Chapter 7

Capital Gains and Other Sales of Property

Learning Objectives

LO 1. Define the terms and identify the tax forms used in sales of property transactions.
LO 2. Classify assets sold as ordinary assets, § 1221 capital assets, or § 1231 business
assets.
LO 3. Explain and apply the tax rules for recognizing gains or losses on the sale of
ordinary assets.
LO 4. Explain and apply the tax rules for recognizing short-term and long-term gains or
losses on the sale of capital assets (§ 1221).
LO 5. Calculate the recognized gain or loss on the sale of §1231 business assets,
including gain recapture provisions of § 1245 and § 1250 property.
LO 6. Describe the tax rules for special types of sales, including block stock sales,
capital gain distributions, sales of mutual funds, worthless securities, and sales of
property received as a gift or through inheritance.

Topics of Primary Importance

 How sales of property are classified for tax purposes.

 Tax rules for recognizing gains and losses on sales of property.
 How to prepare the forms and schedules used to record gains and losses on sales
of property.
 Tax rules for special types of sales.

Student Confusion Areas

 Determining the proper basis of the asset.

 Determining the proper classification of property sold.
 Determining the appropriate tax rule to follow when calculating a gain or loss on
the sale of property.
 Determining the correct form or schedule to use when recording the sale of
property.
 Depreciation recapture rules.

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 Notes Outline

I. LO 1 –Terms and Tax Forms

A. Generally, a gain or loss on the sale of property is the difference between the
amount realized and the adjusted (tax) basis.
1. Sales proceeds include cash received as well as the FMV of other
property received and any assumption of liabilities by the buyer.
2. Defining the basis of the asset sold or transferred must be determined
before the adjusted basis can be figured.
Refer to Table 7-1 for definitions of key terms used in the chapter.

B. Tax reporting for gains and losses depends on the “use” of the asset rather
than on the “form” of the asset.

C. Form 4797 is used to record sales of property used in a trade or business.

Schedule D is used to record sales of property held for investment.

D. A new Form 8949 is completed first and the totals transferred to a revised
Schedule D.

II. LO 2 – Classification of Assets

A. Assets can be classified into three categories:

1. Ordinary income property
2. §1221 property (capital assets)
3. §1231 trade or business property

B. Ordinary income property

1. Tax code does not directly define this type of property except to state
that it is any asset that is “not a capital asset”.
2. Two most common types of ordinary assets are inventory and accounts
receivable.
3. Copyrights and literary, musical, and artistic compositions in the hands
of the creator or artist are included in this definition.

C. §1221 capital property (capital assets)

1. In general, any asset used for personal purposes or investment.
2. Examples include the following:
 investment in stocks and bonds
 home owned and occupied by the taxpayer and his/her family
 timber grown on home property or investment property
 household furnishings
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  a car used for pleasure or commuting
 coin or stamp collections, gems, and jewelry
 gold, silver, and other metals

3. IRC defines a capital asset by “exception.” Includes all assets held by a

taxpayer except:
 ordinary income property described above
 property used in a trade or business
 real property used in a trade or business
 any commodities derivative financial instrument held by a
dealer
 certain hedging transactions entered into in the normal course
of trade or business
 supplies used or consumed in the ordinary course of a trade of
business

4. Artistic works are not capital assets for the creator but when the work is
sold, it becomes a capital asset for the purchaser.

5. Musical compositions and copyrights in musical works are generally

not capital assets. However, an election is available to treat these types of
property as capital assets if they are sold or exchanged beginning after
May 17, 2006, and the taxpayer’s personal efforts created the property or
the taxpayer acquired the property under circumstances entitling him or
her to the basis of the person who created the property or for whom it was
prepared or produced.

D. Trade or business property (§1231 Asset)

1. Defined as property used in a trade or business that is or is not subject
to depreciation and held for more than one year.
2. Land used in a trade or business is a §1231 asset.
3. Property held for less than one year is considered an ordinary asset.

E. Refer to Table 7-2 – Asset Classification Summary

III. LO 3 – Sales of Ordinary Assets

A. Gains on the sale of ordinary assets do not receive preferential tax treatment.

B. Losses on the sale of ordinary assets are fully deductible.

C. Ordinary gains or losses produced outside the normal course of business relate
to sales of property held for less than one year and the sale of accounts receivable.

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 1. Accounts receivable in this case are not generated from the sale of
inventory on credit. This is a unique type of transaction and doesn’t
happen often.
In-class example: A taxpayer sells equipment used in business for $12,800 on
October 31, 2022. The equipment was purchased on December 19, 2021, for
$15,000 and was subject to depreciation in the amount of $2,400. How is the gain
or loss calculated?
1. Determine the adjusted basis.
Cost − Depreciation = Adjusted Basis
$15,000 − $2,400 = $12,600
2. Determine the gain or loss
Sales price − Adjusted basis
$12,800 − $12,600 = $200 gain
3. Determine the nature of the gain.
The holding period requirement was not met for the gain to be
considered long-term; therefore the $200 gain is taxed at ordinary
rates.

IV. LO 4 – Sales of Capital Assets (§1221)

A. Tax treatment of capital assets varies depending on several factors including:

1. The period of time the asset is held
2. Whether the sale of the asset produced a gain or loss
3. The type of capital asset sold
4. The taxpayer’s tax bracket
5. The combination (netting) of all capital gains and losses to derive a net
capital gain or a net capital loss.
6. Whether a capital asset sold is stock of a qualified small business

B. Holding period
1. Short-term capital asset if held =< one year
2. Long-term capital asset if held > one year
3. Holding period starts the day after the taxpayer acquired the property
and includes the day the asset is sold.
4. Property received in a gift or nontaxable exchange generally has the
same basis as the basis in the hands of the transferor.
5. Property received by inheritance is always long-term property
regardless of how long the asset belonged to the decedent or beneficiary.

In-Class Example: An asset is purchased on June 20, 2021. The holding period
starts on June 21, 2021. If the asset is sold on June 20, 2022, any gain or loss is
short-term. If the asset is sold on June 21, 2022 or later, any gain or loss is long-
term.

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 C. Capital gain rates
1. Maximum gain rates are 0%, 15%, and 20%.
2. 25% capital gain rate is for depreciable real property used in a trade or
business (known as §1250 property)
3. 28% capital gain rate is for “collectibles gains”
4. 28% capital gain rate applies to §1202 gains from small business stock
corporations with gross assets of less than $50 million at all times after
August 10, 1993, and held for 5 years or more.
a. One-half of the gain is excluded from gross income and the
remaining gain is taxed at a rate of 28%

b. For stock acquired after February 16, 2009 and before

September 27, 2010, and held for more than five years, the
exclusion increases to 75%.

c. For stock acquired after September 27, 2010 and before

January 01, 2012, and held for more than five years, the exclusion
increases to 100%.

Refer to Table 7-4 – Summary of Capital Gain Tax Rates

D. Netting Capital Gains and Capital Losses

1. Calculate all long-term and short-term capital gains and losses.
a. Net all the short-term gains and losses to obtain a “net” short-
term gain or loss.
b. Net all the long-term gains and losses to obtain a “net” long-
term gain or loss.
2. Remember to separate gains that are taxed at the 28% and 25% rate.
3. The chart below explains the netting process

Net short-term gain  Short-term gain taxed at regular rates

and Net long-term gain
Net short-term gain
and Net long-term loss
Net short-term loss and
Net long-term gain
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 Long-term gain taxed at 0%, 15%, 20%, 25%, or
28%
 Offset long-term loss against short-term gain
 Net short-term gain results are taxed at regular
rates
 Net long-term loss results are deductible up to
$3,000 per year with indefinite carryover to future
years
 Separate long-term gains into 28% 25%, 20%,
15% and 0% groups
 Any net short-term loss first offsets 28% gains,
then 25% gains and if any loss remains, the 20%,
15% or 0% gains
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 Net short-term loss and  Only $3,000 of loss is deductible against other
Net long-term loss income in any one year.
 Short-term losses are deducted first against other
income and if any of maximum remains, then
deduct long-term loss up to $3,000 maximum
 Excess losses carry forward and retain their
original character

In-class Example: Each example is an independent situation

Situation 1: Net long-term gain = $5,000

Long-term gain $8,000 Net short-term gain = $1,000
Long-term loss ($3,000) Results:
Short-term gain $5,000 Net long-term gain taxed at preferential rates
Short-term loss ($4,000) Net short-term gain taxed at ordinary rates
Situation 2: Net long-term loss = ($5,000)
Long-term gain $3,000 Net short-term gain = $1,000
Long-term loss ($8,000) Results:
Short-term gain $5,000 Net the long-term loss against the short-term gain = ($4,000)
Short-term loss ($4,000) Net long-term loss deduction for 2021 = $3,000
Carryover loss to 2022 = ($1,000) considered long-term

Situation 3: Net long-term gain = $5,000

Long-term gain $8,000 Net short-term loss = ($1,000)
Long-term loss ($3,000) Results:
Short-term gain $4,000 Net the short-term loss against the long-term gain = $4,000
Short-term loss ($5,000) Net long-term gain = $4,000 preferential tax rate treatment
Situation 4: Net long-term loss = ($5,000)
Long-term gain $3,000 Net short-term loss = ($1,000)
Long-term loss ($8,000) Results:
Short-term gain $4,000 Net short-term loss used first which will leave $2,000 that
Short-term loss ($5,000) can be deducted in 2021. (Remember maximum of $3,000)
Net long-term loss ($5,000- $2,000) = ($3,000) to be carried
over as a long-term loss to 2022
Situation 5: Short-term loss of ($10,000) applied as follows:
28% gain $4,000 28% = $4,000 − $10,000 = ($6,000) loss to cover 25% gain
25% gain $2,000 25% = $2,000 − $6,000 = ($4,000) loss to cover long-term
Long-term gain $10,000 gain
Short-term loss ($10,000) ($4,000) loss against $10,000 long-term gain = Net long-
term gain of $6,000 taxed at preferential rates.

There is a 3.8% Medicare Surtax (IRC § 1411) on certain net investment income (NII) on
individuals who have modified adjusted gross income (MAGI) above a threshold amount.
In general, net investment income includes some of the more common types of
investments such interest, dividends, rental, and royalty income. It also includes, but is
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not limited to, gains from the sale of stocks, bonds, mutual funds, capital gain
distributions from mutual funds, and gains from the sale of investment real estate (a
second home that is not a primary residence), and sales of interests in passive investments
from a partnership or S Corporation.

The 3.8% surtax is imposed on the lesser of:

• Net investment income (NII) for the year, or
• Modified adjusted gross income (MAGI) over $250,000 for married filing jointly and
qualifying widow(er) with dependent child; $200,000 for single and head of household
(with qualified person); and $125,000 for married filing separately.

V. LO 5 – Sales of Business Property

A. §1231 sales treatment varies depending on three factors:

1. Whether the asset is sold at a gain or loss
2. If a gain, whether the asset had been depreciated
3. Whether the asset was depreciable real property (e.g. building) or
depreciable personal property (e.g. equipment)

B. Gains and losses are netted.

1. Net §1231 gain receives preferential tax treatment subject to recapture
provisions
2. Net §1231 loss is treated as an ordinary loss

C. All sales of business property are initially recorded on Form 4797 and then a
net §1231 gain is transferred to Schedule D while a net §1231 loss is reported on
Form 1040.

D. Recapture provisions
1. Depreciation is an ordinary expense so any of the gain resulting from
depreciation is treated as ordinary income subject to regular rates.
2. Recapture is a term designed to “transform” some of the §1231 capital
gain into an ordinary gain to the extent of depreciation taken.
3. The difference between the total gain and the recapture gain is recorded
as a net long-term §1231 gain and receives capital gain tax treatment.

E. §1245 property
1. Includes personal trade or business property subject to depreciation.

2. Any gain recognized on the sale of §1245 property is “ordinary” to the

extent of depreciation taken.
3. In practice, a §1231 gain on §1245 property is unusual because
equipment rarely appreciates and any gain is usually caused by the
depreciation taken.

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 In-class example: Each example is an independent situation using the following
information:
Purchased a piece of equipment considered §1245 property for $5,500.
Depreciation expense of $3,000 has been taken. Assume the equipment
was held for more than one year. Adjusted basis is $2,500 ($5,500 −
$3,000).

Situation 1: Sold for $7,000 $7,000 − $2,500 = $4,500 gain

Situation 2: Sold for $3,000
Situation 3: Sold for $2,000
§1245 recapture = $3,000 ordinary rate
§1231 gain = $1,500 capital gain rates
$3,000 − $2,500 = $500 gain
§1245 recapture = $500 ordinary rate
No §1231 gain
$2,000 − $2,500 = ($500) loss
§1231 ordinary loss

On January 18, 2019 the Treasury and Internal Revenue Service issued final IRC
199A regulations; [Section 1.199A-3(b)(2)} – Gains and Losses as QBI (1231,
1245, 1250). The final regulations removed the specific reference to Section 1231
assets and provided that any short term or long-term gain or loss are not taken into
account for calculating QBI.

However, if the item is not treated as capital, such as Section 1245 recapture, it is
included in the QBI calculation. Section 1245 recapture provision is due to
depreciation taken in previous years, and as depreciation deductions are made
which reduce business income, the adjusted basis of the property is also adjusted.

When the Section 1245 property is sold for a gain, to the extent any gain is from
depreciation recapture, this amount is ordinary income and is included in the
calculation for QBI. Any excess gain over depreciation taken is considered to be a
capital gain.

Example from the textbook:

For example, on July 28, 2022, ABC Company sold office equipment for $6,500
that was purchased in May 10, 2020 at a cost basis of 8,000. This a section 1245
asset and was depreciated over 7-year MACRS using the half-year convention.
Accumulated depreciation for the period 2020-2022 is $3,802. The adjusted basis
is $8,000 − $3,802 = $4,198. The gain on the sale (from Form 4797) is $6,500 −
$4,198 = $2,302. The gain is considered ordinary income to the extent of
depreciation taken. In this example, the entire gain $2,302 is considered ordinary
income and would be added to income to calculate QBI. Assume taxable income
from Schedule C is 45,000 and ½ of self-employment tax is $3,179; then the total
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 income for QBI on Form 8995 – Qualified Business Income Deduction Simplified
Computation line 1 is calculated as follows:

Income from Schedule C =$45,000

½ SE tax − 3,179
Section 1245 recapture + 2,302
Total $44,123

If there are no other entities to include on line 1 of Form 8995, the QBI deduction
of 20% of $44,123 = $8,825 goes on line 5. After completing Form 8995, the
amount on line 15 is then transferred to line 13 on Form 1040. The amount of
income on line 8 on the Form 1040 is from Schedule 1 – line 3 – Schedule C
income of $45,000 and line 4 – Gain from Form 4797 of $2,302.

F. §1250 property
1. Includes any depreciable property used in a trade or business that has
never been considered §1245 property. Includes all buildings, residential
and nonresidential, used in a business or for the production of income.
2. Any gain on the sale of §1250 property is considered ordinary to the
extent the depreciation taken exceeds straight-line depreciation. Any other
gain is considered a §1231 gain.
 In recent years, few sales are subject to §1250 recapture because
of the requirement to depreciate this property over straight-line
rather than accelerated rates.
3. Any unrecaptured depreciation is taxed at a rate of 25% (as opposed to
§1245 recapture at ordinary rates) and any excess gain is taxed at
preferential rates as other §1231 assets.

In-class example: Each example is an independent situation using the following

information:
Purchased a building for $100,000. Depreciation expense of $60,000 has
been taken. Assume the building was held for more than one year.
Adjusted basis is $100,000 − $60,000 = $40,000.

Situation 1: Sold for $110,000 − $40,000 = $70,000 gain

$110,000 §1250 recapture = $60,000 gain taxed at 25%
§1231 gain = $10,000 taxed at capital gain rates
Situation 2: Sold for $70,000 − $40,000 = $30,000 gain
$70,000 Unrecaptured §1250 = $30,000 gain taxed at 25%
Situation 3: Sold for $35,000 − $40,000 = ($5,000) loss considered
$35,000 §1231 capital loss to be netted with other §1231
assets. If only §1231 asset sold, ordinary loss.

VI. LO 6 – Tax Issues for Special Types of Sales

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 A. Sales of block stock
1. Occurs when blocks of stock are purchased at different times and/or at
different prices.
2. Basis is determined either by specific identification of the stock sold or
using first-in, first-out (FIFO) method.

B. Capital gain distributions and sales of mutual funds

1. A mutual fund is an investment vehicle that pools the resources of
numerous taxpayers and purchases shares of stock in a portfolio.
2. Tax treatment for sales by the fund throughout the year can be complex.
Each taxpayer is responsible for paying taxes on his/her share of these
gains and losses.
3. Capital gain distributions are reported to the taxpayer on Form 1099-
DIV at the end of the year.
4. Capital gain distributions are reported on line 13 of Form 1040 or line
10 of Form 1040A, if there are no other gains or losses to be reported by
the taxpayer. If the taxpayer has gains or losses from other investments, a
Schedule D is prepared.

C. Dividends from mutual funds are treated as ordinary income and are not
considered capital gains. Typically, they are recorded on Schedule B with the total
from all dividends and interest recorded on Form 1040.

D. Sales of shares from the mutual fund will be recorded on Form 1099-B. This
can be a complex situation because the fund has purchased and sold shares of
stock throughout the year.

E. Three methods to figure the “basis” of the shares owned.

1. First-in, first-out. The first shares purchased are assumed to be the first
shares sold. This usually results in the largest gain when the value of the
mutual fund units appreciates.
2. Specific identification. The taxpayer specifies exactly which units are
sold from the fund.
3. Average basis. The taxpayer takes the total cost basis and divides by the
total number of units to get an average cost per unit (single category
method).

In-class example: Using the following data, show the effect of the three methods
on the sale of shares in a mutual fund: 4,500 shares were sold for a price of
$7/share = $31,500

Date Shares × Total Costs

Share Price
2017 1,000 × $5 $5,000

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 2018 1,000 × $6 $6,000
2019 500 × $8 $4,000
2020 1,000 × $7 $7,000
2021 1,500 × $4 $6,000 = $28,000

FIFO Method

Shares × Total Costs

Date Share Price
2017 1,000 × $5 $5,000
2018 1,000 × $6 $6,000
2019 500 × $8 $4,000
2020 1,000 × $7 $7,000
2021 1,000 × $4 $4,000 = $26,000
Gain = $5,500

Specific Identification Assume 1,000 shares each in 2017, 2018;

500 shares each in 2019, 2020 and 1,500
shares in 2021.
Date Shares × Total Costs
Share Price
201 1,000 × $5 $5,000
7 1,000 × $6 $6,000
201 500 × $8 $4,000
8 500 × $7 $3,500
201 1,500 × $4 $6000 = $24,500
9 Gain = $7,000
202
0
202
1

Average Cost

Single Category = $28,000/5,000 shares = $5.60 per share cost

4,500 share × $5.60 = $25,200 cost
$31,500 − $25,200 = $6,300 gain

E. Worthless securities
1. The taxpayer reports a loss from a sale or exchange of a capital asset on
the last day of the taxable year as it is often difficult to pinpoint exactly
when the stock become worthless.

F. Sales of Inherited Property

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 1. Basis to the beneficiary is the FMV at the date of death or alternate
valuation date. The alternate valuation date can only be elected if filing an
estate return and only if the FMV of the property will not increase the
estate’s income.
2. Holding period is always considered long-term and therefore qualifies
for capital gain treatment.

G. Sales of property received as gift

1. To figure the gain or loss from the sale of property received as a gift,
the person who received the gift must know the adjusted basis to the donor
and the FMV at the time the gift was given.
2. If FMV is < donor’s adjusted basis at the time of the gift;
 The basis for figuring a gain is the donor’s basis
 The basis for figuring a loss is the FMV.
3. If FMV is > donor’s adjusted basis at the time of the gift;
 The basis for figuring either a gain or loss is the donor’s
adjusted basis.
4. If sale price falls between the adjusted basis and FMV, there is no gain
or loss on the sale. This is a special provision in the tax law.

In-class example: A taxpayer received a parcel of land as a gift. At the time of

the gift, the land had a FMV of $10,000. The donor’s adjusted basis was $12,000.

Situation # 1
Taxpayer sells the land for $14,500. The gain is $2,500 ($14,500 − $12,000).

Situation #2
Taxpayer sells the land for $9,500. The loss is ($500) ($9,500 − $10,000).

Situation # 3
Taxpayer sells the land for $10,500. The sell price is > FMV but < Basis.

The sell price of $10,500 falls between the basis for a gain ($12,000) and the basis
for a loss ($10,000), neither a gain nor a loss results.

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