Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Principles of Taxation Chapter 7 Property Dispositions

Slide 7-2 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Objectives  Distinguish realization from recognition  Describe installment sale method  Understand limits on related-party losses.  Identify 2 components of capital gain or loss  Define capital assets  Capital loss limits: individuals versus corps.  Section 1231 netting of gains and losses  Depreciation and loss recapture for Section 1231 assets  Other dispositions.

Slide 7-3 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Realized gain or loss  Amount realized on disposition  MINUS adjusted basis of property (e.g. cost - accumulated tax depreciation)  = 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.  Unrealized (mere appreciation or decline in value) gains and losses are neither realized nor recognized.

Slide 7-4 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Amount realized  Cash received  FMV of any property received, including buyer’s note  Relief of debt. AP3.  Reduce the amount realized by selling costs such as sales commissions, broker fees.

Slide 7-5 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Installment sale method  Exception to full recognition of realized gain. Permits deferral of gain recognition until cash is received on the sale.  Gain this year = cash this year x total gain / total sales price. AP4.  Installment method not generally allowed for inventory, or to delay recognition of depreciation recapture.  Remember that financial accounting uses accrual accounting, so installment sales method for tax creates a temporary book-tax difference.

Slide 7-6 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Related party losses  Relative:  family = spouse, sibling, ancestors, lineal descendants  50% controlled corporations  Losses realized on sale of property between related parties are NONdeductible.  Future gain (but NOT loss) by relative can be offset by disallowed loss.

Slide 7-7 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Related party losses - example  Fawn has stock with a basis of $5000. She sells it to her brother Robert for $3000. Fawn’s realized loss of ($2000) may NOT be deducted.  IF Robert sells the stock for $8000 to an unrelated party, he may reduce his realized gain of $5000 by the ($2000) disallowed loss to recognize $3000 gain.  IF Robert sells the stock for $4000 to an unrelated party, he may reduce his realized gain of $1000 by ($1000) of the disallowed loss to recognize 0 gain.  IF Robert sells the stock for $2500 to an unrelated, he recognizes ONLY his own realized loss of ($500). He cannot increase his loss by Fawn’s disallowed loss.

Slide 7-8 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Character of gain or loss - overview Ordinary Capital Section1231 Depr. Recapt 1231 lookback net 1231 loss net 1231 gain Tax or deduct at ordinary rates Net capital gains and losses: Individual may deduct $3000 net loss. Net LT gain taxed at lower rates.

Slide 7-9 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Character of gain or loss  Capital gain or loss requires:  Sale or exchange  Capital asset

Slide 7-10 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Capital asset (negatively) defined  Capital assets (under Section1221) are everything EXCEPT:  1) inventory  2) accounts receivable  3) real or depreciable property used in a trade or business (this is the same as Section 1231 property)  4) copyright, compositions, artistic efforts created by taxpayer. (exception - patents by inventors are capital assets).  5) certain U.S. government publications

Slide 7-11 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Capital losses  Only deduct capital losses UP TO capital gains.  Excess of capital loss over capital gains  Individual taxpayers:  can deduct $3000 of net losses per year against ordinary income  carryforward excess indefinitely against capital gains  Corporation  NO deduction for net loss in current year  carry back 3 years and forward 5 years against capital gains

Slide 7-12 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Capital gains  Individuals obtain preferential taxation on long-term (> 1 year) capital gains - generally 20% tax rate. See Chapter 15.  Corporations pay tax at regular tax rates.

Slide 7-13 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Dispositions of noncapital assets  Sales of inventory and accounts receivable result in ordinary income.  Taxed at regular tax rates.  AP8.

Slide 7-14 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Section 1231 assets  Real or depreciable property used in a trade or business.  GENERAL rule.  Net Section 1231 gains and losses  IF NET GAIN => add to capital gains and losses. Result is 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 ordinary rate benefit of 1231 net losses.

Slide 7-15 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Depreciation recapture  Gain on each separate asset may be subject to depreciation recapture.  Depreciation recapture does NOT apply if the asset is sold at a loss, nor can it increase the amount of the gain.  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.

Slide 7-16 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Depreciation recapture  REALTY:  Special rules apply to pre-1986 depreciation on accelerated methods: most of this property is fully depreciated, so rules seldom apply.  Corporations must recapture up to 20% of straight-line depreciation on realty. AP12.  Depreciation recapture often supercedes other provisions of the law that delay taxation of gains. For example, the amount of gain attributable to recapture may not be deferred using the installment sales method. The ordinary income recapture must be recognized in the year of sale.

Slide 7-17 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Section 1231 netting  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:

Slide 7-18 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Section 1231 look back rule  The net 1231 gain is treated as ordinary income recapture to the extent of unrecaptured Section 1231 losses during the prior five years.  EXAMPLE: Start business in Section 1231 gains and losses.  1990 net gain $10 treated as capital.  1991 net loss ($15) treated as ordinary.  1992 net gain $23 treated as $15 ordinary (recapture 1991) and $8 capital.  1993 net loss ($40) treated as ordinary.  1994 net gain $6 treated as ordinary. Still have $34 unrecaptured loss from  1995 net gain $50 treated as $34 ordinary, $16 capital.

Slide 7-19 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Other property dispositions  Abandonment and worthlessness  In general, an abandonment loss is an ordinary deduction.  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 is treated as a noncapital asset.

Slide 7-20 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Other property dispositions  Foreclosures  Recourse debt. Treat as if sell property for FMV at foreclosure. Any additional debt forgiveness is ordinary income. See AP20.  Nonrecourse debt. Treat as if sell property for face value of mortgage.  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 gain deferral.