Property Dispositions

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PropertyDispositions

• Chapter 7

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Tax Impact on Cash Flow

• Taxes paid on a recognized gain reduce net cash
  flow
• Tax savings generated by a recognized loss
  increase net cash flow
• Tax impact on cash flow is affected by the
• Type of asset and its holding period
• Type of taxpayer
• Taxpayers marginal tax rate

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Types of Dispositions

• Sale seller receives cash or cash equivalents
  in return for asset
• Exchange taxpayer receives property other than
  cash or cash equivalents in return for property
  transferred to the other party
• Involuntary conversion complete or partial
  destruction due to events not under control of
  taxpayer (condemnations, thefts, and casualties)
• Abandonment property is permanently withdrawn
  from use (loss basis of asset)

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Realized Gain or Loss

• Amount realized cash FMV of property received
  sellers liabilities assumed by the buyer (less
  buyers liabilities assumed by the seller) less
  selling expenses
• Amount realized less adjusted basis of property
  given up equals realized gain or loss

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Recognized Gain or Loss

• Almost all realized gains are recognized
  (taxable)
• Losses are usually only recognized (deductible)
  if they are
• Incurred in a business
• Incurred in an investment activity
• Casualty or theft losses

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Holding Period

• The holding period is the period of time the
  taxpayer is credited with owning the property
• The holding period usually begins on date of
  acquisition unless there is a carryover or
  substituted basis for the asset acquired
• Property must be held for more than one year to
  receive favorable tax treatment for
• Section 1231 assets
• Capital assets

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Holding Period

• Gifts holding period carries over from donor
• Exception when FMV at date of gift is used for
  basis, holding period begins on date of gift
• Inherited property always long-term holding
  period

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Types of Assets

• Section 1231 assets fixed assets (property,
  plant, and equipment) used in a trade or business
  and held for more than one year
• Capital assets investment and personal-use
  assets
• Ordinary income assets inventory, accounts
  receivable, and all other assets that are neither
  Section 1231 or capital assets

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Section 1231 Property

• Property used in a business that is subject to
  cost recovery deductions and that is held for
  more than one year (long-term holding period)
• Land used in a business that is held for more
  than one year
• Gains (after recapture provisions are applied)
  and losses on individual Section 1231 property
  dispositions are subject to a netting process to
  determine tax treatment

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Determining Net Section 1231 Gain/Loss Treatment

• Step 1 Determine the gain or loss for each
  Section 1231 asset
• Step 2 Reduce the gains for depreciation
  recapture
• Depreciation recapture is included in ordinary
  income
• Step 3 Net the remaining gains and losses

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Determining Net Section 1231 Gain/Loss Treatment

• Step 4 If the result is a net loss, deduct it in
  full from ordinary income
• Step 5 If the result is a net gain, apply the
  5-year look-back rule
• Gains up to the amount of previously unrecaptured
  Section 1231 losses are included in and taxed as
  ordinary income
• Step 6 The remaining net Section 1231 gain is
  treated as a net long-term capital gain and
  included in capital gain netting process

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Depreciation Recapture

• Depreciation recapture converts part or all of
  the gain recognized on the sale of depreciable
  assets to ordinary income to the extent of the
  reduction in basis attributable to depreciation
  expense previously claimed
• The amount of income recaptured as ordinary
  income can never exceed either the realized gain
  or prior depreciation deductions
• Recapture rules cannot apply to assets on which
  there is a realized loss

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Section 1245 Full Recapture

• Applies to machinery, equipment, furniture, and
  fixtures (but not to buildings or structural
  components)
• Any gain on the sale of section 1245 property is
  ordinary income to the extent of all depreciation
  allowed or allowable for the property
• Any amount expensed under section 179 is included
  in the depreciation allowed
• The income recaptured is the lesser of all
  depreciation taken or the realized gain

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Section 1250Partial Recapture

• Applies to realty
• Section 1250 recaptures the excess of accelerated
  depreciation over straight line depreciation
• For realty placed in service after 1986, for
  which straight-line depreciation must be used,
  there is no Section 1250 recapture for
  noncorporate taxpayers
• Section 291 for corporations
• Section 1250 unrecaptured gain for individuals

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Additional Section 291 Recapture for Corporations

• Section 291 applies to corporate dispositions of
  realty (Section 1250 property)
• Converts to ordinary income (as Section 1250
  recapture) 20 of any Section 1231 gain that
  would have been ordinary income if Section 1245
  full recapture applied
• For realty acquired after 1986, Section 1245 full
  recapture x 20 Section 1250 recapture
• Eliminates some of the capital gains that would
  otherwise be available to offset corporate
  capital losses

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Unrecaptured Section 1250 Gain

• For individuals only, unrecaptured Section 1250
  gains are those long-term capital gains on realty
  that would be taxed as ordinary income if the
  Section 1245 full recapture rules applied
• These long-term capital gains attributable to
  prior depreciation deductions are taxed at a
  maximum rate of 25

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Section 1231 Netting

• Step 1 Net casualty and theft gains (after
  recapture) and losses on Section 1231 assets and
  investment assets
• If a net loss, all gains and losses are ordinary
  except investment losses of individuals
  (miscellaneous itemized deductions)
• A net gain is included in Step 2
• Step 2 Net gains (after recapture) and losses
  from all other Section1231 assets and involuntary
  conversions of investment assets with net gain
  from step 1
• If a net loss, treat as described above
• If a net gain, apply Section 1231 look-back rules

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Section 1231 Netting

• All net gain remaining after the Section 1231
  look-back rules are applied is treated as a
  long-term capital gain and included in the
  capital asset netting process
• This netting process allows taxpayers to claim
  ordinary loss treatment for net losses and
  favorable capital gains treatment for net gains
  after application of the recapture provisions

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Section 1231 Look-Back Rules

• Net Section 1231 gains are taxed as ordinary
  income to the extent of any unrecaptured net
  Section 1231 losses in the five preceding years
• This prevents taxpayers from generating tax
  savings by bunching their Section 1231 gains into
  one year (to receive tax-favored long-term
  capital gains treatment) and losses into
  alternate years (deducting the Section 1231
  losses in full against ordinary income)

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Capital Assets

• Capital assets include stock, bonds, land held
  for appreciation, collectibles (coins, art), and
  personal-use assets
• Long-term holding period is more than one year
• Short-term holding period is one year or less

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Capital Gain and LossNetting Process

• Subtract long-term capital losses from long-term
  capital gains (including net Section 1231 gains)
• Subtract short-term losses from short-term gains
• Continue netting (subtracting losses from gains)
  until only gains or only losses remain
• A (net) short-term capital gain resulting from
  this process is taxed at ordinary income rates
• Taxation of (net) long-term capital gains and all
  capital losses differs for corporations and
  individuals

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Capital Gains and Lossesof C Corporations

• No current deduction for capital losses carry
  back 3 years and forward 5 years to use only
  against capital gains
• Both long-term and short-term capital gains taxed
  as ordinary income
• Benefit of capital gains is limited to ability to
  offset capital losses

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Capital Losses for Individuals

• 3,000 per year deduction against other income
  for capital losses (net) short-term capital
  losses deducted before (net) long-term capital
  losses
• Remaining (net) capital losses are carried
  forward indefinitely (no carry back permitted)
• Losses on personal-use assets are not recognized
  (deductible) even though gains are recognized
  (taxable)

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General Capital GainsRates for Individuals

• 15 rate applies to most long-term capital gains
• 5 rate applies to taxpayers whose ordinary
  income is taxed at the 10 and 15 marginal tax
  brackets to the extent their long-term gains fall
  within these marginal tax brackets

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Special Capital Gains Rates for Individuals

• 25 rate applies to Sec. 1250 unrecaptured gain
  on realty gain in excess of the recapture amount
  is taxed at 15 rate
• If taxpayers ordinary income tax rate is lower
  than 25, then the lower ordinary income rate
  applies to gain that falls within that tax
  bracket
• Collectibles such as antiques, art objects, and
  rare coins are taxed at a 28 rate due to
  potential personal enjoyment of asset
• If taxpayers ordinary tax rate is lower than
  28, then the lower ordinary rate applies to gain
  that falls within that tax bracket

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Ordinary Income Property

• Ordinary income property includes
• Business assets that do not meet the
  more-than-one year holding period under Section
  1231
• Inventory
• Accounts and notes receivable arising from sale
  of goods or services by a business
• Any other asset that is not a capital or a
  Section 1231 asset
• Ordinary gains are taxed as ordinary income and
  losses are fully deductible as ordinary losses

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Mixed-Use Property

• Property that is used partly for business and
  partly for personal use must be divided into
  Section 1231 property and personal-use property
• Gain or loss determined separately for business
  and personal-use parts

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Section 1244 Stock

• Losses on stock are usually capital losses
  individuals are limited to a 3,000 deduction
  against ordinary income annually after netting
  losses against capital gains
• Section 1244 permits an ordinary loss deduction
  of up to 50,000 (100,000 if a joint return)
  annually for losses on qualified stock if an
  individual is the original investor in a domestic
  small business corporation
• Any excess loss is a capital loss

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Section 1244 Stock

• Total capitalization cannot exceed 1 million
• For the 5 preceding years
• The corporation must be an operating company
  deriving 50 or more of its annual gross revenues
  from the sale of goods or services
• Income from rents, royalties, dividends,
  interest, annuities and gain on sales of
  securities is limited to 50 or less

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Section 1202 Small Business Stock Gain Exemption

• Taxpayers may exclude up to 50 of the gain
  realized on the disposition of qualified small
  business stock held for more than 5 years
  (remaining 50 of the gain is taxed at the 28
  long-term capital gain rate)
• Business must be a small C corporation (no more
  than 50 million in assets) operating an active
  business engaged in manufacturing, retailing, or
  wholesaling

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Section 1202 Stock

• Seller of stock must be the original owner who
  acquires the stock in exchange for money,
  property or services
• Excluded gain cannot exceed the greater of
• 10 times the adjusted basis of qualifying stock
  sold in the tax year or
• 10,000,000 less any gain excluded on qualifying
  stock in the preceding tax years by the taxpayer

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Section 1202 Stock

• If taxpayer holds stock at least 6 months and
  invests all proceeds in another qualified small
  business corporations stock, no gain recognized
• If all proceeds not reinvested, only gain
  proportionate to the reinvested proceeds can be
  excluded

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Sale of Principal Residence

• An individual who has owned and occupied a home
  as a principal residence for at least 2 of the 5
  years before the sale can exclude up to 250,000
  of gain (500,000 for qualified married taxpayers
  filing a joint return)
• The full exclusion can only be used once every 2
  years

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Sale of Principal Residence

• Married taxpayers filing jointly can exclude up
  to 500,000 of gain if
• Either spouse owned the home for at least 2 of
  previous 5 years, and
• Both spouses used the home as a principal
  residence for at least 2 of previous 5 years, and
• Neither spouse is ineligible for the exclusion
  because of the once-every-2-year limit

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Sale of Principal Residence

• Partial exclusion available if failure to meet
  two-year time period requirement is due to
• A change in place of employment
• Health (moving into nursing home)
• Other unforeseen circumstances including divorce,
  death of spouse or co-owner, unemployment,
  disasters, and involuntary conversion of residence

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Sale of Principal Residence

• Partial exclusion is calculated by taking
  dividing the number of qualifying months by 24
  and then multiplying this fraction by 250,000
  (500,000 if qualifying jointly)
• The number of qualifying months is the shorter of
• The use and ownership during the 5 preceding
  years or
• The period of time that has passed since the
  taxpayer last claimed the exclusion

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Sale of Principal Residence

• A principal residence does not lose that status
  if temporarily rented during the period of time
  it is for sale
• The exclusion does not apply to any gain
  attributable to depreciation claimed for rental
  or business use of the residence
• The 25 rate for unrecaptured Section 1250 gain
  applies to gain up to the previous depreciation
  deductions

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Sale to Related Party

• Losses on sales to related parties are disallowed
• Related parties include brothers, sisters,
  spouse, ancestors and lineal descendents, as well
  as a more-than 50 owned corporation
• If related buyer later sells property at a gain,
  this gain can be reduced (not below zero) by the
  sellers previously disallowed loss

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The End