Tax Consequence of Property Disposal

1
Chapter 11

• Tax Consequence of Property Disposal

2
Computation of Realized Gain or Loss

• Everything of economic value received in exchange
  for a property comprises the consideration
• If seller receives other property or services as
  part of the transaction, these must be included
  at their fair market value
• Difference between consideration received and the
  adjusted tax basis at the time of the transaction
  is the realized gain or loss on disposal

3
Tax Treatment of Realized Gain or Loss

• Gains are ordinary income when they result from
  recapture of depreciation allowances.
• Gains are also ordinary income when they result
  from selling real estate that has been held for
  resale in the normal course of business (dealer
  property).
• Gains on the sale or exchange of real estate held
  for business or investment purposes are capital
  gains. If the holding period exceeds one year,
  the gain is a long-term capital gain.

4
Tax Treatment of Realized Losses

• Real estate used in a trade or business (includes
  actively managed rental property) and held for
  more than one year are called Section 1231
  assets. Gains on their disposal are treated as
  capital gains, losses are treated as offsets
  against ordinary income.
• Losses on real estate held for investment
  purposes are capital losses. If the real estate
  is held for more than one year, the loss is a
  long-term capital loss

5
Computing Net Gain or Loss on Sale of Assets Held
for Use in Trade or Business

• Offset Section 1231 gains and losses against each
  other.
• Offset long-term capital gains against long-term
  capital losses
• Offset short-term capital against against
  short-term capital losses
• If there are net losses in one category and gains
  in the other, offset the two

6
Tax Consequences Depends Upon Outcome of
Offsetting Gains and Losses

• If outcome is net short-term gains, lump them
  with ordinary income
• If outcome is net long-term gains, they are taxed
  at the maximum rate of 15, regardless of
  taxpayers marginal tax bracket. Recaptured
  depreciation is taxed at 25
• If outcome is net losses, they are offset against
  ordinary income on a dollar-for-dollar basis, but
  only to the extent of 3,000 per year

7
When Realized Gains or Losses Are Recognized

• Gains are realized when a transaction is
  completed
• They may be recognized (and tax consequences
  experienced) in that year or at another time

8
Use of the Installment Method

• If seller takes back a promissory note in part
  payment for property, it may be possible to defer
  recognition of part of the taxable gain until
  principal amount of the note is collected
• Gain that may be deferred is the installment
  method gain total gain minus any portion that
  represents recapture of accelerated depreciation
  allowances

9
Use of the Installment Method

• Contract price is total selling price, less
  balance of any mortgage note payable by the
  purchaser to a third party
• Each year, recognized gain is determined by
  multiplying the amount of the sales price
  actually collected by the seller, multiplied by
  the ratio of the installment method gain to the
  contract price

10
Use of the Installment Method

• Installment note must include a provision for
  reasonable rate of interestotherwise, IRS
  imputes a reasonable rate and recalculates the
  tax consequences of the transaction
• Complex tax rules limit the extent to which a
  taxpayer can defer a gain by using the
  installment method when they themselves own
  substantial amount of mortgage indebtedness

11
Like-Kind Exchanges (1031 Exchanges)

• An otherwise taxable gain realized on an exchange
  of like-kind assets need not be recognized in the
  year of the transaction. Tax liability is
  postponed until a future, taxable transaction
  occurs with respect to the newly acquired
  property.

12
Like-Kind Exchanges (1031 Exchanges)

• Enabling legislation for like-kind exchanges
  (called tax-free exchanges) is contained in
  Section 1031 of the Internal Revenue Code.

13
Like-Kind Exchanges (1031 Exchanges)

• To qualify under Section 1031
• Must have been bona fide exchange of assets
  involved
• Property conveyed must have been held for
  productive use in a trade or business or an
  investment and must be exchanged for like-kind
  property that is also to be used in a trade or
  business or held as an investment
• Property must be of like-kind

14
Like-Kind Exchanges (1031 Exchanges)

• Certain types of property are specifically
  excluded form Section 1031
• Foreign real estate is never considered
  like-kind with domestic real estate

15
Tax Consequences of Like-Kind Exchanges

• If all property involved in an exchange qualifies
  as like-kind and all parties qualify, then no
  party to the exchange may recognize any gain or
  loss on the transaction.
• Should some of the property involved in an
  exchange fail the like-kind test, then some
  portion of a gain must be recognized in the year
  of the transaction.
• Receipt of property that does not meet the
  like-kind definition has the effect of partially
  disqualifying a gain from deferral under Section
  1031.

16
Gifts of Property

• Gifts and legacies are subjected to a unified,
  graduated gift and estate tax that is imposed on
  the person who makes a gift or to the estate of a
  decedent

17
Gifts of Property

• Exemptions and exclusions from the gift and
  estate tax
• One may give as much as 11,000 each to as man
  persons as one wishes each year with no gift tax
  implications (22,000 for spouses)
• Unlimited exemption for gifts or legacies to a
  spouse who is a United States citizen
• Unlimited exemption for payment of tuition and
  medical expenses for others

18
Gifts of Property

• Gifts are cumulative over the givers lifetime
  for purposes of determining the graduated tax
  rate, but gift taxes are due in the year the gift
  is made
• Each taxpayer has a lifetime credit against the
  unified gift and estate tax. The amount of the
  credit will shelter 1,000,000

19
Gifts of Property

• Gift of property that is subject to a mortgage
  will have sale as well as gift elements
• The tax basis of a recipients interest in
  property received as a gift is the same as the
  basis of the givers, unless the giver incurred a
  gift tax liability.
• Letting title pass as a legacy rather than a gift
  works better for highly appreciated property