Property Dispositions Chapter 7 Property Dispositions McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Objectives Distinguish realization from recognition Describe installment sale method. Understand limits on related-party losses. Identify 2 components of capital gain or loss. Capital loss limits: individuals versus corps. Section 1231 netting of gains and losses Depreciation and loss recapture for Section 1231 assets Other dispositions.

Realized Gain or Loss Amount realized on disposition MINUS adjusted basis of property (e.g. cost - accumulated tax depreciation) EQUALS Realized gain or loss. GENERALLY, realized (economic) gains and losses on disposition are recognized (result in taxable income or deductions) unless there is a specific exception. See Chapter 8.

Realized Gain or Loss Unrealized (mere appreciation or decline in value) gains and losses are neither realized nor recognized. The amount of gain or loss that a taxpayer recognizes for tax purposes may not be the same amount reported on the financial statements. This occurs when an asset’s adjusted tax basis does not equal its book basis.

Amount Realized The amount realized from a sale or exchange = Cash received Plus FMV of any property received, including buyer’s note Plus the amount of any debt relief Reduced by selling costs such as sales commissions, broker fees.

Amount Realized A taxpayer sold land with a basis of $35,000 for $10,000 cash, a tractor with a cost of $22,000, fair market value of $12,000 and assumption of a mortgage of $18,000. The taxpayer paid $1,500 in sales commissions. What is the amount of the taxpayer’s realized gain or loss? $10,000 cash $40,000 amount realized + $12, 000 FMV of tractor - 1,500 sales commission + $18,000 mortgage $38,500 Net Amt. realized $40,000 Amount realized - 35,000 Adjusted basis $ 3,500 Realized Gain

Installment Sale Method Permits deferral of gain recognition until cash is received on the sale. Gain recognized this year = (cash this year) x (total gain / total sales price). What accounting concept prescribes this treatment? The ability to pay concept Show me the money!

Installment Sale Method Not allowed for sales of publicly traded stock or for sales of inventory to customers, or to delay recognition of depreciation recapture. Financial accounting uses accrual accounting, so the installment sales method for tax purposes creates a temporary book-tax difference.

Related Party Losses Losses realized on sale of property between related parties are NONdeductible. Relative: family = spouse, sibling, ancestors, lineal descendants An individual and corporations in which the individual owns more than 50% Two corporations owned by the same shareholders. Future gain (but NOT loss) from sale by purchaser can be offset by seller’s disallowed loss.

Related Party Losses - Examples Fawn has stock with a basis of $5,000. She sells it to her brother Robert for $3,000. Fawn’s realized loss of ($2,000) may NOT be deducted. IF Robert sells the stock for $8,000 to an unrelated party, he may reduce his realized gain of $5,000 by the ($2,000) disallowed loss to recognize $3,000 gain. IF Robert sells the stock for $4,000 to an unrelated party, he may reduce his realized gain of $1,000 by ($1,000) of the disallowed loss to recognize $0 gain. IF Robert sells the stock for $2,500 to an unrelated party, he recognizes ONLY his own realized loss of ($500). He cannot increase his loss by Fawn’s disallowed loss.

Character of Gain or Loss - Overview Tax or deduct at ordinary rates Ordinary Depr. Recapt net 1231 loss 5-yr lookback Section1231 net gain net 1231 gain Net capital gains and losses: Individual may deduct $3000 net loss. Net LT gain taxed at lower rates. Capital

Character of Gain or Loss Capital gain or loss requires: Sale or exchange Asset surrendered must be a capital asset If a firm disposes of a capital asset in some way other than a sale or exchange, the realized gain or loss is ordinary in character.

Capital Asset (negatively) Defined Capital assets (under Section1221) are everything EXCEPT: 1) inventory 2) accounts receivable 3) supplies 4) real or depreciable property used in a trade or business (this is the same as Section 1231 property)

Capital Asset (negatively) Defined 5) copyright, compositions, artistic efforts created by taxpayer (exception - patents by inventors are capital assets). 6) certain U.S. government publications 7) Commodities derivative financial instruments held by a dealer 8) Hedging transaction properties.

Capital Loss Limitation Treatment of excess of capital loss over capital gain: Individual taxpayers: can deduct $3,000 of net losses per year against ordinary income carryforward excess loss indefinitely against capital gains Corporation NO deduction for net loss in current year carry back 3 years and forward 5 years against capital gains

Capital Gains Individuals obtain preferential taxation on long-term (> 1 year) capital gains - generally 15% tax rate. See Chapter 15. Corporations pay tax at regular tax rates. Even at regular tax rates, capital gains treatment is preferred to ordinary income because capital gains can be used to absorb capital losses.

Dispositions of Noncapital Assets Sales of inventory and accounts receivable result in ordinary income. Taxed at regular tax rates.

Section 1231 Assets Section 1231 assets are real or depreciable property used in a trade or business. Question 1: BBB Company, which manufactures industrial plastics, owns the following assets. Characterize each asset as either a capital, ordinary, or Section 1231 asset. A computer system used in BBB’ main office A 50% interest in a business partnership organized to conduct a mining operation in Utah

Question 1 continued: Heavy equipment used to mold BBB’s best-selling plastic item. BBB’s customer list developed over 12 years of business. BBB’s inventory of raw materials used in the manufacturing process. An oil painting of BBB’s founder and 1st president that hangs in the board room. A patent developed by BBB’s R&D department BBB’s company airplane.

Section 1231 Assets GENERAL rule (ignoring depreciation recapture). Net Section 1231 gains against 1231 losses IF NET GAIN => add to capital gains and losses. Result is a possible lower tax rate on 1231 net gains. IF NET LOSS => add to ordinary gains and losses. Can also offset salary, interest, dividends, etc. Result is an ordinary rate benefit on 1231 net losses. Note that this treatment offers the best of both worlds – capital gain and ordinary loss!

Depreciation Recapture Gain on each separate asset may be subject to depreciation recapture. For sales of depreciable personalty and amortizable intangibles, the gain is characterized as ordinary up to the amount of accumulated depreciation. Why? Because depreciation has resulted in prior deductions at ordinary rates.

Depreciation Recapture REALTY: Special rules apply to pre-1986 depreciation: Accelerated depreciation in excess of SL is recaptured. By 2004, most of this property is fully depreciated, so rules seldom apply. Corporations must recapture 20% of amount that would have been ordinary had it been personalty (lesser of gain or depreciation).

1231 Netting Rule including Depreciation Recapture After all depreciation recapture, NET the remaining Section1231 gains with Section 1231 losses. If a net loss, treat as an ordinary loss and combine with other ordinary income and losses. If a net gain, then the net gain is treated as a capital gain UNLESS: The net 1231 gain is treated as ordinary income recapture to the extent of unrecaptured Section 1231 losses during the prior five years.

Section 1231 Look Back Rule EXAMPLE: A taxpayer starts a business in 1990 and incurs the following Section 1231 gains and losses: 1998 net gain of $10 - treated as capital. 1999 net loss of ($15) - treated as ordinary. 2000 net gain of $23 - treated as $15 ordinary (recapture 1999) and $8 capital. 2001 net loss of ($40) - treated as ordinary. 2002 net gain of $6 - treated as ordinary. Still have $34 unrecaptured loss from 2001. 2003 net gain of $50 - treated as $34 ordinary, $16 capital.

Other Property Dispositions In the case of abandonment and worthlessness, a firm must take action to indicate that it will not reclaim the asset in the future. In general, an abandonment loss is an ordinary deduction = tax adjusted basis. Exception for securities: worthless securities are treated as sold on the last day of the year for $0. This generally creates a long-term capital loss. Exception for affiliated corporation: securities in an 80% or more controlled domestic subsidiary are treated as a noncapital asset and, thus, fully deductible.

Other Property Dispositions Foreclosures If recourse debt (debt for which the debtor is personally liable), treat as if the property was sold for FMV at foreclosure. Any additional debt forgiveness is ordinary income. If nonrecourse debt (debt which is secured by the property), treat as if the property was sold for face value of mortgage.

Foreclosure Example A firm owns land, used in its business, with a cost of $500,000 and FMV of $600,000. The land is subject to a $375,000 mortgage. The firm goes bankrupt and the bank forecloses on the land. What is the treatment if the loan is recourse debt? The firm treats the foreclosure as if the land were sold for $600,000, realizing a $100,000 Sec. 1231 gain. The mortgage is satisfied in full. What if the loan is nonrecourse debt? The firm treats the foreclosure as if the land were sold for $375,000. Thus, realizing no gain or loss.

Business Casualty and Theft Amount realized = insurance proceeds, if any. Deduct the unrecovered basis. Loss is ordinary. Gain depends on character of property. See Ch8 for gain deferral.