1. Property Dispositions
8-1
Chapter 8
Property Dispositions
McGraw-Hill Education
Copyright © 2015 by McGraw-Hill Education. All rights reserved.

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

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

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 ≠

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

6. Amount Realized Example
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

7. Gain Realized Example
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. 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

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 ≠

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

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

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

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

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

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

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

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%, 20%, 25%, and 28% preferential rates
Corporations pay tax at regular rates
Capital gains are preferred to ordinary income because capital gains absorb capital losses

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

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

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

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!

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

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 2014, 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

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

25. Section 1231 Recapture Example
Acme began business in 2009 and incurred the following Section 1231 net gains and losses:
2009 $100 net gain
$100 treated as capital gain
2011 $150 net loss
$150 ordinary deduction
2013 $83 net gain
$83 ordinary income (recapture of 2011 loss)
2014 $190 net gain
$67 ordinary income (recapture of 2011 loss) and $123 treated as capital gain

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

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

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

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

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

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

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)