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FEDERAL INCOME TAX OUTLINE



INTRODUCTORY MATERIAL
I. Principles oI Tax Law:
A. Equity:
1. 4riz4ntal Equity: The people with the same income should have similar tax burdens
2. 'ertical Equity: People with diIIerent incomes should pay diIIerent amounts oI taxes
Efficiency
1. How costly will the enIorcement oI the code be?
C Enf4rceability
1. Must be an enIorceable provision oI tax law; know the POLICY arguments because while the code
changes the policy behind it does not.
II. US Tax structure: Progressive tax rate structure: as income increases, so do taxes
A. Pr4ressive Tax Rate Structure: As TI rises, a larger proportion oI Income is due in taxes
1. Why we use this structure:
a Ability t4 pay
b. Use the4ry: People who have more use more
c. Redistributi4n 4f Inc42e: taking Irom people who have moer and giving to those with less
(moral obligation)
Alternative Tax Stuctures
1. enefit Principle: Taxes should be apportioned based on the beneIits received.
a. Person would pay taxes based on the gov`t services used.
2. Per Capita 4r ~ead Tax: Divide the money needed among that people to pay taxes and ask that
every person pay their share.
3. Pr4p4rti4nal tax rate: every person pays the same amount oI their income as taxes (Ilat 25
income tax)
4. Reressive tax rate: The more you make, the lower your tax rate will be
a. This is typically not used due to problems w/ ability to pay.
III.Introduction to Tax Law
A. Adam Smith Wealth oI Nations
1. Principles oI taxation
a. Certainty- people need to know how much their taxes will be
b. Cost oI collection (low)
c. Proportionality- people should pay according to ability
d. Timing and payment should be convenient (taxpayer needs liquid assets in order to pay)
2. Introductory Problems
a. 'aluati4n: necessities are hard to argue as having a zero value because a taxpayer would
purchase them in any scenario
b. Liquidity: actual cash in hand, vs. hypothetical value
c Per2anent exclusi4n v Deferral
i. Permanent exclusion: you cannot tax later (rent, imputed income, food)
ii. Deferral: You can tax later (art, savings, gifts)
I'S4urces 4f Tax Law: Researchin Tax
A. Begin with the statute, (IRS Code primary source stemming Irom 16
th
Am) and
B. Then consult the treasury reulati4ns
1. Regs will explain the statute
C. Next move to IRS rulins to know how the IRS has ruled on diIIerent transactions.
1. Note: Not binding, only inIormative
2. Revenue Rulings: interpretation oI the law by the IRS dealing with substantive areas oI the law Ior
the general population.
3. Revenue Procedures (internal Practices oI IRS dealing with procedural issues)
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4. Private letter ruling
a. Individual can rely on a ruling issued to them, but no one else may
D. Case law: Judicial Interpretation oI Code/Regs
1. Supreme Court
2. Circuit Court
3. Tax court, Claims Court or Federal Dist court (this is where tax cases originate)
a. Tax payer can choose where to Iile
b. Tax court 'poor man`s court b/c you do not have to pay beIore you go to court, unlike other
two.
i. Tax Court: Has experts who adjudicate proceedings.
ii. Claims court and Fed Dist court will give you a reIund iI IRS was wrong
iii. Fed Dist court: Jury oI peers
' Calculatin inc42e tax liability
A. Determine Gross Income I)
1. Income anytime there is an increase in wealth
2. 61 deIines GI as ~all inc42e Y) fr42 whatever s4urce derived p 57
a. can be cash or in-kind
b. Reg 161 (p 896) provides list but it is not limited to that list.
i Reg 161-6a) (p 899) The realizati4n principle: D4 n4t tax f4lks until the value 4f
pr4perty has been realized v4luntary sale)
c. Include anything that provides TP with an ECONOMIC BENEFIT (iI no economic beneIit, then
not generally taxable)
i. Compensation Income 61(a)(1)
ii. Gross Income Irom Business 61(a)(2)
iii. Gains Ior dealings in property 61(a)(3)
iv. Discharge oI Indebtedness Income 61(a)(12)
d. Some amounts oI GI will be excluded by other code provisions
i. Imputed Y (no IRC provision)
ii. GiIts 102
iii. Compensation Ior sickness oI personal injury 104
iv. Certain discharges oI indebtedness 108
A) Bankruptcy 108(a)(1)(A)
B) Insolvency 108(a)(1)(B)
C) Farm debt 108(a)(1)(C)
v. QualiIied Scholarships 117
vi. Gain on sale oI principal residence 121
vii.Business related exclusions:
A) Meals and lodgings 119
B) Statutory Iringe beneIits: 132
C) Insurance premiums and payments 105, 106
D) Dependent care assistance 129
E) Educational Expenses 127
B. Determine Adjusted Gross Y AI)
1. 62 p 59) deIines deductions that can be taken ~ab4ve the line n4n-ite2ized), including:
a. Some amount oI GI will be deducted above the line
i. Moving expenses 217
ii. Losses 165
A) Trade or Business 165(c)(1)
B) Investment losses 165(c)(2)
C) Casualty Losses up to the amount oI casualty gains165(c)(3)
iii. Educational Loan interest 221
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b. Trade and business expenses oI employers 62a)1)
c. Reimbursed trade and business expenses oI employees 62a)2)A)
i. ReIlects bias for employer-provided benefits
ii. SpeciIic provisions Ior perIorming artists 62(a)(2)(B), oIIicials 62(a)(2)(C) and teachers
62(a)(2)(C).
2 CI-Above the line deductions ACI
C Determine Taxable Y (TI)
1 63 (p 61) deIines deductions that may be taken bel4w the line, including:
a Deduction Ior Personal expenses 151(d)(1) (p 135)
i EVERYONE GETS $2000
b For people who choose not to itemize:
i Standard deduction 63(c)(2)(C) (p 61)- usually $3000
ii OR itemized deductions 63(d)
A) 163: Interest
1) Investment interest to the extent oI the net income Irom those investments 163(d)
2) QualiIied residence interest 163(h)
) 165c)3), h): Casualty l4sses
1) over 105 oI AGI, Meeting $100 Iloor
C) 170 (p181) Charitable deducti4ns
D) 213 (p221) Medical deducti4nscan only deduct unreimbursed expenses in excess oI
7.5 oI AGI
E) 67: MIDs
1) 2 Iloor
2) Unreimbursed business expenses 162
. ACI - Amounts deductible under g3 1I
3 Why we do these deductions in 2 steps?
a AGI is used to express limits Ior itemized deductions
4 Statute places limits on certain itemized deductions (67) (p 64)
i 2 Ior misc. itemized deductionssuch deductions are only allowed to the extent that the
aggregate oI the deductions exceeds 2 oI AGI.
b Standard deduction use in place oI itemized deduction.
D Determine Tax Liability (TL)
1 1 (p 14) explains how tax liability is calculated
a. 1(c): old rates (deIault rates)
b 1(i): rates until 2010 (temporary rates)
i II you Iile as an individual rather than a married person, then you have to divide the amount
in 1(i) in halI.
ii. You pay taxes within each bracket until you reach the limit of taxable income, not fust the tax
rate within the bracket into which your income falls.
2. Marinal Tax Rate: The rate at which each additional dollar oI Y is taxed,
a. Gives the actual beneIit oI the $ rather than the average.
b. Deducti4ns: When y4u have a deducti4n y4u sh4uld take int4 acc4unt the after tax c4st
i. As your MTR increases, the value oI the deduction also increases
ii. Value oI the deduction is higher to those who have more (this may increase charitable
giving)
iii. The diIIerence between the beIore tax cost and the aIter tax cost is the taxpayer`s savings:
A) e.g. $100 charitable giIt with 30 MTR:
1) $100-$70 $30 tax savings (give 100 dollars Ior only $70)
B) However, iI only at the 10 MTR, the then same giIt oI one hundred dollars costs you 90
bucks.
3. Average Tax Rate: TL/TI- the average oI all tax rates to which the TP`s Y is subject.
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a. e.g., 10 15 25 50/ 3 16.6 avg
E. Determine the Taxes Due:
1. Deduct any credits Irom TL
a. Credits are taken aIter the TL is calculated, which is better Ior the taxpayer than a deduction.
F. DETERMININ TAX LIAILTY Exa2ple: Tammy taxpayer: Lives alone/ single, Salary 50k,
Wins 10k on Jeopardy, Contrib. 5 k to charity, Spends 5k on business trip (reimbursed by boss), 10k in
unreimbursed medical expenses
1. ALWAYS START WITH Gross income (GI) 65k (all income)
a. Salary jeopardy reimbursement Ior business trip
b. 5055 65
2. From GI, subtract business deductions to get Adjusted Gross Income (AGI) 62 (p 58)
a Subtract business trip 62a)2)A)
b. 65-5 60k AGI
3. Personal exemption 151d)1) (p 135): Everyone can take a personal exemption oI $2000 60-3 58
4. You can take the standard deduction OR an itemized deduction.
a. Use whichever reduces your taxable income more
b. 63c)2): Basic standard deduction $3000 58-3 55k
c. Itemized:
i. Gross income is the same (65k)
ii. Business deductions would not change (not itemized, it is ABOVE the AGI line) 5k
iii. Personal exemption is the same 2k
iv. Itemized deductions
A) 5k to charity 170 charity
B) 213 unreimbursed medical expenses over 7.5 over the AGI
1) 7.5 oI AGI 4500, so that is not able to be itemized
2) However, the remaining 5500 can be
C) Total itemized 9500
D) Taxable income 47500 rather than 55k so she SHOULD itemize
5. Apply rates: This is the potential tax liability
6. Then apply credits and get taxes due.
7. Potential tax liability credits taxes due
'I.Formula CI- business deductions ACI - (Personal exemption + standard/itemized deduction)
1I.apply rates 1L - credits 1axes due

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QUESTION 1: IS IT INCOME Y)? ~Is there an ec4n42ic benefit? is the first questi4n y4u ask, then
ask ~Sh4uld we tax it and when?

I Y includes in-kind compensation (something other than cash) under 61 (p 57)
A. US v. Drescher
1. Facts: TP was receiving an insurance annuity oI 5k per year Irom his employer. TP cannot collect
on the annuity until he is 65, and he is currently 45. TP wants to deIer taxes (and recover the 5k cost
oI the policy) now because he says that the policy has no present value/ economic benefit.
a. The annuity had certain provisions including: Certainty Ieature (iI a dies beIore 65, his
beneIiciary would receive the value Ior the ten years), Non-assignable, Employer kept
possession, Non IorIeitable, No cash option, Could change beneIiciary, No cash surrender value
2 Pr4cedural P4sture:
a L4wer C4urt: Not currently taxable because it has n4 present value
3 Issue:
a. What amount should TP be taxed on iI he is required to pay taxes now?
4 4ldin:
a The annuity is currently taxable but the Iull amount is not currently taxable. LiIe annuity
protects against the risk oI longevity and this is a valuable f4r2 4f security. However, the
restrictions may decrease the value oI the policy. REMAND to determine value.
5 Dissent: Not really limited choice
a. The annuity is worth the Iull value paid by the employer
i. The value is the security, particularly Ior beneIiciaries
b. Footnote 2:
i. The interest oI the employer and the employee are similar.
A) There is not limited choice, because Drescher was one oI the people making the decision
to purchase the annuity.
c The dissent was codified in g83, p 90) but with excepti4ns
Tax n4w 4r tax later: Applicati4n 4f 83
1 Under 83, compensation is generally taxed IN FULL when it is received
a TIMIN under 83: include full 2arket value FM') as inc42e NOW if y4u have
transferability OR d4n`t have substantial risk 4f f4rfeiture
i L4ical equivalent: do not include if you have non-transferability AND substantial risk of
forfeiture.
ii Substantial Risk 4f F4rfeiture SRF):
A) 83c)1)- p 91) there is a substantial risk oI IorIeiture where a person`s right oI Iull
enjoyment oI the property is conditioned upon the Iuture perIormance oI substantial
services if y4u 2ust DO s42ethin t4 keep it, there is a SRF)
iii Transferability:
A) 83c)2)- p 91) property is non-transIerable while the property is subject to a SRF
1) e.g. limitations on ability to sell, assign or pledge
2) See reg 1.83-3(d) (p1031)
B) Property is not taxed until it can be transIerred.
C) NOTE: EVEN iI you can deIer taxes until later, you CAN go ahead and pay taxes now iI
you wish. 83(b) (p90)
1) Good plan iI the value is lower now then it will be worth when transIerable and SR oI
F is gone but is really Gambler`s Choice
b. 'aluati4n: how much should you include: FMV unless there are PERMANENT restricti4ns
(ignore all restrictions that are not permanent)
i. For purposes oI valuation, if the restriction is finite, you MUS1 use the full fair market
value.
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A) II permanent, take it into account, iI not, ignore it.
ii. Application to Drescher:
A) Include immediately and at FMV iI we say restrictions are NOT permanent.
) II there is a permanent restriction on the compensation, then the value can be reduced t4
reflect the li2ited ch4ice
C) HOWEVER, sometimes limited choice must be ignored b/c oI the diIIiculty in
administering (see anrahan holding that sums paid to inmate held in account that could
only be used to purchase items Irom the commissary or remit to Iamily or Iriends was
taxable under 61, limited choice notwithstanding)
II Excepti4ns t4 61 and 83: EXCLUSIONS AND DEDUCTIONS:
A W4rkin C4nditi4ns Excepti4n t4 83:
1 In general, we do not tax in-kind benefits furnished by an employer that enable the employee to
perform his job satisfactorily ~WORKIN CONDITIONS)
2 enaglia v. Commissioner 1937):
a Facts: TP receives Iree room and board as part oI his employment as a hotel manager. He and
wiIe lived and ate at one oI the hotels he managed. TP did not include meals and lodging as part
oI his GI
b 4ldin: Meals and lodging are not compensation and were not provided Ior the personal
convenience oI TP, but rather were necessary Ior the perIormance oI services required oI him.
i Must be 4n pre2ises and required as part 4f his j4b.
c Reas4nin:
i While he is receiving a beneIit, it is Ior the c4nvenience 4f the e2pl4yer.
A) Working conditions
ii Now or never situation, not a tax now or later situation like Dreschler
d Dissent:
i The contract oI employment indicated the in kind beneIit, which means it is part oI his
compensation.
A) Taxpayer beneIitted Iinancially, and he does not live on the premises oI all the hotels he
manages, so it may not be 'necessary to the employer
) The taxpayer should have to pay Iair market value, rather than the economic beneIit (36k)
e Applicati4n: N4 h4riz4ntal equity
i Taxpayer A: income 13,600, housing 3600, (only 10k aIter housing), taxed on 13600.
ii Benaglia: income 13,600 housing 0 (13600 aIter housing), taxed on 13600.
f 83: In kind c42pensati4n:
i You include it, even iI limited choice
A) Benaglia: Working conditions and convenience oI employer doctrine is an exception to
83.
3 119 (p 112) CodiIies enaglia's majority view (More exclusive than working condition Iringe
beneIit b/c only applies to meals and lodging)
a In kind beneIits oI meals or lodging may be excluded iI Iurnished by the employer
i. Meals must be on the premises
ii. Lodging
A) Must be required (cannot have choice)
) Must be on premises
C) Must be a condition of employment (in order to properly perform duties)
4 Reg 1.119 (p 942) gives examples oI excludable in kind compensation.
a Must have a business reason Ior wanting to provide in kind compensation.
I2puted Inc42e: Exclusi4n by CON'ENTION n4t by statute
1 Imputed income: II a person provides a service to himselI or herselI, the beneIit is 'imputed
income.
a Imputed income is typically excluded Irom 61 versus someone who pays Ior the service
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i While statue allows Ior inclusion oI the amount, it is typically not included because oI:
A) Measurement Issues
) Liquidity Issues
C) EnIorcement Issues
D) Equity Issues
C Frine enefits:
1 Non- Statutory: The Employee discount: ability to buy something at rate less than that oI the general
public b/c oI where you are employed
a. 1.61-2(d)(2) (p 897): Employee discount is included as Y
b. Minzer v. Commissioner: IMPUTED INCOME ' DISCOUNT
i. Facts: Insurance agent buys himselI insurance and gets a discount via his commission
(either not paying the commission or getting it reimbursed). He did not include the
commission as income. Tax Court addressed this as a discount and held Ior the taxpayer.
IRS appeals.
ii. eld: Discounted policy not deductible; should be treated as Y.
A) This is the exception rather than the general rule. IRS typically not so aggressive
B) Other possible outcome: Treat as imputed income and exclude by convention
2. Statut4ry Frine enefits: 132 (p 123)
a. History: IRS did not attempt to tax Iringe beneIits Ior many years because oI diIIiculty with
administration, but now these beneIits are taxable unless otherwise excluded under 132.
b. g13 Fringe enefits: II your employer provides beneIits to you and they Iall within the
exceptions in 132 or other sections, they are excluded.
i. II they are in kind benefits, 83 (p 90) governs.
ii. 132 list is NOT exhaustive. See 125 etc.
iii. Fringe beneIits must be provided in a n4n-discri2inat4ry 2anner 132(j)
A) Cannot treat the highly-compensated people better than the non-highly-comp people
iv. 132b): (p124) N4 additi4nal c4st service
A) (1): Limited to services that are oIIered Ior sale to customers in the ordinary course oI
business oI the employer to employees perIorming the services.
1) II you work Ior airline division, you cannot get beneIits Irom hotel division.
2) Policy: Don't want to Iavor massive conglomerations.
3) 1.132-2b p 959
4) Reciprocal agreements (between airlines Ior instance) cannot work between diIIerent
divisions within the same company that oIIer diIIerent services.
5) II you work cross divisions, you may get all beneIits.
B) (2): there can be no cost to the employer, including Ioregone revenue
1) For example, you cannot oIIer up a seat on an airplane that a paying customer would
take. This is why Ilights Ior employee beneIit are limited to stand-by Ilights.
C) Charley v. Commissioner: TP traveled Ior work, agent would book coach Ilight, client
would be billed Ior 1
st
class and then TP would use Ilyer miles to upgrade, getting the
diIIerence between the cost and the bill in cash. TP said that the Ilyer miles Ior cash was
a no additional cash Iringe beneIit
1) eld: Cash is taxable; it is not in the line oI business to sell the Ilyer miles
a) II had not been sold Ior cash would likely have been ok.
v. 132c): (p 124) Qualified e2pl4yee disc4unts
A) (c)(1)(A): With respect to pr4perty, it is limited to the gross proIit percentage.(GPP)
B) (c)(1)(B): Whit respect to services: max discount is 20 percent oI the price it is oIIered
to customers
C) (c)(2) Calculating GPP: Areate sales- Areate c4st)/ areate sales
1) Ex: washer sold to public 500, Cost 300
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2) so. (500-300)/500 200/500 40 THIS IS THE MAX DISCOUNT THAT IS
EXCLUDABLE. Anything over is added to gross income.
D) Cannot be something that is easily changed into cash 132(c)(4)
E) JustiIications Ior keeping employee discounts:
1) Employers may need their employees to use their product (Wardrobing at retail
stores).
2) Reliance by employees on the discount
vi 132d): (p125) W4rkin c4nditi4n frine
A) The employee may exclude any property or service provided to an employee oI the
employer to the extent that, iI the employee paid Ior such property or services, such
payment would be allowable as a deduction under 162 or 167
B) Not subject to 132(j), the non-discrimination clause
1) Based on need not on equity.
vii.132e): (p125) De 2ini2is frine: Property services that are so small that the accounting
is unreasonable
A) Ex: OIIice supplies
B) Also not subject to 132(j) non-discrim.
1) xcept: Eating Iacilities: are subject to 132(j) non-discrim.
viii.132f): (p 125) Qualified transp4rtati4n frine
A) Applies to
1) Commuter Highway Vehicle
2) Transit pass
3) QualiIied parking
B) Up to $100 Ior CHV, transit pass, up to $175 Ior qualiIied parking
C) Constructive receipt: cash Ior choosing not to receive the transportation beneIit is still
excludable.
1) 132(j) does not apply. Discrimination is ok.
ix 132): (bottom oI p126) Qualified 24vin expenses
x 1322): (p128) Qualified retire2ent plannin services
A) Employers who have a qualiIied retirement plan may exclude the cost oI planning advice
or inIo that they provide to employees.
1) Encourages wise investment practices.
B) 132(j) applies. Discrimination is not ok.
D. IFTS vs c42pensati4n): With giIts someone is always taxed, it is just a matter oI Iiguring out who.
1. Definiti4n 4f a ift: Not deIined in the IRC
a. Standard to be used to determine whether a transIer is a giIt is whether it is made Irom a
standpoint oI ~detached and disinterested ener4sity
i. II there is a moral obligation or expectation that you do something in Iuture, then no giIt
b. Commissioner v. Duberstein: TP did business with Berman. TP reIerred potential customers to
Berman. Berman gave TP a Cadillac. TP said that he did not need or expect a reward but
accepted the car. Berman took a deduction Ior the car as a business expense. TP did not report
the car on his taxes considering it to be a giIt. The Commissioner asserted a deIiciency.
i. eld: the car was compensation and the value could not be excluded TP`s GI
A) GiIt was not made Irom detached and disinterested generosity.
1) The car could be considered compensation Ior past services or an inducement Ior
Iuture services. Doesn`t matter how the parties characterize the transIer or the lack oI
any obligation to make it.
) 'ift status is n4t dependant 4n sy22etry;
1) Receiver can qualify this as a ift and the iver as a business expense, just n4t in
this case
c. Stanton: (in Duberstein) TP was employed by a church Ior 10 years. When he resigned the
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church voted to give him a gratuity oI $20,000. TP did not include the 'gratuity as part oI gross
income. The Commissioner asserted a deIiciency.
i. Today would be considered compensation
ii. Note: Churches are not deterred Irom making giIts Ior Iear that they won`t be able to deduct
it given 274(b) because the church is tax-exempt and does not have to take deductions in
any case
2. Treat2ent 4f a ift: 102 (p97)
a. 102a) II A gives a giIt to B, B does not have to include the value oI the giIt in his gross income
(GI doesn`t include value oI property acquired by gift, bequest, devise, or inheritance)
i. II the transIer is treated as a giIt it is taxed at A`s marginal tax rate (no deduction is allowed)
A) The tax code assumes that the donor has a higher marginal tax rate. Taxing the donor and
not the donee, under that assumption, is the only way to preserve the progressive tax
structure.
1) Ex: iI A makes $100 giIt to B, B gets to exclude Irom GI under 102(a), but A
doesn`t get deduction because treated as personal under 262 - will be taxed at A`s
rate
ii. II the transIer is treated as compensation, taxed at B`s marginal tax rate (he must include it
and A may take a deduction under 162(a) as ord./nec. bus. Exp).
iii. ifts t4 fa2ily: Because actual ownership among Iamily members is oIten inconsequential,
Iamily members are oIten motivated to put goods in the hands oI the person with the lowest
marginal tax rate. U1 in order to get the maximum benefit, family members was to
transfer as a business expense, not a gift (which would be taxed at the giver's rate).
A) ller v. Commissioner: TPs` children perIormed a variety oI services Ior their parents
businesses. TPs paid the children and deducted the compensation as a business expense.
The Commissioner determined that 90 oI the compensation was unreasonable business
expense and disallowed the deduction.
1) eld: TP`s deduction was allowed because the children perIormed substantial
services.
a) Ex: Assume that children are paid $5,000. $500 is disallowed as a deduction.
Parents pay taxes on $500 and children pay taxes oI $4,500.
b) How do we treat the $500 that is disallowed?
i) TPs want to treat it as a gift because iI it is treated as compensation it will be
taxed twice once by the parents because it is not deductible and once by the
children because it is ordinary income.
ii) Note: Commissioner is not saying that the disallowed amount cannot be
treated as a giIt, simply that is not a reasonable and deductible business
expense.
B) Ex: TP has an AGI oI $10,000 and a marginal tax rate oI 50. TP`s child has a marginal
tax rate oI 15. TP wants to make a giIt oI $1,000 to child.
1) II the giIt is made, TP gets no deduction. TP would owe the IRS $5,000. AIter
making the giIt to the child, the child would have $1,000 but TP would only have
$4,000.
2) II TP characterizes the $1,000 as reasonable compensation the child the parent would
give the child $1,000 plus what the child will owe in taxes or $1,176 (15 oI $1,176
$176). This is called 'grossing up
a) Parents would have a TI oI $8,824 ($10,000 - $1,176) and TL oI $4,412.
Children would have a TL oI $176. IRS gets $4,588 (4412176) ($422 less), TP
gets to keep $4,412 ($412 more) and child will have $1,000 (same place).
iv. II there is a giIt, the donee does not have to include the amount but the donor does not get a
deduction; iI there is no giIt the donor may take a deduction but the donor has to include it in
gross income
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A) Insures that the giIt is always taxed (i.e., prevents the donor Irom taking a deduction Ior
the transIer as a business expense and the donor Irom excluding the transIer as a giIt)
3. Limitations
a. In Duberstein (above) the Court held that as long as a giIt was given with detached and
disinterested generosity it was irrelevant who the transIeror was, BUT:
i. Now 102c) (p 97) says that if the employer makes gift it is not a gift but compensation
A) the giIt exclusi4n oI 102(a) does not apply to any amount transIerred by or Ior an
employer to, or Ior the beneIit oI, an employee (identity oI transIeror IS relevant)
(enacted in 1986)
b. 274b) (p 259) - NO deducti4n under 162 or 212 Ior any expense Ior giIts made directly or
indirectly to any individual
i. This is consistent with the need Ior symmetry iI the transIeror can deduct it, the transIeree
can`t exclude it and iI the transIeree can exclude it, the transIeror can`t deduct it.
A) Ask the giver iI they are going to take a deduction Ior the giIt, because iI so you are
barred Irom treating it as a giIt.
c. With4ut 102(c) and 274(b) the Iollowing problem would arise:
i. Employer has a tax rate oI 34 and pays employee $200. The beIore tax cost is $200 and
aIter tax cost is $132 ($200 34 oI 200 he gets as a deduction). The TP has a marginal tax
rate oI 50. The beIore tax value to him is $200 and aIter tax value is $100. TP tells
employer that he will tax less compensation iI it is treated as giIt. Employer gives TP $101
as a giIt. BeIore tax cost and aIter tax cost to employer is $101 because he gets no deduction.
He saves $31. The beIore tax value and aIter tax value to TP is $101. He earns $1. Both
parties are better oII and the IRS is out.
d Excepti4ns t4 102c) and 274b)
i. 274j) (p 263): E2pl4yee achieve2ent awards:
A) II an award is made Ior length oI service or saIety and iI its cost does not exceed $400 per
employee in a given year, then the employee may exclude it Irom income under 74(c)
and the employer can take a deduction under 274(j)
ii Weddin ifts:
A) Employer may give with detached and disinterested generosity
E. USINESS DEDUCTIONS: 162 (p 142) these deductions are treated as expenses that are ordinary
and necessary in order to make Y, but are NOT provided by the employer. ('Ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade or business)
1. P4licy reas4n: Distinction between personal and business expenses because US does not want to
tax people on the reasonable cost oI producing Y; this would not be an income tax but a gross
receipts tax.
a. Deductions Ior pers4nal c4nsu2pti4n are disallowed under 262 (p243); otherwise we would
only be taxing savings.
2. Meals: Typically considered personal under 262 (p 243) but limited meals may be deducted under
162(a) (p142) as ordinary and necessary business expenses` incurred in carrying on any trade or
business.`
a. Moss v. Commissioner: TP Lawyer at a small law Iirm attempts to take a deduction Ior everyday
business lunch near court. He attempts to take the deduction under 162(a) rather than
162(a)(2) or 119 (p 112).
i eld: Because the expenditure was personal and not Ior business it is not deductible. You
must show that the meal is an expense you would not incur in the absences oI business
purpose
A) Eating w/clients. Would be more easily deductible as 'social lubrication
) Frequency. II less Irequent more easily deductible as 'collegial
C) High cost. II it was more expensive than what you would typically eat, it would be more
easily deductible.
11
b. Christey v. US: Highway patrolman are subject to regulations on when where and how they can
eat. They deduct their business expenses under 162(a) (p 142)
i. eld: The meals are deductible under 162(a) because there were a number of significant
restrictions that made it clear that the meals were a business rather than personal expense.
c. II an entertainment expense, must be substantiated pursuant to 274d) (p 260) as an
entertainment expense with a business purpose (see entertainment below).
d. LIMITATION on 162(a): 274n) (p265) NON-REIMBURSED meals and entertainment are
limited to a deduction oI only 50 oI the expense.
i. Must Iirst meet the Pri2ary Purp4se Test; must be business and not personal (see mixed
motive p.13)
ii. These are treated as misc. itemized deductions subject to 2 Iloor, phase-out and non-
deductibility under the AMT.
iii. II employee is rei2bursed, they can deduct the full amount pursuant to 274e)3) (p261)
and 274(n)(2)(B) (p265).
A) However, rei2bursin e2pl4yer is subject to the 50 deduction pursuant to 274n)
B) Ex:
1) Unreimbursed TP: AGI 10000, 1000 in entertainment and meal expenses. Entitled
to deduct 500. So TI 9500, subject to the 2 Iloor.
iv. Does not affect meals while traveling under 162(a)(2)
3 Entertain2ent: Above restriction in 274(n) are applicable to both meals and entertainment
a. Schultz v. Commissioner TP was a jewelry manuIacturer selling wholesale TP and wiIe
entertained customers and TP also paid Ior horse as advertising; TP tried to deduct the
entertaining and advertising costs as business expenses
i. eld: about deductible, but advertising costs not allowed b/c not directly related enough to
bus. or unlikely to produce bus.
A) There is little to distinguish this entertainment Irom the usual social gatherings among
Iriends
b. 274 put certain restrictions on entertainment deductions (aIter Schul:) that are allowable under
162(a) (p 142). SEE ABOVE LIMITATION ON MEALS. 1: 1his does 1 apply to
g1(a)()
i. 274a)1)A) allows a deduction Ior entertainment when
A) TP establishes that the item was directly related to the active conduct oI TP`s trade or
bus., OR
B) The item was directly preceded or Iollowed by a substantial and bona Iide business
discussion.
1) 1274-2c)7) (p1801) expenditures that aren`t considered directly related are
deductible particularly iI the TP is not present or the distractions are substantial: e.g.,
nightclub, sporting event.
ii. 274d) requires that deductible expenses be substantiated by adequate records or by
suIIicient evidence corroborating the TP`s own statements (a calendar log, etc)
iii. Under 274n), deductions are limited to 50 oI actual costs (see above)
A) Applies to:
1) An employer reimbursing an employee Ior entertaining a client can only deduct 50
oI the cost oI the reimbursement.
a) 162(a) says it is deductible, but employer is subject to 274(n)
2) An e2pl4yee wh4 is not rei2bursed can only deduct 50 oI the cost oI the
entertainment and the deduction is taken below the line (Schultz)
3) 1 An employee who is reimbursed. They can take a deduction Ior the Iull cost
a) 274(n) does not apply due to 274(e)(3)
b) The employer has already been subject to 274(n)
12
c) Where the employee is reimbursed, and we are conIident that purpose was
legitimate.274(n)(2)(B) (p265) exempts reimbursed expenses under 274(e)(3).
B) Rationale Ior 274(n)
1) The person who entertains receives a beneIit Ior himselI
2) Potential Ior tax abuse without it. 274(n) 'splits the diIIerence; Ior example:
a) With no deduction: TP has an AGI oI 1000 and spends $50 on meal Ior selI
w/no deduction, TI is 100 and assuming 50 tax rate, has TL oI $500 and $450
leIt over (minus $50 Ior cost oI meal)
b) w/o 274(n) in place (all deduction): TP invites a Iriend to dinner and 'discusses
business AGI oI 1000 w/a $100 meal deduction under 162(a). TI is $900 and
w/tax rate oI 50, has $450 in TL and has $450 leIt over. In the same position as
iI she had paid Ior her own meal only.
c) w/ 274(n) in place, TP can only deduct $50 when they invite someone to join
them Ior dinner. TI is then $950 and w/tax rate oI 50, TL is $475 less the $50
spent on the meal that isn`t deducted, so TP is leIt w/$425.
3) equity concerns some people will have the ability to entertain Ior business more
oIten and take advantage oI the rule in a way that lower compensated individuals
cannot.
4. 162a)2): p142) provides a deduction Ior the cost oI meals and lodging incurred while away from
home in the pursuit of trade or business.
a. 3 require2ents 4f 162a)2)
i. Reasonable and necessary traveling expense (airIare, meals, lodging)
ii. Incurred while away from home
iii. In pursuit oI a trade or business
b ~Away f4r 42e require2ent
i Rosenspan v. US: 1he DUPLICA1I requirement: TP traveling salesman tries to deduct
meals and lodging as business expenses despite the Iact that he does not have any residence.
A) eld: Such expenses are not deductible or excludible because they are not business
expenses without DUPLICATION.
1) Duplication is the mechanism by which one can tell a personal expense Irom a
business expense.
2) Court does not reach the question oI what is a 'home, instead Iocusing on
duplication requirement.
ii. Commissioner v Flowers: TP took a job in Mobile, AL but continued to live in his home in
Jackson, MS per an agreement with employer that he would pay his own living and travel
expenses. He conducted business in both locations, but the Jackson business dealings were
not necessary to the employer. TP attempts to deduct these expenses Ior meals and lodging
under 162(a)(2)
A) eld: Such expenses are not deductible under 162(a)(2)
1) Tax C4urt: 'Home means business headquarters, which create a situation where the
TP was either 1) not away Irom home (Mobile) or 2) lacked duplication (Jackson)
2) App C4urt: There is no need to address the deIinition oI 'home; TP Iails the third
requirement oI 162(a)(2) in that the expense was not in pursuit oI trade or business,
but was Ior personal reasons, so not deductible under 262 (p 243). This is a
commute and commutes are not deductible under 1.162-2e (p 978)
iii 1: (Important on xam): Court try to avoid deIining home by instead looking to the
duplication or in pursuit oI trade or business requirements. You should do the same.
iv. Sleep or Rest Rule: The costs oI meals are deductable only iI the trip requires the taxpayer
to 'sleep or rest (&S v. Correll)
A) Meals and lodging are considered as a unit but you do not have to pay Ior a hotel in order
to deduct meals. Can stay with Iriends/ Iamily
13
c Mixed M4tive: Where travel is Ior business and personal reasons, whether travel is deductible
as a business expense under 162(a)(2) depends on the primary purpose oI the trip.
i Re 1162-2b)- (p978) The Pri2ary Purp4se test: II a TP travels to a destination and
engages in both business and personal activities, travel expenses to and Irom the destination
are deductible only if the trip is related primarily to TPs trade or business.
A) Pri2ary purp4se can be inIerred Irom the Iacts and circumstances oI the case, i.e., the
amount oI time spent on personal activity compared to that spent on business.
1) Fairly subfective test based on totality oI the circumstances.
a) Re 1162-2b)1): Look to the primary intent
b) Re 1162-2b)2): Look to the amount oI personal v. business time (1:1 is ok)
ii Rudolph v. US: TP insurance agent got an all expense paid trip to NY Ior selling lots oI
insurance. He brought his wiIe, 4.5 days oI travel, day business, and 2 days pleasure; TP
tried to exclude the income, later tried to include but then deduct cost oI the trip as a business
expense (above the line deduction because it is reimbursed). Under 162(a), the employer is
entitled to a deduction no matter what and so has nothing at stake.
A) 4ldin: Because the trip was primarily personal it is not deductible.
1) Business was a very small part oI the trip, and NY was considered an extravagant
location.
B) 274(m)(3): (p265) No deduction Ior spouses traveling on business unless
1) They are also an employee oI the TP AND
2) Spouse has some speciIic purpose AND
3) SatisIies 162(a) by themselves
d Te2p4rary 14bs:
i. 162a)3): (p142): When an employer requires an employee to relocate Ior a period oI less
than one year, and the employee retains his normal home he may take a deducti4n.
A) This is an exception to the deIinition oI home as a 'business headquarters in Flowers
1) One year extended by another year is still considered temporary.
a) II it becomes continual, then it may be ' reasonably Ioreseeable
b) IRS will look at the substance over the Iorm oI the transaction; iI they think the
TP is taking advantage, they will disallow the deduction.
B) Li2itati4ns: Must have a business purpose at home and in the temporary location in
order Ior the exception to apply.
ii antzis v. Commissioner: TP Law student goes to school in Boston but can only get a
summer job in NY but maintains home in Boston. She attempts to write oII travel expenses
and lodging in NY under 162(a)(3).
A) eld: Deduction is not allowed because there was no business purpose in BOTH
locations Ior maintaining two homes. While she had a business reason in NYC, she did
not in Boston.
iii. enderson v. Commissioner: TP tours with Disney on Ice Ior most oI the year, but he goes
back to his parent`s house in Boise in his 'idle time oI a Iew months per year. He attempts
to deduct travel expenses while on tour under 162(a)(2) claiming Boise was his 'tax home.
A) eld: No deduction is allowable under 162(a)(2)
1) Rev Rulin 73-539: elements Ior establishing a 'tax home Ior itinerant workers
a) usiness c4nnecti4n to the claimed tax home
b) Duplicative nature oI expenses
c) Pers4nal attach2ent to the claimed tax home
2) TP does not meet A and B
a) Duplication must be substantial and continuous
) Dissent:
1) There was duplication.
14
2) Tax on happy Iamilies; II the parents paid Ior an apartment next door, he would have
duplication
e. Travel: Typically deductible as a business expense under 162(a)(2), but is subject to 274
limitations.
i Certain F4rein Travel: 274c) p 259)
A) To get a Iull deduction (not prorated)
1) Stay less than one week OR
2) Personal time is less than 25
B) There is a pro-rated deduction iI
1) Stay is longer than one week AND
2) Personal time is greater than or equal 25
C) Example: travel to Paris and spend 8 days, 3 oI which are personal, travel expenses $800
1) Step 1: pri2ary purp4se test 162-2(b)(2) and &S v. Rudolph
a) Is it an ordinary and necessary business expense (can take either position, but
argue in the alternative on the exam)
2) Step 2: II business purpose, use 274(c)
a) Is it longer than a week?
b) How much personal time?
3) Step 3: Since 3/8 personal, prorate (3/8 are not deductible)
D) Re 1274-4 (p 1084) provides guidance on how to count days.
ii F4rein C4nventi4ns
A) 274h)1) no deduction allowed Ior travel expenses incurred attending a convention
in a Ioreign country UNLESS
1) The meeting is directly related to the active conduct oI the trade or business; AND
2) It is reasonable to hold the meeting outside the US taking into consideration
a) the purpose oI the meeting and activities
B) 274h)2) no deduction allowed Ior a convention on a cruise ship
1) Exception Special dispensation is granted iI
a) the meeting is directly related to the active conduct oI the trade or business and
b) the cruise ship is registered in the US and
c) all ports oI call are in the US or US territory
2) LIMIT individual can deduct up to $2k in any given year
iii Luxury Travel
A) 2742)1) (p 265) deduction Ior luxury water transportation is limited to twice the
highest per diem travel allowance Ior Ied gov`t employees
B) o limit for luxurious air travel; you can deduct first class air travel.
5 USINESS DEDUCTIONS CONT`D: IASES IN FA'OR OF REIMURSED EXPENSES
a. A deduction under 162(a)(2) is allowed whether it is reimbursed by the employer or paid out oI
pocket by the employee, but they are treated differently
b 62a)2)A) (p58) allows Ior reimbursed expenses to be calculated above the AGI line.
i Re 1274-5T)f) (p 1089) Reimbursement equal to expenses is excludable.
c Reimbursed expenses are treated better because there is more certainty that the expense is
legitimate.
d ias #1: Unreimbursed expenses are deducted below the line as misc. itemi:ed deductions
(MIDs) under 63d) (p 62).
i 2 disadvantaes t4 MIDs:
A) 67a) (p 64): below the line deductions are allowable only to the extent that the
aggregate amount oI such deductions exceeds 2 oI AGI (subject to 2 Iloor).
1) Ex: TP has salary oI $10k, buys a reIerence book Ior $500. Allowed to deduct the
cost oI the book under 162, but iI not reimbursed then the deduction must be taken
below the line.
15
a) TP has AGI oI 10k (since there is no above the line deduction). Pursuant to 67
she can only deduct allowable expenses that exceed 2 oI her AGI ($200), so she
may only deduct $300 Ior the book.
i) This creates a TI oI $9700, where a reimbursed employee would take an
above the line deduction resulting in a TI oI $9500.
) 68: (p 65) MIDs are subject to phaseout; where AGI exceeds a certain set amount
($100k under 68(b)) the amount oI allowable deductions is reduced by the lesser oI
1) 68(a)(1) 3 oI the AGI over the statutory amount or
2) 68(a)(2) 80 oI the itemized deductions subject to the section (Iigured aIter the 2
Iloor has been calculated).
3) Ex: TP`s AGI $60000 over the applicable amount, and $4000 oI itemized
deductions subject to phase-out (not subject to 68(c) exceptions).
a) Phase-out is equal to the lesser oI
i) 3 oI excess AGI $1800 or
ii) 80 oI the deduction subject to phase-out $3200
b) So rather that being able to deduct $4000, TP can only deduct $4000- $1800
2,200
4) Only apples until Dec 31, 2009 68(g) sunset provisions
e. ias #2: MIDs are not deductible AT ALL under the Alternative Minimum Tax (AMT) (55-
58). (p 47)
i. AMT deIined: Separate tax system that exists alongside the regular tax. Purpose was to
prevent very wealthy people Irom reducing their tax liability to inappropriate amounts
through legit exclusions and deductions.
A) AMT has a broader deIinition oI income but has a lower tax rate.
B) Does not apply to 213 (p 221) deductions Ior medical expenses oI 163 (p 148) interest
deductions
C) II AMT is lower than regular tax liability, then you do not have to worry about the AMT.
Only iI the AMT is higher will the diIIerence between the AMT and the reg. tax liability
have to the paid.
D) There is a statutory minimum Ior the AMT to apply
ii. Alexander v. IRS: TP had a K with his employer to have a pension until age 70, but it was
terminated at 64. He sues, and receives a settlement oI 250k. His lawyer`s Iees were 245k.
The 250k is part oI his AGI, but takes an above the line deduction under 62 Ior the lawyer`s
Iees, giving an AGI oI 5k.
A) eld: The settlement was Y under 61, but the legal Iees were not qualiIied expenses
under 62, so they were MIDs, creating a below the line deduction
1) The resultant increase in income triggered AMT and increased tax liability.
) Note: This could have a very chilling eIIect on civil rights suits in employmet
discrimination cases.
6 Educati4n under 162a) Expenses Ior education are generally not excludable or deductible in
order to prevent the deduction oI education expenses which:
a Are personal expenditures
i. Unlike other bus. expenses, it is diIIicult to determine which portion oI education expenses is
a cost oI producing Y (deductible) and which part is personal consumption (not deductible)
b. Represent capital expenditure which would have to be pro rated hard to administer
i. Timing problem: education is capital expense it will be used up over the career oI a
proIessional (will produce taxable income beyond the current taxable year), but it is diIIicult
to determine how much should be deductible each year (what is the useIul liIe oI your
educational expenditure)
c. Re 1162-5a): (p 979) Exception: EDUCATION IS DEDUCTIBLE IN 2 SITUATIONS
i. The education is business related insoIar as it
16
A) Maintains 4r i2pr4ves existin skills required by the individual in his employment or
other trade or business; OR
B) Meets the express require2ents oI the individual`s employer or meets the requirements
oI applicable law that are imposed as a c4nditi4n t4 retenti4n by the individual oI an
established employment relationship, status, or rate oI compensation
ii. Note: II deduction is allowed but not reimbursed by the employer then it is treated as a
below the line MIDs subject to the 2 Iloor and the AMT.
d. HOWEVER, cannot deduct even iI you meet requirements oI 1.162-5(a) iI the education makes
you:
i. Meet 2in educati4n require2ents f4r a new trade 4r business 1.162-5(b)(2),
A) Creenberg v. Commissioner: psychiatrist completed medical school, internship, and
residency and was qualiIied to practice. While practicing, pursued training in
psychoanalysis. TP claimed that the training undertaken primarily to improve his skills
as a psychiatrist Commissioner claimed that purpose was to prepare Ior the practice oI a
separate specialty
1) eld: The education was deductible because it did not qualiIy the TP Ior a new trade
or business.
a) Old test (this case): Looked to the TP`s subjective intent in pursuing the education
to determine whether or not it was deductible
b) Today the test 4bjective iI you qualiIy Ior a new position or trade, the expenses
are not deductible
c) Problem here is whether a specialty is a new practice or part oI the same practice
i) Regulation today says that Ior a psychiatrist, psychoanalysis is NOT a new
trade or business, so TP in this case would still qualiIy Ior the deduction (Re
1162-5b)3) ex 4)
ii. OR Qualify TP f4r a new trade 4r bus 1.162-5(b)(3)
e. Examples:
i. Lawyer takes 2 day tax seminar: Can deduct maintaining or improving skills, so top part oI
test satisIied, and doesn`t Iall under (b)(2) or (3)
ii. Person who incurs costs associated with an LLM aIter practicing law: Can deduct-- SatisIies
top test because maintaining or improving, and doesn`t Iall under one oI categories on
bottom (LLM doesn`t qualiIy you to be an attorney, helps you be a better lawyer)
iii. Person who gets LLM immediately aIter JD (no bar examination): Not deductible not in an
existing trade or business
iv. Bar review course: Not deductible not employed, doesn`t meet top part oI test; but even iI it
did, it would Iall under (b)(2) b/c would help meet the minimum requirements, or under
(b)(3) would qualiIy you Ior a new trade or business
v. DC attorney takes a bar review course Ior CaliIornia: Not deductible - Meets top test, but diII
law diII market according to IRS
vi. Accountant goes to law school: Not deductible could meet top test, but deIinitely Iails
under bottom test.however, iI go to unaccredited law school, then can deduct
F. Treat2ent 4f Sch4larships: Treated more generously under 117 (p 111) than under 162, b/c even iI
a scholarship is Ior trade or business it may still be excluded
1. ingler: Company allowed employees to apply Ior an educational leave oI absence where company
would pay a stipend based on a oI the employee`s salary and beneIits, but the employee had to
return to the company when they Iinished, had to have research topics approved by the company and
had to submit progress reports. TP Iiled claims Ior reIunds, claiming that the payment was a
scholarship excludable under 117.
a. eld: TP didn`t receive a scholarship and thereIore there was no need to determine whether the
scholarship was one that qualiIied Ior exclusion under 117
17
i. The Ct Iound that the limitations and quid pro quo made this compensation; the employee
was still working Ior the company although getting educated, rather than receiving a true
scholarship
2. 117 today
a. 1
st
determine whether or not the payments are scholarship
i. scholarships have NO STRINGS ATTACHED
b. II you have a scholarship, must be qualiIied 117b), these are the 24st recent chanes t4 the
statute
i. 117(a) must be degree candidate
ii. only applies to tuition and Iees, books, supplies, and equipment, CANNOT be applied to
living expenses (but could be ordinary and necessary bus. expenses under 162, but need
duplication, bus. nexus, and timing (see temp. jobs above))
iii. iI you have to perIorm services in order to get scholarship, then not entitled to exclusion
iv. No portion received Ior teaching or research that is a condition oI receiving the scholarship
can be excluded - 117c)
c. Examples:
i. Private Iull tuition scholarship: Fully excludable under 117 (assuming that no services
required, degree candidate, and scholarship is only Ior tuition)
ii. Full athletic scholarship: II not conditioned on playing sports, excludable (rewards past
activity rather than Iuture activity)
iii. Earns tuition by working at college: Has to perIorm services, so not excludable under 117
iv. Earns tuition by working outside oI college: considered income, not excludable
v. Public university, only pays part oI tuition b/c oI resident status
A) Tax on discount oI 13k? No, because resident oI state, already pays through taxes
. There is no symmetry between 162(a) deductions and 117 scholarship exclusions
a. 162(a) deductions are subfect to exceptions under 1-162.5 b (1-2), and therefore may not be
equal to the exclusions that are allowable for scholarships and not subfect to any exceptions.
b. Although exclusions and above the line deductions are typically equivalent, this situation can
create discrepancies between the two.
Other educati4nal credits, deducti4ns and exclusi4ns:
1. 132 (p 123) iI IBM sends you to a location Ior training, then can exclude as working condition
(see analysis on p. 5)
2. Hope Tax Credit - 25Ab) (p 31) & LiIetime Learning Credit - 25Ac) (p32)
a. Choose one or the other no d4uble-dippin
b. Available 4nly if n4 deducti4n is taken under 162a)
i. Under 25A(d) (p33) the credit is reduced by a phaseout once modiIied AGI exceeds
$40,000 (or amount set by the Code) Y up to set amount gets Iull credit, but then gradually
phases out completely as Y increases
A) to determine amount under phaseout subtract modiIied AGI Irom $40,000 and divide by
$10,000 to determine how much oI the credit you can receive
1) ex: ModiIied AGI is $45,000. $45,000-$40,000 $5,000. $5,000/$10,000 . TP
may only get a credit worth oI the allowable credit (single TP)
B) Note: the sum tells you how much to eliminate Irom the credit, not how much you take
c 4pe Tax Credit - 25Ab)
i. OIIered per person, not by household
ii. Must be American citizen
iii. Must be going at least time in post secondary institution - Available to anybody paying
qualiIied tuition Ior themselves or their dependents Ior undergraduate education or vocational
school, n4t raduate 4r pr4fessi4nal educati4n
iv. Limited to Iirst 2 years oI college/can only be taken twice - Total credit available is limited to
$1,500 the Iirst $1,000 spent get 100 credit, but Ior next 1k spent, get a only a 50 credit
18
v. The credit not available Ior students who have a Ielony drug conviction social policy
agenda being advanced by the code
vi. phaseout
d Lifeti2e Learnin Credit - 25Ac)
i. Can be used Ior graduate school or proIessional education
ii. Available only to people who are Iiling jointly
iii. Total credit available is 20 oI educational expenses up to $10,000 (or $2,000)
iv. Can get over and over again, but limited to the h4useh4ld
1) H spends 10k, gets 2k according to liIetime learning credit
2) W spends 4k can`t use liIetime learning credit b/c oI H
v. Phaseout at 40k (AGI) so iI you make 44k (AGI): (44k-40k)/ 10k 4k/10k 40\
1) At 50k, the LLC is completely phased out.
3 222: p232) iher Educati4n Tax Deducti4n
a. Limited to expenses related Ior graduate and undergraduate education
b. Based on income
i. II income is under $65,000 the deduction is $4,000
ii. II income is between $65,000 and $80,000 the deduction is $2,000
iii. No deduction is allowed iI income is greater than $80,000
c. Cannot be used with other deductions, credits or exclusions
4 221: p230) Student L4an Interest Deducti4n
a. Depending on modiIied AGI, up to $2,500 in interest on student loans may be deducted
b. Student must have been enrolled at least part time when costs were incurred but does not have to
be enrolled to take the deduction- has to lead to degree
c. Includes interest on money used Ior living expenses when such money is part oI an educational
loan
d. Can`t d4uble-dip Ior same expenses (can`t have already taken deduction or exclusion Ior
expenses)
e. Phaseout Mod. AGI 50k/15k, or iI married, MAGI 100k/15k
i. But Ior 2008, phaseout occurs b/w 55k-70k (will only get beneIit b/w these amounts) Ior
single people, and 115k and 145k Ior married people
IIITAX EXPENDITURES: I2ple2entin s4cial p4licy thr4uh the tax c4de
A. Tax expenditures replace direct government Iunds; instead the government chooses not to collect
money that they are directly owed
1. Income deIining provisions (I & II) vs. tax expenditures (III)
a Y-definin:
i. ntrinsic to the tax system: Necessary to allow deduction/exclusion in order to arrive at
proper income.
b Tax Expenditure:
i. Extrinsic to the tax system: Policy determination that the expenditure is worthwhile
A) Deductions: tend to beneIit people with higher Y, where credits are more equitable
ii. Tax Expenditures are not income dependent, but are instead related to how you spend your
money.
iii. Loss oI Iund Irom tax expenditure is budgeted by the gov`t the way direct expenditures are
budgeted.
iv. IRC does not diIIerentiate between tax expenditures and Y-deIining provisions. There can be
debate as to which is which.
Child Care Expenses
1. Smith v. Commissioner: Husband and wiIe both work and try to deduct nanny services as a
'necessary business expense, saying that 'but Ior the nanny, neither parent could work
a. Held: No deduction could be taken; viewed a s personal expense under 262. II the 'but Ior test
is carried t its logical conclusion, anything could be deducted as a necessary business expense
19
(Iood, lodging etc).
i. Nannys are like commutes; you choose to have them.
ii. Still good law.
2 P4licy Aru2ents f4r Relief fr42 Child Care Expenses
a. Social Reform. II you lower the cost oI child care, more people will work (allows people to take
lower paying jobs)
i. Ex. A person has a 20 MTR, cost oI child care is $8400 and other costs oI working outside
the home are $3500 so total cost oI working is $11,900. In order Ior TP to take home $11,900
she would have to make 14,875 (11,900 x 120). No incentive to take a low paying job
without relieI.
b. fficiency Argument: People should be allowed to do what environment is the most productive
Ior them, and should be allowed to make that decision Ior themselves.
c. "uality: Tax break will reduce child care costs and increase its quality by allowing people to
aIIord better child care.
d. quity: Might not want to treat people who stay home better than those who work outside.
There is horizontal inequity--- encourages people to stay home rather than work.
i. 3 Couples: As, Bs, Cs
A) As both work, A1 makes 40k, A2 makes 20k 60 k (no kids) taxed on 60k
B) B1 makes 40k, B2 stays at home with the kid (20k imputed income) 40k (taxed on 40k)
C) C1 makes 40k, C2 makes 20k 60k but spend 20k on childcare (taxed on 60k but only
have 40k aIter child care)
3. Child Care Relief in the C4de: CREDITS
a. Can double dip. Use the same child Ior all tax credits
b. These are Credits: same nominal value Ior everyone, where a deduction increases with
increased Y.
i. Credit seen as more equitable, so in 1976 child care deduction was replaced by a childcare
tax credit 21.
c. 21 (p 25) provides a credit f4r dependent care expenses
A) Replaced the Iormer deduction, where the higher the MTR, the higher the value oI the
deduction (people who made more saved more).
B) Now, the 2ax credit is 35 4f 3k 1050) oI child care expenses Ior one child and 35
4f 6k 2100) Ior multiple kids.
C) The amount oI the credit available depends on the AGI: allowed as the tax credit is
reduced by 1 for each $2k by which TPs AG exceeds $10k, but allowable may
never fall below 20. Everyone gets some beneIit; never truly phases out.
1) II AGI is under 15k or less, the max credit oI 35 is available
2) 15-17k 34
3) 17-19k 33
4) At 45k or above 20 (this is lowest credit)
D) This credit is n4t available if y4u d4 n4t have w4rk related expensesencourages
people to work outside the home.
E) Also, n4t refundable; you lose the value oI the credit that exceeds TL
F) This credit is most beneficial t4 the p44r: Examples
1) AGI 15k, childcare expenses is 7k
a) 35 oI 6k 2100 credit (max credit)
2) AGI 15k child care expense is 5k
a) 35 oI 5k 1750
3) AGI 70k, 20k on childcare
a) 20 oI 6k 1200
d. 32 (p35) Earned Inc42e tax Credit EITC): provides credit Ior low-Y TPs equal to oI the
earned Y (EI) (credit amount is small Ior childless taxpayers, larger Ior 1 kid, even larger Ior 2
20
kids)
i. Available to childless people that satisIy age and income requirements
A) 25-65 (Above 25 b/c targets to long term poor, not the situational poor such as students.
Below 65 b/c other programs are available to the elderly)
B) US citizen
C) Cant be claimed as dependent
ii. The credit is based on a percentage that phases out completely at a certain amount oI Y
A) For an eligible individual with one qualiIying child the credit percentage is 34
B) The phaseout percentage is 15.98
1) The earned amount is $6,330 and the phaseout amount is $11,610
a) $0 - $6,330 EI 34 so the amount oI the credit increases, providing an incentive
to work
i) Ex: 34 oI $5,000 $1,700 and 34 oI $6,330 $2,152
b) $6,330 - $11,610 EI: The credit is the same 34 oI $6,330 or $2,152
i) This neither encourages nor discourages work
c) Over 11,610 the credit begins to phase out
i) Disincentive to work
ii) Ex: TP`s EI $15,610. You start with the maximum credit oI $2,512 and
subtract phaseout percentage oI the amount over the phaseout number :
$2152 |($15,610-$11,610 4000) x 15.98 this is phaseout | $1,513
iii)Ex: Complete phaseout: TP`s EI is 25,610: 2152- |(25,610-1161014000) x
15.98| 2152-2237.2 -85 (Really zero)
iii. the credit is refundable iI tax liability is less than the credit the government will issue a
check Ior the diIIerence
e. 24: (p29) Child tax credit
i. TP can claim a credit oI $1000 Ior each qualiIying child claimed as a dependent
ii Phase4ut
A) Starts at $75000 and is complete at $95000 Ior individuals, $110k and $130k Ior couples
iii Available Ior every child, but typically non-reIundable.
C Medical Care Expenses
1. 104,105 and 106: (p97) Private Health Insurance: amounts received as reimbursement Irom
insurance or employer Ior medical expenses are excludable
a. 104-105: TP may exclude the amounts received in connection with insurance and accidental
health plans; when insurance pays Ior medical bills, amounts are generally excluded Irom AGI
i. Ex. II A has 15k medical expenses, but 5k reimbursed can`t deduct Iull 15k, can only
deduct 10k to extent that it exceeds 7.5 oI AGI
ii. can only deduct 2,500 iI AGI 100k
b. 106: health care premiums paid Ior by an employer are excludable
i. employer provided beneIits are treated better
ii. unlike Iringe beneIits, no limit on amount oI coverage that can be excluded (don`t need to
meet 7.5 Iloor)
2. 213: (p 221) Taxpayers are allowed to take a deduction Ior unrei2bursed medical expenses
(included in tax expenditure budget)
a. P4licy aru2ent: Examples
i. TP A: 40k income, 0 Health Expenses TI 40k
ii. TP B: 20k income, 0 Health expenses TI 20k
iii. TP C: 40k income, 20k health expenses (necessary) TI 20k
iv. TP D: 40k income, 20 health expenses (unnecessary hair plugs) TI 40k
A) Medical expenses for elective cosmetic surgery are not deductible unless due to a
deformity from a congenital abnormality, an infury from an accident or trauma, or a
disfiguring disease 213d)9))
21
B) hat about issues of hori:ontal equity when people do not have enough money to pay for
necessary medical expenses?
b Li2itati4ns:
i. These deductions are taken bel4w the line
ii. You would have to itemize (63(d)) (p 61), so cannot use the standard deduction
A) however, not subject to the 2 Iloor on MIDs under 67 (p 64), instead
iii. Only unreimbursed medical expenses in excess oI 7.5 oI AGI may be deducted.
A) This is in place to diIIerentiate between ordinary and extraordinary medical expenses.
iv Under the AMT uninsured med expenses are deductible but only in excess oI 10 oI AGI -
56b)1)) (p 51)
c. Difficult t4 deter2ine what are ~2edical expenses
i. 213 does not Iocus on the costs oI prevention, only the costs of sickness
A) Deductible:
1) Dentist Iees
2) Physical Therapy
3) Quit smoking program Ior smoking related illness
B) Not deductible: anything preventative (general health)
1) Toothpaste
2) Health club
3) Quit smoking program
ii Weiht l4ss pr4ra2s
A) Rev Rule 79-151 A`s physician recommended that she lose weight to improve her
overall general health. Participation was not Ior the purpose oI curing any speciIic
ailment or disease.
1) eld: An expenditure that is merely beneIicial to the general health oI an individual
is not an expenditure Ior medical care
2) When is program a non-reimbursed med expense only when prescribed and
necessary to alleviate mental or physical condition
B) Private Letter Rulin 8004111 TP`s physician recommended weight loss Ior the
treatment and cure oI hypertension, obesity and hearing problems directly related to
excessive weight.
1) eld: because two doctors had prescribed the program Ior the treat2ent 4f a
specific illness, participation is n4t just f4r eneral health and so a deduction may
be taken
iii. 1hoene v. Commissioner: TP`s psychiatrist and doctor both recommended dancing as
exercise Ior his medical condition and mental health. TP purchased 1,677 hours oI dance
instructions and deducted the amount, treating the expenditures Ior dance lessons as
medical expenses
A) eld: Just because a d4ct4r rec422ends an activity does not mean that is must be
characterized as medical care no deduction allowed.
1) Pri2arily f4r treat2ent 4r f4r eneral well-bein test:
a) general well-being not allowed under 213
2) no close nexus between the treatment and the illness
iv. 4ttled Water: 56-19 not deductible iI Ior general welIare, but deductible iI you have an
immune disease that requires you to drink bottled water
A) However, Iluoride added to bottled water is considered a deductible expense
d. Re 1213-1e)1)iii): (p1039) an expenditure which otherwise qualiIies as a medical
expense under 213 shall n4t be disqualified 2erely because it is a capital expenditure
i. A capital expenditure (anything that last beyond the taxable year) made by a taxpayer may
qualiIy as a medical expense iI it has as its pri2ary purp4se the medical care oI the
taxpayer.
22
A) The expenditure qualiIies to the extent that it exceeds the increase in the value oI the
related property (Increase in value compensation, so not UNREIMBURSED)
ii. Ferris v. Commissioner: Doctor recommended that TP install a swimming pool and use is
twice a day to prevent paralysis. TP built luxury pool and enclosure. The pool cost
$194,000. TP reduced the cost oI the pool to $172,160 Ior recreational Ieatures included
and then tried to deduct halI oI the cost or $97,330 as a 213 expense. Commissioner
claimed that TP was limited to a deduction oI halI oI $13,000 (Ior bare minimum pool).
A) eld: You are not obligated to take cheapest way to medical health. As long as the
expense is reas4nable f4r its functi4n and is n4t pers4nal then it is deductible.
1) Re2anded to determine the reas4nable c4st.
iii. Analytic: 1o apply 21
A) Is it personal or medical?
1) Is it necessary? Must be to deduct (see 123(d)(9) and Thoene)
2) Is it general well-being or treatment?
a) Must be treatment to deduct (See Thoene)
b) Disallowed under 262
3) Is there a capital expenditure?
a) Then deduct the capital gain (improvement to home Ior example) (See Ferris)
b) And then determine the reasonable amount oI the medical expenses
B) Once medical expense amount is determined, then see iI it meets the 7.5 Iloor
C) Take deduction under 213 to the extent that it exceeds the 7.5 Iloor.
D Charitable Deducti4ns:
1. Because deducti4ns (and not credits or exclusions) are used Ior charitable giving, taxpayers with
higher marginal tax rates save more
a. c4ntributi4n base AGI
i. Examples:
A) TP has a 70 marginal tax rate and $10,000 income. TP owes $7,000 to the IRS. TP
makes a $100 charitable contribution. TI is reduced to $9,900 and TL is reduced to
$6,930. The treasury gets $70 less the contribution costs the treasury $70 and the TP
$30.
B) TP has a 20 marginal tax rate and $10,000 income. TP owes $2,000 to the IRS. TP
makes a $100 charitable contribution. TI is reduced to $9,900 and TL is reduced to
$1,980. The treasury gets $20 less the contribution costs the treasury $20 and the TP
$80.
b. Creates an upside down subsidy people who make more get more Ior their money.
i. P4licy c4nsiderati4n: While this was not considered equitable with child care (replaced by
credit) or medical expenses (alleviated by the 7.5 Iloor), here we want to encourage people
who make more to give more
A) May still beneIit poorer people because they may be recipients oI the charity even iI they
don`t get as much oI a deduction
B) The government in eIIect subsidizes charitable giving but taxpayer decides what charity
to contribute to government is obliged to subsidize regardless potential Ior abuse
1) However, unlike child care, charitable giving is not Ior personal consumption
ii Criticis2s 4f Charity deducti4ns:
A) People get beneIit out oI giving (psychic beneIit)
B) Only beneIits rich people in society doesn`t beneIit all members oI society (charities
chosen by rich)
C) Subsidizing religion through the government
D) Not as much oversight can`t manage how the organization uses contribution.
E) Any tax expenditure is diverting money Irom gov`t programs
2. 170: (p181) Deducti4ns f4r charitable c4ntributi4ns
23
a. In order to take these deductions TP has to ite2ize
i. below the line deductions subject to phaseout under 68 and AMT
b. 170f)8): (p190) Can`t take deduction Ior contribution Ior more than $250 without receipt
i. Substantiation requirement: charitable organizations need to acknowledge that you gave that
much money
c. Type A Charities: 170b)1)A) (p181)- II you make a contribution in excess oI 50 oI AGI
(contribution base), then not deductible can only deduct 5" of contribution base (ACI)
d. Type Charities: 170b)1)) (p182)- II the TP makes a contribution to a Type B charity
(private Ioundations, etc. which do not warrant the same support) TP may deduct the lesser oI
i. 3" of the 1P's contribution base; OR
ii. the excess of 5" of the contribution base less the amount of charitable contributions
allowable under A (aka what`s leIt in your 50 limit)
e. Examples assuming contribution base AGI equals $60,000
i. A gives $30,000 to type A charity - $30,000 deduction
A) Allowed to take 50 deduction oI 60k AGI because oI type A
ii. A gives $30,000 to type A charity and $2,000 to type B charity - $30,000 deduction
A) Deduction can never exceed 50 oI contribution base
B) You may carry f4rward Ior the next 5 years any disallowed deduction under
170d)1)A) so that $2,000 contributed to type B charity the next year
1) want to exhaust Type A Iirst
iii. A gives $5,000 to type A charity and $20,000 to type B charity
A) $5,000 Ior type A can be deducted (leaving 25k in the Type A limit)
B) $18,000 Ior type B can be deducted
1) based on the lesser oI
2) 30 oI AGI or (18k)
3) What is leIt in the Type A Limit (25k)
C) $23,000 may be deducted (under 30 cap on type B)
1) The $2,000 not deducted Ior the Type B contribution can be carried Iorward.
3. Charitable deduction must be reduced by the value oI the real goods and services that the contributor
receives Ior his or her contribution
a. N4 quid pr4 qu4: II the contributor receives nothing, 170 applies subject to 170(I)(8)
substantiation requirement.
b. Quid pr4 qu4:
i. iI the contributor receives something insubstantial, 170 applies
A) something is insubstantial Ior the purposes oI 170 iI its value is less than 2 of the
contribution or $71, whichever is less Rev. Rule 90-12, 92-102
ii. iI the contributor receives something substantial he must pr4 rate his contribution to
cognize the value oI what is received - 6115 (p 814) organization needs to tell you what
portion deductible (see below)
A) ppewal v. Commissioner: TP deducted as a charitable contribution the sum oI $900
paid to the school where their children attended. The cost oI operating the school
amounted to $320 per student, but there was no requirement to give any amount. The
Commissioner disallowed the deduction to the extent oI $640 on the ground that this sum
represented the cost to the school oI educating TP`s children and was a non-deductible
expense under 262.
1) eld: TP was getting a quid pro quo Ior his contribution and that to the extent that
you get something back you are not making a charitable contribution
a) Still an 4bjective test; whenever there is a quid pro quo to the extent that there is
a beneIit to the TP then that is not a charitable giIt.
b) Amount in excess oI what is received in return allowable as charitable deduction
B) Rev Rule 83-104: Where several Iactors may indicate no charitable contribution, IRS
24
will consider
1) Absence oI a signiIicant tuition charge
2) Substantial or unusual pressure to contribute applied to parents oI kids attending a
school
3) Contribution appeals made as part oI the admissions/enrollment process
4) Absence oI signiIicant potential sources oI revenue Ior operating the school other
than contributions by parents oI kids attending the school
5) Other Iactors suggesting that a contribution policy has been created as a means oI
avoiding the characterization oI payments as tuition
6) Where such Iactors not present, payments by parent will be deductible contributions
even iI cost oI educating kid exceeds the amount oI any tuition charged Ior kid`s
education
iii. iI the contributor receives something that is c422ensurate with what he gives, no
deduction is allowed
A) Unnamed Case: TP has land that he is going to sell to a developer. He gives part oI the
land to the city with the restriction that is must be used as a school, but also owns all the
property around and sells all oI the lots to consumers. TP tries to deduct the value oI the
land given to the city as a charitable contribution.
1) eld: No deduction allowed. Because the land will be near a school it is worth more
the developer. By giving the land to the city TP will be able to sell it Ior more so he
gets something equal to that which he has given.
B) 6115 (p 814) Charities are required to inIorm (written statement) donors oI how much
oI a contribution is deductible when the donor receives goods or services in return Ior the
donation 4nly applies t4 quid pr4 qu4 c4ntributi4ns in excess 4f 75
1) charity is required to tell the donor that the deduction is allowed only in excess oI the
goods received (pro rate and not insubstantial)
a) must provide donor w/good Iaith estimate oI value oI such goods or services
i) Does not include intangible religious benefits - 6115(b) provides that 'A
quid pro quo contribution does not include any payment made to an
organization . . . in return Ior which the TP receives solely an intangible
religious beneIit that generally is not sold in a commercial transaction outside
the donative context.
C) Car donations can use FMV up to $500 deduction, but then aIter limited to what charity
sells car Ior
1) BUT iI the charity keeps the car, give it to someone, or makes improvements to it,
then can use FMV
iv. 170l): (p 197) iI you make contribution to institution oI higher education and receive
tickets Ior seating at athletic event, then 80 oI what you gave is deductible
v. 170f)A): denial oI a deduction over 500 dollars iI there is no substantiation
vi. Generally, have to include prizes and awards as income74(a), but 74b) permits taxpayer
to exclude Irom Y any prize or award Ior religious, charitable, scientiIic, education, artistic,
literary, or civic achievement, provided that prize or award transIerred to governmental unit
or charity
A) 74(b) (p 87) Winner eligible Ior deduction only iI:
1) selected w/out any action on his part;
2) not required to render substantial Iuture services as a condition to receiving the prize
or award; and
3) prize or award is transIerred by the payor to a governmental unit or organization
described in (1) or (2) oI 170(c)

25
QUESTION #2: WEN IS INCOME RECONIZED? ains and l4sses 4n Pr4perty

I The Realizati4n Principle
A. 2 terms:
1. Realizati4n: whether there has been some change in circumstances that makes it appropriate to
require taxpayer to recognize gains or losses (SALE or EXCHANGE)
a. Under 61a)3) (p58) I includes all gains derived from dealing in property
i. Reali:ation principle. as a rule gains or losses on property are taxable only when the property
is s4ld 4r exchaned (however, there are non-recognition provisions that provide exceptions
Ior otherwise recognizable sales and exchanges).
A) This is to prevent liquidati4n and 2easure2ent issues more eIIicient to wait until sale
or exchange
ii. Unrealized ain: An increase in the value oI property that has been neither sold nor
exchanged
iii. Realizati4n Event: Sale or exchange oI property.
A) Even when a realization event has occurred, the gain is not taxed until it is recognized
b Rec4niti4n: The actual gain or loss that is derived Irom a realization event and then taxed.
i. 161-6a): describes gains derived Irom dealing property as any gain realized on the sale or
exchange in property (pg. 899)
A) You cannot tax without a rec4niti4n event (sale or exchange)
B) You cannot have recognition without realization, but just because a ain is realized
d4es n4t 2ean it is rec4nized.
C) 121 (p141) II you sell your principle residence, there is a realization event, but there will
be no gain needs to be recognized by the TP
c. Exa2ple Pt 1: TP buys land on January 1 Ior $100. On December 31 the land is worth $150. TP
has an economic gain insoIar as the property has appreciated but because TP has not sold or
exchanged the property there is no realization.
i. The realization principle is a transacti4nal principle: taxation does not occur when there is a
gain, only where there is sale/exchange.
d. Pt 2: Over the next two years the property does not appreciate Iurther. TP then sells the property
Ior $150. TP has realized a gain oI $50. Unless some exception applies, TP will have to
recognize the gain and pay taxes.
i. Note the use oI transacti4nal principal: TP realized no economic gain in the year the
property was sold but the completion oI the transaction resulted in realization oI the previous
gain.
e. Pt 3: Instead oI selling the property, TP exchanes it Ior a speedboat worth $150. TP has
realized a gain oI $50. Unless some exception applies, TP will have to recognize the gain and
pay taxes even iI he has no other asset in the world.
i. With exchanges, as opposed to sales, there are pr4ble2s 4f valuati4n and liquidity (see
below).
ii. However, iI we did not consider exchanges as realization even, taxpayers would engage in
trading only to avoid paying taxes resulting in a shrinking oI the tax base.
I. Pt 4: Instead oI buying land, TP buys st4ck, which appreciates Irom 100 to 150 in one year.
A) No realization event, but there is not really a problem oI valuation or liquidity.
) Although it doesn`t seem like it should, the realizati4n principle d4es apply t4 st4ck
1) ncourages people to invest.
Pr4ble2s with Taxin Unrealized ain
1. 'aluati4n: unrealized appreciation can only be measured by valuing property on hand at the end oI
each taxable period to see how much the value exceeds the costs or prior value
a. This would be administratively very burdensome.
2. Liquidity: inclusion oI unrealized appreciation in taxable income would create a tax liability without
26
any corresponding immediate source oI Iunds with which to pay
a. Even though liquidity pr4ble2s d4 n4t apply t4 l4sses (taking a loss makes TP more liquid as
it oIIsets other Y) the IRC still requires a recognition event beIore the loss is recognized
i. Allowing the recognition of losses while not requiring the recognition of gains would distort
economic reality.
A) Ex: TP has $60,000 in salary. TP invests $100,000 in two diIIerent stocks. HalI goes up
by $40,000 and halI goes down by $25,000. We do not require recognition oI the
$40,000 gain because oI the liquidity and valuation problems. II we allowed recognition
oI the $25,000 loss TP would be able to oIIset his salary by that amount and would only
have to recognize $35,000 even tough we know he had total gains oI $35,000 $40,000.
C The Ec4n42ic enefit 4f Tax Deferral
1. Taxpayers want to deIer payment oI taxes through non-realization or non-recognition because oI
the time value of money
2. Disc4untin: determining the value oI deIerring tax liability on a certain amount oI money Ior
a set a amount oI time at a particular interest rate
a. With an interest rate oI 10 the present value oI $1 in one year is the amount which, iI
invested today, it will grow by 10 to equal $1 in one year. 1/1.10 $.09. You would have
to invest $.91 today to have $1 in one year with a 10 interest rate.
b. II you can deIer tax liability you can pay the discounted rate.
D. ifts 4f Pr4perty: The realizati4n principal
1. There are tw4 advantaes oI giving away appreciated property as a giIt
a. Deferral making a giIt oI appreciated property is n4t a realizati4n event. GiIts oI appreciated
property are not taxed until the donee sells or exchanges the property.
b. Taxed at a l4wer rate - gain is realized only when the donee sells or exchanges the property. II
the donee`s marginal tax rate is lower than the donor`s marginal tax rate then the gain is taxed at
a lower rate.
2. A makes giIt to B A paid $100 Ior property and holds it then gives it to B when it`s FMV is $200
a. Gain will be shiIted Irom A to B: when B sells property, gain will be taxed at B`s rate (best Ior
TP iI B`s rate is lower).
i A d4n4r) gets to exclude this under 102a) (p 97)
b. Realized gain oI $100, iI marginal tax rate oI 50, then A would be leIt with $50 but iI gives
to B and B sells to C Ior $200 (realization event), then B`s amount realized is also $200, and has
basis oI $100
i. 1015 (p 589) carry4ver basis, B steps into shoes oI A and basis is what A paid Ior
property,
c. but iI B has a MTR oI 10 gives IRS only $10
3. 1041(p 609) Transfers b/w sp4uses and f4r2er sp4uses incident to divorce IFT
a. II S1 pays $100 Ior property and now has FMV oI $150, then sells to S2 and S2 gives S1 $150
i. AR $150; Bs $100
A) Result: S1 doesn`t realize gain, S2 takes property with S1`s basis and taxed on gain when
sells property
E F4r2ula AR what y4u sell pr4perty f4r) - s y4ur invest2ent) Taxable ain
II Deter2inin asis
A. asis : the amount of an investment in property
1. hen calculating gains and losses do not include the amount invested in the property (Bs)
2 A24unt Received: The amount received when the property is sold.
3. Taxable ain: amount realized less the basis. (realized gain).
4. 1015 (p 589) tells you the basis 4f pr4perty transferred by ift
a. A giIt with detached and disinterested generosity comes with carry4ver basis: transIeree will
have the same basis as the transIeror (in case oI gains)
b. Carry4ver basis preserves ains when giIt is made.
27
i. Ex: M has a basis oI $3,000. She gives property to D. D sells the property Ior $4,000. D uses
M`s basis and has a gain oI $1,000 ($4,000 amount realized - $3,000 basis).
c. owever, LOSS: where the property transIerred has depreciated (basis is greater than FMV)
and the donee sells the property Ior a loss, then the basis is the FM'
i. CAN`T GIVE AWAY LOSSES, ONLY GAINS 1015)
ii. For this exception to apply, 2 requirements:
A) must be depreciated at the ti2e 4f the ift, AND
B) transIeree subsequently must sell pr4perty at a l4ss
iii. Anytime there is depreciated property, and sell in between the FM' and s, no gain or
loss is recognized
A) Ex: M has a basis oI $3,000 and FMV oI $1,000. M gives the property to D and D sells
the property Ior $1,500.
1) We cannot use the carry 4ver basis because that is only used where the property
has a ain(to prevent donor Irom giving away losses).
2) We cannot use the FM' basis because the property was not s4ld f4r a l4ss
a) iI you sell Ior greater than both FMV and carry over basis you have a gain; iI
you sell Ior less then both FMV and carry over basis you have a loss; iI you sell
Ior in between the FMV and the carry over basis you have an absurd result and
there is no gain or loss
d. Using the FMV basis prevents TP fr42 ivin away their l4sses, allowing the transIeree
to greater reduce her tax liability (higher potential Ior abuse).
i. Ex: M has a basis oI $3,000 and the FMV is $1,000. M gives the property to D and D
sells the property Ior $500. Because D 1) received depreciated property and 2) sold that
property Ior a loss her basis is the FMV. D has a loss oI $500 ($1000 basis - $500
amount realized). This reIlects D`s loss only (the value oI the property she received less
the amount realized Irom the sale). II we allowed D to use M`s basis she would have a
loss oI $2,500 ($3,000 - $500). Only $500 oI that loss is D`s; the other $2000 is M`s
loss. ($3,000 - $1,000). Allowing D to recognize M`s loss would result in a great
reduction in D`s tax liability.
e. 165a) (p 163) Losses are deductible Irom TI
I. 1015e) ifts between sp4uses: transIeree uses basis determined by 1041(b)(2) (p 609)
i. Carryover basis; FMV NEVER APPLIES because 1041(b)(2) trumps 1015
III.NON-RECONITION E'ENTS: even iI taxpayer has realized an economic beneIit, the IRC may provide
Ior not recognizing the gain or loss (until a later time or indeIinitely).
A. Why do we not allow people to take some losses:
1. Would distort economic realities
2. Measurement: not sure what it`s worth
3. Symmetry: by allowing people to deIer gains, but also allowing to recognize unrealized losses,
would not create symmetry
B. 3 cate4ries oI non-recognition: In the absences oI these exceptions, there would be recognition
1. C4ntinuity 4f invest2ent: even though there has been a sale or exchange, because TP is in almost
the same position as beIore the sale or exchange, not enough has happened Ior a realization event
and TP cannot recognize a gain or loss
a. Applies to both ains and l4sses
i. eneral Rule: TP wants t4 rec4nize l4sses but n4t ains
2. ardship: it would present a hardship to tax TP
a. Applies only to ains b/c losses lessen the TP`s liability, improving his situation
i. Liquidity issues: Ex. 453 Installment sales
3. Tax av4idance: II the only motivation Ior a transaction is tax avoidance insoIar as the transaction
lacks any economic value/reality, the recognition is disallowed.
a. Applies only to l4sses: TP engages in transactions to create losses that shelter income
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i. TP will not try to create gains
ii. Ex: 267 (related party sales) (p 253), 1091 (wash sales) (p 614) below, 1211 (capital
losses) (p 619), Iorm over substance
C. ifts: The donee oI a giIt realizes an economic beneIit but this beneIit is not recognized under 102(a)
until the donee sells or exchanges the property. See above
D. NON- RECONITION E'ENT #1: ardship
1. Sales f4r Deferred Pay2ent: Installment Sales (can`t use Ior securities stock) There is realization,
but only partial recognition.
a. 453: (p 429) Where TP sells property but is not paid, in whole or part, until another tax year,
the TP is allowed to defer recognition of the gain until TP is actually paid to prevent undue
hardship (at least 2 tax years are involved)
i. Ex: TP owns property with a basis oI $20,000. II TP sells the property Ior $100,000 outright,
TP would have realized a gain oI $80,000 and would have to recognize the gain. But iI TP
sells the property Ior $10,000 outright and $90,000 over the next 10 years, 453 applies.
A) TP has realized a gain Ior the $100,000 in each case, but with the installment sale TP
does not have cash in hand and may have liquidity problems insoIar as paying the tax is
concerned and valuation problems insoIar as TP doesn`t know iI he will receive the entire
purchase price.
B) Because installment sales Iall somewhere between an outright sale and holding on to
property, with similarities and diIIerences to each, it is treated diIIerently.
2. Under 453 each year TP recognizes the proportion of payments received in that year which the
gross profit (realized or to be realized when payment is complete) bears to the total contract price.
a. Ex: TP receives $10,000 a year in income Irom the installment sale. To determine how much
TP must recognize in that year, 2ultiply the pay2ent received ti2es the r4ss pr4fit (gain
to be realized) 4ver the c4ntract price. $10,000 x ($80,000/$100,000). TP must recognize
$8,000 in that year.
i. Install2ent 2eth4d: (PAYMENT X (GROSS PROFIT/K PRICE) recognized Y
ii. Note that iI there was no installment payment TP would have to recognize $80,000. Under
the installment method, assuming that every year TP gets $10,000, TP would recognize
$8,000 per year Ior 10 years Ior a total oI $80,000. In each case TP recognizes the same
amount as would have iI was taxed on whole thing initially, but the installment method
ONLY AFFECTS TIMING; preIerable because oI the time value oI money.
b. Under 453 TP can rec4nize full ain now iI you want to (opt out oI installment method)
i. Good idea iI your current tax rate is l4wer than your Iuture rate, or iI you have a carry-
4ver that is about to expire
3. ye v. U.S.: W invested $30,000 in stock that rose signiIicantly in value. H became a Iinancier Ior a
construction project and needed $100,000. H acquired stock Irom W paying $12,000 in cash upIront
and giving a promissory note Ior $100,000 payable in 11 equal annual installments plus interest. H
sold the stock to raise the money needed Ior the investment. Based on 453 W recognized $9,000
|$12,000 x $90,000/$120,000|. The Commissioner claimed that H was an agent oI W and thereIore
installment sale was disallowed.
a. eld: Transaction valid. The court Iound that the marriage relationship alone was insuIIicient to
deprive an individual oI the beneIit oI 453, especially where, as here, spouses do not
commingle assets
i. ut, W sold H the installment contract at below market interests calling into question
whether the court was correct in Iinding that H and W were dealing at arm`s length.
b Li2itati4ns - It would be harder f4r and W t4 acc42plish this transacti4n t4day
i. Under 1041 (p 609)any transfer between married couples is treated as a gift
A) H would not recognize a gain when he received the stock Irom W but when he sold it he
would have to use W`s basis and assuming H sold the stock Ior $120,000 he would have
a gain oI $90,000 so there is no deferral, just a different taxpayer
29
) applies both to spouses and Iormer spouses incident to divorce
ii. 453e) Restricti4ns 4n related parties: Suspicious oI ability to deal at arms length
A) When a related party sells to another related arty using an installment method, the
transIeror may use 453 to only partially recognize gains until the transIeree disposes oI
the property in a second disposition, at which point the entire remaining gain must be
recognized.
1) Ex: Sister sells stock to Brother in the same vein as Nye. S would be able to use 453
and in the Iirst year would recognize $9,000 and recover $3,000 oI her basis. But, iI B
sells the property to a third party, S would realize $108,000 ($120,000 contract price -
$12,000 already paid). S`s basis would be $27,000 ($30,000 initial basis - $3,000
basis already recovered). In that year S would have a gain oI $108,000 - $27,000 or
$81,000.
i) 2 yr Excepti4n: II B is willing to wait two years beIore making the
disposition to the third party, then S can use the installment basis (II you are
willing to wait 2 years, then there is economic reality and not integrated, and
no problem, but otherwise have to wait until sale is completed in order to sell)
ii) II marketable securities, then 2 year exception doesn`t apply
iii. 453k)2): (p 434) the installment method cannot be used for the sale of stock or
securities traded on an established securities market
iv. 453b): (p 429) Dept. store can`t use installment method to account Ior sale oI reIrigerator
b/c it is considered inventory under 453(b)(2)(B)
A) This provides an unIair advantage Ior stores that can aIIord installment sale method,
whereas smaller stores would be taxed on Iull amount
B) 453(b)(2)(A) says installment sales don't include dealer dispositions, BUT
1) 453(l) (p 434) dealer disposition doesn`t include dealers that sell Iarm property or
timeshares (so 453 does apply) BUT
a) won`t get time value oI money pursuant to 453(l)(3).
2) Must ask the dealer if the item is in their inventory at the close of the taxable year
E NON-RECOINTION E'ENT #2: Tax Av4idance f4r l4sses 4nly)
1. C4224n Law Appr4ach: IRS can always use this argument to disallow deductions
a. Where there is form over substance and the taxpayer is in essentially the same position after the
transaction as he was in before the transaction, TP will not be allowed to recognizes losses
because nothing has actually changed
i. Today this argument is largely a back-up because there are many statues providing Ior non-
recognition oI losses that are easier to apply.
b. iggins v. Smith: InnisIail Corp. was wholly owned by TP. A number oI shares oI stock were
sold to the corporation by TP at a loss which TP recognized. The commissioner disallowed the
recognition.
A) eld: Although 267 (p 253) was not yet enacted, the court Iound that TP did not
actually sustain a loss because although title to the stock passed to the corporation, TP
retained control (TP attempting to put Iorm over substance).
1) Holding now codiIied in 267 (see below)
c. orne v. Commissioner: Note p 271 TP bought a seat on the stock exchange beIore the stock
crash. TP bought another seat. TP sold the Iirst seat ten days later and claimed a $23k loss.
i. eld: TP could not recognize the loss. TP still had the seat and also had losses. It was clear
that he was trying to get around the realization principle (elevating Iorm over substance)
A) 1091 (p 614) did n4t apply because it is only applied to securities and stocks.
2. Related Party Sales
a. 267 (p 253) No deducti4n shall be allowed in respect to any loss Irom the sale or exchange oI
property, directly or indirectly between related persons (b/c related persons are not truly parting
with an asset this provides an irrebuttable presumption that the two parties cannot deal at arms
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length)
i. 267(b)(1) Members oI a Iamily
ii. 267(b)(2) Corporations and individuals that control them
iii. 267(b)(3) Two corps. Controlled by the same group
b. Example: Mom sells property w/ basis oI 500 dollars to daughter Ior 200 dollars, recognizing a
loss oI 300 dollars.
i. TPs are not trustworthy to sell at FMV to Iamily members
A) Has not really parted with the asset, or may wish to sell to daughter at lower price.
B) No incentive to accurately value the property.
c. McWilliams v. Commissioner: H managed W`s estate. H ordered his broker to sell stock Irom
W`s estate and then to buy the same number oI shares oI the same stock Ior his estate,
recognizing a loss. The Commissioner disallowed the deduction under 267.
i. DiIIerent Irom other 267 transactions because there is no direct sale
A) W did not sell her stock to H but to the stock exchange
ii. eld: Not deductible his was an indirect transaction under 267; holding otherwise would
leave too big oI a loophole and Irustrate the purpose oI 267
A) 1091 (p 614)doesn`t apply b/c in this case there are two TPs, 1091 is directed to 1 TP
situations
1) possible to argue that H and W could be acting as 1 economic unit by Iiling joint tax
return/being married
3. Wash Sales: Where it appears that TP has recognized a loss but still has the property apply 1091
a. 1091 provides that in the case oI any loss claimed to have been sustained Irom the sale or
exchange oI stock or securities where it appears that, within a period beginning 30 days beIore
the date oI the sale or exchange or ending 30 days aIter such a date, (look backwards 30 days,
then Iorward 30 days Ior 61 day total) the taxpayer has acquired substantially identical stock or
securities, then n4 deducti4n shall be allowed under 165. (Bought stock in anticipation oI sale)
61-day period
A) 1091 does not look at the taxable year but absolute time.
B) Excepti4n: This section does not apply to a dealer in stock or securities where the loss
is sustained in a transaction made in the ordinary course oI business.
ii. Re 11091-1h) (p 1525) a Ilag is raised when TP has assets and losses regardless oI the
order oI the transactions
A) Ex 1:
1) 1/1/01 TP buys 100 shares Ior $500,
2) 1/15/02 TP sells Ior 250 ($250 loss) so Iar Iine.
3) 1/30/02 TP buys same stock back Ior $300, voiding the 1/15 transaction
4) Note: should TP decide to sell 31 days aIter 1/30, the basis would rise Irom the
original $500 to $550, incorporating the additional 50 dollars spent on 1/30/02.
B) Ex 2:
1) On 9/21/54, TP buys 100 shares Ior $5k ($50/share), then
2) On 12/21/54, TP buys 50 more shares Ior $2750, ($55/share) then
3) On 12/27/54 buys 25 shares or $1,125 ($45/share)
4) On 1/3/55, TP sells 100 shares Ior 1k ($40/share) and says entitled to loss based on
1/3 transaction
a) Look 30 days beIore sale date, did you buy substantially identical stock? Yes
not entitled to loss 75 shares are tainted, but 25 shares Irom original transaction
ok (original purchase oI 100 shares happened back in September more than 30
days)
i) AR 1k (25 x 40) can only take 25 shares oI original transaction and sell
shares at 40/share, SO multiply 25 shares by $40
ii) Bs 1250 (25 x 50: 25 shares Irom original transaction that aren`t tainted)
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iii)Loss 250
5) Then assume that on 1/4/55, TP bought 20 shares oI identical stock only 5 shares
wouldn`t be tainted (bought 75 shares within 30 days beIore sold 100 shares, and then
bought 20 within 30 days aIter sale, original transaction doesn`t matter because more
than 30 days beIore sale)
6) The order oI the transactions does not matter, only the timing.
7) Note that the initial losses are not permanent, but are deIerred. Later we will make an
adjustment to the basis to reIlect the loss.
4. Capital ains and L4sses: The IRC distinguishes between gains and losses Irom ordinary income
and Irom capital gains
a. Ordinary Inc42e: salary, interest on investments, proIits Irom running a business, etc.
i. Ordinary L4sses: includes running a business Ior example
b. Capital ains: Income Irom holding property as an investment such as increases in stock values
c. Type 4f Y depends 4n capacity in which TP holds the property: II TP holds as investment and
sells, then generates investment Y and have a capital gain/loss
d 1ax Preference f4r Capital ains
i. Old law (1202), (p 616)taxpayers received a 60 deduction Ior long term capital gains so
there was a substantial beneIit to having something characterized as a capital versus an
ordinary gain;
A) Ex: TP purchases stock as an investment Ior $6,000 and sells it Ior $10,000. Gain
$4000. II this were an ordinary gain and TP had a marginal tax rate oI 50 he would
have to share $2,000 with the Treasury.
B) Under the old law TP could exclude 60 oI the gain and would only be taxed on 40 so
that TP would be taxed on $1,800 (40 oI $4,000). TP would only owe the Treasury
$800 (50 oI $1,800).
ii. T4day there is still a preIerence but it is achieved by giving a favorable rate for capital
gains rather than a deduction.
A) Instead oI paying the normal rate, TP pays the preIerential capital gains rate in 1h)
1) The rate schedule is complicated as the preIerential rate is based on the ordinary tax
rate
a) iI you have a MTR oI 10 or 15 0 on capital gains
b) All others 15 on capital gains
c) In 2010: these rates are supposed to go back up to 20 and 10
2) TP would like to have assets classiIied as capital gains in order to receive lower rate
) This applies to most capital gains but ains 4n c4llectibles, Ior example, are taxed at a
hiher rate
1) Must hold the asset Ior 12 months, iI not ordinary Y applies
C) Ex: TP has a marginal tax rate oI 50 and a capital gain rate oI 15. She has ordinary
income oI $100,000 and capital gains oI $10,000. TP will owe $50,000 on her ordinary
income and $1,500 on her capital gains Ior total tax liability oI $51,500.
e. The C4rresp4ndin disadvantae f4r Capital L4sses: 1211b): capital losses may be
deducted only to the extent that the taxpayer has recognized capital gains; can`t use losses to
shelter ordinary Y. TPs d4 NOT WANT losses classiIied as capital losses; can only be used to
the extent that you have non-ordinary income based gains.
i. 1211b)1): (p 619)BUT you may use up to 3, of capital losses to offset ordinary
gains in any given year
A) BUT iI you have losses that exceed that 3k, then must carry f4rward indefinitely
B) Ex 1: TP has a marginal tax rate oI 50 and a capital gains rate oI 15. He has a
capital loss oI $50,000, ordinary income oI $100,000 and capital gains oI $10,000. The
Iirst $10,000 oI the capital loss can be used to oIIset the capital gain so that no capital
gains are taxed. $40,000 in capital losses remain. $3,000 oI the capital loss can be used
32
to oIIset the ordinary income (under 1211(b)(1)). ThereIore TP has a tax liability oI
50 oI $97,000 or $48,500.
1) TP has $37,000 oI capital losses remaining. These losses can be carried Iorward
indeIinitely and applied to oIIset capital gains and ordinary gains (up to $3,000 a
year).
2) ut TP preIers to oIIset gains as soon as possible because oI the time value oI money.
C) Ex 2: TP has ordinary loss oI $50k, ordinary income oI $100k and Capital gains oI $10k
1) Can use all ordinary losses 100k- 50k 50k
2) Apply MTR oI 50 50k x .5 25k (TL)
3) Apply rate oI 15 to Cap. Gain 10k x .5 1,500
4) Add Cap. Gain liability to TL. Total TL 26.5k
ii. If n4 1211: Assume TP has salary oI $60,000 and invests $100,000 in stock that appreciates
by $40,000 and $100,000 in stock that depreciates by $40,000.
A) TP would sell the losses and not the gains. TL would be based on 60k rather than 100k.
1) This would allow TP to distort his economic reality, because he is taking losses and
sitting on assets
2) Though he could take the 3k under 1211(b)(1).
B) 1211 prevents TP Irom cherry picking to use the devalued stocks to oIIset income
iii Arguments aainst 1211:
A) Discourages people Irom investing in risky securities b/c ordinary losses are treated the
same as capital losses
F NON-RECONITION E'ENT #3: C4ntinuity 4f invest2ent
1. Like-Kind Exchanes
a. 1031: (p 599) Has a non-recognition provision Ior both gains and losses. This will
automatically apply to like-kind exchanges Ior business 4r trade 4nly; n4t f4r pers4nal use
i. The purpose is to postpone rec4niti4n 4f ains and l4sses, not to exclude them
permanently (deferral provision).
A) Ex 1: Property A is exchanged Ior Property B. A has a basis oI $60 in Property A and the
FMV is $100. The FMV oI Property B is $100. AIter the exchange, A has an amount
realized oI $100. A`s basis is $60 so the gain that would be recognized is $40. However,
because the exchange is like kind under 1031, the gain is preserved, not recognized
immediately. 5 years later A sells Property B to X Ior cash. She sells the property Ior
$100. To Iigure out A`s gain, we use the basis Irom Property A and apply it to Property B
($60) so that the gain is $40 and it is now recognized.
1) Substitutive basis: 1ransferring the basis from A to preserves the gain.
2) Can`t opt out like 453 mandatory provision)
B) Ex 2: Property A is exchanged Ior Property B. A has a basis oI $60 in Property A and the
FMV is $100. The FMV oI Property B is $50. AIter the exchange, A has an amount
realized oI $50 and a basis oI $60, so a recognized loss oI $10. However, because the
exchange is like kind under 1031, the loss is preserved, not recognized immediately.
C) Ex 3: Examine Irom A`s Perspective
1) Prop A FMV oI $100, Bs $50 is exchanged Ior Prop B, FMV 90
2) The realized gain is $40
a) This is a 1031a) transaction.
i) There is no recognition oI her gain, which makes TP happy (she is permitted
to deIer)
D) Ex 4:
1) Prop A FMV 100, Bs 100 is exchanged Ior Property B, FMV 90
2) Amt realized 90, Bs 100 so loss oI 10 dollars
a) This is a 1031(a) transaction too
i) There is no recognition oI the TP`s loss, which makes her sad
33
ii) Can be taken into account through basis adjustment
ii 1031 p 599) Require2ents
A) There is an exchange, NOT A SALE
1) 14rdan Marsh C42pany: TP received $2.3 million Ior property and in return
received a 30 year lease oI the same property (loss oI 700k). TP wanted to deduct a
loss (basis was higher than what they sold the property Ior). Because Reg. 1.1031 (p
1495) provides that a 30 year leasehold is the same as a Iee interest, the
Commissioner held that there was a like-kind exchange and a non-recognition event.
a) 4ldin: The court Iound that there was a sale and not an exchange so that 1031
did not apply, holding Ior TP despite Reg 1.1031
i) TP is ~cashin 4ut a l4sin venture: FMV was used in all transactions, iI
this was not the case it might imply that the two transactions are connected.
ii) This is not a 1031(a) transaction because cash is als4 bein exchaned, not
just property.
iii)TP was in a different p4siti4n he did not receive a leasehold in a diIIerent
property, but in the same property (change in quantum oI ownership).
iv) 1031(c) could apply as this is a loss Irom an exchange not solely inkind (but
is not applied) b/c receiving lease cash and loss
v) IRS could have made a substance over Iorm argument but did not
b) HYPO: Suppose that the taxpayer sold Ior 2.3 million and had an option to
purchase back Ior either
i) 2 million: this is the worst because it is putting the TP in a better position,
which is questionable
ii) 2.3 Million: Still bad because although it put him in the same position TP was
in in the Iirst place and there is a question as to why TP would need to sell.
iii)FMV (increase): This is less bad because everyone would have this option.
B) The property exchanged is held Ior productive use in a trade or business or for
investment (not personal consumption)
1) Reg. 1.1031(a)-1(a) (p 1495)provides that you can exchange property held Ior
productive use in a trade or business Ior property held Ior investment and vice versa
providing some Ilexibility
C) the property is exchanged for property of a like kind that is to be held Ior productive use
in a trade or business or Ior investment
b. What is ~like kind pr4perty?: Make sure property doesn't Iall into one oI the exceptions
Iound in Re 11031a)i)-vi) (p 1495).
i. Real pr4perty is deIined liberally so it is easy Ior two pieces oI real property to be Iound to
be like kind (very broad deIintion oI like-kind)
A) properties don`t have to have comparable values, and # oI parcels doesn`t matter
B) Re 11031a)-1b) says that improved and unimproved property are like kind Ior the
purposes oI this section; refers to nature or character of property, not to its grade or
quality.
C) Exception: 1031h) (p 601) real property held outside oI the United States is not the
same kind as real property held domestically
ii. Pers4nal Pr4perty: the deIinition is diIIerent:
A) Re 11031a)-2, 3 To be considered like kind, personal property must fall in the same
category as the personal property Ior which it is exchanged:
1) depreciable, tangible personal property
2) non-depreciable personal property
3) intangible personal property
B) Personal property 2ust be used in the US f4r like kind exchanges
iii. 11031a-1c): For purposes oI 1031, a fee interest in exchange for a leasehold interest of
34
3 years or more is considered like kind property.
A) Exa2ple: II A gives up Iee interest in prop. A to B in exchange Ior 35 year lease on
prop. B like kind exchange b/c lease over 30 years Iee interest
iv. L4ans: are 1 like kind property:
A) Ex 1: Savings and Loan (S&L) held mortgages that paid 6. Interest rates surged. S&L
owed investors 12 and the value oI the mortgages plunged. S&L would have beneIited
Irom selling the mortgages and taking a loss but could not because they would also have
to record the loss on their book placing them at risk oI closure. Rather, S&L sold 90
participation in loans to another S&L and received substantially identical loans in return.
S&L claimed a loss on the sale and the Commissioner disallowed it claimed that the S&L
did not change position and thereIore could not take the loss under 1001.
1) IRS c4uldn`t use 1031 argument b/c it doesn`t apply to loans or mortgages
B) Cottage Savings Assn v. Commissioner: Reciprocal sale oI mortgage loans by Cottage
S&L in order to realize a loss Ior tax purposes. No actual sale because they did not want
to report the loss to bank regulators. Sold only 90 interest in order to be able to still
service the loans.
1) Recipr4cal sale example:
a) Two sales go on at the same time, Cottage selling mortgages to Rosemont and
vice versa
i) Same risks (geographically the same, same interest rates)
ii) Creates a loss Ior both companies Ior tax purposes.
2) eld: Under 1001 (p 586) a gain or loss cannot be recognized unless the gain or
loss arises Irom the disposition oI properties that are materially different
a) Supre2e C4urt: Allows TP to take the deduction, saying in order to 1001 to
apply:
i) There must be a disp4siti4n 4f pr4perty: exchange of participation interests
is a disposition oI property
ii) The properties must be 2aterially different: here they are materially diIIerent
because they embody legally distinct entitlements
b) The S&L sustained a loss under 165 (p 163)insoIar as the transactions were
conducted at arms length and the S&L retained no ownership over the
participation interests it traded.
c) 1211 (p 619) does not apply b/c it only applies to capital losses, and S&L is
involved in these transactions as part oI ordinary trade or business.
2. Exchanes n4t solely in like kind (Like kind property plus cash)
a. ains: 1031b) where TP exchanges like kind property under 1031(a) and also receives
24ney 4r b44t, then the gain of the 4ther property must be recognized (unlike (c), Iorces you
to recognize)
i. Ex: Property A has FMV oI $100 and a basis oI $50. A gives this property to B and gets
property with FMV oI $90, a $10 necklace and $5 cash. A has realized a gain oI $55
|(AR:90105)-Bs50|. A must recognize FMV oI the additional items ($10 Ior the necklace
and $5 cash). $40 is not recognized in the exchange. Rec4nize ain t4 extent 4f FM' 4f
b44t and cash
b. L4sses: 1031c) where TP exchanges like kind property under 1031(a) and also receives
24ney 4r b44t, then the l4ss is not recognized
i. Ex: Property A has a basis oI $120. Property A is exchanged Ior Property B which has FMV
oI $90. A also receives $10 cash. A has realized $100 and has a loss oI $20. Original owner
oI Property A cannot recognize the loss.
A) However, it will be preserved through basis adjustment.
1) Basis Ior property B (owned now by A) will be adjusted Irom 90 to 110
a) To get Adjusted basis. Take the basis 4f pr4perty A and subtract the cash
35
iven 120-10110 Adj s f4r pr4perty received) asis 4f pr4perty s4ld -
cash received
ii. o symmetry between gains and losses from exchanges not solely in kind
3 Three Party Exchanes
a. When A and B have similar property that each other wants, it is a good deal to exchange. OIten
A and B don`t want each other`s property but A has property B wants and A wants X`s property.
This transaction can be accomplished two ways
i. With4ut a third party exchane, A sells property to B and gets cash. A uses cash to buy
X`s property. The cash is taxed as income even iI A only has it Ior an instant. A has less
money to pay X.
A) A has to recognize gain
ii. In a third party exchane A tells B that A wants X`s property. B uses the cash he was going
to use to buy A`s property to buy X`s property and then B gives A property X and A gives B
property A.
A) There is the same end result A has property X, B has property A and X has cash but
under 1031 A has no recognition event and does not have to pay taxes on the gain.
1) Everyone in same position
2) A would receive prop. X as exchange rather than sale
3) Example oI elevating form over substance, but allowed because most jurisdictions
have Iound that where the primary intent is to engage in an exchange
4) Cash option doesn`t take situation outside oI 1031
iii Si2ultaneity is n4t required
A) Redwing Carriers: TP sold used trucks Ior cash to a truck manuIacturer and several
weeks later bought new trucks Ior cash Irom the same manuIacturer. TP claims that this
is not an exchange because he wants to take losses Ior selling the used trucks.
1) eld: For IRS (apply 1031) that TP gave up cash and old trucks Ior new trucks so
that there was no recognition (like-kind exchange). Court Iound that break in time
between steps was not significant.
a) NOTE: II TP had realized ains rather than losses the IRS w4uld want there t4
be rec4niti4n and the opposite holding.
B) 1031a)3) Li2itati4n: the transactions must 4ccur within a reas4nable ti2e; a like
kind exchange is not allowed iI:
1) Property to be received isn`t identified within 45 days (Irom day transaction begins),
OR earlier of
2) 18 days to receive property runs concurrently w/45 days, OR due date for filing
taxes (aIter 10/16 oI the prior year, you would not get the Iull 180 days)
a) # 4f parcels d4esn`t 2atter, so iI A gives prop. A to B in exchange Ior properties
B and BB, still under (a), but iI exchange is Ior prop B and necklace, then (b) or
(c)
3) Stalker: Not in the book, but tested the limit Ior this type oI transaction by keeping
the transaction open Ior 7 years.
G. IN'OLUNTARY REALIZATIONS:
1. Inv4luntary C4nversi4n: The only n4n-rec4niti4n event where TP isn`t involved
a. 1033: (p 602) provides Ior non-recognition oI ain when property is
i. Compulsorily or involuntarily converted, AND
ii. Must be converted into similar use property
A) The property is converted into property similar or related in service or use to the
property so converted; OR
B) II TP receives cash and within two years uses the cash to buy another property similar
or related in service or use to the property so converted
iii. Expressly permits an intermediate cash step, but iI keep cash and do not reinvest then there
36
is recognition.
A) For instance iI house burns down, insurance pays $$ and TP buys new house, you ignore
the cash step.
iv. Si2ilar use test d4esn`t apply t4 real property used in a trade 4r business or held Ior
investment
A) Use 1033) 'like-kind test
1) Like-kind deIinition not extended to unimproved property
a) Under Reg. 11033a)-2)c)9)i) p 1515) iI you have a house held Ior
investment that burns down and you buy unimproved property with the insurance
money, this is not like kind.
i) More stringent than 1031, which treated undeveloped and developed land the
same
v. 1033 is an elective provision: may choose to recognize a gain iI TP wishes
b CMPARIC gg 131, 133 and 11
i. 1031 (p 599) Like-kind exchanes
A) applies to both gains and losses
B) applies only to direct exchanges
C) applies to voluntary transactions
D) is not elective
E) applies only to property used Ior trade or business or Ior the production oI investment
income
ii. 1033 (p 602) Inv4luntary C4nversi4ns
A) applies only to gains
B) expressly permits and intermediate cash step
C) elective
D) involuntary transaction
iii. 121 (114) Principal Residence Exclusi4n
A) involuntary
B) applies only to gains
C) permits cash transactions
H. 121: Tax treat2ent 4f Sale 4f Pers4nal Residence
1. This is included in the involuntary conversion chapter because not all moves are voluntary, and
needs oI homeowners change (Iamily size etc)
2. 1031 d4es n4t apply because a personal residence is not used Ior trade or business or Ior the
production oI investment income
3. 121 permits married couples to exclude up to $500,000 oI gain on the sale of their principle
residence; single individuals may exclude up to $250,000
a. you do not have to buy another house to get the deduction
b. the exclusion is per2anent so no basis adjustment is necessary
c. non-recognition under this section may be elected once every two years but taxpayer must have
lived in the house for two of the past 5 years (don`t have to live in or own house consecutively
Ior 2 years)
i. Old pr4visi4n 1034: Not required to recognize a gain on a primary residence so long as
bought another house w/in 2 years, but the basis in the new house would be adjusted to
reIlect the gain.
A) Ex. Sold house Bs 4k, AR 10k, gain 6k. II basis in new house 15k, would have to
reduce by 6k making your adjusted basis 9k)
B) Could do this every 2 years.
ii. Old pr4visi4n 121: II age 55 or older, have one time exclusion oI $150k
A) Could use these 2 provisions together
iii. New 121 (1997 Tax RelieI Act) Exclusion oI a gain Irom sale oI principle residence
37
A) DiIIerences:
1) No age requirement
2) Can do it over and over every 2 years no one time limit, but must have resided there
Ior at least 2 out oI 5 years (looking back)
3) Amount is 250k or 500k (single/joint)
4) Permanent exclusion
5) No requirement that you buy a new house
B) 121d)3): II A and B were married and then divorced pursuant to divorce decree in
1041, and A moves out, when go to sell the house IRS will treat A as having lived in
house in order Ior 121 joint amount to apply
C) Exa2ple: TP could buys house with a basis oI 100k, sells Ior cash Ior 600k ten years
later. Gain oI 500k would not have to be realized
I. Da2aes f4r Pers4nal Injury and Sickness
1. 104a)2) (p 97) provides Ior non-recognition oI ains realized Irom damages received for
personal injuries or sickness, including workman`s comp claims.
a. Can't double dip with 213 (med. expenses)
b. Public p4licy: we do not want people to be taxed because oI injuries or sickness
c. Injuries 2ust be physical
d. Punitive da2aes ARE included in Y (104(a)(2) d4es n4t apply)
e. Until 1996 damages Irom non-physical injuries were not recognized
i. AIter 1996, then iI the emotional distress resulted from a physical injury, then you would be
permitted to take the exclusi4n.
J. F4riveness 4f Debt: A rec4niti4n event
1. Under the code, a l4an is treated as n4t pr4ducin inc42e to the borrower because the cash
received is oIIset by a corresponding liability (obligation to pay back), producing no net gain.
2. Under 61a)12) (p 58) f4riveness 4f debt causes inc42e to the borrower
a. Reasoning: There is no longer a liability to offset the gain: no symmetry iI not required to pay
back Iull amount
b. This can include a discharge oI interest that the borrower is obligated to pay.
3. Excepti4ns: Usually where a lender is willing to Iorgive debt it is because the debtor is in financial
distress IRS insistence on the payment oI taxes in this case can cause substantial hardship
a. 108a) (p 102) provides Ior n4n-rec4niti4n f4r the dischare 4f indebtedness where the
Iorgiveness occurs:
i. in connection with bankruptcy proceedings
ii. in connection with a farming trade or business
iii. in connection with real property used for trade or business; or
iv. when the taxpayer is insolvent
A) 108d) (p 105) deIines ins4lvency as a taxpayer who as debts greater than assets
b. 108e)5) 'Purchase-money debt reduction Ior solvent borrowers is treated as price
reducti4n; where the debt is Iorgiven by the seller oI the property then such discharge is treated
as a reduction oI the purchase price rather than a discharge oI indebtedness and n4 taxati4n
4ccurs.
i. II you (solvent buyer) buy a washer Irom Sears Ior 6k and something is wrong with it and
they reduce price to 5k, this is considered purchase-money debt reduction, not loan
Iorgiveness.
c. 108f): (p 108) income arising Irom the f4riveness 4f student l4ans may qualiIy Ior n4n-
rec4niti4n IF
i. The student or Iormer student works in an 4ccupati4n 4r area with un2et needs (tax
exempt charitable organization or gov`t entity) AND
ii. The loan was made by 4v`t, n4n-pr4fits 4r educati4nal instituti4ns
I'ANNUAL ACCOUNTIN
38
A. 441a) (p 420) taxes are t4 be c42puted on the basis oI the taxpayer`s taxable year without reIerence
to any other year; 12 24nth cycle rather than a transactional cycle.
1. Normally this is the calendar year, sometimes taxpayers will use another Iiscal year, but in all cases
the time period must be twelve months
a. ut see 172: (p 202) Corporations can carry net operating losses (expenses exceed gross
income) backward two years or forward 5 years under g17
2. The annual accounting method is used because it is the easiest t4 ad2inister, not necessarily
because it is the best way to do things
a. Ex: Corporation starts business in 1920 and loses $10,000. In 1921 corporation turns a proIit.
Corporation will pay no taxes in 1920 because it had no income; the losses aren`t deducted
because there is nothing to deduct them Irom. Because oI the principle that each tax year stands
on its own, Corporation will not be able to use the 1920 losses to oIIset its 1921 gains. Thus,
Corporation will owe taxes on its 1921 proIits even though over the course oI its history it has
merely broken even.
b. But TODAY see 172 above
Excepti4ns to the annual accounting principle
1. 1212: (p 619) capital l4sses may be carried over
2. 170: (p 181) charitable c4ntributi4ns can be carried Iorward Iive years iI the taxpayer exceeds the
allowable deduction in one year
3. 172: (p 202) net 4peratin l4sses (see above)
4. 174: (p 204) research and experi2ental expenditures can carry Iorward and backwards 2 year
5. Where annual accounting would be overly burdensome
a owers v. Kerbaugh-mpire Co.:TP borrowed money Irom a German bank. All amounts
loaned to TP were spent and lost then allowed as deductions. AIter the United States entered the
WWII, the bank was considered an alien enemy and TP paid back substantially less than
borrowed Ior Iull settlement oI the loan, based on the conversion rate. IRS Iound the diIIerence
between the amount loaned and the amount paid back a discharge of indebtedness and thereIore
Y.
i. eld: Used the transacti4nal appr4ach, n4t annual acc4untin Since there was a net loss
on the money Irom when TP borrowed to when TP repaid, TP not required to include the
discharge oI indebtedness as income.
ii. N4te: 108 (p 102) was not in place yet to help insolvent TPs
b United States v. Kirby Lumber: TP Co. issued its own bonds (incurred debt) Ior $12 million.
Later in the year it purchased the bonds on the open market at a cheaper rate. DiIIerence
between what it received Ior issuance and what it paid to reacquire was $137,000. IRS says this
is income based on the Iorgiveness oI debt.
i eld: That the diIIerence between sales price and purchase price was a ain taxable as Y,
because here there were n4 l4sses t4 4ffset the ain; there was only gain (distinguishes
erbaugh)
ii. Criticis2: Overruled erbaugh; there were oIIset losses because the stock Iell.
c radford v. Commissioner.(decided after 108 enacted): H owed a bank $305,000. He needed
to reduce his debt and persuaded the bank to substitute the note to his wiIe. W executed a note to
the bank Ior $205,000. There was no consideration given to W Ior assuming the debt. Later W
replaced her $205,000 note Ior two notes one Ior $105,000 which was secured and one Ior
$100,000 which was unsecured. The bank examiner required the bank to write oII $50,000 oI the
unsecured loan as a loss. The bank told W that it would sell the $100,000 note Ior $50,000. H
persuaded his brother to buy the note and provided the cash.
i II W had bought the note Ior $50,000 then there would have been a $50,000 discharge oI
indebtedness taxable to her
ii II unrelated 3
rd
party had bought note, they would expect them to pay Iull 100k, so no
discharge oI indebtedness, but because related to brother-in-law, relationship provides a
39
discharge oI indebtedness have to focus on special relationship, also imp. that radfords
gave him the $ (being related may not be enough to get discharge oI indebtedness, may need
related party plus P giving him $).
1) In substance here, W had a IMPLID discharge of indebtedness because her
brother would not make her pay anything on the note.
iii eld: The discharge oI indebtedness was n4t a ift (see Duberstein) because no detached
and disinterested generosity, but in order to Iurther client relationship. Used transactional
approach to say that W had taken on debt Ior noting, so even with the discharge oI
indebtedness has a net l4ss, s4 no need to recognize the gain fr42 the dischare.
iv Rely on radford sparinly
A) This vi4lates 262 p 243)all4ws pers4nal l4sses t4 4ffset business ain) and uses
transacti4nal 2eth4d which is n4t enerally use

40
QUESTION #3: OW MUC AIN OR LOSS?

I Intr4: Deter2inin ains and l4sses and preservati4n thr4uh asis Adjust2ent
A. 1001a) p 586) - deIines gain/loss
1. ain: excess oI the a24unt realized (sale price) 2inus the Adjusted s.
a ain AR - Adj asis
2. L4ss: excess oI the adj s 2inus AR
a L4sses Adj asis - AR
3. 1001b): A24unt Realized AR): Money received Irom realization event the FMV oI the
property (other than cash) received
a. AR Cash + FM' 4f 44t received
B. 1012 (p 587) asis: The Unrecovered investment in a property (cost except as otherwise provided)
C. 1011a) (p 587)Adjusted basis: Running account oI the initial investment that has not been recovered
at that point. 'Basis as determined in 1012 or other appropriate sections, adjusted as provided by
1016
1. 1016a)1): (p 590) proper adjustment shall be made Ior expenditures, receipts, losses, or other
items property chargeable to capital account
2. Depreciation value on a car would be recovered investment; the basis would be adjusted down.
II. PIECEMEAL SALES
A. Example: In 1980: TP buys 4 acres oI land Ior $10k. In 1982 she sells 1 acre to C Ior $6k. In 1986 she
sells the remaining 3 acres to D Ior $29k. There are two diIIerent ways to recognize the gain:
1. Version 1 We can assume that all acres are equal and app4rti4n the basis accordingly. Here there
are Iour acres and the total basis is $10k so the basis Ior each acre is $2,500. When TP makes the
Iirst sale she would recognize $3,500 ($6k (AR) - $2,500 (adj. Bs)). When TP makes the second sale
she would recognize $21,500 |$29,000 ($2,500 x 3)|. In total TP will recognize $25k.
2. Version 2 We could allow TP to use up the basis as she sells the property. In this case, in the Iirst
sale TP would recover $6k oI her basis, recognize no gain and carry over $4k oI her basis, which
was originally 10k. On the second sale, TP would recover the remaining basis and recognize a gain
oI $25k.
a. This is the system that TP w4uld prefer, given the time value oI money, because recognition oI
gain is deIerred until the entire basis is recovered
B. Re 161-6: (p 899) Must app4rti4n the basis in all partial sales
1. Excepti4n: BUT, TP may not be required to apportion basis where doing so would be wholly
i2practicable 4r i2p4ssible
a. Inaja Land Co. v. Commissioner: TP acquired 1000 acres oI land he used Ior a private Iishing
club. The city construction polluted the water. TP sold the city an easement Ior the right to
pollute. TP did not report the income Irom the easement as a gain claiming that since the sum
received Irom the easement was less than the basis oI the entire property he had no gain and
taxation should be postponed until the Iinal disposition. IRS sad the AR Irom the easement
should be apportioned and used to recover part oI the basis.
i. eld: In a partial sale, TP must apportion basis when you can, but when impractical to
apportion, 1P is not required to recognize gain until the entire basis is recovered.
ii. Ex: TP has 100 acres with a basis Ior $15k. The basis per acre is $150. The state acquires an
easement Ior use oI 40 acres Ior $10k. $10k oI the basis is recovered.
A) Using Inaja method, because amount realized is less than basis TP has no gain. The
adjusted basis is $5k and TP will have to recognize the amount realized less $5k at the
Iinal disposition oI the property.
B) II distinguished Irom Inaja, The basis Ior the 10 acres sold Ior to govt AR oI 10k and
Basis oI 6k, realizing a gain oI 4k.
iii. Inaja Rule: Does 1 apply to all easements; when you can isolate a particular area then
apportion
41
b. Depleti4n all4wances: Used to Allocate basis to mineral deposits oI uncertain extent
i. C4st Depleti4n: Basis is allocated by putting asis/esti2ated nu2ber 4f rec4verable units
(e.g. coal deposit has basis oI 100k and contains 10k tons oI coal basis oI each ton mined
and sold $10; iI mine has less than 10k tons, then remaining basis deducted when mine
sold; iI more than 10k tons, then once 10k tons mined, the entire basis deducted and basis Ior
any additional coal that recovered 0)
A) Put Bs over estimated units 100k/10k , so $10/ton iI extract 1 ton and sell Ior $15, will
always have gain oI $5 (AR 15, Bs 10)
ii. Percentae Depleti4n: Fixed oI Y may be deducted each year (coal mines: 10 Under
613(b)(4)) (p 510)
A) May be deducted each year as long as mine operates even iI total depletion deductions
exceed original basis. This allowance Ior deductions in excess oI basis provide tax
incentives Ior mineral extraction
III.PART IFT PART SALES: Taxpayer d4esn`t have t4 app4rti4n their basis where there is part ift/
part sale Excepti4n to 161-6) p 899)
A. The gain realized by the Donor in a part giIt/part sale is another exception to the apportionment
requirement. Because it is not an outright sale we do not require Donor to apportion her basis but
because there is some gain, the Donor must recognize the gain but against the full basis. (in b/w pure
giIt and pure sale)
1. Ex: Donor has stock with a basis oI $20 and FMV oI $100. Donor uses the stock to secure an $80
loan. Then Donor gives the stock to the Donee subject to the $80 debt.
a. This is like a sale insoIar as Donee has to pay $80 oI the debt to get the $100 in stock.
b. This is like a $20 giIt insoIar as the Donee only has to pay $80 Ior the $100 in stock.
c. Also, unlike an outright giIt, the Donor receives a beneIit here the $80 discharge of
indebtedness
We know something is a part ift/part sale if:
1. the ift part and the sale part 4ccur in 4ne transacti4n
2 there is a barain; the property is ~s4ld f4r less than FM'
3. the non-sold portion is given with detached and disinterested generosity
4. anytime the transIeree (donee) has to pay something part giIt/part sale
C. Part giIt/ part sales are oIten used t4 4ffset ift tax on the donor under 2501 (p 755)
1. $10000 minimum beIore giIt tax applies
2. 2502(c): (p 755) II giIt tax applies, the iver pays it.
D. When there is a bargain in the sale portion in conjunction with the giIt, and they are occurring at the
same time, then use Diedrich, below. (Looking Ior only one transaction).
1. The relati4nship is i2p4rtant: Transaction between mother and daughter part sale/part giIt, but iI
transaction occurs between employer/employee considered compensation; iI 2 unrelated parties it
is just a bargain
2. Diedrich v. Commissioner: parents gave children 85k shares oI stock on the condition that the
children assume the resulting giIt tax liability, and argued it was a giIt (Issue: did parents receive Y;
discharge oI indebtedness)
a. eld: part ift/part sale; dischare 4f a TP`s (parents) 4bliati4n t4 pay ift tax by a third
party (child) is equivalent t4 receipt 4f Y (discharge oI indebtedness). The parents were
placed in better p4siti4n and thus received an ec4n42ic benefit
i. Part sale is the amount children pay in giIt taxes
ii. Part giIt is the amount the children receive aIter taxes are paid
b. Cain received by the Donor is the amount of the gift tax less the donor's adjusted basis on
the entire property (can use full basis, not subject to 1.1-).
3. Crane v. Commissioner: TP had mortgage on property and sold property to X based on assumption
oI mortgage.
a. eld: assu2pti4n 4f 24rtae als4 c4nsidered realizati4n 4f Y
42
4. ld Colony 1rust Co: eld: that payment of employee's income tax by employer was Y to the
employee as discharge oI employee`s obligation.
a. Ex: Assume employee had marginal tax rate oI 50. Employer paid employee $1000 in
compensation and employer paid government $500 in taxes Ior employee. Court held that taxes
were due on $1500; $1000 in outright compensation and $500 in payment oI taxes. Employee
owed $250 additional in taxes.
E F4r2ula f4r part ift/part sale: ain derived a24unt 4f ift tax liability - D4n4r`s adj s in
entire pr4perty ain AR - adj s)
1 Ex: Property with FMV oI $200 with basis oI $40 is given to the donee and the donee assumes $50
oI the donor`s debt. Donee sells Ior $200.
a ift: II this is treated as an outright giIt, the donor gets no deduction and does not recognize
anything. When the Donee sells the property the amount realized is $200, the carry over basis oI
$40 is used and the recognized gain is $160.
i The total amount recognized is $160: $40 by the Donor and $160 by the Donee
A) No tax liability Ior the parent
b Sale: Donor sells / oI the property ($50) to the Donee. In a separate transaction the Donor gives
/ oI the property ($150) to the Donee. Sale is subject to 1.61-6 (apportionment).
i The Donor`s amount realized is $50. The basis is apportioned because there is an outright
sale. Apportioned basis is $10 (/ oI $40). Amount recognized by the Donor is $50-$10
$40.
ii The Donee`s amount realized is $200. The basis in the sale portion is $50 (cost basis). The
basis in the giIt portion is $30 (/ oI the Donor`s basis). The total basis is $80. The amount
recognized is $200 - $80 $120.
iii The total amount recognized is $160 : $40 by Donor and $120 by Donee
c Part ift/Part Sale: The $50 (/) received by the Donor represents the sale and the $150
remaining represents the giIt (/).
i The Donor has a gain oI $50. But because this is a part giIt/part sale the Donor uses the full
basis, not the apportioned basis, to determine how much gain to recognize. Donor recognizes
$50 - $40 $10.
ii The Donor has an amount realized oI $200. The basis in the sale portion is $50 (cost basis).
The basis in the giIt portion is the carry over basis. Here the carry over basis is $0 because
the Donor recovered their entire basis. Amount recognized is $200 - $50 $150.
iii The total amount recognized is $160: $10 by Donor and $150 by Donee.
d Note that in each case the same amount oI gain is recognized. The only diIIerence is who pays
how much. What is best Ior the Donor is worst Ior the Donee and vice versa.
F 1011b): (p 587) Part ift/part sale to a charity: The apportioned basis must be used.
1 The apportioned basis must be used because this is the scenario under which the d4n4r pays the
24st in taxes. Because charities have tax exempt status, this is the 4nly tax the IRS will receive.
2 TP makes a giIt oI property with FMV oI $200 to a charity. In return the charity assumes $50 debt
on the property. The basis is $40.
a The Donor realizes $50 Irom the charitable donation. $50 represents a sale oI / oI the property
donated. / oI the basis is $10. ThereIore Donor must realize $50 - $10 $40 in gain.
b Sale oI property at cost doesn`t produce realization except in the case oI sale to charity
I'AFTER A NONRECONITION TRANSACTION
A Where property previously acquired in a non-recognition transaction is disposed oI in a taxable sale or
exchange the taxpayer sometimes is required to recognize the earlier gain or loss; other times, the
taxpayer does not recognize the gain or loss.
When does the IRS remember n4n-rec4niti4n transacti4ns? IRS always remembers:
1 gains or losses arising Irom like-kind exchanes (1031)
2 l4sses arisin fr42 wash sales oI stock (1091) (p 614)
3 ains 4n property transIerred by inter viv4s ift (1015(a)) (p 589)
43
C What does the IRS forget?
1 L4sses fr42 related party sales (267) (p 253)
2 L4sses on property transIerred by inter viv4s ift (1015(a)) (p 589)
3 Gains and losses on testa2entary ifts (1014(a)) (p 587)
D How to determine whether earlier gain or loss will be taken into account l44k t4 the basis assined t4
the pr4perty acquired in a n4n-rec4niti4n transacti4n
1 When forgotten, basis assigned to property is its cost (or FM' iI giIt when giIt made)
2 II remembered, necessary to assign to property a basis other than its cost (where a carry over basis
is used, the loss or gain is preserved)
E Like-Kind Exchanes: 1031
1 Under 1031d) when property is acquired in a like-kind exchange then the basis shall be the same
as that of the property exchanged,
a decreased in amount oI any money received by the taxpayer and
b increased in the amount of gain 4r decreased in the amount of loss the taxpayer recognized in
such exchange.
2 FORMULA: Old basis - Cash received + Rec4nized ain - Rec4nized L4ss New asis
3 1031a): p 599) Pure like-kind exchanes: asis is the same as that of the property exchanged
substitute basis (old basis substituted basis)
a ain: A buys land Ior $10k (old Bs). Later A exchanges land A Ior land B worth $80k. Finally
A sells land B Ior $100k
i When land A is exchanged Ior land B, A realizes $70k in gain (AR $80k Basis $10k). This
gain is not recognized b/c like-kind exchange (look at other section re: value oI property
doesn`t matter)
ii When land B is sold Ior cash, the amount that was not recognized in the exchange is taken
into account by using the substituted basis Irom the property exchanged. AR $100k Basis
$10k $90k recognized gain. This gain reIlects:
A) $70k gain not previously recognized
) $20k appreciation since exchange
b L4ss: A buys land Ior $120k (old Bs). Later A exchanges land A Ior land B worth $100k. Finally
A sells land B Ior $100k.
i When land A is exchanged Ior land B, A realizes $20k in loss (AR $100k Basis $120,000).
This loss is not recognized.
ii When land B is sold Ior cash, the substitute basis is used. AR $100k Basis $120,000
$20k loss that is recognized.
4 1031b) AINS fr42 exchanes n4t s4lely in like kind
a 1031b) N4t s4lely like kind exchanes: pr4perty + cash
i. When there is a not solely like kind exchange of property, the cash portion of the first sale
is recognized at the time of sale. At the time of the second sale, the adjusted basis is
determined by using the basis from the first property, minus the cash received plus the
recognized gain (or minus the loss) Cash received and the a24unt rec4nized will
always be the sa2e and cancel each 4ther 4ut)
ii Ex: A has property with basis oI $60. Property is exchanged Ior property B with FMV oI
$90 and $10 cash. A sells property B Ior $90.
A) AR oI $100 and a basis oI $60 Ior a realized gain oI $40. Under 1031(b) $10 gain Irom
cash is recognized at the time oI the exchange. A has $30 gain that is not recognized.
) To determine A`s basis when the property is sold, we must use the Iormula Irom
1031(d). The substitute basis is $60. The cash received was $10 and the amount
recognized in the exchange was $10 so A`s basis is ($60 - $10 $10) $60.
1) In the sale A has AR oI $90 and basis oI $60. Her recognized gain is $30.
2) This works because A had a total gain oI $40. $10 was recognized at the time oI the
exchange. Rest oI the gain is recognized now.
44
b 1031b) N4t s4lely like kind exchanes: pr4perty + b44t
i Adjusting the Iormula:
A) F4r2ula typically used: Old basis Cash received recognized gain recognized loss
New Basis upon Sale
) To determine A`s basis when the property is sold we have to go back to 1031d) that
says that when like-kind and non-like kind properties are exchanged in one transaction
the basis 2ust be app4rti4ned between the like-kind and n4n-like-kind pr4perty.
The non-like kind property is assigned a basis equal to its fmv on the day oI the exchange
which is subtracted Irom the old basis as determined under the 1031(d) Iormula to
determine the basis oI the new property alone.
C) New F4r2ula: Old basis - Cash received + rec4nized ain- rec4nized l4ss New
asis 4f Pr4perty and 44t up4n Sale - FM' 4f 44t 4n day 4f exchane New
asis 4f Pr4perty Only
ii Ex: A has property with a basis oI $10k. A exchanges property A Ior property B with FMV
oI $80k and a necklace with FMV oI $20k.
A) AR is $100k. A has a realized gain oI $90k. $20k gain Irom the necklace is recognized.
$70k gain is not recognized.
) Using the old Iormula Irom above, A would have a basis oI $30k (10k (substituted Bs) - 0
(cash received) 20k (recognized gain) 0 (recognized loss). This is not correct because
iI we used this basis A would have a recognized gain oI $50k (80k-30k), but we know
Irom (a) that A needs to recognize $70k.
1) SO oI 30k, need to assign basis to necklace which is FMV 20k leaves basis oI
10k Ior prop B
2) So really, AR 80k Bs 10k 70k
3) II she were to sell necklace Ior 20k in exchange Ior 20k AR 20k Bs 20k 0
(no gain or loss)
C) asis has been t4tally assined t4 like-kind pr4perty: This shifts all n4n-rec4nized
ain t4 like-kind pr4perty
1) You don`t have to do this when like-kind property and cash are exchanged Ior
property because cash has no basis
D) Here the FMV oI the necklace oI the day oI the exchange was $20,000. The total basis
under 1031(d) was $30,000. $30,000 - $20,000 $10,000 basis.
1) This works because AR $80,000 - $10,000 $70,000 which was the gain that A
needed to recognize.
iii 1031b): N4t S4lely Like Kind Exchanes: Pr4p A in exchane f4r pr4p + b44t +
cash
A) A`s Bs 10, FMV oI b 60, necklace FMV 20, cash 10
) A`s AR 90 - A`s Bs 10 gain oI 80
C) 1031(b): so recognize only gain to extent oI non-like kind property 20 (necklace) 10
(cash) 30, SO leaves 50 to be recognized
1) Old basis (10) cash (10) recognized gain (30) recognized loss (0) Bs oI 30
2) Have to divide new basis b/w necklace and property FMV oI necklace is basis 20,
so 10 Ior prop b (see Iormula above)
a) So when sells necklace, no gain no loss (unless it appreciates subsequently)
b) When sells prop b, AR 60 Bs 10 gain oI 50
3) WHEN YOU HAVE CASH, DOESN`T AFFECT ALLOCATION
c 1031c): LOSSES fr42 n4t s4lely like kind exchanes
i Apply the sa2e f4r2ula used ab4ve
A) Ex: A buys property Ior $120. A exchanges her property Ior property B with FMV oI
$90 and $10 cash. A sells property B Ior $90.
1) A has an AR oI $100 and a basis oI $120 Ior a realized loss oI $20. Under 1031(c)
45
losses Irom not solely like kind exchanges are not recognized.
2) When A sells property B, basis is determined under 1031(d). Substitute basis is
$120. Cash received is $10. Loss Irom exchange is $0 because it is not recognized
under 1031(c). Basis is $110 ($120 - $10 cash). AR $90 - $110 basis $20 loss
recognized Irom exchange.
ii OWE'ER Re 11031d)-1e): (p 1499) We recognize loss when A ives up non-like
kind depreciated property in a like kind exchange.
A) In the above example, A is receiving like-kind and non-like kind property. When A
relinquishes non-like kind property there might be a recognized loss.
1) There will certainly be recognition of gain or losses under g11
) A buys property Ior $10k. Property A has FMV oI 11k. A buys stock Ior $4k (but only
FMV oI 2k at the time oI the exchange). A exchanges property A and the stock Ior
property B worth $13k. A sells property B Ior $13k.
1) From A`s perspective this is like 1031(c) because she has a $1k (13k (AR) 14k
(Bs)) loss
2) but A is deemed to have sold the stock Ior its FMV at the time oI the exchange and
takes a $2k loss recognition event b/c stock not like kind property
C) Determining A`s basis when she sells property B 1031(d): The substitute basis oI the
property is $14k. (Prop A stock) She has a recognized loss oI $2k (Irom stock) so basis
is $12k. AR is $13k and basis $12k so A has to recognize $1k in gain. (14k (subst. Bs
Irom prop A and stock) 0 (cash) 0 (recognized gain) 2k (recognized loss) 12k)
D) AR 13k Bs (in prop B) 12k gain oI 1k
1) This is the correct result because A`s loss in the like-kind exchange was $1k but she
was permitted to recognize a loss oI $2k. ThereIore, A must recognize $1k in gain.
d Re 11031b)-1c): (p 1499) Like-kind exchanges oI mortgaged property
i A dischare 4f indebtedness 24rtae) is treated as cash then the 1031 f4r2ula is
applied
A) Property B has a basis oI $500k and is encumbered by a mortgage oI $150k. Property C
has FMV oI $600k and is not encumbered by a mortgage. B exchanges property B,
subject to the mortgage, Ior property C and $50k.
1) B`s AR is $600k the $150k discharge oI indebtedness $50k cash $800k. The
basis is $500k so B has a realized gain oI $300,000.
2) This is a 1031(b) exchange because it involves like kind property and cash. B
receives $50k in cash and $150k discharge oI indebtedness that is treated like cash.
Under 1031(b) B recognizes $200k (150k 50k) gain at the time
3) 1031(d): When B sells property C, subst. Bs (500k) (cash (50k) discharge oI
indebtedness (150k)) recognized gain (200k) 500k
a) AR 600k Bs 500k (new basis) gain oI 100k (makes up Ior 100k that still
has to be recognized)
) Re 11031b)-1c): (p 1499) Where both pr4perties are encumbered by mortgages,
the 24rtaes can be 4ffset initially
1) Same situation as above, but A`s Bs 10k and mortgage 5k, BUT FMV oI B 20k
and mortgage 3k
a) Because both props have mortgages, we can NET them (so Ior all practical
purposes, take A`s mortgage and subtract B`s 5k 3k 2k, SO A is
encumbered by mortgage oI 2k) - 1.1031(b)-1(c) (2
nd
sentence)
F Wash Sales
1 1091d): (p 615) When stock is acquired in a wash sale (within appropriate time limit), the basis 4f
such st4ck the basis 4f the st4ck s4ld, increased 4r decreased by price at which the st4ck was
acquired) - price at which the substantially identical st4ck was s4ld)
a II the purchase price is higher than the sales price, the basis increases
46
b II the purchase price is lower than the sales price, the basis decreases
2 Ex: TP buys 5 shares oI stock Ior $100 on Jan. 1. On Jan. 10, TP sells the stock Ior $80. On Jan. 30
TP repurchases substantially the same stock Ior $60. On Jan 31 oI the Iollowing year, TP sells the
stock Ior $130.
a When TP sells the stock on Jan. 10 she has a loss oI $100 - $80 $20. This loss is not
recognized because oI the wash sale, but it is remembered. When TP sells the stock on Dec. 31
she has a gain oI $130 - $60 $70. TP has a total gain oI $70 - $20 $50.
b To determine TP`s basis we have to look at the basis 4f the st4ck s4ld increased 4r decreased
by the difference between the price at which the st4ck was acquired and the price at which
the substantially identical st4ck was s4ld
i The basis oI the stock sold was $100.
ii The stock was acquired Ior $60 and the substantially similar stock was sold Ior $80.60 80
$20.
iii 100 - $20 $80. (If y4u have s42ethin in y4ur p4cket if y4u buy it f4r less than
4riinally received), then subtract)
A) This reIlects the $20 savings TP had Irom the wash sale in selling the stock Ior $80 and
repurchasing substantially the same stock Ior $60. The basis is decreased to reflect this.
iv $80 is TP`s basis in the last sale.
c TP has AR oI $130. Her adjusted basis is $80. Her recognized gain is $50. This reIlects the net
gain Irom (i).
3 Ex: On Jan. 6/ 01 TP buys 100 shares Ior $10k. On Feb. 4/01 TP sells 100 shares Ior $6,500. TP has
a $3500 loss. TP buys 100 shares on Feb. 7/01 Ior $6,700 and ultimately sells on 2/7/02 Ior $12k.
a S4
i 1/6/01 Bs 10,000 in 100 shares
ii 2/4/01 TP sells 100 shares f4r 6500 tainted sale- n4t rec4nized l4ss 4f 3500)
iii 2/7/01 uys f4r 6700
iv 2/7/02 Sells f4r 12000 ain 4f 5300)
b S4 net ain 4f 1800 5300ain-3500l4ss fr42 wash sale)
c TP has a loss oI $3500 at the Iirst sale (tainted) which is not recognized because oI the wash sale.
TP has a gain oI $5,300 when she ultimately sells the stock. TP`s net gain is $5300 - $3500
$1800.
d To determine TP`s basis: We start with $10k basis. We adjust Ior the diIIerence between the
price at which this was sold and the price at which the substantially similar stock was purchased.
i Here the price at which the stock was sold was $6500. The price at which substantially
similar stock was purchased was $6700. The diIIerence is $200.
ii TP`s basis is increased by $200. This reIlects the extra $200 TP had to invest to repurchase
the stock. e increase the basis to reflect this additional investment. TP`s adjusted basis is
$10,200
e AR is $12,000 and Basis is $10,200. $12,000 - $10,200 $1800 recognized. This reIlects the net
gain.
f. When you RC'R part of your original basis, you decrease the basis. When you spend in
excess of the original basis, you ICRAS 1 ASIS
Related Party Sales: A little relieI Ior related party sales
1 267d): (p 254) o basis adjustment Ior related parties, so losses are forgotten, UT iI transIeree
subsequently disposes of property at gain, no recognition until that gain exceeds the loss that has
been disallowed (limited relied under certain circumstances)
a Only applies in limited circumstances, particularly only when you sell at a gain AFTER having
taken a loss.
2 Applies only to original TRANSFEREE, and only to GAINS
a Ex 1: Parent buys stock Ior $500 and sells to child Ior $100. Child sells to X Ior $20.
i Child`s AR 20 Bs oI 100 80 loss
47
ii child can take the loss but parent`s loss is gone Iorever (B/C related party losses are
Iorgotten)
b Ex 2: Parent buys stock Ior $500. Parent sells to child Ior $100. Child sells stock to X Ior $200.
i Child has an AR oI $200 and cost basis oI $100 Ior a total gain oI $100. She does not have to
recognize any of this gain because the gain does not exceed the 4 loss of the parent.
Would only have to recognize iI AR was 501 or more
ii Note that iI this was not a related party, sale child would have a basis oI $500, and a loss
oI $300. Under 267(d) she cannot deduct the loss but does not have to recognize the gain. II
this section did not apply she couldn`t deduct the loss and would have to recognize the gain.
iii II child 1 gives stock to child 2 who sells it to X Ior $501 (siblings), then Child 2 has AR
501, and a carryover Bs ( 1015) oI 100 realized gain oI 401
A) Child 2 has to recognize it all b/c 267(d) is only applicable to the original transIeree
Inter viv4s and Testa2entary ifts
1 Inter vivos gift: Under 1015 (p 589) use carryover basis, BUT if receive depreciated property and
sell such property at a loss, 1P uses FM' at the time the gift basis
a Ex: Basis is $2k. FMV at the time oI the giIt is $1k. The property has depreciated.
i II Donee sells the property Ior $750: Donee has depreciated property, sold Ior a loss. Donee
uses the FMV as the basis. AR $750 basis $1000 $250 loss which is recognized.
ii II Donee sells the property Ior $2,250: Donee has depreciated property (FMV less than Bs),
sold Ior a gain. Donee uses the carry over basis. AR $2,250 basis $2000 $250 gain
which is recognized.
iii II Donee sells the property Ior $1500: Donee has depreciated property but there is no loss or
gain:
A) II we used the carry over basis TP would have a loss ($2000 basis - $1500 AR $500
loss). But where we have depreciated property and a loss, we use the Imv basis.
) II we use the Imv basis TP would have a gain ($1000 basis - $1500 AR $500 gain). But
we can only use the Imv basis when we sell Ior a loss.
C) You reach inconsistent results, so under g 115 you do not recognize a gain or loss if
you sell between the asis and the FM'
b Note that although transactions between spouses are treated as giIts under 1041, the
carry4ver basis can always be used and l4ss taken, pursuant t4 1015e) 1041 trumps
1015.
. 1estamentary gifts: Under 1014a)1) (p 587) the basis for a testamentary gift is ALWAYS FM'
at the date of the decedent's death.
a Any gains and losses that happen in hands oI transIeror are gone Iorever
i. In this situation, where the property has appreciated in value, the basis is called a stepped-
up basis
ii In this situation, where the property has depreciated in value, the basis is called a stepped-
down basis
b Criticism oI 1014:
i UnIair as compared to 1015 because unlike 1015, the gain doesn't have to be recognized.
An aging taxpayer will sell oII depreciated property to recognize the losses during liIe but
will sit on appreciated property so that gains will not have to be recognized.
A) huge tax planning opportunity
ii 4riz4ntal and vertical equity pr4ble2s:
A) 'ertical equity: poor people don`t get beneIit oI 1014; Provides bigger beneIits to people
with more assets
) orizontal equity: aIter TP dies, TP Iiles one last income tax return, taking into account
any income in that last year
1) A has 100k oI salary, and B has 100k oI appreciated property A and B`s kids in
diII. positions when A and B die, b/c A will be taxed on 100k, so kids get less, but
48
when B dies, 100k oI appreciated property passes to Iamily member, and has stepped
up basis (kids oI A don`t have stepped up basis because there is no basis when
receive cash)
2) 2001: (p 713) Estate tax (see (c) Ior rate schedule used below)
a) Doesn`t kick in until donor has 3.5 mill (in 2009) and N/A to transactions passing
to spouse
b) A will have to pay 8200 2400 10,600 oI estate tax, so kids leIt with 39,400
c) B will have to pay 23,800 oI estate tax kids leIt with 76,200
i) So A had to pay to income tax AND estate tax, but B only had to pay estate
tax
d) some have claimed that the provisions are oIIsetting because in 1015 you can
recognize losses which you can`t under 1014 but in reality they aren`t oIIsetting
because gains are excluded more oIten in 1014 than losses are included
49

QUESTION #4: WAT IS TE CARCTER OF A AIN OR LOSS?

I Capital ains: Capital gains have received preferential treatment during most oI the time oI the income
tax.
A 1222: (p 622) Capital gains arise Irom sale or exchange oI capital assets
1 1221 deIines capital assets
Capital gain provisions, unlike non-recognition provisions, are permanent and outright
C 1h): (p 18)Today the capital gains preIerence is in the Iorm oI a lower tax rate for capital gain.
1 1(h): capital gains rates (2008)
a II held Ior 1 months or less ordinary Y rates
b For TPs that have ordinary rates of 1 and 15" their capital assets will be taxed at "
c. igher brackets taxed at 15"
i In 2009, higher brackets pay 20, and 10 and 15 brackets pay 10
ii II received dividends paid in cash, and in higher tax bracket, taxed at rate of 15, but iI in
l4wer tax bracket, taxed at 0
D TP w4uld rather have ains taxed as capital ains, and have l4sses taxed as 4rdinary l4sses
1 Excepti4ns:
a Gains on collectibles (e.g. stamps) taxable up to 28
b Gains on depreciable real estate taxable at rate oI 25 or higher
c Corporate capital gains taxable at same rate as corporate ordinary Y
E Arguments in favor of preferential treatment oI capital gains:
1 L4ck-in: We want people to make more efficient investments. ut in order for 1P to move assets
to a more efficient investment, he will have to sell and realize income, which is taxed.
a II taxes that must be paid on realization are high
i TP will not want to sell and reinvest
ii II TP does sell, he will have less to reinvest
b Ex: Property has a basis oI $100 and FMV oI $200. TP`s marginal tax rate is 50. TP receives
annual payments oI 10 Irom the property. TP Iinds an investment with 12 annual payments.
TP should be encouraged to make the investment with the higher return.
i II TP sells the property Ior the FMV, the amount realized is $200, her basis is $100 and she
has a realized gain oI $100 she must recognize. The gain is taxed at 50 so TP will have to
share $50 with the treasury. TP will have $150 leIt to reinvest. Investing $150 in property
with a 12 rate oI return will only give TP $18 a year while keeping $200 invested in
property with a 10 rate oI return gives TP $20 a year. TP will not make the investment in
the more eIIicient property.
ii II TP is taxed on the property with a 20 capital gains preIerence, now iI TP sells property
with FMV oI $200 she will only have to share $20 with the Treasury and will have $180 to
invest in the second property. II TP invests $180 in property with a 12 rate oI return she
will get $21.60 so it will make sense Ior her to invest in the more eIIicient property.
c Lock-in argument is based on the tax wede
i Tax wede: the diIIerence between the minimum percentage return on an investment that
will induce TP to change and the percentage return on the original property.
A) Using the above example (assuming no tax preIerence) we must determine what
percentage oI $150 will be greater than $20. The answer oI $150 x ? $20 is 13.4. The
diIIerence between 13.4 and 10 is 3.4 TP`s tax wedge
ii. Capital gains rate RDUCS the tax wedge but does not eliminate it.
d We could also address the l4ck-in pr4ble2 4ther ways:
i By treating a reinvestment in a more eIIicient property as a like kind exchane under 1031
A) So long as TP invests in a similar property 1031 could be applied and TP would have no
recognition and so the lock-in problem would not exist.
50
ii By requiring TP to recognize gains as they occur rather than at the time oI sale under an
accreti4n 2eth4d
A) With certain assets this method could work despite the normal problems oI valuation and
liquidity (stocks)
2 Inflati4n: because capital assets are held over a period of time, some argue that providing a capital
gains preference ensures that gains due to inflation are not taxed (nominal gains Irom inIlation are
diIIerentiated Irom real gains)
a Ex: TP makes an investment Ior $100. TP sells the property Ior $300 aIter holding it Ior 5 years.
TP has a gain oI $200. II, over the Iive years the CPI was 60, then 60 oI TP`s gain would be
attributable to inIlation. TP`s gain Irom inIlation would be $120 and TP`s actual gain would be
40 or $80.
i There used to be a 60 exclusion Ior capital gain. II over time the CPI was 60 then the
amount excluded would reIlect inIlation. ut iI the CPI were lower, TP would have a
windIall because he could exclude more than his actual inIlation gain. II the CPI were
higher, TP would have to realize gains attributable to inIlation. Rarely is there a perIect Iit.
b A more accurate way to address the problem of inflation is to index.
i The gain could be indexed Ior inIlation and the a24unt attributable t4 inflati4n c4uld be
deducted
ii The basis could also be indexed Ior inIlation.
3 unchin: the capital gains preIerence is said to grant relief from hardship, under the progressive
rate schedule, of having several years' appreciation taxed in a single year upon realization.
a This is based 4n the assu2pti4n that iI TP realizes gain Irom a capital investment, the
accumulated gain will Iorce TP into a hiher 2arinal tax rate
i &T, TPs who are already pay the highest tax rate will not have a bunching problem because
they cannot be bumped into a higher tax bracket by realizing a gain.
ii Also, the eIIects oI bunching are greater the longer the property is held. But so long as TP
holds the property Ior more than 12 months the preIerence applies.
b Ex: TP buys stock Ior $10k. TP sells stock Ior $100k aIter holding it Ior 10 years. TP has $90k
in gain. Assume that the stock increased in value at the same rate, accruing $9,000 a year. The
rate schedule provides that up to $25,000 is taxed at 25 and over $25,000 is taxed at 50. TP
would be adversely aIIected by bunching.
i Scenari4 1: II TP is taxed when the gain is realized the Iirst $25,000 is taxed at 25 Ior
$6250. The remaining $65,000 is taxed at 50 Ior $32,500. The total tax liability is $38,750.
ii Scenari4 2: II TP had been taxed on the gain each year he would have been taxed at the
lower rate because the gain in no year exceeded $25,000. $9000 x 25 $2250 x 10
$22,500 total tax liability minimizes bunching
iii Scenari4 3: iI taxed at 15 capital gains rate, TL 13,500 minimizes even more
c. Disadvantae: The bunching rationale overlooks, however, the benefit to the taxpayer Irom
bunching in that he gets to defer payment of taxes and take advantage oI the time value of
money.
4 Enc4urain Savins
a Taxing capital gains at ordinary tax rates would represent an undesirable increase in the total tax
burden on investment and savings
i. but, the capital gains preIerence encourages only certain types oI investments but not Ior
others (i.e., investments oI cash do not result in capital gains so there is no incentive to save
or invest cash)
II Dividends:
A TP buys a house Ior 100k and appreciates to 150k, there is no realization event until sale or exchange,
but iI receiving rental Y, then treat as Y
1. Stream of Y from asset is treated differently than appreciation of asset
II you bought stock Ior 100k and appreciates to 150k, no realization event, However iI TP receives
51
dividend in stock, then considered Y (but not recogni:ed b/c no reali:ation event), BUT iI cash
dividend, then taxed as capital gain
1 When receive cash dividend, then taxed as capital gain
2 When receive stock dividend, the gain is not taxed
C Example where receive stock dividend (see isner)
# oI shares FMV FMV oI investment
Original Shares 2,000 bought Ior
100k
$360/share 720k
New Shares (Irom
dividend)
1,000
New Total 3,000 $240/share 720k
D. isner: The receipt oI a stock dividend in the Iorm oI additional shares (not cash) is simply a paper
transaction and not a realization event, so there is not taxable Y.
a. Pizza analogy iI have a pizza that you bought Ior $20 and it is cut into 4 slices, iI you decide to
cut it into 8 slices, still have same size pizza Ior $20
2. 305a) Codifies the isner holding, provided that everyone has to get same thing, and no cash
option is present.
3. 307: no recognition when receive stock dividends, but have to make basis adjustment
a. II your investment is worth 1k and you have 100 shares (1k/100) Bs 10; but iI receive 200
shares as stock dividend, then 1k/200 new Bs $5
b. Have to use the $5 Bs
III. 1221a): (p 620) Capital assets deIined
A. Capital asset: ANY property held by the taxpayer (whether or not connected with trade or business),
unless it Ialls into one oI the 8 excepti4ns (though the preIerence is limited to ones that are held Ior
more than 12 months):
1. Invent4ry-like excepti4ns:
a. Stock in trade (something you make to sell)
b. Inventory
c. Property held primarily Ior sale to customers (not investment) in the ordinary course oI his trade
or business
d. 1221a)1): determining whether property is held primarily Ior sale to customers in the ordinary
course oI business where the property has a dual intent (e.g. buy Iarm with intent to Iarm, but
then becomes more valuable iI sell it to real estate developer as homes sites, and you install roads
and sewers intent seems to change dual intent)
i. Whip-saw. iI TP has a gain, he wants the capital gains preference and will claim that sale to
customers was not his primary purpose; iI TP has a loss, he does not want it to be treated as
a capital asset and will claim sale to customers was his primary purpose
A) Can`t rely solely on the selI-serving statements oI taxpayers
e. Malat v. Riddell: TP was a participant in a joint venture that acquired a 45-acre parcel oI land.
TP claimed that the land was acquired to develop and operate an apartment project. TP was
unable to develop the land due to zoning restrictions. TP attempted to treat gain Irom the sale as
a capital gain. IRS claimed that the property was held primarily Ior sale to customers in the
ordinary course oI business and thereIore subject to ordinary tax.
i. District Court: Primary purpose substantial purpose. The Court Iound that because TP
bought the property to sell it or to develop it, it couldn`t be said that development rather than
sale was the primary purpose.
ii. S. Ct. eld: that primarily" in g11 means FIRS1 AD FRMS1` or 'principally
relative to other objectives
52
A) II TP bought and held the property principally for development than it could be
considered a capital asset; iI TP bought the property principally to sell it, then it was
subject to ordinary tax
I. iedenharn Realty Co. v. United States: TP bought the Hardtimes Plantation in 1935 Ior $50k.
It was Iarmed Ior a number oI years. TP spent $200k improving the land. He subdivided the lots
and between 1964 and 1966 he sold 38. TP treated the gains as capital gains. IRS claimed that
gains were not capital because they were held primarily Ior sale to customers in the ordinary
course oI business under 1221(a). Dist. Ct. holds as capital gain investment, 5
th
Cir. says
ordinary Y b/c oI 4 Iactors:
i Fact4rs used t4 deter2ine whether pr4perty is held pri2arily f4r sale t4 cust42ers in
the 4rdinary c4urse 4f trade 4r business
A) Frequency 4f Sales: First and most important Iactor when disposition oI subdivided
property extends over a long period of time and is numerous, 1P is not normally
entitled to capital gains preference
B) I2pr4ve2ents: When improvements are made to property inconsistent with an
investment intent, it is less likely to be afforded capital gains preference.
C) Other Fact4rs:
1) S4licitati4n and Advertisin Eff4rts: II TP engages in advertising or solicitation oI
customers, the gain is more likely to be ordinary
2) r4kerae Activities: Where a TP turns the entire property over to brokers who
make all decisions including prices, TP may be eligible Ior capital gains treatment
D) Inv4luntary Chane 4f Intent: can be considered capital gain iI forced to change
intent due to acts oI God, zoning law, or land can no longer be used Ior original purpose
(e.g., Iarming) voluntary change more likely to be considered ordinary Y
1) but where the change Irom investment holding to sales activity results Irom
unanticipated, externally induced factors which make it impossible to continue to
hold the property Ior original investment purpose then the initial intent is relevant
g. Pri2ary Purp4se Exa2ples: Question oI primary purpose is one oI degree and circumstances
i. TP purchases a Iarm Ior $1 mill.
A) TP make no improvements. He sells the Iarm Ior $2 million. TP has $1 million in capital
gain. (liquidation)
B) TP makes signiIicant improvements but sells the Iarm as one unit. TP still has capital
gain because the improvements are inconsistent with investment purpose.
C) No improvements are made but the Iarm is sold oII in 20 50acre units to a developer. TP
still has a capital gain because not enough parcels are sold to make it primarily Ior sale.
1) Moving away Irom obvious capital gains. Reasonable minds could diIIer.
D) No improvements are made but the Iarm is sold oII in 100 50acre units which are sold as
Iuture home sites (purchasers are told they will be charged home owner dues). Here TP
has ordinary income more sales are made and sales are made to a particular market.
ii. TP buys property Ior $100k as an investment, holding it until FMV is $400k. At that point
TP decides to develop the property. TP spends $100k on improvements and sells Ior $800k.
A) TP realizes $800k. His basis is $200,000 c4st basis + c4st 4f i2pr4ve2ents). TP has a
$600k ordinary gain because his primary purpose was sales to customers.
B) TP claims that the gain Irom $100,000 to $400,000 should be treated as capital gain
because until then it was held Ior investment. He argues $300,000 should be ordinary
gain and $300,000 should be capital gain.
1) Theoretically this makes sense but the capital and ordinary gains cannot be
apportioned by time.
a) ut, by changing activity Irom investment to sales, the whole gain is changed
Irom capital to ordinary (For administrative ease, the whole gain is tainted when
the TP`s intent changes).
53
iii. Instead oI developing property himselI, when property has FMV oI $400k TP sells the
property to his spouse. Spouse develops the property and sells it to X Ior $800k. TP claims a
capital gain oI $300,000 on the sale to his spouse. Spouse claims $300,000 oI ordinary
income.
A) TP cannot do this because a sale to a spouse is treated as a giIt (1041). TP does not
recognize any gain. Spouse has a carry over basis and will have to recognize $600,000 oI
ordinary gain.
B) ut, iI TP sells the property to his child, rather than his spouse, the transaction is not
treated as a giIt but as a recognition event (267 does not apply because this is not a loss).
Here TP can take $300,000 oI capital gains and Child $300,000 oI ordinary gains.
h. We d4 n4t all4w TP t4 pr4 rate: EITER ALL CAPITAL AIN, OR ALL ORDINARY Y
i. Pro-rating violates the realization principle because there is no sale or exchange when TP
changes purpose
ii. Too much opportunity Ior Iraud: TP wants capital gains and will claim property was held Ior
investment longer than it actually was
iii. 1237 Exception: provides relieI Irom harsh rule that no proration is allowed (what
iedenharn attempted to do)
A) II TP holds lot/parcel and liquidates it without making improvements, and meet the
Iollowing requirements:
1) Cannot be a dealer in real estate
2) Cannot make substantial improvements that are inconsistent with the investment
purpose
3) Must hold the property for at least 5 years
a) BUT, under 1237(b)(3)(B) iI TP held property Ior 1 years instead oI 5, then
may make improvements inconsistent with investment motives, but must
demonstrate to Secretary oI treasury that property wouldn`t be marketable
otherwise. (types oI improvements b(3)(A))
B) Then, the first five sales will be treated as generating capital gains; thereafter, 5" of all
sales will be treated as ordinary income and 95" will be treated as capital income
C) 1237b)3)C): p 632) II this section applies, TP can't increase basis by the costs oI
the improvements
2. Pr4perty used in trade 4r business that is depreciable (or real property used in trade or business)
a. 1221a)2): (p 620) real and depreciable property used in a trade or business are not capital
assets (e.g. truck used Ior deliveries)
b. BUT, under 1231 (p 624) depreciable and real property used in a trade or business 2ay still
qualify f4r preferential treat2ent as a quasi-capital asset
A) 1231b) applies to depreciable property and real property used in a trade or business but
excludes inventory and property held primarily for sale to customers
) In effect, the excepti4n fr42 capital treat2ent under 1221(a)(2) is eli2inated in
1231
1) Today it is seen as a incentive to upgrade equipment
ii Preferential treatment under 1231(a) (p 625)
A) II gains Irom sale and exchange oI 1231 property exceed losses Irom sale and exchange
oI 1231 property, the gain is treated as long term capital ain
) II gains Irom sale and exchange oI 1231 property do not exceed losses Irom sale and
exchange oI 1231 property, the loss is ordinary loss
C) TP ets b4th 4f b4th w4rlds: gains are allowed capital gains preIerence but losses are
not subject to capital gains limits
c International Shoe Machine Corp. v. Commissioner: TP was a shoemaker and purchased shoe
machinery equipment. This equipment was depreciable property. A small part oI TP`s income
54
also came Irom the sale oI shoe making equipment. TP claimed that he was entitled to
preIerential treatment under 1231 Ior the sale oI depreciable property used Ior trade or business.
i eld: even though TP sold depreciable property used Ior trade or business, depreciable
property held primarily for sale to customers in the ordinary course of business and
therefore not available for preferential treatment.
A) NEED TO CHECK ALL EXCEPTIONS TO SEE IF KICKED OUT OF DEF OF
CAPITAL ASSET; Exception trumps.
3 C4pyrihted, literary, 2usical, 4r artistic c42p4siti4n, letter 4r 2e24, 4r si2ilar pr4perty,
held by:
a TP who created such property
b TP Ior whom a letter, memo, or similar property was prepared or produced, OR
c TP in whose hands the Bs oI such property is determined (see statute)
Is not a capital asset
d. 1221a)3)C): p 621) It is tainted either because y4u created it, 4r b/c the pers4n y4u ive
it t4 has t4 use y4ur tainted basis (You cant give away tainted assets in order to get them
treated as capital assets)
i Ex 1. Mr. Miller, a proIessional song writer, sells a tune he wrote. What is the character oI
the gain Irom the sale?
A) Under 1221(a)(1) the tune is n4t a capital asset because it is st4ck in trade
) Under 1221(a)(3)(A) the tune is n4t a capital asset because it was s4ld by the pers4n
wh4 created it
ii Ex 2. Mr. Miller, a proIessional songwriter, writes a song and gives it to his dauhter as a
ift When daughter sells the song how is the gain treated?
A) Daughter is not covered by 1221(a)(1) because song writing is not her trade or business;
nor is she covered by 1221(a)(3)(A) because she did not create the song
1) but when daughter sells the song she will have to use the carry over basis from Mr.
Miller. 1221a)3)C) tells us where the basis 4f the pr4perty references the
basis 4f the pers4n wh4 created the pr4perty, the taint 4f 4rdinary inc42e
cann4t be re24ved ecause Mr. Miller would have to treat the asset as ordinary
income, daughter has to also.
iii. Ex 4. II Miller sells to wife f4r FM', 1041 applies must reIer to Millers basis, so it would
still be tainted and treated as ordinary income.
iv Ex. 5. II Mr. Miller, a proIessional song writer, writes a song and leaves it t4 Mrs Miller in
his will and Mrs. Miller sells it, how is the gain characterized?
A) When Mrs. Miller gets the testamentary giIt uses the stepped-up basis (the FMV as oI the
day oI transIer). Because her basis does not depend on reference to Mr. Miller's basis,
1221(a)(3)(C) does not apply and the gain can be treated as capital.
1) but, iI Mrs. Miller receives the song as a testamentary giIt and sells it along with
Glenn Miller merchandise then the song might be considered to be held primarily for
sale to customers in the ordinary course of business under 1221(a)(1) and treated
as ordinary income.
v Ex 6. Miller sells the tune to his daughter f4r FM', Miller realizes income and child has a
cost basis oI the FMV (Miller`s basis is not carried over, so there is no taint under
1221(a)(3)(C) that would be there iI it was a giIt.
A) Unless the child is in the business oI selling songs, this is considered capital income.
1) II you are in the business oI selling tunes, 1221(a)(1) applies and it is ordinary
income.
vi Miller sells tune to child Ior less than FMV (PART GIFT/PART SALE Irom Diedrich)
A) Song has FMV oI 100; Miller has Bs oI 20; child pays 25 and then she sells Ior
subsequent amount
1) What is character oI gain in hands oI child? First need to see who`s Bs is applicable
55
a) Miller`s AR 25, Bs 20 (Diedrich says can use whole Bs b/c parent) 25-20
gain oI 5.
i) Daughter has / sale , / giIt. Child`s cost / FMV
b) Daughter sells Ior 30; AR 30, Bs / sale (paid 25, but FMV 100) $25 /
giIt use parents carryover Bs 0 (what amount is needed Ior unrecovered
investment; b/c parents have recovered their entire basis and recognized a gain)
Bs 25, so 5 dollar gain. 30-25 5
c) Gain considered ordinary Y 1221(a)(3)(c) b/c reIerenced parent`s Bs tainted
vii.NOTE: 1221b)3) says that the 1P may elect not to have g11(a)(1) or 11(a)(3) apply
to the sale or exchange of self created musical works. Artists may always get capital gains
treatment if they want it.
4 Acc4unts 4r n4tes receivable
5 Publicati4ns 4f US
6 C4224dities and derivatives
7 edin transacti4n
8 Supplies 4f a type reularly used 4r c4nsu2ed by TP in 4rdinary c4urse 4f trade 4r business
4f TP
Unstated excepti4n t4 def 4f capital asset: The nature 4f the asset
1 Under the broad language oI 1221, everything is a capital asset unless one oI the Iew exceptions
directly applies. We have to look beyond the language oI the statute to the nature 4f the asset.
2 II TP receives property in lieu of c42pensati4n c42pensati4n replace2ent), the taint oI
4rdinary inc42e is not removed. Because the property is so much like ordinary income, and is a
substitution Ior ordinary income, it will not be treated as a capital asset
a Ex: uy4ut 4f a C4ach`s K. Coach has a $1 million contract Ior Iive years. At the end oI the
Iirst year the team wants to buy the coach out. Team says that iI the coach will terminate his
contract, they will give him $400,000. Coach gives the team a release, he receives his $400,000
and he is Iree to work Ior any other team. What is the character oI the $400,000?
i TP argues that because the release does not Iall within any oI the exceptions Ior capital assets
under 1221, it is a capital gain under the literal language oI the statute.
ii This is not the result. What the coach receives is like the money owed to him under the
contract which would be treated as ordinary income. ThereIore he does not get capital
preIerence.
b McFall v. Commissioner: TPs were employed by Sparta under a Iive year contract and were to
be compensated $100 a week plus 1/6 proIits. Co. paid TP $175,000 to give a release to Sparta.
TP argues that the amount received Ior the release was a capital asset because none oI the
exception under 1221 applied.
i eld: this was not a capital asset, but ordinary Y.
A) This is not property right, so 1221 is not applicable
) The money is a substitute Ior salary, so treated as ordinary Y
c Miller v. Commissioner: TP was the widow oI Glenn Miller. TP gave Universal studios the
right to make a movie based on the liIe story oI Mr. Miller. Universal paid TP $400,000 plus a
share oI the proIits. TP treated the income as capital income. TP argued that because Universal
was paying her, they were paying her Ior something and that something was not covered by an
exception under 1221 so that it was a capital asset.
i Held: Money Irom the rights to liIe story is ordinary income.
A) eneficiaries of estate of deceased entertainer don't receive by descent a capitalizable
property in the name, reputation, right of publicity, right of privacy or public image of
the deceased
1) Not everything people pay for is property under 1221; here Universal was paying to
prevent later suit
) Substantial payment is not proof of property
56
QUESTION #5: OW ARE COSTS RECO'ERED?

I Treat2ent 4f C4sts
A Deducti4ns under 162 p 142) and depreciati4n
First we have to distinguish between for profit and for pleasure activities
1 For pleasure
a n4t deductible/rec4verable: 262 (p 243), 183 (p 209)
2 For profit activities: (not deIined by code)
a Can be deducted under 165 iI in connection with
i Trade 4r business
ii Pr4ducti4n 4f Y (e.g., buying stock iI you`re a lawyer not your trade or business, but still
has a proIit motive; buying real property and rent out to tenants)
3 Normally there is no deduction for property that you hold, except Ior interest deducti4n
163h)2), (p 152) or 2123) (p 221) can take deduction Ior taxes that you pay, regardless oI
activity
C 165: can deduct losses that are not reimbursed by insurance or otherwise that incurred in trade or
business, any transaction entered into for profit, and those not related to trade or business or entered into
Ior proIit (aka pers4nal) iI they arise Irom fire, storm, shipwreck, or other casualty, or theft
1 No deI. oI trade or business, or ~f4r n pr4fit): need to look at facts and circumstances
a Re 1183-2b)1)-9): (p 922) 12 Fact4rs to help determine whether an activity is for profit
or for pleasure, but no one Iactor is determinative (based on Iacts and circumstances)
i Manner in which TP carried on the activity
ii Expertise oI the TP or his advisers
iii Time and eIIort expended by TP in carrying on the activity
iv Expectation that the assets used in the activity may appreciate in value
v Success oI TP in carrying on similar or dissimilar activities
vi TP`s history oI Y or loss w/respect to activity
viiAmount oI occasional as
viii Financial status oI TP
ix Extent to which elements oI personal pleasure are involved
x. The Primary Purpose Test: ickerson: TP bought a Iarm with the intent oI running a dairy
Iarm Ior proIit but at the time oI the purchase he was an advertising agent. He lived Iive
hours away and on the weekends would go to work on the Iarm. He also hired a tenant
Iarmer to work on the land during the week. He incurred losses restoring the Iarm that he
attempted to deduct pursuant to 165. Didn`t expect to make a Ior 10 years. IRS claimed
that the losses were personal and no deduction was allowed.
xi eld: Losses could be deducted because TP had a bona fide expectation of profit n was
PRIMARY 24tive
A) In order to have a 'Ior proIit activity TP does not have to have proIits right away but
may have start up losses. Here TP just had small losses over several years rather than big
losses in one year.
) TP hired a tenant Iarmer to prepare the land Ior Iarming though he did not spend time
there.
C) TP was learning the business
xiiIRS C4ncern: was an illegal tax shelter: an activity that produces losses that are used to
oIIset or shelter other taxable Y
A) In this case the tax sheltering was legal TP was using legitimate losses to oIIset gains
Irom ordinary income.
) In other cases, tax sheltering is illegal because the only reason Ior the losses is to oIIset
ordinary income, there is no income motive. (Persons with large nonIarm income have a
remarkable propensity to lose money in the Iarm business
57
D 263Ad)1)A): (p 245)any time your pre-productive time (i.e. preparation) is more than years, you
are required to CAP1IALIZ those costs
1 263Ad)1)A)ii): 2 years or less: can EXPENSE it
E 183d): (p 209) II TP has gains from an activity for three out of five years there is a presumption that
the activity is for profit. II the activity is breeding, training, showing or racin h4rses, then TP must
show gains in only two out of seven years to have the Ior proIit presumption
F 183: p 209) 4bby L4ss Situati4n, non-existent at time oI ickerson
1 183: The h4bby l4ss provision provides some relieI Irom the harsh treatment oI not Ior proIit
activities; provides middle ground when activity is not clearly for n
a 183(b)(1) II you could take a deduction regardless of whether for profit or not, then still
entitled to take deduction ( 212 deduction Ior taxes can take regardless oI whether Ior proIit
or not)
b 183(b)(2) May take losses to the extent of gross Y Irom the same activity (need to have made
some money), may not take losses in excess of Y (may always take losses iI you have Y Irom a
certain activity)
i Ex: Chemist has salary oI 100k, and wins $350 Irom chess tournament in order to get to
tournament, chemist spend $650
A) II Ior proIit, then could deduct 650
) II Ior pleasure, then can deduct 650 to extent oI Y earned in activity 350 can deduct
300
ii Ex: winning oI 350, expenses oI 650, tax oI 200
A) Entitled to deduction oI 200 no matter what so can only deduct winnings to the extent
that they exceed 200 150; so entitled to take deduction oI 350 (taxes expenses can`t
exceed the winnings)
iii Note that TP cannot uses losses Irom a Ior pleasure activity to oIIset gains Irom another
activity
2 Zdun: TP was a dentist and grew apples in an orchard. He used organic apples in his dentistry
practice. He tried to claim that dentistry and apple growing were the same activity and thereIore he
could oIIset the gains Irom his dentistry practice with the losses Ior his orchard activity.
a eld: The orchard losses could only be taken to the extent oI the orchard gains, as this was
considered a hobby activity under 183. The orchard wasn`t necessary to run his dentistry
practice, so it wasn`t a Ior proIit activity. The court considered the degree oI organizational and
economic interrelationship, the business purpose served by the undertakings together or
separately, and the similarity oI the undertakings.
3 The hobby loss provision treats individuals with losses from pleasure activities and losses from
business activities the same when gains exceed losses (all losses oIIset by gains); it is only where
losses exceed gains that the diIIerence is important (some losses not oIIset by gains)
a note that losses that cannot be taken because they exceed gains cann4t be carried f4rward
b Less diIIicult with the raising oI horses 183(d) but 165(d) has the opposite eIIect on gambling
on horses (treated as a hobby; cannot use losses to shelter income Irom other sources)
Mixed F4r Pleasure and F4r Pr4fit Activities
1 ome ffices (deduct portion oI rent iI renting, depreciate iI own)
a 280Aa) (p 268) provides that in general a deduction is not allowed Ior a home oIIice, U1
b 280Ac) provides an exception that allows Ior proportional deductions where any portion oI
house is used: (have to meet 1 oI 3)
i exclusively 4n a reular basis
A) As the principal place of business Ior any trade or business oI the TP, OR
1) in the case oI an employee, the home oIIice must be Ior the beneIit oI the employer
2) iI the employer provides an oIIice then no deduction is allowed Ior second oIIice at
home (principal place oI business there is no other place provided Ior you to
conduct administrative or mgmt activities)
58
) As a place oI business which is used by patients, clients, or customers, OR
C) In the case oI a separate structure, deals w/ 1P's trade or bus.
ii St4rae 4f invent4ry in dwellin unit is deductible
2 'acati4n 4uses
a 280Ae): (p 271) iI the vacation property is used Ior personal purposes on any day during the
taxable year, the a24unt deductible shall n4t exceed the a24unt 4f ti2e rented by
percentae 4f days used)
i. MUS1 PRRA1: must distinguish b/w personal and business use
ii Ex: 10 days are used Ior personal reasons. 90 days the house is rented out. Expenses are
$10,000. 90/100 total days 90 business use. Tp can take a deduction Ior 90 oI the
expenses or $9000. Days that the house is not used are ignored.
b 280Ad): iI TP uses property for personal purposes for more than 14 days or 1" of the days
that it is rented - whichever is greater, the property is considered a residence and deducti4ns
are li2ited t4 rental Y
i 280Ac)5): iI the vacation home is a residence, then costs can be deducted only to the
extent that they are oIIset by gains Irom that activity: MAY 1 SL1R 1R Y
A) UT, unlike 183 hobby activity, any amount not deducted in this year can be carried
forward to the next year (indefinite)
ii Ex. (both provisions): Property is rented Ior 200 days and lived in Ior 100 days. TP has
expenses oI $10k and rental income oI $5k. The total number oI days in use is 300. Number
oI days Ior business is 200. 200/300 2/3. At most only 2/3 oI $10,000 or $6,700 can be
deducted per 280A(e). The greater oI 10 oI 200 days or 14 days is 20 but TP lived in the
house Ior 100 days so it is treated as a residence and TP can only deduct costs to the extent
oIIset by income per 280A(c)(5). Here TP can only deduct $5000 oI the $6700 allowable.
The remaining $1700 can be carried Iorward indeIinitely.
3 a2blin L4sses
a g15(d): (p 163) costs oI gambling can be deducted only to the extent that such costs are offset
by winnings, even iI you are a proIessional gambler.
i Prevents gambling losses Irom being used oI oIIset ordinary gains
F4r Pr4fit Activities c4sts are recovered based on type oI cost
1 Re 1446-1a)4)ii): (p 1187) expenditures made during the year shall be properly classiIied as
between capital and expense
2 3 types 4f c4sts:
a. 1: Costs for assets that last less than or equal to the current year
i Can take deduction Ior Iull expenses expensed" (e.g., 162 ordinary and necessary business
expenses)
ii Recover the cost immediately
iii Wasting": Where an item is expected to last no longer than the end oI the current taxable
year
iv Types oI expensed costs:
A) g1(a) (p 142) iI the cost is related to trade or business
1) must be necessary and 4rdinary (terms have independent meanings)
a) necessary cost: any cost that is appropriate or helpful to TPs trade or business or
appropriate to the production oI income
b) 4rdinary cost: is more restrictive, 1) must be consistent with business norms
AND 2) must be something that is not of a capital nature look back to 1221)
2) Welch: TP paid the expenses oI his Iormer employer to engender goodwill with the
Iormer employer`s creditors and enhance TP`s business prospects.
a) eld: that the costs were necessary, but not ordinary capital, b/c last beyond
the taxable year
i) people do not normally pay the debts oI another
59
ii) the goodwill that TP was buying would last Ior more than a year so it was a
capital expense
) 212: (p 221) II the cost is related to production of Y
b : Costs for assets that will last more than 1 year, but less than some ascertainable period (e.g.,
truck) ('wastin capital expenditure)
i. Recover the cost over the useful life of the item
ii 167: p 167) depreciati4n deducti4n: entitled to recover costs Ior trade or business
activities, or Ior production oI Y
A) A deducti4n cann4t be taken until the asset is put in service
1) 168d)4) (p 170) the IRC presumes that an asset put into service at any time during
the year is put into service 6 months into the year. ALWAYS CALCULA1 1
st
YAR
A1 M1S
a) this prevents the TP Irom taking a Iull year depreciation deduction Ior an asset
used only Ior a short period oI time
iii Will have to capitalize the cost (no full deduction)
1) 263A: (p 244) Assets that will last bey4nd 4ne year 2ust be capitalized (except
Ior repairs; see below). N4 deducti4n all4wed f4r any a24unt paid 4ut f4r new
buildins 4r f4r per2anent i2pr4ve2ents 2ade t4 increase value 4f pr4perty
a) 263Ab) UNICAP: uniIorm capitalization rule: all direct and indirect costs of
creating a capital asset (long term benefits) must be capitalized. Applies to
property (real or tangible personal property) produced by TP, and property
(inventory) acquired Ior resale
b) Excepti4ns:
i) 263Ab)): doesn't apply to personal property acquired for resale iI the
average annual gross receipts are less than 1mill
ii) 263Ah): doesn`t apply to Ireelance photographers, writers, or artists
c) Idaho Power Co.: TP, Idaho Power Co., used its own equipment and employees
in the construction oI improvements and additions to its capital Iacilities. On its
books, taxpayer capitalized the construction-related depreciation on equipment
used Ior construction oI the capital asset. But Ior income tax purposes, the
taxpayer deducted the entire amount oI depreciation on equipment used in
construction oI the capital asset under 167(a) including the amount capitalized as
construction costs.
i) eld: Construction-related expense items, such as tools, materials, and
wages to construction workers are treated as part of the cost of acquisition of
a capital asset. Reasonable wages paid in carrying on oI a trade or business
qualiIy as a deduction Irom gross income, but when wages are paid in
connection with construction or acquisition of a capital asset they must be
capitalized and are then entitled to be amortized over the life of the capital
asset so acquired.
2) Anythin ass4ciated with buildin 2ust be capitalized, includin salaries and
pensi4ns
iv Capitalizin Depreciati4n
A) Depreciation is 'capitalized by adding the cost to the basis and recovering it over the
useful life of the asset
1) Basis must be adjusted when depreciation deduction is taken to reIlect costs
recovered
2) Ex 1: TP has a truck that cost $10k and has a 10 year useIul liIe. II the truck is used
in connection with TP`s trade and business (delivery) TP can take a depreciation
deduction oI $1k a year. II TP uses the truck one year to build a new building the $1k
60
depreciation is added to the basis oI the building and will be recovered over the useIul
liIe oI the building
3) Ex 2: TP has the same truck but this year he uses it / oI the time to build and / oI
the time to make deliveries. / oI the depreciation must be capitalized. $250 is added
to the basis oI the building. $750 may be taken as a depreciation deduction. The
adjusted basis Ior the truck at the end oI the year is $9250. ($250 oI which cost not
recovered)
) Depreciati4n Schedule will always report same Y, just recover costs at diIIerent times
1) 1hree variables:
a) Period oI cost oI recovery (POCR) amount oI time over which depreciation is
taken time in which you recover the investment (i.e., useful life)
b) Method oI cost recovery (MOCR) how costs are recovered (i.e., straight line or
accelerated) based on type oI property, must use prescribed method
c) Salvage value value that the asset has when the useful life has ended (e.g.
aIter you`ve used the truck and you sell the parts Ior $500 although there is
always almost some value, statute allows TP to assume salvage value oI 0 -
168b)4))
2) ec4n42ic v taxati4n schedule) depreciati4n
a) ec4n42ic depreciati4n: the diIIerence between the FMV value and the start oI
the year and the FMV at the end oI the year; IRC does not use economic
depreciation even though it reIlect true costs
b) By using depreciation schedule rather than economic depreciation the IRC also
i) Encourages people to upgrade equipment by allowing costs to be recovered
upIront more quickly
ii) Eliminates administrative diIIiculty in valuing actual depreciation each year
iii)Recognizes the time value oI money
C) Tanible assets (real and personal property):
1) 168 (p 169) provides depreciation schedule for tangible assets
a) Re 1167a)-2 (p 1013)describes the types oI property subject to the
depreciation deduction and those not included in the section (LONG LIST)
i) e.g., land on which on oIIice building sits, owner-occupied house
b) Art not depreciable property
2) Accelerated 2eth4d 4f c4st rec4very is used Ior all assets except real property
which uses straiht line 2eth4d
a) Accelerated Method:
i) Two types oI accelerated depreciation: 200 declining balance and 150
declining balance
ii) A24unt 4f the depreciati4n deducti4n is deter2ined by 2ultiplyin the
adjusted basis by 200 4r 150) and dividin by the useful life
iii)when the amount oI the deduction using the SLM exceeds the amount oI the
deduction using the DBM, you switch to the SLM
iv) the period oI cost recovery varies depending on the type oI asset being
depreciated
D) Intanible Assets
1) 167 and 197 (p 167 & 212)provide the depreciation schedules for Intangible
Assets (197(d)(1)(C)(iii))
a) 167a): intangibles can be capital expenditures
b) Re 1167a)-3a): (p 1013) iI an intangible asset is known Irom experience or
other Iactors to be of use in the business or in the production of income for only
a limited period, the length of which can be estimated with reasonable accuracy,
such intangible asset may be the subject of a depreciation allowance
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i) Prior to 1993, the rule used to be that iI an intangible asset is not listed in 197
or elsewhere in the code, TP has the burden oI proving the ascertainable
useIul liIe; iI TP cannot show the burden, then the cost cannot be depreciated
and will not be recovered until the asset is sold or exchanged, BUT NOW:
c) Re 1167a)-3b): in order to determine the depreciation allowance mentioned
in (a), a 1P may treat an intangible asset as having a useful life equal to 15
years, unless the code has provided you with another # somewhere else, or if the
intangible has a useful life other than 15 years which you can show SAF
ARR
2) 197d) provides types oI intangible assets that can be depreciated and the useIul liIe
oI those assets; 197a) gives us amortization period oI 15 years Ior 197 intangibles
a) Excepti4ns: 197e)3): intangible does not include computer software, BUT
i) 167(I)(1): computer soItware can be recovered over 36 months
b) other sections oI the code provide that costs oI some intangible assets can be
expensed to encourage the activity, including
i) 174a)1) research and development, advertising costs ordinary and
necessary. Encourages research and development
c. 3: Costs for items that will last indefinitely (non-wasting capital expenditure)
i N4n-wastin expenses: (won`t ever go away, such as unimproved land) Recover it when
you sell it; costs cannot be deducted or depreciated
A) Costs are included in the basis oI the asset
) Delayed recovery is worst case Ior TP
ii Re 1162-4 (p 978)Excepti4n f4r Repairs: Even though repairs last beyond one year
there is an exception to the capitalization requirement
A) Work will be considered a RPAIR iI it d4es n4t 2aterially add t4 the value 4f the
pr4perty, d4esn`t appreciably pr4l4n its life, but rather keeps it in an 4rdinarily
efficient 4peratin c4nditi4n (TP RET&RNED TO ORGNAL POSTON)
1) The need Ior the repair must not be foreseeable or expected; iI it is, and TP does
build in anticipation then he is not entitled to expense the cost since it should have
been included with other capital costs
) iI you are put in a better position, then capitalize. II it just returns you to where you
were and not foreseeable, then expense
iii 263a): (p 244) no depreciation deduction Ior non-wasting expenses unless it is a repair, and
then get to expense
A) TP preIers repair treatment where the costs are expensed (and not added to basis) because
costs oI improvements must be added to the basis and recovered over the useIul liIe oI
the property
) Midland mpire Packing Co.: TP owned a meat packing plant. For years the basement
leaked water but no repairs were made because damage was not caused. An oil reIinery
was built near the plant and oil began leaking into the basement. TP was required by
health inspectors to Iix the seepage. TP added thicker Iloor and walls stopping both the
oil and water. TP tried to take a deduction but IRS claimed that cost had to be capitalized
because it was an improvement to his property.
1) eld The repair put TP in the position that he had been in beIore so he could expense.
a) IRS thought because water was also blocked there was an improvement but there
was no problem Ior TP with water being in basement; his position did not change
by blocking water
i) The basement was smaller than beIore so TP may have even been in a worse
position
) In determining whether an expenditure is a capital one or expansible, it is
necessary to bear in mind the purpose of the expenditure
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a) Repair: an expenditure Ior the purpose oI keeping the property in an ordinarily
eIIicient operating condition it d4es n4t add t4 the value 4f the pr4perty 4r
appreciable pr4l4n its life
b) Replace2ents, alterati4ns, i2pr4ve2ents 4r additi4ns prolong the liIe oI the
property, increase its value or make it adaptable to a diIIerent use
II C42parin f4r pr4fit and f4r pleasure activity
A Residential Pr4perty
1 Residential properties create inc42e fr42 rent
a. wner occupied homes are used Ior personal reasons and the rental receipts Irom imputed
income are not included in CI
b. II the owner rents his home to a third party, the rental receipts are treated as CI
2 Rec4very 4f c4sts
a Where the home is 4ccupied by the 4wner, the costs are personal and no deduction may be
taken for costs of maintenance and no depreciation deduction may be taken for wear and tear
b. Where the home is rented t4 a third pers4n the costs of maintenance may be deducted and
depreciation deduction is allowed
c Both 4wners 4f rented h42es and 4wner 4ccupied homes get deductions for property taxes
i Sail Boat Example - Type 2 cost (capital expenditure)
A) A boat is purchased Ior $2000. It can be rented Ior $1400 during the year and at the end
oI the year it is worth $1200.
1) II the boat is rented t4 a third party, the rental proceeds are included as part oI GI
under 61(a). A depreciation deduction oI $800 can be taken Ior wear and tear under
167. The owner is taxed on $1400-$800 $600.
2) Bs 2k 800 1200
a) Even though Bs doesn`t matter until sell property, still need to determine Bs and
make adjustment . Runnin acc4unt 4f unrec4vered invest2ent is created by
adjusting Bs Ior Iuture use
b) II the next year the owner sells the boat Ior $1200. The amount realized is $1200.
The basis is not $2000 but $1200 because the owner has already recovered $800
oI her basis through the depreciation deduction. Owner has no gain or loss.
3) II the boat is used by the owner, the imputed rental income is not included as part oI
GI. The owner cannot take a depreciation deduction oI 800 dollars or expense
deduction.
a) II the next year the owner sells the boat Ior $1700. The amount realized is $1700.
The basis is $2000. TP has a loss oI 300; can't take deductions for personal
losses under g , and g 15(c), which says that deductions for losses are
limited to those incurred in trade/business, transactions entered into for profit, or
personal casualty losses (see below)
IIIChanin activity fr42 f4r pleasure t4 f4r pr4fit activity
A Re 1165-9b): p 1008) iI you buy property Ior use as a personal residence and beIore you sell it,
you c4nvert it t4 business use, you are entitled to a loss, but the loss should be the lesser of the
adjusted s or FM'
1 Ex: TP buys a house Ior personal use Ior $120,000. Consumption (wear and tear) causes the house to
depreciate by $10,000. Economic conditions cause the property to depreciate by $60,000. At this
point TP converts the property Irom personal use to Ior proIit use. The FMV is $120,000 - $10,000 -
$60,000 $50,000. Her adjusted basis is the same as her cost basis $120,000 (no depreciation
deduction Ior personal consumption and there is no distinction b/w other Iactors and personal
consumption). TP will have to use FMV basis.
a Note that by Iorcing TP to use the FMV basis, the IRC does not allow her to include the
depreciation Irom use or market conditions that arose during period oI personal use in her basis
and thereby precludes the recognition oI losses Ior either.
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i Though not all loss can be attributed to personal consumption (some can be attributed to
market collapse) the IRC makes no distinction (no distinction made in Gevirtz either)
Re 1165-7a): (p 1006) same provision which applies to other property
1. Cevirtz: TP wanted to buy a tract oI land to build an apartment building. She bought the land and
then decided that building the apartments was a bad idea so she built a 12 room house which cost her
$90,000. TP lived in the house Ior Iive years and then tried Ior three years to Iind a buyer or renter
but was unsuccessIul. TP tried to deduct the $90,000 and take a depreciation deduction.
a eld: No deductions allowed because there was a deIinite abandonment by TP oI her original
proIit motive in purchasing land and devotion oI the personal to a personal residence.
i. 1he mere effort to rent or sell the property did not convert the use into a business use when
the objective purpose is personal
C. 165c)3) p 163) Casualty L4sses: Where losses on property held for pleasure occur from fire,
storm, shipwreck, other casualty, or from theft 1P can take a deduction.
1 In order Ior a loss to count as '4ther casualty is must be similar to a Iire, storm or shipwreck in so
Iar as TP is p4werless t4 prevent it, it is unexpected 4r sudden, and taxpayer is unaware
(Carpenter)
a Note that TP negligence has no bearing on whether or not something qualiIies Ior casualty loss,
but there cannot be a casualty loss for assets recklessly or willfully destroyed
b Carpenter v. Commissioner: upholding casualty loss treatment Ior diamond ring inadvertently
being poured into the sink and destroyed by the garbage disposal.
i eld: Negligence by TP isn`t outcome determinative, but Iact that TP is unaware iI it,
powerless to act, it was sudden, and damages occurred, was outcome determinative
c Rev Rul 63-232: termite damage is slow and not sudden so not 'other casualty
D 165h) p 164) PERSONAL LOSS: li2itati4ns to TPs ability to deduct losses under 165(c)(3)
1 Pr4spect 4f rei2burse2ent (will you be reimbursed by ins. co.)
a 165h)4)e): you may not make the choice to not Iile a claim iI you are insured (People
may not want their ins. premiums to go up, so might otherwise choose not to Iile a claim).
i 1165-1d)2)i): (p 1002) II property is insured TP is required to Iile a claim, and if 1P
has any reasonable prospect of being reimbursed, then no entitlement to deduction
2 100 fl44r (each casualty must be at least $100): each casualty has to meet this Iloor
a 165h)1) $100 limit to control number oI claims; individually, each incident must meet
$100 Iloor
3 10 4f AI fl44r operates in the aggregate (all casualties combined must meet this
requirement): ensures losses are claimed Ior extraordinary costs
a 165h)2): you may always take losses to the extent that you have gains (gains mean you
have been reimbursed)
b EX: TP has AGI oI 150k; personal casualty gain (reimbursed) 40k ; personal casualty
losses 32k
i Assume that you have accounted Ior $100 Iloor (165(h)(1))
ii More gain than loss, so can take all loss because will still have an 8k gain.
A) 10 Iloor has no eIIect.
iii What iI losses 62k? (still assume met $100 requirement)
A) Can automatically take 40k leaves us w/22k oI personal casualty loss so then need
to take 10 oI AGI (150k) 15k
1) How does 10 Iloor work TP can deduct out oI 22k that amount that exceeds
15k (10 oI AGI) 7k
a) SO can deduct 40k 7k 47k