Module 20 Capital Assets

Menu 1. Capital assets 2. Capital gains and losses 3. § Depreciation recapture

Capital Assets Key Learning Objectives n In general n Definition of a capital asset n Special issues

All Assets Are Capital Assets Except n n Inventory n n Accounts/notes receivable from sale of goods or services n n Depreciable or real property used in a trade or business (§1231 property) n n Copyrights and creative works n n Certain U.S. government publications

Special Issues n n Additional clarifications provided by Congress include: u Sales or exchanges by dealers in securities u Sales of subdivided real estate u Nonbusiness bad debts

Capital Gains and Losses Key Learning Objectives n n Sale or exchange n n Holding period n n Corporate taxpayers n n Individual taxpayers

Sale or Exchange n n The recognition of a capital gain or loss n n Usually requires the sale or exchange n n Code doesn't define the terms "sale" and "exchange." n n The Supreme Court, however, says that the terms are to be given their ordinary meaning

Holding Period n n Holding period runs from u u Day after acquisition date to trade date n n Long vs. short controlled by code in effect on date of sale n n Code states more than for holding period

Two Holding Periods for Capital Gains n Short term u < 12 months n Long term u > 12 months

Four Tax Rates for Capital Gains for Individuals n Net short term gains u taxed as ordinary income n Net long term gains u taxed at 20%/10% u taxed at 28% if “collectable” n Some gain from real property taxed at 25% u am’t related to unrecaptured depreciation deductions

25% Rate on Gains From Real Property n Applies to noncorporate taxpayers u "unrecaptured Sec gain,” n Building original cost = $100,000 n Depreciation taken $30,000 (straight line) n Selling price $110,000 n Gain = $40,000 ($110,000 - $70,000) u $30,000 limited to 25% preference rate u $10,000 could be taxed at 20%/10% rates

In Class Exercise: Preference Rate on Capital Gains n Single taxpayer’s taxable income for 2000 is $102,000 n If this is all ordinary income, what is her regular tax liability? n Note: use excerpt from 2000 tax rate schedules on next slide n Solution = $26,301 u Note same answer if income included short term capital gains

Excerpt from 2000 Tax Table

In Class Exercise: Preference Rate on Capital Gains n Single taxpayer’s taxable income for 2000 is $102,000 n If $20,000 of this is a net long term gain, what is her regular tax liability? n Note: use excerpt from 2000 tax rate schedules on previous slide n Solution = $24,101 u [102,000-20,000-63,550]* , ,000 *.20

In Class Exercise: Preference Rate on Capital Gains n Single taxpayer’s T. I. for 2000 is $102,000 n If $20,000 is from the sale of a collectible held more than 12 months, what is her regular tax liability? n Note: use excerpt from 2000 tax rate schedules on earlier slide n Solution = $25,701 u [102,000-20,000-63,550]* , ,000 *.28

Preference Rate for Filers in 15% Tax Bracket n Prior to 1997, filers had to have MTR> 28% before net capital gains had preference treatment n Long term capital gains now give all filers preferential rates n If filer is in 15% MTR, these gains are taxed at 10%

In Class Exercise: Preference Rate on Capital Gains n Single taxpayer’s TI for 2000 is $22,000 n If ordinary income, what is regular tax liability? u In 2000 all ordinary income under $26,250 is taxed at 15% for single filers n Solution = $3,300 u $22,000 *.15 n The same answer applies if income includes short term capital gains or long-term gains from collectibles

In Class Exercise: Preference Rate on Capital Gains n Single taxpayer’s taxable income for 2000 is $22,000 n If $10,000 of this is a net long term gain, what is his regular tax liability? u In 2000 all ordinary income under $26,250 is taxed at 15% for single filers n Solution = $2,800 u [22,000-10,000]* ,000 *.10

Netting Process n n Net by holding period first n n Net across holding periods if they carry opposite signs u Negative and positive

In Class Exercise 1: Netting Capital Gains and Losses n n J&J have $100,000 of taxable income before capital gains transactions u 5,000 ST Capital gain u 30,000 LT Capital Gain n n What is J&Js net capital gain/loss position?

Solution: In Class Exercise 1: Netting Capital Gains and Losses LT STNET Gain 30,0005,000 Loss Net 30,0005,000 N/A* n n *Don’t net if both have same sign n n Only the 30,000 is a net capital gain entitled to maximum 20% tax rate

In Class Exercise 2: Netting Capital Gains and Losses n n Crumb had the following transactions for the year 2000 n n $25,000 long-term capital gain n n $12,000 long-term capital loss n n $8,000 short-term capital gain n n $15,000 short-term capital loss n n What is Crumb’s net capital gain/loss position?

Solution--In Class Exercise 2: Netting Capital Gains and Losses n n LT STNET n n Gain 25,000 8,000 n n Loss12,00015,000 n n Net13,000- 7,000 6,000* n n * Net again if long and short term have different signs n n Only 6,000 is a net capital gain entitled to maximum 20% (10%) tax rate

In Class Exercise 3: Netting Capital Gains and Losses n n Crumb had the following transactions for the year 2000 n n $5,000 long-term capital gain n n $12,000 long-term capital loss n n $8,000 short-term capital gain n n $5,000 short-term capital loss n n What is Crumb’s net capital gain/loss position?

Solution--In Class Exercise 3: Netting Capital Gains and Losses n n LT STNET n n Gain 5,0008,000 n n Loss12,0005,000 n n Net-7,0003,000 -4,000 LTCL

Corporate Taxpayer n n Net capital loss not deducted n n Applies to net aggregate loss, not individual transactions n n Excess losses carry back (3 years) then forward (five years) n n No preference rate on net LTCG

In Class Exercise: Net Capital Loss n n Assume Crumb is a corporation n n Crumb's taxable income is $50,000 before the $4,000 net capital loss n n What is Crumb’s taxable income after the net capital loss is considered?

Solution: In Class Exercise: Net Capital Loss n n Crumb’s taxable income is still $50,000 after the net capital loss is considered n n Corporations may not deduct any net capital losses n n However, the loss can be carried back and used against capital gains of earlier years

Individual Taxpayer n n Capital losses allowed to extent of capital gains + $3,000. n n Capital loss carry forward only n n No time limit to c/o n n Short/long term character retained n n Short-term losses are deducted first

In Class Exercise: Net Capital Loss n n Assume Crumb is an individual taxpayer n n Crumb's taxable income is $50,000 before the $4,000 net capital loss n n What is Crumb’s taxable income after the net capital loss is considered?

Solution: In Class Exercise: Net Capital Loss n n Crumb’s taxable income is $47,000 after the net capital loss is considered n n Individuals can deduct up to $3,000 of net capital losses each year n n The excess $1,000 loss CANNOT be carried back to earlier years n n $1,000 capital loss is carried forward as a long-term capital loss to be used in future

§1231 Key Learning Objectives (1) n In general n §1231 property n §1231 loss n §1231 gain

§1231 Property n n Depreciable or real property u Used in a trade or business AND u Held for more than one year n n Other industry-specific property also qualifies as §1231 property n n Ordinary gain/loss treatment for assets held one year or less

§1231 Netting n n §1231 gain per transaction is amount left after depreciation recapture n n Net all §1231 gains/losses for year n n Net §1231 loss treated as ordinary loss

§1231 Property if Net §1231 Gain n n Lookback to determine if must recapture n n Prior years' §1231 ordinary losses n n Look back period is last 5 tax years n n Net §1231 gain is recharacterized as ordinary income to extent of net §1231 losses in look back period not already recaptured n n Remainder is LTCG

§1231 Key Learning Objectives (2) n Gains in excess of losses n Recapture net §1231 losses n Gains and losses from casualty or theft n §1231 netting procedure summary

In Class Exercise: Recapture Net §1231 Losses n n Jan has $22,650 in net §1231 gains for 2000 n n Apply the lookback rule to determine how much of this is u Ordinary income? u LTCG? n n See next slide for Jan’s net §1231 gains and losses for the five-year look back period

In Class Exercise: Recapture Net §1231 Losses n n Jan's history of § 231 net gains (losses) prior to 2000 (none before 1995) n n ,000 n n 1998 (15,000) n n ,000 n n 1996(17,000) n n ,000

Solution--In Class Exercise: Recapture Net §1231 Losses n n Start with 1995 to calculate un-recaptured net §1231 losses outstanding at n n 1995 $5,000 $5,000 net §1231 gain treated as LTCG n n 1996($17,000) No un-recaptured §1231 losses at $ 17,000 net §1231 loss treated as ordinary

Solution--In Class Exercise: Recapture Net §1231 Losses n n 1997 $20,000 $ 17,000 un-recaptured §1231 losses at $17,000 of 20,000 treated as ordinary $3,000 treated as LTCG n n 1998 ($15,000) No un-recaptured §1231 losses at $15,000 net §1231 loss treated as ordinary

Solution--In Class Exercise: Recapture Net §1231 Losses n n 1999 $9,000 $15,000 un-recaptured §1231 losses at $ 9,000 is treated as ordinary income n n 2000 $22,650 $6,000 un-recaptured §1231 losses at $ 6,000 of $22,650 treated as ordinary $16,650 treated as LTCG

§1231 Property n n Net §1231 gain or loss determination involves a complex 3-step netting process discussed in the text

§1231 Netting Process Step 1 n n Net current year casualty gains and losses n n Net loss is ordinary loss n n Net gain is §1231 gain and goes to Step 2

§1231 Netting Process Step 2 n n Net current year §1231 gains and losses n n Net loss is ordinary loss n n Net gain goes to Step 3

§1231 Netting Process Step 3 n n Apply 5-year lookback n n Recharacterize gain as ordinary to extent of un-recaptured §1231 losses in look back period n n Remainder of gain is long-term capital gain and goes to capital gain and loss netting pool

Depreciation Recapture Key Learning Objectives (1) n In general n Recovery property n Application to losses n §1245 Recapture

§1245 Depreciation Recapture n n Applies to gains only, not losses n n Applies generally to non-real estate u i.e. 3,5,7 year MACRS property n n §1245 recapture potential = total depreciation taken n n Ordinary gain is recognized to the lesser of §1245 recapture potential or realized gain n n Gain not subject to recapture is §1231 gain

In Class Exercise: §1245 Recapture n n T bought a machine in 1998 for $120,000 n n T sold the machine in 2000 for $140,000 n n Total MACRS depreciation taken as of the date of the sale was $75,000 n n How much should T report u As ordinary income under §1245? u As §1231 gain?

Solution: In Class Exercise: §1245 Recapture n n T should report u $75,000 of ordinary income under §1245 u $20,000 §1231 gain n n Amount realized140,000 n n Cost 120,000 n n Depreciation 75,000 n n Basis 45,000 n n Gain 95,000 n n §1245 recapture 75,000

Depreciation Recapture Key Learning Objectives (2) n §1250 Property n Additional issues §1245 and §1250 n Differences between §1245 and §1250 n §291--Additional recapture for corporations

§1250 Recapture n n Applies to gains only, not losses n n Applies to real estate n n Never applies if straight-line method used n n Thus, no recapture for MACRS u Post-1986 realty

Residential Realty §1250 Recapture Potential n n §1250 recapture potential n n Excess of accelerated depreciation over straight-line n n MACRS--S/L only so no recapture

In Class Exercise: §1250 Recapture--Residential n n T purchased residential property for $300,000 in 1982 n n T sold the property in 2000 for $260,000 n n Total ACRS depreciation was $175,000 n n Straight-line depreciation would be $155,000 n n How much should T report u As ordinary income under §1250? u As §1231 gain?

Solution: In Class Exercise: §1250 Recapture Residential n n T should report u $20,000 of ordinary income under §1250 u $115,000 of §1231 gain. n n Amount realized260,000 n n Cost300,000 n n Depreciation175,000 n n Basis125,000 n n Gain135,000

Solution: In Class Exercise: §1250 Recapture Residential n n Accelerated depreciation175,000 n n Straight-line depreciation155,000 n n §1250 recapture 20,000 n n §1231 gain115,000 n n Total gain135,000

Nonresidential Realty §1250 Recapture Potential n n Pre-1981 u Excess of accelerated depreciation over straight-line subject to recapture F Same rule as residential realty n n ACRS ( ) u All depreciation subject to recapture n n MACRS--S/L only so no recapture

In Class Exercise: §1250 Recapture Non-Residential n n T purchased nonresidential real property for $600,000 in 1986 n n T sold the property in 2000 for $460,000 n n Total ACRS depreciation was $345,000 n n Straight-line depreciation would be $315,000. n n How much should T report u As ordinary income under §1250? u As §1231 gain?

Solution: In Class Exercise: §1250 Recapture Non-Residential n n T should treat this as §1245 property AND n n Recognize the entire $205,000 gain as ordinary n n Amount Realized460,000 n n Cost600,000 n n Depreciation345,000 n n Basis255,000 n n Gain205,000

§291--Additional Recapture for Corporations n n Applies to §1250 property n n Additional recapture is based on §1245 rules

§291--Additional Recapture for Corporations n n The additional recapture amount is 20 % of the amount by which §1245 recapture amount exceeds §1250 recapture amount n n Total recapture is sum of §1250 recapture AND §291 amount