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• Abandonment property is permanently withdrawn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

• Holding period is the period of time the taxpayer
  is credited with owning the property and usually
  begins on date of acquisition
• 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, then holding period begins at date of gift
• Inherited property always long-term holding
  period

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Types of Assets

• Section 1231 assets business fixed assets held
  for more than one year
• Capital assets investment and personal-use
  assets
• Ordinary income assets inventory, accounts
  receivable, and other assets that are not in
  either of above categories

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Section 1231 Property

• Property used in a business that can be
  depreciated or amortized and held for more than
  one year (long-term holding period)
• Also includes land used in a business
• Loss is deductible as ordinary loss
• Gain is taxed as long-term capital gain (except
  for recapture)

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Section 1231 Property

• Determine the gain or loss for each Section 1231
  asset
• Reduce the gains for depreciation recapture
  (depreciation recapture is included in ordinary
  income)
• Net the remaining gains and losses
• If the result is a net loss, deduct it in full
  from ordinary income
• If the result is a net gain, apply the 5-year
  look-back rules (taxing gains at regular ordinary
  income rates)
• Balance of net gain becomes 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 that is recaptured will
  never be more than realized gain
• Recapture rules do not apply to losses

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Section 1245 Full Recapture

• Applies to machinery, equipment, furniture, and
  fixtures (but not 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 amount of income recaptured is the lesser of
  all depreciation taken or the amount of realized
  gain

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Section 1250 Partial Recapture

• Applies to realty
• Section 1250 recaptures excess of accelerated
  depreciation over straight line depreciation
• For realty placed in service after 1986 (which
  must use straight line), no Section 1250
  recapture will occur

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Additional Section 291 Recapture for Corporations

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

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Unrecaptured Section 1250 Gain

• For individuals, any long-term capital gain
  attributable to depreciation of realty (Section
  1250 property) will be taxed at a maximum rate of
  25
• The 25 rate applies to long-term capital gain
  that would be taxed as ordinary income if the
  Section 1245 full recapture rules applied and is
  called unrecaptured Section 1250 gain

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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 loss, all gains and losses are ordinary except
  investment losses of individuals (miscellaneous
  itemized deductions)
• 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 loss, treat as described above
• If gain, apply Section 1231 look-back rules

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Section 1231 Look-Back Rules

• Net Section 1231 gains will be 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 Section 1231 gains)
• Subtract short-term losses from short-term gains
• Continue netting (subtracting losses from gains)
  until only gains or only losses remain
• If result is short-term capital gain, then tax at
  ordinary income rates
• Taxation of 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
  (after first netting losses against capital gains
  in current year)
• Balance 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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Capital Gains for Individuals

• 20 (15 of as 5/6/03) rate applies to most
  long-term capital gains
• 10 (5 as of 5/6/03) rate applies to taxpayers
  in 10 and 15 marginal tax brackets
• Reduced rate if held for 5 years repealed as of
  May 6, 2003

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Capital Gains for Individuals

• 25 rate applies to depreciation recapture for
  realty (Sec. 1250 unrecaptured gain) with balance
  of gain taxed at new 15 rate
• If taxpayers ordinary tax rate is lower than
  25, then the lower ordinary rate applies to gain
  that falls in 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 in 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
• Gains taxed as ordinary income and losses 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 (only
  3,000 deductible per year for individuals after
  netting against any capital gains)
• Section 1244 permits an ordinary loss up to
  50,000 (100,000 if a joint return) annually for
  loss on qualified stock if individual is the
  original investor in a domestic small business
  corporation
• Any excess loss is 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 (the
  other half of the gain is taxed as a long-term
  capital gain at a 28 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 the 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 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 2
  year time period 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 number
  of qualifying months divided by 24, and then
  multiplying the 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 after the last date to which
  the exclusion applied.

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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 (unrecaptured Section 1250 gain)
  applies to gain due to depreciation

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Related Party Losses

• Loss on sale to related parties 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
  previously disallowed sellers loss

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The End