Chapter 11 Property Dispositions Kevin Murphy Mark Higgins

Chapter 11 Property Dispositions Kevin Murphy Mark Higgins © 2008 South-Western

Concept Review Under the capital recovery concept, a property’s basis may be recovered before any taxable income is realized from disposal of property. No income or loss is recognized for tax purposes until it has first been realized. © 2008 South-Western Transparency 11 -2

Property Disposition Amount realized from disposition less: Adjusted basis of property Realized gain (loss) less: Allowed deferral Recognized gain (loss) © 2008 South-Western Transparency 11 -3

Amount Realized Amount realized is gross sales price less selling expenses. FGross sales price is the amount received by the seller from the buyer and includes V Cash and FMV of property or services received V Seller’s debt assumed by or paid by the buyer FGross sales price is decreased by amounts given to the buyer by the seller V Buyer’s expenses paid by or assumed by the seller © 2008 South-Western Transparency 11 -4

Effect of Debt Assumption v. Assumption of debt is treated as a realization of income similar to paying or receiving cash FAssumption of the seller’s debt increases sales price (as if buyer paid cash) FAssumption of debt by the seller decreases the sales price (as if buyer received cash) © 2008 South-Western Transparency 11 -5

Character of Gain or Loss less: Amount realized from disposition Adjusted basis of property Realized gain (loss) Allowed deferral Recognized gain (loss) Character of gain (loss) Ordinary Section 1231 Capital Gains © 2008 South-Western Personal Use Loss not deductible Transparency 11 -6

Capital Gains and Losses A capital asset is “any asset other than inventory, receivables, copyrights, assets created by the taxpayer, and depreciable or real property used in a trade or business. ” A collectible gain or loss results from the sale or exchange of works of art, gems, metals, antiques, rugs, stamps, wine, etc. held more than 12 months. © 2008 South-Western Transparency 11 -7

Capital Gains and Losses Holding Period The holding period for capital assets is how long the taxpayer owned the asset. FLong-term means the asset was held for more than 12 months. FShort-term means the asset was held for < 12 months. Determining holding period is the first step in determining tax treatment. © 2008 South-Western Transparency 11 -8

Capital Gains and Losses Netting Procedures The following are treated as long-term gains and losses for the netting procedure FCollectible gains and losses FGains on qualified small business stock FUnrecaptured Section 1250 gain © 2008 South-Western Transparency 11 -9

Capital Gains and Losses Netting Procedures Long-term gains netted against Long-term losses Short-term gains netted against Short-term losses © 2008 South-Western = Net Long-term Gain or Loss = Net Short-term Gain or Loss Transparency 11 -10

Capital Gains and Losses Netting Procedures If one is a loss and one is a gain, then: Net Short-term Gain or Loss netted against Net Long-term Gain or Loss = Net Capital Gain or Loss If both are losses or both are gains, no further netting is done. © 2008 South-Western Transparency 11 -11

Tax Treatment for Net Long-term Gain Individual Taxpayers v. Net long-term gain (minus net collectibles gain, gain on qualified small business stock, and unrecaptured Section 1250 gain) is taxed at a maximum rate of 15% v 5% if marginal tax rate < 15% © 2008 South-Western Transparency 11 -12

Adjusted Net Capital Gains (ANCG) Are taxed at the 15% or 5% rates. ANCG = NLTG - [Net Collectible Gn + Small Business Gain - NSTCL - LTL carryovers]* - unrecaptured Sec. 1250 gain + Eligible Dividend Income * called: “ 28% rate gain” © 2008 South-Western Transparency 11 -13

Tax Treatment for Net Long-term Gain Individual Taxpayers FCollectibles held more than 12 months are taxed at a maximum rate of 28%. F 50% of the gain on qualified small business stock is excluded, the remainder taxed at a maximum rate of 28%. FUnrecaptured Section 1250 gain is taxed at a maximum rate of 25%. © 2008 South-Western Transparency 11 -14

Example Juan has the following capital gains and losses in the current year: Short-term capital loss $ (2, 000) Long-term capital gain 12, 000 Long-term capital loss carryover (5, 000) Collectibles gain 10, 000 © 2008 South-Western Transparency 11 -15

Example Short-term: Short-term capital loss (2, 000) Long-term: Collectibles gain $10, 000 Long-term capital gain 12, 000 Long-term capital loss c/o ( 5, 000) Long-term capital gain 17, 000 Net long-term capital gain © 2008 South-Western $ $ $ 15, 000 Transparency 11 -16

Example Results: “ 28% rate gain” = ($10, 000 -$5, 000 - $2, 000) = $3, 000 ANCG = $15, 000 - $3, 000 = $12, 000 NLTCG is added to taxable income Net capital gain, taxed at 15% = $12, 000 Collectibles gain, taxed at 28% = $3, 000 © 2008 South-Western Transparency 11 -17

Tax Treatment for Net Short-term Gain Individual Taxpayers v. Net short-term capital gain is taxed as ordinary income (i. e. , taxpayer’s marginal tax rate). © 2008 South-Western Transparency 11 -18

Gain Treatment for Corporations v. Corporations do not receive special treatment for capital gains. © 2008 South-Western Transparency 11 -19

Tax Treatment for Net Loss v. Net Capital Loss FIndividuals may use only $3, 000 to offset other income VExcess loss is carried forward indefinitely and retains its short term or long term class for netting purposes FCorporations cannot deduct a net capital loss VExcess loss carried back 3 then forward 5 years to offset capital gains © 2008 South-Western Transparency 11 -20

Qualified Small Business Stock v. Qualified stock FHeld for more than 5 years FPurchased directly from corporation VCorporation with gross assets < $50 million FPurchased after 8/10/93 © 2008 South-Western Transparency 11 -21

Capital Gain Exclusion on Small Business Stock v. Up to 50% of gain may be excluded FLimited to the greater of V 10 times basis in the stock, or V$10 million for each small business FExclusion is based on a 28% rate © 2008 South-Western Transparency 11 -22

Qualified Small Business Stock Rollover Provision v Individual taxpayers may rollover gain on Qualified Small Business Stock FHeld more than 6 months FReplaced with other small business stock purchased within +/- 60 days v Basis in new stock is reduced by deferred gain v Must recognize gain if the gain realized is more than the cost of the replacement stock © 2008 South-Western Transparency 11 -23

Planning Strategies v. Net Capital Gain position FSell assets with unrealized losses v. Net Capital Loss position FSell assets with unrealized gains FOptimize at $3, 000 © 2008 South-Western Transparency 11 -24

Planning Strategies v. Worthless Securities FWorthlessness deemed to occur on the last day of the year FRealized loss = basis in the worthless security v. Basis determination FFIFO FSpecific identification © 2008 South-Western Transparency 11 -25

Section 1231 Asset Definition v. Asset used in a trade or business Fnot for investment v. Held long term © 2008 South-Western Transparency 11 -26

Section 1231 v. Net Section 1231 gains may be allowed capital gain treatment even though they arise from “ordinary” assets. v. Net Sec. 1231 losses are ordinary. © 2008 South-Western Transparency 11 -27

Section 1231 Netting 1 st Step: Net all business casualty gains and losses loss All gains and losses are ORDINARY gain 2 nd Step: Net all other Sec. 1231 gains and losses loss gains are taken to Step 3 © 2008 South-Western Transparency 11 -28

Section 1231 Netting Gains from Step 2 Apply lookback rule 3 rd Step: Gains are ORDINARY to the extent of any previous Sec. 1231 losses Remaining Sec. 1231 gain is treated as a net long-term capital gain netted with other capital gains and losses © 2008 South-Western Transparency 11 -29

Section 1231 Netting Results v. Net Section 1231 gain is classified as long-term capital gain FLookback rule may reclaim some gains as ordinary Vto the extent of Section 1231 loss reported in the previous 5 years v. Net Section 1231 loss is classified as ordinary loss © 2008 South-Western Transparency 11 -30

Section 1231 Disposition of Rental Activities v. Disposition of rental property held for the production of income (investment) yields capital gain or loss v. Disposition of rental property used in a trade or business yields Section 1231 gain or loss © 2008 South-Western Transparency 11 -31

Depreciation Recapture Prevents taxpayers from receiving the dual benefits of a depreciation deduction and special Section 1231 gain treatment © 2008 South-Western Transparency 11 -32

Depreciation Recapture v. Applies to Section 1231 gain property only v. Requires gains to be treated as ordinary to the extent of prior depreciation deductions © 2008 South-Western Transparency 11 -33

Depreciation Recapture Section 1245 v. Requires full recapture of all depreciation FGains are treated as ordinary income to the extent of any depreciation taken v. Any gain in excess of depreciation is netted under Section 1231 © 2008 South-Western Transparency 11 -34

Depreciation Recapture Section 1245 v. Applies to FDepreciable personal property and FNonresidential real estate placed in service between 1981 and 1986 and depreciated under ACRS © 2008 South-Western Transparency 11 -35

Depreciation Recapture Section 1250 v. Requires partial recapture of depreciation FGains are treated as ordinary income to the extent of depreciation taken over straightline amount v. Any gain in excess of depreciation in netted under Section 1231 © 2008 South-Western Transparency 11 -36

Depreciation Recapture Section 1250 v. Applies to depreciable real property FNot covered by Section 1245 and FNot depreciated using the straight-line method VEliminates most MACRS realty © 2008 South-Western Transparency 11 -37

Unrecaptured Section 1250 Gain v. Requires that the portion of the gain attributable to depreciation that is not Section 1250 recapture is taxed at a rate of 25%. v. Applies to depreciable real property sold after 5/7/97. v. Any gain not attributable to depreciation (in excess of original cost) is a Section 1231 gain taxed at 15%. © 2008 South-Western Transparency 11 -38