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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Property Property DispositionsDispositions

Chapter 7Chapter 7


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ObjectivesObjectives

Distinguish realization from recognition Describe installment sale method. Understand limits on related-party losses. Identify 2 components of capital gain or loss. Define (non-)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.


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Realized Gain or LossRealized Gain or Loss

Amount realized on disposition MINUS adjusted basis of property (e.g. cost -

accumulated tax depreciation = “NBV”) = 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.


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Amount RealizedAmount 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. No adjustment for “inflationary gains.”


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Installment Sale MethodInstallment Sale Method

Permits deferral of gain recognition until cash is received on the sale.

Gain recognized this year = (cash this year) x (total gain / total sales price).

Not allowed for sales of publicly traded stock or for inventory, or to delay recognition of depreciation recapture.

Financial accounting uses accrual accounting, so installment sales method for tax creates a temporary book-tax difference.


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Related Party LossesRelated Party Losses

Relative: family = spouse, sibling, ancestors, lineal descendants

Q10 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.


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Related Party Losses - ExampleRelated 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.


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Character of Gain or Loss - OverviewCharacter of Gain or Loss - Overview

Ordinary

Capital

Section1231 Depr.

Recap

t

5-yr

look

back

net 1

231

loss

net 1231

gain

Tax or deductat ordinary rates

Net capital gains and losses: Individual may deduct $3000 net loss. Net LT gain taxed at lower rates.

net gain


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Character of Gain or LossCharacter of Gain or Loss

Capital gain or loss requires: Sale or exchange Capital asset


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Capital Asset (negatively) DefinedCapital Asset (negatively) Defined

Capital assets (under Section1221) are everything EXCEPT:

1) inventory 2) accounts receivable 3) supplies 4) real or depreciable property used in a trade or

business (this is the same as Section 1231 property)


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Capital Asset (negatively) DefinedCapital Asset (negatively) Defined

5) copyright, compositions, artistic efforts created by taxpayer. (exception - patents by inventors are capital assets).

6) certain U.S. government publications 7) Commodities derivative financial instruments

held by a dealer 8) Hedging transaction properties.


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Capital LossesCapital 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


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Capital GainsCapital 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.


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Dispositions of Noncapital AssetsDispositions of Noncapital Assets

Sales of inventory and accounts receivable result in ordinary income.

Taxed at regular tax rates. AP8.


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Section 1231 AssetsSection 1231 Assets

Real or depreciable property used in a trade or business. Q1

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.


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Depreciation RecaptureDepreciation 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.


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Depreciation RecaptureDepreciation 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 20% of amount that would have been ordinary had it been personalty (lesser of gain or depreciation). AP12.

Individuals treat lesser of gain or depreciation as a capital gain subject to a special 25% tax rate - see chapter 15.


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Section 1231 NettingSection 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:


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Section 1231 Look Back RuleSection 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 1990. Section 1231 gains and losses.

1998 net gain $10 treated as capital. 1999 net loss ($15) treated as ordinary. 2000 net gain $23 treated as $15 ordinary (recapture

1999) and $8 capital. 2001 net loss ($40) treated as ordinary. 2002 net gain $6 treated as ordinary. Still have $34

unrecaptured loss from 2001. 2003 net gain $50 treated as $34 ordinary, $16

capital.


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Other Property DispositionsOther Property Dispositions

Abandonment and worthlessness In general, an abandonment loss is an ordinary

deduction = tax adjusted basis. 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 are treated as a noncapital asset.


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Other Property DispositionsOther 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.

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