US Income Tax/Gains and Losses

The previous chapter in this text discussed the broad concept of income. Income often arises in the trading of property, whether real or personal, tangible or intangible. The income to a taxpayer from disposition of property is called gain or loss. Whether it is gain or loss depends on the adjusted basis of the property and the amount realized by the taxpayer in its disposition.

Gains are income to the taxpayer. Losses may be deductible from income, but not always. If losses are incurred by a corporation, or in an individual's trade or business, they reduce adjusted gross income. Nonbusiness profit-seeking losses, as well as some "casualty losses," are treated as itemized personal deductions.

Determining gain and loss
Basis refers to a taxpayer's expenditure in acquiring property. Over time, the basis is "adjusted" to account for improvements, cost recovery, and other factors. When the property is sold, or when another "taxable event" takes place, its adjusted basis is subtracted from the amount realized by the taxpayer. If positive (amount realized exceeds adjusted basis), the amount is a gain. If negative (adjusted basis exceeds amount realized), it is a loss.

For example, a taxpayer might buy a piece of land for $10,000. Its basis thus becomes $10,000. The taxpayer puts a house on the land, at a cost of $40,000. Now, the property's adjusted basis is $50,000: the cost of the land plus the cost of the improvement. If the taxpayer sells the property for $90,000, they realize a gain of $40,000. Conceptually, the other $50,000 does not represent an accession to wealth, because it is wealth the taxpayer already had: they simply shifted its form from cash to property, and did not gain any wealth until they sold the property for more than they paid.

Determining basis
When the taxpayer purchases property for cash, basis is easy to determine. Other scenarios pose different problems.

Financing
Most real estate transactions, and many purchases of personal property, involve debt financing. When a taxpayer takes out a loan to purchase property, the loan is included in the basis of the property. When the property is transferred, the loan is included in the amount realized if the recipient takes the loan with the property.

In the first example above, the taxpayer could purchase the land with a $10,000 loan. The basis becomes $10,000 after purchase, and adjusts to $50,000 after the house is built. When the taxpayer sells the property for $90,000, their amount realized is $90,000 if the property is sold subject to the loan, but is only $80,000 if the taxpayer remains subject to the loan. The taxpayer therefore recognizes $10,000 in additional gain if the property is sold subject to the loan. In a sense, the taxpayer receives more income if the buyer takes on the liability for the loan, just as they would receive income if the buyer paid off their loan for them.

Property as income
In the first example above, the taxpayer might have received their land in exchange for supplying a service to its previous owner. In that case, the basis in the property would become its fair market value&mdash;the same amount claimed by the taxpayer as income. Assuming $10,000 was the fair market value, this achieves the same result as if the taxpayer had received a $10,000 payment from the owner and then bought the land for that amount.

Property as an inheritance
If our example taxpayer received their land as an inheritance upon the previous owner's death, they would not have to declare it as income, and its basis would be reset to its fair market value as of the date of death of the decedent; i.e, the inheritor receives a stepped-up basis in the assets. There is an alternate valuation date, subject to the rules of IRC §2032, which may be used to value assets. The alternate date is six (6) months to the day following the date of death of the decedent. The generally cited reason for this rule is that death is not an appropriate time to tax a person's heirs for the gains of the deceased, especially considering that they may be liable for a separate estate tax. (The rules concerning inheritances will temporarily change in 2010 to coincide with the temporary repeal of the estate tax.)

Note that while inherited property is essentially "free" for income tax purposes, income in respect of a decedent is not. For instance, if a person contracts to sell some property and then dies, the proceeds from the sale will be paid to that person's heirs and will be fully taxable as income to the heirs.

Property as a gift
Gifts by a living person follow a different rule from inheritances. Generally defined as a gratuitous transfer of property, the rule regarding gifts is that the basis in the hands of the donor becomes the basis in the hands of the donee. Effectively, the taxpayer is recognizing the previous owner's gain as well as his own. The reason for this rule is to prevent people from giving property to each other for the sole purpose of resetting its basis and mitigating their gains.