Property Dispositions Chapter 7 Property Dispositions

Property Dispositions Determining tax consequences of a property disposition can be complex. In order to correctly determine the tax consequences, the recognized gain (loss) must be determined and type of property disposed of must be properly classified

Tax Impact on Cash Flow Taxes paid on a recognized gain reduce net cash flow Tax savings generated by a recognized loss increase net cash flow Tax impact of a recognized gain (loss) on cash flow is affected by the Type of asset and its holding period Type of taxpayer Taxpayer’s marginal tax rate

Types of Dispositions Sale – Seller receives cash or cash equivalents in return for property disposed of Exchange – Taxpayer receives qualified property other than cash or cash equivalents in return for property transferred to another party Involuntary Conversion – Complete or partial destruction due to events not under control of taxpayer (e.g., condemnation, theft, casualty) Abandonment – Property permanently withdrawn from use

Owner’s holding period Types of Dispositions To accurately determine the recognized gain (loss) in a property disposition, three conditions must be known: Realized gain (loss) Owner’s holding period No applicable provision allowing nonrecognition or postponement of gain (loss) The character of the gain (loss) is determined by the type of property disposed

Realized Gain (Loss) The realized gain (loss) is calculated as Cash + FMV of property received + Seller’s liabilities assumed by the buyer - Buyer’s liabilities assumed by the seller - Selling expenses Amount Realized - Adjusted basis of property given up Realized gain (loss)

Recognized Gain (Loss) Realized gains are recognized (taxable) unless the code provides for nonrecognition or postpones recognition Losses are generally recognized (deductible) only if they are Incurred in a business Incurred in an investment activity Casualty or theft losses

Holding Period Holding period - Period of time taxpayer is credited with owning the property Usually begins on date of acquisition unless a carryover or substituted basis applies for the asset acquired Property held for more than one year receives favorable tax treatment if either a Section 1231 asset or Capital asset

Holding Period For gifts, the holding period carries over from donor Exception when FMV at date of gift is used for basis, holding period begins on date of gift Inherited property always takes a long-term holding period

Types of Assets Section 1231 assets – Fixed assets (property, plant, and equipment) used in a trade or business and held for more than one year Capital assets – Investment and personal-use assets Ordinary income assets – Inventory, accounts receivable, and all other assets that are neither Section 1231 nor capital assets

Section 1231 Assets Section 1231 assets include: Property used in a business that is subject to cost recovery deductions and is held for more than one year (long-term holding period) Land used in a business that is held for more than one year All of a taxpayer’s gains (after depreciation recapture) and losses from Section 1231 property dispositions are netted to determine tax treatment

Determining Net Section 1231 Gain (Loss) Treatment Step 1: Determine the gain or loss for each Section 1231 asset Step 2: Reduce gain on depreciable property for depreciation recapture (depreciation recapture included in ordinary income) Step 3: Net any remaining gains and losses (two step procedure separates casualty and theft gains (losses) from remaining gains (losses)

Determining Net Section 1231 Gain (Loss) Treatment Step 4: If the result is a net loss, deduct this loss, in full, from ordinary income Step 5: If the result is a net gain, apply the 5-year look-back rule Look-back? Gains up to the amount of previously unrecaptured Section 1231 losses are reclassified as ordinary income Step 6: Any remaining net Section 1231 gain is treated as net long-term capital gain and included in capital gain netting process

Depreciation Recapture Converts recognized gain attributable to the reduction in basis that arises from depreciation deductions to ordinary income Only applies to Section 1231 assets Amount reclassified as ordinary income cannot exceed either the realized gain or prior depreciation deductions Recapture provisions do not apply to realized losses

Section 1245 - Full Recapture Section 1245 property includes machinery, equipment, furniture, and fixtures (not buildings or structural components) Gain on the sale of a Section 1245 asset is classified as ordinary income to the extent of all depreciation allowed (or allowable) Any Section 179 expense is considered “depreciation allowed” The portion of the gain reclassified is lesser of all depreciation taken or realized gain

Section 1250 - Partial Recapture Section 1250 applies to realty Differs from Section 1245 because only the excess of accelerated depreciation over straight line depreciation is recaptured Thus, for realty placed in service after 1986 (on which straight-line depreciation must be used) Section 1250 recapture is, in theory, $0. Why in theory? Section 291 for corporations Section 1250 unrecaptured gain for individuals

Section 291 Recapture Section 291 only applies to corporate dispositions of realty (Section 1250 property) Reclassifies as ordinary income 20% of any Section 1231 gain that would have been ordinary income if Section 1245 recapture applied For realty acquired after 1986, Section 291 recapture = Section 1245 recapture x 20% Reduces capital gains that would otherwise be available to offset corporate capital losses

Unrecaptured Section 1250 Gain For individuals, unrecaptured Sec.1250 gains are the net Sec.1231 gains on realty that are treated as long-term capital gains after Sec. 1231 netting (up to amount of Sec. 1245 recapture if the Section 1245 recapture rules applied) The taxable long-term capital gains attributable to prior depreciation deductions are taxed at a maximum rate of 25%

Section 1231 Netting, Revisited Step 1: Net casualty and theft gains (after recapture) and losses on Section 1231 assets and investment assets If a net loss results, all gains and losses are classified as ordinary except investment losses of individuals (classified as miscellaneous itemized deductions) If a net gain results, the amount is included in Step 2

Section 1231 Netting, Revisited Step 2: Net gain from Step 1 plus gains (after recapture) and losses from all other Section 1231 assets and involuntary conversions of investment assets If a net loss results, treat as described under Step 1 If a net gain results, apply Section 1231 look-back rules

Section 1231 Netting, Revisited Step 3: Any net gain remaining after the Section 1231 look-back rules are applied is treated as a long-term capital gain and included in the capital asset netting process The Section 1231 netting process provides taxpayers the best of both worlds - ordinary loss treatment for net losses and favorable capital gain treatment for net (post recapture) gains

Section 1231 Look-Back Rules Net Section 1231 gains are taxed as ordinary income to the extent of any unrecaptured net Section 1231 losses in the five preceding years This prevents taxpayers from generating tax savings by bunching their Section 1231 gains into one year (to receive tax-favored long-term capital gains treatment) and losses into alternate years (deducting the Section 1231 losses in full against ordinary income)

Capital Assets Capital assets include stocks, bonds, land held for appreciation, collectibles (coins, art), and personal-use assets Long-term holding period is more than one year Short-term holding period is one year or less

Capital Gain (Loss) Netting Step 1: Subtract long-term capital losses from long-term capital gains including net Section 1231 gains (after applying look-back) from Section 1231 netting process Step 2: Subtract short-term losses from short-term gains Step 3: Continue netting (subtracting losses from gains) until only a net gain or loss remains

Capital Gain (Loss) Netting A (net) short-term capital gain resulting from the netting process is taxed at ordinary income rates Taxation of capital gains and losses differs for corporations and individuals

Capital Gains (Losses) - C Corps No current deduction for net capital losses; carry back 3 years and forward 5 years Offset only capital gains Both long-term and short-term capital gains taxed at ordinary income rates Why are capital gains and losses segregated from ordinary gains and losses? Capital losses only offset capital gains

Capital Gains - Individuals 15% rate applies to most long-term capital gains for individuals Higher rates apply for specific types of capital assets (e.g., 25% for unrecaptured Sec. 1250 gain on realty and 28% for collectibles) Lower rates may apply to individuals in low tax brackets

Capital Losses - Individuals $3,000 per year deduction against other income for net capital losses; (net) short-term capital losses deducted before (net) long-term capital losses Remaining (net) capital losses are carried forward indefinitely (no carry back permitted) Losses on personal-use assets are not recognized (deductible) even though gains are recognized (taxable)

Ordinary Income Property Ordinary income property includes: Business assets that do not meet the Section 1231 more-than-one year holding period Inventory Accounts and notes receivable arising from sale of goods or services by a business Any other asset that is not a capital or a Section 1231 asset Gains taxed as ordinary income and losses are fully deductible

Mixed-Use Property Property that is used partly for business and partly for personal use must be divided into Section 1231 property and personal-use property Gain or loss determined separately for business and personal-use portions Character of each portion dictates tax treatment

Investments in New Corporations Code Sections 1244 and 1202 encourage investment in new (i.e., small) corporations by 1. Reclassifying a portion of a loss on the sale of such stock as ordinary (Section 1244) 2. Excluding a portion of the gain on the sale of such stock from gross income (Section 1202)

Section 1244 Stock While losses on the disposition stock are generally classified as capital losses, Section 1244 permits ordinary loss deduction of up to $50,000 ($100,000 for joint returns) annually for losses on qualified stock Applicable only to an individual or partnership that is the original investor in a domestic small business corporation Any excess loss (over the allowable Section 1244 amount) is a capital loss

Section 1244 Stock To qualify as Section 1244 stock Total capitalization cannot exceed $1 million and For the 5 preceding years Corporation must be an operating company deriving 50% or more of its annual gross revenues from the sale of goods or services No more than 50% of income can be derived from rents, royalties, dividends, interest, annuities and gain on sales of securities

Section 1202 Stock To be a qualified small business corporation under Section 1202, the corporation must Be a domestic C corporation, Have no more than $50 million in assets, and Be an active business engaged in manufacturing, retailing, or wholesaling Seller of stock must be the original owner who acquired the stock in exchange for money, property, or services

Section 1202 Stock If the criterion of Section 1202 are satisfied and the qualified small business stock has been held for more than 5 years, taxpayers may exclude up to 50% of the gain realized on the disposition of the stock Remaining 50% of the gain is taxed at the 28% long-term capital gain rate

Section 1202 Stock Excluded gain cannot exceed the greater of 10 times the adjusted basis of qualifying stock sold in the tax year or $10,000,000 less any gain excluded on qualifying stock in the preceding tax years by the taxpayer If taxpayer holds stock at least 6 months and the proceeds from sale are invested in another qualified small business corporation’s stock, gain on sale will be deferred

Sale of Principal Residence An individual who has owned and occupied a home as a principal residence for at least 2 of the 5 years before the sale can exclude up to $250,000 of gain ($500,000 for qualified married taxpayers filing a joint return) The full exclusion can be used only once every 2 years

Sale of Principal Residence Married taxpayers filing jointly can exclude up to $500,000 of gain if: Either spouse owned the home for at least 2 of previous 5 years, and Both spouses used the home as a principal residence for at least 2 of previous 5 years, and Neither spouse is ineligible for the exclusion because of the once-every-2-year limit

Sale of Principal Residence Partial exclusion available if failure to meet two-year time period requirement is due to A change in place of employment, Health (moving into nursing home), or Other unforeseen circumstance (e.g., divorce, death of spouse or co-owner, unemployment, disasters, involuntary conversion of residence)

Sale of Principal Residence Partial exclusion calculated by dividing the number of qualifying months by 24 and multiplying this fraction by $250,000 ($500,000 if qualifying jointly) “Qualifying months” calculated as the shorter of: Use and ownership during 5 preceding years or Period of time that has passed since the taxpayer last claimed the exclusion

Sale of Principal Residence Residence does not lose status as a “principal residence” if temporarily rented during the period of time it is for sale The exclusion does not apply to any gain attributable to depreciation claimed for rental or business use of the residence The 25% rate for unrecaptured Section 1250 gain applies to gain up to the previous depreciation deductions

Sale to Related Party Losses on sales to related parties are disallowed Related parties include brothers, sisters, spouses, ancestors and lineal descendents, as well as a more-than 50% owned corporation If related buyer later sells property at a gain, this gain can be reduced (not below zero) by the seller’s previously disallowed loss

Capital Gains Rates - Individuals 15% rate applies to most long-term capital gains 5% rate applies to taxpayers whose ordinary income is taxed at the 10% and 15% marginal tax brackets to the extent their long-term gains fall within these marginal tax brackets

Capital Gains Rates - Individuals 25% rate applies to Sec. 1250 unrecaptured gain on realty Gain in excess of the recapture amount is taxed at 15% rate Collectibles such as antiques, art objects, and rare coins are taxed at a 28% rate due to potential personal enjoyment of asset For both 25% and 28% assets, if taxpayer’s ordinary income tax rate is 10% or 15%, then the lower ordinary income rate applies to gain that falls within that tax bracket

The End