This proposal would repeal section 1231, which accords capital gain treatment to gains but gives ordinary treatment to losses. That asymmetry increases the expected value of volatile investments over the pretax value of the investments. During a revenue crisis, the tax system should not increase an investment’s value. Moreover, section 1231 has been expanded to make the ordinary business profits from timber, iron ore, and coal eligible for 15 percent capital gains tax rates for individuals, whereas profits from most businesses outside those three areas are ordinary.
This proposal would allow depreciable property used in a trade or business to be eligible for capital gains rates after a recapture of depreciation enhanced by interest. However, losses due to the fluctuation in value of depreciable property used in a trade or business would be subject to capital loss limitations. Profits from timber, iron ore, coal, and other natural resources would be ordinary gain. Casualty losses and gains from casualty insurance would also be ordinary.
A. Current Law
Section 1231 gives assets within its scope the benefit of taxing gains as capital gain but allowing losses as immediate ordinary deductions. An individual’s net gains under section 1231 are taxed at a maximum of 15 percent, but net losses can save tax at a rate of 35 percent. Capital losses, moreover, are generally allowed only against reported capital gains, but section 1231 allows the taxpayer to avoid the capital loss limitations and to immediately deduct the losses.
The asymmetry created by section 1231 was adopted in steps without a satisfying rationale. The Revenue Act of 1938 made depreciable property an ordinary asset so as to exempt capital losses on depreciable property from the limitations on the use of capital losses. The Revenue Act of 1942 reinstated capital gains rates on net gains from depreciable property without removing the benefit of ordinary treatment of losses allowed by the 1938 act.3
The House Ways and Means Committee said that depreciable buildings were like land and afforded capital gain treatment to gains on both the land and buildings, and the Senate extended the asymmetry to all depreciable property. The Senate Finance Committee’s stated rationale in 1942 was that the asymmetry was of ‘‘material benefit to businesses, which due to depressed condition have been compelled to dispose of their plant and equipment at a loss.’’ That rationale focused on the loss side, which was addressed by the 1938 act, while the changes made in 1942 regarded the gain side of the asymmetry. The 1942 act also extended the treatment to involuntary conversions, such as property seized for the World War II effort or war-damaged assets converted to cash by insurance.
The benefit of the asymmetry found in section 1231 has been like soda to yellow jackets, and Congress has expanded eligibility for those benefits. In 1943, Congress expanded section 1231’s capital gains benefit to timber, whether cut by the taxpayer or sold in bulk. In general, corporations get no rate cut for capital gains. But for tax years beginning before May 22, 2009 (but ending after May 22, 2008), corporations will get a 15 percent tax rate on their timber gain for at least a year, and the provision may be extended. In 1951 Congress expanded section 1231 capital gains rates to apply to coal, livestock, and unharvested crops, and in 1964 Congress expanded section 1231 to cover royalties from iron ore.[11 ] The capital gain for timber, coal, iron, livestock, and unharvested crops was given in each case to reverse existing law concerning capital gains. Timber, coal, iron ore, and livestock sold as inventory in the trade or business would be ordinary assets absent section 1231. Profits from the sale of an unharvested crop would be ordinary gain absent section 1231. Royalties on iron ore would be ordinary income allocated as income to the income beneficiaries, and not to the corpus interest as capital gain.
The advantage of asymmetry is limited by the requirement that gains and losses from section 1231 assets be put into a single pool, or hotchpot, to be netted against each other so that the net gain is capital and the net loss is ordinary. That netting hotchpot is applied even if the assets reporting gain and the assets reporting loss have no obvious relationship to each other and the gains and losses are not caused by the same event. Further, section
1231(e) recaptures ordinary losses taken under section 1231 during the last five years by turning net section 1231 gains for the current year into ordinary income. If the gain comes first, however, and the losses follow, the taxpayer can retain capital gain for the gains and ordinary losses for the losses even within a five-year reach.
Outside section 1231, recapture of depreciation overrides section 1231 regarding gain. For equipment, recapture turns gains and sales of equipment into ordinary gains to the extent of prior depreciation on the sold asset. The taxpayer gets capital gains on sales only to the extent that the sales price exceeds the original price of the depreciating equipment. Buildings get the benefit of compromise recapture: Prior depreciation is recaptured at 25 percent, halfway between the capital gain rate of 15 percent and the ordinary tax rate of 35 percent.
Except for the surprise special 2009 15 percent rate for timber, corporations now get no favorable tax rate for capital gain, so that the gain leg of section 1231 has a benefit only to individual taxpayers. The loss leg of section 1231, exempting losses from capital loss limitations, is useful, however, to both corporations and individuals.
B. Reasons for Change
1.Asymmetrical treatment of gains and losses. The heart of section 1231 is its asymmetrical treatment of capital gains and ordinary losses. The asymmetry creates a negative tax or tax absorber for investments eligible for section 1231 during a time when the government desperately needs positive tax revenue. A tax sink for land and depreciable property that becomes more valuable with greater volatility makes no sense even without the revenue emergency, but a repeal that is politically impossible in ordinary times becomes a political necessity in a revenue crisis.
For property that is volatile, the asymmetrical treatment of section 1231 results in an expected tax of less than zero. For example, assume that TP has purchased an equity interest in Blackacre for $100 today that has a 50 percent chance of being worth $220 in a year and a 50 percent chance of being worth nothing. The land is leveraged so that the bank will seize the property in 50 percent of the cases. With an appropriate discount rate of
10 percent, TP’s equity is worth the $100 purchase price in the absence of tax because its expected (probability discounted) value in one year is 50% * 220 + 50% * 0 = $110 and its present value is $110/(1 + 10%) = $100.
With section 1231, however, the tax system delivers a negative tax to the land investment, increasing the expected value of the investment by 85 percent of the pretax gain. If Blackacre rises in value, the gain is subject to 15 percent capital gains tax, so that the property is worth $220 15% * ($220 $100) or $202 after tax, and on the loss leg, the tax deduction is worth 35% * $100 = $35. The expected value in a year is 50% * 202 + 50% * $35 or $118.50. After tax, the investment has a terminal value that is worth $8.50 higher than it was before tax. The result is a negative tax of 85 percent of income because tax increased the return from 10 percent to 18.5 percent.
The value of the asymmetry rises with increases in the volatility of the property. An investment that will have no spread between a high and low expected value will not benefit from the asymmetry; an investment with widely varying high and low expected values receives substantial benefit from section 1231. A tax subsidy that increases for more volatile investments is a terrible idea. Volatility harms real people under the diminishing marginal utility of money because losses cut into more desperately needed income, but gains just add bonuses on top of current income. Increasing volatility is like bringing toxic waste into your living room. Just because the government shares in the losses for the volatility doesn’t mean there should be a subsidy for it.
Land, which qualifies for the asymmetrical treatment, can generate no value by reason of the negative tax. A subsidy to most goods can be expected to increase the price, and in turn the supply, of the good. But land does not increase in supply when its price goes up.
In times of desperate revenue need, section 1231 produces revenue loss. If we repeated the volatility of the hypothetical property a hundred times, the properties by the law of averages would produce tax very close to 50 * ($220 $100), or $900, but would create tax refunds close to 50 * $35, or $1,750, for an overall Treasury loss of $850. With a $1.6 trillion deficit, a tax loss that induces toxic behavior should be repealed.
Netting gains by the annual hotchpot and by section 1231(e) reduces the negative tax or tax sink, but it does not void the negative tax in full. The value of the asymmetry was reduced by the adoption in 1984 of subsection 1231(e),15 which recaptures ordinary deductions for the last five years against reported gains. The asymmetry remains in full, however, if gains come before the losses. Moreover, taxpayers with a single large asset will get more value from the asymmetry because they do not have many assets with gains and losses that will be netted against each other. In any event, the complicated limitations of required annual netting and section 1231(e) justify repeal of the assymetry-creating provision. In other words, the rationale that justified limiting the advantage of the asymmetry also justifies its full repeal.
Corporations do not get lower tax rates on capital gains — except for the 15 percent tax rate for timber in
2009. Corporations, however, do benefit along with individuals from selective realization of losses, avoiding the loss limitations of section 1211, explained next.
2. Exemption from loss limitations. A tax system dependent on realization without restrictions allows the taxpayer to game the government by showing losses only. Realization depends on the taxpayer selling the property, allowing sophisticated taxpayers to show their losses on their tax returns but defer their gains indefinitely. For the same Blackacre land investment discussed above (with a 50 percent chance of being worth $220 and a 50 percent chance of being worth nothing), the taxpayer plays the game by showing the loss to save $35, but hides the gain indefinitely to increase the after-tax return to 50% * $220 + 50% * $35, or $127.50, which represents negative tax of 117.50 percent of the pretax 10 percent. The treasury will lose on millions of those investments at a time when it can’t afford to lose anything. The investments have no special merit over other choices, and they possess the considerable disadvantage that higher volatility increases the negative tax. Volatility should not be so subsidized.
Section 1211 is the best available treatment for selective losses, although it is not a cure. Section 1211 for corporations requires the taxpayer to report gains before capital losses are recognized. That is also the general rule for individuals, but individuals benefit from a small ‘‘dribble out’’ rule under which they (but not corporations) may deduct $3,000 of capital losses each year from ordinary income. The need for section 1211 to counteract selective sales depends not on tax rates imposed on realized gain, but on the ability to avoid tax at all, at whatever rate, just by voiding a sale or other realization. Section 1231 protects all taxpayers from the section 1211 remedy.
If assets must be sold quickly without regard to taxpayer selection, the section 1211 limitation is unnecessary. An inventory of strawberries must be sold before they rot, whether they will be sold at a gain or at a loss. Current law exempts sale of inventory and property held for sale to customers in the ordinary course of a trade of business from the section 1211 loss limitations.
3. Coal, iron, and timber. In 1943 the profits from timber growth were accorded capital gain treatment. A separate analysis concludes that the combination of ordinary deductions for annual costs, the 50-plus-year deferral of tax on the accretion of value of timber, and the capital gains for timber yield negative taxes, in one hypothetical, equal to 4.5 percent of annual income. The negative tax induces investments that cannot meet the going cost of capital in real terms. Timber is an investment that the government should not subsidize. If an incentive is necessary, the free market price will rise to provide it.
In a revenue crisis, we cannot afford a negative tax that induces investments that lose money in real pretax terms. The timber industry should be taxed at 35 percent just like any other industry. Corporations ordinarily get no rate advantage from capital gains, so the surprise 15 percent tax rate for timber cut by corporations is without principle.
Section 1231 was extended to royalties from coal in 1951 and to royalties from iron ore in 1964.20 In both cases Congress cited competition as the reason for the capital gains treatment but did not study the economic damage the provisions might do. Competition is the engine of economic efficiency and protecting taxpayers from competition reduces efficiency. Both coal and iron ore are products of taxpayer business endeavors, and taxpayer-produced or -improved assets are not usually considered to be capital appreciation. The gain from both is through the exploitation of a natural resource and not an appreciation of investment because of market forces beyond the taxpayer’s control. Exploitation of natural resources is a windfall in part and windfalls are excellent sources of high tax. A 15 percent tax rate that is limited to specific business activities influences people to contribute capital to less productive investments. If coal, timber, and iron ore get a 15 percent tax rate on their ordinary profits from business, all business should get that rate. And if revenue needs require a 35 percent tax on business profits, all business profits — including the profits from coal, iron, and timber — should be taxed at the 35 percent rate.
4. Depreciation recapture. Depreciation recapture under sections 1245, 1250, and 617(b) overrides the capital gains accorded by section 1231. Sale at a gain is proof that the taxpayer has not suffered economically from reported depreciation. Depreciation recapture, however, is too narrow to maintain even positive tax rates. A separate shelf project report shows that if an investment is expensed, the entire return must be treated as ordinary income to bring effective tax rates up to zero. Taxing the gain as ordinary only to the extent of prior deduction of the basis leaves a negative tax rate.
Depreciation on real estate is recaptured under current law at only 25 percent, even though the depreciation deductions were deducted against a 35 percent tax rate. The 25 percent rate is a political compromise between no recapture and full recapture. It is not principled in rationale or origin. A 35 percent rate for the input and a
25 percent rate for the output result in a tax arbitrage or negative tax of 10 percent of the amount of the depreciation. Real estate depreciation is allowed in excess of reasonably expected declines in value, so that some of that 10 percent arbitrage is the product of artificial depreciation deductions, not the real economic appreciation of property. A residential building with a steady rent over 50 years will have an adjusted basis of 9 percent of cost after 25 years, but a value of 77 percent of cost. Therefore, a sale of that building after year 25, without any economic appreciation, will generate 68 percent of original basis as a gain derived from artificial depreciation. There is no justification for a negative tax subsidy in the revenue crisis. Government subsidies, if any are to be given, should not be provided through the tax system, but through a federal budget process that reviews government spending annually and critically.
When a taxpayer sells at a gain, indicating that it has not suffered depreciation, the tax law should take away the depreciation deductions. The need for finality implies that the old return should not be reopened, but an interest charge should nonetheless be added for depreciation that never really happened. Increasing recaptured amounts by an interest factor would reduce the rate arbitrage of depreciation combined with 15 percent or 25 percent tax of the gain. Maintaining a set 5 percent increase would be simpler than keeping track of the taxpayer’s actual borrowing costs over the years. The recapture would be limited to the amount of gain, even when depreciation plus interest exceeds the gain.
C. Explanation of the Proposals
The proposal would repeal current section 1231 with the following effects:
1. Business profits. The proposal would repeal section 1231(b)(2) so that gain from the sale of timber, coal, and iron ore would be treated as ordinary business income. Another proposal would clarify current law so that property created or improved by the taxpayer would always be treated as ordinary income. A taxpayer who mines the coal or iron ore or cuts the timber has made sufficient improvement of the natural resource that the gain should be considered to be compensation within that new exception.
Alternatively, we should view profit from timber, coal, and iron not as real capital gain, which is the appreciation of investment because of market forces beyond the taxpayer’s control, but as the exploitation of a natural resource, much like a crop. The taxpayer gets deductions or depreciation for capital invested, but after the invested capital is recovered, the profit is ordinary business profit. Exploitation of a natural resource would and should be ordinary income even if the resource is sold in bulk. A natural resource is a windfall at its core and windfalls are excellent things to tax at ordinary rates because even high rates will not make the resource go away.
2. Extension of section 1211 limitations. The proposal would repeal the section 1231 exemption for depreciable property held for business from the capital loss limitations of section 1211. With the repeal of the exemption, fluctuation losses in the value of property used in business would be usable only against fluctuation gains. Thus, land, real estate, equipment, and livestock held for draft, breeding, dairy, and sporting purposes would be subject to the capital loss limitations and would have to generate capital gains before they are recognized. Because section 1211 is a remedy for selective losses in a realization system and not for rates, the loss limitations would apply even to corporations that get no special rate cut for capital gain. Inventory held for sale to customers would not be subject to the limitations on the assumption that inventory must be sold, not on a selective basis, but hopefully quickly and in full.
With the application of section 1211 to depreciable property, a taxpayer would sometimes prefer to hold onto property to take depreciation deductions under the regular schedule against ordinary income rather than take losses only against current or future capital gains. The proposal would allow a taxpayer to elect to report the sales proceeds as ordinary income in full, as if the proceeds were a rent received from the property and not a sale, but would allow the taxpayer to take depreciation on the normal schedule as if the property had not been sold.
3. Improvement in recapture. Depreciation recapture for both equipment (section 1245) and real estate (section 1250) would be enhanced by 5 percent per year of each depreciation deduction for the years between depreciation and sale. It is unlikely that the enhanced recapture on equipment would make much difference, because equipment only rarely appreciates beyond its original costs plus the interest enhancement. Taxpayers would thus usually just assume that the gain from depreciable equipment is ordinary.
All real estate depreciation would be recaptured, plus a 5 percent annual increment, because of the gain from adjusted basis, which proves that the depreciation did not happen. The current 25 percent quasi-recapture of real estate depreciation in section 1(h)(1)(D) would be repealed and replaced by a 35 percent tax on recaptured depreciation. Because buildings are long-term assets that appreciate above their original cost, including the interest enhancement of recapture, the calculations will come up more often for real estate than for equipment.
The enhanced recapture should be accomplished by amending sections 1250, 1245, and 617(b), and not by simply repealing the capital gains treatment.
4. Depreciable assets are capital gains after enhanced recapture. Land and buildings can appreciate because of market forces beyond the taxpayer’s control, even while the land and buildings are serving the taxpayer’s business. Equipment can also appreciate, especially if the sale occurs fairly soon after purchase. The capital loss limitations of section 1211 would be applied to land and buildings. Consistent with the treatment of losses, depreciable property used within a business would be treated as a capital asset for both gain and loss, after enhanced recapture. Other shelf project proposals would require that capital gain be reinvested to qualify as capital gain and would prohibit capital gain treatment for property the taxpayer has created or improved; and nothing in this proposal would change the other requirements on capital gain proposed elsewhere.
5. Involuntary conversions. A taxpayer can have a gain when insurance pays for damage to the taxpayer’s property caused by casualty. The primary function of the lower tax rate on capital gains is to entice taxpayers to give up the exemption for capital gains available by holding the property until death. Under that rationale there is no reason to give lower capital gains rates to casualties because the taxpayer had no choice but to realize gain. Similarly, the primary function of the section
1211 limitations on capital loss is to counter selective realization of gains and losses, and casualties are not selective realization by taxpayer choice. On both gains and losses, casualty-caused gains and losses would be ordinary.
Eminent domain is also an involuntary event because the taxpayer must sell against its will. This proposal would nonetheless treat that sale like any other sale. The taxpayer usually has the chance to sell to some other taxpayer in anticipation of the possibility of seizure by eminent domain. It may be difficult to distinguish fully voluntary sales from those in anticipation of seizure. If gains are capital, losses caused by the same event must be limited to capital gains to match tax rates and the time when gains are realized. With the requirement of reason able compensation for eminent domain, the gain or loss is measured by market forces, just as for every sale. Casu alty losses, by contrast, are not fluctuating market losses. For these reasons, the proposal would treat a sale under eminent domain as just like any other sale in determining the character of the gain or loss.
Section 1211, however, allows individuals, but not corporations, to deduct up to $3,000 a year of capital loss against ordinary income.
H.R. Rep. No. 76-1860, 1939-1 (Part 2) C.B. 732 (1938).
Revenue Act of 1942, P.L. 77-753, 77th Cong., 2d Sess., section 151.
H.R. Rep. No. 77-2333, Revenue Act of 1942, 1942-2 C.B. 372, 445.
S. Rep. No. 77-1631, Revenue Act of 1942, at 50 (1942).
The asymmetry for involuntary conversions arose in the House. H.R. Rep. No. 77-2333 at 445. Boris Bittker explains the
Congress intended to provide the same capital gain treatment to growers who cut their own timber and have many sales to customers as is accorded those who sell their timber outright. S. Rep. No. 78-627, 25 (1943), reprinted in 1944 C.B. 973, 993.
Section 1201(b)(1), as added by the 2008 Food, Conservation, and Energy Act, P.L. 110-246 (2008 FCEA), section 15311(a) and (d).
S. Rep. No. 82-781, reprinted in 1951-2 C.B. 458, 487-490, describing what is now section 1231(b)(2) (timber, coal, and iron ore), (b)(3) (livestock), and (b)(4) (unharvested crops).
Revenue Act of 1964, P.L. No. 88-272, 88th Cong., 2d Sess., section 227.
Watson v. Commissioner, 345 U.S. 544 (1953).
Section 1(h)(1)(D) (25 percent tax rate) applied as defined in (h)(6). If the taxpayer has taken depreciation in excess of straight-line, section 1250 recaptures the gain at 35 percent. But real estate, under the Accelerated Cost Recovery System is depreciated under straight-line depreciation. Section 168(b)(3).
The after-tax internal rate of return is (118.50/100) 1 = 18.50. Tax increases the return from 10 percent to 18.5 percent, and the effective tax is (10% 18.5%/10%) = -85% tax. Effective tax rate measures the impact of tax on internal rate of return (IRR): Effective tax rate = (IRRpretax IRR posttax) / IRRpretax.
Deficit Reduction Act of 1984, P.L. 98-369, section 176.
If losses are allowed only to the extent of gains, that prevents a negative tax from selective realization, but the taxpayer can still live off a portfolio of appreciating assets, paying zero tax on the amount withdrawn from the portfolio, just by recognizing enough losses to make the realized gains tax free. Eventually the taxpayer drains all the basis in loss assets and can no longer use losses to shelter realized gains, but the unsheltered gains occur only after use of all basis on assets within a volatile portfolio that have declined in value. Marking assets to market accounting is a more complete remedy to the selective reporting of losses but not gains. Under mark-to-market regimes, taxpayers report their gains as they occur, and not only on voluntary sales.
Section 1231(b)(1)(A) and (B). The sale of closing inventory in bulk can be selective. Loss inventory is commonly sold in bulk and gains are realized by sales to customers one unit at a time. The proposal assumes that all inventory sales will avoid the capital loss limitations of section 1211 and this does not solve the problem.
Calvin H. Johnson, ‘‘Timber!’’ Tax Notes, Nov. 16, 2009, p. 801, Doc 2009-23579, 2009 TNT 220-10.
See H.R. Rep. No. 82-586, 31 (citing competition coal faced from other energy sources).
H.R. Rep. No. 88-749, 93 (1963), 1963-2 C.B. 708 (citing competition from foreign iron ore).
Johnson, ‘‘Sale of Goodwill and Other Intangibles as Ordinary Income,’’ Tax Notes, Jan. 14, 2008, p. 321, Doc 2008-331, 2008 TNT 10-31.
Residential property has a tax life of 27.5 years (section 168(c)), and after 25 years, ten-elevenths of the basis would be depreciated leaving 9 percent of cost as adjusted basis. At a 5 percent discount rate, a $100x building would have to generate $5.48x annual rent after expenses, and that rent over 25 more years is worth $77x.
Johnson, ‘‘Cleaning Compensation for Services Out of Capital Gain,’’ Tax Notes, Jan. 11, 2010, p. 233, Doc 2009-27878, 2010 TNT 9-5.
Previously published by the University of TexasSchool of Law, February 2010