Chapter 13 Property Transactions Section 1231 and Recapture

Chapter 13: Property Transactions: Section 1231 and Recapture Federal Taxation 2017: Individuals 131

Capital Gains rate: Very Nice = lower tax rate. Tesla! 1231 gains AND losses Net Gains are Capital Net Losses are Ordinary Ferrari! 1231 gets it ALL 132

Historical Origins of Section 1231 1930 s Depression Era Property was severely depreciated. Businesses didn’t want to recognize capital losses (would be limited on tax return) IRS ruled business property could get ordinary treatment, to encourage movement of business assets For businesses with appreciated property, didn’t want to be taxed on gains at ordinary rates So again… business property wasn’t moving That’s when Section 1231 was born, IRS gave the best of both worlds for losses, and gains 133

Section 1231 Property Used in a Trade or Business (depreciable or real) HELD > ONE YEAR 1) PURE 1231 – ALL of it STAYS 1231 a) Loss Or b) Non-depreciatable Property (land) 2) If Gain Property AND depreciated Personalty is also 1245 for at least part Real (buildings) are also 1250 for at least part of gain Property Used in a Trade or Business HELD ONE YEAR OR LESS Neither 1231, nor capital It’s all ordinary 134

Not § 1231 Property Inventory Copyrights Musical Compositions Letters Literary Compositions Artistic Compositions 135

DEPRECIATION TREATMENT MUST BE MATCHED – SO § 1245/1250 DEPRECIATION RECAPTURE § 1231 buildings and personalty used in T or B are depreciated Depreciation deductions are d-fors and offset ORDINARY income So when sell 1231 property, gain reclassified from capital to ordinary, up to amount of depreciation 136

DEPRECIATION TREATMENT MUST BE MATCHED Example: Taxpayer buys property for 130, 000 and then takes 80, 000 depreciation If taxpayer is in 35% tax bracket tax savings from depreciation = 80, 000 X 35% = 28, 000 TAX SAVINGS FROM DEPRECIATION When Taxpayer sells for 140, 000 AR - 50, 000 (130, 000 Cost – 80, 000 Depreciation) 90, 000 Capital Gain 80, 000 Gain is due to depreciation 10, 000 Gain is due to appreciation in value Can’t tax all 80, 000 as CG. Tax cost would be 80, 000 X 15% = 12, 000 Tax savings for depreciation 28, 000, tax cost only 12, 000 So, when sell AT GAIN and depreciation a factor in basis Depreciation treatment WILL BE matched on sale. 137

Property Used in Trade or Business, Rental or other depreciated 1) PURE 1231 and LOSS 1231 a) Land (non-depreciable property) sold at gain or loss b) ANY 1231 Sold at loss – (Depreciated or not) 2) 1231 -1245 DEPRECIABLE PERSONALTY SOLD AT A GAIN Character of Gain 1) Ordinary – up to depreciation taken (not > than gain) 2) Balance of gain – 1231 Capital Gains Rate 3) 1231 -1250 DEPRECIABLE BUILDINGS SOLD AT A GAIN Character of Gain 1) 1231 with 1250 25% CG rate – up to depreciation taken 2) Balance of gain – 1231 Capital Gains rate 138

Example – Fill in Pure 1231, Capital, 1231 -1245, or 1231 -1250 ITEM USE GAIN OR LOSS CATEGORY Land T or B Loss ______ Land Investment Gain ______ Land T or B Gain ___________ Machinery T or B Loss ______ Building T or B Gain ______ Building T or B Loss ______

Example – Fill in Pure 1231, Capital, 1231 -1245, or 1231 -1250 ITEM USE GAIN OR LOSS CATEGORY Land T or B Loss Pure 1231 Land Investment Gain Capital Land T or B Gain Pure 1231 Machinery T or B Gain 1231/1245 Machinery T or B Loss Pure 1231 Building T or B Gain 1231/1250 Building T or B Loss Pure 1231

13 -32 Land on which factory is located 1231 Equipment 1231/1245 Inventory Neither Patent 1231/1245 Land held primarily for sale* Capital ONLY Factory building 1231/1250 1311

§ 1231 CASUALTY Gains and Losses Net CASUALTY § 1231 Gains Net CASUALTY § 1231 Losses • Excess of § 1231 CASUALTY Gains over Losses. • ALL ITEMS MOVED TO REGULAR 1231. • Excess of § 1231 CASUALTY Losses over Gains. • ALL ITEMS MOVED TO ORDINARY 1312

§ 1231 Gains and Losses Net § 1231 Gains • Excess of § 1231 Gains over Losses. • ALL ITEMS MOVED TO LTCG. Net § 1231 Losses • Excess of § 1231 Losses over Gains. • ALL ITEMS MOVED TO Ordinary 1313

Ordering of netting 1231 Casualty 1231 Other LTC STC Ordinary Tax Formula 514

13 -35 Which of the following transactions or events is treated as a Sec. 1231 gain or loss? All assets are held for more than one year. a. Theft of uninsured diamond ring, $ 800 basis $ 1, 000 FMV. 800 Personal Casualty loss b. Gain due to condemnation of land used in business. 1231 regular (other – not casualty) c. Loss on the sale of a warehouse. 1231 (presuming used in T or B ) d. Gain of $ 4, 000 on the sale of equipment. Depreciation deductions allowed = 10, 000 1231/1245 and all 4000 would be 1245 Ordinary Income EXAMPLE 54, 000 AR 50, 000 AB 4, 000 Gain § 1245 60, 000 Cost 10, 000 Depreciation 50, 000 AB 1315

Ordering of 1231 netting 1231 Casualty Gains (excl depr recap) & Losses 1231 Other 1231 Condemnation Gains (excl depr recap) & Losses LT Capital Gains & Losses 1231 Other Gains (excl depr recap) & Losses 1231 Other Gains & Losses, after lookback (if net gain) 1231 Casualty Gains & Losses (if net gain) Net Loss Ordinary (No Lookback created) Net Gain 1231 Other LTC Net Loss Ordinary (Lookback created) Net Gain � Up to Lookback Ordinary � Rest LTC ST Capital Gains & Losses Follow LT/ST Capital Gain netting rules from Chapter 5 Ordinary 1245/ 1250 depr recapture 1231 Casualty Gains & Losses (if net loss) 1231 Other Gains & Losses (if net loss) Net 1231 Other Gain recaptured by Lookback Tax Formula + Gains GI -Losses* AGI TI Rates on TI: � Net LTCG 0%, 15%, 2 0% � Unrecap 1250 25% max � OI % *CL limited to CG + 3000 OI 516

Ordering of netting 13 -33 a 1231 Casualty 1231 LTC 19, 000 -5, 000 14, 000 NET GAIN All go To LTC 14, 000 @ 15% rate STC Ordinary 40, 000 Taxable Income 40, 000 OI 19, 000 LTC 59, 000 GI -5, 000 LTCL 54, 000 AGI 517

Ordering of netting 13 -33 b 1231 Casualty 1231 10, 000 -22, 000 -12, 000 NET LOSS All go To Ordinary Create Lookback LTC STC Ordinary 40, 000 10, 000 -22, 000 Taxable Income 40, 000 OI 10, 000 Ord 50, 000 GI -22, 000 Ord 28, 000 AGI 518

Ordering of netting 13 -33 c 1231 Casualty 1231 LTC 30, 000 -39, 000 6, 300 - 9, 000 NET LOSS All go To Ordinary Create Lookback 6300 @ 15% STC Ordinary 40, 000 30, 000 -39, 000 Taxable Income 40, 000 OI 6, 300 LTCG 30, 000 Ord 76, 300 GI -39, 000 Ord 37, 300 AGI 519

Ordering of netting 13 -33 d 1231 Casualty 1231 LTC 5, 000 -12, 000 -4, 200 -7, 000 NET LOSS 0 @ 15% All go To Ordinary 1, 200 LTCL carryover STC Ordinary 40, 000 5, 000 -12, 000 Taxable Income 40, 000 OI 5, 000 Ord 45, 000 GI -3, 000 LTCL -12, 000 Ord 30, 000 AGI 520

13 -34 a What are all 3 assets: § 1231, 1231 -1245 or 1231 – 1250? § 1231 – because it is land Is it Casualty? NO NOTE: Made up 200, 000 Salary income 1231 Casualty 1231 LTC 15, 000 -17, 000 5, 000 3, 000 NET GAIN 3, 000 @ 15% rate All go To LTC Net Tax increase = 450 STC Ordinary 200, 000 Taxable Income 200, 000 Salary 15, 000 LTC 220, 000 GI -17, 000 LTCL 203, 000 AGI 521

13 -34 b What Changed? 1231 Casualty Asset #2 not § 1231, not held for more than a year: so ordinary 1231 LTC 15, 000 -17, 000 5, 000 15, 000 20, 000 NET GAIN All go To LTC STC Ordinary 200, 000 -17, 000 20, 000 @ 15% rate Net Tax increase = 3000 @ 33% -5610 Tax Savings Taxable Income 200, 000 Salary 20, 000 LTC 220, 000 GI -17, 000 Ord 203, 000 AGI 3, 000 Increase -5, 610 Tax Savings 2, 610 NET Tax Savings 522

13 -34 c What Changed? 1231 Casualty Capital Gains Rate increases to 20% when Marginal is 39. 6% 1231 LTC 15, 000 -17, 000 5, 000 3, 000 NET GAIN 3, 000 @ 20% rate All go To LTC Net Tax increase = 600 STC Ordinary Taxable Income 450, 000 (? ) 20, 000 LTC 470, 000 GI -17, 000 LTCL 453, 000 AGI 523

a. If LTC 1231 Casualty 13 -36 1231 LTC STC Ordinary 70, 000 Taxable Income 70, 000 OI - 3, 000 Cap 67, 000 AGI STC Ordinary 70, 000 Taxable Income -12, 000 70, 000 GI -12, 000 Ord 58, 000 AGI -12, 000 9, 000 LTCL Carry forward b. IF 1231 Casualty 1231 -12, 000 NET LOSS All go To Ordinary Look back created LTC 524

13 -37 a. IF 1231 Casualty 1231 LTC 80, 000 Current STC CF -95, 000 -15, 000 End of Year Carry Forward Ordinary Taxable Income 80, 000 GI -80, 000 LTCL Would be -83, 000 If individual and Not corporation b. IF Ordinary 1231 Casualty 1231 LTC STC CF -95, 000 End of Year Carry Forward Ordinary 80, 000 Taxable Income 80, 000 GI 0 LTCL Would be - 3, 000 If individual and Not corporation 525

13 -38 § 1231 Condemnation v. Casualty a. IF 1231 GAIN 1231 Casualty 50, 000 Net Gain so all 1231 LTC 60, 000 50, 000 STC Ordinary Taxable Income Net Gain so all LTC b. IF 1231 LOSS 1231 Casualty 1231 LTC 50, 000 -60, 000 50, 000 Net Gain so all 1231 Net Loss so all Ordinary Creates 10, 000 lookback 50, 000 GI -60, 000 dfor

12 -38 c. IF 1231 LOSS 1231 Casualty 50, 000 -200, 000 Net Loss all ordinary 1231 LTC STC Ordinary 50, 000 -200, 000 Creates NO lookback Because net loss is from casualty Taxable Income 50, 000 GI -200, 000 dfor

5 -Year Look-Back Rule Did the taxpayer have § 1231 gains for the current year? NO 5 -year lookback rule does not apply. YE S Did the taxpayer have any net § 1231 YE S losses (nonrecaptured) that were deducted in the previous 5 tax years? The CY net § 1231 net gain is treated as ordinary to the extent of nonrecaptured net § 1231 losses deducted in the previous 5 tax years in the following order: (1) Net § 1231 gain in 25% group. (2) Net § 1231 gain in 20% / 15% group. 1328

13 -39 1231 Casualty 2011 2012 2013 2014 1231 LTC 9, 000 -7, 000 2, 000 @ 15% rate 20, 000 -24, 000 -4, 000 12, 000 -19, 000 -7, 000 9, 000 -4, 000 STC Ordinary Taxable Income No LOOKBACK created 4000 LOOKBACK created 7000 LOOKBACK created 11, 000 TOTAL Lookback 5, 000 LOOKBACK used 20, 000 -24, 000 12, 000 -19, 000 -4, 000 6, 000 TOTAL Lookback Left 529

13 -39 1231 Casualty 2015 2016 Lookback from 2014 = 6000 1231 LTC 25, 000 -13, 200 11, 800 19, 000 -13, 200 5, 800 @ 15% rate 10, 000 -17, 000 -7, 000 STC Ordinary 6, 000 Taxable Income All LOOKBACK used 7000 LOOKBACK created 10, 000 -17, 000 530

13 -40 1231 Casualty Lookback from prior years = 40, 000 1231 LTC STC 200, 000 Salary Income Ordinary Taxable Income 40, 000 200, 000(? ) 40, 000 13, 000 253, 000 All LOOKBACK used 53, 000 13, 000 @ 15% rate 1, 950 X 33% 13, 200 1, 950 Tax on LTCG 13, 200 Tax on Ordinary Sale 15, 150 Total Tax on Sales 531

13 -41 DEPRECIATION TAKEN 650, 000 Cost -350, 000 Depreciation taken 300, 000 AB a. 407, 000 AR -300, 000 AB 107, 000 Gain 107, 000 § 1245 0 § 1231 b. 752, 000 AR -300, 000 AB 452, 000 Gain 350, 000 § 1245 102, 000 § 1231 c. 245, 000 AR -300, 000 AB - 55, 000 Loss 0 § 1245 -55, 000 § 1231 1332

Other § 1231 Issues � Generally, G/L from involuntary conversions or condemnations of T or B property or for profit = § 1231 G/L. � If recognized losses from fire, theft, or casualty > recognized gains, then G/L = ordinary. � If recognized gains from fire, theft, or casualty > recognized losses, then G/L = § 1231 capital G/L. 1333

Netting § 1231 Capital G/L STEP 1: Part a: Determine G/L from casualties or theft of § 1231 property or non-personal use capital assets held > 1 year. Part b: Remove from the G/L in part a that must be recharacterized as ordinary income per § 1245/1250 recapture provisions. 1334

Netting § 1231 Capital G/L (cont’d) STEP 2: Part a: Combine the G/L in this order: 1. Net casualty and theft gains from Step 1. 2. G/L from sale or exchange of § 1231 property. 3. G/L from condemnation of § 1231 property and non- personal-use capital assets held > 1 year. 1335

Netting § 1231 Capital G/L (cont’d) STEP 2, Part b: Net the G/L from Step 2, Part a: ü Net gains = LTCG and LTCL, although there may be ordinary income recapture from 5 year look-back rule (Step 3). ü Net losses = both G/L are considered ordinary. 1336

Netting § 1231 Capital G/L (cont’d) STEP 3: If Step 2, Part b is a net gain, then apply 5 -year look-back rule to determine whether some or all of the LTCG must be re-classified as ordinary income. 1337

Recapture Provisions � Any gain recognized upon sale of § 1231 property may be subject to depreciation recapture. � Recapture will convert that part of the gain from capital in nature to ordinary income. � Most common recapture for § 1231 assets are § 1245 and § 1250 recapture. 1338

Amortizable under § 197 Real property Depreciable business property (e. g. , autos and livestock) Intangible Property Personal Property Section 1245 Property Nonresidential realty placed in service 1981 -1986, using ACRS 1339

Section 1245 Recapture � Residential rental properties are never subject to § 1245 recapture. � Upon sale of § 1245 property, an amount equal to the lessor of: a) depreciation taken since 1/1/1962; or b) recognized gain. � Conversion of § 1231 gain to ordinary income could prevent taxpayer from using capital losses. 1340

Section 1250 Recapture Provisions �§ 1250 property = any depreciable real property other than § 1245 property. � § 1250 property includes residential rental property. � Recharacterizes to ordinary income only additional or “excess” depreciation. 1341

Section 1250 Recapture (cont’d) Additional/Excess = excess amount of accelerated > straight-line depreciation. 1342

Unrecapatured Section 1250 This is whatever was NOT recaptured under Section 1250 recapture Unrecaptured § 1250 gain is taxed at a maximum rate of 25% for property held > 1 year. 1343

Low-Income Housing � If held for 16 years and 8 months, then none of the additional/excess depreciation will need to be recharacterized. � Therefore, all gain can remain capital in nature. 1344

Additional Recapture for Corporations - § 291 requires recapture upon sale of depreciable real estate for corporate taxpayers. § 291 recapture is in addition to any recapture calculated under § 1250. 1345

§ 291 Recapture Calculation § 291 recapture = 20% x (Recapture amount had § 1245 applied in excess of Recapture under § 1250) 1346

Other Application of Recapture Provisions Gifts or Recapture at Death Transactions Charitable contributions Involuntary Conversions Installment Sales Like-Kind Exchanges IDC Conservation § 179 1347