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Property Dispositions

Property Dispositions. Chapter 7. Property Dispositions. Determining tax consequences of a property disposition can be complex.

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Property Dispositions

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  1. PropertyDispositions Chapter 7

  2. Property Dispositions • Determining tax consequences of a property disposition can be complex. • In order to correctly determine the tax consequences, the recognized gain (loss) must be determined and type of property disposed of must be properly classified

  3. 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 of a recognized gain (loss) on cash flow is affected by the • Type of asset and its holding period • Type of taxpayer • Taxpayer’s marginal tax rate

  4. Types of Dispositions • Sale – Seller receives cash or cash equivalents in return for property disposed of • Exchange – Taxpayer receives qualified property other than cash or cash equivalents in return for property transferred to another party • Involuntary Conversion – Complete or partial destruction due to events not under control of taxpayer (e.g., condemnation, theft, casualty) • Abandonment – Property permanently withdrawn from use

  5. Types of Dispositions • To accurately determine the recognized gain (loss) in a property disposition, three conditions must be known: Realized gain (loss) Owner’s holding period No applicable provision allowing nonrecognition or postponement of gain (loss) • The character of the gain (loss) is determined by the type of property disposed

  6. Realized Gain (Loss) The realized gain (loss) is calculated as Cash + FMV of property received + Seller’s liabilities assumed by the buyer - Buyer’s liabilities assumed by the seller - Selling expenses Amount Realized - Adjusted basis of property given up Realized gain (loss)

  7. Recognized Gain (Loss) • Realized gains are recognized (taxable) unless the code provides for nonrecognition or postpones recognition • Losses are generally recognized (deductible) only if they are • Incurred in a business • Incurred in an investment activity • Casualty or theft losses

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

  9. Holding Period • For gifts, the 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 takes a long-term holding period

  10. 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

  11. Section 1231 Assets • Section 1231 assets include: • 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 • All of a taxpayer’s gains (after depreciation recapture) and losses from Section 1231 property dispositions are netted to determine tax treatment

  12. Determining Net Section 1231 Gain (Loss) Treatment

  13. Determining Net Section 1231 Gain (Loss) Treatment

  14. Depreciation Recapture • Converts recognized gain attributable to the reduction in basis that arises from depreciation deductions to ordinary income • Only applies to Section 1231 assets • Amount reclassified as ordinary income cannot exceed either the realized gain or prior depreciation deductions • Recapture provisions do not apply to realized losses

  15. Section 1245 - Full Recapture • Section 1245 property includes machinery, equipment, furniture, and fixtures (not buildings or structural components) • Gain on the sale of a Section 1245 asset is classified as ordinary income to the extent of all depreciation allowed (or allowable) • Any Section 179 expense is considered “depreciation allowed” • The portion of the gain reclassified is lesser of all depreciation taken or realized gain

  16. Section 1250 - Partial Recapture • Section 1250 applies to realty • Differs from Section 1245 because only the excess of accelerated depreciation over straight line depreciation is recaptured • Thus, for realty placed in service after 1986 (on which straight-line depreciation must be used) Section 1250 recapture is, in theory, $0. Why in theory? • Section 291 for corporations • Section 1250 unrecaptured gain for individuals

  17. Section 291 Recapture • Section 291 only applies to corporate dispositions of realty (Section 1250 property) • Reclassifies as ordinary income 20% of any Section 1231 gain that would have been ordinary income if Section 1245 recapture applied • For realty acquired after 1986, Section 291 recapture = Section 1245 recapture x 20% • Reduces capital gains that would otherwise be available to offset corporate capital losses

  18. Unrecaptured Section 1250 Gain • For individuals, unrecaptured Sec.1250 gains are the net Sec.1231 gains on realty that are treated as long-term capital gains after Sec. 1231 netting (up to amount of Sec. 1245 recapture if the Section 1245 recapture rules applied) • The taxable long-term capital gains attributable to prior depreciation deductions are taxed at a maximum rate of 25%

  19. Section 1231 Netting, Revisited

  20. Section 1231 Netting, Revisited

  21. Section 1231 Netting, Revisited The Section 1231 netting process provides taxpayers the best of both worlds - ordinary loss treatment for net losses and favorable capital gain treatment for net (post recapture) gains

  22. 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)

  23. 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

  24. Capital Gain (Loss) Netting

  25. Capital Gain (Loss) Netting • A (net) short-term capital gain resulting from the netting process is taxed at ordinary income rates • Taxation of capital gains and losses differs for corporations and individuals

  26. Capital Gains (Losses) - C Corps • No current deduction for net capital losses; carry back 3 years and forward 5 years • Offset only capital gains • Both long-term and short-term capital gains taxed at ordinary income rates • Why are capital gains and losses segregated from ordinary gains and losses? Capital losses only offset capital gains

  27. Capital Gains - Individuals • 15% rate applies to most long-term capital gains for individuals • Higher rates apply for specific types of capital assets (e.g., 25% for unrecaptured Sec. 1250 gain on realty and 28% for collectibles) • Lower rates may apply to individuals in low tax brackets

  28. Capital Losses - Individuals • $3,000 per year deduction against other income for net 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)

  29. Ordinary Income Property • Ordinary income property includes: • Business assets that do not meet the Section 1231 more-than-one year holding period • 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 are fully deductible

  30. 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 portions • Character of each portion dictates tax treatment

  31. Investments in New Corporations Code Sections 1244 and 1202 encourage investment in new (i.e., small) corporations by 1. Reclassifying a portion of a loss on the sale of such stock as ordinary (Section 1244) 2. Excluding a portion of the gain on the sale of such stock from gross income (Section 1202)

  32. Section 1244 Stock • While losses on the disposition stock are generally classified as capital losses, Section 1244 permits ordinary loss deduction of up to $50,000 ($100,000 for joint returns) annually for losses on qualified stock • Applicable only to an individual or partnership that is the original investor in a domestic small business corporation • Any excess loss (over the allowable Section 1244 amount) is a capital loss

  33. Section 1244 Stock • To qualify as Section 1244 stock • Total capitalization cannot exceed $1 million and • For the 5 preceding years • Corporation must be an operating company deriving 50% or more of its annual gross revenues from the sale of goods or services • No more than 50% of income can be derived from rents, royalties, dividends, interest, annuities and gain on sales of securities

  34. Section 1202 Stock • To be a qualified small business corporation under Section 1202, the corporation 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 acquired the stock in exchange for money, property, or services

  35. Section 1202 Stock • If the criterion of Section 1202 are satisfied and the qualified small business stock has been held for more than 5 years, taxpayers may exclude up to 50% of the gain realized on the disposition of the stock • Remaining 50% of the gain is taxed at the 28% long-term capital gain rate

  36. Section 1202 Stock • 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 • If taxpayer holds stock at least 6 months and the proceeds from sale are invested in another qualified small business corporation’s stock, gain on sale will be deferred

  37. 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 be used only once every 2 years

  38. 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

  39. 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), or • Other unforeseen circumstance (e.g., divorce, death of spouse or co-owner, unemployment, disasters, involuntary conversion of residence)

  40. Sale of Principal Residence • Partial exclusion calculated by dividing the number of qualifying months by 24 and multiplying this fraction by $250,000 ($500,000 if qualifying jointly) • “Qualifying months” calculated as the shorter of: • Use and ownership during 5 preceding years or • Period of time that has passed since the taxpayer last claimed the exclusion

  41. Sale of Principal Residence • Residence does not lose status as a “principal residence” 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 for unrecaptured Section 1250 gain applies to gain up to the previous depreciation deductions

  42. Sale to Related Party • Losses on sales to related parties are disallowed • Related parties include brothers, sisters, spouses, 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

  43. Capital Gains Rates - Individuals • 15% rate applies to most long-term capital gains • 5% 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

  44. Capital Gains Rates - Individuals • 25% rate applies to Sec. 1250 unrecaptured gain on realty • Gain in excess of the recapture amount is taxed at 15% rate • Collectibles such as antiques, art objects, and rare coins are taxed at a 28% rate due to potential personal enjoyment of asset • For both 25% and 28% assets, if taxpayer’s ordinary income tax rate is 10% or 15%, then the lower ordinary income rate applies to gain that falls within that tax bracket

  45. The End

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