1. The vacation home is a personal use asset and is, therefore, a capital asset. The $21,000 loss is nondeductible because it arose from the disposition of a personal use asset. The antique clock is a capital asset held for personal use. The basis of the clock is $2,000 -- its value in Nancy's grandmother's estate. The clock is sold at a $1,500 LTCG gain. The $38,000 song payment is ordinary income because Nancy was in the business of being a songwriter.

2. By the close of business on the day Hyacinth purchases the shares, it must designate them as held for investment. The $48 ($63 - $15) per share gain would be long-term capital gain if the firm sells the shares after holding them more than a year.

Willis, Davis, Raabe, Kaplan, and Engle, CPAs

50 Kellogg Boulevard

St. Paul, Minnesota 55164

March 17, 1998

Vice-President, Finance

Hyacinth, Inc.

200 Morningside Drive

Hattiesburg, Mississippi 39406

Dear Sir or Madam:

The purpose of this letter is to discuss the rules for purchases of stock by a securities dealer such as your firm. A securities dealer may have a long-term capital gain from the sale of stock. The tax law allows you to designate stock you purchase as being held for investment. You must make this designation by the end of the business day on which the stock is acquired. I suggest you check with your account supervisor on how this "designation" is normally done. It is a relatively simple procedure.

As long as you continue to hold the designated shares for investment until you sell them, the shares will be a capital asset. When you sell them at $63 per share, your $48 per share gain will be long-term capital gain if you have held the shares for more than one year.

Thank you for the opportunity to be of service. Please telephone me if you have additional questions.

Sincerely,

Michelle Brown, CPA

Partner

p. 8-6

3. Because Amaryllis Co. has sold more than five lots, it has potential ordinary income equal to 5% of the selling price of each lot. However, since Amaryllis's selling expenses are 7% per lot, it will have no ordinary income because all of the potential ordinary income is first absorbed by the selling expenses. Amaryllis has a total gain of $138,000. None of this gain is ordinary and $138,000 is long-term capital gain. The computations are shown below.

pp. 8-5 and 8-6

4. The option Swan Songs, Inc. holds is an ordinary asset because the firm is a dealer in songs. The tax status of the option is the same as the tax status which the option property would have in the hands of the option holder. Consequently, the gain from selling the option or exercising the option and then selling it is ordinary income. Swan will have the best after-tax cash flow by purchasing the song and then selling it.

pp. 8-6, 8-9, and 8-10

5. Daniel would face the following tax issues:

• What would be the purpose for which Daniel was acquiring the property?
• Is Daniel a dealer in real estate?
• Does the lapse of the option constitute a sale or exchange?

pp. 8-8 and 8-9

6. Since the landowner holds the land as an investment, it is a capital asset to him or her. Because the partnership intends to hold the land for investment, the option is a capital asset to it. The tax status of the option is determined by the firm's tax status for the underlying option property.

a. The landowner (grantor) does not recognize gross income when he or she grants the option and receives $10,000. The option represents a quasi-liability.

b. The option is a legal right, which has some value. Thus, it is an asset with a $10,000 tax basis.

c. The landowner recognizes a $10,000 ordinary gain when the option lapses. The $10,000 does not constitute a capital gain because § 1234 does not treat the expiration of the option on land as a sale or exchange of the property by the grantor. The partnership recognizes a $10,000 short-term capital loss because § 1234 treats the expiration of the option as a sale or exchange by the grantee, and the option (in this fact pattern) was a capital asset that the partnership did not hold for greater than one year.

d. The seller would recognize a $298,000 long-term capital gain ($10,000 option price + $300,000 other amount realized - $12,000 adjusted basis). The partnership has an adjusted basis of $310,000 for the property because the cost of the option is treated as a down payment on the land. pp. 8-8, 8-9, and Concept Summary 8-1

7. Vireo Corporation must be a holder of the patent -- either because it is the creator of the patented part or because it purchased the patent from the inventor before the patent was reduced to practice. Vireo also must transfer all substantial rights in the patent. A transfer of all substantial rights means that (1) all the rights that are valuable at the time of transfer are actually transferred, (2) the transfer is not limited geographically within the U.S., and (3) the entire remaining useful life of the patent is transferred. If all these conditions are met, § 1235 applies and the sale of the patent rights is automatically treated as a long-term capital gain. p. 8-10

8. Freys, Inc. has retained significant powers and rights in the franchise agreement. Therefore, Freys has not made a sale or exchange, but has created a license to use its trademarks, trade name, and mode of operation. Section 1253 requires that Freys treat the $40,000 lump-sum noncontingent payment and the $25,000 contingent payment as ordinary income. Red Company may amortize the $40,000 noncontingent payment over 15 years. The amortization is treated as a business expense. Red may currently deduct the $25,000 contingent payment as a business expense. pp. 8-11 and 8-12

9. The tax factors Irene should consider are: (1) whether or not she has an asset; (2) the tax basis for the asset; (3) the tax status (ordinary, capital, or § 1231) of the asset; (4) the amount of the gain or loss from disposition of the asset; (5) the holding period for the asset; and (6) the nature of gain or loss from disposition of the asset. Irene has an asset -- the lease on her apartment. The asset is a capital asset because all personal use activity assets are capital assets. Irene has no tax basis for the lease because she did not pay anything for it. (Her monthly lease payments are nondeductible personal use activity expenses.) Her holding period for the lease is one year or less. Consequently, she will have a $1,000 short-term capital gain if she accepts the lease cancellation payment. pp. 8-12 and 8-13

10. Thrasher Corporation has not engaged in a "short sale against the box" because it did not own substantially identical stock on the date of the short sale. Also, since Thrasher did not own substantially identical stock at the date of the short sale, any gain or loss from closing the short sale is short-term.

a. The price of the shares rose after Thrasher made the short sale. It lost $5 per share for a total of $500 short-term capital loss from closing the short sale.

b. The holding period for the remaining 100 shares begins with the closing date of the short sale (May 2, 1998). Because the remaining shares were acquired after the short sale date (January 15, 1998), they have a holding period which commences with the earlier of the closing date of the short sale or the sale date of the remaining shares.

c. Thrasher has a $2 per share gain (total of $200) when it sells the remaining shares on January 20, 1999. This gain is short-term because the holding period did not start until the short sale closing date (May 2, 1998). Thrasher must hold the stock more than one year to receive long-term treatment.

p. 8-15

Willis, Davis, Engle, Kaplan, and Raabe, CPAs

50 Kellogg Boulevard

St. Paul, Minnesota 55164

March 17, 1998

Ms. Elaine Case

300 Ireland Avenue

Shepherdstown, West Virginia 25443

Dear Ms. Case:

The purpose of this letter is to discuss the result of your stock transactions for 1998. You had $7,000 (net) of long-term capital gains and $4,000 (net) of short-term capital losses. Subtracting the $4,000 of losses from the $7,000 of gains resulted in a $3,000 net long-term capital gain.

The $3,000 net long-term capital gain and the details of your stock transactions will be reported on the Schedule D attached to your Form 1040. The $3,000 net capital gain qualifies for the alternative tax and will be taxed at a 20% or 28% rate rather than at your marginal tax rate of 36% depending on whether you owned the properties more than 12 months or more than 18 months.

Thank you for the opportunity to be of service. Please telephone me if you have additional questions.

Sincerely,

Michelle Brown, CPA

Partner

pp. 8-15 and 8-17

12. Suzanne's sculpture is a "collectible" and, as such, is taxable at a maximum rate of 28%. Since Suzanne is already in the 36% tax bracket, the 28% rate will apply. A 28% tax of $10,000 translates into a taxable gain of $35,714. Therefore, Suzanne should sell enough stock to generate a capital loss of $44,286 ($80,000 gain on the sculpture-$35,714 desired gain). This loss can be any combination of short-term, 28% property, and long-term capital losses. P. 8-17

13. Silver, Inc. has a net long-term capital loss of $13,000 [($29,000 STCG - $14,000 STCL) - $28,000 LTCL]. A corporation cannot deduct a net capital loss from current year ordinary income. Therefore, Silver's 1998 taxable income is $115,000. Silver has a short-term capital loss carryover of $13,000 because all capital loss carryovers of corporations are treated as short-term. p. 8-24

14. For the seller, June, goodwill represents the disposition of a long-term capital asset with no tax basis. Therefore, the $25,000 payment for goodwill would be long-term capital gain for June and it would qualify for the 20% alternative tax. Payment received for a convenant not to compete is ordinary income, so the $1 would be fully taxable at June's 36% rate. June is better off with the alternative she has proposed.

Mallard, Inc. should be indifferent between paying $25,000 for the goodwill or the covenant not to compete -- both of these assets are capitalizable and amortizable over 15 years under § 197. Therefore, Mallard should accept June's proposal for the payment scheme and close the deal. p. 8-19

15. The tax issues that Sally must properly handle are:

• Should the two casualty items be netted against one another?
• If the items are netted, what type of gain or loss results from the netting?
• How are the results of the netting integrated with Sally's other gains and losses (if any)?
• Should Sally postpone the gain by reinvesting in similar property?

pp. 8-26 and 8-27

16. If the antiques collector is a dealer in antiques, the antique is inventory and, therefore, an ordinary asset. What the antiques collector is trying to accomplish by each of the options listed for disposing of the antique is to make it clear that the antique is a capital asset.

Transferring the antique to his daughter as a gift would probably accomplish the capital asset goal because the daughter would hold the antique as an investment. However, if the daughter has the property and sells it, she has the net proceeds from the sale, not the antiques collector. Such an outcome may or may not be what he was trying to achieve.

If the antiques collector merely assumes that the antique is a capital asset, he runs an audit risk. If his return is audited and the IRS disagrees with the treatment, the antiques collector will not only owe the additional $40,000 in taxes, but will also owe substantial interest and penalties. If the "capital asset" approach is used on his return, there should be substantial tax authority for that approach and documentation of the authority should be kept with his tax records so it is available when (and if) the return is audited.

Exchanging the antique for another antique will postpone the gain if both antiques are not inventory. However, if the antique he presently holds is inventory, the like-kind exchange rules do not apply and a taxable disposition of the antique has occurred. Thus, the exchange does not help solve the basic capital asset versus ordinary asset dilemma for this taxpayer.

17. Tulip & Co. has had two nonpersonal use property casualties. The $30,000 gain is netted against the $27,000 loss and results in a $3,000 net gain. The $3,000 net gain is treated as a § 1231 gain. Since there are no other property transaction gains or losses, and because Tulip has no lookback losses, it has a $3,000 net § 1231 gain for the year. That gain is treated as a long-term capital gain. p. 8-26 and Concept Summary 8-5

Willis, Davis, Raabe, Kaplan, and Engle, CPAs

50 Kellogg Boulevard

St. Louis, Missouri 63121

November 23, 1998

Chief Financial Officer

Tulip & Co.

2000 Meridian Road

Hannibal Point, Missouri 34901

Dear Sir or Madam:

Thank you for the opportunity to discuss the tax effect of the two casualties your company suffered this year. Both the painting and the vase were assets you were holding for investment. The painting casualty resulted in a $10,000 gain because it was insured. The vase casualty resulted in a $7,000 loss because it was not insured.

The $10,000 gain is netted against the $7,000 loss and results in a $3,000 net gain. The $3,000 net gain is treated as a "§ 1231 gain" -- a special type of gain for tax purposes. Since there are no other property transaction gains or losses this year, and because you had no § 1231 losses in prior years, the $3,000 net § 1231 gain for the year is treated as a long-term capital gain. That gain is eligible for a tax rate of no more than 28%.

If you have any questions concerning these transactions or other tax matters, please feel free to telephone me. Thank you.

Sincerely,

Sheila Dailey, CPA

Partner

18. The issue here is whether it is acceptable to ignore complex tax provisions when ignoring them makes no difference in the ultimate tax result. The answer is clearly "no." The tax return preparer does not really know for sure whether proper versus improper compliance makes a difference unless the proper compliance is worked out. But once that has been done, why wouldn't the proper approach be used? Ignoring complex tax provisions because "it won't make any difference" is simply an excuse for shoddy work.

19. Net § 1231 gains must jump a final hurdle before being netted with capital transactions. The net § 1231 gain must exceed the sum of nonrecaptured net § 1231 losses recognized in the five most recent preceding years. The years 1992 through 1995 have a combined nonrecaptured net § 1231 loss of $54,000. The $54,000 § 1231 loss is partially absorbed by the 1996 $10,000 § 1231 gain and the 1997 $20,000 § 1231 gain. Thus, $24,000 of the loss remains for offset against the 1998 $29,000 § 1231 gain.

p. 8-29

20. Iris Co. should sell the § 1231 gain asset this year and the § 1231 loss asset next year. This year, Iris would have $60,000 net § 1231 gain; there would be no lookback nonrecaptured § 1231 loss; the net § 1231 gain would be treated as a long-term capital gain, and the $45,000 short-term capital loss carryover would be offset against this capital gain. For this year, the company would have a $15,000 net long-term capital gain. Next year, Iris could sell the § 1231 loss asset; the $50,000 loss would generate a net § 1231 loss, and that loss would be an ordinary loss. By selling the § 1231 gain asset the year before the § 1231 loss asset, Iris avoids having the § 1231 loss "taint" the § 1231 gain, converting that gain into ordinary gain. pp. 8-27 and 8-29 and Example 43

21. a. Gray Industries has $22,000 ($15,000 + $7,000) of ordinary income due to § 1245 recapture and $7,000 of § 1231 loss.

b. Since Gray does not have a net § 1231 gain, none of the gains are treated as long-term capital gains.

pp. 8-32 to 8-35

22. a. Green Industries has $67,000 ($60,000 + $7,000) of ordinary income due to § 1245 recapture and $48,000 ($55,000 - $7,000) of net § 1231 gain.

1. Green has a $48,000 net § 1231 gain, but only $43,000 is treated as long-term capital gain because the $5,000 of nonrecaptured prior years § 1231 loss causes $5,000 of the current year net § 1231 gain to be treated as ordinary income.

pp. 8-31 to 8-33

23. The propane tank is § 1245 property because either it is tangible depreciable personal property or it is tangible real property employed as an integral part of manufacturing. The $100,000 gain [$1,300,000 sale price - ($2,000,000 cost - $800,000 depreciation)] is all § 1245 gain because the gain does not exceed the $800,000 depreciation recapture potential. pp. 8-32 and 8-33

24. The patent amortization is subject to § 1245 recapture as ordinary income. The balance of the gain is § 1231 gain. pp. 8-32 and 8-33

Willis, Davis, Raabe, Kaplan, and Engle, CPAs

50 Kellogg Boulevard

Bangor, Maine 23800

November 23, 1998

Mr. Siddim Sadatha, Controller

Gray Manufacturing Company

6734 Grover Street

Back Bay Harbor, ME 23890

Dear Siddim:

Thank you for the opportunity to respond to your question concerning the tax treatment of the gain from the disposition of the patent. As you know, amortization of $225 per month has been taken on this patent since it was acquired on December 1, 1996. That amortization totaled $4,275 when you disposed of the patent on June 30, 1998. The $4,275 is taxable as ordinary income because it is "recaptured" by § 1245. The balance of the gain ($19,500) is a "§ 1231 gain." That gain will be taxed as long-term capital gain as no other business property dispositions have occurred this year.

If you have any questions concerning these transactions or other tax matters, please feel free to telephone me. Thank you.

Sincerely,

Rose Goodwin, CPA

Partner

Truck:

Depreciation taken: $3,491 ($6,000 - $2,509).

Adjusted basis: $2,509.

Realized and recognized gain = Amount realized - Adjusted basis of
machine on date of sale = $3,900 - $0 = $3,900.

Realized gain = Amount realized - Adjusted basis = $200,000 - $124,783 =
$75,217.

Auto:

Trampoline:

pp. 8-28 to 8-35

26. The old drafting table has a $450 value which has been received by Macklin when the table is converted to his personal use. Macklin should file a Form 4797 reporting the disposition of the drafting table for $450 and report § 1245 depreciation recapture gain of $450 since the table has a zero tax basis and $3,700 of depreciation has been taken. If the conversion to personal use of fully depreciated (but still valuable) business assets could be done tax-free, the tax law would have a significant gap.

b. If the property is nonresidential real property, all the depreciation is subject to recapture under § 1245.

c. Willis, Davis, Raabe, Kaplan, and Engle, CPAs

Ms. Cora Hassant

2345 Westridge Street #23

Walter Smith, CPA

pp. 8-36 to 8-38

pp. 8-36 to 8-39

30. Joanne has two alternatives for helping Susan:

(1) Joanne could sell the equipment, but probably not to Susan since she could not afford it. Joanne would have a taxable ordinary gain of $50,000 [$85,000 sale price - ($135,000 cost - $100,000 depreciation)] due to depreciation recapture under § 1245. After paying her tax of $19,800 ($50,000 X 39.6%), Joanne would have $65,200 ($85,000 sale price - $19,800 tax) to give to Susan. That may not be enough cash for Susan to buy the equipment she needs. It would not be beneficial for Joanne to sell the equipment on the installment basis because all the gain would be immediately recognized since all the gain is recapture gain. p. 8-42

(2) Joanne could give the equipment to Susan. The $100,000 depreciation recapture potential would carry over to Susan and Susan would take Joanne's basis ($35,000) for the property. Any depreciation which Susan takes on the property would increase the depreciation recapture potential. However, it appears that Susan may not sell the property for quite a while and is probably in a lower tax bracket than Joanne. p. 8-40

31. Death eliminates all recapture potential and the inheritor of the property gets a basis for the property equal to its value at the date of the decedent's death. Thus, Adrian would have a $73,000 basis for the equipment. p. 8-40

32. Orange recognizes ordinary income under § 1239 (the ordinary income resulting from a sale between related taxpayers provision) because Jane, the transferee, will be depreciating the property. She can depreciate the equipment because it will be business use property. Orange has $14,000 ($59,000 sale price - $45,000 adjusted basis) ordinary income. Jane will have a $59,000 basis for the property. p. 8-42

33. The key to this problem is that all equipment depreciation taken is subject to recapture as ordinary income due to § 1245. However, if the equipment is sold for more than was paid for it, the excess of the selling price over the original cost is § 1231 gain. There appears to be three ways to allocate the purchase price:

(1) Subtract the $100,000 total adjusted basis from the $300,000 selling price to yield a $200,000 gain. Since total depreciation on the three assets exceeds $200,000, all of the gain is § 1245 gain.

(2) Allocate the $300,000 selling price to each asset based on its relative original cost. For instance, the driller would be sold for $37,113 ($120,000/$970,000 X $300,000). The gains and losses using this approach are shown below.

The $31,134 gain would all be § 1245 gain because the skidder cost $230,000 and was "sold" for $71,134. The $22,887 loss on the driller would be a § 1231 loss. The $191,753 gain on the platform would all be § 1245 gain because it cost $620,000 and was "sold" for $191,753.

(3) Allocate the $300,000 selling price to each asset based on its relative adjusted basis. For instance, the driller would be sold for $180,000 ($60,000/$100,000 X $300,000). The gains using this approach are shown below.

The $80,000 skidder gain would all be § 1245 gain because the skidder cost $230,000 and was "sold" for $120,000. The $120,000 gain on the driller would be a $60,000 § 1245 gain (equals depreciation taken) and $60,000 § 1231 gain (equals excess of sale price over original cost of $120,000). The sale of the platform would generate no gain or loss because it was "sold" for nothing and the adjusted basis was $0. pp. 8-32 and 8-33

§ 1231 gain    X payment received = $560,000   X $250,000 = $140,000

Contract price $1,000,000

35. The U.S. Court of Appeals (3rd Circuit) in the Prudential Insurance Co. of America, 64 AFTR2d 89-5225, 89-2 USTC ¶9501 882 F.2d 832, (1989) determined that charges for prepayment of mortgages were capital gains rather than interest charges taxable as ordinary income. The prepayment charges were received in exchange for mortgages which Prudential held on the homeowner's real property. The Court of Appeal's decision overturned a Tax Court decision treating the payments as ordinary investment income. The Prudential case was decided under § 1232 which was repealed in 1984. However, the mortgages would appear to be capital assets because they do not fit any of the capital asset exclusions of § 1221. Therefore, it should be concluded that the prepayment fees received by Banc Two Mortgage Company would be capital gains - short or long-term depending on the holding period.

36. Section 1245(a)(4) designates player contracts as § 1245 property. Previously unrecaptured depreciation with respect to initial contracts is depreciation taken on contracts acquired with the purchase of the franchise that has not already been recaptured due to earlier sales of those contracts. The purpose of this recapture is to force recognition of ordinary income on disposition of the player contracts. See § 1245(a)(4)(B). p. 8-12

37. a. Barbara's recognized gain is $10,000 [$30,000 (sales price) - $20,000 (basis)]. The donor's basis is used to compute the gain when the sale price exceeds the donor's basis.

b. Barbara's gain is ordinary because the song is not a capital asset. She received it by gift from the song's creator. Her basis is determined by reference to Gary's basis; consequently, she (and Gary) did not own a capital asset.

p. 8-5

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