Federal Income Tax
Chapter 1. Introduction
A. Introduction to Terminology and Structure p. 2
· The starting point in computing a taxpayer’s tax liability for the year is the taxpayer’s gross income.
o Salary from a job is included in gross income.
o § 61 (a)(2) provides that gross income includes “gross income derived from business.”
§ A taxpayer’s gross income from business means the gross receipts from the business less the cost of the taxpayer’s inventory sold.
o § 61 (a)(3) states that gross income includes “gains derived from dealings in property.”
§ Appreciation in the value of property is taxed when the gain is realized, for example when the property is sold or exchanged.
· The Code calls the amount the taxpayer receives on the sale or exchange the amount realized.
· The Code calls the taxpayer’s unrecovered investment in the property the adjusted basis.
· A taxpayer’s realized gain = (the amount realized) – (adjusted basis in the property sold)
· A taxpayer’s realized loss = (adjusted basis) – (the taxpayer’s amount realized)
· A taxpayer’s gross income from “dealings in property” is net of the taxpayer’s unrecovered investment in property.
o For example (p. 3): Betsy buys raw land for 400,000. In year 10, Betsy sells the land for 2 million.
à2 million = amount realized
à400,000 = adjusted basis
à1.6 million = realized gain
o If Betsy had instead bought property with a limited, such as an apartment building, she would be allowed to depreciate the property, meaning that she would be allowed to deduct, for purposes of computing tax she owes, part of the cost of the property each year during the item she owned it. If, Betsy were allowed to take 100,000 in depreciation deductions, her unrecovered investment in the property is no longer 400,000; since she recovers, for tax purposes, 100,000 of her investment through depreciation deductions, her uncovered investment is 300,000.
à400,000 = original basis
à300,000 = adjusted basis
à Sold the apartment building for 2 million
à1.7 million = realized gain
· A realized gain is included in gross income only if the gain is also recognized.
· However, a realized gain is not recognized if a nonrecognition rule in the Code applies to the sale or exchange. There are a number of nonrecognition rules in the Code. They generally apply to transactions in which the taxpayer has exchanged property but has continued her investment in another form. If one of the specific nonrecognition rules applies to a transaction, the tax on the gain realized in the transaction is deferred until the taxpayer sells the property received in the nonrecognition transaction.
o For example: See p. 3-4
o § 1031 – “like-kind exchange” non recognition rule
· After computing the taxpayer’s gross income, the next step is to compute the taxpayer’s adjusted gross income. § 62 defines adjusted gross income as gross income less certain costs
urchase an income-producing asset that will be used in the business and has a limited useful life, the taxpayer’s expense for the asset is allocated across the years in which the asset is expected to produce income. Each year during the useful life of the asset, the taxpayer will deduct a portion of the cost of the asset, in the form of depreciation deductions.
o If the asset purchased by the taxpayer does not have a limited useful life (for example, raw land), the taxpayer is not permitted to recover her investment in the asset until she sells or exchanges it, at which time the taxpayer’s amount realized for the asset is reduced by her adjusted basis in the asset.
· After computing the taxpayer’s taxable income, the next step is to compute the amount of tax due on the taxpayer’s taxable income.
· Individuals, estates, and trust pay lower tax rates on capital gain other than short-term capital gain.
o Capital gain is gain from the sale of a capital asset.
o Capital gain is short term if the capital asset sold was held by the taxpayer for a year or less before the sale.
A capital asset, loosely speaking, an investment asset as opposed to an asset used in an operating business.