Property Dispositions 8-1 Chapter 8 Property Dispositions McGraw-Hill Education Copyright © 2015 by McGraw-Hill Education. All rights reserved.

Objectives Distinguish realization from recognition Apply the installment sale method Understand the limits on related-party losses Identify two components of capital gain or loss Apply the capital loss limitation Explain the Section 1231 netting process Compute depreciation recapture Describe the tax consequences of other asset dispositions

Realized Gain or Loss Amount realized on disposition (Adjusted basis of property) Realized gain or (loss) Realized gains or losses on disposition are recognized (result in taxable income or deductions) unless there is a specific exception. See Chapter 9

Realized Gain or Loss Unrealized gains and losses (appreciation or decline in value) are neither realized nor recognized The tax gain or loss that a taxpayer recognizes may differ from the gain or loss reported on the financial statements. This occurs when an asset’s adjusted tax basis does not equal book basis ≠

Amount Realized The amount realized from a disposition equals: Cash received Plus FMV of any property received, including buyer’s note Plus the amount of any debt relief Reduced by selling costs such as sales commissions, broker fees

Amount Realized Example A taxpayer sold land with a $29,200 basis for $10,000 cash, a tractor with a $12,000 FMV, and the purchaser’s assumption of an $18,000 mortgage on the land. The taxpayer paid a $1,500 sales commission. Amount realized equals $38,500 $10,000 cash + $12,000 FMV of tractor + $18,000 debt relief - $1,500 commission

Gain Realized Example A taxpayer sold land with a $29,200 basis for a $38,500 amount realized Gain realized equals $9,300 $38,500 amount realized - $29,200 adjusted basis

Installment Sale Method Permits deferral of gain recognition until cash is received Gain recognized equals cash received × gross profit percentage (GP%) GP% = gain realized/contract price Interest received on the installment note is taxable under normal rules

Installment Sale Method Not allowed for sales of publicly traded stock or sales of inventory to customers The installment sale method is not permitted under GAAP so the installment sales method for tax purposes creates a temporary book-tax difference ≠

Related Party Losses Losses realized on sales of property between related parties are disallowed (not recognized) Related parties include: Family members (spouse, sibling, ancestors, lineal descendants) An individual and a corporations in which the individual owns more than 50% of the stock Two corporations owned by the same shareholders Future gain from sale by purchaser is reduced by seller’s disallowed loss

Related Party Losses - Examples Fawn sold stock with a $5,000 basis to her brother Robert for $3,000. Fawn’s $2,000 realized loss was disallowed (not recognized) Robert’s basis in the stock is his $3,000 cost If Robert sells the stock for $7,500 to an unrelated party, he may reduce his $4,500 realized gain by the $2,000 disallowed loss. His recognized gain is $2,500

Related Party Losses - Examples If Robert sells the stock for $3,800 to an unrelated party, he may reduce his $800 realized gain by $800 of the disallowed loss. His recognized gain is zero If Robert sells the stock for $2,500 to an unrelated party, he recognizes his $500 realized loss. This loss is not increased by the disallowed loss

Character of Recognized Gain or Loss Capital gain or loss results from the sale or exchange of a capital asset Dispositions of capital assets other than by sale or exchange do not result in capital gain or loss Recognized gain or loss is ordinary in character

Capital Asset Defined Under Section 1221, all assets are capital assets except for the following business assets: Inventory Accounts receivable Supplies Real property used in a business Depreciable or amortizable personalty used in a business

Capital Asset Defined Under Section 1221, all assets are capital assets except for the following assets: Copyrights, compositions, artistic efforts created by the taxpayer Exception for created patents Certain U.S. government publications Commodities and derivative financial instruments held by a dealer Hedging transaction properties

Capital Loss Limitation Treatment of excess of capital loss over capital gain (net capital loss) Individuals: Can deduct $3,000 of net loss per year against ordinary income Carryforward remaining loss indefinitely Corporations: No deduction for net loss Carryback three years and forward five years against capital gains

Capital Gains Individuals have preferential tax rates on long-term capital gain (See Chapter 16) Gains and losses from sales and exchanges of capital assets held for more than 12 months are long-term 0%, 15%, 20%, 25%, and 28% preferential rates Corporations pay tax at regular rates Capital gains are preferred to ordinary income because capital gains absorb capital losses

Dispositions of Noncapital Assets Sales of inventory and accounts receivable result in ordinary income taxed at regular rates

Section 1231 Assets Section 1231 assets are real or depreciable/amortizable properties used in a business BBB Company, which manufactures industrial plastics, owns the following assets. Identify each as a capital, ordinary, or Section 1231 asset Computer system used in BBB’s main office A 50% interest in a partnership organized to conduct a mining operation in Utah

Section 1231 Assets Heavy equipment used to mold BBB’s best-selling plastic item BBB’s customer list developed over 12 years BBB’s inventory of raw materials used in the manufacturing process An oil painting of BBB’s founder and 1st president that hangs in the board room A patent developed by BBB’s R&D department BBB’s company airplane

Character of Net Section 1231 Gain or Loss General rule for gains and losses realized on sales and exchanges of Section 1231 assets Gains and losses for the year are netted Net gain is treated as capital gain Net loss is ordinary (fully deductible) This treatment offers the best of both worlds – capital gain and ordinary loss!

Depreciation Recapture Gain recognized on the sale or exchange of a Section 1231 asset may be subject to depreciation recapture Recapture rules have no effect on recognized losses For sales of depreciable personalty and amortizable intangibles, gain is characterized as ordinary to the extent of accumulated depreciation

Depreciation Recapture For sales of depreciable real property: Accelerated depreciation in excess of SL is recaptured Applies only to buildings placed in service before 1987 By 2014, most of these buildings are fully depreciated so no recapture potential Corporations must recapture 20% of amount that would be ordinary under a full depreciation recapture rule

Recapture of Prior Year Net Section 1231 Loss Net 1231 gain is characterized as ordinary income to the extent of unrecaptured Section 1231 losses Unrecaptured Section 1231 loss is a net Section 1231 loss deducted in any of the five preceding taxable years Once a prior year net Section 1231 loss is recaptured as ordinary income, it is no longer an unrecaptured loss Any remaining net Section 1231 gain is treated as capital gain

Section 1231 Recapture Example Acme began business in 2009 and incurred the following Section 1231 net gains and losses: 2009 $100 net gain $100 treated as capital gain 2011 $150 net loss $150 ordinary deduction 2013 $83 net gain $83 ordinary income (recapture of 2011 loss) 2014 $190 net gain $67 ordinary income (recapture of 2011 loss) and $123 treated as capital gain

Disposition by Abandonment Taxpayer may abandon worthless property by disclaiming any ownership interest in the property Loss recognized equals adjusted basis of abandoned property Loss is characterized as ordinary regardless of the type of asset because there is no sale or exchange

Worthless Securities The abandonment rules do no apply to worthless securities Taxpayers are treated as selling worthless securities on the last day of the taxable year for an amount realized of zero Loss recognized equals adjusted basis of securities Loss is characterized as capital loss because the loss resulted from the constructive sale of a capital asset

Exception for Securities in Affiliated Corporation A corporate parent’s recognized loss on worthless securities issued by a domestic subsidiary is ordinary if the subsidiary is an affiliated corporation Definition of affiliated corporation 80% or more of outstanding stock is owned by corporate parent Subsidiary derives more than 90% of annual gross receipts from the conduct of an active business

Disposition by Foreclosure If property is foreclosed to settle a recourse debt (debtor is personally liable), the foreclosure is treated as a sale of the property for FMV If the creditor forgives any amount of recourse debt, the debtor recognizes ordinary cancellation-of-debt income If property is foreclosed to settle a nonrecourse debt (debtor is not personally liable), the foreclosure is treated a sale for the full amount of the debt

Recourse Debt Example A business owned investment land with a $340,000 FMV and a $400,000 basis and subject to a $375,000 recourse mortgage. The firm defaulted on the mortgage, and the mortgage holder foreclosed on the land The business recognizes a $60,000 capital loss on disposition of the land $340,000 FMV - $400,000 basis If the mortgage holder forgives the $35,000 remaining debt, the business recognizes $35,000 ordinary income

Nonrecourse Debt Example A business owned investment land with a $340,000 FMV and a $400,000 basis and subject to a $375,000 nonrecourse mortgage. The firm defaulted on the mortgage, and the mortgage holder foreclosed on the land The business recognizes a $25,000 capital loss on disposition of the land $375,000 debt relief - $400,000 basis

Disposition by Casualty or Theft Business assets may be disposed of because of a casualty or theft Amount realized equals any insurance proceeds If proceeds are less than the asset’s basis, the recognized loss is ordinary If proceeds are more than the asset’s basis, recognition of the gain may be deferred (See Chapter 9)