CHAPTER 10 – ADJUSTED BASIS / PROPERTY ACQUISITIONS & COST RECOVERY:

PROPERTY ACQUISIITONS:

1. Introduction:
a. If a taxpayer purchases or otherwise acquires an asset that has a life extending beyond the current year,
that asset must be capitalized rather than expensed. Taxpayers must keep track of their asset investment
because of the capital recovery doctrine. The exception is cost of de minimums:
b. Cost of de minimis purchases can be deducted immediately:
i. If a taxpayer maintains applicable financial statements (“AFS”) and has a policy to deduct any item
less than $5,000 for financial reporting, can follow the same policy for tax.
ii. If no AFS is maintained, then the threshold is reduced to $2,500. Once a cost exceeds the
threshold it must be capitalized and is subject to cost recovery.
c. A taxpayer is entitled to recover the amount invested in an asset before the taxpayer realizes any income
from the sale or other disposition of the asset, under the capital recovery doctrine.
d. Capital invested in an asset may be recovered in one of two ways:
i. 1) annual depreciation (tangible property), amortization (intangible property), or depletion
deductions (natural resources). Chapter 10
ii. 2) basis offset against amounts realized when the taxpayer disposes of an asset. Ch 11
e. “Basis” is the tax system’s way of keeping track of a taxpayer’s investment in property. “Adjusted basis” is
analogous to “net book value” for GAAP purposes.
2. Property Defined: Property is any asset owned or possessed by a taxpayer. Property is classified by use and
type.
a. Use – used in business, for production of income, personally (PERSONALLY IS NOT ENTITLES TO
DEPRECIATION DEDUCTION), or as a mixed-use asset (ex – duplex, rent/ live).
b. Type – property is intangible OR tangible:
i. Intangible – lacks physical existence. (goodwill, patents, copyrights, trademarks)
ii. Tangible – has physical existence. Tangible can be:
1. Real (real or real estate) property such as land, buildings, and improvements OR
Personal property such as moveable property that isn’t affixed to land or buildings.
(machinery, equipment, furniture)
3. Adjusted basis (AB) of property (generally)
a. The starting point in calculating adjusted basis is to calculate the original investment in an asset. (All costs
incurred up to the date the asset is placed in service are capitalized to the initial basis of the asset.) The
original investment in an asset by a purchaser may include the following:
i. + Cash and fair market value (FMV) of property given
+ FMV of services provided to acquire property
+ Increase in taxpayer’s liabilities related to the purchase
+ Other costs of acquiring property (commissions, legal fees, testing costs, etc.)
b. Once the original investment in property is calculated, the initial basis in the asset may be increased
by the following:
i. + Additional capital invested (i.e. betterments, restorations, or new or different uses).
+ Costs of protecting ownership (i.e. costs to defend title)
+ Special real property tax assessments

EXAMPLE 1 – Carlson, Inc. purchased a new machine to assist in manufacturing furniture. The invoice price of the
machine was $10,000. Carlson, Inc. also paid $500 to ship the machine to its factory and $1,000 to calibrate and test
it. Once calibrated and tested, Carlson, Inc. placed the machine in service on January 31, 2024. The machine is subject
to annual routine maintenance and recalibration, which Carlson, Inc. paid $700 on December 13, 2024. What is the
initial basis of the machine?

Invoice Price 10,000

Shipping 500
Initial Calibration 1,000
Initial Basis 11,500
$700 annual maintenance and calibration is deducted as incurred as routine maintenance under Reg §1.263(a)-3(i)
 c. The following items decrease a taxpayer’s adjusted basis in property:
i. Cost recovery (depreciation, amortization, and depletion)
ii. Other receivables (such as casualty losses)
4. Calculating initial adjusted basis in special circumstances:
a. Basis of assets purchased form a business (basket purchase) : the purchase price is allocated among assets
based on the FMV of the assets purchased.
i. If purchase price > FMV of asset, the excess is deemed to be paid for goodwill
ii. If purchase price < FMV of asset, the purchase price is allocated amongst the assets in proportion
to assets FMV

EXAMPLE 2 – Basis of assets purchased (Excel sheet) NewCo purchased all the assets of OldCo for $1,000,000 on April
11, 2024. The FMV of the assets purchased is as follows:

What basis does NewCo take in the assets purchased?

Purchase Price 1,000,000

Inventory 50,000
A/R 100,000
Equipment 250,000
Land 150,000
Patent 75,000
Assignable FMV 625,000
Goodwill 375,000

Assets are assigned basis = FMV at purchase. Excess FMV is goodwill. If

the purchase price is less than the total FMV, assets are allocated cost in proportion to FMV

b. Basis of property acquired by gift:

i. General rule: Basis of the property received by the donee as a gift is = to the donor's basis.
(Carryover basis). Any gift tax paid by the donor on the net appreciation on the property gifted is
added to the donee's basis.
ii. Exception - Split (or dual) basis rule for loss property :
1. If donor’s basis on the date of the gift > FMV of property, then the donee's basis for gain
purposes is still the donor's basis.
a. But the donee's basis for loss purposes is the FMV on the date of the gift.
2. If the donee later sells the gifted property for a price between the gain basis and loss basis,
the donee does not recognize gain or loss.
iii. Holding period of gifted property:
1. If donee is using carryover basis from donor, holding period of the donor tacks on to the
holding period of the donee (donee’s holding period includes donor’s holding period)
2. If FMV on date of the gift is used (loss basis), the holding period begins on the date of the
gift
c. Basis of property acquired by inheritance: basis of any property received from a decedent is stepped up (or
down) to the FMV of the property on the date of decedent’s death. The holding period for all inherited
property if long term.
d. Basis of property converted from personal use to business use :
i. If the FMV of property converted is > taxpayer’s adjusted basis, the basis for converted purposes
is a carryover basis.
ii. If the FMV of the property converted is < taxpayer’s adjusted basis, the basis is the lesser of the
FMV or adjusted basis at conversion
EXAMPLE 3 – Conversion of personal to business use property: Charles was relocated from Minneapolis to San Diego
for work. Instead of selling his house in Minneapolis, he decided to convert to a rental property. At the date of
conversion, the FMV of his house was $275,000. Charles originally purchased the property for $225,000. What basis
does Charles use to compute depreciation on his new rental property?

Carryover Basis = $225,000

What if the FMV of the house was $200,000 at the date of conversion?
Basis = $200,000
Converted property = lesser of FMV or Basis at the date of conversion

COST RECOVERY DEDUCTIONS:

1. Introduction: Cost recovery is the process used to allocate the capitalized cost of an asset over the
accounting periods the asset produces income. Cost recovery shows up as depreciation for tangible property,
amortization for intangible property, and depletion for natural resources.
a. From tax planning perspective: cost recovery elections and methods provide an opportunity for
profitable businesses to accelerate cost recovery deductions to generate more tax savings early,
increasing the PV of tax savings and lowering the after-tax cost of assets
b. Financial accounting and tax accounting treat cost recovery on tangible assets (depreciation) very
differently. These create temporary book/ tax differences and lead to deferred tax liabilities because of
the accelerated nature of tax depreciation:
i. Financial accounting – when business asset is acquired, useful life and salvage value is
determined and depreciation expense if often calculated using the straight-line method.
ii. Tax accounting – accelerate cost recovery deductions using the MACRS to calculate cost recovery
on tangible property. The straight-line method is used to calculate cost recovery on intangible
property.
c. For cost recovery to be taken on an asset, it must be used in a trade or business or for the production of
income. (LAND IS NEVER DEPRECIABLE). Cost recovery must be deducted in the year it is allowable, the
tax basis of the property is still reduced.
2. Cost recovery for tangible property
a. Introduction – to depreciate an asset for tax purposes you must determine the:
i. Depreciation method – MARCS, ADS, SL
ii. Class life (recovery period); and
iii. Convention
b. Depreciation Methods
i. MACRS (Modified Accelerated Cost Recovery System). Uses 200% declining balance (DDB) for
tangible personal property, and straight-line method for real property.
ii. Other tax depreciation methods:
1. Accelerated cost recovery system (ARCS) used for assets placed in service between 1980-
1987.
2. Alternative depreciation system (ADS) is an election a taxpayer can make. The ADS uses
150% declining balance and longer recovery periods. The ADS must be used for
alternative minimum tax purposes (AMT).
c. Class Life (Recovery Period): Class life is assigned by IRS and is used to determine the applicable
recovery period. SEE THE HANDOUT FOR CHAPTER 10 FOR SUMMARY OF RECOVERY PERIODS.

EXAMPLE 5 : NewCo purchased and placed in service the following assets in 2024:

NewCo elected out of bonus depreciation and did not elect §179 expensing.
Compute the first-year and second-year cost recovery on the above assets
 d. Convention: 3 possible convention methods:
i. 1. Half-year (aka mid-year) convention: used mostly for tangible personal property. his
convention assumes that all property is placed in service and disposed of in the middle of the tax
year.
1. Table 1 in Appendix A, which begins on page 10-40 of the text has the half- year MACRS
depreciation table for tangible personal property with class lives of 5 to 20 years. See also
the Handout for Chapter 10.
ii. 2. Mid-quarter convention: used for tangible personal property if over 40% of the assets
purchased during the year are placed in service during the last three months of the
tax year. This convention assumes that all property is placed in service and disposed of in the
middle of the quarter in which the property was acquired or disposed of.
1. Table 2a through Table 2d in Appendix A, beginning on page 10-40 of the text, has the
mid-quarter MACRS depreciation tables for tangible personal property with class lives of 5
and 7 years. See also the Handout for Chapter 10

EXAMPLE 6- NewCo placed in-service general manufacturing equipment in July 7, 2021. The original cost of the
equipment was $100,000, and NewCo did not elect §179 and elected out of bonus depreciation. NewCo sold the
general manufacturing equipment on September 9, 2024. What cost recovery can NewCo deduct in 2024 assuming
the general manufacturing equipment is on the half-year convention?

2021 => 2022 => 2023 => 2024

YR1 YR2 YR3 YR4
$100,000 × 12.49% × ½ = $6,245
In the year of sale, under the half-year convention, the asset is deemed sold in the middle of the year. Hence, ½ the
fourth-year depreciation.
What if the general manufacturing equipment is on the mid-quarter convention?
$100,000 × 13.02% × (2.5 ÷ 4) = $8,138
Purchased in July – purchased in Q3 – Use Q3 MQ Tables
Sold Sept. 9th - Deemed sold in the middle of Q3

iii. 3. Mid-month convention: used for all real property. This convention assumes that all property
is placed in service and disposed of in the middle of the month in which the property was
acquired or disposed of.
1. Table 3 on page 10-42 of the text is the mid-month MACRS depreciation table for
residential rental real estate. Table 5 on page 10-43 of the text is the mid-month MACRS
depreciation tables for nonresidential real estate placed in service after May 12, 1993.
See also the Handout for Chapter 10

EXAMPLE 4 – Conventions: ABC, Inc. purchased and placed in service $50,000 of office furniture on August 17, 2024.
No other personal property was placed in service in 2024. ABC, Inc. elects out of bonus depreciation and does not
elect §179. What is the first-year cost recovery, assuming no other assets were placed in service in 2024?

Method = MACRS
Life = 7
Convention = Half-year
$50,000 * 14.29% = $7,145 first-year cost recovery deduction
What is the second-year cost recovery on the office furniture, and what is its adjusted basis at the end 2024?
$50,000 * 24.49% = 12,245 second-year cost recovery deduction
$50,000 - $7,145 - $12,245 = $30,610 Adjusted Basis

e. Using the tables - Once the depreciation method, recovery period, and convention are known, the
depreciable basis (initial basis - Section 179 election - additional first- year bonus depreciation taken)
is multiplied by the factor in the appropriate recovery year row and recovery period column.
i. This amount is the current year’s regular tax depreciation expense for that asset. In the
succeeding tax year, the depreciable basis is multiplied by the second-year factor. This
calculation is made annually until the asset is disposed of or fully depreciated.
f. Section 179 Election – taxpayers elect (PG 5). Taxpayers may elect to immediately expense (Max
$1,220,000) instead of depreciate certain property acquired for use in a trade or business.
i. To elect 179 on an asset purchase:
1. Property must be used in trade or business
2. Must be purchased property
3. Must be tangible personal property
ii. maximum amount a taxpayer can elect to expense under Section 179 is $1,220,000. The limit
applies to individuals, C corporations, S corporations and partnerships

EXAMPLE 7 - NewCo purchased and placed in service the following assets in 2024:

NewCo elected out of bonus depreciation and elected179

expensing. Compute the first-year cost recovery on the above assets.

iii. maximum 179 amount is $1,200,000 is PHASED OUT on a dollar-for-dollar basis when the
tangible personal property placed in service by the taxpayer exceeds $3,050,000.
1. if a taxpayer purchases more than $4,270,000 ($3,050,000 + $1,220,000) of tangible
personal property during the 2024 tax year, no Section 179 election is allowed.
iv. 179 election is limited to active business income before taking 179 election into account
v. Calculation of depreciable basis when 179 is elected:
1. If 179 is elected on an asset, the taxpayer reduces the taxpayer’s basis in the asset by
the amount of Section 179 election.
a. Ex – a taxpayer purchased specialized equipment in 2024 for $1,420,000 and
elected Section 179 of $1,200,000 on that equipment, the taxpayer’s depreciable
basis in equipment for MARCS would be $200,000 (1,360,000-1,160,000). MARCS
depreciation would then be calculated on the depreciable basis of specialized
equipment.
i. So, if asset had a 7-year recovery period and the HY convention was used,
the taxpayer deducts $28,580 (200,000 * 0.1429) of MARDS depreciation in
addition to $1,248,580. In 2025 taxpayer would deduct $48,980 of MARCS
depreciation ($200,000 * 0.2449) ….

EXAMPLE 8 - NewCo purchased and placed in service the following assets in 2024:
 NewCo elected out of bonus depreciation and elects
§179 expensing. Compute the first-year cost recovery on the above assets:

g. Additional first-year bonus depreciation on tangible personable property (non-100% bonus

years) – taxpayers may claim additional first-year 60% bonus depreciation on assets placed in service
after 12/31/2023 and before Jan 1,2025. Bonus depreciation is phased out until after 2026, when no
bonus depreciation is allowed.
i. To qualify for bonus depreciation, tangible personal property must be purchased for use in a
trade or business or to produce income. (Bonus depreciation only applies to tangible personal
property with cost recovery period of 20 year or less.)
1. BONUS DEPRECIATION DOES NOT APPLY TO REALTY
ii. Assets in service before Sep 27,2017, only NEW tangible personal property purchased by the
taxpayer qualifies for additional first-year bonus deprecation. Assets placed in service after
September 27, 2017, both new and used tangible personal property qualifies for additional first-
year depreciation.
iii. Taxpayer who purchases property for additional first-year bonus depreciation must claim it
unless an election is made not to claim it for the tax year. n other words, the additional first-year
bonus depreciation is required unless the taxpayer elects out of it. The election not to claim
additional first-year bonus depreciation is made for each class of property (3-year, 5-year, 7-year
property).
iv. There is no purchase limit on qualifying property, nor is there an active business income limit for
additional first-year bonus depreciation

EXAMPLE 9 - Same facts as example 7, but NewCo does not elect out of bonus depreciation in 2024. Compute the first
year cost recovery

3. Amortization of intangible assets:

a. Intangible assets acquired in connection with the purchase of a business (197)
i. Taxpayer amortizes the intangible assets over 15 years using the straight-line method beginning
in the month the intangible asset is acquired. The 15-year period is used regardless of the actual
useful life of the intangible asset purchased. Amortization uses the full-month convention,
 where the entire month of amortization is allowed in the month the intangible asset is placed in
service.
ii. 197 intangible assets include purchased goodwill, customer lists, patents, copyrights, licenses or
permits issues by the government, and covenants not to compete
iii. Note – patents and copyrights acquired separately by taxpayers are amortized over their legal
life.

EXAMPLE 10 - Assume the same facts in Example 2. What is the NewCo’s amortization deduction on the patent and
goodwill in 2024? In 2025?

b. Start-up Costs – costs related to starting a new business entity

i. Include: market surveys and analytics; travel to investigate locations; advertising; training
salaries; operating expenses incurred by the taxpayer before the taxpayer begins to produce any
gross income.
ii. Tax treatment of start-up expenses depends on the taxpayer and whether the business was
acquired:
1. if the taxpayer is not currently in the trade or business and does not acquire the trade or
business being investigated, the expenses are not deductible
2. If the taxpayer is currently in the trade or business, it doesn’t matter whether the trade or
business being investigated is acquired. The start-up costs are deductible in full as trade
or business expenses
3. If the taxpayer is not currently in the trade or business and does acquire the trade or
business being investigated, the taxpayer may elect to immediately deduct up to $5,000
of start-up expenses in the year in which the trade or business begins. The $5,000
amount is reduced (but not below zero) by the amount by which the cumulative cost of
start-up expenses exceeds $50,000. Amounts not immediately expensed are amortized
over 15 years (180 months).
c. Organizational Costs – costs incurred to organize a corporation. These expenditures create an
intangible asset (the corporation) that lasts for the life of the entity:
i. Includes: legal fees for drafting organizational documents; necessary accounting services; filing
fees paid to the state of incorporation; expenses of organizational meetings
1. Note – stock issuance costs are non-deductible as organizational expenses and are
capitalized to deduct in final year return for the organization
ii. Tax treatment is like start-up costs. A corporation may elect to immediately deduct up to $5,000
of
organizational expenses in the year in which the trade or business begins. The $5,000 amount is
reduced (but not below zero) by the amount by which the cumulative cost of organizational
expenses exceeds $50,000. Amounts not immediately expensed are amortized over 15 years
(180 months)
iii. Note – sole proprietorships cannot deduct organizational expenses since no legal entity is
deemed to exist for tax purposes.
EXAMPLE 11 - Carlson Co. was formed on June 12, 2024, and incurred $4,000 in legal and accounting fees to organize
the company. How much of the organizational costs can be deducted in 2024?
All $4,000 deductible in 2024 < $5,000
What if Carlson incurred $30,000 in organizational costs?

What if Carlson incurred $53,000 in organization costs?

CHAPTER 11 – PROPERTY DISPOSITIONS:

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1. Introduction:
a. Taxes are paid on gains from a property disposition reduce the taxpayer’s after-tax cash flow. Taxes
saved because of deducting a loss on a property disposition increase the taxpayer’s after-tax cash flow.
b. To plan for asset disposition, consider how the asset is categorized, the timing of disposition, how any
gain is classified, and what tax rate the taxpayer will pay on any gain. If the disposition results in a loss,
the taxpayer must consider whether the loss will be deductible and what savings the loss deduction will
generate.
c. Property dispositions may be taxable transactions or take the form of tax-deferred exchanges.
2. Calculation of realized and recognized gain: To calculate the realized and recognized gain on a property
disposition, the taxpayer first determines the total amount realized, the subtracts out adjusted basis in the
property disposition, the realized gain = recognized gain.

a.
 b. The realized gain or loss will be recognized by the taxpayer unless the property disposition is a tax-
deferred exchange or excludible.
c. Accelerated depreciation used for tax purposes creates book/tax timing differences, which will reverse
when business property is sold in a taxable disposition. The taxable disposition of property on which
accelerated depreciation has been taken will result in a tax gain higher than book gain, which will
reduce the deferred tax liability on the balance sheet.
3. Adjusted Basis (Special Issues): = Initial basis – Accumulated cost recovery (depreciation, amortization,
depletion)
a. Basis of property acquired by gift:
i. General Rule – basis of property received by done as a gift from the donor is = to donor’s basis.
This is known as “carryover” basis.
ii. Exception: Split (dual) basis rule on loss property – Dual basis rules only exist when FMV <
Basis at date of gift. If the donor’s basis on the date of the gift > FMV, the donees basis for
gain purposes is still the donor’s basis. BUT the donees basis for loss purposes for a price
between the gain basis and loss basis, the done does not recognize gain or loss.
iii. Holding period of gifted property - If the donee is using a carryover basis from the donor, the
holding period of the donor tacks on to the holding period of the donee. (The donee's holding
period includes the donor's holding period.) If FMV on the date of the gift is used (loss basis), the
holding period begins on the date of the gift.

EXAMPLE 1: Sano, Inc. sold a building in 2024 that it originally purchased for $1,000,000 and had depreciated
$400,000. The building was subject to a mortgage with a remaining balance of $500,000. In exchange, Sano, Inc.
received $ 750,000 in cash, and the buyer assumed the remaining mortgage. Sano, Inc. also paid $30,000 in real
estate agent commissions. Compute the gain or loss realized and recognized by Sano, Inc

- Recognized Gan = 620,000

EXAMPLE 2: Gifted property (dual basis rules)

Erin gifted Britta stock on January 1, 2019. At the date of the gift, the stock had an FMV of $1,000 and a basis of
$1,200. If Britta sells the stock at $1,400, what is her basis to compute her gain or loss?

- Gain basis: 1,400 sales price – 1,200 bases = 200 recognized gains

What if she sold the stock for $700?

- Loss Basis: 700 sales price - $1,000 FMV basis = ($300) loss

What if she sold the stock for $1,100?

- No gain or loss
b. Basis of Property acquired by inheritance: the basis of any property received from a decedent is
stepped up (or down) to the fair market value of the property on the date of the decedent’s death. The
holding period for all inherited property is long term.
c. Basis of property converted from personal use to business use: if the FMV of property converted
is greater than the taxpayer's adjusted basis, the basis for business purposes is a carryover basis. If the
FMV of
 the property converted is less than the taxpayer’s adjusted basis, the basis for business purpose is the
FMV. The basis is the lesser of the FMV or adjusted basis at conversion
4. Character of Gain or Loss depends on the time the asset has been held (holding period) and type of
property sold.
a. Holding Period: the holding period generally begins on the date the asset is acquired. Short term
gain (loss) = held for 1 year or less, Long-term gain (loss) = held for more than 1 year.
i. Exceptions – exceptions for the holding period
1. Carryover basis holding period tacks – if the taxpayer’s basis carries over from
another asset, the holding period carries over too.
2. Substituted basis holding period tacks – if the taxpayer’s basis is taken by reference
to another asset, the holding period of the other asset is considered as well.
a. Example – a taxpayer organizes a corporation and transfers property to the
corporation and receives stock in exchange, the shareholder’s holding period in
the assets transferred to the new corporation is generally added to the
shareholders basis in the new stock received.
3. Property received from an estate – holding period of property received from an estate
is always treated as being held for more than one year so the gain or loss is always long
term.
b. Charter of Assets (types of property): three classifications: capital assets, Section 1231 assets,
ordinary income assets:
i. 1. Ordinary income assets:
1. Inventory
2. Receivables
3. Creative Works
4. Certain US government documents
5. real or depreciable property used in a trade or business or for the production of income
that has been held for one year or less (short term)

EXAMPLE 3: IDENTIFYING PROPERTY TYPE: O = Ordinary; C = Capital; §1231 = §1231 trade or business assets

- Stock: Capital
- Accounts Receivable: Ordinary
- Personal use residence: Capital
- Trade or business equipment used for 5 years: §1231 trade or business assets
- Trade or business equipment used for 6 months: Ordinary
- Inventory: Ordinary
- Trade or business building held 30 years: §1231 trade or business assets
- Land held for investment: Capital
ii. 2. Capital Assets are defined under IRC Section 1221 as any assets OTHER THAN:
1. Inventory - stock in trade for sale in the ordinary course of business.
2. Receivables – (accounts or notes) for the performance of services or the sale of inventory
in the ordinary course of business.
3. Certain US government documents
4. real or depreciable property used in a trade or business or for the production of income
that has been held for one year or less (short term)
5. Copyright, literary, musical, or artistic compositions held by the one who created it or by
the one who received the property by gift from the creator
6. Capital Assets are generally investment assets and personal use assets .
iii. Section 1231 Assets are:
1. (1) real or depreciable property (2) used in a trade or business ore used in production of
income that has been (3) held by the taxpayer for more than one year.
2. Timber, coal, and domestic iron ore
3. Cattle and horses used for draft, breeding, dairy or spotting purposes that have been held
for 24 months or more
4. other livestock used for draft, breeding, dairy or sporting purposes that have been held
for 12 months or more.
 5. unharvested crops on land held for more than 1 year if the crop and land are sold or
exchanged at the same time.
6. certain purchased in tangible assets that are eligible for amortization
- Within section 1231, there are two possible additional asset classifications :
o Section 1245 assets: depreciable and amortizable personal property held for more than one year
that is sold at a gain.
o Section 1250 assets: depreciable real property held for more than one year that is sold at a gain.
iv. Mixed use assets – note that an asset that is used in a trade or business and personally is a
mixed-used asset. When a mixed-use asset is sold the gain or loss must be allocated between
the business portion and the personal-use portion of the asset.

1.
c. Classification of gains or loss:
i. Capital gain or loss results from the sale or other taxable disposition of a capital assets
ii. Ordinary income or Loss – results from the sale or other taxable disposition of an ordinary
income asset.
iii. Section 1231 gain or loss results from the sale or other taxable disposition of a Section 1231
asset.
1. If the Section 1231 asset is depreciable and the sale or other taxable disposition results in
a gain, it must first be determined whether Section 1245, Section 1250, or Section
291 applies. After these sections are applied, then the Section 1231 look-back rule is
applied:
a. Section 1231 gains are taxed as long-term capital gains after the below
provisions are applied:
i. Section 1245 reclassifies as ordinary income the portion of Section 1231
gain on personal property that is due to depreciation deductions.
1. Depreciable and amortizable personal property held for more than 1
year that is sold at gain.
2. Section 1245 applies primarily to machinery, equipment, furniture,
and fixtures. It does not generally apply to real property. It may also
apply to intangible assets that have been amortized.
3. Section 1245 Recapture: reclassified gain from the sale of Section
1231 personal property that is due to depreciation or amortization
deductions taken in prior years as ordinary income taxed at
marginal rates.
4. Section 1245 does not apply when Section 1231 personal property
is sold at a loss

EXAMPLE 4: §1245 Recapture: On January 1, 2024, Hanson Corp. sold a machine purchased several years ago and
used it in his trade or business for $26,000. The machine was originally acquired for $24,000. He had taken $20,000 of
MACRS depreciation on the machine. How is the gain characterized?
Same as the previous example, except Hanson Corp sold the machine for $18,000.

Same as the previous example, except Hanson Corp. sold the machine for $3,000.

ii. Section 1250 assets are (in general): Depreciable real property held for
more than one year that is sold at a gain.
1. Section 1250 partial recapture – This is ACRS only so ignore.
2. Unrecaptured Section 1250 gain for individuals - Section 1250
reclassifies gain from the sale of Section 1231 real property that is
due to prior years MARCS depreciation deductions as unrecaptured
Section 1250 gain and taxes it at a max rate of 25%.
a. 3.8% NII surtax could apply to unrecaptured Section 1250
gains from production of income property

EXAMPLE 5: UNRECAPTURED GAIN: In 2024, Bill sold a building used in his trade or business for $150,000. The
building was
purchased in 2006 for $100,000 and was depreciated using MACRS (straight-line method). Depreciation on the
building through the date of sale totaled $38,000. What is the character of gain or loss, and what are the tax rates
applied to the sale of the building?
 3. Section 291 recapture for C corporations – Section 291
reclassifies 20% of the recognized gain from the sale of Section
1231 real property that is due to prior years MACRS depreciation
deductions as ordinary income. The 20% reclassification is
computed on the lesser of the (1) recognized gain or (2) the
accumulated depreciation on the property.

EXAMPLE 6: §291 gain: Red Corporation, a C-Corporation, purchased a building for $800,000. Straight-line depreciation
was taken of $450,000. The building was sold in 2024 for $1,100,000. Determine the character of any gain or loss
recognized:

2. Section 1231 losses are deducted as ordinary losses

3. Section 1231 netting process is discussed later.
5. Netting of Gains and Losses - Section 1231 netting: offset 1231 gains
a. Depreciation recapture rules (above) must be applied to 1231 assets sold at a gain (any recaptured
amounts become ordinary gain).
b. 1231 loss after netting - Net the remaining 1231 gains with the 1231 losses. If the 1231 losses
netting proceeds yields at a 1231 loss. The net loss becomes an ordinary loss.
c. 1231 gain after netting - If the netting process produces a net 1231 gain, the taxpayer applies the
1231 look-back rule to determine if any remaining 1231 gain should be recharacterized as ordinary
gain. Under the look-back rules, the unrecaptured 1250 gains will be recharacterized before the regular
1231 gain. Any gain remaining after applying the look-back rule is treated as long-term capital gain
(including unrecaptured 1250 gains). This gain is included in the capital gains netting process:
i. Section 1231 look-back rule – if a taxpayer has a net 1231 gain, before assuming it’s a capital
gain, the taxpayer must look back 5 years to see if the taxpayer previously deducted a Section
1231 loss. To the extent the taxpayer deducted section 1231 losses in the prior 5 years, and they
haven’t been previously recaptured as ordinary income, the taxpayer must reclassify any current
year Section 1231 gain as ordinary income.

EXAMPLE 7 AND 8: §1231 Lookback

7. Taxpayer sold two §1231 assets in 2024. Asset A resulted in a §1231 gain of $20,000 and Asset B resulted in §1231
loss of ($4,000). In addition, Taxpayer had the following net §1231 gains and losses for the previous five years:
2019 - 0 -
2020 ($4,000) §1231 loss
2021 - 0 -
2022 - 0 -
2023 ($10,000) §1231 loss

How is the Net §1231 gain characterized in 2024?

8. Assume the same facts as Example 7 except Taxpayer had the following net §1231 gains and losses over the
previous five years:
2019 - 0 -
2020 ($4,000) loss
2021 $3,000 gain
2022 - 0 -
2023 ($10,000) loss

How is the Net §1231 gain characterized in 2024?

6. Tax Deferred Exchanges:

a. Sometimes, the tax law allows taxpayers to defer the recognition of gains and losses.
i. The difference between excluding gain or loss and deferring the recognition of gain or
loss: When a gain or loss is excluded, it creates a permanent book/tax difference between
financial and tax accounting. If a gain or loss is deferred, it generally creates a book/tax timing
difference rather than a permanent difference.
ii. Tax law allows taxpayers to defer gain recognition and requires them to postpone loss
recognition in certain transactions because the economic position of the taxpayer has not
changed.
iii. The deferral of gain and the postponement of loss are accomplished in our tax system by a
series of basis adjustments. In general, when gain recognition is deferred, the basis of the asset
acquired is reduced by the amount of the deferred gain. Likewise, when loss recognition is
postponed, the basis of the asset acquired is increased by the amount of the postponed loss.
iv. Focusing on Section 1031 like-kind exchanges and Section 1033 involuntary conversions.
7. Section 1031 Like-Kind Exchanges: The nonrecognition provisions of Section 1031 are mandatory if the
requirements of Section 1031 are met. Note that gains and losses are both deferred if the requirements set
forth below are met:
a. Requirements: limited to real estate.
i. Both the property transferred, and the property received by the taxpayer must be held:
 1. For productive use in a trade or business (so cant be personal residence) or
2. For investment
3. (if personal use property is transferred or received by 1 party, the exchange doesn’t
qualify as a tax-deferred exchange under Section 1031)
ii. The property exchanged by both parties must be like-kind property:
1. Like-kind real property means any type of business or investment real property (improved
or unimproved) may be exchanged as long as it is in the US. The rules for exchanging real
property are flexible. However, that personal use property (ex – principal residence) does
not qualify for tax-deferred exchange treatment.
iii. The exchange of property must be:
1. A direct exchange
2. An indirect exchange where a 3rd party property in which the taxpayer is interested in a
taxable exchange and then exchanges that property with the taxpayer
3. A non-simultaneous exchange in which the taxpayer transfers like-kind property to a
qualified intermediary. The qualified intermediary must hold any proceeds, so they are
not available to the taxpayer. The taxpayer must identify like-kind property within 45 days
of the transfer of the like-kind property to the qualified intermediary. The qualified
intermediary acquires like-kind replacement property, and the exchange with the
taxpayer must be completed by the earlier of the due date of the taxpayer’s tax return or
180 days from the date the like-kind property was transferred by the taxpayer.
b. Calculation of the realized and recognized gain or loss: switching real estate
i. Realized gain or loss is calculated as follows:
+ Property received (including):
+ FMV of property received
+ “Boot” received (cash / other property that is not like-kind property to make exchange fair)
+ Net debt relief (liabilities attached to real estate)
- Property given up (including):
- Adjusted Basis of property given up
- Boot given (cash or other property that is not like-kind property)
- Net debt assumed
= Realized gain or loss (so can be adjusted in the future)
ii. Realized gain is the LESSER OF recognized gain or boot received.
iii. If each party to a like-kind exchange assumes the mortgage of the other party, the debt the
taxpayer assumed plus any cash booth paid by the taxpayer is netted against the debt relief
enjoyed by the taxpayer and only cash received by the taxpayer as part of the transaction is not
part of the netting process and is always treated as boot.

EXAMPLE 9 (boot) + 10 (liability)

Example 9: §1031 Like-Kind Exchange

In 2024, Glenn exchanges a building (this includes the land the building sits on) used in his trade or business with
Ashton for a piece of land used in Ashton's trade or business. The basis of Glenn's old building is $1,000,000 and has a
FMV $1,500,000. Glenn also gives Ashton cash of $200,000. Ashton's basis in his land is $500,000 and has a FMV
$1,700,000.
What is the gain or loss realized by both Glenn and Ashton?
What is the gain or loss recognized by both Glenn and Ashton?

What is the basis in the new asset for Glenn and Ashton?

Example 10: §1031 Like-Kind Exchange w/ liabilities - Andrea transfers an apartment building with a fair market value
of $1,450,000 and a basis of $1,000,000 and subject to a $300,000 mortgage to Bob for Bob's apartment building
worth $1,150,000 and a basis of $600,000. Bob will assume Andrea's mortgage on her apartment building.
What is the gain or loss realized by both Andrea and Bob?

What is the gain or loss recognized by both Andrea and Bob?

What is the basis in the new asset for Andrea and Bob?

c. Basis of like-kind property received:

i. Basis of like-kind property received:

1.
ii. Chack basis calculation:

1.
d. Holding period for like-kind property received: (for like-kind property) qualifying exchange
includes the holding period of the property surrendered. The holding period of the like-kind property
exchanged tacks on to the holding period of the like-kind property received. The holding period for boot
received by the taxpayer always begins on the date of the like-kind exchange.
8. Involuntary Conversions: loss or gain?
a. Introduction – involuntary conversion is defined as theft, casualty, destruction, seizure, condemnation,
or other disposition of the taxpayer’s property beyond control.
i. Theft includes embezzlement, larceny, and robbery, but does not include losing or misplacing an
item.
ii. A casualty is a sudden, unexpected, and unusual event that affects the taxpayer’s property.
Casualties include fires, floods, hurricanes, tornadoes, and acts of vandalism.
iii. A condemnation is the lawful taking of property for fair value by a governmental unit under the
right of eminent domain
b. Losses from Involuntary Conversions –
i. Business or Investment Property –
1. If a business or investment property is stolen or destroyed, the loss is measured using the
adjusted basis of the property. The gain or loss on conversion is calculated as follows:
 Insurance proceeds
– adjusted basis
= gain/(loss)
(If the insurance reimbursement exceeds the adjusted basis, there is a casualty gain.)
2. If business or investment property is partially destroyed, the casualty loss is measured
differently. The casualty loss is the lesser of:
a. the decline in fair market value; or
b. adjusted basis of property damage - insurance reimbursement (If the insurance
reimbursement exceeds the adjusted basis, there is a casualty gain.)
3. If casualty gains exceed casualty losses for the year they are included in Section 1231
netting process, unless they are deferred under Section 1033. If casualty losses exceed
casualty gains, they are deductible as either ordinary business losses or production of
income losses.
ii. Basis Adjustments - The basis of property damaged by a casualty loss is adjusted as follows:
1. Beginning adjusted basis of property before casualty loss
- Insurance proceeds received because of casualty loss
- Deductible casualty loss
+ Cost of repairs to damaged property
= Adjusted basis of property after casualty loss
c. Gains on involuntary conversions - Under Section 1033, the gain resulting from an involuntary
conversion will be deferred if the amount reinvested in qualifying replacement property equals or
exceeds the amount realized by the taxpayer. Losses from involuntary conversions are not deferred:
i. Qualifying replacement property depends upon taxpayer’s use:
1. Qualifying replacement property depends upon taxpayer's use:
a. Owner-user must meet the functional-use test. (ex – warehouse) The taxpayer’s
use of replacement property and involuntarily converted property must be of
similar and related service or use. This test is restrictive. For example, an
involuntarily converted personal residence must be replaced with a personal
residence
b. Owner-investor must meet the taxpayer-use test. The replacement property must
be used by the taxpayer in similar activities. Ex - If rental property is involuntarily
converted, replacement rental property (even though not identical rental use)
meets the taxpayer-use test.
c. Exception: If business or investment is condemned real property, the taxpayer
must only purchase like-kind property as replacement property.
ii. Time limits for acquiring qualifying replacement property ,
1. The taxpayer has 2 years after the close of the tax year in which any gain is realized
from an involuntary conversion to replace the involuntarily converted property.
2. The taxpayer has 3 years after the close of the tax year to replace the property of the
involuntary conversion is condemnation of real property
iii. Calculation of realized and recognized gain on inventory conversion :
1. Realized gain is calculated as follows:
Amount realized
- adjusted basis
= realized gain
2. Recognized gain is the lesser of: Realized gain OR Amount not reinvested in qualifying
replacement property
3. Basis in qualifying replacement property
iv. Basis in qualifying replacement property:
1. + Cost of qualifying replacement property
- Deferred gain
= Basis in qualifying replacement property
EXAMPLE 11: §1033 Involuntary Conversion Gain - Buxton Corporation owns realty that is seized through eminent
domain by the county. The county paid Buxton Corp. $450,000 for the realty, which has an adjusted basis of $325,000.
What are Buxton Corp's realized and recognized gains, assuming it does not replace the condemned property?

$125,000 ($450,000 - $325,000) realized and recognized gain.

What is the recognized gain, assuming Buxton Corp. spends $425,000 on qualifying replacement property within the 1
year?
$25,000 ($450,000 - $425,000) recognized gain. Deferred gain $100,000 ($125,000 - $25,000)
What is the basis of the replacement property?
$325,000 ($425,000 - $100,000 deferred gain

9. Special Types of Property Dispositions:

a. Related party sales –
i. Under Section 267, if a taxpayer sells property to a related party at a loss, the loss is not
deductible, but is disallowed.
1. Related parties are defined as the taxpayer and his or her:
a. spouse; siblings; lineal descendants including children and grandchildren;
ancestors including parents and grandparents; corporation if taxpayer owns more
than 50% of the stock; and partnership if taxpayer owns more than a 50% interest.
ii. If the property sold to a related party is later sold by that related party to a third (unrelated
party), at a gain, a portion or all the prior disallowed loss may be used to offset the gain.
iii. If the property sold to a related party is later sold by that related party to a third (unrelated
party), at a loss, the deductible loss is measured using the purchase price paid by the related
party. SO, the original disallowed loss is never recognized
iv. If a taxpayer sells property to a related party at a gain, the gain is taxable. If the property sold is
depreciable property to the buyer, under Section 1239, the entire gain is characterized as
ordinary income to the seller.
b. Installment method of accounting for property dispositions:
i. The installment method is required for cash method taxpayers who sell real or personal property
at a gain and receive proceeds from the sale in a year other than the year of the sale. This
method of accounting is a taxpayer-friendly provision and is based on the wherewithal to pay
concept. A taxpayer reports a portion of the gain in the year each installment payment is
received.
1. The installment method of accounting is not available if a property disposition results in a
loss rather than a gain.
2. The installment method of reporting is available to report gain but is not available to
report interest on an installment obligation. Interest income is reported under normal
interest income reporting methods
ii. If a cash method taxpayer does not want to use the installment method of accounting, the
taxpayer must affirmatively elect out of the installment method by reporting the entire gain in
the year of the sale
 iii. Certain types of property sales are not eligible for the installment method of
accounting. Sales ineligible for the installment method include:
1. the sale of inventory.
2. and the sale of stocks or securities traded on an established market.
iv. Property dispositions that may be accounted for using the installment method of accounting by
cash method taxpayers include:
1. the sale of real property.
2. and casual sales of personal property.
v. The amount of gain to be reported on the installment method of accounting in a year a payment
is received is calculated as follows:
1. Recognized gain from sale x Payment received = Recognized gain Contract price
vi. The contract price is the amount realized less any indebtedness assumed by the buyer, which is
not more than the seller’s basis in the property. The recognized gain over the contract price is
frequently referred to as the gross profit percentage.
vii. Note that if a portion of gain must be reclassified as ordinary income under Section 1245 (for
personal property) or under Section 291 (C corporations), that portion of the gain must be
reported in the year of sale and is not eligible for the installment method
EXAMPLE 12 – Installment Method. In 2024, Sara sold land she originally purchased for $10,000 for $20,000 of
cash and a $50,000 note receivable. The note receivable is payable in $10,000 installments over
the next 5 years. How much gain did Sara realize and recognize in 2024

CHAPTER 12 – EQUITY BASED COMPENSATION:

1. Introduction to Equity Based Compensation:
a. Equity Based Compensation refers to a form of non-cash remuneration where employees receive a
stake in the company (form of stock options, restricted stock, other equity instruments).
i. Instead of paying only in cash, companies offer art of their compensation package tied to the
ownership or performance of the company. This form of compensation aligns employees’
interests with shareholders by linking their financial rewards to the company’s success. When
the company's stock price rises, employees benefit financially, creating an incentive to
contribute to the
company's growth.
b. Advantages:
i. Alignments of interest – employees are peart-owners of the company, so would be more
willing to work harder
 ii. Cost-Effective in Cash Flow – ways to pay employees without depending on cash reserves
iii. Retention and Loyalty – vesting schedules encourage employees to stay with the company
iv. Market Competitiveness – many top companies offer equity to stay competitive
c. Disadvantages:
i. Dilution of Ownership – existing shareholders’ ownership stakes are diluted
ii. Uncertain Value for Employees – value of equity is tied to volatile stock performance.
iii. Complex Accounting and Taxation - administrative burden
iv. Short-term thinking – employees may focus on immediate stock performance, not long term
v. Potential overhang – large amount of unvested stock options or RSUs
vi. Retention Risk after Vesting – once employee stock is fully vested, why would they stay.
d. Types of equity-based compensation:
i. Stock Options
1. Nonqualified Stock Options (NQOs)
2. Incentive Stock Options
ii. Stock awards
1. Nonrestricted Stock
2. Restricted Stock
3. Restricted Stock Units (RSUs)
iii. Phantom Stock Plans
iv. Stock Appreciation Rights (SARs)
2. Stock Options: Rights to acquire additional shares of stock. Employers may grant stock options to
employees as incentive to stay with the corporation. Options require no cash outflow.
a. Definitions:
i. Grant date – date the option is offered to the employee
ii. The option, strike, or exercise price – stated price at which the employee can purchase the
shares
iii. Option period - period the employee has to purchase shares
iv. Exercise date – date the employee exercises the option and purchase the shares
v. Spread or Bargain element – difference between the exercise price and the fair market value
of the stock on exercise date
vi. Sale date – date the employee sells the stock
b. Nonqualified Stock Options (NQO)
i. A NQO doesn’t meet the requirements of an ISO because it doesn’t conform to ISO plan
requirements or because the employee did not hold the ISO stock for requisite holding
period.
ii. Tax consequences of NQO (assuming no ascertainable FMV of the option)
1. Employee:
a. Grate date – employee does not recognize income on the grant date
b. Exercise date -If the NQO is exercised, the employee reports compensation
income equal to the spread or bargain element (difference between FMV of
stock and exercise price) in the year the NQO is exercised
c. Sale Date - When the employee sells the stock, the employee reports capital
gain (or loss) on the difference between the stock sales price and employee's
basis in the stock (exercise price + spread). The holding period is based
on the time lapsed from the exercise date to the date of sale
2. Employer:
a. Grant Date - employer is not entitled to a deduction on the grant date
b. Exercise Date - If the NQO is exercised, the employer deducts compensation
equal to the spread in the year the NSO is exercised
c. Sale Date – there are no tax consequences to the employer after the exercise
date since any future appreciation is no longer tied to the employee / employer
relationship

EXAMPLE 1: Non-qualifying Stock Options

On January 1, 2019, Bashir’s employer, Hanson Corporation, granted him 1,000 nonqualified stock options (each
option gives him the right to purchase 1 share of Hanson Corporation stock). The options vest after one year of
continuous employment. The shares have a strike price of $10 per share, the FMV of the shares on the grant date. On
January 1, 2020, the 1,000 options vests, and Bashir exercised the options when the stock price was $17 per share. On
March 15, 2024, Bashir sold all 1,000 shares for $30 a share. What are the income tax consequences to Bashir and his
employer resulting from the NQOs? Assume Bashir’s capital gain tax rate is 15%, ordinary income marginal tax rate is
35%, and Bashir’s employer is a C-Corporation (21% tax rate)

c. Incentive Stock Options (ISO)

i. General Requirements:
1. Employer must establish ISO plan
2. Option must be granted within 10 years from the date the ISO plan is established, and
the option period cannot exceed 10 years
3. Option price cannot be less than the FMV of the stock on the grant date.
4. The option price cannot be less than the FMV of the stock on the grant date
5. The option is not transferable during the employee's life.
6. Option must be granted to an employee who owns less than 10% of the employer's
stock
7. Employees can purchase no more than $100,000 of stock under an ISO plan.
ii. Tax Consequences of ISO:
1. Employee –
a. Holding period – employee cannot sell the stock purchased under the ISO plan
for one year after exercising the option or two years after the grant date (the
latest)
b. Qualifying Disposition - If the holding period is met, the employee does not
recognize income when the ISO is granted or exercised. When the stock
is sold, the employee recognizes long-term capital gain for the difference
between the exercise price and the price at which the stock is sold.
i. Note that the spread (the difference between the exercise price and the
fair market value of the stock on the exercise date) is subject to
alternative minimum tax
c. Disqualifying Disposition - If the holding period is not met by the employee, the
stock option is taxed as a nonqualified stock option
2. Employer –
a. Qualifying Disposition – If holding period is met by the employee, the employer
is not entitled to a compensation deduction at any time for the ISO
EXAMPLE 2: Incentive Stock Options – Qualifying Disposition

Assume the same facts as Example 1, except the options granted to Bashir are incentive stock options (ISOs) rather
than NQOs

b. Disqualifying Disposition: If the holding period is not met by the employee, the
employer treats the stock option like a nonqualified stock option for
tax purposes

EXAMPLE 3: Incentive Stock Options – Disqualifying Disposition

Assume the same facts as Example 1 except the options granted to Bashir are incentive stock options (ISOs) rather
than NQOs. What are the tax consequences to Bashir and Hanson Corp if Bashir sold all 1,000 shares of stock on June
30, 2020 for $20 per share?
3. Stock Awards: an employer may issue stock to its employees to save cash outflow and encourage
employees to work for the success of the business.
a. Nonrestricted Stock: stock issued outright to an employee with no restriction to ownership.
Nonrestricted stock awards is taxable income to the employee based on the stock’s FMV on the date
of the award. Employers get a corresponding compensation deduction equal to the stock FMV when
issued to the employee.
b. Restricted Stock: Type of equity compensation awarded to the employees that comes with certain
conditions or restrictions, such as vesting schedules or performance milestones. These restrictions
must be satisfied before the employee gains full ownership and control of the stock. Restrictions
may include time-based vesting or performance-based vesting.
i. Definitions:
1. Forfeiture – If the employee leaves the company before vesting or fails to meet
performance criteria, the stock is forfeited
2. Shareholder Rights – In most cases, employees have some rights (e.g., voting rights
and dividend eligibility) even before the stock vests, though this can vary by plan
3. Grant date – When the stock is awarded to the employee, but ownership is
conditioned on restriction
4. Vesting date - When the employee satisfies the restriction conditions and gains full
ownership of the stock
ii. Tax Consequences of Restricted Stock:
1. Employee:
a. Grant Date: The employee does not recognize income on the grant date
b. Vesting date: When the stock vests, the employee reports compensation
income equal to the fair market value of the shares at the vesting date. This
amount is subject to payroll taxes and reported on the employee’s W-2
c. Sale Date: After vesting, if the employee sells the stock, any appreciation in
value from the vesting date to the sale date is taxed as a capital gain:
 i. Short-term capital gain if sold within one year of vesting.
ii. Long-term capital gain if held for more than one year.
2. Employer:
a. Grant Date: The employer is not entitled to a deduction on the grant date.
b. Exercise Date: When the stock vests, the employer is entitled to a
compensation deduction equal to the fair market value of the shares at the
vesting date
c. Sale Date: The employer is not entitled to a deduction on the grant date

EXAMPLE 4 – RESTRICTED STOCK: James received 4,000 shares of restricted stock on June 1, 2023, when the stock
was
valued at $3 per share. The shares vest on June 1, 2024, when the shares are valued at $8 per share. James later sold
the shares at $11 per share on December 1, 2024. His marginal tax bracket is 35%. What is his tax liability on the
grant date, vesting date, and sale date? Also, assuming his employer is a C-Corporation, what deduction can it claim,
if any?

- James:
Grant date: No tax consequence
Vesting date: $8 per share × 4,000 shares = $32,000 × 35% = $11,200 tax.
Sale date: $11 per share x 4,000 shares = $44,000 amount realized - $32,000 basis (comp recognized at
vesting) = $12,000 STCG x 35% = $4,200 tax.
- Employer:
Grant date: No tax consequence
Vesting date: $8 per share × 4,000 shares = $32,000 deduction x 21% = $6,720 tax savings
Sale date: No tax consequences
iii. §83(b) Election: An employee may elect (within 30 days after the stock is received) to
include the restricted stock in income in the year of receipt at its fair market value even
though it is subject to forfeiture.
1. Employer correspondingly deducts the fair market value as compensation. If the stock
is later forfeited by the employee, the employee is not entitled to deduct any loss on
the stock forfeiture. Under the tax benefit rule, the employer must repay taxes saved
on account of the compensation deduction taken in the earlier year.
2. When an §83(b) election in place, the holding of the stock begins on the grant date.
3. An employee who is confident the stock will vest and appreciate during the vesting
period could convert ordinary income into capital gain by making the election

EXAMPLE 5: §83(b) Election Assume the same facts as Example 4, except James makes a timely §83(b) election. What
is his tax liability on the grant date, vesting date, and sale date? Also, assuming his employer is a C-Corporation, what
deduction can it claim, if any? Assume James LTCG rate is 15%

- James:
Grant date: $3 per share × 4,000 shares = $12,000 x 35% = $4,200 tax
Vesting date: No tax consequences
Sale date: $11 per share x 4,000 shares = $44,000 amount realized - $12,000 basis (comp recognized at grant)
= $32,000 STCG x 15% = $4,800 tax.
- Employer:
Grant date: $3 per share × 4,000 shares = $12,000 deduction x 21% = $2,520 tax savings
Vesting date: No tax consequences
Sale date: No tax consequences

CHAPTER 13 – RETIREMENT SAVINGS:

Overview: Retirement savings represent a cornerstone of long-term planning, and the IRC shapes the options
available to individuals and employers. IRA encourages saving for retirement by providing tax advantages for
contributions (401k, IRA). These provisions also balance immediate tax benefits with future income security.
Employer Provided Qualified Retirement Plans:

- A qualified retirement plan meets the requirements of the IRC and Employee Retirement Income Security Act.
The plan must be:
o funded by the employer.
o nondiscriminatory against rank-and-file employees; and
o employees must be fully vested (have a nonforfeitable right to retirement benefits) after a certain
number of years of employment.
- Tax consequences of qualified retirement plans:
o Employer: the employer is entitled to deduct the contributions it makes as they are paid into the plan.
o Employee (Traditional Plans):
 If an employee makes contributions to a qualified traditional retirement plan, the taxation of
these is deferred until withdrawn by employee.
 Earnings on contributions to a qualified retirement plan accumulate tax deferred to the
employee until withdrawn.
 When an employee retires and starts to receive distributions from the qualified retirement plan,
the distributions are taxed to the retiree at ordinary income rates.
 If an employee prematurely withdraws funds from a qualified retirement plant (generally
before 59.5 and still employed or 55 years of age and retired), the funds withdrawn are subject
to income tax and a 10% penalty. Exceptions to the 10% penalty exist for premature
withdrawals due to death or disability of the employee.
 If an employee terminated employment with one employer and accepts employment with
another employer, an employee may generally roll funds form one qualified retirement plan into
another or into an IRA account to avoid income tax on distribution.
 A participant at age 73 must withdraw the required minimum distribution (RMD) or face a 25%
excise tax.
o Most Common Employer-provided qualified retirement plans :
 Defined Benefit plans (Pensions):
 A defined benefit plan provides for a fixed benefit at retirement based on an employee’s
years of service and compensation. Contributions are actuarially calculated to provide
the promised benefits. Defined benefit plans are funded entirely by the employer and
can be costly because of the minimum funding standards. The employer bears the risk of
investment losses.
 The maximum contribution for each employee in 2024 is the lesser of 100% of an
employee’s average compensation for the 3 highest paid years or $275,000.
 Defined Contribution plans:
 A Defined Contribution Plan is a retirement savings plan in which employees, employers,
or both make regular contributions to individual accounts for each participating
employee. In general, the employee directs how the contributions are invested, and the
employee bears the risk of investment losses.
 Types of Defined Contribution Plans:
 401(k) plans are used by for profit companies
 403(b) plans are used by nonprofit organizations and educational institutions.
 457 plans are used by government agencies.
 Money purchase plan, the employer (and the employee if it is a contributory plan)
contributes a fixed percentage of the employee’s salary to the plan
 Traditional 401(k) Plan:
 Allows employees to reduce taxable compensation by designating portion of pre-tax
compensation to be contributed to the plan.
 Employers can make matching contributions to plans to incent employees to partake.
 In 2024, the maximum pre-tax compensation that can be contributed by an employee is
$23,000. In addition, if the employee is age 50 or over, the employee may contribute an
additional “catch-up” contribution in the maximum amount of $7,500 in 2024
(maximum employee contribution age 50 is $30,500)
  The maximum contribution for both employee and employer combined contributions in
2024 is the lesser of (1) 100% of an employee’s compensation or (2) $69,000 ($76,500
with “catch-up contribution)

EXAMPLE 1: Bridget’s (45 years ole) employer HRD who provides a 401(k) plan for it’s employee’s retirement. In
addition to the 401(k) plan, HRD contributes 20% of employee’s into a money purchase plan. In 2024, Bridget’s salary
was $250,000. How much employee contribution can Bridget make to her 401(k)?
$250,000 x 20% = $50,000 employer contribution to money purchase plan.
Max employee/employer contribution $69,000
Employer contribution ($50,000)
Remaining employee contribution $19,000
While the maximum employee contribution in 2024 is $23,000, since Bridget’s employer contribution is
so high, she is limited to contributing $19,000 to her 401(k)

What if her salary was $100,000?

$100,000 x 20% = $20,000 employer contribution to money purchase plan.

Max employee/employer contribution $69,000
Employer contribution ($20,000)
Remaining employee contribution $49,000
Briget is not limited and can contribute the full $23,000 employee contribution to her 401(k)

 General Tax Treatment:

o Contributions are not taxed when made (pre-tax contributions).
o Growth (investment earnings) is tax-deferred
o Distributions in retirement are taxed as ordinary income.
 Penalties:
o If an employee prematurely withdraws funds from a qualified retirement
plan (generally before age 59 ½ and still employed or 55 years of
age and retired), the funds withdrawn are subject to income tax and a
10 percent penalty. Exceptions to the 10% penalty exist for premature
withdrawals due to death or disability of the employee.
o Upon reaching the age of 73 a participant in a qualified retirement plan
must withdraw the required minimum distribution (RMD) or face a 25%
excise tax. The calculation of the RMD amount is beyond the scope of this
class

EXAMPLE 2: Early distribution penalty: Assume that when Carla is 57 years of age and still employed by C B A, she
requests
and receives a $60,000 distribution from her 401(k) account. What amount of tax and penalty is Carla required to pay
on the distribution? (Assume her marginal tax rate is 32 percent.)

$25,200 = $19,200 taxes ($60,000 × 32%) + $6,000 penalty ($60,000 × 10%)

What if Carla is 57 years old but retired?

$19,200 taxes ($60,000 × 32%). No penalty on early withdrawal is assessed.

 Roth 401k:
 Permits an employee to make after-tax contributions to the plan. Unlike a traditional
401(k), contributions to a Roth 401(k) do not reduce taxable income.
 Employer contributions will go into a Traditional 401(k) account. However, employer
contributions may go into a Roth 401(k) account only if the contributions are fully vested
to the employee. Employees are immediately taxed on employer contributions to
employee’s Roth 401(k) account
 In 2024, the maximum pre-tax compensation that can be contributed by an employee is
$23,000. In addition, if the employee is age 50 or over, the employee may contribute an
additional “catch-up” contribution in the maximum amount of $7,500 in 2024
(maximum employee contribution age 50 is $30,500)
  The maximum contribution for both employee and employer combined contributions in
2024 is the lesser of (1) 100% of an employee’s compensation or (2) $69,000 ($76,500
with “catch-up contribution)
 General Tax Treatment:
o Contributions are taxed when made (after-tax contributions).
o Growth (investment earnings) is tax deferred.
o Qualified distributions are not taxable
 Qualifying Distributions are those made on account that has been opened for 5 years,
and 59.5 at time of distribution
 Nonqualifying distributions of account earnings taxable and subject to 10% early
withdrawal penalty unless employee is at least 55 yes and retired at least 59.5 years of
age if not retired. Distributions of contributions not taxed or penalized
 Roth 401k accounts are not subject to the required minimum distribution.
 Traditional vs Roth 401(k):
 Traditional 401(k) provides a better after-tax return if the taxpayer’s current marginal tax
rate is greater than their future marginal tax rate in retirement.
 Roth 401(k) provides a better after-tax return if the taxpayer’s current marginal tax rate
is less than their future marginal tax rate in retirement
 A diversification strategy is to contribute to both Traditional and Roth accounts to hedge
against future tax changes. This allows for marginal tax rate management in retirement

EXAMPLE 5: Roth vs Traditional

Steven wants to contribute $7,000 to IRA and doesn’t know whether he should contribute to a traditional or Roth. If he
contributes to a Roth, he will have to reduce his contribution by the amount of taxes owed on the contribution.
Steven’s marginal tax rate in 2024 is 24% and he anticipates his marginal tax rate will be 24% in retirement.
Assuming an average annual growth rate of 8%, which account will result in the highest after-tax balance in 25 years,
when Steven plans to retire?

What if his marginal tax rate is 22% today but he expects it to be 35% in retirement?

What if his marginal tax rate is 35% today but he expects it to be 22% in retirement?
Individual Retirement Accounts (IRAs):

- There are 2 types of IRA: Traditional (regular) IRA and Rother IRAs. The primary difference between a traditional
IRA and a Roth IRA is the tax treatment of contributions and distributions:
o A contribution to a traditional or regular IRA is generally deductible by the individual taxpayer when it
is made and distributions upon retirement are taxed to the individual retiree at ordinary income rates.
(The tax treatment of traditional IRAs is like the tax treatment of contributions and distributions from a
traditional 401(k))
o In contrast, a contribution to a Roth IRA is not deductible by the individual taxpayer when made and
distributions upon retirement are excluded from the retiree’s income.
- Requirements and limits common to both traditional and Roth IRAs :
o The maximum annual contribution that an individual taxpayer may make to a traditional or Roth IRA in
2024 is the lesser of $7,000 ($8,000 if 50 or over) or earned income of the taxpayers. A
married taxpayer may contribute an additional $7,000 ($8,000 if 50 or over) to a spousal
IRA for a nonworking spouse provided their combined earned income is at least $14,000
($16,000 if 50 or over)
o Contributions must be made by the unexpended due date of the tax return. For most individual
taxpayers, a 2024 contribution must be made by April 15, 2025
- Additional rules for traditional IRA’s:
o If the taxpayer is not an active participant in any other qualified retirement plan, the contribution to a
traditional IRA is fully deductible for AGI.
o If a taxpayer(s) participates in an employer sponsored retirement plan, the deductibility of traditional
IRA contributions may be limited based on MAGI (MAGI is the taxpayer’s AGI disregarding the
deduction for the traditional IRA itself and certain other items). The phase-out ranges in the chart
below are applied to the IRA contribution limit. (ex - $7,000 or $8,000 if 50 of over) to determine the
maximum deductible traditional IRA contribution:


o A taxpayer may still contribute to a traditional IRA even though the contribution is nondeductible
(referred to as a nondeductible contribution). The taxpayer must keep track of his or her “basis” in the
traditional IRA since the contribution was made with post-tax dollars. This is the basis for a back-door
Roth contribution.
o Distributions from a traditional IRA are taxed as ordinary income
o If distribution before taxpayer is 59½, 10 percent penalty generally applies (unless taxpayer
rolls over to other qualified account)
 o Required minimum distributions begin for the year in which the taxpayer turns the applicable age. The
applicable age is 73 for 2024

EXAMPLE 3 Traditional IRA Limits - Unmarried

Nick, age 32, is single and has AGI of $66,000. He participates in his employer sponsored retirement plan. What is the
maximum deductible traditional IRA contribution Nick can make in 2024?
$7,000. Nick’s AGI is below the phase-out threshold

What if Nick’s AGI is $82,500?

($82,500 - $77,000) / $10,000 = 55%. Nick’s maximum deductible contribution is $3,150 = $7,000 x (1.0 – 0.55)

What if Nick’s AGI is $126,000

No deductible contribution allowed since his AGI exceeds $87,000

EXAMPLE 4 Traditional IRA Limits - Married

Rebecca (38 years old) and Gary (35 years old) are married filing jointly in 2024. Their AGI for 2024 is $155,000, all
from earned income sources. All of the AGI comes from Rebecca’s employment where she participates in her employer
sponsored retirement plan. Gary is a Ph.D. student and is unemployed, having no earned income in 2024. What is the
maximum traditional IRA contribution Rebecca and Gary each make in 2024?

Rebecca, can deduct $0 since she is active in an employer sponsored plan and the couples AGI exceeds the upper
end of the phase-out range, $143,000.
Rebecca can make a deductible spousal contribution for Gary of $7,000 since the couples AGI is below the lower
end of the phase-out range of $230,000

- Additional rules for Roth IRAs:

o Contributions are NOT deductible
o In 2024, contributions to Roth IRAs phase out for unmarried taxpayers with MAGI between $146,000
and $161,000 and for married taxpayers with MAGI between $230,000 and $240,000
o taxpayer can receive tax free withdrawals of his or her contributions from a Roth IRA
o Qualified distributions are not taxable. Qualified distributions of earnings generally cannot begin until
5 tax years after the contribution is made, and the taxpayer has reached the age of 59 ½.
o Nonqualifying distributions of account earnings are taxed at ordinary rates and Subject to 10 percent
penalty unless taxpayer is at least 59½ at time of distribution.
o There are no required minimum distribution (RMD) rules for Roth IRAs.
- Rollovers from Traditional to Roth IRAs:
o Any taxpayer can roll a traditional IRA into a Roth IRA
o The amount converted is fully taxable but not necessarily penalized. Careful tax planning must be
undertaken to determine whether such a rollover is advisable.

Saver’s Credit: Allows for tax credit based on a percentage of retirement accounting contributions up to $2,000. The
credit is based on the taxpayer’s filing status, and AGI. The maximum credit is $1,000, but is phased-out as the
taxpayer’s AGI increases based on the following table:
The credit is calculated by multiplying the lesser of the taxpayer’s (1) retirement contributions or (2) $2,000 by the
applicable percentage in the above table.

EXAMPLE 6: Savers Credit. Janeen is single and her AGI after contribution to her $401(k) is $32,000. She made a
$3,000 traditional 401(k) contribution is 2024. What is Janeen’s saver’s credit in 2024?

Max creditable retirement savings $2,000 x 10% = $200

Since Janeen is single, and her AGI is between $25,001 and $38,250, the applicable percentage for the saver’s credit
is 10%