Advanced Individual Income Tax

Accounting 811: Spring, 1998

Week 11: Capital Gains and Losses

Control Panel

An Argument Against the Capital Gains Tax

1. Capital Asset Transactions: Overview:

Significance of Cap Asset status

Cap loss limits: individual and corp

Favorable treatment of long gains (net of losses)

40% of CG are corporate stock

20% investment realty

25% personal residence

15% all other

Charitable contribution advantage if FMV > basis

Complication as part of 1997 rate cuts

2. The limits on capital losses

Sec 1211 limitation on losses

for corps, CL only against gains

For non-corps: lower of excess losses or $3,000

Sec. 1212 excess loss carryovers

(a) Corporations: back 3, forward 5, treat as ST

(b) Others: NSL - NLC is ST loss year 2

NLL - NSG is LT loss year 2

(b)(2): Treat Sec. 1211 amount as a STG

(effectively means that ST losses count first towards the 3K limit)

3. The Netting process

Multiple "nettings", based on holding period

Preference historically given to LT gains
But limit on all losses: use against gains
So both LT and ST losses potentially offset the LT gains

holding period rules: Sec. 1223

(1) tacks on in exchanges
(2) tacks on in carryovers
(11) inherited property is long term

Net Capital Gain (sec. 1222)

calculate net LTG
subtract net STL, if any

no favorable tax rule for a net STG: just add to income

4. The Advantage of long gains

History:

1923 - 1986: exclusion of a fraction of NCG from income

1986: tax reform: no NCG advantage (still loss limits)

Sec. 1(h) eff 1991: Maximum capital gains rate: 28% on "NCG"

How it worked in 1996 (before 1997 tax act)

Maximum tax on Net CG was 28%

Two calculations required, pay the lesser of:

tax calculated the regular way

Regular tax on (Y - Net CG), plus 28% (not 31, 36% or 39.6%) of Net CG

5. Defining the subject matter: "capital assets":

Sec. 1221 is the core -- and the heart of the problem

related to Sec. 1231: "business assets"

Many, many ad hoc rules elsewhere re cap vs ord or sale/exchange

Capital Asset per 1221 means all property except

Except inventory

or other property primarily held for sale to customers in the ord course, T/Biz

Many cases try to draw this line

What's a T/biz: 1 shot import of art objects? - yes

What's the ordinary course?

regular fixed asset dispositions: rent-a car fleet

Hollywood baseball: minor league player contracts

Land Sales by Subdividers

Except depreciable assets and land used in business

They are "1231 assets" if held > 1 year

idea is best of both worlds for plant & equipment
in practice, complex interactions

Other "Sec. 1231 assest"

timber, coal and iron ore, livestock (not poultry)

Sec 1231 also covers some "investment" cap assets
held over 1 yr, not personal use

Except copyrights and artistic works

Compare with Sec. 1235: (P) rights as long term CG

to inventor and financial backers

Note mechanics of 1221(3) : author, recipient, one w/ basis from the author

Case: Chronical Publishing v CIR (1991)

Chron's "morgue"/ clipping file not a capital asset
significance: Sec. 170 (e)

Except AR's from inventory or services

Except free gov't documents

Nixon v. CIR

6. 75 Years of Loopholes and Plugs

Conversion: ord deductions creating capital gains

Problem w/ Sec. 1231 and depreciable assets

accelerated depreciation meant low basis, so gains on sale
ordinary deductions converted to capital income on sale
possible tax profit on transaction w/o economic profit

Solution: Recapture of depreciation

treat gain as ordinary (not 1231)
to extent of depreciation taken (or extent of accel dep)
Form: p. 2 of 4797

Two Categories of Recapture: 1245 and 1250

Sec. 1245 equipment and some blds
(ACRS accelerated non-res)
Full recapture

Sec. 1250 blds recap only excess of dep taken over s/l

some (mostly old) tricky rules phased in bldg recapture - 1976

Recapture of expensing on premature disposition

Recapture override of installment sale rules

Partal Building recapture: Corps and 291

self-created property: labor to capital gains

House improvement, corporate stock options

Wrapping ordinary income in cap asset shell

Inside and outside sales: corp assets or stock.

Collapsible Corporations: the 341 maze

Hot Asset partnerships: the 751 snarl

Compensation vs. capital gain

try to disguise services as asset sales: contract rights

Specialized financial and derivative assets

So special rules for short sales, futures, options, related party sales, churns, venture capital, specialized small business investment companies, employee stock ownership plans

Yet another complication: pass thru’s (partnerships and S-Corps)

There are others: mutual funds. Trusts.

7. The 1997 Capital Gains Rules

Driving the changes: Political pressures

Pressure to cut the CG rate

Very sensitive political issue
CG tax causes economic inefficiency

But CG’s are very concentrated.
Top 1% by income have about 50% of NCG’s

Wanted to avoid new CG advantage for "unproductive" "collectibles"

Wanted to limit "depreciation conversion"

taking depreciation against high tax income

when sell w/ lower basis, report lo tax income

Wanted to share the tax break with low income taxpayers

Wanted to avoid reducing tax collections too much

Big question: will sales increase if taxes are lower? Will the increased sales offset the lower tax on each sale).

Wanted to make it effective as of May 7, tho bill passed late July

Didn’t want all sales to freeze up in anticipation

Result: an extremely complicated new set of CG rules

Still sort asset sales by holding period

But now also a 12+ to 18 month holding period

"Mid-term

Added to legislation at last minute as an afterthought to meet the tax revenue and effective date concerns

Calculate all gains an losses, and net by holding period.

Sch D l. 7: Net SG/L
L. 16: Net LG/L
New column G: how much of the long gain/loss is:

before 5/7/97

or "collectible"

or "mid-term" and after 7/28/97

The Computational Snarl Sched D p. 2

First Net the Nettings

Line 17: Capital Gain Net Income. To 1040 line 13

If txbl income is positive, use Part 4 if you have a NCG

i.e. if you have a gain overall and some or all of it is long term

Line 18. Deduct Net Capital loss vs. Other income ($3K maximum)

Worksheet if AGI is a loss, or if capital loss exceeds $3K

Page 2 Part 4. The Triumph of Confusion

A mechanical, baffling seeming calculation of how much gain qualifies for which rate

Trying to implement the following:

the maximum tax on NCG not to exceed 28%

Within that, the maximum tax on building sale gains, to the extent of depreciation, not covered by some other rule ("Sec 1250 recapture") to be 25%

And the maximum rate on a non-collectible non-building, held longer than 18 months, sold after 7/28/97 (or more than 12 months sold from 5/7/to 7/28), to be 20%

And to the extent the Tp is in a 15% bracket for gain that would be taxed at that 20% rate, the rate is 10%

Build date 4/13/98

Gwailo says: "The Road to Hell is Paved with Good Intentions"