Generally, any property held as an investment is a capital asset, except that rental real estate is typically not a capital asset because it is treated as a trade or business asset.¹The Code defines a “capital asset” by exclusion. So for purposes of determining whether a certain type of property is a capital asset, the following types of property are excluded:

(1)     property (including inventory and stock in trade) held primarily for sale to customers;

(2)     real or depreciable property used in the taxpayer’s trade or business;

(3)     patents, inventions, models or designs (whether or not patented), a secret formula or process, copyrights and literary, musical, or artistic compositions (or similar properties) created by the taxpayer, or merely owned by him, if the taxpayer’s basis in the property is determined (other than by reason of IRC Section 1022, which governs the basis determination of inherited property) by reference to the creator’s tax basis;

(4)     letters, memoranda, and similar properties produced by or for the taxpayer, or owned by him if the taxpayer’s basis is determined by reference to the tax basis of the producer or recipient;

(5)     accounts or notes receivable acquired in the taxpayer’s trade or business for services rendered or sales of property described in (1), above;

(6)     certain publications of the United States government;

(7)     any commodities derivative financial instrument held by a commodities derivatives dealer;

(8)     any hedging instrument clearly identified as such by the required time; or

(9)     supplies of a type regularly used or consumed by the taxpayer in the ordinary course of the taxpayer’s trade or business.²

Editor’s Note: The 2017 tax reform law retained the current tax rates that apply to long-term capital gains and qualified dividend income. However, the income thresholds that determine to whom those rates will apply have changed along with the changes to the individual income tax rates (see below).For long-term capital gain, adjusted net capital gain (see Q 8606) is generally subject to the following tax rates:

(1)     0 percent for taxpayers in the 10 and 15 percent tax brackets in 2017. In 2024, with respect to adjusted net capital gain, the 0 percent rate will apply to joint filers who earn less than $94,050 (half the amount for married taxpayers filing separately), heads of households who earn less than $63,000, single filers who earn less than $47,025, and trusts and estates with less than $3,150 in income;

(2)     15 percent for taxpayers in the 25 percent, 28 percent, 33 percent and 35 percent tax brackets in 2017. In 2024, the 15 percent rate will apply to joint filers who earn more than $94,050 but less than $583,750 (half the amount for married taxpayers filing separately), heads of households who earn more than $63,000 but less than $551,350, single filers who earn more than $47,025 but less than $518,900, and trusts and estates with more than $3,150 but less than $15,450 in income; and

(3)     20 percent for taxpayers in the 39.6 percent tax bracket in 2017. In 2024, the 20 percent rate will apply to joint filers who earn more than $583,750 (half that amount for married taxpayers filing separately), heads of households who earn more than $551,350, single filers who earn more than $518,900, and trusts and estates with more than $15,450 in income.

The long-term capital gains rates for 2023 are:

The 0 percent capital gains rate applies to joint filers who earn less than $89,250 (half of that amount for married taxpayers filing separately), heads of households who earn less than $59,750, single filers who earn less than $44,625, and trust and estates with less than $3,000 in income.

The 15 percent rate applies to joint filers who earn more than $89,250 but less than $553,850 (half of that amount for married taxpayers filing separately), heads of households who earn more than $59,750 but less than $523,050, single filers who earn more than $44,625, but less than $492,300 and trust and estates with more than $3,000 but less than $14,650 in income.

The 20 percent rate applies to joint filers who earn more than $553,850 (half of that amount for married taxpayers filing separately), heads of households who earn more than $523,050, single filers who earn more than $492,300, and trusts and estates with more than $14,650 in income.

However, detailed rules as to the exact calculation of the capital gains tax result in some exceptions. See Q 8606 (determining amount of capital gain), Q 8607 (Section 1250, Section 1202 and collectibles property) and Q 8625 (holding period requirement for determining whether gain is subject to long-term or short-term rates).¹

See Q 8631 for an outline of the netting process used in determining capital gains and losses when multiple asset classes are involved.

Beginning in 2013, taxpayers with adjusted gross income in excess of certain thresholds may be subject to the 3.8 percent net investment income tax pursuant to IRC Section 1411 (see Q 8637 to Q 8647). This 3.8 percent is a surtax added to the taxpayer’s otherwise applicable tax rate. This tax was not impacted by the 2017 tax reform legislation.

Net capital gain is the excess of net long-term capital gain for the taxable year over net short-term capital loss for such year.¹ However, net capital gain for any taxable year is reduced (but not below zero) by any amount the taxpayer takes into account under the investment income exception to the investment interest deduction.²If a taxpayer has net capital gain for any tax year, the IRC provides that the tax will not exceed the sum of the following six items:

(A)    the tax computed at regular rates (without regard to the rules for capital gain) on the greater of (i) taxable income reduced by the net capital gain, or (ii) the lesser of (I) the amount of taxable income taxed at the rates that apply if taxable income is below the relevant income threshold (see Q 8605), or (II) taxable income reduced by the adjusted net capital gain;

(B)    0 percent of the taxpayer’s adjusted net capital gain (or, if less, taxable income) that does not exceed the excess (if any) of (i) the amount of taxable income that would (without regard to this paragraph) be taxed at the rates that apply if taxable income is below the relevant income threshold (see Q 8605) over (ii) the taxable income reduced by the adjusted net capital gain;

(C)    15 percent of the lesser of (i) so much of the taxpayer’s adjusted net capital gain (or, if less, taxable income) as exceeds the amount on which a tax is determined under (B), above, or (ii) the excess of (I) the amount of taxable income which would be taxed at the rates that apply if taxable income is below the relevant income threshold (see Q 8605) over (II) the sum of the amounts on which a tax is determined under (A) and (B), above;

(D)    20 percent of the taxpayer’s adjusted net capital gain (or, if less, taxable income) in excess of the sum of the amounts on which tax is determined under (B) and (C), above;

(E)     25 percent of the excess (if any) of (i) the unrecaptured IRC Section 1250 gain (or, if less, the net capital gain (determined without regard to qualified dividend income)), over (ii) the excess (if any) of (I) the sum of the amount on which tax is determined under (A) above, plus the net capital gain, over (II) taxable income (see Q 8607 for a discussion of unrecaptured IRC Section 1250 gain); and

(F)      28 percent of the amount of taxable income in excess of the sum of the amounts on which tax is determined under (A) through (D) above. See Q 8607 for a discussion of 28 percent gain.

For most long-term capital gains, this complicated formula generally results in a maximum capital gains rate on adjusted net capital gain equal to 20 percent, 15 percent, or 0 percent, depending upon income level. Note that under the 2017 tax reform legislation, these thresholds no longer neatly align with the ordinary income tax brackets.

Gain attributable to the sale or exchange of collectibles, IRC Section 1202 gain (i.e., qualified small business stock), and unrecaptured IRC Section 1250 gain are subject to different tax rates. Gain on the sale or exchange of collectibles and IRC Section 1202 property is taxed at 28 percent, and unrecaptured gain on IRC Section 1250 property is taxed at 25 percent.¹“Collectibles gain” is taxable gain on the sale or exchange of a collectible that is a capital asset held for more than one year.² Examples of collectibles include artwork, gems and coins.³

“Section 1202 gain” is the gain on the sale or exchange of Section 1202 stock. Pursuant to IRC Section 1202, an individual may exclude 50 percent of the taxable gain on the sale or exchange of “qualified small business stock” that is held for more than five years.

“Unrecaptured Section 1250 gain” is the portion of the gain on the sale or exchange of real property attributable to depreciation. Nonresidential real property (such as commercial buildings) and residential rental property (such as apartment buildings) are Section 1250 property and are depreciated under the straight line method (i.e., the same amount of depreciation is taken every tax year).⁴ Each year’s depreciation reduces the basis of the real property by a like amount.⁵ So when such real property is sold, the gain attributable to the basis reduction is considered unrecaptured Section 1250 gain.

Example: Asher owns a commercial building with an original basis in the building of $500,000. After several years, when the basis of the building had been reduced to $350,000, Asher sells the building for $500,000. Even though the building did not appreciate, Asher has a gain of $150,000 ($500,000 minus $350,000), all of which is attributable to the depreciation reduction of basis. Such gain is considered to be unrecaptured Section 1250 gain.

Congress has taken steps in recent years to reduce the rates applicable to long-term capital gains. As such, long-term capital gains recognized on or after May 6, 2003 are subject to lower tax rates today than has historically been the case. Under the 2017 tax reform legislation, those lower rates continue to apply, but the income thresholds that determine to whom those rates will apply have changed along with the changes to the individual income tax rates.Up until 2018, for taxpayers in the 25, 28, 33 and 35 percent ordinary income tax brackets, the rate on long-term capital gains was reduced from 20 percent to 15 percent in 2003 through 2012. For taxpayers in the 10 and 15 percent brackets, the rate on long-term capital gains was reduced from 10 percent to 5 percent in 2003 through 2007, and then to 0 percent in 2008 through 2012. As discussed below, these lower capital gain rates have been made permanent for tax years beginning after 2012.¹

The American Taxpayer Relief Act of 2012 (“ATRA”) extended the 0 percent and 15 percent capital gain rates for most taxpayers and increased the rates for taxpayers in the highest income tax bracket. ATRA permanently increased the rate on long-term capital gains to 20 percent for taxpayers with taxable income that placed them in the highest 39.6 percent income tax rate bracket (for 2012-2017).² The applicable threshold amounts were adjusted annually for inflation.³ For taxpayers in the 10 or 15 percent income tax brackets, the rate on long-term capital gains was set at 0 percent for 2012-2017. Taxpayers in the 25, 28, 33 and 35 percent tax brackets were taxed at 15 percent on long-term capital gains for 2012-2017.⁴

2024 Long-Term Capital Gains Rates

The 0 percent capital gains rate applies to joint filers who earn less than $94,050 (half of that amount for married taxpayers filing separately), heads of households who earn less than $63,000, single filers who earn less than $47,025, and trust and estates with less than $3,150 in income.

The 15 percent rate applies to joint filers who earn more than $94,050 but less than $583,750 (half of that amount for married taxpayers filing separately), heads of households who earn more than $63,000 but less than $551,350, single filers who earn more than $47,025, but less than $518,900 and trust and estates with more than $3,150 but less than $15,450 in income.

The 20 percent rate applies to joint filers who earn more than $583,750 (half of that amount for married taxpayers filing separately), heads of households who earn more than $551,350, single filers who earn more than $518,900, and trusts and estates with more than $15,450 in income.⁵

2023 Long-Term Capital Gains Rates

The 0 percent rate will apply to joint filers who earn less than $89,250 (half the amount for married taxpayers filing separately), heads of households who earn less than $59,750, single filers who earn less than $44,625, and trusts and estates with less than $3,000 in income.

The 15 percent capital gains rate will apply to joint filers who earn more than $89,250 but less than $553,850 (half the amount for married taxpayers filing separately), heads of households who earn more than $59,750 but less than $523,050, single filers who earn more than $44,625 but less than $492,300, and trusts and estates with more than $3,000 but less than $14,650 in income.

The 20 percent capital gains rate will apply to joint filers who earn more than $553,850 (half that amount for married taxpayers filing separately), heads of households who earn more than $523,050, single filers who earn more than $492,300, and trusts and estates with more than $14,650 in income.⁶

As of January 1, 2013, an investment income tax of 3.8 percent applies to certain investment-type income (including income received from capital gains). The investment income tax was not impacted by the 2017 tax reforms and applies for taxpayers whose annual adjusted gross income exceeds the investment income threshold amount ($250,000 for married taxpayers filing jointly, $125,000 for married taxpayers filing separately and $200,000 for all other taxpayers).⁷ See Q 8637 to Q 8647 for a detailed discussion of the investment income tax.

The rates applicable for collectibles gain, IRC Section 1202 gain (i.e., qualified small business stock), and unrecaptured IRC Section 1250 gain remained unchanged. See Q 8607.⁸

Repeal of qualified 5-year gain. For tax years beginning after December 31, 2000, if certain requirements were met, the maximum rates on “qualified 5-year gain” could be reduced to 8 percent and 18 percent (in place of 10 percent and 20 percent, respectively). Furthermore, a noncorporate taxpayer in the 25 percent bracket (or higher) who held a capital asset on January 1, 2001 could elect to treat the asset as if it had been sold and repurchased for its fair market value on January 1, 2001 (or on January 2, 2001 in the case of publicly traded stock). If a noncorporate taxpayer made this election, the holding period for the elected assets began after December 31, 2000, thereby making the asset eligible for the 18 percent rate if it was later sold after having been held by the taxpayer for more than five years from the date of the deemed sale and deemed reacquisition.⁹ Under JGTRRA 2003, the 5-year holding period requirement, and the 18 percent and 8 percent tax rates for qualified 5-year gain, were repealed. Though this repeal was scheduled to sunset along with the reduced rates on long-term capital gains, it was made permanent under ATRA.

“Tax basis” is a taxpayer’s after-tax investment in property. In other words, when a taxpayer acquires property for money, the purchase price is presumed to be his or her after tax investment in such property.¹ When property is sold or exchanged, for purposes of computing gain, the difference between the amount received less the taxpayer’s basis in the property is the taxable gain.² Similarly, for purposes of computing a loss (meaning the taxpayer received less than the original cost of the property), the difference between the taxpayer’s basis in the property and the amount received is the taxable loss.³

Example: In 2023, Asher purchased Apple stock for $1,000. In 2024, Asher sold the stock for $1,500. Asher’s taxable gain is $500, or the difference between the amount received and his basis in the stock ($1,500 minus $1,000). No tax applies to the $1,000 received because that amount represents the recovery of Asher’s initial after-tax investment in the property, i.e., his basis.

In the alternative, if Asher sold the Apple stock for $500, his taxable loss would be $500, or the difference between his basis in the stock (what he paid for it) and what he received in the sale ($1,000 minus $500). In this case, Asher would recognize a loss because the amount he received is less than what he originally paid.

If the taxpayer acquires property other than by purchase, basis is determined pursuant to different rules. For example, if the taxpayer acquires property from a decedent by inheritance or bequest, the basis in the property is its fair market value as of the date of the decedent’s death.⁴

New rules regarding consistent basis reporting provide, generally, that the basis of property acquired from a decedent cannot exceed the final value of such property that has been used for estate tax purposes.⁵

With respect to a gift of property, the general rule is the donee taxpayer takes the donor’s basis in the property.⁶

Example: Asher gifts Apple stock he purchased for $1,000 to his friend Ashley. At the time of the gift, the stock had a fair market value of $1,500. Ashley’s basis in the stock is $1,000, the same as Asher’s. So, if she sold the stock for $1,500, she would recognize a $500 gain.

On the other hand, there is an exception to the rule that the donee taxpayer takes the donor’s basis in the property. This occurs when, at the time of the gift, the donor’s basis is greater than the fair market value of the gifted property. In that case, the donee taxpayer’s basis is the fair market value of the property.⁷

Example: Asher gifts Apple stock he purchased for $1,000 to his friend Ashley. At the time of the gift, the stock had a fair market value of $500. Because Asher’s basis of $1,000 is greater than the $500 fair market value, Ashley’s basis in the stock is $500. As a result, if she sold the stock for $500, she would recognize no gain or loss. The reason for this rule is to prevent one taxpayer from shifting a taxable loss to the other taxpayer. If Ashley had taken Asher’s $1,000 basis, she would have reported a $500 loss rather than Asher.

As discussed in Q 8609, gain or loss is measured by determining whether the amount received in a sale or exchange of property was more or less than the taxpayer’s “basis.” If the amount received is more than basis, there is a taxable gain. Conversely, if basis is greater than the amount received there is a loss. However, during the period of a taxpayer’s ownership of property, certain adjustments to the original tax basis are required. Thus, tax basis, as adjusted, is referred to as “adjusted basis.”In the course of a taxpayer’s ownership of property, basis can be increased or it can be decreased.

Capital Improvement

Example: Asher purchases a 10 story office building for $500,000. Subsequently, Asher decides to add an 11th story to the building at a cost of $100,000. As a capital improvement, Asher’s original $500,000 basis is adjusted upward to $600,000¹ and becomes the adjusted basis in the building.

Depreciation

Generally, depreciation is a means of deducting the cost of an asset over its useful life. For example, the cost of a commercial building (excluding land, which is nondepreciable) is depreciated over a useful life of 39 years.² Based on a tax fiction, at the end of the 39 year depreciation period, the building will be completely “used up” and worth nothing. Therefore, every year, the basis of the building is adjusted downward by the amount of that year’s depreciation deduction.³

Example: Asher purchases a 10 story office building for $390,000.⁴ Because the building is depreciable over 39 years, Asher claims a $10,000 depreciation deduction each year. After nine years, Asher’s original basis is adjusted downward to $300,000 ($390,000 minus $90,000). At that time, if Asher were to sell the building for $400,000, he would have a taxable gain of $100,000 ($400,000 minus $300,000).

Depreciation is a deduction that permits recovery, over a period of time, of capital invested in tangible property used in a trade or business or held for the production of income.¹ It is a deduction taken in arriving at adjusted gross income.²Only property that has a limited useful life may be depreciated. Land does not have a limited life and, therefore, cannot be depreciated. However, the improvements on land can be depreciated. Inventory and stock in trade are not depreciable.³ A taxpayer who purchases a term interest in property cannot amortize or depreciate the cost of the property during any period in which the remainder interest is held by a related person.⁴ On the other hand, life tenants and beneficiaries of estates and trusts may be allowed the regular depreciation deduction if the property is depreciable property.⁵

The method used to determine the rate of depreciation depends on when the property was placed into service. Property is “placed into service” when it is first placed in a condition or state of readiness and availability for a specifically assigned function for use in a trade or business, for the production of income, or in a tax-exempt or personal activity.⁶ See Q 8616 for a discussion of the bonus depreciation rules that apply post-tax reform.

Generally, the Accelerated Cost Recovery System (ACRS) was modified for property placed in service after 1986.¹ If real property is acquired before 1987 and converted from personal use to a depreciable use after 1986, the post-1986 ACRS is to be used.²The ACRS deduction is calculated by applying to the basis of the property either (1) a declining balance method that switches to the straight line method at a time which maximizes the deduction or (2) a straight line method.³ The initial basis in the property is the basis of the property upon acquisition (usually the cost of the property), reduced by the amount, if any, elected for amortization or an IRC Section 179 deduction, and further reduced by any basis reduction required in connection with taking the investment tax credit.⁴ The basis of the property is reduced each year by the amount of the depreciation allowable.⁵ Optional depreciation tables set out in Revenue Procedure 87-57 may be used in place of the methods above.⁶ Because land cannot be depreciated, the cost basis of improved land must be allocated between the land and improvements.⁷ The ACRS deduction is limited in the case of certain automobiles and other “listed property” placed in service after June 18, 1984.

For property used both in an individual’s trade or business (or for the production of income) and in a personal or tax-exempt activity during a taxable year, depreciation is allocated to all uses of the property, and only the portion attributable to the trade or business or production of income use is deductible.⁸

Certain rights that are not acquired in a transaction involving the acquisition of a trade or business are subject to special rules for depreciation. Depreciation deductions for (1) rights to receive tangible property or services under a contract or a government grant; (2) interests in patents or copyrights; or (3) certain contracts of fixed duration or amount, are to be defined in the regulations.⁹ Regulations generally require the amortization of the right to receive property under a contract or government grant by multiplying the basis of the right by a fraction. The numerator of the fraction is the amount of property or services received during the taxable year and the denominator is the total amount to be received under the contract or government grant. For a patent or copyright, the deduction is generally equal to the amount paid during a taxable year if the purchase price is paid on an annual basis as either a fixed amount per use or a fixed percentage of revenue from the patent or copyright, otherwise it is depreciated either ratably over its useful life or by using the income forecast method. The basis of a right to an unspecified amount over a fixed duration of less than 15 years is amortized ratably over the period of the right.¹⁰

In the years in which property is acquired or disposed of, depreciation is limited to the portion of the year in which the property is considered to be held under the following conventions: Residential rental property, nonresidential real property, and railroad grading or tunnel bore are treated as placed in service (or disposed of) on the mid-point of the month in which placed in service (or disposed of). Property, other than such real property, is generally treated as placed in service (or disposed of) on the mid-point of the year in which placed in service.However, the mid-quarter convention (instead of the mid-year convention) applies to depreciable property placed in service during the taxable year if the aggregate bases of property placed in service during the last three months of the taxable year exceeds 40 percent of the aggregate bases of property placed in service (or disposed of) during the taxable year (“the 40 percent test”). “Aggregate bases” is defined as the sum of the depreciable bases of all items of depreciable property taken into account in applying the 40 percent test.

For taxable years ending after January 30, 1991, property not taken into account in applying the test include the following: (1) real property subject to the mid-month convention (described above), and (2) property placed in service and disposed of in the same taxable year. Conversely, property that would be taken into account in applying the 40 percent test includes: (1) listed property placed in service during the taxable year, and (2) property placed in service, disposed of, subsequently reacquired, and again placed in service in the same taxable year (but only the basis of the property on the later of the dates that the property is placed in service is considered).¹ The IRS provided some relief from the mid-quarter convention if a taxpayer’s third or fourth quarter included September 11, 2001.²

Regardless of whether the mid-year convention or the mid-quarter convention applies, no depreciation deduction is available for property placed in service and disposed of in the same year.³

Property subject to the mid-month convention is treated as placed in service (or disposed of) on the mid-point of the month without regard to whether the taxpayer has a short taxable year (i.e., a taxable year that is less than 12 months). The mid-quarter 40 percent test is also made without regard to the length of the taxable year. Thus, if property (with exceptions, as noted in the preceding paragraphs) is placed in service in a taxable year of three months or less, the mid-quarter convention applies regardless of when such property was placed in service (i.e., 100 percent of property has been placed in service in the last three months).⁴

In the case of a short taxable year and with respect to property to which the mid-year or mid-quarter convention applies, the recovery allowance is determined by multiplying the deduction that would have been allowable if the recovery year were not a short taxable year by a fraction. The numerator of this fraction equals the number of months in the short taxable year and the denominator of which is 12.⁵ Proposed regulations under IRC Section 168(f)(5) (as in effect prior to TRA ’86) provided that a taxable year of a person placing property in service did not include any month prior to the month in which the person began engaging in a trade or business or holding recovery property for the production of income.⁶ Presumably, this principle would continue to apply after TRA ’86.

The classification of property by recovery period and depreciation method is as follows:¹

3 years 200% DB*	class life of 4 years or less, certain horses, qualified rent-to-own property
5 years 200% DB*	class life of more than 4 but less than 10 (e.g., heavy trucks, buses, offshore drilling equipment, most computer and data handling equipment, cattle, helicopters and non-commercial aircraft, automobiles and light trucks)
7 years 200% DB*	class life of 10 or more but less than 16 (e.g., most office furnishings, most agricultural machinery and equipment, theme park structures, most railroad machinery, equipment and track, commercial aircraft), motorsports entertainment complexes, Alaska neutral gas pipelines, property without a class life and not otherwise classified under TRA ‘86
10 years 200% DB*	class life of 16 or more but less than 20 (e.g., vessels, barges and similar water transportation equipment, petroleum refining equipment)
15 years 150% DB*	class life of 20 or more but less than 25 (e.g., industrial steam and electric generation/distribution systems, cement manufacturing equipment, commercial water transportation equipment (freight or passenger), nuclear power production plants)
20 years 150% DB*	class life of 25 or more (e.g., certain farm buildings, railroad structures and improvements, telephone central office buildings, gas utility production plants and distribution facilities), but excluding real property with class life of 27.5 years or more
27.5 years straight line	residential rental property
39 years straight line	nonresidential real property (class life of 27.5 years or more)
50 years straight line	railroad grading or tunnel bore
* Declining balance method switching to the straight line method at a time to maximize the deduction. Substitute 150 percent DB for 200% DB if 3-, 5-, 7-, or 10-year property is used in a farming business. An election can be made to use the straight line method instead of the declining balance method. Also, with respect to 3-, 5-, 7-, and 10-year property, an election can be made to use 150 percent DB.

Property is assigned to various class lives in Revenue Procedure 87-56.² These class lives can also be found in IRS Publication 946.

The Tax Reform Act of 1986 assigned certain property to recovery periods without regard to their class life (e.g., automobiles and light trucks). Also, intangible property that is depreciable is subject to special recovery periods. If computer software is depreciable, the deduction is calculated using a straight line method over 36 months.³ Computer software acquired after August 10, 1993 is generally depreciable if it (a) is a program designed to cause a computer to perform a desired function, (but generally not a database) and (b) either (1) is readily available for purchase by the general public, is subject to a nonexclusive license, and has not been substantially modified, or (2) is not acquired in a transaction involving the acquisition of assets constituting a trade or business.⁴ Certain mortgage servicing rights may be depreciated over 108 months using the straight line method.⁵

Instead of using ACRS (see Q 8614), a property owner may elect to use the unit of production method of depreciation (if appropriate) or any other method not expressed in a term of years.¹ For example, under the unit of production method, the depreciation deduction for a machine that, it is estimated, will produce 1,000,000 shoes (units) before wearing out, and that produces 250,000 units in the first year, would be:

(250,000 ÷ 1,000,000) × basis

Editor’s Note: See heading below for a discussion of the changes made by the 2020 CARES Act.Bonus depreciation is essentially an extra amount of depreciation that a taxpayer is entitled to take in the first year that newly acquired qualified property is placed into service (the percentage of bonus depreciation available varies by year, as listed in the schedule below).¹ The IRS has provided procedures on how to claim bonus depreciation (see Q 8619 for special rules that apply post-reform).² Bonus first-year depreciation applies only to qualified property (see Q 8617) and is claimed in the first year that the property is placed in service.

Under the 2017 tax reform legislation, the bonus depreciation allowable depends upon the year the property is placed in service, and is the following percentage of the unadjusted depreciable basis of qualified property:

• Property placed in service after September 27, 2017 and before January 1, 2023: 100 percent expensing.
• Property placed in service after December 31, 2022 and before January 1, 2024: 80 percent expensing.
• Property placed in service after December 31, 2023 and before January 1, 2025: 60 percent expensing.
• Property placed in service after December 31, 2024 and before January 1, 2026: 40 percent expensing.
• Property placed in service after December 31, 2025 and before January 1, 2027: 20 percent expensing.
• 2027 and thereafter: 0 percent expensing.³

For certain property with longer production periods, the modified schedule that applies under the 2017 tax reform legislation is as follows:

• Property placed in service after September 27, 2017 and before January 1, 2024: 100 percent expensing.
• Property placed in service after December 31, 2023 and before January 1, 2025: 80 percent expensing.
• Property placed in service after December 31, 2024 and before January 1, 2026: 60 percent expensing.
• Property placed in service after December 31, 2025 and before January 1, 2027: 40 percent expensing.
• Property placed in service after December 31, 2026 and before January 1, 2028: 20 percent expensing.
• 2028 and thereafter: 0 percent expensing.⁴

Under a transition rule, a business was entitled to elect to apply a 50 percent depreciation allowance instead of the 100 percent allowance for the taxpayer’s first tax year ending after September 27, 2017 (see Q 8619 for more information on making this election).⁵

The 2020 CARES Act

The CARES Act provided retroactive relief for many business owners, including fixing the so-called “retail glitch” to allow businesses to take advantage of 100 percent bonus depreciation on qualified improvement property through 2022. The CARES Act retroactively reduced the recovery period for qualified improvement property placed in service after 2017 from 39 years to 15 years. Eligible taxpayers may be entitled to a refund. Corporate taxpayers should also examine the interaction between the depreciation relief and the CARES Act NOL carryback relief (see Q 8013 and Q 8014).

The IRS has provided guidance on how to make, revoke or withdraw elections relating to the CARES Act bonus depreciation rule changes. Because of the administrative burden of filing amended returns and AARs, the IRS will treat late or revocable elections for property placed in service by taxpayers during their 2018, 2019, or 2020 taxable years, as a change in method of accounting with a Section 481(a) adjustment for a limited period of time. As a result, taxpayers can generally make, revoke or withdraw elections with respect to bonus depreciation by filing an amended tax return, AAR or Form 3115 (with the taxpayer’s federal income tax return or Form 1065). The action is essentially treated as changing from an impermissible method of determining depreciation to a permissible method. Returns or forms were generally required to be filed by October 15, 2021. This amended return or AAR must include the adjustment to taxable income for the change in determining depreciation of the qualified improvement property and any collateral adjustments to taxable income or to tax liability.

These election methods do not apply to certain farming businesses or electing real property businesses, who must make elections under the procedures in Revenue Procedure 2020-22. Partnerships subject to the partnership audit rules use the procedures in Revenue Procedure 2020-23.

Revenue Procedure 2020-23 provides relief so that partnerships subject to the new partnership audit rules can also now file amended returns, rather than waiting to file current year returns to claim the benefits. Preexisting law may have prevented partnerships from filing amended Forms 1065 and Schedules K-1. Partnerships may file amended returns and issue revised Schedules K-1 for 2018 and 2019 to take advantage of retroactive CARES Act bonus depreciation relief.

The Revenue Procedure 2020-23 relief applies for 2018 and 2019 as long as the original Forms 1065 and Schedules K-1 were filed/issued before April 13, 2020 (the date Rev. Proc. 2020-23 was released). Partnerships can file amended Form 1065 and Schedule K-1 (electronically or by mail), by checking the Form 1065 “amended return” box and writing “FILED PURSUANT TO REV PROC 2020-23” at the top. The same notation must be included in a statement attached to amended Schedules K-1 sent to partners. The amended returns had to be filed/furnished to partners by September 30, 2020.

Editor’s Note: The CARES Act provided retroactive relief for many business owners, including fixing the so-called “retail glitch” to allow businesses to take advantage of 100 percent bonus depreciation on qualified improvement property through 2022. The CARES Act retroactively reduced the recovery period for qualified improvement property placed in service after 2017 from 39 years to 15 years. Eligible taxpayers may be entitled to a refund. See Q 8616 for more detailed information.For purposes of IRC Section 168(k) bonus depreciation rules, qualified property generally includes property where the original use began with the taxpayer (see Q 8620 and Q 8621 for the rules governing used and leased property). The depreciable property must have also been acquired by the taxpayer after September 27, 2017 for the new bonus depreciation schedules to apply.

The general classes of qualified property eligible for bonus depreciation that are enumerated in the statute include:

1. Property to which Section 168 applies that has a recovery period of 20 years or less,
2. Certain computer software defined in IRC Section 167(f)(1)(B)—software for which a deduction is allowed under IRC Section 167(a) without regard to Section 168(k),
3. Water utility property,
4. Certain qualified film or TV production property under Section 181(d) and qualified live theatrical productions defined under IRC Section 181(e).¹ In this case, the owner of the qualified film, TV or theatrical production is the only taxpayer entitled to the deduction and that owner must be the taxpayer placing the property in service.²

The 2017 tax reform law eliminated qualified improvement property from the category of “qualified property” even though the relevant recovery period is generally 15 years for this property (the new rule applies for property placed into service after 2017). However, see Q 8164 for a discussion of the so-called “retail glitch” fix.The 2017 tax reform legislation also removed qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property from the class of property that qualifies for bonus depreciation.¹ The preamble to the final regulations governing these changes, released in September of 2019, clarifies that a legislative change would be necessary to include these classes of property among the types of property that qualify for bonus depreciation.² That change was included in the 2020 CARES Act, fixing the “retail glitch”.

Property that must be depreciated under the alternative depreciation system (ADS) is also not qualified property for bonus depreciation purposes. However, under the final regulations, simply using ADS to determine the adjusted basis of the taxpayer’s assets for certain business interest allocation purposes does not render the property ineligible.³

Businesses with floor plan financing indebtedness are generally unable to take advantage of the bonus depreciation rules. However, the 2019 proposed regulations provide that the determination of whether a trade or business has floor plan financing is to be made on an annual basis.⁴ Further, whether floor plan financing is relevant also interacts with the rules governing the business interest deduction. Generally, floor plan financing interest is not taken into account for the taxable year by a trade or business that has had floor plan financing indebtedness if the sum of the amounts calculated under IRC Section 163(j)(1)(A) and (B)⁵ for the trade or business for the taxable year equals or exceeds the business interest, as defined in Section 163(j)(5), for the taxable year.⁶

Under the 2019 regulations, the mere fact that a business leases property to a disqualified business does not “taint” the property, meaning that such exclusion from the additional first year depreciation deduction does not apply to lessors of property to a trade or business described in IRC Section 168(k)(9) so long as the lessor is not described the section (i.e., unless the lessor is somehow excluded from taking bonus depreciation because of the floor plan financing issue, character of the property, etc.).⁷

Yes. Some taxpayers expressed concern that the tax reform legislation’s changes to the bonus depreciation rules came too late for taxpayers to make the relevant elections on their 2016 or 2017 tax returns. In response, the IRS released guidance permitting taxpayers to revoke an election, or make a late election, for bonus depreciation with respect to certain property acquired by the taxpayer after September 27, 2017 and placed into service (or planted) during the tax year that included September 28, 2017.For taxpayers who filed their 2016 or 2017 returns on time, and claimed additional 100-percent bonus depreciation for property acquired after September 27, 2017 and placed in service during 2016 or 2017 tax years, the taxpayer could (1) file an amended return changing (to revoke or make a late election) the election before the taxpayer filed its federal tax return for the first taxable year succeeding the 2016 taxable year or the 2017 taxable year or (2) file a Form 3115 with the taxpayer’s federal tax return for the first, second, or third taxable year succeeding the 2016 taxable year or the 2017 taxable year.

Taxpayers who wished to make the election to deduct 50-percent, rather than 100-percent, bonus depreciation, could change their election by filing an amended return or Form 3115 within the same time frames.¹ However, the preamble to the 2019 regulations makes clear that taxpayers cannot use the 50-percent election for some property and the 100-percent election for other property—the election, in other words, is all or nothing.

The bonus depreciation rules may be applied to used property if the property was not used by the taxpayer (or a predecessor) prior to the acquisition. The property is considered to have been used by the taxpayer or a predecessor prior to the acquisition if the taxpayer or predecessor had a depreciable interest in the property at any time prior to the acquisition, regardless of whether depreciation deductions were actually claimed.Under the 2019 final regulations, “predecessor” is defined to include:

1. a transferor of an asset to a transferee in a transaction to which IRC Section 381(a) applies;
2. a transferor of an asset to a transferee in a transaction in which the transferee’s basis in the asset is determined, in whole or in part, by reference to the basis of the asset in the hands of the transferor;
3. a partnership that is considered as continuing under IRC Section 708(b)(2);
4. the decedent in the case of an asset acquired by an estate; or
5. a transferor of an asset to a trust.¹

Additionally, see Q 8621 for a discussion of the 90-day safe harbor exception finalized in 2020 and see below for a discussion of the five-year “lookback” window provided in the final regulations.²

In addition, all of the following must be true:

1. the property was not acquired from certain related parties;
2. the property was not acquired by one member of a controlled group from another member of that group;
3. the property was acquired by purchase, within the meaning of IRC Section 179;
4. the basis of the property in the hands of the person acquiring it is not determined in whole or part by reference to the adjusted basis of the property in the hands of the person from whom it was acquired or under IRC Section 1014(a) (basis of property acquired from a decedent);
5. the cost of the property does not include the basis of the property as determined by reference to the basis of other property held by the taxpayer.³

The “related parties” mentioned in (1) above are defined as:

• the taxpayer’s spouse, ancestors and descendants,
• an individual and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the individual,
• a grantor and a fiduciary of any trust,
• a fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts,
• a fiduciary and a beneficiary of a trust,
• a fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts,
• a fiduciary of a trust and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust,
• a person and an organization to which IRC Section 501 (relating to certain educational and charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual,
• a corporation and a partnership if the same person owns more than 50 percent of the outstanding stock in the corporation or capital interest or profits of the partnership,
• an S corporation and another S corporation if the same person owns more than 50 percent of the outstanding stock of each corporation,
• an S corporation and a C corporation, if the same persons own more than 50 percent in value of the outstanding stock of each corporation,
• the executor and beneficiary of an estate,
• two partnerships in which the same person owns more than 50 percent of the capital interests and profits or
• a partnership and a person owning more than 50 percent of the capital interests and profits of the partnership.

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Planning Point: The 2020 final regulations contain a general anti-abuse rule that will apply to determine related party status. The rules provide that in a series of related transactions, the property is treated as though it was transferred directly from its original owner to its ultimate owner. The relationship between the original owner and the ultimate owner is tested immediately after the last transfer in the series of transactions. See below for more details.

Under the 2019 proposed regulations, the IRS amended the pre-existing rule to provide that a party in the series who is neither the original transferor nor the ultimate transferee is disregarded in applying the relatedness test if the party placed in service and disposed of the property in the party’s same taxable year or did not place the property in service. ⁴

The final regulations also provide a “lookback” period of five calendar years immediately prior to the taxpayer’s current placed-in-service year of the property. The 2020 final regulations clarify that the portion of the calendar year covering the period up to the placed-in service date is also included. If the taxpayer and a predecessor have not been in existence for five years, only the number of calendar years the taxpayer and the predecessor have been in existence is taken into account.

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Series of Related Transaction Rules

The final regulations provide guidance on testing for related-party status when a series of transactions is at issue. Generally, the relationship between the parties must be tested immediately after each step in the transaction. The relationship between the original and ultimate parties must be tested after the final transaction. Under the 2020 final regulations, each transferee must test its relationship with (1) the transferor from which the transferee acquires the property and (2) the original transferor. If the transferee is related to either its immediate transferor or the original transferor, then the transferee would be ineligible for bonus depreciation even if the property was otherwise qualified.

If a party in a series of related transactions ceases to exist prior to the completion of the series of transactions, that party is deemed to still exist for purposes of testing related party status. The final regulations also provide that if a transferor comes into existence during a series of transactions, that transferor must test its relatedness with the original transferor. In other words, each transferee must test for related party status with its immediate transferor and with the original transferor. This is true regardless of whether it is formed or dissolved during the series of transactions.

In order to claim bonus depreciation with respect to used property, the property must not be used by the taxpayer or a predecessor at any time before the taxpayer acquired the property (see Q 8620). This requirement raised questions as to whether bonus depreciation could be available with respect to property that the taxpayer previously leased, or in which the taxpayer previously held an interest but did not own entirely.Under a complicated set of regulations introduced between 2018 and 2020, bonus depreciation may now be available for property that a taxpayer previously leased and later acquired. In some situations, a taxpayer may make improvements to property that is leased and obtain a depreciable interest in the property as a result. If the taxpayer later acquires the property, bonus depreciation is unavailable with respect to the portion of the property in which the taxpayer held a depreciable interest during the lease period.¹

Relatedly, if a taxpayer originally held a depreciable interest in property, and later acquires an additional depreciable interest in an additional portion of the same property, the additional depreciable interest is not treated as though it was used by the taxpayer prior to acquisition (i.e., it is eligible for bonus depreciation under the used property rules if all other requirements are satisfied). If the taxpayer previously had a depreciable interest in the subsequently acquired additional portion, bonus depreciation is not available.

A different rule applies in situations where a taxpayer sells a partial interest in property and later buys a partial interest in the same property. If a taxpayer holds a depreciable interest in a portion of the property, sells that portion or a part of that portion, and later acquires a depreciable interest in another portion of the same property, the taxpayer is treated as previously having a depreciable interest in the property up to the amount of the portion for which the taxpayer held a depreciable interest in the property before the sale.²

Short Holding Period Exception

The 2020 final regulations provide a safe harbor exception to the depreciable interest rule—so that the taxpayer is not considered to have had a depreciable interest in the property-in situations where the taxpayer disposes of the property within a short period of time after placing the property in service. If the following are true:

(a)     a taxpayer acquires and places in service property,

(b)     the taxpayer or a predecessor did not previously have a depreciable interest in the property,

(c)     the taxpayer disposes of the property to an unrelated party within 90 calendar days after the date the property was originally placed in service by the taxpayer (without taking into account the applicable convention), and

(d)     the taxpayer reacquires and again places in service the property,

the taxpayer’s depreciable interest in the property during that 90-day period is not taken into account for determining whether the property was used by the taxpayer or a predecessor at any time prior to its reacquisition by the taxpayer.³ The rule does not apply if the taxpayer reacquires and again places in service the property during the same taxable year the taxpayer disposed of the property.

The 2019 proposed bonus depreciation regulations provided a “look-through” rule under which a partner was considered to have a depreciable interest in a portion of property equal to the partner’s total share of depreciation deductions during the current calendar year and previous five calendar years. This rule limited bonus depreciation in many situations involving partnerships transactions.

The 2020 final regulations rescinded this rule because of administrative and compliance burdens both for taxpayers and the IRS. Under the new rules, partners are not treated as having a prior depreciable interest in property solely because of membership in a partnership. Rather than simply replacing the rule, the IRS pointed to the series of related transaction rules that apply to prevent abuse. See Q 8620 for more details on the related party rules.

The proposed bonus depreciation regulations clarify when bonus depreciation will be available in the context of a partnership buyout. Availability under the regulations depends upon whether the partnership itself buys out the departing partner in a redemption-type buyout, or whether the individual partners buy out the partner in a cross-purchase type buyout.If the partnership redeems the departing partner’s interest in partnership assets at a premium, so that the basis in the relevant assets increases, bonus depreciation is not available. This is because the IRS views a redemption-type buyout as a transaction in which the partnership previously had an interest in the assets in question, rendering the assets ineligible for used asset treatment under Section 168(k).

If the individual partners buy out the departing partner at a premium, resulting in an increase in basis, the “step up” in basis is eligible for bonus depreciation. This is because the IRS views each partner as owning a separate and divided interest in the partnership property owned by the partnership, so that one partner does not have a previously existing interest in another partner’s share of partnership assets.¹

In situations where a partnership distributes property to a partner, other than in a liquidation of the partner’s interest, the partner’s basis in the property is determined based upon the adjusted basis to the partnership immediately before the distribution.² If property is distributed upon liquidation of the partner’s interest in the partnership, the basis of the property is equal to the adjusted basis of the partner’s interest in the partnership, reduced by any money received in the transaction.³ In these situations, the property is not eligible for bonus depreciation in the hands of the receiving partner.⁴

Each year, an individual’s basis is reduced by the amount of the depreciation deduction taken so that his adjusted basis in the property reflects accumulated depreciation deductions. If depreciation is not deducted, his basis must nonetheless be reduced by the amount of depreciation allowable, but the deduction may not be taken in a subsequent year.¹

Recapture

Upon disposition of property, the seller often realizes more than return of basis after it has been reduced for depreciation. Legislative policy is that on certain dispositions of depreciated property the seller realizes a gain that is, at least in part, attributable to depreciation. To prevent a double benefit, the IRC requires that some of the gain that would otherwise generally be capital gain must be treated as ordinary income. In effect, it requires the seller to “recapture” some of the ordinary income earlier offset by the depreciation.² In addition, if depreciated property ceases to be used predominantly in a trade or business before the end of its recovery period, the owner must recapture in the tax year of cessation any benefit derived from expensing such property.³

Whether a capital gain or loss is long-term or short-term is determined by how long the taxpayer owned the property in question. Generally, a capital gain or loss is long-term if the property giving rise to the gain or loss was owned for more than one year and short-term if the property was owned for one year or less.¹To determine how long a taxpayer has owned property (i.e., the “holding period”), the taxpayer must begin counting on the day after the property is acquired. For these purposes, the same date in each successive month is considered to be the first day of a new month. The date on which the property is disposed of is included (i.e., counted) in the holding period.²

If property is acquired on the last day of the month, the holding period begins on the first day of the following month. Therefore, if it is sold prior to the first day of the 13th month following the acquisition, the gain or loss will be short-term.³ According to IRS Publication 544 (published in November 1982), if property is acquired near the end of the month and the holding period begins on a date that does not occur in every month (e.g., the 29th, 30th, or 31st), the last day of each month that lacks that date is considered to begin a new month (however, later editions of Publication 544 have omitted this statement).

Example 1: Mrs. Murphy bought a capital asset on January 1, 2024. She would begin counting on January 2, 2024. The 2nd day of each successive month would begin a new month. If Mrs. Murphy sold the asset on January 1, 2025, her holding period would not be more than one year. To have a long-term capital gain or loss she would have to sell the asset on or after January 2, 2025.

Example 2: Mrs. Tate bought a capital asset on January 30, 2024. She would begin counting on January 31, 2024. Since February does not have 31 days, Mrs. Tate will start a new month on February 28. In months that have only 30 days, the 30th will begin a new month.

In some cases, such as when property is received as a gift or in a like-kind exchange, the IRC allows for the “tacking” of a holding period meaning that the holding period of a previous owner of the property carries over to the new owner or the holding period of an asset exchanged for another carries over to the exchanged property.⁴

Example: Abe buys 500 shares of XYZ Corp. stock for $7,500, on December 4, 2023. On September 20, 2024, Abe transfers the stock to his daughter, Diana, as a gift. On December 20, 2024, Diana sells the stock for $9,000. Even though Diana actually owned the stock for more than a year, by application of the “tacking” rule, the holding period begins on December 4, 2023, the date the stock was purchased by Abe. Additionally, Diana assumes Abe’s $7,500 basis in the stock. Upon sale, Diana has a $1,500 long-term capital gain ($9,000 minus $7,500).

Whether capital gain or loss on a short sale is long-term or short-term will ordinarily be determined by the seller’s holding period in the stock used to close the sale.¹ For most purposes, the capital gain or loss is long-term if the holding period is more than one year. If the holding period is one year or less, the gain is short-term. (See Q 8625 for a detailed discussion of the holding period requirement.)In a “short sale,” a seller agrees to sell stock to another at a fixed price on a future date. If the future date is more than a year from the date the taxpayer acquired the stock, he or she would be able to convert short-term capital gain (taxed at ordinary tax rates, i.e., up to 37 percent) to long-term capital gain (i.e., with rates of 0 percent, 15 percent or 20 percent). IRC Sections 1233 and 1259 are designed to prevent such abuse.

Example: On March 1, 2023, Asher acquires stock for $200. On September 1, the fair market value of the stock is $300. To lock in the appreciation, Asher enters a short sale to close on April 1, 2024. Without IRC Sections 1233 and 1259, Asher would effectively convert a short-term holding period into a long-term holding period; and, thus, recognize long-term capital gain.

To prevent individuals from using short sales to convert short-term gains to long-term gains or long-term losses to short-term losses, and to prevent the creation of artificial losses, the IRC and regulations provide special rules as follows:

(1)     If on the date the short sale is closed (see below), any “substantially identical property” has been held by the seller for a period of one year or less, any gain realized on property used to close the sale will, to the extent of the quantity of such substantially identical property, be short-term capital gain.² This is true even though the stock actually used to close the short sale has been held by the seller for more than one year. This rule does not apply to losses realized on the property used to close the sale;

(2)     If any substantially identical property is acquired by the seller after the short sale and on or before the date the sale is closed, any gain realized on property used to close the sale will, to the extent of the quantity of such substantially identical property, be short-term capital gain.³ This is true regardless of how long the substantially identical property has been held, how long the stock used to close the short sale has been held, and how much time has elapsed between the short sale and the date the sale is closed. This rule does not apply to losses realized on the property used to close the sale;

(3)     The holding period of any substantially identical property held one year or less, or acquired after the short sale and on or before the date the short sale is closed will, to the extent of the quantity of stock sold short, be deemed to have begun on the date the sale is closed or the date such property is sold or otherwise disposed of, whichever is earlier. If the quantity of such substantially identical property held for one year or less or so acquired exceeds the quantity of stock sold short, the “renewed” holding period will normally be applied to individual units of such property in the order in which they were acquired (beginning with earliest acquisition), but only to so much of the property as does not exceed the quantity sold short. Any excess retains its original holding period.⁴ Where the short sale is entered into as part of an arbitrage operation in stocks or securities, this order of application is altered so that the “renewed” holding period will be applied first to substantially identical property acquired for arbitrage operations and held at the close of business on the day of the short sale and then in the order of acquisition as described in the previous sentence. The holding period of substantially identical property not acquired for arbitrage operations will be affected only to the extent that the quantity sold short exceeds the amount of substantially identical property acquired for arbitrage operations;⁵

(4)     If on the date of a short sale any substantially identical property has been held by the seller for more than one year, any loss realized on property used to close the sale will, to the extent of the quantity of such substantially identical property, be long-term capital loss.⁶ This is true even though the stock actually used to close the short sale has been held by the seller for a year or less. This rule does not apply to gains realized on the property used to close the sale.

If an individual sells property at a loss to a related person (as defined below), that loss is disallowed and may not be used to offset capital gains for income tax purposes.¹ It makes no difference that the sale was a bona fide, arm’s-length transaction.² Neither does it matter that the sale was made indirectly through an unrelated middleman.³ The loss on the sale of stock will be disallowed even though the sale and purchase are made separately on a stock exchange and the stock certificates received are not the certificates sold.⁴ However, these rules will not apply to any loss of the distributing corporation (or the distributee) in the case of a distribution in complete liquidation.⁵A loss realized on the exchange of properties between related persons will also be disallowed under these rules.⁶

“Related persons” for this purpose includes the following:

(1)     members of the same family (i.e., brothers, sisters, spouses, ancestors, and lineal descendants (but not if they are in-laws));⁷

(2)     an individual and a corporation of which the individual actually or constructively owns more than 50 percent of the stock;

Example: Amy owns a parcel of land with a fair market value of $50,000. Amy’s basis in the land is $100,000. Amy sells the land to a corporation wholly owned by her brother, Asher. Although Asher owns no stock of the corporation, through the attribution rules, a taxpayer is deemed to constructively own all the stock owned by his brother.⁸ For that reason, the $50,000 loss would be disallowed.

(3)     a grantor and a fiduciary of a trust. The relationship between a grantor and fiduciary did not prevent recognition of loss on a sale of stock between them where the fiduciary purchased the stock in his individual capacity and where the sale was unrelated to the grantor-fiduciary relationship;⁹

(4)     fiduciaries of two trusts if the same person is the grantor of both;

(5)     a fiduciary and a beneficiary of the same trust;

(6)     a fiduciary of a trust and a beneficiary of another trust set up by the same grantor;

(7)     a fiduciary of a trust and a corporation of which the trust or the grantor of the trust actually or constructively owns more than 50 percent of the stock;

(8)     a person and an IRC Section 501 tax-exempt organization controlled by the person or members of his family (as described in (1) above);

(9)     a corporation and a partnership if the same person actually or constructively owns more than 50 percent of the stock of the corporation, and has more than a 50 percent interest in the partnership;

(10)   two S corporations if the same persons actually or constructively own more than 50 percent of the stock of each;

(11)   an S corporation and a C corporation, if the same persons actually or constructively own more than 50 percent of the stock of each;

(12)   generally, an executor and a beneficiary of an estate; or

(13)   possibly an individual and an individual retirement account (IRA).¹⁰

Special rules apply for purposes of determining constructive ownership of stock.¹¹

Generally, loss will be disallowed on a sale between a partnership and a partner who owns more than a 50 percent interest, or between two partnerships if the same persons own more than a 50 percent interest in each.¹² Furthermore, with respect to transactions between two partnerships having one or more common partners or in which one or more of the partners in each partnership are related, a portion of the loss will be disallowed according to the relative interests of the partners.¹³ If the transaction is between a partnership and an individual who is related to one of the partners, any deductions for losses will be denied with respect to the related partner’s distributive share, but not with respect to the relative shares of each unrelated partner.¹⁴ Loss on a sale or exchange (other than of inventory) between two corporations that are members of the same controlled group (using a 50 percent test instead of 80 percent) is generally not denied but is deferred until the property is transferred outside the controlled group.¹⁵

If the related person to whom property was originally sold (or exchanged), sells or exchanges the same property (or property whose tax basis is determined by reference to such property) at a gain, the gain will be recognized only to the extent it exceeds the loss originally denied by reason of the related parties rules.¹⁶

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Planning Point: If one family member is considering selling a closely held business to another at a loss, there are probably better ways to achieve tax savings than for the seller to give up a tax loss. A related party buyer might pay a little more for a business than a non-related party. The goodwill may be justifiably higher because of the relationship, the customer base or the reputation, among other reasons. The seller can realize tax savings through the deal structure; the buyer can realize savings by depreciation and amortization.

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Redemption of a debt obligation can result in recognition of gain or loss in situations where the obligation was acquired at a premium or discount. The relevant issue for determining whether the retirement or satisfaction of the debt can result in a capital gain or loss is whether a sale or exchange has taken place. Historically, cases dealing with the subject have found that no sale or exchange takes place when the maker of a debt satisfies the obligations under the debt instrument.¹ IRC Section 1271 was enacted to change this result in many situations involving the redemption of debt obligations.Under Section 1271, amounts received by the holder when the debt instrument is redeemed are treated as having been received in an exchange.² Because of this, gain or loss realized upon redemption can qualify for capital gains treatment.

However, some debt instruments contain “original issue discount” which is a type of interest. These include debt instruments in which the maturity price exceeds the purchase price. The difference is the interest component.

Example: Asher purchases an original issue discount debt for $1,000 that matures two years later for $1,250. The difference between the maturity amount and the purchase amount, $250, is essentially interest.

Original issue discount interest is reportable as ordinary income. Such ordinary income may be realized, however, in some transactions where there was an intention to call the obligation before maturity at the time the obligation was originally issued.³ If this is the case, any gain realized in the transaction must be treated as ordinary income to the extent that the amount of gain does not exceed the sum of (a) the original issue discount, reduced by (b) the portion of original issue discount previously included in the gross income of any holder of the obligation.⁴

The requirement that ordinary income be recognized does not apply to certain tax-exempt obligations and to holders who purchased the debt instrument at a premium.⁵

The sale or exchange of an option to purchase property may result in capital gain if the underlying property subject to the option is a capital asset. Similarly, losses arising from the taxpayer’s failure to exercise the option may be treated as capital losses if the underlying property is a capital asset.¹

Example: Brenda is considering an investment in real property, but, because the purchase price is high, she purchases an option to buy the property for $5,000 within the next two years. The option is a capital asset because if Brenda had purchased the property outright it would have been a capital asset. Eleven months later, Brenda sells the option for $6,000. The $1,000 gain ($6,000 selling price minus $5,000 basis) is a short-term capital gain because Brenda held the option for less than one year.

Similarly, if the taxpayer fails to exercise the option, the option is treated as though it was sold or exchanged on the day the option expired for no consideration. Based on the taxpayer’s holding period, the loss will be either long-term or short-term capital loss.²

In a Tax Court decision, the Tax Court held that a taxpayer was entitled to an ordinary loss deduction, rather than recognition of a capital loss, when the taxpayer abandoned an option to purchase certain real property. Because the taxpayer was in the business of purchasing and developing real property, the underlying real property was not a “capital asset.” For that reason, the loss realized by the taxpayer when he abandoned his option was treated as an ordinary loss rather than a capital loss.³

IRC Section 1234 provides special rules with regard to options to buy or sell stock, securities or commodities. Specifically, IRC Section 1234(b) provides short-term capital gain or loss treatment for the grantor of an option as follows:

• The option lapses or is terminated in a closing transaction.
• The underlying property is stock, securities, commodities or commodities futures.
• The option is not issued in the ordinary course of the grantors trade or business.

A “closing transaction” is defined as any transaction that terminates the taxpayer’s obligations under the option other than an exercise or lapse of the option.⁴

See Q 8604 for a discussion of what constitutes a capital asset for purposes of capital gains treatment.

Editor’s Note The 2017 tax reform legislation provides that gain or loss from the disposition of a self-created patent, invention, model or design, or secret formula or process will be taxed as ordinary income or loss for tax years beginning after 2017. The election to treat musical compositions and copyrights in music as capital assets was not changed.¹Unlike typical asset sales, if the sale or exchange of a patent meets certain requirements, the sale will automatically qualify for long-term capital gains treatment regardless of the transferor’s holding period and whether or not the patent would have been classified as a capital asset in the hands of the holder who transfers the patent.²

Sale of a patent will qualify for long-term capital gains treatment if the holder of the patent transfers either “all substantial rights” in the patent or an undivided interest in the patent.

The phrase “all substantial rights” is defined in the regulations to mean all rights in the patent that have value at the time the rights to the patent are transferred, whether or not the holder of the patent is the owner of those rights.³ The holder does not transfer all substantial rights in the patent if the rights to the patent are:

(1)     limited geographically within the country;

(2)     confined to a period of time that is less than the entire remaining life of the patent;

(3)     limited to a grant of rights, in fields of use within trades or industries, which are less than all the rights covered by the patent that exist and have value at the time of the transfer; or

(4)     limited to a grant of rights that does not give the transferee rights to all the claims and inventions covered by the patent that exist and have value at the time of sale.⁴

Conversely, the holder does not lose long-term capital gain treatment by retaining rights that are not considered substantial. The regulations provide that, depending upon all of the facts and circumstances of the transaction as a whole, the holder may retain the right to prohibit sub-licensing or sub-assignment by the transferee and may also fail to convey the right to use or sell the property that is the subject of the patent.⁵

The holder transfers an “undivided interest” in a patent when the holder transfers the same fractional share of every substantial right in the patent. A sale of the right to income from a patent, for example, does not constitute the sale of an undivided interest in the patent.⁶

This treatment is not available to all patent holders, however. The term “holder” is defined in IRC Section 1235 to include only (1) the original inventor of the property subject to the patent and (2) an individual who obtained his rights in the patent in exchange for money or other property before the property subject to the patent was actually put to use if that individual is neither (i) the inventor’s employer or (ii) related to the inventor.⁷

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Planning Point: Due to the limited definition of “holder” under the patent laws, if an employer maintains the rights to patents on property invented by its employees, the employer will not be eligible for this special capital gains treatment upon sale of the patent.

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The complex rules applicable to capital gains taxation essentially establish four different types of capital assets. These groups of capital assets are:

(1)     short-term capital assets, with no special tax rate;

(2)     28 percent capital assets, generally consisting of collectibles gain or loss, and IRC Section 1202 gain;

(3)     25 percent capital assets, consisting of assets that generate unrecaptured IRC Section 1250 gain; and

(4)     all other long-term capital assets, which are taxed according to the taxpayer’s taxable income at 20 percent, 15 percent, or 0 percent.

Within each group, gains and losses must be netted. Generally, if, as a result of this process, there is a net loss from asset-group “(1),” it is applied to reduce any net gain from groups “(2),” “(3),” or “(4),” in that order. If there is a net loss from group “(2),” it is applied to reduce any net gain from groups “(3)” or “(4),” in that order. If there is a net loss from group “(4),” it is applied to reduce any net gain from groups “(2)” or “(3),” in that order.¹

If net capital losses result from the netting process described above, up to $3,000 ($1,500 in the case of married individuals filing separately) of losses can be deducted against ordinary income.² Any losses that are deducted would be treated as reducing net loss from groups “(1),” “(2),” or “(4),” in that order.

If there are net gains, such gains would generally be taxed as described above and discussed in Q 8605 and Q 8606.

If the taxpayer has capital gains and capital losses from investment property as well as gains and losses from Section 1231 business property (depreciable property used in a trade or business and held for more than one year), the latter gains and losses are netted against each other. If the netting results in a net gain, the gain is treated as if it were a long-term capital gain and included in the netting process for capital gains in group (4). On the other hand, if the netting results in a net loss from Section 1231 assets, this net loss is fully deductible as an ordinary loss and not subject to capital gain and loss netting.

Example: Claire, an attorney, sold 500 shares of stock, recognizing a $1,500 long-term capital gain and 200 shares of stock recognizing a $300 short-term capital gain. In the same year she sold an oriental rug used in her home for the past 5 years at a loss of $700 and a rental property, owned for 9 months, for a short-term capital loss of $5,000. From her office she sold a computer system (a Section 1231 asset) at a loss of $1,200 and a set of law books (a Section 1231 asset) at a gain of $200. Both of these had been used in her practice for more than one year.

Claire’s various gains and losses (“G/L”) must first be grouped according to the following column headings and a net total computed for each group:

	Long-Term Capital G/L	Short-Term Capital G/L	IRC 1231 Business Assets
500 shares of stock	1,500
200 shares of stock		300
oriental rug *	—	—	—
rental property		(5,000)
computer			(1,200)
law books			200
Net totals	1,500	(4,700)	(1,000)
* No loss deduction is allowed for the oriental rug since it was held for personal use.3

Because the netting of the Section 1231 assets resulted in a net $1,000 loss, it is treated as a fully deductible ordinary loss and not subject to further netting. Netting short-term capital gain against short-term capital loss results in a net short-term capital loss of $4,700. That amount is netted against Claire’s net long-term gain of $1,500, resulting in a net short-term loss of $3,200. Only $3,000 worth of capital losses in excess of capital gains are deductible in any single tax year. The remaining $200 capital loss is carried forward to subsequent tax years subject to the same rules.

Although as discussed in Q 8631 above, like long-term capital gain, short-term capital gain is netted against capital losses, net short-term capital gain is <em>not </em>subject to the preferential capital gains rates. Instead, such gain is taxed as ordinary income (up to 37 percent).

Unlike ordinary losses that are deductible against any type of income (ordinary or capital), capital losses are deductible against capital gains (long and short-term). However, a noncorporate taxpayer who has capital losses in excess of capital gains is entitled to deduct from ordinary income the lesser of (a) $3,000 ($1,500 for married taxpayers filing separately) or (b) the excess of the taxpayer’s net capital losses over gains.¹ Any nondeductible losses may be carried forward indefinitely to subsequent tax years. Losses that are carried forward retain their character as either short-term or long-term in future years.Conversely, corporations are only permitted to recognize capital losses to the extent of capital gains with no exception.² However, unlike noncorporate taxpayers who must carry forward nondeductible losses to subsequent tax years, corporations may carry disallowed capital losses back for three tax years (beginning with the earliest of the three) with any remaining nondeductible capital losses to be carried forward for five successive tax years (beginning with the earliest of the five).³

New boxes have been added to Form 1099-DIV to allow for the reporting of qualified dividends (Box 1b) and post-May 5, 2003 capital gain distributions (Box 2b). Likewise, new boxes have also been added to Form 1099-B for reporting post-May 5, 2003 profits or losses from regulated futures or currency contracts.¹ Payments made in lieu of dividends (“substitute payments”) are not eligible for the lower rates applicable to qualified dividends.