The Internal Revenue Code taxes “gains derived from dealings in property.” However, two types of gains exist, and the Code taxes only one. “Realized” gains are not subject to taxation. This type of gain represents net appreciation in property that has not yet been sold or exchanged. For example, an astute taxpayer might own a Monet purchased many years ago for $10,000 and now worth $1,000,000, but as long as the painting were not sold, no tax would be occasioned. On the other hand, that same person might own one share of LILCO, which when sold yields $1 of profit. That dollar would be reportable, since not only was it “realized” in the tax sense, but it was also “recognized.”
In the preceding example, had the Monet been sold, it would have yielded a profit of $990,000. Taxable gain has some affinity to the concept of profit, but this general correlation is subject to a number of modifications which may ultimately render the two terms at polar extremes. While profit is important in the economic sense, it has less relevance in taxation.
Taxable, or recognized, gain is measured by the difference between the amount realized (AR) in the sale or other disposition of the property, and the property’s adjusted basis (AB). This concept can be represented by the following equation: Gain = AR – AB. The amount realized is generally the fair market value of money or other property (including services) received in exchange for the property given up. Since maximization of the amount realized (AR) is almost always desirable for economic reasons, to minimize taxable gain one must also maximize adjusted basis (AB). Thus, maximization of basis is almost always a primary tax objective.
Not only does basis reduce gain upon eventual disposition of the property, but it also serves as the foundation for depreciation deductions. If depreciable property were purchased by a business for $10,000, and were not subject to expensing, the cost of the equipment could be recovered by yearly depreciation deductions. In five years the acquisition cost of “five year” property could be “written off” to zero. If the property still had residual value and were sold after having been fully depreciated, the entire sales price would constitute taxable gain.
Until now, we have discussed gain as if it were a unitary concept. In fact, the sale or exchange of noncapital assets yields ordinary gain, subject to the new higher income tax rates. However, the sale or exchange of “capital asset” property yields capital gains, which are taxed at a flat rate of 28 percent.
The Code defines capital assets by exclusion. Thus, all property held by the taxpayer is a capital asset, with the exception of inventory property, accounts receivable, and certain other property. Thus, the LILCO gain above would be a capital gain. The sale of the Monet would also produce capital gain, provided the seller was not in the business of collecting and trading art. Since the difference between $990,000 taxed as capital gain as opposed to ordinary gain (assuming a marginal rate of 39.6%) is $114,840, one would expect more frequent disputes between the Service and the taxpayer with respect to whether persons, such as the owner of the Monet, are casual collectors, or are in the business of collecting.
Suppose that the holder of the Monet wishes to pass on the value of the property represented by the painting to his son. Should he sell the painting and then give his son the proceeds, should he give his son the painting and let him sell it (or keep it), or should he hold the property until his own death, and bequeath it to his son?
If he bequeaths it to his son, the $990,000 of inherent taxable gain will vanish, since the basis of all property is “stepped up” to its fair market value at death. Thus, if the son sold the Monet one day after he inherited it for $1,000,000, he would report no capital gain. More than that, the son would realize no income upon his inheritance of the painting since for income tax purposes gross income does not include the value of property received by gift or bequest.
The tax consequences to the father’s estate in holding this property until death must also be considered. Even if the father had not yet made any use of his $600,000 lifetime exemption from transfer taxes, the retention of the painting worth $1,000,000 will occasion the levy of an estate tax of 38 percent on $400,000 (i.e., $1,000,000 fair market value at death of painting less $600,000 exemption equivalent), or $152,000.
Were the Monet instead sold outright, the sale would occasion a capital gains tax of $277,000 (i.e., $990,000 capital gain taxed at 28 percent). If the father lived 25 years, he could conceivably make yearly transfers that would qualify for the $10,000 annual exclusion, thereby preserving his $600,000 exemption equivalent. However, there is talk of the $10,000 annual exclusion being reduced to $3,000. There is also speculation that the $600,000 lifetime exemption from transfer taxes may be reduced.
What if the father simply gifted the painting to his son today? The son would be very happy, and further appreciation of the Monet would be removed from the estate, but the potential basis step-up would be lost. Instead, the son would take a “transferred” basis of $1,000 in the painting, setting the stage for a large potential capital gains tax. Moreover, since the gift tax, which is based on the fair market value of at the time of transfer, is also imposed at the time of transfer, the father would incur a gift tax of $152,000 today, calculated in a manner similar to that described for his estate, above.
In sum, if the father were willing to assume the risk that a substantial reduction in the $600,000 lifetime exemption would not occur before his death, he might consider holding the property until death. This would neutralize the potential capital gains tax (assuming the basis step-up provision is not repealed), and would also avoid the necessity of his being forced to make a painful prepayment of transfer taxes during his lifetime, which might cause liquidity problems if the gift were of the Monet itself, rather than its sale proceeds. This analysis also assumes that the benefit of removing potential appreciation of the Monet from the father’s estate is not so great as to tilt the scales back in favor of a lifetime gift.