Income Tax Law: Taxation on Capital Gains

Income Tax Law: Taxation on Capital Gains


Taxation on Capital Gains

            In the seminal gross income case Eisner v. Macomber [1] the Supreme Court held that “income” for purposes of the 16th Amendment (and, therefore, for purposes of tax law in general) includes not only the income one derives from one’s personal services but also “gain derived from capital.” What this means is that when a taxpayer makes an investment—purchases shares of stock in a corporation, for example, or a parcel of real estate, or really any kind of “property”—the profit the taxpayer later realizes on that investment can be subjected to the federal income tax. Section 61(a)(3) of the Code[2] essentially codifies this ruling by providing that a taxpayer’s gross income shall include “gains derived from dealings in property.”[3]


            The Code measures this income—the “gain derived from dealings in property”—by the relatively simple formula found in section 1001(a): gain is the excess of amount realized over adjusted basis (G = AR – AB). Section 1001(c) then mandates that whatever gain is so realized by application of this formula must be recognized by the taxpayer—that is, included in gross income.


Amount Realized


            The statute defines the “amount realized” in a sale or other disposition of property as the sum of (a) the amount of any money received plus (b) the fair market value of any property received.[4] Generally this is simply the sales price, and in a cash sale is a straightforward matter. If a taxpayer sells, say, a share of stock in a corporation for $100, the amount realized on the sale is $100. From that amount is then deducted the taxpayer’s adjusted basis in that share of stock to compute the resulting gain (or loss). If the taxpayer’s adjusted basis in the stock is $10, then the taxpayer has realized, and must recognize, a $90 gain.


A taxpayer could, however, dispose of property for consideration other than cash. A taxpayer might exchange one property for a very different property without any cash changing hands at all, in fact. Say a taxpayer owns a bridge that he is willing to trade for a license the taxpayer needs to operate a railway. If he can manage this, the taxpayer will have “disposed of” his property (he won’t own the bridge anymore), thus the gain or loss rule of section 1001 is triggered by this “other disposition of property.” The taxpayer must now count as his amount realized the fair market value of the property received in the exchange. In this case if the fair market value of the license (the property received) is greater than the taxpayer’s adjusted basis in the property disposed of (the bridge), the taxpayer has realized, and must recognize, a gain.[5]


What if the property disposed of is encumbered by a debt at the time of the sale? If it’s a cash sale then the seller will include that cash in her amount realized then, presumably, use some of that cash to pay off the debt. Most loans require, however, that if the collateral securing the loan is disposed of, then the debt becomes immediately due and payable. A sensible buyer will therefore insist that he himself pay off the seller’s debt at the time of the sale. (If he doesn’t do so, the lender may come after him—or in particular, the property he purchased—to satisfy the debt.) If the buyer pays off the debt as part of his consideration for the property, however, the seller has not, strictly speaking, “received” that much of the purchase price as money or property to include in amount realized. The money was paid directly to the lender instead. The Treasury Regulations anticipate this very common transaction, however, and require that the amount realized on a disposition will include any debt discharged as a result.[6] Thus if a homeowner sells her home for $1,000,000 when that home is encumbered by an $800,000 mortgage, the buyer will deposit the entire purchase price into escrow, whereupon the escrow company will pay $800,000 to the homeowner’s lender to retire the mortgage and disburse the remaining $200,000 to the homeowner. Although the homeowner received only $200,000, her amount realized on the sale is nevertheless $1,000,000 ($200,000 cash received plus $800,000 discharged indebtedness).[7]


Adjusted Basis


            It is a long-accepted interpretation of Congress’s 16th Amendment taxing power that income usually means “profit.”  It is thought, in other words, that the appropriate amount of income to tax, especially in the context of dealings in property, is the amount returned on the investment. That “investment,” in the parlance of tax law, is called basis.


            Section 1012 of the Code provides that the basis of some item of property is typically its “cost.” If a taxpayer buys a car for $50,000, then his basis in the car is $50,000. If the taxpayer later sells the car for $60,000 in cash, then he has a $10,000 gain ($60,000 amount realized less $50,000 adjusted basis, assuming no adjustments to the original cost basis).[8] Note that this math holds up even when the original purchase of the car was financed by debt. If in the above example the taxpayer had borrowed all $50,000 to purchase the car in the first place, his cost basis is nevertheless still $50,000[9] and, if he sells it for $60,000, his gain is still $10,000. This result is quite sensible: the taxpayer actually expended none of his personal funds in this transaction—he borrowed all $50,000 to purchase the car. When he sold the car he presumably used $50,000 of the $60,000 sales price to repay the lender, leaving him with $10,000 extra cash: $10,000 in extra cash, $10,000 in taxable income. Sensible.


Property may be acquired in any number of ways other than a direct purchase, however. If property is acquired by gift, then the donor’s adjusted basis “carries over” to the donee.[10] Thus if a taxpayer’s grandfather gives her a pocket watch that the grandfather purchased for $10 fifty years before, the taxpayer’s basis in the watch is $10 even if it’s worth far more than that at the time of the gift. Property a taxpayer receives as an inheritance, on the other hand, takes a basis “stepped up” to its fair market value.[11] Thus if in the above example the taxpayer had inherited the watch after her grandfather’s death when the watch was worth $500, then her basis in the watch would be $500.[12]


The bases described above are best thought of as the “initial” basis in an item of property. Any initial basis may be “adjusted” by a variety of events subsequent to the property’s initial acquisition. The owner may add to or improve the property, for example, in which case the basis is adjusted upward (i.e., increased) by the cost of those improvements. If the property is used in a trade or business activity, then the basis may be adjusted downward (i.e., decreased) by depreciation deductions the owner takes against it. After considering these upward and downward adjustments the taxpayer arrives at the “adjusted basis” that is used in determining gain or loss on the property’s later disposition.[13]


Footnotes

[1] 252 U.S. 189 (1920).

[2] The Internal Revenue Code of 1986, as amended (the “Code” or “IRC”).

[3] Neither that case nor any case since has held that a loss one sustains in such an investment must, according to the Constitution, be deductible by a taxpayer. Nevertheless, Congress has chosen to allow for the deduction of losses from dealings in property by providing, in section 1001, that not only should realized gains be recognized but so should realized losses. Although this general rule allows for the recognition—i.e., deduction—of realized losses, Congress has imposed many complex limitations on just how much tax benefit those deductions will actually produce, putting the subject outside the scope of this article.

[4] IRC § 1001(b).

[5] See Philadelphia Park Amusement Co. v. United States, 126 F. Supp. 184 (Ct. Cl. 1954). The issue in this case was whether the taxpayer’s “cost” (and hence the basis for computing a later loss) for the railway license was the fair market value of the license (the property received) or the fair market value of the bridge (the property given up). The court concluded that inasmuch as the taxpayer recognized the license’s fair market value as gross income on the exchange (in the form of the amount realized), the “cost” to the taxpayer was that amount, not the amount of the property given up.

[6] Treas. Reg. § 1.1001-2(a).

[7] Note that a taxpayer could also dispose of property only in exchange for forgiveness of a debt. A taxpayer might owe a bank $100,000 but, realizing that she cannot repay the debt in cash as agreed, instead transfer a piece of property worth $100,000 to the lender. This is still a section 1001 disposition, but in this case the taxpayer’s entire amount realized is the amount of the discharged debt. This is, in fact, how a property foreclosure is recognized for income tax purposes, though Congress does (on and off) allow some relief to taxpayers under certain circumstances. See, generally, IRC § 108.

[8] Recall also that “cost” can be established by recognizing gross income upon the receipt of property in an exchange, as in the Philadelphia Park case. See supra n. 5. In that case, the taxpayer’s “cost” basis for the railway license was the fair market value of the license when it was received because that is the amount the taxpayer included in gross income (i.e., in the amount realized) by reason of the exchange.

[9] This is true even if the $50,000 is nonrecourse—i.e., the borrower is not personally liable for the debt. See Crane v. Commissioner, 331 U.S. 1 (1947).

[10] IRC § 1015.

[11] IRC § 1014.

[12] There is a logic in the rule that steps up basis for an inheritance. Presumably the value of the grandfather’s estate—including the pocket watch—was subject to taxation upon his death by way of the estate & gift tax. If the basis of the inherited property were not stepped-up to its fair market value, but rather the granddaughter took a $10 carryover basis, then if she were to sell the watch for its $500 fair market value she’d have a $490 taxable gain. That $490 has already been taxed in the grandfather’s estate, however, thus stepping up the basis to fair market value avoids double taxation. This seems logical and fair, yet Congress could, and occasionally does consider, changing this rule to provide for a carried over basis in inheritances instead.

[13] See IRC § 1016.