Taxchapter10.docx

1、Taxchapter10Chapter 10Property: DispositionsSOLUTIONS MANUALDiscussion 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

2、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

3、 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 warehou

4、se 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

5、the liability, the relief of debt increases the amount realized. Thus, Potomacs 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 s

6、ells 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 s

7、ale. What is Maxs amount realized on the sale?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 rece

8、ived (e.g. marketable securities or a similar asset), or relief of debt. In addition, selling expenses reduce the amount realized. Therefore, Maxs 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 $60,0

9、00 (selling expenses reduce the amount realized, S.C. Chapin, CA-8, 50-1 USTC 9171). Anything the seller gives up in the 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

10、 Maxs amount realized. Note, however, that making these improvements decreases his realized gain by increasing Montana Maxs 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

11、claimed a total of $42,000 in depreciation deductions against the asset. Explain how to calculate Hawkeyes 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 takennamely, deprecia

12、tion. Therefore, Hawkeyes 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

13、 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 b

14、etween 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 realiz

15、ed gains or losses become recognized gains or losses and are included on the taxpayers tax return and increases (or decreases in the case of a loss) the taxpayers taxable income and subsequent tax. However, there are some realized gains or losses that are excluded from income or deferred to a later

16、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 taxpayers tax liability. The character depends on a combination of two factor

17、s: 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 t

18、hese 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 all gains and losses are not equal. Ordinary gains and losses are taxed at ordinary income rates, regardless of the holding period.

19、 Capital gains on assets held for more than a year receive preferential rates while capital gains on assets held for one year or less do not. Section 1231 gains and losses receive the best of both worldsthe gains become long-term capital gains and the losses become ordinary. However, to qualify as a

20、 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 taxpayers business (e.g. inventory) or arises from sales in the o

21、rdinary course of business (e.g. accounts receivable). Capital assets are held for investment (expecting appreciation) or are personal-use assets (e.g. a taxpayers personal belongings). A 1231 assets is used in a trade or business or for the production of income and is held for more than one year. A

22、n 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

23、 gains. Explain why corporate taxpayers might prefer capital gains over ordinary gains.Individual taxpayers prefer capital gains because they can be taxed at preferential rates. Long-term capital gains are taxed at preferential rates (5 or 15%). Short-term capital gains are simply taxed at ordinary

24、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 ord

25、inary income and capital gains, they prefer capital gains because capital gains can offset capital losses. Capital losses cannot be used to offset ordinary income. Corporate taxpayers can carry capital losses back three years and forward five years. However, after the carry back and carry forward pe

26、riods 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 Da

27、kota 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 b

28、usiness 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

29、is considered to be inventory (for example a real-estate dealer). The loss would be non-deductible to Dakota if he held the land for personal-use purposes.10. LO 2 Lincoln has used a piece of land in her business for the past five years. The land qualifies as 1231 property. It is unclear whether Lin

30、coln will have to recognize a gain or loss when she eventually sells the asset. She asks her accountant how the gain or loss would be characterized if she decides to sell. Her accountant said that selling 1231 assets gives sellers “the best of both worlds.” Explain what her accountant means by “the

31、best of both worlds.” An asset qualifies as a 1231 asset if used in a trade or business or held for the production of income for more than one year. The tax treatment is sometimes described as receiving “the best of both worlds” because if they result in gains, the gain will receive capital gain tre

32、atment and if they result in losses the loss will receive ordinary loss treatment. Capital gains are preferable because they are taxed at a preferential rate (for non-corporate taxpayers) and can offset capital losses which cannot always be offset against ordinary income. Ordinary losses are preferred to capital losses because they offset ordinary income in the current year rather than being accumulated to offset future capital gains. 11. LO 3 Explain Congresss rationale for depreciation recapture.The purpose of depreciation recapture is to treat the gain on the sale