EA1 Study Unit 9.1-9.10 Property Transactions: Basis and Dispositions

• Basis is critical in federal income taxation.
• Basis represents a taxpayer's investment in property.
• It's the amount a taxpayer can recover tax-free.
• Property basis guides the calculation of gain or loss from a property transaction.
• An asset's basis is typically its cost.
• The basis can change over time due to events like capital expenditures or returns.
• Capital expenditures increase the basis
• Capital returns decrease it.
• An increase in basis reduces the gain or increases the loss.
• A decrease in basis increases the gain or reduces the loss.

Cost Basis

• Cost basis includes cost, substituted, transferred, exchanged, and converted basis.
• Cost Basis equals capitalized acquisition costs.
• Substituted basis refers to basis in other property.
• Transferred basis refers to basis in the same property.
• Exchanged basis refers to basis in other property previously held.
• Converted basis applies when converting personal property to business use.
• Use the lower of the property's basis or FMV at conversion.

Capitalized Acquisition Costs

• Include costs for acquisition, title, and major improvements.
• Common Capitalized Costs (Sec. 1012) involve the purchase price, miscellaneous costs, closing costs, and major improvements.
• Purchase price includes liabilities.
• Miscellaneous costs include appraisal fees, freight, installation, and testing.
• Closing costs consist of brokerage commissions, pre-purchase taxes, sales tax, excise taxes, title transfer taxes, title insurance, recording fees, attorney fees, and document review.
• Major improvements are new roofs, gutters, water lines, demolition expenses, and electrical wiring.
• Maintaining and operating costs are excluded from basis, i.e., interest, insurance, and ordinary repairs.
• Basis in a rental house is the purchase price plus closing costs; long-term improvements are added to capitalize.
• Capitalized improvements are depreciated over 27.5 years.
• Short-term repairs are expensed in the year made.

Uniform Capitalization Rules

• Costs to construct real/personal property for use in business or for sale to customers are capitalized.
• Capitalize all costs to prepare property for use, including direct and indirect costs.
• Construction-period interest and taxes are capitalized.
• Cost basis using the FMV of property given if the FMV is undeterminable
• Capital acquisition expenditures includes cash, cash equivalents, property, liability, or services.
• Rebates reduce the purchase price.
• Uniform capitalization rules do not apply if property is acquired for resale, and average gross receipts are under $30 million.

Liabilities

• Acquisition basis increases for notes to the seller (minus unstated interest).
• Acquisition basis increases for liabilities the acquired property is subject.

Property and Services

• The FMV of property received for services is income to the provider if unrestricted.
• The property acquired has a tax cost basis equal to the FMV.
• An employee sale of stock below FMV is gross income.
• Restricted stock basis is the price paid.
• Upon restriction lapse, ordinary gross income is the spread between FMV and amounts paid.
• Basis increases with the same amount.
• Transferee elects to include FMV minus cost spread in gross income upon purchase.
• The basis includes tax cost but no subsequent deduction is allowed if stock is forfeited.

Lump Sum Purchase

• Apportion costs based on relative FMV of each asset.

Allocable cost (basis) = (FMV of asset / FMV of all assets purchased) * Lump sum purchase price

• Transferor/transferee may agree in writing on allocation or FMV of assets.
• The agreement is binding unless deemed improper by the IRS.
• Use the residual method if the agreement is improper, especially for business transfers.
• Allocate purchase price to asset categories up to FMV.
  • Cash and cash equivalents
  • Near-cash items like CDs and government securities
  • Accounts receivable, debt instruments
  • Inventory
  • All other assets (except Sec. 197 intangibles)
  • Sec 197 intangibles (patents)
  • Goodwill
• For purchase under aggregate FMV of assets, allocate the price to cash, then assets 2-6 based on relative FMVs.

Sale of Stock

• Use specific identification to compute gain on stock sales, use FIFO if not possible.

Demolition

• Costs and losses are allocated to the land: remaining basis and demolition costs.

Property Received by Gift

• Basis is the donor's basis plus a portion of gift tax paid attributable to appreciation.

Gift tax paid * [(FMV at gift - Donor's basis) / (FMV at gift - Annual exclusion)]

• The 2024 annual exclusion for gift tax is $18,000 per person.
• The donee has a dual basis if the FMV is less than the donor's basis.
• FMV at gift date is the loss basis: used if the property is later transferred at a loss
• Donor's basis is the gain basis: used if the property is later transferred at a gain.
• No gain/loss is recognized if the property is transferred for more than the FMV at the gift date but less than the donor's basis at the gift date.
• For depreciable basis, it's adjusted based on gift taxes paid.
• Use donor's AB if the gift property is used immediately as business property.
• If gift property is converted from personal to business use later, the depreciable basis is the lower of the transferor's AB or the FMV on the date of conversion.

Property Received for Services

• Compensation for services is gross income
• The payment form is irrelevant.
• Income is the fair market value of property received minus cash given.
• Property basis is the amount included in income plus cash given.
• An employee's gross income includes liability paid by an employer.

Inherited Property

• Basis is FMV on the date of death.
• Assets sold or distributed in first 6 months after death, basis equals FMV on sale or distribution date.
• FMV basis rule applies to:
  • One-half of community property interests
  • Property acquired via survivorship (unless consideration to a non-spouse was paid)
  • Property received before death without full consideration or that is subject to revocation
• Reduce basis by depreciation deductions allowed to the donee.
• The FMV rule excludes income a decedent would have received and appreciated property given to the decedent within 1 year of death.
• Stockholder reports their share of any income that is income in respect of a decedent.

Stock Dividends

• A corporation recognizes no gain/loss on transactions of its own stock.
• A proportionate distribution of stock issued by the corporation is not gross income to shareholders.
• A shareholder allocates the total adjusted basis (AB) in old stock to old/new based on FMV.
• Apportion basis by relative FMV to different classes of stock.
• The holding period of distributed stock includes that of old stock.
• Earnings and profits (E&P) are not altered for a tax-free dividend.

Stock Rights

• Treated as distribution of stock.
• Allocate basis based on the FMV of the rights.
• 0 stock rights basis if FMV is less than 15% of stock, unless election to allocate.
• If right is exercised, the basis is any allocated basis plus exercise price.
• The holding period starts on the exercise date.
• No deduction is allowed for basis allocated to rights that lapse.
• Basis otherwise allocated remains in the underlying stock.

Taxable Stock Distribution

• Distributions are subject to tax and distributions are the FMV of stock or stock rights.
• Include:
  • If a shareholder has an option to choose between a distribution of stock or a distribution of other property
  • Distribution of preferred stock is made with respect to preferred stock.
  • Convertible preferred stock is distributed, and the effect is to change the shareholder's proportionate stock ownership.
  • Some shareholders receive property, and other shareholders receive an increase in their proportionate interests.
• E&P are reduced by the FMV of stock and stock rights distributed.
• The underlying stock's basis does not change, only the new stock or rights basis is their FMV.
• Holding period begins the day after the distribution date.
• Basis is the FMV at acquisition if a distribution is taxable, the holding period begins the day following acquisition date.

Stock Split

• Not a taxable distribution.
• The basis of the old stock is divided by the number of new shares.
• The holding period includes that of the old stock.

Adjustments to Asset Basis

• Initial basis is adjusted with tax-relevant events.

Subsequent to Acquisition

• Expenditures increase basis, such as legal fees for title defense or title insurance.

Prolong Life

• Increase the basis for expenses that add at least 1 year to the life or increase value.
• Examples are major improvements and zoning changes.
• Maintenance, repair, and operating costs are a current-period deduction, not capitalized.
• Basis can increase from a liability secured by real property to extend its life.

Depreciation

• Depreciation decreases basis for business property.
• The base for MACRS depreciation is the cost.
• Assets under the General Depreciation System (GDS) and MACRS must be in a class (5, 7, or 20 year).
  • Five-year property includes automobiles, computers, office machinery, and research equipment.
  • Seven-year property includes office furniture, fixtures, and agricultural machinery.
• Residential real property is any property from which 80% of its gross rental income comes from dwelling units (27.5 years recovery period).
• Nonresidential real property is Sec. 1250 property.
• This includes office buildings or warehouses and has a 39-year recovery period.
• Basis must be reduced by depreciation allowed or allowable.
• Unimproved land is not depreciated.
• Section 179 expense is treated as a depreciation deduction; The Sec. 179 amount is $1,220,000 for 2024.

Contributed Property

• A shareholder does not recognize gain on voluntary contributions to a corporation.
• The shareholders stock basis is increased in the basis of contributed property.
• A corporation has a transferred basis in the property.

Dividends

• Taxable as distributions out of earnings and profits (E&P), dividends do not reduce basis.

Return of Capital

• A distribution not out of E&P is a nontaxable return of capital to zero.
• Distributions over basis are capital gain.
• Specific identification if shareholders purchase several stocks.
• The FIFO method is used when specific identification is impossible.
• When unable to identify shares subject to a return of capital, the basis of the earliest shares are reduced first.

Stock Rights

• Stock basis is allocated to new shares and made upon stock which distribution was made.
• Allocate basis in proportion to FMV of stock and distribution if new/old shares are not identical.
• Divide the old basis across all shares if the new/old stock are identical.
• The stock rights have zero basis of FMV that is less than 15% of the stock which it was issued, unless an election is made to allocate basis.

Tax Benefits

• Basis adjustment is required for certain specific items.

Casualty Losses

• Basis is reduced by the casualty loss allowed/insurance.
• Itemized deductions for personal casualty and theft losses (tax years 2018-2025) is limited.
  • Loss attributed to a federally declared disaster.
  • Non-federally declared disaster losses limited to casualty gains.

Debt Discharge

• Exclusion from gross income is allowed to insolvent persons for debt discharged and requires reduction in basis for amounts excluded.

Credit on Asset Purchases

• Credits are allowed on certain asset purchases and a partial/full amount of the credit must be deducted from basis.

Partial Disposition of Property

• Equitably apportion the basis via relative FMV.

Personal Use Converted to Business Use

• The basis for depreciation is whichever is less: the FMV at the conversion date or the adjusted basis at conversion.

Leasehold Improvements

• Lessors report no income when a lessee alters the leasehold or it reverts.
• The lessor has a zero basis in leasehold improvements.

Holding Period (HP)

• Measured in calendar months and begins on the date after acquisition and includes the disposal date.
• The holding period may include that of the transferor.
• A year or less is considered short-term.
• More than a year is long-term.
• Holding Period (HP) Starts or by reference to...
  • Acquisition by or of... Sale or exchange, Use conversion, Residence, Involuntary conversion, Ordinary income property, Community property, Partnership interest, Stock dividend, Corporate stock, Like-kind, Nontaxable exchanges, Inheritance, Gift (for loss).

Capital Gains and Losses

• A capital asset sale/exchange gains or losses.

Capital Assets

• All property is capital, unless expressly excluded.
  • Inventory (or stock-in-trade): property held primarily for sale to customers in the ordinary course of a trade or business
  • Real or depreciable property used in a trade or business
  • Accounts acquired in the ordinary course of trade or business.
  • Copyrights and artistic compositions held by the person who composed them.
  • Certain U.S. government publications acquired at reduced cost
• Property held for personal use/income is capital.

Goodwill

• Capital asset generated within the business.
• Goodwill acquired with purchase trade/business is amortizable asset under Sec. 197.
• Ability to amortize characterizes acquired goodwill as a Sec. 1231 asset.

Stocks, Bonds, Commodities

• Capital assets for investors/traders, not dealers.
• A dealer holds an asset primarily for sale to customers.
• A dealer identifies assets as held for investment by day's end, such assets are capital.
• Traders buy and sell assets for his or her own account; they are capital assets.
  • To be trading securities as a business
    • Seek profit from daily market movements, not dividends/appreciation.
    • The activity must be substantial and with continuity/regularity.
  • If nature doesn't qualify as a business, individual investor and not a trader.
• Investors purchase/sell and expect income, not conducting a trade/business.

Land Investment

• Investment land, then subdivided converts into property held for sale in business.
• Subdivision for sale establishes property is held for sale/business.
• Subdivided land is a capital asset, if conditions are satisfied and no improvements were made.

Sale or Exchange

• Gains are realized on the “sale or other disposition of property”.
• A sale is property exchanged for money that pays money.
• For real property: sale/exchange is transfer of ownership/burdens to the buyer.
• Liquidating distributions/losses are sales/exchanges.

Gain (Loss) Recognized

• Realized gains are recognized by the IRC, conversely, unless the IRC provides the deduction is not allowed for losses.
• To figure the taxpayer's Gain: The adjusted basis is more than what is realized then there is a loss - amount realized (money/property received) is more than adjusted basis then there is a gain.

Capital Gains Rates

• A long-term capital gain or loss (LTCG or LTCL) are realized in a capital asset that is held for more than a year; Short-term rates (STCG) are realized in about a year or less.
• Filing jointly rate is under $94,050; Household under $63,000; Single under $47,025; Separately under $47,025; and Estates and Trusts under $3,150.
• The capital gains rate is 25% on Sec. 1250.
• The capital gains rate is 28% on collectibles from gains and losses.

Carryover of NLTCL

• A carry over loss continues down to the 0%.
• Net STCL also has its losses carry over to the highest long-term basket.

Limit Losses

• An individual loses income up to $3,000, forward carrying excess Cls unlimited.
• Carry-forward treatment as CL by CY is used.
• No inherited carry over.
• A corporation can only use CLs not CG each and carries the rest back 3 years/forward 5 years and characterizes all STCLs (regardless of character).

Schedule D

• This schedule is used to compute and summarize total capital gains and losses when selling assets via form 8949 - the summary combines both the short term and long term gains.
• If there is a capital gain the gains are all net to it: is called "capital gain net income."
• If a taxpayer is asked capital gain distributions and no other capital gains or losses, the capital gains distributions may be reported directly on line 7 of Form 1040 (without using Schedule D), provided that the following conditions are met: -(S)he only has capital gains from box 2a from Form 1099-DIV to report. -No amounts appear in box 2b (unrecaptured Sec. 1250 gain), box 2c (Sec. 1202 gain), or box 2d [collectibles (28%) gain]. -is not being filed, or, also adds all net capital gains from the disposition of property held for investment..
• Liabilities are discharged in bankruptcy- Schedule D creditors get it as a short-term capital loss/ regardless of how long a debt was in the hands of the creditor.

Capital Gains on Sales of Stock

• Taxed from the disposition of securities.
• Securities held by investors are capital assets.

Return of Capital

• Shareholders basis reduces when the stock turns zero.

Undistributed Gains.

• Income are taxed as capital in the current period and credit is then allowed by tax.

60/40 Rule

• If regulated contracts,options and currency are sold, it will be treated as if they were sold on the last day of the financial year.
  • Profits gains under this rules are with 60%/short-term-40%

Section 1202 Stock

• Can exclude 50% on sale of QSB: stock must have been issues after August 10 and 5 years more.
• After Feb 17 by Sept 28 = increased exclusion to 75%.
• After Sept 27 = 100% exclusion can be made.

Limit Assets

• It should be 50 Million. If not, it has limits.
  • An example is personal services.
  • An annual gain - the taxpayer can qualify and under the year, he can claim the gain based on stock during year.

AMT Preference

• Alternative minimum tax AMT is only 7% of gain.
• No minimum tax credit if stock is acquired after 2010.

Gain Rollover

• Sec 1202 stock can be rollover and transferred to business and is bought within 60 days.
  • You should've had the stock for 6 mos.
  • When applying/deferring the gain/ business stock is acquired, and the stock period are deferred..
  • Tax payers can have QSB stock, as entities

Section 1244

• A individual can have an ordinary loss due to sale/exchange.
• A small business stock does'nt exceeds $1 million
  • Time stock is issued.
  • They must be must be the original owner
• 50K max; Joint return 100K
• All investments must be documented for eligibility.
• Form 4797 documents the loss.