Gain or loss on sale. When taxpayers dispose of property, they must calculate any gain or loss on the transaction and report the gain or loss on their tax returns. The gain or loss realized is equal to the difference between the amount realizedamount realizedIn the sale or exchange of property, the value of cash, property, and debt relief to be received. on the sale or exchange of the property and the taxpayer’s adjusted basis in the property.

How gains and losses are reported depends on the nature of the property and the length of time the property has been owned. Gains and losses on the sale of capital assets are known as capital gains and losses and are classified as either short-term or long-term. For a gain on the sale of a capital asset to be classified as a long-term capital gain, the taxpayer must have held the asset for the required holding period.

The definition of a capital asset is a definition by exception. All property owned by a taxpayer, other than property specifically noted as an exception, is a capital asset. The tax law defines a capital asset as any property, whether or not used in a trade or business, but does not include:

Depreciable property and real estate used in a trade or business are referred to as section 1231 assets and will be discussed later in this chapter since special rules apply to such assets. Other assets excluded from the definition of a capital asset generate ordinary income or loss on their disposition.

Gains from the sale of capital assets held for personal use (e.g., automobile, home furnishings) are taxable. Losses from the sale of capital assets held for personal use are not deductible.

Compute adjusted basis. A taxpayer must calculate the amount realized and the adjusted basis of property sold or exchanged to arrive at the amount of the gain or loss realized on the disposition. The gain or loss is calculated using the following formula:

The realization of a gain or loss requires the “sale or exchange” of an asset. “Sale or exchange” is not defined in the tax law, but a sale generally requires the receipt of money or the relief from liabilities in exchange for property, and an exchange is the transfer of ownership of one property for another property.

The amount realized from a sale or other disposition of property is equal to the sum of the money received, plus the fair market value (FMV) of other property received, less the costs paid to transfer the property. If the taxpayer is relieved of a liability, the amount of the liability is added to the amount realized.

Calculate the adjusted basis of property from the original basis and then add capital (major) improvements and deduct depreciation allowed or allowable, as illustrated by the following formula:

The original basis is usually the cost of the property at the date of acquisition, plus other purchase costs such as title insurance, escrow fees, and inspection fees. Capital improvements are major expenditures for permanent improvements to, or restoration of, the taxpayer’s property. These expenditures include amounts that result in an increase in the value of the taxpayer’s property, substantially increase the useful life of the property, or change the property for a new use. For example, architect fees paid for an addition to a building, as well as the cost of the addition, must be added to the original basis of the asset as capital improvements. Ordinary repairs and maintenance costs are not improvements.

If property is received as an inheritance, the original basis is equal to the fair market value at the decedent’s date of death. For property acquired as a gift, the amount of the recipient’s basis depends on whether the property is later sold for a gain or a loss by the recipient. If a gain results from the disposition of the property, the recipient’s basis is equal to the donor’s basis. If the disposition of the property results in a loss, the recipient’s basis is equal to the lesser of the donor’s basis or the fair market value of the property at the date of the gift. When property acquired by gift is disposed of at an amount between the basis for gain and the basis for loss, no gain or loss is recognized. Note that the basis for gain and the basis for loss will be different only where the gifted property has a fair market value on the date of the gift, which is less than the donor’s adjusted basisadjusted basisOriginal cost of an asset, plus improvements, and less any depreciation or amortization taken. in the property.

Related partyrelated partyCertain family members and business entities of those family members. transactions. When taxpayers are not independent of each other and engage in transactions, there is potential for tax abuse. To prevent this abuse, the tax law contains provisions that govern related party transactions. Under these rules, related parties who undertake certain types of transactions may find their tax benefits limited.

There are two types of transactions between related parties restricted by section 267 of the tax law. These transactions are:

Under the tax law, “losses from sale or exchange of property...directly or indirectly,” are disallowed between related parties. When the property is later sold to an unrelated party, any disallowed loss may be used to offset gain on that transaction.

Under section 267, related taxpayers are prevented from engaging in tax avoidance schemes in which one taxpayer uses the cash method of accounting and the other taxpayer uses the accrual method.

Section 267 has a complex set of rules to define who is a related party for disallowance purposes. The common related parties under section 267 would include the following:

Related party rules also consider constructive ownership in determining whether parties are related to each other. Under these rules, taxpayers are deemed to own stock owned by certain relatives and related entities. The common constructive ownership rules are as follows:

Go to, Publication 17 and read chapter 13: Basis of Property.