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Property Dispositions

Property Dispositions. Chapter 7. 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

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Property Dispositions

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  1. PropertyDispositions Chapter 7

  2. 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 • Taxpayer’s marginal tax rate

  3. 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to events not under control of taxpayer (condemnations, thefts, and casualties) • Abandonment – property is permanently withdrawn from use (loss = basis of asset)

  4. Amount Realized Cash + FMV of property received + Seller’s liabilities assumed by the buyer - Buyer’s liabilities assumed by the seller - Selling expenses Amount Realized

  5. Realized Gain or Loss Amount realized - Adjusted basis of property given up Realized gain or loss

  6. 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

  7. Holding Period • Holding period • The period of time the taxpayer is credited with owning the property • Usually begins on date of acquisition unless there is a carryover or substituted basis for the asset acquired • Property held for more than one year receives favorable tax treatment if • Section 1231 assets • Capital assets

  8. 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

  9. 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 nor capital assets

  10. Section 1231 Property • Property used in a business that is subject to cost recovery deductions and 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

  11. 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 included in ordinary income) Step 3: Net the remaining gains and losses

  12. 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

  13. 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 do not apply to assets on which there is a realized loss

  14. 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

  15. 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

  16. 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

  17. Unrecaptured Section 1250 Gain • For individuals, 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%

  18. 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

  19. Section 1231 Netting • 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 under step 1 • If a net gain, apply Section 1231 look-back rules

  20. Section 1231 Netting • Step 3: Any 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

  21. 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)

  22. Capital Assets • Capital assets include stocks, 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

  23. Capital Gain and LossNetting Process • Step 1: Subtract long-term capital losses from long-term capital gains (including net Section 1231 gains) • Step 2: Subtract short-term losses from short-term gains • Step 3: Continue netting (subtracting losses from gains) until only gains or only losses remain

  24. Capital Gain and LossNetting Process • 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

  25. 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

  26. 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)

  27. General Capital GainsRates for Individuals • 15% rate applies to most long-term capital gains for individuals • Zero rate may apply to low income individuals (in the 10% and 15% tax brackets) • Rates of up to 28% may apply in some cases

  28. 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

  29. 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 • Character of each part dictates treatment

  30. Section 1244 Stock • Losses on stock are usually capital losses; individuals are limited to an annual $3,000 deduction against ordinary income 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 • Individual must be the original investor in a domestic small business corporation • Any excess loss is a capital loss

  31. 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

  32. Section 1202 Stock • To be a qualified small business corporation it must • Be a domestic C corporation, • Have no more than $50 million in assets, and • Be an active business engaged in manufacturing, retailing, or wholesaling • Seller of stock must be the original owner who acquires the stock in exchange for money, property, or services

  33. Section 1202 Small Business Stock Gain Exemption • Taxpayers may excludeup to 50% of the gain realized on the disposition of qualified small business stock held for more than 5 years (for stock acquired before 2/18/09 and after 12/31/10) • Remaining taxable portion of the gain is taxed at the 28% long-term capital gain rate • For small business stock acquired after 2/17/09 and before 1/1/11, 75% of the realized gain may be excluded

  34. Section 1202 Stock • Gain eligible for the exclusion cannot exceed the greater of • 10 times the adjusted basis of qualifying stock sold in the tax year or • $10,000,000 less any eligible gain on qualifying stock in the preceding tax years by the taxpayer • If taxpayer holds stock at least 6 months and invests all proceeds in another qualified small business corporation’s stock, no gain recognized • If all proceeds not reinvested, only gain proportionate to the reinvested proceeds can be excluded

  35. 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

  36. 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

  37. Sale of Principal Residence • For sales after 2007, a surviving spouse can qualify for the up-to-$500,000 exclusion if • the sale occurs not later than 2 years after the spouse’s death • the requirements for the $500,000 exclusion were met immediately before the spouse’s death and • the survivor has not remarried as of the date of sale

  38. 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

  39. Sale of Principal Residence • Partial exclusion is calculated by 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

  40. Sale of Principal Residence • 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

  41. Sale of Principal Residence • For sales after 2008, the exclusion will not apply to any gain attributable to periods (after 2008) when the home was not used as the principal residence of the taxpayer or the taxpayer’s spouse or former spouse • Nonqualified use would include time it was used as a vacation home or rental property

  42. Sale of Principal Residence • Gain allocated to periods of nonqualified use is the total amount of gain multiplied by a fraction • The numerator is the aggregate period of nonqualified use (starting after 2008) during the period the property was owned by the taxpayer • The denominator is the period the taxpayer owned the property

  43. 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 seller’s previously disallowed loss

  44. General Capital GainsRates for Individuals • 15% rate applies to most long-term capital gains • Zero 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

  45. 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 • 28% rate applies to collectibles (such as antiques, art objects, and rare coins) due to potential personal enjoyment of asset • For both 25% and 28% rate gains, if taxpayer’s ordinary tax rate is 10% or 15%, then the lower ordinary rate applies to gain that falls within that tax bracket

  46. The End

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