Introductory Income Tax OutlineRoin 2002

Table Of Contents

Basics/Misc. Income vs. other taxes Consumption vs. Income Tax Cash vs. Accrual

Income Tax Structure Tax Rates Manipulation Marriage Penalty/Benefit Fringe Benefits

Transfer of Property Capital Recovery Gifts DOI Debt Transfer

When to count Income Realization/Recognition Imputed Income Tax exempt Bonds

Deductions Progressivity and Solution Alternative Minimum Tax Business Investment Personal Tax Shelters

Capital Gains What and Why Changing Purposes Hedging Substitutes for OI

Statutes

Terms

Basics/Misc

Income vs. other tax regimes:

Low admin costs, but easy to fraud Other possibilities: Consumption, property, social security

Progressive scale : o Higher burden on wealthy who 1) can pay more and 2) may benefit more from social programs (roads, etc)o Supports desire to keep equality, kill aristocracy; but harms ideal of keeping what you work for.o Easier to raise $ on few than many, but potential to “drive off” wealthy either literally or because they stop

working. o Ongoing tension between capitalism and redistribution

Consumption vs. Income Tax

Systems will lead to same economic result, but may differ in adminsterability Debate is over whether consumption tax would increase investment or whether investors would be content with “traditional

returns”

Accrual vs. Cash Accounting

Cash: Income gained/lost when payment occurs Simpler administration

Accrual: Income gained/lost when earned (regardless of when payment occurs) More correct, but tougher to administer Avoids realization problems

Income Tax Structure

Tax Rates

§1 Individual Income Taxes(a)-(d) Tax Rates imposed on a) Joint, b) HOH, c) Unmarried, d) Married but separate filing(f) Removal of “bracket creep” (see Rev Proc for current amounts)(i) Introduction of 10% bracket after 2000

Reduction in rates after June 30, 2001§11 Corporation Income Taxes

Manipulation of Tax Base

§61 Gross Income = “all income from whatever source derived” §101(a) NO GI from Life Insurance policies

§62 Above the line deductions (Adjusted Gross Income (AGI) = §61 - §62)(a)(1) Trade/Business costs (not as an employee)(a)(2)(A) Expenses reimbursed by employer

§63 Below the line (itemized) deductions which are subject to reductions in §67 and §68(c)(2) Standard deductions (varies by type of filing – see Rev Proc)

§67 2% Floor on Misc. Itemized(a) Only amount over 2% AGI is deductible(b) Floor does NOT apply to these deductions, including §163 (inv int), § 165 (losses), § 170 (charity), § 213

(med)

§68 Overall limitation on Itemized Deductions(a) Itemized deductions reduced by LOWER of

1) 3% AGI over applicable amount 2) 80% allowable itemized deductions

(b) See Rev Proc for “applicable amount”; note that ½ amount for married filing separates(c) Limitation does NOT apply to § 163, § 165, § 213(f) Phase-out of §68(a) beginning in 2005

§151 Personal Exemptions(a) Above the line deduction (???)(b)-(c) TP + Spouse (if joint filing) + kids(d) Exemption amount found in Rev Proc

Amount lowered by 2% for each $2500 AGI is over applicable “Threshold amount” - (see Rev Proc)

Effects of Manipulation:o Gov’t can increase revenues w/o much “fuss” because TPs don’t noticeo Actual marginal rates often higher than §1 rates indicateo Sometimes $1.00 increase in income will push AGI over threshold and result in $100s tax liability (bracket

problem)o Bubble: Marginal rates increase as income increase, but then decrease around $800K

Marriage Penalty/Benefit

Two single filers, each making ½ of a Joint Filer, will pay less overall taxes (Marriage Penalty)o Ex: 2*35K = $12567 (pre 2001 act) ; 1*70K = $13724

But as the income of the single filers grows apart, they will pay more than the Joint Filer (Marriage Benefit)o Ex: 60K + 10K = $14783 ; 1*70K = 13724

Point: Marriage penalty is a result of progressive tax system. In any progressive tax system you cannot have marriage neutrality. Only solution is a flat tax

Fringe Benefits

§119 Benaglia rule incorporated into code where room/board is 1) provide for employer’s convenience and 2) located on premise

§274(n)Businesses can only deduct 50% of cost of meals and entertainment (basically gov’t splits with businesses instead of 100/0 game)

§132 Certain fringe benefits excluded from GI(b) no-additional cost(c) Qualified employee discount(d) Working condition fringe(d) de minimis fringe

(h) Definition of persons qualifying for (b) and (c)(j) Specialty rules (basically loss of exclusion for (b) and (c) in certain circumstances)

Rationale: Often inexpensive and convenient for business to offer. Little distribution effect if everyone’s business does it

Old Colony: Company pays officer’s income tax. Court holds this payment as taxable income as it discharged an obligation

Drescher. Court finds present taxable interest in future guaranteed annuity (paid for by officer’s company) because there is a current market in which the property interest could be sold.

Hypo Company promises to pay tuition of officer’s daughter. Though no obligation (Old Colony), still taxable income, but tax not paid until interest received because no current market for such interest (Drescher). Thus TP still gains TMV

Benaglia No taxable income for room/board paid to hotel manager who had to live/eat in hotel as part of job. Though benefit received by manager, tough to value and feel sympathy because he “has” to buy

Transfer of Property

Capital Recovery

§1001 Gains/Losses from dealings in property = Amount realized – Adjusted Basis

§1012 Basis in property = cost of propertyTR 1.61-6 Basis equally apportioned among parts sold

§1016 Adjusted Basis = Basis – certain adjustments

§1014 “Step up in basis”: Basis in donee’s inherited property = value at time of conveyance, NOT donor’s basis

Point: death is not a realization, probably because of difficult in determining original basis. Small potential of a “step-down”

§1015 “Carry-over basis”: Basis in donee’s inter-vivos gift = basis of donorPoint: Rule only applies to gains, not to losses. Otherwise easy to evade taxes and larger potential for “step-down”Also, if donee sells property for less than original basis, but more than FMV, no gain or loss (limbo property)

Org. Basis FMV at time of gift Sale price Gain/Loss10 6 5 (1) - not (5)10 6 8 0 - limbo10 6 14 4

Point: Can avoid taxes by giving property with gain to someone in lower tax bracket, but never advantageous to give away property with loss as the loss can’t transfer.

Inaja Land Co. Gov’t condemns and pays for easement. Court rules that basis of easement inseparable from basis of property in

gross and so no current taxes. Instead, $ reduces basis and so increase in future taxes. Still, Π gets TVM Note: Courts today would allow apportionment on estimate of value of easement

Hort. Court disallows reduction in value of acquired rental property where tenant defaults. Rationale: property value increased to amount of rent lost because now possible to get new tenant. It’s a wash.

Clark Π sues lawyer for bad tax advice (he pays too much) and wins recovery. Court finds no taxable income in recovery (but in doing so creates an artificial basis)

Gifts§274 Disallowance of certain expenses

(b) Gifts by employers to employees limited to $25. (j) “Achievement awards” are limited to cap ($400 - $1600)

o Note that employers can still pay lower taxes on gifts given than employees would if treated as income

Point: Purpose is to disallow arbitrage (incurrence of deductive expense for purpose of generating tax-favored income)

§102 Generally, no GI from gifts, inheritance;(b) Does not exclude income derived from such property (rent, etc)(c) Gifts from employers to employees now included in GI

Deberstein. Court counts as income car given by employer to employee where employer counts it as a deductionPoint: To be a gift, intent to give must be detached from intent to compensate for servicesNote: Still a little importance after §102(3)

Stanton. Court doesn’t count as income a “retirement thank-you” from church to pastor, by looking to “intent of donor”Note: Case has no influence after §102(3)

Diedrich Gift of encumbered property (see Crane-Tufts for sale of encumbered)Rule: 100K property (20K cash + 80K NRD) given away is a realization event – 80K gain

This gain is taxed to the donor, not donee, so as to avoid transfer of tax to lower bracket payer

Discharge of Indebtedness

Generally, loans are not counted as GI because they will be paid back

§61(a)(12) DOI is GI

§108 DOI excluded from GI if TP 1) insolvent or 2) DOI occurs in bankruptcy

(a)(3) For insolvency, tax avoidance only for amount ABOVE insolvency Ex: 100K debt forgiven, but TP has 20K assets. Only 80K tax free Note that for Ch 11, all DOI tax free, even if not 100% insolvent

(b)(2)(A) TP can NOTt carry forward NOL “used up” in DOI – otherwise a double benefit would occur

(e)(5) Solvent debtor DOI can be excluded if “purchase price reduction” – meaning forgiven by seller, NOT byloaner

Note: Solvent debtor DOI normally included as GI under Kirby Lumber Note: Technically only applies to real property, though Zarin allows for

gambling debt

Secured vs. Non-secured debt (Problem Set #4) Non Gain/loss treated as DOI Sec Gain/loss treated as DOI if debt is RD; as Capital gain if debt is NRD

Note: both would be forgiven under bankruptcy law

Zarin. Court finds DOI of gambling “debt” is NOT taxable income because no real debt obligation (Casino and TP had settled and IRS wants to include as income difference between debt Casino claims (3.4M) and settlement value(500K))

Transfer of property subject to debt

TR 1.1001-2 Where property sold partially/fully for assumption of debt, no DOI where debt was recourse debt (RD)Example 7 For NRD, property and transaction NOT separated at end – thus gain/loss treated as capital

gain/lossExample 8 For RD, property and transaction separated at end – thus gain/loss treated as DOI

Woodsam No realization where owner of property with FMV>Basis mortgages it for NRD.Ex: 100K basis now worth 250K. NRD mortgage does not yield 150K income to TP

Crane “Amount realized” by seller of mortgaged property (NRD here) includes both cash and face amount of mortgageCrane + Woodsam: Original NRD is included, but not subsequent NRD on property

Tufts TP mortgages property with NRD, take several years of depreciation, and then sells.

TP position: NRD not real debt. Gain/loss computed from difference in sale price and adjusted basis (after depreciation). This allows for large Tax Shelter

IRS/Majority position:NRD is an obligation. Gain/loss computed from difference in sale price and original basis (before depreciation). This allows for small Tax Shelter to degree that marginal rates > capital gains rate

O’Conner position: Treat depreciation as DOI instead of capital loss. This makes Tax Shelter unprofitablePoint: O’Conner would treat RD and NRD equally; Majority and IRS still views them as distinct

When to Count Income

Realization and Recognition

Realization change in circumstances where gain/loss MIGHT be countedRecognition change in circumstance where gain/loss IS counted

Benefits:o Avoids Ability to pay problemso Avoids Valuation problemso Avoids taxation where no change in taxpayer’s net worth position

Dangers:

o Who decides? – taxpayers! Thus taxpayers can benefit from system by realizing losses and postponing gains. This creates 1) loss of tax revenue and 2) distorts economic transactions (“lock-in” effect and “lock-out” effect)

§61(a)(3) No income from property until a “dealing” occurs

Ad hoc case history resolved by following congressional acts meant to keep benefits and reduce danger:

§305 Stock dividends not included in incomeAllocate original basis evenly amongst all shares

Response to Macumber (no realization where company divides stocks so TP now has twice as many, but same ownership %)

Note: w/o 2) TP will sell “old” shares first (keeping the “new” 0 basis ones) to avoid gains

§109 GI does NOT include income (other than rent) derived by a lessor or real property on the termination of a lease

Response to Helvering (realization where lessee builds building, defaults, and IRS wants to include building as income to lessor)

Point: Tax liability depends on whether income (ex: building) meant as rent or something else Note: If income excluded from GI then also excluded from basis under §1019. Thus §109 allows

delay, but not avoidance of income

§1031 (a)Non-recognition of income (or loss) where ALL of the following occur: (Basis stays the same)1) Must be a trade of property (you can’t sell and reinvest proceeds)

Odd in that it allows TP to push of gains, but doesn’t prevent them from putting off losses if they but include cash in between the transactions

Jordan Marsh TP sells building w/ 4.8 M basis for 2.3M + 30 year lease. IRS doesn’t allow loss write off on view that lease=fee simple (at some point they must be equal). But court sides with TP, allowing TPs to have this win-win situation under §1031

2) Both properties must be seen as (trade, business or investment) by taxpayer Ex: A trades farm from another farm, but plans to use new farm just for residence; §1031

doesn’t apply. Note : intent of use by other party irrelevant. If A trades farm for residence, but planning to

rent residence as a business then §1031 applies3) Property must be “of like kind”

Can’t exchange garage for trucks, even if both needed in your business However, can exchange trucking garage for inner-city parking garage, even though types of

businesses are very different4) Specific exclusions found in:

1031 (a) (2) – stock, bonds, other interests 1031 (e) – animals of different sexes not the same 1031 (f) – family relations and tax avoidance

cont.“ Mixed Property exchanges” (§1031(a) + other property (cash, etc))

(b) Gain from mixed recognized up to FMV of non-§1031(a) propertyo Ex: 75K 1031(a) property traded for 90K 1031(a) property + 10K cash = only 10K

recognized (with potential recognition up to 25K of non-1031(a) property)(c) Loss from mixed NOT recognized

o Ex: 50K 1031(a) property traded + 10K cash trade for 90K 1031(a) property = no loss recognition of 10K, but basis increased to 60K (§1031(d))

Basis after Mixed: All Non-1031 get basis up to their FMV (apportion if not enough) Then remainder apportioned amongst 1031 property

Imputed Income

Income which can not be seen, but is generally “felt” to exist (also felt is an inequality)Ex: Homemaker vs. workforce; Homeowner vs. renter

§163 Interest(a) As a general rule, all interest on indebtedness is deductible(h) No deduction for “personal interest”

Exceptions: trade or business, investment, qualified residence, etc.

Solutions:1) Allow deduction for party hurt

o Congress does help a little with childcare, other deductions; but many areas do not allow deductions (ex: housekeeping)

2) Allow imputation of income to benefited partyo No attempt by congress to do

Point: Congress typically ignores the issue. Rationales:

Windfalls are good incentives Huge Valuation problems for either imputation or deductions (do we trust TPs to be reasonable?)

Me on imputed income (homemaking) First, if we impute income to homemaker, don’t we need to subtract the value of the homemaking services? Thus the real problem isn’t that homemaker chooses to make $0 as homemaker instead of $60K in workforce, but the

difference between what she could earn ($60K) and what she is choosing to earn now ($20K)

Thus the following problems with imputing income :o 1) Requires imperfect estimates of what you could make and possibly estimates of the value of the services

you currently contribute - if society doesn’t give them an express dollar value (such as with homemakers)o 2) Necessarily leads to the conclusion that those to whom we impute income are not rational.o 3) Necessarily leads to imputing income to all those who choose to make less than they could, such as:

Law Professors Doctors who take sabbaticals to help aids patients in Africa Elementary School Teachers The President

o Result: If carried to the logical extreme (that all COULD earn what the highest wage earner earns) then imputation results in a per-head tax.

Tax exempt bonds

§103 (a) Interest from State/local bonds not included in GI(b) Exceptions:

Private activity bond States can’t pass benefits of lower rate bonds (above a cap set in § 141) on to businesses to

encourage them to develop in the state/local. Allowance would lead to net-loss on nation Arbitrage bond

States can’t issue bonds to raise money just to invest it in private securities w/ higher rate, though not clear what to do about windfall between time when $ raised and when finally paid to bondholders

Non-registered bond

Effect 1: Moves revenue from Federal to State/local governments (maybe inefficiently) States prefer §103 over direct Federal grants to states because it allows them more autonomy over

1) Use and 2) Issuance Amounts within above exceptions. May also enhance inter-state competition

Effect 2: Allows greater savings for higher tax bracket payers because issuers can’t price discriminate and they must appeal to less-than-highest bracket payers to get all the bonds sold

Example: State must sell to 40% and 25% brackets so must offer 7.5% return instead of 6% return (where market bears 10%). Here bonds sold to 25% bracket yield 25% to state and 0% to bondholders; those to 40% bracket yield 25% to state and 15% to bond holders – thus inefficient

Point: States like §103 because the highest tax bracket payers help lobby congress to keep §103 (because they get extra benefit) and would not help lobby congress to keep direct grants (which don’t help highest bracket at all)

Suggested changes to deal with capitalization problem:1) Allow cap on # of bonds so that only highest bracket will invest (drives rates down)2) Allow borrowing of funds to purchase bonds (currently §265(a)(2) prevents this). This will also drive down rates as highest bracket will borrow

Deductions

Effects of Progressivity

Currently, higher brackets get bigger deduction benefito Note: This is less of a concern with baseline deductions (ex. Medical expenses) which do not have a consumption

element, than with subsidies (ex. Charitable donations) which do have a consumption elementNo way to create parity between both:

o Intra-bracket TPs (Biglaw attorney vs. Solo practitioner w/ high overhead)o Inter-bracket TPs (Lawyer vs. Trashman)

Complicated current solution: 1) Allow deductions, but compensate for discrepancy between brackets by:

Partial deductions based on AGI% floors. Phase-outs for highest bracket Allow minimum standard deduction which the lower brackets will use more (around 70% of all taxpayers

don’t itemize)2) Baselines tend to show up as “above the line” deductions, whereas Subsidies show as “below the line”

Alternative Minimum Tax Problem: Shadow tax system which isn’t used much now (most people have higher rates under standard system and code requires

paying higher rate) – created to ensure very wealthy who had tax shelters and huge deductions (and thus paid no tax) would have to pay tax

But projection that many middle income people (especially those with many kids) will start having to pay Min Alt Tax in future (which doesn’t allow for many deductions)

Business Deductions Mostly above the line

§162 Deduction allowable for trade/business expensesTest: Whether expenditure is based on a legitimate business interest, NOT whether purpose is primarily business

relatedNote: Allowing businesses total discretion would help encourage best use of “new necessities” (ex. Computers),

but also allow employers to arbitrage with employees(a)(3) Property payments (ex. rents) count as expenses so long as no title/equity gained; otherwise see §263 for

capitalization.

§167 Generally, capitalized depreciation allowed for property used in trade/business or production of income

§168 ACRS – Accelerated Cost Recovery System (for tangible property) Instead of trying to set exact depreciation (old formula) code chooses to benefit TPs in following ways:

(b)(1) TP can choose each year to use either double-declining balance or straight line (which ever is greater)

(e)(1) Generously low class-life for property (ex: 5 yr period if property has avg life between 4 and 10 years)

Straight-line depreciation : Just divide basis over X years. Depreciation is removed from basis (§1016(a)(2)) as it offset OI and sale of property at end yields OI = price – remaining basis (§1245)

Double-declining depreciation : Double year 1 straight-line %. Depreciate each year this new % of existing basis.

Ex: $100 asset over 5 years yields 2*20%=40% depreciation. Basis after year 1=$60; After year 2=$36 (60 – (.4)(60))

Point: Purpose is to encourage business investment and remove admin struggles with TPs

§195 Start-up expenses can be amortized over at least 60 months; otherwise no deduction

§197 Goodwill and other intangibles can be amortized/deducted over 15-year period

§274 Disallowance of certain expenses(n) Employers (including self-employed) can only deduct 50% of cost of business meals and entertainment, etc

not furnished on premise of business (see section (e) for exceptions)

(?) Prohibitions on sky boxes, luxury water transport, etc(?) Caps on deductions for business cars, etc.

§263 No deductions for permanent improvements (w/ some exceptions for mines, etc.)

§263A Generally, Assets and Improvements which last longer than 1 year must be capitalized for depreciationNote: Repairs can be expensed (w/o capitalization)Training: Though initial job training and search costs (ex. Law school tuition) cannot be capitalized and

depreciated, going back to school training can be (ex: many GSB students can deduct)

Midland Empire Court rules “oil-proofing” of basement to be a repair instead of improvement where company had operated for many years with dirt basement and oil leakage from new neighbor was NOT FORESEEABLE

Point: Depreciation methods which best match expenses to income are difficult to administer. Code and Midland are more administrable and tend to favor the government over TPs

Investment Deductions Mostly below the line

§212 Deduction allowable for production of income

Moller Rule: In order to be a trader (escape §212) instead of an investor, activities must be short-term trading w/ income derived from sale of securities rather than dividends and interest

Key: TPs want to be in trade/business because of much better chance of receiving §62 (above the line) deduction

Personal Deductions Mostly Below the Line Note: Alimony is above the line. Med Expenses and others are immune from §67 and §68

§163 Interest(a) As a general rule, all interest on indebtedness is deductible(h) No deduction for “personal interest”

Exceptions: trade or business, investment, qualified residence, etc.

§165 Deduction allowable for losses(a) Deduction for loss sustained by TP allowed if NOT compensated for by insurance, etc.(b) Deduction allowed is lesser of 1) Basis or 2) FMV

Rationale: Tax system never recognized the gain (no realization) (same with charitable services)Example: Say 100 basis goes up to 1000 FMV and is destroyed. If we allow write off of 1000, then we’d also have to include 900 appreciation and end result would be the same 100 as basis

(c) Losses to Individuals limited to 1) Trade/Business, 2) For-Profit, 3) Fire, Storm, Shipwreck, Other Casualty, or Theft

(h) Individual Floors: (c)(3) deductions allowed only to extent above $100 per casualty or theft Total of (c) deductions allowed only to extent total is above 10% AGI

§213 Medical, Dental, etc.

(a) Deduction allowed to extent ABOVE 7.5% Floor

Medical expense: mitigation, treatment or prevention of disease” for the “purpose of affecting [a] structure or function of the body.”

Current Rule: Decide whether majority (51%) or costs are medical (treatment) or personal (replacement of lost services) and treat ALL costs as such

Better Rule: Divide personal from medical and allow deduction for medical (though cost of administration)

Taylor No deduction allowed for taxpayer w/ asthma who hires another to cut his lawnOchs No deduction allowed for taxpayer whose wife needs peace/quiet to recover and sends his kids to boarding school

§170 Charitable Deductions(e) For OI and Short-term gain, deduction allowed only for LESSER of 1) Basis or 2) FMV(a) For Long-term gain, deduction allowed for FMV (Huge incentive to donate property instead of proceeds of

property) Property must generate LT capital gains Property must be used by donee in a fashion related to the purpose for allowing this exemption

(b) (A) Limitations as to who is a charity and (B) Caps based on AGI above which charitable deductions must be carried over to subsequent years (and apply §68)Note: TP can elect to deduct entire basis instead of taking 30 or 50% capsNote: TP can carryover capped deductions up to 5 years

Note: To prevent collusion and overvaluing of donations, steep punitives if caught and §68 phase-outs

Sell/Donate vs. Just Donate If Short term/OI System is neutral – no difference If Long term Old rule (allowing deduction of only basis) would encourage TP to sell/donate to

get higher tax savings (tax only at CG rate)New rule (allowing deduction of FMV) encourages TP to Just Donate, but has drawback of possible overvaluation

§262 Generally, NO deduction for personal, family or living expenses Ex: Makeovers, cab fares, etc Exceptions only where clothing, etc. not “normal” such as nurse uniform or clown paint

§183 Generally, NO deduction for non-profit (“hobby”) activities(b) Exception: below the line deduction allowed up to amount of income derived from activity(d) Presumption: If GI derived in 3 of previous 5 years than presumption that activity is for-profit

Note: No presumption the other way. Otherwise many startups or airlines (which often lose $ more many years) would be deemed non-profits

Nickerson Test : Factors such as amount and % of time dedicated to activity to determine if it was “fun”Note: Test only used outside above presumption

Training: Though initial job training and search costs (ex. Law school tuition) cannot be capitalized and depreciated, going back to school training can be (ex: many GSB students can deduct)

Henderson No deduction allowed for decorations to office of State Atty General.Moss No deduction allowed for lunches outside office w/ other employees (where they discuss clients)

Tax Shelters

Categories: Deferral: pushing income into future, deductions today Conversion: changing income types to more tax favored (ex: capital gains) Arbitrage: incurring deductive expenses for purpose of generating tax-favored income

o Create a tax loss in excess of economic loss to offset other income

Investment Income Shelters Only applicable to investment income (§212), NOT to trade or business (§162)Congressional response disallows tax advantage ONLY to borrowers. Wealthy can still take advantage

Gov’t allows some such as Home Ownership arbitrage (§163(h))

Congress removes other arbitrages in following sections:

§264 NO deduction for annuity or other retirement policies where policy purchased with borrowed funds Knetsch: Court disallowed such a deduction where annuity policy was NRD, never gained equity

and was only used to pay off other interest obligation – basically the TP wasn’t following congress’ purpose for favorable tax treatment of annuities (to encourage retirement savings and lower SSI)

§265 NO deduction for tax-favored bonds (municipality, etc) where purchased with borrowed funds Note: States take some of the tax advantage here, but still some for top bracket to degree that states

have to sell to other brackets as well

§163(d) Non-corporations can only deduct interest expense up to amount of interest income(2) Carryover allowed(4)(B) TP can “elect” whether to use CG as:

1) Present Investment Income Deduction (advantage = TVM from present deduction); (or)2) Future CG Income (advantage = lower tax rate on CG than OI)Point: Correct choice depends on likelihood of future OI. If high then wait to use CGNote: CG can be split – it doesn’t have to be all 1) or 2)

Point: Borrowing will only occur if taxpayer thinks payoff will be greater than his interest payments (speculation). Most incentive to borrow for investing is removed (maybe even some disincentive from TVM)

Trade/Business Shelters Only applicable to trade or business income (§162), NOT investment income (§212) Congressional response disallows tax advantage to BOTH borrowers and wealthy

Franklin (Typical Shelter): o Sale w/ payments over many years ending in NRD balloon payment + Leaseback w/ payments equal to sales

payments. This allows parties to set sale price as high as they want, not exchange any money and allows purchaser to write off artificially large depreciation. Only the IRS loses

Congressional Responses:§465 – Deduction limited to amount of risk

(a) Deductions only allowed up to amount of risk(a)(2) Losses can be carried over as NOL

(b) Amount of risk includes: direct investment (in cash) basis of other property contributed borrowings which the taxpayer is personally liable for (no NRD unless guaranteed by gov’t or

other fair market property – congress won’t trust personal estimates of value)(c)(1) – specifies activities to which section applies (ex: film, oil exploration, etc – what shelters had been previously used)(c)(3) – catch all – now applies to ALL activities

§469 – Passive activity losses limited(a) Losses from passive activities NOT deductible (even up to point of investment),

(b) but held in “suspense” until future income (c) Passive activities:

1) Trade or business where taxpayer doesn’t materially participate (500 hours); 2) Rental activities not carried on by certain limited real estate professionals

Exceptions: o (c) Those spending over 750 hours and ½ of work time can deduct ALLo (i) Those making less than 100K/year can only claim up to 25K (phaseout for those

over 100K) Point: rental almost always passive because of rampant misuse

(g) All remaining “suspense” can be deducted once ALL TPs interest in property is extinguishedNote: Except for (g), all passive deduction allowed (ie 25K) can ONLY be used to offset passive income. Thus interest, dividends, etc don’t countNote: §465 has little if any significance after §469 – nothing really gets by 469 which 465 would stop

Also strong penalties for tax evasion to counter problem that IRS can’t go after all breaches

Capital Gains

Whether asset is Captial depends on:1) intrinsic nature of property (§1221)2) relationship of property to holder3) method by which asset is disposed of

Why treat CG differently from OI?

o Bunching Not fair to tax all income at highest bracket when realized in year 10, where income earned over 10 years. But this could be avoided by 1) income averaging over the time periods; or 2) getting rid of realization; or 3) getting rid of progressive tax structure

o Lock-in Current system encourage people to hold assets until then die (instead of sell to higher valuer) in order to get 1041 step-up in basis. By allowing reduced CG rates, property holders will sell instead of hold forever. (Best Rationale)

o Realization Key: If realization requirement removed, then almost all rationale for CG rates goes away

§1(h) Rates for Capital Gains/Losses 10%-28% rates depending on:

1) Marginal bracket of TP2) Type of asset

§1211 Limitations of Capital Losses(a) Corporations: Losses allowed in canceling Capital GAINS(b) Individuals: 3K of losses allowed against OI; remainder allowed only against capital GAINS

§1212 Carryover of Capital Losses(a) Corporations: Can carry BACK 3 years or FORWARD 5/8/10 years depending on type of asset

Note: Corps often use tax shelters “freshen capital gains”(b) Individuals NO carry BACK, but unlimited carry FORWARD

§1221 Capital Asset Defined(a) All property except:

(1) Inventory: Stock or other property held primarily for sale to customers in trade/businesso Rationale: otherwise brokers would only sell losers (“cherry-pick”), though clearly unfair

to those who only hold loser-stock(2) Depreciable property under §167 or real property used in trade/business

o See §1231 for additional treatment(3) Copyright or similar composition, etc

o Note: Only applies to original author. Subsequent purchaser (speculator) gets capital treatment

(4) Accounts/Notes Receivable for (1) Inventory(5) US Publications

o Note: Meant to prevent congressmen from getting free text and then selling(7) Hedging Transaction clearly identified as such

o Key: This allows certainty for honest TPs, but dishonest can choose not to identify and try to game system

o Point: Still may be possible to read Corn Products “congressional intent” to force this exception on undeclared

(8) Regularly consumed supplies in the course of trade/businesso Point: Adds clarity to supplies such as corn syrup or jet fuel, but does NOT apply to

Futures Ks or intangibles

§1222 Other Terms (Long vs. Short Term) Short-term gain/loss Held LESS than 1 year Long-term gain/loss Held MORE than 1 year “Net Capital Gain” Net Long GAIN – Net Short LOSS

Long GAIN = LT gain – LT loss Short LOSS = ST loss – ST gain

Note: §1223 allows term to add time of previous holder in some circumstance

§1231 Quasi-Capital Assets (Applies to Corps and Individuals) §1231 Property = §1221(a)(2) - Real property used in trade/business or depreciated under §167

Net §1231 Property treated as follows: If GAIN LT Capital under §1221 If LOSS OI Loss which escapes §1221Point: Win-win for TP

Windfall reduced by following :

§1245 All gains up to amount of realized depreciation counts as OI, not CG Note: only applies to depreciable personal property (Widgets) – not Real estate Point: 1231 only benefits TP to amount property sold for more than purchase price This prevents depreciating asset to offset OI and then claiming gain as CG

§1250 Applies §1245 to real estate – but has no practical purpose today because no one can depreciate real estate faster than straight-line

§1(h) Un-recaptured 1250 gain (real estate) taxed at 25%. CG (amount over original purchase price) still taxed according to 1221

Changing/Joint Purposes:

Professionals (ex: Broker or RE Pro) can hold both inventory and investment, but they have to take recording steps to show which property is of which type (otherwise fraud potential from claiming CGs and OLs)

Winthrop Factors: To decide if change of purpose occurred, look at:1) Substantiality and frequency of sales2) Improvements 3) Solicitation and advertising efforts4) Broker’s activities

Biedenharn Rule: Where change of purpose found then last use becomes entire use (no bifurcation – past history is irrelevant). This is because CG/CL comes from sale of Capital Asset (determined at time of sale)

Exception: §262 trumps Biedenharn rule. §262 specific disallowance for personal, family expenses (though no disallowance of tax on gain). If personal property (w/ loss) converted to business property then bifurcation of uses and business only starts from day of business useExample: 100K house bought now worth 60K. TP rents house for 1 year to change purpose. Only gain loss after change in treatment (60K) treated as business (OI). Original 40K loss is still personal loss

Gangi: G and M bought and managed property for purpose of retiring there together. Relationship dies and they

convert ton condos. Despite Biedenharn, Court looks at initial (and majority) intention of TPs instead of last use. This

allows CG instead of OI. No change of purpose, though purpose did change Point: This application not found anywhere else so limit to facts – still look at last use under Biedenharn

Hedging

Corn Products Δ engages in futures Ks of raw materials instead of storing the raw material itself in order to stabilize process. This

allows firm (when spot higher than futures) to buy and count as OL (expense) and sell future K and count as CG (lower taxes)

Court rules that hedging was business transaction, not a capital asset dealing, and so taxed as OI – not CG Point: Court adds additional §1221 exception based on “purpose of congress”. Though correct in this case, has led

to mass confusion

Arkansas Best Court reinterprets Corn Products (limits it) and reverts to strict interpretation of code in deciding type of property

Substitutes for Ordinary Income

Basic example: Say attorney does services in exchange for promissory note to pay $100K. Attorney sells note to bank and counts $100K as CG = clearly NOT allowed

Hort Rule: If lease and building held together, then both are Ordinary assets. If only the lease is held, then it is a capital asset

TP inherits building subject to lease. Tenant pays off TP to get out of lease because in 1933 land values plummet (payment = difference between current lease value and K price)

o Note: In ordinary years no damages would be paid because property could be leased for defaulted amount

TP: Payment for a capital asset (just like a bond) and thus capital tax treatment (CL?) IRS: 1) No original basis in lease and 2) lease in not a capital asset

Ferrer Split in asset between OI and CG allowed

TP sells:o 1) Production rights - Court rules as copyright and gives CG treatment

Note that this doesn’t exclude from 1221 as 1221(3) only excludes copyright of AUTHOR. Rationale is that original creation is personal work, whereas buyer of right would have a capital asset because no personal investment, but just purchase of asset on speculation it will rise in value

Also note that patents are not explicitly/implicitly excluded from 1221 (in fact 1235 gives CG treatment to patents)

o 2) Right to receive % of production profits – Court rules as OI Rationale is that % dependent on TPs efforts to produce a good production

o Point: Court here divides asset in CG and OI CG if no personal services aspect of asset (just owned production rights) OI if personal services aspect of asset (value of production % depends highly on doing

good production) Note: Similarly, covenants not to compete are treated as OI

Statutes

§1 Individual Income Taxes(a)-(d) Tax Rates imposed on a) Joint, b) HOH, c) Unmarried, d) Married but separate filing(f) Removal of “bracket creep” (see Rev Proc for current amounts)(i) Introduction of 10% bracket after 2000

Reduction in rates after June 30, 2001(h) Rates for Capital Gains/Losses

10%-28% rates depending on:1) Marginal bracket of TP2) Type of asset

§11 Corporation Income Taxes

§61 Gross Income = “all income from whatever source derived”(a)(3) No income from property until a “dealing” occurs (a)(12) DOI is GI

§62 Above the line deductions (Adjusted Gross Income (AGI) = §61 - §62)(a)(1) Trade/Business costs (not as an employee)(a)(2)(A) Expenses reimbursed by employer

§63 Below the line (itemized) deductions which are subject to reductions in §67 and §68(c)(2) Standard deductions (varies by type of filing – see Rev Proc)

§67 2% Floor on Misc. Itemized(a) Only amount over 2% AGI is deductible(b) Floor does NOT apply to these deductions, including §163 (inv int), § 165 (losses), § 170 (charity), § 213

(med)

§68 Overall limitation on Itemized Deductions(a) Itemized deductions reduced by LOWER of

1) 3% AGI over applicable amount 2) 80% allowable itemized deductions

(b) See Rev Proc for “applicable amount”; note that ½ amount for married filing separates(c) Limitation does NOT apply to § 163, § 165, § 213(f) Phase-out of §68(a) beginning in 2005

§101(a)NO GI from Life Insurance policies

§102 Generally, no GI from gifts, inheritance(b) Does not exclude income derived from such property (rent, etc)(c) Gifts from employers to employees now included in GI

§103 (a) Interest from State/local bonds not included in GI(b) Exceptions:

Private activity bond States can’t pass benefits of lower rate bonds (above a cap set in § 141) on to businesses to

encourage them to develop in the state/local. Allowance would lead to net-loss on nation Arbitrage bond

States can’t issue bonds to raise money just to invest it in private securities w/ higher rate, though not clear what to do about windfall between time when $ raised and when finally paid to bondholders

Non-registered bond

§108 DOI excluded from GI if TP 1) insolvent or 2) DOI occurs in bankruptcy(a)(3) For insolvency, tax avoidance only for amount ABOVE insolvency

Ex: 100K debt forgiven, but TP has 20K assets. Only 80K tax free Note that for Ch 11, all DOI tax free, even if not 100% insolvent

(b)(2)(A) TP can NOTt carry forward NOL “used up” in DOI – otherwise a double benefit(e)(5) Solvent debtor DOI can be excluded if “purchase price reduction” – meaning forgiven by

seller, NOT by loaner Note: Solvent debtor DOI normally included as GI under Kirby Lumber Note: Technically only applies to real property, though Zarin allows for

gambling debt

Secured vs. Non-secured debt (Problem Set #4) Non Gain/loss treated as DOI Sec Gain/loss treated as DOI if debt is RD; as Capital gain if debt is NRD

Note: both would be forgiven under bankruptcy law

§109 GI does NOT include income (other than rent) derived by a lessor or real property on the termination of a lease

Response to Helvering (realization where lessee builds building, defaults, and IRS wants to include building as income to lessor)

Point: Tax liability depends on whether income (ex: building) meant as rent or something else Note: If income excluded from GI then also excluded from basis under §1019. Thus §109 allows

delay, but not avoidance of income

§119 Benaglia rule incorporated into code where room/board is 1) provide for employer’s convenience and 2) located on premise

§132 Certain fringe benefits excluded from GI(b) no-additional cost(c) Qualified employee discount(d) Working condition fringe(d) de minimis fringe(h) Definition of persons qualifying for (b) and (c)(j) Specialty rules (basically loss of exclusion for (b) and (c) in certain circumstances)Rationale: Often inexpensive and convenient for business to offer. Little distribution effect if all businesses offer

§151 Personal Exemptions(a) Above the line deduction (???)(b)-(c) TP + Spouse (if joint filing) + kids(d) Exemption amount found in Rev Proc

Amount lowered by 2% for each $2500 AGI is over applicable “Threshold amount” - (see Rev Proc)

§162 Deduction allowable for trade/business expensesTest: Whether expenditure is based on a legitimate business interest, NOT whether purpose is primarily business

relatedNote: Allowing businesses total discretion would help encourage best use of “new necessities” (ex. Computers),

but also allow employers to arbitrage with employees(a)(3) Property payments (ex rents) count as expenses so long as no title or equity gained; otherwise see §263 for

capitalization

§163 Interest(a) As a general rule, all interest on indebtedness is deductible(h) No deduction for “personal interest”

Exceptions: trade or business, investment, qualified residence, etc.(d) Non-corporations can only deduct interest expense up to amount of interest income

(2) Carryover allowed(4)(B) TP can “elect” whether to use CG as:

o 1) Present Investment Income Deduction (advantage = TVM from present deduction); (or)o 2) Future CG Income (advantage = lower tax rate on CG than OI)

o Point: Correct choice depends on likelihood of future OI. If high then wait to use CGo Note: CG can be split – it doesn’t have to be all 1) or 2)

Point: Borrowing will only occur if taxpayer thinks payoff will be greater than his interest payments (speculation). Most incentive to borrow for investing is removed (maybe even some disincentive from TVM)

§165 Deduction allowable for losses(a) Deduction for loss sustained by TP allowed if NOT compensated for by insurance, etc.(b) Deduction allowed is lesser of 1) Basis or 2) FMV

Rationale: Tax system never recognized the gain (no realization) (same with charitable services)Example: Say 100 basis goes up to 1000 FMV and is destroyed. If we allow write off of 1000, then we’d also have to include 900 appreciation and end result would be the same 100 allowed as basis

(d) Losses to Individuals limited to 1) Trade/Business, 2) For-Profit, 3) Fire, Storm, Shipwreck, Other Casualty, or Theft

(i) Individual Floors: (c)(3) deductions allowed only to extent above $100 per casualty or theft Total of (c) deductions allowed only to extent total is above 10% AGI

§167 Generally, capitalized depreciation allowed for property used in trade/business or production of income

§168 ACRS – Accelerated Cost Recovery System (for tangible property) Instead of trying to set exact depreciation (old formula) code chooses to benefit TPs in following ways:

(b)(1) TP can choose each year to use either double-declining balance or straight line (which ever is greater)(e)(1) Generously low class-life for property (ex: 5 yr period if property has avg life between 4 and 10 years)

Straight-line depreciation: Just divide basis over X years. Depreciation is removed from basis (§1016(a)(2)) as it offset OI and sale of property at end yields OI = price – remaining basis (§1245)Double-declining depreciation: Double year 1 straight-line %. Depreciate each year this new % of existing basis.Ex: $100 asset over 5 years yields 2*20%=40% depreciation. Basis after year 1=$60; After year 2=$36 (60 – (.4)(60))

§170 Charitable Deductions(e) For OI and Short-term gain, deduction allowed only for LESSER of 1) Basis or 2) FMV(a) For Long-term gain, deduction allowed for FMV (Huge incentive to donate property instead of proceeds of

property) Property must generate LT capital gains Property must be used by donee in a fashion related to the purpose for allowing this exemption

(b) (A) Limitations as to who is a charity and (B) Caps based on AGI above which charitable deductions must be carried over to subsequent years (and apply §68)

Note: To prevent collusion and overvaluing of donations, steep punitives if caught and §68 phase-outs

Sell/Donate vs. Just Donate If Short term/OI System is neutral – no difference If Long term Old rule (allowing deduction of only basis) would encourage TP to sell/donate to

get higher tax savings (tax only at CG rate)New rule (allowing deduction of FMV) encourages TP to Just Donate, but has drawback of possible overvaluation

§183 Generally, NO deduction for non-profit (“hobby”) activities(c) Exception: below the line deduction allowed up to amount of income derived from activity(d) Presumption: If GI derived in 3 of previous 5 years than presumption that activity is for-profit

Note: No presumption the other way. Otherwise many startups or airlines (which often lose $ more many years) would be deemed non-profits

Nickerson Test : Factors such as amount and % of time dedicated to activity to determine if it was “fun”Note: Test only used outside above presumption

§195 Start-up expenses can be amortized over at least 60 months; otherwise no deduction

§197 Goodwill and other intangibles can be amortized/deducted over 15-year period

§212 Deduction allowable for production of incomeMoller Rule: In order to be a trader (escape §212) instead of an investor, activities must be short-term

trading w/ income derived from sale of securities rather than dividends and interestKey: TPs want to be in trade/business because of much better chance of receiving §62 (above the line)

deduction

§213 Medical, Dental, etc.(a) Deduction allowed to extent ABOVE 7.5% Floor

Medical expense: mitigation, treatment or prevention of disease” for the “purpose of affecting [a] structure or function of the body.”

Current Rule: Decide whether majority (51%) or costs are medical (treatment) or personal (replacement of lost services) and treat ALL costs as such

Better Rule: Divide personal from medical and allow deduction for medical (though cost of administration)

§262 Generally, NO deduction for personal, family or living expenses Ex: Makeovers, cab fares, etc Exceptions only where clothing, etc. not “normal” such as nurse uniform or clown paint

§263 No deductions for permanent improvements (w/ some exceptions for mines, etc.)

§263A Generally, Assets and Improvements which last longer than 1 year must be capitalized for depreciationNote: Repairs can be expensed (w/o capitalization)

§264 NO deduction for annuity or other retirement policies where policy purchased with borrowed funds Knetsch: Court disallowed such a deduction where annuity policy was NRD, never gained equity and was

only used to pay off other interest obligation – basically the TP wasn’t following congress’ purpose for favorable tax treatment of annuities (to encourage retirement savings and lower SSI)

§265 NO deduction for tax-favored bonds (municipality, etc) where purchased with borrowed fundsNote: States take some of the tax advantage here, but still some for top bracket to degree that states have to sell to other brackets as well

§274 Disallowance of certain expenses(b) Gifts by employers to employees limited to $25. (j) “Achievement awards” are limited to cap ($400 - $1600)

Note that employers can still pay lower taxes on gifts given than employees would if treated as income

(n) Businesses can only deduct 50% of cost of meals and entertainment not furnished on premise of business (basically gov’t splits with businesses instead of 100/0 game)

(?) Prohibitions on sky boxes, luxury water transport, etc(?) Caps on deductions for business cars, etc.Point: Purpose is to disallow arbitrage (incurrence of deductive expense for purpose of generating tax-favored income)

§305 Stock dividends not included in income

Allocate original basis evenly amongst all shares Response to Macumber (no realization where company divides stocks so TP now has twice as many,

but same ownership %) Note: w/o 2) TP will sell “old” shares first (keeping the “new” 0 basis ones) to avoid gains

§465 – Deduction limited to amount of risk(a) Deductions only allowed up to amount of risk

(a)(2) Losses can be carried over as NOL(b) Amount of risk includes:

direct investment (in cash) basis of other property contributed borrowings which the taxpayer is personally liable for (no NRD unless guaranteed by gov’t or

other fair market property – congress won’t trust personal estimates of value)(c)(1) – specifies activities to which section applies (ex: film, oil exploration, etc – what shelters had been previously used)(c)(3) – catch all – now applies to ALL activities

§469 – Passive activity losses limited(c) Losses from passive activities NOT deductible (even up to point of investment), (d) but held in “suspense” until future income (c) Passive activities:

1) Trade or business where taxpayer doesn’t materially participate (500 hours); 2) Rental activities not carried on by certain limited real estate professionals

Exceptions: o (c) Those spending over 750 hours and ½ of work time can deduct ALLo (i) Those making less than 100K/year can only claim up to 25K (phaseout for those

over 100K) Point: rental almost always passive because of rampant misuse

(g) All remaining “suspense” can be deducted once ALL TPs interest in property is extinguishedNote: Except for (g), all passive deduction allowed (ie 25K) can ONLY be used to offset passive income. Thus interest, dividends, etc don’t countNote: §465 has little if any significance after §469 – nothing really gets by 469 which 465 would stop

§1001 Gains/Losses from dealings in property = Amount realized – Adjusted Basis

§1012 Basis in property = cost of propertyTR 1.61-6 Basis equally apportioned among parts sold

§1016 Adjusted Basis = Basis – certain adjustments

§1014 “Step up in basis”:Basis in donee’s inherited property = value at time of conveyance, NOT donor’s basis

§1015 “Carry-over basis”: Basis in donee’s inter-vivos gift = basis of donorPoint: Rule only applies to gains, not to losses. Otherwise easy to evade taxes.Limbo: if donee sells property for less than original basis, but more than FMV, no gain or loss

§1031 (a)Non-recognition of income (or loss) where ALL of the following occur:1) Must be a trade of property (you can’t sell and reinvest proceeds)

Odd in that it allows TP to push of gains, but doesn’t prevent them from putting off losses if they but include cash in between the transactions

Jordan Marsh TP sells building w/ 4.8 M basis for 2.3M + 30 year lease. IRS doesn’t allow loss write off on view that lease=fee simple (at some point they must be equal). But court sides with TP, allowing TPs to have this win-win situation under §1031

2) Both properties must be seen as (trade, business or investment) by taxpayer Ex: A trades farm from another farm, but plans to use new farm just for residence; §1031

doesn’t apply. Note : intent of use by other party irrelevant. If A trades farm for residence, but planning to

rent residence as a business then §1031 applies

3) Property must be “of like kind” Can’t exchange garage for trucks, even if both needed in your business However, can exchange trucking garage for inner-city parking garage, even though types of

businesses are very different4) Specific exclusions found in:

1031 (a) (2) – stock, bonds, other interests 1031 (e) – animals of different sexes not the same 1031 (f) – family relations and tax avoidance

“ Mixed Property exchanges” (§1031(a) + other property (cash, etc)) (b) Gain from mixed recognized up to FMV of non-§1031(a) property

o Ex: 75K 1031(a) property traded for 90K 1031(a) property + 10K cash = only 10K recognized (with potential recognition up to 25K of non-1031(a) property)

(c) Loss from mixed NOT recognizedo Ex: 50K 1031(a) property traded + 10K cash trade for 90K 1031(a) property = no loss

recognition of 10K, but basis increased to 60K (§1031(d))

§1211 Limitations of Capital Losses(a) Corporations: Losses allowed in canceling Capital GAINS(b) Individuals: 3K of losses allowed against OI; remainder allowed only against capital GAINS

§1212 Carryover of Capital Losses(a) Corporations: Can carry BACK 3 years or FORWARD 5/8/10 years depending on type of asset

Note: Corps often use tax shelters “freshen capital gains”(b) Individuals NO carry BACK, but unlimited carry FORWARD

§1221 Capital Asset Defined(a) All property except:

(1) Inventory: Stock or other property held primarily for sale to customers in trade/businesso Rationale: otherwise brokers would only sell losers (“cherry-pick”), though clearly

unfair to those who only hold loser-stock(2) Depreciable property under §167 or real property used in trade/business

o See §1231 for additional treatment(3) Copyright or similar composition, etc

o Note: Only applies to original author. Subsequent purchaser (speculator) gets capital treatment

(4) Accounts/Notes Receivable for (1) Inventory(5) US Publications

o Note: Meant to prevent congressmen from getting free text and then selling(7) Hedging Transaction clearly identified as such

o Key: This allows certainty for honest TPs, but dishonest can choose not to identify and try to game system

o Point: Still may be possible to read Corn Products “congressional intent” to force this exception on undeclared

(8) Regularly consumed supplies in the course of trade/businesso Point: Adds clarity to supplies such as corn syrup or jet fuel, but does NOT apply to

Futures Ks or intangibles

§1222 Other Terms (Long vs. Short Term) Short-term gain/loss Held LESS than 1 year Long-term gain/loss Held MORE than 1 year “Net Capital Gain” Net Long GAIN – Net Short LOSS

Long GAIN = LT gain – LT loss Short LOSS = ST loss – ST gain

Note: §1223 allows term to add time of previous holder in some circumstance

§1231 Quasi-Capital Assets (Applies to Corps and Individuals) §1231 Property = §1221(a)(2) - Real property used in trade/business or depreciated under §167

Net §1231 Property treated as follows: If GAIN LT Capital under §1221 If LOSS OI Loss which escapes §1221Point: Win-win for TP

Windfall reduced by following :

§1245 All gains up to amount of realized depreciation counts as OI, not CG Note: only applies to depreciable personal property (Widgets) – not Real

estate Point: 1231 only benefits TP to amount property sold for more than purchase

price This prevents depreciating asset to offset OI and then claiming gain as CG

§1250 Applies §1245 to real estate – but has no practical purpose today because no one can depreciate real estate faster than straight-line

§1(h) Un-recaptured 1250 gain (real estate) taxed at 25%. CG (amount over original purchase price) still taxed according to 1221

TR 1.1001-2 Where property sold partially/fully for assumption of debt, no DOI where debt was recourse debt (RD)Example 7 For NRD, property and transaction NOT separated at end – thus gain/loss treated as capital

gain/lossExample 8 For RD, property and transaction separated at end – thus gain/loss treated as DOI

Terms: AGI Adjusted Gross Income GI Gross Income TP Taxpayer TVM Time value of money TR Treasury Regulation DOI Discharge of Indebtedness RD Recourse Debt NRD Non-recourse Debt