TCP Area IV: Property Transactions

Basis of property §1012 / §1014 / §1015

Basis is the taxpayer's investment in property for tax purposes. It is the starting point for measuring gain or loss on a later disposition, and it drives depreciation deductions. How basis is determined depends on how the property was acquired: by purchase, by gift, or by inheritance.

Cost basis (§1012)

Property acquired by purchase takes a cost basis equal to the cash paid plus the FMV of any property given up plus liabilities assumed or taken subject to. Cost basis also includes acquisition costs that are capitalized, such as sales tax, freight, installation, legal fees, title insurance, and recording fees.

Basis adjustments

After acquisition, basis is adjusted up and down over the holding period to arrive at adjusted basis:

• Increase basis for capital improvements, additions, and certain legal costs that add to value or extend useful life.
• Decrease basis for depreciation, amortization, depletion, casualty loss deductions, and tax-free returns of capital.

Adjusted basis = original basis + improvements − accumulated depreciation (and other downward adjustments).

Gifted property: the dual-basis rule (§1015)

The donee generally takes the donor's basis (carryover or "transferred" basis), but a special rule prevents shifting a built-in loss to the donee. The basis used depends on the FMV at the date of the gift and on the later selling price:

• Basis for gain: the donor's carryover (adjusted) basis. Use this when the donee later sells above the carryover basis.
• Basis for loss: the lesser of the donor's carryover basis or the FMV at the date of gift. Use this only when the donee sells below that FMV.
• The "no gain, no loss" middle range: if the donee sells at a price between the FMV at the date of gift and the carryover basis, there is no recognized gain and no recognized loss.

The dual-basis (loss) limitation applies only when FMV at the date of gift is below the donor's basis. If FMV equals or exceeds the donor's basis at the gift date, the carryover basis is used for both gain and loss.

Holding period for gifts

When the donee uses the donor's carryover basis (the gain basis), the donor's holding period tacks on (carries over). When the donee is forced to use FMV at the date of gift (the loss basis), the holding period begins on the date of the gift.

Gift tax paid on appreciation

If the donor paid gift tax, the donee adds to basis the portion of the gift tax attributable to the net appreciation in the property. The add-on is computed as:

Gift tax paid × (net appreciation ÷ taxable gift), where net appreciation = FMV at gift date − donor's adjusted basis.

Inherited property (§1014)

Property acquired from a decedent takes a basis equal to its FMV at the date of death, giving the heir a "step-up" (or step-down) to FMV. If the executor elects the alternate valuation date (AVD), basis is FMV six months after death (or the date of disposition if sold earlier). The AVD election is available only if it reduces both the gross estate and the estate tax.

Inherited property automatically receives long-term holding period treatment regardless of how long the heir actually holds it.

Amount realized, gain/loss & holding period §1001 / §1222 / §1223

A disposition produces a realized gain or loss, but only the recognized portion is reported on the return. The character (capital vs ordinary, short-term vs long-term) then flows into the netting process.

Amount realized (§1001)

The amount realized on a sale or exchange equals everything the seller receives:

• Cash received, plus
• FMV of any property received, plus
• Liabilities of the seller assumed by (or taken subject to by) the buyer, less
• Selling expenses (commissions, legal fees) that reduce the amount realized.

Realized vs recognized

Realized gain or loss = amount realized − adjusted basis. Recognized gain or loss is the amount actually included in taxable income. The two are equal unless a nonrecognition provision (such as §1031, §1033, §121, §267, or §1091) defers or disallows part of the result.

Holding period (§1222)

The holding period determines whether a capital gain or loss is short-term or long-term:

• Short-term: held one year or less (≤ 1 year).
• Long-term: held more than one year (> 1 year).

The holding period begins the day after acquisition and includes the date of disposition.

Tacking of holding periods (§1223)

In several situations the prior owner's (or prior property's) holding period carries over, or "tacks":

• Gifts: when the donee uses the donor's carryover basis, the donor's holding period tacks.
• Inherited property: automatically long-term, regardless of actual holding time.
• Like-kind exchanges (§1031) and involuntary conversions (§1033): the holding period of the property given up tacks to the replacement property when basis carries over.

Netting overview

Once each disposition is classified by character and holding period, short-term items net against short-term and long-term against long-term, and the net results are then combined. The detailed steps appear in the next card.

Capital gains & losses; netting §1(h) / §1211 / §1212

Capital assets receive preferential rates on net long-term gains, but capital losses are limited. Knowing what is (and is not) a capital asset is the first step.

Capital asset definition and exclusions

A capital asset is any property held by the taxpayer except the statutory exclusions. The common exclusions (which produce ordinary income or §1231 treatment) are:

• Inventory and property held primarily for sale to customers.
• Accounts and notes receivable from the sale of inventory or services.
• Depreciable property and real property used in a trade or business (these are §1231 assets).
• Self-created copyrights, literary, musical, or artistic works in the hands of the creator (note: self-created patents/inventions are also ordinary, but a taxpayer may elect capital treatment for certain musical compositions).
• Supplies used in a business.

Preferential long-term rates (§1(h))

Net long-term capital gain of individuals is taxed at preferential rates that depend on the taxpayer's bracket:

• 0% / 15% / 20% for most long-term gains, based on taxable income thresholds.
• 28% maximum rate on collectibles gain and the taxable portion of §1202 qualified small business stock.
• 25% maximum rate on unrecaptured §1250 gain (the straight-line depreciation portion of real property gain).

The netting process

Capital gains and losses are netted within each holding-period group first, then combined:

1. Net all short-term gains and losses into a net short-term position.
2. Net all long-term gains and losses into a net long-term position.
3. If one is a gain and the other a loss, net them against each other; the surviving character controls.
4. A net long-term gain that survives is taxed at the preferential rates; a net short-term gain is taxed at ordinary rates.

Capital loss limitations (§1211 / §1212)

§1244 small business stock

A loss on qualifying §1244 stock is treated as an ordinary loss up to $50,000 per year ($100,000 MFJ); any excess loss is capital. Gains on §1244 stock remain capital.

§1202 qualified small business stock (QSBS)

Noncorporate taxpayers may exclude a percentage (50%, 75%, or 100% depending on acquisition date) of gain on QSBS held more than five years, subject to a per-issuer cap of the greater of $10 million or 10 times basis.

§1231 assets & the netting process §1231

§1231 governs property used in a trade or business and gives taxpayers the best of both worlds: net gains are capital, net losses are ordinary.

What is a §1231 asset?

§1231 assets are depreciable personal property and real property used in a trade or business and held more than one year (> 1 year). It also covers certain involuntary conversions of business and investment property. Inventory, property held for sale to customers, and property held one year or less are excluded.

The "best of both" result

• If §1231 gains exceed §1231 losses, the net gain is treated as long-term capital gain (preferential rates).
• If §1231 losses exceed §1231 gains, the net loss is treated as ordinary loss (fully deductible, no $3,000 cap).

Five-year lookback recapture

To prevent taxpayers from bunching losses in one year (ordinary benefit) and gains in another (capital benefit), a net §1231 gain is recharacterized as ordinary income to the extent of "nonrecaptured" net §1231 losses deducted in the five preceding tax years. Only the excess over those prior losses gets long-term capital gain treatment.

Interaction with casualty gains and losses

Casualty and theft gains and losses on business and investment property are first netted separately in a preliminary step:

• If casualty losses exceed casualty gains, the net casualty loss is ordinary and stays out of the main §1231 pool.
• If casualty gains exceed casualty losses, the net amount enters the main §1231 netting.

Depreciation recapture §1245 / §1250

Recapture converts part of a §1231 gain back into ordinary income because depreciation previously reduced ordinary income. Recapture applies only to gains, never to losses, and never creates additional gain.

§1245 recapture (personal property)

For depreciable personal property (machinery, equipment, furniture), §1245 recaptures as ordinary income the lesser of:

• The total recognized gain, or
• The total depreciation (and amortization) taken on the asset.

Any remaining gain beyond the recapture amount is §1231 gain (potential long-term capital gain). Because most equipment sells for less than original cost, the entire gain is often ordinary recapture.

§1250 recapture (real property)

For depreciable real property, §1250 recaptures as ordinary income only the "additional" depreciation, meaning depreciation taken in excess of straight-line. Because MACRS requires straight-line for real property placed in service after 1986, §1250 recapture is usually $0.

However, the straight-line depreciation portion of the gain is unrecaptured §1250 gain, taxed at a maximum 25% rate for individuals (it is still §1231/capital in character, just rate-capped).

Corporate §291 adjustment

For C corporations selling §1250 property, §291 converts an additional amount to ordinary income: 20% of the excess of (the amount that would be ordinary if the property were §1245) over (the amount actually treated as ordinary under §1250). This effectively makes 20% of the would-be §1245 recapture ordinary for corporations.

Like-kind exchanges & involuntary conversions §1031 / §1033

These provisions defer gain (and loss, for §1031) when property is exchanged for similar property or replaced after an involuntary loss, so that the taxpayer's investment continues without a cash-out event.

§1031 like-kind exchanges

Post-TCJA, §1031 applies only to real property held for productive use in a trade or business or for investment. Personal property (equipment, vehicles, intangibles) no longer qualifies. Real property is broadly "like-kind" to other real property (improved for unimproved, land for a building).

• Gain and loss are deferred, not eliminated (mandatory, not elective, when the requirements are met).
• Property held for personal use and inventory do not qualify.

Boot

Boot is non-like-kind property received (cash, other property, or net liability relief). When boot is received, recognized gain = the lesser of realized gain or boot received. Loss is never recognized on a §1031 exchange, even if boot is received.

Basis in replacement property

Two equivalent ways to compute the substituted basis of the replacement real property:

• FMV of replacement property − deferred (unrecognized) gain, or
• Adjusted basis of property given up + boot paid + gain recognized − boot received.

The holding period of the relinquished property tacks to the replacement property.

Related-party two-year rule

If like-kind property is exchanged between related parties, both parties must hold their replacement property for at least two years. If either disposes of it within two years, the originally deferred gain is triggered (recognized).

§1033 involuntary conversions

When property is involuntarily converted (casualty, theft, condemnation), gain may be deferred (elective) if the taxpayer reinvests the proceeds in qualifying replacement property within the replacement period:

• Generally 2 years after the close of the tax year in which gain is first realized.
• 3 years for real property held for business or investment that is condemned.

Replacement property must meet a qualifying-use (functional-use or, for condemned realty, like-kind) test. Gain is recognized to the extent proceeds are not reinvested. Unlike §1031, §1033 deferral is elective and direct exchange is not required.

Other nonrecognition & loss-disallowance rules §121 / §267 / §1091

Beyond exchanges, several rules either exclude gain on personal-use property or disallow losses in suspect situations.

§121 home-sale exclusion

An individual may exclude gain on the sale of a principal residence:

• Up to $250,000 (single) or $500,000 (MFJ).
• Ownership and use test: the taxpayer must have owned and used the home as a principal residence for at least 2 of the last 5 years.
• Generally available only once every two years.
• Partial exclusion (prorated) is available for a sale due to change in employment, health, or other unforeseen circumstances even if the 2-year tests are not fully met.

A loss on a personal residence is never deductible.

§267 related-party loss disallowance

Losses on sales between related parties (family members, and an individual and a more-than-50%-owned entity) are disallowed to the seller. Related parties for this rule include spouses, siblings, ancestors, and lineal descendants (but not in-laws).

When the related buyer later sells to an unrelated third party, the buyer may use the previously disallowed loss to offset any gain on that later sale (the "right of offset"). The offset cannot create or increase a loss for the buyer; any unused disallowed loss simply disappears.

§1091 wash-sale rule

A loss on the sale of stock or securities is disallowed if the taxpayer buys substantially identical securities within 30 days before or after the sale (a 61-day window). The disallowed loss is added to the basis of the replacement securities, preserving it for the future, and the holding period tacks. The wash-sale rule applies only to losses, not gains.

§1041 transfers between spouses

Transfers of property between spouses (or incident to divorce) are nonrecognition events: no gain or loss is recognized, and the transferee takes a carryover basis (treated as a gift for basis purposes, including the donor's holding period).

Installment sales & planning §453

The installment method lets a seller report gain as cash is collected rather than all in the year of sale, smoothing income and deferring tax. It is the default method for an eligible sale with at least one payment received after the year of sale.

How the installment method works

Each principal collection carries out gain at the gross profit percentage:

• Gross profit = selling price − adjusted basis (and selling expenses).
• Contract price = generally the selling price (reduced by qualifying mortgage assumed, within limits).
• Gross profit percentage = gross profit ÷ contract price.
• Recognized gain in a year = gross profit percentage × principal collected that year.

Interest stated (or imputed) on the deferred payments is reported separately as ordinary interest income.

Ineligible items

The installment method may not be used for:

• Inventory or dealer property (regular sales of inventory).
• Publicly traded securities (stocks and bonds traded on an established market).
• Depreciation recapture under §1245/§1250, which is recognized in full in the year of sale (see trap below).

Interest on deferred tax (large obligations)

For large installment obligations, the seller may owe interest on the deferred tax liability. This applies to nondealer obligations when the face amount of all such obligations outstanding at year-end exceeds $5 million, and to certain dealer-related rules. It is a cost of deferral the planner must weigh.

Planning considerations

• Spreading gain across multiple years can keep the seller in lower capital-gains and ordinary brackets and manage thresholds (such as the net investment income tax).
• A taxpayer may elect out of the installment method and report all gain in the year of sale, which can be useful when current rates are low or to absorb expiring losses or credits.
• The election out is made by reporting the full gain on a timely filed return for the year of sale.