McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 8 Property Dispositions McGraw-Hill/IrwinCopyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

8-2 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

8-3 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

8-4 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 ≠

8-5 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

8-6 Amount Realized  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

8-7 Gain Realized  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

8-8 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

8-9 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 ≠

8-10 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

8-11 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

8-12 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

8-13 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

8-14 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

8-15 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

8-16 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

8-17 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%, 25%, and 28% preferential rates  Corporations pay tax at regular rates  Capital gains are preferred to ordinary income because capital gains absorb capital losses

8-18 Dispositions of Noncapital Assets  Sales of inventory and accounts receivable result in ordinary income taxed at regular rates

8-19 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

8-20 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 1 st president that hangs in the board room  A patent developed by BBB’s R&D department  BBB’s company airplane

8-21 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!

8-22 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

8-23 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 2008, 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

8-24 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

8-25 Example  Acme began business in 2000 and incurred the following Section 1231 net gains and losses:  2002 $100 net gain  $100 treated as capital gain  2004 $150 net loss  $150 ordinary deduction  2006 $83 net gain  $83 ordinary income (recapture of 2004 loss)  2008 $190 net gain  $67 ordinary income (recapture of 2004 loss) and $123 treated as capital gain

8-26 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

8-27 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

8-28 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

8-29 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

8-30 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

8-31 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

8-32 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)

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