Capital Gains and Losses

Author:Deborah A. Geier
Pages:408-444
 
FREE EXCERPT
Chapter 14: Capital Gains and Losses
In Chapter 12, you learned that the first step in analyzing the tax consequences of a property
disposition is to determine the realized gain or loss under § 1001 (the difference between amount
realized and adjusted basis). The second step is to determine whether the realized gain is includable
in Gross Income under § 61(a)(3) or realized loss is deductible under § 165. Only if the gain is
includable or the loss is deductible is it necessary to go on to the third step: characterizing the
includable gain or deductible loss as ordinary, capital, or § 1231 gain or loss (and determining why
that characterization matters). This chapter explores that third step in more detail.
A gain or loss is “capital” if described in § 1222(1) through (4). The common ingredients found
in each of those four subsections provide that an otherwise includable § 1001 gain or otherwise
deductible § 1001 loss (under § 165) is “capital” only if the gain or loss arises from the “sale or
exchange” of a “capital asset.” Section 1221 defines “capital asset.” Moreover, those subsections
also confirm that an includable capital gain or deductible capital loss is short term if the property
sold or exchanged was held for one year or less and long term if held for more than one year.
You were introduced in Chapter 1 to the two most important consequences that arise when a
gain or loss is characterized as “capital” because they had immediate relevance to many topics
already explored.
Otherwise deductible (under § 165) capital losses are treated less favorably than deductible
ordinary losses because only the former are subject to the § 1211(b) capital loss limitation
rule (cross-referenced in § 165(f)).
“Net capital gain,” as defined in § 1222(11), is treated more favorably than ordinary income
and gain because it is taxed at a preferential rate under § 1(h) when realized by individuals.1
Part A. examines the § 1211(b) capital loss limitation (and the § 1212(b) carryover rule) more
closely. Part B. explores the asserted rationales for a tax preference for net capital gain, the
definition of net capital gain, and the planning possibilities implied by that definition. Part C
considers the § 1221 definition of “capital asset,” including the Arrowsmith doctrine, as well as
the sale or exchange requirement. Part D. considers the treatment of § 1231 gains and losses, as
well as so-called depreciation recapture under §§ 1245 and 1250. Finally, Part E. briefly describes
the various special rates applicable to net capital gain found in § 1(h).
A. Capital losses
A taxpayer who realizes more capital losses than capital gains in a given year cannot have any
hope of preferentially taxed “net capital gain” within the meaning of § 1222(11). The only question
at issue in this scenario is the extent to which the capital losses are deductible.
Section 165(f) reminds us that an otherwise deductible § 1001 loss—i.e., a loss described in §
1 The rate schedule for corporations is found in § 11, which has no counterpart to § 1(h). Thus, the net capital gain
realized by corporations is not subject to a reduced tax rate. Corporations are nevertheless subject to the deduction
restriction (and carryover) for capital losses, though these rules differ from those applied to individuals. See §§ 1211(a)
and 1212(a).
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165(c) in the case of an individual—is subject to limitation under § 1211 if the deductible loss is
“capital” in nature. Under the language in § 1211(b), the aggregate of otherwise deductible
capital losses (whether long term or short term) is allowed in the year realized only to the
extent of the sum of (1) the aggregate of realized and included capital gains (whether short
term or long term) and (2) up to $3,000 of included ordinary income. Any excess
(undeducted) capital loss is carried forward and treated as realized in each succeeding
taxable year under § 1212(b) until either the loss is deducted or the taxpayer dies.2
Section 1211(b) is needed so long as the law incorporates both the realization requirement (as
opposed to a mark-to-market system, described in Chapter 1) and a preferential rate for net capital
gain. It addresses the cherr y-picking problem that would, in the absence of § 1211, otherwise allow
a taxpayer (1) to deduct what looks like a wealth decrease when in fact the taxpayer is wealthier
or (2) to engage in rate arbitrage by using capital losses to offset high-taxed ordinary income
instead of low-taxed capital gain.
To illustrate, assume that Lindsey, who earns $100,000 in wages each year, purchases both
Whiteacre and Blackacre for investment on January 1 of Year 1. By December 31 of Year 1,
Whiteacre has increased in value by $10,000, and Blackacre has decreased in value by $8,000. If
the realization requirement were abolished and Lindsey had to mark to market both Whiteacre and
Blackacre each year, she would include the $10,000 Whiteacre gain in her Gross Income (and
increase her Whiteacre basis by $10,000) and deduct the $8,000 Blackacre loss (and reduce her
Blackacre basis by $8,000), accurately reflecting her $2,000 net wealth increase for the year.
Because of the realization requirement, however, Lindsey has the power to choose when (and if)
to realize the Whiteacre gain and the Blackacre loss. Absent § 1211(b), Lindsey could choose to
realize and deduct only the $8,000 Blackacre loss (and not the $10,000 Whiteacre unrealized gain)
in Year 1, making it appear that she has suffered an $8,000 wealth reduction when, in fact, she has
actually enjoyed an economic net wealth increase of $2,000 for the year when both Blackacre and
Whiteacre are considered together. Moreover, absent § 1211(b), Lindsey could use that $8,000
deduction to offset $8,000 of her high-taxed wages, saving the $10,000 of capital gain to be taxed
at the low net capital gain rate in, say, Year 3 (a year in which she realizes no capital losses) by
waiting to sell Whiteacre until then.
In essence, § 1211(b) forces Lindsey to sell both Whiteacre and Blackacre if she wishes to fully
deduct the $8,000 Blackacre loss in Year 1. If Lindsey sells only Blackacre in Year 1 and realizes
no capital gain, she can deduct only $3,000 of her $8,000 realized loss and must carry forward the
remaining $5,000 undeducted loss under § 1212(b). If Lindsey again fails to sell Whiteacre in
Years 2 and 3, she could deduct only $3,000 of her $5,000 carryover loss in Year 2, carrying the
remaining $2,000 loss to Year 3, when she could finally deduct it. The $3,000 in capital losses that
Lindsey is permitted to deduct in excess of her realized and included capital gains each year is
nothing more than a de minimis rule intended to allow individuals like Lindsey to deduct small
capital losses without the bother of carrying them to future years. Nevertheless, the $3,000 de
minimis rule is valuable for Lindsey, as it allows capital losses to offset high-taxed income. (More
on tax planning possibilities in Part B., below.)
2 Unused deductions at the time of a decedent's death, including capital loss carryovers, cannot be transferred to the
decedent's heirs for their use. Recall from Chapter 7 that, as described by Henry Simons, an income tax is not a tax on
income per se but rather is a tax imposed on peopleas measured by their wealth accessions and wealth reductions
(representing their ability to pay). Do not feel too sorry for the heirs for being unable to deduct wealth decreases
suffered by others, however. Remember §§ 102 and 1014, which benefit heirs mightily.
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How does Lindsey know whether any capital loss carryover should be treated as a long-term
capital loss or as a short-term capital loss in any future carryover year? While its nature as a long-
term loss or short-term loss is irrelevant under § 1211(b) in determining the deductibility of capital
losses, this determination might have an impact on possible “net capital gain” in the future year to
which she carries the loss. Thus, Lindsey needs to know whether any carryover loss under §
1212(b) is to be considered short term or long term in future years.
As I have made clear many times before, I think that it is important for students to become
comfortable with pulling apart statutory language and figuring out what it means, which is why I
have always encouraged you to do so with respect to the relevant statutory language under study.
Every rule has its exceptions, however, and I do not think it is worth the trouble in connection with
§ 1212(b). You can take my word for it that I am accurately describing here the mechanics of §
1212(b).
To determine the nature of a capital loss carryover as short term or long term under §
1212(b), the taxpayer must net together any short-term capital gains and short-term capital
losses in the realization year and do the same with long-term capital gains and long-term
capital losses. The taxpayer’s capital loss carryover maintains the same character (as short
term or long term) as the taxpayer’s net loss position in the realization year.
For example, assume that Lindsey, who earns $100,000 in wages each year, realizes the
following includable gains and deductible losses (under § 165(c)) in Year 1:
short-term cap gain short-term cap loss long-term cap gain long-term cap loss
$3,000 $10,000 $13,000 $12,000
Because Lindsey realizes more capital losses ($22,000) than capital gains ($16,000), she has no
hope of any preferentially taxed “net capital gain.” Her only questions are (1) the extent to which
she can deduct her capital losses under § 1211(b) and (2) the character of any capital loss carryover
under § 1212(b). The answer to the first question is that she can deduct $19,000 of her $22,000 in
aggregate capital losses, equal to the $16,000 in realized and included capital gains plus $3,000.
She must carry forward the remaining $3,000 of her otherwise deductible capital losses to Year 2
under § 1212(b). Moreover, because she realizes a $7,000 net short-term capital loss ($10,000
short-term capital loss less $3,000 short-term capital gain) and $1,000 net long-term capital gain
($13,000 long-term capital gain less $12,000 long-term capital loss) in Year 1, her $3,000 capital
loss carryover is treated as a short-term capital loss in Year 2 (the same as her net loss position in
the realization year).
What if Lindsey realizes a net loss in both her short-term and long-term columns? For example,
assume the same facts except that Lindsay realizes a $14,000 long-term capital loss instead of a
$12,000 long-term capital loss in Year 1.
short-term cap gain short-term cap loss long-term cap gain long-term cap loss
$3,000 $10,000 $13,000 $14,000
As in the prior iteration, Lindsey can deduct $19,000 of her aggregate capital losses, equal to the
$16,000 in realized and included capital gains plus $3,000. She now has a $5,000 carryover loss
under § 1212(b), however, instead of a $3,000 carryover loss. In Year 1, Lindsey realized a $7,000
net short-term capital loss ($10,000 short-term capital loss less $3,000 short-term capital gain) and
a $1,000 net long-term capital loss ($14,000 long-term capital loss less $13,000 long-term capital

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