Chp 11 Individual tax homework

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al.

Chapter 11

Property: Dispositions

SOLUTIONS MANUAL

Discussion Questions

1. [LO 1] Compare and contrast different ways in which a taxpayer triggers a realization

event by disposing of an asset.

A realization event for tax purposes is created in many ways. Virtually any

disposal will result in a sale or other disposition. These include a sale, trade,

gift to charity, disposal to the landfill, or destruction in a natural disaster. In a

sale or trade (exchange), the taxpayer receives something of value in return for

the asset. In contrast, a charitable contribution, disposal, or destruction from a

natural disaster generally results in a loss of any remaining basis in the asset

without compensation (unless reimbursed by insurance).

2. [LO 1] Potomac Corporation wants to sell a warehouse that it has used in its business

for 10 years. Potomac is asking $450,000 for the property. The warehouse is subject

to a mortgage of $125,000. If Potomac accepts Wyden Inc.’s offer to give Potomac

$325,000 in cash and assume full responsibility for the mortgage on the property,

what amount does Potomac realize on the sale?

When the property disposed of is subject to a liability and the buyer assumes the

liability, the relief of debt increases the amount realized. Thus, Potomac’s

amount realized consists of $450,000, which is cash of $325,000 plus $125,000

relief of debt. This assumes that the buyer hypothetically transfers cash to the

seller in order to pay off the mortgage.

3. [LO 1] Montana Max sells a 2,500-acre ranch for $1,000,000 in cash, a note

receivable of $1,000,000, and debt relief of $2,400,000. He also pays selling

commissions of $60,000. In addition, Max agrees to build a new barn on the property

(cost $250,000) and spend $100,000 upgrading the fence on the property before the

sale. What is Max’s amount realized on the sale?

$4,340,000. Anything received by the seller during a sale or exchange is

included in the amount realized. Most dispositions result in cash to the seller.

However, amount realized includes, but is not limited to, cash, the fair market

value of any other property received (e.g. marketable securities or a similar

asset), or relief of debt. In addition, selling expenses reduce the amount

realized. Therefore, Max’s amount realized includes the $1,000,000 of cash,

$1,000,000 note receivable, relief of debt of $2,400,000, and is reduced by

selling commissions of $60,000 (selling expenses reduce the amount realized,

S.C. Chapin, CA-8, 50-1 USTC ¶9171). Anything the seller gives up in the

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transaction is added to the basis of the property given up and is not considered

part of the amount realized. Therefore, the barn and fence improvements are

not considered part of Max’s amount realized. Note, however, that making these

improvements decreases his realized gain by increasing Montana Max’s

adjusted basis in the property due to the improvements.

4. [LO 1] Hawkeye sold farming equipment for $55,000. It bought the equipment four

years ago for $75,000, and it has since claimed a total of $42,000 in depreciation

deductions against the asset. Explain how to calculate Hawkeye’s adjusted basis in

the farming equipment.

Hawkeye will calculate its adjusted basis in the farming equipment by reducing

the historical cost by any cost recovery deductions taken—namely, depreciation.

Therefore, Hawkeye’s adjusted basis is $33,000 ($75,000 less $42,000). The tax

adjusted basis is usually different than the book adjusted basis. This is because

most assets use a different recovery period, cost recovery method (e.g. double

declining balance), and convention (e.g. half-year) for tax than for book

purposes. See Chapter 9 for how these differences arise. Due to the difference

in cost recovery deductions, the adjusted basis is likely different unless the asset

is fully depreciated for both book and tax purposes.

5. [LO 1] When a taxpayer sells an asset, what is the difference between realized and

recognized gain or loss on the sale?

The realized gain or loss is simply the amount realized less the adjusted basis of

the asset sold. Every sale or disposition results in a realized gain or loss

(unless, of course, the amount realized is equal to the adjusted basis). Most

realized gains or losses become recognized gains or losses and are included on

the taxpayer’s tax return and increases (or decreases in the case of a loss) the

taxpayer’s taxable income and subsequent tax. However, there are some

realized gains or losses that are excluded from income or deferred to a later

time period.

6. [LO 2] What does it mean to characterize a gain or loss? Why is characterizing a gain

or loss important?

Once a gain or loss is recognized, a taxpayer must determine how the

recognized gain or loss affects the taxpayer’s tax liability. The character

depends on a combination of two factors: purpose or use of the asset and

holding period. The purpose or use of the asset is important because the law

does not treat all assets equally. The general use categories are: (1) trade or

business, (2) for the production of income (rental activities), (3) investment, and

(4) personal. Based on these criteria, we can categorize an asset into one of

three groups: (1) ordinary, (2) capital, or (3) section 1231. Characterizing the

gain or loss is important because the tax treatment for gains and losses vary

depending on the character. Ordinary gains and losses are taxed at ordinary

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income rates, regardless of the holding period. Capital gains on assets held for

more than a year have preferential tax rates for non-corporate taxpayers while

capital gains on assets held for one year or less do not. Section 1231 gains and

losses receive the best of both worlds—the gains become long-term capital

gains and the losses become ordinary. However, to qualify as a §1231 asset, the

asset must be used in a trade or business for more than a year.

7. [LO 2] Explain the difference between ordinary, capital, and §1231 assets.

An ordinary asset is an asset that is held for sale in the ordinary course of a

taxpayer’s business (e.g. inventory) or arises from sales in the ordinary course

of business (e.g. accounts receivable). Capital assets are held for investment

(expecting appreciation) or are personal-use assets (e.g. a taxpayer’s personal

belongings). §1231 assets are used in a trade or business or for the production

of income and are held for more than one year. An asset that is used in a trade

or business or for the production of income and is held for one year or less is an

ordinary asset. Gains on personal use property are capital gains while losses

are non-deductible.

8. [LO 2] Discuss the reasons why individuals generally prefer capital gains over

ordinary gains. Explain why corporate taxpayers might prefer capital gains over

ordinary gains.

Individual taxpayers prefer capital gains because they may be taxed at

preferential rates. Net long-term capital gains are taxed at preferential rates

(0%, 15%., or 20%). Short-term capital gains are simply taxed at ordinary

rates. Capital gains can offset capital losses, while ordinary gains cannot.

Additionally, individual taxpayers can offset $3,000 of net capital losses against

ordinary income and carry the remaining capital loss forward indefinitely.

Even though corporate taxpayers are taxed at the same rate on ordinary income

and capital gains, they prefer capital gains because capital gains can offset

capital losses. Capital losses cannot be used to offset ordinary income;

therefore, capital gains allow corporate taxpayers to benefit from their capital

losses. Corporate taxpayers can carry capital losses back three years and

forward five years. However, after the carry back and carry forward periods

expire, capital losses expire and are worthless.

9. [LO 2] Dakota Conrad owns a parcel of land he would like to sell. Describe the

circumstances in which the sale of the land would generate §1231 gain or loss,

ordinary gain or loss, or capital gain or loss. Also describe the circumstances where

Dakota would not be allowed to deduct a loss on the sale.

The parcel of land could qualify as a capital asset if it is held by Dakota as an

investment (e.g. the purpose for holding the land is for expected appreciation in

value). The land could qualify as a §1231 asset if Dakota uses it in a trade or

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business such as a sole-proprietorship or for the production of income (a rental

property) and he uses it for these purposes for more than one year. The land

could be ordinary income property to Dakota if it is held in a trade or business

or for the production of income for one year or less or if it is considered to be

inventory (for example a real-estate dealer). The loss would be non-deductible