MODULE 19 Computing Gain or Loss on Disposition of Assets

Menu 1. Computing gains and losses 2. Basis considerations 3. Installment sales

Computing Gains and Losses Key Learning Objectives The gains and (losses) formula Applicable law Amount realized Adjusted basis

The Gains and (Losses) Formula Sales price Sales price -Selling expenses Amount realized -Adjusted basis Realized gain (loss) -Deferred gain (loss) Recognized gain (loss)

Applicable Law n The gain or loss from the sale of property u Determined by the law in force at the date of sale n Depreciation adjustments reduce basis u Determined by the law in force at the time the property is acquired

Amount Realized n Sum of u Any money received u Plus FMV of property received u Less any selling expenses

Uncovered Cost of the Asset Adjusted Basis Uncovered Cost of the Asset n Original cost basis n Minus cost recoveries n Plus improvements

Basis Considerations Key Learning Objectives n n Recovery of capital doctrine n n Determining cost basis n n Cost basis factors n n Gift basis n n Property acquired from decedent n n Property converted from personal use

Adjusted Basis Determined by n How acquired u Purchase u Gift u Inherited

Basis Determined by Purchase n Purchase u Cash/FMV of property received u Debt assumption u Non-deductible improvements

Basis Determined by Gift n Note: D= doner; D'e = donee; Date of gift = DOG n General rule if FMV > basis at DOG u Use D's basis and u Adjust for gift taxes n If FMV < basis at DOG see special rules

Adjustment for Gift Taxes Paid Basis Determined by Gift Adjustment for Gift Taxes Paid n D = doner; D'e = donee; DOG = date of gift n Gift taxes are paid by D n Gift taxes are based on FMV at DOG n Adjustment to D’e basis only if u FMV > basis at DOG n D’e gets gift taxes relating to appreciation [FMV- basis] FMV FMV

In Class Exercise: Adding Gift Taxes to Basis n D = doner; D'e = donee; DOG = date of gift n At DOG FMV = $17,000 n D’s basis = 13,500 n Gift tax = 2,000 n Calculate D’e basis

Solution--In Class Exercise: Adding Gift Taxes to Basis n Property is appreciated at DOG n So start with adjusted basis of $13,500 n Add % of gift taxes relating to appreciation u $412 n Gift taxes x (FMV - AB) ÷ FMV n $2,000 x ($17,000 - $13,500) ÷ $17,000 n Total basis to D'e = $13,912 ( $13,500+$412 )

FMV < Basis at DOG Basis Determined by Gift FMV < Basis at DOG n n D = doner; D'e = donee; DOG = date of gift n n No adjustment for gift taxes n n Basis (AB) determined when D’e sells n n If used by D’e and subject to depreciation, use FMV at DOG

FMV < Basis at DOG Basis Determined by Gift FMV < Basis at DOG n D= doner; D'e = donee; DOG = date of gift n Sold for u > D's basis then AB = D's basis u < FMV at DOG then AB = FMV at DOG u FMV at DOG F AB = Amount realized F No gain/loss recognized to D’e

FMV < Basis at DOG In Class Exercise: Gift Basis FMV < Basis at DOG n D = doner; D'e = donee; DOG = date of gift n At DOG: AB = $12,000 FMV = $10,000 n D’e sells at a later date for: Case A B C Case A B C AR = $13,000 $11,000 $9,000 AR = $13,000 $11,000 $9,000 n What is adjusted basis in each case? n What is total gain realized?

FMV < Basis at DOG In Class Exercise: Gift Basis FMV < Basis at DOG n At DOG: AB = $12,000 FMV = $10,000 CaseAB C CaseAB C AR = $13,000 $11,000 $ 9,000 AR = $13,000 $11,000 $ 9,000 AB = 12,000 11,000 10,000 GL = $ 1,000 0 (1,000) n Note that you would plug any basis for AR between $10,000 and $12,000

Conversion From Personal Use n Follow rules similar to gift rules u If FMV > A/B use A/B u If FMV < A/B use FMV

In Class Exercise: Conversion from Personal Use n John has an automobile used 100% for personal purposes for two years n He converts it to 100% business use when n A/B = $16,000FMV = $8,500 n What is John’s basis for business purposes?

Solutions: In Class Exercise: Conversion from Personal Use n He converts it to 100% business use when n A/B = $16,000FMV = $8,500 n John uses $8,500 since FMV is lower than A/B when the property is converted n The $7,500 decline in value is considered to be a non-deductible personal expenditure

Basis Determined by Inheritance n Use value reported on estate’s tax return n Generally FMV at date of death (DOD) n Estate may choose to use alternative valuation date u FMV 6 months after DOD

Installment Sales Key Learning Objectives n n Eligible sales n n Ineligible sales n n Mandatory reporting n n Gain reported n n Problem areas

Installment Sale n At least one payment is received after the close of the tax year in which the disposition of the asset occurs

Ineligible Sales n Dealer disposition of property held for sale to customers n Gains relating of the recapture provisions of §1245 and §1250 n Stock or securities traded on an established securities market n Property of any kind regularly traded on an established market

Mandatory Reporting Unless Election Out n Any sale that is covered by the definition of an “installment sale” n Must elect out of the installment method to avoid n Election out attached to a timely tax return n Entire gain included in income for the taxable year

Consequences of Electing Out of Installment Method n Cash basis amount realized u Money and FMV of property n Accrual basis amount realized u Money and FMV of property u Face value of any obligation received

Installment Method Gain Reported As Cash Collected n Gross profit = A/R - A/B n Gross profit percentage = Gross profit ÷ total contract price Gross profit ÷ total contract price n Gain recognized = Gross profit percentage x am’t received Gross profit percentage x am’t received n Ratio applied to payments received in the current period

In Class Exercise: Gain Reported on Installment Sale n Mary agrees to sell for $500,000 n Land for which she paid $300,000 n She will receive $100,000 a year for 5 years n Interest will be paid at the required rate n How much gain will she recognize each year ?

Solution: In Class Exercise: Gain Reported on Installment Sale n Gross profit = A/R - A/B n $200,000 = $500, ,000 n Gross profit percentage = gross profit ÷ total contract price gross profit ÷ total contract price n 40% = $200,000 ÷ $500,000

Solution: In Class Exercise: Gain Reported On Installment Sale n Gross profit percentage = 40% n Amount received each year = $100,000 n Gain recognized each year = $40,000 Gross profit percentage x am’t received Gross profit percentage x am’t received 40% x $100,000 40% x $100,000 n Total gain recognized is $200,000 u $40,000 x 5

In Class Exercise: Gain Reported on Installment Sale & §1250 n Gains associated with depreciation cannot be deferred through an installment sale n How would Mary’s gain recognition change if the property she sold was a building AND n $50,000 of the gain is §1250 recapture?

Solution: In Class Exercise: Gain Reported on Installment & §1250 n Gross profit = A/R - A/B n $200,000 = $500,000 -$300,000 n BUT $50,000 is recognized immediately so gross profit is reduced to $150,000 n Gross profit percentage = Gross profit ÷ total contract price Gross profit ÷ total contract price n 30% = $150,000 ÷ $500,000

Solution: In Class Exercise: Gain Reported On Installment & §1250 n Gross profit percentage = 30% n Amount received each year = 100,000 n Gain recognized each year = 30,000 Gross profit percentage x am’t received Gross profit percentage x am’t received 30% x $100,000 30% x $100,000 n Total gain recognized is $200,000 u $30,000 x 5 + $50,000

Installment Method Problem Area: Imputed Interest n If the contract does not specify an interest rate equal to the applicable federal rate n Then interest will be imputed at that rate

Problem Area-- Related Party Sales n Sale between related parties u Spouses, children, grandchildren, and parents u Controlled corporation, partnership, trust, estate n Normal rules apply, unless u Property is depreciable or u Purchaser resells the property before payment of the original sales price n Rules can be avoided if the taxpayer can establish (to the Secretary’s satisfaction) that tax avoidance was not the motive for the transaction

Transferring an Installment Obligation n Sale, gift, or other transfer of the installment obligation n Unreported gain may be reported at the time of transfer n Difference between u Basis in the obligation and u Amount realized n Fair market value of the obligation

Basis in Obligation n Excess of the face value of the obligation over an amount equal to the income which would be returnable were the obligation satisfied in full

Interest on Deferred Taxes n Require the taxpayer to pay interest n Only required if the sales price of the property exceeds $150,000 n Obligations from all such sales that arise during and are outstanding at the end of the tax year exceed $5,000,000 n Gains associated in excess of $5,000,000