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7 - 1 ©2004 Prentice Hall, Inc. Property Dispositions Chapter 7
7 - 2 ©2004 Prentice Hall, Inc. 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 on cash flow is affected by the Type of asset and its holding period Type of taxpayer Taxpayer’s marginal tax rate
7 - 3 ©2004 Prentice Hall, Inc. Types of Dispositions Sale – seller receives cash or cash equivalents in return for asset Exchange – taxpayer receives property other than cash or cash equivalents in return for property transferred to the other party Involuntary conversion – complete or partial destruction due to events not under control of taxpayer (condemnations, thefts, and casualties) Abandonment – property is permanently withdrawn from use (loss = basis of asset)
7 - 4 ©2004 Prentice Hall, Inc. Realized Gain or Loss Amount realized = cash + FMV of property received + seller’s liabilities assumed by the buyer (less buyer’s liabilities assumed by the seller) less selling expenses Amount realized less adjusted basis of property given up equals realized gain or loss
7 - 5 ©2004 Prentice Hall, Inc. Recognized Gain or Loss Almost all realized gains are recognized (taxable) Losses are usually only recognized (deductible) if they are: Incurred in a business Incurred in an investment activity Casualty or theft losses
7 - 6 ©2004 Prentice Hall, Inc. Holding Period Holding period is the period of time the taxpayer is credited with owning the property and usually begins on date of acquisition Property must be held for more than one year to receive favorable tax treatment for Section 1231 assets Capital assets
7 - 7 ©2004 Prentice Hall, Inc. Holding Period Gifts – holding period carries over from donor Exception – when FMV at date of gift is used for basis, then holding period begins at date of gift Inherited property – always long-term holding period
7 - 8 ©2004 Prentice Hall, Inc. Types of Assets Section 1231 assets – business fixed assets held for more than one year Capital assets – investment and personal-use assets Ordinary income assets – inventory, accounts receivable, and other assets that are not in either of above categories
7 - 9 ©2004 Prentice Hall, Inc. Section 1231 Property Property used in a business that can be depreciated or amortized and held for more than one year (long-term holding period) Also includes land used in a business Loss is deductible as ordinary loss Gain is taxed as long-term capital gain (except for recapture)
7 - 10 ©2004 Prentice Hall, Inc. Section 1231 Property 1. Determine the gain or loss for each Section 1231 asset 2. Reduce the gains for depreciation recapture (depreciation recapture is included in ordinary income) 3. Net the remaining gains and losses If the result is a net loss, deduct it in full from ordinary income If the result is a net gain, apply the 5-year look- back rules (taxing gains at regular ordinary income rates) Balance of net gain becomes net long-term capital gain and included in capital gain netting process
7 - 11 ©2004 Prentice Hall, Inc. Depreciation Recapture Depreciation recapture converts part or all of the gain recognized on the sale of depreciable assets to ordinary income to the extent of the reduction in basis attributable to depreciation expense previously claimed The amount of income that is recaptured will never be more than realized gain Recapture rules do not apply to losses
7 - 12 ©2004 Prentice Hall, Inc. Section 1245 Full Recapture Applies to machinery, equipment, furniture, and fixtures (but not buildings or structural components) Any gain on the sale of section 1245 property is ordinary income to the extent of all depreciation allowed or allowable for the property Any amount expensed under section 179 is included in the depreciation allowed The amount of income recaptured is the lesser of all depreciation taken or the amount of realized gain
7 - 13 ©2004 Prentice Hall, Inc. Section 1250 Partial Recapture Applies to realty Section 1250 recaptures excess of accelerated depreciation over straight line depreciation For realty placed in service after 1986 (which must use straight line), no Section 1250 recapture will occur
7 - 14 ©2004 Prentice Hall, Inc. Additional Section 291 Recapture for Corporations Section 291 applies to corporate dispositions of realty (Section 1250 property) and eliminates some of the capital gains that would otherwise be available to offset corporate capital losses Converts to ordinary income 20% of any Section 1231 gain which would have been ordinary income if Section 1245 full recapture applied (rather than Section 1250 partial recapture) For realty acquired after 1986, Section 1245 full recapture x 20% = Section 291 recapture
7 - 15 ©2004 Prentice Hall, Inc. Unrecaptured Section 1250 Gain For individuals, any long-term capital gain attributable to depreciation of realty (Section 1250 property) will be taxed at a maximum rate of 25% The 25% rate applies to long-term capital gain that would be taxed as ordinary income if the Section 1245 full recapture rules applied and is called unrecaptured Section 1250 gain
7 - 16 ©2004 Prentice Hall, Inc. Section 1231 Netting Step 1: Net casualty and theft gains (after recapture) and losses on Section 1231 assets and investment assets If loss, all gains and losses are ordinary except investment losses of individuals (miscellaneous itemized deductions) Step 2: Net gains (after recapture) and losses from all other Section1231 assets and involuntary conversions of investment assets with net gain from step 1 If loss, treat as described above If gain, apply Section 1231 look-back rules
7 - 17 ©2004 Prentice Hall, Inc. Section 1231 Look-Back Rules Net Section 1231 gains will be 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)
7 - 18 ©2004 Prentice Hall, Inc. Capital Assets Capital assets include stock, 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
7 - 19 ©2004 Prentice Hall, Inc. Capital Gain and Loss Netting Process Subtract long-term capital losses from long-term capital gains (including Section 1231 gains) Subtract short-term losses from short-term gains Continue netting (subtracting losses from gains) until only gains or only losses remain If result is short-term capital gain, then tax at ordinary income rates Taxation of long-term capital gains and all capital losses differs for corporations and individuals
7 - 20 ©2004 Prentice Hall, Inc. Capital Gains and Losses of C Corporations No current deduction for capital losses; carry back 3 years and forward 5 years to use only against capital gains Both long-term and short-term capital gains taxed as ordinary income Benefit of capital gains is limited to ability to offset capital losses
7 - 21 ©2004 Prentice Hall, Inc. Capital Losses for Individuals $3,000 per year deduction against other income (after first netting losses against capital gains in current year) Balance carried forward indefinitely (no carry back permitted) Losses on personal-use assets are not recognized (deductible) even though gains are recognized (taxable)
7 - 22 ©2004 Prentice Hall, Inc. Capital Gains for Individuals 20% (15% of as 5/6/03) rate applies to most long-term capital gains 10% (5% as of 5/6/03) rate applies to taxpayers in 10% and 15% marginal tax brackets Reduced rate if held for 5 years repealed as of May 6, 2003
7 - 23 ©2004 Prentice Hall, Inc. Capital Gains for Individuals 25% rate applies to depreciation recapture for realty (Sec. 1250 unrecaptured gain) with balance of gain taxed at new 15% rate If taxpayer’s ordinary tax rate is lower than 25%, then the lower ordinary rate applies to gain that falls in that tax bracket Collectibles such as antiques, art objects, and rare coins are taxed at a 28% rate due to potential personal enjoyment of asset If taxpayer’s ordinary tax rate is lower than 28%, then the lower ordinary rate applies to gain that falls in that tax bracket
7 - 24 ©2004 Prentice Hall, Inc. Ordinary Income Property Ordinary income property includes: Business assets that do not meet the more- than-one year holding period under Section 1231 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 fully deductible as ordinary losses
7 - 25 ©2004 Prentice Hall, Inc. 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 parts
7 - 26 ©2004 Prentice Hall, Inc. Section 1244 Stock Losses on stock are usually capital losses (only $3,000 deductible per year for individuals after netting against any capital gains) Section 1244 permits an ordinary loss up to $50,000 ($100,000 if a joint return) annually for loss on qualified stock if individual is the original investor in a domestic small business corporation Any excess loss is capital loss
7 - 27 ©2004 Prentice Hall, Inc. Section 1244 Stock Total capitalization cannot exceed $1 million For the 5 preceding years The corporation must be an operating company deriving 50% or more of its annual gross revenues from the sale of goods or services Income from rents, royalties, dividends, interest, annuities and gain on sales of securities is limited to 50% or less
7 - 28 ©2004 Prentice Hall, Inc. Section 1202 Small Business Stock Gain Exemption Taxpayers may exclude up to 50% of the gain realized on the disposition of qualified small business stock held for more than 5 years (the other half of the gain is taxed as a long-term capital gain at a 28% rate) Business must be a small C corporation (no more than $50 million in assets) operating an active business engaged in manufacturing, retailing, or wholesaling
7 - 29 ©2004 Prentice Hall, Inc. Section 1202 Stock Seller of stock must be the original owner who acquires the stock in exchange for money, property or services 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
7 - 30 ©2004 Prentice Hall, Inc. Section 1202 Stock If taxpayer holds stock at least 6 months and invests all proceeds in another qualified small business corporation’s stock, no gain recognized If all proceeds not reinvested, only gain proportionate to the reinvested proceeds can be excluded
7 - 31 ©2004 Prentice Hall, Inc. Sale of Principal Residence An individual who has owned and occupied the 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 exclusion can only be used once every 2 years
7 - 32 ©2004 Prentice Hall, Inc. 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
7 - 33 ©2004 Prentice Hall, Inc. Sale of Principal Residence Partial exclusion available if failure to meet 2 year time period is due to: A change in place of employment Health (moving into nursing home) Other unforeseen circumstances including divorce, death of spouse or co-owner, unemployment, disasters, and involuntary conversion of residence
7 - 34 ©2004 Prentice Hall, Inc. Sale of Principal Residence Partial exclusion is calculated by taking number of qualifying months divided by 24, and then multiplying the fraction by $250,000 ($500,000 if qualifying jointly) The number of qualifying months is the shorter of: The use and ownership during the 5 preceding years or The period of time after the last date to which the exclusion applied.
7 - 35 ©2004 Prentice Hall, Inc. Sale of Principal Residence A principal residence does not lose that status 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 (unrecaptured Section 1250 gain) applies to gain due to depreciation
7 - 36 ©2004 Prentice Hall, Inc. Related Party Losses Loss on sale to related parties disallowed Related parties include brothers, sisters, spouse, 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 previously disallowed seller ’ s loss
7 - 37 ©2004 Prentice Hall, Inc. The End
Individual Income Tax Overview
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