Examples and Exhibits for Review Chapter 9

Example 9-3Teton is using the 200 percent declining balance method and half-year convention to compute depreciation expense on its current year personal property additions. What is Teton’s depreciation expense for these assets?

Asset Date Places in Service

(1)Original Basis

(2)Rate

(1)X(2) Depreciation

Office Furniture February 3 $10,000 14.29% $1,429Machinery July 22 $510,000 14.29% 72,879Used Delivery Truck August 17 15,000 20.00% 3,000Total $77,308Because the office furniture and machinery have a seven-year recovery period and it is the first year for depreciation, the depreciation rate is 14.29%. The depreciation rate for the used delivery truck (five-year property) is determined in a similar manner.

Example 9-7What if: Let’s replace the facts from the base scenario presented in Exhibit 9-5 with the fallowing alternative scenario 1 facts. In this alternative set of facts, we assume the machinery was acquired during the fourth quarter on October 25 as follows:Asset Date Acquired Quarter Acquired Cost BasisOffice Furniture 2/3/13 First $10,000Delivery Truck 8/17/13 Third 15,000Machinery 10/25/13 Fourth 510,000Total Personal Property 535,000

Under alternative scenario 1, is Teton required to use the md-quarter convention?Answer: Yes. Of the personal property it placed in service during the year, is placed 95.3 percent in service in the last quarter (this is greater than 40 percent). See the calculations below

Description Amount Explanation(1) Cost of all personal property placed in service during current year

535,000

(2) Cost of personal property placed in service the fourth quarter during current year

510,000

(3) Percentage of all personal property placed in service during current year that was placed in service in the fourth quarter

95.3%(2)/(1)

What if: Assume that Teton also placed in service on July 1 a building costing 1,000,000. Is Teton subject to the mid-quarter convention?

Answer: Yes. Because the building is real property (not personal property). It is not included in the mid-quarter calculation. The calculation is exactly the same as the calculation in alternative scenario 1.

Example 9-8

What if: For this example, we assume the facts from alternative scenario 1 presented in Example 9-7. What is Teton’s year 1 depreciation expense for its personal property additions under the alternative scenario 1 presented in Example 9-7?

Asset Purchase Date Quarter Original Basis Rate DepreciationOffice furniture (7-year) February 3 First 10,000 25% 2,500Delivery Truck (5-year) August 17 Third 15,000 15% 2,250Machinery (7 year) October 25 Fourth 510,000 3.57% 18207

22,957

Example 9-26

In September of Year 1, Teton purchased a patent with a remaining life of 10 years from Chouinard Equipment for $60,000. What amount of amortization expense is Teton allowed to deduct for the patent in year 1?

Description Amount Explanation(1)Cost of Patent $60,000(2)Remaining life of patent in months 120 10 years(3)Monthly Amortization $500 (1)/(2)(4)Months in year 1 Teton held patent X4 September through December(5)Monthly straight-line amortization $2,000 (3)x(4)Unamortized cost of patent at end of year 1 58,000 (1)-(5)

Example 9-27

Ken’s cost basis in the gold is the 150,000 he paid for it. Based on a mining engineer’s estimate that the gold deposit probably holds 1,000 ounces of gold, Ken can determine his cost depletion. What is Ken’s cost depletion for year 1 and year 2, assuming that he extracts 300 and 700 ounces of gold in year 1 and year 2 respectively?

Description Amount Explanation(1)Cost basis in gold $150,000(2)Estimated ounces of gold 1,000(3)Per ounce cost depletion rate 150 (1)/(2)(4)Year 1 ounce extracted 300(5)Year 1 cost depletion $45,000 (3)x(4)(6)Basis remaining after Year 1 depletion 105,000 (1)-(5)(7)Year 2 ounces extracted 700(8)Year 2 cost depletion $105,000 (7)x(3)Basis remaining after Year 2 depletion $0 (6)-(8)Ken is not eligible for cost depletion after year 2 because as of the end of year 2, his cost basis has been reduced to $0.

Chapter 10

Exhibit 10-3 Character of Assets Depending on Property Use and Holding Period

Property useHolding Period Trade or Business Investment or

Personal Use AssetInventory and Accounts Receivable

Short term (one year or less) Ordinary Short term capital OrdinaryLong term (more than 1 year) §1231 Long term capital Ordinary

Example 10-6

What if: let’s assume the same facts as in the previous example and Exhibit 10-2, except that Teton sells the machinery for $520,000. What is the amount and character of the gain Teton would recognize on this sale?

Machinery sale: Scenario 2(Assumed sale price=$520,000)

Description Amount Explanation(1)Amount realized 520,000(2)Original basis 510,000 Exhibit 10-2(3)Accumulated depreciation 381,827 Exhibit 10-2(4)Adjusted basis 191,173 (2)-(3)(5)Gain(loss) recognized 328,827 (1)-(4)(6) ordinary income(§1245 depreciation recapture)

318,827 Lesser of (3) or (5)

§1231 gain 10,000 (5)-(6)

Example 10-11

What if: suppose that Teton is organized as a corporation and Steve is the sole shareholder. Steve sells equipment that he was using for personal purposes to Teton for 90,000(originally purchased for 80,000). The equipment was a capital asset to Steve because he has been using it for personal purposes (he did not depreciate it). What is the amount and character of the gain Steve would recognize on the sale?

Answer: 10,000 of ordinary income (amount realized 90,000 – 80,000 adjusted basis). Even though Steve is selling what is capital asset to him, because it is a depreciable asset to Teton and because Steve and Teton are considered to be related parties, Steve is required to characterize the entire amount of gain as ordinary under §1239. Without the §1239 provision, Steve would have recognized a capital gain.

Example 10-12

What if: suppose that Teton began business in year 1 and that is recognized a 7,000 net §1231 loss in year 1. Assume that the current year is year 6 and that Teton reports a net §1231 gain of 25,000 for the year. Teton did not recognize any §1231 gains or losses in year 2-5. For year 6, what would be the ultimate character of the 25,000 net §1231 gain?

Answer: 7,000 ordinary income and 18,000 long term capital gain. Because it recognized a net §1231 loss in year 1, it must recharacterize 7,000 of its net §1231 gain in year 6 as ordinary income. The remaining 18,000 §1231 gain is taxed as long-term capital gain.

What if: Assume the same facts as above, except that Teton also recognized a 2,000 net §1231 loss in year 5. For year 6 what would the ultimate character of the 25,000 net §1231 gain?

Answer: 9,000 ordinary income and 16,000 long term capital gain. Note that the overall gain is still 25,000, but to the extent of the 7,000 loss in year 1 and the 2,000 loss in year 5, the §1231 gain is recharacterized as ordinary income under the §1231 look back rule.

Example 10-14

Teton would like to trade machinery worth 29,500 (adjusted basis of 18,742) for new machinery worth 29,500. How much gain does Teton recognize on this exchange?

Answer: 0. Teton’s exchange qualifies as a like-kind exchange and the 10,758 realized gain (29,500 amount realized minus 18,742 adjusted basis) is deferred,

What is Teton’s basis in the new machinery?Answer: 18,742, the basis it had in the old machinery traded in.

Chapter 11

Exhibit 11-1 Formulas for the Annual After-Tax Rate of Return and the After Tax Future Value of Investment with Constant Rate of Return

Annual after-tax rate of return=before tax rate of return x (1-marginal tax rate)

Exhibit 11-3 Classification of Capital Gains by Maximum Applicable Tax Rates

Short term or long term Type Maximum RateShort Term All 35%Long Term Collectibles 28%Held>5 years Qualified small business stock 0%Long term Unrecaptured §1250 gain from

depreciable reality25%

Long term All remaining capital (an §1231 gains) gain not included elsewhere

20

Example 11-8

Jeb Landers has recently retired and now wants to pursue his life-long dream of owning a sailboat. To come up with the necessary cash, he sells the following investments:

Stock Market Value Basis Capital Gain/Loss

Scenario 1 Type

Scenario 2 Type

A 40,000 5000 35000 Long ShortB 20,000 30,000 (10,000) Long ShortC 20,000 12,000 8,000 Short LongD 17,000 28,000 (11,000) Short Long

What is the amount and nature of Jeb’s capital gains and losses (scenario 1)?

Answer: 22,000 net capital gain (treated as long term capital gain), computed as follows

Step 1: Net short term gains and short term losses. The 8,000 short term gain on stock C is netted against the 11,000 short term loss on stock D, yielding a NSTCL of 3,000.

Step2: Net long term gains and long term losses. The 35,000 long term gain on stock A is netted against the 10,000 long term loss on stock B, producing a NLTCG of 25,000

Step3: Net the results of step1 and step2. The NSTCL from step 1 is netted with the NLTCG from step2 yielding a 22,000 net capital gain [(3,000)+(25,000)] taxable at long term capital gains rates.

What if: consider the original facts, except that Scenario 2 dictates the long and short term capital gains. What is the amount and character of Jeb’s net gain(loss) on the sale of the shares in this situation

Answer: 22,000 net short term capital gain computed as follows:

Step1: The gain from stock A would first be netted with the loss from stock B to produce a 25,000 NSTCG [35,000+ (10,000)]

Step2: The loss from stock D and the gain from stock C are combined to provide a 3,000 NLTCL [(11,000) +8,000]

Step3: the results from step 1 and step 2 are netted to reach a 22,000 net short term capital gain [25,000 NSTCG + (3,000) NLTCL].

Item Investment Interest ExpenseDescription Interest expense on loans used to acquire

investmentDeduction type Interest expense itemized deductionDeduction Limitations Deduction limited to taxpayer’s net investment

income for the year. Net investment income is gross investment income reduced by deductible investment expenses.

Nondeductible amounts due to limitations Carryover indefinitelyExhibit 11-7 Summary of Investment-Related Expenses

Example 11-18

During the year, Nick and Rachel recognized the following income from investments: 3,000 of qualified dividends and 500 of taxable interest. What is the Suttons’ gross investment income?

Answer: 500. The taxable interest is included, and the qualified dividends are excluded because they are taxed at a preferential rate

What is the Suttons’ net investment income?

Answer: 500. Recall that net investment income is gross investment income minus deductible (taxable income reducing) investment expenses. We learned in Example 11-17 that the Suttons’ deductible investment expenses are 0. Thus, their net investment income is 500 (500-0).

Example 11-21

What if: Assume that instead of investing solely in assets that generate portfolio income, Nick and Rachel used 10,000 of the inheritance from Nick’s grandmother to acquire a 5% interest in a limited partnership (a flow through entity) called Color Comfort Sheets (CCS). The Suttons’ share of CCS’s loss for the year is 15,000. What amount of this loss are the Suttons allowed to deduct after applying the tax basis and at risk limitations?

Answer: 10,000. Since the Suttons’ tax basis and at risk amount in their CCS interest are both 10,000 (the amount of cash invested), the tax basis and at risk amount limitations result in the same limitation. Thus, the Suttons may deduct 10,000 of the 15,000 loss before consulting the passive activity loss limits discussed below.

Chapter 14

Example 14-2

What if: suppose that when Tyler and Jasmine were married, Jasmine moved into Tyler’s home located in Denver Colorado. Tyler had purchased the home two years before marriage. After the marriage, the couple lived in the home together as their principle residence for four years before selling the home to move to Chicago. Tyler was the sole owner of the home for the entire six years he resided in the home. Would gain on the sale of the home qualify for the 500,000 exclusion available to married couples filing jointly even though Jasmine was never an owner of the home?

Answer: Yes. Gain on the sale qualifies for the full 500,000 exclusion available to married couples filing jointly because Tyler met the ownership test, and both Tyler and Jasmine met the use test.

What if: Suppose that Tyler and Jasmine lived in the home together for only one year before selling it. Would the couple be allowed to exclude any gain on sale?

Answer: Yes, but because only Tyler meets the ownership test and use test they would qualify only for the 250,000 exclusion even if they file a joint return.

Example 14-16

At the beginning of the year, the Jeffersons purchased a vacation home in Scottsdale, Arizona, for 500,000 (400,000 for the building and 100,000 for the land). They paid 200,000 down and financed the remaining 300,000 with a 6 percent mortgage secured by the home. During the year, the jeffersons used the home for personal purposes for 30 days and rented the home for 200 days. Thus, the home falls in the residence with significant rental use category. They received 37,000 of rental revenue and incurred 500 of rental advertising expenses. How are their expenses allocated to the rental use under the IRS and Tax Court methods?

Allocation Method to Rental UseExpense Amount Tier IRS Method

(200/230)Tax Court Method (200/365

Tier1 200/230 other)Advertising 500 1 500 500Interest 18,000 1 15,652 9,863Real estate taxes 5,000 1 4,348 2,740Total Tier 1 Expenses 23,500 1 20,500 13,103Utilities 4,500 2 3,913 3,913Repairs 1,800 2 1,565 1,565Insurance 3,500 2 3,043 3,043Maintenance 3,200 2 2,783 2,783Total Tier 2 Expenses 13,000 2 11,304 11,304Tier 3: Depreciation 13,939 3 12,121 12,121Total expenses 50,439

Net income from rental IRS Method Tax Court MethodRental Expense 37,500 37,500Less Tier 1 expenses (20,500) (13,103)Income after Tier 1 Expenses 17,000 24,397Less Tier 2 expenses (11,304) (11304)Income after Tier 2 Expenses 5,696 13,093Less : Tier 3 expenses (5,696) (12,121)Taxable rental income 0 972Deductible personal expenses (interest and property taxes)

3,000 10,397

Deductible rental expenses (sum of Tier 1, 2, and 3 expenses

37,500 36,528

Total personal and rental expenses 40,500 46,925 Note that under the Tax Court method, the Jeffersons are able to deduct 7,397 (10,397-3000) more in itemized deductions for interest and real property taxes than they do under the IRS method, and they deduct 972 (37,500 minus 36,528) fewer rental expenses (for AGI) under the Tax Court method relative to the IRS method. In total, the Jeffersons are allowed to deduct 6,425 more in total deductions under the Tax Court method than the IRS method in the current year (46,925 minus 40,500). However, under the IRS method, the Jeffersons are allowed to carry forward to next year the 6,425 in depreciation expense that they were not allowed to deduct in the current year (12,121-5,696).