Properly Accounting for, and the Nonrecognition of, § 1001 Realized Gain or Loss

Author:Deborah A. Geier
Pages:351-375
 
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Chapter 12: Properly Accounting for, and the
Nonrecognition of, § 1001 Realized Gain or Loss
There is a logical order in the steps to take when analyzing th e tax consequences of a realization
event, i.e., when property is sold (for cash), exchanged (for other property), destroyed, stolen, etc.
On the disposition of property
Step 1: What is the § 1001 realized gain or loss? This step must always come first in the
analysis, as this amount is what may possibly be included in § 61(a)(3) Gross Income (if a gain)
or deducted under § 165 (if a loss). Moreover, do not lose sight of the fact that basis must always
be recovered tax free under § 1001, regardless of the manner of disposition, if we are to avoid
doubly taxing the same dollars to the same taxpayer. If property is subject to debt, your
determination of § 1001 realized gain and loss will necessarily take into account the material that
you just learned in Chapter 11.
Step 2: If a gain, is it includable? See, e.g., §§ 61(a)(3), 1041(a), 1033, 1031, 121. If a loss,
is it deductible? See, e.g., §§ 165(c), 1041(a), 1031, 267(a)(1), 1091. Section 61(a)(3) provides
that “gain derived from dealings in property” is an item of Gross Income, and § 1001(a) defines
“gain” as the excess of § 1001(b) amount realized over adjusted basis. The introductory clause to
§ 61 (“except as otherwise provided in this subtitle”) reminds us, however, that other Code sections
may provide authority for a realized gain to go unrecognized, which means not taken into account
now. You encountered your first nonrecognition provision in Chapter 8 when you studied § 1041,
which applies to transfers between spouses or, if incident to divorce, between former spouses.
Although the gain or loss may be realized within the meaning of § 1001 under Davis v.
Commissioner,1 it goes unrecognized under the authority of § 1041(a). In this chapter, you will
study §§ 1033 and 1031, which also permit realized gain to go unrecognized.
Realized losses within the meaning of § 1001—the excess of adjusted basis over amount
realizedmay go unrecognized not only under § 1041 but also under §§ 1031, 267(a)(1), and
1091, each of which we shall examine in this chapter. Do not forget, however, that even if a
realized loss under § 1001 is recognized (because no nonrecognition provision applies), the loss
may nevertheless not be deductible. Recall from Chapter 1 that, for a wealth reduction to be
deductible, a taxpayer must find a Code section saying “there shall be allowed as a deduction” and
satisfy its terms. For a “loss,” the Code section providing that authority is § 165. With respect to
individuals, the loss must be described in § 165(c), which generally provides for deduction of
business and investment losses only. If the realized loss pertains to personal-use property, the loss
is generally not deductible, except for a limited category of personal casualty and theft loss.2
Step 3: If (and only if) the answer to (2), above, is “yes,” what is the character of the gain
or loss (ordinary, capital, or § 1231), and why does that character matter? See §§ 1221, 1222,
1211, 1212, 1245, 1250, 1231, 1(h). Only if a realized gain is includable or a realized loss is
1 370 U.S. 65 (1962).
2 Section 1001(c), which provides that, “[e]xcept as otherwise provided in this subtitle,” realized gains and losses
“shall be recognized,” is mere surplusage. Section 61(a)(3) requires inclusion of realized gains in any event, “[e]xcept
as otherwise provided by this subtitle.” And no realized loss can be deducted unless § 165 is satisfied. Thus, § 1001(c)
has no independent force.
Chapter 12 Realization and Recognition of § 1001 Gain and Loss Chapter 12
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deductible does it matter whether it is capital, ordinary, or § 1231 gain or loss. If the realized gain
is not includable or realized loss is not deductible, its character is irrelevant. We shall explore
characterization issues in Chapter 14.
Step 4: If new property is obtained, what is the basis of the new property? See §§ 1012,
1041(b)(2), 1033(b)(2), 1031(d). Determining the basis of new property (if any) obtained is the
very last step in the analysis. This step must come last because the determination of basis
sometimes requires knowing the outcome of the analysis in Step 2.
You learned in Chapter 8 that unrecognized § 1041 gain or loss is not laundered out of the tax
system, as it is under § 1014 on the transfer of property at death (studied in Chapter 7). Rather, the
unrecognized gain is preserved for future reckoning because the transferee spouse takes the same
basis that the transferor spouse had in the property under § 1041(b)(2). Similarly, you also learned
in Chapter 7 that gifts are not realization events and that the donee generally takes the same basis
that the donor had in the property under § 1015(a). Such a basis was historically referred to as a
carryover basisand, as an old dog, I still refer to it as a carryover basisthough now it is
technically called a transferred basis. See § 7701(a)(43).
Another kind of basis that preserves unrecognized gain for future reckoning is a substituted
basis (or exchanged basis), a concept that you will shortly learn when we examine § 1031. See §
7701(a)(42) and (44). In general, a substituted basis in property received in an exchange (property
2) is determined by reference to the basis of the property exchanged (property 1) if some or all of
the realized gain or loss with respect to property 1 is unrecognized. In either case, carryover and
substituted bases are instrumental tools that are used to transform what may look like a complete
forgiveness provision at first glance into a mere deferral provision.3
Part A. explores both (1) how to properly measure § 1001 realized and recognized gain or loss
in Step 1 and (2) the proper timing of inclusions and deductions of such gain or loss. Part B. then
considers several nonrecognition provisions: involuntary conversions (§ 1033), like kind
exchanges (§ 1031), sales of built-in loss property between related parties (§ 267), and so-called
wash sales of securities with built-in loss.
A. Properly accounting for realized and recognized gain and loss
Section 1001 must generally be applied separately to each piece of property sold or exchanged,
even if the dispositions occur in a single transaction, in order to ensure that the tax consequences
of each are not distorted.
Assume, for example, that Barbara owns (1) a diamond ring that she purchased many years ago
for $5,000, which she wears for personal purposes, and (2) a personal-use car that she purchased
for $20,000 a few years ago. Barbara, who needs to raise cash, decides to sell both properties, and
she finds Bob Buyer, who is interested in purchasing both for $30,000. Barbara cannot simply add
the $5,000 basis in her ring to the $20,000 basis in the car and subtract this aggregate $25,000
basis from the $30,000 paid by Bob Buyer, resulting in a § 1001 gain of $5,000. Rather, she must
allocate the $30,000 sales proceeds to each property according to their relative fair market values
(FMVs) and calculate her § 1001 realized gain (or loss) separately for each property. If the
3 In contrast, § 121, a nonrecognition provi sion that we shall examine in Chapter 17, allo ws certain gain realized on
the sale of a principal residence to be completely forgiven.

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