Review of Property Dispositions Dr. Richard Ott

Realized and Recognized Gains (Losses) from Property Sales or Exchanges

Realized Gains (Losses) Calculation: Amount realized [IRC §1001(b)] – Adjusted tax basis [IRC §1011] = Realized gain (loss) [IRC §1001(a)] Calculation: Amount realized [IRC §1001(b)] – Adjusted tax basis [IRC §1011] = Realized gain (loss) [IRC §1001(a)]

Amount Realized Includes [IRC §1001(b)]: Includes [IRC §1001(b)]: Cash received Cash received FMV of property received FMV of property received Receivables Receivables Services Services Other property Other property Discharge of liabilities [Reg. § (a)] Discharge of liabilities [Reg. § (a)] With proper adjustments for real property taxes, where applicable With proper adjustments for real property taxes, where applicable

Adjusted Tax Basis Calculation Initial basis [IRC §1012 through §1015]  Adjustments to basis [IRC §1016] = Adjusted tax basis [IRC §1011] Calculation Initial basis [IRC §1012 through §1015]  Adjustments to basis [IRC §1016] = Adjusted tax basis [IRC §1011]

Recognized Gains (Losses) “Except as otherwise provided in this subtitle” the entire amount of any realized gains (losses) are recognized [IRC §1001(c)] “Except as otherwise provided in this subtitle” the entire amount of any realized gains (losses) are recognized [IRC §1001(c)]

Some Exceptions to IRC §1001(c) Corporate formations [IRC §351(a) and (b)] Corporate formations [IRC §351(a) and (b)] Related party losses [IRC §267(a)] Related party losses [IRC §267(a)] Installment sale gains [IRC §453(a)] Installment sale gains [IRC §453(a)] Wash sale losses [IRC §1091(a)] Wash sale losses [IRC §1091(a)] Tax-free reorganizations [IRC §354(a)] Tax-free reorganizations [IRC §354(a)] Partial exclusion for gain from certain small business stock [IRC §1202] Partial exclusion for gain from certain small business stock [IRC §1202] Like-kind exchanges [IRC §1031] Like-kind exchanges [IRC §1031] Involuntary conversion [IRC §1033] Involuntary conversion [IRC §1033]

Capital versus Ordinary Gains (Losses)

Capital versus Ordinary Gains Corporate taxpayers are taxed at the same rates on net capital gains (capital gains in excess of capital losses) and ordinary gains [IRC §11] Corporate taxpayers are taxed at the same rates on net capital gains (capital gains in excess of capital losses) and ordinary gains [IRC §11] Individual taxpayers are taxed at more favorable rates on net long-term capital gains and on qualifying dividend income [IRC §1(h)] Individual taxpayers are taxed at more favorable rates on net long-term capital gains and on qualifying dividend income [IRC §1(h)]

Capital versus Ordinary Losses Corporate taxpayers can only deduct capital losses against capital gains [IRC §1211(a)] Corporate taxpayers can only deduct capital losses against capital gains [IRC §1211(a)] Capital losses > capital gains carry back 3 years and forward 5 years to offset net capital gains [IRC §1212(a)] Capital losses > capital gains carry back 3 years and forward 5 years to offset net capital gains [IRC §1212(a)] Individual taxpayers can only deduct capital losses against capital gains plus $3,000 per year [IRC §1211(b)] Individual taxpayers can only deduct capital losses against capital gains plus $3,000 per year [IRC §1211(b)] Capital losses not deductible in current year carry forward indefinitely [IRC §1212(b)] Capital losses not deductible in current year carry forward indefinitely [IRC §1212(b)]

Capital versus Ordinary Losses For both corporate and individual taxpayers, there is no general overall limitation on the deductibility of ordinary losses but ordinary losses may still be subject to limitations that apply to all losses such as: For both corporate and individual taxpayers, there is no general overall limitation on the deductibility of ordinary losses but ordinary losses may still be subject to limitations that apply to all losses such as: Passive activity losses [IRC §469] Passive activity losses [IRC §469] Carryovers in corporate acquisitions [IRC §381] Carryovers in corporate acquisitions [IRC §381] Carryovers and certain built-in losses after ownership change [IRC §382] Carryovers and certain built-in losses after ownership change [IRC §382]

Determining the Character of Recognized Gains (Losses)

Categories of Assets All assets fall into one of the following three categories: All assets fall into one of the following three categories: Capital assets Capital assets IRC §1231 assets IRC §1231 assets Ordinary assets Ordinary assets

Capital Assets Capital assets include all assets except those specifically listed in IRC §1221(a) Capital assets include all assets except those specifically listed in IRC §1221(a) Listed assets are IRC §1231 assets or ordinary assets Listed assets are IRC §1231 assets or ordinary assets

IRC §1231 Assets IRC §1231 assets include [IRC §1231(b)]: IRC §1231 assets include [IRC §1231(b)]: All depreciable property and real property used in a trade or business and held for more than one year All depreciable property and real property used in a trade or business and held for more than one year Includes amortizable intangible assets [IRC §197(f)(7)] Includes amortizable intangible assets [IRC §197(f)(7)] Certain livestock, unharvested crops, timber, coal, or domestic iron ore Certain livestock, unharvested crops, timber, coal, or domestic iron ore

Ordinary Assets Ordinary assets are those assets excluded from both capital assets [IRC §1221(a)] and IRC §1231 assets [IRC §1231(b)] and include: Ordinary assets are those assets excluded from both capital assets [IRC §1221(a)] and IRC §1231 assets [IRC §1231(b)] and include: Inventory and/or property held primarily for sale to customers in the ordinary course of the business Inventory and/or property held primarily for sale to customers in the ordinary course of the business Accounts and notes receivable acquired in the ordinary course of the business Accounts and notes receivable acquired in the ordinary course of the business Supplies used in the ordinary course of the business Supplies used in the ordinary course of the business Depreciable property and/or real property used in a trade or business and held for 1 year or less Depreciable property and/or real property used in a trade or business and held for 1 year or less Certain copyrights, compositions, letters, or similar property, government publications, commodities derivatives, and hedging transactions Certain copyrights, compositions, letters, or similar property, government publications, commodities derivatives, and hedging transactions

Character of Gains (Losses) Character of recognized gains (losses) from sales or exchanges of property depends on the category the asset falls into (capital, IRC §1231 or ordinary asset) Character of recognized gains (losses) from sales or exchanges of property depends on the category the asset falls into (capital, IRC §1231 or ordinary asset) However, several provisions in the Code override these categories However, several provisions in the Code override these categories

Overriding Provisions Gains from sales or exchanges of depreciable property between certain related taxpayers are ordinary gains [IRC §1239] Gains from sales or exchanges of depreciable property between certain related taxpayers are ordinary gains [IRC §1239] Losses on qualifying small business stock is ordinary to up to $50,000 ($100,000 MFJ) for qualifying individuals [IRC §1244] Losses on qualifying small business stock is ordinary to up to $50,000 ($100,000 MFJ) for qualifying individuals [IRC §1244] Depreciation recapture on sales or exchanges of depreciable property is ordinary gain Depreciation recapture on sales or exchanges of depreciable property is ordinary gain IRC §1245 for tangible personal property IRC §1245 for tangible personal property IRC §1250 for real property IRC §1250 for real property IRC §291(a) additional recapture on real property for corporations IRC §291(a) additional recapture on real property for corporations

Depreciation Recapture – In General All depreciable assets that are sold or exchanged at a recognized gain are subject to depreciation recapture rules All depreciable assets that are sold or exchanged at a recognized gain are subject to depreciation recapture rules Depreciation recapture is ordinary gain, any gain remaining may be capital or IRC §1231 gain Depreciation recapture is ordinary gain, any gain remaining may be capital or IRC §1231 gain Depreciation recapture amount depends on the type of asset and when it was placed in service Depreciation recapture amount depends on the type of asset and when it was placed in service All depreciable assets fall into one of two categories: All depreciable assets fall into one of two categories: IRC §1245 property (tangible personal property) or IRC §1245 property (tangible personal property) or IRC §1250 property (real property) IRC §1250 property (real property) Additional depreciation recapture under IRC §291(a) applies to IRC §1250 property dispositions made by corporate taxpayers Additional depreciation recapture under IRC §291(a) applies to IRC §1250 property dispositions made by corporate taxpayers

Depreciation Recapture – IRC §1245 Applies to all depreciable tangible personal property and amortizable intangible assets Applies to all depreciable tangible personal property and amortizable intangible assets Recognized gain on the disposition of IRC §1245 property is ordinary income up to the extent of all previously recognized deductions for: Recognized gain on the disposition of IRC §1245 property is ordinary income up to the extent of all previously recognized deductions for: MACRS MACRS IRC §179 IRC §179 Bonus depreciation Bonus depreciation Amortization Amortization

Depreciation Recapture – IRC §1245 See Example 1 and Solution See Example 1 and SolutionExample 1 SolutionExample 1 Solution See Example 2 and Solution See Example 2 and Solution

Depreciation Recapture – IRC §1250 Applies to all depreciable real property Applies to all depreciable real property Recognized gain on the disposition of IRC §1250 property is ordinary gain up to the extent that the sum of all previously recognized deductions exceed the amounts that would have been deducted using the straight-line method Recognized gain on the disposition of IRC §1250 property is ordinary gain up to the extent that the sum of all previously recognized deductions exceed the amounts that would have been deducted using the straight-line method Since MACRS is calculated using the straight-line method for real property placed in service after 12/31/86, the IRC §1250 depreciation recapture is zero for these properties Since MACRS is calculated using the straight-line method for real property placed in service after 12/31/86, the IRC §1250 depreciation recapture is zero for these properties

Depreciation Recapture – IRC §291(a) Applies only to IRC §1250 property held by corporate taxpayers Applies only to IRC §1250 property held by corporate taxpayers Additional depreciation recapture amount is ordinary gain. Additional amount is the lesser of: Additional depreciation recapture amount is ordinary gain. Additional amount is the lesser of: 20% X [Hypothetical IRC §1245 depreciation recapture less actual IRC §1250 depreciation recapture (if any)], or 20% X [Hypothetical IRC §1245 depreciation recapture less actual IRC §1250 depreciation recapture (if any)], or 20% X [Recognized gain less IRC §1250 depreciation recapture (if any)] 20% X [Recognized gain less IRC §1250 depreciation recapture (if any)]

Depreciation Recapture – IRC §1250 See Example 3 and Solution See Example 3 and SolutionExample 3 SolutionExample 3 Solution See Example 4 and Solution See Example 4 and Solution

Character of Gains (Losses) General Rule: Gains (losses) from sales or exchanges of capital assets are capital gains (losses) [IRC §1222] General Rule: Gains (losses) from sales or exchanges of capital assets are capital gains (losses) [IRC §1222] If the asset was held for 1 year or less, the gain (loss) is short-term If the asset was held for 1 year or less, the gain (loss) is short-term If the asset was held for more than 1 year, the gain (loss) is long-term If the asset was held for more than 1 year, the gain (loss) is long-term Caveat: Caveat: Gains are ordinary to the extent of any required depreciation recapture Gains are ordinary to the extent of any required depreciation recapture Other overriding provisions may apply Other overriding provisions may apply

Character of Gains (Losses) Recognized gains on the sale or exchange of ordinary assets are ordinary gains [IRC §64] Recognized gains on the sale or exchange of ordinary assets are ordinary gains [IRC §64] Recognized losses on the sale or exchange of ordinary assets are ordinary losses [IRC §65] Recognized losses on the sale or exchange of ordinary assets are ordinary losses [IRC §65]

Character of Gains (Losses) When the sum of all IRC §1231 losses > the sum of all IRC §1231 gains: When the sum of all IRC §1231 losses > the sum of all IRC §1231 gains: All the IRC §1231 gains (losses) are ordinary gains (losses) [IRC §1231 (a)(2)] All the IRC §1231 gains (losses) are ordinary gains (losses) [IRC §1231 (a)(2)] When the sum of all IRC §1231 losses < the sum of all IRC §1231 gains: When the sum of all IRC §1231 losses < the sum of all IRC §1231 gains: All the gains (losses) are capital gains (losses) [IRC §1231 (a)(1)] except to the extent of: All the gains (losses) are capital gains (losses) [IRC §1231 (a)(1)] except to the extent of: Depreciation recapture [IRC §1245 or IRC §1250 and §291] Depreciation recapture [IRC §1245 or IRC §1250 and §291] IRC §1231 recapture [IRC §1231(c)] IRC §1231 recapture [IRC §1231(c)]

IRC §1231 Recapture Applies if: Applies if: Taxpayer has a net IRC §1231 gain (IRC §1231 gains exceed IRC §1231 losses) in the current year and Taxpayer has a net IRC §1231 gain (IRC §1231 gains exceed IRC §1231 losses) in the current year and Taxpayer reported a net IRC §1231 loss during any one of the previous five years Taxpayer reported a net IRC §1231 loss during any one of the previous five years

IRC §1231 Recapture Current year net IRC §1231 gain is ordinary to the extent of any non-recaptured net IRC §1231 loss over the previous five years [IRC §1231(c)] Current year net IRC §1231 gain is ordinary to the extent of any non-recaptured net IRC §1231 loss over the previous five years [IRC §1231(c)] Non-recaptured net IRC §1231 loss = net IRC §1231 losses over the past 5 years less amounts already recaptured during that time period Non-recaptured net IRC §1231 loss = net IRC §1231 losses over the past 5 years less amounts already recaptured during that time period

IRC §1231 Recapture – Example 1 A taxpayer had the following net IRC §1231 gains (losses) over the past five years (there were no IRC §1231 gains or losses for years prior to 2001): A taxpayer had the following net IRC §1231 gains (losses) over the past five years (there were no IRC §1231 gains or losses for years prior to 2001): 2001 $(5,000) 2001 $(5,000) 2002 $ 8, $ 8, $(4,000) 2003 $(4,000) 2004 $ 2, $ 2, $(3,000) For the 2006 taxable year, the non-recaptured IRC §1231 loss over the previous five years is $5, $(3,000) For the 2006 taxable year, the non-recaptured IRC §1231 loss over the previous five years is $5,000

IRC §1231 Recapture – Example 2 A taxpayer had the following net IRC §1231 gains (losses) over the past five years (there were no IRC §1231 gains or losses for years prior to 2001): A taxpayer had the following net IRC §1231 gains (losses) over the past five years (there were no IRC §1231 gains or losses for years prior to 2001): 2001 $18, $18, $ $ $(15,000) 2003 $(15,000) 2004 $(6,000) 2004 $(6,000) 2005 $(3,000) For the 2006 taxable year, the non-recaptured IRC §1231 loss over the previous five years is $24, $(3,000) For the 2006 taxable year, the non-recaptured IRC §1231 loss over the previous five years is $24,000

IRC §1231 Assets Netting Process See Example 5 and Solution See Example 5 and SolutionExample 5 SolutionExample 5 Solution See Example 6 and solution See Example 6 and solution See Example 7 and solution See Example 7 and solution