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Timing Questions

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1. Default Rule. Realized gains are recognized unless there is an exception set forth in the Code (SS1001(c)).

2. NonRecognition Transactions. Certain sections of the Code provide that gain or loss realized on the sale, exchange, or other disposition of property should not be recognized. Examples of non
recognition dispositions include (1) like kind exchange; (2) involuntary conversion; and (3) sale of principal residence.

3. Exchanges of "Like Kind" Properties. Under SS1031, no gain or loss can be recognized when certain property held for production of income is exchanged for property of a like kind. Unlike other non
recognition provisions, SS1031 is nonelective, so in theory it prevents recognition of loss as the result of a like kind exchange. However,
SS1031 can be avoided by structuring a transaction as a sale and reinvestment of sale proceeds. Section 1031 does not apply to inventory or other property held primarily for sale to customers, or to most capital assets. Properties exchanged must be of a similar nature. Thus, an exchange of real property for personal property does not qualify for SS1031 treatment because it is not an exchange of "like kind" properties. Real Estate. Exchange of improved realty for unimproved realty is considered to be a "like kind" exchange. Thus, most real estate can be exchanged for other real property without recognition, provided that the real property is held for investment or productive use in a trade of business. Policy Justification. There does not appear to be a convincing policy justification for this rule. The rule allows taxpayers who own assets that qualify for SS1031 treatment to elect whichever tax result---non
recognition or recognition---is most advantageous.

4. Exchanges of "Like Kind" Properties: Basis and Boot. When "like kind" properties of equal value are exchanged in a non
recognition transaction, the basis of the property given up becomes the basis of the property received. If the properties exchanged are not of equal value, one party will also transfer "boot." "Boot" is money or other nonqualifying property (e.g., assumption of

outstanding mortgage) used to equalize an exchange of like kind property. A taxpayer who received boot and like kind property will recognize gain on the boot up to the amount of gain realized. The basis of the like kind property will be adjusted downward to reflect any boot received and upward by any gain recognized. The taxpayer paying boot adds the boot to the basis of the likekind property given up in the exchange.

5. Involuntary Conversions. Section 1033 permits nonrecognition of gain (but not loss) resulting from involuntary conversion, provided that the taxpayer uses the proceeds to acquire "property similar or related in service or use" to the property converted. The taxpayer must acquire the new property by the end of the second year following the taxable year in which the conversion occurs. Unlike SS1031, SS1033 is elective. Basis for the taxpayer is the cost of the replacement property less any gain realized but not recognized as the result of the involuntary conversion.

6. Principal Residence. A taxpayer may exclude $250,000 of gain from the sale of her principal residence (SS121).

7. Specialized Small Business Investment Companies. A taxpayer is permitted to forgo recognition of gain on the sale of publiclytraded securities provided the proceeds are invested in a "specialized small business investment" company within 60 days of sale. The taxpayer's basis in the SSBIC stock is reduced by the gain not recognized (that is, the taxpayer gets to count as basis only the money paid out of pocket for the stock).

8. Qualified Small Business Stock. A taxpayer can defer recognition of gain on the sale of "qualified small business stock" so long as the stock has been held for more than six months and the taxpayer purchases replacement stock in another qualified small business company (SS1045). B. CONSTRUCTIVE REALIZATION Note that problems associated with constructive realization are limited to cashmethod taxpayers---accrual method taxpayers are already be taxable after a constructive realization transaction because "all events" would have occurred "which determine the fact of liability and the amount of such liability" would be determinable "with reasonable accuracy."

1. Halperin Article: Halperin argues that most people agree "it is inappropriate for taxpayers to be able to dispose of the economic risks and rewards of owning appreciated property without realizing income for tax purposes." But in light of new financial innovations, this is exactly what is happening: "we can no longer rely on the investor's desire to change or reduce risk to assure substantial payment of the tax on appreciation in property." To respond to this problem, Halperin argues that we should move to a marktomarket system. Such a system would permit full usage of all economic losses, eliminate the need for special treatment of capital gains (because there would be no risk of "lock in"), and would allow for the Code to be simplified substantially.

2. Constructive Sale Rule. SS1259 taxes the holder on any gain where there is deemed to be a constructive sale of an appreciated financial position. A constructive sale is deemed to exist where the taxpayer enters a short sale or an offsetting notional principal contract with respect to the same or substantially identical property, or enters a futures or forward contract to deliver the same or substantially identical property. A constructive sale also occurs where the taxpayer holds an appreciated short position in the property and acquires a long position in the same property.

3. Short Sale Against the Box. Under prior law, when a taxpayer sold securities identified as borrowed securities, gain or loss could not be computed because the taxpayer's cost for the securities was not known. Recognition of gain or loss on the sale of borrowed securities was postponed until the taxpayer closed the sale by returning identical property to the lender. Taxpayers exploited this rule in the following manner: A taxpayer with 100 shares would borrow 100 shares in the same corporation to sell. No gain or loss would be realized on the sale of the borrowed shares until the taxpayer closed the sale by returning identical property to the lender. Because the taxpayer had 100 shares in the "box," he could close out at any time and was not subject to any risk with regard to stock price. Thus, he could borrow up to 95% of the sale proceeds, because he effectively frozen the value of his stock in the "box." Under SS1259(c)(1)(A), a short sale against the box will give rise to automatic realization.

4. Futures Contracts and Put Options. A futures contract is a contract to deliver a certain quantity of stock in the future for a fixed price (thus, eliminating both negative and positive risk on the stock). A put option is an option to sell a security at its current value (thus, a hedge against future decline in the stock value).

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