Taxation of Business Entities Property Transactions: Capital Gains and Losses, Section 1231, and Recapture Provisions Text: Chapter 8

Outline Capital Assets Defined Section 1231 Assets Defined Sale/Exchange Holding Period Tax Treatment Section 1231 Assets Defined Look-back Provisions Depreciation Recapture Section 1245 Section 1250 Section 291 “Un-recaptured” Section 1250 Gain 5

Taxation of Capital Gains And Losses Capital gains and losses must be separated from other types of gains and losses for two reasons: Long-term capital gains may be taxed at a lower rate than ordinary gains. A net capital loss: Is only deductible up to $3,000 per year by individuals. Can only be used to offset capital gains of corporations.

Proper Classification of Gains and Losses Depends on three characteristics: The tax status of the property Capital asset, § 1231 asset, or ordinary asset The manner of the property’s disposition By sale, exchange, casualty, theft, or condemnation The holding period of the property Short term and long term

Capital Assets § 1221 defines capital assets as everything except: Inventory (stock in trade) Notes and accounts receivables acquired from the sale of inventory or performance of services Realty and depreciable property used in trade or business (§ 1231 assets) Creative works (e.g., art, music, copyrights) when created by taxpayer (or for which taxpayer takes a carryover basis from the creator) However, 2006 Tax Act allows self-created musical compositions or copyrights to be treated as capital assets Certain publications of U.S. government Hedging instruments that are an integral part of inventory system

Capital Assets Thus, capital assets are: Assets held for investment (e.g., stocks, bonds, land) Personal use assets (e.g., residence, car) Miscellaneous assets selected by Congress (e.g. patents, songs)

Sale or Exchange Recognition of capital gains and losses generally requires a sale or exchange of assets. Sale or exchange is not defined in the Code. There are some exceptions to the sale or exchange requirement. Worthless securities A security that becomes worthless creates a deductible capital loss without being sold or exchanged

Capital Assets – Special Rules Patents A patent held by an individual is considered to be a capital asset. When all substantial rights are transferred (sold) to another, the transfer produces a long-term capital gain or loss. Franchises, trademarks, and trade names The licensing of trade names, trademarks, and other intangibles is generally not considered a sale or exchange of a capital asset. Therefore, ordinary income results to transferor.

Holding Period Short-term: Asset held for 1 year or less Long-term: Asset held for more than 1 year Holding period starts on the day after the property is acquired and includes the day of disposition

Holding Period Like-Kind Exchange: Inherited Property: Holding period of property received in a like-kind exchange includes the holding period of the asset exchanged if property exchanged was either a capital asset or a § 1231 asset. Inherited Property: Holding period is treated as long term no matter how long property is actually held by heir. Property Received by Gift: Holding period includes donor’s holding period, unless “loss” basis is used.

Tax Treatment of Capital Gains and Losses – Non Corporate Taxpayers Capital gains and losses must be netted by holding period: Short-term capital gains and losses are netted. Long-term capital gains and losses are netted. If possible, long-term gains or losses are then netted with short-term gains or losses. If the result is a net loss: The capital loss deduction is limited to a maximum deduction of $3,000. Unused amounts retain their character and carryforward indefinitely.

Tax Treatment of Capital Gains and Losses – Non Corporate Taxpayers If net gain from capital transactions, tax treatment depends on holding period. Short-term (assets held 12 months or less) Taxed at ordinary income tax rates. Long-term (assets held more than 12 months) An alternative tax calculation is available using preferential tax rates.

Non Corporate Taxpayers – Long-term Capital Gain Rates Net long-term capital gain is eligible for one or more of four alternative tax rates: 0% (2008 – 2010), 15%, 25%, and 28%. The 25% rate applies to unrecaptured § 1250 gain and is related to gain from sale of buildings. The 28% rate applies (primarily) to “collectibles.” Furthermore, for qualifying small business stock that is owned for more than 5 years (Sec. 1202 stock), 50% of gain is excluded, and included gain is taxed at maximum rate of 28%. The 0%/15% rates apply to any remaining net long-term capital gain (called “regular” LTCGs).

Non Corporate Taxpayers – Long-term Capital Gain Rates Netting between long-term “buckets” is done based on what is most favorable to the taxpayer. If net gain in more than one long-term “bucket”, any STCL is netted against highest rate “bucket” first.

Capital Gain Netting Examples - Individual Compute additional tax for a taxpayer with 33% marginal rate in 2009 who has: $5,000 25% gain $3,000 “regular” LTCG ($2,000) STCL What if marginal rate was 15% instead?

Tax Treatment of Capital Gains and Losses of Corporate Taxpayers Corporations pay tax on net capital gains at the same rate as ordinary income. Capital losses of corporations can only offset capital gains (i.e., no $3,000 deduction in excess of capital gains). Net capital losses are carried back 3 years and carried forward 5 years as short-term losses. Carryovers always treated as short-term.

§ 1231 Assets § 1231 assets defined: Depreciable OR real property (includes land) used in a trade or business, and held for more than 1 year. Purchased intangibles that are eligible for amortization. Includes timber, coal, iron, livestock, unharvested crops.

§ 1231 Assets Transactions included in § 1231 “bucket.” Sale, exchange, or involuntary conversions of 1231 assets and involuntary conversion of non-personal use capital assets Includes net gains but not net losses from casualty and theft. Treatment of net 1231 gain/loss Net § 1231 loss = ordinary loss Net § 1231 gain = LTCG (subject to look-back rule). SEE “Bucket” handout

§ 1231 Assets Provides the best results for the taxpayer Ordinary loss that is fully deductible FOR AGI. Gains treated as LTCGs. Look-back provision for net § 1231 gain There would be an advantage to having all § 1231 losses (ordinary losses) in a different year from gains (long-term capital gains). To control manipulation, net § 1231 gains are treated as ordinary income to the extent that the taxpayer has recognized ordinary losses from § 1231 assets in the prior 5 year period.

§ 1231 Assets Look-back provision example: Taxpayer had the following net § 1231 gains and losses: 2006 $ 4,000 loss 2007 10,000 loss 2008 16,000 gain 2009 5,000 gain What is the character of these losses and gains?

Depreciation Recapture Assets that are eligible for depreciation, cost recovery and/or amortization are subject to depreciation recapture when disposed of at a gain. Depreciation recapture characterizes gains that would otherwise be § 1231 as ordinary income. Depreciation recapture includes bonus depreciation (additional first-year depreciation).

§ 1245 Recapture Depreciation recapture for § 1245 property Applies to tangible and intangible personalty. Recapture potential is entire amount of accumulated depreciation for asset. A recognized loss on the sale of § 1245 property is always a § 1231 loss! When recognized gain on the disposal of a § 1245 asset is less than the total amount of accumulated depreciation: The total gain will be treated as depreciation recapture (i.e., ordinary income).

§ 1245 Recapture When the recognized gain on the disposition of a § 1245 asset is greater than the total amount of accumulated depreciation: Total accumulated depreciation will be recaptured (as ordinary income), and The gain in excess of depreciation recapture will be § 1231 gain (and go in the bucket).

§ 1245 Recapture - Example Knight Corporation purchased 7-year MACRS property on 3/1/2007, for $20,000. This property was sold on 5/1/2009. Accumulated depreciation taken = $9,500. Compute the amount and character of gain/loss recognized by Knight assuming the property was sold for: $18,000 $23,000 $4,000

§ 1250 Recapture Depreciation recapture for § 1250 property: Applies to depreciable real property. Recapture potential is limited to excess of accelerated depreciation taken on asset over depreciation that would have been deductible if straight-line depreciation had been used.

§ 1250 Recapture Straight-line depreciation on real property: If straight-line depreciation has been taken on real property, no depreciation recapture potential exists under § 1250. All real property acquired after 1986 must use straight-line depreciation. Therefore, no Sec 1250 depreciation recapture potential for such property. Exception: If you hold Sec. 1250 property for 1 year or less, all depreciation is “additional depreciation” (i.e., recapture potential exists).

Additional Recapture for C Corporations § 291, HOWEVER, requires additional recapture for 1250 property. Recapture amount = 20% of the difference between what would have been recaptured under § 1245 recapture rules and what was actually recaptured under § 1250. Example: Building with original cost of $100,000, straight-line depreciation of $18,000 had been taken. Building was sold 6 years after initial purchase for $105,000. What is the amount and character of gain recognized if owner is a C Corp?

Real Estate 25% Gain Applies to NON-Corporate Taxpayers Also called unrecaptured § 1250 gain or 25% gain. For real property placed in service after 12/31/86 “un-recaptured 1250 gain” will be the lesser of: Recognized Gain, OR Depreciation Allowed. Note: This gain is still characterized as 1231 gain and is netted with other 1231 transactions. In the example on the previous slide, what is the amount and character of gain recognized if owner is NOT a C Corp?

Comprehensive Example Start with HW Problem 8-29. Add the following facts: Dave has NO other itemized deductions. Dave’s personal exemption after phase-out is $2,333. Compute Dave’s TAX LIABILITY for 2009.