have it and she can take the XYZ stock. Mary agrees.

John forgot to analyze the built-in tax effects. If John were to sell the stockimmediately, he would realize a taxable gain of $16,000. On the other hand, sellingthe XYZ stock now would generate a $10,000 loss. This loss could offset othercapital gain or offset ordinary income by $3,000 per year.

11

44444444444444444444444444444444444444444444444444444444444444TAX SAVER!! The parties should structure the division of investment propertysuch that highly appreciated assets (low basis and, therefore, built-in gain potential)should be transferred to the one with the lower marginal tax rate. Built-in lossproperty should be transferred to the one with the higher tax rate, particularly if it canoffset ordinary income up to $3,000 per year. Any tax savings from this strategyshould be shared in an equitable manner.

44444444444444444444444444444444444444444444444444444444444444

Example 8

Refer to the facts of Example 7 and assume that John receives the ABC stockand Mary receives the XYZ stock. Assume that John is in the 15% tax bracket (0%for capital gain income in 2016) and Mary is in the 33% bracket (15% for capital gainincome in 2016). Also, assume that both have some separate property which they areplanning to sell for a gain and which would offset the entire capital loss from the saleof XYZ. At the current rates and property values, John would pay no tax assuminghe does not climb out of the 15% tax rate and Mary would save $1,500 (($20,000 -$30,000) x 15% capital gains tax rate). Thus, the net effect is a tax savings of $1,500($1,500 - $0).

If they had split the property equally and sold the property in the same year,each would realize a net capital gain of $3,000 ($8,000 gain from ABC and $5,000loss from stock XYZ). John would pay no tax and Mary would pay tax of $450 asa result of the sale. The combined tax is $450.

Note that the difference in the two strategies is $1,950 ($1,500 savingscompared to $450 tax). Therefore, it would be prudent to transfer the ABC stock toJohn and transfer a sufficient amount of extra cash or other property so that Johnshares in the overall tax savings from choosing this strategy.

** REVIEW QUESTIONS AND SOLUTIONS **

Questions

1. Regarding alimony, which one of the following statements is false?

a. If the divorce decree states the payment is child support, it cannot be treated asalimony for tax purposes.

b. The spouses or former spouses may not be members of the same household duringthe entire taxable year.

c. Alimony payments must cease upon the death of the recipient spouse.

2. The divorce decree states that Dan is required to pay Bonnie alimony of $50,000 per yearfor10 years or until her death, whichever is earlier. If Bonnie dies before 10 years, the decreerequires Dan to pay child support of $30,000 per year for the remainder of the ten-yearperiod. How much of the annual payment is treated as alimony?

a. $50,000.b. $30,000.c. $20,000.

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3. Frank pays Janice the following amounts of alimony under their Year 1 divorce decree: Year1 - $65,000, Year 2 - $55,000, Year 3 - $30,000, and Year 4 - $20,000. How much, if any,of the Year 1 alimony payment must be recaptured in Year 3?

a. $12,500.b. $10,000.c. $ 7,500.

Solutions

1. "B" is the correct response. While the spouses may not be members of the samehousehold after the alimony payments begin, they could have been living in the same houseduring the year before the alimony payments started.

"A" is an incorrect response. The second requirement concerning the definition ofalimony is that the agreement must not designate the payment as not being alimony.

"C" is an incorrect response. This is the fourth requirement mentioned above concerningthe definition of alimony. Section A.2.

2. "C" is the correct response. Alimony payments must cease upon the death of the recipientspouse. If the agreement provides for any portion of the payment to continue beyond thespouse’s life, it is not treated as alimony. In this case, $30,000 of payments would continue,so only $20,000 ($50,000 - $30,000) of the payment is treated as alimony.

"A" is an incorrect response. Although $50,000 is the amount of alimony paymentdesignated in the divorce decree, the substitute payment that would continue after thespouse’s death is not treated as alimony. See Example 2.

"B" is an incorrect response. $30,000 is the substitute payment that is treated as childsupport rather than alimony. Section A.22.

3. "A" is the correct response. $10,000 of the Year 2 payment is subject to recapture sincethe difference between the Year 2 and Year 3 payments exceeds $15,000 by $10,000($55,000 - ($30,000 + $15,000)). For purposes of calculating the Year 1 recapture, the Year2 payment is reduced by the $10,000 recapture to $45,000. The Year 1 recapture amountequals the Year 1 payment less the sum of (1) the average of the Year 2 and Year 3payments, and (2) $15,000. Thus, the recapture amount equals $65,000 - (($45,000 +$30,000)/2) + $15,000), or $12,500. Note that if the Year 4 payment were made in Year 3(for a total payment of $50,000), no recapture would have resulted.

"B" is an incorrect response. $10,000 would be correct if the recapture of the Year 1payment equaled the difference between the Year 1 and Year 2 payments.

"C" is an incorrect response. $7,500 would be correct if the Year 2 payment did not haveto be reduced by the Year 2 recapture amount. Section A.3.

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B. SOCIAL SECURITY BENEFITS


Social security benefits (SSBs): Amounts received by the taxpayer by reason of entitlement to (1)a monthly benefit under title II of the Social Security Act, or (2) a tier 1 railroad retirement benefit.

Provisional Income: Equals a taxpayer’s modified adjusted gross income (MAGI) plus 50% of thenet SSBs received during the year.

MAGI: This stands for modified adjusted gross income and is used in many tax calculations suchas the amount of SSB which is taxable and the amount of an IRA contribution is deductible. Thedefinition of MAGI varies depending on the provision. For purposes of calculating the amount ofSSB which is taxable, it equals AGI before considering SSBs plus tax-exempt interest income.


1. Identify which payments are considered social security benefits.

2. Compute provisional income.

3. Determine the amount of social security benefits includible in gross income.

B.1 Definition of Social Security Benefits

Social security benefits (SSBs) are defined as amounts received by the taxpayer by reason

of entitlement to (1) a monthly benefit under title II of the Social Security Act, or (2) a tier 1 railroad

retirement benefit. Generally these are amounts received from the Social Security Administration18

by the taxpayer after attaining a specific age (between 65 and 67 depending on the taxpayer’s year

of birth or age 62 if the taxpayer elects to receive reduced benefits). They also include monthly

survivor and disability benefits but do not include supplemental security income (SSI) payments,

which are not taxable.19

Equivalent tier 1 railroad retirement benefits are the part of tier 1 benefits that a railroad

employee or beneficiary would have been entitled to receive under the social security system. They

are commonly called the social security equivalent benefit (SSEB) portion of tier 1 benefits.

Taxpayers who received these benefits during the year should have received a Form SSA-1099,

Social Security Benefit Statement, or Form RRB-1099, Payments by the Railroad Retirement Board,

showing the amount. The net benefits reported on Box 5 of both forms are the amounts that are

14

reported on line 20a of Form 1040 to determine how much, if any, of the benefits are included in

taxable income.

B.2 Calculation of Taxable Portion of Social Security Benefits

B.21 Provisional Income

Whether any of the taxpayer’s SSBs is includible in the taxpayer’s gross income depends on

the amount of the taxpayer’s (1) provisional income, and (2) filing status. Provisional income is

defined as the taxpayer’s modified adjusted gross income (MAGI) plus 50% of the net SSBs received

during the year. For most taxpayers, MAGI is the same as the taxpayer’s AGI before considering

SSBs, plus tax-exempt interest income.20

B.22 SSBs Fully Excludable From Income

A taxpayer’s SSBs are fully excludable if provisional income is less than or equal to the base

amount. The base amount depends on the taxpayer’s filing status and is: (1) $32,000 for married

filing jointly, (2) zero for married taxpayers filing separately who live together at least part of the

taxable year, and (3) $25,000 for all other taxpayers.21

Example 9

Jim and Sara Jones file a joint return for the current year. They have wagesof $13,000, taxable retirement benefits of $12,000, tax-exempt interest income of$1,000, and SSBs of $10,000. Their MAGI equals $26,000 (AGI of $25,000 +$1,000 tax-exempt income) and their provisional income equals $31,000 ($26,000+ 50% of $10,000). Since their provisional income is less than the $32,000 baseamount, none of the SSBs are included in their gross income.

B.23 SSBs up to 50% Includible in Income

If the taxpayer’s provisional income is greater than the base amount provided above but is

less than the adjusted base amount, the amount of SSBs which is includible in gross income is the

lesser of: (1) 50% of SSBs, or (2) 50% of (provisional income less the base amount). The adjusted

base amount also depends on the taxpayer’s filing status and is: (1) $44,000 for married filing jointly,

(2) zero for married taxpayers filing separately who live together at least part of the taxable year, and

(3) $34,000 for all other taxpayers.22

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Example 10

Refer to the facts of Example 9 except Jim and Sara also had long-termcapital gain income of $9,000. Their provisional income is now $40,000 ($31,000+ $9,000 of capital gain income) and the amount of SSBs which is includible in theirgross income equals $4,000 (lesser of $5,000 (50% of $10,000 SSBs) or $4,000 (50%of ($40,000 - $32,000).

44444444444444444444444444444444444444444444444444444444444444TAX SAVER!! Note that when comparing Examples 9 and 10, an additional $9,000of capital gain income resulted in an additional $4,000 of SSBs being included ingross income. The first $1,000 of capital gain income brought their provisionalincome to $32,000. From that point on, each additional $1 of capital gain incomeincreases the amount of SSBs that is included in gross income by $.50 (the remaining$8,000 of capital gain income resulted in $4,000 of SSBs being included in grossincome). Taxpayers whose income is near the base amount should carefully considerthe tax consequences of realizing additional income during the year and the amountof additional SSBs which must be included in gross income. If the capital gain is notrealized until near the end of the year, perhaps the sale could be delayed until thebeginning of the next year.

44444444444444444444444444444444444444444444444444444444444444

B.24 SSBs up to 85% Includible in Income

Once the taxpayer’s provisional income exceeds the adjusted base amounts ($44,000 for

married joint returns, $0 for married separate returns, and $34,000 for all other taxpayers), the

calculation of the includible portion of SSBs becomes more complicated. The amount of SSBs

which is includible in gross income is the lesser of: (1) 85% of SSBs, or (2) 85% of (provisional

income less the adjusted base amount), plus the lesser of (a) 50% of SSB, or (b) $6,000 for married

taxpayers filing a joint return, $0 for married taxpayers filing separately as described above, and

$4,500 for single taxpayers.

Example 11

Refer to the facts of Example 10 except Jim and Sara had long-term capitalgain income of $15,000 rather than $9,000. Their provisional income is now $46,000($40,000 + $6,000 more of capital gain income) and the amount of SSBs which isincludible in their gross income equals $6,700 – the lesser of (1) $8,500 (85% of$10,000 SSBs), or (2) $6,700 (85% of ($46,000 - $44,000), which is $1,700, plus$5,000 (the lesser of 50% of $10,000 of SSBs or $6,000)).

16


Questions

4. Jim and Debra Burkett file a joint return for the current year. They are retired and have$40,000 in taxable retirement benefits, $4,000 of tax-exempt interest income and $40,000of social security benefits (SSBs). How much of the SSBs is included in their gross income?

a. $23,000.b. $34,000.c. $40,000.

Solutions

4. "A" is the correct response. Their provisional income equals $64,000 ($40,000 + $4,000of tax-exempt interest plus 50% of SSB) and the amount of SSBs which is includible in theirgross income equals $23,000 – the lesser of (1) $34,000 (85% of $40,000 SSBs) or (2)$23,000 (85% of ($64,000 - $44,000), which is $17,000, plus $6,000 (the lower of 50% of$40,000 of SSBs or $6,000)).

"B" is an incorrect response. $34,000 (85% of $40,000) is the maximum amount thatwould have to be includible in gross income regardless of the amount of provisional income.

"C" is an incorrect response. $40,000 is the total SSBs received, but only a maximum of85% of the amount of SSBs received is includible in gross income. Section B.24.

C. SCHOLARSHIPS AND FELLOWSHIPS


Scholarship: An amount received for paying educational-related expenses. It’s tax consequences aredependent on what costs the scholarship covers and whether the student qualifies for the scholarshiptax exclusion.


1. Identify which education costs covered under a scholarship are not taxable.

2. Identify the requirements for tax free scholarships.

C.1 General Requirements for Exclusion

When a student receives an amount for a scholarship or fellowship, all or some of the amount

may be excluded from gross income. Here are the requirements which must be met in order for the

scholarship or fellowship to be excluded from gross income:

1. The student must be a candidate for a degree at a qualified educational organization(generally, four-year baccalaureate degree-granting and two-year technical schoolsqualify).23

17

2. The amount received must be spent for tuition, fees, and course-related fees, books,supplies, and equipment – course-related fees must be required of all students in theparticular course of instruction. Amounts spent for incidental expenses such as roomand board, travel, and equipment and other expenses which are not required for eitherenrollment or attendance at the educational organization, or in a course of instructionthere, do not qualify for exclusion from gross income.24

Example 12

Sam receives a $400 scholarship to take a correspondence course from theNorth American Correspondence School (NACS). Sam receives and returns alllessons through the mail. No students are in attendance at NACS's place of business.Since NACS is not a qualifying educational organization, Sam must include theentire $400 in his gross income.

Example 13

Bill receives a $11,650 scholarship to the state university which is used forthe following expenses: $5,000 for tuition; $5,500 for room and board; $250 forbooks for his courses; and, $900 for a computer. He bought the computer becauseit was a suggested item for one of the courses in which Bill was enrolled. Bill mustinclude $6,400 ($5,500 + $900) of the scholarship in his gross income.

Examples of scholarships covered by these rules are Pell Grants, Supplemental Educational

Opportunity Grants, and grants to states for state student incentives.

Any part of a scholarship or fellowship which is for teaching, research, or other services,

even if all degree candidates are required to perform the services to receive the degree, must be

included in gross income.

Example 14

Tammy Belton is notified in January 2016, that she will receive a scholarshipto the state university for the 2016 spring semester. Tammy must serve as a part-timeteaching assistant as a condition to receiving the scholarship. The scholarship is for$6,500, and $2,000 represents payment for her teaching services. Tammy may notexclude more than $4,500 of the scholarship from her 2016 gross income.

C.2 Other Items Related to Scholarships or Fellowships

Generally, the value of a qualified tuition reduction is not included in gross income. A

qualified tuition reduction represents the amount of reduction in tuition provided to an employee of

an educational institution for the employee's education by any educational institution. The exclusion

also applies to a qualified tuition reduction for the employee's spouse and any dependent children.

The tuition must be for education below the graduate level.25

18

Under a different rule, a graduate student who is engaged in teaching or research activities

at an educational institution may exclude from gross income the value of any qualified tuition

reduction which he or she receives for education furnished by the institution. In all cases, any

qualified tuition reduction received as payment for services must be included in gross income.

Two other special issues with respect to scholarships and fellowships are (1) valuing the

portion of scholarship or fellowship grants which represents payment for services, and (2)

recordkeeping requirements necessary to justify an income exclusion for a scholarship or a

fellowship.

If part of a scholarship or fellowship grant represents payment for services, the grantor must

compute the amount of the grant which is allocated to payment for services. Some of the factors

which the grantor may use to make the allocation are:

1. compensation which the grantor pays for similar services performed by non-granteestudents with qualifications comparable to those of the person receiving thescholarship or fellowship.

2. compensation which the grantor pays for similar services performed by full-time orpart-time non-student employees.

3. compensation paid by educational organizations, other than the scholarship- orfellowship-grantor, for similar services which either students or other employeesperform.26

The Department of the Treasury has indicated that the recipient of a qualified scholarship

must maintain records which show amounts spent for qualified tuition and related expenses, as well

as the total of qualified tuition and related expenses. The Treasury requires two types of27

information to be maintained:

1. copies of relevant bills, receipts, cancelled checks, or other documentation or recordswhich clearly reflect the use of the scholarship money, and

2. documentation which establishes receipt of the grant, notification date of the grant,and the conditions and requirements of the particular grant.

The part of a scholarship or fellowship which represents payment for teaching, research, or

other services is earned income. Accordingly, the grantor should provide the recipient with a W-2

for such amounts. On the other hand, any part of the scholarship or fellowship which is

19

noncompensatory, but is included in gross income because it is not for tuition and course-related

expenses, is earned income only for purposes of the standard deduction used by a student who is

claimed as a dependent.


Questions

5. William Dover receives a full scholarship to McKesson University. The value of thescholarship is $18,000, and it covers the following: $6,000 tuition, $1,500 related fees,$8,000 room and board, $1,000 books, and $1,500 computer. The computer is required forenrollment at McKesson University. How much of his $18,000 scholarship must Williaminclude in his gross income?

a. $10,500.b. $ 9,500.c. $ 8,000.

Solutions

5. "C" is the correct response. Only the cost of room and board must be included inWilliam’s gross income. The other items (the computer, like the books, is required of allstudents) may be excluded from William’s gross income.

"A" is an incorrect response. $10,500 would be correct if the books and computer alsowere includible in income. As noted in item #2 just above Example 12, books are excludableas well as equipment purchases that are required for enrollment or attendance.

"B" is an incorrect response. $9,500 would be correct if the purchase of the computer wasnot required for enrollment or attendance. See Example 13. Section C.1.

D. PRIZES AND AWARDS


Charitable achievement awards: Certain awards that are received by a taxpayer for one of sevenreasons and donated to a charitable organization. These awards are nontaxable if certain provisionsare satisfied.

Employee achievement awards: Generally two types of awards granted by an employer – (1) lengthof service and (2) safety achievement that are excludible from an employee’s income and deductibleby the employer if certain provisions are satisfied.


1. Identify the requirements for excluding from gross income an achievement awardreceived by the taxpayer which is later donated to a charitable organization.

20

2. Identify the requirements of employee achievement and safety achievement awards.

3. Compute the employer deduction for employee achievement and safety achievementawards.

D.1 Charitable Achievement Awards

Taxpayers generally must include the fair market value of prizes and awards in gross

income. However, there is an exception for prizes and awards made to recognize past28

accomplishments in religious, charitable, scientific, artistic, educational, literary, or civic fields.

Prominent examples are the Pulitzer, Nobel, and similar prizes.

Under the exception, the fair market value of the prize or award is excluded from gross

income if the following requirements are met:

1. the recipient of the prize or award is selected without any action on his part to enterthe contest or proceeding,

2. the recipient is not required to perform substantial future services as a condition toreceiving the prize or award, and

3. the prize or award is transferred by the payer to a governmental unit or tax-exemptcharitable organization designated by the recipient.29

The IRS specifies several conditions which apply to the transfer from the payer to the

governmental unit or tax-exempt charitable organization. These conditions are:30

1. the recipient can not use the prize or award (e.g., if the recipient receives money, hemay not spend, deposit, or invest it) before it is transferred,31

2. a document containing the recipient's designation should be provided before the prizeor award is presented (if the recipient receives an unexpected prize or award, therecipient must return the prize or award before he uses it, and then provide hisdesignation), and

3. after the payer makes the transfer, the recipient should obtain a written response fromthe payer which states (a) when, and (b) to whom the designated amount wastransferred.

The IRS delineates the items which the document containing the designation (from number2 above) should contain. These items are:

1. the purpose of the document, i.e., a statement making reference to Section 74(b)(3)of the Internal Revenue Code,

2. a description of the prize or award,

21

3. the name and address of the organization to which the prize or award is to betransferred,

4. the recipient's name, address, and social security number, and

5. the recipient's signature and the date of his signature.

D.2 Employee Awards

Employee achievement awards, subject to certain dollar limitations, are excludable from an

employee's gross income. The following are characteristics of employee achievement awards: 32

1. The award is tangible personal property -- cash, gift certificates, andintangible and real property do not qualify;

2. The employer makes the award to the employee for length of service or safetyachievement -- an award for productivity or any other purpose does notqualify;

3. The award is made as part of a meaningful presentation; and,

4. The award is made under conditions and circumstances that do not create asignificant likelihood of the payment's being disguised compensation.

If the award meets the characteristics above, then generally the cost of the award is deductible

by the employer. Also, the fair market value of the award is fully excludable from the employee's

gross income. There are limitations imposed on amounts which the employer may deduct. If these

limitations are exceeded, some portion of the fair market value of the prize or award may have to be

included in the employee's gross income.

Two limitations are placed on an employer's deduction for awards given employees. The33

limitations apply with respect to each employee. First, an employer may not deduct more than $400

for the cost of all employee achievement awards (which are not qualified plan awards) per employee

per year. Second, an employer may not deduct more than $1,600 per employee per year for qualified

plan awards. The $1,600 also acts as the ceiling per employee for all employee achievement awards

(i.e., both qualified and unqualified plans). Generally, a qualified plan award is an employee

achievement award made under a written plan or program. The plan or program can not discriminate

in favor of highly compensated employees.

22

Example 15

Mandarin Corporation gives $300 of employee achievement non-qualifiedplan awards and $1,500 of employee achievement qualified plan awards to one of itsemployees during a year. Mandarin Corporation may deduct the $300 for thenon-qualified plan awards and $1,300 ($1,600 - $300) of the $1,500 for qualifiedplan awards.

If the cost of an employee achievement award is fully deductible by the employer, the fair

market value of the award is excludable from the employee's gross income.

If any part of the cost of an employee achievement award exceeds the dollar limitations

imposed on the employer, and thus is not fully deductible by the employer, then an exclusion is not

available to the employee for the entire fair market value of the award. The tax rules require the

employee to include the greater of the following amounts in gross income: (1) the portion of the

cost which the employer can not deduct (but not in excess of the fair market value of the award),

or (2) the excess of the fair market value of the award over the maximum dollar amount which the

employer can take as a deduction. The rest of the fair market value of the award is excluded from

the employee's gross income.

Example 16

Mobile Corporation makes a safety achievement award, not under a qualifiedplan, to an employee, Moe Bell. The cost of the award is $500; the fair market valueis $475. Mobile can take a $400 deduction. Moe includes in his income the greaterof (1) $75 ($475 - $400; the $500 cost is limited to the $475 fair market value of theaward), or (2) $75 ($475 - $400). Thus, Moe includes $75 in his gross income; theremaining $400 of fair market value is excluded from Moe's gross income.

If all of the facts were the same, except that the fair market value were $600,Moe would include in his gross income the greater of (1) $100 ($500 - $400), or (2)$200 ($600 - $400). Thus, Moe includes $200 in his gross income, and he excludesfrom gross income the remaining $400 of fair market value.

The employer must put the includible portion of the award on the employee's Form W-2.

Any portion excluded from gross income also is excluded from FICA compensation. The exclusion

is not available for any award which a sole proprietorship makes to the sole proprietor.

23


Questions

6. Pursuant to an unqualified employee achievement award, Company A awards an employeeproperty. The property cost the company $650, and its fair market value is $900. Theproperty is the only award that the company makes for its current tax year. How much maythe company deduct, and how much does the employee include in gross income as aconsequence of the award?

a $650 company deduction; $250 employee gross income.b. $400 company deduction; $250 employee gross income.c. $400 company deduction; $500 employee gross income.

Solutions

6. "C" is the correct response. The company’s deduction for its tax year is limited to $400for the cost of all employee achievement awards per employee which are not qualified plans.When the cost of the award to the company is not fully deductible, as is the case here, theemployee must include in gross income the greater of the part of the cost which the companycan not deduct, $250 here, or the excess of the $900 fair market value of the award over theemployer’s maximum $400 deduction, $500 here. So, the employee must include $500 ingross income.

"A" is an incorrect response. The maximum employer deduction for unqualified planaward is $400. $250 is the smaller of the two amounts of which the greater of the twoamounts must be included in gross income.

"B" is an incorrect response. This response would be correct if the inclusion amount werethe lesser rather than the greater of the two items described in Response C. Section D.2.

E. INCOME UNDER THE TAX BENEFIT RULE


Tax benefit rule: Deals with recoveries of previous expenses in the current year where a taxpayer hadreceived a tax benefit from the expense in a prior year. A tax benefit occurs only if the expensereduced the taxpayer’s tax liability in a prior year.


1. Compute the amount of income under the tax benefit rule.

2. Determine where recoveries under the tax benefit rule are reported on the tax return.

E.1 General Concepts

The tax benefit rule deals with recoveries of previous expenses in the current year where a

taxpayer had received a tax benefit from the expense in a prior year. A tax benefit occurs only34

24

if the expense reduced the taxpayer’s tax liability in a prior year. The full recovery may not have to

be included in income. Rather, the recovery is included in income only to the extent that the

deduction or credit reduced the federal income tax in a prior year.

There are several special issues with respect to recoveries: (1) itemized deduction recoveries,

(2) recoveries attributable to amounts paid in two or more tax years, and (3) differences between the

amount of a state and/or local income tax refund and the amount reported as income on Form 1040.

The Treasury regulations use an exclusion approach to apply the tax benefit rule.

Specifically, the amount of the recovery which is included in a taxpayer’s gross income equals the

recovery amount less the “recovery exclusion.” The "recovery exclusion" equals the portion of the

aggregate amount of such deductions or credits which could be disallowed without causing an

increase in the taxpayer's income tax. The Treasury regulations specify that an income exclusion is

available for income attributable to the recovery of bad debts, prior taxes, delinquency amounts, and

similar items to the extent of the "recovery exclusion" with respect to those items. 35

If the taxpayer previously did not itemize a deduction for which there is a subsequent

recovery, the amount recovered is not included in income. The "recovery exclusion" approach above

explains this result, because the deduction could be disallowed, and there would be no increase in

the taxpayer's income tax. Another way of dealing with recoveries is through an "income inclusion"

approach.

The income inclusion is limited to the smaller of (1) the amount deducted on Schedule A,

and (2) the amount of the recovery. Thus, any part of the recovery which exceeds the amount

deducted in a prior year is not included in income. Also, the inclusion will not exceed the itemized

deduction / standard deduction difference for the deduction year. There is an income inclusion only

if taxable income in the deduction year is positive. State and local income tax refunds are reported

on line 10 of Form 1040, and the total of all other recoveries for itemized deductions is reported on

line 21 of Form 1040.

25

Example 17

Joe and Molly Ramsay filed a joint return for 2015. They filed a Form1040A, thereby not itemizing deductions. In 2016 they receive a refund of some oftheir 2015 state income taxes. The refund is not included in 2016 income since notax benefit was realized in 2015 for the tax payment that resulted in a refund.

Example 18

Sam and Sally Jackson filed a joint return for 2015. They itemized theirdeductions. One of their itemized deductions was for medical expenses. Theirmedical expenses were $1,750, but their deduction was limited to $150 because ofthe 10% of AGI limitation. In 2016 the Jacksons receive $650 for 2015 expensesunder their medical expense policy. Only $150 of the $650 is included in income.

Example 19

Rick and Susan Monihan filed a joint return in 2015 for which the standarddeduction is $12,600. Their itemized deductions totaled $12,800. The only itemizeddeduction for which they receive a recovery in 2016 is state income taxes. Their stateincome tax deduction in 2015 was $4,500. Their 2015 refund received in 2016 is$1,650. Only $200 ($12,800 - $12,600) of the refund is included in their 2016income. They report the $200 on line 10 of their Form 1040.

Example 20

The Kings file a joint return in 2015. Their itemized deductions were$15,600, including a state income tax deduction of $6,000. The 2015 standarddeduction for joint return taxpayers is $12,600 and none of their itemized deductionswere phased out in 2015. In 2016, the Kings receive a state income tax refund of$2,500.

In this case, the state refund included in the 2016 is the lower of (1) the refundamount, which is $2,500 and (2) the itemized deductions in excess of the standarddeduction which is $3,000 ($15,600 - $12,600), so the $2,500 refund is includible ingross income.

E.2 Other Issues

An allocation of the recoveries is necessary if all recoveries do not have to be included in

income (itemized deductions less standard deduction is smaller than the total recoveries) and the

taxpayer has both a state (local) income tax refund and other itemized deductions for which there

is a recovery. The IRS requires this allocation so that the recovery connected with a state (local)

income tax refund can be reported on line 10 of Form 1040 and any remaining recovery reported on

line 21 of Form 1040. The amount of the recoveries included in income for the tax year that is

allocable to the state (local) income tax refund is computed by multiplying the taxable recoveries by

26

a fraction. The fraction equals the state (local) income tax refund divided by the total of all itemized

deduction recoveries. The balance of total taxable recoveries is allocated to other itemized deduction

recoveries.36

Example 21

Sam and Cathy Hanes had $62,000 of taxable income for 2015. They fileda joint return for which the standard deduction was $12,600. Their itemizeddeductions totaled $13,350. In 2016, the Hanes receive recoveries as follows foramounts deducted in 2015:

Medical expenses........................... $ 750State and local income tax refund.. 1,000Real estate tax rebate .................... 625Interest expense ............................ 125

Total recoveries ................ $2,500

Their total recoveries of $2,500 are more than the $750 difference betweenthe $12,600 standard deduction for 2015 and their 2015 itemized deductions of$13,350. Therefore, only $750 of the recoveries is taxable, and included in their2016 income.

The amount of the recoveries for the tax year allocable to the state income taxrefund is computed by multiplying the $750 of taxable recoveries by the fraction,$1,000 / $2,500 (the state income tax refund divided by the total of all itemizeddeduction recoveries). Thus, $300 (40% of $750) is reported on line 10 of the Hanes'Form 1040, and the $450 ($750 - $300) taxable recovery balance is reported on line21.

Example 22

Assume the same facts as Example 21 except that their itemized deductionsequal $16,600. Since the itemized deductions in excess of the standard deduction($4,000) is greater than the total recoveries, all of the recoveries are included inincome. $1,000 is reported on line 10 of the Hanes' Form 1040, and the $1,500($2,500 - $1,500) taxable recovery balance is reported on line 21.

A second issue with respect to recoveries involves the situation in which there is a recovery

attributable to amounts paid in two or more tax years. An example would be when state income

taxes are paid over two tax years, and a recovery of some of the taxes is received in the second tax

year. An allocation is required to apportion the recovery between the two tax years. The allocation

yields the portion of the recovery which is taxable and the portion of the recovery which reduces the

current deduction for state income taxes.

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Example 23

Ted Brendle is self-employed and makes estimated payments for his stateincome tax liability. Ted owns a home and has sizable interest and other itemizeddeductions. He itemizes his deductions for 2015 and 2016. Included in his 2015itemized deductions are three estimated payments of $1,200 each which were madetoward his 2015 state income tax liability. He also made a fourth $1,200 payment inJanuary, 2016. Ted's total itemized deductions for 2015 were $12,000 (the standarddeduction for single taxpayers in 2015 is $6,200). In 2016, Ted receives a $340refund of his 2015 state income taxes paid (which included the January, 2016payment). Ted receives no other 2016 recoveries for 2015 itemized deductions.

Ted must allocate the $340 refund between 2015 and 2016 payments. Since2015 payments represent 75% of the total payments ((3 x $1,200) / (4 x $1,200)),75% of the $340 recovery, or $255, is allocated to 2015. The $85 balance isallocated to 2016. The $255 is included on line 10 of Ted's 2016 Form 1040. The$85 reduces Ted's 2016 deduction for state income taxes paid.

**REVIEW QUESTIONS AND SOLUTIONS**

Questions

7. The Nardoskis, who file jointly, make estimated state income tax payments with respect totheir 2015 tax year. They make four equal payments of $500, three during 2015, and thefinal payment in January, 2016. The Nardoskis had $16,100 of total itemized deductions in2015. In May, 2016, the Nardoskis receive a $300 refund of 2015 state income taxes, theironly 2016 recovery. How do the Nardoskis treat the $300 refund?

a. Form 1040 line 10, 2016 taxable recovery – $225; reduction of 2016 state incometax deduction – $75.

b. Form 1040 line 10, 2016 taxable recovery – $75; reduction of 2016 state income taxdeduction – $225.

c. Form 1040 line 10, 2016 taxable recovery – $300; reduction of 2016 state incometax deduction – $0.

Solutions

7. "A" is the correct response. The Nardoskis must allocate the recovery between 2015 and2016, determining how much of the recovery is includible in income, and how much of therecovery reduces their 2016 deduction for state income taxes. Three-fourths of the $300recovery ((3 x $500) / (4 x $500)), or $225, is includible in income, and the $75 balancereduces their 2016 state income tax deduction. Refer to Example 23 and the paragraphbefore it.

"B" is an incorrect response. This response would be correct if 75% rather than 25% ofthe 2015 state income tax payments were made in 2016. Section E.2.

"C" is an incorrect response. This response would be correct if no allocation to the stateincome tax reduction were required.

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F. COURT AWARDS, DAMAGES, AND BACK PAY


Physical personal injuries: A requirement for exclusion from gross income under Section 104whenever a taxpayer receives payments due to injuries or sickness. Payments for nonphysicalinjuries generally are taxable.

Contingent attorney fees: Attorney payments which are required only when the taxpayer wins a caseor settlement (usually a percentage of the award). Depending on the circumstances, these paymentsare deductible either above-the-line or below the line.


1. Determine which awards for damages received for injuries are excluded from grossincome.

2. Compute the amount of employer legal settlement payments which are included ingross income.

3. Determine whether the payment of contingent attorney fees is deductible above-the-lineor below the line.

F.1 General Concepts

Internal Revenue Code Section 104 provides that amounts received for damages on account

of physical personal injuries or physical sickness are excluded from gross income. This section37

includes amounts received on account of personal injuries or sickness (1) under worker's

compensation, (2) through accident or health insurance, and (3) from a lawsuit or by agreement for

the payment of damages. Generally, amounts received as damages for nonphysical injuries or

sickness are taxable. If the taxpayer has emotional distress due to physical injuries or physical

sickness, the damages received for such emotional distress can be excluded from gross income to

the extent paid for medical care. Emotional distress includes physical symptoms that result from

emotional distress, for example, headaches, insomnia, and stomach disorders.38

Amounts received for violation of contractual rights are included in gross income. Examples

of amounts to be included in gross income are:

1. compensation for lost wages.

2. amounts received in settlement of pension rights, where the employee did notcontribute to the pension plan.

29

3. damages for patent or copyright infringement and breach of contract.

Punitive damages, compensation for lost profits, damages for interference with business operations,

and interest on any award are included in gross income.39

The Tax Court has held that severance pay received by a basketball coach, who was fired

before his contract expired, was includible in gross income. The Federal Circuit Court of Appeals40

has upheld a federal district court decision which required that disability retirement payments

determined by length of service be included in gross income.41

The United States Supreme Court considered whether amounts which an employee received

for backpay under Title VII of the Civil Rights Act of 1964 were taxable. The employee's employer42

had withheld income taxes from the award, and the employee sued the IRS for a refund of the taxes.

The Supreme Court concluded that since the amounts were for backpay due the employee because

of discriminatory underpayments by the employer, rather than compensatory payments or other

damages, the amounts received were taxable.43

Back pay received to satisfy a claim for denial of promotion due to disparate treatment

employment discrimination under Title VII of the 1964 Civil Rights Act (as amended in 1991) is not

excludable from gross income. Amounts received for emotional distress to satisfy such a denial

claim are not excludable except to the extent they are damages paid for medical care attributable to

emotional distress.44

A 2004 Tax Court decision addressed the applicability of Section 104 to Social Security

disability payments. The taxpayer was a highly decorated Vietnam veteran who was exposed to45

Agent Orange. In 1993, he was diagnosed with lung cancer which resulted from his exposure to

Agent Orange. On account of his lung cancer, he was awarded Social Security disability insurance

benefits. The issue was whether these benefits are excluded from gross income under Section

104(a)(4). This provision excludes from gross income amounts received as a pension, annuity, or

similar allowance for personal injuries or sickness resulting from active service in the Armed Forces

of any country.

30

The taxpayer argued that the benefits were excludable because they were based solely on his

disability which resulted from his active service in the U.S. Armed Forces. Social Security disability

insurance benefits do not take into consideration the nature or cause of the disability. That is, it is

not relevant whether the disability arose from service in the Armed Forces or whether it was

attributable to combat-related injuries. What is considered is the individual’s prior work record. As

a result, the Tax Court ruled that the taxpayer’s benefits were not paid for personal injuries or

sickness resulting from military service, and accordingly the Social Security disability insurance

benefits are includible in income to the extent provided under IRC Section 86 (discussed in section

B above). The taxpayer also received monthly benefits from the Veteran’s Administration on the

basis of his exposure to Agent Orange. The exclusion of these benefits from income was not

contested by the IRS, and hence this issue was not addressed in the Tax Court decision.

F.2 Contingent Attorney Fees

Related to the issue of the taxability of damage awards is the issue relating to contingent

attorney fees. An item of extensive controversy for many years was how contingent attorney fees

that a taxpayer pays are treated.

The issue involves which of the following two treatments applies: (1) the taxpayer includes

the entire amount of the award in gross income, and takes a deduction for the contingent attorney fee;

the deduction often is a miscellaneous itemized deduction (on Schedule A under the category “Job

Expenses and Certain Miscellaneous Deductions”), subject to the 2% of adjusted gross income

limitation; also, it is not deductible if the taxpayer is subject to the alternative minimum tax. (2) the

taxpayer includes the net amount of the award (gross award reduced by the contingent attorney fee)

in gross income.

This issue was addressed by the Congress in 2004 legislation, the American Jobs Creation

Act of 2004 (AJCA ‘04). Also, this issue was addressed by the Supreme Court in a 2005 Supreme

Court decision. The Supreme Court held in Commissioner of Internal Revenue v. Banks (1/24/05)46

that when a litigant’s recovery constitutes gross income, the litigant’s income includes the portion

of the recovery paid to the attorney as a contingent fee.

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The AJCA ‘04 provides in some cases an above-the-line deduction for attorney fees and other

costs that the taxpayer pays or that are paid on the taxpayer’s behalf: in other words, the net amount

of the award is included in the taxpayer’s adjusted gross income.

The AJCA ‘04 is very specific as to the type of action for which contingent attorney fees may

be deducted above the line. An above-the-line deduction is provided for: (1) a claim of unlawful

discrimination, i.e., a civil rights award ( eighteen examples of acts of “unlawful discrimination” are

listed ); (2) certain claims against the federal government; and, (3) a private cause of action under47

the Medicare secondary payer statute. The treatment applies to fees and costs that are paid after48

October 22, 2004, with regard to any judgment or settlement that occurs after that date.

Example 24

During the current year, Mary Jones was awarded $1,000,000 as a result ofa lawsuit against her employer for violations of the Americans with Disabilities Actof 1990. This violation is considered an unlawful discrimination under the AJCA‘04. Pursuant to an agreement with her attorney, she receives 70% of the award andher attorney receives 30% of the award.

Generally amounts received as damages for nonphysical injuries or sicknessare taxable. Thus $1,000,000 of the award is includible in gross income after the2005 Supreme Court decision in Banks. However, as a result of the AJCA ‘04,contingent attorney fees may be deducted above the line for certain types of action,including unlawful discrimination. Therefore, $300,000 is deductible above-the-line,resulting in an AGI increase of $700,000 ($1,000,000 - $300,000).

If the award did not qualify for one of the three categories described above,her AGI increase would be $1,000,000 and her itemized deduction for attorney’s feeswould be $300,000. It would be deductible as a miscellaneous deduction subject tothe 2% AGI limitation.

PART 2 – PROPERTY TRANSACTIONS

A. COMPUTATION OF BASIS


Basis: Generally equals the cost of property plus improvement less capital recovery allowances(deductions). This amount is used in determining the amount of depreciation expense and thetaxpayer’s gain or loss upon the property’s disposition.

Donee's basis: Equals the basis of property received by gift and is dependent on the donor’s basisand the fair market value of the property at the date of the gift.

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Alternate valuation date: Six months after the date of death of the decedent. It is used to determinethe value of the decedent’s property for estate tax purposes as well as the basis of the propertyreceived by the beneficiary.


1. Calculate the basis of stock received by gift.

2. Calculate the basis of stock received by a stock dividend.

3. Compute the basis of stock qualifying under the wash sales rules.

A.1 General Rules

Before the tax consequences from the disposition of property can be determined, the taxpayer

needs to know the property’s basis. For capital assets and trade or business assets, to determine

whether the gain or loss is long-term or short-term, the holding period must be calculated. Generally,

the basis of most properties acquired by the taxpayer is calculated as follows:

Purchase Price

+ Cost of Improvements

- Capital Recovery Allowances (for business assets and assets heldfor the production of income such as rental property)

Purchase price includes sales tax charges, commission costs, delivery costs, and settlement costs.

Settlement costs include the following: (1) title fees; (2) attorney fees related to title search and

preparation of sales contract and deed; (3) recording fees; (4) survey costs; (5) owner’s title

insurance; and, (6) transfer taxes. They do not include (1) charges connected with obtaining a49

loan, and (2) prepaid escrow accounts for insurance, taxes, and utilities. 50

Example 25

On July 1, 2010, Bill Ramsey purchased an office building for $300,000. Hemade a down payment of $50,000 and borrowed $250,000. Settlement costsincluded (1) $1,000 of legal fees, (2) $300 in survey costs, (3) $1,300 in owner’s titleinsurance, (4) $400 in recording fees, (5) $2,500 in loan discount points, (6) $100 fora credit report, (7) $800 for an appraisal required by the lender, and (8) $1,000 for anescrow payment to cover two months of insurance and real estate taxes. On July 30,2016, Bill sold the property for $450,000. Over the years of ownership of the officebuilding, he added $10,000 of improvements. Accumulated depreciation equals$33,000.

Bill’s initial basis in the building is $303,000 ($300,000 plus $3,000 insettlement costs related to the first four items above). Items 5-7 represent loan costs

33

which may be amortizable over the life of the loan and item 8 is an escrow paymentwhich is not deductible (the actual payments out of the escrow account may bedeductible). His basis at the time of sale is $280,000 ($303,000 + $10,000 - $33,000)and his gain realized from the sale is $170,000 ($450,000 - $280,000).

For the sale of stock which is purchased at different dates, the first-in-first-out (FIFO) method

must be used if the identity of the stock cannot be determined.

Example 26

Sally Gold sells 100 shares of stock on December 10, 2016 for $1,200 ($12per share). Sally had purchased 100 shares in 2006 for $6 per share and 150 sharesin 2011 for $15 per share. Unless she can demonstrate that 100 shares of the latterpurchase were sold resulting in a $3 per share loss, the FIFO method requires Sallyto assume that the earlier purchase was deemed sold. Thus, Sally would recognizea gain of $6 per share

Five cases involving basis determination for purposes of computing gain or loss that warrant

special attention are (1) property received as a gift; (2) inherited property; (3) property held for

personal use which is converted to business or rental use; (4) property acquired from a stock split;

and, (5) property acquired in a wash sale. These are covered below.

A.2 Gift and Inherited Property

In computing the gain or loss on property received as a gift, you need to know the donor's

adjusted basis and fair market value when the gift was made. Also, if the donor paid gift tax, you

need to know how much gift tax was paid.51

To compute gain on appreciated gifted property (at the gift date) which subsequently is sold

or exchanged, the donee’s basis equals the donor's adjusted basis. If gift tax is paid, the basis is

increased by multiplying the gift tax by the following percentage: appreciation in the property/fair

market value at gift date.

To compute loss, also use the donor's adjusted basis unless the fair market value of the

property when the gift was made was less than the donor's adjusted basis. In that case, use fair

market value to compute loss. If gifted property which had depreciated in value before the time of

gift subsequently is sold for an amount between the donor's adjusted basis and fair market value at

the time of the gift, there will be neither gain nor loss on the sale.

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Example 27

Bob's mother gave Bob 100 shares of XYZ stock in 2015 when her adjustedbasis in the stock was $13,000 and its fair market value was $10,000. Bob's motherpaid no gift tax on the transfer.

Bob sells the stock in 2016 for $10,500. Bob uses the $13,000 to computegain. When compared to the $10,500 proceeds, there is no gain. He uses the$10,000 to compute loss. When compared to the $10,500 proceeds, there is no losseither. Thus, in situations where gifted property with a value below the donor's basisat the gift date later is sold at a price below the donor's basis, but above the value atthe gift date, the donee's basis equals the selling price. As a result, no gain or loss isrecognized.

4444444444444444444444444444444444444444444444444444444444444TAX SAVER!! The above example illustrates that generally it is not a good taxplanning technique to gift property which has declined in value. Bob's loss deductionis zero whereas Bob's mother's capital loss would have been $2,500 ($10,500 -$13,000). For nonsentimental property such as publicly-held stock, it is better to sellthe loss stock and gift the proceeds from the sale of the property rather than theproperty.

4444444444444444444444444444444444444444444444444444444444444

Other than for certain property inherited during 2010, the beneficiary's basis generally is the

fair market value at the date of the decedent's death or six months after that date, if the alternate

valuation date is used to value the estate. The alternate valuation date must be chosen by the52

representative of the estate. The election applies to all of the properties owned by the estate. The

election can be made only if it results in a decrease in the total value of the estates’s properties and

a decrease in the estate tax with respect to the property includible in the decedent’s gross estate.53

If the alternate valuation date is used and property is distributed between the decedent’s date of death

and the alternate valuation date, the basis of the property equals the fair market value on the date of

distribution.

Example 28

Bill Bridges died on January 15, 2016. On March 7, 2016, property A isdistributed to the sole beneficiary when its value is $500,000. Its value on January15, 2016 is $400,000. On August 12, 2016, property B is distributed to the solebeneficiary when its value is $2,450,000. Its value on January 15, 2016 is $2,600,000and its value on July 15, 2016 (six months after the date of death) is $2,400,000.

If the date of death is used to value the property for estate tax purposes, thebeneficiary’s bases in property’s A and B are $400,000 and $2,600,000, respectively(fair market value on the date of death). If the alternate valuation date is used, thebases are $500,000 (value on the distribution date since it was distributed before the

35

alternate valuation date) and $2,400,000 (value at the alternate valuation date),respectively.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA ‘01) replaced

the basis step-up rule to a modified carryover basis rule for property inherited beginning in 2010.

However, subject to a special election available to executors of decedents dying in 2010, the Tax

Relief Act of 2010 restored the stepped-up basis rules for decedent’s dying after 2009. In other

words, if the special election is not made, the stepped-up basis rules would apply in 2010. For a

taxpayer who inherited property in 2010, the basis in the property would not equal the property’s fair

market at the date of death (or alternate valuation date) if the special election was made. Therefore,

this topic is covered in some detail below.

Why wouldn’t an executor have stepped up the basis of the decedent’s property to fair market

value in 2010? The primary reason was to avoid the estate tax in 2010 as provided by the EGTRRA

‘01. That is, if this election were made in 2010, the good news is that the estate tax was avoided in

2010. The bad news is that the basis of the estate’s assets are determined in accordance with the

modified carryover basis rules established by the EGTRRA ‘01. While most executors of large

estates were likely to make this election to avoid the estate tax, executors of smaller estates had to

weigh the benefits (stepped up basis) and costs (some estate tax) of not making the election.

Under the modified carryover basis rule, the basis of inherited property between January 1,

2010 and December 31, 2010 is the lesser of (1) the decedent’s adjusted basis in the property, or (2)

the fair market value of the property at the date of the decedent’s date. The executor of the54

decedent’s estate could increase the basis of the decedent’s properties by two basis adjustments.

First, regardless of who is the beneficiary of the decedent’s property, the basis of the property may

be increased by $1,300,000. This amount is increased by any capital loss or net operating loss55

carryovers from the decedent’s last taxable year. Second, if the beneficiary of the property is the

decedent’s spouse, the basis may be increased by an additional $3,000,000. The executor has the56

authority to choose which assets are adjusted provided the adjustment does not increase the basis

above the fair market value of the property.

36

Example 29

James Bradley died in 2010, leaving an estate that consists entirely of 100,000shares of ABC stock valued at $7,000,000. The decedent’s basis in the stock was$4,000,000 and the executor elected to apply the modified carryover basis rules. Ifthe beneficiary of the stock is not the decedent’s spouse, the basis of the stock in thehands of the beneficiary is $5,300,000 ($4,000,000 plus $1,300,000 general basisincrease). If the beneficiary of the stock is the decedent’s spouse, the basis of thestock in the hands of his spouse is $7,000,000 ($4,000,000 plus $1,300,000 generalbasis increase plus $3,000,000 spousal property basis increase, not to exceed theproperty’s fair market value of $7,000,000).

A.3 Personal-Use Property Converted to Business/Rental Use

Often property which is held for personal use is converted to business or rental use. For

example, an individual may begin using his personal automobile in his capacity as a real estate agent,

or an individual may convert her personal residence to rental property. When the property is sold

or exchanged, the basis to be used to compute gain or loss depends on whether there is a gain or loss.

Special rules also apply to determine the basis for depreciation.

The basis to calculate gain is the original cost (or other basis) increased by the cost of

permanent improvements or additions, and decreased by depreciation. The basis to calculate loss

and/or depreciation deductions is the lesser of original cost or fair market value at conversion,

adjusted by the increases and decreases specified above. Similar to gifts, if converted property57

subsequently is sold for an amount between its adjusted basis and fair market value at the time of

conversion, there is neither gain nor loss at disposition.

Example 30

Martha paid $75,000 to purchase her first home. Several years later, shebought another home and began using her former residence as rental property. WhenMartha converted her first home to rental use, its fair market value was $67,000.Martha properly claimed $9,500 of depreciation (based on $67,000 basis) before laterselling the property for $81,000. No other adjustments were made to the basis of theproperty.

Martha uses a $65,500 basis ($75,000 - $9,500) to compute her gain on sale.Thus, she has a $15,500 gain ($81,000 - $65,500). If she had sold the property for$54,000, she would use a $57,500 basis ($67,000 - $9,500) to compute a $3,500 losson sale. If she sold the property in the $57,500 to $65,500 range, she would haveneither gain nor loss on the sale.

37

A.4 Stock Splits and Stock Dividends

If a taxpayer receives additional shares of stock through a stock dividend or stock split, the

basis of the original shares of stock which gives him the right to receive the additional shares is

allocated among the old and new shares of stock. If the additional shares of stock are the same as

the original shares of stock, the original stock basis is allocated equally among the outstanding

shares. If the additional shares received are not identical to the stock already owned, the basis is

allocated to the two types of stock on the basis of their relative fair market values.

Example 31

Amy Fisher owns 80 shares of ABC common stock. It is worth $75 per share($6,000) and its basis is $50 per share ($4,000). On June 1 of the current year, shereceives a stock dividend of 20 shares of ABC stock.

Assume the newly-acquired shares of stock are identical to the 80 sharesalready owned (same class of common stock). The basis of each share of stock afterthe stock dividend equals $40 ($4,000/100 outstanding shares).

Assume the shares are preferred stock and their value is $2,000 ($100 pershare). The basis of the common stock after the stock dividend equals $3,000($6,000/$8,000 x $4,000), which is $37.50 ($3,000/80 shares) per share. The basisof the preferred stock after the stock dividend equals $1,000 ($2,000/$8,000 x$4,000), which is $50 ($1,000/20 shares) per share.

A.5 Wash Sales

A wash sale occurs whenever a sale of a stock results in a loss and, if within 30 days prior

to or subsequent to the sale of such stock, substantially identical stock is purchased. The deduction58

of the loss from the wash sale is not allowed. Instead, it is added to the basis of the newly acquired

stock. If only a portion of the stock is reacquired within the 30-day period prior to or subsequent

to the sale of the stock, a portion of the stock loss is allowed and a portion is disallowed.

Example 32

Steve Jones owns 100 shares of XYZ common stock. It was purchasedseveral years ago for $10,200 ($102 per share). On December 23, 2015, he sells itfor $200 ($2.00 per share) resulting in a loss of $10,000. On January 8, 2016, hepurchases 80 shares of XYZ stock for $180 ($2.25 per share).

Since he reacquired 80 shares of the same stock, 80% (80/100) of the lossrealized on December 23, 2015 is not recognized. Therefore, $8,000 of the loss isnot recognized and $2,000 of the loss is recognized. The $8,000 of unrecognizedloss is added to the basis of the newly-acquired stock for a total basis of $8,180,

38

which computes to a basis of $102.25 per share. Note that this is the same basis asbefore ($102 per share) plus the extra $.25 per share he paid for the stock above whatit was sold for on December 23.


Questions

8. Which one of the following settlement costs is included in the basis of the purchase of anoffice building?

a. $ 500 for the cost of the land survey.b. $1,000 escrow payment for insurance and taxes.c. $3,000 of loan discount points.

9. On February 1, 2016, Grandma Roberts dies. On May 7, 2016, Grandson Kyle receivesproperty worth $120,000 from his Grandma’s estate. This property was worth $125,000 onFebruary 1, 2016. Six months after her death, the property is worth $110,000. If thealternative valuation date (AVD) is used to value the property for estate tax purposes, whatis Kyle’s basis in the property.

a. $125,000.b. $120,000.c. $110,000.

10. Concerning stock dividends and wash sales, which one of the following statements is false?

a. For wash sales, the basis of the new stock equals the cost of the new stock plus thedisallowed loss from the wash sale.

b. If only a portion of the stock which is sold for a loss is repurchased within 30 daysfrom its sale, some of the loss will be allowed.

c. If a taxpayer receives 20 shares of preferred stock as a result of owning 80 shares ofcommon stock, the basis of the preferred stock is 20% of the original basis in thecommon stock.

Solutions

8. "A" is the correct response. In the first paragraph of Section A.1, there is a list of 6 typesof settlement costs which are included in the basis of a property purchase. Survey costs aretype #4.

"B" is an incorrect response. In the first paragraph of Section A.1, there is a list of 2 typesof settlement costs which are not included in the basis of a property purchase. Escrowprepayments are included in type #2.

"C" is an incorrect response. Loan discount points are included in type #1 of costs that arenot included in the basis of a property purchase. Section A.1.

9. "B" is the correct response. If the AVD is used, generally the value of the property sixmonths after the AVD is the basis of the property in the hands of the beneficiary. Oneexception is if the property is distributed within six months. In this case, the basis is thevalue on the distribution date.

39

"A" is an incorrect response. $125,000 would be correct if the AVD is not used to valuethe property for estate tax purposes. The basis is the fair market value at the date of death.

"C" is an incorrect response. $110,000 would be correct if the AVD is used and theproperty is distributed after that date. Section A.2.

10. "C" is the correct response. The basis of the original common stock is allocated to thecommon and preferred stocks on the basis of relative fair market value, not on the basis ofthe total shares of stock.

"A" is an incorrect response. Although a wash sale results in the nonrecognition of loss,the taxpayer is able to increase the basis of the new stock by the unrecognized loss

"B" is an incorrect response. See Example 32 above where 20% of the loss was allowedbecause only 80% of the stock was repurchased within 30 days of the sale of the originalstock. Sections A.4 and A.5.

B. GAINS AND LOSSES FROM PROPERTY TRANSACTIONS


Capital assets: Generally investments that receive favorable tax treatment when sold for a gain andunfavorable treatment when sold for a loss.

Trade or business assets: Generally, long-term assets used in a taxpayer’s trade or business.

Ordinary income assets: Generally accounts receivable and goods held primarily for resale(inventory).

Qualified small business stock: Certain stock held more than 5 years which receives favorable taxtreatment when it is sold.

Collectibles: Generally includes a work of art, rug, antique, metal (such as gold, silver, and platinumbullion), gem, stamp, coin, or alcoholic beverage held more than 1 year. The maximum tax rate onthe gain from its sale currently is 28%.

Unrecaptured section 1250 gain: Represents the portion of gain from the sale of depreciable realproperty from depreciation deductions. The maximum tax rate on the gain from its sale currently is25%.


1. Determine which assets qualify as capital assets.

2. Compute the tax consequences from the sale of depreciable assets.

3. Compute the tax consequences from the sale of capital assets.

4. Determine the character and amount of capital loss carryovers.

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B.1 Asset Classification

Currently, there are three major categories of assets and five general categories of income.

The three asset categories are (1) capital assets; (2) trade or business assets; and, (3) ordinary income

assets. The definition of a capital asset is really a “negative definition.” IRC Section 1221 indicates

that capital assets are property held by the taxpayer except for the following items: (1) inventory; (2)

receivables; (3) depreciable property and land used in business; (4) copyright, literary, musical, or

artistic composition, or similar property held by the creator (other than patents); and, (5) a

publication of the U.S. Government (received for free or purchased below fair market value).

Trade or business assets generally include the long-term assets (held more than one year) of

a company’s business such as property, plant, and equipment. Normally, these assets are depreciable

assets although land, a nondepreciable asset, which is used in a trade or business and held for more

than one year is considered a trade or business asset. The term also includes timber, coal or domestic

ore, certain livestock, and unharvested crops.59

The most common ordinary income asset is inventory, or any other property held by the

taxpayer primarily for sale to customers. It also includes the company’s accounts receivable as well

as the property discussed above in item #4. To encourage technological advancement, Congress

excepted patents from item #4 by providing long-term capital gain treatment for the sale of most

patents.60

The most important variable in determining the character of an asset is to determine what the

asset is being used for. For example, if the asset is land, it may be classified as a capital asset (e.g.,

land held for investment), trade or business asset (e.g., the parcel of land the office building or plant

is located on), or an ordinary income asset (e.g., land a real estate developer subdivides and sells to

customers, unless it qualifies as capital gain under IRC Section 1237).

The five major categories of gain/income and loss are (1) capital; (2) trade or business; (3)

ordinary; (4) dividend income (qualified dividend income is subject to preferential tax rates); and,

(5) tax-exempt income. The focus of this section of the course is on the first three types of

gain/income and loss.

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Example 33

ABC company owns the following assets (1) land #1 that it is holding forspeculative investment; (2) land #2 that it uses as a parking lot that is across the streetfrom an office building that it leases from another company; (3) three patents it ownsfrom three of inventions; (4) computer equipment; (5) office furniture; and, (6) acopyright the company owns related to one of its products it sells.

Because land #1 is not used in ABC’s business nor is it held primary forresale, it does not meet any of the five exceptions to capital asset classification listedabove. A result, it is a capital asset. On the other hand, land #2 is used in ABC’strade or business so it is classified as a business asset. As discussed above, Congressenacted a specific provision which treats the sale of most patents as the sale orexchange of a capital asset. The computer equipment and office furniture are usedin ABC’s trade or business so they are classified as business assets. Finally,copyrights held by the creator are one of five exceptions (item #4) of propertycategorized as capital assets. They are considered ordinary income assets.

B.2 Capital Gains and Losses

Currently, there are five different tax rates that apply to long-term capital gain income – (1)

28% (or the taxpayer’s marginal tax rate, if lower); (2) 25% (or the taxpayer’s marginal tax rate, if

lower); (3) 20% for taxpayers whose marginal tax rate is 39.6%; (4) 15% for taxpayers whose

marginal tax rate is above 15% and below 39.6%; and, (5) 0% for taxpayers whose marginal tax rate

is 15% or lower. Except for patents (and inherited assets), long-term capital gain treatment requires

a holding period exceeding one year. The rate on short-term capital gain income is the taxpayer’s

marginal tax rate.

The 28% tax rate applies to gains from collectibles and qualified small business stock. Gain

or losses from collectibles result from the sale or trade of a work of art, rug, antique, metal (such as

gold, silver, and platinum bullion), gem, stamp, coin, or alcoholic beverage held more than 1 year.61

In order to constitute qualified small business stock, seven tests must be met. Some of these are: (1)

it is C Corporation stock issued after August 10, 1983; (2) the gross assets of the corporation are less

than $50 million; and, (3) the taxpayer held the stock for more than five years. Although the rate is

28%, traditionally, only one-half of the gain is included in gross income so the effective tax rate is

14% (50% of 28%).

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44444444444444444444444444444444444444444444444444444444444444TAX SAVER!! Given that most capital gain income from the sale of stocks is taxedat 15%, the 1% reduction in tax rate may not be worth holding on to the stock forfour additional years. But see the next paragraph for stock purchases after 2/17/09.

44444444444444444444444444444444444444444444444444444444444444

Recently, six laws modified the exclusion percentage for qualified small business stock

acquired between February 17, 2009 and December 31, 2011. First, the American Recovery and

Reinvestment Tax Act of 2009 increased the exclusion to 75% for stock acquired between 2/17/09

and 12/31/10. Second, the Small Business Job Act of 2010 upped the percentage to 100% for stock

acquired between 9/27/10 and 12/31/10. Third, the Tax Relief Act of 2010 extended the 100%

exclusion for stock acquired during 2011. Fourth, the American Taxpayer Relief Act of 2012

extended the 100% exclusion for stock acquired during 2012 - 2013. Fifth, the Tax Increase

Prevention Act of 2014 extended the 100% exclusion for stock acquired during 2014. Sixth, the

Path Act made the 100% exclusion permanent for stock acquired after 2014. Therefore, for qualified

small business stock acquired on or after 9/27/10, 100% of the gain is excluded.

The 25% tax rate applies to “unrecaptured section 1250 gain.” This amount represents the

portion of gain from the sale of depreciable real property from depreciation deductions that is not

recaptured as ordinary income under the depreciation recapture rules that apply to property placed

into service before 1987. Depreciation recapture for real property equals the accumulated

depreciation in excess of the what the accumulated depreciation deduction would have been under

the straight-line method. This is referred to as “excess or additional depreciation” and is taxed as

ordinary income at the marginal tax rate of the taxpayer. For depreciable real property placed into

service after 1986, the straight-line method is the only allowable depreciation method. Therefore,

for depreciable real property placed into service after 1986, all of the gain attributable to depreciation

deductions is taxed at the lower of 25% or the taxpayer’s marginal tax rate.

Example 34

On August 2, 2016, James Henry sells depreciable real property for$1,000,000. Its basis is $200,000 and its accumulated depreciation is $500,000. Thegain realized equals $800,000 ($1,000,000 - $200,000). Assume that the propertywas purchased after 1986 and his marginal tax rate is 35%. $500,000 of the gain isconsidered unrecaptured section 1250 gain and is taxed at the rate of 25% assuming

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there are no capital losses to reduce some or all of the gain. The remaining gain of$300,000 ($800,000 - $500,000) is taxed at the rate of 15%.

Assume instead that the property was placed in service before 1987. Theexcess depreciation is $100,000, and the taxpayer’s marginal tax rate is 35%.$100,000 of gain is taxed at 35%, $400,000 ($500,000 - $100,000) of gain is taxedat 25%, and $300,000 of gain is taxed at 15%.

The 20% tax rate applies to all other types of long-term capital gain income for taxpayers

who are in the highest tax bracket (39.6%). For 2016, the 39.6% marginal tax rate applies for

taxable incomes in excess of the following amounts: $466,950 for taxpayers filing a joint return; (2)

$441,000 for taxpayers filing as head of household; and, (3) $415,050 for taxpayers filing as single.

The 15% tax rate on capital gain income applies to taxpayers whose marginal tax rate is above 15%

and below 39.6% . For taxpayers in the 10% and 15% marginal tax rates, the tax on all other types

of long-term capital gain income is taxed at a 0% rate.

B.3 Steps in the Netting Process

If all of the sales of property during the year resulted in gains, there would be no need for the

netting process and the tax on the gain would be computed on the basis of the rates discussed in

Section B.2 above. When losses from property sales occur, there is an ordering of the losses. The

steps in the netting process are as follows:

1. Net the current year’s casualty gains and losses. Net gains are treated as trade orbusiness gains whereas net losses are treated as casualty losses.

2. Net the current year’s trade and business gains and losses (including net casualtygains from step #1). Net gains are treated as capital gains and net losses are treatedas ordinary losses. For losses, the lookback recapture rule may apply (explainedbelow).

3. Classify capital gains & losses as short-term (held one year or less), 28%, 25%, or20%/15%/0%. Net the gains and losses against each other within the variouscategories, including loss carryovers from prior years.

4. If all of the categories net to a gain, no further steps are necessary. Apply theapplicable rates in Section B.2.

5. If there is no 25% gain (this can only be positive) and all other categories net to aloss, no further steps are necessary. Losses up to $3,000 may be deducted againstordinary income. Short-term capital losses are deducted first and any excess loss iscarried over to future years.

6. If some categories net to a gain and some net to a loss, the netting rules are asfollows: (a) 28% group losses are netted first against 25% gain, then against

44

20%/15% gain, then against net short-term gain, if any; (b) 20%/15% group lossesare netted first against 28% gain, then against 25% gain, then against net short-termgain, if any; and, (c) a net short-term capital loss is netted against the net long-termcapital gain with the highest rate (netted first against 28% gain, then against 25%gain, then against 20%/15% gain, if any).

Example 35

Mary Gant is in the 35% tax rate and sells multiple capital assets during theyear resulting in the following gains and losses:

Type Gain/LossShort-term capital gain (STCG) 5,000Short-term capital loss (STCL) (19,000)28% Rate LTCG 15,00028% Rate LTCL ( 5,000)15% LTCG 14,00015% LTCL ( 6,000)

Mary would first net the gains and losses within each category leaving a ($14,000)net STCL, a $10,000 net 28% LTCG, and an $8,000 net 15% LTCG. Next shewould net the $14,000 net STCL against the $10,000 net 28% LTCG. The remaining$4,000 of net STCL is deducted against $4,000 of the 15% net LTCG leaving a netLTCG of $4,000 which would be subject to $600 of tax ($15% x $4,000).

Example 36

Assume the same facts as in Example 35 except (1) the 15% LTCL was$20,000, resulting in a net 15% LTCL of $6,000, and (2) the STCL was zero,resulting in a net STCG of $5,000. If the taxpayer could choose, she would net the$6,000 loss against the STCG before the 28% net LTCG. However, as noted in step#6b, the $6,000 net 15% LTCL must be netted against the 28% net LTCG.

Example 37

Kathy recognizes a $4,000 long-term capital loss from the sale of commonstock, a $6,000 long-term capital gain from the sale of common stock, a $10,000long-term capital gain from the sale of her stamp collection, and a $4,000 short-termcapital gain from the sale of common stock. In addition to her wages as anemployee, she has a side business which netted a profit of $6,000. She is in the 35%tax bracket and would like to know how much she should pay in estimated federalincome taxes to account for the investment sales and side business income.

As in the previous example, Kathy would like to use her long-term capitalloss against the income which is taxed at the highest income tax rate. In this case,both the short-term capital gain and side business income are taxed at her marginalrate of 35%. A capital loss cannot be netted against the side business income becauseit does not qualify as capital gain income. As noted in step #3, before any capital losscan be netted against other types of capital gain income, it first must be netted withinits own category. This would leave a net long-term capital gain of $2,000 ($6,000 -$4,000), which is taxed at 15%, since her marginal tax rate is below 39.6%. Her totalfederal income tax on her capital gain income and side business income equals$6,600 computed as follows:

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$2,000 net LTCG from sale of stock @ 15% $ 300$10,000 of collectible capital gain @ 28% $2,800$4,000 of STCG from sale of stock @ 35% $1,400$6,000 of net profit from business @ 35% $2,100

Total estimated federal income tax $6,600

Note: This example excludes any taxes related to self-employment taxes on the sidebusiness income and the 3.8% tax on investment income.

Under the lookback recapture rule, before net trade or business gains are treated as long-

term capital gain income, the gain must first be netted against net trade or business losses during the

previous five years. The portion of the gain netted against previous losses is treated as ordinary

income (the previous losses had been deducted against ordinary income). This rule essentially takes

away the timing of recognizing trade and business gains and losses over different taxable years,

realizing capital gains in one year and ordinary losses in another year.

Example 38

For 2016, Mark Shram recognized $50,000 in trade or business gains. Tradeor business gains and losses recognized during 2011 - 2015 are as follows: 2011 –($20,000); 2012 – ($10,000); 2013 – $15,000; 2014 – $5,000; and 2015 - ($25,000).Total losses equal $55,000 (years 2011, 2012, and 2015). However, the $20,000 ofnet gains in 2013 and 2014 were recaptured as ordinary income against the 2011 lossof $20,000. Therefore, the net trade or business losses during the previous five yearsis only $35,000 ($55,000 - $20,000), so $35,000 of this year’s trade or business gainsis taxed as ordinary income and $15,000 ($50,000 - $35,000) is treated as capital gainincome.

One final type of recapture is depreciation recapture of IRC Section 1245 property.

Generally, this property is depreciable personal property such as equipment, machinery, and

automobiles used in the taxpayer’s trade or business. The depreciation recapture is reported as

ordinary income. It equals the lower of the gain realized on the disposition of the property or the

accumulated depreciation.

Example 39

Terry Johns owns a manufacturing plant. During the year, he sold some ofthe manufacturing equipment for $100,000. The basis of the equipment is $60,000and the accumulated depreciation is $80,000. The gain realized is $40,000 ($100,000- $60,000). Since the gain is less than the accumulated depreciation, all of the$40,000 gain is treated as ordinary income. If the accumulated depreciation had been$30,000, $30,000 of the gain is treated as ordinary income and $10,000 of the gainis treated as capital gain.

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B.4 Special Loss Situations

Property held for personal use is a capital asset. Gains from the sale or exchange of a

personal-use asset are capital gains, and generally are includible in gross income in the year of sale

or exchange. Losses are not deductible unless they result from personal casualties or thefts.62

As indicated in Section B.3 above, capital losses deductible against ordinary income are

limited to $3,000 ($1,500 if filing married separately) per year. The excess losses retain their

character and are carried over as a separate item to the next taxable year. Two special rules must63

be borne in mind.

First, if the capital loss exceeds the limitation, the amount of the capital loss carryover is

specially calculated. The carryover equals the amount by which the capital loss exceeds the lesser

of the following:

1. The capital loss deduction which is allowed for the current taxable year.

2. Taxable income (if deductions exceed gross income, then the negative amount isused) plus the capital loss deduction allowed for the taxable year plus the amountdeducted for personal exemptions ($4,000 in 2015 and $4,050 in 2016).64

Example 40

Frances and Carol Hays file a joint return for 2015. They have severalsecurities sales which resulted in a total capital loss of $15,000, consisting of a netshort-term capital loss of $8,000 and a net long-term capital loss of $7,000. Theyhave no other capital transactions. Their taxable income for 2015 is a negative$9,200, and they have two personal exemptions.

The Hays have a 2015 capital loss deduction of $3,000. They calculate theircapital loss carryover to 2016 in the following manner. The lesser of the capital lossdeduction allowed for 2015 ($3,000) and taxable income as calculated from # 2above ($-9,200 + $3,000 + (2 x $4,000) = $1,800) is $1,800. The total capital lossof $15,000 exceeds the $1,800 by $13,200. The capital loss carryover to 2016 is$13,200. The $13,200 consists of a short-term carryover of $6,200 ($8,000 short-term capital loss - $1,800) and a long-term carryover of $7,000.

Second, there are special rules for married taxpayers who file or have filed separate returns.

Married taxpayers who file separately may not use any part of the other's capital loss. Joint filers

who previously had filed separately are required to combine each of their capital loss carryovers.

Separate filers who previously had filed jointly must allocate any capital loss carryover to the person

who actually had the capital loss.65

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Two types of losses not involving sales or exchanges which are subject to special rules are

(1) losses from worthless corporate securities and (2) losses from nonbusiness bad debts. Losses66 67

from worthless corporate securities are specially treated under the federal income tax laws.

Examples of such losses are losses from worthless corporate stock, stock rights, or corporate or

government bonds which are registered or have interest coupons. Losses from a worthless corporate

security are treated as though the security is a capital asset which is sold on the last day of the taxable

year in which it becomes worthless. The loss is a short-term capital loss if the time between when

the security was acquired and the last day of the year is one year or less, and long-term if the time

is more than one year.

Example 41

On November 15, 2015, an individual purchases for $1,750 the stock of awidely held corporation. On March 7, 2016, the corporation suddenly goes out ofbusiness, and the individual loses all of his investment. He reports a $1,750 long-term capital loss on his 2016 return because of the worthless stock. He is consideredto have held the security from November 16, 2015, through December 31, 2016.

Losses from nonbusiness bad debts are treated as short-term capital losses. Schedule D,

"Capital Gains and Losses" is used to determine the overall gain or loss from transactions reported

on Form 8949, “Sales and other Dispositions of Capital Assets.” A deduction is permitted for a

nonbusiness bad debt only if the debt is totally worthless. Nonbusiness bad debts are those which

the taxpayer does not obtain in the course of operating his trade or business.


Questions

11. Jan’s 2016 marginal tax rate in the current year is 35%. He sells an office building(purchased in 1996) he used in his trade or business for $300,000. It had cost $260,000 andaccumulated depreciation is $60,000. His total gain equals $100,000 ($300,000 - $200,000).He also sold business equipment for $55,000. It had cost $50,000 and accumulateddepreciation is $20,000. His total gain equals $25,000 ($55,000 - $30,000). Disregarding the3.8% tax on net investment income, what is his net increase in tax liability as a result of thetwo sales?

a. $28,750.b. $26,750.c. $18,750.

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12. Regarding losses from worthless securities and nonbusiness debts, which one of thefollowing statements is true?

a. Losses from worthless securities are considered short-term capital losses.

b. Losses from nonbusiness bad debts are treated as ordinary losses.

c. Losses from worthless securities are recognized as if sold on the last day of the yearthe securities are deemed to be worthless.

Solutions

11. "A" is the correct response. For the office building, $60,000 of the gain attributable todepreciation deductions is taxed at the 25% rate (unrecaptured Section 1250 gain) and theremaining gain is taxed at the 15% capital gain rate resulting in a combined tax of $21,000($15,000 + $6,000). For the equipment, the Section 1245 depreciation recapture of $20,000(lower of accumulated depreciation and gain realized) is taxed at 35% and the remaining gainis taxed at the 15% capital gain rate resulting in a combined tax of $7,750 ($7,000 + $750).The total tax increase is $28,750 ($21,000 + $7,750).

"B" is an incorrect response. $26,750 would be the correct answer if the depreciationrecapture on the equipment were taxed at the 25% unrecaptured Section 1250 rate ratherthan at the marginal tax rate.

"C" is an incorrect response. $18,750 would be the correct answer if the entire gain weretaxed at the 15% capital gain rate. Sections B.2 and B.3.

12. "C" is the correct response. Securities which become worthless are deemed to be sold onthe last day of the year in which they become worthless.

"A" is an incorrect response. Losses from worthless securities are considered short-termcapital losses only if they were purchased in the same year that they are deemed to beworthless.

"B" is an incorrect response. Losses from nonbusiness bad debts are treated as short-termcapital losses. Section B.4.

C. GAIN EXCLUSION FOR SALE OF PRINCIPAL RESIDENCE


Residential gain exclusion: Currently $500,000 for married taxpayers filing a joint return and$250,000 for single taxpayers providing the requirements for the residential gain exclusion provisionare satisfied.

Ownership test: One of the requirements of the residential gain exclusion provision where thetaxpayer must have owned the home for at least two years prior to its sale over a five-year period.

Use test: Another requirement of the residential gain exclusion provision where the taxpayer musthave use the home as his or her principal residence for at least two years prior to its sale over a five-year period.

49

Unforseen circumstances: One of the ways a taxpayer may qualify for a partial residential gainexclusion if the ownership and/or use tests are not satisfied. The Treasury provides several exampleswhich qualify as an unforseen circumstance.

Principal residence: Generally a dwelling used a majority of the time during the year as thetaxpayer’s home.


1. Apply the ownership and use tests to determine whether a taxpayer qualifies for theresidential gain exclusion.

2. Determine whether a taxpayer meets the requirements for a partial residential gainexclusion.

3. Compute the amounts of the residential gain exclusion and the partial residential gainexclusion.

4. Determine whether a dwelling qualifies as the taxpayer’s principal residence under theresidential gain exclusion rules.

C.1 General Rules

The residential gain exclusion is $250,000 for single taxpayers and $500,000 for taxpayers

filing a joint return. Generally, the exclusion may be used no more frequently than once every two68

years. To be eligible for the exclusion, a taxpayer must have owned the residence and occupied it

as a principal residence for at least two of the five years prior to the sale or exchange. Any gain69

on the sale of the residence that is attributable to any depreciation for the rental or business use of

the home after May 6, 1997, is not eligible for the gain exclusion.70

Example 42

Jim and Virginia Ann Edwards, who file jointly, sold their home in thecurrent year for $640,000. Selling expenses were $40,000. They have owned andused the home as their residence for 17 years. The basis of the home is $200,000.

The gain realized on the sale of the home is $400,000 ($640,000 - $40,000 -

$200,000). Since this is less than the exclusion amount, the entire $400,000 wouldbe excluded.

Assume the same facts as above except that part of the home has been usedas a home office. Depreciation deductions after May 6, 1997, amount to $2,000. Thegain recognized is $2,000 for the post May 6, 1997, depreciation deductions.

44444444444444444444444444444444444444444444444444444444444444TAX SAVER!! The normal period for which records are maintained is three years.Since basis is relevant for gain, loss, conversion, and depreciation purposes, any costsand depreciation deductions related to the taxpayer's residence should be kept in apermanent file. This procedure will facilitate the calculations for any of the abovepurposes.

44444444444444444444444444444444444444444444444444444444444444

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If a single taxpayer who otherwise is eligible for an exclusion marries someone who used the

exclusion within two years, the maximum exclusion is $250,000. For property settlements pursuant

to a divorce proceeding, the period the taxpayer owns the property and uses it as a principal residence

includes the time the transferor owned and used the property.71

For military and foreign service members, the five-year test period for satisfying the two-year

ownership and occupancy requirements may be extended up to ten years of duty time.

What if the taxpayer’s residence is damaged or destroyed in an involuntary conversion and

the insurance proceeds exceed the basis of the taxpayer’s residence? The IRS in Chief Counsel

Advice 200734021 addresses this issue. IRC Section 121 provides that an involuntary conversion72

qualifies as a sale or exchange available for the Section 121 $250,000 gain exclusion ($500,000 on

a joint return). However, the IRS concludes that the home must be completely destroyed in order

for the exclusion to apply. The IRS states that, in the case of a residence, complete destruction

occurs when the residence is damaged to the extent that the remaining structure cannot be utilized

to advantage in restoring the property to its prior condition. Whether damage to a taxpayer's

principal residence is sufficient to result in its destruction is a factual determination.

C.2 Ownership and Use Tests

The ownership and use tests do not have to be satisfied at the same time during the five-year

period ending on the date of the sale. In establishing whether a taxpayer has satisfied the two-year73

use requirement, occupancy of the residence is required. For example, if a taxpayer is trying to sell74

the property but moves to another location, the period between the move and sale will not count

toward the two-year occupancy requirement. However, short temporary absences are counted as

periods of use. Several examples in Treasury Regulation Section 1.121-1(c)(4) clarify several

aspects of the ownership and use tests. Samples of these examples are provided below.

Example 43

Joe Sands has owned and used his house as his principal residence since1990. On January 1, 2014, he moves to another state and leases his house from thatdate until April 18, 2016, when he sells it. Joe is eligible for the exclusion becausehe has owned and used the house as his principal residence for at least 2 years out of

51

the 5 years preceding the sale (however, see changes for nonqualified use after 2008discussed in Section C.21 below).

Example 44

Jennifer Banks lived in a townhouse that she rented from 2008 through 2013.On January 1, 2014, she purchased this townhouse. On February 1, 2015, she movedinto her daughter's home. On March 1, 2016, while still living in her daughter'shome, Jennifer sold her townhouse. The IRC Section 121 exclusion will apply togain from the sale because she owned the townhouse for at least 2 years out of the 5years preceding the sale (from January 1, 2014 until March 1, 2016) and she used thetownhouse as her principal residence for at least 2 years during the 5-year periodpreceding the sale (from March 1, 2011, until February 1, 2015).

Example 45

Ellen Knotts purchased a house on February 1, 2014, that she used as herprincipal residence. During 2014 and 2015, Ellen left her residence for a 2-monthsummer vacation. She sold the house on March 1, 2016. Although, in the 5-yearperiod preceding the date of sale, the total time Ellen used her residence is less than2 years (21 months), the exclusion is allowed because the 2-month vacations areshort temporary absences and are counted as periods of use in determining whetherEllen used the residence for the requisite period.

C.21 Nonqualified Use After 2008

The “Housing and Recovery Act of 2008" (HRA “08) added a provision to the residential

gain exclusion that affects taxpayers who use their home as a vacation home or for rental for a period

of time but otherwise qualify for the two-year use before they sell the residence. For example under

prior law, if a taxpayer (1) rented a beach home for 10 years, (2) moved into the home for two years

as his residence, and (3) sold it shortly after he qualified for the gain exclusion provisions, all of the

gain except the gain attributable to depreciation deductions from renting it would be eligible for the

gain exclusion.

The provision under the HRA ‘08 prohibits gain allocable to periods of “nonqualified use”

to be eligible for the gain exclusion. Nonqualified use means any period during which the property

is not used as the principal residence of the taxpayer, the taxpayer’s spouse, or the taxpayer’s former

spouse after December 31, 2008. There are three exceptions to this definitions:75

1. Any portion of the 5-year period which is after the last date that the property is usedas the taxpayer’s principal residence. Presumably, this gives the taxpayer time to sellthe house after the taxpayer moves out.

52

2. Any period up to 10 years that a taxpayer or spouse is serving on qualified officialextended duty.

3. Any temporary absences not to exceed two years due to a change in employment,health conditions or such other unforseen circumstances as specified by theTreasury.76

The gain attributable to depreciation taken after May 6, 1997 is not taken into account in

determining the amount of gain allocated to nonqualified use. The gain allocated to nonqualified

use is computed by multiplying the residential gain (other than from post May 6, 1997 depreciation)

times a percentage computed by dividing the period of nonqualified use by the total period the home

is owned by the taxpayer.

Example 46

Jane Thomas buys property on 1/1/2012 for $400,000, uses it as rental propertyfor 2 years, claims $20,000 of depreciation deductions, and converts it to her principalresidence on 1/1/2014. She moves out on 1/13/2016, and sells the property for$700,000 on 1/1/2017. Of the $320,000 gain, the $20,000 is recaptured in income.Since after 2008, she used it 2 years for “nonqualified use,” 40% (2 years / 5 years –2016 does not count as “nonqualified use) of the remaining gain, or $120,000 can notbe excluded. The $180,000 balance of the gain is excluded under Section 121.

C.22 Reacquisition of Principal Residence

Suppose a taxpayer owner finances the sale of their residence and later reacquires it after the

buyer quit making payments on the loan. A 2015 Tax Court case addresses this and applies seldom

used IRC Section 1038. The taxpayers sold their home in 2006 for $1.4 million pursuant to an77

installment contract. The gain realized on the transaction was $657,796. Using their $500,000

residential gain exclusion, they planned on recognizing the remaining gain over the installment

period. In the first three years, they collected $505,000 and reported $56,920 of gain. After three

years, the buyer defaulted and the taxpayers reacquired the property, incurring $3,723 in costs. The

taxpayers treated this event as a reacquisition of property in full satisfaction of indebtedness under

Section 1038. In calculating their realized gain on the reacquisition, they again applied the $500,000

principal-residence exclusion and reported a net gain of $97,153 ($657,796 less the $500,000

exclusion, less the $56,920 of gain previously recognized, less the $3,723 of reacquisition costs) as

long-term capital gain related to the reacquisition of the property for tax year 2009.

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Section 1038 applies to reacquisitions of real property sold on an installment method and

generally provides that the taxpayer must recognize gain from the acquisition to the extent that the

fair market value of the property received prior to the reacquisition exceeds the gain recognized

during the periods prior to the acquisition. Section 1038(e) allows a taxpayer to continue to apply

the principal-residence exclusion when calculating taxable gain if the property is sold within one

year from the date of acquisition. However, the taxpayers did not resell the property within one year.

The IRS determined that the taxpayers' recognized gain from the reacquisition should be $448,080

($505,000 - $56,920) since the gain exclusion did not apply. The Tax Court agreed with the IRS and

the taxpayers appealed to the Eighth Circuit. The taxpayers argued that there is nothing in Section

1038 that requires a taxpayer to recognize gain that was previously excluded under Section 121.

They argued that the Tax Court's interpretation is counter to Congressional intent and renders an

unduly harsh result based solely on the timing of the resale of a principal residence. The Eighth

Circuit first noted that gain excluded on the sale in 2006 cannot be considered gain recognized

during the periods prior to the acquisition. It also dismissed the taxpayers' argument that Section

1038 is unduly harsh in restricting the gain exclusion to the timing of the resale of a principal

residence since it was Congress that limited the time period for the exclusion. As a result, the Eighth

Circuit affirmed the Tax Court's decision and ruled that the taxpayers could not use the gain

exclusion to reduce the amount of gain recognized under Section 1038. Note: Not reselling a

personal residence after reacquiring it was very costly to the taxpayers in this case. Tax

professionals should alert their clients who owner-finance the sale of their home about this seldom-

applied provision (Section 1038), particularly about the need to resell the property within one year

of acquisition.

C.3 Partial Exclusion

A taxpayer who fails to meet the two-year ownership and use requirements by reason of a

change of (1) employment, (2) health, or (3) unforseen circumstances is entitled to a portion of the

residential gain exclusion.

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In determining whether the taxpayer meets one of the three reasons for the reduced exclusion,

the regulations indicate that a facts and circumstances test will be applied. Factors suggested by the

Treasury include the following: (1) the sale or exchange and the circumstances giving rise to the sale

or exchange are proximate in time; (2) the suitability of the property as the taxpayer's principal

residence materially changes; (3) the taxpayer's financial ability to maintain the property materially

changes; (4) the taxpayer uses the property as the taxpayer's residence during the period of the

taxpayer's ownership of the property; (5) the circumstances giving rise to the sale or exchange are

not reasonably foreseeable when the taxpayer begins using the property as the taxpayer's principal

residence; and, (6) the circumstances giving rise to the sale or exchange occur during the period of

the taxpayer's ownership and use of the property as the taxpayer's principal residence.78

The regulations provide safe harbors for meeting one of the three reasons to obtain the

reduced maximum exclusion. The sale of the taxpayer’s residence for employment reasons will be

satisfied if the taxpayer meets the distance test for the moving expense deduction. The new place

of employment of a qualified individual must be at least fifty miles farther from the residence sold

or exchanged than was the former place of employment. If the individual was unemployed, the

distance between the new place of employment and the residence sold or exchanged must be at least

fifty miles. Employment includes the commencement of employment with a new employer, the79

continuation of employment with the same employer, and the commencement or continuation of self-

employment. 80

The sale of the taxpayer’s residence for health reasons will be satisfied if the taxpayer's

primary reason for the sale or exchange is (1) to obtain, provide, or facilitate the diagnosis, cure,

mitigation, or treatment of disease, illness, or injury of a qualified individual, or (2) to obtain or

provide medical or personal care for a qualified individual suffering from a disease, illness, or

injury. The regulations also provide a safe harbor that the primary reason for the sale or exchange81

is deemed to be health if a physician recommends a change of residence for reasons of health. 82

55

The general definition of unforseen circumstances is the occurrence of an event that the

taxpayer does not anticipate before purchasing and occupying the residence. A taxpayer's primary

reason for the sale or exchange is deemed to be unforeseen circumstances if one of the safe harbor

events occurs during the taxpayer's ownership and use of the property. The safe harbor events include

the involuntary conversion of the residence, a natural or man-made disaster or act of war or terrorism

resulting in a casualty to the residence, and, in the case of a qualified individual: (1) death, (2) the

cessation of employment as a result of which the individual is eligible for unemployment

compensation, (3) a change in employment or self-employment status that results in the taxpayer's

inability to pay housing costs and reasonable basic living expenses for the taxpayer's household, (4)

divorce or legal separation under a decree of divorce or separate maintenance, and (5) multiple births

resulting from the same pregnancy. A qualified individual for this purpose includes the taxpayer,83

the taxpayer's spouse, a co-owner of the residence, and a person whose principal place of abode is

in the same household as the taxpayer.

The excluded portion of the gain equals the product of the exclusion amount ($250,000 or

$500,000) and a fraction. The fraction is determined by dividing by two the shorter of (1) the period

(years in fractional terms) the residence is owned and occupied as the taxpayer’s principal residence,

or (2) the period after the most recent sale. Alternatively, months can be used in the fraction where84

the denominator is 24 months and the numerator is the least of three numbers – (1) the number of

months the residence was owned; (2) the number of months the residence was occupied as the

taxpayer's principal residence; or, (3) the number of months after the most recent sale.

Example 47

Greg Stanton, a single taxpayer, sells his home on August 1, 2016, realizinga gain of $300,000. If he had owned and used the home as his principal residence forat least two years during the last five years, his gain recognized equals $50,000($300,000 - $250,000).

Assume instead that Greg had owned and used the home as his principalresidence for 1.5 of the last five years and the reason for the sale is for employment-related purposes (moved to a new job location). His most recent sale was three yearsago. The gain excluded equals $187,500 ($250,000 x 1.5/2 (or 18/24)). His gainrecognized equals $112,500 ($300,000 - $187,500).

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As illustrated in Example 47 above, it is the exclusion that is prorated rather than the realized

gain. The exclusion also is reduced if there is more than one sale within two years, even if the85

second sale is for employment reasons. Nevertheless, the partial exclusion should cover most, if not

all, of the gain. The home would have to appreciate a substantial amount in a relatively short period

of time before any gain has to be recognized. A married couple living in the home for just one year

still could exclude $250,000 ($500,000 x ½) of gain (provided one of the reasons is met).

In situations where taxpayers own homes individually before getting married and

subsequently sell their home after marriage but before the other spouse has lived in the home the

requisite two-year period, the amount of the exclusion is calculated separately as if the spouses were

single.86

Example 48

Jane, age 68, and Frank, age 72, each has been widowed for several years andmarry in 2015. During 2015, each sells the home that each has owned and lived infor many years. Jane realized a gain of $270,000 on the sale of her home and Frankrealized a gain of $220,000. They move to Arizona and buy a new home where theywill live during retirement. They file a joint return for 2015.

Because Jane would not satisfy the 2-year use test for the sale of Frank's homeand Frank would not satisfy the 2-year use test for the sale of Jane's home, the lawrequires that each computes the recognized gain from the sale of the homes as if heor she were single. Thus, $20,000 ($270,000 - $250,000) of gain is recognized fromthe sale of Jane's home and no gain ($220,000 is less than the $250,000 exclusion)is recognized from the sale of Frank's home.

Note that the total gain of $490,000 ($270,000 + $220,000) is less than$500,000 (the maximum gain exclusion for joint return taxpayers). However, theregulations make clear that Jane may not use any of Frank's unused exclusion.87

If a sale of a residence were due to one of the reasons permitting partial exclusion, and one

of the spouses satisfied the two-year rules and the other did not, a $250,000 exclusion plus a partial

exclusion is permitted. The "Mortgage Forgiveness Debt Relief Act of 2007" provides some relief

for a spouse who sells a principal residence within 2 years after the other spouse has died. In this

case the full $500,000 gain exclusion is allowed if, at the other spouse’s death, only one spouse met

the 2-year ownership requirement. However, both spouses must have met the 2-year use

requirement. If these requirements are not satisfied, a partial exclusion is available since death of

a spouse within the two-year period qualifies as an unforseen circumstance.

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44444444444444444444444444444444444444444444444444444444444444TAX SAVER!! In the case of a partial exclusion, each month a taxpayer owns andlives in the home, the exclusion is increased by $10,417 ($20,833 for joint returnswhere neither spouse satisfies the two-year rules). For taxpayers who have realizedgains exceeding the exclusion, delaying the move a couple of months could savetaxpayers a significant amount of taxes.

44444444444444444444444444444444444444444444444444444444444444

If a taxpayer sells her residence in the same year as the death of her spouse, the maximum

exclusion is $500,000. However, if the sale is in the year after the death of her spouse, the maximum

exclusion is $250,000. A taxpayer is treated as owning and using property as the taxpayer's88

principal residence during any period that the taxpayer's deceased spouse owned and used the

property as a principal residence before death if (1) the taxpayer's spouse is deceased on the date of

the sale or exchange of the property, and (2) the taxpayer has not remarried at the time of the sale

or exchange of the property.89

C.4 Principal Residence

In most cases, it is clear whether the home sold is the taxpayer's residence. However, there

are situations that arise (such as when you have two homes and live in them about the same amount

of time each year) where uncertainty exists. For taxpayers owning more than one home, the principal

residence is the home used a majority of the time. Property used by the taxpayer as a principal90

residence may include a houseboat, a house trailer, or stock held by a tenant-stockholder in a

cooperative housing corporation.91

In determining a taxpayer's principal residence include, the Treasury lists the following

factors as relevant: (1) the taxpayer's place of employment; (2) the principal place of abode of the

taxpayer's family members; (3) the address listed on the taxpayer's federal and state tax returns,

driver's license, automobile registration, and voter registration card; (4) the taxpayer's mailing

address for bills and correspondence; (5) the location of the taxpayer's banks; and, (6) the location

of religious organizations and recreational clubs with which the taxpayer is affiliated. 92

The Guinan case addressed the principal residence issue shortly after the regulations were93

issued. During the five-year period prior to the 1998 sale of their residence located in Wisconsin,

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the taxpayers also owned homes in Georgia and Arizona. The Georgia home was sold in 1996, at

which time they purchased the Arizona home. The taxpayers resided at their Wisconsin home during

the warmer months and at their Georgia or Arizona homes during the rest of the year. During the

five-year period preceding the sale of the Wisconsin home, the taxpayers claimed that they occupied

their Wisconsin residence for 847 days, their Georgia residence for 563 days, and their Arizona

residence for 375 days. While more time was spent in the Wisconsin home than either of the two

other homes, the combined time of the Georgia and Arizona homes (52.5%) was greater than the

time the Wisconsin home was used as a residence (47.5%). As the regulations require that the home

must be used a majority of the time as the taxpayer’s principal residence, the District Court noted

that the taxpayers’ case actually favored the IRS’s position that the Wisconsin home was not the

taxpayer’s residence. It also noted that the governing regulations refer to the time spent in a

residence during a single year. That is, “most often” is not synonymous with majority and the

principal residence requirement is made on a year-by-year basis over the five-year period preceding

the sale of the home. In examining the six factors listed above, the District Court ruled that the

following facts taken as a whole do not establish the Wisconsin home as their principal residence:

(1) while recreational and service activities were conducted at all the homes, the husband lectured

at local Georgia colleges; (2) none of their children lived in any of the three homes; (3) while one

car and two boats were registered in Wisconsin, two cars were registered at their Georgia home and

then at their Arizona home; (4) the taxpayers did not file any Wisconsin tax returns but did file state

tax returns in Georgia and Arizona; (5) neither taxpayer had a Wisconsin driver’s license but both

had driver’s licenses in Georgia, and then Arizona; and, (6) the taxpayers treated their Arizona home

as their principal residence in 1999 when they sold that home.

Consider the situation when a taxpayer purchases 50 acres of land and builds a home on the

property. If he sells the property after living there two years, does the entire gain qualify for the

residential gain exclusion? The Treasury regulations provide that vacant land that is adjacent to the

taxpayer’s residence qualifies as part of the taxpayer’s residence if it has been used as the taxpayer’s

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residence and if the sale of the dwelling unit occurs within two years before or after the sale or

exchange of the vacant land. Only one maximum exclusion of $250,000 ($500,000 for certain joint94

returns) applies to the combined sales.


Questions

13. What are the maximum gain exclusions from the sale of the taxpayers' residence for singletaxpayers and married taxpayers filing a joint return, respectively?

a. $250,000 and $500,000, respectively.b. $125,000 and $250,000, respectively.c. $500,000 and $500,000, respectively.

14. What is the minimum required period that the home must be used as a principal residencein order to qualify for the full gain exclusion?

a. 2 Years.b. 3 Years.c. 5 Years.

15. John and Megan, who file a joint tax return, purchased a home on October 1, 2013 for$400,000. This is their first home. On April 1, 2016, 18 months after the purchase of thehome, they sell it for a net sales price of $560,000 resulting in a realized gain of $160,000.Assuming that they qualify under the partial exclusion rules, how much of the realized gainmust be recognized in 2016.

a. $120,000.b. $ 40,000.c. $ -0-.

16. Assume that a taxpayer sold her residence in 2016, but did not use her principal residencefor the required time for the gain exclusion. Which one of the following circumstanceswould not allow her to use a portion of the gain exclusion?

a. She divorced and sold the residence to an unrelated third party.

b. She bought a larger home in the same area.

c. She lost her job and is collecting unemployment compensation.

Solutions

13. "A" is the correct response. As noted in Section C.1, the maximum exclusion from thesale of a taxpayer's home under current law is $250,000 for single taxpayers and $500,000for joint return taxpayers.

"B" is an incorrect response. The former once-in-a-lifetime exclusion was $125,000 forsingle taxpayers and married taxpayers filing a joint return. The exclusion has doubled forsingle taxpayers and quadrupled for joint return taxpayers.

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"C" is an incorrect response. While the amount of the former once-in-a-lifetime exclusionwas the same for single taxpayers and married taxpayers filing a joint return, the newexclusion amount for joint return taxpayers is twice the amount for single taxpayers. SectionC.2.

14. "A" is the correct response. As noted in Section C.2, the minimum required period thatthe home must be used as a principal residence in order to qualify for the full exclusion istwo years.

"B" is an incorrect response. Under the former once-in-a-lifetime exclusion provision,a taxpayer had to own and use the property as her residence for three out of five years.

"C" is an incorrect response. Five years is the “look-back period” during which the two-year ownership and use tests must be satisfied. Section C.2.

15. "C" is the correct response. The maximum residential gain exclusion for marriedtaxpayers filing jointly is $500,000. If the two-year rules are not satisfied and the partialexclusion rules are satisfied, the excluded portion equals the product of $500,000 and in thiscase 18/24, where 18 is the number of months they lived in and owned the dwelling as theirresidence and 24 is the denominator which is used if the exclusion is prorated over monthsrather than days. In this case, the exclusion is $375,000 ($500,000 x 18/24), so none of the$160,000 gain is recognized.

"A" is an incorrect response. $120,000 would be the exclusion amount if the exclusionwere 18/24 of the $160,000 gain rather than the $500,000 maximum exclusion.

"B" is an incorrect response. $40,000 would be the correct inclusion amount if theexclusion were 18/24 of the $160,000 gain rather than the $500,000 maximum exclusion.Section C.3.

16. "B" is the correct response. Paragraphs 3 - 5 of Section C.3 deal with reasons that qualifyfor the partial exclusion if the two-year tests are not met. Buying a larger home is not areason.

"A" is an incorrect response. Paragraph 5 of Section C.3 deals with unforseencircumstances that qualify for the partial exclusion . Divorce is item #4.

"C" is an incorrect response. Unemployment is the second-mentioned unforseencircumstance. Section C.3.

D. LIKE-KIND EXCHANGES


Like-kind exchange: An exchange of one property for another property that qualifies for tax-freetreatment under the like-kind exchange provisions.

Replacement property: The property acquired in a like-kind exchange.

Relinquished property: The property given up in a like-kind exchange.

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Boot received: Property received in a like-kind exchange transaction that does not qualify as like-kind property. Non-simultaneous exchange: Exchanges where the disposition of the relinquished property does notoccur at the same time as the acquisition of the replacement property.


1. Determine which transactions qualify under the like-kind exchange provisions.

2. Compute the gain recognized under the like-kind exchange provisions.

3. Determine the deadline to acquire replacement property under the non-simultaneouslike-kind exchange provisions.

D.1 Qualifications

Like-kind exchanges have become big business (e.g., see http://1031.org/ ). The most

common types of like-kind exchanges involve (1) real estate investment exchanges (such as

exchanging one beach property or other resort home for another), and (2) trading in old business

equipment for new business equipment (such as trading in a business automobile for a new business

automobile). This section of the course (1) provides an overview of like-kind exchanges, including

the types of property that qualify, (2) explains the tax consequences of partial exchanges, where other

property (such as cash) is received in addition to like-kind property, and (3) provides a brief

description of non-simultaneous changes, including deferred exchanges and reverse like-kind

exchanges. For a more in-depth analysis of like-kind exchanges, consult IRS Publication 544.

The like-kind provision should be distinguished from the residential gain exclusion provision

discussed in the preceding section. In contrast to the residential gain exclusion provision, the like-

kind exchange provision defers rather than excludes the recognition of gain. As discussed below,

if the like-kind property received in the exchange (replacement property) is later sold in a taxable

disposition, the unrealized gains that accrued in both the original property (relinquished property)

and the replacement property will be recognized.

In order to qualify for a like-kind exchange, the property received must be (1) qualifying

property, and (2) like-kind property. Qualifying property is either property held for investment or

property held for productive use in a trade or business of the taxpayer. Qualifying property does not

http://www.1031.org)

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include the following: (1) personal-use property; (2) business inventory; (3) bonds and marketable

securities; (4) partnership interests; (5) certificates of trust; and, (6) choses in action.95

Like-kind properties are properties of the same nature or character, even if they differ in

grade or quality. The exchange of real estate for real estate and the exchange of personal property

for similar personal property are exchanges of like-kind property. However, an exchange of personal

property for real property does not qualify as a like-kind exchange. For example, an exchange of

business equipment for a store building does not qualify as a like-kind exchange.

Example 49

Sam Nash owns 10 acres of land that he has held as an investment for 10years and he would like to engage in a like-kind exchange. Since land is realproperty, he may exchange it for other real property either held as an investment orused in his business. In this case, the most obvious example of like-kind property isother land that Sam would hold as investment property. It would also include othertypes of real estate such as (1) an office building which Sam would use in one of hisbusinesses, (2) an office building that he rents out to tenants, and a (3) warehouse heuses to store his business assets.

Examples of replacement property that would not be considered like-kindproperty in this case are (1) dwelling that he uses as his principal residence – whilethis is real property, it is not investment or business property, and (2) a coincollection that Sam would retain as an investment – while this is investment property,it would not constitute like-kind property because it is personal property rather thanreal property.

What if a taxpayer exchanges real estate property for other real estate property but had

partially used the former property for personal purposes, such as a beach home which is rented only

during the summer season? The IRS in Revenue Procedure 2008-16 considered this situation. In96

certain instances, some personal use is permitted as long as the personal use of either the

relinquished property or replacement property does not exceed amounts similar to those specified

under the vacation home provision (IRC Section 280A). Specifically, the IRS provides that

like-kind exchange treatment will be granted for dwelling units used both for personal use and rental

use under the following conditions: (1) the relinquished property must be owned by the taxpayer for

at least 24 months immediately before the exchange, (2) in each of the two 12-month periods

immediately preceding the exchange, the relinquished property is rented for at least 14 days and the

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personal use does not exceed the greater of 14 days or 10% of the days rented, and (3) the same

requirements are satisfied for the replacement property (owned at least 24 months, rented at least 14

days, and restricted personal use). Note: Personal-use days under the vacation home provision are

calculated on a calendar basis whereas personal-use days under the like-kind exchange provision in

this ruling are calculated on an anniversary date basis (date of sale). Thus it is possible that one

provision is satisfied while the other provision is not.

For depreciable personal property, the exchanged properties either can be like-kind or like

class. Like-class properties are depreciable tangible personal properties within the same General

Asset Class or Product Class. General Asset Classes describe the types of property frequently 97

used in many businesses. Some of these classes included the following: (1) office furniture, fixtures,

and equipment (asset class 00.11); (2) computers and peripheral equipment (asset class 00.12); and,

(3) automobiles and taxis (asset class 00.22). Product Classes include property listed in a 6-digit

product class in sectors 31 through 33 of the North American Industry Classification System. A98

complete listing of the product classes may be obtained at http://www.census.gov/eos/www/naics/.

The example below is Example 4 of Treasury Regulation Sec. 1.1031(a)-2(b)(7).

Example 50

Taxpayer G transfers a personal computer (asset class 00.12), an airplane(asset class 00.21) and a sanding machine (NAICS code 333210), to H in exchangefor a printer (asset class 00.12), a heavy general purpose truck (asset class 00.242)and a lathe (NAICS code 333210). The personal computer and the printer are of alike class because they are within the same general asset class. The sanding machineand the lathe are of a like class because they are within the same product class(although neither property is within any of the general asset classes). The airplaneand the heavy general purpose truck are neither within the same general asset classnor within the same product class, and are not of a like kind.

D.2 Tax Consequences of Exchanges Not Wholly Like-Kind

In most exchanges, the value of the relinquished property will not equal the value of the

replacement property. As a result, the taxpayer will either receive additional property or surrender

additional property to equalize the exchange. If the additional property received is not like-kind

property, some gain will be recognized. The gain recognized equals the lower of the (1) gain

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64

realized or (2) boot received. The gain realized equals the fair market value of the consideration99

received less the basis of the relinquished property. In cases where debt is assumable, the

consideration received is increased by any liabilities assumed by the other party, and is reduced by

liabilities assumed by the transferor.

The boot received includes two general categories. The first category is the fair market value

of the other property received, (non-like-kind property) including cash. The second category

concerns assumable debt and it equals the debt relieved less the debt assumed. If this is a negative

number, it is considered boot given.

Example 51

Lindsey Roberts exchanges rental property A in Myrtle Beach, SC with avalue of $500,000 for rental property B in Hilton Head, SC with a value of $460,000plus cash of $40,000. Her basis in property A is $300,000. Her gain recognized is$40,000 (lower of $200,000 gain realized and $40,000 boot received).

Assume instead that property A has a mortgage of $100,000 and sheexchanges property A for property B which has a value of $460,000, a mortgage of$85,000 plus cash of $25,000. Lindsey assumes property B’s mortgage while theother party assumes the $100,000 debt on property A. In this case, boot received isthe sum of (1) $25,000 cash plus (2) $15,000 in debt reduction. Again, the gainrecognized is $40,000.

There are two methods to compute the basis of the replacement property. The first method

is described in IRC Section 1031(d) and is as follows:

1. Basis of like-kind property surrendered.

2. Plus boot given.

3. Plus gain recognized.

4. Less boot received.

5. Less loss recognized on non-like-kind property (only when boot given has a basis lessthan its fair market value).

The second method is conceptual and illustrates that this provision is a deferral provision rather than

an exclusion provision. The basis is computed by subtracting the gain deferred on the relinquished

property (gain realized less gain recognized) from the fair market value of the replacement property.

65

Example 52

Refer to the first paragraph in Example 51. Under method one, the basis ofthe replacement property equals $300,000 ($300,000 + $0 + $40,000 - $40,000 + $0).Under method two, $300,000 is calculated as follows: $460,000 - $160,000($200,000 gain realized less $40,000 gain recognized).

If the replacement property were sold immediately for cash, the gain realized and recognized

would equal the deferred gain ($460,000 - $300,000 = $160,000 in example 52). Observe from

Example 52 that if the taxpayer does not give boot, the basis of the new property equals the basis of

the old property. This is because the boot received equals the gain recognized so two of the

components in method one of the basis calculation cancel out each other.

It should be noted that this provision is nonelective. Thus, exchanges qualifying under this

provision must follow it. So, if the value of the relinquished property is less than its basis, the loss

may not be recognized if the exchange qualifies under the like-kind provision.

D.3 Non-Simultaneous Exchanges

Suppose a taxpayer has identified property that she would like to acquire and would like to

purchase the property by exchanging other property that she already owns. In most cases,

particularly involving real property, the owner of the desired property may not be interested in the

taxpayer’s property. Similarly, suppose a person wants to purchase a taxpayer’s property but the

buyer has no property that the taxpayer is interested in acquiring in a nontaxable exchange. The

taxpayer could identify a property he is interested in acquiring, the buyer could buy the property, and

then the buyer could exchange the acquired property with the property owned by the taxpayer. To

accommodate these scenarios as well as other types of nonsimultaneous exchanges, Congress added

a provision to the like-kind rules which allows certain nonsimultaneous exchanges (or deferred like-

kind exchanges) to qualify for gain deferral. The Treasury regulations added four safe harbors and

the IRS added a revenue procedure which assure like-kind treatment if certain conditions are

followed. These provisions are fairly complex and a detailed analysis of these rules is beyond the

scope of this course. A brief overview of these provisions is provided below.

66

Replacement property that is received by the taxpayer subsequent to the transfer of

relinquished property is not considered like-property if either (1) the replacement property is

identified more than 45 days after the transfer of the relinquished property, or (2) the replacement

property is received by the taxpayer more than180 days after the transfer of the relinquished property

or after the due date for filing the tax return (including extensions) if this is earlier than 180 days.100

The replacement property must be identified in a written document which must be delivered to the

other person involved in the exchange. The property must be clearly described, such as the legal

street address of the property for real property. Multiple properties may be identified as long as they

do not exceed the greater of (1) three, or (2) any number of properties where the sum of the values

of the replacement properties does not exceed more than twice the value of the relinquished

property.101

Example 53

ABC Corporation and Rich Gabel enter into an agreement for an exchangeof property that requires ABC to transfer property X to Rich. Under the agreement,ABC is to identify like-kind property which Rich is required to purchase and transferto ABC. ABC transfers property X on November 16, 2015.

The identification period ends on December 31, 2015, the day which is 45days after the date of transfer of property X. The exchange period ends at midnighton March 17, 2016, the due date for ABC's Federal income tax return for the taxableyear in which ABC transferred property X. However, if ABC files a timely automaticsix-month extension for filing its tax return, the exchange period ends at midnight onMay 17, 2016, the day which is 180 days after the date of transfer of property X.102

If, before the taxpayer receives the replacement property, he actually or constructively

receives cash or unlike property in full payment for the relinquished property, the transaction will

be treated as a sale rather than as a deferred exchange. Cash or unlike property is constructively

received if the cash or property is made available to the taxpayer or credited to his account. The

regulations provide four safe harbors which if used will not result in the constructive receipt of cash

or unlike property. These safe harbor provisions deal with the following items: (1) the transferee’s

obligation to transfer replacement property to the taxpayer is secured or guaranteed; (2) the transferee

places funds in a qualified escrow account or in a qualified trust as security; (3) the taxpayer’s

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transfer of relinquished property involves a qualified intermediary; and, (4) the taxpayer may be

entitled to receive interest income with respect to the deferred exchange.103

With respect to the first safe harbor, the security may be a (1) mortgage, deed of trust, or

other security interest other than cash; (2) a standby letter of credit; or, (3) a third party guarantee.

The safe harbor will be inapplicable at the time the taxpayer has an immediate ability or unrestricted

right to receive money or other property pursuant to the security or guarantee agreement.104

If an escrow account or qualified trust is used as security, the escrow holder or trustee may

not be the taxpayer or a disqualified person. Disqualified persons include a person who has been the

taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker

within the 2-year period before the transfer of the relinquished property.105

If the relinquished property is transferred through a qualified intermediary, the transfer of the

property given up and receipt of like-kind property are treated as an exchange. A qualified

intermediary is a person (other than a disqualified person) who enters into a written exchange

agreement with the taxpayer to acquire and transfer the relinquished property and to acquire the

replacement property and transfer it to the taxpayer. This agreement must expressly limit the106

taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other

property held by the qualified intermediary.107

The Internal Revenue Code and Treasury Regulations do not cover situations where taxpayers

purchase replacement property before transferring the relinquished property. The IRS, in Revenue

Procedure 2000-37, provides for a “reverse like-kind” exchange that involves “parking” the108

relinquished property with an accommodation party until the relinquished property is transferred to

the eventual buyer. For reverse like-kind exchanges under a qualified exchange accommodation

arrangement (QEAA), the replacement property is transferred to an exchange accommodation

titleholder (EAT), who is treated as the beneficial owner of the property. Such an arrangement will

qualify only if the following conditions are satisfied: (1) there is a written agreement between the

taxpayer and EAT; (2) the time limits for identifying and transferring the property are met; and, (3)

68

the qualified indications of ownership of property are transferred to an EAT. The 45-day and 180-

day time limits are similar to those for deferred exchanges except the relinquished property must be

transferred to the eventual buyer within 180 days after the transfer of the relinquished property to the

EAT. A more detailed analysis of reverse like-kind exchanges is provided in IRS Publication 544

and Revenue Procedure 2000-37.


Questions

17. James owns a parcel of land held for investment worth $500,000 with a basis of $400,000.He exchanges the land and $100,000 cash for a dwelling to be used as rental property worth$600,000. What is his basis in the dwelling?

a. $600,000.b. $500,000.c. $400,000.

18. On July 31, 2016, Jack engages in a deferred like-kind exchange where his relinquishedproperty is transferred to the new owner. What is the latest date by which Jack must identifyreplacement property?

a. September 14, 2016 (45 days after the transfer of the relinquished property).

b. January 27, 2017 (180 days after the transfer of the relinquished property).

c. April 15, 2017 (due date of her 2016 tax return).

Solutions

17. "B" is the correct response. There are two ways to compute basis. The first is use thebasis formula after Example 51 above. Since he received no boot, no gain is recognized soitem #s 3 and 4 do not apply. Since he gave boot that was cash, item #2 applies but item #5does not. This leaves a basis of $500,000 ($400,000 in item #1 plus $100,000 in item #2).The second method is to subtract the unrecognized gain ($100,000) from the fair marketvalue of the property received ($600,000 - $100,000 = $500,000).

"A" is an incorrect response. $600,000 would be correct if the transaction did not qualifyas a tax-free exchange. It would equal its cost (fair market value at the time of thetransaction).

"C" is an incorrect response. $400,000 would be correct if there is no boot given and theboot received is less than the gain realized (item #s 3 and 4 would cancel out, leaving the$400,000 basis in the property surrendered). Section D.2.

18. "A" is the correct response. For deferred like-kind exchanges, the taxpayer must identifyreplacement property (or properties) within 45 days after the transfer of the relinquishedproperty.

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"B" is an incorrect response. For deferred like-kind exchanges, the taxpayer must acquirereplacement property within180 days after the transfer of the relinquished property.

"C" is an incorrect response. If the due date for filing the tax return is earlier than the 180-day period, either an extension must be filed or the replacement property must be acquiredby the due date of the tax return. Section D.3.

E. CONCLUDING REMARKS

This course has discussed some of the more common income items and property transactions.

This course reflects legislative changes made through the “Protecting Americans from Tax Hikes

Act of 2015,” the PATH Act, signed by President Obama on December 18, 2015. Tax planning

strategies have been illustrated throughout the course.

Significant current income tax law affecting individuals which has not been covered substan-

tively in this course are in other courses in our “Individual Income Tax Series”: Course [2] –

“Above-the-Line Deductions”; Course [3] – “Itemized Deductions”; and, Course [4] – “Rates,

Credits Against Tax, and Special Issues.”

70

44444444444444444444444444444444444444444444444444444444444444444444444444444444444444444444

INDEX

Adjusted base amount, 14,15Alimony, 1-12Alimony recapture, 1-3,7,8Alternate valuation date, 32,34,35Base amount, 14,15Basis,10,11,30-39,42,43,45,50,

64,65,68Beneficiary, 32,34-36,38Boot received, 61,64,65,68Capital assets, 39-41,44,46,47Capital loss carryover, 39,46Charitable achievement awards,

19,20Child support, 1-4,6,9-12Collectibles, 39,41,45Contingent attorney fees, 28,30,

31Contingent payments, 1,6Copyright, 40,41Date of death, 32,34,35,39Deferred exchange, 61,66-68

Donee's basis, 31,33,34Employee achievement awards,19,21,23Gain realized, 33,42,45,48,49Length of service, 19,21Like-kind exchange, 60-63,65,

67-69Lookback recapture rule, 43,45Modified AGI (MAGI), 13,14Nonqualified use, 51,52Nonsimultaneous exchange, 65,

66Ordinary income assets, 39-41Ownership test, 48Patent, 40,41Physical personal injuries, 28Principal residence, 48-60,62Property settlement, 1,2,5,6,9,10Provisional Income, 13-16Punitive damages, 29Qualified intermediary, 67

Qualified small business stock,39,41,42

Recoveries, 23-27Recovery exclusion, 24Relinquished property, 60-69Replacement property, 60-69Residential gain exclusion, 48,49,

51-53,58,60,61Reverse like-kind, 61,67,68Safety achievement, 19-22Scholarship, 16-19Social security benefits (SSBs),

13-1 6Tax benefit rule, 23,24Trade or business assets, 39,40Unforseen circumstances, 49,52,

55,56,60Unrecaptured section 1250 gain,

39,42,48Use test, 48-50,56,60

44444444444444444444444444444444444444444444444444444444444444444444444444444444444444444444444444444444444444

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QUIZ QUESTIONS

Place your answers to the following 30 Multiple Choice Questions on the enclosed answer sheet.To test on-line, go to www.cpelite.com and log in to your account page.

1. Under a divorce decree, Ken is required to pay Connie $40,000 per year for 7 years or until herdeath, whichever is earlier. If Connie dies before 7 years, the decree requires Ken to pay childsupport of $22,000 per year for the remainder of the seven-year period. How much of theannual payment is treated as alimony?

a. $18,000.b. $22,000.c. $40,000.

2. Concerning the definition of alimony, which one of the following statements is false?

a. Cash payments to a third party to pay for certain expenses of the former spouse mayqualify as alimony if certain requirements are met, such as if they are pursuant to a writtenrequest of the former spouse.

b. An oral divorce agreement is not allowed (must be written).

c. A taxpayer may fulfill his alimony obligation by transferring marketable securities to hisformer spouse rather than making cash payments.

3. Jean pays Steve the following amounts of alimony under their Year 1 divorce decree: Year 1 -$90,000, Year 2 - $50,000, and Year 3 - $20,000. How much, if any, of the Year 1 alimonypayment must be recaptured in Year 3?

a. $25,000.b. $40,000.c. $47,500.

4. Which one of the following statements is false?

a. Alimony payments must be made in cash.

b. Through proper tax planning, it is possible for one former spouse to deduct the paymentas alimony and for the other former spouse to treat the payment received as nontaxableincome.

c. If alimony recapture occurs, the individual who reported the amount received as incomewill be able to claim a deduction for the alimony recapture portion.

5. Concerning social security benefits (SSBs), which one of the following statements is true?

a. Social security benefits include supplemental security income payments.

b. A single taxpayer’s SSBs are not includible in gross income if his provisional income isless than or equal to $25,000.

c. One-half of a taxpayer’s tax-exempt interest income is included in her provisional incomefor purposes of calculating how much of the SSBs is includible in income.

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6. George Means, a single taxpayer receives the following income items during the year: (1)$30,000 of taxable retirement income; (2) $4,000 of capital gain income; and, (3) $20,000 ofsocial security benefits (SSBs). How much of the SSBs is included in his gross income?

a. $ 8,500.b. $13,000.c. $17,000.

7. During the year, Chip Brenner, a full-time student, receives a $20,000 scholarship to StateUniversity which is used for the following expenditures: (1) $14,000 for tuition; (2) $500 forlab fees; (3) $1,000 for books; and, (4) $4,500 for part of his room and board (actual room andboard costs were $6,000). How much of the scholarship is includible in gross income?

a. $4,500.b. $5,000.c. $6,000.

8. Regarding the exclusion for qualified scholarships, which one of the following statements istrue?

a. The taxpayer is required to maintain records which show the total amounts spent forqualified tuition and related expenses.

b. The exclusion for scholarships does not apply to graduate students.

c. The amount of tuition reduction granted by an education institution to an employee of theinstitution must be included in the employee’s gross income.

9. Which one of the following is not a requirement to exclude from income the value of anaward received by a taxpayer?

a. The recipient of the award must not be required to perform substantial services as acondition of receiving the award.

b. The recipient of the award must be selected without any action on his part.

c. The award must be made in cash.

10. Which one of the following statements about prizes and awards is false?

a. A recipient who receives an award, the terms of which require the recipient to performsubstantial future services, may exclude the value of the award from gross income.

b. An award recipient qualifies an award as a gross income exclusion by transferring theaward to a tax-exempt charitable organization. The award recipient may not claim acharitable deduction for the transfer of the award.

c. Generally, the fair market value of an employee achievement award valued at less than$400 is excluded from the employee's gross income.

11. During the year, Milton Corporation gives Josh Caleb, one of Milton’s employees, twoemployee achievement plan awards – (1) $700 of employee achievement non-qualified planaward and (2) $2,000 of employee achievement qualified plan award. How much is MiltonCorporation’s deduction with respect to these awards?

a. $ 700.b. $1,600.c. $2,700.

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12. The Kaplans file a joint return in 2015. They do not itemize their deductions in 2015. In 2016,the Kaplans receive a state income tax refund of $1,000. How much gross income do they havein 2016 as a consequence of receiving the state income tax refund?

a. $1,000.b. $ 800.c. $ 0.

13. Tim and Mary Smiley have 2015 taxable income of $60,000. They file a joint return, anditemize their personal deductions which exceed their standard deduction amount for 2015 by$2,000. In 2016, the Smileys recover the following amounts for items deducted on their 2015return: $1,000 of medical expenses, and $1,500 for a state income tax refund. How much ofand where are the two recoveries reported?

a. $1,000 on line 21; $1,500 on line 10.b. $1,000 on line 21; $1,000 on line 10.c. $ 800 on line 21; $1,200 on line 10.

14. With respect to amounts a taxpayer receives for damages on account of personal injuries, whichone of the following statements is false?

a. Generally, amounts received as damages for nonphysical injuries or sickness are excludedfrom gross income.

b. Generally, damages received for physical injuries or physical sickness can be excludedfrom gross income.

c. Damages received for physical symptoms resulting from emotional distress due tophysical injury may be excluded from gross income to the extent paid for medical care.

15. On March 10 of the current year, pursuant to an agreement effective November 11 of the prioryear, George Parker receives a $135,000 settlement from his former employer. By virtue oftheir settlement agreement, George determines that the $135,000 settlement represents thefollowing: $15,000 for back pay, $45,000 for damages to George's character, and $75,000 forpunitive damages. How should George report the $135,000 settlement on his current year’sfederal income tax return?

a. $ -0- nontaxable; $135,000 taxable.b. $120,000 nontaxable; $15,000 taxable.c. $90,000 nontaxable; $45,000 taxable.

16. During the current year, Scott Johnson is awarded $100,000 as a result of a lawsuit with hisneighbor, who violated the subdivision rules and damaged some of Scott’s property. Pursuantto an agreement with his attorney, Scott receives 75% of the award and his attorney receives25% of the award. How is the $25,000 payment to his attorney treated by Scott on his taxreturn.

a. As an above-the line deduction.

b. As an itemized deduction under the category “Other Miscellaneous Deductions,” whichis not subject to the 2% AGI limitation.

c. As an itemized deduction under the category “Job Expenses and Certain MiscellaneousDeductions,” which is subject to the 2% AGI limitation.

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17. Stuart Wells is given 1,000 shares of ABC stock by his mother. The basis of the stock toStuart's mother at the time of the gift was $17,000. The stock’s fair market value at the timeof the gift was $22,000. Stuart sells the stock two years later for $18,000. What is Stuart's gainor loss on the sale?

a. $4,000 loss.b. $1,000 gain.c. No gain or loss.

18. A taxpayer owns 1,000 shares of common stock with a FMV of $8,000 and a basis of $6,000.She receives 1,000 shares of preferred stock worth $2,000 as a stock dividend. What is thebasis of the preferred stock?

a. $1,200.b. $1,500.c. $3,000.

19. On June 2, 1998, Homer purchased 1,000 shares of XYZ Stock for $100,000 ($100 per share).The company ran into trouble and he sold the stock for $2,000 ($2 per share) on December 21,2015. On January 4, 2016, he re-purchased 800 shares of XYZ Stock for $1,800 ($2.25 pershare). What is the total basis of the 800 new shares of XYZ Stock?

a. $99,800.b. $80,200.c. $ 1,800.

20. Which one of the following assets is not a capital asset?

a. A patent held by the inventor.

b. Marketable securities (stocks and bonds).

c. An office building used by the owner and the owner’s employees to conduct businessactivities.

21. Jerry’s marginal tax rate in the current year is 25%. He sells an office building (purchased tenyears ago) that he used in his trade or business for $260,000. It had cost $200,000 andaccumulated depreciation is $40,000. His total gain equals $100,000 ($260,000 - $160,000).Disregarding the 3.8% tax on net investment income, what is Jerry’s net increase in tax liabilityas a result of this sale?

a. $19,000.b. $25,000.c. $15,000.

22. Martha’s marginal tax rate in the current year is 35%. She recognizes a $4,000 long-termcapital gain from the sale of common stock, a $3,000 long-term capital gain from the sale ofher coin collection, and a $2,000 short-term capital loss from the sale of common stock.Disregarding the 3.8% tax on net investment income, what is her net increase in tax liability asa result of these sales?

a. $1,140.b. $ 880.c. $ 750.

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23. The Smiths file a joint return in 2015 . They have a net short-term capital loss of $4,000 anda net long-term capital loss of $5,000. Their taxable income is $10,000. They have twopersonal exemptions ($4,000 per exemption). What is the amount and character of the Smiths'capital loss carryover to next year?

a. $2,500 short-term; $3,500 long-term.b. $4,000 short-term; $2,000 long-term.c. $1,000 short-term; $5,000 long-term.

24. Which one of the following taxpayers will be able to exclude the entire gain on the sale of thetaxpayer's residence?

a. A married couple filing a joint return purchased the home on May 1, 2012, for $150,000.They used it as their residence until December 22, 2016, when they sold it for $490,000.

b. A married couple filing a joint return purchased the home on October 12, 2002, for$125,000. They used it as their residence until February 15, 2016, when they sold it for$300,000. Accumulated depreciation on the portion of the home used as an office is$1,000.

c. A single taxpayer has rented a home for six years. In December 2014, he purchased it for$225,000, lived in it another eighteen months and sold it on June 1, 2016, for $300,000.

25. Assume a taxpayer sells her home before she has owned it two years. Which one of thefollowing events will not qualify for the partial residential gain exclusion?

a. The taxpayer recently lost her job and currently is receiving unemployment compensation.

b. The taxpayer gave birth to her third child and needs to live in a larger home.

c. The taxpayer and her former spouse finalize their divorce.

26. John, a single taxpayer, purchased a home on July 1, 2015 for $180,000. This is the first homehe has ever owned. During 2016, his employer transferred him to another city. Sixteen monthsafter the purchase of his home, he sold it for a net sales price of $380,000, resulting in a realizedgain of $200,000. How much of the realized gain must be recognized in 2016 (assume eachmonth has an equal number of days)?

a. $200,000.b. $ 66,667.c. $ 33,333.

27. In which one of the following cases is it not likely that the taxpayer will qualify for theresidential gain exclusion provision?

a. The taxpayer sells a mobile home which he has owned and used as his principal residencefor the last three years.

b. The taxpayer sells a second home (vacation home) which she has been using about three

months of the year as her residence for the last six years.

c. The taxpayer sells a houseboat which he has owned and used as his principal residencefor the last ten years.

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28. Which one of the following exchanges will not qualify for the like-kind exchange provisions?

a. Land held as an investment which is exchanged for an office building that will be used inan active business.

b. 100 shares of XYZ common stock which is exchanged for 100 shares of ABC commonstock.

c. Office furniture used in the taxpayer’s business which is exchanged for other officefurniture to be used in the taxpayer’s business.

29. Alexis owns a parcel of land held for investment worth $150,000 with a basis of $131,000. Shedecides to swap the property for some other property. The other party agrees to give her someland to be held for investment worth $135,000 (which is free and clear of any debt), marketablesecurities worth $10,000, and $5,000 cash. What is the amount of gain recognized by Alexisas a result of the swap?

a. $19,000.b. $ 5,000.c. $15,000.

30. On May 31, 2016, Missy sells 1,000 acres of land which had been held for investment. Theproceeds of the property are deposited in an escrow account where the taxpayer is not entitledto receive the proceeds and such proceeds will be used to purchase replacement property. Whatis the latest date that Missy must acquire replacement property?

a. July 15, 2016 (45 days after the sale of the relinquished property).

b. November 27, 2016 (180 days after the sale of the relinquished property).

c. April 15, 2017 (due date of her 2016 tax return).

77

1. Public Law 114-113, containing both the Path Act and the Consolidated AppropriationsAct, 2016.

2. Internal Revenue Code Section (IRC Sec.) 215(a).

3. IRC Sec. 71(a).

4. IRC Sec. 71(b)(1)(A).

5. IRC Secs. 71(b)(2)(A) and (B).

6. IRC Sec. 71(b)(1).

7. IRC Sec. 71(c).

8. IRS Publication (Pub.) 504, page 16.

9. Ewell, 71 TCM 3134 (TC 1996).

10. Iglicki and Stultz, T.C. Memo. 2015-80 (TC 2015).

11. Moore, 102 TCM 487 (TC 2011).

12. The example is similar to Example 1 in Pub. 504, page 16.

13. The example is similar to Example 2 in Pub. 504, pages 16-17.

14. Pub. 504, page 16.

15. Pub. 504, page 15.

16. The example is similar to the example in Pub. 504, page 18.

17. Pub. 504, page 18.

18. IRC Sec. 86(d)(1).

19. Pub. 915, page 2.

20. Items that have to be added back to AGI are income exclusions from the following items:(1) interest from qualified U.S. savings bonds; (2) employer-provided adoption benefits;(3) foreign earned income or foreign housing; and, (4) income earned by bona fideresidents of American Samoa or Puerto Rico.

21. IRC Sec. 86(c)(1).

22. IRC Sec. 86(c)(2).

23. IRC Sec. 117(a).

24. IRC Sec. 117(b).

ENDNOTES

78

25. IRC Sec. 117(d).

26. Proposed Treasury Regulations Section (Reg. Sec.) 1.117-6(d)(3).

27. Proposed Treasury Reg. Sec. 1.117-6(e).

28. IRC Sec. 74(a).

29. IRC Sec. 74(b).

30. Pub. 525, page 33.

31. IRS authority in this respect is derived from the House Committee Report, the TaxReform Act of 1986 (Public Law 99-514), Section 122, amending IRC Sec. 74.

32. IRC Sec. 74(c).

33. IRC Sec. 274(j).

34. IRC Sec. 111.

35. Treasury Reg. Sec. 1.111-1(b)(2)(I).

36. Pub. 525, page 24.

37. IRC Sec. 104(a)(2). Also, see Treasury Reg. Sec. 1.104-1(c).

38. See the Shaltz (85 TCM 1489 (2003)) case, where the Tax Court noted that emotionaldistress, including symptoms such as insomnia, headaches, and stomach disorders, is notconsidered a physical injury or physical sickness, but that an exclusion may be allowedfor the amounts that are paid for medical care that is attributable to the emotional distress. In the case, the Tax Court found that because no medical costs were incurred in dealingwith the taxpayer’s emotional distress, no part of the award received in a sexualharassment suit was excludable from the taxpayer’s gross income.

39. Brabson, 96-1 USTC Paragraph 50,038 (CA-10; 1/11/96).

40. Lindsey v. Comm., 66 TCM 488 (1993).

41. Kane, 95-1 USTC Paragraph 50,060 (CA-Fed. Cir.; 12/29/94).

42. U. S. v. Burke, 92-1 USTC Paragraph 50,254 (SC, 5/26/92).

43. See also the Tax Court decision in Fogle (64 TCM 242 (1992)) which held that amountsreceived under Title VII of the Civil Rights Act of 1964 are not excludable from grossincome. The Tax Court used the Burke result in its analysis. In Revenue Ruling 96-65(1996-2 CB 6), the IRS states that back pay received to satisfy a claim for denial ofpromotion due to disparate treatment employment discrimination under Title VII of the1964 Civil Rights Act is not excludable from gross income, although damages receivedfor emotional distress to satisfy such a denial claim are excludable.

44. Revenue Ruling 96-65, 1996-2 CB 6 (12/30/96).

79

45. Reimels, 123 TC 245 (August 26, 2004).

46. CIR v. John w. Banks, II. CIR v. Sigitas J. Banaitis. 2005-1 USTC Paragraph 50,155(January 24, 2005).

47. IRC Sec. 62(e), as added by the AJCA ‘04.

48. IRC Sec. 62(a)(19)(20), as added by the AJCA ‘04.

49. Pub. 551, page 2.

50. Pub. 551, page 3.

51. IRC Sec. 1015.

52. IRC Sec. 1014.

53. IRC. Sec. 2032(c).

54. IRC Sec. 1022(a)(2).

55. IRC Sec. 1022(b)(2)(B).

56. IRC Sec. 1022(c)(2).

57. Pub. 551, page 10.

58. IRC Sec. 1091(a).

59. IRC Sec. 1231(b).

60. IRC Sec. 1235(a).

61. Pub. 17, page 118.

62. IRC Sec. 165(c)(3).

63. IRC Sec. 1212(b).

64. Pub. 17, page 117.

65. Pub. 17, page 118.

66. IRC Sec. 165(g).

67. IRC Sec. 166(d).

68. IRC Secs. 121(b)(1) and (b)(2).

69. IRC Sec. 121(a).

70. IRC Sec. 121(d)(6).

71. IRC Sec. 121(d)(3)(A).

80

72. Chief Counsel Advice 200734021 (5/23/07).

73. Reg. Sec. 1.121-1(c)(1).

74. Reg. Sec. 1.121-1(c)(2).

75. IRC Sec. 121(b)(5)(C)(I).

76. IRC Sec. 121(b)(5)(C)(ii).

77. DeBough, 106 AFTR 2d, para.5192 (8 Cir. 2015)th

78. Reg. Sec. 1.121-3(b).

79. Reg. Sec. 1.121-3(c)(2)(ii).

80. Reg. Sec. 1.121-3(c)(3).

81. Reg. Sec. 1.121-3(d)(1).

82. Reg. Sec. 1.121-3(d)(2).

83. Reg. Sec. 1.121-3(e)(2).

84. IRC Sec. 121(c)(1).

85. IRC Sec. 121(c)(1).

86. IRC Sec. 121(b)(2).

87. Reg. Sec. 1.121-2(a)(4), Example 3.

88. Reg. Sec. 1.121-2(a)(4), Example 6.

89. Reg. Sec. 1.121-4(a)(1).

90. Reg. Sec. 1.21-1(b)(2).

91. Reg. Sec. 1.21-1(b)(1).

92. Reg. Sec. 1.121-1(b)(2).

93. Guinan, 2003-1 USTC Para 50,50,475 (DC, Arizona, 2003)

94. Reg. Sec. 1.121-1(b)(3).

95. IRC Sec. 1031(a)(2).

96. Revenue Procedure 2008-1 CB 547 (February 15, 2008).

97. Reg. Sec. 1.1031(a)-2(b).

98. Reg. Sec. 1.1031(a)-2(b)(3).

81

99. IRC Sec. 1031(b).

100. IRC Sec. 1031(a)(3).

101. Reg. Sec. 1.1031(k)-1(c)(4).

102. Example is from Reg. Sec. 1.1031(k)-1(b)(3).

103. Reg. Secs. 1.1031(k)-1(g)(2) - (g)(5), respectively.

104. Reg. Sec. 1.1031(k)-1(g)(2)(ii).

105. Reg. Sec. 1.1031(k)-1(k)(2).

106. Reg. Sec. 1.1031(k)-1(g)(3)(iii)(B).

107. Reg. Sec. 1.1031(k)-1(g)(2)(vi).

108. Revenue Procedure 2000-37, 2000-2 CB 308 (September 18, 2000).

Documents

2016 INCOME ITEMS AND PROPERTY TRANSACTIONS · The completion d ate on your answer sheet will be the date designated on your certificate. The latest recommended completion date is