Your client, Steven Kupka, a calendar year/cash method taxpayer, was involved in a number of transactions during the 2022 calendar year. For whatever reason, Mr. Kupka failed to seek your advice prior to engaging in any of these transactions. Thus, it is your job to analyze each of the following completed transactions.

                                        1. RENTAL PROPERTY

In 2015, Mr. Kupka bought a home that he used as his personal residence by paying $200,000 cash and borrowing $600,000 secured by a mortgage on the property. Later in 2015, Mr. Kupka took out a home equity loan in the amount of $75,000, securing the loan through a second mortgage on the property. On December 1, 2019, Mr. Kupka moved out and rented the property to Mr. Ty for $4,500 per month on a four-year lease. Mr. Ty also paid Mr. Kupka $13,500 as a security deposit. In addition to the right to occupancy, the lease also gave Mr. Ty the right to purchase the property at any time during the lease term for $1,950,000. The agreement provides that both the security deposit and 10% of the monthly rent paid to the date of exercise will be credited against the purchase price. On November 1, 2022, Mr. Kupka entered into an exchange contract with Ms. Smart, under which Mr. Kupka would transfer the residence to Ms. Smart in exchange for a fourplex.

The agreed-upon prices for the properties were $1,750,000 for Mr. Kupka's residence and $2,050,000 for Ms. Smart's rental property. In addition, the contract called for Ms. Smart to assume the existing mortgage on Mr. Kupka's property. In return, Mr. Kupka agreed to the following:

(i) to assume the existing first mortgage on Ms. Smart's property (which had a balance of $632,475 at the time of closing),

(ii) to pay Ms. Smart $200,000 in cash, and

(iii) to transfer to Ms. Smart a painting. (The appraised value of the painting was between $37,000 and $42,000.)

 In addition, Ms. Smart agreed to take the property subject to the outstanding lease and option held by Mr. Ty. The deal closed on these terms on December 31, 2022.

 

                                    2. WAREHOUSE

 

On 7-1-2022, Mr. Kupka acquired a warehouse in the Silver Terrace district of San Francisco for $4,333,000. He financed this by paying $1,083,250 and financing the remainder with a conventional commercial loan. The purchase agreement provided that the seller would retain possession of all or a portion of the premises rent-free on an as-needed basis over the 12-month period commencing 7-1-2022, at the end of which the seller would completely abandon the warehouse. Once any portion of the premises was abandoned during this 12- month period, the seller forfeited any further right to its possession. (I.e., Mr. Kupka would be able to take possession of the abandoned portion to use as he saw fit.) As portions of the building were abandoned, Mr. Kupka became obligated to pay the seller an amount equal to $1.50 per square foot per month multiplied by the number of months remaining in the 12-month period at the time of abandonment.

 

                     3. SALES OF SECURITIES

 

During the year, Mr. Kupka sold publicly traded securities on the open market in the number of shares, on the dates and for the amounts set forth in the following table:

 

Description Date                                Sold                                                    Net Sales

Proceeds

10,000 com shs ABC, Inc                9-25-2022                                                   $322,500

20,000 com shs JKL, Inc                 8-26-2022                                                  $240,000

15,000 com shs XYZ, Inc                11-14-2022                                                   $274,000

 

The shares were acquired by Mr. Kupka in the following manner:

 

• the ABC shares were purchased by Mr. Kupka and were sold in two 5,000- Share lots. One of the lots was used to cover a "short sale" of 5,000 shares of ABC stock that Mr. Kupka entered into on 8-28-2022, giving him 30 days to close.

• the JKL shares were purchased by Mr. Kupka on 6-16-2022 for $80,000 plus convertible debentures.

• the XYZ shares were received from Mr. Kupka's grandmother as a result of her death on 12-30-2021. She originally purchased the shares for $305,000 on 12-17-2021.

 

 

4. MIMI'S FURNITURE & APPLIANCE

 

On 1-1-2020, Mr. Kupka purchased "Mimi's Furniture & Appliance" from his friend Emilio Castillo. Mimi's Furniture is a retail business located in Oakland, California. Mr. Kupka did business as a sole proprietor under the Mimi's Furniture name, and running the business was his principal occupation during the entire time that he owned it. Alas, all good things must pass. Having tired of the smell of Barca-Loungers in the morning, Mr. Kupka decided to sell out. The deal closed on July 22, 2022. The buyer, Mick Gillette, acquired the following assets:

 

Asset                                                 FMV                                                                      Cost

Accounts Receivable                        27,000                                                                    39,000

Inventory                                          178,000                                                                  198,000

Equipment                                         56,000                                                                    87,000

Leasehold                                           4,000                                                                      -0-

Trade Name                                       415,000                                                                  360,000

Covenant Not To Compete                175,000                                                                 195,000

 

("FMV" represents the value of the property on the date of sale. "Cost" refers to Mr. Kupka's original cost.)

 

The total sales price was satisfied by Mr. Gillette paying Mr. Kupka $984,000 in cash, and by assuming the liabilities of the company - accounts payable ($68,000), and short-term debt ($36,000).

Although he is otherwise a cash method taxpayer, Mr. Kupka adopted the accrual method of accounting for income tax purposes for Mimi's Furniture. (As a sole proprietor, Mr. Kupka reports the associated income on Schedule C.) 

Thus, the "cost" shown for accounts receivable reflects the face value of these receivables, which Mr. Kupka has already included in income. They have been discounted to take account of the inherent risk in their collection. Similarly, the cost of inventory reflects all of the costs properly capitalized as part of ending inventory for tax purposes. The value paid reflects the amount a retailer would currently pay a manufacturer for these goods.

 The equipment sold consists of the following:

 

(i) Furniture and fixtures used in the retail outlet, which had an original cost of $82,000 in the aggregate, and an aggregate value of $54,000 on the date of sale.

(ii) Software for the store's computer system, which is used to ring up retail sales and to keep track of inventory. It cost Mr. Kupka $5,000, and was placed in service on 1-15-2022. Its fair market value at the time of salewas $2,000.

 

At the time Mr. Kupka purchased Mimi's Furniture, he entered into a new 5-year lease for the premises in which it did business. The lease was entered into under terms that proved to be quite favorable for Mr. Kupka. Because of the great location, Mr. Gillette wished to succeed to the leasehold. The lease allowed Mr.Kupka to assign it subject to the landlord's approval of the new tenant. Mr. Kupkaobtained the required consent and assigned the lease to Mr. Gillette.

When Mr. Kupka purchased Mimi's Furniture from Mr. Castillo, he paid $360,000 for the "Mimi's" name. In addition, he paid Mr. Castillo the sum of $195,000 for Mr. Castillo's promise not to compete against Mimi's Furniture at any time during the 10-year period following the completion of the purchase.Similarly, in addition to acquiring the assets listed above, Mr. Gillette agreed topay Mr. Kupka $100,000 for Mr. Kupka's promise not to compete with Mimi'sFurniture at any time over the next 5 years.

The amounts allocated to each of the assets listed above were mutually agreed to by Messrs. Kupka and Gillette. The nature and scope of the covenant not to compete are reasonable for purposes of local law.

On the whole, your job is to analyze each of these transactions and to determine the resulting income tax consequences to Mr. Kupka in the aggregate. You need not determine the tax consequences to the parties with whom Mr. Kupka dealt.

Analyze each individual transaction. As part of your analysis, you should perform each of the following tasks for each transaction:

 

a) Where appropriate, (hint: the lease to Mr. Ty and the warehouse purchase), determine the true classification of the transaction (i.e., its economic substance) for income tax purposes.

 

b) Calculate the amount of realized gain or loss respecting each transaction. (That necessarily means you must determine Mr. Kupka's amount realized for each disposition and his adjusted basis in the asset being disposed of. Be sure to calculate depreciation as necessary, and to adjust your basis accordingly.)

 

c) Determine the amount of recognized gain or loss on

 

c) Determine the amount of recognized gain or loss on each transaction.(Remember the golden rule: generally realized gain or loss must be recognized unless there is a rule of nonrecognition that applies. The only transaction where nonrecognition comes into play is the exchange between

Mr. Kupka and Ms. Smart. (Don't assume that Mr. Kupka qualifies for nonrecognition treatment. You must explain why he does or doesn't!)

 

d) Determine the amount of ordinary income generated by the operation of Mimi's Furniture & Appliance and the amount of Mr. Kupka's rental income from the warehouse and the lease with Mr. Ty for 2022.

 

e) Determine the character of recognized gain or loss from each transaction (as (i) ordinary income, (ii) §1231, (iii) STCG/L, (iv) LTCG/L).

 

f) With respect to any assets Mr. Kupka has acquired in these transactions, determine Mr. Kupka's basis and holding period in the acquired property.

 

For purposes of your analysis:

 

• Assume that all parties with whom Mr. Kupka dealt are unrelated parties

for income tax purposes unless the facts clearly indicate otherwise.

• Assume that Mr. Kupka is a solvent taxpayer.

• Calculate any depreciation deduction available to Mr. Kupka where

required for your analysis.

• Ignore the impact of §199A.

• Ignore the OID rules.

• Ignore the impact of California sales taxes.