Archive for Capital Loss
November 29, 2012 John R. Dundon II Basis, Business Expense, Business Income, Capital Gain, Capital Loss, Cost Basis, Deductible Expense, Mark to Market, Net Operating Loss, NOL, Tax Court, Tax Deductible Expenses, Tax Records While many individual taxpayers claim to be traders in securities
as compared to investors, in Henricus C. van der Lee, et ux. v. Commissioner TC Memo 2011-234 we learn in my humble opinion that the facts and circumstances of each and every specific taxpayer’s operation must be reviewed to make a proper determination in these regards. The bottom line is though as best I can tell if you want to be considered a ‘trader of securities’ you must at the very least be able to:
1. show that your activity is for the purposes of profiting from market fluctuation rather than appreciation in underlying investment securities
2. have frequent and regular transactions and
3. elect to use the mark-to-market method of accounting under §475(f).
In Henricus the taxpayer tried to avoid the capital loss treatment of stock transactions due to the $3,000 ceiling on capital losses under §1211(b) as investors in securities cannot treat their losses on the sale of securities in any other way. As an aside ‘Dealers’ in securities are exempt from these rules due to the nature of their business as ‘Securities’ are treated like inventory. ‘Traders’ or those who buy and sell stock on a regular basis to profit from the short-term market fluctuations, are subject to the $3,000 capital loss limit unless they elect to use the mark-to-market method of accounting under §475(f).
Regardless of whether the mark-to-market election is made, traders are allowed to deduct their investment expenses as business expenses on Schedule C under §212. However the ‘trader’ has the burden of proof that these expenditures are ordinary and necessary in the production or collection of income.
In the case of Mr. Van Der Lee the main area of dispute was his trading activity. The IRS reclassified his loss on stock trades as capital losses and disallowed the claimed business expenses because the filed tax return did not have a mark-to-market election under §475(f) attached. The Tax Court considered Mr. Van Der Lee’s intent, nature of derived income, as well as frequency, extent and regularity of the securities transactions. In 2002 148 trades were processed. Of these 35 were sales of shares acquired before 2002. Also not a single security was bought and sold on the same day, a purported norm of the ‘trading’ community. As such it was determined that the potential for profit in these sales was based on the general expectation of market appreciation rather than market fluctuation.
The Tax Court agreed with the IRS that Mr. van der Lee was not a trader, but rather an investor in securities in 2002. The loss of $1,388,327 reclassified by the Service as a capital loss was appropriate and as such only $3,000 per year is available to offset ordinary income under §1211(b).
To add insult to injury the legal, travel and meal expenses were not substantiated sufficiently with no specific business purpose stated and as such were disallowed. Additionally the home office expenses claimed were disallowed under §280A because investing in securities is not a trade or business. The net result of the Court’s findings was a complete dis-allowance of all expenses. What a kick in the jimmie.
The requirements for reporting short-term and long-term transactions on separate IRS Form 8949‘s by type A, B or C are still required. When the totals on brokerage statements include both type A and type B transactions, you will need to manually subtotal the transactions between the two types and report each on separate 8949 forms. The instructions to Schedule D state to enter the combined totals from all the attached statements on Form 8949 with the appropriate box checked.
For example, check box A on Form 8949 and report on Line 3 all long-term gains and losses from transactions your broker reported on IRS Form 1099-B showing that the basis of the property sold was reported to the IRS. If you have statements from more than one broker, report the totals from each broker on a separate line.
According to IRS Publication 544 holding period is generally speaking the length of time a capital asset is owned. It is important because of the tax benefits of long term capital gain or loss treatment according to IRC Sec 1223. If the capital gain property is held for more than 12 months, gain or loss is long-term according to IRC Sec. 1222.
In determining a property’s holding period you generally exclude the purchase date but include the sale date. To determine if property has been held long enough to qualify as long-term capital gain, begin counting the holding period on the day after the property was acquired.
When the basis of transferred property carries over, as in an IRC Sec. 1031 exchange, the holding period of the prior owner “tacks on” to the current owner’s holding period according to IRC Sec. 1223(1).
If property is constructed over a period longer than one year and is sold after completion, it may have been held partly for the short-term and partly for the long-term holding periods. The cost of construction completed within the short-term holding period ending with the date of sale has a short-term holding period. The cost of construction completed more than 12 months before the date of sale has a long-term holding period. Land and improvements usually tend to have different holding periods because most people buy land first and then build on that land at a later date. As such the holding period varies based on when development begins and/or improvements constructed.
The purpose of taxing capital gains at lower rates than other income was to stimulate consummation of profitable transactions in property bought for investment according to the Revenue Act 1921, § 206(b).
In tax year 2011 the IRS created Form 8949, Sales and Other Dispositions of Capital Assets, for taxpayers to calculate capital gains and losses. List all capital gain and loss transactions on this form. The subtotals from this form will then be carried over to Schedule D (Form 1040), where gain or loss will be calculated.
Additional resources about reporting capital gains and losses are the Schedule D instructions, IRS Publication 550 Investment Income and Expenses and IRS Publucation 17 Your Federal Income Tax.
Capital assets include for example your home, household furnishings and stocks and bonds held in a personal account. When you sell a capital asset, the difference between the basis or generally the amount you paid for the asset and its sales price is a capital gain or capital loss.
Almost everything you own and use for personal purposes, pleasure or investment is a capital asset. You must report all capital gains however you may only deduct capital losses on investment property, not on personal-use property.
Capital gains and losses are classified as long-term or short-term. If you hold the property more than one year, your capital gain or loss is long-term. If you hold it one year or less, the gain or loss is short-term. If you have long-term gains in excess of your long-term losses, the difference is normally a net capital gain. Subtract any short-term losses from the net capital gain to calculate the net capital gain you must report.
The tax rates that apply to net capital gain are generally lower than the tax rates that apply to other income. If your capital losses exceed your capital gains, you can deduct the excess on your tax return to reduce other income, such as wages, up to an annual limit of $3,000, or $1,500 if you are married filing separately.
If your total net capital loss is more than the yearly limit on capital loss deductions, you can carry over the unused part to the next year and treat it as if you incurred it in that next year.
The IRS has a new Form 8949, Sales and Other Dispositions of Capital Assets that taxpayers must use to report most capital gains and losses. Any properties you own for investment purposes and most properties you own for personal purposes (ie your house) are for the most part considered capital assets. Use Form 8949 to report the sale or exchange of a capital asset you are not reporting elsewhere such as Form 6252 or 8824. Procedure wise you’ll need to fill out Form 8949 before you fill out line 1, 2, 3, 8, 9 or 10 of Form 1040 (Schedule D)
Use as many Forms 8949 as necessary to report all transactions, but make sure that each Form 8949 includes only the type of transactions described in the text for the box checked. Basically at the top of each Form 8949 you file, you’ll need to check box A, B or C, based on what is indicated in box 3 of the Form 1099-B or substitute statement.
Check box A if your broker reported the transaction to you and the basis of the securities sold also was reported to the IRS
Check box B if the transaction was reported to you but box 3 of the Form 1099-B is blank or your statement says the basis was not reported to the IRS.
Check box C for all other transactions.
There has been some confusion surrounding the fact that in order to adjust a gain or loss, you may have to enter a code in column (b) and an adjustment in column (g). For clarification I suggest reading the 2011 Instructions for Schedule D and Form 8949.
Under §121, if married taxpayers own and use property as their principal residence for at least two of the five years ending on the
date of sale, they can exclude up to $500,000 of capital gain on a joint return. However, I do not believe the terms “property” and “principal residence” are not defined in the Code or regulations.
Based on legislative history, it can be concluded that Congress intended the terms “property” and “principal residence” to mean a house or other dwelling unit in which the taxpayer actually resided. For example, the sale of land alone may qualify for the exclusion if the taxpayer sells the dwelling unit within two years before or after the sale of the land.
However, the exclusion only applies if the dwelling unit the taxpayer sells was actually used as his or her principal residence for two out of five years ending on the date of sale.
It can be argued that demolishing and rebuilding a house is no different than remodeling a house based on the ambiguity in determining if there is some level of remodeling that ‘restarts’ the clock as it were in regards to occupying the property for capital gains purposes. What if you demolishes the house but not the foundation and live in a tent on the property during the construction effort? Are you remodeling or rebuilding? It can be difficult to ascertain. The best bet is to live in the house for 2 years before selling it.
Another tax treatment to consider if you demolish and rebuild, treat the original house as being sold for zero dollars when demolished with the basis of the house going to the land and apply §121 to a subsequent sale of the land and new house.
Generally you are eligible to exclude the gain from income if you have owned and used your home as your main home for two years out of the five years prior to the date of its sale.
If you have a gain from the sale of your main home, you may be able to exclude up to $250,000 of the gain from your income ($500,000 on a joint return in most cases).
You are not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home.
If you can exclude all of the gain, you do not need to report the sale on your tax return.
You cannot deduct a loss from the sale of your main home.
Worksheets are included in IRS Publication 523, Selling Your Home, to help you figure the adjusted basis of the home you sold, the gain (or loss) on the sale, and the gain that you can exclude.
If you have more than one home, you can exclude a gain only from the sale of your main home. You must pay tax on the gain from selling any other home. If you have two homes and live in both of them, your main home is ordinarily the one you live in most of the time.
If you received the first-time homebuyer credit and within 36 months of the date of purchase, the property is no longer used as your principal residence, you are required to repay the credit. Repayment of the full credit is due with the income tax return for the year the home ceased to be your principal residence, using IRS Form 5405, First-Time Homebuyer Credit and Repayment of the Credit. The full amount of the credit is reflected as additional tax on that year’s tax return.
When you move, be sure to update your address with the IRS and the U.S. Postal Service to ensure you receive refunds or correspondence from the IRS. Use IRS Form 8822, Change of Address, to notify the IRS of your address change.
A foreclosure on rental property technically involves the sale of the property back to the lender. Form 1099-A Acquisition or Abandonment of Secured Property reports that the lender has repossessed or foreclosed on the property. Box 2 is the amount of the outstanding mortgage debt, and box 4 is the fair market value of the property. If the value of the foreclosed property exceeds the amount of outstanding debt, the debt is considered fully satisfied because the value of the property exceeds the outstanding debt meaning that there would be no debt to cancel after the lender acquires the property.
However if the lender also cancels debt associated with the transaction, there may be income to report from the cancellation of debt on IRS Form 1099-C.
When a foreclosed property is ‘sold’ back to the lender the gain or loss on that transaction is realized by the property owner or taxpayer. The gain or loss is the difference between the amount realized when the property is sold and the taxpayer’s adjusted basis or cost in purchasing and upgrading the property. IRS Publication 551 Basis of Assets is a good source of information on how the basis in the property might be increased or decreased during ownership.
The realized amount is contingent on whether the debt is recourse debt or non-recourse debt. If the debt is non-recourse debt the lender essentially cannot claim assets of the debtor if the secured property does not fully satisfy the outstanding debt. If the debt is recourse debt the lender essentially claims assets of the debtor when the secured property does not fully satisfy the outstanding debt. When the foreclosure involves recourse debt the amount realized is the smaller of the outstanding debt immediately before the foreclosure reduced by any amount of recourse debt for which the taxpayer was liable, or the fair market value of the property.
It is important to remember that Sec. 1245 property in the rental unit may be subject to depreciation recapture which is taxed as ordinary income and also that Sec. 1250 property does not necessarily require depreciation recapture particularly if the straight-line method is used. Sec. 1231 basically says that if the property is foreclosed or ‘sold’ at a loss, the loss is categorized as an ordinary loss not a capital loss.
The sale of the property is reported on IRS Form 4797 Sales of Business Property. The sale of the building is reported in Part I of Form 4797 if sold at a loss and in Part III if sold at a gain. Report the sale of the land separately in Part I, whether sold at a gain or loss. Any non-recaptured Sec. 1250 gain is entered in Part III of Schedule D Form 1040 Capital Gains and Losses.
According to Tax Court Memo 2010-261, a husband and wife purchased real estate, refurbished it and reported the sale on Form 4797. They contended the homes were purchased for use as rentals; however, over the three-year period at issue, none of the homes were rented. The IRS determined that in actuality the couple was in the business of refurbishing real estate for resale and as such the tax payers were subject to self employment tax on ordinary income.
The determination of whether property is held primarily for sale to customers in the ordinary course of a trade or business requires several factors be taken into consideration according to the Tax Court including:
• Your purpose in acquiring the property.
• The purpose for which the property was subsequently held.
• Your everyday business and the relationship of income from the property to the total income.
• The frequency, continuity and substance of sales of property.
• The extent of developing and improving the property to increase the sales revenue.
• The extent to which the taxpayer used advertising, promotion or other activities to increase sales.
• The use of a business office for the sale of property.
• The character and degree of supervision or control you exercised over any representative selling the property.
• The time and effort you habitually devoted to the sales.
I’ve been getting quite a few calls lately from taxpayers that have received ‘settlement’ money and are confused over the prospective tax ramifications of receiving such money. The Internal Revenue Service recognizes that receiving a settlement award (amount) from a personal injury suit may create new tax issues for some individuals. The following information is provided to assist recipients of cash settlements. The type of settlement you receive is determined by your Final Settlement Agreement.
Physical injuries or physical sickness settlements are generally non-taxable. If you receive a settlement for physical injuries or physical sickness and did not take an itemized deduction for medical expenses related to this injury in prior years, the full amount is non-taxable and generally does not need to be reported on your income tax return. If however you receive a settlement for physical injuries or physical sickness and did deduct medical expenses related to the injury, the tax benefit amount is taxable and should be reported as “Other Income” on line 21 of Form 1040. The lesson to be learned here is that contrary to what ambulance chasers belch out on late night television NOT ALL PERSONAL INJURY SETTLEMENT DOLLARS RECEIVED ARE NECESSARILY TAX FREE.
Interest, punitive damages, emotional distress or mental anguish, and employment discrimination or injury to reputation settlements are generally taxable.
Interest: Amounts on any settlement are taxable as “Interest Income” and should be reported on line 8a of Form 1040.
Punitive Damages: Amounts are taxable and should be reported as “Other Income” on line 21 of Form 1040. It does not matter if punitive damages are related to a physical injury or physical sickness.
Emotional distress or mental anguish: Amounts are taxable to the extent that they exceed medical costs, not previously deducted, for treatment of emotional distress or mental anguish. A statement showing the entire settlement amount less related medical costs should be attached to the return. The net taxable amount should be reported as “Other Income” on line 21 of Form 1040.
Employment discrimination or injury to reputation: Amounts are taxable and should be reported as “Other Income” on line 21 of Form 1040.
Loss-of-use or loss-in-value of property settlements may be taxable if the settlement exceeds your basis in the property. Property settlements that are less than the adjusted basis of your property are not taxable and generally do not need to be reported on your tax return. When property settlements exceed your adjusted basis in the property, the excess is gain.
Gains on personal capital assets are reported on Form 1040’s Schedule D, Capital Gains and Losses. Gains on business capital assets are reported on Form 4797, Sale of Business Property.
Some settlement recipients may need to make estimated tax payments if they expect their tax to be $1,000 or more after subtracting credits & withholding.
