This course examines the U.S. federal tax system as it relates to property transactions of business owners and shareholders. Topics include cost recovery, such as depreciation, amortization, and depletion; calculation of realized versus recognized gains and losses; evaluation of the potential tax effects of nontaxable exchanges; and the combining, or netting, gains and losses that are different in nature. Assignments facilitate self-discovery of knowledge and development of a variety of professional skills.
Disallowed Losses
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Del curso dictado por University of Illinois at Urbana-Champaign
Federal Taxation II: Property Transactions of Business Owners and Shareholders
30 calificaciones
University of Illinois at Urbana-Champaign
30 calificaciones
Curso 2 de 5 en SpecializationU.S. Federal Taxation
De la lección
Module 5 Property Transactions: Gains, Losses, and Like-Kind Exchanges
In this module, you will learn about unique property transactions where gains and/or losses are deferred. First, we’ll discuss circumstances where certain losses on the disposal of property are not allowed to be recognized. Next, we’ll discover what wash sales are and the dates that determine whether or not the losses can be recognized. Next, we’ll discuss a type of non-taxable exchange called “like-kind exchange,” which allows properties to be exchanged with no tax recognition, and the rules governing its tax deferred status. Next, we’ll discuss specific circumstances where part of the non-taxable transaction actually becomes taxable due to receipt of non-like-kind property, called boot. Last, we’ll talk about what basis the newly exchanged property should have, and what the holding period should be.
Conoce a los instructores
Matthew HutchensLecturer of Accountancy
Department of Accountancy
Petro Lisowsky, PhD, CPAAssociate Professor of Accountancy
College of Business: Department of Accountancy
Recall from our previous videos that we've been looking at calculating realized gains or
losses as the difference between the amount realized and the adjusted basis.
Here from the seller's perspective,
the amount realized is the sum of any cash received,
plus fair market value of other property received,
plus the disposition of liabilities, minus selling expenses.
The adjusted basis was defined as the original basis,
minus accumulated cost recovery deductions like
accumulated depreciation, plus capital additions.
In the simplest terms,
the realized gain is the difference between the value of what
the taxpayer got and the adjusted basis of what the taxpayer gave up.
Now, there could be a difference between
the realized gain or loss or economic gain or loss,
and the recognized gain or loss,
or the gain or loss that actually gets reported on the tax return.
The differences here could be due to
postponed or deferred gains or losses, that is for example,
although the gain might be realized in the transaction,
the taxpayer might not have to report it on
his or her tax return until some period in the future.
Another difference between realized and recognized gains or losses,
is that the gain may be entirely tax-free,
or the loss may be disallowed,
that is, never deductible.
Finally, recall that the gain or loss can either be
capital in character or ordinary in character.
For individuals and sole proprietor businesses,
capital gains receive preferential tax rates,
while ordinary gains are taxed at the top applicable marginal tax rates.
We'll look at character in a later module.
In this video and the next set of videos,
we will look more deeply at these differences between
realized and recognized gains and losses.
So, first, let's define Recognized Gains and Losses.
The recognized gains and losses are simply the portion of
the realized gains that are included in
the current year's gross income or the portion of
the realized losses that are deductible against income.
For the most part in fact,
taxpayers will recognize the majority of realized gains and losses.
That is for the most part, there really isn't a difference
between realized and recognized gains and losses.
However, as we saw earlier,
not all realized gains and losses are
recognized because some gains may be deferred or excluded,
while some losses may be deferred or completely disallowed.
Some examples here, for the most part,
losses from the sale exchange or condemnation of
personal use assets are not recognized for tax purposes.
That is, if I sell my personal car, or personal house,
or personal furniture at a loss,
I actually cannot deduct that loss on my tax return.
Those losses are disallowed,
they are not deductible.
There are a few exceptions here though.
Beginning in 2018, a realized casualty or theft loss on
personal-use property can only be recognized in two instances.
First, a casualty or theft loss on personal-use property
can offset a casualty gain on personal-use property.
Second, such a loss is deductible as
an itemized deduction if the loss occurred in a federally declared disaster area,
and that loss exceeds a $100 per event floor and a 10 percent of AGI threshold.
In contrast, interestingly enough,
gains realized from the sale or other disposition of
personal use assets generally are fully recognized.
So, if I sell my personal car at a gain,
I will actually have to recognize that gain on my tax return and pay tax.
In other words, the treatment between gains and losses
for personal-use assets are asymmetric.
Generally, gains are incredible and gross income,
but losses are not deductible.
There are also two major other types of
losses that are not deductible that we should discuss.
The first, very briefly has to do with
transactions between what are known as related parties.
Under Internal Revenue Code Section 267,
related parties include family members or a corporation and
a shareholder who owns a greater than 50 percent interest in the corporation,
or a partnership and a partner who owns more than 50 percent interest in the partnership.
In other words, these are parties that may transact between each other,
but the price may not be the market price or the arm's length price.
The price might be set in a way that gives an advantage to one party or another,
perhaps for tax reasons.
The IRS is worried about transactions between related parties,
and has decided that losses on the sale of assets between related parties are disallowed.
So, here's an example.
Let's say I'm in the highest income tax rate bracket and
my brother is in the lowest tax rate bracket.
I want to help him,
and I'm thinking of gifting him some property,
maybe some stock that has actually done quite poorly for me.
I bought it at $10,000,
and now it's worth only $1,000.
But, instead of gifting the stock to my brother, in which case,
I cannot claim a deduction for the $9,000 loss,
I decide to sell it to my brother.
However, to engineer, the largest possible loss also my stock to him for one dollar.
Now, he's happy because he has $1,000 in stock that he only paid one dollar for,
and I'm happy because I just gave him property of
significant value that I was probably going to give him anyway,
and because I sold it to him for only one dollar,
I basically engineer a much larger loss that I can now deduct on my tax return.
That is, I now have a $9,999 loss.
What the IRS says is that,
because the transaction occurred between two related parties,
that as between my brother and myself,
the entire loss that I generated will be disallowed.
I cannot deduct that loss on my tax return.
Separate from related parties,
another type of disallowed loss pertains to what's known as Wash Sales.
What happens here is that, a taxpayer will dispose of a security.
Let's say a stock or a bond at a loss,
but then acquire back the same or substantially
identical security within 30 days before or after the date of the lost sale.
So, what's going on here?
Why did the taxpayer sell the security and then buy it back?
While the IRS's fear is that the taxpayer is selling the security at a loss
just to try to recognize the loss and deducted on his or her current year tax return.
But, by buying the security back,
the taxpayer really doesn't encounter
any economic risk in the investment if prices fluctuate.
Therefore, the IRS disallows these types of
losses because they do not want taxpayers to continue
their investment in a security while just trying to
recognize a bunch of losses for purely tax purposes.
Now, if you're outside this 30 day window,
then it's actually fine to repurchase
those sold loss securities and continue to recognize the original loss.
That is, waiting the 30 days will let you keep the deduction of the original loss.
So, once you sell a security at a loss,
you need to keep it sold for at least 30 days before buying it
back if you would like to deduct a loss from the sale on that security.
So, what happens if you buy back the security within the 30-day period?
Here, any disallowed loss that you generated will be added to the basis
of the newly purchased same or a substantially identical security.
Furthermore, the holding period of the new security
begins on the date of the acquisition of the old security.
A new holding period does not start with
the purchase of the same or identically similar security.
Just to be clear, the Wash Sale rules disallow the deduction of losses,
but these rules do not apply to gains that are realized upon selling securities.
That is, if you sell a security at a gain,
then you will recognize the gain immediately and have to pay tax on it.
The IRS doesn't care if you repurchase that security again within 30 days.
This is interesting because through the Wash Sale rules,
the tax laws really limit the ability to take the losses as a deduction,
because recognizing these losses will reduce tax revenues to the government.
But if you have a gain,
the tax laws don't limit you here,
because this will actually generate tax revenue to the government.
So, go ahead and buy and sell your securities day after day.
As long as you sell them at a gain,
the IRS will be kind to you and let you recognize
those gains immediately so that you get immediately pay your tax.
Final point here about wash sale rules.
If a taxpayer acquires fewer shares than the number sold,
then the loss from the sale is prorated between the recognized and disallowed loss
based on the ratio of the number of new shares acquired to the number of old shares sold.
In other words, if you sold 10 shares of stock at a loss,
but then within 30 days you repurchased two of those shares,
then the loss that you incurred on the two shares
that you sold and bought back will be disallowed,
but the loss that you incurred on the eight shares that you sold ended not buy back,
that is the stayed sold,
then the loss on those shares will be allowed.
You can continue to deduct those losses.
Let's look at some examples here.
Sarah owns 100 shares of XYZ stock with an adjusted basis of $50,000.
On October 11th, year 20x1,
she sells the 100 shares for their fair market value of $45,000.
But on November 5th, 20x1,
she purchases 125 shares of the same XYZ stock for $57,500.
What is Sarah's realized gain or loss from the 100 shares sold on October 11th?
Well, going back to our basic model of calculating gains and losses,
we calculate the realized gain or loss as
the difference between the amount realized or in this case,
the sales price, and the adjusted basis.
So, here, Sarah sold her shares for $45,000 on October 11th.
This is her sales price.
Her adjusted basis, however, was $50,000.
Because her adjusted basis is greater than her sales price,
she will realize a $5,000 loss on the October 11th sale of the XYZ stock.
Next, what is Sarah's recognized gain or loss from
the 100 shares she sold on October 11th?
Well, we saw it from the previous slide that she realized a $5,000 loss.
Can she recognize it or deduct that loss on her tax return?
In this case, no.
The $5,000 realized loss is not recognized.
Why is that? Because this is a wash sale.
Sarah repurchased 100 shares of the same security
within 30 days of selling them at a loss.
Now, given that Sarah has purchased 125 shares of XYZ stock for $57,500,
but now she has a $5,000 disallowed loss,
what will be her adjusted basis for these new 125 shares?
Well, the rules say that the disallowed loss will
increase the basis of the newly purchased shares.
Therefore, we take the $57,500 basis or the cost of
the 125 shares and add in the $5,000 disallowed loss to get a basis of $62,500.
Now, let's take a step back and figure out what's going on here.
Why do we include the disallowed loss in the basis?
Well, by increasing the basis,
the loss is essentially built in now and will only be
recognized once Sarah sells her shares in a non-wash sale.
So, for example, let's say she just holds on to
the 125 shares of XYZ stock for two more months.
Let's say the price didn't change at all from November 5th.
That is, the price is still $57,500.
So, two months later, she decides to sell the 125 shares of stock for $57,500.
What's your gain or loss?
Well, if she sold the stock for what she bought it for,
then her sales price is $57,500.
We compare that sales price to the basis of $62,500.
When we do that, Sarah now has a recognized loss of $5,000.
In other words, the disallowed loss is built into
the basis so that when Sarah subsequently sells her shares,
she's comparing the sales price to a higher basis,
which in this case, upon the stock sale releases that postpone loss.
In other words, the $5,000 disallowed loss wasn't lost forever.
It was just postponed and sitting within
the basis waiting to be recognized in a non-wash sale.
Now, what if Sarah repurchased only 75 shares of XYZ stock for
$34,500 on November 5th instead of purchasing 125 shares of XYZ stock?
Well, here she only repurchased 75 of the 100 shares she originally sold at a loss.
Therefore, 75 percent of her $5,000 loss is disallowed.
However, for the 25 shares that she had sold and that they have stayed sold,
Sarah does get to recognize that loss.
Therefore, 25 percent of the $5,000 loss is recognized.
So, here we see that $3,750 is disallowed.
Building on the previous example,
we take this disallowed loss and add it to
the basis in the new shares to obtain the new basis.
In this case, we add $3,750 to the $34,500 amount Sarah paid for
the 75 new shares to obtain a basis of $38,250 in those new shares.
Again, because 25 of the 100 shares were sold and they stayed sold,
the portion of the $5,000 loss pertaining to that sale is deductible.
That is, the wash sale rules do not apply because she did not
repurchase those 25 shares back within 30 days of selling them at a loss.
Finally, what if Sarah purchased the 125 shares on November 15th,
instead of November 5th, for $57,500.
Which date would you recommend from a tax perspective?
Well, if she sold the stock on November 15th,
that would be outside the 30-day window that started on October 11th.
Therefore, the original $5,000 loss would be recognized
and the basis in the new shares would simply be the $57,500.
Therefore, from a tax perspective,
to avoid the wash sale disallowance rules,
the recommended repurchase date is November 15th.
So in all, in this video,
we learned about two important situations where
the realized gain or loss maybe different from the recognized gain or loss.
First, losses between related parties will be disallowed.
Second, losses from the sale of securities will be disallowed if
the same or substantially identical security
is repurchased within 30 days of the loss sale.
These wash sale rules make it very important for taxpayers to keep track of
when they sell securities at a loss and when they might repurchase them.
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