Income
Tax I
Bogdanski
Fall 2012
Sample Answers to Question 2
Exam No. 3570
Purchase:
The first thing that needs to be determine is if George just made a business purchase or a hobby purchase. The test for determining if the purchase was a hobby is based on the Nickerson case. Unfortunately, its an intent test, which can be hard to judge. The question is, "was George really trying to run a business?" Factors to consider included: manner in which George carries on the activity, his expertise, time and effort in the activity, expectation that assets used in activity will appreciate in value, success of George in carrying on other similar activities, amount of profits, financial status of George, and elects of personal pleasure or recreation. As applied to George: when George purchased the property, he was a lawyer which suggests that he has no expertise in running a christmas tree farm and that he's fairly well off (since he paid for the farm with cash from his "sizable bank account". There are no facts besides that George wants to start a new life as a christmas tree farmer to suggest that this is a business. However, the facts in the nickerson case are somewhat similar and the court found that he was engaged in a for-profit activity b/c one day he was going to open up a dairy on the farm. Therefore, it really does come down to George's intent. The IRS has decided though that there is a rebuttable presumption of it being a business if the gross income from the activity for 3 or more years in 5 consecutive years exceeds the deductions. We do not yet know if George will be able to establish the rebuttable presumption.
If George intends to run a business, then he can deduct the property taxes, interest on the mortgage, his travel, maintenance, repairs, insurance, utilities, etc. All of these deductions would go above the line and George could deduct them against his lawyer income (unless he fully retires before becoming a christmas tree farmer and then he can deduct them against whatever income he has, including income from the xmas tree farm). Additionally, all of the transaction costs would go into the basis of George's property ($2000 from the lawyer and $8,000 in other costs), so George's basis would be $510,000 ($400,000 in mortgage and cash, plus $10,000 in transaction costs). But, since the property is land, it is not a depreciable asset. So George will have made a capital expenditure on the land (b/c its an asset that will give a benefit beyond a year) and won't be able to regain any of his basis until he sells the land.
If George is taking up a hobby and not a business, then he can only deduct his hobby expenses against his hobby gains and then only if they exceed 2% of his AGI b/c hobby losses are considered miscellaneous. But, George will still be able to deduct the property taxes, if he itemized, since property taxes are a below the line deduction. He will not be able to deduct the interest on the mortgage b/c he does not yet have a residence on the property.
The $400,000 loan George took to buy the land is not income.
Bulldozer:
If the farm is just a hobby, George can only deduct hobby expenses against hobby gains and since he hasn't sold any trees yet, he has no gain from which to deduct the expense of the bulldozer from.
If George has started a business, the bulldozer will also be considered a capital expenditure b/c he will get a benefit of more than 1 year from it. And since the bulldozer is subject to wear and tear, he will be able to depreciate it. The amount of the depreciation depends on which method of depreciation he uses. The classic method is usually only used these days for intangible property. But if George used it, he would be able to deduct 1/6 of the bulldozer each year since the bulldozer has a class life of 6 years. But sometimes, he would only be able to depreciate to salvage value. In 2012, he would deduct $1,666.66
If he used the accelerated cost recovery systems, then we need to know which method he's using (for the period, since it has a class life of 6 years, its 5 year property per 168)
- straight line method: his annual deduction would be: his original basis (10,000) divided by total number of years in period (5). In this case, he could deduct $2000 each year off the basis of his bulldozer. This method is required for real estate, but optional personal property like bulldozers.
- double-declining balance method: his deduction would be: adjusted basis (10,000) divided by total number of years in the period (5) time 2 = $4000 each year. He would repeat that deduction every year until the straight line deduction is larger than the double declining, then he would deduct the remaining basis / remaining years.
Next: the applicable convention is 1/2 year, so he gets 1/2 of the first year's depreciation initially and then gets the full amount the following years. Therefore, if he's using the straight line method, he get's $1000 the first year. If he's using the double declining method, he gets $2000 the first year. Therefore, it will take him 6 years to depreciate his 5 year property.
BUT, sec 179 allows a deduction for a $25,000 of basis in the first year for certain kinds of depreciable property, namely equipment, up to property that costs $200,000. Since, the bulldozer is clearly equipment and only has $10,000 in basis in it, George can deduct all $10,000 in the first year under 179! After he took this depreciation (above the line) his basis in the bulldozer would be $0.
This is great news for George and probably a tax shelter, so we need to look to 469 to make sure he can actually take the deduction. 469 applies to individuals and closely held corporations, so George falls in it. 469 breaks life into 3 categories, active business, passive actives and portfolio. Active business is the taxpayers employment (George is lawyer and maybe a farmer). Passive activity is "any trade or business in which the taxpayer does not materially participate" (e.g. limited partner). So the issue here is whether George is active in this business or passive. If he's active, he gets the deduction. If he's passive, he can only deduct passive activity loss (including depreciation) against passive activity gain. George bought the bulldozer to build a farmhouse for his christmas tree farm. He probably will pass the hobby test meaning that he's involved in business activity. He is not a limited partner in the farm, but rather THE farmer. Therefore, I think that the IRS would find this to be George's active business, even though he is still currently a lawyer. Therefore, he can take all $10,000 of depreciation in the bulldozer. But, if it is in fact a passive activity (perhaps b/c he's not a farmer yet), he won't be able to take the loss yet b/c he doesn't have any gain. (He can carry the loss forward, though, until he does have gain).
The fuel for the bulldozer is deductible right away as a business expense b/c fuel is not a capital expenditure (it does not give a benefit of more than 1 year). If this is a hobby farm, the fuel is deductible against hobby gains, miscellaneous, though. If its a business, he can deduct the fuel above the line.
The property taxes and mortgage interest, as explained above are all deductible above the line if its a business, below the line, miscellaneous if this is a hobby.
Water Rights:
This fact pattern is awfully similar to Gladden. In Gladden, water rights were sold off. The court decided that this was not like Inaja, where the IRS allowed a basis first deduction for the sale of an easement (which meant the land owner didn't have to recognize any gain, but his basis was reduced as a result of the sale). Instead, the court remanded for the apportionment rule in which the basis is equitably apportioned between the part sold and the part kept. So here, the IRS would likely apportion the basis of the property between the water rights George sold and the land George kept. George would be able to deduct his basis in the water rights against the $40,000 he received from Dave, the rest would be capital gain (b/c gain real property used in a business is considered capital gain). Since George can't depreciate land, he is not subject to the depreciation recapture rules in sec 1250. If this is a hobby, the gain would still be a capital gain (and then he'd have something to deduct his hobby losses against!)
But, George might be able to argue that this is more like Inaja than gladden b/c the George sold Dave perpetual water rights, which might be more like an easement than a part of the property. But, the water rights don't affect the entire parcel, which was one of the conditions in Inaja b/c George stated that the farm does not need any water beyond the natural occurring rainfall. Therefore, this case is more like gladden (apportionment is possible) than Inaja (apportionment not possible). But, if George could make a convincing inaja argument, he could use his basis against the $40,000 and not have to recognize any gain. His adjusted basis in the property would then be $470,000.
As for the payments from Dave: since neither Dave nor George are dealers in real property or selling stocks on the public market, the installment method can apply to them since Dave is paying George in 2 installments. If that's the case, George will have to recognize a portion of each payment as income, the rest of each payment being a return of his basis (as determined above based on whether Inaja or Gladden applies). In 2012, Dave is paying George 20,000, so to figure out which portion is capital gain and which portion is a return of basis: multiply the payment ($20,000) x the gross profit ratio (gross profit/ total K price) ((amount realized minus adjusted basis) / 40,000) = amount of capital gain George has to recognize as income.
But, George could elect 453(d) and opt out of the installment method. Then he can chose which of the transaction treatments he wants.
1. open transaction treatment: all payments would be considered a return of basis until all basis has been received, then he would be taxed. So the first year, there would be no tax unless he has less than $20,000 in basis in the property. This is a very rare method and only applies if there is no IOU of the FMV. Here, Dave owes George $40,000 total, so its not speculative and therefore this method would not apply.
2. Closed transaction for accrual taxpayers. Since George and Dave are individuals, they are probably on the cash method, so this probably doesn't apply either. But if George elected it, George would have constructive receipt of all $40,000, so he would have to recognize all $40,000 gain in the first year (subtracting out his basis in the water rights).
3. Closed transaction for cash taxpayers: this is probably the only other method George would chose. Here, there would be an appraisal of the FMV of the IOU from Dave ($20,000). The FMV of the IOU depends on how likely Dave is to pay the remaining $20,000. George would have to recognize in the first year the FMV of the IOU in addition to the $20,000 Dave paid up front, but he would still be able to subtract out the applicable amount of basis.
George's remaining basis in the property would depend on how much basis he recovered from selling off the water rights. If Inaja applies, then his new basis is $470,000. If gladden applies, it depends on how the apportionment comes out.
Exam No. 3085
Purchase of Greenacre
There is an initial issue of whether G's Christmas tree farm venture will be treated as a hobby or a profit-oriented venture. The answer will depend upon the intent of G--whether it is primarily for pleasure or profit--under Nickerson and the factors in Reg. 1.183-2. Here, the fact that G is an attorney with an already sizable bank account, who lives in a large city likely weigh against the venture being treated as profit oriented. On the other hand, the fact that he immediately got to work improving the land, the fact that Christmas tree farming may not be that pleasurable to a lot of city-folk, and the fact that the land appears to be promising, given that it needs no additional water beyond annual rain fall all weigh in favor of this being treated as a profit-oriented venture. In fact, these facts are similar to those in Nickerson, where a city-dweller with a day job was granted profit-oriented status when he sought to set up a dairy farm. So, at bottom, it is likely that G's venture will be treated as profit-oriented and he will be able to deduct most expenses (as detailed below) as either ordinary and necessary costs of doing business under 162 or ordinary and necessary costs of producing income under 212. However, if this is a hobby, G will only be allowed otherwise allowable deductions--such as qualified residence interest and property tax, as detailed below--but hobby losses will be deductible only against hobby income, which at this point, G does not appear to have.
The basis of Green will be the 400,000 mortgage, because a mortgage is includable in basis under Crane, as well as the 100,000 cash payment G made. Additionally, the 2,000 cost of the lawyer's fees and the 8,000 cost of other transaction fees will likely be included in the basis of G as costs of buying, which are no immediately deductible, but rather must be capitalized under Reg. 1.263(a)-2T. There may be some question of whether the lawyer's fee might be immediately deductible as an above the line business expense, as business advice often is, but here the lawyer was reviewing purchase documents, so her fee is probably a cost of buying the property. Thus, at this point, G's basis in Green is 510,000. G cannot take depreciation deductions again this basis because land is not depreciable.
G's property taxes will be deductible under 164 as below the line deductions not subject to the 2% floor on miscellaneous deductions. Additionally, it is likely that the property taxes will be prorated in the year of sale and divided up between G and the previous owner under 164(d).
G's mortgage interest likely will be deductible, either as business interest under 162 (if not a hobby as discussed above), which would be an above the line under 62(a)(1). If this is a hobby, it is possible that the interest will be deductible as qualified residence interest, if the farmhouse is G's vacation home under 163(h)(3), as a below the line deduction, because 163(h)(3)(B) allows acquisition indebtedness up to one million, and here the acquisition indebtedness is only 400,000. But the problem here is that G is not able to use it as a vacation home yet since the farmhouse hasn't been constructed yet, so it is possible that he won't be able to deduct the mortgage interest in the event the venture is deemed a hobby.
Purchase of Bulldozer
The bulldozer has a cost basis of 10,000. The bulldozer will provide G with a long-term benefit, and it is not a recurring expense, so its cost is not immediately deductible but is instead a capital expenditure under 263. In terms of depreciating the bulldozer, G likely has two options, to get things started. First, under 179, he can immediately deduct the full amount of the bulldozer because its 10,000 cost is less than the 25,000 allowable amount; this would leave him with an ordinary deduction of 10,000 and a basis of zero in the bulldozer. It is possible that G will not qualify for 179 if he has made other equipment purchases this year, as there is a phaseout for those who purchase more than 200,000 worth of equipment in the year. If he doesn't qualify for 179, then he can take bonus depreciation under 168(k), which allows him to immediately deduct 50% of his basis. This will leave him with a 5,000 ordinary deduction and a basis of 5,000 in the bulldozer.
If he does the bonus depreciation, or if does not take one of the two options at all, he will take the bulldozer's adjusted basis and run that through the ACRS under 168. Under 168(e), property with a class life of 6 years is treated as 5 year property, meaning it is depreciated over a period of 5 years. In terms of method, G has two options under 168(b). He can use the straight line method, which will allow him to divide the basis (either 10,000 or 5,000) by the 5 year period and deduct that amount each year, leaving him with an ordinary deduction of ether 2,000 or 1,000 (subject to the half-year convention described below). He can also elect to take the double declining balance, under which he will take the basis divided by the total years in the period and multiply that number by two. Thus, he would have an ordinary deduction of either 4,000 or 2,000. Because G is subject to the half-year convention, meaning it will be assumed that he purchased the bulldozer in the middle of the year, his deduction will be cut in half in the first year. G's basis will be deducted by whatever amount he deducted under whichever ACRS election he made as described above.
Notably, G likely will not be subject to 469, a provision meant to curb tax shelters, which allows passive activity losses to only be taken against passive activity gains. Here, it looks like G is actively involved in the venture, so it will not be a passive activity for him. Thus, he will be allowed to take the above deductions against his ordinary income as an attorney. If, for some reason, this were deemed a passive activity, he would have to wait until he had some gains on the farm before he could take any of the above deductions.
The cost of fuel for the bulldozer will be immediately deductible as a business expense above the line under 62(a)(1), as will the depreciation deductions described above (subject to caveats already described). These will all be ordinary deductions.
The sale of perpetual water rights will almost
certainly be treated as a sale of an easement, not as a rental agreement per Inaja
and Gladden. If G is lucky, his sale of the water rights will be treated
under the rule of Inaja, which will allow him to apply basis first
against the payments he receives from D for the water rights. In effect, this
will mean that G will realize no gains on the sale of the water rights, given
that his basis of 510,000 in G is greater than the 40,000 purchase price of the
water rights. However, some have questioned the rule of Inaja as only
applying to the sale of easements that cannot easily be valued. Here, the water
rights clearly were valued by the parties in an arm's length transaction as
being worth 40,000. Thus, under the rule of
The sale is structured as an installment sale under 453(b) because one or more payments is made in subsequent years. Under the default rule under 453(c), G will be taxed on the installment method. This will require him to compute the gross profit ratio by dividing his gross profit by the total K price and multiply that by the 20,000 payment D makes in 2012. The gross profit will depend upon whatever portion of G's basis he is allowed to use and will be the difference between the total K price and the basis.
G could also choose the 453(d) election and try for open treatment, which would be a rare result under Reg. 1.1001-1(a), particularly in a case like this where the transaction is simple and it looks like D's note will be easy to value. If for some reason he were treated under the open method, he could use his basis first. However, if he chooses the election, he will probably be stuck with the closed cash method, which would mean his gain in the first year would be the first year's payment plus the FMV of D's IOU minus G's basis in the water right (which will be computed either under Inaja or Gladden as discussed above). To the extent that G has gain--which seems unlikely given that he will probably be treated under Inaja as using basis first, and given that he just purchased Green this year and has a cost basis in it--it will likely be taxed as ordinary income, not capital gain because he has not held the property for more than a year and thus it would not be a long-term capital gain subject to the favorable rates in 1(h) under 1222.
It is further worth noting that whatever basis G uses against the water rights payment--let's assume 40,000--will reduce the basis in Green; thus, leaving him with an adjusted basis in Green of 470,000.
The interest G will receive in 2013 from D per their agreement, will be treated as ordinary income.
Exam No. 3740
Greenacre
George's purchase of Greenacre looks a bit fishy,
like he might be trying to take hobby loss ded'ns.
The IRS is going to be very suspicious of this purchase. § 183 defines a hobby as an activity that isn't engaged in for
profit. The IRS will look at several factors to determine if George is engaged
in this Christmas tree farm for profit. Among some of these factors are:
whether George is carrying on the activity in a businesslike manner; whether he
is an expert in farming Christmas trees; how much time & effort he expends
on the activity; whether he expects the activity to be profitable, and so on
(see Reg. § 1.183-2 for all factors). George may be in trouble here--he's not
doing much to become an expert in tree-farming. It might look like he's just
some attorney from a big city who wants a nice vacation home that produces business
ded'ns because it's a disguised business. If the IRS
doesn't believe that he's engaged in this tree farming business for a profit,
he will only be able to take losses from this "tree farm" against any
gains it produces. § 183(b). However, if the IRS does believe this isn't a
hobby, George is entitled to a whole slew of business ded'ns.
George would be required to capitalize his purchase of Greenacre, along with his transaction costs, since this is a purchase of property that hopefully will produce long-term benefits for him. § 1.263(a)-2T. Thus, George must capitalize the $500,000 purchase price, plus the $10,000 in lawyers' fees and transactional costs. Capital expenditures are not currently deductible; he will place these amounts into the basis of the property and take depreciation ded'ns over a period of years.
For his depreciation ded'ns on Greenacre (income-producing property), George is required to use the straight-line method of depreciation. He will also need to know two other things to take the ded'n: 1) the "recovery period (39 yrs for nonresidential real property--§ 168(c)), and 2) the convention. Since this is real property, there is a mid-month convention (the year is split into 24 half-months--§ 168(d)). The formula George would use is: $510,000 (cost) / 39 years = $13076 per year. He would then have to apply convention to figure out his first year's ded'n.
Each year, George may also take a ded'n for the property taxes and mortgage interest he pays on Greenacre. § 162.
Since George plans to grow and sell Christmas trees, it is likely that he is also subject to the UNICAP rules, which require him to place all direct & indirect costs of producing the Christmas trees into the basis of the trees to be sold. § 263A.
Bulldozer
George's purchase of the bulldozer is also a capital expenditure because it is
a current outlay that will produce long-term benefits to him. § 263. He can
therefore use his basis to take depreciation ded'ns
for the bulldozer, since it is property he uses in his trade or business &
it's subject to wear & tear. § 165. George may
also use the ACRS system for the bulldozer, since it's
tangible property. In 2012, George can choose to either use the straight-line
method or the double-declining balance method when depreciating the bulldozer.
If he uses the straight-line method, he can take a ded'n
of $833 ($10k cost / 6 years = 1666 / half-year convention = $833). If he
chooses to uses the double-declining balance method (the default for non-real
estate tangible property), then he can take a ded'n
in 2012 of $3,333 ($10k basis / 6 years x 2). He will probably choose the
double-declining balance method because it's more favorable.
George can also deduct the costs for fuel for the bulldozer, since it's an ordinary & necessary business expense. § 162. It would be an ordinary ded'n.
Sale of Water Rights to Dave
George's sale of water rights to Dave doesn't qualify for the Inaja Land
"basis first" approach (Gladden). Therefore, he is required to
allocate his basis in the water rights and realize a gain or loss on this
transaction. This is an "installment sale" under § 453. George could
elect out of using the installment method under § 453(d), in hopes that he
could use the open transaction method. Unfortunately, he wouldn't have much
luck with trying to use the open transaction treatment, since it's only
available for IOUs that are so speculative that they can't currently be given a
FMV (Burnet v. Logan). Reg. § 1.1001-1(a) provides that such will rarely
be the case. He would then be stuck with the closed transaction treatment which
is much less favorable to taxpayers.
Using the installment method, George would figure his gain in 2012 & 2013 by multiplying the payment received each year by the "gross profit ratio." § 453(c). The ratio is the gross profit to be derived from the transaction, divided by the total K price. His gross profit depends on allocating the value of the water rights against the full value of the real estate, then determining his gain (40,000 amount realized minus adjusted basis in the water rights = gain/gross profit). His gain received on this transaction would qualify for capital gains treatment. Greenacre is "depreciable real property" because it is real property used for business purposes, so it is not, by definition, a capital asset. However, § 1250 provides that gain from the sale of depreciable real property still receives capital gains treatment, albeit usually at a top rate of 25%.
The interest payments George receives in 2013 will be taxed as ordinary gross income.