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Chapter8PropertyDispositions

Chapter 8
Questions and Problems for Discussion
1.

a. Section 1231 asset.


b. Capital asset.
c.

Section 1231 asset.

d. Capital asset.
e. Noncapital asset.
f.

Capital asset.

g. Capital asset.
h. Section 1231 asset.
2.

In a sale of property, the amount realized consists of cash or a cash equivalent (purchasers
note). In an exchange of property, the amount realized includes noncash assets.

3.

If a taxpayer is relieved of a debt on the disposition of an asset (i.e., the purchaser assumes the
sellers debt), the relief of debt is an amount realized. If the taxpayer receives services in
exchange for the asset, the fair market value of the services is an amount realized.

4.

If a taxpayer has losses that could be deducted against gain recognized on an installment sale,
the taxpayer might elect out of the installment sale method. Alternatively, if the taxpayers
marginal rate in the year of sale is considerably lower than the projected marginal rate in future
years, the taxpayer might prefer to recognize the entire gain in the year of sale.

5.

The characterization of gain or loss for tax purposes has no effect on the computation of net
income per books.

6.

A firms tax basis in an asset includes any portion of the assets cost that the firm borrowed from
another party to purchase the asset, even if the asset is the collateral for the debt. A firms equity
in an asset equals the fair market value of the asset less any creditor claims on the asset.

7.

Corporation A generated its goodwill through its own business operations. Such internally
created goodwill is not a depreciable or amortizable business asset and, therefore, is a capital
asset by default. Corporation Z acquired its goodwill by purchase, thereby establishing an
amortizable cost basis in this business asset. Amortizable goodwill meets the definition of a
Section 1231 asset.

8.

Mrs. Carlys gain on sale will be capital gain only if the land is a capital asset in her hands.
Whether the land is a capital asset depends on how Mrs. Carly has held the land since she
acquired it eight years ago. If she held the land as inventory in a real estate business, the land is
not a capital asset, and her gain on sale will be ordinary income. If she held the land as an
investment, the land is a capital asset, and her gain on sale will be capital. The accountant
cannot answer the question without further information from Mrs. Carly.

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Chapter8PropertyDispositions
9.

a. Firm OP bears the entire risk of a $125,000 loss because it must repay $550,000 to the
creditor regardless of any decrease in the value of the land.
b. In this case, Firm OP bears the risk of loss for its $50,000 equity in the land, and the
commercial creditor bears the risk of loss for the $75,000 excess of the $550,000 debt over
the $475,000 value of the land.

10. While the sale may not be an arms length transaction because of the close personal relationship
between Mr. K and Mr. P, friends are not defined as related parties for tax purposes.
Consequently, Mr. K may recognize his realized loss on the sale.
11. Both corporate and noncorporate (individual) taxpayers prefer capital gains to ordinary income
because capital losses are deductible without limit to the extent of capital gains but are
nondeductible against ordinary income. Individuals have a second reason to prefer capital gains:
the preferential tax rates on such gains.
12. Under the Section 1250 partial recapture rule, only that portion of gain equal to the excess of
accelerated over straight-line depreciation is recaptured as ordinary income on the sale or
exchange of depreciable realty. Under MACRS, realty must be depreciated under the straightline method so no excess accelerated depreciation is possible.
13. If the insurance reimbursement exceeds the adjusted basis in property destroyed by casualty or
theft, the owner of the property realizes a gain on the involuntary disposition.
14. Firm F is adequately protected only if asset As market/replacement value does not exceed
$75,000. The adjusted basis of an asset does not reflect the value of the asset to Firm F.
Application Problems
1.

a. Amount realized on sale


Cost basis
$30,000
Accumulated book depreciation (12,000)
Adjusted book basis
Book loss

$13,000

b. Amount realized on sale


Cost basis
Accumulated tax depreciation
Adjusted tax basis
Tax gain

$13,000

c.

(18,000)
$(5,000)

$30,000
(19,100)
(10,900)
$2,100

Cash received on sale


Tax cost (30% $2,100 tax gain)
After-tax cash flow

$13,000
(630)
$12,370

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Chapter8PropertyDispositions
2.

a. $50,000 cost $37,200 acc. book depr. = $12,800 book basis


$50,000 cost $41,000 acc. book depr. = $9,000 tax basis
b. $41,000 tax depr. $37,200 book depr. = $3,800 excess tax depreciation
$3,800 favorable difference 35% = $1,330 deferred tax liability
c.

$14,750 amount realized $12,800 book basis = $1,950 book gain


$14,750 amount realized $9,000 tax basis = $5,750 tax gain

d. The $3,800 excess of tax gain over book gain is an unfavorable difference and a reversal of
the favorable difference represented by the excess tax depreciation through date of sale.
Therefore, this book tax difference results in a $1,330 reduction in the deferred tax liability
computed in b.
3.

a. Firm CS must recognize $38,500 ordinary income on the receipt of the securities as
payment for services rendered. CSs basis in the securities is $38,500.
b. Company P must recognize $13,500 capital gain on the transfer of the securities ($38,500
value of consulting services purchased - $25,000 basis).
c.

Assuming that Company P can deduct the consulting expense, the fact that the expense
was paid with a noncash asset is irrelevant. The amount of the deduction is $38,500.

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Chapter8PropertyDispositions
4.

a. Amount realized on sale


Basis in inventory
Gain realized on sale
Tax cost

$40,000
(15,700)
$24,300
.35
$8,505

Cash received on sale


Tax cost
After-tax cash flow from sale

$10,000
(8,505)
$(1,495)

b. Amount realized on sale


Basis in inventory
Loss realized on sale
Tax savings from loss deduction

$40,000
(47,000)
$(7,000)
.35
$2,450

Cash received on sale


Tax savings
After-tax cash flow from sale
c.

Amount realized on sale


Basis in inventory
Gain realized on sale

$5,000
2,450
$7,450

Tax cost

$40,000
(18,000)
$22,000
.35
$7,700

Cash received on sale


Tax cost
After-tax cash flow from sale

$40,000
(7,700)
$32,300

d. Amount realized on sale


Basis in inventory
Loss realized on sale
Tax savings from loss deduction

$40,000
(44,000)
$(4,000)
.35
$1,400

Cash received on sale


Tax savings
After-tax cash flow from sale

$40,000
1,400
$41,400

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Chapter8PropertyDispositions
5.

a. $100,000 ($15,000 cash + $85,000 relief of debt)


b. KNBs realized gain on sale is $60,000 ($100,000 amount realized $40,000 adjusted
basis), and the tax cost of the transaction is $20,400 ($60,000 gain 34%). Therefore,
KNBs after-tax cash flow is negative: $15,000 cash received $20,400 tax cost = $(5,400).

6.

a. Amount realized on sale:


Cash
Relief of mortgage

$40,000
166,700
$206,700

Cost
Acc. depr.
Adjusted basis
Gain recognized

$235,000
(184,200)
(50,800)
155,900

b. Cash received
Tax cost ($155,900 gain 35%)
After-tax cash flow from sale
7.

a. Amount realized on sale:


Cash
Purchasers note

$40,000
(54,565)
$(14,565)

$75,000
675,000
$750,000
(535,000)
$215,000

Adjusted basis
Gain realized on sale

b. $215,000 gain recognized. TPWs tax basis in the note at the end of year equals the notes
$641,250 face value ($675,000 original face value $33,750 August principal payment).
c.

$215,000 gain realized $750,000 contract price = 28.67% gross profit percentage.
Cash received in year of sale:
Cash at closing
$75,000
August principal payment 33,750
$108,750
.2867
$31,179

Gain recognized
Face value of note at end of year
Deferred gain:
Realized gain
$215,000
Recognized gain
(31,179)

(183,821)
$457,429

TPWs tax basis in note


8.

a. Book gain
Tax gain
Book/tax difference

$641,250

$215,000
(31,179)
$183,821

b. The excess of book gain over tax gain is a favorable difference.


c.

$183,821 35% = $64,338 deferred tax liability

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Chapter8PropertyDispositions
9.

a. $67,500 principal payment 28.67% = $19,352 gain recognized


b. Face value of note at end of year:
$641,250 $67,500 payment
Deferred gain:
Realized gain
$215,000
Recognized gain:
$31,179 + $19,352
(50,531)

(164,469)
$409,281

TPWs tax basis in note


10. a. Tax gain
Book gain
Book/tax difference

$573,750

$19,352
-0$19,352

b. The excess of tax gain over book gain is an unfavorable favorable difference.
c.

$19,352 35% = $6,773 reduction in deferred tax liability

11. a. Amount realized on sale:


Cash
Purchasers note

$15,000
80,000
$95,000
(61,000)
$34,000

Adjusted basis
Realized gain

$34,000 realized gain $95,000 contract price = 35.79% gross profit percentage
2004 recognized gain: $15,000 cash 35.79% = $5,369
2005 recognized gain: $8,000 cash 35.79% = $2,863
b. At date of pledge, Aldos basis in the installment note is $35,958 ($56,000 principal
$20,042 deferred gain [56,000 35.79%]). The pledge is treated as a disposition of the note
for $56,000 cash, which triggers recognition of the entire $20,042 deferred gain in 2007.
12. a. Amount realized on sale:
Cash
Purchasers note

$15,000
80,000
$95,000
(100,000)
$(5,000)

Adjusted basis
Realized and recognized loss in 2004

The installment sale method does not apply to realized losses


b. Because the installment sale method does not apply in this case, Aldos basis in the
installment note equals the notes principal balance. The pledge of the note as collateral has
no tax consequences.
13. a. $60,000 amount realized $45,250 basis = $14,750 gain recognized.
b. $60,000 amount realized $45,250 basis = $14,750 gain recognized. The fact that seller
and buyer are related parties is irrelevant.
c.

$38,000 amount realized $45,250 basis = $7,250 loss recognized.

d. $38,000 amount realized $45,250 basis = $7,250 loss realized, but no loss is recognized
because seller and buyer are related parties.
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Chapter8PropertyDispositions
14. a. PPR has a $110,000 cost basis in the land.
b. Because PPR and Silo are related parties, Silos $35,000 realized loss on sale of the land
was disallowed. PPR can use this loss when it sells the land as follows.
(1) PPRs $10,000 realized loss on sale = $10,000 recognized loss.
(2) PPRs $6,000 realized gain on sale $6,000 loss from Silo = -0- recognized gain.
(3) PPRs $40,000 realized gain on sale $35,000 loss from Silo = $5,000 recognized gain.
15. a. The inventory asset and the receivable attributable to the sale of inventory were noncapital
assets. Thus, Firm J recognized a $7,000 ordinary gain on sale of inventory and a $2,000
ordinary loss on sale of the receivable.
b. If the asset was a capital asset, the receivable attributable to its sale was also a capital
asset. Thus, Firm J recognized a $7,000 capital gain on sale of the asset and a $2,000
capital loss on sale of the receivable.
16. a. The facts strongly suggest that Firm RD converted the land into inventory held for sale to
customers in the regular course of business. In this case, RDs $532,000 gain is
characterized as ordinary gain.
b. In this case, the facts suggest that Firm RD held the land as an investment rather than as a
business asset, so the $532,000 gain is characterized as capital gain.
17. a. $13,000 amount realized $11,900 basis = $1,100 ordinary income from sale of inventory
b. $13,000 amount realized zero basis = $13,000 ordinary income on sale of a noncapital
asset
c.

$13,000 amount realized $14,250 basis = $1,250 ordinary loss on sale of a noncapital
asset

18. a. $6,000 amount realized zero basis = $6,000 ordinary income on sale of a creative asset by
the creator
b. $10,000 amount realized $6,000 cost basis = $4,000 ordinary income on sale of inventory
c.

$45,000 amount realized $10,000 cost basis = $35,000 capital gain on sale of a capital
asset (nondepreciable business personalty)

19. a. Koils taxable income is $732,400 ($718,400 ordinary income + $45,000 capital gain
$31,000 capital losses).
b. Koils taxable income is $735,400 ($718,400 ordinary income + $17,000 ordinary gain +
$22,300 capital gain $22,300 allowable capital loss). The $35,700 capital loss in excess of
capital gain is nondeductible this year.
c.

Koils taxable income is $709,600 ($718,400 ordinary income + $9,000 capital gain $9,000
capital loss $8,800 ordinary loss). The $7,100 capital loss in excess of capital gain is
nondeductible this year.

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Chapter8PropertyDispositions
20. a. PRSs taxable income is $300,000 ($300,000 consulting income + $36,000 capital gain $36,000 allowable capital loss). The $13,000 capital loss in excess of capital gain is
nondeductible in the current year.
b. PRSs taxable income is $287,000 ($300,000 consulting income + $36,000 ordinary gain $49,000 ordinary loss).
c.

PRSs taxable income is $336,000 ($300,000 consulting income + $36,000 ordinary gain).
The $49,000 capital loss is nondeductible in the current year.

d. PRSs taxable income is $287,000 ($300,000 consulting income + $36,000 capital gain $49,000 ordinary loss).
21. a. Zeno has a $27,400 nondeductible net capital loss in 2007. It can carry the loss back three
years to deduct against net capital gain in those years. Zeno can deduct $4,120 capital loss
carryback against 2005 capital gain and $13,600 capital loss carryback against 2006 capital
gain to generate a $6,025 tax refund ($17,720 34%).
b. Zenos capital loss carryforward is $9,680 ($27,400 $17,720).
22. a.
Operating income
Capital loss
Income

Book

Tax

$427,300
(13,590)
$413,710

$427,300
ND
427,300

b. The $13,590 excess of tax over book income is an unfavorable difference resulting in a
$4,621 deferred tax asset ($13,590 34%)
c.

Because KZ had a $11,900 net Section 1231 gain treated as capital gain, it can deduct
$11,900 of its capital loss carryforward from its first year.
Operating income
Section 1231 gain
Section 1231 loss
CL carryforward
Income

Book

Tax

$500,800
19,300
(7,400)

$500,800
19,300
(7,400)
(11,900)
$500,800

$512,700

d. The $11,900 excess of book over tax income is a favorable difference resulting in a $4,046
reduction ($11,900 34%) in the deferred tax asset that originated in the prior year.
Therefore, the deferred tax asset at the end of the year is $575.
23. a. $10,000 $12,685 adjusted basis = $2,685 Section 1231 loss
b. $13,000 $12,685 adjusted basis = $315 recaptured ordinary income
c.

$17,500 $12,685 adjusted basis = $4,815 recaptured ordinary income

d. $22,500 $12,685 adjusted basis = $7,315 recaptured ordinary income and $2,500 Section
1231 gain

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Chapter8PropertyDispositions
24

a. Zerons taxable income is $88,200 ($87,200 service income + $1,000 ordinary income +
$2,400 Section 1231 gain $2,400 capital loss). The $4,600 capital loss in excess of
Section 1231 gain is nondeductible in the current year.
b. Zerons taxable income is $80,600 ($87,200 service income $6,600 Section 1231 loss).
The $1,700 capital loss is nondeductible in the current year.
c.

Zerons taxable income is $93,810 ($87,200 service income + $3,900 ordinary income +
$1,510 Section 1231 gain + $1,200 capital gain).

d. Zerons taxable income is $80,900 ($87,200 service income $10,300 Section 1231 loss +
$4,000 capital gain).
e. Zerons taxable income is $88,900 ($87,200 service income + $2,800 Section 1231 gain +
$5,200 capital gain $6,300 capital loss).
25. QIOs gains and losses from assets sales are computed and characterized as follows.

Computer equipment
Construction equipment
Furniture
Transportation equipment

Amount
Realized

Adjusted
Basis

Realized
Gain/(Loss)

$4,500
50,000
4,750
55,000

$3,800
53,300
4,500
57,200

$700
(3,300)
250
(2,200)

QIOs taxable income is computed as follows.


Net income from operations
Ordinary income from asset sales
Deductible Section 1231 loss
Taxable income

$192,400
950
(5,500)
$187,850

8-9

Ordinary Section 1231


Gain
Gain/(Loss)
$700
$(3,300)
250
___
$950

(2,200)
$(5,500)

Chapter8PropertyDispositions
26. a. Sigmas gains and losses from sales of business assets are computed and characterized as
follows.

Production equipment
Business land
Business building

Amount
Realized

Adjusted
Basis

Realized
Gain/(Loss)

$30,000
180,000
210,000

$17,000
165,000
141,700

$13,000
15,000
68,300

Ordinary Section 1231


Gain Gain/(Loss)
$13,000
11,660*
$24,660

* 20 percent recapture of $58,300 accumulated depreciation


Sigmas taxable income is computed as follows.
Net income from operations
Ordinary income from sales of business assets
Section 1231 gain (treated as capital gain)
Sale of marketable securities:
Amount realized
$64,000
Basis
(144,000)
Realized loss
$(80,000)
Deductible loss limited to Section 1231 gain
Taxable income

$612,000
24,660
71,640

(71,640)
$636,660

b. Sigmas taxable income is computed as follows.


Net income from operations
Ordinary income from sales of business assets
Section 1231 gain
Sale of marketable securities:
Amount realized
$150,000
Basis
(144,000)
Capital gain
Taxable income

8-10

$612,000
24,660
71,640

6,000
$714,300

$15,000
56,640
$71,640

Chapter8PropertyDispositions
27. a. EzTechs gains and losses from sales of business assets are computed and characterized
as follows.
Amount
Adjusted
Realized
Ordinary Section 1231
Realized
Basis
Gain/(Loss)
Gain Gain/(Loss)
Machinery
Office equipment
Warehouse

$70,000
57,500
125,000

$57,840
37,530
141,880

$12,160
19,970
(16,880)

$12,160
12,470
0
$24,630

$7,500
(16,880)
$(9,380)

EzTechs net capital loss from the sale of its investment assets is computed as follows:

Investment securities
Investment land

Amount
Realized

Adjusted
Basis

Capital
Gain/(Loss)

$83,100
328,000

$72,700
350,000

$10,400
(22,000)
(11,600)

EzTechs taxable income is computed as follows.


Net income from operations
Ordinary gain from sales of business assets
Section 1231 loss
Taxable income

$994,300
24,630
(9,380)
$1,009,550

b. If EzTechs land was a Section 1231 asset instead of a capital asset, the $22,000 loss
recognized on sale would increase the corporations Section 1231 loss to $31,380, and
EzTechs taxable income is computed as follows.
Net income from operations
Ordinary gain from sales of business assets
Section 1231 loss
Capital gain from sale of investment securities
Taxable income

$994,300
24,630
(31,380)
10,400
$997,950

28. a. Corporation Q has $6,400 nonrecaptured Section 1231 losses from 2005 and 2006.
Therefore, the entire $4,000 Section 1231 gain recognized in 2007 is recaptured as ordinary
income.
b. In 2008, Corporation Q recognized a $14,700 net Section 1231 gain. It must recapture
$2,400 ($6,400 Section 1231 losses from 2005 and 2006 $4,000 recaptured in 2007) of
this gain as ordinary income. The $12,300 remaining gain is treated as capital gain.

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Chapter8PropertyDispositions
29. a. Amount realized on sale:
Cash
Relief of debt

$80,000
225,000
$305,000

Adjusted basis:
Cost
$315,000
Accumulated depreciation
(92,300)
(222,700)
$82,300

Realized and recognized gain

b. Lynn must recognize $16,460 gain (20% $82,300 recognized gain) as ordinary income
under the 20 percent recapture rule. The $65,840 remaining gain is Section 1231 gain.
c.

If Lynn is a noncorporate business, the 20 percent recapture rule is inapplicable. Because


Lynn claimed only straight-line depreciation on the warehouse, the entire $82,300 gain is
Section 1231 gain.

30. a. Amount realized on sale


Adjusted basis:
Cost
Accumulated depreciation

$450,000
$1,000,000
(814,000)
(186,000)
$264,000

Realized gain

Ordinary income (excess of $814,000 accelerated


over $625,000 straight-line depreciation)
$189,000
Section 1231 gain
75,000
Recognized gain
$264,000
b. If Firm P is a corporation, it must recapture an additional amount of ordinary income.
Ordinary income (excess of $814,000 accelerated
over $625,000 straight-line depreciation)
20 percent additional recapture (20% $75,000)
Section 1231 gain
Recognized gain
31. Amount realized on sale of purchased goodwill
Adjusted basis ($200,000 cost $74,000 amortization)
Gain realized
Ordinary income (recaptured amortization)
Section 1231 gain
Recognized gain

$189,000
15,000
60,000
$264,000
$250,000
(126,000)
$124,000
$74,000
50,000
$124,000

32. a. $7,000 amount realized $5,000 adjusted basis = $2,000 recaptured ordinary income
b. $1,000 amount realized $5,000 adjusted basis = $4,000 Section 1231 loss
c. $5,000 adjusted basis = $5,000 ordinary abandonment loss
33. Firm L can deduct its $22,800 adjusted basis in the demolished walls as an ordinary
abandonment loss.

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Chapter8PropertyDispositions
34. a. The stock is treated as sold on the last day of the year for an amount realized of zero.
Consequently, the $82,700 loss is a capital loss.
b. The stock is treated as sold on the last day of the year for an amount realized of zero.
Consequently, the $82,700 loss is a capital loss.
c.

Barlo is the corporate taxpayers wholly-owned operating subsidiary and therefore is an


affiliated corporation. Consequently, the $82,700 loss is an ordinary loss.

35. a. Lyle recognizes a $25,000 Section 1231 gain ($100,000 FMV $75,000 adjusted tax basis)
on foreclosure of the real estate.
b. Lyle recognizes a $25,000 Section 1231 gain ($100,000 FMV $75,000 adjusted tax basis)
on foreclosure of the real estate and $20,000 ordinary cancellation-of-debt income.
36. Lyle recognizes a $45,000 Section 1231 gain ($120,000 relief of nonrecourse debt $75,000
adjusted tax basis).
37. a. Amount realized on sale (cash + debt relief)
Basis of land
Gain recognized on sale
Tax rate
Tax
Cash received on sale
Tax cost
Net cash flow

$33,000
(4,550)
$28,450

b. Amount realized on sale


Basis of land
Gain recognized on sale
Tax rate
Tax

c.

$113,000
(100,000)
$13,000
.35
$4,550

$113,000
(100,000)
$13,000
.35
$4,550

Cash received on sale


Debt repayment
Tax cost
Net cash flow

$113,000
(80,000)
(4,550)
$28,450

Amount realized on sale


Basis of land
Loss recognized on sale
Tax rate
Tax savings from loss deduction

$82,000
(100,000)
$(18,000)
.35
$6,300

Cash received on sale


Debt repayment
Tax savings
Net cash flow

$82,000
(80,000)
6,300
$8,300

d. Amount realized on sale (value of land)


Basis of land
Loss recognized on sale
Cancellation-of-debt income
Net loss
Tax rate
Tax savings from loss deduction

$64,000
(100,000)
$(36,000)
16,000
$(20,000)
.35
$7,000

Net cash flow (tax savings)

$7,000

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Chapter8PropertyDispositions
e. Amount realized on sale (value of land)
Basis of land
Loss recognized on sale
Tax rate
Tax savings from loss deduction

$64,000
(100,000)
$(36,000)
.35
$12,600

Cash payment to settle debt


Tax savings
Net cash flow

$(16,000)
12,600
$(3,400)

38. Amount realized on sale (relief of nonrecourse debt)


Adjusted basis of real property
Gain recognized on surrender of real property
Tax rate .25
Tax on gain

$300,000
(195,000)
$105,000
$26,250

The surrender of property results in $26,250 negative cash flow, which is Firm Rs tax cost of the
transaction.
39. a. Company J can deduct a $39,000 ordinary casualty loss ($450,000 insurance
reimbursement $489,000 adjusted basis).
b. Company J can deduct a $489,000 ordinary casualty loss.
40. Balis net book income before tax
Excess of book over tax depreciation
Book gain on equipment sale
$(23,000)
Tax gain on equipment sale
38,000

$605,800
25,600
15,000
23,550
$669,950

Nondeductible loss on sale to related party


ZEJs taxable income

The $75,000 gain realized on the securities sale to a related party is taxable and does not cause
a book/tax difference.
41. St. Georges net book income before tax
Installment sale gain (50.12% $62,000)
Deduction for disallowed loss of related seller
Excess of book casualty loss over tax casualty loss
St. Georges taxable income

$711,800
31,074
(12,700)
7,600
$737,774

42. Ms. D recognized the following gains on the sale of her business assets.

Inventory
Other balance sheet assets
Goodwill/going concern value

Amount
Realized

Adjusted
Basis

Ordinary
Gain

Capital
Gain

$145,000
63,700
91,300
$300,000

$125,000
63,700
-0-

$20,000
-0______
$20,000

$91,300
$91,300

Her net cash flow is computed as follows.


Sales proceeds
Tax on ordinary gain ($20,000 35%)
Tax on capital gain ($91,300 15%)
Net cash flow

$300,000
(7,000)
(13,695)
$279,305
8-14

Chapter8PropertyDispositions
Issue Recognition Problems
1.

Does DS Company plan to dispose of any other Section 1231 assets at a loss? Will the $85,000
Section 1231 gain on the sale of the office building be the companys net Section 1231 gain for
the year?

2.

Are the 20,000 shares of MXP stock worthless so that Firm LD can recognize a $160,000 capital
loss? What facts and circumstances determine if securities are worthless? Does the bankruptcy
of a company create a presumption that its securities are worthless?

3.

Does Firm L recognize any loss on the decline in value of the industrial equipment? How does
the firm account for the $10,000 insurance proceeds?

4.

Can Company LR deduct any unrecovered basis in the leasehold improvements that were
destroyed? Does it have an ordinary abandonment loss for any unrecovered basis in the
leasehold improvements?

5.

What is the character of Corporation Ms $12,700 realized gain on the sale of the note?

6.

If a corporate capital loss and net operating loss can be carried back to the same taxable year,
which loss is deducted first?

7.

Is the basis of property (for purposes of determining gain or loss realized on sale) reduced by
actual depreciation deducted or the correct depreciation that the owner should have deducted?
Can WD amend its tax returns for the last 12 years to reflect the correct depreciation
deductions?

8.

Does Corporation AD have any substantiation or independent evidence that the value of the
desk on the date of sale to Mr. C was only $35,000? Is ADs marginal tax rate more or less than
Mr. Cs preferential tax rate on capital gains?

9.

Does the $100,000 payment received by Mr. V for his promise not to compete represent ordinary
income or capital gain? Does the $100,000 payment represent self-employment income? Can
Mr. V recognize the $100,000 income over the four-year period of the covenant not to compete?

10. Can Corporation TJ deduct the unrecovered basis in its organizational costs and goodwill on its
final tax return? Can TJ claim an ordinary abandonment loss for the unrecovered basis in the
organizational costs and goodwill?
11. Can Firm GH claim an ordinary abandonment loss for its $290,000 basis in the LSR stock?
Is the LSR stock considered worthless (triggering a $290,000 capital loss to GH) even though it
is still trading on a public market?

8-15

Chapter8PropertyDispositions
Research Problems
1.

This case is based on the facts in George Stotis, TC Memo 1996-431. In that case, the Tax
Court ruled that cash paid by building owner to a tenant in exchange for the tenant leasehold
rights was an amount realized by the tenant on sale of those rights. The amount realized also
included the fair rental value of a dwelling unit provided free of charge by the building owner to
the tenant. In Rev. Rul. 72-85, 1972-1 CB 234, the IRS ruled that a leasehold in real property
used in a trade or business is a Section 1231 asset. Consequently, gain recognized on sale of
such leasehold rights is Section 1231 gain. (See also Ltr. Rul. 200045019, Nov. 13, 2000).
Assuming that George has a zero basis in his leasehold rights in 129 Main, he will recognize
Section 1231 gain equal to the amount realized on sale of the rights to Kramer. The amount
realized will equal the $50,000 cash payment plus the $1,300 monthly fair rental value of the
new office space. George will recognize $50,000 gain on receipt of the cash and $1,300 gain
each month over the 36-month period that he occupies the new office space on a rent free basis.

2.

Graham Inc. realized a $302,750 gain on sale of the land ($865,000 amount realized $562,250
basis), and its gross profit percentage for the installment sale method was 35 percent ($302,750
$865,000 sale price). It has received $221,000 cash since the sale ($865,000 original note
principal $644,000 current principal balance) and recognized $77,350 gain (35% $221,000
cash received). Grahams adjusted tax basis in the note itself was $418,600 ($644,000 current
principal balance $225,400 deferred gain). Graham also had a $40,800 tax basis in the
accrued interest receivable on the note.
Reg. Sec. 1.1038-1(a) requires a taxpayer who repossesses real property in satisfaction of
an installment obligation must recognize gain equal to the excess of cash received prior to the
repossession over the gain recognized under the installment sale method. However, Reg. Sec.
1.1038-1(c) limits the amount of gain recognized to the taxpayers original gain realized on the
sale less the gain recognized under the installment sale method. Reg. Sec. 1.1038-1(d) specifies
that the character of the gain is the same as the character of the original gain on sale.
Grahams cash received
Gain recognized under installment sale method
Excess cash over gain

$221,000
(77,350)
$143,650

Gain realized on sale


Gain recognized under installment sale method
Limitation on gain recognition

$302,750
(77,350)
$225,400

Therefore, Graham must recognize $143,650 capital gain on repossession of the land. Reg.
Sec. 1.1038-1(g)(1) provides that Grahams basis in the land equals the adjusted tax basis of all
indebtedness of the purchaser to the seller plus any gain recognized on repossession. Thus,
Grahams tax basis in the repossessed land is $603,050 ($418,600 basis of note + $40,800
basis of interest receivable + $143,650 gain recognized on repossession).

8-16

Chapter8PropertyDispositions
3.

This case is based on the facts in William T. Gladden, 112 TC 209 (1999). In this case, the IRS
argued that federal water rights were not capital assets, and that the amount realized on the
taxpayers sale of the rights was ordinary income. The taxpayer argued that the water rights
were a capital asset, and that the sale of the rights resulted in capital gain. The taxpayer also
maintained that the cost basis of the land to which the rights related could be allocated to the
rights to offset the amount realized on sale. The Tax Court agreed that the water rights were
capital assets because they did not fit within any of the definitional exceptions listed in Section
1221. However, the court held that the taxpayer could not allocate any of their cost basis in the
land to the water rights.
The taxpayers appealed the Tax Courts decision on the basis allocation issue to the Ninth
Circuit in Gladden v. Commissioner, 262 F.3d 851 (CA-9, 2001). The appellate court held that if
the taxpayers paid any premium on purchase of the land based on a realistic expectation that
water rights would attach to the land in the future, they could allocate a portion of their cost basis
equal to such premium to the water rights. Therefore, if Big Skye Partnership can prove that
some portion of its $695,500 original cost of the land reflected the value of the expectation of
future water rights, the partnership can allocate this amount of basis to the water rights and
compute its capital gain on sale accordingly. If Big Skye cannot prove its case, it must recognize
a $175,000 capital gain on the sale of the water rights.

4.

Section 267(a)(1) disallows a deduction for a loss realized on the sale of property between
related parties as defined in subsection (b). Section 267(b)(10) specifies that a corporation and a
partnership are related parties if the same persons own more than 50 percent of the value of the
corporations outstanding stock and more than 50 percent of the capital or profits of the
partnership. Section 267(c)(2) and (e)(3) provide that an individual is considered to own any
corporate stock or partnership interest owned by a family member. Finally, Section 267(c)(4)
states that an individuals family includes siblings and children.
For Section 267 purposes, Ann Olsen owns 1,057 shares (her shares plus her brothers
shares) of 2,000 BPL shares outstanding. Ann also owns a 57 percent capital and profits interest
(her interest plus her daughters interest) in Kaier Partnership. Therefore, BPL and Kaier are
related parties, and BPL could not recognize its loss realized on the sale of land to Kaier.

8-17

Chapter8PropertyDispositions
Tax Planning Cases
1.

a. Investment 1:
Year

Initial
Annual Income/
Investment
Cash Flow
0
$(100,000)
1
2
3
4
5
100,000
NPV

Tax Cost
at 35%

$12,000
12,000
12,000
12,000
12,000

$4,200
4,200
4,200
4,200
4,200

Initial
Investment

Gain on
Sale

Tax Cost
at 35%

0
$(100,000)
5
165,000
NPV

$65,000

$22,750

Net Cash
Flow
$(100,000)
7,800
7,800
7,800
7,800
107,800

Present
Value at 6%
$(100,000)
7,355
6,942
6,552
6,178
80,527
$7,554

Investment 2:
Year

Net Cash
Flow

Present
Value at 6%

$(100,000)
142,250

$(100,000)
106,261
$6,261

Firm Z should make Investment 1 because it has the greater NPV.


b. Investment 1 has the same $7,554 NPV to the noncorporate taxpayer.
Investment 2:
Year

Initial
Investment

Gain on
Sale

Tax Cost
at 15%

Net Cash
Flow

Present
Value at 6%

0
$(100,000)
5
165,000
NPV

$65,000

$9,750

$(100,000)
155,250

$(100,000)
115,972
$15,972

Because of the preferential rate on capital gain, Investment 2 has a greater NPV than
Investment 1, and Firm Z should make Investment 2.

8-18

Chapter8PropertyDispositions
2.

Mr. RHs development option will generate $1,318,500 after-tax cash flow.
Sales proceeds (90 lots sold for $20,000 each)
Basis ($935,000 cost + $275,000 improvements)
Ordinary gain on sale of inventory
Tax rate
Tax

$1,800,000
(1,210,000)
$590,000
.35
$206,500

Cash proceeds
Cost of improvements
Tax cost
After-tax cash flow

$1,800,000
(275,000)
(206,500)
$1,318,500

Mr. RHs sale of the undeveloped land will generate $1,307,000 after-tax cash flow.
Sales proceeds
Basis
Capital gain on sale of investment land
Tax rate
Tax

$1,350,000
(935,000)
$415,000
.15
$62,250

Cash proceeds
Tax cost
After-tax cash flow

$1,350,000
(62,250)
$1,287,750

Therefore, Mr. RH should develop the land to maximize after-tax cash flow.
3.

Corporation Ys 2007 tax rate is 34 percent. Assuming continued growth, its future income will be
taxed at a rate no less than 34 percent. By selling the second capital asset this year, the
corporation will pay only $340 tax on the $21,000 realized gain (34% $1,000 net capital gain)
instead of $7,140 (34% $21,000). Consequently, the $20,000 capital loss is worth $6,800. If
Corporation Y carries the capital loss back, its tax refund will be only $3,240.
Reduction in 2004 taxable income
Marginal tax rate

$19,000
.15

Reduction in 2005 taxable income


Marginal tax rate

$1,000
.39

$2,850
390
3,240
Consequently, Corporation Y will maximize the value of the capital loss by selling the second
capital asset in 2007.
4. If Olno uses the installment sale method to recognize gain, it can deduct $14,190 of the capital
loss carryforward to reduce its current year (year 0) capital gain to zero. The NPV of the tax cost
of the $127,710 deferred gain is $33,786.
Annual tax cost in years 1-9 ($14,190 35%)
Discount factor for 9 period annuity
NPV of future tax costs

$4,967
6.802
$33,786

If Olno elects out of the installment sale method and recognizes the entire $141,900 capital gain
this year, it can deduct the entire $52,100 capital loss carryforward to reduce its taxable gain to
$89,800. The 35 percent tax on this gain would be only $31,430. Consequently, Olno should elect
out of the installment sale method to minimize its tax cost.

8-19