The Realization Requirement

The Realization Requirement

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  Regulation § 1.61-14. Miscellaneous items of gross income.
  

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  Benefits
  
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    prevents liquidity problems
    
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    easily administered (no mark-to-market)
    
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    savings subsidy (to the extent that we want to incentivize savings)
    
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  Problems:
  
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    (in conjunction with stepped up basis) assets kept within a family won’t be taxed
    
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    Horizontal equity—asset values change, only pay during realization events
    
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    Begins to look like a consumption tax—only taxed at liquidation  can spend the money you would be taxed at a different rate/different times
    
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    Lock-in effect—avoid realization & you won’t ever be taxed  lower ATR
    
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  In class example:
  
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    If you invest $100 in a really risky stock and have a 50-50 chance of year 2 value of $200 or $0
    
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      Win—gain $100 and defer taxes—elect to not realize gain by not selling stock
      
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      Lose—deduct the $100 loss—value = $100 x MTR (50%) =$50  $100 loss and $50 tax benefit  lose only $50
      
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      Incentive:
      
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        Trigger losses and not gains—could exacerbate business cycles
        
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        Invest in more risky assets
        

(scenario 2) 50% chance you’ll have $0—realize tax benefit of loss immediately

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  Compliance Complexity—forms and frequency of filing—LOTS in mark-to-market
  
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  Rule Complexity—lots of time spent reading codes and regulations (ironic since realization req. isn’t in Code)
  
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    Transactional Complexity—when you ex ante reorganize behavior for tax reasons—lock-in effect
    
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  Alternatives:
  
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    Blended system—mark-to-market for assets that are easy to value
    
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      but would exacerbate the problem of incentivizing investment in a certain type of asset
      
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      when would we mark the assets to market? Would influence valuation
      
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    What if we just assumed? i.e. stocks gain at about 20%  we’ll just tax at 20%
    
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      We might be on net taxing Hague-Simons but there would be individual tax inequities
      
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      Holt—this is what we do with depreciation, but sometimes catastrophes like the Great Depression come along and we have to adjust our valuation
      

Cesarini bought a piano and then found money inside—owes taxes on windfall profit—year found, not bought

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  Rev. Rul. 1953-1 “the finder of treasure-trove is in receipt of taxable income”
  

Unsolicited textbooks sent to a principle, given to a library, and recorded as charitable deductions are taxable

Is the exchange of residential mortgage loans a realization event for tax-deductible losses (even if not required to be reported on the balance sheet)? YES

Cottage Savings swapped $6.9M in assets for $4.5M and claimed a $2,447,091 deduction for the loss—“the issue before us is whether the transaction constitutes a ‘disposition of property’”

Policy behind delaying tax benefits: ease of administration

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  Why didn’t they just sell the mortgages?
  
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    If they had gotten cash it would have been a realization event—their regulator FHLBB (Federal Home Loan Bank Board) said that they didn’t have to report the loss on a swap but they would have to report a loss on a sale
    
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     Wanted tax benefit of loss w/o book loss that would require regulators close down S&L
    
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      Would realize the $2.4 M loss and for tax purposes they would have an asset worth $4.5M but for regulatory purposes they would still have an asset worth $6.9M
      
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      Keep them on the books looking like they’re ok but still getting the tax benefit—but the tax benefit makes perfect sense, but sounds like shady regulatory practice
      
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  **very common to have a difference between book and tax accounting
  
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    Accountants use actual depreciation—tax accountants use estimated, backed out depreciation
    
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    Discrepancy creates incentive for tax shelters
    
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       want books to show valuable assets and taxes to show no assets
      
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  Did Cottage Savings realize a loss? Look to section § 1001
  
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    Requires a sale or disposition of property to realize a loss
    
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    Reg § 1.1001-1—in order for there to be a realization event (if this is a disposition) there needs to be an exchange of materially different properties
    
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    Compare to Phellis, Marr, and Weiss
    
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      Phellis and Marr—Companies reincorporating from New Jersey to Delaware
      
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        Legally distinct entitlement—materially different to own all the same assets in a different state
        
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      Weiss—stayed within the original state
      
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        NOT a legally distinct entitlement—same assets under the same laws
        
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  Are we moving closer or farther away from taxing Hague-Simons income?
  
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    Tiny change in legal entitlements creates a realization event  closer to mark-to-market and Hague-Simons income
    

1. 
   In early October of 2010, first-year Met Jason Bay is putting the finishing touches on a historic season for an otherwise struggling Metropolitans organization. Bay has recently hit his 73rd home run, tying the single-season record. Quinn, a diehard Mets fan, pays a scalper $2,000 for a ticket to the Mets’ final game of the season. The face value of the ticket is $50.
   

1. 
   Quinn sells the ball for $500,000 in 2010.
   

2. 
   Quinn sells the ball in 2012 for $600,000.
   

Taxable gain of $100,000 in 2012

3. 
   Bay is stripped of the record for confirmed use of performance-enhancing drugs. Quinn, disgusted, sells the ball in 2012 for $1,000.
   

4. 
   Quinn immediately returns the ball to Jason Bay after the game.