Table of Contents introduction & vocabulary 2

CAPITAL GAINS AND LOSSES

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  Code § 11. Tax imposed.
  
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  Code § 1211. Limitation on capital losses.
  
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  Code § 1212. Capital loss carrybacks and carryovers. (caps the loss deductions for corporations at gains and non-corporate taxpayers at gains + $3,000)
  
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  Code § 1221(a). Capital asset defined—In general.
  
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  Code § 1221(b)(3). Capital asset defined—Definitions and special rules.
  
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  Code § 1222. Other terms relating to capital gains and losses.
  

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  More than 12 months  long–term capital asset & preferential treatment (15%, or if your ordinary income is taxed at 0-10% you get 0% tax on capital gains)
  
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    Less than 12 months, short-term
    
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  Basketing effect—individuals can use capital loss to offset ordinary income up to $3,000
  
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    Can carryback excess losses 3 years, or carry forward 5 years
    
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    (Corporations can only deduct losses to the extent that they have gains)
    
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  ONLY applies when you have a sale or exchange
  
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    Sometimes you have to bifurcate your gains—i.e. if your employer pays $14.1K for an asset worth $12.1K that you bought for $10--$2.1K capital gains, $2K compensation (or you could try to justify an idiosyncratic value)
    
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  Interest income is capital income (as in income from saving and investing) but it’s NOT a capital gain
  
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  Capital assets are not necessarily just assets you capitalize—we have to look at code to see what qualifies to generate capital gains/losses
  
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  Individuals
  
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    Capital losses are fully deductible against capital gains § 1211(d)
    
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    You can deduct a loss against up to $3,000 in ordinary income
    
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    If IBM stock that you’ve held for more than 1 year loses $5,000 you can deduct the loss against any capital gains and $3,000 of ordinary income and the rest you can carry forward to deduct against capital gains and $3,000 of ordinary income in the next year
    
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    Can carry forward indefinitely—but can only carry forward to the extent of your capital income
    
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      If you have: 8,000 Net capital loss; Taxable income = 4,000
      
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      Deduct 3,000 against TI; carry forward 4,000; lose 1,000 of deduction
      
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    Can deduct short-term capital losses against long-term capital gains
    
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  Corporations
  
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    can only carryback for 3 years and forward 5 years
    
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    Why can’t corporations carry forward indefinitely?
    
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      We want to limit corporations cherry picking—selling losing capital assets for deductions and never realizing income on appreciating capital assets
      
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      Driven by the realization requirement—motivates concern about cherry picking
      

1. 
   The transaction must involve “property” that is a “capital asset”
   
2. 
   The property must be transferred in a “sale or exchange” and
   
3. 
   The minimum holding period must be met.
   

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  Policy Discussion: Capital Gains Preference
  
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    Arguments FOR Preference
    
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      Bunching
      
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        problem arises because people would otherwise cherry pick to avoid the implications of the realization requirement and stepped up basis § 1014
        
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          Other potential responses to bunching?
          
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            Mark-to-market and accrual taxation
            
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            Income averaging—apply gains to all years that taxpayer held the asset
            
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        Inflation—capital gains increase long-term lockstep with inflation  capital gains try to tax only growth over the inflation rate
        
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          We inflation-adjust the brackets—much more difficult than it sounds
          
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      Lock-in
      
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        Stepped up basis
        
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        You have to hold a capital asset for a year to get preferable treatment—exacerbates lock in effect
        
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        If you raise the capital gains rate people might hold assets longer to delay realization
        
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          If you suggest cut the capital gains rate—someone will have a study that says it will raise more revenue—does not seem to be the case in the long run
          
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      Dynamic Scoring
      
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        Takes into account macroeconomic effect
        
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        Makes revenue estimates depend on feedback effects and assumptions
        
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        Capital gains are concentrated among high-income households
        
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      Encourages savings and economic growth
      
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        Will stimulate more savings overall
        
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        Incentivizes investing in risky assets
        

1. 
   Ruth is an individual taxpayer in the 35% bracket. She has the choice to invest in one of the following three assets:
   
   1. 
      A bond selling for $10,000 that will pay $1,000 each year for two years, (ORDINARY INCOME)
      
   2. 
      $10,000 of growth stock that will pay no dividends and that Ruth expects to be worth $12,100 in two years when she will set it, (CAPITAL ASSET § 1221(a)(1)) or
      
   3. 
      Stock selling for $10,000, which will pay dividends of $1,000 each year for the next two years and maintain its initial value. (CAPITAL ASSET § 1221(a)(1) + DIVIDENDS TAXED AT PREFERENTIAL RATE)
      
2. 
   If Ruth were indifferent between these investment choices (pre-tax), how might tax considerations influence her behavior?
   

B—preferential rate—$12,100 subject to long-term cap gains rate in 2 years

C –preferential rate—$11,000 at cap gains rate in 2 years and $1,000 at preferential rate in 1 year (dividends taxed like capital gains § 1(h)(11))

**TVM of payment of preferential rate 1 year earlier makes B more favorable than C and preferential rates make both B and C more favorable than A.

3. 
   If the taxpayer in (1) was a university instead of an individual in the 35% tax bracket, how might tax considerations influence its behavior?
   

4. 
   Given the answers in (1) and (2), how might the market react to the cost of the investments described above?