1. Chapter 8 Property Transactions:
Capital Gains and Losses, Section 1231, and Recapture Provisions

2. Taxation of Capital Gains and Losses
Capital gains and losses must be separated from other types of gains and losses for two reasons:
Long-term capital gains may be taxed at a lower rate than ordinary gains
The deduction of a net capital loss may be limited 2

3. Proper Classification of Gains and Losses
Depends on three characteristics:
The tax status of the property
Capital asset, §1231 asset, or ordinary asset
The manner of the property’s disposition
By sale, exchange, casualty, theft, or condemnation
The holding period of the property
Short term and long term 3

4. Capital Assets (slide 1 of 5)
§1221 defines capital assets as everything except:
Inventory (stock in trade)
Notes and accounts receivables acquired from the sale of inventory or performance of services
Realty and depreciable property used in a trade or business (§1231 assets) 4

5. Capital Assets (slide 2 of 5)
§1221 defines capital assets as everything except (cont’d):
Certain copyrights; literary, musical, or artistic compositions; or letters, memoranda, or similar property
Taxpayers may elect to treat a sale or exchange of certain musical compositions or copyrights in musical works as the disposition of a capital asset
Certain publications of U.S. government
Supplies of a type regularly used or consumed in the ordinary course of a business 5

6. Capital Assets (slide 3 of 5)
Thus, capital assets usually include:
Assets held for investment (e.g., stocks, bonds, land)
Personal use assets (e.g., residence, car)
Miscellaneous assets selected by Congress 6

7. Capital Assets (slide 4 of 5)
Dealers in securities
In general, securities are the inventory of securities dealers, thus ordinary assets
However, a dealer can identify securities as an investment and receive capital gain treatment
Clear identification must be made on the day of acquisition 7

8. Capital Assets (slide 5 of 5)
Real property subdivided for sale
Taxpayer may receive capital gain treatment on the subdivision of real estate if the following requirements are met:
Taxpayer is not a corporation
Taxpayer is not a real estate dealer
No substantial improvements made to the lots
Taxpayer held the lots for at least 5 years
Capital gain treatment occurs until the year in which the 6th lot is sold
Then up to 5% of the revenue from lot sales is potential ordinary income
That potential ordinary income is offset by any selling expenses from the lot sales 8

9. Sale or Exchange (slide 1 of 11)
Recognition of capital gains and losses generally requires a sale or exchange of assets
Sale or exchange is not defined in the Code
There are some exceptions to the sale or exchange requirement 9

10. Sale or Exchange–Worthless Securities and § 1244 Stock (slide 2 of 11)
A security that becomes worthless creates a deductible capital loss without being sold or exchanged
The Code sets an artificial sale date for the securities on the last day of the year in which worthlessness occurs
Section 1244 allows an ordinary deduction on disposition of stock at a loss
The stock must be that of a small business company
The ordinary deduction is limited to $50,000 ($100,000 for married individuals filing jointly) per year 10

11. Sale or Exchange (slide 3 of 11)
Worthless securities example:
Calendar year taxpayer purchased stock on December 5, 2009
The stock becomes worthless on April 5, 2010
The loss is deemed to have occurred on December 31, 2010
The result is a long-term capital loss 11

12. Sale or Exchange–Retirement of Corporate Obligations (slide 4 of 11)
Collection of the redemption value of corporate obligations (e.g., bonds payable) is treated as a sale or exchange and may result in a capital gain or loss
OID amortization increases basis and reduces gain on disposition or retirement 12

13. Sale or Exchange–Options (slide 5 of 11)
For the grantee of the option, if the property subject to the option is (or would be) a capital asset in the hands of the grantee
Sale of an option results in capital gain or loss
Lapse of an option is considered a sale or exchange resulting in a capital loss
For the grantor of an option, the lapse creates
Short-term capital gain, if the option was on stocks, securities, commodities or commodity futures
Otherwise, ordinary income 13

14. Sale or Exchange–Options (slide 6 of 11)
Exercise of an option by a grantee
Increases the gain (or reduces the loss) to the grantor from the sale of the property
Gain is ordinary or capital depending on the tax status of the property
Grantee adds the cost of the option to the basis of the property acquired 14

15. Sale or Exchange–Patents (slide 7 of 11)
When all substantial rights to a patent are transferred by a holder to another, the transfer produces long-term capital gain or loss
The holder of a patent must be an individual, usually the creator, or an individual who purchases the patent from the creator before the patented invention is reduced to practice 15

16. Sale or Exchange–Franchises, Trademarks, and Trade Names (slide 8 of 11)
The licensing of franchises, trade names, trademarks, and other intangibles is generally not considered a sale or exchange of a capital asset
Therefore, ordinary income results to transferor
Exception: Capital gain (loss) may result if the transferor does not retain any significant power, right, or continuing interest 16

17. Significant powers, rights, or continuing interests include:
Sale or Exchange–Franchises, Trademarks, and Trade Names (slide 9 of 11)
Significant powers, rights, or continuing interests include:
Control over assignment, quality of products and services
Sale or advertising of other products or services
The right to require that substantially all supplies and equipment be purchased from the transferor
The right to terminate the franchise at will, and
The right to substantial contingent payments 17

18. Sale or Exchange–Franchises, Trademarks, and Trade Names (slide 10 of 11)
Noncontingent payments are ordinary income to the transferor
The franchisee capitalizes the payments and amortizes them over 15 years
Contingent payments are ordinary income for the franchisor and an ordinary deduction for the franchisee 18

19. Sale or Exchange–Lease Cancellation Payments (slide 11 of 11)
Lessee treatment
Treated as received in exchange for underlying leased property
Capital gain results if asset leased was a capital asset (e.g., personal use )
Ordinary income results if asset leased was an ordinary asset (e.g., used in lessee’s business and lease has existed for one year or less when canceled)
Lease could be a § 1231 asset if the property is used in lessee’s trade or business and the lease has existed for > a year when it is canceled
Lessor treatment
Payments received are ordinary income (rents) 19

20. Holding Period (slide 1 of 3)
Short-term
Asset held for 1 year or less
Long-term
Asset held for more than 1 year
Holding period starts on the day after the property is acquired and includes the day of disposition 20

21. Holding Period (slide 2 of 3)
Nontaxable Exchanges
Holding period of property received includes holding period of former asset if a capital or §1231 asset
Transactions involving a carryover basis
Former owner’s holding period tacks on to present owner’s holding period if a nontaxable transaction and basis carries over
Inherited property is always treated as long term no matter how long it is held by the heir 21

22. Holding Period (slide 3 of 3)
Short sales
Taxpayer sells borrowed securities and then repays the lender with substantially identical securities
Gain or loss is not recognized until the short sale is closed
Generally, the holding period for a short sale is determined by how long the property used for repayment is held
If substantially identical property (e.g., other shares of the same stock) is held by the taxpayer, the short-term or long-term character of the short sale gain or loss may be affected 22

23. Tax Treatment of Capital Gains and Losses (slide 1 of 6)
Noncorporate taxpayers
Capital gains and losses must be netted by holding period
Short-term capital gains and losses are netted
Long-term capital gains and losses are netted
If possible, long-term gains or losses are then netted with short-term gains or losses
If the result is a loss:
The capital loss deduction is limited to a maximum deduction of $3,000
Unused amounts retain their character and carryforward indefinitely 23

24. Tax Treatment of Capital Gains and Losses (slide 2 of 6)
Noncorporate taxpayers (cont’d)
If net from capital transactions is a gain, tax treatment depends on holding period
Short-term (assets held 12 months or less)
Taxed at ordinary income tax rates
Long-term (assets held more than 12 months)
An alternative tax calculation is available using preferential tax rates 24

25. Tax Treatment of Capital Gains and Losses (slide 3 of 6)
Noncorporate taxpayers (cont’d)
Net long-term capital gain is eligible for one or more of four alternative tax rates: 0%, 15%, 25%, and 28%
The 25% rate applies to unrecaptured §1250 gain and is related to gain from disposition of §1231 assets
The 28% rate applies to collectibles
The 0%/15% rates apply to any remaining net long-term capital gain 25

26. Tax Treatment of Capital Gains and Losses (slide 4 of 6)
Income Layers for Alternative Tax on Capital Gain Computation
*May include qualified dividend income 26

27. Tax Treatment of Capital Gains and Losses (slide 5 of 6)
Collectibles, even though they are held long term, are subject to a 28% alternative tax rate
Collectibles include any:
Work of art
Rug or antique
Metal or gem
Stamp
Alcoholic beverage
Historical objects (documents, clothes, etc.)
Most coins 27

28. Tax Treatment of Capital Gains and Losses (slide 6 of 6)
The alternative tax on net capital gain applies only if taxable income includes some net long-term capital gain
Net capital gain may be made up of various rate layers
For each layer, compare the regular tax rate with the alternative tax rate on that portion of the net capital gain
The layers are taxed in the following order: 25% gain, 28% gain, the 0% portion of the 0%/15% gain, and then the 15% portion of the 0%/15% gain
This allows the taxpayer to receive the lower of the regular tax or the alternative tax on each layer of net capital gain 28

29. Tax Treatment of Capital Gains and Losses - Corporate Taxpayers
Differences in corporate capital treatment
There is a NCG alternative tax rate of 35 %
Since the max corporate tax rate is 35 %, the alternative tax is not beneficial
Net capital losses can only offset capital gains (i.e., no $3,000 deduction in excess of capital gains)
Net capital losses are carried back 3 years and carried forward 5 years as short-term losses 29

30. §1231 Assets (slide 1 of 4) §1231 assets defined
Depreciable and real property used in a business or for production of income and held >1 year
Includes timber, coal, iron, livestock, unharvested crops
Certain purchased intangibles 30

31. §1231 Assets (slide 2 of 4)
§1231 property does not include the following:
Property not held for the long-term holding period
Nonpersonal use property where casualty losses exceed casualty gains for the taxable year
Inventory and property held primarily for sale to customers
Copyrights, literary, musical, or artistic compositions and certain U.S. government publications
Accounts receivable and notes receivable arising in the ordinary course of a trade or business 31

32. §1231 Assets (slide 3 of 4)
If transactions involving §1231 assets result in:
Net §1231 loss = ordinary loss
Net §1231 gain = long-term capital gain 32

33. §1231 Assets (slide 4 of 4)
Provides the best of potential results for the taxpayer
Ordinary loss that is fully deductible for AGI
Gains subject to the lower capital gains tax rates 33

34. Special Rules For Certain §1231 Assets (slide 1 of 2)
Casualty gains and losses from §1231 assets and from long-term nonpersonal use capital assets are determined and netted together
If a net loss, items are treated separately
§1231 casualty gains and nonpersonal use capital asset casualty gains are treated as ordinary gains
§1231 casualty losses are deductible for AGI
Nonpersonal use capital asset casualty losses are deductible from AGI subject to the 2% of AGI limitation
If a net gain, treat as §1231 gain 34

35. Special Rules For Certain §1231 Assets (slide 2 of 2)
The special netting process for casualties & thefts does not include condemnation gains and losses
A § 1231 asset disposed of by condemnation receives § 1231 treatment
Personal use property condemnation gains and losses are not subject to the § 1231 rules
Gains are capital gains
Personal use property is a capital asset
Losses are nondeductible
They arise from the disposition of personal use property 35

36. General Procedure for § 1231 Computation (slide 1 of 3)
Step 1: Casualty Netting
Net all recognized long-term gains & losses from casualties of § 1231 assets and nonpersonal use capital assets
If casualty gains exceed casualty losses, add the excess to the other § 1231 gains for the taxable year
If casualty losses exceed casualty gains, exclude all casualty losses and gains from further § 1231 computation
All casualty gains are ordinary income
Section 1231 asset casualty losses are deductible for AGI
Other casualty losses are deductible from AGI 36

37. General Procedure for § 1231 Computation (slide 2 of 3)
Step 2: § 1231 Netting
After adding any net casualty gain from previous step to the other § 1231 gains and losses, net all § 1231 gains and losses
If gains exceed the losses, net gain is offset by the ‘‘lookback’’ nonrecaptured § 1231 losses from the 5 prior tax years
To the extent of this offset, the net § 1231 gain is classified as ordinary gain
Any remaining gain is long-term capital gain
If the losses exceed the gains, all gains are ordinary income
Section 1231 asset losses are deductible for AGI
Other casualty losses are deductible from AGI 37

38. General Procedure for § 1231 Computation (slide 3 of 3)
Step 3: § 1231 Lookback Provision
The net § 1231 gain from the previous step is offset by the nonrecaptured net § 1231 losses for the five preceding taxable years
To the extent of the nonrecaptured net § 1231 loss, the current-year net § 1231 gain is ordinary income
The nonrecaptured net § 1231 losses are those that have not already been used to offset net § 1231 gains
Only the net § 1231 gain exceeding this net § 1231 loss carryforward is given long-term capital gain treatment 38

39. Lookback Provision Example
Taxpayer had the following net §1231 gains and losses:
2008 $ 4,000 loss
2009 $10,000 loss
2010 $16,000 gain
In 2010, taxpayer’s net §1231 gain of $16,000 will be treated as $14,000 of ordinary income and $2,000 of long-term capital gain 39

40. Section 1231 Netting Procedure40

41. Depreciation Recapture (slide 1 of 3)
Assets subject to depreciation or cost recovery may be subject to depreciation recapture when disposed of at a gain
Losses on depreciable assets receive §1231 treatment
No recapture occurs in loss situations 41

42. Depreciation Recapture (slide 2 of 3)
Depreciation recapture characterizes gains that would appear to be §1231 as ordinary gain
The Code contains two major recapture provisions
§1245
§1250 42

43. Depreciation Recapture (slide 3 of 3)
Depreciation recapture provisions generally override all other Code Sections
There are exceptions to depreciation recapture rules, for example:
In dispositions where all gain is not recognized
e.g., like-kind exchanges, involuntary conversions
Where gain is not recognized at all
e.g., gifts and inheritances 43

44. §1245 Recapture (slide 1 of 3)
Depreciation recapture for §1245 property
Applies to tangible and intangible personalty, and nonresidential realty using accelerated methods of ACRS (placed in service )
Recapture potential is entire amount of accumulated depreciation for asset
Method of depreciation does not matter 44

45. §1245 Recapture (slide 2 of 3)
When gain on the disposition of a §1245 asset is less than the total amount of accumulated depreciation:
The total gain will be treated as depreciation recapture (i.e., ordinary income) 45

46. §1245 Recapture (slide 3 of 3)
When the gain on the disposition of a §1245 asset is greater than the total amount of accumulated depreciation:
Total accumulated depreciation will be recaptured (as ordinary income), and
The gain in excess of depreciation recapture will be §1231 gain or capital gain 46

47. §1245 Recapture Example (slide 1 of 2)
On January 1, 2010, Jake sold for $26,000 a machine acquired several years ago for $24,000. He had taken $20,000 of depreciation on the machine.
Amount Realized $26,000
Adj. Basis-Cost $24,000
Acc. Depr , ,000
Realized Gain $22,000
Sec – Ordinary Income ,000
Sec Gain $ 2,000 47

48. §1245 Recapture Example (slide 2 of 2)
Same as previous example except Jake sold
the machine for $18,000.
Amount Realized $18,000
Adj. Basis-Cost $24,000
Acc. Depr , ,000
Realized Gain $14,000
Sec – Ordinary Income ,000
Sec Gain $
The § 1231 gain is $0 because the selling price ($18,000) does not exceed the original purchase price ($24,000). 48

49. Observations on § 1245 (slide 1 of 3)
Usually total depreciation taken will exceed the recognized gain
Therefore, disposition of § 1245 property usually results in ordinary income rather than § 1231 gain
Thus, generally, no § 1231 gain will occur unless the § 1245 property is disposed of for more than its original cost 49

50. Observations on § 1245 (slide 2 of 3)
Recapture applies to the total amount of depreciation allowed or allowable regardless of
The depreciation method used
The holding period of the property
If held for < the long-term holding period the entire recognized gain is ordinary income because § 1231 does not apply 50

51. Observations on § 1245 (slide 3 of 3)
Section 1245 does not apply to losses which receive § 1231 treatment
Gains from the disposition of § 1245 assets may also be treated as passive activity gains 51

52. §1250 Recapture (slide 1 of 2)
Depreciation recapture for §1250 property
Applies to depreciable real property
Exception: Nonresidential realty classified as §1245 property (i.e., placed in service after 1980 and before 1987, and accelerated depreciation used)
Intangible real property, such as leaseholds of § 1250 property, is also included 52

53. §1250 Recapture (slide 2 of 2)
Section 1250 recapture rarely applies since only the amount of additional depreciation is subject to recapture
To have additional depreciation, accelerated depreciation must have been taken on the asset
Straight-line depreciation is not recaptured (except for property held one year or less)
Depreciable real property placed in service after 1986 can generally only be depreciated using the straight-line method
Therefore, no depreciation recapture potential for such property
§ 1250 does not apply if the real property is sold at a loss 53

54. Real Estate 25% Gain (slide 1 of 2)
Also called unrecaptured §1250 gain or 25% gain
25% gain is some or all of the §1231 gain treated as long-term capital gain
Used in the alternative tax computation for net capital gain 54

55. Real Estate 25% Gain (slide 2 of 2)
Maximum amount of 25% gain is depreciation taken on real property sold at a recognized gain reduced by:
Certain §1250 and §1245 depreciation recapture
Losses from other §1231 assets
§1231 lookback losses
Limited to recognized gain when total gain is less than depreciation taken 55

56. Additional Recapture for Corporations
Corporations that sell depreciable real estate face an additional amount of depreciation recapture
Section 291(a)(1) requires recapture of 20% of the excess of the amount that would be recaptured under § 1245 over the amount actually recaptured under § 1250 56

57. Related Effects of Recapture (slide 1 of 5)
Gifts
The carryover basis of gifts, from donor to donee, also carries over depreciation recapture potential associated with asset
That is, donee steps into shoes of donor with regard to depreciation recapture potential 57

58. Related Effects of Recapture (slide 2 of 5)
Inheritance
Death is only way to eliminate recapture potential
That is, depreciation recapture potential does not carry over from decedent to heir 58

59. Related Effects of Recapture (slide 3 of 5)
Charitable contributions
Recapture potential reduces the amount of charitable contribution deductions that are based on FMV 59

60. Related Effects of Recapture (slide 4 of 5)
Nontaxable transactions
When the transferee carries over the basis of the transferor, the recapture potential also carries over
Included in this category are transfers of property pursuant to the following:
Nontaxable incorporations under § 351
Certain liquidations of subsidiary companies under § 332
Nontaxable contributions to a partnership under § 721
Nontaxable reorganizations
Gain may be recognized in these transactions if boot is received
If gain is recognized, it is treated as ordinary income to the extent of the recapture potential or recognized gain, whichever is lower 60

61. Related Effects of Recapture (slide 5 of 5)
Like-kind exchanges and involuntary conversions
Property received in these transactions have a substituted basis
Basis of former property and its recapture potential is substituted for basis of new property
Any gain recognized on the transaction will first be treated as depreciation recapture, then as §1231 or capital gain
Any remaining recapture potential carries over 61

62. Dr. Donald R. Trippeer, CPA
If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:
Dr. Donald R. Trippeer, CPA
SUNY Oneonta 62