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Federal Income Taxation

May, 2002
Professor Chirelstein

Time Allowed B Three Hours


This is a limited open-book examination. You may bring with you to the examination
room your Code and Regulations volume, but nothing else.

The examination consists of six equally weighted short-answer or short-essay questions.

For Question 2(A) and (B) and Question 6, no more than names and numbers may be needed.
For the other questions, two or three brief but highly legible paragraphs explaining your
reasoning should be sufficient. If you finish early, good!

Question 1: In the Acme P acking Co. case, the taxpayer-corporation, located in El Paso and in the
business of packaging dried fruits of all kinds, entered into a 2-year em ployment agreement with Ralph, a
high ly-rated executive with experience in the packaging field. U neasy about having to buy a new family
house in E l Paso, Ralph insisted that Acme promise to buy back the new hou se for an amount not less
than Ralph had paid for it if Ralph=s employment should not be renewed at the end of the 2-year term.
Acme agreed. Sure enough, Acme dismissed Ralph at the end of the 2-year term and, as required, bought
Ralph=s house for $285,000, which was equal to Ralph=s purchase price. Acme tried at once to resell the
house but found no one w illing to pay more than $200,000 for it. Finally, after peddling it around for
nearly eighteen months, Acm e sold the house for only $185 ,000, taking a $100 ,000 loss on the deal.

Acme never attempted to rent the house and never used it in its packaging operations. Acme had
substantial net income from its ordinary business activities during the year in question but no gains or
losses from the sale of property (other than the sale of Ralph=s former residence).

How should Acme treat the $100,000 loss for federal income tax purposes? And: How should Ralph treat
the $285,000 that he received from Acme?

Question 2(A): Diggory makes a gift of stock to his daughter, Eustacia. The stock cost Diggory
$20,000, but at the date of the gift it is worth only $15,000. Eustacia later sells the stock for (a)
$22,000, (b) $13,000, or (c) $18,000. How much gain or loss does Eustacia recognize under
each alternative?

Question 2(B): Suppose Eustacia received the stock (worth $15,000) from her employer as a
year-end bonus. Assuming the same alternatives as above, how much gain or loss would
Eustacia recognize on sale?

Question 3. Caspar (a pleasant fellow) collects coins as a hobby, and has for many years. Last
year he paid $1,000 to a reputable coin dealer for a dime that bore the mark AD@ for Denver
mintage, such dimes being very rare. Caspar subsequently observed that the AD@ was slightly
raised from the surface of the coin, and for that reason he concluded that the AD@ was counterfeit.
Caspar promptly confronted the dealer and demanded his money back, but the dealer, insisting
that the coin was genuine, rejected Caspar=s demand. In the end, to avoid controversy the dealer
settled with Caspar by repurchasing the dime from him for $400.

Last year, also, Caspar sold a rare half-dollar to another collector for $800. The half-dollar,
which he had purchased some years earlier, cost Caspar $500.

Caspar asks you how he should treat these events on his federal income tax return. Advise him.

Question 4. Proponents of the so-called Flat Tax B a tax on wages, salaries and other personal
service income only B generally call for the elimination of the present deduction for home
mortgage interest. Briefly explain (a) why eliminating the home mortgage interest deduction is a
necessary, or at least a consistent, element of the Flat Tax plan, and say also (b) who would be
helped (?) and who would be hurt (?) if the Flat Tax were adopted and the home mortgage
interest deduction actually were eliminated.

Question 5. Osmond leased two acres of land from Isabel for the purpose of storing heavy
equipment that Osmond uses in his business. The five-year lease required Osmond to pay a
monthly rental of $500, or $6,000 a year. At the same time, Isabel gave Osmond an option to
buy the property any time during the term of the lease. The price was $100,000 in the first year,
but increased by $5,000 in each subsequent year (i.e., $105,000 in the second year, $110,000 in
the third year, etc). If Osmond exercised the option, 33.3% of his previously paid rent would be
credited against the purchase price.

Osmond exercises the buy-option at the end of the third year, paying Isabel $104,000, i.e.,
$110,000 minus 3 x $2,000 = $104,000.

To what extent can Osmond deduct his $500 monthly rent payments in years one through three?
And: What are the tax consequences to Osmond of exercising his buy-option?

Question 6. Miriam owns Greenacre, investment property, with a basis of $100,000 and a value
of $60,000, but subject to a mortgage of $25,000. Baxter owns Whiteacre, also investment
property, with a basis of $30,000 and a value of $80,000, but subject to a mortgage of $5,000.
Miriam exchanges Greenacre for Whiteacre and pays Baxter $40,000 in cash. .

How much gain or loss, if any, does Miriam recognize on the exchange, and what is her basis for
Whiteacre? How much gain or loss, if any, does Baxter recognize on the exchange, and what is
his basis for Greenacre?