McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

Chapter 8Chapter 8

Property DispositionsProperty Dispositions

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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ObjectivesObjectives

Distinguish realization from recognition Apply the installment sale method Understand the limits on related-party losses Identify two components of capital gain or loss Apply the capital loss limitation Explain the Section 1231 netting process Compute depreciation recapture Describe the tax consequences of other asset

dispositions

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Realized Gain or LossRealized Gain or Loss

Amount realized on disposition

(Adjusted basis of property)

Realized gain or (loss)

Realized gains or losses on disposition are recognized (result in taxable income or deductions) unless there is a specific exception. See Chapter 9

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Realized Gain or LossRealized Gain or Loss

Unrealized gains and losses (appreciation or decline in value) are neither realized nor recognized

The tax gain or loss that a taxpayer recognizes may differ from the gain or loss reported on the financial statements. This occurs when an asset’s adjusted tax basis does not equal book basis

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Amount RealizedAmount Realized

The amount realized from a disposition equals: 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 RealizedAmount Realized

A taxpayer sold land with a $29,200 basis for $10,000 cash, a tractor with a $12,000 FMV, and the purchaser’s assumption of an $18,000 mortgage on the land. The taxpayer paid a $1,500 sales commission.

Amount realized equals $38,500 $10,000 cash + $12,000 FMV of tractor + $18,000 debt

relief - $1,500 commission

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Gain RealizedGain Realized

A taxpayer sold land with a $29,200 basis for a $38,500 amount realized.

Gain realized equals $9,300

$38,500 amount realized - $29,200 adjusted basis

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Installment Sale MethodInstallment Sale Method

Permits deferral of gain recognition until cash is received

Gain recognized equals cash received × gross profit percentage (GP%) GP% = gain realized/contract price

Interest received on the installment note is taxable under normal rules

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Installment Sale MethodInstallment Sale Method

Not allowed for sales of publicly traded stock or sales of inventory to customers

The installment sale method is not permitted under GAAP so the installment sales method for tax purposes creates a temporary book-tax difference

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Related Party LossesRelated Party Losses

Losses realized on sales of property between related parties are disallowed (not recognized)

Related parties include: Family members (spouse, sibling, ancestors, lineal

descendants) An individual and a corporations in which the individual

owns more than 50% of the stock Two corporations owned by the same shareholders

Future gain from sale by purchaser is reduced by seller’s disallowed loss

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Related Party Losses - ExamplesRelated Party Losses - Examples

Fawn sold stock with a $5,000 basis to her brother Robert for $3,000. Fawn’s $2,000 realized loss was disallowed (not recognized) Robert’s basis in the stock is his $3,000 cost

If Robert sells the stock for $7,500 to an unrelated party, he may reduce his $4,500 realized gain by the $2,000 disallowed loss. His recognized gain is $2,500

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Related Party Losses - ExamplesRelated Party Losses - Examples

If Robert sells the stock for $3,800 to an unrelated party, he may reduce his $800 realized gain by $800 of the disallowed loss. His recognized gain is zero

If Robert sells the stock for $2,500 to an unrelated party, he recognizes his $500 realized loss. This loss is not increased by the disallowed loss

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Character of Recognized Gain or LossCharacter of Recognized Gain or Loss

Capital gain or loss results from the sale or exchange of a capital asset

Dispositions of capital assets other than by sale or exchange do not result in capital gain or loss Recognized gain or loss is ordinary in character

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Capital Asset DefinedCapital Asset Defined

Under Section 1221, all assets are capital assets except for the following business assets: Inventory

Accounts receivable

Supplies

Real property used in a business

Depreciable or amortizable personalty used in a business

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Capital Asset DefinedCapital Asset Defined

Under Section 1221, all assets are capital assets except for the following assets: Copyrights, compositions, artistic efforts created by the

taxpayer

Exception for created patents

Certain U.S. government publications

Commodities and derivative financial instruments held by a dealer

Hedging transaction properties

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Capital Loss LimitationCapital Loss Limitation

Treatment of excess of capital loss over capital gain (net capital loss) Individuals:

Can deduct $3,000 of net loss per year against ordinary income

Carryforward remaining loss indefinitely Corporations:

No deduction for net loss Carryback three years and forward five years

against capital gains

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Capital GainsCapital Gains

Individuals have preferential tax rates on long-term capital gain (See Chapter 16) Gains and losses from sales and exchanges of capital

assets held for more than 12 months are long-term 0%, 15%, 25%, and 28% preferential rates

Corporations pay tax at regular rates Capital gains are preferred to ordinary income because

capital gains absorb capital losses

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Dispositions of Noncapital AssetsDispositions of Noncapital Assets

Sales of inventory and accounts receivable result in ordinary income taxed at regular rates

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Section 1231 AssetsSection 1231 Assets

Section 1231 assets are real or depreciable/amortizable properties used in a business

BBB Company, which manufactures industrial plastics, owns the following assets. Identify each as a capital, ordinary, or Section 1231 asset Computer system used in BBB’s main office A 50% interest in a partnership organized to conduct a

mining operation in Utah

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Section 1231 AssetsSection 1231 Assets

Heavy equipment used to mold BBB’s best-selling plastic item

BBB’s customer list developed over 12 years

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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Character of Net Section 1231 Gain or LossCharacter of Net Section 1231 Gain or Loss

General rule for gains and losses realized on sales and exchanges of Section 1231 assets

Gains and losses for the year are netted

Net gain is treated as capital gain

Net loss is ordinary (fully deductible)

This treatment offers the best of both worlds – capital gain and ordinary loss!

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Depreciation RecaptureDepreciation Recapture

Gain recognized on the sale or exchange of a Section 1231 asset may be subject to depreciation recapture Recapture rules have no effect on recognized losses

For sales of depreciable personalty and amortizable intangibles, gain is characterized as ordinary to the extent of accumulated depreciation

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Depreciation RecaptureDepreciation Recapture

For sales of depreciable real property: Accelerated depreciation in excess of SL is

recaptured Applies only to buildings placed in service before 1987 By 2008, most of these buildings are fully depreciated

so no recapture potential Corporations must recapture 20% of amount that

would be ordinary under a full depreciation recapture rule

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Recapture of Prior Year Net Section 1231 LossRecapture of Prior Year Net Section 1231 Loss

Net 1231 gain is characterized as ordinary income to the extent of unrecaptured Section 1231 losses

Unrecaptured Section 1231 loss is a net Section 1231 loss deducted in any of the five preceding taxable years

Once a prior year net Section 1231 loss is recaptured as ordinary income, it is no longer an unrecaptured loss

Any remaining net Section 1231 gain is treated as capital gain

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ExampleExample

Acme began business in 2000 and incurred the following Section 1231 net gains and losses: 2002 $100 net gain

$100 treated as capital gain 2004 $150 net loss

$150 ordinary deduction 2006 $83 net gain

$83 ordinary income (recapture of 2004 loss) 2008 $190 net gain

$67 ordinary income (recapture of 2004 loss) and $123 treated as capital gain

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Disposition by AbandonmentDisposition by Abandonment

Taxpayer may abandon worthless property by disclaiming any ownership interest in the property

Loss recognized equals adjusted basis of abandoned property

Loss is characterized as ordinary regardless of the type of asset because there is no sale or exchange

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Worthless SecuritiesWorthless Securities

The abandonment rules do no apply to worthless securities

Taxpayers are treated as selling worthless securities on the last day of the taxable year for an amount realized of zero

Loss recognized equals adjusted basis of securities

Loss is characterized as capital loss because the loss resulted from the constructive sale of a capital asset

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Exception for Securities in Affiliated CorporationException for Securities in Affiliated Corporation

A corporate parent’s recognized loss on worthless securities issued by a domestic subsidiary is ordinary if the subsidiary is an affiliated corporation

Definition of affiliated corporation

80% or more of outstanding stock is owned by corporate parent

Subsidiary derives more than 90% of annual gross receipts from the conduct of an active business

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Disposition by ForeclosureDisposition by Foreclosure

If property is foreclosed to settle a recourse debt (debtor is personally liable), the foreclosure is treated as a sale of the property for FMV

If the creditor forgives any amount of recourse debt, the debtor recognizes ordinary cancellation-of-debt income

If property is foreclosed to settle a nonrecourse debt (debtor is not personally liable), the foreclosure is treated a sale for the full amount of the debt

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Recourse Debt ExampleRecourse Debt Example

A business owned investment land with a $340,000 FMV and a $400,000 basis and subject to a $375,000 recourse mortgage. The firm defaulted on the mortgage, and the mortgage holder foreclosed on the land

The business recognizes a $60,000 capital loss on disposition of the land $340,000 FMV - $400,000 basis

If the mortgage holder forgives the $35,000 remaining debt, the business recognizes $35,000 ordinary income

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Nonrecourse Debt ExampleNonrecourse Debt Example

A business owned investment land with a $340,000 FMV and a $400,000 basis and subject to a $375,000 nonrecourse mortgage. The firm defaulted on the mortgage, and the mortgage holder foreclosed on the land

The business recognizes a $25,000 capital loss on disposition of the land $375,000 debt relief - $400,000 basis

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Disposition by Casualty or TheftDisposition by Casualty or Theft

Business assets may be disposed of because of a casualty or theft

Amount realized equals any insurance proceeds If proceeds are less than the asset’s basis, the

recognized loss is ordinary If proceeds are more than the asset’s basis,

recognition of the gain may be deferred (See Chapter 9)

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