  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-1 McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Property Dispositions Chapter 7

  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-2Objectives  Distinguish realization from recognition  Describe installment sale method.  Understand limits on related-party losses.  Identify 2 components of capital gain or loss.  Define (non-)capital assets.  Capital loss limits: individuals versus corps.  Section 1231 netting of gains and losses  Depreciation and loss recapture for Section 1231 assets  Other dispositions.

  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-3 Realized Gain or Loss  Amount realized on disposition  MINUS adjusted basis of property (e.g. cost - accumulated tax depreciation = “NBV”)  = Realized gain or loss.  GENERALLY, realized (economic) gains and losses on disposition are recognized (result in taxable income or deductions) unless there is a specific exception. See Chapter 8.  Unrealized (mere appreciation or decline in value) gains and losses are neither realized nor recognized.

  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-4 Amount Realized  Cash received  FMV of any property received, including buyer’s note  Relief of debt. AP3.  Reduce the amount realized by selling costs such as sales commissions, broker fees.  No adjustment for “inflationary gains.”

  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-5 Installment Sale Method  Permits deferral of gain recognition until cash is received on the sale.  Gain recognized this year = (cash this year) x (total gain / total sales price).  Not allowed for sales of publicly traded stock or for inventory, or to delay recognition of depreciation recapture.  Financial accounting uses accrual accounting, so installment sales method for tax creates a temporary book-tax difference.

  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-6 Related Party Losses  Relative:  family = spouse, sibling, ancestors, lineal descendants Q10  50% controlled corporations  Losses realized on sale of property between related parties are NONdeductible.  Future gain (but NOT loss) by relative can be offset by disallowed loss.

  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-7 Related Party Losses - Example  Fawn has stock with a basis of $5000. She sells it to her brother Robert for $3000. Fawn’s realized loss of ($2000) may NOT be deducted.  IF Robert sells the stock for $8000 to an unrelated party, he may reduce his realized gain of $5000 by the ($2000) disallowed loss to recognize $3000 gain.  IF Robert sells the stock for $4000 to an unrelated party, he may reduce his realized gain of $1000 by ($1000) of the disallowed loss to recognize 0 gain.  IF Robert sells the stock for $2500 to an unrelated, he recognizes ONLY his own realized loss of ($500). He cannot increase his loss by Fawn’s disallowed loss.

  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-8 Character of Gain or Loss - Overview Ordinary Capital Section1231 Depr. Recapt 5-yr lookback net 1231 loss net 1231 gain Tax or deduct at ordinary rates Net capital gains and losses: Individual may deduct $3000 net loss. Net LT gain taxed at lower rates. net gain

  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-9 Character of Gain or Loss  Capital gain or loss requires:  Sale or exchange  Capital asset

  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-10 Capital Asset (negatively) Defined  Capital assets (under Section1221) are everything EXCEPT:  1) inventory  2) accounts receivable  3) supplies  4) real or depreciable property used in a trade or business (this is the same as Section 1231 property)

  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-11 Capital Asset (negatively) Defined  5) copyright, compositions, artistic efforts created by taxpayer. (exception - patents by inventors are capital assets).  6) certain U.S. government publications  7) Commodities derivative financial instruments held by a dealer  8) Hedging transaction properties.

  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-12 Capital Losses  Only deduct capital losses UP TO capital gains.  Excess of capital loss over capital gains  Individual taxpayers:  can deduct $3000 of net losses per year against ordinary income  carryforward excess indefinitely against capital gains  Corporation  NO deduction for net loss in current year  carry back 3 years and forward 5 years against capital gains

  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-13 Capital Gains  Individuals obtain preferential taxation on long-term (> 1 year) capital gains - generally 20% tax rate. See Chapter 15.  Corporations pay tax at regular tax rates.

  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-14 Dispositions of Noncapital Assets  Sales of inventory and accounts receivable result in ordinary income.  Taxed at regular tax rates.  AP8.

  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-15 Section 1231 Assets  Real or depreciable property used in a trade or business. Q1  GENERAL rule.  Net Section 1231 gains and losses  IF NET GAIN => add to capital gains and losses. Result is possible lower tax rate on 1231 net gains.  IF NET LOSS => add to ordinary gains and losses. Can also offset salary, interest, dividends, etc. Result is ordinary rate benefit of 1231 net losses.

  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-16 Depreciation Recapture  Gain on each separate asset may be subject to depreciation recapture.  Depreciation recapture does NOT apply if the asset is sold at a loss, nor can it increase the amount of the gain.  For sales of depreciable personalty and amortizable intangibles, the gain is characterized as ordinary up to the amount of accumulated depreciation.  Why? because depreciation has resulted in prior deductions at ordinary rates.

  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-17 Depreciation Recapture  REALTY:  Special rules apply to pre-1986 depreciation on accelerated methods: most of this property is fully depreciated, so rules seldom apply.  Corporations must recapture 20% of amount that would have been ordinary had it been personalty (lesser of gain or depreciation). AP12.  Individuals treat lesser of gain or depreciation as a capital gain subject to a special 25% tax rate - see chapter 15.

  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-18 Section 1231 Netting  After all depreciation recapture, NET the remaining Section1231 gains with Section 1231 losses.  If a net loss, treat as an ordinary loss and combine with other ordinary income and losses.  If a net gain, then the net gain is treated as a capital gain UNLESS:

  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-19 Section 1231 Look Back Rule  The net 1231 gain is treated as ordinary income recapture to the extent of unrecaptured Section 1231 losses during the prior five years.  EXAMPLE: Start business in Section 1231 gains and losses.  1998 net gain $10 treated as capital.  1999 net loss ($15) treated as ordinary.  2000 net gain $23 treated as $15 ordinary (recapture 1999) and $8 capital.  2001 net loss ($40) treated as ordinary.  2002 net gain $6 treated as ordinary. Still have $34 unrecaptured loss from  2003 net gain $50 treated as $34 ordinary, $16 capital.

  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-20 Other Property Dispositions  Abandonment and worthlessness  In general, an abandonment loss is an ordinary deduction = tax adjusted basis.  Exception for securities: worthless securities are treated as sold on the last day of the year for $0. This generally creates a long-term capital loss.  Exception for affiliated corporation: securities in an 80% or more controlled domestic subsidiary are treated as a noncapital asset.

  Click to edit Master text styles   Second level   Third level   Fourth level   Fifth level #7-21 Other Property Dispositions  Foreclosures  Recourse debt. Treat as if sell property for FMV at foreclosure. Any additional debt forgiveness is ordinary income. See AP20.  Nonrecourse debt. Treat as if sell property for face value of mortgage.  Business casualty and theft  Amount realized = insurance proceeds, if any.  Deduct the unrecovered basis. Loss is ordinary. Gain depends on character of property. See Ch8 gain deferral.