Recall from our previous videos, that we've been looking at calculating realized gains or losses, as the difference between the amount realized, and the adjusted basis. Here, from the seller's perspective, the amount realized is the sum of any cash received plus fair market value of other property received plus the disposition of liabilities minus selling expenses. The adjusted basis was defined as the original basis, minus accumulated cost recovery deductions, like accumulated depreciation plus capital additions. In the simplest terms, the realized gain is the difference between the value of what the taxpayer got, and the adjusted basis of what the tax payer gave up. Now, there could be a difference between the realized gain or loss, or economic gain or loss, and the recognized gain or loss, or the gain or loss that actually gets reported on the tax return. The differences here could be due to postponed or deferred gains or losses. That is, for example, although the gain might be realized in the transaction, the taxpayer might not have to report it on his or her tax return until some period in the future. Another difference between realized and recognized gains or losses is that the gain may be entirely tax-free, or the loss may be disallowed, that is, never deductible. Finally, recall that the gain or loss can either be capital in character, or ordinary in character. For individuals and sole proprietor businesses, capital gains receive preferential tax rates while ordinary gains are taxed at the top applicable marginal tax rates. We'll look at character in a later module. In this video, and the next set of videos, we will look more deeply at these differences between realized and recognized gains and losses. So first, let's define recognized gains and losses. The recognized gains and losses are simply the portion of the realized gains that are included in the current year's gross income, or the portion of the realized losses that are deductible against income. For the most part in fact, taxpayers will recognize the majority of realized gains and losses. That is, for the most part, there really isn't a difference between realized and recognized gains and losses. However, as we saw earlier, not all realized gains and losses are recognized because some gains may be deferred or excluded, while some losses may be deferred or completely disallowed. Some examples here are that, for the most part, losses from the sale, exchange, or condemnation of personal use assets are not recognized for tax purposes. That is, if I sell my personal car, or personal house, or personal furniture at a loss, I actually cannot deduct that loss on my tax return. Those losses are disallowed. They are not deductible. There are a few exceptions here though. Beginning in 2018, a realized casualty or theft loss on personal use property can only be recognized in two instances. First, a casualty or theft loss on personal use property can offset a casualty gain on personal use property. Second, such a loss is deductible as an itemized deduction, if the loss occurred in a federally declared disaster area, and if that loss exceeds $100 per event floor, and a 10 percent of AGI threshold. In contrast, interestingly enough, gains realized from the sale, or other disposition of personal use assets, generally are fully recognized. So if I sell my personal car at a gain, I will actually have to recognize that gain on my tax return, and pay tax. In other words, the treatment between gains and losses for personal use assets are asymmetric. Generally, gains are includable in gross income, but losses are not deductible. There are also two major other types of losses that are not deductible that we should discuss. The first, very briefly, has to do with transactions between what are known as related parties. Under Internal Revenue Code Section 267, related parties include family members, or a corporation and a shareholder who owns a greater than 50 percent interest in the corporation, or a partnership and a partner who owns any more than 50 percent interest in the partnership. In other words, these are parties that may transact between each other, but the price may not be the market price, or the arm's length price. The price might be set in a way that gives an advantage to one party or another, perhaps for tax reasons. The IRS is worried about transactions between related parties, and has decided that losses on the sale of assets between related parties are disallowed. So here's an example; let's say I'm in the highest income tax rate bracket, and my brother is in the lowest tax rate bracket. I want to help him, and I'm thinking of gifting him some property, maybe some stock that has actually done quite poorly for me. I bought it at $10,000 and now, it's worth only $1,000. But instead of gifting the stock to my brother, in which case I cannot claim a deduction for the $9,000 loss, I decide to sell it to my brother. However, to engineer the largest possible loss, I'll sell my stock to him for one dollar. Now, he's happy because he has $1,000 in stock, that he only paid $1 for, and I'm happy because I just gave him property of significant value, that I was probably going to give him anyway. Because I sold it to him for only one dollar, I basically engineered a much larger loss, that I can now deduct on my tax return. That is, I now have a $9,999 loss. What the IRS says, is that because the transaction occurred between two related parties, that is, between my brother and myself, the entire loss that I generated will be disallowed. I cannot deduct that loss on my tax return.
