Solutions to Chapter 7 Problems



Solutions to Chapter 7 Problem Assignments

Check Your Understanding

3. Realized vs. Recognized Gain

Explain the difference between a realized gain and a recognized gain.

Solution: A realized gain is the excess of the amount realized on a sale or exchange over the adjusted basis of the property sold or exchanged. The recognized gain is the amount of this realized gain that will be treated as income and subject to tax on the seller’s income tax return.

4. Asset Classification

What type of assets are Section 1231 assets? What type of assets are capital assets? What type of assets are ordinary income assets? Give several examples of each type of asset.

Solution: The most common Section 1231 assets are depreciable realty and personalty used in a trade or business and nondepreciable trade or business realty that have been held for more than one year. Long-term capital gain property held for the production of income that is involuntarily converted is also Section 1231 property. To qualify, all of these assets must have been held for more than one year. Section 1231 assets include machinery and equipment, office furniture and fixtures, rental real estate, factory buildings and land held for future expansion of a business.

Capital assets include most investment properties and personal-use assets. They exclude inventory, real and depreciable property used in a trade or business, and accounts and notes receivable from the sale of inventory in the ordinary course of business. Capital assets include investment stocks and bonds and other investment property, personal residences, and personal property items such as furs, jewelry, autos, and clothing.

Ordinary assets include inventory, stock in trade, and accounts and notes receivable from inventory sales in the ordinary course of business. In addition, any asset that cannot be classified as a capital or Section 1231 asset must be an ordinary asset. Section1231-type assets that fail to meet the more-than-one-year holding period are generally ordinary income assets.

5. Recapture

Why do taxpayers have to recapture depreciation on depreciable assets sold at a gain? To which assets do the Section 1245 and 1250 recapture provisions apply?

Solution: Taxpayers deduct depreciation expenses against ordinary income resulting in a tax savings equal to the depreciation expense times the ordinary income marginal tax rate. Without recapture, all of the gain that is realized and recognized on the disposition of a depreciable asset would be Section 1231 gain and could receive favorable tax treatment as long-term capital gain. To ensure that all or part of the gain that results from the basis reduction for depreciation is taxed at ordinary income rates, depreciation recapture was instituted.

Section 1245 full recapture and Section 1250 partial recapture apply to depreciable property (including property on which Section 179 expensing was claimed) that has been disposed of at a gain (it does not apply to losses). Section 1245 property includes all depreciable personalty and Section 1250 applies to most depreciable realty.

7. Section 291 Recapture

What is Section 291 recapture? Compare this to unrecaptured Section 1250 gains.

Solution: Section 291, applicable only to corporations, requires corporations to recapture (tax as ordinary income) an additional amount of Section 1231 gain beyond the recapture amount required by the Section 1250 recapture rules. This recapture applies even if there is no required Section 1250 recapture on the realty sold and it simply converts part of the Section 1231 gain realized to ordinary income. Section 291 recapture is 20% of the excess of Section 1245 recapture (as if Section 1245 recapture applied) over the Section 1250 recapture. This corporate recapture rule eliminates some of the capital gains that would otherwise be available to offset capital losses as corporations can only offset capital losses with capital gains.

Unrecaptured Section 1250 gains apply to individual taxpayers. This provision applies a maximum 25% tax rate to gains on the sale of realty that would be a Section 1250 gain if all prior depreciation were recaptured (similar to the rules for Section 1245 recapture). These capital gains would usually be taxed at a 15% capital gains tax rate otherwise.

8. Section 1231 Netting

How are net losses treated in the Section 1231 netting process? How is a net Section 1231 gain taxed?

Solution: Net Section 1231 losses that are the result of the Section 1231 netting process are deductible from ordinary income of both corporations and individuals. When there is a net Section 1231 gain, the taxpayer must first recapture as ordinary income any unrecaptured Section 1231 losses from the previous five years. The remaining net Section 1231 gain enters the capital asset netting process and can offset capital losses. If the taxpayer has no capital gains or losses, the net Section 1231 gain is included in the taxpayer’s income for taxation. In this case, the net Section 1231 gains of corporations are taxed as ordinary income, but the net Section 1231 gains of individuals are taxed as long-term capital gains subject to a maximum 15% capital gains tax rate.

12. Capital Gains Tax Rates

What tax rates apply to an individual’s long-term capital gains on the sale of stocks, antiques and collectibles, and unrecaptured Section 1250 gains?

Solution: The general maximum tax rate for long-term capital gains for individuals is 15%. The maximum tax rate for gains on antiques and collectibles is 28% and the maximum tax rate for unrecaptured Section 1250 gains is 25%. These tax rates may be modified if the individual’s marginal tax rate on ordinary income is less than these rates. To the extent the taxpayer’s taxable income (including capital gains) does not exceed the 15% tax bracket, the 25% and 28% assets are taxed at the 15% rate and the 15% assets are taxed at zero percent.

13. Section 1244 Stock

What is the significance of having stock qualify as Section 1244 stock?

Solution: Up to $50,000 of the loss ($100,000 if married filing jointly) on the sale of Section 1244 stock in any year may be treated as an ordinary loss rather than as a capital loss. Any loss in excess of this limit is capital loss. This provision only applies to individuals or partnerships that are the original owners of the stock.

Crunch the Numbers

17. Realized Gain or Loss

Charlie sold Whiteacre for $40,000 cash and the buyer assumed Charlie’s $19,000 mortgage on the property. Charlie paid a realtor commission of $2,000 on the sale. What is his realized gain or loss if Whiteacre has an adjusted basis of

a. $47,000?

b. $67,000?

Solution: a. ($40,000 + $19,000 - $2,000) - $47,000 = $10,000 realized gain.

b. ($40,000 + $19,000 - $2,000) - $67,000 = $10,000 realized loss.

18. Determination and Character of Gains and Losses

Allan received $5,000 cash and an auto worth $15,000 in exchange for land that was encumbered by a $13,000 liability that the buyer assumed.

a. What is the amount realized on this sale?

b. If Allan had a basis of $34,000 in the land, what is his gain or loss on the sale?

c. If Allen has owned the land for five years as an investment, what is the character of the gain or loss?

d. How would your answer to (c) change if the land had been used by Allan’s business as a parking lot?

Solution: a. $5,000 + $15,000 + $13,000 = $33,000 amount realized.

b. $33,000 - $34,000 = $1,000 loss.

c. Long-term capital loss.

d. If the property had been used in a business, it would be Section 1231 property and Allan would have a Section 1231 loss.

19. Determination and Character of Gain

Corgill Corporation sold land that it had used for storing old equipment. Corgill owned the land for seven years and it had a basis of $234,000. Corgill received $50,000 cash and a note for $100,000 and the purchaser assumed Corgill’s $150,000 mortgage on the property. Corgill also paid a realtor’s fee of $15,000 and other selling expenses of $2,000.

a. What is Corgill’s gain or loss on the sale and what is its character?

b. If Corgill had held the land as an investment, how would your answer change?

Solution: a. $50,000 + $100,000 + $150,000 - $15,000 - $2,000 - $234,000 = $49,000 Section 1231 gain.

b. As an investment, the gain would be long-term capital gain.

21. Determination and Character of Gains and Losses

DDF Corporation sold land it had used for parking and storage for 20 years for $575,000. Its basis in the land was $68,000. It also sold some manufacturing equipment for $125,000 that it replaced with more modern equipment. The equipment sold had a basis of $760,000.

a. Determine the amount and character of DDF’s gains or losses on these sales.

b. If DDF has no other property transactions, how is the net gain or loss treated?

Solution: a. DDF has $507,000 ($575,000 - $68,000) Section 1231 gain on the land sale. It has a $635,000 ($125,000 - $760,000) Section 1231 loss on the sale of the equipment.

b. The $635,000 loss is netted against the $507,000 gain. The result is a $128,000 net Section 1231 loss that is deducted against DDF Corporation’s ordinary income.

22. Determination and Character of Gain

Barry Corporation sold a machine used in its business for two years for $27,000. The machine originally cost $24,000 and it had an adjusted basis at the time of the sale of $17,000. Determine the amount and type of gain realized on the sale.

Solution: $27,000 - $17,000 = $10,000 total gain. $7,000 ($24,000 - $17,000) of the gain is taxed as ordinary income due to Section 1245 recapture; the remaining $3,000 gain is Section 1231 gain.

23. Determination and Character of Gains and Losses

The Grid Corporation owns a bank of boring machines. They regularly replace two machines each year. In the current year, the company sold Machine 8 for $12,000. It was purchased six years earlier for $40,000 and its adjusted basis was $14,000. Machine 6 was sold for $24,000. It was purchased four years ago for $45,000 and had an adjusted basis of $19,000.

a. How much gain or loss is realized on each asset?

b. What is the character of the gain or loss?

c. If the company disposed of no other assets during the year, how are the results of these sales treated for tax purposes?

Solution: a. Machine 8: $12,000 – $14,000 = $2,000 loss realized. Machine 6: $24,000 - $19,000 = $5,000 gain realized.

b. The machines are Section 1231 property. The loss on Machine 8 is a Section 1231 loss; the gain on Machine 6 is ordinary income due to Section 1245 recapture because the gain is less than the prior depreciation deductions ($45,000 - $19,000 = $26,000 accumulated depreciation).

c. The $2,000 loss is deducted directly from ordinary income; the $5,000 Section 1245 recapture is included directly in ordinary income.

24. Determination and Character of Gains and Losses

Jonas, an individual, acquired a building nine years ago for $650,000. He sold it in the current year for $680,000 when its adjusted basis was $500,000. Determine the amount and type of gain or loss realized on the sale

a. if the building is a factory.

b. if the building is an apartment complex.

c. if Jonas is a corporation rather than an individual.

Solution: a. $680,000 - $500,000 = $180,000 Section 1231 gain; $150,000 ($650,000 - $500,000) of this gain would be unrecaptured Section 1250 gain subject to a maximum 25% rate.

b. $680,000 - $500,000 = $180,000 Section 1231 gain; $150,000 ($650,000 - $500,000) of this gain would be unrecaptured Section 1250 gain subject to a maximum 25% rate.

c. $30,000 Section 291 recapture ($150,000 x 20%); the remaining $150,000 ($180,000 - $30,000) of gain is Section 1231 gain.

26. Section 1231 Recapture

Barbara had the following Section 1231 gains and losses in the previous four years:

|Year |Section 1231 gain (loss) |

|1 |$50,000 |

|2 | (45,000) |

|3 |$20,000 |

|4 |$15,000 |

a. How will Barbara treat a $25,000 gain in year 5?

b. Is there any unrecaptured Section 1231 loss remaining?

Solution: a. Only $10,000 of the $25,000 of Section 1231 gain must be recaptured as ordinary income; Barbara deducted a $45,000 Section 1231 loss in year 2, and $35,000 ($20,000 + $15,000) was recaptured in years 3 and 4. The remaining $15,000 ($25,000 - $10,000 recaptured) of the gain is simply Section 1231 gain.

b. There is no unrecaptured loss remaining after year 5.

27. Recapture

The Angel Corporation acquired an office building for $600,000 12 years ago. The corporation claimed $80,000 of cost recovery deductions before it sold the building for $700,000.

a. Determine the amount and type of gain or loss that Angel Corporation must recognize on the sale of the building.

b. Would your answer change if Angel were a sole proprietorship?

c. Would your answer change if Angel Corporation incurred $43,000 of Section 1231 losses in the prior year?

Solution: a. $700,000 – ($600,000 - $80,000) = $180,000 total gain. Only $80,000 of this gain is subject to Section 291 recapture, however, as that is the limit of Section 1245 recapture if that provision applied. Thus, the Section 291 recapture = 20% x $80,000 = $16,000. The corporation recognizes $16,000 of ordinary income due to Section 291 and the remaining $164,000 ($180,000 – $16,000) is Section 1231 gain.

b. If Angel were a sole proprietorship, there would be no Section 291 recapture. The entire $180,000 gain would be Section 1231 gain; however, the $80,000 unrecaptured Section 1250 gain would be subject to the 25% capital gains tax rate when included in the sole proprietor’s tax return.

c. If Angel Corporation has $43,000 of Section 1231 losses in the prior year, $43,000 of the $164,000 Section 1231 gain would be recaptured (under the look-back rules) and included in ordinary income (along with the $16,000 Section 291 recapture). Only the remaining $121,000 ($180,000 - $16,000 - $43,000) is Section 1231 gain.

28. Section 1245/1250 Recapture

Performance Industries, Inc. sold three pieces of equipment and a small building on March 1, year 6. Data on these disposals are as follows:

|Machine |Cost |Date Acquired |Depreciation |Selling Price |

|1 |$45,000 |April 24, year 2 |$35,000 |$19,000 |

|2 |$105,000 |May 2, year 1 |$90,000 |$24,000 |

|3 |$63,000 |June 4, year 4 |$12,000 |$66,000 |

|Building |$400,000 |April 30, year 1 |$45,000 |$425,000 |

a. Determine the amount and character of the gain or loss on each of these machines.

b. Determine the sum of each type of gain or loss and the net effect these gains/losses have on Performance Industries’ net income.

c. How would your answer change if Performance Industries had $6,000 of Section 1231 losses in year 3?

Solution: a. Machine #1: $19,000 – ($45,000 - $35,000) = $9,000 Section 1245 recapture.

Machine #2: $24,000 – ($105,000 – $90,000) = $9,000 Section 1245 recapture.

Machine #3: $66,000 – ($63,000 - $12,000) = $12,000 Section 1245 recapture; $3,000 Section 1231 gain.

Building: $425,000 - ($400,000 - $45,000) = $70,000 total gain; $9,000 (20% x $45,000) is Section 1250 gain (by operation of Section 291); the remaining $61,000 ($70,000 - $9,000) gain is Section 1231 gain.

b. Performance Industries would have $39,000 in ordinary income [$30,000 Section 1245 recapture and $9,000 Section 1250 gain (by operation of Section 291)] and $64,000 in long-term capital gain (from the Section 1231 gains), increasing net income by $103,000.

c. If Performance had $6,000 of Section 1231 losses in year 3, it would be required to treat $6,000 of its Section 1231 gain as ordinary income, reducing its Section 1231 gain to $58,000 ($64,000 - $6,000) and subsequently reducing the long-term capital gain to $58,000.

29. Capital Gains and Losses

Determine the amount of the capital gain or loss in each of the following transactions and state whether the gain or loss is long term or short term.

a. 100 shares of Bilco stock bought for $8,000 on January 22 of year 3 and sold for $10,000 on January 22 of year 4.

b. 20 acres of investment land bought for $8,000 on January 31 of year 3 and sold for $7,000 on February 2 of year 4.

c. 150 shares of Dantron stock bought for $15,000 on April 1 of year 3 and sold for $17,000 on May 28 of year 5.

Solution: a. $10,000 – $8,000 = $2,000 short-term capital gain (held only one year).

b. $7,000 - $8,000 = $1,000 long-term capital loss.

c. $17,000 - $15,000 = $2,000 long-term capital gain.

31. Capital Asset Netting

In the current year, Serena sold investment land for $105,000 that she purchased six years ago for $61,000; a diamond engagement ring for $1,800 that her ex-fiancée had given her nine months ago (purchased for $2,500 a week before giving it to her); 2,000 shares of stock for $14,000 that had been purchased two years ago for $18,000; and a personal auto for $12,000 purchased two months ago for $10,900. Determine the capital gain or loss on each sale, if it is short- or long-term, and the result of the capital asset netting process.

Solution: Investment land: $44,000 ($105,000 - $61,000) long-term capital gain; Engagement ring: $700 ($1,800 - $2,500) short-term capital loss that is a nondeductible personal loss; Stock: $4,000 ($14,000 - $18,000) long-term capital loss; Auto: $1,100 ($12,000 - $10,900) short-term capital gain. Netting the $44,000 LTCG with the $4,000 LTCL yields a net $40,000 LTCG. Serena must include both the net $40,000 LTCG and the $1,100 STCG in her income. The STCG is taxed at her marginal tax rate and the LTCG is taxed at a maximum rate of 15%. Although the auto was also a personal asset, she is not allowed to offset the nondeductible personal loss on the ring against the gain on the auto.

32. Capital Asset Netting

Sharon has salary income of $68,000, a net short-term capital gain of $15,000, and a net long-term capital loss of $24,000. What is Sharon’s adjusted gross income if she has no other income items?

Solution: $65,000. Netting the $15,000 STCG with the $24,000 LTCL results in a $9,000 LTCL. Sharon can deduct only $3,000 of this capital loss in the current year; thus, her adjusted gross income is $65,000 ($68,000 - $3,000). She can carry the remaining $6,000 LT capital loss forward.

33. Section 1231 Netting with Prior Section 1231 Loss

Wilma had a loss of $25,000 on some bearer bonds that were stolen and never recovered. She suffered a $20,000 loss when a piece of land she had held as an investment was condemned to make way for a new city park. She also had a Section 1231 gain of $60,000 and a Section 1231 loss of $15,000 from asset sales by her sole proprietorship.

a. Determine the result of both Step 1 and Step 2 of the Section 1231 netting process and explain the treatment of the resulting gain or losses.

b. How would your answer change if Wilma had a Section 1231 loss of $12,000 two years ago?

Solution: a. Wilma has a $25,000 casualty loss on the bearer bonds (an investment asset) that is the only item in Step 1 of the Section 1231 netting process; as a result it is deductible immediately as an investment casualty loss. In Step 2 of the netting process, Wilma will net the $20,000 loss on the condemned land (an investment asset) with the $60,000 Section 1231 gain and the $15,000 Section 1231 loss for a net Section 1231 gain of $25,000. This $25,000 net gain will enter the capital asset netting process and will be treated as if it is a long-term capital gain.

b. If Wilma had a Section 1231 loss two years ago, she would be required to recapture $12,000 of her Section 1231 net gain from Step 2 of the netting process as ordinary income. Only the remaining $13,000 ($25,000 - $12,000) of the Section 1231 gain would enter the capital asset netting process to be treated as a long-term capital gain.

35. Capital Asset and Section 1231 Netting

An individual taxpayer has the following gains and losses from property transactions. What is the effect on the taxpayer's taxable income?

|$ 4,000 |Long-term capital gain |

|7,000 |Long-term capital loss |

|10,000 |Section 1231 gain |

|6,000 |Section 1231 loss |

|3,000 |Short-term capital gain |

|6,000 |Short-term capital loss |

Solution: Taxable income is reduced by $2,000.

Step 1. Net the $10,000 Section 1231 gain with the $6,000 Section 1231 loss; the result is a net Section 1231 gain of $4,000.

Step 2. Net the $4,000 Section 1231 gain with the long-term capital gains and losses; the result is a net $1,000 long-term capital gain ($4,000 + $4,000 - $7,000).

Step 3. The $3,000 short-term capital gain is netted with the $6,000 short-term capital loss; the result is a net $3,000 short-term capital loss.

Step 4. The $3,000 STCL and $1,000 LTCG are netted; the result is a $2,000 STCL. This loss is deducted from the taxpayer’s other income, reducing taxable income by $2,000.

38. Section 1244 Stock

Vanessa bought 2,000 shares of Barbco stock when the company was formed for $107,000. The company had $900,000 of total capital upon formation; thus, it qualified as Section 1244 stock. Vanessa sold the stock three years later for $3,000. If Vanessa is single, how much and what kind of gain or loss does she have?

Solution: Vanessa has a total loss on the Section 1244 stock of $104,000 ($3,000 – $107,000). She can treat $50,000 of the loss as an ordinary loss, deductible from ordinary income. The remaining $54,000 loss is a long-term capital loss. She can deduct $3,000 this year as a capital loss giving her a total deduction of $53,000 in the current year. The remaining $51,000 of the long-term capital loss can only be carried forward and deducted at a rate of $3,000 per year after offsetting other net capital gains in future years.

40. Section 1244 Stock

George bought 6,000 shares of Section 1244 stock from Dorado Corporation six years ago for $160,000. The company has not done well so this year George sold all of his stock for $45,000.

a. Determine the amount and type of George’s loss if he is single.

b. How would your answer change if George is married and files a joint return?

Solution: a. George has a loss on the Section 1244 stock of $115,000 ($160,000 - $45,000). As a single person, he can deduct only $50,000 of this loss as an ordinary loss plus $3,000 of the remaining loss as a capital loss from his other income. The remaining $62,000 ($115,000 - $53,000) of the loss will have to be carried forward as a capital loss and deducted against future capital gains and/or deducted at a rate of $3,000 per year if he has no capital gains.

b. If George is married and files a joint return, he can deduct $100,000 of the loss as ordinary income on the Section 1244 stock. He can still deduct an additional $3,000 as a capital loss. The remaining $12,000 loss ($115,000 - $103,000) must be carried forward as a capital loss.

44. Related Party Transaction

Marilyn owned 500 shares of Ibis stock that she purchased several years ago for $25,000. This year, she sold 200 of the shares to her brother for $7,000, its fair market value, when she wanted money for some plastic surgery. Determine Marilyn’s realized and recognized gain or loss on the sale and her basis in the 300 shares remaining. Determine her brother’s basis in the purchased stock and his realized and recognized gain or loss if he sells the shares for $12,000 the following year.

Solution: Marilyn’s basis in the shares sold = $10,000 [(200/500) x $25,000]. She has a realized loss of $3,000 ($7,000 - $10,000) but she can recognize none of it because the sale was to her brother. Her basis in her remaining 300 shares is $15,000 ($25,000 - $10,000 sold).

Her brother’s basis in the shares he purchased is the purchase price of $7,000. When he sells the stock for $12,000, he has a $5,000 realized gain ($12,000 - $7,000). He only has to recognize $2,000 of the gain, however, as he can offset his sister’s unrecognized $3,000 loss against his $5,000 gain.

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