1. Property Dispositions 8-1 Chapter 8 McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 8-2 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

3. 8-3 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 ≠

4. 8-4 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

5. 8-5 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

6. 8-6 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 ≠

7. 8-7 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

8. 8-8 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

9. 8-9 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

10. 8-10 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

11. 8-11 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

12. 8-12 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%, 25%, and 28% preferential rates  Corporations pay tax at regular rates  Capital gains are preferred to ordinary income because capital gains absorb capital losses

13. 8-13 Dispositions of Noncapital Assets  Sales of inventory and accounts receivable result in ordinary income taxed at regular rates

14. 8-14 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

15. 8-15 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 1 st president that hangs in the board room  A patent developed by BBB’s R&D department  BBB’s company airplane

16. 8-16 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!

17. 8-17 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

18. 8-18 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 2012, 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

19. 8-19 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

20. 8-20 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

21. 8-21 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

22. 8-22 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

23. 8-23 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

24. 8-24 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)