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Taxmap/pubs/p550-026.htm#TXMP6b438e72 Capital Gains   and Losses

Capital Gains and Losses

Words you may need to know (see Glossary)

• 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.

Taxmap/pubs/p550-026.htm#TXMP6f805415 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. 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 and unrecaptured section 1250 gain, see Capital Gain Tax Rates under Reporting Capital Gains and Losses, later.

Taxmap/pubs/p550-026.htm#TXMP5e10f43b Capital or Ordinary   Gain or Loss

Sale of Property, 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.

Taxmap/pubs/p550-026.htm#TXMP561f6ae0 Capital Assets and   Noncapital Assets

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. For more information, see section 1221 of the Internal Revenue Code.
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. For more information, see the definition of hedging transaction earlier, and the discussion of hedging transactions under Commodity Futures, later.
9. Supplies of a type you regularly use or consume in the ordinary course of your trade or business.

Taxmap/pubs/p550-026.htm#TXMP4060a2d2 Investment property.

Investment property is a capital asset. Any gain or loss from its sale or trade generally is a capital gain or loss.

Taxmap/pubs/p550-026.htm#TXMP1840ef03 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.

Taxmap/pubs/p550-026.htm#TXMP2f03ff04 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.

Taxmap/pubs/p550-026.htm#TXMP56ac606c 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.

Taxmap/pubs/p550-026.htm#TXMP5de6aeb3

Taxmap/pubs/p550-026.htm#TXMP1bb36814 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.

Taxmap/pubs/p550-026.htm#TXMP599b772d 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.

Taxmap/pubs/p550-026.htm#TXMP55564bab 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.

Taxmap/pubs/p550-026.htm#TXMP74b4001f 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.

Taxmap/pubs/p550-026.htm#TXMP228458de 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.

Taxmap/pubs/p550-026.htm#TXMP54798f82
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.

Taxmap/pubs/p550-026.htm#TXMP3ffb22d9 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.

Taxmap/pubs/p550-026.htm#TXMP6680d07b
Example.

You bought a 30-year, 6% government bond for $700 at original issue on April 1, 1985, and sold it for $900 on April 21, 2004, 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.

Taxmap/pubs/p550-026.htm#TXMP0f3ec30c 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.

Taxmap/pubs/p550-026.htm#TXMP2453cd2a
Example 1.

On February 4, 2002, 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, 2004, you sold the bond for $9,040. Assume you have included $334 of the OID in your gross income (including the amount accrued for 2004) 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.

Taxmap/pubs/p550-026.htm#TXMP15c48898
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

Because the amount in (3) is more than your gain of $1,106, your entire gain is ordinary income.

Taxmap/pubs/p550-026.htm#TXMP033fcefc 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:

1. Issued before July 19, 1984, and
2. 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. (The limit on the 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."

Taxmap/pubs/p550-026.htm#TXMP608b95e6 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.

Taxmap/pubs/p550-026.htm#TXMP02845b2c 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.

Taxmap/pubs/p550-026.htm#TXMP00c049e8 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.

Taxmap/pubs/p550-026.htm#TXMP64fc5e19 Obligations required to be in registered form.

Any obligation must be in registered form unless:

1. It is issued by a natural person,
2. It is not of a type offered to the public,
3. It has a maturity at the date of issue of not more than 1 year, or
4. It was issued before 1983.

Taxmap/pubs/p550-026.htm#TXMP5cd7fc19 Deposit in Insolvent or   Bankrupt Financial Institution

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).

Taxmap/pubs/p550-026.htm#TXMP16d13ffd 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.

Taxmap/pubs/p550-026.htm#TXMP07b29b5e 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.

Taxmap/pubs/p550-026.htm#TXMP7c1d27f1 Sale of Annuity

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.

Taxmap/pubs/p550-026.htm#TXMP3643df28 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.

1. 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.
2. The transaction is one of the following.
   1. A straddle as defined under Straddles, later, but including any set of offsetting positions on stock.
   2. 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.
   3. Any other transaction that is marketed or sold as producing capital gains from a transaction described in (1).

Taxmap/pubs/p550-026.htm#TXMP629571f4 Amount treated as ordinary income.

The amount of gain treated as ordinary income is the smaller of:

1. The gain recognized on the disposition or other termination of the position, or
2. The "applicable imputed income amount."

Taxmap/pubs/p550-026.htm#TXMP728ae9cd Applicable imputed income amount.

Figure this amount as follows.

1. 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:
   1. The date when you dispose of the position, or
   2. 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.
   
2. 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.

Taxmap/pubs/p550-026.htm#TXMP4776d49b 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.

Taxmap/pubs/p550-026.htm#TXMP6e2b5849 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).

Taxmap/pubs/p550-026.htm#TXMP237fd630 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.

Taxmap/pubs/p550-026.htm#TXMP69dde7a7 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.

Taxmap/pubs/p550-026.htm#TXMP6181ef7e Options dealers and commodities traders.

These rules do not apply to options dealers and commodities traders.

Taxmap/pubs/p550-026.htm#TXMP33261864 How to report.

Use Form 6781, Gains and Losses From Section 1256 Contracts and Straddles, to report conversion transactions. See the instructions for lines 11 and 13 of Form 6781.

Taxmap/pubs/p550-026.htm#TXMP6c1c119b Commodity Futures

A commodity futures contract is a standardized, exchange-traded contract for the sale or purchase of a fixed amount of a commodity at a future date for a fixed price.

If the contract is a regulated futures contract, the rules described earlier under Section 1256 Contracts Marked To Market apply to it.

The termination of a commodity futures contract generally results in capital gain or loss unless the contract is a hedging transaction.

Taxmap/pubs/p550-026.htm#TXMP6e9216ff Hedging transaction.

A futures contract that is a hedging transaction generally produces ordinary gain or loss. A futures contract is a hedging transaction if you enter into the contract in the ordinary course of your business primarily to manage the risk of interest rate or price changes or currency fluctuations on borrowings, ordinary property, or ordinary obligations. (Generally, ordinary property or obligations are those that cannot produce capital gain or loss under any circumstances.) For example, the offset or exercise of a futures contract that protects against price changes in your business inventory results in an ordinary gain or loss.

For more information about hedging transactions, see Regulations section 1.1221-2. Also, see Hedging Transactions under Section 1256 Contracts Marked to Market, earlier.

If you have numerous transactions in the commodity futures market during the year, the burden of proof is on you to show which transactions are hedging transactions. Clearly identify any hedging transactions on your books and records before the end of the day you entered into the transaction. It may be helpful to have separate brokerage accounts for your hedging and nonhedging transactions. For specific requirements concerning identification of hedging transactions and the underlying item, items, or aggregate risk that is being hedged, see Regulations section 1.1221-2(f).

Taxmap/pubs/p550-026.htm#TXMP7767e8f7 Gains From Certain Constructive Ownership Transactions

Gain From Certain Constructive Ownership Transactions

If you have a gain from a constructive ownership transaction entered into after July 11, 1999, involving a financial asset (discussed later) and the gain normally would be treated as long-term capital gain, all or part of the gain may be treated instead as ordinary income. In addition, if any gain is treated as ordinary income, your tax is increased by an interest charge.

Taxmap/pubs/p550-026.htm#TXMP4a0ef3f9 Constructive ownership transactions.

The following are constructive ownership transactions.

1. A notional principal contract in which you have the right to receive all or substantially all of the investment yield on a financial asset and you are obligated to reimburse all or substantially all of any decline in value of the financial asset.
2. A forward or futures contract to acquire a financial asset.
3. The holding of a call option and writing of a put option on a financial asset at substantially the same strike price and maturity date.

This provision does not apply if all the positions are marked to market. Marked to market rules for section 1256 contracts are discussed in detail under Section 1256 Contracts Marked to Market, earlier.

Taxmap/pubs/p550-026.htm#TXMP6722e708 Financial asset.

A financial asset, for this purpose, is any equity interest in a pass-through entity. Pass-through entities include partnerships, S corporations, trusts, regulated investment companies, and real estate investment trusts.

Taxmap/pubs/p550-026.htm#TXMP62be7627 Amount of ordinary income.

Long-term capital gain is treated as ordinary income to the extent it is more than the net underlying long-term capital gain. The net underlying long-term capital gain is the amount of net capital gain you would have realized if you acquired the asset for its fair market value on the date the constructive ownership transaction was opened, and sold the asset for its fair market value on the date the transaction was closed. If you do not establish the amount of net underlying long-term capital gain by clear and convincing evidence, it is treated as zero.

Taxmap/pubs/p550-026.htm#TXMP78262369 More information.

For more information about constructive ownership transactions, see section 1260 of the Internal Revenue Code.

Taxmap/pubs/p550-026.htm#TXMP7707da7f Losses on Section 1244   (Small Business) Stock

Section 1244, Small Business Stock

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

Any gain on section 1244 stock is a capital gain if the stock is a capital asset in your hands. Do not offset gains against losses that are within the ordinary loss limit, explained later in this discussion, even if the transactions are in stock of the same company. Report the gain on Schedule D (Form 1040).

If you must figure a net operating loss, any ordinary loss from the sale of section 1244 stock is a business loss.

Taxmap/pubs/p550-026.htm#TXMP62d239f5 Ordinary loss limit.

The amount that you can deduct as an ordinary loss is limited to $50,000 each year. On a joint return the limit is $100,000, even if only one spouse has this type of loss. If your loss is $110,000 and your spouse has no loss, you can deduct $100,000 as an ordinary loss on a joint return. The remaining $10,000 is a capital loss.

Taxmap/pubs/p550-026.htm#TXMP45166d40 Section 1244 (small business) stock.

This is stock that was issued for money or property (other than stock and securities) in a domestic small business corporation. During its 5 most recent tax years before the loss, this corporation must have derived more than 50% of its gross receipts from other than royalties, rents, dividends, interest, annuities, and gains from sales and trades of stocks or securities. If the corporation was in existence for at least 1 year, but less than 5 years, the 50% test applies to the tax years ending before the loss. If the corporation was in existence less than 1 year, the 50% test applies to the entire period the corporation was in existence before the day of the loss. However, if the corporation's deductions (other than the net operating loss and dividends received deductions) were more than its gross income during this period, this 50% test does not apply.

The corporation must have been largely an operating company for ordinary loss treatment to apply.

If the stock was issued before July 19, 1984, the stock must be common stock. If issued after July 18, 1984, the stock may be either common or preferred. For more information about the requirements of a small business corporation or the qualifications of section 1244 stock, see section 1244 of the Internal Revenue Code and its regulations.

Taxmap/pubs/p550-026.htm#TXMP5583c920 The stock must be issued to the person taking the loss.

You must be the original owner of the stock to be allowed ordinary loss treatment. To claim a deductible loss on stock issued to your partnership, you must have been a partner when the stock was issued and have remained so until the time of the loss. You add your distributive share of the partnership loss to any individual section 1244 stock loss you may have before applying the ordinary loss limit.

Taxmap/pubs/p550-026.htm#TXMP700abe20 Stock distributed by partnership.

If your partnership distributes the stock to you, you cannot treat any later loss on that stock as an ordinary loss.

Taxmap/pubs/p550-026.htm#TXMP7ef802e0 Stock sold through underwriter.

Stock sold through an underwriter is not section 1244 stock unless the underwriter only acted as a selling agent for the corporation.

Taxmap/pubs/p550-026.htm#TXMP6280cf54 Stock dividends and reorganizations.

Stock you receive as a stock dividend qualifies as section 1244 stock if:

1. You receive it from a small business corporation in which you own stock, and
2. The stock you own meets the requirements when the stock dividend is distributed.

If you trade your section 1244 stock for new stock in the same corporation in a reorganization that qualifies as a recapitalization or that is only a change in identity, form, or place of organization, the new stock is section 1244 stock if the stock you trade meets the requirements when the trade occurs.

If you hold section 1244 stock and other stock in the same corporation, not all of the stock you receive as a stock dividend or in a reorganization will qualify as section 1244 stock. Only that part based on the section 1244 stock you hold will qualify.

Taxmap/pubs/p550-026.htm#TXMP1a52e031
Example.

Your basis for 100 shares of X common stock is $1,000. These shares qualify as section 1244 stock. If, as a nontaxable stock dividend, you receive 50 more shares of common stock, the basis of which is determined from the 100 shares you own, the 50 shares are also section 1244 stock.

If you also own stock in the corporation that is not section 1244 stock when you receive the stock dividend, you must divide the shares you receive as a dividend between the section 1244 stock and the other stock. Only the shares from the former can be section 1244 stock.

Taxmap/pubs/p550-026.htm#TXMP649dad36 Contributed property.

To determine ordinary loss on section 1244 stock you receive in a trade for property, you have to reduce the basis of the stock if:

1. The adjusted basis (for figuring loss) of the property, immediately before the trade, was more than its fair market value, and
2. The basis of the stock is determined by the basis of the property.

Reduce the basis of the stock by the difference between the adjusted basis of the property and its fair market value at the time of the trade. You reduce the basis only to figure the ordinary loss. Do not reduce the basis of the stock for any other purpose.

Taxmap/pubs/p550-026.htm#TXMP0fb70fa7
Example.

You transfer property with an adjusted basis of $1,000 and a fair market value of $250 to a corporation for its section 1244 stock. The basis of your stock is $1,000, but to figure the ordinary loss under these rules, the basis of your stock is $250 ($1,000 minus $750). If you later sell the section 1244 stock for $200, your $800 loss is an ordinary loss of $50 and a capital loss of $750.

Taxmap/pubs/p550-026.htm#TXMP3991dffc Contributions to capital.

If the basis of your section 1244 stock has increased, through contributions to capital or otherwise, you must treat this increase as applying to stock that is not section 1244 stock when you figure an ordinary loss on its sale.

Taxmap/pubs/p550-026.htm#TXMP0178d503
Example.

You buy 100 shares of section 1244 stock for $10,000. You are the original owner. You later make a $2,000 contribution to capital that increases the total basis of the 100 shares to $12,000. You then sell the 100 shares for $9,000 and have a loss of $3,000. You can deduct only $2,500 ($3,000 × $10,000/$12,000) as an ordinary loss under these rules. The remaining $500 is a capital loss.

Recordkeeping. You must keep records sufficient to show your stock qualifies as section 1244 stock. Your records must also distinguish your section 1244 stock from any other stock you own in the corporation.

Taxmap/pubs/p550-026.htm#TXMP31e8cc69 Losses on Small Business Investment Company Stock

Small Business Stock

A small business investment company (SBIC) is one that is licensed and operated under the Small Business Investment Act of 1958.

If you are an investor in SBIC stock, you can deduct as an ordinary loss, rather than a capital loss, a loss from the sale, trade, or worthlessness of that stock. A gain from the sale or trade of that stock is a capital gain. Do not offset your gains and losses, even if they are on stock of the same company.

Taxmap/pubs/p550-026.htm#TXMP2533e52f How to report.

You report this type of ordinary loss on Form 4797, Part II, line 10. In addition to the information required by the form, you must include the name and address of the company that issued the stock. Report a capital gain from the sale of SBIC stock on Schedule D of Form 1040.

Taxmap/pubs/p550-026.htm#TXMP6522b459 Short sale.

If you close a short sale of SBIC stock with other SBIC stock that you bought only for that purpose, any loss you have on the sale is a capital loss. See Short Sales, later in this chapter, for more information.

Taxmap/pubs/p550-026.htm#TXMP6eefb1f0 Holding Period

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 a long-term capital gain or loss.

Taxmap/pubs/p550-026.htm#TXMP71e8835a 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.

Taxmap/pubs/p550-026.htm#TXMP63d6f16f
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 have a long-term capital gain or loss.

Taxmap/pubs/p550-026.htm#TXMP60d1738a Securities traded on an 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.

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.

Taxmap/pubs/p550-026.htm#TXMP42b46a6e
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 sale 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.

Taxmap/pubs/p550-026.htm#TXMP1f8da032 U.S. Treasury notes and bonds.

The holding period of U.S. Treasury notes and bonds sold at auction on the basis of yield starts the day after the Secretary of the Treasury, through news releases, gives notification of acceptance to successful bidders. The holding period of U.S. Treasury notes and bonds sold through an offering on a subscription basis at a specified yield starts the day after the subscription is submitted.

Taxmap/pubs/p550-026.htm#TXMP0134dd6c 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.

Taxmap/pubs/p550-026.htm#TXMP5240de1b 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.

Taxmap/pubs/p550-026.htm#TXMP5c61136e 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.

Taxmap/pubs/p550-026.htm#TXMP5fe968b3 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.

Taxmap/pubs/p550-026.htm#TXMP710c1822 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.

Taxmap/pubs/p550-026.htm#TXMP303ec2a6 Real property repossessed.

If you sell real property but keep a security interest in it, and then later repossess the property under the terms of the sales contract, your holding period for a later sale includes the period you held the property before the original sale and the period after the repossession. Your holding period does not include the time between the original sale and the repossession. That is, it does not include the period during which the first buyer held the property.

Taxmap/pubs/p550-026.htm#TXMP001f4dbb 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.

Taxmap/pubs/p550-026.htm#TXMP2d095c19 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.

Taxmap/pubs/p550-026.htm#TXMP1eb55d27 Section 1256 contracts.

Gains or losses on section 1256 contracts open at the end of the year, or terminated during the year, are treated as 60% long term and 40% short term, regardless of how long the contracts were held. See Section 1256 Contracts Marked to Market, earlier.

Taxmap/pubs/p550-026.htm#TXMP623d1f97 Option exercised.

Your holding period for property you acquire when you exercise an option begins the day after you exercise the option.

Taxmap/pubs/p550-026.htm#TXMP28e2550d Wash sales.

Your holding period for substantially identical stock or securities you acquire in a wash sale includes the period you held the old stock or securities.

Taxmap/pubs/p550-026.htm#TXMP39ce0524 Qualified small business stock.

Your holding period for stock you acquired in a tax-free rollover of gain from a sale of qualified small business stock, described later under Gains on Qualified Small Business Stock, includes the period you held the old stock.

Taxmap/pubs/p550-026.htm#TXMP351609d3 Commodity futures.

Futures transactions in any commodity subject to the rules of a board of trade or commodity exchange are long term if the contract was held for more than 6 months.

Your holding period for a commodity received in satisfaction of a commodity futures contract, other than a regulated futures contract subject to Internal Revenue Code section 1256, includes your holding period for the futures contract if you held the contract as a capital asset.

Taxmap/pubs/p550-026.htm#TXMP54efa438 Securities futures contract.

Your holding period for a security received in satisfaction of a securities futures contract, other than one that is a section 1256 contract, includes your holding period for the futures contract if you held the contract as a capital asset.

Your holding period for a security received in satisfaction of a securities futures contract to sell, other than one that is a section 1256 contract, is determined by the rules that apply to short sales, discussed later under Short Sales.

Taxmap/pubs/p550-026.htm#TXMP3aeeb344 Loss on mutual fund or REIT stock held 6 months or less.

If you hold stock in a regulated investment company (commonly called a mutual fund) or real estate investment trust (REIT) for 6 months or less and then sell it at a loss (other than under a periodic liquidation plan), special rules may apply.

Taxmap/pubs/p550-026.htm#TXMP219f3efa Capital gain distributions received.

The loss (after reduction for any exempt-interest dividends you received, as explained next) is treated as a long-term capital loss up to the total of any capital gain distributions you received and your share of any undistributed capital gains. Any remaining loss is short-term capital loss.

Taxmap/pubs/p550-026.htm#TXMP62c4abc5 Exempt-interest dividends on mutual fund stock.

If you received exempt-interest dividends on the stock, at least part of your loss is disallowed. You can deduct only the amount of loss that is more than the exempt-interest dividends.

Taxmap/pubs/p550-026.htm#TXMP06532100 Loss on stock that paid qualified dividends.

Any loss on the sale or trade of stock must be treated as a long-term capital loss to the extent you received, from that stock, qualified dividends (defined in chapter 1) that are extraordinary dividends. This is true regardless of how long you actually held the stock. Generally, an extraordinary dividend is a dividend that equals or exceeds 10% (5% in the case of preferred stock) of your adjusted basis in the stock.

Taxmap/pubs/p550-026.htm#TXMP51581bb4 Nonbusiness Bad Debts

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.

There are two kinds of bad debts — business and nonbusiness. A business bad debt, generally, is one that comes from operating your trade or business and is deductible as a business loss. All other bad debts are nonbusiness bad debts and are deductible as short-term capital losses.

Taxmap/pubs/p550-026.htm#TXMP2d77a4aa
Example.

An architect made personal loans to several friends who were not clients. She could not collect on some of these loans. They are deductible only as nonbusiness bad debts because the architect was not in the business of lending money and the loans do not have any relationship to her business.

Taxmap/pubs/p550-026.htm#TXMP141bbd1e Business bad debts.

For information on business bad debts of an employee, see Publication 529. For information on other business bad debts, see chapter 11 of Publication 535.

Taxmap/pubs/p550-026.htm#TXMP3449770b Deductible nonbusiness bad debts.

To be deductible, nonbusiness bad debts must be totally worthless. You cannot deduct a partly worthless nonbusiness debt.

Taxmap/pubs/p550-026.htm#TXMP6de6e14d 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.

Taxmap/pubs/p550-026.htm#TXMP5f1fe442 Loan or gift.

For a bad debt, you must show that there was an intention at the time of the transaction to make a loan and not a gift. If you lend money to a relative or friend with the understanding that it may not be repaid, it is considered a gift and not a loan. You cannot take a bad debt deduction for a gift. There cannot be a bad debt unless there is a true creditor-debtor relationship between you and the person or organization that owes you the money.

When minor children borrow from their parents to pay for their basic needs, there is no genuine debt. A bad debt cannot be deducted for such a loan.

Taxmap/pubs/p550-026.htm#TXMP6bc3a70b 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 (most individuals are), you generally cannot take a bad debt deduction for unpaid salaries, wages, rents, fees, interest, dividends, and similar items.

Taxmap/pubs/p550-026.htm#TXMP7a1227e1 When deductible.

You can take a bad debt deduction only in the year the debt becomes worthless. You do not have to wait until a debt is due to determine whether it is worthless. A debt becomes worthless when there is no longer any chance that the amount owed will be paid.

It is not necessary to go to court if you can show that a judgment from the court would be uncollectible. You must only show that you have taken reasonable steps to collect the debt. Bankruptcy of your debtor is generally good evidence of the worthlessness of at least a part of an unsecured and unpreferred debt.

If your bad debt is the loss of a deposit in a financial institution, see Deposit in Insolvent or Bankrupt Financial Institution, earlier.

Taxmap/pubs/p550-026.htm#TXMP3b7f4401 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. (Claims not due to bad debts or worthless securities generally must be filed within 3 years from the date a return is filed, or 2 years from the date the tax is paid, whichever is later.) For more information about filing a claim, see Publication 556, Examination of Returns, Appeal Rights, and Claims for Refund.

Taxmap/pubs/p550-026.htm#TXMP669e3386 Loan guarantees.

If you guarantee a debt that becomes worthless, you cannot take a bad debt deduction for your payments on the debt unless you can show either that your reason for making the guarantee was to protect your investment or that you entered the guarantee transaction with a profit motive. If you make the guarantee as a favor to friends and do not receive any consideration in return, your payments are considered a gift and you cannot take a deduction.

Taxmap/pubs/p550-026.htm#TXMP0915fc50
Example 1.

Henry Lloyd, an officer and principal shareholder of the Spruce Corporation, guaranteed payment of a bank loan the corporation received. The corporation defaulted on the loan and Henry made full payment. Because he guaranteed the loan to protect his investment in the corporation, Henry can take a nonbusiness bad debt deduction.

Taxmap/pubs/p550-026.htm#TXMP337ae9a4
Example 2.

Milt and John are co-workers. Milt, as a favor to John, guarantees a note at their local credit union. John does not pay the note and declares bankruptcy. Milt pays off the note. However, since he did not enter into the guarantee agreement to protect an investment or to make a profit, Milt cannot take a bad debt deduction.

Taxmap/pubs/p550-026.htm#TXMP4e3c4039 Deductible in year paid.

Unless you have rights against the borrower, discussed next, a payment you make on a loan you guaranteed is deductible in the year you make the payment.

Taxmap/pubs/p550-026.htm#TXMP104da5b0 Rights against the borrower.

When you make payment on a loan that you guaranteed, you may have the right to take the place of the lender (the right of subrogation). The debt is then owed to you. If you have this right, or some other right to demand payment from the borrower, you cannot take a bad debt deduction until these rights become totally worthless.

Taxmap/pubs/p550-026.htm#TXMP2f62e5d5 Debts owed by political parties.

You cannot take a nonbusiness bad debt deduction for any worthless debt owed to you by:

1. A political party,
2. A national, state, or local committee of a political party, or
3. A committee, association, or organization that either accepts contributions or spends money to influence elections.

Taxmap/pubs/p550-026.htm#TXMP2d452f98 Mechanics' and suppliers' liens.

Workers and material suppliers may file liens against property because of debts owed by a builder or contractor. If you pay off the lien to avoid foreclosure and loss of your property, you are entitled to repayment from the builder or contractor. If the debt is uncollectible, you can take a bad debt deduction.

Taxmap/pubs/p550-026.htm#TXMP43b62581 Insolvency of contractor.

You can take a bad debt deduction for the amount you deposit with a contractor if the contractor becomes insolvent and you are unable to recover your deposit. If the deposit is for work unrelated to your trade or business, it is a nonbusiness bad debt deduction.

Taxmap/pubs/p550-026.htm#TXMP44d8040e Secondary liability on home mortgage.

If the buyer of your home assumes your mortgage, you may remain secondarily liable for repayment of the mortgage loan. If the buyer defaults on the loan and the house is then sold for less than the amount outstanding on the mortgage, you may have to make up the difference. You can take a bad debt deduction for the amount you pay to satisfy the mortgage, if you cannot collect it from the buyer.

Taxmap/pubs/p550-026.htm#TXMP58ca0215 Worthless securities.

If you own securities that become totally worthless, you can take a deduction for a loss, but not for a bad debt. See Worthless Securities under What Is a Sale or Trade, earlier in this chapter.

Taxmap/pubs/p550-026.htm#TXMP6e91175d Recovery of a bad debt.

If you deducted a bad debt and in a later tax year you recover (collect) all or part of it, you may have to include the amount you recover in your gross income. However, you can exclude from gross income the amount recovered up to the amount of the deduction that did not reduce your tax in the year deducted. See Recoveries in Publication 525.

Taxmap/pubs/p550-026.htm#TXMP1e02f78d 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.

Taxmap/pubs/p550-026.htm#TXMP4ec649ea Short Sales

Short Sale

A short sale occurs when you agree to sell property you do not own (or own but do not wish to sell). You make this type of sale in two steps.

1. You sell short. You borrow property and deliver it to a buyer.
2. You close the sale. At a later date, you either buy substantially identical property and deliver it to the lender or make delivery out of property that you held at the time of the sale. Delivery of property borrowed from another lender does not satisfy this requirement.

You do not realize gain or loss until delivery of property to close the short sale. You will have a capital gain or loss if the property used to close the short sale is a capital asset.

Taxmap/pubs/p550-026.htm#TXMP28ea3a92 Exception if property becomes worthless.

A different rule applies if the property sold short becomes substantially worthless. In that case, you must recognize gain as if the short sale were closed when the property became substantially worthless.

Taxmap/pubs/p550-026.htm#TXMP5c52ee62 Exception for constructive sales.

Entering into a short sale may cause you to be treated as having made a constructive sale of property. In that case, you will have to recognize gain on the date of the constructive sale. For details, see Constructive Sales of Appreciated Financial Positions, earlier.

Taxmap/pubs/p550-026.htm#TXMP06555230
Example.

On May 3, 2004, you bought 100 shares of Baker Corporation stock for $1,000. On September 3, 2004, you sold short 100 shares of similar Baker stock for $1,600. You made no other transactions involving Baker stock for the rest of 2004 and the first 30 days of 2005. Your short sale is treated as a constructive sale of an appreciated financial position because a sale of your Baker stock on the date of the short sale would have resulted in a gain. You recognize a $600 short-term capital gain from the constructive sale and your new holding period in the Baker stock begins on September 3.

Taxmap/pubs/p550-026.htm#TXMP67c13aea Short-Term or Long-Term   Capital Gain or Loss

Sale of Property, Gain or Loss