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Pub. 17, Your Federal Income Tax 2004 Tax Year

Chapter 15 - Sale of Property

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Table of Contents

Reminder

Foreign income. If you are a U.S. citizen who sells property located outside the United States, you must report all gains and losses from the sale of that property on your tax return unless it is exempt by U.S. law. This is true whether you reside inside or outside the United States and whether or not you receive a Form 1099 from the payer.

Introduction

This chapter discusses the tax consequences of selling or trading investment property. It explains:

  • What a sale or trade is,

  • Figuring gain or loss,

  • Nontaxable trades,

  • Related party transactions,

  • Capital gains or losses,

  • Capital assets and noncapital assets,

  • Holding period, and

  • Rollover of gain from publicly traded securities.

Other property transactions.   Certain transfers of property are not discussed here. They are discussed in other IRS publications. These include:
Installment sales, covered in Publication 537, Installment Sales,
Transfers of property at death, covered in Publication 559, Survivors, Executors, and Administrators,
Transactions involving business property, covered in Publication 544, Sales and Other Dispositions of Assets,
Dispositions of an interest in a passive activity, covered in Publication 925, Passive Activity and At-Risk Rules, and
Sales of a main home, covered in chapter 16.

   Publication 550, Investment Income and Expenses (Including Capital Gains and Losses), provides more detailed discussion about sales and trades of investment property. Publication 550 includes information about the rules covering nonbusiness bad debts, straddles, section 1256 contracts, puts and calls, commodity futures, short sales, and wash sales. It also discusses investment-related expenses.

Useful Items - You may want to see:

Publication

  • 550 Investment Income and Expenses

  • 564 Mutual Fund Distributions

Form (and Instructions)

  • Schedule D (Form 1040)
    Capital Gains and Losses

  • 8824
    Like-Kind Exchanges

Sales and Trades

If you sold property such as stocks, bonds, or certain commodities through a broker during the year, you should receive, for each sale, a Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, or an equivalent statement from the broker. You should receive the statement by January 31 of the next year. It will show the gross proceeds from the sale. The IRS will also get a copy of Form 1099-B from the broker.

Use Form 1099-B (or an equivalent statement received from your broker) to complete Schedule D (Form 1040).

What Is a Sale or Trade?

This section explains what is a sale or trade. It also explains certain transactions and events that are treated as sales or trades.

A sale is generally a transfer of property for money or a mortgage, note, or other promise to pay money.

A trade is a transfer of property for other property or services and may be taxed in the same way as a sale.

Sale and purchase.   Ordinarily, a transaction is not a trade when you voluntarily sell property for cash and immediately buy similar property to replace it. The sale and purchase are two separate transactions. But see Like-kind exchanges under Nontaxable Trades, later.

Redemption of stock.   A redemption of stock is treated as a sale or trade and is subject to the capital gain or loss provisions unless the redemption is a dividend or other distribution on stock.

Dividend versus sale or trade.   Whether a redemption is treated as a sale, trade, dividend, or other distribution depends on the circumstances in each case. Both direct and indirect ownership of stock will be considered. The redemption is treated as a sale or trade of stock if:

  1. The redemption is not essentially equivalent to a dividend (see chapter 9),

  2. There is a substantially disproportionate redemption of stock,

  3. There is a complete redemption of all the stock of the corporation owned by the shareholder, or

  4. The redemption is a distribution in partial liquidation of a corporation.

Redemption or retirement of bonds.   A redemption or retirement of bonds or notes at their maturity is generally treated as a sale or trade.

Surrender of stock.   A surrender of stock by a dominant shareholder who retains control of the corporation is treated as a contribution to capital rather than as an immediate loss deductible from taxable income. The surrendering shareholder must reallocate his or her basis in the surrendered shares to the shares he or she retains.

Worthless securities.    Stocks, stock rights, and bonds (other than those held for sale by a securities dealer) that became worthless during the tax year are treated as though they were sold on the last day of the tax year. This affects whether your capital loss is long-term or short-term. See Holding Period, later.

   If you are a cash basis taxpayer and make payments on a negotiable promissory note that you issued for stock that became worthless, you can deduct these payments as losses in the years you actually make the payments. Do not deduct them in the year the stock became worthless.

How to report loss.    Report worthless securities on Schedule D (Form 1040), line 1 or line 8, whichever applies. In columns (c) and (d), enter “Worthless.” Enter the amount of your loss in parentheses in column (f).

Filing a claim for refund.   If you do not claim a loss for a worthless security on your original return for the year it becomes worthless, you can file a claim for a credit or refund due to the loss. You must use Form 1040X, Amended U.S. Individual Income Tax Return, to amend your return for the year the security became worthless. You must file it within 7 years from the date your original return for that year had to be filed, or 2 years from the date you paid the tax, whichever is later. For more information about filing a claim, see Amended Returns and Claims for Refund in chapter 1.

How To Figure Gain or Loss

You figure gain or loss on a sale or trade of property by comparing the amount you realize with the adjusted basis of the property.

Gain.   If the amount you realize from a sale or trade is more than the adjusted basis of the property you transfer, the difference is a gain.

Loss.   If the adjusted basis of the property you transfer is more than the amount you realize, the difference is a loss.

Adjusted basis.   The adjusted basis of property is your original cost or other original basis properly adjusted (increased or decreased) for certain items. See chapter 14 for more information about determining the adjusted basis of property.

Amount realized.   The amount you realize from a sale or trade of property is everything you receive for the property. This includes the money you receive plus the fair market value of any property or services you receive. If you received a note or other debt instrument for the property, see How To Figure Gain or Loss in chapter 4 of Publication 550 to figure the amount realized.

If you finance the buyer's purchase of your property and the debt instrument does not provide for adequate stated interest, the unstated interest that you must report as ordinary income will reduce the amount realized from the sale. For more information, see Publication 537.

Fair market value.   Fair market value is the price at which the property would change hands between a buyer and a seller, neither being forced to buy or sell and both having reasonable knowledge of all the relevant facts.

Example.

You trade A Company stock with an adjusted basis of $7,000 for B Company stock with a fair market value of $10,000, which is your amount realized. Your gain is $3,000 ($10,000 - $7,000).

Debt paid off.    A debt against the property, or against you, that is paid off as a part of the transaction, or that is assumed by the buyer, must be included in the amount realized. This is true even if neither you nor the buyer is personally liable for the debt. For example, if you sell or trade property that is subject to a nonrecourse loan, the amount you realize generally includes the full amount of the note assumed by the buyer even if the amount of the note is more than the fair market value of the property.

Example.

You sell stock that you had pledged as security for a bank loan of $8,000. Your basis in the stock is $6,000. The buyer pays off your bank loan and pays you $20,000 in cash. The amount realized is $28,000 ($20,000 + $8,000). Your gain is $22,000 ($28,000 - $6,000).

Payment of cash.   If you trade property and cash for other property, the amount you realize is the fair market value of the property you receive. Determine your gain or loss by subtracting the cash you pay plus the adjusted basis of the property you trade in from the amount you realize. If the result is a positive number, it is a gain. If the result is a negative number, it is a loss.

No gain or loss.   You may have to use a basis for figuring gain that is different from the basis used for figuring loss. In this case, you may have neither a gain nor a loss. See Basis Other Than Cost in chapter 14.

Nontaxable Trades

This section discusses trades that generally do not result in a taxable gain or deductible loss. For more information on nontaxable trades, see chapter 1 of Publication 544.

Like-kind exchanges.   If you trade business or investment property for other business or investment property of a like kind, you do not pay tax on any gain or deduct any loss until you sell or dispose of the property you receive. To be nontaxable, a trade must meet all six of the following conditions.

  1. The property must be business or investment property. You must hold both the property you trade and the property you receive for productive use in your trade or business or for investment. Neither property may be property used for personal purposes, such as your home or family car.

  2. The property must not be held primarily for sale. The property you trade and the property you receive must not be property you sell to customers, such as merchandise.

  3. The property must not be stocks, bonds, notes, choses in action, certificates of trust or beneficial interest, or other securities or evidences of indebtedness or interest, including partnership interests. However, you can have a nontaxable trade of corporate stocks under a different rule, as discussed later.

  4. There must be a trade of like property. The trade of real estate for real estate, or personal property for similar personal property is a trade of like property. The trade of an apartment house for a store building, or a panel truck for a pickup truck, is a trade of like property. The trade of a piece of machinery for a store building is not a trade of like property. Real property located in the United States and real property located outside the United States are not like property. Also, personal property used predominantly within the United States and personal property used predominantly outside the United States are not like property.

  5. The property to be received must be identified in writing within 45 days after the date you transfer the property given up in the trade.

  6. The property to be received must be received by the earlier of:

    1. The 180th day after the date on which you transfer the property given up in the trade, or

    2. The due date, including extensions, for your tax return for the year in which the transfer of the property given up occurs.

   If you trade property with a related party in a like-kind exchange, a special rule may apply. See Related Party Transactions, later in this chapter. Also, see chapter 1 of Publication 544 for more information on exchanges of business property and special rules for exchanges using qualified intermediaries or involving multiple properties.

Partly nontaxable exchange.   If you receive money or unlike property in addition to like property, and the above six conditions are met, you have a partly nontaxable trade. You are taxed on any gain you realize, but only up to the amount of the money and the fair market value of the unlike property you receive. You cannot deduct a loss.

Like property and unlike property transferred.   If you give up unlike property in addition to the like property, you must recognize gain or loss on the unlike property you give up. The gain or loss is the difference between the adjusted basis of the unlike property and its fair market value.

Like property and money transferred.   If conditions (1) – (6) are met, you have a nontaxable trade even if you pay money in addition to the like property.

Basis of property received.   To figure the basis of the property received, see Nontaxable Exchanges in chapter 14.

How to report.    You must report the trade of like property on Form 8824. If you figure a recognized gain or loss on Form 8824, report it on Schedule D (Form 1040) or on Form 4797, Sales of Business Property, whichever applies.

  For information on using Form 4797, see chapter 4 of Publication 544.

Corporate stocks.   The following trades of corporate stocks generally do not result in a taxable gain or a deductible loss.

Corporate reorganizations.   In some instances, a company will give you common stock for preferred stock, preferred stock for common stock, or stock in one corporation for stock in another corporation. If this is a result of a merger, recapitalization, transfer to a controlled corporation, bankruptcy, corporate division, corporate acquisition, or other corporate reorganization, you do not recognize gain or loss.

Stock for stock of the same corporation.   You can exchange common stock for common stock or preferred stock for preferred stock in the same corporation without having a recognized gain or loss. This is true for a trade between two stockholders as well as a trade between a stockholder and the corporation.

Convertible stocks and bonds.   You generally will not have a recognized gain or loss if you convert bonds into stock or preferred stock into common stock of the same corporation according to a conversion privilege in the terms of the bond or the preferred stock certificate.

Property for stock of a controlled corporation.   If you transfer property to a corporation solely in exchange for stock in that corporation, and immediately after the trade you are in control of the corporation, you ordinarily will not recognize a gain or loss. This rule applies both to individuals and to groups who transfer property to a corporation. It does not apply if the corporation is an investment company.

  For this purpose, to be in control of a corporation, you or your group of transferors must own, immediately after the exchange, at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the outstanding shares of each class of nonvoting stock of the corporation.

  If this provision applies to you, you must attach to your return a complete statement of all facts pertinent to the exchange.

Additional information.   For more information on trades of stock, see Nontaxable Trades in chapter 4 of Publication 550.

Insurance policies and annuities.   You will not have a recognized gain or loss if the insured or annuitant is the same under both contracts and you trade:

  1. A life insurance contract for another life insurance contract or for an endowment or annuity contract,

  2. An endowment contract for an annuity contract or for another endowment contract that provides for regular payments beginning at a date not later than the beginning date under the old contract, or

  3. An annuity contract for another annuity contract.

  You also may not have to recognize gain or loss on an exchange of a portion of an annuity contract for another annuity contract. See Revenue Ruling 2003-76 and Notice 2003-51.

  Exchanges of contracts not included in this list, such as an annuity contract for an endowment contract, or an annuity or endowment contract for a life insurance contract, are taxable.

Demutualization of life insurance companies.   If you received stock in exchange for your equity interest as a policyholder or an annuitant, you generally will not have a recognized gain or loss. See Demutualization of Life Insurance Companies in Publication 550.

U.S. Treasury notes or bonds.   You can trade certain issues of U.S. Treasury obligations for other issues designated by the Secretary of the Treasury, with no gain or loss recognized on the trade.

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 in the following situations.

  • The recipient spouse or former spouse is a nonresident alien.

  • Property is transferred in trust. Gain must be recognized to the extent the amount of the liabilities assumed by the trust, plus any liabilities on the property, exceed the adjusted basis of the property.

For other situations, see Publication 550.

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.

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 of 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 filed for the year in which the later disposition occurs.

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.

  1. 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.).

  2. A partnership in which you directly or indirectly own more than 50% of the capital interest or the profits interest.

  3. A corporation in which you directly or indirectly own more than 50% in value of the outstanding stock. (See Constructive ownership of stock, later.)

  4. 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.

  1. A grantor and fiduciary, or the fiduciary and beneficiary, of any trust.

  2. Fiduciaries of two different trusts, or the fiduciary and beneficiary of two different trusts, if the same person is the grantor of both trusts.

  3. 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.

  4. 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.

  5. Two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation.

  6. 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.

  7. An executor and a beneficiary of an estate (except in the case of a sale or trade to satisfy a pecuniary bequest).

  8. Two corporations that are members of the same controlled group. (Under certain conditions, however, these losses are not disallowed but must be deferred.)

  9. 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 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 in chapter 4 of Publication 550 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

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 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. Reporting capital gains and losses is explained in chapter 17.

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.

  1. Property held mainly for sale to customers or property that will physically become a part of the merchandise that is for sale to customers.

  2. Depreciable property used in your trade or business, even if fully depreciated.

  3. Real property used in your trade or business.

  4. A copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property:

    1. Created by your personal efforts,

    2. Prepared or produced for you (in the case of a letter, memorandum, or similar property), or

    3. 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.

  5. 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).

  6. U.S. Government publications that you received from the government for 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 for free or for less than the normal sales price.

  7. Certain commodities derivative financial instruments held by commodities derivatives dealers.

  8. 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.

  9. 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 is generally 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 you have 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 held for sale by a securities dealer. However, if you own small business stock, see Losses on Section 1244 (Small Business) Stock and Losses on Small Business Investment Company Stock in chapter 4 of Publication 550.

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 of Publication 550.

Short-term nongovernment obligations.   Treat gains on short-term nongovernment obligations as ordinary income up to your ratable share of original issue discount (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 of Publication 550.

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 Debt Instruments in chapter 4 of Publication 550.

  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 is ordinary income.

  You figure the 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 of Publication 550.

   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, 1993, 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, 2004) 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 the 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.

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 8 for information about the OID that you must report on your tax return.

  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.

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. The rest of the gain is capital gain. See Market Discount Bonds in chapter 1 of Publication 550.

  A different rule applies to market discount bonds issued before July 19, 1984, and purchased by you before May 1, 1993. See Market discount bonds under Discounted Debt Instruments in chapter 4 of Publication 550.

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.

  1. The lender is not in the business of lending money.

  2. The amount of the loan, plus the amount of any outstanding prior loans, is $10,000 or less.

  3. 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.

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.

  1. Ordinary loss,

  2. Casualty loss, or

  3. 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 Schedule A (Form 1040), line 22. 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:

  1. You own at least 1% of the financial institution,

  2. You are an officer of the institution, or

  3. 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 choose to treat the loss as a bad debt, see How to report 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.

Losses on Section 1244 (Small Business) Stock

You can deduct as an ordinary loss, rather than as a capital loss, your loss on the sale, trade, or worthlessness of section 1244 stock. Report the loss on Form 4797, line 10.

Any gain on this stock is capital gain and is reported on Schedule D (Form 1040) if the stock is a capital asset in your hands. See Losses on Section 1244 (Small Business) Stock in chapter 4 of Publication 550.

Losses on Small Business Investment Company Stock

See Losses on Small Business Investment Company Stock in chapter 4 of Publication 550.

Holding Period

If you sold or traded investment property, you must determine your holding period for the property. Your holding period determines whether any capital gain or loss was a short-term or long-term capital gain or loss.

Long term or short term.   If you hold investment property more than 1 year, any capital gain or loss is a long-term capital gain or loss. If you hold the property 1 year or less, any capital gain or loss is a short-term capital gain or loss.

  To determine how long you held the investment property, begin counting on the date after the day you acquired the property. The day you disposed of the property is part of your holding period.

Example.

If you bought investment property on February 5, 2003, and sold it on February 5, 2004, your holding period is not more than 1 year and you have a short-term capital gain or loss. If you sold it on February 6, 2004, your holding period is more than 1 year and you will have a long-term capital gain or loss.

Securities traded on established market.   For securities traded on an established securities market, your holding period begins the day after the trade date you bought the securities, and ends on the trade date you sold them.

  
Caution
 Do not confuse the trade date with the settlement date, which is the date by which the stock must be delivered and payment must be made.

Example.

You are a cash method, calendar year taxpayer. You sold stock at a gain on December 29, 2004. According to the rules of the stock exchange, the sale was closed by delivery of the stock 3 trading days after the sale, on January 3, 2005. You received payment of the sales price on that same day. Report your gain on your 2004 return, even though you received the payment in 2005. The gain is long term or short term depending on whether you held the stock more than 1 year. Your holding period ended on December 29. If you had sold the stock at a loss, you would also report it on your 2004 return.

Automatic investment service.   In determining your holding period for shares bought by the bank or other agent, full shares are considered bought first and any fractional shares are considered bought last. Your holding period starts on the day after the bank's purchase date. If a share was bought over more than one purchase date, your holding period for that share is a split holding period. A part of the share is considered to have been bought on each date that stock was bought by the bank with the proceeds of available funds.

Nontaxable trades.   If you acquire investment property in a trade for other investment property and your basis for the new property is determined, in whole or in part, by your basis in the old property, your holding period for the new property begins on the day following the date you acquired the old property.

Property received as a gift.   If you receive a gift of property and your basis is determined by the donor's adjusted basis, your holding period is considered to have started on the same day the donor's holding period started.

  If your basis is determined by the fair market value of the property, your holding period starts on the day after the date of the gift.

Inherited property.   If you inherit investment property, your capital gain or loss on any later disposition of that property is treated as a long-term capital gain or loss. This is true regardless of how long you actually held the property.

Real property bought.   To figure how long you have held real property bought under an unconditional contract, begin counting on the day after you received title to it or on the day after you took possession of it and assumed the burdens and privileges of ownership, whichever happened first. However, taking delivery or possession of real property under an option agreement is not enough to start the holding period. The holding period cannot start until there is an actual contract of sale. The holding period of the seller cannot end before that time.

Stock dividends.   The holding period for stock you received as a taxable stock dividend begins on the date of distribution.

  The holding period for new stock you received as a nontaxable stock dividend begins on the same day as the holding period of the old stock. This rule also applies to stock acquired in a “spin-off,” which is a distribution of stock or securities in a controlled corporation.

Nontaxable stock rights.   Your holding period for nontaxable stock rights begins on the same day as the holding period of the underlying stock. The holding period for stock acquired through the exercise of stock rights begins on the date the right was exercised.

Nonbusiness Bad Debts

If someone owes you money that you cannot collect, you have a bad debt. You may be able to deduct the amount owed to you when you figure your tax for the year the debt becomes worthless.

Bad debts that did not come from operating your trade or business are nonbusiness bad debts and are deductible as short-term capital losses. To be deductible, nonbusiness bad debts must be totally worthless. You cannot deduct a partly worthless nonbusiness debt.

Genuine debt required.   A debt must be genuine for you to deduct a loss. A debt is genuine if it arises from a debtor-creditor relationship based on a valid and enforceable obligation to repay a fixed or determinable sum of money.

Basis in bad debt required.    To deduct a bad debt, you must have a basis in it — that is, you must have already included the amount in your income or loaned out your cash. For example, you cannot claim a bad debt deduction for court-ordered child support not paid to you by your former spouse. If you are a cash method taxpayer (as most individuals are), you generally cannot take a bad debt deduction for unpaid salaries, wages, rents, fees, interest, dividends, and similar items.

How to report bad debts.    Deduct nonbusiness bad debts as short-term capital losses on Schedule D (Form 1040).

  On Schedule D, Part I, line 1, enter the name of the debtor and “statement attached” in column (a). Enter the amount of the bad debt in parentheses in column (f). Use a separate line for each bad debt.

  For each bad debt, attach a statement to your return that contains:

  1. A description of the debt, including the amount, and the date it became due,

  2. The name of the debtor, and any business or family relationship between you and the debtor,

  3. The efforts you made to collect the debt, and

  4. Why you decided the debt was worthless. For example, you could show that the borrower has declared bankruptcy, or that legal action to collect would probably not result in payment of any part of the debt.

Filing a claim for refund.    If you do not deduct a bad debt on your original return for the year it becomes worthless, you can file a claim for a credit or refund due to the bad debt. To do this, use Form 1040X to amend your return for the year the debt became worthless. You must file it within 7 years from the date your original return for that year had to be filed, or 2 years from the date you paid the tax, whichever is later. For more information about filing a claim, see Amended Returns and Claims for Refund in chapter 1.

Additional information.   For more information, see Nonbusiness Bad Debts in Publication 550. For information on business bad debts, see chapter 11 of Publication 535, Business Expenses.

Rollover of Gain From Publicly Traded Securities

You may qualify for a tax-free rollover of certain gains from the sale of publicly traded securities. This means that if you buy certain replacement property and make the choice described in this section, you postpone part or all of your gain.

You postpone the gain by adjusting the basis of the replacement property as described in Basis of replacement property, later. This postpones your gain until the year you dispose of the replacement property.

You qualify to make this choice if you meet all the following tests.

  1. You sell publicly traded securities at a gain. Publicly traded securities are securities traded on an established securities market.

  2. Your gain from the sale is a capital gain.

  3. During the 60-day period beginning on the date of the sale, you buy replacement property. This replacement property must be either common stock or a partnership interest in a specialized small business investment company (SSBIC). This is any partnership or corporation licensed by the Small Business Administration under section 301(d) of the Small Business Investment Act of 1958, as in effect on May 13, 1993.

Amount of gain recognized.   If you make the choice described in this section, you must recognize gain only up to the following amount.

  1. The amount realized on the sale, minus

  2. The cost of any common stock or partnership interest in an SSBIC that you bought during the 60-day period beginning on the date of sale (and did not previously take into account on an earlier sale of publicly traded securities).

If this amount is less than the amount of your gain, you can postpone the rest of your gain, subject to the limit described next. If this amount is equal to or more than the amount of your gain, you must recognize the full amount of your gain.

Limit on gain postponed.   The amount of gain you can postpone each year is limited to the smaller of:

  1. $50,000 ($25,000 if you are married and file a separate return), or

  2. $500,000 ($250,000 if you are married and file a separate return), minus the amount of gain you postponed for all earlier years.

Basis of replacement property.   You must subtract the amount of postponed gain from the basis of your replacement property.

How to report and postpone gain.    See chapter 4 of Publication 550 for details on how to report and postpone the gain.

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