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CHAPTER 13

PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES,


§ 1231 AND RECAPTURE PROVISIONS

SOLUTIONS TO PROBLEM MATERIALS

Status: Q/P
Question/ Present in Prior
Problem Topic Edition Edition

1 Issue ID New
2 Issue ID Unchanged 3
3 Definition of capital assets Unchanged 4
4 Definition of capital assets Unchanged 5
5 Section 1237 treatment Unchanged 6
6 Issue ID Unchanged 7
7 Patents New
8 Lease cancellation New
9 Holding period New
10 Issue ID Unchanged 10
11 Issue ID Unchanged 11
12 Capital loss carryovers New
13 Issue ID Unchanged 12
14 Issue ID Unchanged 13
15 Section 1231: realized versus recognized New
16 Section 1231: business use property New
condemnation
17 Issue ID New
18 Section 1231 gain from disposition with § 1245 Unchanged 15
depreciation recapture
19 Issue ID Unchanged 16
20 Section 1245 recapture and short-term holding period Unchanged 17
21 Section 1245 recapture and nonresidential real estate Unchanged 18
22 Issue ID Unchanged 19
23 Section 1250 and residential real estate Unchanged 20
24 Section 1250 recapture Unchanged 21
25 Recapture and holding period Unchanged 22

13-11
13-2 2004 Comprehensive Volume/Solutions Manual

Status: Q/P
Question/ Present in Prior
Problem Topic Edition Edition

26 Residential rental housing New


27 Unrecaptured § 1250 gain Unchanged 23
28 Depreciation recapture and gifts New
29 Depreciation recapture and death New
30 Depreciation recapture for corporation: property Unchanged 24
distributions
31 Related party transactions Unchanged 25
32 Capital assets Modified 26
33 Capital assets Modified 27
34 Capital assets Unchanged 28
* 35 Section 1237 treatment Unchanged 29
36 Nonbusiness bad debt and worthless securities, Unchanged 30
§ 1244 stock
37 Options New
38 Patents New
39 Franchises Unchanged 34
40 Lease cancellation Unchanged 35
41 Holding period Unchanged 36
* 42 Net capital gain Unchanged 38
* 43 Net capital loss Unchanged 39
44 Net capital gain and alternative tax Unchanged 40
45 Corporate net capital loss and carryover Unchanged 41
46 Covenant not to compete versus goodwill Unchanged 42
* 47 Section 1231 computation and farm assets Modified 43
48 Section 1231 nonpersonal use property casualty Unchanged 44
* 49 Section 1231 lookback Modified 45
50 Section 1231 gain and loss planning Unchanged 46
* 51 Section 1245 recapture Unchanged 47
* 52 Section 1245 recapture and § 1231 lookback Unchanged 48
* 53 Section 1231 gain, § 1250 recapture, and Unchanged 49
unrecaptured § 1250 gain
* 54 Section 1231 gain and § 1250 recapture Modified 50
* 55 Comprehensive §§ 1231, 1245, and 1250 Modified 51
* 56 Sections 1245 and 1250 recapture, § 1231 gain, Modified 52
and unrecaptured § 1250 gain
57 Recapture and gifts Unchanged 53
58 Section 1245 and inheritances New
59 Section 1245 and property distributions Unchanged 56
* 60 Sections 1245 and 1231 gain and sales price Unchanged 57
allocation
* 61 Cumulative Unchanged 58
* 62 Cumulative Modified 59

*The solution to this problem is available on a transparency master.


Property Transactions: Capital Gains and Losses, § 1231, Recapture Provisions 13-3

CHECK FIGURES

33. $173,000 ordinary income. 48. $3,000 net § 1231 gain.


34. Designate stock as an investment. 49. 2002 $30,000 ordinary gain; 2003
35. $2,000 ordinary gain; $70,000 long- $39,000 ordinary gain, $0 LTCG.
term capital gain. 50. Sell the § 1231 gain asset this year
36.a. $3,700 short-term capital loss; and the § 1231 loss asset next year.
$10,000 long-term capital loss; 51.a. Rack $60,000 ordinary gain, $35,000
$20,000 ordinary loss. § 1231 gain; forklift $7,000 § 1231
36.b. $42,000. loss; bin $7,000 ordinary gain.
36.c. $700 short-term; $10,000 long-term. 51.b. $23,000.
37.a. $116,000 long-term capital gain. 52.a. Rack $5,000 ordinary gain; forklift
37.b. $116,000 ordinary income. $7,000 § 1231 loss; bin $3,000
38. Sell the patent now and have § 1231 loss.
$40,000 per year of long-term capital 52.b. $0.
gain for 10 years. 53.a. $41,032 cost recovery; $358,968
39. Freys treats all payments as ordinary; adjusted basis of building.
Reynaldo may amortize $60,000 53.b. $11,032 § 1231 gain.
over 15 years and deduct the $30,000 54.a. $5,347 § 1250 ordinary gain and
currently. $315,066 § 1231 gain.
41. $800 short-term capital gain. 54.b. $400,000 § 1231 gain.
42. $13,000 net capital gain. 55.b. AGI $461,108.
43. Net LTCL $1,000. 56.a. $9,300 § 1250 gain; $61,700 § 1231
44. Tax on taxable income is $15,936. gain.
45. $455,000 taxable income and 56.b. $71,000 § 1245 gain.
$45,000 short-term capital loss 58. $1,000 ordinary gain.
carryover. 59. $5,000 ordinary income.
46. Selling the process for $850,000 61. $1,495 refund for 2002.
yields the highest long-term capital 62. AGI is $272,982; taxable income is
gain. $256,412; tax refund is $4,686
47. AGI $62,450.
13-4 2004 Comprehensive Volume/Solutions Manual

DISCUSSION QUESTIONS

1. The taxpayer has to determine whether there were short-term and/or long-term capital
gains and losses from these transactions. Thus, the factors to be considered are the
holding period of the assets sold and whether there was a gain or loss on the sale. p. 13-3

2. Meredith has a zero tax basis for the supplies because she has already deducted their cost.
Therefore, she has a gain of $3,000 from selling them. The supplies are not a capital
asset because § 1221 specifically defines supplies as not a capital asset. Meredith has an
ordinary gain from disposition of the supplies. p. 13-4

3. Accounts receivable are not a capital asset because § 1221 specifically defines them as
not a capital asset. Magenta has a tax basis for the receivables equal to its face value
because Magenta’s revenues were increased by that amount when the account receivable
was recorded. Therefore, Magenta has a $35,400 ordinary loss [$236,000 – ($236,000 X
.85)] from the disposition of the receivables. p. 13-5

4. Since Arnold is a securities dealer, normally securities he purchases would not be capital
assets. However, here he properly notified his employer by the end of the day that he
acquired the securities that he was holding them as an investment. Consequently, when
he sells the securities for a $2,200 loss ($3,200 cost – $1,000 sale price), the loss is a
short-term capital loss because he held the securities for one year or less. p. 13-7

5. Felecia is an individual that has not made substantial improvements to the property and,
since she inherited the farmland, her holding period is not relevant (i.e., automatically
long term). She qualifies for the real property subdivided for sale provisions. She sold
all the 23 lots in one year; so she will be eligible for capital gain treatment to the extent
her gain exceeds 5 percent of the selling price minus her selling expenses. p. 13-8

6. Mubsin was the grantee of the option and, since he exercised the option, the $10,000
option price is added to the $112,000 cost of the property to determine Mubsin’s adjusted
basis for the property. The property is not a capital asset because Mubsin will hold it for
use as rental property. He would have to determine how much of this basis is allocable to
the land and how much is allocable to the building to determine his basis for
depreciation. p. 13-11

7. Since Charles is a holder, the patent has not been reduced to practice, and he has given up
all substantial rights in the patent, the $37,000 gain ($40,000 amount realized – $3,000
adjusted basis) is automatically a long-term capital gain. pp. 13-12 and 13-13

8. The lessor has received a payment for cancellation of a lease. The $14,000 amount is
ordinary income to the lessor because the payment is considered to be in lieu of rental
payments. p. 13-16

9. Felicia’s holding period begins at the date of the transaction. Felicia’s basis for the
automobile is what she paid for it. The fact that Martha cannot deduct the realized loss
because of the related party loss disallowance provision does not affect Felicia’s basis or
holding period for the automobile. p. 13-17

10. A former owner’s holding period is tacked on to the present owner’s holding period if the
transaction is nontaxable and the former owner’s basis carries over to the present owner.
Here, the value of the property was less than Juan’s (the donor) basis at the time of the
gift. Miguel’s (the donee) holding period will not be known until Miguel sells the
property. If Miguel sells the property for more than Juan’s basis, Juan’s holding period
Property Transactions: Capital Gains and Losses, § 1231, Recapture Provisions 13-5

will tack on to Miguel’s. If Miguel sells the property for less than its fair market value at
the date of gift ($7,000), Miguel’s holding period will start at the date of the gift.
p. 13-17 and Examples 24 and 25

11. Byron should sell enough stock to generate a $10,000 long-term capital gain. This will
reduce his 2003 net capital loss to $3,000 and that $3,000 will be a for AGI capital loss
deduction. pp. 13-26 to 13-28

12. The corporation may not reduce its 2003 taxable income by the net short-term capital
loss. The corporation may carry over (three years back and five years forward) the loss
and offset it against capital gains of the carryover year(s). pp. 13-29 and 13-30

13. If Aretha does not have any other nonpersonal use property casualties or thefts during the
year, her casualty and theft netting will result in a loss and the loss will be treated as
ordinary. Consequently, the land gain will be the only § 1231 gain and, barring the
presence of any § 1231 lookback losses, will be treated as a long-term capital gain.
p. 13-35 and Concept Summary 13-6

14. The tax issues that Sally must properly handle are:

• Should the two casualty items be netted against one another?

• If the items are netted, what type of gain or loss results from the netting?

• How are the results of the netting integrated with Sally’s other gains and losses (if
any)?

• Should Sally postpone the gain by reinvesting in similar property?

pp. 13-35, 13-36, and Chapter 12

15. Section 1231 has no effect on whether or not realized gain or loss is recognized. Instead,
§ 1231 merely dictates how such recognized gain or loss is classified (ordinary, capital,
or § 1231) under certain conditions. p. 13-35

16. Since the property was used in a trade or business and held more than a year, it was a
§ 1231 asset. Disposition by condemnation (unlike disposition by casualty or theft) is not
subject to any special netting rules. The loss is a § 1231 loss initially. Personal use
property condemnation gains and losses are not subject to the § 1231 rules, but the
property here was business use property. p. 13-35

17. The factors that will influence whether any of the 2003 net § 1231 is treated as long-term
capital gain are:

• What is the amount of the 2000 net § 1231 loss?

• What is the amount of the 2001 net § 1231 gain, and after reducing the 2000 net
§ 1231 loss by the 2001 net § 1231 gain, does any of the 2000 net § 1231 loss
remain?

• If any of the 2000 net § 1231 loss remains, what is the amount of the 2002 net § 1231
gain, and after reducing the remaining 2000 net § 1231 loss by the 2002 net § 1231
gain, does any of the 2000 net § 1231 loss remain?
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• If any of the 2000 net § 1231 loss remains, what is the amount of the 2003 net § 1231
gain?

• After reducing the 2003 net § 1231 gain by the remaining 2000 net § 1231 loss, does
any of the 2003 net § 1231 gain remain?

pp. 13-36 and Examples 48 to 51

18. The machine would have to be sold for more than the amount that was paid for it.
p. 13-39

19. To properly handle this transaction, Sylvia must determine the following:

• The tax status of the property (§ 1231 asset, capital asset, or ordinary asset).

• The applicability of § 1245 depreciation recapture.

• The outcome of the § 1231 netting process.

Both assets are § 1231 assets. Section 1245 depreciation recapture causes the entire gain
of $2,510 ($40,000 – $37,490) to be taxed as ordinary income since the selling price does
not exceed the $100,000 original cost of the asset. Since the loss of $14,490 ($23,000 –
$37,490) on the other asset is the only § 1231 gain or loss, there is a net loss of $14,490
that is treated as an ordinary loss. Consequently, Sylvia is partially correct, the $2,510
gain from one of the items does offset the $14,490 loss from the other item. However,
these transactions are reported separately from her 2003 business income. The $11,980
net loss is deductible for adjusted gross income on her 2003 tax return. pp. 13-31, 13-36,
and 13-39

20. Section 1245 depreciation recapture generally applies to § 1231 assets; in this case
depreciable equipment held more than one year. This asset was held one year or less; so
it was an ordinary asset rather than a § 1231 asset. Since the asset is ordinary, the gain
from disposition is also ordinary and § 1245 does not apply. pp. 13-31 and 13-39

21. All of the gain is subject to § 1245 depreciation recapture because nonresidential real
estate acquired after 1980 and before 1987 for which accelerated depreciation was used is
subject to § 1245 depreciation recapture. p. 13-41

22. The unrecaptured § 1250 gain is related to the depreciation taken on the property and
requires that the property be sold at a recognized gain. The greater the portion of the
sales price that relates to the land, rather than to the building, the smaller the recognized
gain from disposition of the building will be. The issues raised include the following:

• The original cost of the land and the building.

• The portion of the sales price related to the land and to the building.

• The depreciation taken on the building.

p. 13-46

23. Section 1250 depreciation recapture would not apply to an asset acquired in 1999
because straight-line depreciation would have to be used for the building. Section 1250
depreciation recapture only applies when there is an excess of accelerated depreciation
Property Transactions: Capital Gains and Losses, § 1231, Recapture Provisions 13-7

over straight-line depreciation. However, a portion of the recognized gain from


disposition of the building may be taxed at a maximum of 25% because of the
unrecaptured § 1250 gain rules. pp. 13-43 and 13-44

24. The amount in the 2002 additional depreciation column is negative because the straight-
line depreciation exceeded the accelerated depreciation. As the holding period of the
depreciable property gets longer, yearly straight-line depreciation of the original cost
begins to exceed yearly declining balance depreciation. p. 13-44

25. The gain would be an ordinary gain due to § 1250. All depreciation is recaptured if the
property is purchased and disposed of in one year or less. p. 13-43

26. Property qualifies as residential rental housing only if at least 80 percent of the gross
rental income is rental income from dwelling units. p. 13-44

27. Abigail’s maximum unrecaptured § 1250 gain is the amount of the depreciation she took
on the real estate. If the $45,000 recognized gain is less than the depreciation taken, that
would be the maximum. She would have no § 1250 depreciation recapture because she
acquired the real estate after 1986. Therefore, only straight-line depreciation was taken
on the property. pp. 13-45 to 13-47

28. The § 1245 depreciation recapture potential carries over to the donee. p. 13-47

29. The § 1245 depreciation recapture potential does not carry over to the beneficiary.
p. 13-47

30. The distribution of the truck is a taxable transaction for the corporation. All of the gain is
§ 1245 gain because the truck is a § 1231 asset and the fair market value is less than the
original cost. pp. 13-41 and 13-49

31. The distribution of the truck is a taxable transaction for the corporation. All of the gain is
ordinary gain due to § 1239 because the shareholder is a related taxpayer and will use the
truck in a business. Therefore, the truck is depreciable by the shareholder and § 1239
makes all the gain of the transferor ordinary gain. p. 13-52

PROBLEMS

32. All the assets are capital assets because they do not fit any of the items listed in § 1221 as
not capital assets. The 1963 Ford is a “collectible.” Therefore, the $15,000 loss
($32,000 sale price – $47,000 basis) is a long-term capital loss that would first be netted
against any 28% long-term capital gain. The Blue Growth Fund $11,000 gain ($23,000
sale price – $12,000 basis) is a long-term capital gain that is potentially taxable at 10%
and/or 20%. The Orange Bonds are sold for a $7,250 gain ($42,000 proceeds – $750
interest income – $34,000 basis). The gain is a long-term capital gain potentially taxable
at 10% and/or 20%. The sale of the Green stock results in a $2,000 ($11,000 sale price –
$13,000 basis) short-term capital loss because the stock was held one year or less. The
$750 interest income is includible in Eric’s gross income. pp. 13-4 and 13-21 to 13-24

33. Sara is in the trade or business of being an artist. Her artworks are not capital assets, but
are ordinary assets instead. Since she has a zero tax basis for the art that was sold, her
ordinary income is $173,000. p. 13-5
13-8 2004 Comprehensive Volume/Solutions Manual

34. By the close of business on the day Brenda purchases the shares, she must designate them
as held for investment. The $55 ($200 – $145) per share gain would be long-term capital
gain if she sells the shares after holding them more than a year.

Willis, Hoffman, Maloney, and Raabe, CPAs


5191 Natorp Boulevard
Mason, OH 45040

March 17, 2004

Ms. Brenda Reynolds


200 Morningside Drive
Hattiesburg, MS 39406

Dear Ms. Reynolds:

The purpose of this letter is to discuss the rules for purchases of stock by a securities
dealer such as yourself. Your co-workers are incorrect that a securities dealer may never
have a long-term capital gain from the sale of stock. The tax law allows you to designate
stock you purchase as being held for investment. You must make this designation by the
end of the business day on which the stock is acquired. I suggest you check with your
supervisor on how this “designation” is normally done at your firm. I am sure it is a
relatively simple procedure.

As long as you continue to hold the designated shares for investment until you sell them,
the shares will be a capital asset. When you sell them at $200 per share, your $55 per
share gain will be long-term capital gain if you have held the shares for more than one
year.

Thank you for the opportunity to be of service. Please telephone me if you have
additional questions.

Sincerely,

Michelle Brown, CPA


Partner

p. 13-7

35. Because Gerald has sold more than five lots, he has potential ordinary income equal to
5% of the selling price of each lot. Gerald has a total recognized gain of $72,000. This is
classified as $2,000 ordinary gain and $70,000 long-term capital gain. The computations
are shown below:

Selling price (10 X $20,000) $200,000


Less: selling expenses ($200,000 X 4%) (8,000)
Amount realized $192,000
Basis (10 X $12,000) (120,000)
Realized and recognized gain $ 72,000

Classification of recognized gain:


Property Transactions: Capital Gains and Losses, § 1231, Recapture Provisions 13-9

Ordinary income
5% of selling price (5% X $200,000) $ 10,000
Less: selling expenses (8,000)
Ordinary gain 2,000
Capital gain ($72,000 – $2,000) $ 70,000

pp. 13-7, 13-8, and Example 9

36. a. When Sue made the loan to a friend, she had a nonbusiness receivable. When the
loan is not repaid, she has a $3,700 nonbusiness bad debt assuming the debt is a
bona-fide debt. The $3,700 is treated as a short-term capital loss, no matter how
long Sue held the loan. Whether the receivable was a capital asset and whether its
holding period was long or short-term are not relevant because the Code defines
the loss as a short-term capital loss.

Sue also is the holder of a worthless bond. The bond is deemed to have become
worthless on the last day of 2003—the year in which it became worthless. Sue’s
holding period for the bond is long-term because the time period from November
10, 2002 through December 31, 2003 is more than one year. The $10,000 loss on
the bond is a long-term capital loss. The $20,000 loss on the disposition of the
§ 1244 stock is an ordinary loss. The loss is a deduction for adjusted gross
income.

b. Sue’s adjusted gross income is $42,000 [$65,000 – $3,000 (capital loss deduction)
– $20,000 (§ 1244 ordinary loss deduction)].

c. Since short-term capital losses are used first to make up the capital loss deduction,
Sue has a $700 ($3,700 – $3,000) short-term capital loss carryforward and a
$10,000 long-term capital loss carryforward.

pp. 13-9, 13-21, 13-27, and 13-28

37. a. An option usually sets the price at which the grantee (Frank) can buy the property
and the option expires after a specified period of time. The right of first refusal
did not specify a price at which Frank could buy the property. Generally, the
grantee’s sale or exchange of the option results in capital gain if the option
property is (or would be if purchased) a capital asset to the grantee. Thus, if
Frank treats the right of first refusal as an option, he will have a holding period
for it that exceeds one year and will have $116,000 ($120,000 proceeds from sale
of the right of first refusal – $4,000 adjusted basis) of long-term capital gain. If
the amount paid for the right of first refusal is not an asset whose holding period
began fourteen months ago, then Frank either has an ordinary gain of $116,000 or
has a short-term capital gain of $116,000. Therefore, it is best to treat the right of
first refusal as an option and get long-term capital gain treatment.
b. If Frank is a dealer in land, then the right of first refusal is an ordinary asset
because the land would be an ordinary asset if Frank purchased it. Instead of
being taxed no higher than 20% on a long-term capital gain, Frank has $116,000
of ordinary income.

pp. 13-11 and 13-12


13-10 2004 Comprehensive Volume/Solutions Manual

38. If Mateen sells the patent for $400,000, he has automatic long-term capital gain because
he is a “holder.” He is the inventor, the patent has not yet been reduced to practice, and
he will have sold all substantial rights to the patent. His maximum long-term capital gain
tax rate is 20%. He will receive $40,000 per year for the next 10 years and could use the
installment sale method (see Chapter 15) to recognize the gain as the sale proceeds are
received. However, he will be taking a risk that the payments will actually be received
and should consider the time value of money in analyzing this alternative.

If Mateen contributes the patent to a new business and receives shares of stock of that
business, he has made a nontaxable exchange under § 351. He will not be currently taxed
on the exchange, but is taking the risk that the business will be profitable and he will be
able to sell the shares of stock later at a gain equal to or greater than what he could
receive in cash over the next ten years. Once he has held the company’s shares of stock
for more than one year, he would have long-term capital gain treatment from disposition
of the shares of stock. Without much more information (such as the credit worthiness of
the investors, the income potential from manufacturing and selling the process, etc.), it is
not possible to make an informed decision either way at this time. pp. 13-12, 13-13, and
13-17

39. Freys, Inc. has retained significant powers and rights in the franchise agreement.
Therefore, Freys has not made a sale or exchange, but has created a license to use its
trademarks, trade name, and mode of operation. Section 1253 requires that Freys treat
the $60,000 lump-sum noncontingent payment and the $30,000 contingent payment as
ordinary income. Reynaldo may amortize the $60,000 noncontingent payment over 15
years. The amortization is treated as a business expense. Reynaldo may currently deduct
the $30,000 contingent payment as a business expense. pp. 13-13 and 13-14

40. The tax factors Irene should consider are: (1) whether or not she has an asset; (2) the tax
basis for the asset; (3) the tax status (ordinary, capital, or § 1231) of the asset; (4) the
amount of the gain or loss from disposition of the asset; (5) the holding period for the
asset; and (6) the nature of gain or loss from disposition of the asset. Irene has an asset—
the lease on her apartment. The asset is a capital asset because all personal use activity
assets are capital assets. Irene has no tax basis for the lease because she did not pay
anything for it. (Her monthly lease payments are nondeductible personal use activity
expenses.) Her holding period for the lease is one year or less. Consequently, she will
have a $1,000 short-term capital gain if she accepts the lease cancellation payment.
p. 13-15

41. The stock is a capital asset for Felicia with an eight-month holding period at the date of
the sale. Since the fair market value of the shares was greater than the aunt’s cost at the
time of the gift, Felicia gets a carryover basis and holding period from the aunt.
Therefore, Felicia has an $800 ($3,800 amount realized – $3,000 tax basis) short-term
capital gain from the disposition of the shares. Example 24

42. Net long-term capital gain ($22,000 – $5,000 long-term loss) $17,000
Net short-term capital loss ($19,000 – $23,000) (4,000)
Net capital gain $13,000
Property Transactions: Capital Gains and Losses, § 1231, Recapture Provisions 13-11

Willis, Hoffman, Maloney, and Raabe, CPAs


5191 Natorp Boulevard
Mason, OH 45040

March 17, 2004

Ms. Elaine Case


300 Ireland Avenue
Shepherdstown, WV 25443

Dear Ms. Case:

The purpose of this letter is to discuss the result of your stock transactions for 2003. You
had $17,000 (net) of long-term capital gains and $4,000 (net) of short-term capital losses.
Subtracting the $4,000 of losses from the $17,000 of gains resulted in a $13,000 net long-
term capital gain.

The $13,000 net long-term capital gain and the details of your stock transactions will be
reported on the Schedule D attached to your Form 1040. The $13,000 net capital gain
qualifies for the alternative tax and will be taxed at a 20% rate rather than at your
marginal tax rate of 35%.

Thank you for the opportunity to be of service. Please telephone me if you have
additional questions.

Sincerely,
Michelle Brown, CPA
Partner
pp. 13-21 to 13-23
43. The $18,000 loss on the sale of the personal residence is not deductible because it is a
loss on the sale or exchange of a personal use asset. The patent is subject to automatic
long-term capital treatment because it was purchased from the individual creator by an
unrelated party, the invention had not yet been reduced to practice, and when Betty sold
it, she transferred all rights to the patent. Thus, under § 1235, the $1,000 ($8,000 cost –
$7,000 sales price) loss on her sale of the patent is a long-term capital loss.
Patent LTCL ($ 1,000)
2003 stock LTCL (3,000)
2002 LTCL carryover (12,000)
Net LTCL ($16,000)
STCG $21,000
STCL (6,000)
Net STCG $15,000
Net LTCL ($16,000 – $15,000) ($ 1,000)
Of the $1,000 net LTCL, $1,000 is deductible for AGI.
13-12 2004 Comprehensive Volume/Solutions Manual

Willis, Hoffman, Maloney, and Raabe, CPAs


5191 Natorp Boulevard
Mason, OH 45040

March 17, 2004

Ms. Betty Jarow


1120 West Street
Ashland, OR 97520

Dear Ms. Jarow:

This letter is in response to your request for an explanation of the tax treatment of the
sale of your residence. As you know, the residence was sold for less than your cost.
Thus, you had an $18,000 tax loss on the residence sale. Unfortunately, the tax law does
not allow that loss to be deducted on your tax return because the home was a personal use
asset. The only type of loss deductible on personal use assets is a casualty loss.

Thank you for the opportunity to be of service. Please telephone me if you have
additional questions.

Sincerely,

Steve Warren, CPA


Partner

pp. 13-4 and 13-21 to 13-24


44. Janine and Bill’s taxable income without the long-term capital gain is $69,000 ($87,000 –
$5,000 – $13,000). The short-term capital gain of $2,100 is taxed at regular tax rates.
The married filing jointly tax on $69,000 is $12,336 {[($69,000 – $47,450) X .27] +
$6,517.50}. Even though the long-term capital gain asset was held more than five years,
the couple is no longer in the 15% bracket; so their $5,000 long-term capital gain is taxed
at 20% rather than 8%. The tax on the long-term capital gains of $18,000 ($5,000 +
$13,000) is $3,600 ($18,000 X .2). The total tax on taxable income is $15,936 ($12,336
+ $3,600). pp. 13-21 to 13-24
45. Mauve, Inc. cannot reduce its operating taxable income by the $45,000 long-term capital
loss. Mauve’s taxable income is $455,000 and it has a $45,000 short-term capital loss
carryover because all corporate net capital losses carry over as short term. p. 13-30
46. The process that Hsui is selling is an intangible asset with a zero tax basis to Hsui. It is
in the nature of goodwill and is probably a capital asset. If the process is copyrighted, it
is not a capital asset. A copyright is specifically defined as not being a capital asset by
§ 1221. If the process is patented, the payment might automatically be long-term capital
gain under § 1235. But the process is not patented. The specific exclusions from capital
asset status of § 1221 do not seem to include this situation. Therefore, the conclusion is
that the process is a capital asset. The covenant not to compete payments are ordinary
income to Hsui as they are received and will be taxed at ordinary income rates.
Consequently, Hsui should take the $850,000 for the process, treat it as long-term capital
gain, and pay tax on it of 20%. The $45,000 per year should be taken as a covenant not
to compete payment and be treated as ordinary income when it is received. For the
Property Transactions: Capital Gains and Losses, § 1231, Recapture Provisions 13-13

acquirer, both payments are § 197 intangible assets that have to be capitalized and
amortized over 15 years. pp. 13-4, 13-5, 13-12, 13-13, and 13-52
47. Cattle and horses must be held 24 months or more to qualify as § 1231 assets. Since the
cow was held only 15 months, it is an ordinary asset and the $7,000 gain ($25,000 sales
price – $18,000 adjusted basis) is an ordinary gain. The workhorse was held 66 months,
so it is a § 1231 asset. The $650 gain ($1,000 sales price – $350 adjusted basis) is a
§ 1231 gain. Since there is only a § 1231 gain for the year, the net § 1231 gain is $650
and that gain is treated as an ordinary gain because the $2,000 of prior nonrecaptured
losses causes application of the § 1231 lookback rule. None of the $650 net § 1231 gain
is treated as a long-term capital gain; so the $200 long-term capital loss is deductible for
AGI.

Section 1231 gain from sale of horse (treated as an ordinary gain) $ 650
Long-term capital loss from corporate stock sale (200)
Ordinary gain from sale of milk cow 7,000
Other adjusted gross income 55,000
Adjusted gross income $62,450

p. 13-33 and Concept Summary 13-6

48. Kwan has had two nonpersonal use property casualties. The $10,000 gain is netted
against the $7,000 loss and results in a $3,000 net gain. The $3,000 net gain is treated as
a § 1231 gain. Since there are no other property transaction gains or losses, and because
Kwan has no lookback losses, he has a $3,000 net § 1231 gain for the year. That gain is
treated as a long-term capital gain since both assets had been held more than 12 months
when the flood occurred. p. 13-33 and Concept Summary 13-6

Willis, Hoffman, Maloney, and Raabe, CPAs


5191 Natorp Boulevard
Mason, OH 45040
November 23, 2003

Mr. Kwan Lee


2367 Meridian Road
Hannibal Point, MO 34901

Dear Mr. Lee:


Thank you for the opportunity to discuss the tax effect of the two casualties you suffered
this year. Both the painting and the vase were assets you were holding for investment.
The painting casualty resulted in a $10,000 gain because it was insured. The vase
casualty resulted in a $7,000 loss because it was not insured.

The $10,000 gain is netted against the $7,000 loss and results in a $3,000 net gain. The
$3,000 net gain is treated as a "§ 1231 gain" – a special type of gain for tax purposes.
Since there are no other property transaction gains or losses this year, and because you
had no § 1231 losses in prior years, the $3,000 net § 1231 gain for the year is treated as a
long-term capital gain. That gain is eligible for a tax rate of no more than 20%.

If you have any questions concerning these transactions or other tax matters, please feel
free to telephone me. Thank you.
13-14 2004 Comprehensive Volume/Solutions Manual

Sincerely,

Sheila Dailey, CPA


Partner

p. 13-33

49. Net § 1231 gains must jump a final hurdle before being netted with capital transactions.
The net § 1231 gain must exceed the sum of nonrecaptured net § 1231 losses recognized
in the five most recent preceding years. The years 1998 through 2000 have a combined
nonrecaptured net § 1231 loss of $101,000. The $101,000 nonrecaptured § 1231 loss is
partially absorbed by the 2001 $31,000 § 1231 gain and the 2002 $30,000 § 1231 gain.
Thus, $40,000 of the nonrecaptured § 1231 loss remains for offset against the 2003
$39,000 § 1231 gain.

Net Sec. Before Lookback:


1231 Loss Current Year Long-Term
Subject to Net Sec. Ordinary Capital
Recapture 1231 Gain Income Gain
1998 - 2000 ($101,000)
2001 31,000 $ 31,000 $ 31,000 $ -0-
Remaining potential recapture ($ 70,000)
2002 30,000 30,000 30,000 -0-
Remaining potential recapture ($ 40,000)
2003 39,000 39,000 39,000 -0-
Totals $ 1,000 $100,000 $100,000 $ -0-

pp. 13-35 to 13-37

50. Yoshida should sell the § 1231 gain asset this year and the § 1231 loss asset next year.
This year, Yoshida would have $40,000 net § 1231 gain; there would be no lookback
nonrecaptured § 1231 loss; the net § 1231 gain would be treated as a long-term capital
gain, and the $25,000 short-term capital loss carryover would be offset against this
capital gain. For this year, Yoshida would have a $15,000 net long-term capital gain
which would be taxed at a maximum rate of 20%. Next year, Yoshida could sell the §
1231 loss asset; the $30,000 loss would generate a net § 1231 loss, and that loss would be
an ordinary loss deductible for AGI. By selling the § 1231 gain asset the year before the
§ 1231 loss asset, Yoshida avoids having the § 1231 loss “taint” the § 1231 gain,
converting that gain into ordinary gain. pp. 13-36, 13-37, and Example 74

51. a. Green has $67,000 ($60,000 + $7,000) of ordinary income due to § 1245
recapture and $28,000 ($35,000 – $7,000) of net § 1231 gain.
Property Transactions: Capital Gains and Losses, § 1231, Recapture Provisions 13-15

Asset Sold For Less Adjusted Basis Gain or Loss Character


Rack $135,000 $40,000 ($100,000 – $95,000 $60,000
$60,000) ordinary
income due
to § 1245
recapture;
$35,000
§ 1231 gain

Forklift $5,000 $12,000 ($35,000 – ($7,000) § 1231 loss


$23,000)

Bin $60,000 $53,000 ($87,000 – $7,000 All ordinary


$34,000) income due
to § 1245
recapture

b. Green has a $28,000 net § 1231 gain, but only $23,000 is treated as capital gain
because the $5,000 of nonrecaptured prior years § 1231 loss causes $5,000 of the
current year net § 1231 gain to be treated as ordinary income.

pp. 13-33 and 13-39 to 13-41

52. a. Magenta has $5,000 of ordinary income due to § 1245 recapture and $10,000 of
§ 1231 loss.

Asset Sold For Less Adjusted Basis Gain or Loss Character


Rack $55,000 $50,000 ($110,000 – $5,000 All ordinary
$60,000) income due
to § 1245
recapture

Forklift $15,000 $22,000 ($45,000 – ($7,000) § 1231 loss


$23,000)

Bin $60,000 $63,000 ($97,000 – ($3,000) § 1231 loss


$34,000)

b. Since Magenta has a $10,000 net § 1231 loss, there is no gain to be treated as
capital gain. The $5,000 § 1245 depreciation recapture gain is treated as ordinary
income and the $10,000 net § 1231 loss is treated as an ordinary loss deduction for
AGI.

pp. 13-39 to 13-41

53. a. Store cost $400,000


1999 cost recovery rate .01391
2000 cost recovery rate .02564
2001 cost recovery rate .02564
2002 cost recovery rate .02564
2003 cost recovery rate (.02564 X 5.5/12) .01175
13-16 2004 Comprehensive Volume/Solutions Manual

Total recovery rate X .10258


Total cost recovery $ 41,032

Adjusted basis ($400,000 – $41,032) of building $358,968

b. Selling price $470,000


Adjusted basis ($358,968 + $100,000) (458,968)
Recognized gain $ 11,032

Since the store was real estate used in business, it is a § 1231 asset. None of the
gain is § 1250 gain because only straight-line cost recovery was used. Therefore,
all of the gain is § 1231 gain. However, all of the $11,032 § 1231 gain is
unrecaptured § 1250 gain because the gain is less than the depreciation taken of
$41,032. pp. 13-43 to 13-47

54. a. The gain on the sale of the building is subject to § 1250 depreciation recapture
because it is residential rental real estate acquired after 1975 and before January
1, 1987 on which accelerated depreciation was taken. The gain from the sale is
$320,413, $5,347 is ordinary income due to § 1250, and the $315,066 balance of
the gain is § 1231 gain.

Selling price of building $345,000


Cost of building $350,000
1986-2002 depreciation (.914 X $350,000) (319,900)
2003 depreciation [(.042 X 4.5/12) X $350,000)] (5,513)
May 20, 2003 adjusted basis (24,587)
Gain on sale $320,413
1986-2002 straight-line depreciation $313,158
[($350,000/19) X 17 years]
2003 straight-line depreciation 6,908
[($350,000/19) X (4.5/12)]
Additional depreciation ($319,900 + $5,513 –
$313,158 – $6,908) = § 1250 ordinary income 5,347
Balance of gain = § 1231 gain $315,066

b. The land is also a § 1231 asset because it was part of the residential rental real
estate. However, there is no § 1250 recapture because it was not depreciated.
The § 1231 gain from the sale of the land is $400,000 ($500,000 selling price –
$100,000 adjusted basis). pp. 13-44 to 13-47
55. a. Land:
Condemnation proceeds $25,000
Allocable basis (40,000)
Realized and recognized § 1231 loss ($15,000)
Truck:
Depreciation taken: $3,491 ($6,000 – $2,509).
Adjusted basis: $2,509.
Realized gain: $3,500 – $2,509 = $991.
Recognized gain: $991 ordinary income under § 1245.
Rowing machine:
Realized and recognized gain = Amount realized – Adjusted basis of
machine on date of sale = $3,900 – $0 = $3,900.
Property Transactions: Capital Gains and Losses, § 1231, Recapture Provisions 13-17

Section 1245 recapture = Amount of depreciation claimed ($5,200) or gain


recognized ($3,900), whichever is less = $3,900.
Apartment building:
Realized gain = Amount realized – Adjusted basis = $200,000 – $124,783 =
$75,217.
Section 1231 gain recognized = $75,217. No § 1250 recapture is recognized
because the taxpayer used the straight-line method of depreciation. Of the
$75,217 § 1231 gain, $25,217 is unrecaptured § 1250 gain because the
depreciation taken of $25,217 ($150,000 cost – $124,783 basis) is less than the
$75,217 recognized gain.

Yacht:
Personal casualty loss (without regard to the 10% of AGI limitation) = Fair
market value at date of theft – Insurance proceeds – Floor = $20,000 –
$12,500 – $100 = $7,400.
Auto:
Realized loss = Amount realized – Adjusted basis = $9,600 – $20,800 =
$11,200. The loss relates to a personal use asset. Therefore, it is not
recognized.
Trampoline:
$6,000 business casualty loss is deductible for AGI. The casualty loss is
measured by the adjusted basis of the property at the time of the theft. There
is no $100 or 10% of AGI floor for a business casualty.
Section Section
Recognized 1245 Casualty and 1231
b. Item Gain/Loss Recapture Theft Loss Gain
Land ($15,000) ($15,000)
Truck 991 $ 991
Rowing machine 3,900 3,900
Building 75,217 75,217
Yacht (7,400) ($7,400)
Auto -0-
Trampoline (6,000) (6,000)
$4,891 $60,217
Ordinary $6,000 Net Gain:
income business loss Receives
for AGI; LTCG
No Net treatment
personal loss **
from AGI*
Adjusted gross income computation:
Other sources $402,000
Ordinary income from depreciation recapture, as above 4,891
Long-term capital gain, as above 60,217
Business casualty loss, as above (6,000)
Adjusted gross income $461,108

*None of the personal use activity property casualty loss is deductible from AGI because
10% of the $461,108 AGI is greater than the casualty loss of $7,400.
13-18 2004 Comprehensive Volume/Solutions Manual

**Of the $60,217 § 1231 gain, $25,217 is unrecaptured § 1250 gain because according
to the 2002 Form 1040, Schedule D instructions, if the net § 1231 gain is greater than the
potential unrecaptured § 1250 gain, all of the unrecaptured § 1250 gain is in the § 1231
gain that is carried from Form 4797 to line 11 of the 2002 Form 1040 Schedule D. Thus,
the $60,217 § 1231 gain is comprised of $25,217 of unrecaptured § 1250 gain and
$35,000 of 10%/20% gain. There is no 8% gain because the taxpayer is probably going
to be out of the 15% bracket due to his very high AGI. References are to the 2002 tax
forms because the 2003 forms were not yet available.

pp. 13-33 to 13-36 and 13-38 to 13-47

56. a. If the property is residential real property, the § 1250 recapture rules apply and
some of the gain is § 1231 gain.

Selling price $89,000


Adjusted basis (18,000)
Recognized gain $71,000
Less: Gain recaptured by § 1250 ($100,000 – $18,000 = $82,000
accelerated depreciation; $82,000 – $72,700 straight-line
cost recovery = additional depreciation) (9,300)
§ 1231 gain $61,700

Of the $61,700 § 1231 gain, $61,700 is unrecaptured § 1250 gain because the
$82,000 of depreciation taken less the $9,300 § 1250 depreciation recapture is
greater than the § 1231 gain.

b. If the property is nonresidential real property, all the depreciation is subject to


recapture under § 1245.

Selling price $89,000


Adjusted basis (18,000)
Recognized gain (all § 1245 gain because the gain is less than the $71,000
$82,000 depreciation taken)

c. Willis, Hoffman, Maloney, and Raabe, CPAs


5191 Natorp Boulevard
Mason, OH 45040

March 17, 2003

Ms. Cora Hassant


2345 Westridge Street #23
Homer, MT 67342

Dear Ms. Hassant:

The purpose of this letter is to answer the tax question which we discussed last
week. Below you will find the specific question restated and the answer to it.

Question: What difference is there between the recapture rules for residential
rental real estate acquired in 1986 as opposed to residential rental real estate
acquired in 1987 and thereafter?
Property Transactions: Capital Gains and Losses, § 1231, Recapture Provisions 13-19

Answer: Residential rental real estate acquired in 1986 was eligible for
accelerated depreciation. If accelerated depreciation was used, the gain upon
disposition of the property may be partially taxable as ordinary income due to a
special tax rule called "§ 1250 recapture." Residential rental real estate acquired
in 1987 (and later years) is not eligible for accelerated depreciation. Therefore,
there is no depreciation recapture applicable to the gain from disposition of such
property. All of the gain is potentially taxable as capital gain.

Thank you for your inquiry. If we can be of any further service, please contact us.

Sincerely,

Walter Smith, CPA


Tax Partner

pp. 13-43 and 13-44

57. Joanne has two alternatives for helping Susan:

(1) Joanne could sell the equipment, but probably not to Susan since she could not
afford it. Joanne would have a taxable ordinary gain of $50,000 [$85,000 sale
price – ($135,000 cost – $100,000 depreciation)] due to depreciation recapture
under § 1245. After paying her tax of $19,300 ($50,000 X 38.6%), Joanne would
have $65,700 ($85,000 sale price – $19,300 tax) to give to Susan. That may not
be enough cash for Susan to buy the equipment she needs. It would not be
beneficial for Joanne to sell the equipment on the installment basis because all the
gain would be immediately recognized since all the gain is recapture gain.
p. 13-49

(2) Joanne could give the equipment to Susan. The $100,000 depreciation recapture
potential would carry over to Susan and Susan would take Joanne’s basis
($35,000) for the property. Any depreciation which Susan takes on the property
would increase the depreciation recapture potential. However, it appears that
Susan may not sell the property for quite a while and is probably in a lower tax
bracket than Joanne. p. 13-47

58. Terry has a basis of $63,000 (fair market value at the date of the father’s death) for the
equipment. His adjusted basis is $51,000 ($63,000 original basis – $12,000 depreciation)
at the time of the sale. His recognized $1,000 gain ($52,000 amount realized – $51,000
adjusted basis) is all ordinary gain due to § 1245 depreciation recapture since the gain
does not exceed the depreciation taken on the equipment. p. 13-47

59. Magenta will recognize a $5,000 [$37,000 (fair market value) – $32,000 (adjusted basis)]
gain on the property distribution. The gain will be ordinary income due to § 1245
depreciation recapture. p. 13-49

60. The key to this problem is that all equipment depreciation taken is subject to recapture as
ordinary income due to § 1245. However, if the equipment is sold for more than was
paid for it, the excess of the selling price over the original cost is § 1231 gain. There
appears to be three ways to allocate the purchase price:
13-20 2004 Comprehensive Volume/Solutions Manual

(1) Subtract the $100,000 total adjusted basis from the $300,000 selling price to yield
a $200,000 gain. Since total depreciation on the three assets exceeds $200,000,
all of the gain is § 1245 gain.

(2) Allocate the $300,000 selling price to each asset based on its relative original
cost. For instance, the driller would be sold for $37,113 ($120,000/$970,000 X
$300,000). The gains and losses using this approach are shown below.

Asset Alloc. S.P. Adj. Basis Gain


Skidder $ 71,134 $ 40,000 $ 31,134
Driller 37,113 60,000 (22,887)
Platform 191,753 -0- 191,753
Totals $300,000 $100,000 $200,000

The $31,134 gain would all be § 1245 gain because the skidder cost $230,000 and
was “sold” for $71,134. The $22,887 loss on the driller would be a § 1231 loss.
The $191,753 gain on the platform would all be § 1245 gain because it cost
$620,000 and was “sold” for $191,753.

(3) Allocate the $300,000 selling price to each asset based on its relative adjusted
basis. For instance, the driller would be sold for $180,000 ($60,000/$100,000 X
$300,000). The gains using this approach are shown below.

Asset Alloc. S.P. Adj. Basis Gain


Skidder $120,000 $ 40,000 $ 80,000
Driller 180,000 60,000 120,000
Platform -0- -0- -0-
Totals $300,000 $100,000 $200,000

The $80,000 skidder gain would all be § 1245 gain because the skidder cost
$230,000 and was “sold” for $120,000. The $120,000 gain on the driller would
be a $60,000 § 1245 gain (equals depreciation taken) and $60,000 § 1231 gain
(equals excess of sale price over original cost of $120,000). The sale of the
platform would generate no gain or loss because it was “sold” for nothing and the
adjusted basis was $0. p. 13-42

CUMULATIVE PROBLEMS
61. Gross income:
Schedule C income $30,000
Interest income (Note 1) 600
Dividend income (Note 2) 440
Alimony received 5,000
Net long-term capital gain (Note 3) 2,880
$38,920
Deductions for adjusted gross income:
50% of self-employment tax (Note 4) $2,120
70% of health insurance premiums (Note 5) 2,100
(4,220)
Adjusted gross income $34,700
Less: itemized deductions
Medical expenses (Note 6) $ 83
State income tax 1,830
Property Transactions: Capital Gains and Losses, § 1231, Recapture Provisions 13-21

Real estate tax 3,230


Home mortgage interest 8,137
Investment interest (Note 7) 830
Charitable contributions 940 (15,050)
Less: Personal exemption and dependency deductions (2 X $3,000) (6,000)
Taxable income $13,650

Tax on taxable income (Note 8) $ 1,346


Self-employment tax (Note 4) 4,239
Child care credit (Note 9) (480)
Child tax credit (Note 10) (600)
Estimated tax payments (6,000)
Net tax payable (or refund due) ($ 1,495)

See the tax return solution beginning on p. 13-25 of the Solutions Manual.

Notes

(1) The $800 of interest income from the State of Ohio bonds is excludible from
gross income.

(2) The $440 of dividends is comprised of: Blue $30 (10 shares X $3), Green $30
(30 shares X $1), Purple $30 (15 shares X $2), Yellow $100 (100 shares X $1),
White $100 (100 shares X $1), and Amber $150 (75 shares X $2).

(3) There is a $515 short-term capital loss and a $3,395 long-term capital gain. These
net to a $2,880 long-term capital gain. All of this gain is qualified 5-year gain.

Short-term: Blue [(10 shares X $72) – (10 shares X $80) = $80 loss] + Purple
[(15 shares X $33) – (15 shares X $62) = $435 loss] = $515 short-term loss.

Long-term: Green [(30 shares X $47) – (30 shares X $33) = $420 gain] + Yellow
[(100 shares X $46) – (100 shares X $18) = $2,800 gain] + Gold [(35 shares X
$12) – (35 shares X $7) = $175 gain] = $3,395 long-term gain.

(4) The self-employment tax is $30,000 Schedule C net income X .9235 X .153 =
$4,239. Half of the $4,239 or $2,120 is deductible as a for AGI deduction.

(5) The for AGI deduction for Sue’s health insurance deduction is $2,100 ($3,000
premiums X 70%). The $900 balance is treated as a medical expense on Schedule
A (itemized deductions). On Schedule A the $900 + $1,786 of other
unreimbursed medical expenses are combined and reduced by 7.5% of AGI. See
Note 6.

(6) The total medical expenses are $2,686 ($1,786 unreimbursed medical expenses
for Sue and Kania + $900 balance of medical insurance premiums). This amount
must be reduced by 7.5% of AGI.

Medical expenses $2,686


7.5% of AGI (7.5% X $34,700) (2,603)
Deductible medical expenses $ 83

(7) The $830 of interest expense is investment interest expense because Sue used the
loan proceeds to purchase investment assets. All of the $830 interest is deductible
13-22 2004 Comprehensive Volume/Solutions Manual

because it is less than her $1,040 ($600 interest income and $440 dividends) of
net investment income.

(8) Sue qualifies for head of household filing status. All $2,880 of net long-term
capital gain will be taxed at 8 percent since the taxable income does not exceed
$37,450—the point at which Sue would no longer be in the 15 percent rate
bracket.
Tax on TI – NCG ($13,650 – $2,880) from Tax Table $1,116
Tax on $2,880 NCG @ 8% 230
Total alternative tax $1,346

(9) The annual maximum of qualifying expenses for the child care credit is $2,400
with one eligible child. Since Sue has $34,700 of AGI, her credit percentage is
20%; so she receives a credit of $480 ($2,400 X .2).

(10) Sue’s 10-year old dependent son entitles her to a $600 child tax credit.

62. Justin qualifies as a head of household. He has $272,982 of adjusted gross income,
$256,412 of taxable income, $60,314 of Federal income tax on that taxable income, and
would have a net tax refund of $4,686. The computations appear below and are followed
by the completed 2002 Form 1040 and its schedules A, B, D, E and Forms 4562 and
4797.

Note: The alternative minimum tax was ignored in this solution.

Wages $ 87,000
Interest income—Blue 5,000
Interest income—State Bank 3,000
Rent income—Building 1 (Note 1) 8,455
Rent income—Building 2 (Note 2) 13,755
Rent income—Building 3 (Note 3) 22,474
Equipment sale ordinary income (Note 4) 14,000
Net long-term capital gain (Notes 5 and 6) 122,298
Total income $275,982
IRA deduction (3,000)
Adjusted gross income $272,982
Itemized deductions: State income taxes $ 4,300
Real estate taxes 5,600
Home mortgage interest 8,900
Charitable contributions 760
Phase out (4,070)
Total itemized deductions (Note 7) (15,490)
Taxable income before exemption deduction $257,492
Exemption deduction (Note 8) (1,080)
Taxable income $256,412

Tax on taxable income (Note 9) $ 60,314


Child tax credit (phased out) (-0-)
Net tax due after credits $ 60,314
Federal income tax withholding $20,000
Federal estimated tax payments 45,000
Total Federal income tax payments (65,000)
Net tax payable (or refund due) $ ( 4,686)
Property Transactions: Capital Gains and Losses, § 1231, Recapture Provisions 13-23

See the tax return solution on p. 13-35 of this Solutions Manual

Note 1: Rent revenue—building 1 $30,000


Repairs ($ 4,000)
Interest (12,000)
Miscellaneous (1,000)
Depreciation ($125,000 X .03636) (4,545)
Total expenses (21,545)
Net income $ 8,455

Note 2: Rent revenue—building 2 $47,000


Repairs ($ 5,000)
Interest (17,000)
Miscellaneous (2,300)
Depreciation ($246,000 X .03636) (8,945)
Total expenses (33,245)
Net income $13,755

Note 3: Rent revenue—building 3 $88,000


Repairs ($ 8,000)
Interest (37,000)
Miscellaneous (7,800)
Depreciation ($400,000 X .03636 X 10.5/12)
(Sold after 10.5 months of 2002) (12,72
6)
Total expenses (65,526)
Net income $22,474

Note 4: $14,000 equipment sale price – $0 adjusted basis = $14,000 § 1245


ordinary gain because $25,000 of depreciation was taken on the property.

Note 5: $450,000 building 3 sale price – ($400,000 cost – $57,572 pre-2002


depreciation – $12,726 2002 depreciation) = $120,298 § 1231 gain.
$70,298 of the gain is potential 25% gain (equals depreciation taken) and
the $50,000 balance of the gain is potential 10%/20% gain. None of the
gain is potential 8% gain because the building was not held longer than
five years.

Note 6: $2,000 capital gain distribution + $120,298 § 1231 gain treated as a long-
term capital gain = $122,298 net long-term capital gain. $52,000 is
potential 10%/20% gain and $70,298 is potential 25% gain.

Note 7: The itemized deduction reduction applies since AGI exceeds $137,300.
Itemized deductions total $19,560, but only $15,490 {$19,560 –
[($272,982 – $137,300) X .03]} is deductible.

Note 8: Since AGI exceeds $171,650, the personal and dependency exemption
deduction is subject to a phaseout. The $6,000 (2 X $3,000) deduction is
reduced to $1,080. $272,982 AGI – $171,650 head of household phaseout
threshold = $101,332; $101,332/$2,500 = 40.5328; rounded up to 41; 41
X 2% = 82% phaseout; $6,000 – ($6,000 X .82) = $1,080.
13-24 2004 Comprehensive Volume/Solutions Manual

Note 9: The alternative tax on taxable income yields a lower tax because of the net
long-term capital gains. The tax is $60,314. This is the sum of the tax on
ordinary taxable income of $134,114 [($256,412 TI – $122,298 net
LTCG) = $32,339]; the tax on the 25% gain portion of the $122,298 net
LTCG [($70,298 X .25) = $17,575]; and the tax on the 20% gain portion
of the net LTCG [($52,000 X .20) = $10,400].
Property Transactions: Capital Gains and Losses, § 1231, Recapture Provisions 13-25

61.
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