Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard...

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Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey

Transcript of Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard...

Page 1: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Chapter 11 Investments

Howard Godfrey, Ph.D., CPAUNC Charlotte

Copyright © 2012, Dr. Howard Godfrey

Page 2: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

11. Investments1. How interest income and dividend income are taxed.2. Compute the tax consequences associated with the

disposition of capital assets, including the netting process for calculating gains and losses.

3. Common sources of tax-exempt investment income and explain the rationale for exempting some investments from taxation.

4. Calculate the deduction for portfolio investment-related expenses, including investment expenses and investment interest expense.

5. Understand the distinction between portfolio investments and passive investments and apply tax basis, at-risk, and passive activity loss limits to losses from passive investments.

Page 3: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

1. How interest income and dividend income are taxed.

Page 4: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

2. Compute the tax consequences associated with the disposition of capital assets, including the netting process for calculating gains and losses.

Page 5: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

3. Calculate the deduction for portfolio investment-related expenses, including investment expenses and investment interest expense.

Page 6: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

4. Understand the distinction between portfolio investments and passive investments.

Page 7: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

5. Apply tax basis, at-risk, and passive activity loss limits to losses from passive investments.

Page 8: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Textbook page 11-4Discount or Premium. How is the bond price computed? How is the amount of the periodic interest payment determined? The amount of interest expense, and amortization? Please study illustration on next few pages.

Page 9: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

HK Co. Bond IIlustration – Slide 1 of 19Great Corporation issues bonds with a face value of $100,000 on 1-1-09. The bonds mature 2 years later on 12-31-11.The bonds pay interest of 10% per year, payable twice per year ($5,000 each 6 months).HK Co. buys the bonds, at a price based on a 12% yield.

Page 10: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Bond IIlustration – Slide 2 of 19

If the market rate for companies with similar credit standing is 10%, the bonds will sell for $100,000 (plus any accrued interest if sold between interest dates).

Page 11: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Bond IIlustration – Slide 3 of 19Assume the market rate of interest is 12% compounded semiannually, the bonds will sell for less than $100,000. The bonds will sell at a discount to provide additional earnings for the investor beyond the $5,000 interest payments.

Page 12: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Bond IIlustration – Slide 4 of 19

Both the borrower and the investor (if held to maturity) must amortize bond discount using the constant interest rate method (withsemiannual compounding).

Page 13: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Bond IIlustration – Slide 5 of 19

How would you compute the amount to be paid for these bonds, if yield is 12%, compounded semiannually?

Page 14: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Bond IIlustration – Slide 6 of 19

Discount the interest payments and principal payment, at 12%, compounded semiannually.

Page 15: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

HK Co. Bond IIlustration – Slide 7 of 19On 1-1-11, issue $100,000 of bonds.On 12-31-12 the bonds will mature.Bonds have stated interest of 10%. Bonds pay interest of $5,000 each 6 months. HK Co. buys bonds at price to yield 12%, with semi-annual compounding. Compute price paid by HK Co. by discounting cash flows at 6% per interest period.

Page 16: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

June Dec. June Dec

PV $5,000

PV $5,000

PV $5,000

PV $5,000

PV $100,000

Price

HK Co. Bond IIlustration – Slide 8 of 19

2011 2012

Page 17: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Interest Payments $5,000.00PV Factor [Pg. 682]=PV(0.06,4,-5000,,0)

PV of annuity of $5,000 $17,325.53

PV of $100,000(4 periods, 6% per period)

Principal Payment $100,000.00Factor =1/(1+0.06)^4 0.792093663PV of $100,000 payment $79,209.37

Price of Bond $96,534.89

Bonds – Slide 9 of 19.PV of 4 interest payments

Page 18: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Bond IIlustration – Slide 10 of 19Prepare amortization table.Note: The PV factors on preceding page were computed with Excel. These factors are a little more accurate than those taken from tables in your book (because of rounding in the textbook).

Page 19: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

HK Co. Bond IIlustration – Slide 7 of 19On 1-1-11, issue $100,000 of bonds.On 12-31-12 the bonds will mature.Bonds have stated interest of 10%. Bonds pay interest of $5,000 each 6 months. HK Co. buys bonds at price to yield 12%, with semi-annual compounding. Compute price paid by HK Co. by discounting cash flows at 6% per interest period.

Page 20: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Book Interest Interest Unamort Book

Yr Value Received Income Amort. Disc/Prm Value

2011 96,535

2011

2012

2012 -

Bond IIlustration – Slide 12 of 19 On Jan. 1, 2011, issued $100,000, 10%, 2 year bonds.

Interest is paid on 6-30 and 12- 31. Mature 12-31-12.

Bonds were sold at a price to yield 12% per year.

Page 21: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Book Interest Interest Unamort Book

Yr Value Received Income Amort. Disc/Prm Value

2011 96,535 5,000 5,792 792 2,673 97,326.99

2011 97,327 5,000 5,840 840 1,833 98,166.61

2012 98,167 5,000 5,890 890 943 99,056.61

2012 99,057 5,000 5,943 943 (0) 100,000

Bond IIlustration – Slide 12 of 19 On Jan. 1, 2011, issued $100,000, 10%, 2 year bonds.

Interest is paid on 6-30 and 12- 31. Mature 12-31-12.

Bonds were sold at a price to yield 12% per year.

Page 22: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Income(DR) (DR) (CR) (DR)

Bond Bonds InterestTransaction Cash Discount Payable Expense

IssueBonds 96,535 3,465 (100,000)

PayInterest (5,000) 5,000

AmortizeDiscount (792) 792

Totals 2,673 (100,000) 5,792Book Value - bonds - 6-30-06 ($97,327)

Balance Sheet

Bond Illustration. [13 of 19]

Page 23: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Begin Bal. Int. 6% W/draw End. Bal. 1 96,535.00 5,792.10 (5,000) 97,327.10 2 97,327.10 5,839.63 (5,000) 98,166.73 3 98,166.73 5,890.00 (5,000) 99,056.73 4 99,056.73 5,943.40 (5,000) 100,000.13

Page 24: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Cash 96,535 Discount 3,465

Bonds Payable 100,000

Interest Expense 5,000 Cash 5,000

Interest Expense 792 Discount 792

Great Co. Issues Bonds -14 of 19

Issues Bonds 1-1-07

Adjusting Entry 6-30-07

Interest Payment 6-30-07

Page 25: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Bond Investment 96,535 Cash 96,535

Cash 5,000 Interest Revenue 5,000

Bond Investment 792 Interest Revenue 792

HK Co. Buys Bonds -15 of 19

HK Co. Buys Bonds 1-1-07

Adjusting Entry 6-30-07

Interest Received 6-30-07

Page 26: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Bond IIlustration – Slide 16 of 19

How much income is recognized by HK in first year?

Page 27: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Bond IIlustration – Slide 17 of 19

How much income is recognized by HK in first year?$5,792.09 plus $5,839.62.

Page 28: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Cash Other Current AssetsBuilding and LandAccumulated Deprec.Net Fixed Assets

Total AssetsCurrent LiabilitiesLong-Term Debt

Bonds Payable 100,000Less Discount

Common StockRetained EarningsTotal Debt & Equity

Bond IIlustration – Slide 18 of 19

Page 29: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Bond IIlustration – Slide 19 of 19

How much would the bonds sell for if they pay zero interest?Answer:$79,209.37 (Slide 9 of 19)

Page 30: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

On Jan. 1, 2007, Carr Corp purchased Fay Corp. 9%. 10-year bonds with a face amount of $400,000 for $375,600, to yield 10%. The bonds are dated January 1, 2007, mature on December 31, 2017, and pay interest annually on Dec. 31. Carr uses the interest method of amortizing discount. What is Carr’s interest revenue for 2007?$40,000 b. $37,560 c. $36,000 d. $34,440(Source: CPA)Ignore some rounding in the price computation

Page 31: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Carr CorporationAnswer is BFace value of investment $400,000Book value of investment $375,600Yield rate 10%Interest earned (revenue) $37,560Interest received

(9% of face value) $36,000Amortization of discount $1,560

Page 32: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

2. Compute the tax consequences associated with the disposition of capital assets, including the netting process for calculating gains and losses.

Page 33: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Capital Gains and LossesA capital asset is “any asset other than inventory, receivables, copyrights, assets created by the taxpayer, and depreciable or real property used in a trade or business.”A collectible gain or loss results from the sale or exchange of works of art, gems, metals, antiques, rugs, stamps, wine, etc. held more than 12 months.

Page 34: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Four One Buckets Bucket

Net Net NetShort-T. Long-T. Gain (Loss) Return

Yr 1 STCG $4,000

Yr 1 STCL ($2,400)

Yr 1 LTCG $4,000

Yr 1 LTCL ($3,500)

Net Gain

Gain taxed at ordinary rates

Gain taxed at capital gains rates

Stock Trans.

Barb-1 TwoBuckets

Page 35: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Four One Buckets Bucket

Net Net NetShort-T. Long-T. Gain (Loss) Return

Yr 1 STCG $4,000

Yr 1 STCL ($2,400) $1,600

Yr 1 LTCG $4,000

Yr 1 LTCL ($3,500) $500

$2,100

$2,100

$1,600

$500

Net Gain

Gain taxed at ordinary rates

Gain taxed at capital gains rates

Stock Trans.

Barb-2 TwoBuckets

Page 36: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Tax Treatment for Net Long-term GainIndividual Taxpayers

– Collectibles held more than 12 months are taxed at a maximum rate of 28%.

– 50% of the gain on qualified small business stock is excluded, the remainder taxed at a maximum rate of 28%.

– Unrecaptured Section 1250 gain is taxed at a maximum rate of 25%.

Page 37: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Short-term capital loss ($2,000)

Long-term capital gain $12,000

Long-term capital

loss carryover ($5,000)

Collectibles gain $10,000

Juan has these capital gains and losses in the current year:

Page 38: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Example Short-term:S.T. capital loss ($2,000)

Long-term:Collectibles gain $10,000L.T. capital gain $12,000L.T. capital loss c/o ($5,000)

L.T. capital gain $17,000Net L.T. capital gain $15,000

Page 39: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

ExampleResults:“28% rate gain” = ($10,000 -$5,000 - $2,000)

= $3,000

ANCG = $15,000 - $3,000 = $12,000

NLTCG is added to taxable incomeNet capital gain, taxed at 15% = $12,000Collectibles gain, taxed at 28% = $3,000

Page 40: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Tax Treatment for Net Short-term Gain

Individual Taxpayers • Net short-term capital gain

is taxed as ordinary income (i.e., taxpayer’s marginal tax rate).

Page 41: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Gain Treatment for Corporations

•Corporations do not receive special treatment for capital gains.

Page 42: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Tax Treatment for Net Loss• Net Capital Loss– Individuals may use only $3,000 to offset

other income• Excess loss is carried forward indefinitely

and retains its short term or long term class for netting purposes

–Corporations cannot deduct a net capital loss• Excess loss carried back 3 then forward 5

years to offset capital gains

Page 43: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Four One Buckets Bucket

Net Net NetShort-T. Long-T. Gain (Loss) Return

Yr 1 STCG $0

Yr 1 STCL ($2,400)

Yr 1 LTCG $400

Yr 1 LTCL ($3,500)

Deduct STCL

Deduct LTCL

Carry over to next year

Deduction limit this year

Bob-1

TwoBuckets

Page 44: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Four One Buckets Bucket

Net Net NetShort-T. Long-T. Gain (Loss) Return

Yr 1 STCG $0

Yr 1 STCL ($2,400) ($2,400)

Yr 1 LTCG $400

Yr 1 LTCL ($3,500) ($3,100)

($5,500)

($2,400)

($600)

($3,000)

($2,500)

Deduct STCL

Deduct LTCL

Carry over to next year

Deduction limit this year

Bob-2

TwoBuckets

Page 45: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Sharon’s Capital Asset Sales-1Sharon has salary income of $68,000, a net short-term capital gain of $15,000, and a net long-term capital loss of $24,000. What is Sharon’s adjusted gross income if she has no other income items?

Page 46: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Sharon-Cap. Asset Sale Details Capital Ordinary Return

Other Income (Other AGI) $68,000 $68,000

Net L.T. capital gain or loss

Net S.T. capital loss or loss

Gain (loss) non-cap. asset:

Gain (Loss)-bus. use asset

Sec. 1231 gain (Cap. Gain.)

Net capital gain or loss

Cap. Loss limited to $3,000

Net capital gain or loss in AGI

Adjusted Gross Income

Carryforward

Page 47: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Sharon-Cap. Asset Sale Details Capital Ordinary Return

Other Income (Other AGI) $68,000 $68,000

Net L.T. capital gain or loss $15,000

Net S.T. capital loss or loss (24,000) (9,000)

Gain (loss) non-cap. asset:

Gain (Loss)-bus. use asset

Sec. 1231 gain (Cap. Gain.)

Net capital gain or loss (9,000)

Cap. Loss limited to $3,000 (3,000)

Net capital gain or loss in AGI (3,000)

Adjusted Gross Income $65,000

Carryforward ($6,000)

Page 48: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Qualified Small Business Stock• Qualified stock –Held for more than 5 years–Purchased directly from corporation• Corporation with gross assets < $50 million

–Purchased after 8/10/93• Up to 50% of gain may be excluded– Limited to the greater of• 10 times basis in the stock, or• $10 million for each small business

– Exclusion is based on a 28% rate

Page 49: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Planning Strategies• Net Capital Gain position– Sell assets with unrealized losses

• Net Capital Loss position– Sell assets with unrealized gains – Optimize at $3,000 (deduct $3,000 from Ord. Inc.)

• Worthless Securities– Worthlessness deemed to occur on the last day of

the year– Realized loss = basis in the worthless security

• Basis determination– FIFO– Specific identification

Page 50: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Section 1231

1231 Property

1231 Netting

Page 51: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Section 1231•Net Section 1231 gains may

be allowed capital gain treatment even though they arise from “ordinary” assets.•Net Sec. 1231 losses are

ordinary.

Page 52: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

$2,000

($8,000)

($4,000)auto (owned 2 years)

Adjusted gross income?

Jill had AGI of $100,000, before these transactions.

Long-term capital gain

Short-term capital loss

Loss on sale of business

Page 53: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

$2,000

($8,000)

($4,000)

$93,000

auto (owned 2 years)

Adjusted gross income?

Jill had AGI of $100,000, before these transactions.

Long-term capital gain

Short-term capital loss

Loss on sale of business

Page 54: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

$2,000

($8,000)

$4,000 land (owned 2 years)

Adjusted gross income?

Jack had AGI of $100,000, before these transactions.

Long-term capital gain

Short-term capital loss

Gain on sale of business

Page 55: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

$2,000

($8,000)

$4,000

$98,000

land (owned 2 years)

Adjusted gross income?

Jack had AGI of $100,000, before these transactions.

Long-term capital gain

Short-term capital loss

Gain on sale of business

Page 56: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Section 1231 Netting Results• Net Section 1231 gain is classified as

long-term capital gain–Lookback rule may reclaim some gains

as ordinary• to the extent of Section 1231 loss

reported in the previous 5 years• Net Section 1231 loss is classified as

ordinary loss

Page 57: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Section 1231Disposition of Rental Activities

• Disposition of rental property held for the production of income (investment) yields capital gain or loss• Disposition of rental property used

in a trade or business yields Section 1231 gain or loss

Page 58: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Deprec. Recapture

Section 1245 Recapture

Section 1250 Recapture

Section 1245 Property

Section 1250 Property

Unrecaptured 1250 Gain

Page 59: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Depreciation RecapturePrevents taxpayers from receiving the dual benefits of a depreciation deduction and special Section 1231 gain treatment.Applies to Sec. 1231 gain property onlyRequires gains to be treated as ordinary

to the extent of prior depreciation deductions

Page 60: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Depreciation Recapture-Section 1245• Requires full recapture of all

depreciation–Gains are treated as ordinary

income to the extent of any depreciation taken

• Any gain in excess of depreciation is netted under Section 1231

Page 61: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Depreciation Recapture-Section 1245

• Applies to –Depreciable personal property

and–Nonresidential real estate placed

in service between 1981 and 1986 and depreciated under ACRS

Page 62: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Depreciation Recapture• Depreciation recapture converts part or

all of the gain on the sale of depreciable assets to ordinary income to the extent of the reduction in basis attributable to depreciation expense previously claimed

• The amount of income recaptured as ordinary income can never exceed either the realized gain or prior depreciation deductions

• Recapture rules cannot apply to assets on which there is a realized loss

Page 63: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Section 1245 Full Recapture• Applies to machinery, equipment,

furniture, and fixtures (but not to buildings or structural components)

• Any gain on the sale of section 1245 property is ordinary income to the extent of all depreciation allowed or allowable for the property– Any amount expensed under section 179 is

included in the depreciation allowed– The income recaptured is the lesser of all

depreciation taken or the realized gain

Page 64: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Asset - Section 1245 Machine

Owner Individual

Selling Price $290,000Cost 300,000Accum. Deprec. (S/L) (60,000) Additional Dep. DDB -

Adjusted Basis

Gain

Section 1245 GainSection 1231 gain (CG?)

Page 65: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Asset - Section 1245 Machine

Owner Individual

Selling Price $290,000Cost 300,000Accum. Deprec. (S/L) (60,000) Additional Dep. DDB

Adjusted Basis 240,000

Gain 50,000

Section 1245 Gain 50,000 Section 1231 gain (CG?)

Page 66: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Asset - Section 1245 Machine

Owner Individual

Selling Price $320,000Cost 300,000Accum. Deprec. (S/L) (60,000) Additional Dep. DDB

Adjusted Basis

Gain

Section 1245 GainSection 1231 gain (CG?)

Page 67: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Asset - Sec. 1245 Machine

Owner Individual

Selling Price 320,000$ Cost 300,000Accum. Deprec. (S/L) (60,000) Additional Dep. DDB

Adjusted Basis 240,000

Gain 80,000

Section 1245 Gain 60,000 Section 1231 gain (CG?) 20,000

Page 68: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Asset - Section 1250 Apartment

Owner Individual

Selling Price 250,000$ Cost 300,000Accum. Deprec. (S/L) (80,000) Additional Dep. DDB

Adjusted Basis 220,000

Gain 30,000

Section 1245 GainSection 1250 gain - Section 1231 gain (CG?) 30,000

Unrecaptured 1250 gain

Page 69: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

The next slide has an illustration of how the tax law worked for accelerated depreciation on residential real estate. However, only the straight-line method has been allowed for buildings acquired in last 25 years.Buildings bought more than 25 years ago would actually already be fully depreciated by now (shorter life used then).But this shows how it worked.

Page 70: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Asset - Section 1250 Apartment

Owner Individual

Selling Price 250,000$ Cost 300,000Accum. Deprec. (S/L) (80,000) Additional Dep. DDB (40,000)

Adjusted Basis 180,000

Gain 70,000

Section 1245 GainSection 1250 gain 40,000 Section 1231 gain (CG?) 30,000

Page 71: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Depreciation Recapture-Section 1250• Requires partial recapture of

depreciation–Gains are treated as ordinary income

to the extent of depreciation taken in excess of straight-line amount

• Any gain in excess of depreciation is netted under Section 1231

Page 72: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Depreciation Recapture-Section 1250• Applies to depreciable real

property –Not covered by Section 1245 and –Not depreciated using the

straight-line method• Eliminates most MACRS realty

Page 73: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Unrecaptured Section 1250 Gain• Requires that the portion of the gain

attributable to depreciation that is not Section 1250 recapture is taxed at a rate of 25%. • Applies to depreciable real property

sold after 5/7/97.• Any gain not attributable to

depreciation (SP in excess of original cost) is a Section 1231 gain taxed at 15%.

Page 74: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Owner GailAsset Apt BldgSelling Price $390,000Cost $400,000Accum. Dep. (S/L) (60,000) Extra depreciationAdjusted Basis 340,000 Gain 50,000 Section 1245 Gain OrdinarySection 1250 Gain OrdinarySection 1231 gain UnRecap.25%Section 1231 gain Cap. Gain-15%

Page 75: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Owner GailAsset Apt BldgSelling Price $390,000Cost $400,000Accum. Dep. (S/L) (60,000) Extra depreciationAdjusted Basis 340,000 Gain 50,000 Section 1245 Gain Ordinary - Section 1250 Gain Ordinary - Section 1231 gain UnRecap.25% 50,000 Section 1231 gain Cap. Gain-15%

Page 76: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Owner GusAsset Apt BldgSelling Price $410,000Cost $400,000Accum. Dep. (S/L) (60,000) Extra depreciation - Adjusted BasisGainSection 1245 Gain OrdinarySection 1250 Gain OrdinarySection 1231 gain UnRecap.25%Section 1231 gain Cap. Gain-15%

Page 77: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Owner GusAsset Apt BldgSelling Price $410,000Cost $400,000Accum. Dep. (S/L) (60,000) Extra depreciationAdjusted Basis 340,000 Gain 70,000 Section 1245 Gain Ordinary - Section 1250 Gain Ordinary - Section 1231 gain UnRecap.25% 60,000 Section 1231 gain Cap. Gain-15% 10,000

Page 78: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Section 1231 Look-Back Rules • Net Section 1231 gains are taxed as ordinary

income to the extent of any unrecaptured net Section 1231 losses in the five preceding years– This prevents taxpayers from generating tax

savings by bunching their Section 1231 gains into one year (to receive tax-favored long-term capital gains treatment) and losses into alternate years (deducting the Section 1231 losses in full against ordinary income)

Page 79: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Year 1 Year 2 Year 3 Year 4

$50,000 ($45,000) $20,000 $15,000

a.

b.

c.

d. $0 $15,000

(loss)Gain or

How will she treat the $15,000 gain in yr 4?

$10,000 $5,000

$15,000 $0

Section 1250 Lookback Barbara had these Sec. 1231 gains & losses:

Ordinary Income Capital Gain

$5,000 $10,000

Page 80: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Ori

gin

al C

ost

-

$400

,000

Buy, Use and Sell Business Asset$400,000

SL-$50,000

Sel

lin

g P

rice

$4

00

,00

0

Ori

gin

al C

ost

-

$400

,000

$300,000

$400,000

SL-$50,000

Extra-$50,000

Book

Val

ue

$300

,000

Case 1 Case 2Buy Asset Use Asset

Sel

lin

g P

rice

$4

00

,00

0

Selli

ng P

rice

$200

,000

Ori

gin

al C

ost

-

$400

,000

$300,000

$200,000

Book

Val

ue

$300

,000

$100,000

Page 81: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Wash Sales• Wash sale - identical securities acquired

within 30 days before or after the sale date (a 61-day period)–Wash sale losses are disallowed but gains are

taxed– Loss is deferred by adding disallowed loss to

basis of new shares– If more stock is sold than is purchased within

the 61-day period, only a portion of the loss representing the repurchased stock is deferred

Page 82: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Ms. Rich had these transactions in GM Corp. stock.

No. of Total

Date Event Shares Amount

01/02/01 Bought: 4,000 Cost $20,000

12/31/11 Sold: 4,000 Sell. Price $12,000

01/02/12 Bought: 2,000 Cost $6,000

How much loss may she deduct for 2011?

What is the basis of the stock bought in 2011?

Page 83: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

3. Calculate the deduction for portfolio investment-related expenses, including investment expenses and investment interest expense.

Page 84: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Note that business expenses are deductible under Section 162, while non-business expenses of earning income are deductible under Sec. 212.

Investment interest is deductible under 163(d). Note the limits.

Sec. 62, and Sec. 67 determine where to take the deductions.

Page 85: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

See Page 11-27+ for discussion of Educational Savings Plans

Page 86: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Text H/W no. 78 [LO 4] Mickey & Jenny file a joint tax return. They itemize deductions. They incur $2,000 in employment-related mis. itemized deductions. They also incur $3,000 of investment interest expense. Their income consists of $150,000 in salary, and $2,500 of interest income.•Investment interest expense deduction?•Investment interest expense deduction, if they also had a ($2,000) long-term capital loss?

Page 87: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

a. The $3,000 of investment interest expense is deductible to the extent of net investment income. In this problem, investment income and net investment income are $2,500 because there are no investment expenses. Consequently, $2,500 of the investment interest expense is deductible and $500 is carried forward to next year.

Page 88: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

b. If the Porters also have a $2,000 long-term capital loss, their net investment income is reduced to $500 (i.e., $2,500 + ($2,000)). Consequently, only $500 of the investment interest expense is deductible and $2,500 is carried over to next year.

Page 89: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

4. Understand the distinction between portfolio investments and passive investments.

Page 90: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Tax Shelter Losses Passive Activity Loss

• Passive Activity Loss Rules disallow the deduction of passive activity losses from other forms of income

A passive activity is any trade or business in which the taxpayer does not materially participate.

Page 91: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Types of Income and Losses• Active: salary and wages of an employee

and income earned from a business in which the owner/recipient materially participates

• Portfolio: interest and dividends• Passive: tax shelter income, income

passed through to limited partners, and income from other businesses in which owner/recipient does not materially participate

Page 92: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Passive Activity Loss• Taxpayers subject to the limitations:–All non-corporate taxable entities–Conduit entity passive losses flow-through

to owners• Taxpayers not subject to the limitations:–Publicly held corporations • PAL can offset active and portfolio income

–Closely held corporations• PAL can offset active income, but not portfolio

Page 93: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Passive Activity LossGeneral Rules for Limitations

• Passive activity losses must be netted against passive activity income–Net passive losses are not

deductible–Net passive gains are reported

with other income

Page 94: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Passive Activity LossException for Rental Real Estate

• By definition, all rental activities and limited partnership interests are passive• But, taxpayers who materially

participate in rental real estate business are allowed to offset any losses against other active or portfolio income

Page 95: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Passive Activity LossDisposition of Passive Activities

• Excess (suspended) losses must be accounted for in the year of disposition

• Disposition by sale frees the suspended loss to offset income of any other activity– First, offsets other passive income– Second, offsets gain from disposal– Third, any remaining PAL offsets ordinary income

Page 96: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Disposition of Passive Activities• Disposition upon death leaves the passive

activity in the decedent’s estate– Passive activity with unrealized gain• Beneficiary takes passive activity with stepped-up

basis• Released excess loss is deductible against other

income, but• Any unrealized gain on activity decreases amount

of suspended loss to release

– Passive activity with unrealized loss• No suspended loss is released

Page 97: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

5. Apply tax basis, at-risk, and passive activity loss limits

Page 98: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Building bought on 1/1/Yr 1Cost 1/1/Yr-1 $400,000 RentalMort 10% $400,000 Office Annual Deprec. Expense $10,000 BuildingAnnual insurance & exp. $15,000Value 1/1/Yr-1 $400,000Value 12/31/Yr-1 $500,000

Rental income

Per Year

Individual Taxpayer

$60,000

Page 99: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Study the information given on the building on the preceding page. Assume the owner only pays interest on the mortgage.What is gain or loss on sale of the building, if it is sold on 1-1-Yr2, for $500,000?What happens to the taxable loss from Yr 1? We will also consider what happens if the value of the building declines over the period of ownership. You can lose from operations and from selling the property for less than basis.

Page 100: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

T/P buys Rental Building on 1-1-Yr-1Cost 1/1/Yr-1 $400,000Mortgage 10% $400,000Value of Build. 1/1/Yr-1 $400,000Value of Build. 12/31/Yr-1 $500,000Rent RevenueDepreciationInterest ExpenseTaxes,insuranceTaxable Income (loss)Economically - Is there a loss?

Page 101: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

T/P buys Rental Building on 1-1-08Cost 1/1/Yr-1 $400,000Mortgage 10% $400,000Value of Build. 1/1/Yr-1 $400,000Value of Build. 12/31/Yr-1 $500,000Rent Revenue $60,000Depreciation (10,000)Interest Expense (40,000)Taxes,insurance (15,000)Taxable Income (loss) ($5,000)Really - Is there a loss?

Page 102: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Assume Taxpayer owns the building for exactly 4 years and in each year the income statement looks like the one on the preceding slide.After 4 years (12-31-Yr-4), Taxpayer sells the building for $350,000.Taxpayer has been paying interest only.What is the gain or loss on the building?What happens to 4 years of losses?

Page 103: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Yr-1 Yr-2 Yr-3 Yr-4

Rent Revenue $60,000 $60,000 $60,000 $60,000

Depreciation (10,000) (10,000) (10,000) (10,000)

Interest Expense (40,000) (40,000) (40,000) (40,000)

Taxes, insurance (15,000) (15,000) (15,000) (15,000)

Loss(Suspended) ($5,000) ($5,000) ($5,000) ($5,000)

Building Basis $390,000 $380,000 $370,000 $360,000

What is total cash inflow (after expenses) in 4 years?

Page 104: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

T/P Sells Rental Build. on 12-31-Yr-4

Cost 1/1/Yr-1 $400,000

Accum. Deprec. ($40,000)

Book Value 12/31/Yr-4 $360,000

Selling Price $350,000

Loss on Bldg. 12/31/Yr-4 ($10,000)

Operating loss Year - 4 ($5,000)

Suspended Loss Three yrs. ($15,000)

Total loss ($30,000)

Page 105: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

T/P Sells Rental Build. on 12-31-Yr-4

Four Year Cash Flow Analysis

Annual revenueSelling price

Cash inflowsInterest ExpenseTaxes, InsuranceCost of property

Cash outflowsExcess outflow

Page 106: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

T/P Sells Rental Build. on 12-31-Yr-4

Four Year Cash Flow AnalysisTotal annual revenue $240,000

Selling price $350,000

Cash inflows $590,000

Interest ExpenseTaxes, InsuranceCost of property

Cash outflowsExcess outflow

Page 107: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

T/P Sells Rental Build. on 12-31-Yr-4

Four Year Cash Flow AnalysisAnnual revenue $240,000Selling price $350,000

Cash inflows $590,000Interest Expense ($160,000)Taxes, Insurance ($60,000)Cost of property ($400,000)

Cash outflows ($620,000)Excess outflow ($30,000)

Page 108: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Rental Real Estate Relief• Taxpayers can qualify for up to $25,000

deduction for rental real estate losses• Taxpayer must own at least 10% and

actively participate in management–Set rents, qualify renters, approve

repairs• Deduction phases out for AGIs

between $100,000 and $150,000

Page 109: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Bud is single & received wages of $140,000 from IBM in 2010. Bud is a 50% partner in a partnership engaged in a rental real estate activity which generated a $60,000 loss for the partnership. Bud was an active participant in the rental real estate activity. He had no other income. How much of the partnership rental loss may Bud deduct on his 20 income tax return? (Sec. 469(i))a. $0 b. $5,000 c. $15,000 d. $25,000

Page 110: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Bud - Loss from rental activity.

Maximum loss write-off

Threshhold

Phase-out percentage

AGI- above threshhold

Reduction in max loss

Maximum write-off

Page 111: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Bud - Loss from rental activity.

Maximum loss write-off $25,000

Threshhold 100,000

Phase-out percentage 50%

AGI- above threshhold 40,000

Reduction in max loss 20,000

Maximum write-off $5,000

Page 112: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Real PropertyBusiness Exception• Taxpayers must spend more

than half their time in real property businesses in which they materially participate and time spent equals or exceeds 750 hours

Page 113: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

A taxpayer has this income (losses) for the current year:Active Income $43,000 Portfolio Income $29,000Passive Income $(27,000)What is the taxpayers taxable income (loss) if:

Page 114: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

T/P is single individual & passive income is not from rental?An individual cannot deduct passive losses against active or portfolio income. The individual taxpayer has taxable income of $72,000 ($43,000 + $29,000) and a suspended loss of $27,000.

Page 115: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

T/P is single. Passive income results from a rental activity for which the taxpayer qualifies as a real estate professional? A real estate professional can deduct all losses from the activity against active and portfolio income. The taxable income is $45,000 ($43,000 + $29,000 - $27,000).

Page 116: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

T/P is a single individual. Passive income results from a rental activity for which the taxpayer fails to qualify as a real estate professional?Individual - active participant in a rental real estate activity - is allowed to deduct up to $25,000 of losses from rental activities against active and portfolio income. The taxable income is $47,000 ($43,000 + $29,000 - $25,000).

Page 117: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Laura owns a commercial office building. She spends more than 500 hours a year managing the building. She also spends 1,700 hours working in her own real estate development firm.

Page 118: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Laura qualifies as a real estate professional. She spends more than 50% of her personal service time in a real property trade or business, the amount of time spent in the real property trade or business is greater than 750 hours, and she materially participates in the rental activity (i.e., spends greater than 500 hours managing the rental activity). Because she qualifies as a real estate professional, office building is not passive activity.

Page 119: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Assume same facts as in preceding slide, except that Laura hires a full-time manager for the commercial office building. She spends 75 hours meeting with manager and reviewing operations.

The office building is a passive activity. Because Laura does not spend more than 500 hours managing the rental property, she does not qualify as a real estate professional.

Page 120: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Sale to Related PartyThe remaining slides cover a topic mentioned on page 11-21, but is covered in Chapter 10.

Page 121: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Sale to Related Party• Losses on sales to related parties are

disallowed– Related parties include brothers, sisters,

spouse, ancestors and lineal descendents, as well as a more-than 50% owned corporation

• If related buyer later sells property at a gain, this gain can be reduced (not below zero) by the seller’s previously disallowed loss

Page 122: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Loss on Sale to Relative - 1In April 2011, Pam sold stock with a cost basis of $17,000, to Lisa, her sister, for $10,000. In September 2011, Lisa sold the same shares of stock to her neighbor, Niki, for $20,000. What is Lisa's gain for 2011?a. $0 b. $3,000 c. $7,000 d. $10,000

Page 123: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Price received by Pam $10,000

Pam's basis in stock 17,000

Loss realized by Pam

Loss Disallowed

on sale by Pam

Loss recognized by Pam

Loss on Sale to Relative - 2

Page 124: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Price received by Pam $10,000

Basis to Pam 17,000

Loss realized by Pam (7,000)

Loss Disallowed

on sale by Pam (7,000)

Loss recognized by Pam $0

Loss on Sale to Relative - 3

Page 125: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Price received by Lisa

Basis to Lisa

Gain realized by Lisa

Less Loss Disallowed

on sale by Pam

Gain recognized by Lisa

Loss on Sale to Relative - 4

Page 126: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

Price received by Lisa $20,000

Basis to Lisa 10,000

Gain realized by Lisa 10,000

Less Loss Disallowed

on sale by Pam (7,000)

Gain recognized by Lisa $3,000

Loss on Sale to Relative - 5

Page 127: Chapter 11 Investments Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2012, Dr. Howard Godfrey.

The End