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timer Asked: Nov 19th, 2016

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In Module 6, you learned the capital asset fundamentals (What is a capital asset? What is basis? How is basis adjusted?). What is the significance of the Module 6 concepts with respect to Module 7?

What are some capital assets that you have (list 10 that are not securities)? How would you be taxed on each asset if you were to sell it today?

Module 6 1. Capital Assets Before we can discuss the tax treatment of capital assets, we must first get an understanding of what they are. First, the IRS does not define a capital asset. Like the definition of gross income, it is defined by exclusion. The tax code (Section 1221) essentially states what is not a capital asset. The excluded items are: 1. 2. 3. 4. 5. Items used in a trade or business Accounts or notes receivable Certain derivative instruments Government publications Certain literary, copyright, and artistic compositions The tax benefit of capital assets comes from the gain (or income that comes from the sale of a capital asset). Typically, if a capital asset is held for more than one year, the gain is taxed at capital-gain rates. These rates are lower than the tax rates applied to ordinary income. Ordinary income is the income earned most frequently from working a job, owning a business, or contracting. The beneficial tax rates are a reward for the acquisition of capital assets. Some of the most popular investment capital assets are securities (stocks and bonds) and real estate. There is a benefit derived from the economy by investing in such assets because there is a multiplier when you acquire such assets. Stocks add capital to a corporation that allows it to hire employees, acquire equipment, inventory etc. Investing in real estate employs contractors, realtors, attorneys, etc. Let’s take a share of stock. When you acquire a share of stock that is capital for a corporate entity, the resources that you provide allows that entity to grow into new markets, hire new employees, or acquire new equipment. Each of these actions can help a company grow. If the company grows, you as a shareholder benefit from the increased value of the shares of stock purchased. If you allow the entity more than one year to use your invested capital, upon sale of that stock would come lower tax rates on the gain. When a taxpayer sells a capital asset, the taxpayer realizes a gain or loss. We discussed this in the previous section. In this section, we will discuss how gain and loss is determined. The gain or loss is determined by subtracting what is referred to as the asset basis from the sale proceeds. Using a residence as an example, the basis is essentially the cost of the capital asset minus any allowed depreciation plus any capital improvements (additional costs for property fixtures). Personal use assets (personalty) fall under that category of capital assets. Jewelry is a capital asset. If the jewelry is later sold for more than the purchase price, there is capital gain (and yes, it must be reported). The good news is that (assuming the jewelry was held for more than one year) favorable capital-gains rates would apply. Unfortunately, there is a downside. If the jewelry dropped in value and it was sold for less than the purchase price, the loss is not allowed. The deductibility of losses from the sale of personal capital assets is prohibited. 2. Asset Basis and Basis Adjustment It is important to review cost recovery concepts in an individual tax course because the concepts are very important to sole proprietors, real estate investors, and investors in flow-through entities. The potential depreciation deduction may be significant. In addition, some of the concepts also apply to other investment vehicles where basis is tracked. For example, stock has basis even though it is not depreciated. The concept of basis is still applied when selling stock. The basis of an asset is typically the cost of the asset. The cost may include other expenses required to obtain the asset, such as setup costs. It is important to understand that basis refers to the asset that may be depreciated. With real property (or realty), the costs should be allocated between the actual structure and the land because land does not depreciate. Keeping with the real-property example, let’s look at some things that change basis. Basis increases when the economic value or life of the asset is extended. If a roof is replaced on a home, the economic life and value of the property are increased. The items that increase basis (particularly for durable, tangible assets) are called capital improvements. These are items that are typically fixtures to the property. These costs do not include regular maintenance costs like painting, cleaning, or regular replacement items. It does include an addition to the home. Another example of a capital improvement would be the replacement of an engine in a car. This extends the life and economic value. Regular costs like an oil change, filter change, and annual maintenance would not count as improvements that would add to basis. The decrease to basis typically comes from the use of the asset. The use of a long-term tangible asset over time is called depreciation. Other terms for depreciation are amortization (with the use of an intangible asset) and depletion (with the use of natural resources). In tax, the term cost recovery is used. We cover the cost-recovery concepts on the next page. The following video covers the cost-basis concepts as they relate to securities. Cost Basis Calculator http://www.youtube.com/watch?v=DnWbcoFZ4yw 3. Cost-Recovery Concepts The tax code allows a business to recover the cost that it invests in an asset. The U.S. Supreme Court affirmed this position in Doyle v. Mitchell Bros. Co. (1916). This is referred to as the Recovery of Capital Doctrine. First, let’s understand that terminology. The cost-allocation terms are essentially the same to an accountant and a tax preparer. There are three different terms used to describe cost recovery depending upon the type of long-term asset for which cost is recovered.    Tangible assets use the popular term depreciation. Intangible assets use the term amortization. Natural resources use the term depletion. There are various methods used to recover the cost of an asset used in business. Basically, there is the straight-line method and then there are various forms of accelerated methods. The determination of the cost-recovery amount depends upon: 1. The amount of recovery time 2. The amount of cost that is to be recovered 3. The percentage of business use The amount of cost that is recovered is tracked on what is called the asset basis. The asset basis is equal to asset cost minus the accumulated depreciation plus capital improvements. Capital improvements are costs that extend the expected asset life. In taxation, most asset recovery takes place under the Modified Asset Cost Recovery System. Under this system, assets are assigned to a property class that is determined by the expected property life. Assets are depreciated when the asset is put into service by the business. However, the dates are set according to the conventional time frame. An asset that has a mid-year conventional time frame is assumed to be put in service in the middle of the year regardless of when the asset is actually put into service. Likewise, an asset with a mid-month convention is assumed to be put into service of the middle of the month that the asset was put into service regardless of when it was actually put into service. Businesses may elect to expense certain assets that are put into service. Section 179 expense election allows a company to expense up to $500,000 of the cost of a tangible asset. This election is also annually limited by: 1. The extent to which the asset cost exceeds $2,000,000 2. The taxable income of the business Module 7 1. The Effect of Holding Period In Module 6, we discussed the concepts of basis and cost recovery. These concepts are important in determining gain or loss from the sale of a capital asset. The gain or loss is calculated by subtracting the basis of the capital asset when sold (or otherwise disposed of) from the fair market value of what was received for the capital asset. The taxpayer has an advantage when there is a gain from the sale of a capital asset. That gain is taxed at a more favorable rate. We will discuss the rates on Page III. Holding Sales Purchase Asset Basis Sales Date Period (in Price Date days) Stock A $100 $200 1/2/2000 6/12/2013 4910 Stock B $500 $400 4/12/2012 7/12/2013 456 Stock C $400 $600 1/23/2013 12/12/2013 323 Stock D $200 $150 2/2/2013 12/31/2013 332 The favorable gain rates apply only when a capital asset had been held for more than one year. If the capital asset is held for one year or less, then the gain for the sale is taxed at the same rates that would normally apply to the taxpayer (called ordinary tax rates). From the example above, you see that Stock A and Stock B were held for more than 365 days. 2. Netting of Capital Gains and Losses Once the holding period has been established for each capital asset, the gain or loss on each asset is then calculated. This gain or loss for each asset is then netted to determine the overall capital gain or loss for the tax period. The table below extends our example from Page I with gain or loss from each asset sale characterized. Holding Period Gain/ Character (in days) Loss 6/12/2013 4910 $100 LTCG 7/12/2013 456 -$200 LTCL 12/12/2013 323 $200 STCG 12/31/2013 332 -$50 STCL Asset Basis Sales Price Purchase Date Sales Date Stock A Stock B Stock C Stock D $100 $600 $400 $200 $200 $400 $600 $150 1/2/2000 4/12/2012 1/23/2013 2/2/2013 Long-term capital gain (LTCG): A capital asset held for more than one year sold for more than its basis Short-term capital gain (STCG): A capital asset held for one year or less sold for more than its basis Long-term capital loss (LTCL): A capital asset held for more than one year sold for less than its basis Short-term capital loss (STCL): A capital asset held for one year or less sold for less than its basis Here are the steps in the netting process: 1. Net all capital gains as short-term or long-term a. NetLTCL = $100 (LTCG + LTCL; or $100 - $200) b. NetSTCG = $150 (STCG + CTCL; or $200 - $50) 2. Net NetLTCL with NetSTCG to get NetSTCG = $50 (=$150 - $100) 3. Since the overall gain is short-term, it is taxed as ordinary income. You can also use the table below as a cheat sheet for the netting process and the character of the resulting income Stock A Stock B Stock C Long Term $100 $100 $0 Short Term $0 $50 $100 Stock D $0 Stock E Asset Gain/Loss Character $100 $150 $100 LTCG LTCG STCG -$100 -$100 STCL $100 $50 $150 Stock F -$100 $200 $100 LTCG=%100 STCG=$50 STCG Stock G -$100 -$100 -$200 STCL Tax Effect on Current Period Capital Gain Capital Gain Ordinary Offset Ordinary Income up to $3,000 Capital = $100; Ordinary =$50 Ordinary Offset Ordinary Income up to $3,000 3. Taxation of Capital Gains Capital gains and losses are netted. If a capital asset is held for more than one year and is sold at a gain (this gain is referred to as LTCG), the beneficial tax rates apply. If the capital asset is sold at a gain and held less than a year (STCG), it is treated as ordinary income and the ordinary (unfavorable) tax rates apply. The capital-gains rates range between 0% and 20% depending upon your ordinary income-tax bracket. The ordinary income-tax rates range from 10% to 39.6%. There are losses and gains that can potentially come from several capital assets. The gains and losses from the sale of capital assets appear on Schedule D. That makes the gain or loss a gross income amount if it is positive (net capital gain) or a deduction (net capital loss) for AGI if it is negative.   Positive amounts that are net short-term capital gains are taxed as ordinary income. Positive amounts that are net long-term capital gains are taxed at the favorable capitalgains rates.   Negative amounts are from netted capital losses and are limited to $3,000 against ordinary income. Excess capital losses are carried forward to be netted or deducted on a future tax return.
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