A CASE STUDY

Netting Property Transactions at Year-end: Update to the Worksheet Approach for Capital Gain Rate Differentials

By John O.Everett, William A. Duncan, Richard Boley, and Nancy B. Nichols

Five Netting Procedures

Personal casualty and theft netting. All gains and losses (after a $100 floor reduction for losses) from personal casualty and thefts are combined. If the net result is a gain, it is transferred to the long-term capital gains column; if the net result is a loss, it is reduced by 10% of adjusted gross income and deducted from adjusted gross income as an itemized deduction. Technically, the netting includes both long- and short-term transactions (the IRC does not restrict this netting to long-term transactions). If a net gain results, each gain or loss is transferred to the appropriate long-term or short-term component of the capital gains column.

Business and investment casualty and theft netting. All gains and losses from casualty and thefts on business and investment properties held longer than one year are combined. If the net result is a gain, it is transferred to the section 1231 column; if the net result is a loss, the net result is treated as an ordinary loss deductible for adjusted gross income (AGI).

IRC section 1231 gain and loss netting. Net all gains and losses classified as IRC section 1231 gains and losses, including gains and losses from the sale or exchange of business properties held longer than one year, involuntary conversions (other than by casualty or theft) of the same types of properties, and any net gains from the business and investment casualty and theft netting. If the net result is a gain, it is treated as a long-term capital gain and is transferred to the long-term section of the capital gains and loss column. If the net result is a loss, it is treated as an ordinary loss deductible for AGI and is transferred to the ordinary income column.

Capital gain and loss netting. All gains and losses from sales or exchanges of capital assets are combined. This procedure involves determining a net short-term and a net long-term result, and then combining that result with ordinary income. At this point in the process, netsection 1231 gains have been included in long-term capital gains. Moreover, net section 1231 gains will include any net gains from business or investment casualty or theft. In addition, if personal casualty and theft gains exceed losses, each gain and loss is treated as a capital gain or loss and is split into short- and long-term elements.

Ordinary income netting. Before closing the ordinary income column, AGI and the 10% of AGI reduction in net personal casualty and theft losses must be calculated if the first column nets to a loss. Only the loss remaining after reduction is available as an itemized deduction. The fifth column of the spreadsheet can also be used to compute final taxable income by including all other sources of income and deduction (e.g., exemption deductions, itemized deductions). This column would also include any depreciation recaptures and section 1231 recaptures reportable as ordinary income and any gains or losses on sales of business properties held one year or less.

Case Study

A case study will illustrate the process: Exhibit A provides the basic facts of the case, Exhibit B presents the transactions within the framework of the two worksheets, and Exhibit Cprovides an analysis of each transaction.

The following notes clarify the case presentation:

• The net capital gain of $25,150 in the five-column transaction worksheet includes a net section 1231 gain of $22,650, and this net section 1231 gain includes a net business and investment casualty and theft gain of $450. Thus, every gain and loss in each of these three netting results must be tagged as a 20%, 25%, or 28% gain or loss, and the individual amounts are then entered separately in the appropriate column of the four-column worksheet.

• In the five-column worksheet, the personal casualty and theft column nets to a $17,900 loss; this is treated as an ordinary loss (itemized) deduction from AGI. However, the net loss must be reduced by 10% of AGI, so this column is closed only after AGI is determined in the ordinary column.

• In transaction (h), the sale of the rental duplex yields both 20% and 25% rate gains. The $5,000 gain on the land is a 20% rate gain, since the land is not depreciable. The $22,000 gain on the building ($70,000 amount realized less $48,000 adjusted basis) is composed of $4,000 ordinary income under section 1250 ("excess depreciation" taken on pre-1987 residential realty) and $18,000 section 1231 gain. However, since the building is depreciable realty, a portion of the section 1231 gain is taxed as 25% rate gain. This amount is $8,000, the difference between hypothetical depreciation recapture under section 1245 ($12,000 total depreciation taken) and actual recapture under section 1250 ($4,000). The remaining $10,000 is, by default, 20% rate gain.

• When all gains and losses are entered into the capital gain rate worksheet, the only category that nets to a loss is the short-term capital gain and loss grouping. This $1,000 net loss is transferred to the 28% rate column (the highest remaining rate grouping with a net gain). Thus, the taxpayer receives the maximum benefit from a short-term loss when long-term gains are present.

• The net capital gain rate results of the four-column rate worksheet may be used to determine the final tax liability, calculated (at 1999 rates) to be $26,127. These worksheet results can be used to check the Schedule D result: The gain taxable for each possible rate should agree with the "bulleted" portion of page 2 of Schedule D, which highlights gains taxed at each possible capital gains rate. (After the recent rate changes, anyone who actually tries to complete page 2 of Schedule D without the use of tax prep software does so at their own peril.)

Exhibit A

Comprehensive Case Study Information

Jan Washington is a single, self-employed taxpayer who owns and operates several parking lots. During 1999 she had a $100,000 Schedule C business income and paid state income taxes of $4,500, federal income taxes of $19,000, and charitable contributions of $5,000. She also incurred the following transactions:

(a) Sold 100 shares of XYZ Corporation stock for $50 a share on 3/2/99 (originally purchased for $60 a share on 9/12/98).

(b) Sold 100 gold coins held as a collectibles investment on 4/1/99 for $13,500 (originally purchased on 2/3/90 for $8,500).

(c) Sold 100 shares of Delco stock for $30 a share on 4/30/99 (originally purchased for $45 a share on 4/2/91).

(d) Sold one-half acre of land used in the business on 7/12/99 for $8,000 (originally purchased for $9,400 on 1/4/85).

(e) Sold a business storage building on 6/2/99 for $50,000. The storage building was purchased on 1/27/99 for $52,000, and $1,850 depreciation had been deducted.

(f) Received $3,200 on an 8/2/99 insurance settlement for a machine destroyed by fire. The machine originally cost $4,800 on 3/1/97 and had an adjusted basis of $3,550 on the date of the fire (less than its value of $3,900).

(g) Sold four auto elevators (personal property) on 9/3/99 for a total of $9,600. The elevators were purchased for $9,000 on 6/1/97, and a total of $2,200 depreciation had been deducted.

(h) Sold a two-unit rental duplex and one acre of land on 11/4/99 for a total of $100,000 ($30,000 allocated to the land, $70,000 to the building). The land and building were originally purchased for $85,000 on 11/1/86 ($25,000 allocated to the land, $60,000 to the building). Accelerated depreciation deducted on the building up to the date of sale was $12,000; straight-line would have been $8,000.

(i) Received $2,100 insurance recovery on an office painting that was stolen. The painting originally cost $1,300 on 5/1/92.

(j) Realized a loss on the 6/1/99 theft of an uninsured diamond ring. The ring originally cost $18,000 in 1984 and was worth $20,000 at the time of the theft.

 

Exhibit B

Comprehensive Case Study Solution

Property Transaction Worksheet

Personal Cas & Thft Gain (Loss)

Bus/Inv Cas & Thft Gain (Loss)

Section1231

Gain (Loss)

Capital Gain (Loss)

Ordinary Income

     

ST:

100,000

(17,900) [j]

( 350) [f] *

( 1,400) [d] *

(1,000) [a]

 
 

800 [i] *

600 [g] *

(1,000)-

( 150) [e]

|

 

5,000 [h1] *

LT:

| 2,200 [g]

|

 

8,000 [h2] **

5,000 [b] **

| 4,000 [h2]

|

____

10,000 [h2] *

(1,500) [c] *

|-> 25,150   

|

450 * ->

450 *

 

26,150   

|

 

22,650 ->

22,650

 

|

     

______

|

 

Gross Income

131,200

|

Less One-Half of Self-Employment Tax

( 5,840)

|

 

Adjusted Gross Income

125,360

->Less 10% of $125,360 AGI

-> Net Casualty Loss

( 5,364)

   

State Income Taxes Paid

( 4,500)

   

Charitable Contributions

( 5,000)

   

Personal Exemption

( 2,750)

   

Taxable Income

107,746

         

* 20% Gain ** 25% Gain *** 28% Gain

         

Capital Gain Rate Worksheet

Short-term Gain (Loss)

28% Rate Gain (Loss)

25% Rate Gain (Loss)

20% Rate Gain (Loss)

( 1,000) [a]

5,000 [c]

8,000 [h2]

( 1,500) [c]

____-_

 

__-__

( 1,400) [d]

( 1,000)

-> ( 1,000)

8,000

600 [g]

 

4,000

 

5,000 [h1]

     

10,000 [h2]

     

( 350) [f]

     

800 [i]

     

13,150    

 

Tax Computation (Per Schedule D)

 

Tax on $82,596 ($107,746 - $25,150) noncapital gains income
(per 1999 tax tables)

$ 20,377

Tax on $ 4,000 long-term capital gain @ 28%

1,120

Tax on $ 8,000 long-term capital gain @ 25%

2,000

Tax on $13,150 long-term capital gain @ 20%

2,630

Total Tax Liability

$ 26,127

       

 

 

 

Exhibit C

Comprehensive Case Study: Explanation of Transactions

[a] The sale of XYZ stock yields a $1,000 short-term loss.

[b] The sale of the gold coins, a collectible, yields a $5,000 28% rate gain.

[c] The sale of the Delco stock yields a $1,500 20% rate loss.

[d] The sale of the business land yields a $1,400 section 1231 20% rate loss.

[e] The sale of the storage building yields a $150 ordinary loss, as this property is not a section 1231 asset (it was not held longer than a year) and it is not a capital asset under section 1221.

[f] This transaction is a business casualty that results in a $350 20% rate loss.

[g] This transaction yields a $2,800 gain, of which $2,200 is reportable as ordinary income under section 1245 (total depreciation taken on personal property held longer than one year), and $600 is reportable as section 1231 20% rate gain (any remaining gain not recaptured under section 1245).

[h] The sale of the rental duplex and land is covered by section 1231, as both properties were held longer than one year. The $5,000 [h1] gain on the land is reportable as section 1231 20% rate gain, and the $22,000 [h2] gain on the duplex building is reported as $4,000 ordinary income under section 1250 (excess depreciation taken), $8,000 gain reported as 25% rate gain (unrecaptured section 1250 gain), and $10,000 section 1231 20% rate gain (any remaining gain).

[i] The $800 gain realized on the insurance recovery on the painting is business casualty 20% rate gain (property used in the business and held longer than one year).

[j] The $18,000 personal theft loss on the diamond ring is reportable as a personal casualty and theft loss, and must first be reduced by the $100 floor to $17,900 (and eventually also reduced by the 10% of AGI floor in the final netting). Any net deductible loss is ordinary (Schedule A) loss.

Final netting. The personal casualties and thefts column cannot be closed until AGI is known. The business casualties and thefts net to a $450 gain, which is closed to the section 1231 column. The section 1231 transactions net to a $22,650 gain, which is closed to the long-term capital gains column. The taxpayer’s AGI of $125,360 includes the $100,000 Schedule C income, recaptures, the $25,150 net capital gain, and a reduction for one-half of the self-employment tax due on $100,000 of income. The personal casualty is reduced by 10% of AGI to $5,364. Finally, subtracting other itemized deductions and the exemption yields a final taxable income of $107,746.

Capital gains composition. The taxpayer’s property transactions included gains or losses in the short-term, 28%-rate gain, 25%-rate gain, and 20%-rate gain categories. The short-term capital transactions netted to a $1,000 loss, which first offsets the highest-taxed capital gains (in this case, the 28% gains). Thus, the taxpayer’s final taxable income includes $4,000 in 28% rate gains, $8,000 in 25% rate gains, and $13,150 in 20% rate gains. Each of these gains is taxed at the appropriate rate; none of the gains qualify for the 10% rate, since the taxpayer’s ordinary (noncapital gain) income exceeds $25,750 (the beginning of the 28% rate bracket in 1999).

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