UNDERSTANDINGFEDERAL INCOME

TAXATION

(2016–Pub.426)

UNDERSTANDINGFEDERAL INCOMETAXATION

Fifth Edition

J. Martin BurkeProfessor of Law EmeritusUniversity of Montana School of Law

Michael K. FrielProfessor of Law and Director, Graduate Tax ProgramUniversity of Florida Levin College of Law

Copyright © 2016

Carolina Academic Press, LLC

All Rights Reserved

ISBN: 978–1–5221–0348–6 (print)

Library of Congress Cataloging-in-Publication Data

Names: Burke, J. Martin, author. | Friel, Michael K., author.

Title: Understanding federal income taxation / J. Martin Burke, Professor of Law Emeritus, University of

Montana School of Law; Michael K. Friel, Professor of Law and Director, Graduate Tax Program.

Description: Fifth edition. | Durham, North Carolina : Carolina Academic Press, 2016. | Series:

Understanding series | Includes bibliographical references and index.

Identifiers: LCCN 2016013217 (print) | LCCN 2016013545 (ebook) | ISBN 9781522103486 (alk. paper) |

ISBN 9781522103493 (ebook)

Subjects: LCSH: Income tax--Law and legislation--United States.

Classification: LCC KF6369.85 .B87 2016 (print) | LCC KF6369.85 (ebook) | DDC 343.7305/2--dc23

LC record available at https://lccn.loc.gov/2016013217

Carolina Academic Press, LLC

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Durham, NC 27701

Telephone (919) 489-7486

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Printed in the United States of America

(2016–Pub.426)

Dedication

To Jackie and Jonathan

and My Mother and Father

— MKF

To My Mother and Father

and My Eleven Brothers and Sisters

— JMB

iii

Preface

As experienced tax professors, we know that students encountering the complexities of

the tax code for the first time are often frustrated by its difficulties and look to their

casebooks or to supplemental material for an adequate overview of the principles and

policies underlying federal income tax law and for a detailed explanation of the

interpretation and application of pertinent provisions of the Internal Revenue Code. Thus,

such overviews and explanations have been principal features of the authors’ casebook,

Taxation of Individual Income. This book in turn adapts material from Taxation of

Individual Income for those students using other casebooks who seek such supplemental

material to assist them in their study. We have specifically designed this book to

supplement other casebooks used in traditional courses in federal individual income

taxation.

This book consists of forty-four chapters with each chapter addressing a basic topic in

individual income taxation, e.g., the taxation of personal injury awards, the interest

deduction, installment sales. Because the provisions of the Internal Revenue Code are

necessarily at the heart of tax study, we have included in each chapter a part or all of the

Code section(s) pertinent to the specific topic. Likewise, the chapters contain summaries

of leading cases and relevant administrative rulings as well as numerous examples

explaining the application of the law.

For students in law schools or business programs, we suggest that, before turning to

this book, students first read the cases and other materials assigned by their professors.

With that reading as background, students should then read the corresponding materials

in this book to acquire a broader overview of the area including the development of the

law related to a specific topic.

While this book is designed primarily for students, we recognize that it may also prove

valuable to the general practitioner. Before representing a client in a divorce or some

property transaction, the attorney may be well advised to read the chapter(s) relevant to

the representation. Not only will this book provide the attorney with helpful overviews of

the tax law related to a client matter, it will also serve as a tool for locating cases and

other relevant authority.

In sum, we have written this book as a basic guide for students studying the tax law for

the first time and for general practitioners handling transactions with an individual

income tax dimension. A word of caution: neither this guide nor any casebook or

supplemental material should be viewed as a substitute for careful reading of the Internal

Revenue Code. Lawyers and accountants must ultimately base their decisions on the

Code and the judicial and administrative interpretations of the Code. Our hope is that this

book will aid in the study of the Code and the application of its provisions.

v

Acknowledgments

We are indebted to a number of people for their assistance in the development of this

book. We have benefitted greatly from the comments and suggestions by our colleagues

and our students at the University of Montana School of Law and the University of

Florida College of Law, and we wish to acknowledge their help and that of our tax

colleagues at other law schools. We are also indebted to Linda Kirby of the University of

Florida College of Law. Her assistance and support in the preparation of this manuscript

were indispensable, and for that we are most grateful and appreciative.

vii

Table of Contents

Chapter 1 INTRODUCTION TO FEDERAL INCOME TAX . . . . . . . 1

§ 1.01 A BRIEF HISTORY OF FEDERAL INCOME TAX . . . . . . . . . . . . . . . . 1

§ 1.02 RESOLUTION OF TAX ISSUES THROUGH THE

JUDICIAL PROCESS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

[A] Trial Courts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

[1] The Tax Court . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

[2] Federal District Courts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

[3] The United States Court of Federal Claims . . . . . . . . . . . . . . . . . . . . 3

[B] Appellate Courts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

[C] Selection of Forum . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

§ 1.03 COMPUTATION OF TAX LIABILITY . . . . . . . . . . . . . . . . . . . . . . . . . 5

[A] Basic Questions Addressed by an Income Tax System . . . . . . . . . . . . . . 5

[B] Evaluating Tax Liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

[1] Gross Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

[2] The Concept of Adjusted Gross Income . . . . . . . . . . . . . . . . . . . . . . . 7

[3] Deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

[4] Calculating Adjusted Gross Income . . . . . . . . . . . . . . . . . . . . . . . . . 11

[5] Taxable Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

[a] Itemize or Elect Standard Deduction . . . . . . . . . . . . . . . . . . . . . . 12

[b] Section 67: The 2% Floor on Miscellaneous Itemized Deductions . . 12

[c] The Section 68 Overall Limitation on Itemized Deductions . . . . . . 13

[d] Personal Exemptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

[e] Calculating Taxable Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

[6] Tax Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

[7] Credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

§ 1.04 CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

Chapter 2 GROSS INCOME CONCEPTS AND LIMITATIONS . . . . 17

§ 2.01 THE SEARCH FOR A DEFINITION OF INCOME . . . . . . . . . . . . . . . . 17

§ 2.02 INCOME REALIZED IN ANY FORM . . . . . . . . . . . . . . . . . . . . . . . . . 20

§ 2.03 REALIZATION, IMPUTED INCOME AND BARGAIN PURCHASES . 21

[A] The Realization Requirement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

[B] Imputed Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

[C] Bargain Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

ix

Chapter 3 THE EFFECT OF AN OBLIGATION TO REPAY . . . . . . 29

§ 3.01 LOANS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

§ 3.02 CLAIM OF RIGHT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

§ 3.03 ILLEGAL INCOME . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

§ 3.04 DEPOSITS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

Chapter 4 GAINS DERIVED FROM DEALINGS IN PROPERTY . . 39

§ 4.01 COMPUTING GAIN DERIVED FROM DEALINGS IN PROPERTY . . . 39

§ 4.02 TAX COST BASIS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

§ 4.03 IMPACT OF LIABILITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

[A] Impact on Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

[B] Impact on Amount Realized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

§ 4.04 BASIS OF PROPERTY ACQUIRED IN TAXABLE EXCHANGES . . . . 46

Chapter 5 GIFTS, BEQUESTS AND INHERITANCE . . . . . . . . . . . . 51

§ 5.01 EXCLUSION OF GIFTS FROM INCOME . . . . . . . . . . . . . . . . . . . . . . 51

[A] The Nature of a Gift . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

[1] Employer-Employee “Gifts” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

[2] Business Gifts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

[B] The Nature of a Bequest or Inheritance . . . . . . . . . . . . . . . . . . . . . . . . 54

[C] Statutory Limitations on the Exclusion — Section 102(b) . . . . . . . . . . . 55

§ 5.02 BASIS OF PROPERTY RECEIVED BY GIFT, BEQUEST OR

INHERITANCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

[A] Gifts of Appreciated Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

[B] Gifts of Property — Basis in Excess of Fair Market Value . . . . . . . . . . 59

[C] Basis of Property Received by Bequest or Inheritance . . . . . . . . . . . . . 61

§ 5.03 PART-GIFT, PART-SALE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

Chapter 6 SALE OF A PRINCIPAL RESIDENCE . . . . . . . . . . . . . . . 67

§ 6.01 OWNERSHIP AND USE REQUIREMENTS . . . . . . . . . . . . . . . . . . . . 67

§ 6.02 AMOUNT EXCLUDABLE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

§ 6.03 EXCLUSION FOR TAXPAYERS FAILING TO

MEET CERTAIN REQUIREMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . 75

§ 6.04 LIMITATION ON EXCLUSION FOR DEPRECIATION CLAIMED . . . 78

§ 6.05 PRINCIPAL RESIDENCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

§ 6.06 CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81

Chapter 7 SCHOLARSHIPS AND PRIZES . . . . . . . . . . . . . . . . . . . . 83

§ 7.01 PRIZES AND AWARDS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

[A] Prizes and Awards Generally Taxable . . . . . . . . . . . . . . . . . . . . . . . . . 84

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[B] Employee Achievement Awards Exempt . . . . . . . . . . . . . . . . . . . . . . 84

§ 7.02 QUALIFIED SCHOLARSHIPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87

[A] Limitation of Exclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87

[B] Scholarships as Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88

[C] Tuition Reduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89

[D] Educational Assistance Programs . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90

[E] Gifts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

Chapter 8 LIFE INSURANCE, ANNUITIES, AND INDIVIDUAL

RETIREMENT ACCOUNTS . . . . . . . . . . . . . . . . . . . . . . 93

§ 8.01 LIFE INSURANCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93

[A] Exclusion of Mortality Gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93

[B] Death of the Insured . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96

[C] Accelerated Death Benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96

[D] Surrender for Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

[E] Interest Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98

[F] Transfer for Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

[G] Group-term Life Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

§ 8.02 ANNUITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

§ 8.03 INDIVIDUAL RETIREMENT ACCOUNTS . . . . . . . . . . . . . . . . . . . . 104

[A] Deductible IRAs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105

[B] Nondeductible IRAs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106

[C] Roth IRAs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106

Chapter 9 DISCHARGE OF INDEBTEDNESS . . . . . . . . . . . . . . . . 109

§ 9.01 HISTORICAL BACKGROUND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109

§ 9.02 SPECIFIC RULES GOVERNING EXCLUSION . . . . . . . . . . . . . . . . . 111

[A] Discharge of Indebtedness When Taxpayer Is Insolvent . . . . . . . . . . . 111

[1] Case Law Pre-1980 Bankruptcy Tax Act . . . . . . . . . . . . . . . . . . . . 111

[2] The Insolvency Exclusion Under Section 108 . . . . . . . . . . . . . . . . . 112

[B] Discharge of Qualified Real Property Business Indebtedness . . . . . . . . 115

[C] Discharge of Indebtedness on Principal Residence Before

January 2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

[D] Purchase-Money Debt Reduction for Solvent Debtors . . . . . . . . . . . . 117

[E] Acquisition of Indebtedness by Person Related to Debtor . . . . . . . . . . 119

[F] Discharge of Deductible Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119

[G] Discharge of Certain Student Loans . . . . . . . . . . . . . . . . . . . . . . . . . 120

§ 9.03 DISPUTED OR CONTESTED DEBTS . . . . . . . . . . . . . . . . . . . . . . . . 121

§ 9.04 DISCHARGE OF INDEBTEDNESS AS GIFT,

COMPENSATION, ETC. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123

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§ 9.05 INAPPLICABILITY OF SECTION 108 TO GAIN REALIZED

ON TRANSACTIONS INVOLVING DISCHARGE

OF INDEBTEDNESS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124

Chapter 10 COMPENSATION FOR PERSONAL PHYSICAL

INJURY AND PHYSICAL SICKNESS . . . . . . . . . . . . . . 125

§ 10.01 INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125

§ 10.02 DAMAGES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126

[A] Business or Property Damages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126

[B] Exclusion for Damages Received on Account of Personal

Physical Injuries or Physical Sickness . . . . . . . . . . . . . . . . . . . . . . . . 127

[C] Supreme Court Limitations on Section 104(a)(2) . . . . . . . . . . . . . . . . 130

[1] What is a “Personal Injury”? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130

[2] When are Damages Received “On Account Of” a Personal Injury? . . 130

[D] Restricting the Exclusion to Physical Injury or Physical Sickness . . . . 132

[1] Distinction Between Physical and Non-Physical Injuries . . . . . . . . . 132

[2] Personal Physical Injury or Physical Sickness . . . . . . . . . . . . . . . . . 134

[3] Emotional Distress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

[4] Recoveries by Individuals Other than Individuals Suffering

Personal Physical Injury or Physical Sickness . . . . . . . . . . . . . . . . . 137

[E] The Current Regulations and the Definition of “Damages” . . . . . . . . . 138

[F] Punitive Damages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139

[G] Allocation of Awards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140

[H] Periodic Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

§ 10.03 PAYMENT UNDER ACCIDENT AND HEALTH

INSURANCE POLICIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142

§ 10.04 PREVIOUSLY DEDUCTED MEDICAL EXPENSES . . . . . . . . . . . . . 145

§ 10.05 WORKERS’ COMPENSATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

§ 10.06 CERTAIN DISABILITY PENSIONS . . . . . . . . . . . . . . . . . . . . . . . . . 146

Chapter 11 FRINGE BENEFITS . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147

§ 11.01 MEALS AND LODGING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147

[A] The Treatment of Meals and Lodging Prior to 1954 . . . . . . . . . . . . . . 147

[B] Section 119 — Meals or Lodging Furnished for the

Convenience of the Employer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148

§ 11.02 FRINGE BENEFITS AND SECTION 132 . . . . . . . . . . . . . . . . . . . . . . 151

[A] No-Additional-Cost Service . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

[B] Qualified Employee Discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

[C] Working Condition Fringe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158

[D] De Minimis Fringe Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159

[E] Qualified Transportation Fringe . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

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[F] On-Premises Gyms and Other Athletic Facilities . . . . . . . . . . . . . . . . 161

§ 11.03 VALUATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162

Chapter 12 BUSINESS AND PROFIT SEEKING EXPENSES . . . . . . 163

§ 12.01 BUSINESS DEDUCTIONS — SECTION 162 . . . . . . . . . . . . . . . . . . . 163

[A] The Expense Must be “Ordinary and Necessary” . . . . . . . . . . . . . . . . 164

[1] Is the Expense “Ordinary”? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164

[2] Is the Expense “Necessary”? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168

[3] “Reasonable” Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170

[4] Clothing Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174

[5] Public Policy Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175

[6] Lobbying Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176

[B] “Carrying On a Trade or Business” . . . . . . . . . . . . . . . . . . . . . . . . . . 177

[1] What Constitutes a “Trade or Business”? . . . . . . . . . . . . . . . . . . . . 177

[2] The “Carrying On” Requirement . . . . . . . . . . . . . . . . . . . . . . . . . . 178

[3] Section 195 and the Amortization of Certain Pre-Operational

or Start-Up Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180

[4] Application of the “Carrying On” Requirement to Employees . . . . . 182

§ 12.02 SECTION 212 DEDUCTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185

Chapter 13 CAPITAL EXPENDITURES . . . . . . . . . . . . . . . . . . . . . . 187

§ 13.01 DEDUCTIBLE EXPENSE OR CAPITAL EXPENDITURE? . . . . . . . . 187

§ 13.02 DEFINING CAPITAL EXPENDITURES — INDOPCO . . . . . . . . . . . 188

§ 13.03 ADMINISTRATIVE GUIDANCE: THE CAPITAL

EXPENDITURES REGULATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . 191

[A] Amounts Paid to Acquire or Produce Tangible Property . . . . . . . . . . . 192

[B] Amounts Paid to Improve Tangible Property . . . . . . . . . . . . . . . . . . . 194

[1] Improvements: Historic Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194

[2] Improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198

[3] Amounts Paid to Acquire or Create Intangibles . . . . . . . . . . . . . . . . 203

[4] Amounts Paid with Regard to the Sale, Removal, or

Retirement of an Asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205

§ 13.04 MISCELLANEOUS ITEMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206

[A] Expansion Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206

[B] Business Downsizing Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207

[C] Employee Training Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208

[D] Advertising Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208

§ 13.05 PURCHASE OR LEASE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209

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Chapter 14 DEPRECIATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211

§ 14.01 DEPRECIATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211

[A] Depreciable Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211

[B] Recovery Period — The Useful Life Concept . . . . . . . . . . . . . . . . . . 214

[1] Historical Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214

[2] Current Recovery Periods — Modified Accelerated Cost

Recovery System (MACRS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215

[C] Depreciation Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217

[D] Conventions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219

§ 14.02 COMPUTING THE DEPRECIATION DEDUCTION . . . . . . . . . . . . . . 221

§ 14.03 ADDITIONAL FIRST YEAR DEPRECIATION . . . . . . . . . . . . . . . . . 224

§ 14.04 AMORTIZATION OF INTANGIBLES — SECTION 197 . . . . . . . . . . 225

§ 14.05 RELATIONSHIP BETWEEN BASIS AND DEPRECIATION . . . . . . . 225

§ 14.06 SECTION 179 — EXPENSING TANGIBLE PERSONAL PROPERTY . 226

§ 14.07 THE RELATIONSHIP OF DEBT TO DEPRECIATION . . . . . . . . . . . . 229

Excerpt From REVENUE PROCEDURE 87–56 . . . . . . . . . . . . . . . . 230

Excerpt From REVENUE PROCEDURE 87-57 . . . . . . . . . . . . . . . . 232

Chapter 15 LOSSES AND BAD DEBTS . . . . . . . . . . . . . . . . . . . . . . . 235

§ 15.01 LOSSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235

[A] The Business or Profit Requirement for Individuals . . . . . . . . . . . . . . 236

[1] Personal Losses Not Deductible . . . . . . . . . . . . . . . . . . . . . . . . . . 236

[2] Conversion of Personal Use Property to Income

Producing Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238

[B] When Is a Loss Sustained? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239

[1] Worthless Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240

[2] Theft Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241

[C] Amount of the Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241

[1] Reimbursement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242

[2] Post-Conversion Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242

[D] Disallowed Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243

§ 15.02 BAD DEBTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243

[A] Bona Fide Debt Requirement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244

[B] Worthlessness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244

[C] Business or Nonbusiness Debts . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244

[D] Amount Deductible . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247

[E] Guarantees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248

§ 15.03 BAD DEBTS AND LOSSES: THE INTERPLAY

BETWEEN SECTIONS 166 AND 165 . . . . . . . . . . . . . . . . . . . . . . . . 248

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Chapter 16 TRAVEL EXPENSES . . . . . . . . . . . . . . . . . . . . . . . . . . . 249

§ 16.01 COMMUTING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249

§ 16.02 OTHER TRANSPORTATION EXPENSES . . . . . . . . . . . . . . . . . . . . . 253

§ 16.03 EXPENSES FOR MEALS AND LODGING WHILE

IN TRAVEL STATUS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254

§ 16.04 WHERE IS THE TAXPAYER’S “HOME” FOR

SECTION 162(a)(2) PURPOSES? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256

§ 16.05 OTHER CONSIDERATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260

[A] Travel Expenses of Spouse . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260

[B] Reimbursed Employee Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 261

[C] Business-Related Meals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262

[D] Limitations on Foreign Travel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263

[E] Relationship to Section 212 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263

[F] Substantiation Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264

Chapter 17 ENTERTAINMENT AND BUSINESS MEALS . . . . . . . . 265

§ 17.01 BUSINESS OR PLEASURE? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266

[A] Historical Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266

[B] Percentage Cutback for Meal and Entertainment Expenses . . . . . . . . . 267

[C] Business Meals and Entertainment Ticket Limitations . . . . . . . . . . . . 269

§ 17.02 ENTERTAINMENT ACTIVITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . 270

[A] “Directly Related” Entertainment . . . . . . . . . . . . . . . . . . . . . . . . . . . 270

[B] “Associated with” Entertainment . . . . . . . . . . . . . . . . . . . . . . . . . . . 271

§ 17.03 ENTERTAINMENT FACILITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . 272

§ 17.04 SUBSTANTIATION REQUIREMENTS . . . . . . . . . . . . . . . . . . . . . . . 274

§ 17.05 EXCEPTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275

§ 17.06 BUSINESS MEALS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276

Chapter 18 EDUCATIONAL EXPENSES . . . . . . . . . . . . . . . . . . . . . 281

§ 18.01 CATEGORIZATION OF EDUCATIONAL EXPENSES . . . . . . . . . . . 281

§ 18.02 THE SKILL-MAINTENANCE OR

EMPLOYER-REQUIREMENT TESTS . . . . . . . . . . . . . . . . . . . . . . . . 282

§ 18.03 THE MINIMUM EDUCATIONAL REQUIREMENTS

AND NEW TRADE OR BUSINESS TESTS . . . . . . . . . . . . . . . . . . . . 284

§ 18.04 TRAVEL EXPENSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288

§ 18.05 EDUCATION TAX INCENTIVES . . . . . . . . . . . . . . . . . . . . . . . . . . . 289

[A] Education Credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289

[B] Education Deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291

[C] Education Exclusions from Income . . . . . . . . . . . . . . . . . . . . . . . . . . 291

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Chapter 19 OTHER DEDUCTIBLE PERSONAL EXPENSES . . . . . . 295

§ 19.01 MOVING EXPENSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295

§ 19.02 CHILD CARE EXPENSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

§ 19.03 LEGAL EXPENSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302

Chapter 20 HOBBY LOSSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305

§ 20.01 HISTORICAL DEVELOPMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305

§ 20.02 SECTION 183 ACTIVITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306

§ 20.03 DEDUCTIONS ALLOWABLE UNDER SECTION 183 . . . . . . . . . . . . 311

Chapter 21 HOME OFFICES, VACATION HOMES AND

OTHER DUAL USE PROPERTY . . . . . . . . . . . . . . . . . . 313

§ 21.01 HOME OFFICE DEDUCTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313

[A] General Background — Bodzin v. Commissioner . . . . . . . . . . . . . . . 315

[B] Enactment of Section 280A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317

[C] Principal Place of Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318

[D] Convenience of Employer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319

[E] Limitation on Amount of Deduction . . . . . . . . . . . . . . . . . . . . . . . . . 320

§ 21.02 VACATION HOME DEDUCTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . 322

§ 21.03 OTHER DUAL USE PROPERTY . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326

[A] Computers and Other “Listed Property” . . . . . . . . . . . . . . . . . . . . . . 326

[B] Passenger Automobiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329

§ 21.04 CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331

Chapter 22 THE INTEREST DEDUCTION . . . . . . . . . . . . . . . . . . . . 333

§ 22.01 WHAT CONSTITUTES INTEREST? . . . . . . . . . . . . . . . . . . . . . . . . . 333

§ 22.02 DEDUCTION OF PERSONAL INTEREST . . . . . . . . . . . . . . . . . . . . . 334

[A] Qualified Residence Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337

[B] Interest on Education Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341

§ 22.03 INVESTMENT INTEREST . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342

§ 22.04 TIMING ISSUES AND LIMITATIONS . . . . . . . . . . . . . . . . . . . . . . . 345

[A] Allocation of Prepaid Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345

[B] Capitalization of Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347

[C] Payment Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347

Chapter 23 THE DEDUCTION FOR TAXES . . . . . . . . . . . . . . . . . . 351

§ 23.01 HISTORICAL BACKGROUND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351

§ 23.02 TAXES DEDUCTIBLE UNDER SECTION 164 . . . . . . . . . . . . . . . . . 351

§ 23.03 PARTY ELIGIBLE TO CLAIM THE DEDUCTION . . . . . . . . . . . . . . 353

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§ 23.04 SPECIAL PROBLEMS ASSOCIATED WITH THE DEDUCTION OF

REAL PROPERTY TAXES AND ASSESSMENTS . . . . . . . . . . . . . . . 354

[A] Real Property Assessments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354

[B] Apportionment of Real Property Taxes Between Buyer and Seller . . . . 355

§ 23.05 PUBLIC POLICY CONSIDERATIONS . . . . . . . . . . . . . . . . . . . . . . . 358

Chapter 24 CASUALTY LOSSES . . . . . . . . . . . . . . . . . . . . . . . . . . . 361

§ 24.01 DEFINITIONAL QUESTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362

[A] Casualty Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362

[B] Theft Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366

§ 24.02 TIMING OF THE LOSS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367

§ 24.03 AMOUNT OF THE LOSS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367

§ 24.04 INSURANCE COVERAGE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370

Chapter 25 MEDICAL EXPENSES . . . . . . . . . . . . . . . . . . . . . . . . . . 371

§ 25.01 DEDUCTIBILITY OF MEDICAL EXPENSES . . . . . . . . . . . . . . . . . . 372

[A] Medicine and Drugs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372

[B] Counseling Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373

[C] Capital Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374

[D] Meals and Lodging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376

[E] Illegal Operations or Treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376

[F] Qualified Long-Term Care . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377

[G] Transportation Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377

§ 25.02 MEDICAL vs. PERSONAL EXPENSES . . . . . . . . . . . . . . . . . . . . . . . 378

Chapter 26 CHARITABLE DEDUCTIONS . . . . . . . . . . . . . . . . . . . . 381

§ 26.01 IN GENERAL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381

§ 26.02 REQUIREMENTS FOR CHARITABLE DEDUCTIONS . . . . . . . . . . . 381

[A] Who Is a Qualified Recipient? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382

[B] What Is a “Contribution” or “Gift”? . . . . . . . . . . . . . . . . . . . . . . . . . 385

[C] Actual Payment Required . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389

[D] Limitation on Charitable Deductions . . . . . . . . . . . . . . . . . . . . . . . . . 389

§ 26.03 CONTRIBUTION OF SERVICES . . . . . . . . . . . . . . . . . . . . . . . . . . . 392

§ 26.04 CONTRIBUTION OF APPRECIATED PROPERTY . . . . . . . . . . . . . . 392

§ 26.05 CONTRIBUTIONS OF PARTIAL INTERESTS IN PROPERTY . . . . . . 396

§ 26.06 BARGAIN SALE TO CHARITY . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399

§ 26.07 SUBSTANTIATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

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Chapter 27 LIMITATIONS ON DEDUCTIONS . . . . . . . . . . . . . . . . 403

§ 27.01 SECTION 267: LOSSES BETWEEN RELATED PARTIES . . . . . . . . . 403

[A] Section 267(a)(1) Loss Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403

[B] The Section 267(a)(2) Matching Requirement . . . . . . . . . . . . . . . . . . 407

[C] Other Matching Rules — Section 404(a)(5) and Section 83 . . . . . . . . . 408

§ 27.02 SECTION 265: EXPENSES RELATED TO TAX-EXEMPT INCOME . 410

[A] Section 265(a)(1) General Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . 410

[B] Section 265(a)(2): Tax-Exempt Interest . . . . . . . . . . . . . . . . . . . . . . . 412

[C] Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414

§ 27.03 SECTION 1091: WASH SALES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414

§ 27.04 JUDICIAL LIMITATIONS ON INTEREST DEDUCTIONS . . . . . . . . . 416

Chapter 28 CASH METHOD ACCOUNTING . . . . . . . . . . . . . . . . . . 421

§ 28.01 INCOME UNDER THE CASH METHOD . . . . . . . . . . . . . . . . . . . . . . 421

[A] In General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 421

[B] Constructive Receipt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422

[1] Specific Factors Affecting Application of Constructive Receipt

Doctrine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 423

[a] Distance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 423

[b] Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425

[c] Contractual Arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425

[d] Forfeitures or Other Penalties . . . . . . . . . . . . . . . . . . . . . . . . . . 425

[e] Relationship of the Taxpayer to the Payor . . . . . . . . . . . . . . . . . . 426

[2] Specific Exceptions to Constructive Receipt Rules . . . . . . . . . . . . . 427

[C] Cash Equivalency Doctrine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 428

[D] Economic Benefit Doctrine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431

[E] Non-Qualified Deferred Compensation Arrangements . . . . . . . . . . . . 434

[F] Section 409A and Revenue Ruling 60-31 . . . . . . . . . . . . . . . . . . . . . 436

[G] Lottery Prizes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437

[H] Prepayments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 438

§ 28.02 DEDUCTIONS UNDER THE CASH METHOD . . . . . . . . . . . . . . . . . 438

[A] In General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 438

[B] Cash Method Prepayments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 441

Chapter 29 ACCRUAL METHOD ACCOUNTING . . . . . . . . . . . . . . 445

§ 29.01 THE ALL EVENTS TEST . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 445

§ 29.02 ACCRUAL OF INCOME . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 446

[A] General Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 446

[B] Income Prior to Receipt: Accrual Issues . . . . . . . . . . . . . . . . . . . . . . 447

[C] Receipt Prior to Earning: Prepayments . . . . . . . . . . . . . . . . . . . . . . . 450

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§ 29.03 DEDUCTIONS UNDER THE ACCRUAL METHOD . . . . . . . . . . . . . 454

[A] General Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 454

[B] Premature Accruals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 456

[C] The Economic Performance Test: Section 461(h) . . . . . . . . . . . . . . . . 457

[D] The Recurring Item Exception and the 3½ Month Exception

to the Economic Performance Test . . . . . . . . . . . . . . . . . . . . . . . . . . 460

[E] Safe Harbor Method of Accounting for Ratable Service Contracts . . . . 462

[F] Capitalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 464

[G] Contested Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 464

§ 29.04 CHOICE OF ACCOUNTING METHODS . . . . . . . . . . . . . . . . . . . . . . 466

Chapter 30 ANNUAL ACCOUNTING . . . . . . . . . . . . . . . . . . . . . . . . 469

§ 30.01 RESTORING AMOUNTS RECEIVED UNDER

A CLAIM OF RIGHT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469

[A] Appearance of a Right . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 472

[B] No Unrestricted Right . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473

§ 30.02 THE TAX BENEFIT RULE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474

[A] The “Fundamental Inconsistency” Test . . . . . . . . . . . . . . . . . . . . . . . 477

[B] Erroneous Original Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 478

§ 30.03 NET OPERATING LOSSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 479

Chapter 31 CAPITAL GAINS AND LOSSES . . . . . . . . . . . . . . . . . . . 483

§ 31.01 HISTORICAL OVERVIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 483

[A] Preferential Treatment for Long-Term Capital Gain . . . . . . . . . . . . . . 484

[B] Limitation on the Deduction of Capital Losses . . . . . . . . . . . . . . . . . . 487

[C] Justification for Preferential Capital Gain Treatment . . . . . . . . . . . . . . 488

§ 31.02 CURRENT LAW: SECTION 1(h) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489

[A] Maximum Rates on Long-term Capital Gain under the Current Law . . 489

[B] The Components of Net Capital Gain: 28-Percent Rate Gain;

Unrecaptured Section 1250 Gain; and Adjusted Net Capital Gain . . . . 491

[1] 28-Percent Rate Gain: Collectibles Gain and Section 1202 Gain . . . . 492

[2] Unrecaptured Section 1250 Gain — 25% Rate . . . . . . . . . . . . . . . . 493

[3] Adjusted Net Capital Gain: 20%, 15% and 0% Rates . . . . . . . . . . . . 493

[4] Adjusted Net Capital Gain: Qualified Dividend Income . . . . . . . . . . 495

[C] Attribution of Capital Losses Included in the Computation of

Net Capital Gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497

§ 31.03 THE SECTION 1211(b) LIMITATION ON THE

DEDUCTION OF CAPITAL LOSSES . . . . . . . . . . . . . . . . . . . . . . . . 499

§ 31.04 DEFINITION OF CAPITAL ASSET . . . . . . . . . . . . . . . . . . . . . . . . . . 503

[A] Section 1221(a)(1): Inventory, Stock in Trade and Property Held

Primarily for Sale to Customers in the Ordinary Course of the

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Taxpayer’s Trade or Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505

[B] Section 1221(a)(2): Property Used in the Taxpayer’s

Trade or Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507

[C] Section 1221(a)(3): Copyrights, Literary, Musical, or

Artistic Compositions, Etc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507

[D] Section 1221(a)(4): Accounts Receivable for Services Rendered or

Inventory-Type Assets Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508

[E] Section 1221(a)(5): Certain Publications of the U.S. Government . . . . 508

[F] Section 1221(a)(8): Supplies Used or Consumed in the

Taxpayer’s Trade or Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509

[G] Judicially Established Limits on Capital Asset Definition . . . . . . . . . . 509

§ 31.05 THE SALE OR EXCHANGE REQUIREMENT . . . . . . . . . . . . . . . . . . 513

§ 31.06 THE ARROWSMITH RULE: CHARACTERIZATION OF CERTAIN

GAINS OR LOSSES DEPENDENT ON PRIOR TAX TREATMENT

OF RELATED GAINS OR LOSSES . . . . . . . . . . . . . . . . . . . . . . . . . . 515

§ 31.07 HOLDING PERIOD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516

Chapter 32 QUASI-CAPITAL ASSETS: SECTION 1231 . . . . . . . . . . 519

§ 32.01 IDENTIFYING SECTION 1231 GAINS AND LOSSES . . . . . . . . . . . . 519

§ 32.02 THE HOTCHPOT ANALYSIS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523

§ 32.03 RECAPTURE OF NET ORDINARY LOSSES: SECTION 1231(c) . . . . 526

Chapter 33 DEPRECIATION RECAPTURE . . . . . . . . . . . . . . . . . . . 529

§ 33.01 SECTION 1245 RECAPTURE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 530

§ 33.02 SECTION 179 RECAPTURE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 534

§ 33.03 SECTION 1250 RECAPTURE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535

§ 33.04 UNRECAPTURED SECTION 1250 GAIN . . . . . . . . . . . . . . . . . . . . . 537

§ 33.05 SECTION 1239 ORDINARY INCOME . . . . . . . . . . . . . . . . . . . . . . . 539

§ 33.06 OTHER RECAPTURE PROVISIONS . . . . . . . . . . . . . . . . . . . . . . . . . 541

Chapter 34 ASSIGNMENT OF INCOME . . . . . . . . . . . . . . . . . . . . . 543

§ 34.01 THE PROGRESSIVE RATE STRUCTURE . . . . . . . . . . . . . . . . . . . . 543

§ 34.02 DEVELOPMENT OF RULES LIMITING INCOME-SHIFTING . . . . . . 544

§ 34.03 COMMUNITY PROPERTY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 546

§ 34.04 APPLICATION OF THE ASSIGNMENT OF INCOME RULES . . . . . . 547

§ 34.05 THE KIDDIE TAX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 551

Chapter 35 BELOW-MARKET LOANS . . . . . . . . . . . . . . . . . . . . . . 559

§ 35.01 HISTORY: PRE-SECTION 7872 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 559

[A] Early IRS Attempts at Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 559

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[B] Gift Tax Consequences of Interest-Free Loans . . . . . . . . . . . . . . . . . . 561

[C] Post Dean/Johnson History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 561

§ 35.02 RATIONALE FOR SECTION 7872 . . . . . . . . . . . . . . . . . . . . . . . . . . 563

§ 35.03 OPERATION OF SECTION 7872 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 564

[A] Treatment of Term Loans Other Than Term Gift Loans . . . . . . . . . . . 566

[B] Demand Loans and Term Gift Loans . . . . . . . . . . . . . . . . . . . . . . . . 568

[C] Exceptions to the Basic Operating Rules . . . . . . . . . . . . . . . . . . . . . . 570

Chapter 36 TAX CONSEQUENCES OF DIVORCE . . . . . . . . . . . . . 573

§ 36.01 ALIMONY: GENERAL REQUIREMENTS . . . . . . . . . . . . . . . . . . . . 573

§ 36.02 CHILD SUPPORT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 578

§ 36.03 EXCESS FRONT-LOADING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 581

§ 36.04 ALIMONY TRUSTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 586

§ 36.05 DEPENDENCY EXEMPTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 586

§ 36.06 FILING STATUS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 591

§ 36.07 PROPERTY TRANSFERS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 592

§ 36.08 SPECIAL RULES REGARDING PERSONAL RESIDENCE —

SECTION 121 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 597

§ 36.09 LEGAL EXPENSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 599

Chapter 37 EFFECT OF DEBT ON BASIS AND

AMOUNT REALIZED . . . . . . . . . . . . . . . . . . . . . . . . . . 601

§ 37.01 CRANE v. COMMISSIONER . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 601

§ 37.02 COMMISSIONER v. TUFTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 602

§ 37.03 NONRECOURSE BORROWING AND THE SECTION 108

INSOLVENCY EXCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 606

§ 37.04 NONRECOURSE BORROWING AND APPRECIATED PROPERTY . 608

§ 37.05 IMPACT OF CONTINGENT LIABILITIES . . . . . . . . . . . . . . . . . . . . 610

Chapter 38 LIKE-KIND EXCHANGES . . . . . . . . . . . . . . . . . . . . . . . 613

§ 38.01 CONTINUITY OF INTEREST . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 614

§ 38.02 THE LIKE-KIND REQUIREMENT . . . . . . . . . . . . . . . . . . . . . . . . . . 615

§ 38.03 THE HOLDING REQUIREMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . 618

§ 38.04 “SOLELY” FOR LIKE KIND PROPERTY: THE PRESENCE

OF “BOOT” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 622

§ 38.05 TREATMENT OF LIABILITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . 623

§ 38.06 BASIS CALCULATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 624

§ 38.07 THE RELATIONSHIP BETWEEN § 267(a)(1) AND § 1031 . . . . . . . . 630

§ 38.08 SALE OR EXCHANGE? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 630

§ 38.09 THREE-WAY EXCHANGES AND DEFERRED EXCHANGES . . . . . 632

§ 38.10 REVERSE STARKER EXCHANGES . . . . . . . . . . . . . . . . . . . . . . . . . 635

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§ 38.11 EXCHANGES QUALIFYING FOR BOTH § 121 AND § 1031 . . . . . . . 636

§ 38.12 SECTION 121(d)(10) — PROPERTY ACQUIRED IN A

LIKE-KIND EXCHANGE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 638

Chapter 39 INVOLUNTARY CONVERSIONS . . . . . . . . . . . . . . . . . 641

§ 39.01 GENERAL POLICY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 641

§ 39.02 THE MANDATORY AND ELECTIVE RULES OF SECTION 1033 . . . 642

§ 39.03 INVOLUNTARY CONVERSION EVENTS . . . . . . . . . . . . . . . . . . . . 643

§ 39.04 SIMILAR OR RELATED IN SERVICE OR USE . . . . . . . . . . . . . . . . . 644

[A] Special Rule for Condemnation of Real Property Used

for Business or Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 647

[B] Federally Declared Disasters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 650

§ 39.05 TIME FOR REPLACEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 653

§ 39.06 PARTIAL RECOGNITION OF GAIN UNDER SECTION 1033 . . . . . . 654

§ 39.07 BASIS OF REPLACEMENT PROPERTY . . . . . . . . . . . . . . . . . . . . . . 654

§ 39.08 HOLDING PERIOD OF REPLACEMENT PROPERTY . . . . . . . . . . . . 656

§ 39.09 INVOLUNTARY CONVERSION OF PRINCIPAL RESIDENCE . . . . . 656

Chapter 40 INSTALLMENT SALES . . . . . . . . . . . . . . . . . . . . . . . . . 659

§ 40.01 STATUTORY FRAMEWORK . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 659

§ 40.02 PAYMENTS AND LIABILITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . 661

§ 40.03 RECAPTURE INCOME . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 664

§ 40.04 ELECTING OUT OF THE INSTALLMENT METHOD . . . . . . . . . . . . 665

§ 40.05 EXCLUSIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 665

§ 40.06 CONTINGENT PAYMENT SALES . . . . . . . . . . . . . . . . . . . . . . . . . . 666

§ 40.07 DISPOSITIONS OF INSTALLMENT OBLIGATIONS . . . . . . . . . . . . 668

§ 40.08 SECOND DISPOSITIONS BY RELATED PERSONS . . . . . . . . . . . . . 670

§ 40.09 SALES OF DEPRECIABLE PROPERTY TO RELATED PERSONS . . 674

§ 40.10 SPECIAL RULES FOR NONDEALERS . . . . . . . . . . . . . . . . . . . . . . . 674

§ 40.11 INSTALLMENT OBLIGATIONS AND LIKE-KIND EXCHANGES . . 676

Chapter 41 SALE OF A BUSINESS AND SALE-LEASEBACKS . . . . 679

§ 41.01 SALE OF A SOLE PROPRIETORSHIP . . . . . . . . . . . . . . . . . . . . . . . 679

[A] The Standard of Williams v. McGowan . . . . . . . . . . . . . . . . . . . . . . 679

[B] Goodwill, Going Concern Value and Covenants Not to Compete . . . . . 680

[1] Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 680

[2] Going Concern Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 681

[3] Covenant Not to Compete . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 681

[C] Tax Consequences of Allocation of Purchase Price . . . . . . . . . . . . . . 682

[1] Historic Allocation Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . 682

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[2] Section 197 — Amortization of Business Intangibles . . . . . . . . . . . 683

§ 41.02 VALUING GOODWILL, GOING CONCERN VALUE,

AND COVENANTS NOT TO COMPETE . . . . . . . . . . . . . . . . . . . . . . 687

§ 41.03 SALE-LEASEBACK . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 692

[A] Sale-Leaseback Characterized as Financing Arrangement . . . . . . . . . . 693

[B] Sale-Leaseback Characterized as a Tax-Free Exchange . . . . . . . . . . . . 694

Chapter 42 AN INTRODUCTION TO ORIGINAL

ISSUE DISCOUNT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 697

§ 42.01 ORIGINAL ISSUE DISCOUNT: INTRODUCTION . . . . . . . . . . . . . . 697

§ 42.02 OID: DEBT INSTRUMENTS ISSUED FOR CASH . . . . . . . . . . . . . . . 700

[A] Determining the Amount of OID . . . . . . . . . . . . . . . . . . . . . . . . . . . 703

[B] Current Inclusion of OID . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 704

[C] Deduction of OID . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 706

[D] Gain or Loss on Sale, Exchange or Retirement . . . . . . . . . . . . . . . . . . 706

[E] Market Discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 708

§ 42.03 SALES AND EXCHANGES OF PROPERTY AND

SECTION 467 RENTAL AGREEMENTS . . . . . . . . . . . . . . . . . . . . . . 708

Chapter 43 LIMITATIONS ON TAX SHELTERS . . . . . . . . . . . . . . . 711

§ 43.01 THE AT RISK RULES — SECTION 465 . . . . . . . . . . . . . . . . . . . . . . 711

[A] General Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 711

[B] Operation of the at Risk Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 712

[1] Activities Subject to the at Risk Rules . . . . . . . . . . . . . . . . . . . . . . 714

[2] Determination of the Initial Amount at Risk . . . . . . . . . . . . . . . . . . 714

[3] Qualified Nonrecourse Financing . . . . . . . . . . . . . . . . . . . . . . . . . 715

[4] Adjustments to the Amount at Risk . . . . . . . . . . . . . . . . . . . . . . . . 715

§ 43.02 SECTION 469 — LIMITATION ON PASSIVE ACTIVITY

LOSSES AND CREDITS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 718

[A] Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 718

[B] Section 469 — In General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720

[C] Passive Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 721

[1] Material Participation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 722

[2] Rental Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 723

[D] Scope of Passive Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 724

[E] Treatment of Losses and Credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . 725

[F] Portfolio Income and Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 726

[G] Exception for Active Participation in Rental Real Estate . . . . . . . . . . . 727

[H] Disposition of Taxpayer’s Entire Interest in Passive Activity . . . . . . . . 728

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Chapter 44 THE ALTERNATIVE MINIMUM TAX . . . . . . . . . . . . . 731

§ 44.01 MECHANICS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 731

§ 44.02 DETERMINING ALTERNATIVE MINIMUM TAXABLE INCOME . . 735

[A] Section 56 and 58 Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . 737

[1] Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 737

[2] Limitation on Itemized Deductions, Standard Deductions

and Personal Exemptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 737

[B] Section 57 Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 739

§ 44.03 DETERMINING TAX LIABILITY . . . . . . . . . . . . . . . . . . . . . . . . . . . 740

§ 44.04 CREDITS ALLOWED . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 741

Appendix A NOTE ON MISCELLANEOUS EXCLUSIONS . . . . . . . . 743

Appendix B ADDITIONAL ACCOUNTING CONSIDERATIONS . . . 749

TABLE OF CASES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TC-1

TABLE OF STATUTES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TS-1

TABLE OF AGENCY DECISIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TA-1

INDEX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . I-1

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