Tax

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If punitive damages

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Includible in gross income

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Personal injury exception for tort damages on account of personal physical injury

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Excludable even though may include lost earnings (but not punitives). All excludable even if for emotional distress

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Other tort damages

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Included in gross income except for medical expenses arising from emotional distress

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Scholarship

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Excludable up to tuition books and fees. Must be degree candidate. Not payment for services rendered.

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Loans

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Not gross income. When paid no deduction for principal, sometimes deduction for nterest

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Loan exception

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If loan discharged for less than full balance, difference is gross income (DOI OR COD) - discharge of indebtedness income

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DOI exceptions

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Forgiveness of loan as a gift
Adjustment of purchase price of property
Borrower is bankrupt or insolvent

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Alimony definition

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Payments in cash to or for benefit of ex-spouse. Pursuant to written instrument that requires it. Payor and payee don't live together. If payee dies before payments are complete, payor's obligation to pay ceases.

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Alimony

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Included in gross income of payee, deductible by payor.

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Option to treat as non-alimony

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Both parties agree in writing or divorce so decrees. Then not includible in income by payee and not deductible by payor

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Child support disguised as alimony

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Even if meet definition of alimony, not alimony to the extent they're reduced upon the occurrence of an event related to a child. Not includible by payee/not deductible by payor.

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Property settlement disguised as alimony

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Not alimony to the extent payments are "loaded" in the first two years after dissolution of the marriage

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Stolen items

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Gross income to thief even though legal obligation to make restitution. Theft is not a loan because victim didn't consent

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Illegal income

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Gross income. 5th amendment does not prohibit Congress from taxing

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Tax benefit rule

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“Correction” of past year’s deductions to reflect changes circumstances. If:
• Taxpayer took a legitimate deduction in a prior year, and
• Something that happens in the current year that is “fundamentally inconsistent” with the premise of the deduction, then
• Taxpayer must report as income in the current year the amount of the previous year’s deduction.

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Tax benefit rule examples

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o State income tax refunds if that tax was previously deducted (e.g. as itemized deduction)
o Federal tax refunds not income because weren’t deductible when paid
o Medical insurance reimbursements are tax-benefit-rule income if patient previously paid and deducted the medical expenses
o Returned charitable contributions that were deducted

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Tax benefit rule exception

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If earlier deductions gave taxpayer no tax benefit, inconsistent event does not trigger income in the current year.

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Gains from dealings in property general rule

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When property is sold or exchanged, gain or loss is realized

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Realization requirement

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Gain/loss not triggered unless or until there is a realizing event, such as sale or exchange of the property

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Realization examples

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Property increasing or decreasing in value is not a realizing event
A gift (unless donee takes donor's debt and debt is more than basis) is not a realizing event
Stock splits or stock dividends is not a realizing event

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Computation of gain/loss

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Amount realized - adjusted basis = Realized gain/loss

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Amount realized

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What the taxpayer got on the sale or exchange. Cash that the taxpayer received for the property, plus FMV of any other property that the taxpayer received for it.

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Adjusted basis

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Generally, cost, what the taxpayer paid to buy the property (including loans that the taxpayer took out to buy it).

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Basis of property received as taxable compensation

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FMV when received - "tax cost"

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Basis of gift property

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Basis of property received by gift from a live person = carryover basis, i.e. same as donor. Basis of property received from a decedent = FMV on the date of death.

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Basis of gift property exception

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Lifetime gifts exception - Donor can't shift built in loss to donee

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Basis of gambling

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Treated like a sale. Amount wagered is basis, winnings are amount realized. Gains are income, however, gambling losses are deductible only against gambling gains for the taxpayer’s current year.

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Basis of property when buyer assumes a loan

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Outstanding balance on the loan is treated as an additional amount realized on the sale (money received by the seller). Buyer’s basis is the buyer’s cash payment, plus the liability he/she has taken over – part of his/her cost.

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Depreciation and basis

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If property is producing income and is of the type that will wear out eventually, taxpayer can deduct part of its basis year by year until the basis is completely deducted. Reflects wear and tear on the asset. Period very loosely corresponds to the useful life of the property, but is usually shorter. The depreciation deduction reduces the basis of the asset, dollar for dollar.

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Basis and equity loans

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The assumed liability must be counted as an amount realized even were it was not part of the seller’s basis. For example, if the mortgage is a home equity loan, and the seller used the loan for purposes other than improving the home, the buyer’s assumption of that mortgage is part of the seller’s amount realized, even though the loan was not included in seller’s basis.

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Transfer of property to satisfy debt and basis

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Treated as a sale of property. The amount realized is the amount of the debt paid off.

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Exclusion of gain on sale of principal residence

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Taxpayer does not have gain on sale of his/her principal residence, provided he/she has used it as such for 2 out of 5 years preceding the sale. Maximum amount of gain excludable: $250,000 per sale ($500,000 for married couple filing joint return).

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Accounting methods

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Cash, Accrual, Installment

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Cash method

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Used by most individuals. Gross income is reported when the taxpayer actually or constructively receives it. Deductions are taken when the taxpayer actually pays the amount in question.

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Cash method constructive receipt

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Items are treated as received by a cash method taxpayer when they have been set aside for the taxpayer, credited to his/her account, or otherwise made available so that he/she can draw upon them at any time. Examples interest earned on bank account left at bank, dividends reinvested in more shares, money in escrow for damages if allowed to withdraw at any time.

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Accrual method - When income is reported

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Used by most businesses. Gross income is reported when (1) all the events have occurred which fix the taxpayer’s right to it, and (2) the amount can be determined with reasonable accuracy.

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Accrual method - When deductions are taken

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when (1) all the events have occurred which fix the taxpayer’s obligation to pay, (2) the amount can be determined with reasonable accuracy, and (3) economic performance occurs (other party to transaction performs). Income/deductions tend to occur sooner under the accrual method than under the cash method.

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Installment method

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When property is sold for a series of payments, seller can sometimes wait until payments are received to report gain on the sale. Under the installment method, each payment is treated as part gain, part return of basis, under mathematical formula.

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If installment reporting unavailable

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Buyer’s I.O.U. is treated as valuable property received at closing, and gain is “bunched” into year of sale (even though seller will not be paid until later).

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Sales that don't qualify for installment reporting

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Sales by retailers and real estate dealers and sales by anyone of publicly traded stock.

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Elect out of installment reporting

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Ok if taxpayers wish to do so

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Claim of right

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Income is realized when the taxpayer receives it under a claim of right, with no restrictions on spending it, even though there is some possibility that he/she may have to return it in the future (D has to pay judgment pending appeal). In contrast, disputed right to income is not presently taxable.

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Corrections when reports income and later required to restore it. 2 options for reporting the payback

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• Deduct the repayment in the current year, using the current year’s tax rates, even if they are higher than when he/she had the income, OR
• Reopen the prior year, determine how much tax he/she paid on the income in that year, and take that amount as a credit against tax in the current year.

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Nonrecognition definition

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Sometimes sales or exchanges of property give rise to realized gains (or losses), but Congress has decided that special circumstances warrant postponing the taxation of the gain (or deduction of the loss). In these situations, Congress has declared that the gain or loss on the sale or exchange is not recognized for tax purposes – i.e. it does not go on the tax return. Must be realized and recognized.

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Nonrecognition categories

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Transfers between spouses
Divorce property settlements
Like-kind exchanges
Involuntary conversion

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Nonrecognition - Transfers between spouses

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Any transfer between live spouses is a nonrecognition event – no gain/loss recognized. Transferee takes a “carryover” basis from the transferor. Always treated as a gift. Includes outright sales, exchanges, etc., as well as gifts. Bequests, devise or inheritance from deceased spouse is also a nonrecognition event, but basis “steps up” or “steps down” to FMV at death.

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Nonrecognition - Divorce property settlements

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On dissolution of marriage, same rule applies as during marriage – nonrecognition of gain/loss and “carryover” basis (except alimony). Transferee may later have to pay tax on transferor’s gain, or get to deduct transferor’s loss.

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Nonrecognition - Like-kind exchanges

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No gain or loss is recognized if business or investment property is exchanged for other business or investment property of “like kind” with the property being given up in exchange. Basis is the carryover basis in the old property.

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Like-kind exchanges definitions of like-kind transactions

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• Real estate and personal property are automatically not like-kind with each other.
• All real estate is like-kind with all other real estate for this purpose – skyscraper is like farmland.
• Personal property rules not as lax, but trucks are like trucks, computers like computers, etc.
• Stocks, bonds, notes, etc. disqualified. Personal assets disqualified. Inventory and other property that the taxpayer holds for sale to customers (e.g., real estate in hands of real estate dealer) disqualified.

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Boot - Recognition

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If taxpayer receives money or non-like-kind property in the exchange (“boot”), gain is recognized up to the lesser of (1) the realized gain, or (2) the amount of the “boot.” Thus, if taxpayer handles money in the transaction, he or she is likely to recognize gain. Note, however, you cannot recognize more gain than you realize. If don’t realize full boot, then basis decreased by amount of untaxed boot.

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Mortgages as Boot - Recognition

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If the other party to the exchange takes over the taxpayer’s liability, not only is that an additional amount realized – the mortagage is also “boot” (treated as money received by the taxpayer transferring the mortgaged property), causing gain to be recognized.

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Nonrecognition - Involuntary conversion

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A “rollover” provision – taxpayer can transfer property in exchange for cash and still get nonrecognition, so long as he/she replaces the property given up. If taxpayer has a gain as a result of an involuntary conversion (e.g. theft, destruction, or condemnation), taxpayer can elect not to recognize gain if he/she buys “similar or related” property within statutory replacement period. Basis generally carries over from converted asset to replacement asset.

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Nonrecognition - Involuntary conversion rules

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• Period begins when conversion takes place, and ends two years after the end of that year – more than two years, but less than 3 years.
• Applies to any kind of property.
• No dollar limit.
• Any proceeds of the involuntary conversion that are not reinvested in the replacement property are taxed like “boot” in a like-kind exchange.
• Basis rules are similar to those governing like-kind exchanges – typically, a “carryover” basis from taxpayer’s old property to new.

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Long-term capital gains taxation

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Taxed at a lower rate than ordinary income. For example, the top rate on long-term capital gain is 15%, rather than 35% for other types of income. Long-term gains are those on property held for more than one year.

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Capital losses taxation

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 Capital losses (both long-term and short-term) are subject to special limitations. For individuals, capital losses for any year are deductible only against capital gains from that year, plus $3,000 of ordinary income. Except for the $3,000, any excess of capital loss over capital gain must be carried forward to future years for deduction against future capital gains (or the annual $3,000 allowance). If die before you get to take them, don’t get them.

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Why care? Whether ordinary or capital gains

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 A taxpayer prefers gains to be capital and losses to be ordinary. The IRS wants the opposite.

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Capital gain or loss - 2 things

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• Dividends on corporate stock (treated as long-term capital gain)
• The gain or loss on the sale or exchange of a capital asset.

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Capital gain or loss - Requires a sale or exchange

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o Except for dividends on stock, only sales and exchanges of property generate capital gain and loss. If a transaction is merely payment for services rendered by the taxpayer, it does not produce capital gain, even if the taxpayer tries to disguise the transaction as a property sale. And rents and interest are not capital gains, because there is no sale or exchange of property. The income from these sources is ordinary income. (Dividends are the only capital gain that does not require a sale or exchange).

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Capital gain or loss - Requires that the asset sold or exchanged be a capital asset

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o Assuming a sale or exchange is present, to generate capital gain/loss, the sale or exchange must be of a capital interest.

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Capital gain or loss - Personal property

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o Losses on sales or exchanges of personal-use assets are not deductible at all (includes your home). Gains on sales and exchanges of such assets, however, are taxable as capital gains.