Ordinarily, a transaction is not a trade when you voluntarily sell property for cash and immediately buy similar property to replace it. The sale and purchase are two separate transactions. But see Like-Kind Exchanges under Nontaxable Trades, later.

A redemption of stock is treated as a sale or trade and is subject to the capital gain or loss provisions unless the redemption is a dividend or other distribution on stock.

Whether a redemption is treated as a sale, trade, dividend, or other distribution depends on the circumstances in each case. Both direct and indirect ownership of stock will be considered. The redemption is treated as a sale or trade of stock if:

A redemption or retirement of bonds or notes at their maturity generally is treated as a sale or trade. See Stocks, stock rights, and bonds and Discounted Debt Instruments under Capital or Ordinary Gain or Loss, later.

In addition, a significant modification of a bond is treated as a trade of the original bond for a new bond. For details, see section 1.1001–3 of the regulations.

A surrender of stock by a dominant shareholder who retains control of the corporation is treated as a contribution to capital rather than as an immediate loss deductible from taxable income. The surrendering shareholder must reallocate his or her basis in the surrendered shares to the shares he or she retains.

The transfer of investment property to a corporation, trust, fund, foundation, or other organization, in exchange for a fixed annuity contract that will make guaranteed annual payments to you for life, is a taxable trade. If the present value of the annuity is more than your basis in the property traded, you have a taxable gain in the year of the trade. Figure the present value of the annuity according to factors used by commercial insurance companies issuing annuities.

The transfer of property of a decedent to the executor or administrator of the estate, or to the heirs or beneficiaries, is not a sale or other disposition. No taxable gain or deductible loss results from the transfer.

The cancellation, lapse, expiration, or other termination of a right or obligation (other than a securities futures contract) with respect to property that is a capital asset (or that would be a capital asset if you acquired it) is treated as a sale. Any gain or loss is treated as a capital gain or loss.

This rule does not apply to the retirement of a debt instrument. See Redemption or retirement of bonds, earlier.

Report worthless securities on line 1 or line 8 of Schedule D (Form 1040), whichever applies. In columns (c) and (d), print “Worthless.” Enter the amount of your loss in parentheses in column (f).

If you do not claim a loss for a worthless security on your original return for the year it becomes worthless, you can file a claim for a credit or refund due to the loss. You must use Form 1040X, Amended U.S. Individual Income Tax Return, to amend your return for the year the security became worthless. You must file it within 7 years from the date your original return for that year had to be filed, or 2 years from the date you paid the tax, whichever is later. (Claims not due to worthless securities or bad debts generally must be filed within 3 years from the date a return is filed, or 2 years from the date the tax is paid.) For more information about filing a claim, see Publication 556, Examination of Returns, Appeal Rights, and Claims for Refund.

You are treated as having made a constructive sale of an appreciated financial position if you:

You are also treated as having made a constructive sale of an appreciated financial position if a person related to you enters into a transaction described above with a view toward avoiding the constructive sale treatment. For this purpose, a related person is any related party described under Related Party Transactions, later in this chapter.

A contract for sale of any stock, debt instrument, or partnership interest that is not a marketable security is not a constructive sale if it settles within 1 year of the date you enter into it.

Do not treat a transaction as a constructive sale if all of the following are true.

If a closed transaction is reestablished in a substantially similar position during the 60-day period beginning on the date the first transaction was closed, this exception still applies if the reestablished position is closed before the end of the 30th day after the end of your tax year in which the first transaction was closed and, after that closing, (2) and (3) above are true.

This is any interest in stock, a partnership interest, or a debt instrument (including a futures or forward contract, a short sale, or an option) if disposing of the interest would result in a gain.

An appreciated financial position does not include the following.

For the constructive sale rules, an interest in an actively traded trust is treated as stock unless substantially all of the value of the property held by the trust is debt that qualifies for the exception to the definition of an appreciated financial position (explained in (2) above).

A transaction treated as a constructive sale of an appreciated financial position is not treated as a constructive sale of any other appreciated financial position, as long as you continue to hold the original position. However, if you hold another appreciated financial position and dispose of the original position before closing the transaction that resulted in the constructive sale, you are treated as if, at the same time, you constructively sold the other appreciated financial position.

This is a contract that:

This is a contract that:

Bank forward contracts with maturity dates that are longer than the maturities ordinarily available for regulated futures contracts are considered to meet the definition of a foreign currency contract if the above three conditions are satisfied.

Special rules apply to certain foreign currency transactions. These transactions may result in ordinary gain or loss treatment. For details, see Internal Revenue Code section 988 and regulations sections 1.988-1(a)(7) and 1.988-3.

This is any listed option (defined later) that is not an equity option. Nonequity options include debt options, commodity futures options, currency options, and broad-based stock index options. A broad-based stock index is based upon the value of a group of diversified stocks or securities (such as the Standard and Poor's 500 index).

Cash-settled options based on a stock index and either traded on or subject to the rules of a qualified board of exchange are nonequity options if the Securities and Exchange Commission (SEC) determines that the stock index is broad based.

This rule does not apply to options established before the SEC determines that the stock index is broad based.

This is any option that is traded on, or subject to the rules of, a qualified board or exchange (as discussed earlier under Regulated futures contract). A listed option, however, does not include an option that is a right to acquire stock from the issuer.

This is any listed option that, for an options dealer:

An options dealer is any person registered with an appropriate national securities exchange as a market maker or specialist in listed options.

This is any option:

Equity options include options on a group of stocks only if the group is a narrow-based stock index.

For any dealer in securities futures contracts or options on those contracts, this is a securities futures contract (or option on such a contract) that:

A securities futures contract that is not a dealer securities futures contract is treated as described later under Securities Futures Contracts.

The marked to market rules do not apply to hedging transactions. See Hedging Transactions, later.

Under the marked to market system, 60% of your capital gain or loss will be treated as a long-term capital gain or loss, and 40% will be treated as a short-term capital gain or loss. This is true regardless of how long you actually held the property.

The 60/40 rule does not apply to dealer equity options or dealer securities futures contracts that result in capital gain or loss allocable to limited partners or limited entrepreneurs (defined later under Hedging Transactions). Instead, these gains or losses are treated as short term.

The marked to market rules also apply if your obligation or rights under section 1256 contracts are terminated or transferred during the tax year. In this case, use the fair market value of each section 1256 contract at the time of termination or transfer to determine the gain or loss. Terminations or transfers may result from any offsetting, delivery, exercise, assignment, or lapse of your obligation or rights under section 1256 contracts.

An individual or partnership having a net section 1256 contracts loss (defined later) for 2002 can elect to carry this loss back 3 years, instead of carrying it over to the next year. See How To Report, later, for information about reporting this election on your return.

The loss carried back to any year under this election cannot be more than the net section 1256 contracts gain in that year. In addition, the amount of loss carried back to an earlier tax year cannot increase or produce a net operating loss for that year.

The loss is carried to the earliest carryback year first, and any unabsorbed loss amount can then be carried to each of the next 2 tax years. In each carryback year, treat 60% of the carryback amount as a long-term capital loss and 40% as a short-term capital loss from section 1256 contracts.

If only a portion of the net section 1256 contracts loss is absorbed by carrying the loss back, the unabsorbed portion can be carried forward, under the capital loss carryover rules, to the year following the loss. (See Capital Losses under Reporting Capital Gains and Losses, later.) Figure your capital loss carryover as if, for the loss year, you had an additional short-term capital gain of 40% of the amount of net section 1256 contracts loss absorbed in the carryback years and an additional long-term capital gain of 60% of the absorbed loss. In the carryover year, treat any capital loss carryover from losses on section 1256 contracts as if it were a loss from section 1256 contracts for that year.

This loss is the lesser of:

This gain is the lesser of:

Figure your net section 1256 contracts gain for any carryback year without regard to the net section 1256 contracts loss for the loss year or any later tax year.

Gain or loss from the trading of section 1256 contracts is capital gain or loss subject to the marked to market rules. However, this does not apply to contracts held for purposes of hedging property if any loss from the property would be an ordinary loss.

The determination of whether an individual's gain or loss from any property is ordinary or capital gain or loss is made without regard to the fact that the individual is actively engaged in dealing in or trading section 1256 contracts related to that property.

Use Part I of Form 6781, Gains and Losses From Section 1256 Contracts and Straddles, to report your gains and losses from all section 1256 contracts that are open at the end of the year or that were closed out during the year. This includes the amount shown in box 9 of Form 1099–B. Then enter the net amount of these gains and losses on Schedule D (Form 1040). Include a copy of Form 6781 with your income tax return.

If the Form 1099–B you receive includes a straddle or hedging transaction, defined later, it may be necessary to show certain adjustments on Form 6781. Follow the Form 6781 instructions for completing Part I.

To carry back your loss under the election procedures described earlier, file Form 1040X or Form 1045, Application for Tentative Refund, for the year to which you are carrying the loss with an amended Form 6781 attached. Follow the instructions for completing Form 6781 for the loss year to make this election.

If you are a limited partner or entrepreneur in a syndicate, the amount of a hedging loss you can claim is limited. A “hedging loss” is the amount by which the allowable deductions in a tax year that resulted from a hedging transaction (determined without regard to the limit) are more than the income received or accrued during the tax year from this transaction.

Any hedging loss that is allocated to you for the tax year is limited to your taxable income for that year from the trade or business in which the hedging transaction occurred. Ignore any hedging transaction items in determining this taxable income. If you have a hedging loss that is disallowed because of this limit, you can carry it over to the next tax year as a deduction resulting from a hedging transaction.

If the hedging transaction relates to property other than stock or securities, the limit on hedging losses applies if the limited partner or entrepreneur is an individual.

The limit on hedging losses does not apply to any hedging loss to the extent that it is more than all your unrecognized gains from hedging transactions at the end of the tax year that are from the trade or business in which the hedging transaction occurred. The term “unrecognized gain” has the same meaning as defined under Straddles, later.

Once you identify personal property as being part of a hedging transaction, you must treat gain from its sale or exchange as ordinary income, not capital gain.

If you buy property on a time-payment plan that charges little or no interest, the basis of your property is your stated purchase price, minus the amount considered to be unstated interest. You generally have unstated interest if your interest rate is less than the applicable federal rate. For more information, see Unstated Interest and Original Issue Discount in Publication 537.

This is the price at which the property would change hands between a buyer and a seller, neither being forced to buy or sell and both having reasonable knowledge of all the relevant facts. Sales of similar property, around the same date, may be helpful in figuring fair market value.

If you receive, as payment for services, property that is subject to certain restrictions, your basis in the property generally is its fair market value when it becomes substantially vested. Property becomes substantially vested when it is transferable or is no longer subject to substantial risk of forfeiture, whichever happens first. See Restricted Property in Publication 525 for more information.

If you buy investment property at less than fair market value, as payment for services, you must include the difference in income. Your basis in the property is the price you pay plus the amount you include in income.

If the fair market value of the property at the time of the gift was less than the donor's adjusted basis just before the gift, your basis for gain on its sale or other disposition is the same as the donor's adjusted basis plus or minus any required adjustments to basis during the period you hold the property. Your basis for loss is its fair market value at the time of the gift plus or minus any required adjustments to basis during the period you hold the property.

If you use the basis for figuring a gain and the result is a loss, and then use the basis for figuring a loss and the result is a gain, you will have neither a gain nor a loss.

If the fair market value of the property at the time of the gift was equal to or more than the donor's adjusted basis just before the gift, your basis for gain or loss on its sale or other disposition is the donor's adjusted basis plus or minus any required adjustments to basis during the period you hold the property. Also, you may be allowed to add to the donor's adjusted basis all or part of any gift tax paid, depending on the date of the gift.

If you received property as a gift before 1977, your basis in the property is the donor's adjusted basis increased by the total gift tax paid on the gift. However, your basis cannot be more than the fair market value of the gift at the time it was given to you.

If you received property as a gift after 1976, your basis is the donor's adjusted basis increased by the part of the gift tax paid that was for the net increase in value of the gift. You figure this part by multiplying the gift tax paid on the gift by a fraction. The numerator (top part) is the net increase in value of the gift and the denominator (bottom part) is the amount of the gift.

The net increase in value of the gift is the fair market value of the gift minus the donor's adjusted basis. The amount of the gift is its value for gift tax purposes after reduction by any annual exclusion and marital or charitable deduction that applies to the gift.

If you get property in a transfer that is partly a sale and partly a gift, your basis is the larger of the amount you paid for the property or the transferor's adjusted basis in the property at the time of the transfer. Add to that amount the amount of any gift tax paid on the gift, as described in the preceding discussion. For figuring loss, your basis is limited to the property's fair market value at the time of the transfer.

For information on gift tax, see Publication 950, Introduction to Estate and Gift Taxes.

Your basis in certain appreciated property that you inherited is the decedent's adjusted basis in the property immediately before death rather than its fair market value. This applies to appreciated property that you or your spouse gave the decedent as a gift during the one-year period ending on the date of death. Appreciated property is any property whose fair market value on the day you gave it to the decedent was more than its adjusted basis.

See Publication 551, Basis of Assets, for more information on the basis of inherited property, including community property, a joint tenancy or tenancy by the entirety, a qualified joint interest, and a farm or business.

If you can adequately identify the shares of stock or the bonds you sold, their basis is the cost or other basis of the particular shares of stock or bonds.

If you buy and sell securities at various times in varying quantities and you cannot adequately identify the shares you sell, the basis of the securities you sell is the basis of the securities you acquired first. Except for certain mutual fund shares, discussed later, you cannot use the average price per share to figure gain or loss on the sale of the shares.

You will make an adequate identification if you show that certificates representing shares of stock from a lot that you bought on a certain date or for a certain price were delivered to your broker or other agent.

If you have left the stock certificates with your broker or other agent, you will make an adequate identification if you:

If you bought stock in different lots at different times and you hold a single stock certificate for this stock, you will make an adequate identification if you:

Stock identified this way is the stock sold or transferred even if stock certificates from a different lot are delivered to the broker or other agent.

If you sell part of the stock represented by a single certificate directly to the buyer instead of through a broker, you will make an adequate identification if you keep a written record of the particular stock that you intend to sell.

These methods of identification also apply to bonds sold or transferred.

The basis of shares in a regulated investment company (mutual fund) or a real estate investment trust (REIT) is generally figured in the same way as the basis of other stock.

Your cost basis in a mutual fund often includes a sales fee, also known as a load charge. But, in certain cases, you cannot include the entire amount of a load charge in your basis if the charge gives you a reinvestment right. For more information, see Publication 564.

You can choose to use the average basis of mutual fund shares if you acquired the shares at various times and prices and left them on deposit in an account kept by a custodian or agent. The methods you can use to figure average basis are explained in Publication 564.

If you had to include in your income any undistributed capital gains of the mutual fund or REIT, increase your basis in the stock by the difference between the amount you included and the amount of tax paid for you by the fund or REIT. See Undistributed capital gains of mutual funds and REITs under Capital Gain Distributions in chapter 1.

If you participate in an automatic investment service, your basis for each share of stock, including fractional shares, bought by the bank or other agent is the purchase price plus a share of the broker's commission.

If you participate in a dividend reinvestment plan and receive stock from the corporation at a discount, your basis is the full fair market value of the stock on the dividend payment date. You must include the amount of the discount in your income.

If, before 1986, you excluded from income the value of stock you had received under a qualified public utility reinvestment plan, your basis in that stock is zero.

Stock dividends are distributions made by a corporation of its own stock. Generally, stock dividends are not taxable to you. However, see Distributions of Stock and Stock Rights under Nontaxable Distributions in chapter 1 for some exceptions. If the stock dividends are not taxable, you must divide your basis for the old stock between the old and new stock.

If the new stock you received as a nontaxable dividend is identical to the old stock on which the dividend was declared, divide the adjusted basis of the old stock by the number of shares of old and new stock. The result is your basis for each share of stock.

If the new stock you received as a nontaxable dividend is not identical to the old stock on which it was declared, the basis of the new stock is calculated differently. Divide the adjusted basis of the old stock between the old and the new stock in the ratio of the fair market value of each lot of stock to the total fair market value of both lots on the date of distribution of the new stock.

Figure the basis of stock dividends received on stock you bought at various times and at different prices by allocating to each lot of stock the share of the stock dividends due to it.

If your stock dividend is taxable when you receive it, the basis of your new stock is its fair market value on the date of distribution. The basis of your old stock does not change.

Figure the basis of stock splits in the same way as stock dividends if identical stock is distributed on the stock held.

A stock right is a right to acquire a corporation's stock. It may be exercised, it may be sold if it has a market value, or it may expire. Stock rights are rarely taxable when you receive them. See Distributions of Stock and Stock Rights under Nontaxable Distributions in chapter 1.

If you receive stock rights that are taxable, the basis of the rights is their fair market value at the time of distribution. The basis of the old stock does not change.

If you receive nontaxable stock rights and allow them to expire, they have no basis.

If you exercise or sell the nontaxable stock rights and if, at the time of distribution, the stock rights had a fair market value of 15% or more of the fair market value of the old stock, you must divide the adjusted basis of the old stock between the old stock and the stock rights. Use a ratio of the fair market value of each to the total fair market value of both at the time of distribution.

If the fair market value of the stock rights was less than 15%, their basis is zero. However, you can choose to divide the basis of the old stock between the old stock and the stock rights. To make the choice, attach a statement to your return for the year in which you received the rights, stating that you choose to divide the basis of the stock.

If you exercise the stock rights, the basis of the new stock is its cost plus the basis of the stock rights exercised.

In general, if you receive investment property as a distribution in partial or complete liquidation of a corporation and if you recognize gain or loss when you acquire the property, your basis in the property is its fair market value at the time of the distribution.

You must increase your basis in stock of an S corporation by your pro rata share of the following items.

You must decrease your basis in stock of an S corporation by your pro rata share of the following items.

However, your basis in the stock cannot be reduced below zero.

If you bought this stock or interest as replacement property for publicly traded securities you sold at a gain, you must reduce the basis of the stock or interest by the amount of any postponed gain on that sale. See Rollover of Gain From Publicly Traded Securities, later.

If you bought this stock as replacement property for other qualified small business stock you sold at a gain, you must reduce the basis of this replacement stock by the amount of any postponed gain on the earlier sale. See Gains on Qualified Small Business Stock, later.

If you cannot deduct payments you make to a lender in lieu of dividends on stock used in a short sale, the amount you pay to the lender is a capital expense, and you must add it to the basis of the stock used to close the short sale.

See Payments in lieu of dividends, later, for information about deducting payments in lieu of dividends.

If you buy a bond at a premium, the premium is treated as part of your basis in the bond. If you choose to amortize the premium paid on a taxable bond, you must reduce the basis of the bond by the amortized part of the premium each year over the life of the bond.

Although you cannot deduct the premium on a tax-exempt bond, you must amortize it to determine your adjusted basis in the bond. You must reduce the basis of the bond by the premium you amortized for the period you held the bond.

See Bond Premium Amortization in chapter 3 for more information.

If you include market discount on a bond in income currently, increase the basis of your bond by the amount of market discount you include in your income. See Market Discount Bonds in chapter 1 for more information.

If you include acquisition discount on a short-term obligation in your income currently, increase the basis of the obligation by the amount of acquisition discount you include in your income. See Discount on Short-Term Obligations in chapter 1 for more information.

Increase the basis of a debt instrument by the amount of OID that you include in your income. See Original Issue Discount (OID) in chapter 1.

OID on tax-exempt obligations is generally not taxable. However, when you dispose of a tax-exempt obligation issued after September 3, 1982, that you acquired after March 1, 1984, you must accrue OID on the obligation to determine its adjusted basis. The accrued OID is added to the basis of the obligation to determine your gain or loss.

For information on determining OID on a long-term obligation, see Debt Instruments Issued After July 1, 1982, and Before 1985 or Debt Instruments Issued After 1984, whichever applies, in Publication 1212 under Figuring OID on Long-Term Debt Instruments.

If the tax-exempt obligation has a maturity of 1 year or less, accrue OID under the rules for acquisition discount on short-term obligations. See Discount on Short-Term Obligations in chapter 1.

If you acquired a stripped tax-exempt bond or coupon after October 22, 1986, you must accrue OID on it to determine its adjusted basis when you dispose of it. For stripped tax-exempt bonds or coupons acquired after June 10, 1987, part of this OID may be taxable. You accrue the OID on these obligations in the manner described in chapter 1 under Stripped Bonds and Coupons.

Increase your basis in the stripped tax-exempt bond or coupon by the taxable and nontaxable accrued OID. Also increase your basis by the interest that accrued (but was not paid, and was not previously reflected in your basis) before the date you sold the bond or coupon. In addition, for bonds acquired after June 10, 1987, add to your basis any accrued market discount not previously reflected in basis.

If the amount you realize from a sale or trade is more than the adjusted basis of the property you transfer, the difference is a gain.

If the adjusted basis of the property you transfer is more than the amount you realize, the difference is a loss.

The amount you realize from a sale or trade of property is everything you receive for the property. This includes the money you receive plus the fair market value of any property or services you receive.

If you finance the buyer's purchase of your property and the debt instrument does not provide for adequate stated interest, the unstated interest will reduce the amount realized. For more information, see Publication 537.

Fair market value is the price at which property would change hands between a buyer and a seller, neither being forced to buy or sell and both having reasonable knowledge of all the relevant facts.

The fair market value of notes or other debt instruments you receive as a part of the sale price is usually the best amount you can get from selling them to, or discounting them with, a bank or other buyer of debt instruments.

A debt against the property, or against you, that is paid off as a part of the transaction or that is assumed by the buyer must be included in the amount realized. This is true even if neither you nor the buyer is personally liable for the debt. For example, if you sell or trade property that is subject to a nonrecourse loan, the amount you realize generally includes the full amount of the note assumed by the buyer even if the amount of the note is more than the fair market value of the property.

If you trade property and cash for other property, the amount you realize is the fair market value of the property you receive. Determine your gain or loss by subtracting the cash you pay and the adjusted basis of the property you traded in from the amount you realize. If the result is a positive number, it is a gain. If the result is a negative number, it is a loss.

You may have to use a basis for figuring gain that is different from the basis used for figuring loss. In this case, you may have neither a gain nor a loss. See No gain or loss in the discussion on the basis of property you received as a gift under Basis Other Than Cost, earlier.

If you receive cash or unlike property in addition to the like property, and the preceding six conditions are met, you have a partly nontaxable trade. You are taxed on any gain you realize, but only up to the amount of the cash and the fair market value of the unlike property you receive. You cannot deduct a loss.

If you give up unlike property in addition to the like property, you must recognize gain or loss on the unlike property you give up. The gain or loss is the difference between the adjusted basis of the unlike property and its fair market value.

If conditions (1) — (6) are met, you have a nontaxable trade even if you pay money in addition to the like property.

You figure your basis in property received in a nontaxable or partly nontaxable trade as explained earlier under Basis Other Than Cost, earlier.

You must report the trade of like property on Form 8824. If you figure a recognized gain or loss on Form 8824, report it on Schedule D of Form 1040 or on Form 4797, Sales of Business Property, whichever applies.

For information on using Form 4797, see chapter 4 of Publication 544.

In some instances, a company will give you common stock for preferred stock, preferred stock for common stock, or stock in one corporation for stock in another corporation. If this is a result of a merger, recapitalization, transfer to a controlled corporation, bankruptcy, corporate division, corporate acquisition, or other corporate reorganization, you do not recognize gain or loss.

You can exchange common stock for common stock or preferred stock for preferred stock in the same corporation without having a recognized gain or loss. This is true for a trade between two stockholders as well as a trade between a stockholder and the corporation.

If in an otherwise nontaxable trade you receive money or other property in addition to stock, then your gain on the trade, if any, is taxed, but only up to the amount of the money or other property. Any loss is not recognized.

Nonqualified preferred stock is generally treated as property other than stock. Generally, this applies to preferred stock with one or more of the following features.

For a detailed definition of nonqualified preferred stock, see section 351(g)(2) of the Internal Revenue Code.

You generally will not have a recognized gain or loss if you convert bonds into stock or preferred stock into common stock of the same corporation according to a conversion privilege in the terms of the bond or the preferred stock certificate.

Generally, if you convert the bonds of one corporation into common stock of another corporation, according to the terms of the bond issue, you must recognize gain or loss up to the difference between the fair market value of the stock received and the adjusted basis of the bonds exchanged. In some instances, however, such as trades that are part of mergers or other corporate reorganizations, you will have no recognized gain or loss if certain requirements are met. For more information about the tax consequences of converting securities of one corporation into common stock of another corporation, under circumstances such as those just described, consult the respective corporations and the terms of the bond issue. This information is also available on the prospectus of the bond issue.

If you transfer property to a corporation solely in exchange for stock in that corporation, and immediately after the trade you are in control of the corporation, you ordinarily will not recognize a gain or loss. This rule applies both to individuals and to groups who transfer property to a corporation. It does not apply if the corporation is an investment company.

If you are in a bankruptcy or a similar proceeding and you transfer property to a controlled corporation under a plan, other than a reorganization, you must recognize gain to the extent the stock you receive in the exchange is used to pay off your debts.

For this purpose, to be in control of a corporation, you or your group of transferors must own, immediately after the exchange, at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the outstanding shares of each class of nonvoting stock of the corporation.

If this provision applies to you, you must attach to your return a complete statement of all facts pertinent to the exchange.

If, in an otherwise nontaxable trade of property for corporate stock, you also receive money or property other than stock, you may have a taxable gain. However, you are taxed only up to the amount of money plus the fair market value of the other property you receive. The rules for figuring taxable gain in this situation generally follow those for a partially nontaxable exchange discussed earlier under Like-Kind Exchanges. If the property you give up includes depreciable property, the taxable gain may have to be reported as ordinary income because of depreciation. (See chapter 3 of Publication 544.) No loss is recognized.

Nonqualified preferred stock (described earlier under Stock for stock of the same corporation) received is generally treated as property other than stock.

The basis of the stock you receive is generally the adjusted basis of the property you transfer. Increase this amount by any amount that was treated as a dividend, plus any gain recognized on the trade. Decrease this amount by any cash you received and the fair market value of any other property you received.

The basis of any other property you receive is its fair market value on the date of the trade.

If you sell or trade to a related party a number of blocks of stock or pieces of property in a lump sum, you must figure the gain or loss separately for each block of stock or piece of property. The gain on each item may be taxable. However, you cannot deduct the loss on any item. Also, you cannot reduce gains from the sales of any of these items by losses on the sales of any of the other items.

You cannot deduct your loss on the sale of stock through your broker if, under a prearranged plan, a related party buys the same stock you had owned. This does not apply to a trade between related parties through an exchange that is purely coincidental and is not prearranged.

In determining whether a person directly or indirectly owns any of the outstanding stock of a corporation, the following rules apply.

Stock directly or indirectly owned by or for a corporation, partnership, estate, or trust is considered owned proportionately by or for its shareholders, partners, or beneficiaries.

An individual is considered to own the stock that is directly or indirectly owned by or for his or her family. Family includes only brothers and sisters, half-brothers and half-sisters, spouse, ancestors, and lineal descendants.

An individual owning, other than by applying rule 2, any stock in a corporation is considered to own the stock that is directly or indirectly owned by or for his or her partner.

When applying rule 1, 2, or 3, stock constructively owned by a person under rule 1 is treated as actually owned by that person. But stock constructively owned by an individual under rule 2 or rule 3 is not treated as owned by that individual for again applying either rule 2 or rule 3 to make another person the constructive owner of the stock.

If you sell or trade at a gain property that you acquired from a related party, you recognize the gain only to the extent that it is more than the loss previously disallowed to the related party. This rule applies only if you are the original transferee and you acquired the property by purchase or exchange. This rule does not apply if the related party's loss was disallowed because of the wash sale rules, described later under Wash Sales.

If you sell or trade at a loss property that you acquired from a related party, you cannot recognize the loss that was not allowed to the related party.

You need to classify your gains and losses as either ordinary or capital gains or losses. You then need to classify your capital gains and losses as either short term or long term. If you have long-term gains and losses, you must identify your 28% rate gains and losses. If you have a net capital gain, you must also identify your qualified 5-year gain and any unrecaptured section 1250 gain.

The correct classification and identification helps you figure the limit on capital losses and the correct tax on capital gains. For information about determining whether your capital gain or loss is short term or long term, see Holding Period, later. For information about 28% rate gain or loss, qualified 5-year gain, and unrecaptured section 1250 gain, see Reporting Capital Gains and Losses and Capital Gain Tax Rates, later.

Investment property is a capital asset. Any gain or loss from its sale or trade generally is a capital gain or loss.

These are capital assets except when they are held for sale by a dealer. Any gain or loss from their sale or trade generally is a capital gain or loss.

All of these, including stock received as a dividend, are capital assets except when they are held for sale by a securities dealer. However, see Losses on Section 1244 (Small Business) Stock and Losses on Small Business Investment Company Stock, later.

Property held for personal use only, rather than for investment, is a capital asset, and you must report a gain from its sale as a capital gain. However, you cannot deduct a loss from selling personal use property.

Discounted Debt Instruments

Treat your gain or loss on the sale, redemption, or retirement of a bond or other debt instrument originally issued at a discount or bought at a discount as capital gain or loss, except as explained in the following discussions.

Any obligation must be in registered form unless:

If you can reasonably estimate your loss, you can choose to treat the estimated loss as either an ordinary loss or a casualty loss in the current year. Either way, you claim the loss as an itemized deduction.

If you claim an ordinary loss, report it as a miscellaneous itemized deduction on line 22 of Schedule A (Form 1040). The maximum amount you can claim is $20,000 ($10,000 if you are married filing separately) reduced by any expected state insurance proceeds. Your loss is subject to the 2%-of-adjusted-gross-income limit. You cannot choose to claim an ordinary loss if any part of the deposit is federally insured.

If you claim a casualty loss, attach Form 4684, Casualties and Thefts, to your return. Each loss must be reduced by $100. Your total casualty losses for the year are reduced by 10% of your adjusted gross income.

You cannot choose either of these methods if:

If the actual loss that is finally determined is more than the amount you deducted as an estimated loss, you can claim the excess loss as a bad debt. If the actual loss is less than the amount deducted as an estimated loss, you must include in income (in the final determination year) the excess loss claimed. See Recoveries in Publication 525, Taxable and Nontaxable Income.

If you do not choose to deduct your estimated loss as a casualty loss or an ordinary loss, you wait until the year the amount of the actual loss is determined and deduct it as a nonbusiness bad debt in that year. Report it as a short-term capital loss on Schedule D (Form 1040), as explained under Nonbusiness Bad Debts, later.

The amount of gain treated as ordinary income is the smaller of:

Figure this amount as follows.

If the term of the conversion transaction is indefinite, the applicable rate is the federal short-term rate in effect under section 6621(b) of the Internal Revenue Code during the period of the conversion transaction, compounded daily.

In all other cases, the applicable rate is the “applicable federal rate” determined as if the conversion transaction were a debt instrument and compounded semi-annually.

The rates discussed above are published by the IRS in the Internal Revenue Bulletin. Or, you can contact the IRS to get these rates. See chapter 5 for information on contacting the IRS.

To determine your net investment in a conversion transaction, include the fair market value of any position at the time it becomes part of the transaction. This means that your net investment generally will be the total amount you invested, less any amount you received for entering into the position (for example, a premium you received for writing a call).

A special rule applies when a position with a built-in loss becomes part of a conversion transaction. A built-in loss is any loss that you would have realized if you had disposed of or otherwise terminated the position at its fair market value at the time it became part of the conversion transaction.

When applying the conversion transaction rules to a position with a built-in loss, use the position's fair market value at the time it became part of the transaction. But, when you dispose of or otherwise terminate the position in a transaction in which you recognize gain or loss, you must recognize the built-in loss. The conversion transaction rules do not affect whether the built-in loss is treated as an ordinary or capital loss.

Before determining the amount of gain treated as ordinary income, you can net certain gains and losses from positions of the same conversion transaction. To do this, you have to dispose of all the positions within a 14-day period that is within a single tax year. You cannot net the built-in loss against the gain.

You can net gains and losses only if you identify the conversion transaction as an identified netting transaction on your books and records. Each position of the conversion transaction must be identified before the end of the day on which the position becomes part of the conversion transaction. For conversion transactions entered into before February 20, 1996, this requirement is met if the identification was made by that date.

These rules do not apply to options dealers and commodities traders.

Use Form 6781, Gains and Losses From Section 1256 Contracts and Straddles, to report conversion transactions. See the instructions for lines 11 and 13 of Form 6781.

A futures contract that is a hedging transaction generally produces ordinary gain or loss. A futures contract is a hedging transaction if you enter into the contract in the ordinary course of your business primarily to manage the risk of interest rate or price changes or currency fluctuations on borrowings, ordinary property, or ordinary obligations. (Generally, ordinary property or obligations are those that cannot produce capital gain or loss under any circumstances.) For example, the offset or exercise of a futures contract that protects against price changes in your business inventory results in an ordinary gain or loss.

For more information about hedging transactions, see section 1.1221–2 of the regulations. Also, see Hedging Transactions under Section 1256 Contracts Marked to Market, earlier.

The following are constructive ownership transactions.

This provision does not apply if all the positions are marked to market. Marked to market rules for section 1256 contracts are discussed in detail under Section 1256 Contracts Marked to Market, earlier.

A financial asset, for this purpose, is any equity interest in a pass-through entity. Pass-through entities include partnerships, S corporations, trusts, regulated investment companies, and real estate investment trusts.

Long-term capital gain is treated as ordinary income to the extent it is more than the net underlying long-term capital gain. The net underlying long-term capital gain is the amount of net capital gain you would have realized if you acquired the asset for its fair market value on the date the constructive ownership transaction was opened, and sold the asset for its fair market value on the date the transaction was closed. If you do not establish the amount of net underlying long-term capital gain by clear and convincing evidence, it is treated as zero.

For more information, see section 1260 of the Internal Revenue Code.

The amount that you can deduct as an ordinary loss is limited to $50,000 each year. On a joint return the limit is $100,000, even if only one spouse has this type of loss. If your loss is $110,000 and your spouse has no loss, you can deduct $100,000 as an ordinary loss on a joint return. The remaining $10,000 is a capital loss.

This is stock that was issued for money or property (other than stock and securities) in a domestic small business corporation. During its 5 most recent tax years before the loss, this corporation must have derived more than 50% of its gross receipts from other than royalties, rents, dividends, interest, annuities, and gains from sales and trades of stocks or securities. If the corporation was in existence for at least 1 year, but less than 5 years, the 50% test applies to the tax years ending before the loss. If the corporation was in existence less than 1 year, the 50% test applies to the entire period the corporation was in existence before the day of the loss. However, if the corporation's deductions (other than the net operating loss and dividends received deductions) were more than its gross income during this period, this 50% test does not apply.

The corporation must have been largely an operating company for ordinary loss treatment to apply.

If the stock was issued before July 19, 1984, the stock must be common stock. If issued after July 18, 1984, the stock may be either common or preferred. For more information about the requirements of a small business corporation or the qualifications of section 1244 stock, see section 1244 of the Internal Revenue Code and its regulations.

You must be the original owner of the stock to be allowed ordinary loss treatment. To claim a deductible loss on stock issued to your partnership, you must have been a partner when the stock was issued and have remained so until the time of the loss. You add your distributive share of the partnership loss to any individual section 1244 stock loss you may have before applying the ordinary loss limit.

If your partnership distributes the stock to you, you cannot treat any later loss on that stock as an ordinary loss.

Stock sold through an underwriter is not section 1244 stock unless the underwriter only acted as a selling agent for the corporation.

Stock you receive as a stock dividend qualifies as section 1244 stock if:

If you trade your section 1244 stock for new stock in the same corporation in a reorganization that qualifies as a recapitalization or that is only a change in identity, form, or place of organization, the new stock is section 1244 stock if the stock you trade meets the requirements when the trade occurs.

If you hold section 1244 stock and other stock in the same corporation, not all of the stock you receive as a stock dividend or in a reorganization will qualify as section 1244 stock. Only that part based on the section 1244 stock you hold will qualify.

To determine ordinary loss on section 1244 stock you receive in a trade for property, you have to reduce the basis of the stock if:

Reduce the basis of the stock by the difference between the adjusted basis of the property and its fair market value at the time of the trade. You reduce the basis only to figure the ordinary loss. Do not reduce the basis of the stock for any other purpose.

If the basis of your section 1244 stock has increased, through contributions to capital or otherwise, you must treat this increase as applying to stock that is not section 1244 stock when you figure an ordinary loss on its sale.

You report this type of ordinary loss on line 10, Part II, of Form 4797. In addition to the information required by the form, you must include the name and address of the company that issued the stock. Report a capital gain from the sale of SBIC stock on Schedule D of Form 1040.

If you close a short sale of SBIC stock with other SBIC stock that you bought only for that purpose, any loss you have on the sale is a capital loss. See Short Sales, later in this chapter, for more information.

If you hold investment property more than 1 year, any capital gain or loss is a long-term capital gain or loss. If you hold the property 1 year or less, any capital gain or loss is a short-term capital gain or loss.

To determine how long you held the investment property, begin counting on the date after the day you acquired the property. The day you disposed of the property is part of your holding period.

For securities traded on an established securities market, your holding period begins the day after the trade date you bought the securities, and ends on the trade date you sold them.

Do not confuse the trade date with the settlement date, which is the date by which the stock must be delivered and payment must be made.

The holding period of U.S. Treasury notes and bonds sold at auction on the basis of yield starts the day after the Secretary of the Treasury, through news releases, gives notification of acceptance to successful bidders. The holding period of U.S. Treasury notes and bonds sold through an offering on a subscription basis at a specified yield starts the day after the subscription is submitted.

In determining your holding period for shares bought by the bank or other agent, full shares are considered bought first and any fractional shares are considered bought last. Your holding period starts on the day after the bank's purchase date. If a share was bought over more than one purchase date, your holding period for that share is a split holding period. A part of the share is considered to have been bought on each date that stock was bought by the bank with the proceeds of available funds.

If you acquire investment property in a trade for other investment property and your basis for the new property is determined, in whole or in part, by your basis in the old property, your holding period for the new property begins on the day following the date you acquired the old property.

If you receive a gift of property and your basis is determined by the donor's adjusted basis, your holding period is considered to have started on the same day the donor's holding period started.

If your basis is determined by the fair market value of the property, your holding period starts on the day after the date of the gift.

If you inherit investment property, your capital gain or loss on any later disposition of that property is treated as a long-term capital gain or loss. This is true regardless of how long you actually held the property.

To figure how long you have held real property bought under an unconditional contract, begin counting on the day after you received title to it or on the day after you took possession of it and assumed the burdens and privileges of ownership, whichever happened first. However, taking delivery or possession of real property under an option agreement is not enough to start the holding period. The holding period cannot start until there is an actual contract of sale. The holding period of the seller cannot end before that time.

If you sell real property but keep a security interest in it, and then later repossess the property under the terms of the sales contract, your holding period for a later sale includes the period you held the property before the original sale and the period after the repossession. Your holding period does not include the time between the original sale and the repossession. That is, it does not include the period during which the first buyer held the property.

The holding period for stock you received as a taxable stock dividend begins on the date of distribution.

The holding period for new stock you received as a nontaxable stock dividend begins on the same day as the holding period of the old stock. This rule also applies to stock acquired in a spin-off, which is a distribution of stock or securities in a controlled corporation.

Your holding period for nontaxable stock rights begins on the same day as the holding period of the underlying stock. The holding period for stock acquired through the exercise of stock rights begins on the date the right was exercised.

Gains or losses on section 1256 contracts open at the end of the year, or terminated during the year, are treated as 60% long term and 40% short term, regardless of how long the contracts were held. See Section 1256 Contracts Marked to Market, earlier.

Your holding period for property you acquire when you exercise an option begins the day after you exercise the option.

Your holding period for substantially identical stock or securities you acquire in a wash sale includes the period you held the old stock or securities.

Your holding period for stock you acquired in a tax-free rollover of gain from a sale of qualified small business stock, described later, includes the period you held the old stock.

Futures transactions in any commodity subject to the rules of a board of trade or commodity exchange are long term if the contract was held for more than 6 months.

Your holding period for a commodity received in satisfaction of a commodity futures contract, other than a regulated futures contract subject to Internal Revenue Code section 1256, includes your holding period for the futures contract if you held the contract as a capital asset.

Your holding period for a security received in satisfaction of a securities futures contract, other than one that is a section 1256 contract, includes your holding period for the futures contract if you held the contract as a capital asset.

Your holding period for a security received in satisfaction of a securities futures contract to sell, other than one that is a section 1256 contract, is determined by the rules that apply to short sales, discussed later under Short Sales.

If you hold stock in a regulated investment company (commonly called a mutual fund) or real estate investment trust (REIT) for 6 months or less and then sell it at a loss (other than under a periodic liquidation plan), special rules may apply.

The loss (after reduction for any exempt-interest dividends you received, as explained next) is treated as a long-term capital loss up to the total of any capital gain distributions you received and your share of any undistributed capital gains. Any remaining loss is short-term capital loss.

If you received exempt-interest dividends on the stock, at least part of your loss is disallowed. You can deduct only the amount of loss that is more than the exempt-interest dividends.

For information on business bad debts of an employee, see Publication 529. For information on other business bad debts, see chapter 11 of Publication 535.

To be deductible, nonbusiness bad debts must be totally worthless. You cannot deduct a partly worthless nonbusiness debt.

A debt must be genuine for you to deduct a loss. A debt is genuine if it arises from a debtor-creditor relationship based on a valid and enforceable obligation to repay a fixed or determinable sum of money.

For a bad debt, you must show that there was an intention at the time of the transaction to make a loan and not a gift. If you lend money to a relative or friend with the understanding that it may not be repaid, it is considered a gift and not a loan. You cannot take a bad debt deduction for a gift. There cannot be a bad debt unless there is a true creditor-debtor relationship between you and the person or organization that owes you the money.

When minor children borrow from their parents to pay for their basic needs, there is no genuine debt. A bad debt cannot be deducted for such a loan.

To deduct a bad debt, you must have a basis in it — that is, you must have already included the amount in your income or loaned out your cash. For example, you cannot claim a bad debt deduction for court-ordered child support not paid to you by your former spouse. If you are a cash method taxpayer (most individuals are), you generally cannot take a bad debt deduction for unpaid salaries, wages, rents, fees, interest, dividends, and similar items.

You can take a bad debt deduction only in the year the debt becomes worthless. You do not have to wait until a debt is due to determine whether it is worthless. A debt becomes worthless when there is no longer any chance that the amount owed will be paid.

It is not necessary to go to court if you can show that a judgment from the court would be uncollectible. You must only show that you have taken reasonable steps to collect the debt. Bankruptcy of your debtor is generally good evidence of the worthlessness of at least a part of an unsecured and unpreferred debt.

If your bad debt is the loss of a deposit in a financial institution, see Deposit in Insolvent or Bankrupt Financial Institution, earlier.

If you do not deduct a bad debt on your original return for the year it becomes worthless, you can file a claim for a credit or refund due to the bad debt. To do this, use Form 1040X to amend your return for the year the debt became worthless. You must file it within 7 years from the date your original return for that year had to be filed, or 2 years from the date you paid the tax, whichever is later. (Claims not due to bad debts or worthless securities generally must be filed within 3 years from the date a return is filed, or 2 years from the date the tax is paid.) For more information about filing a claim, see Publication 556, Examination of Returns, Appeal Rights, and Claims for Refund.

If you guarantee a debt that becomes worthless, you cannot take a bad debt deduction for your payments on the debt unless you can show either that your reason for making the guarantee was to protect your investment or that you entered the guarantee transaction with a profit motive. If you make the guarantee as a favor to friends and do not receive any consideration in return, your payments are considered a gift and you cannot take a deduction.

Unless you have rights against the borrower, discussed next, a payment you make on a loan you guaranteed is deductible in the year you make the payment.

When you make payment on a loan that you guaranteed, you may have the right to take the place of the lender (the right of subrogation). The debt is then owed to you. If you have this right, or some other right to demand payment from the borrower, you cannot take a bad debt deduction until these rights become totally worthless.

You cannot take a nonbusiness bad debt deduction for any worthless debt owed to you by:

Workers and material suppliers may file liens against property because of debts owed by a builder or contractor. If you pay off the lien to avoid foreclosure and loss of your property, you are entitled to repayment from the builder or contractor. If the debt is uncollectible, you can take a bad debt deduction.

You can take a bad debt deduction for the amount you deposit with a contractor if the contractor becomes insolvent and you are unable to recover your deposit. If the deposit is for work unrelated to your trade or business, it is a nonbusiness bad debt deduction.

If the buyer of your home assumes your mortgage, you may remain secondarily liable for repayment of the mortgage loan. If the buyer defaults on the loan and the house is then sold for less than the amount outstanding on the mortgage, you may have to make up the difference. You can take a bad debt deduction for the amount you pay to satisfy the mortgage, if you cannot collect it from the buyer.

If you own securities that become totally worthless, you can take a deduction for a loss, but not for a bad debt. See Worthless Securities under What Is a Sale or Trade, earlier in this chapter.

If you deducted a bad debt and in a later tax year you recover (collect) all or part of it, you may have to include the amount you recover in your gross income. However, you can exclude from gross income the amount recovered up to the amount of the deduction that did not reduce your tax in the year deducted. See Recoveries in Publication 525.

Deduct nonbusiness bad debts as short-term capital losses on Schedule D (Form 1040).

In Part I, line 1 of Schedule D, enter the name of the debtor and “statement attached” in column (a). Enter the amount of the bad debt in parentheses in column (f). Use a separate line for each bad debt.

For each bad debt, attach a statement to your return that contains:

If you are a shareholder in an S corporation, your share of any nonbusiness bad debt will be shown on a schedule attached to your Schedule K–1 (Form 1120S) that you receive from the corporation.

A different rule applies if the property sold short becomes substantially worthless. In that case, you must recognize gain as if the short sale were closed when the property became substantially worthless.

Entering into a short sale may cause you to be treated as having made a constructive sale of property. In that case, you will have to recognize gain on the date of the constructive sale. For details, see Constructive Sales of Appreciated Financial Positions, earlier.

Special rules may apply to gains and losses from short sales of stocks, securities, and commodity and securities futures (other than certain straddles) if you held or acquired property substantially identical property to that sold short. But if the amount of property you sold short is more than the amount of that substantially identical property, the special rules do not apply to the gain or loss on the excess.

If you held the substantially identical property for 1 year or less on the date of the short sale, or if you acquired the substantially identical property after the short sale and by the date of closing the short sale, then:

Rule 1. Your gain, if any, when you close the short sale is a short-term capital gain, and

Rule 2. The holding period of the substantially identical property begins on the date of the closing of the short sale or on the date of the sale of this property, whichever comes first.

If, on the date of the short sale, you held substantially identical property for more than 1 year, any loss you realize on the short sale is a long-term capital loss, even if you held the property used to close the sale for 1 year or less. Certain losses on short sales of stock or securities are also subject to wash sale treatment. For information, see Wash Sales, later.

Under certain elections, you can avoid the treatment of loss from a short sale as long term under the special rule. These elections are for positions that are part of a mixed straddle. See Other elections under Mixed Straddles, later, for more information about these elections.

A substitute payment means a payment in lieu of:

If you borrow stock to make a short sale, you may have to remit to the lender payments in lieu of the dividends distributed while you maintain your short position. You can deduct these payments only if you hold the short sale open at least 46 days (more than 1 year in the case of an extraordinary dividend as defined below) and you itemize your deductions.

You deduct these payments as investment interest on Schedule A (Form 1040). See Interest Expenses in chapter 3 for more information.

If you close the short sale by the 45th day after the date of the short sale (1 year or less in the case of an extraordinary dividend), you cannot deduct the payment in lieu of the dividend that you make to the lender. Instead, you must increase the basis of the stock used to close the short sale by that amount.

To determine how long a short sale is kept open, do not include any period during which you hold, have an option to buy, or are under a contractual obligation to buy substantially identical stock or securities.

If your payment is made for a liquidating distribution or nontaxable stock distribution, or if you buy more shares equal to a stock distribution issued on the borrowed stock during your short position, you have a capital expense. You must add the payment to the cost of the stock sold short.

If you close the short sale within 45 days, the deduction for amounts you pay in lieu of dividends will be disallowed only to the extent the payments are more than the amount that you receive as ordinary income from the lender of the stock for the use of collateral with the short sale. This exception does not apply to payments in place of extraordinary dividends.

If the amount of any dividend you receive on a share of preferred stock equals or exceeds 5% (10% in the case of other stock) of the amount realized on the short sale, the dividend you receive is an extraordinary dividend.

The wash sale rules apply to losses from sales or trades of contracts and options to acquire or sell stock or securities. They do not apply to losses from sales or trades of commodity futures contracts and foreign currencies. See Coordination of Loss Deferral Rules and Wash Sale Rules under Straddles, later, for information about the tax treatment of losses on the disposition of positions in a straddle.

Losses from the sale, exchange, or termination of a securities future contract to sell generally are treated in the same manner as losses from the closing of a short sale, discussed later in this section.

The wash sale rules apply if you sell common stock at a loss and, at the same time, buy warrants for common stock of the same corporation. But if you sell warrants at a loss and, at the same time, buy common stock in the same corporation, the wash sale rules apply only if the warrants and stock are considered substantially identical, as discussed next.

In determining whether stock or securities are substantially identical, you must consider all the facts and circumstances in your particular case. Ordinarily, stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation. However, they may be substantially identical in some cases. For example, in a reorganization, the stocks and securities of the predecessor and successor corporations may be substantially identical.

Similarly, bonds or preferred stock of a corporation are not ordinarily considered substantially identical to the common stock of the same corporation. However, where the bonds or preferred stock are convertible into common stock of the same corporation, the relative values, price changes, and other circumstances may make these bonds or preferred stock and the common stock substantially identical. For example, preferred stock is substantially identical to the common stock if the preferred stock:

If the number of shares of substantially identical stock or securities you buy within 30 days before or after the sale is either more or less than the number of shares you sold, you must determine the particular shares to which the wash sale rules apply. You do this by matching the shares bought with an equal number of the shares sold. Match the shares bought in the same order that you bought them, beginning with the first shares bought. The shares or securities so matched are subject to the wash sale rules.

Loss from a wash sale of one block of stock or securities cannot be used to reduce any gains on identical blocks sold the same day.

The wash sale rules do not apply to a dealer in stock or securities if the loss is from a transaction made in the ordinary course of business.

The wash sale rules apply to a loss realized on a short sale if you sell, or enter into another short sale of, substantially identical stock or securities within a period beginning 30 days before the date the short sale is complete and ending 30 days after that date.

For purposes of the wash sale rules, a short sale is considered complete on the date the short sale is entered into, if:

Otherwise, a short sale is not considered complete until the property is delivered to close the sale.

This treatment also applies to losses from the sale, exchange, or termination of a securities futures contract to sell.

The wash sale rules generally will apply to the sale of your residual interest in a real estate mortgage investment conduit (REMIC) if, during the period beginning 6 months before the sale of the interest and ending 6 months after that sale, you acquire any residual interest in any REMIC or any interest in a taxable mortgage pool that is comparable to a residual interest. REMICs are discussed in chapter 1.

Report a wash sale or trade on line 1 or line 8 of Schedule D (Form 1040), whichever is appropriate. Show the full amount of the loss in parentheses in column (f). On the next line, enter “Wash Sale” in column (a) and the amount of the loss not allowed as a positive amount in column (f).

If you have a loss because you did not exercise an option to buy or sell, you are considered to have sold or traded the option on the date that it expired.

If you write (grant) an option, how you report your gain or loss depends on whether it was exercised.

If you are not in the business of writing options and an option you write on stocks, securities, commodities, or commodity futures is not exercised, the amount you receive is a short-term capital gain.

Gain or loss is recognized on the exercise of an option on a section 1256 contract. Section 1256 contracts are defined under Section 1256 Contracts Marked to Market, earlier.

A cash settlement option is treated as an option to buy or sell property. A cash settlement option is any option that on exercise is settled in, or could be settled in, cash or property other than the underlying property.

Gain or loss from the closing or expiration of an option that is not a section 1256 contract, but that is a capital asset in your hands, is reported on Schedule D (Form 1040).

If an option you purchased expired, enter the expiration date in column (c) and write “EXPIRED” in column (d).

If an option that you wrote expired, enter the expiration date in column (b) and write “EXPIRED” in column (e).

If you buy a call or a put, you may not deduct its cost. It is a capital expenditure.

If you sell the call or the put before you exercise it, the difference between its cost and the amount you receive for it is either a long-term or short-term capital gain or loss, depending on how long you held it.

If the option expires, its cost is either a long-term or short-term capital loss, depending on your holding period, which ends on the expiration date.

If you exercise a call, add its cost to the basis of the stock you bought. If you exercise a put, reduce your amount realized on the sale of the underlying stock by the cost of the put when figuring your gain or loss. Any gain or loss on the sale of the underlying stock is long term or short term depending on your holding period for the underlying stock.

Buying a put option is generally treated as a short sale, and the exercise, sale, or expiration of the put is a closing of the short sale. See Short Sales, earlier. If you have held the underlying stock for 1 year or less at the time you buy the put, any gain on the exercise, sale, or expiration of the put is a short-term capital gain. The same is true if you buy the underlying stock after you buy the put but before its exercise, sale, or expiration. Your holding period for the underlying stock begins on the earliest of:

If you write (grant) a call or a put, do not include the amount you receive for writing it in your income at the time of receipt. Carry it in a deferred account until:

If your obligation expires, the amount you received for writing the call or put is short-term capital gain.

If a call you write is exercised and you sell the underlying stock, increase your amount realized on the sale of the stock by the amount you received for the call when figuring your gain or loss. The gain or loss is long term or short term depending on your holding period of the stock.

If a put you write is exercised and you buy the underlying stock, decrease your basis in the stock by the amount you received for the put. Your holding period for the stock begins on the date you buy it, not on the date you wrote the put.

If you enter into a closing transaction by paying an amount equal to the value of the call or put at the time of the payment, the difference between the amount you pay and the amount you receive for the call or put is a short-term capital gain or loss.

Table 4–1. Puts and Calls

This is any property of a type that is actively traded. It includes stock options and contracts to buy stock, but generally does not include stock.

Although stock is generally excluded from the definition of personal property when applying the straddle rules, it is included in the following two situations.

A position is an interest in personal property. A position can be a forward or futures contract, or an option.

An interest in a loan that is denominated in a foreign currency is treated as a position in that currency. For the straddle rules, foreign currency for which there is an active interbank market is considered to be actively-traded personal property. See also Foreign currency contract under Section 1256 Contracts Marked to Market, earlier.

This is a position that substantially reduces any risk of loss you may have from holding another position. However, if a position is part of a straddle that is not an identified straddle (described later), do not treat it as offsetting to a position that is part of an identified straddle.

Two or more positions will be presumed to be offsetting if:

To determine if two or more positions are offsetting, you will be treated as holding any position that your spouse holds during the same period. If you take into account part or all of the gain or loss for a position held by a flowthrough entity, such as a partnership or trust, you are also considered to hold that position.

This is:

The loss deferral rules do not apply to:

Losses from positions in an identified straddle are deferred until you dispose of all the positions in the straddle.

Any straddle (other than a straddle described in (2) or (3) above) is an identified straddle if all of the following conditions exist.

A straddle is not subject to the loss deferral rules for straddles if both of the following are true.

But see Special year-end rule, later, for an exception.

A qualified covered call option is any option you grant to purchase stock you hold (or stock you acquire in connection with granting the option), but only if all of the following are true.

A deep-in-the-money option is an option with a strike price lower than the lowest qualified benchmark (LQB). The strike price is the price at which the option is to be exercised. The LQB is the highest available strike price that is less than the applicable stock price. However, the LQB for an option with a term of more than 90 days and a strike price of more than $50 is the second highest available strike price that is less than the applicable stock price. Strike prices are listed in the financial section of many newspapers.

The availability of strike prices for equity options with flexible terms does not affect the determination of the LQB for an option that is not an equity option with flexible terms.

The applicable stock price for any stock for which an option has been granted is:

If the applicable stock price is $25 or less, the LQB will be treated as not less than 85% of the applicable stock price. If the applicable stock price is $150 or less, the LQB will be treated as not less than an amount that is $10 below the applicable stock price.

On May 13, 2002, you held XYZ stock and you wrote an XYZ/September call option with a strike price of $120. The closing price of one share of XYZ stock on May 12, 2002, was $130.25. The strike prices of all XYZ/September call options offered on May 13, 2002, were as follows: $110, $115, $120, $125, $130, and $135. Because the option has a term of more than 90 days, the LQB is $125, the second highest strike price that is less than $130.25, the applicable stock price. The call option is a deep-in-the-money option because its strike price is lower than the LQB. Therefore, the option is not a qualified covered call option, and the loss deferral rules apply if you closed out the option or the stock at a loss during the year.

If you hold stock and you write a qualified covered call option on that stock with a strike price less than the applicable stock price, treat any loss from the option as long-term capital loss if, at the time the loss was realized, gain on the sale or exchange of the stock would be treated as long-term capital gain. The holding period of the stock does not include any period during which you are the writer of the option.

The loss deferral rules for straddles apply if all of the following are true.

You cannot deduct a loss on the disposition of shares of stock or securities that make up the positions of a straddle if, within a period beginning 30 days before the date of that disposition and ending 30 days after that date, you acquired substantially identical stock or securities. Instead, the loss will be carried over to the following tax year, subject to any further application of Rule 1 in that year. This rule will also apply if you entered into a contract or option to acquire the stock or securities within the time period described above. See Loss carryover, later, for more information about how to treat the loss in the following tax year.

If you are a dealer in stock or securities, this loss treatment will not apply to any losses you sustained in the ordinary course of your business.

You cannot deduct a loss on the disposition of less than all of the positions of a straddle (your loss position) to the extent that any unrecognized gain at the close of the tax year in one or more of the following positions is more than the amount of any loss disallowed under Rule 1:

A successor position is a position that is or was at any time offsetting to a second position, if both of the following conditions are met.

If you have a disallowed loss that resulted from applying Rule 1 and Rule 2, you must carry it over to the next tax year and apply Rule 1 and Rule 2 to that carryover loss. For example, a loss disallowed in 2001 under Rule 1 will not be allowed in 2002, unless the substantially identical stock or securities (which caused the loss to be disallowed in 2001) were disposed of during 2002. In addition, the carryover loss will not be allowed in 2002 if Rule 1 or Rule 2 disallows it.

If the sale of a loss position would have resulted in a capital loss, you treat the carryover loss as a capital loss on the date it is allowed, even if you would treat the gain or loss on any successor positions as ordinary income or loss. Likewise, if the sale of a loss position (in the case of section 1256 contracts) would have resulted in a 60% long-term capital loss and a 40% short-term capital loss, you treat the carryover loss under the 60/40 rule, even if you would treat any gain or loss on any successor positions as 100% long-term or short-term capital gain or loss.

The rules for coordinating straddle losses and wash sales do not apply to the following loss situations.

Treat the loss on the sale of one or more positions (the loss position) of a straddle as a long-term capital loss if both of the following are true.

Special rules apply to a loss position that is part of a mixed straddle and that is a non-section 1256 position. A mixed straddle is a straddle:

Treat the loss as 60% long-term capital loss and 40% short-term capital loss, if all of the following conditions apply.

The special holding period and loss treatment for straddle positions does not apply to positions that:

You can elect out of the marked to market rules, discussed under Section 1256 Contracts Marked to Market, earlier, for all section 1256 contracts that are part of a mixed straddle. Instead, the gain and loss rules for straddles will apply to these contracts. However, if you make this election for an option on a section 1256 contract, the gain or loss treatment discussed earlier under Options will apply, subject to the gain and loss rules for straddles.

You can make this election if:

If you make this election, it will apply for all later years as well. It cannot be revoked without the consent of the IRS. If you made this election, check box A of Form 6781. Do not report the section 1256 component in Part I.

You can avoid the 60% long-term capital loss treatment required for a non-section 1256 loss position that is part of a mixed straddle, described earlier, if you choose either of the two following elections to offset gains and losses for these positions.

These two elections are alternatives to the mixed straddle election. You can choose only one of the three elections. Use Form 6781 to indicate your election choice by checking box A, B, or C, whichever applies.

Under this election, you must clearly identify each position that is part of the identified mixed straddle by the earlier of:

If you dispose of a position in the mixed straddle before the end of the day on which the straddle is established, this identification must be made by the time you dispose of the position. You are presumed to have properly identified a mixed straddle if independent verification is used.

The basic tax treatment of gain or loss under this election depends on which side of the straddle produced the total net gain or loss. If the net gain or loss from the straddle is due to the section 1256 contracts, gain or loss is treated as 60% long-term capital gain or loss and 40% short-term capital gain or loss. Enter the net gain or loss in Part I of Form 6781 and identify the election by checking box B.

If the net gain or loss is due to the non-section 1256 positions, gain or loss is short-term capital gain or loss. Enter the net gain or loss on Part I of Schedule D and identify the election.

For the specific application of the rules of this election, see regulations section 1.1092(b)–3T.

You may elect to establish one or more accounts for determining gains and losses from all positions in a mixed straddle. You must establish a separate mixed straddle account for each separate designated class of activities.

Generally, you must determine gain or loss for each position in a mixed straddle account as of the close of each business day of the tax year. You offset the net section 1256 contracts against the net non-section 1256 positions to determine the “daily account net gain or loss.”

If the daily account amount is due to non-section 1256 positions, the amount is treated as short-term capital gain or loss. If the daily account amount is due to section 1256 contracts, the amount is treated as 60% long-term and 40% short-term capital gain or loss.

On the last business day of the tax year, you determine the “annual account net gain or loss” for each account by netting the daily account amounts for that account for the tax year. The “total annual account net gain or loss” is determined by netting the annual account amounts for all mixed straddle accounts that you had established.

The net amounts keep their long-term or short-term classification. However, no more than 50% of the total annual account net gain for the tax year can be treated as long-term capital gain. Any remaining gain is treated as short-term capital gain. Also, no more than 40% of the total annual account net loss can be treated as short-term capital loss. Any remaining loss is treated as long-term capital loss.

The election to establish one or more mixed straddle accounts for each tax year must be made by the due date (without extensions) of your income tax return for the immediately preceding tax year. If you begin trading in a new class of activities during a tax year, you must make the election for the new class of activities by the later of either:

You make the election on Form 6781 by checking box C. Attach Form 6781 to your income tax return for the immediately preceding tax year, or file it within 60 days, if that applies. Report the annual account net gain or loss from a mixed straddle account in Part II of Form 6781. In addition, you must attach a statement to Form 6781 specifically designating the class of activities for which a mixed straddle account is established.

For the specific application of the rules of this election, see regulations section 1.1092(b)–4T.

You cannot deduct interest and carrying charges that are allocable to any positions held in a mixed straddle account. Treat these charges as an adjustment to the annual account net gain or loss and allocate them proportionately between the net short-term and the net long-term capital gains or losses.

To find the amount of interest and carrying charges that is not deductible and that must be added to the annual account net gain or loss, apply the rules described in chapter 3 under Interest expense and carrying charges on straddles to the positions held in the mixed straddle account.

You must make the election no later than the due date (including extensions) for filing your tax return for the year in which you sold the stock. If your original return was filed on time, you may make the election on an amended return filed no later than 6 months after the due date of your return (excluding extensions). Write “Filed pursuant to section 301.9100–2” at the top of the amended return, and file it at the same address you used for your original return.

Report the entire gain realized on line 8 of Schedule D. To make the choice to postpone gain, enter “Section 1042 election” in column (a) of the line directly below the line on which you reported the gain. Enter in column (f) the amount of the gain you are postponing or expecting to postpone. Enter it as a loss (in parentheses). If the actual postponed gain is different from the amount you report, file an amended return.

Also attach the following statements.

For details, see section 1042 of the Internal Revenue Code and Temporary Regulations section 1.1042–1T.

If you make the choice described in this section, you must recognize gain only up to the following amount:

If this amount is less than the amount of your gain, you can postpone the rest of your gain, subject to the limit described next. If this amount is equal to or more than the amount of your gain, you must recognize the full amount of your gain.

The amount of gain you can postpone each year is limited to the smaller of:

You must subtract the amount of postponed gain from the basis of your replacement property.

Report the entire gain realized from the sale on line 1 or line 8 of Schedule D (Form 1040), whichever is appropriate. To make the choice to postpone gain, enter “SSBIC Rollover” in column (a) of the line directly below the line on which you reported the gain. Enter the amount of gain postponed in column (f). Enter it as a loss (in parentheses).

Also, attach a schedule showing how you figured the postponed gain, the name of the SSBIC in which you purchased common stock or a partnership interest, the date of that purchase, and your new basis in that SSBIC stock or partnership interest.

You must make the choice to postpone gain no later than the due date (including extensions) for filing your tax return for the year in which you sold the securities. If your original return was filed on time, you may make the choice on an amended return filed no later than 6 months after the due date of your return (excluding extensions). Write “Filed pursuant to section 301.9100–2” at the top of the amended return, and file it at the same address you used for your original return.

Your choice is revocable with the consent of the IRS.

This is stock that meets all the following tests.

For more information about tests 6 and 7, see the regulations under section 1202 of the Internal Revenue Code.

A corporation meets this test for any period of time if, during that period, both the following are true.

Any specialized small business investment company (SSBIC) is treated as meeting the active business test. An SSBIC is an eligible corporation that is licensed to operate under section 301(d) of the Small Business Investment Act of 1958 as in effect on May 13, 1993.

This is any U.S. corporation other than:

This is any trade or business other than:

If you make the choice described in this section, you must recognize the capital gain only up to the following amount:

If this amount is less than the amount of your capital gain, you can postpone the rest of that gain. If this amount equals or is more than the amount of your capital gain, you must recognize the full amount of your gain.

You must subtract the amount of postponed gain from the basis of your replacement stock.

Your holding period for the replacement stock includes your holding period for the stock sold, except for the purpose of applying the 6-month holding period requirement for choosing to roll over the gain on its sale.

A pass-through entity (a partnership, S corporation, or mutual fund or other regulated investment company) also may make the choice to postpone gain. The benefit of the postponed gain applies to your share of the entity's postponed gain if you held an interest in the entity for the entire period the entity held the stock.

If a pass-through entity sold qualified small business stock held for more than 6 months and you held an interest in the entity for the entire period the entity held the stock, you also may choose to postpone gain if you, rather than the pass-through entity, buy the replacement stock within the 60-day period.

Report the entire gain realized from the sale on line 1 or line 8 of Schedule D (Form 1040), whichever is appropriate. To make the choice to postpone the gain, enter “Section 1045 Rollover” in column (a) of the line directly below the line on which you reported the gain. Enter the amount of gain postponed in column (f). Enter it as a loss (in parentheses).

You must make the choice to postpone gain no later than the due date (including extensions) for filing your tax return for the year in which you sold the stock. If your original return was filed on time, you may make the choice on an amended return filed no later than 6 months after the due date of your return (excluding extensions). Write “Filed pursuant to section 301.9100–2” at the top of the amended return, and file it at the same address you used for your original return.

If the stock is specialized small business investment company (SSBIC) stock that you bought as replacement property for publicly traded securities you sold at a gain, you must reduce the basis of the stock by the amount of any postponed gain on that earlier sale, as explained earlier under Rollover of Gain From Publicly Traded Securities. But do not reduce your basis by that amount when figuring your section 1202 exclusion.

The amount of your gain from the stock of any one issuer that is eligible for the exclusion in 2002 is limited to the greater of:

Report the entire gain realized from the sale in column (f) of line 8 of Schedule D (Form 1040). Report an amount equal to the excluded gain in column (g). Directly below the line on which you report the gain, enter “Section 1202 exclusion” in column (a) and enter the amount of the exclusion in column (f). Enter it as a loss (in parentheses).

For information about additional requirements that may apply, see section 1202 of the Internal Revenue Code.

This means certain stock or partnership interests in an enterprise zone business. It also includes certain tangible property used in an enterprise zone business. You must have acquired the asset after December 21, 2000.

If you make the choice described in this section, you must recognize gain only up to the following amount:

If this amount is equal to or more than the amount of your gain, you must recognize the full amount of your gain. If this amount is less than the amount of your gain, you can postpone the rest of your gain by adjusting the basis of your replacement property as described next.

You must subtract the amount of postponed gain from the basis of the qualified empowerment zone assets you bought as replacement property.

Report the entire gain realized from the sale on line 8 of Schedule D (Form 1040). To make the choice to postpone gain, enter “Section 1397B Rollover” in column (a) of the line directly below the line on which you reported the gain. Enter the amount of gain postponed in column (f). Enter it as a loss (in parentheses).

For more information about empowerment zones, see Publication 954, Tax Incentives for Empowerment Zones and Other Distressed Communities. For more information about this rollover of gain, see section 1397B of the Internal Revenue Code.

You cannot use the installment method to report a gain from the sale of stock or securities traded on an established securities market. You must report the entire gain in the year of sale (the year in which the trade date occurs).

Special at-risk rules apply to most income-producing activities. These rules limit the amount of loss you can deduct to the amount you risk losing in the activity. The at-risk rules also apply to a loss from the sale or trade of an asset used in an activity to which the at-risk rules apply. For more information, see Publication 925, Passive Activity and At-Risk Rules. Use Form 6198, At-Risk Limitations, to figure the amount of loss you can deduct.

If you have gains or losses from a passive activity, you may also have to report them on Form 8582. In some cases, the loss may be limited under the passive activity rules. Refer to Form 8582 and its separate instructions for more information about reporting capital gains and losses from a passive activity.

If you sold property, such as stocks, bonds, or certain commodities, through a broker, you should receive Form 1099–B or an equivalent statement from the broker. Use the Form 1099–B or equivalent statement to complete Schedule D.

Report the gross proceeds shown in box 2 of Form 1099–B as the gross sales price in column (d) of either line 1 or line 8 of Schedule D, whichever applies. However, if the broker advises you, in box 2 of Form 1099–B, that gross proceeds (gross sales price) less commissions and option premiums were reported to the IRS, enter that net sales price in column (d) of either line 1 or line 8 of Schedule D, whichever applies.

If the net amount is entered in column (d), do not include the commissions and option premiums in column (e).

Use Form 6781 to report gains and losses from section 1256 contracts and straddles before entering these amounts on Schedule D. Include a copy of Form 6781 with your income tax return.

Report the sale or trade of a market discount bond on Schedule D (Form 1040), line 1 or line 8. If the sale or trade results in a gain and you did not choose to include market discount in income currently, enter “Accrued Market Discount” on the next line in column (a) and the amount of the accrued market discount as a loss in column (f). Also report the amount of accrued market discount as interest income on Schedule B (Form 1040), line 1, and identify it as “Accrued Market Discount.”

If you sold or traded reportable real estate, you generally should receive from the real estate reporting person a Form 1099–S, Proceeds From Real Estate Transactions, showing the gross proceeds.

“Reportable real estate” is defined as any present or future ownership interest in any of the following:

A “real estate reporting person” could include the buyer's attorney, your attorney, the title or escrow company, a mortgage lender, your broker, the buyer's broker, or the person acquiring the biggest interest in the property.

Your Form 1099–S will show the gross proceeds from the sale or exchange in box 2. Follow the instructions for Schedule D to report these transactions, and include them on line 1 or 8 as appropriate.

If you sell a block of stock or other property that you bought at various times, report the short-term gain or loss from the sale on one line in Part I of Schedule D and the long-term gain or loss on one line in Part II. Write “Various” in column (b) for the “Date acquired.” See the Comprehensive Example later in this chapter.

Add to your cost or other basis any expense of sale such as broker's fees, commissions, state and local transfer taxes, and option premiums. Enter this adjusted amount in column (e) of either Part I or Part II of Schedule D, whichever applies, unless you reported the net sales price amount in column (d).

Capital gain or loss on the sale or trade of investment property held 1 year or less is a short-term capital gain or loss. You report it in Part I of Schedule D. If the amount you report in column (f) is a loss, show it in parentheses.

You combine your share of short-term capital gain or loss from partnerships, S corporations, and fiduciaries, and any short-term capital loss carryover, with your other short-term capital gains and losses to figure your net short-term capital gain or loss on line 7 of Schedule D.

A capital gain or loss on the sale or trade of investment property held more than 1 year is a long-term capital gain or loss. You report it in Part II of Schedule D. If the amount you report in column (f) is a loss, show it in parentheses.

You also report the following in Part II of Schedule D:

The result after combining these items with your other long-term capital gains and losses is your net long-term capital gain or loss (line 16 of Schedule D).

Enter in column (g) the amount, if any, from column (f) that is a 28% rate gain or loss. Enter any loss in parentheses.

A 28% rate gain or loss is:

For more information, see Capital Gain Tax Rates, later.

You do not have to file Schedule D if all of the following are true.

If all the above statements are true, report your capital gain distributions directly on line 13 of Form 1040 and check the box on that line. Also, use the Capital Gain Tax Worksheet in the Form 1040 instructions to figure your tax.

You can report your capital gain distributions on line 10 of Form 1040A, instead of on Form 1040, if both of the following are true.

To figure your total net gain or loss, combine your net short-term capital gain or loss (line 7) with your net long-term capital gain or loss (line 16). Enter the result on line 17, Part III of Schedule D. If your losses are more than your gains, see Capital Losses, next. If both lines 16 and 17 are gains and line 39 of Form 1040 is more than zero, see Capital Gain Tax Rates, later.

Your allowable capital loss deduction, figured on Schedule D, is the lesser of:

You can use your total net loss to reduce your income dollar for dollar, up to the $3,000 limit.

If you have a total net loss on line 17 of Schedule D that is more than the yearly limit on capital loss deductions, you can carry over the unused part to the next year and treat it as if you had incurred it in that next year. If part of the loss is still unused, you can carry it over to later years until it is completely used up.

When you figure the amount of any capital loss carryover to the next year, you must take the current year's allowable deduction into account, whether or not you claimed it.

When you carry over a loss, it remains long term or short term. A long-term capital loss you carry over to the next tax year will reduce that year's long-term capital gains before it reduces that year's short-term capital gains.

The amount of your capital loss carryover is the amount of your total net loss that is more than the lesser of:

If your deductions are more than your gross income for the tax year, use your negative taxable income in computing the amount in item (2).

Complete the Capital Loss Carryover Worksheet in the Schedule D (Form 1040) instructions to determine the part of your capital loss for 2002 that you can carry over to 2003.

When you figure your capital loss carryover, use your short-term capital losses first, even if you incurred them after a long-term capital loss. If you have not reached the limit on the capital loss deduction after using the short-term capital loss, use the long-term capital losses until you reach the limit.

A capital loss sustained by a decedent during his or her last tax year (or carried over to that year from an earlier year) can be deducted only on the final return filed for the decedent. The capital loss limits discussed earlier still apply in this situation. The decedent's estate cannot deduct any of the loss or carry it over to following years.

If you and your spouse once filed separate returns and are now filing a joint return, combine your separate capital loss carryovers. However, if you and your spouse once filed a joint return and are now filing separate returns, any capital loss carryover from the joint return can be deducted only on the return of the spouse who actually had the loss.

The 10% maximum capital gain rate is lowered to 8% for “qualified 5-year gain.”

This is long-term capital gain from the sale of property that you held for more than 5 years.

If you claim a deduction for investment interest, you may have to reduce the amount of your net capital gain that is eligible for the capital gain tax rates. Reduce it by the amount of the net capital gain you choose to include in investment income when figuring the limit on your investment interest deduction. This is done on lines 21–23 of Schedule D. For more information about the limit on investment interest, see Interest Expenses in chapter 3.

This is gain or loss from the sale or trade of a work of art, rug, antique, metal (such as gold, silver, and platinum bullion), gem, stamp, coin, or alcoholic beverage held more than 1 year.

Collectibles gain includes gain from the sale of an interest in a partnership, S corporation, or trust attributable to unrealized appreciation of collectibles.

If you realized a gain from qualified small business stock that you held more than 5 years, you generally can exclude one-half of your gain from your income. The taxable part of your gain equal to your section 1202 exclusion is a 28% rate gain. See Gains on Qualified Small Business Stock, earlier in this chapter.

Generally, this is any part of your capital gain from selling section 1250 property (real property) that is due to depreciation (but not more than your net section 1231 gain), reduced by any net loss in the 28% group. Use the worksheet in the Schedule D instructions to figure your unrecaptured section 1250 gain. For more information about section 1250 property and section 1231 gain, see chapter 3 of Publication 544.

You apply these rules by using Part IV of Schedule D (Form 1040) to figure your tax.

Use Part IV if both of the following are true.

If you have any collectible gain, gain on qualified small business stock, or unrecaptured section 1250 gain, you may also have to use the Schedule D Tax Worksheet in the Schedule D instructions to figure your tax. See the directions below line 19 of Schedule D.

See the Comprehensive Example, later, for an example of how to figure your tax on Schedule D using the capital gain rates.

If you have capital gain distributions but do not have to file Schedule D (Form 1040), figure your tax using the Capital Gain Tax Worksheet in the instructions for Form 1040A or Form 1040, whichever you file. For more information, see Capital gain distributions only, earlier.

These capital gain rates are also used in figuring alternative minimum tax.

Emily sold stock in two different companies that she held for less than a year. In June, she sold 100 shares of Trucking Co. stock that she had bought in February. She had an adjusted basis of $1,150 in the stock and sold it for $400, for a loss of $750. In July, she sold 25 shares of Computer Co. stock that she bought in June. She had an adjusted basis in the stock of $2,000 and sold it for $2,500, for a gain of $500. She reports these short-term transactions on line 1 in Part I of Schedule D.

Emily had three other stock sales that she reports as long-term transactions on line 8 in Part II of Schedule D. In February, she sold 60 shares of Car Co. for $2,100. She had inherited the Car stock from her father. Its fair market value at the time of his death was $2,500, which became her basis. Her loss on the sale is $400. Because she had inherited the stock, her loss is a long-term loss, regardless of how long she and her father actually held the stock. She enters the loss in column (f) of line 8.

In June, she sold 500 shares of Furniture Co. stock for $5,000. She had bought 100 of those shares in 1991, for $1,000. She had bought 100 more shares in 1993 for $2,200, and an additional 300 shares in 1996 for $1,500. Her total basis in the stock is $4,700. She has a $300 ($5,000 - $4,700) gain on this sale, which she enters in column (f) of line 8. Because she held all 500 shares for more than 5 years, the entire gain is qualified 5-year gain.

In December, she sold 20 shares of Toy Co. stock for $4,100. This was qualified small business stock that she had bought in September 1997. Her basis is $1,100, so she has a $3,000 gain, which she enters in column (f) of line 8. Because she held the stock more than 5 years, she has a $1,500 section 1202 exclusion. She enters that amount in column (g) as a 28% rate gain and claims the exclusion on the line below by entering $1,500 as a loss in column (f).

She received a Form 1099–B (not shown) from her broker for each of these transactions. The entries shown in box 2 of these forms total $14,100.

Emily makes sure that the total of the amounts reported in column (d) of lines 3 and 10 of Schedule D is not less than the total of the amounts shown on the Forms 1099–B she received from her broker. For 2002, the total of lines 3 and 10 of Schedule D is $14,100, which is the same amount reported by the broker on Forms 1099–B.

During 2002, Emily had a realized loss from a regulated futures contract of $11,000. She also had an unrealized marked to market gain on open contracts of $27,000 at the end of 2002. She had reported an unrealized marked to market gain of $1,000 on her 2001 tax return. (This $1,000 must be subtracted from her 2002 profit.) These amounts are shown in boxes 6, 7, and 8 of the Form 1099–B she received from her broker. Box 9 shows her combined profit of $15,000 ($27,000 - $1,000 - $11,000). She reports this gain in Part I of Form 6781 (not shown). She shows 40% as short-term gain on line 4 of Schedule D and 60% as long-term gain on line 11 of Schedule D.

The Form 1099–B that Emily received from her broker, XYZ Trading Co., is shown later.

Emily has a capital loss carryover to 2002 of $800, of which $300 is short-term capital loss, and $500 is long-term capital loss. She enters these amounts on lines 6 and 14 of Schedule D.

She kept the completed Capital Loss Carryover Worksheet in her 2001 Schedule D instructions (not shown), so she could properly report her loss carryover for the 2002 tax year without refiguring it.

Because Emily has gains on both lines 16 and 17 of Schedule D and has taxable income, she goes to Part IV of Schedule D to figure her tax. But because line 15 of Schedule D is more than zero (due to her section 1202 gain from selling qualified small business stock), she must also use the Schedule D Tax Worksheet to figure her tax. She must also complete the Qualified 5-Year Gain Worksheet (not shown) in her Schedule D instructions.

After entering the gain from line 17 on line 13 of her Form 1040, she completes the rest of Form 1040 through line 41. She enters the amount from that line, $30,000, on line 1 of the Schedule D Tax Worksheet. After filling out the rest of that worksheet, she figures her tax is $3,958. This is less than the tax she would have figured without the capital gain tax rates, $4,453.

If you made the mark-to-market election, you should report all gains and losses from trading as ordinary gains and losses in Part II of Form 4797, instead of as capital gains and losses on Schedule D. In that case, securities held at the end of the year in your business as a trader are marked to market by treating them as if they were sold (and reacquired) for fair market value on the last business day of the year. But do not mark to market any securities you held for investment. Report sales from those securities on Schedule D, not Form 4797.

Interest expense and other investment expenses that an investor would deduct on Schedule A (Form 1040) are deducted by a trader on Schedule C (Form 1040), Profit or Loss From Business, if the expenses are from the trading business. Commissions and other costs of acquiring or disposing of securities are not deductible but must be used to figure gain or loss. The limit on investment interest expense, which applies to investors, does not apply to interest paid or incurred in a trading business.

Gains and losses from selling securities as part of a trading business are not subject to self-employment tax. This is true whether the election is made or not.