Rachel, a medical doctor, purchases a painting to hang on the wall of her living room (i.e., for personal enjoyment) for $15,000 in February of Year 1 from an up-and-coming artist, Randy Borehall. At the end of Year 1, the painting is appraised at $17,000. At the end of Year 2, after a particularly nasty piece of publicity regarding Borehalls antics, the painting is appraised at $10,000. When Borehall dies in Year 3, Rachel is able to sell the painting in November for $20,000 in cash (you know what death can do to the value of an artists work) to Jacob.

a. What does Rachel include in Gross Income (or deduct in reaching Taxable Income) in each of Years 1, 2, and 3 under current law?

b. In a., what is the character of Rachels 1001 realized gain: capital or ordinary? Why does Rachel care?

c. Does your answers to a. change if Rachel exchanges the painting for a boat owned by Jacob that is worth $20,000 (rather than selling the painting for $20,000 in cash)?