Transcript No Slide Title

#7-1
Chapter 7
Property
Dispositions
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
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Objectives
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Distinguish realization from recognition
Describe installment sale method.
Understand limits on related-party losses.
Identify 2 components of capital gain or loss.
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 Loss
• Amount realized on disposition
• MINUS adjusted basis of property
(e.g. cost - accumulated tax depreciation)
• EQUALS 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.
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Realized Gain or Loss
• Unrealized (mere appreciation or decline in value)
gains and losses are neither realized nor
recognized.
• The amount of gain or loss that a taxpayer
recognizes for tax purposes may not be the same
amount reported on the financial statements. This
occurs when an asset’s adjusted tax basis does not
equal its book basis.
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Amount Realized
• The amount realized from a sale or exchange =
• Cash received
• Plus FMV of any property received, including
buyer’s note
• Plus the amount of any debt relief
• Reduced by selling costs such as sales
commissions, broker fees.
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Amount Realized
• A taxpayer sold land with a basis of $35,000 for
$10,000 cash, a tractor with a cost of $22,000, fair
market value of $12,000 and assumption of a
mortgage of $18,000. The taxpayer paid $1,500 in
sales commissions. What is the amount of the
taxpayer’s realized gain or loss?
$10,000 cash
+ $12, 000 FMV of tractor
+ $18,000 mortgage
$40,000 Amount realized
$40,000 amount realized
- 1,500 sales commission
$38,500 Net Amt. realized
- 35,000 Adjusted basis
$ 3,500 Realized Gain
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Installment 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).
• What accounting concept prescribes this treatment?
The ability to pay concept
Show me the money!
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Installment Sale Method
• Not allowed for sales of publicly traded stock or for
sales of inventory to customers, or to delay
recognition of depreciation recapture.
• Financial accounting uses accrual accounting, so
the installment sales method for tax purposes
creates a temporary book-tax difference.
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Related Party Losses
• Losses realized on sale of property between related
parties are NONdeductible.
• Relative:
• family = spouse, sibling, ancestors, lineal descendants
• An individual and corporations in which the individual
owns more than 50%
• Two corporations owned by the same shareholders.
• Future gain (but NOT loss) from sale by purchaser
can be offset by seller’s disallowed loss.
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Related Party Losses - Examples
• Fawn has stock with a basis of $5,000. She sells it to her
brother Robert for $3,000. Fawn’s realized loss of ($2,000)
may NOT be deducted.
• IF Robert sells the stock for $8,000 to an unrelated party, he
may reduce his realized gain of $5,000 by the ($2,000)
disallowed loss to recognize $3,000 gain.
• IF Robert sells the stock for $4,000 to an unrelated party, he
may reduce his realized gain of $1,000 by ($1,000) of the
disallowed loss to recognize $0 gain.
• IF Robert sells the stock for $2,500 to an unrelated party, 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 - Overview
Tax or deduct
at ordinary rates
Ordinary
Section1231
net gain
Capital
Net capital gains and
losses: Individual may
deduct $3000 net loss.
Net LT gain taxed at
lower rates.
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Character of Gain or Loss
• Capital gain or loss requires:
• Sale or exchange
• Asset surrendered must be a capital asset
• If a firm disposes of a capital asset in some way
other than a sale or exchange, the realized gain or
loss is ordinary in character.
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Capital 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) 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 Loss Limitation
• Treatment of excess of capital loss over capital
gain:
• Individual taxpayers:
• can deduct $3,000 of net losses per year against ordinary
income
• carryforward excess loss 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 Gains
• Individuals obtain preferential taxation on long-term
(> 1 year) capital gains - generally 15% tax rate.
See Chapter 15.
• Corporations pay tax at regular tax rates.
• Even at regular tax rates, capital gains treatment is
preferred to ordinary income because capital gains can be
used to absorb capital losses.
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Dispositions of Noncapital Assets
• Sales of inventory and accounts receivable result in
ordinary income.
• Taxed at regular tax rates.
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Section 1231 Assets
• Section 1231 assets are real or depreciable
property used in a trade or business.
• Question 1:
• BBB Company, which manufactures industrial
plastics, owns the following assets. Characterize
each asset as either a capital, ordinary, or Section
1231 asset.
• A computer system used in BBB’ main office
• A 50% interest in a business partnership organized to
conduct a mining operation in Utah
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Question 1 continued:
• Heavy equipment used to mold BBB’s best-selling
plastic item.
• BBB’s customer list developed over 12 years of
business.
• BBB’s inventory of raw materials used in the
manufacturing process.
• An oil painting of BBB’s founder and 1st president
that hangs in the board room.
• A patent developed by BBB’s R&D department
• BBB’s company airplane.
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Section 1231 Assets
• GENERAL rule (ignoring depreciation recapture).
• Net Section 1231 gains against 1231 losses
• IF NET GAIN => add to capital gains and losses. Result
is a 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 an
ordinary rate benefit on 1231 net losses.
• Note that this treatment offers the
best of both worlds – capital
gain and ordinary loss!
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Depreciation Recapture
• Gain on each separate asset may be subject to
depreciation recapture.
• 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 Recapture
• REALTY:
• Special rules apply to pre-1986 depreciation:
Accelerated depreciation in excess of SL is
recaptured. By 2004, 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).
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1231 Netting Rule including Depreciation Recapture
• 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:
• The net 1231 gain is treated as ordinary income
recapture to the extent of unrecaptured Section
1231 losses during the prior five years.
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Section 1231 Look Back Rule
EXAMPLE: A taxpayer starts a business in 1990 and
incurs the following Section 1231 gains and losses:
• 1998 net gain of $10 - treated as capital.
• 1999 net loss of ($15) - treated as ordinary.
• 2000 net gain of $23 - treated as $15 ordinary
(recapture 1999) and $8 capital.
• 2001 net loss of ($40) - treated as ordinary.
• 2002 net gain of $6 - treated as ordinary. Still have $34
unrecaptured loss from 2001.
• 2003 net gain of $50 - treated as $34 ordinary, $16
capital.
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Other Property Dispositions
• In the case of abandonment and worthlessness, a
firm must take action to indicate that it will not
reclaim the asset in the future.
• 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 and, thus, fully deductible.
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Other Property Dispositions
• Foreclosures
• If recourse debt (debt for which the debtor is
personally liable), treat as if the property was sold for
FMV at foreclosure. Any additional debt forgiveness
is ordinary income.
• If nonrecourse debt (debt which is secured
by the property), treat as if the property
was sold for face value of mortgage.
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Foreclosure Example
• A firm owns land, used in its business, with a cost of
$500,000 and FMV of $600,000. The land is
subject to a $375,000 mortgage. The firm goes
bankrupt and the bank forecloses on the land.
• What is the treatment if the loan is recourse debt?
• The firm treats the foreclosure as if the land were sold for
$600,000, realizing a $100,000 Sec. 1231 gain. The
mortgage is satisfied in full.
• What if the loan is nonrecourse debt?
• The firm treats the foreclosure as if the land were sold for
$375,000. Thus, realizing no gain or loss.
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Business Casualty and Theft
• 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
for gain deferral.
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