| Pub. 550, Investment Income and Expenses |
2005 Tax Year |
4.
Sales and Trades of Investment Property
This chapter explains the tax treatment of sales and trades of investment property.
Investment property.
This is property that produces investment income. Examples include stocks, bonds, and Treasury bills and notes. Property
used in a trade or
business is not investment property.
Form 1099-B.
If you sold property such as stocks, bonds, or certain commodities through a broker during the year, you should receive,
for each sale, a Form
1099-B, Proceeds From Broker and Barter Exchange Transactions, or an equivalent statement from the broker. You should receive
the statement by January
31 of the next year. It will show the gross proceeds from the sale. The IRS will also get a copy of Form 1099-B from the broker.
Use Form 1099-B (or an equivalent statement received from your broker) to complete Schedule D of Form 1040. For more
information, see Form
1099-B transactions under Reporting Capital Gains and Losses, later.
Nominees.
If someone receives gross proceeds as a nominee for you, that person will give you a Form 1099-B, which will show
gross proceeds received on your
behalf.
If you receive Form 1099-B that includes gross proceeds belonging to another person, see Nominees later under Reporting Capital
Gains and Losses for more information.
Other property transactions.
Certain transfers of property are discussed in other IRS publications. These include:
-
Sale of your main home, discussed in Publication 523, Selling Your Home,
-
Installment sales, covered in Publication 537, Installment Sales,
-
Various types of transactions involving business property, discussed in Publication 544, Sales and Other Dispositions of Assets,
-
Transfers of property at death, covered in Publication 559, Survivors, Executors, and Administrators, and
-
Disposition of an interest in a passive activity, discussed in Publication 925, Passive Activity and At-Risk Rules.
Topics - This chapter discusses:
Useful Items - You may want to see:
Form (and Instructions)
-
Schedule D (Form 1040)
Capital Gains and Losses
-
6781
Gains and Losses From Section 1256 Contracts and Straddles
-
8582
Passive Activity Loss Limitations
-
8824
Like-Kind Exchanges
See chapter 5 for information about getting these publications and forms.
Terms you may need to know (see Glossary):
| Equity option |
| Futures contract |
| Marked to market |
| Nonequity option |
| Options dealer |
| Regulated futures contract |
| Section 1256 contract |
| Short sale |
This section explains what is a sale or trade. It also explains certain transactions and events that are treated as sales
or trades.
A sale is generally a transfer of property for money or a mortgage, note, or other promise to pay money.
A trade is a transfer of property for other property or services, and may be taxed in the same way as a sale.
Sale and purchase.
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.
Redemption of stock.
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.
Dividend versus sale or trade.
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:
-
The redemption is not essentially equivalent to a dividend — see Dividends and Other Corporate Distributions in chapter 1,
-
There is a substantially disproportionate redemption of stock,
-
There is a complete redemption of all the stock of the corporation owned by the shareholder, or
-
The redemption is a distribution in partial liquidation of a corporation.
Redemption or retirement of bonds.
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 Regulations section
1.1001-3.
Surrender of stock.
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.
Trade of investment property for an annuity.
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.
Transfer by inheritance.
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.
Termination of certain rights and obligations.
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.
Stocks, stock rights, and bonds (other than those held for sale by a securities dealer) that became worthless during the tax
year are treated as
though they were sold on the last day of the tax year. This affects whether your capital loss is long-term or short-term.
See Holding
Period, later.
If you are a cash basis taxpayer and make payments on a negotiable promissory note that you issued for stock that became worthless,
you can deduct
these payments as losses in the years you actually make the payments. Do not deduct them in the year the stock became worthless.
How to report loss.
Report worthless securities on Schedule D (Form 1040), line 1 or line 8, whichever applies. In columns (c) and (d),
enter “ Worthless.” Enter
the amount of your loss in parentheses in column (f).
Filing a claim for refund.
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, whichever is later.) For more information about filing a claim, see Publication
556, Examination of Returns,
Appeal Rights, and Claims for Refund.
Constructive Sales of Appreciated Financial Positions
You are treated as having made a constructive sale when you enter into certain transactions involving an appreciated financial
position (defined
later) in stock, a partnership interest, or certain debt instruments. You must recognize gain as if the position were disposed
of at its fair market
value on the date of the constructive sale. This gives you a new holding period for the position that begins on the date of
the constructive sale.
Then, when you close the transaction, you reduce your gain (or increase your loss) by the gain recognized on the constructive
sale.
Constructive sale.
You are treated as having made a constructive sale of an appreciated financial position if you:
-
Enter into a short sale of the same or substantially identical property,
-
Enter into an offsetting notional principal contract relating to the same or substantially identical property,
-
Enter into a futures or forward contract to deliver the same or substantially identical property (including a forward contract
that provides
for cash settlement), or
-
Acquire the same or substantially identical property (if the appreciated financial position is a short sale, an offsetting
notional
principal contract, or a futures or forward contract).
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.
Exception for nonmarketable securities.
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.
Exception for certain closed transactions.
Do not treat a transaction as a constructive sale if all of the following are true.
-
You closed the transaction before the end of the 30th day after the end of your tax year.
-
You held the appreciated financial position throughout the 60-day period beginning on the date you closed the transaction.
-
Your risk of loss was not reduced at any time during that 60-day period by holding certain other positions.
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 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 exception also applies to successive short sales of an entire appreciated financial position. For more information,
see Revenue Ruling 2003-1
in Internal Revenue Bulletin 2003-3. This bulletin is available at
www.irs.gov/pub/irs-irbs/irb03-03.pdf.
Appreciated financial position.
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.
Exceptions.
An appreciated financial position does not include the following.
-
Any position from which all of the appreciation is accounted for under marked to market rules, including section 1256 contracts
(described
later under Section 1256 Contracts Marked to Market).
-
Any position in a debt instrument if:
-
The position unconditionally entitles the holder to receive a specified principal amount,
-
The interest payments (or other similar amounts) with respect to the position are payable at a fixed rate or a variable rate
described in
Regulations section 1.860G-1(a)(3), and
-
The position is not convertible, either directly or indirectly, into stock of the issuer (or any related person).
-
Any hedge with respect to a position described in (2).
Certain trust instruments treated as stock.
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).
Sale of appreciated financial position.
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.
Section 1256 Contracts Marked to Market
If you hold a section 1256 contract at the end of the tax year, you generally must treat it as sold at its fair market value
on the last business
day of the tax year.
A section 1256 contract is any:
-
Regulated futures contract,
-
Foreign currency contract,
-
Nonequity option,
-
Dealer equity option, or
-
Dealer securities futures contract.
Regulated futures contract.
This is a contract that:
-
Provides that amounts that must be deposited to, or can be withdrawn from, your margin account depend on daily market conditions
(a system
of marking to market), and
-
Is traded on, or subject to the rules of, a qualified board of exchange. A qualified board of exchange is a domestic board
of trade
designated as a contract market by the Commodity Futures Trading Commission, any board of trade or exchange approved by the
Secretary of the Treasury,
or a national securities exchange registered with the Securities and Exchange Commission.
Foreign currency contract.
This is a contract that:
-
Requires delivery of a foreign currency that has positions traded through regulated futures contracts (or settlement of which
depends on the
value of that type of foreign currency),
-
Is traded in the interbank market, and
-
Is entered into at arm's length at a price determined by reference to the price in the interbank market.
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.
Nonequity option.
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).
Warrants based on a stock index that are economically, substantially identical in all material respects to options based on
a stock index are
treated as options based on a stock index.
Cash-settled options.
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.
Listed option.
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.
Dealer equity option.
This is any listed option that, for an options dealer:
-
Is an equity option,
-
Is bought or granted by that dealer in the normal course of the dealer's business activity of dealing in options, and
-
Is listed on the qualified board of exchange where that dealer is registered.
An “ options dealer” is any person registered with an appropriate national securities exchange as a market maker or specialist in listed
options.
Equity option.
This is any option:
-
To buy or sell stock, or
-
That is valued directly or indirectly by reference to any stock or narrow-based security index.
Equity options include options on a group of stocks only if the group is a narrow-based stock index.
Dealer securities futures contract.
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:
-
Is entered into by the dealer (or, in the case of an option, is purchased or granted by the dealer) in the normal course of
the dealer's
activity of dealing in this type of contract (or option), and
-
Is traded on a qualified board or exchange (as defined under Regulated futures contract, earlier.)
A securities futures contract that is not a dealer securities futures contract is treated as described later under Securities Futures
Contracts.
A section 1256 contract that you hold at the end of the tax year will generally be treated as sold at its fair market value
on the last business
day of the tax year, and you must recognize any gain or loss that results. That gain or loss is taken into account in figuring
your gain or loss when
you later dispose of the contract, as shown in the example under 60/40 rule, below.
Hedging exception.
The marked to market rules do not apply to hedging transactions. See Hedging Transactions, later.
60/40 rule.
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.
Example.
On June 23, 2004, you bought a regulated futures contract for $50,000. On December 31, 2004 (the last business day of your
tax year), the fair
market value of the contract was $57,000. You recognized a $7,000 gain on your 2004 tax return, treated as 60% long-term and
40% short-term capital
gain.
On February 2, 2005, you sold the contract for $56,000. Because you recognized a $7,000 gain on your 2004 return, you recognize
a $1,000 loss
($57,000 - $56,000) on your 2005 tax return, treated as 60% long-term and 40% short-term capital loss.
Limited partners or entrepreneurs.
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.
Terminations and transfers.
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.
Loss carryback election.
An individual having a net section 1256 contracts loss (defined later) for 2005 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.
Net section 1256 contracts loss.
This loss is the lesser of:
-
The net capital loss for your tax year determined by taking into account only the gains and losses from section 1256 contracts,
or
-
The capital loss carryover to the next tax year determined without this election.
Net section 1256 contracts gain.
This gain is the lesser of:
-
The capital gain net income for the carryback year determined by taking into account only gains and losses from section 1256
contracts,
or
-
The capital gain net income for that year.
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.
Traders in section 1256 contracts.
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.
Treatment of underlying property.
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.
If you disposed of regulated futures or foreign currency contracts in 2005 (or had unrealized profit or loss on these contracts
that were open at
the end of 2004 or 2005), you should receive Form 1099-B, or an equivalent statement, from your broker.
Form 6781.
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 11 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.
Loss carryback election.
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 and an amended Schedule D attached. Follow the instructions
for completing Form 6781
for the loss year to make this election.
The marked to market rules, described earlier, do not apply to hedging transactions. A transaction is a hedging transaction
if both of the
following conditions are met.
-
You entered into the transaction in the normal course of your trade or business primarily to manage the risk of:
-
Price changes or currency fluctuations on ordinary property you hold (or will hold), or
-
Interest rate or price changes, or currency fluctuations, on your current or future borrowings or ordinary obligations.
-
You clearly identified the transaction as being a hedging transaction before the close of the day on which you entered
into it.
This hedging transaction exception does not apply to transactions entered into by or for any syndicate. A syndicate is a partnership,
S
corporation, or other entity (other than a regular corporation) that allocates more than 35% of its losses to limited partners
or limited
entrepreneurs. A limited entrepreneur is a person who has an interest in an enterprise (but not as a limited partner) and
who does not actively
participate in its management. However, an interest is not considered held by a limited partner or entrepreneur if the interest
holder actively
participates (or did so for at least 5 full years) in the management of the entity, or is the spouse, child (including a legally
adopted child),
grandchild, or parent of an individual who actively participates in the management of the entity.
Hedging loss limit.
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.
Sale of property used in a hedge.
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.
Gains and losses derived in the ordinary course of a commodity or option dealer's trading in section 1256 contracts and property
related to these
contracts are included in net earnings from self-employment. In addition, the rules relating to contributions to self-employment
retirement plans
apply. For information on retirement plan contributions, see chapter 3 of Publication 535, Business Expenses, Publication
560, Retirement Plans for
Small Business, and Publication 590, Individual Retirement Arrangements (IRAs).
Basis of Investment Property
Terms you may need to know (see Glossary):
| Basis |
| Fair market value |
| Original issue discount (OID) |
Basis is a way of measuring your investment in property for tax purposes. You must know the basis of your property to determine
whether you have a
gain or loss on its sale or other disposition.
Investment property you buy normally has an original basis equal to its cost. If you get property in some way other than buying
it, such as by gift
or inheritance, its fair market value may be important in figuring the basis.
The basis of property you buy is usually its cost. The cost is the amount you pay in cash, debt obligations, or other property
or services.
Unstated interest.
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 (OID) in Publication 537.
There are times when you must use a basis other than cost. In these cases, you may need to know the property's fair market
value or the adjusted
basis of the previous owner.
Fair market value.
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.
Property Received for Services
If you receive investment property for services, you must include the property's fair market value in income. The amount you
include in income then
becomes your basis in the property. If the services were performed for a price that was agreed to beforehand, this price will
be accepted as the fair
market value of the property if there is no evidence to the contrary.
Restricted property.
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.
Bargain purchases.
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.
Property Received in Taxable Trades
If you received investment property in trade for other property, the basis of the new property is its fair market value at
the time of the trade
unless you received the property in a nontaxable trade.
Example.
You trade A Company stock for B Company stock having a fair market value of $1,200. If the adjusted basis of the A Company
stock is less than
$1,200, you have a taxable gain on the trade. If the adjusted basis of the A Company stock is more than $1,200, you have a
deductible loss on the
trade. The basis of your B Company stock is $1,200. If you later sell the B Company stock for $1,300, you will have a gain
of $100.
Property Received in Nontaxable Trades
If you have a nontaxable trade, you do not recognize gain or loss until you dispose of the property you received in the trade.
See Nontaxable
Trades, later.
The basis of property you received in a nontaxable or partly nontaxable trade is generally the same as the adjusted basis
of the property you gave
up. Increase this amount by any cash you paid, additional costs you had, and any gain recognized. Reduce this amount by any
cash or unlike property
you received, any loss recognized, and any liability of yours that was assumed or treated as assumed.
Property Received From Your Spouse
If property is transferred to you from your spouse (or former spouse, if the transfer is incident to your divorce), your
basis is the same as your spouse's or former spouse's adjusted basis just before the transfer. See Transfers Between Spouses, later.
Recordkeeping. The transferor must give you the records necessary to determine the adjusted basis and holding period of the property as
of the date of the transfer.
Property Received as a Gift
To figure your basis in property that you received as a gift, you must know its adjusted basis to the donor just before it
was given to you, its
fair market value at the time it was given to you, the amount of any gift tax paid on it, and the date it was given to you.
Fair market value less than donor's adjusted basis.
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.
No gain or loss.
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.
Example.
You receive a gift of investment property having an adjusted basis of $10,000 at the time of the gift. The fair market value
at the time of the
gift is $9,000. You later sell the property for $9,500. You have neither gain nor loss. Your basis for figuring gain is $10,000,
and $9,500 minus
$10,000 results in a $500 loss. Your basis for figuring loss is $9,000, and $9,500 minus $9,000 results in a $500 gain.
Fair market value equal to or more than donor's adjusted basis.
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.
Gift received before 1977.
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.
Example 1.
You were given XYZ Company stock in 1976. At the time of the gift, the stock had a fair market value of $21,000. The donor's
adjusted basis was
$20,000. The donor paid a gift tax of $500 on the gift. Your basis for gain or loss is $20,500, the donor's adjusted basis
plus the amount of gift tax
paid.
Example 2.
The facts are the same as in Example 1 except that the gift tax paid was $1,500. Your basis is $21,000, the donor's adjusted
basis plus the gift
tax paid, but limited to the fair market value of the stock at the time of the gift.
Gift received after 1976.
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.
Example.
In 2005, you received a gift of property from your mother. At the time of the gift, the property had a fair market value of
$101,000 and an
adjusted basis to her of $40,000. The amount of the gift for gift tax purposes was $90,000 ($101,000 minus the $11,000 annual
exclusion), and your
mother paid a gift tax of $21,000. You figure your basis in the following way:
Part sale, part 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.
Gift tax information.
For information on gift tax, see Publication 950, Introduction to Estate and Gift Taxes.
Property Received as Inheritance
If you inherited property, your basis in that property generally is its fair market value (its appraised value on the federal
estate tax return)
on:
-
The date of the decedent's death, or
-
The later alternate valuation date if the estate qualifies for, and elects to use, alternate valuation.
If no federal estate tax return was filed, use the appraised value on the date of death for state inheritance or transmission
taxes.
Appreciated property you gave the decedent.
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.
More information.
See Publication 551, Basis of Assets, for more information on the basis of inherited property, including community
property, property held by a
surviving tenant in a joint tenancy or tenancy by the entirety, a qualified joint interest, and a farm or closely held business.
Before you can figure any gain or loss on a sale, exchange, or other disposition of property or figure allowable depreciation,
depletion, or
amortization, you usually must make certain adjustments (increases and decreases) to the basis of the property. The result
of these adjustments to the
basis is the adjusted basis.
Adjustments to the basis of stocks and bonds are explained in the following discussion. For information about other adjustments
to basis, see
Publication 551.
The basis of stocks or bonds you own generally is the purchase price plus the costs of purchase, such as commissions and recording
or transfer
fees. If you acquired stock or bonds other than by purchase, your basis is usually determined by fair market value or the
previous owner's adjusted
basis as discussed earlier under Basis Other Than Cost.
The basis of stock must be adjusted for certain events that occur after purchase. For example, if you receive more stock from
nontaxable stock
dividends or stock splits, you must reduce the basis of your original stock. You must also reduce your basis when you receive
nondividend
distributions (discussed in chapter 1). These distributions, up to the amount of your basis, are a nontaxable return of capital.
Identifying stock or bonds sold.
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.
Adequate identification.
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.
Broker holds stock.
If you have left the stock certificates with your broker or other agent, you will make an adequate identification
if you:
-
Tell your broker or other agent the particular stock to be sold or transferred at the time of the sale or transfer, and
-
Receive a written confirmation of this from your broker or other agent within a reasonable time.
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.
Single stock certificate.
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:
-
Tell your broker or other agent the particular stock to be sold or transferred when you deliver the certificate to your broker
or other
agent, and
-
Receive a written confirmation of this from your broker or other agent within a reasonable time.
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.
Bonds.
These methods of identification also apply to bonds sold or transferred.
Identification not possible.
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.
Example.
You bought 100 shares of stock of XYZ Corporation in 1992 for $10 a share. In January 1993 you bought another 200 shares for
$11 a share. In July
1993 you gave your son 50 shares. In December 1995 you bought 100 shares for $9 a share. In April 2005 you sold 130 shares.
You cannot identify the
shares you disposed of, so you must use the stock you acquired first to figure the basis. The shares of stock you gave your
son had a basis of $500
(50 × $10). You figure the basis of the 130 shares of stock you sold in 2005 as follows:
Shares in a mutual fund or REIT.
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.
Mutual fund load charges.
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.
Choosing average basis for mutual fund shares.
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.
Undistributed capital gains.
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.
Automatic investment service.
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.
Dividend reinvestment plans.
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.
Public utilities.
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.
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 Nondividend 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.
New and old stock identical.
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.
Example 1.
You owned one share of common stock that you bought for $45. The corporation distributed two new shares of common stock for
each share held. You
then had three shares of common stock. Your basis in each share is $15 ($45 ÷ 3).
Example 2.
You owned two shares of common stock. You had bought one for $30 and the other for $45. The corporation distributed two new
shares of common stock
for each share held. You had six shares after the distribution—three with a basis of $10 each ($30 ÷ 3) and three with a basis
of $15
each ($45 ÷ 3).
New and old stock not identical.
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.
Example.
You bought a share of common stock for $100. Later, the corporation distributed a share of preferred stock for each share
of common stock held. At
the date of distribution, your common stock had a fair market value of $150 and the preferred stock had a fair market value
of $50. You figure the
basis of the old and new stock by dividing your $100 basis between them. The basis of your common stock is $75 ($150/$200
× $100), and the basis
of the new preferred stock is $25 ($50/$200 × $100).
Stock bought at various times.
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.
Taxable stock dividends.
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.
Stock splits.
Figure the basis of stock splits in the same way as stock dividends if identical stock is distributed on the stock
held.
Stock rights.
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 Nondividend Distributions in
chapter 1.
Taxable stock rights.
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.
Nontaxable stock rights.
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.
Basis of new stock.
If you exercise the stock rights, the basis of the new stock is its cost plus the basis of the stock rights exercised.
Example.
You own 100 shares of ABC Company stock, which cost you $22 per share. The ABC Company gave you 10 nontaxable stock rights
that would allow you to
buy 10 more shares at $26 per share. At the time the stock rights were distributed, the stock had a market value of $30, not
including the stock
rights. Each stock right had a market value of $3. The market value of the stock rights was less than 15% of the market value
of the stock, but you
chose to divide the basis of your stock between the stock and the rights. You figure the basis of the rights and the basis
of the old stock as
follows:
If you sell the rights, the basis for figuring gain or loss is $2.18 ($21.78 ÷ 10) per right. If you exercise the rights,
the basis of the
stock you acquire is the price you pay ($26) plus the basis of the right exercised ($2.18), or $28.18 per share. The remaining
basis of the old stock
is $21.78 per share.
Investment property received in liquidation.
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.
S corporation stock.
You must increase your basis in stock of an S corporation by your pro rata share of the following items.
-
All income items of the S corporation, including tax-exempt income, that are separately stated and passed through to you as
a
shareholder.
-
The nonseparately stated income of the S corporation.
-
The amount of the deduction for depletion (other than oil and gas depletion) that is more than the basis of the property being
depleted.
You must decrease your basis in stock of an S corporation by your pro rata share of the following items.
-
Distributions by the S corporation that were not included in your income.
-
All loss and deduction items of the S corporation that are separately stated and passed through to you.
-
Any nonseparately stated loss of the S corporation.
-
Any expense of the S corporation that is not deductible in figuring its taxable income and not properly chargeable to a capital
account.
-
The amount of your deduction for depletion of oil and gas wells to the extent the deduction is not more than your share of
the adjusted
basis of the wells.
However, your basis in the stock cannot be reduced below zero.
Specialized small business investment company stock or partnership interest.
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.
Qualified small business stock.
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.
Short sales.
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.
Premiums on bonds.
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.
Market discount on bonds.
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.
Bonds purchased at par value.
A bond purchased at par value (face amount) has no premium or discount. When you sell or otherwise dispose of the
bond, you figure the gain or loss
by comparing the bond proceeds to the purchase price of the bond.
Example.
You purchased a bond several years ago for its par value of $10,000. You sold the bond this year for $10,100. You have a gain
of $100. However, if
you had sold the bond for $9,900, you would have a loss of $100.
Acquisition discount on short-term obligations.
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.
Original issue discount (OID) on debt instruments.
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.
Discounted tax-exempt obligations.
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.
Stripped tax-exempt obligation.
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.
How To Figure Gain or Loss
You figure gain or loss on a sale or trade of property by comparing the amount you realize with the adjusted basis of the
property.
Gain.
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.
Loss.
If the adjusted basis of the property you transfer is more than the amount you realize, the difference is a loss.
Amount realized.
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
that you must report as ordinary income will reduce the amount realized from the sale. For more information, see Publication
537.
If a buyer of property issues a debt instrument to the seller of the property, the amount realized is determined by
reference to the issue price of
the debt instrument, which may or may not be the fair market value of the debt instrument. See Regulations section 1.1001-1(g).
However, if the debt
instrument was previously issued by a third party (one not part of the sale transaction), the fair market value of the debt
instrument is used to
determine the amount realized.
Fair market value.
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.
Example.
You trade A Company stock with an adjusted basis of $7,000 for B Company stock with a fair market value of $10,000, which
is your amount realized.
Your gain is $3,000 ($10,000 minus $7,000). If you also receive a note for $6,000 that has an issue price of $6,000, your
gain is $9,000 ($10,000 plus
$6,000 minus $7,000).
Debt paid off.
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.
Example.
You sell stock that you had pledged as security for a bank loan of $8,000. Your basis in the stock is $6,000. The buyer pays
off your bank loan and
pays you $20,000 in cash. The amount realized is $28,000 ($20,000 plus $8,000). Your gain is $22,000 ($28,000 minus $6,000).
Payment of cash.
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 trade 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.
No gain or 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.
This section discusses trades that generally do not result in a taxable gain or a deductible loss. For more information on
nontaxable trades, see
chapter 1 of Publication 544.
If you trade business or investment property for other business or investment property of a like kind, you do not pay tax
on any gain or deduct any
loss until you sell or dispose of the property you receive. To be nontaxable, a trade must meet all six of the following conditions.
-
The property must be business or investment property. You must hold both the property you trade and the property you receive
for productive
use in your trade or business or for investment. Neither property may be property used for personal purposes, such as your
home or family car.
-
The property must not be held primarily for sale. The property you trade and the property you receive must not be property
you sell to
customers, such as merchandise.
-
The property must not be stocks, bonds, notes, choses in action, certificates of trust or beneficial interest, or other securities
or
evidences of indebtedness or interest, including partnership interests. However, you can have a nontaxable trade of corporate
stocks under a different
rule, as discussed later under Corporate Stocks.
-
There must be a trade of like property. The trade of real estate for real estate, or personal property for similar personal
property, is a
trade of like property. The trade of an apartment house for a store building, or a panel truck for a pickup truck, is a trade
of like property. The
trade of a piece of machinery for a store building is not a trade of like property. Real property located in the United States
and real property
located outside the United States are not like property. Also, personal property used predominantly within the United States
and personal property
used predominantly outside the United States are not like property.
-
The property to be received must be identified in writing within 45 days after the date you transfer the property given up
in the trade. If
you received the replacement property before the end of the 45-day period, you automatically are treated as having met the
45-day written notice
requirement.
-
The property to be received must be received by the earlier of:
-
The 180th day after the date on which you transfer the property given up in the trade, or
-
The due date, including extensions, for your tax return for the year in which the transfer of the property given up occurs.
If you trade property with a related party in a like-kind exchange, a special rule may apply. See Related Party Transactions, later in
this chapter. Also, see chapter 1 of Publication 544 for more information on exchanges of business property and special rules
for exchanges using
qualified intermediaries or involving multiple properties.
Partly nontaxable exchange.
If you receive money 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 money and the fair market value of the unlike
property you receive. You
cannot deduct a loss.
Like property and unlike property transferred.
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.
Like property and money transferred.
If conditions (1) - (6) are met, you have a nontaxable trade even if you pay money in addition to the like property.
Basis of property received.
You figure your basis in property received in a nontaxable or partly nontaxable trade as explained earlier under Basis Other Than Cost,
earlier.
How to report.
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 (Form 1040)
or on Form 4797, Sales of Business Property, whichever applies.
For information on using Form 4797, see chapter 4 of Publication 544.
The following trades of corporate stocks generally do not result in a taxable gain or a deductible loss.
Corporate reorganizations.
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.
Example 1.
On April 19, 2005, KP1 Corporation was acquired by KP2 Corporation. You held 100 shares of KP1 stock with a basis of $3,500.
As a result of the
acquisition, you received 70 shares of KP2 stock in exchange for your KP1 stock. You do not recognize gain or loss on the
transaction. Your basis in
the 70 shares of the new stock is still $3,500.
Example 2.
On July 27, 2005, RGB corporation divests itself of SFH corporation. You hold 75 shares of RGB stock with a basis of $5,400.
You receive 25 shares
of SFH stock as a result of the spin-off. You do not recognize any gain or loss on the transaction. You receive information
from RGB corporation that
your basis in SFH stock is equal to 10.9624% of your basis in RGB stock ($5,400). Thus, your basis in SFH stock is $592.00.
Your basis in RGB stock
(after the spin-off) is $4,808 ($5,400 - $592).
Note: In the case of a spin-off, the divesting corporation should send you information that includes details on how to allocate
basis between the old and
new stock. Keep this information until the period of limitations expires for the year in which you dispose of the stock in
a taxable disposition.
Usually, this is 3 years from the date the return was due or filed, or 2 years from the date the tax was paid, whichever is
later.
Stock for stock of the same corporation.
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 you receive cash for fractional shares, see Fractional shares under Distributions of stock and stock rights in chapter 1.
Money or other property received.
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.
If you received cash for fractional shares, see Fractional shares under Distributions of Stock and Stock Rights in chapter 1.
Nonqualified preferred stock.
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.
-
The holder has the right to require the issuer or a related person to redeem or purchase the stock.
-
The issuer or a related person is required to redeem or purchase the stock.
-
The issuer or a related person has the right to redeem the stock, and on the issue date, it is more likely than not that the
right will be
exercised.
-
The dividend rate on the stock varies with reference to interest rates, commodity prices, or similar indices.
For a detailed definition of nonqualified preferred stock, see section 351(g)(2) of the Internal Revenue Code.
Convertible stocks and bonds.
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.
Example.
In November, you bought for $1 a right issued by XYZ Corporation entitling you, on payment of $99, to subscribe to a bond
issued by that
corporation.
On December 2, you subscribed to the bond, which was issued on December 9. The bond contained a clause stating that you would
receive one share of
XYZ Corporation common stock on surrender of one bond and the payment of $50.
Later, you presented the bond and $50 and received one share of XYZ Corporation common stock. You did not have a recognized
gain or loss. This is
true whether the fair market value of the stock was more or less than $150 on the date of the conversion.
The basis of your share of stock is $150 ($1 + $99 + $50). Your holding period is split. Your holding period for the part
based on your ownership
of the bond ($100 basis) begins on December 2. Your holding period for the part based on your cash investment ($50 basis)
begins on the day after you
acquired the share of stock.
Bonds for stock of another corporation.
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.
Property for stock of a controlled corporation.
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.
Money or other property received.
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 partly 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.
Basis of stock or other property received.
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.
Insurance Policies and Annuities
You will not have a recognized gain or loss if the insured or annuitant is the same under both contracts and you trade:
-
A life insurance contract for another life insurance contract or for an endowment or annuity contract,
-
An endowment contract for an annuity contract or for another endowment contract that provides for regular payments beginning
at a date not
later than the beginning date under the old contract, or
-
An annuity contract for another annuity contract.
You also may not have to recognize gain or loss from an exchange of a portion of an annuity contract for another annuity contract.
See Revenue
Ruling 2003-76 and Notice 2003-51 in Internal Revenue Bulletin 2003-33. This bulletin is available at
www.irs.gov/pub/irs-irbs/irb03-33.pdf.
Exchanges of contracts not included in this list, such as an annuity contract for an endowment contract, or an annuity or
endowment contract for a
life insurance contract, are taxable.
Demutualization of Life Insurance Companies
A life insurance company may change from a mutual company to a stock company. This is commonly called demutualization. If
you were a policyholder
or annuitant of the mutual company, you may have received either stock in the stock company or cash in exchange for your equity
interest in the mutual
company.
If the demutualization transaction qualifies as a tax-free reorganization under section 368(a)(1) of the Internal Revenue
Code, no gain or loss is
recognized on the exchange. Your holding period for the new stock includes the period you held an equity interest in the mutual
company as a
policyholder or annuitant.
If the demutualization transaction does not qualify as a tax-free reorganization under section 368(a)(1) of the Internal Revenue
Code, you must
recognize a capital gain or loss. Your holding period for the stock does not include the period you held an equity interest
in the mutual company.
If you received cash in exchange for your equity interest, you must recognize a capital gain. If you held an equity interest
for more than 1 year,
your gain is long-term.
U.S. Treasury Notes or Bonds
You can trade certain issues of U.S. Treasury obligations for other issues, designated by the Secretary of the Treasury, with
no gain or loss
recognized on the trade.
See the discussion in chapter 1 under U.S. Treasury Bills, Notes, and Bonds for information about
income from these investments.
Transfers Between Spouses
Generally, no gain or loss is recognized on a transfer of property from an individual to (or in trust for the benefit of)
a spouse or, if incident to a divorce, a former spouse. This nonrecognition rule does not apply in the following situations.
-
The recipient spouse or former spouse is a nonresident alien.
-
Property is transferred in trust. Gain must be recognized to the extent the amount of the liabilities assumed by the trust,
plus any
liabilities on the property, exceed the adjusted basis of the property.
-
An installment obligation is transferred in trust. For information on the disposition of an installment obligation, see Publication
537,
Installment Sales.
-
Certain stock redemptions, which are taxable to a spouse under the tax law, a divorce or separation instrument, or a valid
written
agreement, discussed in Regulations section 1.1041-2.
Any transfer of property to a spouse or former spouse on which gain or loss is not recognized is treated by the recipient
as a gift and is not
considered a sale or exchange. The recipient's basis in the property will be the same as the adjusted basis of the giver immediately
before the
transfer. This carryover basis rule applies whether the adjusted basis of the transferred property is less than, equal to,
or greater than either its
fair market value at the time of transfer or any consideration paid by the recipient. This rule applies for purposes of determining
loss as well as
gain. Any gain recognized on a transfer in trust increases the basis.
A transfer of property is incident to a divorce if the transfer occurs within 1 year after the date on which the marriage
ends, or if the transfer
is related to the ending of the marriage. For more information, see Property Settlements in Publication 504, Divorced or Separated
Individuals.
Related Party Transactions
Special rules apply to the sale or trade of property between related parties.
Gain on Sale or Trade of Depreciable Property
Your gain from the sale or trade of property to a related party may be ordinary income, rather than capital gain, if the property
can be
depreciated by the party receiving it. See chapter 3 in Publication 544 for more information.
Generally, if you trade business or investment property for other business or investment property of a like kind, no gain
or loss is recognized.
See Like-Kind Exchanges, earlier, under Nontaxable Trades.
This rule also applies to trades of property between related parties, defined next under Losses on Sales or Trades of Property. However,
if either you or the related party disposes of the like property within 2 years after the trade, you both must report any
gain or loss not recognized
on the original trade on your return for the year in which the later disposition occurs.
This rule generally does not apply to:
-
Dispositions due to the death of either related party,
-
Involuntary conversions (see chapter 1 of Publication 544), or
-
Trades and later dispositions whose main purpose is not the avoidance of federal income tax.
If a property holder's risk of loss on the property is substantially diminished during any period, that period is not counted
in determining
whether the property was disposed of within 2 years. The property holder's risk of loss is substantially diminished by:
-
The holding of a put on the property,
-
The holding by another person of a right to acquire the property, or
-
A short sale or any other transaction.
Losses on Sales or Trades of Property
You cannot deduct a loss on the sale or trade of property, other than a distribution in complete liquidation of a corporation,
if the transaction
is directly or indirectly between you and the following related parties.
-
Members of your family. This includes only your brothers and sisters, half-brothers and half-sisters, spouse, ancestors (parents,
grandparents, etc.), and lineal descendants (children, grandchildren, etc.).
-
A partnership in which you directly or indirectly own more than 50% of the capital interest or the profits interest.
-
A corporation in which you directly or indirectly own more than 50% in value of the outstanding stock (see Constructive ownership of
stock, later).
-
A tax-exempt charitable or educational organization that is directly or indirectly controlled, in any manner or by any method,
by you or by
a member of your family, whether or not this control is legally enforceable.
In addition, a loss on the sale or trade of property is not deductible if the transaction is directly or indirectly between
the following
related parties.
-
A grantor and fiduciary, or the fiduciary and beneficiary, of any trust.
-
Fiduciaries of two different trusts, or the fiduciary and beneficiary of two different trusts, if the same person is the grantor
of both
trusts.
-
A trust fiduciary and a corporation of which more than 50% in value of the outstanding stock is directly or indirectly owned
by or for the
trust, or by or for the grantor of the trust.
-
A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation
and more than 50%
of the capital interest, or the profits interest, in the partnership.
-
Two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation.
-
Two corporations, one of which is an S corporation, if the same persons own more than 50% in value of the outstanding stock
of each
corporation.
-
An executor and a beneficiary of an estate (except in the case of a sale or trade to satisfy a pecuniary bequest).
-
Two corporations that are members of the same controlled group (under certain conditions, however, these losses are not disallowed
but must
be deferred).
-
Two partnerships if the same persons own, directly or indirectly, more than 50% of the capital interests or the profit interests
in both
partnerships.
Multiple property sales or trades.
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.
Indirect transactions.
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.
Constructive ownership of stock.
In determining whether a person directly or indirectly owns any of the outstanding stock of a corporation, the following
rules apply.
Rule 1.
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.
Rule 2.
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.
Rule 3.
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.
Rule 4.
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.
Property received from a related party.
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.
Example 1.
Your brother sells you stock for $7,600. His cost basis is $10,000. Your brother cannot deduct the loss of $2,400. Later,
you sell the same stock
to an unrelated party for $10,500, realizing a gain of $2,900. Your reportable gain is $500 — the $2,900 gain minus the $2,400
loss not allowed
to your brother.
Example 2.
If, in Example 1, you sold the stock for $6,900 instead of $10,500, your
recognized loss is only $700 — your $7,600 basis minus $6,900. You cannot deduct the loss that was not allowed to your brother.
Terms you may need to know (see Glossary):
| Call |
| Commodity future |
| Conversion transaction |
| Forward contract |
| Limited partner |
| Listed option |
| Nonequity option |
| Options dealer |
| Put |
| Regulated futures contract |
| Section 1256 contract |
| Straddle |
| Wash sale |
This section discusses the tax treatment of gains and losses from different types of investment transactions.
Character of gain or loss.
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 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 and unrecaptured section 1250 gain, see Capital Gain Tax Rates under Reporting Capital Gains and Losses, later.
Capital or Ordinary Gain or Loss
If you have a taxable gain or a deductible loss from a transaction, it may be either a capital gain or loss or an ordinary
gain or loss, depending
on the circumstances. Generally, a sale or trade of a capital asset (defined next) results in a capital gain or loss. A sale
or trade of a noncapital
asset generally results in ordinary gain or loss. Depending on the circumstances, a gain or loss on a sale or trade of property
used in a trade or
business may be treated as either capital or ordinary, as explained in Publication 544. In some situations, part of your gain
or loss may be a capital
gain or loss, and part may be an ordinary gain or loss.
Capital Assets and Noncapital Assets
For the most part, everything you own and use for personal purposes, pleasure, or investment is a capital asset. Some examples
are:
-
Stocks or bonds held in your personal account,
-
A house owned and used by you and your family,
-
Household furnishings,
-
A car used for pleasure or commuting,
-
Coin or stamp collections,
-
Gems and jewelry, and
-
Gold, silver, or any other metal.
Any property you own is a capital asset, except the following noncapital assets.
-
Property held mainly for sale to customers or property that will physically become a part of the merchandise that is for sale
to customers.
-
Depreciable property used in your trade or business, even if fully depreciated.
-
Real property used in your trade or business.
-
A copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property —
-
Created by your personal efforts,
-
Prepared or produced for you (in the case of a letter, memorandum, or similar property), or
-
Acquired under circumstances (for example, by gift) entitling you to the basis of the person who created the property or for
whom it was
prepared or produced.
-
Accounts or notes receivable acquired in the ordinary course of a trade or business for services rendered or from the sale
of property
described in (1).
-
U.S. Government publications that you received from the government for free or for less than the normal sales price, or that
you acquired
under circumstances entitling you to the basis of someone who received the publications for free or for less than the normal
sales price.
-
Certain commodities derivative financial instruments held by commodities derivatives dealers. For more information, see section
1221 of the
Internal Revenue Code.
-
Hedging transactions, but only if the transaction is clearly identified as a hedging transaction before the close of the day
on which it was
acquired, originated, or entered into. For more information, see the definition of hedging transaction earlier, and the discussion
of hedging
transactions under Commodity Futures, later.
-
Supplies of a type you regularly use or consume in the ordinary course of your trade or business.
Investment property.
Investment property is a capital asset. Any gain or loss from its sale or trade generally is a capital gain or loss.
Gold, silver, stamps, coins, gems, etc.
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.
Stocks, stock rights, and bonds.
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.
Personal use property.
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.
Short-term government obligations.
Treat gains on short-term federal, state, or local government obligations (other than tax-exempt obligations) as ordinary
income up to your ratable
share of the acquisition discount. This treatment applies to obligations that have a fixed maturity date not more than 1 year
from the date of issue.
Acquisition discount is the stated redemption price at maturity minus your basis in the obligation.
However, do not treat these gains as income to the extent you previously included the discount in income. See Discount on Short-Term
Obligations in chapter 1 for more information.
Short-term nongovernment obligations.
Treat gains on short-term nongovernment obligations as ordinary income up to your ratable share of OID. This treatment
applies to obligations that
have a fixed maturity date of not more than 1 year from the date of issue.
However, to the extent you previously included the discount in income, you do not have to include it in income again.
See Discount on
Short-Term Obligations, in chapter 1, for more information.
Tax-exempt state and local government bonds.
If these bonds were originally issued at a discount before September 4, 1982, or you acquired them before March 2,
1984, treat your part of the OID
as tax-exempt interest. To figure your gain or loss on the sale or trade of these bonds, reduce the amount realized by your
part of the OID.
If the bonds were issued after September 3, 1982, and acquired after March 1, 1984, increase the adjusted basis by
your part of the OID to figure
gain or loss. For more information on the basis of these bonds, see Discounted tax-exempt obligations under Stocks and Bonds,
earlier in this chapter.
Any gain from market discount is usually taxable on disposition or redemption of tax-exempt bonds. If you bought the
bonds before May 1, 1993, the
gain from market discount is capital gain. If you bought the bonds after April 30, 1993, the gain from market discount is
ordinary income.
You figure market discount by subtracting the price you paid for the bond from the sum of the original issue price
of the bond and the amount of
accumulated OID from the date of issue that represented interest to any earlier holders. For more information, see Market Discount Bonds in
chapter 1.
A loss on the sale or other disposition of a tax-exempt state or local government bond is deductible as a capital
loss.
Redeemed before maturity.
If a state or local bond that was issued before June 9, 1980, is redeemed before it matures, the OID is not taxable
to you.
If a state or local bond issued after June 8, 1980, is redeemed before it matures, the part of the OID that is earned
while you hold the bond is
not taxable to you. However, you must report the unearned part of the OID as a capital gain.
Example.
On July 1, 1994, the date of issue, you bought a 20-year, 6% municipal bond for $800. The face amount of the bond was $1,000.
The $200 discount was
OID. At the time the bond was issued, the issuer had no intention of redeeming it before it matured. The bond was callable
at its face amount
beginning 10 years after the issue date.
The issuer redeemed the bond at the end of 11 years (July 1, 2005) for its face amount of $1,000 plus accrued annual interest
of $60. The OID
earned during the time you held the bond, $73, is not taxable. The $60 accrued annual interest also is not taxable. However,
you must report the
unearned part of the OID ($127) as a capital gain.
Long-term debt instruments issued after 1954 and before May 28, 1969 (or before July 2, 1982, if a government instrument).
If you sell, trade, or redeem for a gain one of these debt instruments, the part of your gain that is not more than
your ratable share of the OID
at the time of sale or redemption is ordinary income. The rest of the gain is capital gain. If, however, there was an intention
to call the debt
instrument before maturity, all of your gain that is not more than the entire OID is treated as ordinary income at the time
of the sale. This
treatment of taxable gain also applies to corporate instruments issued after May 27, 1969, under a written commitment that
was binding on May 27,
1969, and at all times thereafter.
Example.
You bought a 30-year, 6% government bond for $700 at original issue on April 1, 1986, and sold it for $900 on April 21, 2005,
for a $200 gain. The
redemption price is $1,000. At the time of original issue, there was no intention to call the bond before maturity. You have
held the bond for 228
full months. Do not count the additional days that are less than a full month. The number of complete months from date of
issue to date of maturity is
360 (30 years). The fraction 228/360 multiplied by the discount of $300 ($1,000 - $700) is equal to $190. This is your ratable
share of OID for
the period you owned the bond. You must treat any part of the gain up to $190 as ordinary income. As a result, $190 is treated
as ordinary income and
$10 is capital gain.
Long-term debt instruments issued after May 27, 1969 (or after July 1, 1982, if a government instrument).
If you hold one of these debt instruments, you must include a part of the OID in your gross income each year that
you own the instrument. Your
basis in that debt instrument is increased by the amount of OID that you have included in your gross income. See Original Issue Discount
(OID) in chapter 1.
If you sell or trade the debt instrument before maturity, your gain is a capital gain. However, if at the time the
instrument was originally issued
there was an intention to call it before its maturity, your gain generally is ordinary income to the extent of the entire
OID reduced by any amounts
of OID previously includible in your income. In this case, the rest of the gain is a capital gain.
An intention to call a debt instrument before maturity means there is a written or oral agreement or understanding
not provided for in the debt
instrument between the issuer and original holder that the issuer will redeem the debt instrument before maturity. In the
case of debt instruments
that are part of an issue, the agreement or understanding must be between the issuer and the original holders of a substantial
amount of the debt
instruments in the issue.
Example 1.
On February 4, 2003, you bought at original issue for $7,600, Jones Corporation's 10-year, 5% bond which has a stated redemption
price at maturity
of $10,000. On February 3, 2005, you sold the bond for $9,040. Assume you have included $334 of the OID in your gross income
(including the amount
accrued for 2005) and increased your basis in the bond by that amount. Your basis is now $7,934. If at the time of the original
issue there was no
intention to call the bond before maturity, your gain of $1,106 ($9,040 amount realized minus $7,934 adjusted basis) is capital
gain.
Example 2.
If, in Example 1, at the time of original issue there was an intention to call the bond before maturity, your entire gain is ordinary
income. You figure this as follows:
Because the amount in (3) is more than your gain of $1,106, your entire gain is ordinary income.
Market discount bonds.
If the debt instrument has market discount and you chose to include the discount in income as it accrued, increase
your basis in the debt
instrument by the accrued discount to figure capital gain or loss on its disposition. If you did not choose to include the
discount in income as it
accrued, you must report gain as ordinary interest income up to the instrument's accrued market discount. See Market Discount Bonds in
chapter 1. The rest of the gain is capital gain.
However, a different rule applies if you dispose of a market discount bond that was:
-
Issued before July 19, 1984, and
-
Purchased by you before May 1, 1993.
In that case, any gain is treated as interest income up to the amount of your deferred interest deduction for the year you
dispose of the bond.
The rest of the gain is capital gain. (The limit on the interest deduction for market discount bonds is discussed in chapter
3 under When To
Deduct Investment Interest.)
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 in column (f) as interest
income on Schedule B
(Form 1040), line 1, and identify it as “ Accrued Market Discount.”
Retirement of debt instrument.
Any amount that you receive on the retirement of a debt instrument is treated in the same way as if you had sold or
traded that instrument.
Notes of individuals.
If you hold an obligation of an individual that was issued with OID after March 1, 1984, you generally must include
the OID in your income
currently, and your gain or loss on its sale or retirement is generally capital gain or loss. An exception to this treatment
applies if the obligation
is a loan between individuals and all of the following requirements are met.
-
The lender is not in the business of lending money.
-
The amount of the loan, plus the amount of any outstanding prior loans, is $10,000 or less.
-
Avoiding federal tax is not one of the principal purposes of the loan.
If the exception applies, or the obligation was issued before March 2, 1984, you do not include the OID in your income
currently. When you sell or
redeem the obligation, the part of your gain that is not more than your accrued share of the OID at that time is ordinary
income. The rest of the
gain, if any, is capital gain. Any loss on the sale or redemption is capital loss.
You cannot deduct any loss on an obligation required to be in registered form that is instead held in bearer form. In addition,
any gain on the
sale or other disposition of the obligation is ordinary income. However, if the issuer was subject to a tax when the obligation
was issued, then you
can deduct any loss, and any gain may qualify for capital gain treatment.
Obligations required to be in registered form.
Any obligation must be in registered form unless:
-
It is issued by a natural person,
-
It is not of a type offered to the public,
-
It has a maturity at the date of issue of not more than 1 year, or
-
It was issued before 1983.
Deposit in Insolvent or Bankrupt Financial Institution
If you lose money you have on deposit in a qualified financial institution that becomes insolvent or bankrupt, you may be
able to deduct your loss
in one of three ways.
-
Ordinary loss,
-
Casualty loss, or
-
Nonbusiness bad debt (short-term capital loss).
Ordinary loss or casualty loss.
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 Schedule A (Form 1040), line 22.
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:
-
You own at least 1% of the financial institution,
-
You are an officer of the institution, or
-
You are related to such an owner or officer. You are related if you and the owner or officer are “related parties,” as defined earlier
under Related Party Transactions, or if you are the aunt, uncle, nephew, or niece of the owner or officer.
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.
Nonbusiness bad debt.
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 part of any gain on the sale of an annuity contract before its maturity date that is based on interest accumulated on
the contract is ordinary
income.
Generally, all or part of a gain on a conversion transaction is treated as ordinary income. This applies to gain on the disposition
or other
termination of any position you held as part of a conversion transaction that you entered into after April 30, 1993.
A conversion transaction is any transaction that meets both of these tests.
-
Substantially all of your expected return from the transaction is due to the time value of your net investment. In other words,
the return
on your investment is, in substance, like interest on a loan.
-
The transaction is one of the following.
-
A straddle as defined under Straddles, later, but including any set of offsetting positions on stock established before October
22, 2004.
-
Any transaction in which you acquire property (whether or not actively traded) at substantially the same time that you contract
to sell the
same property, or substantially identical property, at a price set in the contract.
-
Any other transaction that is marketed or sold as producing capital gains from a transaction described in (1).
Amount treated as ordinary income.
The amount of gain treated as ordinary income is the smaller of:
-
The gain recognized on the disposition or other termination of the position, or
-
The “applicable imputed income amount.”
Applicable imputed income amount.
Figure this amount as follows.
-
Figure the amount of interest that would have accrued on your net investment in the conversion transaction for the period
ending on the
earlier of:
-
The date when you dispose of the position, or
-
The date when the transaction stops being a conversion transaction.
To figure this amount, use an interest rate equal to 120% of the “applicable rate,” defined later.
-
Subtract from (1) the amount treated as ordinary income from any earlier disposition or other termination of a position held
as part of the
same conversion transaction.
Applicable rate.
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.
Net investment.
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).
Position with built-in loss.
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.
Netting rule for certain conversion transactions.
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.
Options dealers and commodities traders.
These rules do not apply to options dealers and commodities traders.
How to report.
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 commodity futures contract is a standardized, exchange-traded contract for the sale or purchase of a fixed amount of a commodity
at a future date
for a fixed price.
If the contract is a regulated futures contract, the rules described earlier under Section 1256 Contracts Marked to Market apply to it.
The termination of a commodity futures contract generally results in capital gain or loss unless the contract is a hedging
transaction.
Hedging transaction.
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 Regulations section 1.1221-2. Also, see Hedging Transactions under Section
1256 Contracts Marked to Market, earlier.
If you have numerous transactions in the commodity futures market during the year, the burden of proof is on you to show which
transactions are
hedging transactions. Clearly identify any hedging transactions on your books and records before the end of the day you entered
into the transaction.
It may be helpful to have separate brokerage accounts for your hedging and nonhedging transactions. For specific requirements
concerning
identification of hedging transactions and the underlying item, items, or aggregate risk that is being hedged, see Regulations
section 1.1221-2(f).
Gains From Certain Constructive Ownership Transactions
If you have a gain from a constructive ownership transaction entered into after July 11, 1999, involving a financial asset
(discussed later) and
the gain normally would be treated as long-term capital gain, all or part of the gain may be treated instead as ordinary income.
In addition, if any
gain is treated as ordinary income, your tax is increased by an interest charge.
Constructive ownership transactions.
The following are constructive ownership transactions.
-
A notional principal contract in which you have the right to receive all or substantially all of the investment yield on a
financial asset
and you are obligated to reimburse all or substantially all of any decline in value of the financial asset.
-
A forward or futures contract to acquire a financial asset.
-
The holding of a call option and writing of a put option on a financial asset at substantially the same strike price and maturity
date.
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.
Financial asset.
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.
Amount of ordinary income.
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.
More information.
For more information about constructive ownership transactions, see section 1260 of the Internal Revenue Code.
Losses on Section 1244 (Small Business) Stock
You can deduct as an ordinary loss, rather than as a capital loss, a loss on the sale, trade, or worthlessness of section
1244 stock. Report the
loss on Form 4797, Sales of Business Property, line 10.
Any gain on section 1244 stock is a capital gain if the stock is a capital asset in your hands. Do not offset gains against
losses that are within
the ordinary loss limit, explained later in this discussion, even if the transactions are in stock of the same company. Report
the gain on Schedule D
(Form 1040).
If you must figure a net operating loss, any ordinary loss from the sale of section 1244 stock is a business loss.
Ordinary loss limit.
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.
Section 1244 (small business) stock.
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.
The stock must be issued to the person taking the loss.
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.
Stock distributed by partnership.
If your partnership distributes the stock to you, you cannot treat any later loss on that stock as an ordinary loss.
Stock sold through underwriter.
Stock sold through an underwriter is not section 1244 stock unless the underwriter only acted as a selling agent for
the corporation.
Stock dividends and reorganizations.
Stock you receive as a stock dividend qualifies as section 1244 stock if:
-
You receive it from a small business corporation in which you own stock, and
-
The stock you own meets the requirements when the stock dividend is distributed.
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.
Example.
Your basis for 100 shares of X common stock is $1,000. These shares qualify as section 1244 stock. If, as a nontaxable stock
dividend, you receive
50 more shares of common stock, the basis of which is determined from the 100 shares you own, the 50 shares are also section
1244 stock.
If you also own stock in the corporation that is not section 1244 stock when you receive the stock dividend, you must divide
the shares you receive
as a dividend between the section 1244 stock and the other stock. Only the shares from the former can be section 1244 stock.
Contributed property.
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:
-
The adjusted basis (for figuring loss) of the property, immediately before the trade, was more than its fair market value,
and
-
The basis of the stock is determined by the basis of the property.
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.
Example.
You transfer property with an adjusted basis of $1,000 and a fair market value of $250 to a corporation for its section 1244
stock. The basis of
your stock is $1,000, but to figure the ordinary loss under these rules, the basis of your stock is $250 ($1,000 minus $750).
If you later sell the
section 1244 stock for $200, your $800 loss is an ordinary loss of $50 and a capital loss of $750.
Contributions to capital.
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.
Example.
You buy 100 shares of section 1244 stock for $10,000. You are the original owner. You later make a $2,000 contribution to
capital that increases
the total basis of the 100 shares to $12,000. You then sell the 100 shares for $9,000 and have a loss of $3,000. You can deduct
only $2,500 ($3,000
× $10,000/$12,000) as an ordinary loss under these rules. The remaining $500 is a capital loss.
Recordkeeping.
You must keep records sufficient to show your stock qualifies as section 1244 stock. Your records must also
distinguish your section 1244 stock from any other stock you own in the corporation.
Losses on Small Business Investment Company Stock
A small business investment company (SBIC) is one that is licensed and operated under the Small Business Investment Act of
1958.
If you are an investor in SBIC stock, you can deduct as an ordinary loss, rather than a capital loss, a loss from the sale,
trade, or worthlessness
of that stock. A gain from the sale or trade of that stock is a capital gain. Do not offset your gains and losses, even if
they are on stock of the
same company.
How to report.
You report this type of ordinary loss on Form 4797, Part II, line 10. In addition to the information required by the
form, you must include the
name and address of the company that issued the stock. If applicable, also include the reason the stock is worthless and the
approximate date it
became worthless. Report a capital gain from the sale of SBIC stock on Schedule D of Form 1040.
Short sale.
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 sold or traded investment property, you must determine your holding period for the property. Your holding period determines
whether any
capital gain or loss was a short-term or a long-term capital gain or loss.
Long-term or short-term.
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.
Example.
If you bought investment property on February 5, 2004, and sold it on February 5, 2005, your holding period is not more than
1 year and you have a
short-term capital gain or loss. If you sold it on February 6, 2005, your holding period is more than 1 year and you have
a long-term capital gain or
loss.
Securities traded on an established market.
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.
Example.
You are a cash method, calendar year taxpayer. You sold stock at a gain on December 29, 2005. According to the rules of the
stock exchange, the
sale was closed by delivery of the stock 3 trading days after the sale, on January 4, 2006. You received payment of the sale
price on that same day.
Report your gain on your 2005 return, even though you received the payment in 2006. The gain is long term or short term depending
on whether you held
the stock more than 1 year. Your holding period ended on December 29. If you had sold the stock at a loss, you would also
report it on your 2005
return.
U.S. Treasury notes and bonds.
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.
Automatic investment service.
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.
Nontaxable trades.
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.
Property received as a gift.
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.
Inherited property.
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.
Real property bought.
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.
Real property repossessed.
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.
Stock dividends.
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.
Nontaxable stock rights.
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.
Section 1256 contracts.
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.
Option exercised.
Your holding period for property you acquire when you exercise an option begins the day after you exercise the option.
Wash sales.
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.
Qualified small business stock.
Your holding period for stock you acquired in a tax-free rollover of gain from a sale of qualified small business
stock, described later under
Gains on Qualified Small Business Stock, includes the period you held the old stock.
Commodity futures.
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.
Securities futures contract.
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.
Loss on mutual fund or REIT stock held 6 months or less.
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.
Capital gain distributions received.
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.
Exempt-interest dividends on mutual fund stock.
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.
Loss on stock that paid qualified dividends.
Any loss on the sale or trade of stock must be treated as a long-term capital loss to the extent you received, from
that stock, qualified dividends
(defined in chapter 1) that are extraordinary dividends. This is true regardless of how long you actually held the stock.
Generally, an extraordinary
dividend is a dividend that equals or exceeds 10% (5% in the case of preferred stock) of your adjusted basis in the stock.
If someone owes you money that you cannot collect, you have a bad debt. You may be able to deduct the amount owed to you when
you figure your tax
for the year the debt becomes worthless.
There are two kinds of bad debts — business and nonbusiness. A business bad debt, generally, is one that comes from operating
your trade or
business and is deductible as a business loss. All other bad debts are nonbusiness bad debts and are deductible as short-term
capital losses.
Example.
An architect made personal loans to several friends who were not clients. She could not collect on some of these loans. They
are deductible only as
nonbusiness bad debts because the architect was not in the business of lending money and the loans do not have any relationship
to her business.
Business bad debts.
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.
Deductible nonbusiness bad debts.
To be deductible, nonbusiness bad debts must be totally worthless. You cannot deduct a partly worthless nonbusiness
debt.
Genuine debt required.
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.
Loan or gift.
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.
Basis in bad debt required.
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.
When deductible.
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.
Filing a claim for refund.
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, whichever is
later.) For more information about filing a claim, see Publication 556, Examination of Returns, Appeal Rights, and Claims
for Refund.
Loan guarantees.
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.
Example 1.
Henry Lloyd, an officer and principal shareholder of the Spruce Corporation, guaranteed payment of a bank loan the corporation
received. The
corporation defaulted on the loan and Henry made full payment. Because he guaranteed the loan to protect his investment in
the corporation, Henry can
take a nonbusiness bad debt deduction.
Example 2.
Milt and John are co-workers. Milt, as a favor to John, guarantees a note at their local credit union. John does not pay the
note and declares
bankruptcy. Milt pays off the note. However, since he did not enter into the guarantee agreement to protect an investment
or to make a profit, Milt
cannot take a bad debt deduction.
Deductible in year paid.
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.
Rights against the borrower.
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.
Debts owed by political parties.
You cannot take a nonbusiness bad debt deduction for any worthless debt owed to you by:
-
A political party,
-
A national, state, or local committee of a political party, or
-
A committee, association, or organization that either accepts contributions or spends money to influence elections.
Mechanics' and suppliers' liens.
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.
Insolvency of contractor.
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.
Secondary liability on home mortgage.
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.
Worthless securities.
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.
Recovery of a bad debt.
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.
How to report bad debts.
Deduct nonbusiness bad debts as short-term capital losses on Schedule D (Form 1040).
On Schedule D, Part I, line 1, 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:
-
A description of the debt, including the amount, and the date it became due,
-
The name of the debtor, and any business or family relationship between you and the debtor,
-
The efforts you made to collect the debt, and
-
Why you decided the debt was worthless. For example, you could show that the borrower has declared bankruptcy, or that legal
action to
collect would probably not result in payment of any part of the debt.
A short sale occurs when you agree to sell property you do not own (or own but do not wish to sell). You make this type of
sale in two steps.
-
You sell short. You borrow property and deliver it to a buyer.
-
You close the sale. At a later date, you either buy substantially identical property and deliver it to the lender or make
delivery out of
property that you held at the time of the sale. Delivery of property borrowed from another lender does not satisfy this requirement.
You do not realize gain or loss until delivery of property to close the short sale. You will have a capital gain or loss if
the property used
to close the short sale is a capital asset.
Exception if property becomes worthless.
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.
Exception for constructive sales.
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.
Example.
On May 3, 2005, you bought 100 shares of Baker Corporation stock for $1,000. On September 3, 2005, you sold short 100 shares
of similar Baker stock
for $1,600. You made no other transactions involving Baker stock for the rest of 2005 and the first 30 days of 2006. Your
short sale is treated as a
constructive sale of an appreciated financial position because a sale of your Baker stock on the date of the short sale would
have resulted in a gain.
You recognize a $600 short-term capital gain from the constructive sale and your new holding period in the Baker stock begins
on September 3.
Short-Term or Long-Term Capital Gain or Loss
As a general rule, you determine whether you have short-term or long-term capital gain or loss on a short sale by the amount
of time you actually
hold the property eventually delivered to the lender to close the short sale.
Example.
Even though you do not own any stock of the Ace Corporation, you contract to sell 100 shares of it, which you borrow from
your broker. After 13
months, when the price of the stock has risen, you buy 100 shares of Ace Corporation stock and immediately deliver them to
your broker to close out
the short sale. Your loss is a short-term capital loss because your holding period for the delivered property is less than
one day.
Special rules.
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.
Gains and holding period.
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.
|
Losses.
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.
Mixed straddles.
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 Straddle Elections, later, for more information
about these elections.
Reporting Substitute Payments
If any broker transferred your securities for use in a short sale, or similar transaction, and received certain substitute
dividend payments on
your behalf while the short sale was open, that broker must give you a Form 1099-MISC or a similar statement, reporting the
amount of these payments.
Form 1099-MISC must be used for those substitute payments totaling $10 or more that are known on the payment's record date
to be in lieu of an
exempt-interest dividend, a capital gain dividend, a return of capital distribution, or a dividend subject to a foreign tax
credit, or that are in
lieu of tax-exempt interest. Do not treat these substitute payments as dividends or interest. Instead, report the substitute
payments shown on Form
1099-MISC as “Other income” on line 21 of Form 1040.
Substitute payment.
A substitute payment means a payment in lieu of:
-
Tax-exempt interest (including OID) that has accrued while the short sale was open, and
-
A dividend, if the ex-dividend date is after the transfer of stock for use in a short sale and before the closing of the short
sale.
Payments in lieu of dividends.
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.
Exception.
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.
Extraordinary dividends.
I
f 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.
You cannot deduct losses from sales or trades of stock or securities in a wash sale.
A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you:
-
Buy substantially identical stock or securities,
-
Acquire substantially identical stock or securities in a fully taxable trade, or
-
Acquire a contract or option to buy substantially identical stock or securities.
If you sell stock and your spouse or a corporation you control buys substantially identical stock, you also have a wash sale.
If your loss was disallowed because of the wash sale rules, add the disallowed loss to the cost of the new stock or securities.
The result is your
basis in the new stock or securities. This adjustment postpones the loss deduction until the disposition of the new stock
or securities. Your holding
period for the new stock or securities begins on the same day as the holding period of the stock or securities sold.
Example 1.
You buy 100 shares of X stock for $1,000. You sell these shares for $750 and within 30 days from the sale you buy 100 shares
of the same stock for
$800. Because you bought substantially identical stock, you cannot deduct your loss of $250 on the sale. However, you add
the disallowed loss of $250
to the cost of the new stock, $800, to obtain your basis in the new stock, which is $1,050.
Example 2.
You are an employee of a corporation that has an incentive pay plan. Under this plan, you are given 10 shares of the corporation's
stock as a bonus
award. You include the fair market value of the stock in your gross income as additional pay. You later sell these shares
at a loss. If you receive
another bonus award of substantially identical stock within 30 days of the sale, you cannot deduct your loss on the sale.
Options and futures contracts.
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.
Securities futures contract to sell.
Losses from the sale, exchange, or termination of a securities futures contract to sell generally are treated in the
same manner as losses from the
closing of a short sale, discussed later in this section under Short sales.
Warrants.
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.
Substantially identical.
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:
-
Is convertible into common stock,
-
Has the same voting rights as the common stock,
-
Is subject to the same dividend restrictions,
-
Trades at prices that do not vary significantly from the conversion ratio, and
-
Is unrestricted as to convertibility.
More or less stock bought than sold.
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.
Example 1.
You bought 100 shares of M stock on September 24, 2004, for $5,000. On December 18, 2004, you bought 50 shares of substantially
identical stock for
$2,750. On December 26, 2004, you bought 25 shares of substantially identical stock for $1,125. On January 6, 2005, you sold
for $4,000 the 100 shares
you bought in September. You have a $1,000 loss on the sale. However, because you bought 75 shares of substantially identical
stock within 30 days
before the sale, you cannot deduct the loss ($750) on 75 shares. You can deduct the loss ($250) on the other 25 shares. The
basis of the 50 shares
bought on December 18, 2004, is increased by two-thirds (50 ÷ 75) of the $750 disallowed loss. The new basis of those shares
is $3,250 ($2,750
+ $500). The basis of the 25 shares bought on December 26, 2004, is increased by the rest of the loss to $1,375 ($1,125 +
$250).
Example 2.
You bought 100 shares of M stock on September 24, 2004. On February 3, 2005, you sold those shares at a $1,000 loss. On each
of the 4 days from
February 10-13, 2005, you bought 50 shares of substantially identical stock. You cannot deduct your $1,000 loss. You must
add half the disallowed loss
($500) to the basis of the 50 shares bought on February 10. Add the other half ($500) to the basis of the shares bought on
February 11.
Loss and gain on same day.
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.
Example.
During 2000, you bought 100 shares of X stock on each of three occasions. You paid $158 a share for the first block of 100
shares, $100 a share for
the second block, and $95 a share for the third block. On December 23, 2005, you sold 300 shares of X stock for $125 a share.
On January 6, 2006, you
bought 250 shares of identical X stock. You cannot deduct the loss of $33 a share on the first block because within 30 days
after the date of sale you
bought 250 identical shares of X stock. In addition, you cannot reduce the gain realized on the sale of the second and third
blocks of stock by this
loss.
Dealers.
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.
Short sales.
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:
-
On that date, you own stock or securities identical to those sold short (or by that date you enter into a contract or option
to acquire that
stock or those securities), and
-
You later deliver the stock or securities to close the short sale.
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.
Example.
On June 2, you buy 100 shares of stock for $1,000. You sell short 100 shares of the stock for $750 on October 6. On October
7, you buy 100 shares
of the same stock for $750. You close the short sale on November 17 by delivering the shares bought on June 2. You cannot
deduct the $250 loss ($1,000
- $750) because the date of entering into the short sale (October 6) is considered the date the sale is complete for wash
sale purposes and you
bought substantially identical stock within 30 days from that date.
Residual interests in a REMIC.
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.
How to report.
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).
Securities Futures Contracts
A securities futures contract is a contract of sale for future delivery of a single security or of a narrow-based security
index.
Gain or loss from the contract generally will be treated in a manner similar to gain or loss from
transactions in the underlying security. This means gain or loss from the sale, exchange, or termination of the contract will
generally have the same
character as gain or loss from transactions in the property to which the contract relates. Any capital gain or loss on a sale,
exchange, or
termination of a contract to sell property will be considered short-term, regardless of how long you hold the contract. These
contracts are not
section 1256 contracts (unless they are dealer securities futures contracts).
Options are generally subject to the rules described in this section. If the option is part of a straddle, the loss deferral
rules covered later
under Straddles may also apply. For special rules that apply to nonequity options and dealer equity options, see Section 1256
Contracts Marked to Market, earlier.
Gain or loss from the sale or trade of an option to buy or sell property that is a capital asset in your hands, or would be
if you acquired it, is
capital gain or loss. If the property is not, or would not be, a capital asset, the gain or loss is ordinary gain or loss.
Example 1.
You purchased an option to buy 100 shares of XYZ Company stock. The stock increases in value and you sell the option for more
than you paid for it.
Your gain is capital gain because the stock underlying the option would have been a capital asset in your hands.
Example 2.
The facts are the same as in Example 1, except that the stock decreases in value and you sell the option for less than you paid for it.
Your loss is a capital loss.
Option not exercised.
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.
Writer of option.
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
(or repurchased), the amount you receive is a short-term capital gain.
If an option requiring you to buy or sell property is exercised, see Writers of calls and puts, later.
Section 1256 contract options.
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.
Cash settlement option.
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.
How to report.
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 enter “ Expired” in column (d).
If an option that you wrote expired, enter the expiration date in column (b) and enter “ Expired” in column (e).
Calls and puts are options on securities and are covered by the rules just discussed for options. The following are specific
applications of these
rules to holders and writers of options that are bought, sold, or “closed out” in transactions on a national securities exchange, such as the
Chicago Board Options Exchange. (But see Section 1256 Contracts Marked to Market, earlier, for special rules that may apply to nonequity
options and dealer equity options.) These rules are also presented in Table 4-1.
Calls and puts are issued by writers (grantors) to holders for cash premiums. They are ended by exercise, closing transaction,
or lapse.
A “call option” is the right to buy from the writer of the option, at any time before a specified future date, a stated number of shares
of
stock at a specified price. Conversely, a “put option” is the right to sell to the writer, at any time before a specified future date, a stated
number of shares at a specified price.
Holders of calls and puts.
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.
Put option as short sale.
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:
-
The date you dispose of the stock,
-
The date you exercise the put,
-
The date you sell the put, or
-
The date the put expires.
Writers of calls and puts.
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:
-
Your obligation expires,
-
You sell, in the case of a call, or buy, in the case of a put, the underlying stock when the option is exercised, or
-
You engage in a closing transaction.
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.
Examples of non-dealer transactions.
-
Expiration. Ten JJJ call options were issued on April 8, 2005, for $4,000. These equity options expired in December 2005, without
being exercised. If you were a holder (buyer) of the options, you would recognize a short-term capital loss of $4,000. If
you were a writer of the
options, you would recognize a short-term capital gain of $4,000.
-
Closing transaction. The facts are the same as in (1), except that on May 10, 2005, the options were sold for $6,000. If you were
the holder of the options who sold them, you would recognize a short-term capital gain of $2,000. If you were the writer of
the options and you bought
them back, you would recognize a short-term capital loss of $2,000.
-
Exercise. The facts are the same as in (1), except that the options were exercised on May 27, 2005. The buyer adds the cost of
the options to the basis of the stock bought through the exercise of the options. The writer adds the amount received from
writing the options to the
amount realized from selling the stock to figure gain or loss. The gain or loss is short term or long term depending upon
the holding period of the
stock.
-
Section 1256 contracts. The facts are the same as in (1), except the options were nonequity options, subject to the rules for
section 1256 contracts. If you were a buyer of the options, you would recognize a short-term capital loss of $1,600, and a
long-term capital loss of
$2,400. If you were a writer of the options, you would recognize a short-term capital gain of $1,600, and a long-term capital
gain of $2,400. See
Section 1256 Contracts Marked to Market, earlier, for more information.
Table 4-1. Puts and Calls
| Puts |
| When a put: |
If you are the holder: |
If you are the writer: |
|
Is exercised
|
Reduce your amount realized from sale of the underlying stock by the cost of the put.
|
Reduce your basis in the stock you buy by the amount you received for the put.
|
|
Expires
|
Report the cost of the put as a capital loss on the date it expires.*
|
Report the amount you received for the put as a short-term capital gain.
|
|
Is sold by the holder
|
Report the difference between the cost of the put and the amount you receive for it as a capital gain or
loss.*
|
This does not affect you. (But if you buy back the put, report the difference between the amount you pay and the
amount you received for the put as a short-term capital gain or loss.)
|
| Calls |
| When a call: |
If you are the holder: |
If you are the writer: |
|
Is exercised
|
Add the cost of the call to your basis in the stock purchased.
|
Increase your amount realized on sale of the stock by the amount you received for the
call.
|
|
Expires
|
Report the cost of the call as a capital loss on the date it expires.*
|
Report the amount you received for the call as a short-term capital gain.
|
|
Is sold by the holder
|
Report the difference between the cost of the call and the amount you receive for it as a capital gain or
loss.*
|
This does not affect you. (But if you buy back the call, report the difference between the amount you
pay and the amount you received for the call as a short-term capital gain or loss.)
|
|
*See Holders of calls and puts and Writers of calls and puts in the
accompanying text to find whether your gain or loss is short term or long term.
|
This section discusses the loss deferral rules that apply to the sale or other disposition of positions in a straddle. These
rules do not apply to
the straddles described under Exceptions, later.
A straddle is any set of offsetting positions on personal property. For example, a straddle may consist of a purchased option
to buy and a
purchased option to sell on the same number of shares of the security, with the same exercise price and period.
Personal property.
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.
Straddle rules for 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.
-
The stock is of a type which is actively traded and at least 1 of the offsetting positions is a position on that stock or
substantially
similar or related property.
-
The stock is in a corporation formed or availed of to take positions in personal property that offset positions taken by any
shareholder.
Note: For positions established before October 22, 2004, condition (1) above does not apply. Instead, personal property includes
stock if condition (2)
above applies or the stock was part of straddle in which at least one of the offsetting positions was:
-
An option to buy or sell the stock or substantially identical stock or securities,
-
A securities futures contract on the stock or substantially identical stock or securities, or
-
A position on substantially similar or related property (other than stock).
Position.
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.
Offsetting position.
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.
Presumed offsetting positions.
Two or more positions will be presumed to be offsetting if:
-
The positions are established in the same personal property (or in a contract for this property), and the value of one or
more positions
varies inversely with the value of one or more of the other positions,
-
The positions are in the same personal property, even if this property is in a substantially changed form, and the positions'
values vary
inversely as described in the first condition,
-
The positions are in debt instruments with a similar maturity, and the positions' values vary inversely as described in the
first
condition,
-
The positions are sold or marketed as offsetting positions, whether or not the positions are called a straddle, spread, butterfly,
or any
similar name, or
-
The aggregate margin requirement for the positions is lower than the sum of the margin requirements for each position if held
separately.
Related persons.
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.
Generally, you can deduct a loss on the disposition of one or more positions only to the extent that the loss is more than
any unrecognized gain
you have on offsetting positions. Unused losses are treated as sustained in the next tax year.
Unrecognized gain.
This is:
-
The amount of gain you would have had on an open position if you had sold it on the last business day of the tax year at its
fair market
value, and
-
The amount of gain realized on a position if, as of the end of the tax year, gain has been realized, but not recognized.
Example.
On July 1, 2005, you entered into a straddle. On December 16, 2005, you closed one position of the straddle at a loss of $15,000.
On December 31,
2005, the end of your tax year, you have an unrecognized gain of $12,750 in the offsetting open position. On your 2005 return,
your deductible loss on
the position you closed is limited to $2,250 ($15,000 - $12,750). You must carry forward to 2006 the unused loss of $12,750.
Note: If you physically settle a position established after October 21, 2004, that is part of a straddle by delivering property
to which the position
relates (and you would realize a loss on that position if you terminated it), you are treated as having terminated the position
for its fair market
value immediately before the settlement and as having sold the property used to physically settle the position at its fair
market value.
Exceptions.
The loss deferral rules do not apply to:
-
Identified positions established after October 21, 2004, comprising an identified straddle,
-
Certain straddles consisting of qualified covered call options and the stock to be purchased under the options,
-
Hedging transactions, described earlier under Section 1256 Contracts Marked to Market, and
-
Straddles consisting entirely of section 1256 contracts, as described earlier under Section 1256 Contracts Marked to Market (but
see Identified straddle, next).
Note: For positions established before October 22, 2004, the loss deferral rules also do not apply to a straddle that is an identified
straddle at the
end of the tax year.
Identified straddle.
Any straddle (other than a straddle described in (2) or (3) above) is an identified straddle if both of the following
conditions exist.
-
You clearly identified the straddle on your records before the close of the day on which you acquired it.
-
The straddle is not part of a larger straddle.
If there is a loss from any identified position in an identified straddle, you must increase the basis of each of
the identified positions that
offset the loss position in the identified straddle. The increase is the loss multiplied by a fraction. The numerator of the
fraction is the
unrecognized gain (if any) on the offsetting position and the denominator of the fraction is the total unrecognized gain on
all positions that offset
the loss position in the identified straddle. For this purpose, your unrecognized gain is the excess of the fair market value
of the identified
position that is part of an identified straddle at the time you incur a loss on another identified position in the identified
straddle, over the fair
market value of that position when you identified it as a position in the straddle.
Neither you nor anyone else can take into account any loss on an identified position that is part of an identified
straddle to the extent that the
loss increases the basis of any identified positions that offset the loss position in the identified straddle.
Note: For positions established before October 22, 2004, identified straddles have to meet two additional conditions:
-
All of the original positions that you identify were acquired on the same day.
-
All of the positions included in item (1) were disposed of on the same day during the tax year, or none of the positions were
disposed of by
the end of the tax year.
Also, the losses from positions are deferred until you dispose of all the positions in the straddle. The rule discussed above
for increasing
the basis of each of the identified positions does not apply.
Qualified covered call options and optioned stock.
A straddle is not subject to the loss deferral rules for straddles if both of the following are true.
-
All of the offsetting positions consist of one or more qualified covered call options and the stock to be purchased from you
under the
options.
-
The straddle is not part of a larger straddle.
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.
-
The option is traded on a national securities exchange or other market approved by the Secretary of the Treasury.
-
The option is granted more than 30 days before its expiration date.
For covered call options entered into after July 28, 2002, the option is granted not more than 12 months before its expiration
date or satisfies
term limitation and qualified benchmark requirements published in the Internal Revenue Bulletin.
-
The option is not a deep-in-the-money option.
-
You are not an options dealer who granted the option in connection with your activity of dealing in options.
-
Gain or loss on the option is capital gain or loss.
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. Strike prices are listed in the financial section of
many newspapers. 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.
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:
-
The closing price of the stock on the most recent day on which that stock was traded before the date on which the option was
granted,
or
-
The opening price of the stock on the day on which the option was granted, but only if that price is greater than 110% of
the price
determined in (1).
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.
Example.
On May 13, 2005, 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, 2005, was $130.25. The strike prices of all XYZ/September call options offered on May 13, 2005, 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.
Capital loss on qualified covered call options.
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.
Special year-end rule.
The loss deferral rules for straddles apply if all of the following are true.
-
The qualified covered call options are closed or the stock is disposed of at a loss during any tax year.
-
Gain on disposition of the stock or gain on the options is includible in gross income in a later tax year.
-
The stock or options were held less than 30 days after the closing of the options or the disposition of the stock.
How To Report Gains and Losses (Form 6781)
Report each position (whether or not it is part of a straddle) on which you have unrecognized gain at the end of the tax year
and the amount of
this unrecognized gain in Part III of Form 6781. Use Part II of Form 6781 to figure your gains and losses on straddles before
entering these amounts
on Schedule D (Form 1040). Include a copy of Form 6781 with your income tax return.
Coordination of Loss Deferral Rules and Wash Sale Rules
Rules similar to the wash sale rules apply to any disposition of a position or positions of a straddle. First apply Rule 1,
explained next, then
apply Rule 2. However, Rule 1 applies only if stocks or securities make up a position that is part of the straddle. If a position
in the straddle does
not include stock or securities, use Rule 2.
Rule 1.
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.
Dealers.
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.
Example.
You are not a dealer in stock or securities. On December 2, 2005, you bought stock in XX Corporation (XX stock) and an offsetting
put option. On
December 13, 2005, there was $20 of unrealized gain in the put option and you sold the XX stock at a $20 loss. By December
16, the value of the put
option had declined, eliminating all unrealized gain in the position. On December 16, you bought a second XX stock position
that is substantially
identical to the XX stock you sold on December 13. At the end of the year there is no unrecognized gain in the put option
or in the XX stock. Under
these circumstances, the $20 loss will be disallowed for 2005 under Rule 1 because, within a period beginning 30 days before
December 13, and ending
30 days after that date, you bought stock substantially identical to the XX stock you sold.
Rule 2.
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.
-
Successor positions.
-
Offsetting positions to the loss position.
-
Offsetting positions to any successor position.
Successor position.
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.
-
The second position was offsetting to the loss position that was sold.
-
The successor position is entered into during a period beginning 30 days before, and ending 30 days after, the sale of the
loss position.
Example 1.
On November 1, 2005, you entered into offsetting long and short positions in non-section 1256 contracts. On November 12, 2005,
you disposed of the
long position at a $10 loss. On November 14, you entered into a new long position (successor position) that is offsetting
to the retained short
position, but that is not substantially identical to the long position disposed of on November 12. You held both positions
through year end, at which
time there was $10 of unrecognized gain in the successor long position and no unrecognized gain in the offsetting short position.
Under these
circumstances, the entire $10 loss will be disallowed for 2005 because there is $10 of unrecognized gain in the successor
long position.
Example 2.
The facts are the same as in Example 1, except that at year end you have $4 of unrecognized gain in the successor long position and $6
of unrecognized gain in the offsetting short position. Under these circumstances, the entire $10 loss will be disallowed for
2005 because there is a
total of $10 of unrecognized gain in the successor long position and offsetting short position.
Example 3.
The facts are the same as in Example 1, except that at year end you have $8 of unrecognized gain in the successor long position and $8
of unrecognized loss in the offsetting short position. Under these circumstances, $8 of the total $10 realized loss will be
disallowed for 2005
because there is $8 of unrecognized gain in the successor long position.
Loss carryover.
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 2004 under Rule 1 will not be allowed in 2005, unless the substantially
identical stock or
securities (which caused the loss to be disallowed in 2004) were disposed of during 2005. In addition, the carryover loss
will not be allowed in 2005
if Rule 1 or Rule 2 disallows it.
Example.
The facts are the same as in the example under Rule 1 above. On December 30, 2006, you sell the second XX stock at a $20 loss
and there is $40 of
unrecognized gain in the put option. Under these circumstances, you cannot deduct in 2006 either the $20 loss disallowed in
2005 or the $20 loss you
incurred for the December 30, 2006, sale of XX stock. Rule 1 does not apply because the substantially identical XX stock was
sold during the year and
no substantially identical stock or securities were bought within the 61-day period. However, Rule 2 does apply because there
is $40 of unrecognized
gain in the put option, an offsetting position to the loss positions.
Capital loss carryover.
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.
Exceptions.
The rules for coordinating straddle losses and wash sales do not apply to the following loss situations.
-
Loss on the sale of one or more positions in a hedging transaction. (Hedging transactions are described under Section 1256 Contracts
Marked to Market, earlier.)
-
Loss on the sale of a loss position in a mixed straddle account. (See Mixed straddle account (Election C), later.)
-
Loss on the sale of a position that is part of a straddle consisting only of section 1256 contracts.
Holding Period and Loss Treatment Rules
The holding period of a position in a straddle generally begins no earlier than the date on which the straddle ends (the date
you no longer hold an
offsetting position). This rule does not apply to any position you held more than 1 year before you established the straddle.
But see
Exceptions, later.
Example.
On March 6, 2004, you acquired gold. On January 5, 2005, you entered into an offsetting short gold forward contract (nonregulated
futures
contract). On April 1, 2005, you disposed of the short gold forward contract at no gain or loss. On April 8, 2005, you sold
the gold at a gain.
Because the gold had been held for 1 year or less before the offsetting short position was entered into, the holding period
for the gold begins on
April 1, 2005, the date the straddle ended. Gain recognized on the sale of the gold will be treated as short-term capital
gain.
Loss treatment.
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.
-
You held (directly or indirectly) one or more offsetting positions to the loss position on the date you entered into the loss
position.
-
You would have treated all gain or loss on one or more of the straddle positions as long-term capital gain or loss if you
had sold these
positions on the day you entered into the loss position.
Mixed straddles.
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:
-
That is not part of a larger straddle,
-
In which all positions are held as capital assets,
-
In which at least one (but not all) of the positions is a section 1256 contract, and
-
For which the mixed straddle election (Election A, discussed later) has not been made.
Treat the loss as 60% long-term capital loss and 40% short-term capital loss, if all of the following conditions apply.
-
Gain or loss from the sale of one or more of the straddle positions that are section 1256 contracts would be considered gain
or loss from
the sale or exchange of a capital asset.
-
The sale of no position in the straddle, other than a section 1256 contract, would result in a long-term capital gain or loss.
-
You have not made a straddle-by-straddle identification election (Election B) or mixed straddle account election (Election
C), both
discussed later.
Example.
On March 1, 2005, you entered into a long gold forward contract. On July 15, 2005, you entered into an offsetting short gold
regulated futures
contract. You did not make an election to offset gains and losses from positions in a mixed straddle. On August 9, 2005, you
disposed of the long
forward contract at a loss. Because the gold forward contract was part of a mixed straddle and the disposition of this non-section
1256 position would
not result in long-term capital loss, the loss recognized on the termination of the gold forward contract will be treated
as a 60% long-term and 40%
short-term capital loss.
Exceptions.
The special holding period and loss treatment for straddle positions does not apply to positions that:
-
Constitute part of a hedging transaction,
-
Are included in a straddle consisting only of section 1256 contracts, or
-
Are included in a mixed straddle account (Election C), discussed later.
If you disposed of a position in a mixed straddle and make one of the elections described in the following discussions, report
your gain or loss as
indicated in those discussions. If you do not make any of the elections, report your gain or loss in Part II of Form 6781.
If you disposed of the
section 1256 component of the straddle, enter the recognized loss (line 10, column (h)) or your gain (line 12, column (f))
in Part I of Form 6781, on
line 1. Do not include it on line 11 or 13 (Part II).
Mixed straddle election (Election A).
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:
-
At least one (but not all) of the positions is a section 1256 contract, and
-
Each position forming part of the straddle is clearly identified as being part of that straddle on the day the first section
1256 contract
forming part of the straddle is acquired.
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.
Other elections.
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.
-
Election B. Make a separate identification of the positions of each mixed straddle for which you are electing this treatment (the
straddle-by-straddle identification method).
-
Election C. Establish a mixed straddle account for a class of activities for which gains and losses will be recognized and offset
on a periodic basis.
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.
Straddle-by-straddle identification election (Election B).
Under this election, you must clearly identify each position that is part of the identified mixed straddle by the
earlier of:
-
The close of the day the identified mixed straddle is established, or
-
The time the position is disposed 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.
Example.
On April 1, you entered into a non-section 1256 position and an offsetting section 1256 contract. You also made a valid election
to treat this
straddle as an identified mixed straddle. On April 8, you disposed of the non-section 1256 position at a $600 loss and the
section 1256 contract at an
$800 gain. Under these circumstances, the $600 loss on the non-section 1256 position will be offset against the $800 gain
on the section 1256
contract. The net gain of $200 from the straddle will be treated as 60% long-term capital gain and 40% short-term capital
gain because it is due to
the section 1256 contract.
Mixed straddle account (Election C).
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:
-
The due date of your return for the immediately preceding tax year (without extensions), or
-
60 days after you entered into the first mixed straddle in the new class of activities.
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.
Interest expense and carrying charges relating to mixed straddle account positions.
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 earlier to the positions held in the mixed straddle account. See
Interest expense and
carrying charges on straddles in chapter 3 under Nondeductible Expense.
Sales of Stock to ESOPs or Certain Cooperatives
If you sold qualified securities held for at least 3 years to an employee stock ownership plan (ESOP) or eligible worker-owned
cooperative, you may
be able to elect to postpone all or part of the gain on the sale if you bought qualified replacement property (certain securities)
within the period
that began 3 months before the sale and ended 12 months after the sale. If you make the election, you must recognize gain
on the sale only to the
extent the proceeds from the sale exceed the cost of the qualified replacement property.
You must reduce the basis of the replacement property by any postponed gain. If you dispose of any replacement property, you
may have to recognize
all of the postponed gain.
Generally, to qualify for the election the ESOP or cooperative must own at least 30% of the outstanding stock of the corporation
that issued the
qualified securities. Also, the qualified replacement property must have been issued by a domestic operating corporation.
How to make the election.
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). Enter “ 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.
How to report and postpone gain.
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.
-
A “statement of election” that indicates you are making an election under section 1042(a) of the Internal Revenue Code and that
includes the following information.
-
A description of the securities sold, the date of the sale, the amount realized on the sale, and the adjusted basis of the
securities.
-
The name of the ESOP or cooperative to which the qualified securities were sold.
-
For a sale that was part of a single, interrelated transaction under a prearranged agreement between taxpayers involving other
sales of
qualified securities, the names and identifying numbers of the other taxpayers under the agreement and the number of shares
sold by the other
taxpayers.
-
A notarized “statement of purchase” describing the qualified replacement property, date of purchase, and the cost of the property and
declaring the property to be qualified replacement property for the qualified stock you sold. The statement must have been
notarized no later than 30
days after the purchase. If you have not yet purchased the qualified replacement property, you must attach the notarized “statement of purchase”
to your income tax return for the year following the election year (or the election will not be valid).
-
A verified written statement of the domestic corporation whose employees are covered by the ESOP acquiring the securities,
or of any
authorized officer of the cooperative, consenting to the taxes under sections 4978 and 4979A of the Internal Revenue Code
on certain dispositions, and
prohibited allocations of the stock purchased by the ESOP or cooperative.
More information.
For details, see section 1042 of the Internal Revenue Code and Regulations section 1.1042-1T.
Rollover of Gain From Publicly Traded Securities
You may qualify for a tax-free rollover of certain gains from the sale of publicly traded securities. This means that if you
buy certain
replacement property and make the choice described in this section, you postpone part or all of your gain.
You postpone the gain by adjusting the basis of the replacement property as described in Basis of replacement property, later. This
postpones your gain until the year you dispose of the replacement property.
You qualify to make this choice if you meet all the following tests.
-
You sell publicly traded securities at a gain. Publicly traded securities are securities traded on an established securities
market.
-
Your gain from the sale is a capital gain.
-
During the 60-day period beginning on the date of the sale, you buy replacement property. This replacement property must be
either common
stock or a partnership interest in a specialized small business investment company (SSBIC). This is any partnership or corporation
licensed by the
Small Business Administration under section 301(d) of the Small Business Investment Act of 1958, as in effect on May 13, 1993.
Amount of gain recognized.
If you make the choice described in this section, you must recognize gain only up to the following amount:
-
The amount realized on the sale, minus
-
The cost of any common stock or partnership interest in an SSBIC that you bought during the 60-day period beginning on the
date of sale (and
did not previously take into account on an earlier sale of publicly traded securities).
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.
Limit on gain postponed.
The amount of gain you can postpone each year is limited to the smaller of:
-
$50,000 ($25,000 if you are married and file a separate return), or
-
$500,000 ($250,000 if you are married and file a separate return), minus the amount of gain you postponed for all earlier
years.
Basis of replacement property.
You must subtract the amount of postponed gain from the basis of your replacement property.
How to report and postpone gain.
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). Enter “ 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.
Gains on Qualified Small Business Stock
This section discusses two provisions of the law that may apply to gain from the sale or trade of qualified small business
stock. You may qualify
for a tax-free rollover of all or part of the gain. You may be able to exclude part of the gain from your income.
Qualified small business stock.
This is stock that meets all the following tests.
-
It must be stock in a C corporation.
-
It must have been originally issued after August 10, 1993.
-
The corporation must have total gross assets of $50 million or less at all times after August 9, 1993, and before it issued
the stock. Its
total gross assets immediately after it issued the stock must also be $50 million or less.
When figuring the corporation's total gross assets, you must also count the assets of any predecessor of the corporation.
In addition, you must
treat all corporations that are members of the same parent-subsidiary controlled group as one corporation.
-
You must have acquired the stock at its original issue, directly or through an underwriter, in exchange for money or other
property (not
including stock), or as pay for services provided to the corporation (other than services performed as an underwriter of the
stock). In certain cases,
your stock may also meet this test if you acquired it from another person who met this test, or through a conversion or trade
of qualified small
business stock that you held.
-
The corporation must have met the active business test, defined next, and must have been a C corporation during substantially
all the time
you held the stock.
-
Within the period beginning 2 years before and ending 2 years after the stock was issued, the corporation cannot have bought
more than a
de minimis amount of its stock from you or a related party.
-
Within the period beginning 1 year before and ending 1 year after the stock was issued, the corporation cannot have bought
more than a
de minimis amount of its stock from anyone, unless the total value of the stock it bought is 5% or less of the total value of all its
stock.
For more information about tests 6 and 7, see the regulations under section 1202 of the Internal Revenue Code.
Active business test.
A corporation meets this test for any period of time if, during that period, both the following are true.
-
It was an eligible corporation, defined below.
-
It used at least 80% (by value) of its assets in the active conduct of at least one qualified trade or business, defined below.
Exception for SSBIC.
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.
Eligible corporation.
This is any U.S. corporation other than:
-
A Domestic International Sales Corporation (DISC) or a former DISC,
-
A corporation that has made, or whose subsidiary has made, an election under section 936 of the Internal Revenue Code, concerning
the Puerto
Rico and possession tax credit,
-
A regulated investment company,
-
A real estate investment trust (REIT),
-
A real estate mortgage investment conduit (REMIC),
-
A financial asset securitization investment trust (FASIT), or
-
A cooperative.
Qualified trade or business.
This is any trade or business other than:
-
One involving services performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing
arts,
consulting, athletics, financial services, or brokerage services,
-
One whose principal asset is the reputation or skill of one or more employees,
-
Any banking, insurance, financing, leasing, investing, or similar business,
-
Any farming business (including the business of raising or harvesting trees),
-
Any business involving the production or extraction of products for which percentage depletion can be claimed, or
-
Any business of operating a hotel, motel, restaurant, or similar business.
You may qualify for a tax-free rollover of capital gain from the sale of qualified small business stock held more than 6 months.
This means that,
if you buy certain replacement stock and make the choice described in this section, you postpone part or all of your gain.
You postpone the gain by adjusting the basis of the replacement stock as described in Basis of replacement stock, later. This postpones
your gain until the year you dispose of the replacement stock.
You can make this choice if you meet all the following tests.
-
You buy replacement stock during the 60-day period beginning on the date of the sale.
-
The replacement stock is qualified small business stock.
-
The replacement stock continues to meet the active business requirement for small business stock for at least the first 6
months after you
buy it.
Amount of gain recognized.
If you make the choice described in this section, you must recognize the capital gain only up to the following amount:
-
The amount realized on the sale, minus
-
The cost of any qualified small business stock you bought during the 60-day period beginning on the date of sale (and did
not previously
take into account on an earlier sale of qualified small business stock).
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.
Basis of replacement stock.
You must subtract the amount of postponed gain from the basis of your replacement stock.
Holding period of 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.
Pass-through entity.
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.
How to report gain.
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). Enter “ 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.
You generally can exclude from your income up to 50% of your gain from the sale or trade of qualified small business stock
held by you for more
than 5 years. The exclusion can be up to 60% for certain empowerment zone business stock. See Empowerment zone business stock, later.
The eligible gain minus your section 1202 exclusion is a 28% rate gain. See Capital Gain Tax Rates, later.
SSBIC stock.
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.
Limit on eligible gain.
The amount of your gain from the stock of any one issuer that is eligible for the exclusion in 2005 is limited to
the greater of:
-
Ten times your basis in all qualified stock of the issuer that you sold or exchanged during the year, or
-
$10 million ($5 million for married individuals filing separately) minus the amount of gain from the stock of the same issuer
that you used
to figure your exclusion in earlier years.
How to report gain.
Report the entire gain realized from the sale on Schedule D (Form 1040), line 8, column (f). Directly below the line
on which you report the gain,
enter “ Section 1202 exclusion” in column (a) and enter the amount of the allowable exclusion in column (f). Enter it as a loss (in parentheses).
If you are completing line 18 of Schedule D, enter as a positive number the amount of the exclusion on line 2 of the 28% Rate
Gain Worksheet in the
Schedule D instructions. But if you excluded 60% of the gain, enter ⅔ of the exclusion.
More information.
For information about additional requirements that may apply, see section 1202 of the Internal Revenue Code.
Empowerment zone business stock.
You can exclude up to 60% of your gain if you meet all of the following additional requirements.
-
You sell or trade stock in a corporation that qualifies as an empowerment zone business during substantially all of the time
you held the
stock, and
-
You acquired the stock after December 21, 2000.
Condition (1) will still be met if the corporation ceased to qualify after the 5-year period that begins on the date you acquired
the stock.
However, the gain that qualifies for the 60% exclusion cannot be more than the gain you would have had if you had sold the
stock on the date the
corporation ceased to qualify.
For more information about empowerment zone businesses, see Publication 954, Tax Incentives for Distressed Communities.
Rollover of Gain From Sale of Empowerment Zone Assets
You may qualify for a tax-free rollover of certain gains from the sale of qualified empowerment zone assets. This means that
if you buy certain
replacement property and make the choice described in this section, you postpone part or all of the recognition of your gain.
You qualify to make this choice if you meet all the following tests.
-
You hold a qualified empowerment zone asset for more than 1 year and sell it at a gain.
-
Your gain from the sale is a capital gain.
-
During the 60-day period beginning on the date of the sale, you buy a replacement qualified empowerment zone asset in the
same zone as the
asset sold.
Any part of the gain that is ordinary income cannot be postponed and must be recognized.
Qualified empowerment zone asset.
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.
Amount of gain recognized.
If you make the choice described in this section, you must recognize gain only up to the following amount:
-
The amount realized on the sale, minus
-
The cost of any qualified empowerment zone asset that you bought during the 60-day period beginning on the date of sale (and
did not
previously take into account in rolling over gain on an earlier sale of qualified empowerment zone assets).
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.
Basis of replacement property.
You must subtract the amount of postponed gain from the basis of the qualified empowerment zone assets you bought
as replacement property.
How to report and postpone capital gain.
Report the entire gain realized from the sale on Schedule D (Form 1040), line 8, as you otherwise would without regard
to the choice to postpone
gain. 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).
More information.
For more information about empowerment zones, see Publication 954, Tax Incentives for Distressed Communities. For
more information about this
rollover of gain, see section 1397B of the Internal Revenue Code.
Reporting Capital Gains and Losses
This section discusses how to report your capital gains and losses on Schedule D (Form 1040). Enter your sales and trades
of stocks, bonds, etc.,
and real estate (if not reported on Form 4684, 4797, 6252, 6781, or 8824) on line 1 of Part I or line 8 of Part II, as appropriate.
Include all these
transactions even if you did not receive a Form 1099-B or 1099-S (or substitute statement). You can use Schedule D-1 as a
continuation schedule to
report more transactions.
Be sure to add all sales price entries in column (d) of lines 1 and 2 and enter the total on line 3. Also add all sales price
entries in column (d)
of lines 8 and 9 and enter the total on line 10. Then add the following amounts reported to you for 2005 on Forms 1099-B and
Forms 1099-S (or on
substitute statements):
-
Proceeds from transactions involving stocks, bonds, and other securities, and
-
Gross proceeds from real estate transactions (other than the sale of your main home if you had no taxable gain) not reported
on another form
or schedule.
If this total is more than the total of lines 3 and 10, attach a statement to your return explaining the difference.
Installment sales.
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).
At-risk rules.
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.
Passive activity gains and losses.
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.
Form 1099-B transactions.
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 sales price is entered in column (d), do not include the commissions and option premiums in column (e).
Section 1256 contracts and straddles.
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.
Market discount bonds.
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.”
Form 1099-S transactions.
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:
-
Improved or unimproved land, including air space,
-
Inherently permanent structures, including any residential, commercial, or industrial building,
-
A condominium unit and its accessory fixtures and common elements, including land, and
-
Stock in a cooperative housing corporation (as defined in section 216 of the Internal Revenue Code).
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.
It is unlawful for any real estate reporting person to separately charge you for complying with the requirement to file Form
1099-S.
Nominees.
If you receive gross proceeds as a nominee (that is, the gross proceeds are in your name but actually belong to someone
else), report on Schedule
D, lines 3 and 10, only the proceeds that belong to you. Then add the following amounts reported to you for 2005 on Forms
1099-B and 1099-S (or
substitute statements) that you are not reporting on another form or schedule included with your return:
-
Proceeds from transactions involving stocks, bonds, and other securities, and
-
Gross proceeds from real estate transactions (other than the sale of your main home if you are not required to report it).
If the total of (1) and (2) is more than the total of lines 3 and 10, attach a statement to your return explaining the reason
for the
difference.
File Form 1099-B or Form 1099-S with the IRS.
If you received gross proceeds as a nominee in 2005, you must file a Form 1099-B or Form 1099-S for those proceeds
with the IRS. Send the Form
1099-B or Form 1099-S with a Form 1096, Annual Summary and Transmittal of U.S. Information Returns, to your Internal Revenue
Service Center by
February 28, 2006 (March 31, 2006, if you file Form 1099-B or Form 1099-S electronically). Give the actual owner of the proceeds
Copy B of the Form
1099-B or Form 1099-S by January 31, 2006. On Form 1099-B, you should be listed as the “ Payer.” The other owner should be listed as the
“ Recipient.” On Form 1099-S, you should be listed as the “ Filer.” The other owner should be listed as the “ Transferor.” You do not,
however, have to file a Form 1099-B or Form 1099-S to show proceeds for your spouse. For more information about the reporting
requirements and the
penalties for failure to file (or furnish) certain information returns, see the General Instructions for Forms 1099, 1098,
5498, and W-2G.
Sale of property bought at various times.
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. Enter “ Various” in column (b) for the “ Date acquired.” See the
Comprehensive Example later in this chapter.
Sale expenses.
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).
Short-term gains and losses.
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.
Long-term gains and losses.
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:
-
Undistributed long-term capital gains from a regulated investment company (mutual fund) or real estate investment trust (REIT),
-
Your share of long-term capital gains or losses from partnerships, S corporations, and fiduciaries,
-
All capital gain distributions from mutual funds and REITs not reported directly on line 10 of Form 1040A or line 13 of Form
1040,
and
-
Long-term capital loss carryovers.
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 15 of
Schedule D).
Capital gain distributions only.
You do not have to file Schedule D if both of the following are true.
-
The only amounts you would have to report on Schedule D are capital gain distributions from box 2a of Form 1099-DIV (or substitute
statement).
-
You do not have an amount in box 2b, 2c, or 2d of any Form 1099-DIV (or substitute statement).
If both of the above statements are true, report your capital gain distributions directly on line 13 of Form 1040 and check
the box on line 13.
Also, use the Qualified Dividends and 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.
-
None of the Forms 1099-DIV (or substitute statements) you received have an amount in box 2b, 2c, or 2d.
-
You do not have to file Form 1040 for any other capital gains or losses.
Total net gain or loss.
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
15). Enter the result on Schedule D, Part III, line 16. If your losses are more than your gains, see Capital Losses, next. If both lines 15
and 16 are gains and line 43 of Form 1040 is more than zero, see Capital Gain Tax Rates, later.
If your capital losses are more than your capital gains, you can claim a capital loss deduction. Report the deduction on line
13 of Form 1040,
enclosed in parentheses.
Limit on deduction.
Your allowable capital loss deduction, figured on Schedule D, is the lesser of:
-
$3,000 ($1,500 if you are married and file a separate return), or
-
Your total net loss as shown on line 16 of Schedule D.
You can use your total net loss to reduce your income dollar for dollar, up to the $3,000 limit.
Capital loss carryover.
If you have a total net loss on line 16 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.
Figuring your carryover.
The amount of your capital loss carryover is the amount of your total net loss that is more than the lesser of:
-
Your allowable capital loss deduction for the year, or
-
Your taxable income increased by your allowable capital loss deduction for the year and your deduction for personal exemptions.
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 Worksheet 4-1 to determine the part of your capital loss for 2005 that you can carry over to 2006.
Example.
Bob and Gloria sold securities in 2005. The sales resulted in a capital loss of $7,000. They had no other capital transactions.
Their taxable
income was $26,000. On their joint 2005 return, they can deduct $3,000. The unused part of the loss, $4,000 ($7,000 - $3,000),
can be carried
over to 2006.
If their capital loss had been $2,000, their capital loss deduction would have been $2,000. They would have no carryover.
Worksheet 4-1. Capital Loss Carryover Worksheet
Use this worksheet to figure your capital loss carryovers from 2005 to 2006 if Schedule D, line 21, is a loss and (a) that
loss is a smaller
loss than the loss on Schedule D, line 16, or (b) Form 1040, line 41, is a loss. Otherwise, you do not have any carryovers.
|
1.
|
Enter the amount from Form 1040, line 41. If a loss, enclose the amount in
parentheses
|
1.
|
|
|
|
2.
|
Enter the loss from Schedule D, line 21, as a positive amount
|
2.
|
|
|
|
3.
|
Combine lines 1 and 2. If zero or less, enter -0-
|
3.
|
|
|
|
4.
|
Enter the smaller of line 2 or line 3
|
4.
|
|
|
| |
If line 7 of Schedule D is a loss, go to line 5; otherwise, enter -0- on
line 5 and go to line 9.
|
|
|
|
|
5.
|
Enter the loss from Schedule D, line 7, as a positive amount
|
5.
|
|
|
|
6.
|
Enter any gain from Schedule D, line 15
|
6.
|
|
|
|
|
|
7.
|
Add lines 4 and 6
|
7.
|
|
|
|
8.
|
Short-term capital loss carryover to 2006. Subtract line 7 from line 5. If
zero or less, enter -0-
|
8.
|
|
|
| |
If line 15 of Schedule D is a loss, go to line 9; otherwise, skip lines 9
through 13.
|
|
|
|
|
9.
|
Enter the loss from Schedule D, line 15, as a positive amount
|
9.
|
|
|
|
10.
|
Enter any gain from Schedule D, line 7
|
10.
|
|
|
|
|
|
11.
|
Subtract line 5 from line 4. If zero or less, enter -0-
|
11.
|
|
|
|
|
|
12.
|
Add lines 10 and 11
|
12.
|
|
|
|
13.
|
Long-term capital loss carryover to 2006. Subtract line 12 from line 9. If
zero or less, enter -0-
|
13.
|
|
|
Use short-term losses first.
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 losses, use the long-term
capital losses until you
reach the limit.
Decedent's capital loss.
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.
Joint and separate returns.
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 tax rates that apply to a net capital gain are generally lower than the tax rates that apply to other income. These lower
rates are called the
maximum capital gain rates.
The term “net capital gain” means the amount by which your net long-term capital gain for the year is more than your net short-term capital
loss.
For 2005, the maximum capital gain rates are 5%, 15%, 25%, and 28%. See Table 4-2 for details.
If you figure your tax using the maximum capital gain rate and the regular tax computation results in a lower tax, the regular
tax computation
applies.
Example.
All of your net capital gain is from selling collectibles, so the capital gain rate would be 28%. Because you are single and
your taxable income is
$25,000, none of your taxable income will be taxed above the 15% rate. The 28% rate does not apply.
Investment interest deducted.
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 the Schedule D Tax Worksheet or the Qualified Dividends and Capital Gain Tax Worksheet.
For more information about
the limit on investment interest, see Interest Expenses in chapter 3.
28% rate gain.
This gain includes gain or loss from the sale of collectibles and the eligible gain from the sale of qualified small
business stock minus the
section 1202 exclusion.
Collectibles gain or loss.
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 due to unrealized
appreciation of
collectibles.
Gain on qualified small business stock.
If you realized a gain from qualified small business stock that you held more than 5 years, you generally can exclude
up to 50% of your gain from
your income. The exclusion can be up to 60% for certain empowerment zone business stock. The eligible gain minus your section
1202 exclusion is a 28%
rate gain. See Gains on Qualified Small Business Stock, earlier in this chapter.
Unrecaptured section 1250 gain.
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 Unrecaptured Section 1250 Gain 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.
Table 4-2. What Is Your Maximum Capital Gain Rate?
| IF your net capital gain is from ... |
THEN your maximum
capital gain rate is ... |
|
collectibles gain
|
28% |
|
eligible gain on qualified small business stock minus the section 1202 exclusion
|
28% |
|
unrecaptured section 1250 gain
|
25% |
|
other gain
1 and the regular tax rate that would apply is 25% or higher
|
15% |
|
other gain
1 and the regular tax rate that would apply is lower than 25%
|
5% |
| 1“Other gain” means any gain that is not collectibles gain, gain on small business stock, or unrecaptured section 1250
gain.
|
| |
Tax computation using maximum capital gains rates.
Use the Qualified Dividends and Capital Gain Tax Worksheet or the Schedule D Tax Worksheet (whichever applies) to
figure your tax if you have
qualified dividends or net capital gain. You have net capital gain if Schedule D, lines 15 and 16, are both gains.
Schedule D Tax Worksheet.
You must use the Schedule D Tax Worksheet in the Schedule D instructions to figure your tax if:
-
You have to file Schedule D, and
-
Schedule D, line 18 (28% rate gain) or line 19 (unrecaptured section 1250 gain), is more than zero.
See the Comprehensive Example later for an example of how to figure your tax using the Schedule D Tax Worksheet.
Qualified Dividends and Capital Gain Tax Worksheet.
If you do not have to use the Schedule D Tax Worksheet (as explained above) and any of the following apply, use the
Qualified Dividends and Capital
Gain Tax Worksheet in the instructions for Form 1040 or Form 1040A (whichever you file) to figure your tax.
-
You received qualified dividends. (See Qualified Dividends in chapter 1.)
-
You do not have to file Schedule D and you received capital gain distributions. (See Capital gain distributions only
earlier.)
-
Schedule D, lines 15 and 16, are both more than zero.
Alternative minimum tax.
These capital gain rates are also used in figuring alternative minimum tax.
Emily Jones is single and, in addition to wages from her job, she has income from stocks and other securities. For the 2005
tax year, she had the
following capital gains and losses, which she reports on Schedule D. Her filled-in Schedule D is shown at the end of this
example.
Capital gains and losses—Schedule D.
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 1994, for $1,000.
She had bought 100 more
shares in 1996 for $2,200, and an additional 300 shares in 1999 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.
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 2000. 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 claims the exclusion on the line below by entering $1,500 as a loss in column (f). She also enters
the exclusion as a
positive amount on line 2 of the 28% Rate Gain Worksheet.
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.
Reconciliation of Forms 1099-B.
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 2005, 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 (not shown).
Form 6781.
On June 2, 2005, 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 2005. She had reported an unrealized marked to market gain of $1,000 on her 2004 tax return.
(This $1,000 must be
subtracted from her 2005 profit.) These amounts are shown in boxes 8, 9, and 10 of the Form 1099-B she received from her broker
for these
transactions. Box 11 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% ($6,000) as short-term gain on line 4, column (f) of Schedule D and 60% ($9,000) 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.
Capital loss carryover from 2004.
Emily has a capital loss carryover to 2005 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 also enters the $500 long-term capital loss carryover on line 5 of the 28% Rate
Gain Worksheet.
She kept the completed Capital Loss Carryover Worksheet in her 2004 edition of Publication 550 (not shown), so she
could properly report her loss
carryover for the 2005 tax year without refiguring it.
Tax computation.
Because Emily has gains on both lines 15 and 16 of Schedule D, she checks the “ Yes” box on line 17 and goes to line 18. On line 18 she enters
$1,000 from line 7 of the 28% Rate Gain Worksheet. Because line 18 is greater than zero, she checks the “ No” box on line 20 and uses the Schedule
D Tax Worksheet to figure her tax.
After entering the gain from line 16 on line 13 of her Form 1040, she completes the rest of Form 1040 through line
43. 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 $3,279. This is
less than the tax she would have figured without the capital gain tax rates, $4,171.
.
.
Schedule D Tax Worksheet Keep for your Records
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Complete this worksheet only if line 18 or line 19 of Schedule D is more than zero. Otherwise,
complete the Qualified Dividends and Capital Gain Tax Worksheet on page D-9 of the Instructions for Schedule D to figure your
tax. |
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Exception:Do not use the Qualified Dividends and Capital Gain Tax Worksheet or this worksheet to figure your tax if:
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Line 15 or line 16 of Schedule D is zero or less and you have no qualified dividends on Form 1040, line 9b, or
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Form 1040, line 43, is zero or less.
Instead, see the instructions for Form 1040, line 44.
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1.
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Enter your taxable income from Form 1040, line 43
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1.
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30,000
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2.
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Enter your qualified dividends from Form 1040, line 9b
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2.
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3.
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Enter the amount from Form 4952, line 4g
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3.
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4.
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Enter the amount from Form 4952, line 4e*
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4.
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5.
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Subtract line 4 from line 3. If zero or less, enter -0-
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5.
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6.
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Subtract line 5 from line 2. If zero or less, enter -0-
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6.
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7.
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Enter the smaller of line 15 or line 16 of Schedule D
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7.
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9,900
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8.
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Enter the smaller of line 3 or line 4
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8.
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9.
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Subtract line 8 from line 7. If zero or less, enter -0-
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9.
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9,900
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10.
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Add lines 6 and 9
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10.
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9,900
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11.
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Add lines 18 and 19 of Schedule D
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11.
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1,000
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12.
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Enter the smaller of line 9 or line 11
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12.
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1,000
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13.
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Subtract line 12 from line 10.
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13.
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8,900
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14.
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Subtract line 13 from line 1. If zero or less, enter -0-.
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14.
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21,100
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15.
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Enter the smaller of:
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$59,400 if married filing jointly or qualifying widow(er); or
$39,800 if head of household
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15.
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29,700
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16.
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Enter the smaller of line 14 or line 15
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16.
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21,100
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17.
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Subtract line 10 from line 1. If zero or less, enter -0-
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17.
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20,100
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18.
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Enter the larger of line 16 or line 17
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18.
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21,100
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If lines 15 and 16 are the same, skip lines 19 and 20 and go to line 21. Otherwise, go to
line 19.
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19.
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Subtract line 16 from line 15
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19.
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8,600
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20.
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Multiply line 19 by 5% (.05)
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20.
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430
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If lines 1 and 15 are the same, skip lines 21 through 33 and go to line 34. Otherwise, go
to line 21.
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21.
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Enter the smaller of line 1 or line 13
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21.
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8,900
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22.
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Enter the amount from line 19 (if line 19 is blank, enter -0-)
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22.
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8,600
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23.
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Subtract line 22 from line 21. If zero or less, enter -0-
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23.
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300
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24.
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Multiply line 23 by 15% (.15)
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24.
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45
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If Schedule D, line 19, is zero or blank, skip lines 25 through 30 and go to line 31.
Otherwise, go to line 25.
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25.
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Enter the smaller of line 9 above or Schedule D, line 19
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25.
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26.
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Add lines 10 and 18
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26.
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27.
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Enter the amount from line 1 above
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27.
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28.
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Subtract line 27 from line 26. If zero or less, enter -0-
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28.
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29.
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Subtract line 28 from line 25. If zero or less, enter -0-
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29.
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30.
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Multiply line 29 by 25% (.25)
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30.
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If Schedule D, line 18, is zero or blank, skip lines 31 through 33 and go to line 34.
Otherwise, go to line 31.
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31.
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Add lines 18, 19, 23, and 29
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31.
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30,000
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32.
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Subtract line 31 from line 1
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32.
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0
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33.
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Multiply line 32 by 28% (.28)
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33.
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0
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34.
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Figure the tax on the amount on line 18. Use the Tax Table or Tax
Computation Worksheet, whichever applies
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34.
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2,804
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35.
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Add lines 20, 24, 30, 33, and 34
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35.
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3,279
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36.
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Figure the tax on the amount on line 1. Use the Tax Table or Tax
Computation Worksheet, whichever applies
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36.
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4,171
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37.
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Tax on all taxable income (including capital gains and qualified
dividends). Enter the smaller of line 35 or line 36. Also enter this amount on Form 1040, line 44
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37.
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3,279
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*If applicable, enter instead the smaller amount you entered on the dotted line
next to line 4e of Form 4952.
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28% Rate Gain Worksheet—Line 18 Keep for your Records
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1.
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Enter the total of all collectibles gain or (loss) from items you reported on line 8,
column (f), of Schedules D and D-1
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1.
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2.
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Enter as a positive number the amount of any section 1202 exclusion you reported on
line 8, column (f), of Schedules D and D-1, for which you excluded 50% of the gain, plus ⅔ of any section 1202 exclusion you
reported
on line 8, column (f), of Schedules D and D-1, for which you excluded 60% of the gain
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2.
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1,500.00
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3.
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Enter the total of all collectibles gain or (loss) from Form 4684, line 4 (but only
if Form 4684, line 15, is more than zero); Form 6252; Form 6781, Part II; and Form 8824
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3.
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4.
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Enter the total of any collectibles gain reported to you on:
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4.
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5.
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Enter your long-term capital loss carryovers from Schedule D, line 14, and Schedule
K-1 (Form 1041), box 11, code C
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5.
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( 500.00)
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6.
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If Schedule D, line 7, is a (loss), enter that (loss) here. Otherwise, enter
-0-
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6.
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-0-
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7.
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Combine lines 1 through 6. If zero or less, enter -0-. If more than zero, also enter
this amount on Schedule D, line 18
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7.
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1,000.00
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Special Rules for Traders in Securities
Special rules apply if you are a trader in securities in the business of buying and selling securities for your own account.
To be engaged in
business as a trader in securities, you must meet all the following conditions.
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You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital
appreciation.
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Your activity must be substantial.
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You must carry on the activity with continuity and regularity.
The following facts and circumstances should be considered in determining if your activity is a securities trading business.
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Typical holding periods for securities bought and sold.
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The frequency and dollar amount of your trades during the year.
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The extent to which you pursue the activity to produce income for a livelihood.
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The amount of time you devote to the activity.
If your trading activities are not a business, you are considered an investor, and not a trader. It does not matter
whether you call yourself a trader or a “day trader.”
Note.
You may be a trader in some securities and have other securities you hold for investment. The special rules discussed here
do not apply to the
securities held for investment. You must keep detailed records to distinguish the securities. The securities held for investment
must be identified as
such in your records on the day you got them (for example, by holding them in a separate brokerage account).
Transactions from trading activities result in capital gains and losses and must be reported on Schedule D (Form 1040). Losses
from these
transactions are subject to the limit on capital losses explained earlier in this chapter.
Mark-to-market election made.
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.
Expenses.
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.
Self-employment tax.
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.
How To Make the Mark-to-Market Election
To make the mark-to-market election for 2006, you must file a statement by April 15, 2006. This statement should be attached
to either your 2005
individual income tax return or a request for an extension of time to file that return. The statement must include the following
information.
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That you are making an election under section 475(f) of the Internal Revenue Code.
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The first tax year for which the election is effective.
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The trade or business for which you are making the election.
If you are not required to file a 2005 income tax return, you make the election by placing the above statement in your books
and records no later
than March 15, 2006. Attach a copy of the statement to your 2006 return.
After making the election to change to the mark-to-market method of accounting, you must change your method of
accounting for securities under Revenue Procedure 2002-9. Revenue Procedure 2002-9 requires you to file Form 3115, Application
for Change in
Accounting Method. Follow its instructions. Label the Form 3115 as filed under “Section 10A of the Appendix of Rev. Proc. 2002-9.”
Once you make the election, it will apply to 2006 and all later tax years, unless you get permission from IRS to revoke it.
The effect of making
the election is described under Mark-to-market election made, earlier.
For more information on this election, see Revenue Procedure 99-17, 1999-1 CB
503.
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