GENERAL SCHEME OF TAXATION

long-term capital gains are taxed at a lower rate. Net capital loss is subject to deduction limitations.

CAPITAL ASSETS
1. Personal use assets and investment assets (land, stock) are the most common capital assets. Business assets are
ordinary assets
The gain would be a long-term capital gain if the asset was capital asset and held more than a year.
2. following are not capital assets
-Inventory; Accounts and notes receivable; Depreciable property or real estate used in a business.
-A patent; a secret formula or process; certain copyrights; artistic compositions; or letters
-Certain U.S. government publications.
-Supplies used in a business.
3. a. securities held by a dealer are inventory and are not subject to capital gain or loss treatment.
If a securities dealer clearly identifies certain securities as being held for investment purposes by the close of
business on the day of acquisition, they will be treated as a capital asset
If dealer redesignates the stock as held for resale (inventory) and then sells it, any gain is ordinary, but any loss is capital
loss.
b. § 1237 allows real estate investors capital gain treatment if the following requirements are met:
-The taxpayer may not be a corporation.
-The taxpayer may not be a real estate dealer.
-No substantial improvements may be made to the lots sold (Shopping centers)
-The taxpayer must have held the lots sold for at least 5 years, except for inherited property.
If these requirements are met, all gain is capital gain.
Sales of contiguous lots to a single buyer count as the sale of one lot.
Beginning with the tax year the sixth lot is sold, 5 percent of the revenue is potential ordinary income. That
potential ordinary income is offset by any selling expenses
A loss from the sale of subdivided real property is an ordinary loss
c. nonbusiness bad debt is treated as a short-term capital loss.

Maria meets the requirements of § 1237 (subdivided realty). In 2019, she begins selling lots and sells four separate
lots to four different purchasers. She also sells two contiguous lots to another purchaser. The sales price of each lot is
$30,000. Maria’s basis for each lot is $15,000. Selling expenses are $500 per lot.
a. What are the realized and recognized gain?
Realized and recognized gain: 6*30,000-6*500-6*15,000=87,000
b. Explain the nature of the gain
The entire 87,000 is long-term capital gain from the sale of the first five lots. Contiguous or adjacent lots sold to a
single purchaser count as one lot.
c. Would your answers change if, instead, the lots sold to the fifth purchaser were not contiguous? If so, how?
The total lots sold would be six rather than five. Because Maria has now sold 6 lots, 5% of the total selling price is
treated as ordinary income. This ordinary income is offset by any selling expenses
5%*180,000-3000=6000 (ordinary income)
The remaining 81,000 recognized gain is long-term capital gain.

SALE OR EXCHANGE
1. Worthless Securities and 1244 Stock
1. When a security becomes worthless, it is treated as long-term capital loss
2. Section 1244 allows an ordinary loss on the disposition of small business corporation stock. However, the
ordinary loss treatment is limited to $50,000
2. Retirement of Corporate Obligations
Original issue discount (OID) arises when the issue price is less than the maturity value. The OID amortization added
to basis for the bond.
Fran acquires $1,000 of Osprey Corporation bonds for $980 in the open market. If the bonds are held to maturity, the
$20 difference is treated as capital gain.
Jerry purchases $10,000 of newly issued White Corporation bonds for $6,000. The bonds have OID of $4,000. Jerry
must amortize the discount over the life of the bonds. After Jerry has amortized $1,800 of OID, he sells the bonds for $8,000.
Jerry has a capital gain of $200 [8000-(6000cost+1800 OID amortization)]
3. Options
1. An option gives the potential buyer (grantee) the right to purchase property at a set price during a specified
time period from the owner (grantor). The grantee pays the grantor for this right.
2. grantee’s sale or exchange of the option results in capital gain or loss if the option property is a capital asset
3. If an option holder fails to exercise the option, the loss is a capital loss if the property subject to the option is
a capital asset
The grantor of an option on stocks, securities, commodities, or commodity futures receives short-term capital
gain treatment. Options on property other than stocks, securities, commodities, or commodity futures result in
ordinary income to the grantor
4. If the option is exercised, the amount paid for the option is added to the optioned property’s selling price. The
grantee adds the cost of the option to the basis of the property purchased.
Maurice purchases 100 shares of Eagle Company stock for $5,000. On April 1, 2019, he writes a call option on the stock,
giving the grantee the right to buy the stock for $6,000 during the following six-month period. Maurice (the grantor) receives
a call premium of $500 for writing the call.
If the call is exercised by the grantee, Maurice has $1,500 ($6,000 +$500 -$5,000) of short-term capital gain from the
sale of the stock. The grantee has a $6,500 ($500 option premium +$6,000 purchase price) basis for the stock.
Assume that the original option expired unexercised. Maurice has a $500 short-term capital gain. The grantee has 500
capital loss.
4. Patents
1. If all substantial rights relating to a patent are transferred by the “qualifying holder”, the disposition is
automatically considered a sale of a long-term capital asset regardless of whether the patent is a capital asset and
regardless of how long the patent was retained by the holder.
2. A qualifying holder of a patent must be an individual and is usually the creator of the invention or an
individual who purchases the patent rights before the patented invention is put into production. The creator's
employer are not eligible for long-term capital gain treatment, the gain from sale of patent is ordinary gain.
5. Franchises, Trademarks, and Trade Names
1. noncontingent payment can be considered capital gain if the transferor does not retain any significant
power, right, or continuing interest. The franchisee capitalizes the payments and amortizes them over 15 years.
2. noncontingent payments are ordinary income to the transferor if the transferor does not retain any
significant power. The franchisee capitalizes the payments and amortizes them over 15 years.
3. Contingent franchise payments produce ordinary income for the transferor and ordinary deductions for the
franchises in all situations.
Freys, Inc., sells a 12-year “stuffed potato” franchise to Reynaldo. The franchise contains many restrictions on how
Reynaldo may operate his store. When the franchise contract is signed, Reynaldo makes a noncontingent $160,000
payment to Freys. During the same year, Reynaldo pays Freys $300,000—14% of Reynaldo’s sales. How does Freys
treat each of these payments? How does Reynaldo treat each of the payments?
Freys has retained significant power and rights in the franchise agreement. Section 1253 requires that Freys treat the
160,000 lump-sum noncontingent payment and 300,000 contingent payment as ordinary income. Reynaldo may
amortize the 160,000 noncontingent payment over 15 years. Reynaldo may currently deduct the $300,000 contingent
payment as business expense.
6. Lease Cancellation Payments
1. Payments received by a lessee (tenant) in consideration of a lease cancellation produce capital gains
Mark owns an apartment building that he is going to convert into an office building. Vicki is one of the apartment tenants
and receives $1,000 from Mark to cancel the lease.
Vicki has a capital gain of $1,000. Mark has an ordinary deduction of $1,000.
2. Payments received by a lessor (landlord) are always ordinary income
Floyd owns an apartment building near a university campus. Hui-Fen is one of the tenants. Hui-Fen is graduating early and
offers Floyd $800 to cancel the apartment lease. Floyd accepts the offer.
Floyd has ordinary income of $800. Hui-Fen has a nondeductible payment because the apartment was personal use property.

HOLDING PERIOD
1. Property must be held more than one year to qualify for long-term capital gain or loss treatment.
2. Special Holding Period Rules
1. Holding period of property received in a nontaxable exchange includes the holding period of the former asset
2. When a gift occurs, the donor’s holding period is tacked onto the recipient’s holding period. (gain rule applies
3. The holding period for inherited property is treated as long term

TAX TREATMENTOF NONCORPORATE TAXPAYERS

1. Net long-term capital gains of noncorporate taxpayers are eligible for an alternative tax calculation that normally
results in a lower tax liability.
2. Net short-term capital gain are treated as ordinary income at marginal tax rate.
3. The 25% gain is called the unrecaptured § 1250 gain.
The 28% gain relates to collectibles and small business stock gain
collectibles include: Any work of art; Any rug or antique; Any metal or gem; Any stamp; Any alcoholic beverage.
Most coins; Any historical objects
4. qualified small business stock. Any amount not excluded from income is taxed at 28 percent
100 percent of the gain is excluded for qualified stock acquired after September 27, 2010.
75 percent of the gain is excluded for qualified stock acquired after February 17, 2009, and before September
28, 2010.
50 percent of the gain is excluded for qualified stock acquired before February 18, 2009.
Additional requirements including:
The company’s assets must not exceed $50 million when the stock was issued.
The exclusion is limited to the greater of 10 times the stock's basis or $10 million per taxpayer
The taxpayer must have held the stock for greater than 5 years.
5. QDI is added to the net 0%/15%/20% gain long-term capital gain
6. An individual taxpayer can deduct up to $3,000 of capital losses against ordinary income.
If you have both Short term and Long-term Capital Losses, you use the Short term first for the $3,000 limit.

In March 2019, Yolanda realized a $100,000 gain on the sale of qualified small business stock that she acquired in 2006.
Yolanda’s marginal tax rate is 32% without considering this gain.
As the stock was acquired before February 18, 2009, $50,000 of this gain (50%) is excluded from gross income, and the
other $50,000 is taxed at the maximum rate of 28%. As a result, Yolanda owes Federal income tax of $14,000 (50,000*28%)
on the stock sale, an effective tax rate of 14% on the entire $100,000 gain.

Rachel purchased $100,000 of qualified small business stock when it was first issued in October 2002. This year, she sold
the stock for $4 million. Her gain is $3.9 million ($4,000,000-$100,000).
Although this amount exceeds 10 times her basis ($100,000 *10 = $1,000,000), it is less than $10 million. As a result, the
entire $3.9 million gain is eligible for a 50% exclusion.

Jane and Blair are married taxpayers filing jointly and have 2019 taxable income of $107,000. The taxable income
includes $5,000 of gain from a capital asset held five years, $2,100 of gain from a capital asset held seven months, and
$13,000 of gain from a capital asset held four years. Jane and Blair also have qualified dividend income of $3,000.
What is the couple’s tax on taxable income and the related tax savings from the alternative tax computation (if any)?
Jane and Blair’s 107,000 taxable income is comprised of 86,000 other taxable income, 18,000 0% 15% 20% net long-
term capital gain (5000+13,000) and 3000 qualified dividend income.
Total tax using the alternative tax calculation:
Tax on other taxable income: (86,000-78950) * 0.22+9086=10637
Tax on 0% 15% 20% income: 0.15* 18000=2700
Tax on QDI: 0.15*3000=450
TOTAL=13787
Regular tax on 107,000 taxable income=15,257 [(107,000-78950) *0.22+9086]
Tax saving from alternative tax computation=15257-13787=1470

For 2019, Wilma has properly determined taxable income of $36,000, including $3,000 of unrecaptured § 1250 gain
and $8,200 of 0%/15%/20% gain. Wilma qualifies for head-of-household filing status. Compute Wilma’s tax liability
and the tax savings from the alternative tax on net capital gain.
Wilma has 24,800 of other taxable income [36,000-3000-8200]
Total tax using the alternative tax calculation:
Tax on other taxable income: (24800-13850) * 0.12+1385=2699
Tax on 25% gain= 3000*0.12=360
Tax on 0% 15% 20% income=8200*0%=0
Total=3059
Regular tax on 36000 taxable income (36,000-13850) * 0.12+1385=4043

Asok’s AGI for 2019 is $133,250. Included in this AGI is a $45,000 25% long-term capital gain and a $13,000
0%/15%/20% long-term capital gain. Asok is single and uses the standard deduction. Compute his taxable income, the
tax liability, and the tax savings from the alternative tax on net capital gain.
Asok’s taxable income is 121,050 (133,250 AGI-12,200 standard deduction). His other taxable income is 63050
(121,050-45,000-13,000)
Total tax using the alternative tax calculation:
Tax on other taxable income: (63,050-39475) *0.22+4543=9730
Tax on 25% gain=0.22*21,150+0.24*23850=10377
Tax on 0% 15% 20% income= 0.15*13,000=1950
Total=22057
Regular tax on 121050 taxable income: (121050-84200) * 0.24+14382.5=23227
Tax saving=1170
TAX TREATMENT OF CORPORATE TAXPAYERS
A. Capital gains are taxed at the ordinary corporate tax rates.
B. Capital gains can offset capital losses without limit. However, capital losses in excess of capital gains CANNOT
be used as a deduction against ordinary income.
C. There is a 3 year carryback and a 5 year carryforward allowed for net capital losses. The carrybacks and
carryforwards are always treated as short-term, regardless of their original nature.
Gray, Inc., a C corporation, has taxable income from operations of $1,452,000 for 2019. It also has a net long-term
capital loss of $355,000 from the sale of a subsidiary’s stock. The year 2019 is the first year in the last 10 years that
Gray has not had at least $500,000 per year of net long-term capital gains. What is Gray’s 2019 taxable income?
What, if anything, can it do with any unused capital losses?
Gray has taxable income of 1,452,000 because the 2019 355,000 net long-term capital loss cannot be deducted. Gray
can carryback that loss as a short-term capital loss against its 2016 capital gains, recalculate its 2016 tax liability, and
file a claim for refund.