1. Taxation of Business Entities C8-1 Chapter 8 Property Transactions: Capital Gains and Losses, Section 1231, and Recapture Provisions Property Transactions: Capital Gains and Losses, Section 1231, and Recapture Provisions Copyright ©2010 Cengage Learning Taxation of Business Entities

2. C8-2 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 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

3. Taxation of Business Entities C8-3 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 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

4. Taxation of Business Entities C8-4 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 trade or business (§1231 assets) §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 trade or business (§1231 assets)

5. Taxation of Business Entities C8-5 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 when created by taxpayer (or for which taxpayer takes a carryover basis from the creator) For tax years beginning after May 17, 2006, taxpayers may elect to treat a sale or exchange of musical compositions or copyrights in musical works as the disposition of a capital asset –Supplies of a type regularly used or consumed in the ordinary course of a business –Certain publications of U.S. government §1221 defines capital assets as everything except (cont’d): –Certain copyrights; literary, musical, or artistic compositions; or letters, memoranda, or similar property when created by taxpayer (or for which taxpayer takes a carryover basis from the creator) For tax years beginning after May 17, 2006, taxpayers may elect to treat a sale or exchange of musical compositions or copyrights in musical works as the disposition of a capital asset –Supplies of a type regularly used or consumed in the ordinary course of a business –Certain publications of U.S. government

6. Taxation of Business Entities C8-6 Capital Assets (slide 3 of 5) Thus, capital assets are: –Assets held for investment (e.g., stocks, bonds, land) –Personal use assets (e.g., residence, car) –Miscellaneous assets selected by Congress Thus, capital assets are: –Assets held for investment (e.g., stocks, bonds, land) –Personal use assets (e.g., residence, car) –Miscellaneous assets selected by Congress

7. Taxation of Business Entities C8-7 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 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

8. Taxation of Business Entities C8-8 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 6 th 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 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 6 th 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

9. Taxation of Business Entities C8-9 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 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

10. Taxation of Business Entities C8-10 Sale or Exchange–Worthless Securities (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 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

11. Taxation of Business Entities C8-11 Sale or Exchange (slide 3 of 11) Worthless securities example: –Calendar year taxpayer purchased stock on December 5, 2008 –The stock becomes worthless on April 5, 2009 –The loss is deemed to have occurred on December 31, 2009 The result is a long-term capital loss Worthless securities example: –Calendar year taxpayer purchased stock on December 5, 2008 –The stock becomes worthless on April 5, 2009 –The loss is deemed to have occurred on December 31, 2009 The result is a long-term capital loss

12. Taxation of Business Entities C8-12 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 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

13. Taxation of Business Entities C8-13 Sale or Exchange– Options (slide 5 of 11) For the grantee of the option –Sale of an option results in capital gain or loss if the option property is a capital asset to the grantee –Lapse of an option on a capital asset 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 For the grantee of the option –Sale of an option results in capital gain or loss if the option property is a capital asset to the grantee –Lapse of an option on a capital asset 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

14. Taxation of Business Entities C8-14 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 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

15. Taxation of Business Entities C8-15 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 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

16. Taxation of Business Entities C8-16 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 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

17. Taxation of Business Entities C8-17 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 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

18. Taxation of Business Entities C8-18 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 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

19. Taxation of Business Entities C8-19 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) Lessor treatment –Payments received are ordinary income (rents) 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) Lessor treatment –Payments received are ordinary income (rents)

20. Taxation of Business Entities C8-20 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 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

21. Taxation of Business Entities C8-21 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 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

22. Taxation of Business Entities C8-22 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, t he 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 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, t he 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

23. Taxation of Business Entities C8-23 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 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

24. Taxation of Business Entities C8-24 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 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

25. Taxation of Business Entities C8-25 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 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

26. Taxation of Business Entities C8-26 Tax Treatment of Capital Gains and Losses (slide 4 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 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. Taxation of Business Entities C8-27 Tax Treatment of Capital Gains and Losses (slide 5 of 6) When there are both short and long-term capital gains and losses, a complicated ordering procedure is required because the long-term capital gains may be taxed at various rates

28. Taxation of Business Entities C8-28 Tax Treatment of Capital Gains and Losses (slide 6 of 6) 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 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. Taxation of Business Entities C8-29 §1231 Assets (slide 1 of 4) §1231 assets defined –Depreciable and real property used in a business or for production of income and held greater than 1 year –Includes timber, coal, iron, livestock, unharvested crops –Certain purchased intangibles §1231 assets defined –Depreciable and real property used in a business or for production of income and held greater than 1 year –Includes timber, coal, iron, livestock, unharvested crops –Certain purchased intangibles

30. Taxation of Business Entities C8-30 §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 § 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. Taxation of Business Entities C8-31 §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 If transactions involving §1231 assets result in: –Net §1231 loss = ordinary loss –Net §1231 gain = long-term capital gain

32. Taxation of Business Entities C8-32 §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 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. Taxation of Business Entities C8-33 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 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. Taxation of Business Entities C8-34 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 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. Taxation of Business Entities C8-35 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 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. Taxation of Business Entities C8-36 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 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. Taxation of Business Entities C8-37 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 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. Taxation of Business Entities C8-38 Lookback Provision Example Taxpayer had the following net §1231 gains and losses: 2007$ 4,000 loss 2008 10,000 loss 2009 16,000 gain –In 2009, taxpayer’s net §1231 gain of $16,000 will be treated as $14,000 of ordinary income and $2,000 of long-term capital gain Taxpayer had the following net §1231 gains and losses: 2007$ 4,000 loss 2008 10,000 loss 2009 16,000 gain –In 2009, 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. Taxation of Business Entities C8-39 §1231 Netting Procedure (slide 1 of 2) §1231 asset and long-term nonpersonal use capital asset casualty gains minus §1231 asset and long-term nonpersonal use capital asset casualty losses §1231 asset and long-term nonpersonal use capital asset casualty gains minus §1231 asset and long-term nonpersonal use capital asset casualty losses Net Gain (add to §1231 gains) Net Gain (add to §1231 gains) Items treated separately: Gains are ordinary income, §1231 asset losses are deductible for AGI, Other losses deductible from AGI §1231 gains minus §1231 losses §1231 gains minus §1231 losses Net Gain Net Loss Net Gain NLoss Net Loss

40. Taxation of Business Entities C8-40 §1231 Netting Procedure (slide 2 of 2) Lookback Provision: Net gain is offset against nonrecaptured net §1231 losses from 5 prior tax years Gain offset by lookback losses is ordinary gain Remaining gain is LTCG Net Gain

41. Taxation of Business Entities C8-41 Depreciation Recapture (slide 1 of 3) Assets subject to depreciation or cost recovery are subject to depreciation recapture when disposed of at a gain –Losses on depreciable assets receive §1231 treatment No recapture occurs in loss situations Assets subject to depreciation or cost recovery are subject to depreciation recapture when disposed of at a gain –Losses on depreciable assets receive §1231 treatment No recapture occurs in loss situations

42. Taxation of Business Entities C8-42 Depreciation Recapture (slide 2 of 3) Depreciation recapture characterizes gains that would otherwise be capital or §1231 as ordinary income –The Code contains two major recapture provisions §1245 §1250 Depreciation recapture characterizes gains that would otherwise be capital or §1231 as ordinary income –The Code contains two major recapture provisions §1245 §1250

43. Taxation of Business Entities C8-43 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 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

44. Taxation of Business Entities C8-44 §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 1981-86) Recapture potential is entire amount of accumulated depreciation for asset Method of depreciation does not matter Depreciation recapture for §1245 property –Applies to tangible and intangible personalty, and nonresidential realty using accelerated methods of ACRS (placed in service 1981-86) Recapture potential is entire amount of accumulated depreciation for asset Method of depreciation does not matter

45. Taxation of Business Entities C8-45 §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) 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)

46. Taxation of Business Entities C8-46 §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 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

47. Taxation of Business Entities C8-47 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 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

48. Taxation of Business Entities C8-48 Observations on § 1245 (slide 2 of 3) Recapture applies to the total amount of depreciation allowed or allowable regardless of the depreciation method used Recapture applies regardless of 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 Recapture applies to the total amount of depreciation allowed or allowable regardless of the depreciation method used Recapture applies regardless of 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

49. Taxation of Business Entities C8-49 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 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

50. Taxation of Business Entities C8-50 §1250 Recapture (slide 1 of 3) 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) 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)

51. Taxation of Business Entities C8-51 §1250 Recapture (slide 2 of 3) Depreciation recapture for §1250 property –Recapture potential is limited to excess of accelerated depreciation taken on asset over depreciation that would have been deductible if straight-line depreciation had been used Depreciation recapture for §1250 property –Recapture potential is limited to excess of accelerated depreciation taken on asset over depreciation that would have been deductible if straight-line depreciation had been used

52. Taxation of Business Entities C8-52 §1250 Recapture (slide 3 of 3) Straight-line depreciation on real property –If straight-line depreciation has been taken on real property, no depreciation recapture potential exists under §1250 –All real property acquired after 1986 must use straight-line depreciation Therefore, no depreciation recapture potential for such property Straight-line depreciation on real property –If straight-line depreciation has been taken on real property, no depreciation recapture potential exists under §1250 –All real property acquired after 1986 must use straight-line depreciation Therefore, no depreciation recapture potential for such property

53. Taxation of Business Entities C8-53 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 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. Taxation of Business Entities C8-54 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 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. Taxation of Business Entities C8-55 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 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. Taxation of Business Entities C8-56 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 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. Taxation of Business Entities C8-57 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 Inheritance –Death is only way to eliminate recapture potential –That is, depreciation recapture potential does not carry over from decedent to heir

58. Taxation of Business Entities C8-58 Related Effects of Recapture (slide 3 of 5) Charitable contributions –Recapture potential reduces the amount of charitable contribution deductions that are based on FMV Charitable contributions –Recapture potential reduces the amount of charitable contribution deductions that are based on FMV

59. Taxation of Business Entities C8-59 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 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. Taxation of Business Entities C8-60 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 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. Taxation of Business Entities C8-61 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta