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7 - 1 ©2005 Prentice Hall, Inc. Property Dispositions Chapter 7
7 - 2 ©2005 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 ©2005 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to events not under control of taxpayer (condemnations, thefts, and casualties) Abandonment – property is permanently withdrawn from use (loss = basis of asset)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 ©2005 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 ©2005 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 ©2005 Prentice Hall, Inc. Holding Period The holding period is the period of time the taxpayer is credited with owning the property The holding period usually begins on date of acquisition unless there is a carryover or substituted basis for the asset acquired Property must be held for more than one year to receive favorable tax treatment for Section 1231 assets Capital assets
7 - 7 ©2005 Prentice Hall, Inc. Holding Period Gifts – holding period carries over from donor Exception – when FMV at date of gift is used for basis, holding period begins on date of gift Inherited property – always long-term holding period
7 - 8 ©2005 Prentice Hall, Inc. Types of Assets Section 1231 assets – fixed assets (property, plant, and equipment) used in a trade or business and held for more than one year Capital assets – investment and personal-use assets Ordinary income assets – inventory, accounts receivable, and all other assets that are neither Section 1231 or capital assets
7 - 9 ©2005 Prentice Hall, Inc. Section 1231 Property Property used in a business that is subject to cost recovery deductions and that is held for more than one year (long-term holding period) Land used in a business that is held for more than one year Gains (after recapture provisions are applied) and losses on individual Section 1231 property dispositions are subject to a netting process to determine tax treatment
7 - 10 ©2005 Prentice Hall, Inc. Determining Net Section 1231 Gain/Loss Treatment Step 1: Determine the gain or loss for each Section 1231 asset Step 2: Reduce the gains for depreciation recapture Depreciation recapture is included in ordinary income Step 3: Net the remaining gains and losses
7 - 11 ©2005 Prentice Hall, Inc. Determining Net Section 1231 Gain/Loss Treatment Step 4: If the result is a net loss, deduct it in full from ordinary income Step 5: If the result is a net gain, apply the 5-year look-back rule Gains up to the amount of previously unrecaptured Section 1231 losses are included in and taxed as ordinary income Step 6: The remaining net Section 1231 gain is treated as a net long-term capital gain and included in capital gain netting process
7 - 12 ©2005 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 recaptured as ordinary income can never exceed either the realized gain or prior depreciation deductions Recapture rules cannot apply to assets on which there is a realized loss
7 - 13 ©2005 Prentice Hall, Inc. Section 1245 Full Recapture Applies to machinery, equipment, furniture, and fixtures (but not to 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 income recaptured is the lesser of all depreciation taken or the realized gain
7 - 14 ©2005 Prentice Hall, Inc. Section 1250 Partial Recapture Applies to realty Section 1250 recaptures the excess of accelerated depreciation over straight line depreciation For realty placed in service after 1986, for which straight-line depreciation must be used, there is no Section 1250 recapture for noncorporate taxpayers Section 291 for corporations Section 1250 unrecaptured gain for individuals
7 - 15 ©2005 Prentice Hall, Inc. Additional Section 291 Recapture for Corporations Section 291 applies to corporate dispositions of realty (Section 1250 property) Converts to ordinary income (as Section 1250 recapture) 20% of any Section 1231 gain that would have been ordinary income if Section 1245 full recapture applied For realty acquired after 1986, Section 1245 full recapture x 20% = Section 1250 recapture Eliminates some of the capital gains that would otherwise be available to offset corporate capital losses
7 - 16 ©2005 Prentice Hall, Inc. Unrecaptured Section 1250 Gain For individuals only, unrecaptured Section 1250 gains are those long-term capital gains on realty that would be taxed as ordinary income if the Section 1245 full recapture rules applied These long-term capital gains attributable to prior depreciation deductions are taxed at a maximum rate of 25%
7 - 17 ©2005 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 a net loss, all gains and losses are ordinary except investment losses of individuals (miscellaneous itemized deductions) A net gain is included in Step 2 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 a net loss, treat as described above If a net gain, apply Section 1231 look-back rules
7 - 18 ©2005 Prentice Hall, Inc. Section 1231 Netting All net gain remaining after the Section 1231 look-back rules are applied is treated as a long-term capital gain and included in the capital asset netting process This netting process allows taxpayers to claim ordinary loss treatment for net losses and favorable capital gains treatment for net gains after application of the recapture provisions
7 - 19 ©2005 Prentice Hall, Inc. Section 1231 Look-Back Rules Net Section 1231 gains are 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 - 20 ©2005 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 - 21 ©2005 Prentice Hall, Inc. Capital Gain and Loss Netting Process Subtract long-term capital losses from long-term capital gains (including net Section 1231 gains) Subtract short-term losses from short-term gains Continue netting (subtracting losses from gains) until only gains or only losses remain A (net) short-term capital gain resulting from this process is taxed at ordinary income rates Taxation of (net) long-term capital gains and all capital losses differs for corporations and individuals
7 - 22 ©2005 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 - 23 ©2005 Prentice Hall, Inc. Capital Losses for Individuals $3,000 per year deduction against other income for capital losses; (net) short-term capital losses deducted before (net) long- term capital losses Remaining (net) capital losses are carried forward indefinitely (no carry back permitted) Losses on personal-use assets are not recognized (deductible) even though gains are recognized (taxable)
7 - 24 ©2005 Prentice Hall, Inc. General Capital Gains Rates for Individuals 15% rate applies to most long-term capital gains 5% rate applies to taxpayers whose ordinary income is taxed at the 10% and 15% marginal tax brackets to the extent their long-term gains fall within these marginal tax brackets
7 - 25 ©2005 Prentice Hall, Inc. Special Capital Gains Rates for Individuals 25% rate applies to Sec. 1250 unrecaptured gain on realty; gain in excess of the recapture amount is taxed at 15% rate If taxpayer’s ordinary income tax rate is lower than 25%, then the lower ordinary income rate applies to gain that falls within 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 within that tax bracket
7 - 26 ©2005 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 Ordinary gains are taxed as ordinary income and losses are fully deductible as ordinary losses
7 - 27 ©2005 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 - 28 ©2005 Prentice Hall, Inc. Section 1244 Stock Losses on stock are usually capital losses; individuals are limited to a $3,000 deduction against ordinary income annually after netting losses against capital gains Section 1244 permits an ordinary loss deduction of up to $50,000 ($100,000 if a joint return) annually for losses on qualified stock if an individual is the original investor in a domestic small business corporation Any excess loss is a capital loss
7 - 29 ©2005 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 - 30 ©2005 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 (remaining 50 % of the gain is taxed at the 28% long-term capital gain 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 - 31 ©2005 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 - 32 ©2005 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 - 33 ©2005 Prentice Hall, Inc. Sale of Principal Residence An individual who has owned and occupied a 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 full exclusion can only be used once every 2 years
7 - 34 ©2005 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 - 35 ©2005 Prentice Hall, Inc. Sale of Principal Residence Partial exclusion available if failure to meet two-year time period requirement 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 - 36 ©2005 Prentice Hall, Inc. Sale of Principal Residence Partial exclusion is calculated by taking dividing the number of qualifying months by 24 and then multiplying this 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 that has passed since the taxpayer last claimed the exclusion
7 - 37 ©2005 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 for unrecaptured Section 1250 gain applies to gain up to the previous depreciation deductions
7 - 38 ©2005 Prentice Hall, Inc. Sale to Related Party Losses on sales to related parties are 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 the seller ’ s previously disallowed loss
7 - 39 ©2005 Prentice Hall, Inc. The End
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