Transfers Between Spouses
Generally, no gain or loss is recognized on a transfer of property
from an individual to (or in trust for the benefit of) a spouse or, if incident to
a divorce, a former spouse. This nonrecognition rule does not apply if the recipient
spouse or former spouse is a nonresident alien. The rule also does not apply to a transfer
in trust to the extent the adjusted basis of the property is less than the amount of the
liabilities assumed plus any liabilities on the property.
Any transfer of property to a spouse or former spouse on which gain or loss is not
recognized is treated by the recipient as a gift and is not considered a sale or exchange.
The recipient's basis in the property will be the same as the adjusted basis of the giver
immediately before the transfer. This carryover basis rule applies whether the adjusted
basis of the transferred property is less than, equal to, or greater than either its fair
market value at the time of transfer or any consideration paid by the recipient. This rule
applies for purposes of determining loss as well as gain. Any gain recognized on a
transfer in trust increases the basis.
A transfer of property is incident to a divorce if the transfer occurs within 1 year
after the date on which the marriage ends, or if the transfer is related to the ending of
the marriage. For more information, see Property Settlements in Publication 504, Divorced
or Separated Individuals.
Related Party Transactions
Special rules apply to the sale or trade of property between related
parties.
Gain on Sale or Trade
of Depreciable Property
Your gain from the sale or trade of property to a related party may
be ordinary income, rather than capital gain, if the property can be depreciated by
the party receiving it. See chapter 3 in Publication 544 for more information.
Like-Kind Exchanges
Generally, if you trade business or investment property for other
business or investment property of a like kind, no gain or loss is recognized. See Like-Kind
Exchanges, earlier, under Nontaxable Trades.
This rule also applies to trades of property between related parties, defined next
under Losses on Sales or Trades of Property. However, if either you or the
related party disposes of the like property within 2 years after the trade, you both must
report any gain or loss not recognized on the original trade on your return for the year
in which the later disposition occurs.
This rule generally does not apply to:
- Dispositions due to the death of either related party,
- Involuntary conversions (see chapter 1 of Publication 544), or
- Trades and later dispositions whose main purpose is not the avoidance of federal income
tax.
If a property holder's risk of loss on the property is substantially diminished during
any period, that period is not counted in determining whether the property was disposed of
within 2 years. The property holder's risk of loss is substantially diminished by:
- The holding of a put on the property,
- The holding by another person of a right to acquire the property, or
- A short sale or any other transaction.
Losses on Sales or
Trades of Property
You cannot deduct a loss on the sale or trade of property, other than
a distribution in complete liquidation of a corporation, if the transaction is
directly or indirectly between you and the following related parties.
- Members of your family. This includes only your brothers and sisters, half-brothers and
half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants
(children, grandchildren, etc.).
- A partnership in which you directly or indirectly own more than 50% of
the capital interest or the profits interest.
- A corporation in which you directly or indirectly own more than 50% in value of the
outstanding stock (see Constructive ownership of stock, later).
- A tax-exempt charitable or educational organization that is directly or indirectly
controlled, in any manner or by any method, by you or by a member of your family, whether
or not this control is legally enforceable.
In addition, a loss on the sale or trade of property is not deductible if the
transaction is directly or indirectly between the following related parties.
- A grantor and fiduciary, or the fiduciary and beneficiary, of any trust.
- Fiduciaries of two different trusts, or the fiduciary and beneficiary of two different
trusts, if the same person is the grantor of both trusts.
- A trust fiduciary and a corporation of which more than 50% in value of the outstanding
stock is directly or indirectly owned by or for the trust, or by or for the grantor of the
trust.
- A corporation and a partnership if the same persons own more than 50% in value of the
outstanding stock of the corporation and more than 50% of the capital interest, or the
profits interest, in the partnership.
- Two S corporations if the same persons own more than 50% in value of the outstanding
stock of each corporation.
- Two corporations, one of which is an S corporation, if the same persons own more than
50% in value of the outstanding stock of each corporation.
- An executor and a beneficiary of an estate (except in the case of a sale or trade to
satisfy a pecuniary bequest).
- Two corporations that are members of the same controlled group (under certain
conditions, however, these losses are not disallowed but must be deferred).
- Two partnerships if the same persons own, directly or indirectly, more than 50% of the
capital interests or the profit interests in both partnerships.
Multiple property sales or trades. If you sell or trade to a related
party a number of blocks of stock or pieces of property in a lump sum, you must figure the
gain or loss separately for each block of stock or piece of property. The gain on each
item may be taxable. However, you cannot deduct the loss on any item. Also, you cannot
reduce gains from the sales of any of these items by losses on the sales of any of the
other items.
Indirect transactions. You cannot deduct your loss on the sale of
stock through your broker if, under a prearranged plan, a related party buys the same
stock you had owned. This does not apply to a trade between related parties through an
exchange that is purely coincidental and is not prearranged.
Constructive ownership of stock. In determining whether a person directly or indirectly owns any of the
outstanding stock of a corporation, the following rules apply.
Rule 1. Stock directly or indirectly owned by or for a
corporation, partnership, estate, or trust is considered owned proportionately by or for
its shareholders, partners, or beneficiaries.
Rule 2. An individual is considered to own the stock that
is directly or indirectly owned by or for his or her family. Family includes only brothers
and sisters, half-brothers and half-sisters, spouse, ancestors, and lineal descendants.
Rule 3. An individual owning, other than by applying rule
2, any stock in a corporation is considered to own the stock that is directly or
indirectly owned by or for his or her partner.
Rule 4. When applying rule 1, 2, or 3, stock constructively
owned by a person under rule 1 is treated as actually owned by that person. But stock
constructively owned by an individual under rule 2 or rule 3 is not treated as owned by
that individual for again applying either rule 2 or rule 3 to make another person the
constructive owner of the stock.
Property received from a related party. If you sell or trade at a
gain property that you acquired from a related party, you recognize the gain only to the
extent that it is more than the loss previously disallowed to the related party. This rule
applies only if you are the original transferee and you acquired the property by purchase
or exchange. This rule does not apply if the related party's loss was disallowed because
of the wash sale rules, described later under Wash Sales.
If you sell or trade at a loss property that you acquired from a related party, you
cannot recognize the loss that was not allowed to the related party.
Example 1. Your brother sells you stock for $7,600. His cost
basis is $10,000. Your brother cannot deduct the loss of $2,400. Later, you sell the same
stock to an unrelated party for $10,500, realizing a gain of $2,900. Your reportable gain
is $500 - the $2,900 gain minus the $2,400 loss not allowed to your brother.
Example 2. If, in Example 1, you sold the stock for $6,900
instead of $10,500, your recognized loss is only $700 - your $7,600 basis minus $6,900.
You cannot deduct the loss that was not allowed to your brother.
Capital Gains
and Losses
- Call
- Commodity future
- Conversion transaction
- Forward contract
- Limited partner
- Listed option
- Nonequity option
- Options dealer
- Put
- Regulated futures contract
- Section 1256 contract
- Straddle
- Wash sale
This section discusses the tax treatment of gains and losses from different types of
investment transactions.
Character of gain or loss. You need to classify your gains and
losses as either ordinary or capital gains or losses. You then need to classify your
capital gains and losses as either short term or long term. If you have long-term gains
and losses, you must identify your 28% rate gains and losses. If you have a net capital
gain, you must also identify your qualified 5-year gain and any unrecaptured section 1250
gain.
The correct classification and identification helps you figure the limit on capital
losses and the correct tax on capital gains. For information about determining whether
your capital gain or loss is short term or long term, see Holding Period, later.
For information about 28% rate gain or loss, qualified 5-year gain, and unrecaptured
section 1250 gain, see Reporting Capital Gains and Losses and Capital Gain
Tax Rates, later.
Capital or Ordinary
Gain or Loss
If you have a taxable gain or a deductible loss from a transaction, it may be either a
capital gain or loss or an ordinary gain or loss, depending on the circumstances.
Generally, a sale or trade of a capital asset (defined next) results in a capital gain or
loss. A sale or trade of a noncapital asset generally results in ordinary gain or loss.
Depending on the circumstances, a gain or loss on a sale or trade of property used in a
trade or business may be treated as either capital or ordinary, as explained in
Publication 544. In some situations, part of your gain or loss may be a capital gain or
loss, and part may be an ordinary gain or loss.
Capital Assets and
Noncapital Assets
For the most part, everything you own and use for personal purposes,
pleasure, or investment is a capital asset. Some examples are:
- Stocks or bonds held in your personal account,
- A house owned and used by you and your family,
- Household furnishings,
- A car used for pleasure or commuting,
- Coin or stamp collections,
- Gems and jewelry, and
- Gold, silver, or any other metal.
Any property you own is a capital asset, except the following noncapital assets.
- Property held mainly for sale to customers or property
that will physically become a part of the merchandise that is for sale to
customers.
- Depreciable property used in your trade or business, even if fully
depreciated.
- Real property used in your trade or business.
- A copyright, a literary, musical, or artistic composition, a letter or
memorandum, or similar property -
- Created by your personal efforts,
- Prepared or produced for you (in the case of a letter, memorandum, or similar property),
or
- Acquired under circumstances (for example, by gift) entitling you to the basis of the
person who created the property or for whom it was prepared or produced.
- Accounts or notes receivable acquired in the ordinary course of a trade
or business for services rendered or from the sale of property described in (1).
- U.S. Government publications that you received from the government free
or for less than the normal sales price, or that you acquired under circumstances
entitling you to the basis of someone who received the publications free or for less than
the normal sales price.
- Certain commodities derivative financial instruments held by commodities
derivatives dealers. For more information, see section 1221 of the Internal Revenue Code.
- Hedging transactions, but only if the transaction is clearly identified
as a hedging transaction before the close of the day on which it was acquired, originated,
or entered into. For more information, see the definition of hedging transaction
earlier, and the discussion of hedging transactions under Commodity Futures, later.
- Supplies of a type you regularly use or consume in the ordinary course
of your trade or business.
Investment property. Investment
property is a capital asset. Any gain or loss from its sale or trade generally is a
capital gain or loss.
Gold, silver, stamps, coins, gems, etc. These are capital
assets except when they are held for sale by a dealer. Any gain or loss from their sale or
trade generally is a capital gain or loss.
Stocks, stock rights, and bonds. All of these, including stock received as a dividend, are capital assets
except when they are held for sale by a securities dealer. However, see Losses
on Section 1244 (Small Business) Stock and Losses on Small Business Investment
Company Stock, later.
Personal use property. Property held for personal use only, rather
than for investment, is a capital asset, and you must report a gain from its sale as a
capital gain. However, you cannot deduct a loss from selling personal use property.
Discounted Debt Instruments
Treat your gain or loss on the sale, redemption, or retirement of a
bond or other debt instrument originally issued at a discount or bought at a
discount as capital gain or loss, except as explained in the following discussions.
Short-term government obligations. Treat gains on short-term federal, state, or local government obligations
(other than tax-exempt obligations) as ordinary income up to your ratable share of
the acquisition discount. This treatment applies to obligations that have a fixed maturity
date not more than 1 year from the date of issue. Acquisition discount is
the stated redemption price at maturity minus your basis in the obligation.
However, do not treat these gains as income to the extent you previously included the
discount in income. See Discount on Short-Term Obligations in chapter 1 for more
information.
Short-term nongovernment obligations. Treat gains on short-term
nongovernment obligations as ordinary income up to your ratable share of OID. This
treatment applies to obligations that have a fixed maturity date of not more than 1 year
from the date of issue.
However, to the extent you previously included the discount in income, you do not have
to include it in income again. See Discount on Short-Term Obligations, in chapter
1, for more information.
Tax-exempt state and local government bonds. If these bonds were originally issued at a discount before September 4, 1982,
or you acquired them before March 2, 1984, treat your part of the OID as tax-exempt
interest. To figure your gain or loss on the sale or trade of these bonds, reduce the
amount realized by your part of the OID.
If the bonds were issued after September 3, 1982, and acquired after March 1, 1984,
increase the adjusted basis by your part of the OID to figure gain or loss. For more
information on the basis of these bonds, see Discounted tax-exempt obligations under
Stocks and Bonds, earlier in this chapter.
Any gain from market discount is usually taxable on disposition or redemption of
tax-exempt bonds. If you bought the bonds before May 1, 1993, the gain from market
discount is capital gain. If you bought the bonds after April 30, 1993, the gain from
market discount is ordinary income.
You figure market discount by subtracting the price you paid for the bond from the sum
of the original issue price of the bond and the amount of accumulated OID from the date of
issue that represented interest to any earlier holders. For more information, see Market
Discount Bonds in chapter 1.
A loss on the sale or other disposition of a tax-exempt state or local government bond
is deductible as a capital loss.
Redeemed before maturity. If a state or local bond that was
issued before June 9, 1980, is redeemed before it matures, the OID is not
taxable to you.
If a state or local bond issued after June 8, 1980, is redeemed before
it matures, the part of the OID that is earned while you hold the bond is not taxable to
you. However, you must report the unearned part of the OID as a capital gain.
Example. On July 1, 1991, the date of issue, you bought a
20-year, 6% municipal bond for $800. The face amount of the bond was $1,000. The $200
discount was OID. At the time the bond was issued, the issuer had no intention of
redeeming it before it matured. The bond was callable at its face amount beginning 10
years after the issue date.
The issuer redeemed the bond at the end of 11 years (July 1, 2002) for its face amount
of $1,000 plus accrued annual interest of $60. The OID earned during the time you held the
bond, $73, is not taxable. The $60 accrued annual interest also is not taxable. However,
you must report the unearned part of the OID ($127) as a capital gain.
Long-term debt instruments issued after 1954 and before May 28, 1969 (or before July
2, 1982, if a government instrument). If you sell, trade, or redeem for a
gain one of these debt instruments, the part of your gain that is not more than your
ratable share of the OID at the time of sale or redemption is ordinary income. The rest of
the gain is capital gain. If, however, there was an intention to call the debt instrument
before maturity, all of your gain that is not more than the entire OID is treated as
ordinary income at the time of the sale. This treatment of taxable gain also applies to
corporate instruments issued after May 27, 1969, under a written commitment that was
binding on May 27, 1969, and at all times thereafter.
Example. You bought a 30-year, 6% government bond for $700 at
original issue on April 1, 1983, and sold it for $900 on April 20, 2002 for a $200 gain.
The redemption price is $1,000. At the time of original issue, there was no intention to
call the bond before maturity. You have held the bond for 228 full months. Do not count
the additional days that are less than a full month. The number of complete months from
date of issue to date of maturity is 360 (30 years). The fraction 228/360 multiplied by
the discount of $300 ($1,000 - $700) is equal to $190. This is your ratable share of OID
for the period you owned the bond. You must treat any part of the gain up to $190 as
ordinary income. As a result, $190 is treated as ordinary income and $10 is capital gain.
Long-term debt instruments issued after May 27, 1969 (or after July 1, 1982, if a
government instrument). If you hold one of these debt instruments, you
must include a part of the OID in your gross income each year that you own the instrument.
Your basis in that debt instrument is increased by the amount of OID that you have
included in your gross income. See Original Issue Discount (OID) in chapter 1.
If you sell or trade the debt instrument before maturity, your gain is a capital gain.
However, if at the time the instrument was originally issued there was an intention to
call it before its maturity, your gain generally is ordinary income to the extent of the
entire OID reduced by any amounts of OID previously includible in your income. In this
case, the rest of the gain is a capital gain.
An intention to call a debt instrument before maturity means there is a written or oral
agreement or understanding not provided for in the debt instrument between the issuer and
original holder that the issuer will redeem the debt instrument before maturity. In the
case of debt instruments that are part of an issue, the agreement or understanding must be
between the issuer and the original holders of a substantial amount of the debt
instruments in the issue.
Example 1. On February 4, 2000, you bought at original issue for
$7,600, Jones Corporation's 10-year, 5% bond which has a stated redemption price at
maturity of $10,000. On February 3, 2002, you sold the bond for $9,040. Assume you have
included $334 of the OID in your gross income (including the amount accrued for 2002) and
increased your basis in the bond by that amount. Your basis is now $7,934. If at the time
of the original issue there was no intention to call the bond before maturity, your gain
of $1,106 ($9,040 amount realized minus $7,934 adjusted basis) is capital gain.
Example 2. If, in Example 1, at the time of original
issue there was an intention to call the bond before maturity, your entire gain is
ordinary income. You figure this as follows:
| 1) |
Entire OID ($10,000 stated redemption price at maturity minus $7,600 issue price) |
$2,400 |
| 2) |
Minus: Amount previously included in income |
334 |
| 3) |
Maximum amount of ordinary income |
$2,066 |
Market discount bonds. If the
debt instrument has market discount and you chose to include the discount in income as it
accrued, increase your basis in the debt instrument by the accrued discount to
figure capital gain or loss on its disposition. If you did not choose to include the
discount in income as it accrued, you must report gain as ordinary interest income up to
the instrument's accrued market discount. See Market Discount Bonds in chapter 1.
The rest of the gain is capital gain.
However, a different rule applies if you dispose of a market discount bond that was:
- Issued before July 19, 1984, and
- Purchased by you before May 1, 1993.
In that case, any gain is treated as interest income up to the amount of your deferred
interest deduction for the year you dispose of the bond. The rest of the gain is capital
gain. (Deferred interest deduction for market discount bonds is discussed in chapter 3
under When To Deduct Investment Interest.)
Report the sale or trade of a market discount bond on Schedule D (Form 1040), line 1 or
line 8. If the sale or trade results in a gain and you did not choose to include market
discount in income currently, enter Accrued Market Discount on the next line in
column (a) and the amount of the accrued market discount as a loss in column (f). Also
report the amount of accrued market discount in column (f) as interest income on Schedule
B (Form 1040), line 1, and identify it as Accrued Market Discount.
Retirement of debt instrument. Any amount that you receive on the
retirement of a debt instrument is treated in the same way as if you had sold or traded
that instrument.
Notes of individuals. If you
hold an obligation of an individual that was issued with OID after March 1, 1984, you
generally must include the OID in your income currently, and your gain or loss on
its sale or retirement is generally capital gain or loss. An exception to this treatment
applies if the obligation is a loan between individuals and all of the following
requirements are met.
- The lender is not in the business of lending money.
- The amount of the loan, plus the amount of any outstanding prior loans, is $10,000 or
less.
- Avoiding federal tax is not one of the principal purposes of the loan.
If the exception applies, or the obligation was issued before March 2, 1984, you do not
include the OID in your income currently. When you sell or redeem the obligation, the part
of your gain that is not more than your accrued share of the OID at that time is ordinary
income. The rest of the gain, if any, is capital gain. Any loss on the sale or redemption
is capital loss.
Bearer Obligations
You cannot deduct any loss on an obligation required to be in
registered form that is instead held in bearer form. In addition, any gain on the
sale or other disposition of the obligation is ordinary income. However, if the issuer was
subject to a tax when the obligation was issued, then you can deduct any loss, and any
gain may qualify for capital gain treatment.
Obligations required to be in registered form. Any obligation must be in registered form unless:
- It is issued by a natural person,
- It is not of a type offered to the public,
- It has a maturity at the date of issue of not more than 1 year, or
- It was issued before 1983.
Deposit in Insolvent or
Bankrupt Financial Institution
If you lose money you have on deposit in a qualified financial
institution that becomes insolvent or bankrupt, you may be able to deduct your loss
in one of three ways.
- Ordinary loss,
- Casualty loss, or
- Nonbusiness bad debt (short-term capital loss).
Ordinary loss or casualty loss. If you can reasonably estimate your
loss, you can choose to treat the estimated loss as either an ordinary loss or a casualty
loss in the current year. Either way, you claim the loss as an itemized deduction.
If you claim an ordinary loss, report it as a miscellaneous itemized deduction on line
22 of Schedule A (Form 1040). The maximum amount you can claim is $20,000 ($10,000 if you
are married filing separately) reduced by any expected state insurance proceeds. Your loss
is subject to the 2%-of-adjusted-gross-income limit. You cannot choose to claim an
ordinary loss if any part of the deposit is federally insured.
If you claim a casualty loss, attach Form 4684, Casualties and Thefts, to
your return. Each loss must be reduced by $100. Your total casualty losses for the year
are reduced by 10% of your adjusted gross income.
You cannot choose either of these methods if:
- You own at least 1% of the financial institution,
- You are an officer of the institution, or
- You are related to such an owner or officer. You are related if you and the owner or
officer are related parties, as defined earlier under Related Party
Transactions, or if you are the aunt, uncle, nephew, or niece of the owner or
officer.
If the actual loss that is finally determined is more than the amount you deducted as
an estimated loss, you can claim the excess loss as a bad debt. If the actual loss is less
than the amount deducted as an estimated loss, you must include in income (in the final
determination year) the excess loss claimed. See Recoveries in Publication 525, Taxable
and Nontaxable Income.
Nonbusiness bad debt. If you do not choose to deduct your estimated
loss as a casualty loss or an ordinary loss, you wait until the year the amount of the
actual loss is determined and deduct it as a nonbusiness bad debt in that year. Report it
as a short-term capital loss on Schedule D (Form 1040), as explained under Nonbusiness
Bad Debts, later.
Sale of Annuity
The part of any gain on the sale of an annuity contract before its
maturity date that is based on interest accumulated on the contract is ordinary
income.
Conversion Transactions
Generally, all or part of a gain on a conversion transaction is
treated as ordinary income. This applies to gain on the disposition or other
termination of any position you held as part of a conversion transaction that you entered
into after April 30, 1993.
A conversion transaction is any transaction that meets both of these tests.
- Substantially all of your expected return from the transaction is due to the time value
of your net investment. In other words, the return on your investment is, in substance,
like interest on a loan.
- The transaction is one of the following.
- A straddle as defined under Straddles, later, but including any set of
offsetting positions on stock.
- Any transaction in which you acquire property (whether or not actively traded) at
substantially the same time that you contract to sell the same property, or substantially
identical property, at a price set in the contract.
- Any other transaction that is marketed or sold as producing capital gains from a
transaction described in (1).
Amount treated as ordinary income. The amount of gain treated as
ordinary income is the smaller of:
- The gain recognized on the disposition or other termination of the position, or
- The applicable imputed income amount.
Applicable imputed income amount. Figure this amount as follows.
- Figure the amount of interest that would have accrued on your net investment in the
conversion transaction for the period ending on the earlier of:
- The date when you dispose of the position, or
- The date when the transaction stops being a conversion transaction.
To figure this amount, use an interest rate equal to 120% of the applicable rate,
defined later.
- Subtract from (1) the amount treated as ordinary income from any earlier disposition or
other termination of a position held as part of the same conversion transaction.
Applicable rate. If the term of the conversion transaction
is indefinite, the applicable rate is the federal short-term rate in effect under section
6621(b) of the Internal Revenue Code during the period of the conversion transaction,
compounded daily.
In all other cases, the applicable rate is the applicable federal rate
determined as if the conversion transaction were a debt instrument and compounded
semi-annually.
The rates discussed above are published by the IRS in the Internal Revenue
Bulletin. Or, you can contact the IRS to get these rates. See chapter 5 for
information on contacting the IRS.
Net investment. To determine your net investment in a conversion
transaction, include the fair market value of any position at the time it becomes part of
the transaction. This means that your net investment generally will be the total amount
you invested, less any amount you received for entering into the position (for example, a
premium you received for writing a call).
Position with built-in loss. A special rule applies when a position
with a built-in loss becomes part of a conversion transaction. A built-in loss is any loss
that you would have realized if you had disposed of or otherwise terminated the position
at its fair market value at the time it became part of the conversion transaction.
When applying the conversion transaction rules to a position with a built-in loss, use
the position's fair market value at the time it became part of the transaction. But, when
you dispose of or otherwise terminate the position in a transaction in which you recognize
gain or loss, you must recognize the built-in loss. The conversion transaction rules do
not affect whether the built-in loss is treated as an ordinary or capital loss.
Netting rule for certain conversion transactions. Before determining
the amount of gain treated as ordinary income, you can net certain gains and losses from
positions of the same conversion transaction. To do this, you have to dispose of all the
positions within a 14-day period that is within a single tax year. You cannot net the
built-in loss against the gain.
 You can net gains
and losses only if you identify the conversion transaction as an identified netting
transaction on your books and records. Each position of the conversion transaction must be
identified before the end of the day on which the position becomes part of the conversion
transaction. For conversion transactions entered into before February 20, 1996, this
requirement is met if the identification was made by that date.
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