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© 2012 Pearson Education, Inc. publishing as Prentice Hall I:13-1

Chapter I:13 Property Transactions-Section 1231 and Recapture Discussion Questions I:13-1 Gain on the sale or exchange of land held as inventory is ordinary while the gain is a Sec. 1231 gain if the land is used in a trade or business and held more than one year. If the land is used in a trade or business and held for one year or less, the gain is ordinary. If the land is held as an investment, the gain is LTCG if held more than one year. pp. I:13-5 and I:13-6. I:13-2 The gain was classified as ordinary income. In 1942, Congress created the predecessor of Sec. 1231, which allowed taxpayers to treat net gains from the sale of business property as capital gains and net losses as ordinary losses. p. I:13-2. I:13-3 Yes, $140,000 of the gain may be treated as Sec. 1231 gain if Alice elects to treat the cutting of timber as a sale or exchange. The gain is determined by comparing the timber's adjusted basis for depletion with its fair market value on the first day of the taxable year in which it is cut. The remaining gain of $10,000 is ordinary. pp. I:13-5 and I:13-6. I:13-4 Gains and losses due to the condemnation of business assets held more than one year are classified as Sec. 1231 gains and losses. Gains and losses due to casualties or thefts of business assets held more than one year are combined with gains and losses due to casualties or thefts of nonpersonal use capital assets held more than one year. If the result is a net gain, the gains and losses are treated as Sec. 1231 gains and losses. If the result is a net loss, the gains and losses are ordinary. pp. I:13-6 through I:13-8. I:13-5 Livestock held by the taxpayer for draft, breeding, dairy, or sporting purposes for more than one year is considered to be Sec. 1231 property. Cattle and horses must be held for 24 months or more. p. I:13-6. I:13-6 Net Sec. 1231 gain is treated as ordinary income to the extent of any nonrecaptured net Sec. 1231 losses for the five most recent preceding years. p. I:13-3. I:13-7 a. The $10,000 is ANCG and Carlie’s regular tax rate is more than 15%. The gain is probably from the sale of land or a depreciable asset that is sold for more than its original basis.

b. Her regular tax rate is 35% and she has at least $10,000 of unrecaptured Sec. 1231 losses, which means that the gain is taxed as ordinary income.

c. The gain is from the sale of a building and she has $10,000 Sec. 1231 gain and all of the gain is unrecaptured Sec. 1250 gain.

d. Same as (a.) except her regular tax rate is 15% or less. p. I:13-4.


I:13-8 Equipment is Sec. 1245 property and gain to the extent of total depreciation is ordinary income but limited to the amount of realized gain. Generally, the amount of depreciation is greater than the gain realized. Taxpayers must sell the equipment for more than the original basis to have any of the gain treated as Sec. 1231 gain. p. I:13-8. I:13-9 If the holding period is one year or less, the $500 loss is ordinary. If the holding period is more than one year, the loss is a Sec. 1231 loss that may offset other Sec. 1231 gains which would otherwise be granted LTCG treatment (i.e., if Sec. 1231 gains exceed Sec. 1231 losses). p. I:13-3. I:13-10 If the straight-line method is used, the amount of the gain will be smaller than if an accelerated method is used. It may be advantageous for Jackie to have smaller deductions in years one and two with a smaller gain in year three than have higher deductions in years one and two, when her tax rate is lower, with a higher gain in year three, when her tax rate is higher. Consideration should also be given to the time value of money. pp. I:13-8 and I:13-9. I:13-11 The entire realized gain of $3,721 ($3,721 - $0) is Sec. 1245 ordinary income. pp. I:13-9 and I:13-20. I:13-12 The motel must have been placed in service after 1980 and before 1987 and the ACRS statutory rates were used. p. I:13-10. I:13-13 A taxpayer may avoid having additional depreciation by using the straight-line method of depreciation or holding the property until it is fully depreciated. Additional depreciation may only result in Sec. 1250 property placed into service before 1987. This is the case because only straight-line depreciation is permitted on Sec. 1250 property after 1986. p. I:13-11. I:13-14 None of the gain is recaptured as ordinary income due to Sec. 1250 since there is no additional depreciation. Marty is not a corporate taxpayer and, therefore, Sec. 291(a) does not apply. p. I:13-11. I:13-15 The inventory and marketable securities do not qualify as Sec. 1231 property. pp. I:13-5 and I:13-6. I:13-16 An office building is subject to the depreciation recapture rules of Sec. 1245 if the building is placed in service after 1980 and before 1987 and the ACRS statutory rates are used to determine the cost recovery deductions. p. I:13-10. I:13-17 No. The building is not residential rental property. For a building to qualify as residential rental property, 80% or more of the gross rental income from the building must be rental income from dwelling units. p. I:13-13. I:13-18 Zero. Roger’s estate will not recognize any gain because the estate's basis for the apartment complex will be $2 million. p. I:13-18.


I:13-19 Rashad would never have to recognize any Sec. 1245 ordinary income as a result of selling residential rental property even if the property is placed in service after 1980 and before 1987. p. I:13-13. I:13-20 John will pay $7,500 (15% x $50,000) which is less than what Karen will pay because some or all of her Sec. 1231 gain is unrecaptured Sec. 1250 gain taxed at 25%. If all of the gain is unrecaptured Sec. 1250 gain, she pays $12,500 (25% x $50,000). If depreciation amounted to $40,000, Karen pays $11,500 [(25% x $40,000) + (15% x $10,000)]. pp. I:13-4 and I:13-12. I:13-21 A corporate taxpayer must apply the recapture rules of Sec. 291(a). If a corporate taxpayer disposes of Sec. 1250 property, 20% of the excess of the amount that would be recaptured if the property was Sec. 1245 property over the amount recaptured as ordinary income under Sec. 1250 is ordinary income. p. I:13-16. I:13-22 No. Given the same sale, the corporate taxpayer and the individual taxpayer should have the same amount of Sec. 1245 ordinary income. Sec. 291 does not trigger additional recapture for the corporation because Sec. 1250 does not apply to equipment. pp. I:13-16 and I:13-17. I:13-23 a. There is no recapture to the donor. The recapture potential carries over to the donee.

b. There is no recapture to the donor. However, the donor's charitable contribution deduction is reduced by the amount of ordinary income that would have been recognized if the property were sold.

c. Dale must recognize $40,000 of ordinary income if he disposes of the equipment in an installment sale despite the fact that Dale only receives $10,000. pp. I:13-18 through I:13-20. I:13-24 Without considering any limitations due to his adjusted gross income, his charitable contribution deduction is $325,000, the FMV ($500,000) less the amount of gain that would be ordinary income if he sells the property ($175,000). p. I:13-18. I:13-25 Ted may elect to defer $500,000 of the realized gain of $580,000 ($580,000 - $0). He must recognize $80,000 of Sec. 1245 ordinary income. The $500,000 cost of the replacement property is $80,000 less than the amount received due to the involuntary conversion. If Ted does not make the election to defer, the $580,000 gain is ordinary under Sec. 1245. p. I:13-19. I:13-26 The amounts subject to recapture include both the amounts deducted as IDC and for depletion. The amount of ordinary income due to the recapture of IDC and depletion is not more than the realized gain. p. I:13-21. I:13-27 Yes, gain resulting from the sale of the building is ordinary income under Sec. 1239 because the building is depreciable property, and William owns more than 50% of the corporation. The land is not subject to recapture under Sec. 1239 because it is not depreciable. p. I:13-22.


Issue Identification Questions I:13-28 What is the character of the gain or loss resulting from the sale of the 11 chinchillas from her breeding stock? Sec. 1231 should apply. Sec. 1231 does apply to livestock held for breeding if the holding period is 12 months or more (24 for cattle and horses), and Revenue Ruling 57-588 [1957-2 CB 305] include chinchillas as livestock.

In Cedarburg Fox Farms, Inc. [60-2 USTC 9760, 283 F2d 711] the 7th Circuit stated that culled breeding stock qualified as Sec. 1231 property.

All of the sales from the market group would result in ordinary income or loss. pp. I:13-5 and I:13-6. I:13-29 The primary tax issue for Green Acres is whether the $130,000 represents amounts received from the sale or exchange of property used in a trade or business under Sec. 1231. The facts in this question are similar to those in R.T. Watts v. U.S., 10 AFTR 2d 5832, 62-2 USTC ¶ 9778 (D.C. Ore., 1962) which held that the proceeds came under Sec. 1231. The principal issue for Stanley is whether the payments are deductible as an ordinary and necessary business expense which should be the case. p. I:13-5. I:13-30 The primary tax issue for Sarah is the character of the gain that would be recognized if she sells her business (i.e., what type of property is structure X and structure Y)? The facts in this question are similar to those in Rev. Rul. 80-151, 1980-1 C.B. 7 which held that both types of properties are Sec. 1231 properties since they both represent depreciable property used in a trade of business. Structure X is Sec. 1245 property and structure Y is Sec. 1250 property because it is a permanent structure.

Key issues considered when determining if property is tangible personal property or inherently permanent structures:

1. Is property capable of being moved and has it been moved? 2. Is property designed or constructed to remain permanently in place? 3. Do circumstances suggest that property will have to be moved? 4. How difficult is it to remove the property? 5. How much damage will the property sustain upon its removal? 6. What is the manner of affixation of the property to the land?

pp. I:13-5, I:13-9, and I:13-11. I:13-31 The key issue is whether the transfer of the automobile from business use to personal use constitutes a disposition resulting in Sec. 1245 ordinary income of $1,620 to Sylvester. The facts in this question are similar to those in Rev. Rul. 69-487, 1969-2 C.B. 165 which held that the conversion is not a disposition for purposes of Sec. 1245 but Sec. 1245 may apply to a subsequent disposition of the automobile. p. I:13-9.


Problems I:13-32

Sec. 1231 Sec. 1245

Sec. 1250

Land on which factory is located Equipment Inventory Patent Land held primarily for sale* Factory building

yes yes --- yes --- yes

--- yes --- yes --- ---

--- --- --- --- --- Yes

*Gain or loss is ordinary because the land is held for sale. pp. I:13-5, I:13-9 and I:13-11. I:13-33 AGI

a. $54,000 ($40,000 + $14,000 NLTCG) b. $28,000 ($40,000 - $ 12,000 ordinary loss) c. $37,300 ($40,000 + $ 6,300 NLTCG - $9,000 ordinary loss) d. $30,000 ($40,000 - $ 3,000 LTCL - $7,000 ordinary loss)

p. I:13-3. I:13-34 a. $450 ($3,000 x 15%). The net Sec. 1231 gain of $3,000 is taxed at 15%.

b. Decrease by $2,950 ($5,950 - $3,000). The net Sec. 1231 gain of $20,000 is taxed at 15%, resulting in tax of $3,000. The $17,000 loss is ordinary and her tax is reduced by $5,950 (35% x $17,000). pp. I:13-3 and I:13-4. I:13-35 a. Sec. 1231 does not apply to personal use assets

b. Sec. 1231 gain c. Sec. 1231 loss d. All of the $4,000 gain is Sec. 1245 ordinary income.

pp. I:13-5, I:13-6 and I:13-8. I:13-36 a. $67,000 ($70,000 - $3,000)

b. $58,000 ($70,000 - $12,000) If the $12,000 realized loss ($23,000 - $35,000) is a capital loss, only $3,000 of the loss may be deducted in the current year, and $9,000 of the loss is carried forward for an indefinite period. If the $12,000 realized loss is a Sec. 1231 loss and there are no Sec. 1231 gains, the $12,000 loss is an ordinary loss and is deductible. Vicki is assumed to be in an active trade or business and the passive loss limitations do not apply. p. I:13-3.


I:13-37 a. $80,000. The gain is a Sec. 1231 gain that is classified as a LTCG since the corporation does not have any Sec. 1231 losses.

b. Zero. The capital loss carryforward may be used only to offset capital gain income. pp. I:13-3, I:13-7 and I:13-8. I:13-38 a. $110,000. Because the $50,000 gain due to the casualty exceeds casualty losses (zero), the $50,000 gain is combined with the $60,000 Sec. 1231 gain and Sean has net capital gain of $110,000.

b. Zero. As in case a, the $50,000 gain is combined with other Sec. 1231 gains and losses. Because the $60,000 Sec. 1231 loss exceeds the Sec. 1231 gain of $50,000, Sean does not have net capital gain. He may deduct $10,000 as ordinary loss.

c. Zero. The $50,000 casualty gain is combined with the $200,000 casualty loss. Because the net amount is a loss, the gain and loss are not treated as Sec. 1231. Sean has net capital gain of zero. He has an ordinary loss of $150,000 ($200,000 - $50,000). pp. I:13-6 and I:13-7. I:13-39 2006 $2,000 NLTCG

2007 Zero - $4,000 ordinary loss 2008 Zero - $7,000 ordinary loss 2009 Zero - The $5,000 net Sec. 1231 gain is ordinary income since there is $11,000 of

nonrecaptured net Sec. 1231 losses at the beginning of the year. The nonrecaptured net Sec. 1231 losses at the end of the year are $6,000.

2010 $5,800 NLTCG and $6,000 of ordinary income 2011 Zero - $7,000 ordinary loss. pp. I:13-3, I:13-7 and I:13-8.

I:13-40 $15,150 ($13,200 + $1,950). $40,000 of the gain from the sale is ordinary income due to the five-year look back rule; thus $40,000 is taxed at 33%. The remaining gain of $13,000 is taxed at 15%. pp. I:13-3, I:13-7 and I:13-8. I:13-41

Case

Gain (Loss) Ordinary

Sec. 1231

a b c

$107,000 452,000 ( 55,000)

$107,000 350,000 ---

--- $ 102,000 ( 55,000)

pp. I:13-8 and I:13-9. I:13-42 a. $230,000. The maximum selling price that Elizabeth could sell the equipment for without having to recognize Sec. 1245 ordinary income is $230,000, the adjusted basis. Any gain due to depreciation is Sec. 1245 ordinary income.

b. $291,000. The first $270,000 of gain resulting from the sale of the equipment is Sec. 1245 ordinary income. If she sells the property and has a $61,000 gain, the gain is Sec. 1245 ordinary income. If SP - $230,000 = $61,000, then the selling price is $291,000. pp. I:13-8 and I:13-9.


I:13-43 a. Depreciation of $403 ($4,200 x 0.1920 x 0.5) is allowed in 2011. The 50% results from the half-year convention.

b. Business Portion

of Truck Personal Use Portion

Amount realized Minus: Adjusted basis Realized gain (loss)

$2,100* (1,613)**

$ 487

$ 900 ( 1,800) ($ 900)

* (0.70 x $3,000) ** ($4,200 - $2,587)

The $487 gain is ordinary income under Sec. 1245. The $900 loss is a capital loss, but is not deductible since that portion of the truck is a personal use asset. pp. I:13-8 and I:13-9. I:13-44 a. Realized gain is $28,000 ($72,000 - $44,000).

b. Recognized gain is $28,000 since the boot received is more than the realized gain. c. $26,000 of the gain is Sec. 1245 ordinary income. d. $2,000 of the gain is Sec. 1231. e. Basis of the marketable securities is $30,000 f. Basis of equipment received is $42,000 ($44,000 - $30,000 + $28,000). p I:13-19.

I:13-45 a. $6,000. ($40,000 - $34,000).

b. Zero. The exchange is a like-kind exchange. c. $34,000. d. $20,000. ($41,000 - $21,000) of Sec. 1245 ordinary income. e. The gain is $31,000. ($52,000 - $21,000). $29,000 of Sec. 1245 ordinary income and

$2,000 of Sec. 1231 gain. p. I:13-19. I:13-46 a. $58,000 ($110,000 - $52,000) b. $58,000 Sec. 1245 does not affect the amount of gain. Sec. 1245 affects the

character of the gain. c. $11,600 ($20,300 - $8,700) (35% times the Sec. 1245 ordinary income of $58,000)

– (15% times the LTCG due to Sec. 1231) p. I:13-9. I:13-47 a. $610,000 ($720,000 - $110,000)

b. $130,000 ($690,000 - $560,000) is Sec. 1250 ordinary income and $480,000 is Sec. 1231 gain. The $480,000 gain is unrecaptured Sec. 1250 gain taxed at the rate of 25%.

c. $80,000 ($180,000 - $100,000) Sec. 1231 gain


I:13-48 a. $610,000 b. $226,000 of Sec. 1250 ordinary income and $384,000 of Sec. 1231 gain. More ordinary income must be recognized in (b) since Sec. 291(a) must be considered. Total Sec. 1250 ordinary income is $130,000; Sec. 291 ordinary income is $96,000 {0.20 x ($610,000 - $130,000)} and Sec. 1231 gain is $384,000. For corporations, none of the gain is unrecaptured Sec. 1250 gain. pp. I:13-12 through I:13-14 and I:13-16 and I:13-17. c. $80,000 I:13-49 a. $3,960 increase. $12,000 ($40,000 - $28,000) Sec. 1245 ordinary income is taxed at his 33% marginal tax rate.

b. $4,650 increase. $19,000 ($80,000 - $61,000) Sec. 1231 gain but $10,000 is ordinary because of the nonrecaptured net Sec. 1231 losses ($10,000 x 33%) + ($9,000 x 15%).

c. $6,550 increase. $10,000 of the Sec. 1231 gain of $23,000 ($163,000 - $140,000) is ordinary taxed at 33% and $13,000 is unrecaptured Sec. 1250 gain taxed at 25% ($13,000 x 25%).

d. $4,290 decrease ($13,000 x 33%) . Sec. 1231 loss of $13,000 ($127,000 - $140,000). I:13-50 a. $307,145. $250,000 expensed under Sec. 179 and $50,000 of bonus depreciation ($250,000 + $50,000 + .1429 x $50,000) b. $6,123 (24.49% x $50,000 x 1/2)

c. $113,268 Sec 1245 ordinary income. ($150,000 - $36,732)

I:13-51 a. $62,730 (3.485% x $1,800,000) Property is residential rental property. b. $51,813 (3.636% x $1,800,000 x 9.5/12) c. No, because no depreciation recapture is required for property that is depreciated

using the straight-line method if the taxpayer is a noncorporate taxpayer. d. $629,991 Sec. 1231 gain ($2,250,000 - $1,620,009 = $629,991). The basis of

$1,620,009 is computed as follows: Cost $1,800,000 Depreciation: 2009 62,730 2010 65,448 2011 51,813 ( 179,991) $1,620,009

e. $50,000 Sec. 1231 gain ($250,000 - $200,000) f. Yes, $179,991, the gain due to depreciation allowed for the building, which is

unrecaptured Sec. 1250 gain.


I:13-52 a. Building-90% Land-10% Amount realized Minus: Adjusted basis Realized gain Ordinary income Sec. 1231 gain

$112,500 ( -0-)* $112,500 -0-** $112,500

$12,500 (10,000) $ 2,500 2,500

* $90,000 - $90,000. ** $90,000 - $90,000.

b. Jesse must recognize $90,000 of Sec. 1245 ordinary income and $22,500 of Sec. 1231 gain due to the sale of the building. The $2,500 gain on the sale of land is Sec. 1231 gain. pp. I:13-11 through I:13-14 and I:13-19.

I:13-53 a. $227,000. The maximum selling price that Rosemary could sell the building for without having to recognize Sec. 1250 ordinary income is $227,000, the adjusted basis.

b. $278,000. The first $73,000 (i.e., the additional depreciation) of gain resulting from the sale of the building would be Sec. 1250 ordinary income. If SP - $227,000 = $51,000, then the selling price is $278,000. pp. I:13-13 and I:13-14.

I:13-54 1. T. Gain to the extent of excess depreciation, the excess of accelerated over straight-line depreciation, is Sec. 1250 ordinary income. The statement would be false if the building is fully depreciated because there is no additional depreciation and none of the gain is ordinary.

2. T. Gain due to depreciation, but not excess depreciation, is unrecaptured Sec. 1250 income taxed at 25%.

3. T. If accelerated cost recovery is used, building #2 is Sec. 1245 property. 4. T. If straight-line method is used, building #2 is Sec. 1231 property. 5. T. If accelerated cost recovery is used and the building is sold for more than its original

basis, gain due to depreciation is Sec. 1245 ordinary income and the remaining gain is Sec. 1231 gain.

6. T. Gain due to depreciation, but not excess depreciation, is unrecaptured Sec. 1250 income taxed at 25%. Because the straight-line method of depreciation was used, all of the gain due to depreciation is taxed at 25%.

7. F. A building is Sec. 1245 property only if placed in service during the period from January 1, 1981 to December 31, 1986 and accelerated cost recovery is allowed. 8. T. Gain due to depreciation, but not excess depreciation, is unrecaptured Sec. 1250

income taxed at 25%. Because the building was placed in service after 1986, the straight-line method of depreciation must be used, and there is no excess depreciation for building #3.

9. F. Because the straight-line method of depreciation must be used, there is no excess depreciation and thus no Sec. 1250 ordinary income.

10. F. $30,000 might be ordinary income due to the five-year-lookback rule, but not $40,000.


I:13-55 1. T. Gain to the extent of excess depreciation, the excess of accelerated over straight-line depreciation is Sec. 1250 ordinary income.

2. F. Corporate taxpayers do not have unrecaptured Sec. 1250 gain taxed at 25%. 3. T. If accelerated cost recovery is used, building #2 is Sec. 1245 property. 4. T. If straight-line method is used, building #2 is Sec. 1231 property. Some of the gain

is Sec. 1250 gain, not more than 20% of depreciation, but most of the gain is Sec. 1231

gain. 5. T. If accelerated cost recovery is used and the building is sold for more than its original basis, gain due to depreciation is Sec. 1245 ordinary income and the remaining gain is Sec. 1231 gain. 6. F. Corporate taxpayers do not have unrecaptured Sec. 1250 gain taxed at 25%. 7. F. A building is Sec. 1245 property only if placed in service during the period from

January 1, 1981, to December 31, 1986, and accelerated cost recovery is allowed. 8. F. Corporate taxpayers do not have unrecaptured Sec. 1250 gain taxed at 25%. 9. T. 20% (gain that would be ordinary income if building was Sec. 1245 less gain that is

Sec. 1250 ordinary income) is additional Sec. 1250 ordinary income for corporate taxpayers.

10. F. $30,000 might be ordinary income due to the five-year-lookback rule and $8,000 is Sec. 1250 ordinary income [20% ($40,000 – 0)] but all $40,000 would not be ordinary income.

I:13-56 a.

Building SP $4,050,000

AB Original cost Accumulated depreciation

$2,700,000 1,000,000 _1,700,000

Sec. 1231 Gain $2,350,000 b.

Land SP $450,000 AB 300,000 Sec. 1231 Gain $150,000

c. $1,000,000. All of the gain to the extent of depreciation taken. d. Reduce gain taxed at 25%, capital losses reduce gains at the highest tax rates first.


I:13-57 a.

b.

c. zero. The 25% rate does not apply to corporations I:13-58 a. $13,200 ($40,000 x 33%) b. $40,000 cash received due to the sale ( 4,500) cash needed for taxes on $30,000 Sec. 1231 gain at 15% (35,500) cash contributed to the university 11,715 tax savings due to the contribution (33% x $35,500) Raquel would be $1,485 better off as a result of donating the stock instead of selling the stock and donating the cash. Further, the university would only receive $35,500 as compared to $40,000 in Part a. Bottom line: taxes play a significant role in structuring transactions. Note to Instructor: By reducing Raquel’s AGI, the difference in the two alternatives could be reduced. With an AGI of $100,000, she could deduct only $30,000 with a $10,000 carryforward. If she donates cash, she could deduct the entire $35,500.

SP $4,050,000 AB 1,700,000 Gain $2,350,000 Ordinary – Sec. 1250 200,000 20% ($1,000,000 – 0)Sec. 1231 G $2,150,000

SP $450,000 AB - 300,000 Sec. 1231 G $150,000


I:13-59 Sec. 1231

Gain (Loss) Ordinary Income

Taxed at 33%

Taxed at 25%

Taxed at 15%

Building purchased in 1995 for $220,000 with adjusted basis of $165,000 $35,000

$35,000

Equipment purchased in 2007 for $300,000 with adjusted basis of $144,000 $56,000 $56,000 Land purchased in 1990 for $30,000 to use as a building site $170,000 $170,000 Building purchased in 1994 for $150,000 with adjusted basis of $112,000 $88,000 $38,000 $50,000 Equipment purchased in 2008 for $180,000 with adjusted basis of $140,000 $20,000 $40,000 $40,000 $20,000 I:13-60 a. The recognized gain is $225,000 ($825,000 - $600,000), and $40,000 (0.40 x $100,000) is ordinary income. The remaining $185,000 is Sec. 1231 gain.

b. The recognized gain is $15,000 and all of the gain is ordinary income since it is less than the amount of soil and water conservation expenditures recaptured. pp. I:13-20 and I:13-21.

I:13-61 The recognized gain is $100,000 ($900,000 - $800,000) and all of the gain is ordinary income since the gain is less than the amount of IDC ($300,000) subject to recapture. p. I:13-21. I:13-62 a. The realized gain is $250,000 ($950,000 - $700,000) and all the gain is ordinary income under Sec. 1254. All gain to the extent of depletion ($200,000) and IDC that was expensed ($170,000) is recaptured as ordinary income.

b. Jack must sell the property for more than $1,070,000 ($700,000 + $370,000) before he has a Sec. 1231 gain since the first $370,000 ($200,000 depletion + $170,000 IDC that was expensed) is ordinary income. p. I:13-21. I:13-63 a. The $330,000 gain ($500,000 - $170,000) due to the sale of the building is ordinary income since Ed and the Crane Corporation are related parties and the building is depreciable property.

b. The $135,000 gain ($200,000 - $65,000) due to the sale of the land is a Sec 1231 gain. p. I:13-22.


Comprehensive Problem I:13-64 a. $160,000. Sale of the racehorse results in Sec. 1245 ordinary income.

b. Zero. c. No. The pony is a personal-use asset. d. $565,000. The net Sec. 1231 gain exists because of four transactions:

$200,000 casualty gain - building 35,000 condemnation of land 350,000 sale of racehorse for more than original cost ( 20,000) loss on exchange of equipment

e. Yes. The casualty gain is netted against casualty losses of Sec. 1231 property and non-personal use capital assets held more than one year. Since there are no such losses, the $200,000 gain is combined with Sec. 1231 gains and losses. After all Sec. 1231 gains and losses are netted, a net Sec. 1231 gain of $565,000 ($585,000 - $20,000) exists, thus all Sec. 1231 gains and losses are treated as LTCG and LTCL.

f. $130,000. The unrecaptured Sec. 1250 gain is taxed at 25%. If Sec. 1250 provided for the recapture of all depreciation instead of just additional depreciation, $130,000 of the gain resulting from the involuntary conversion would have been ordinary income. pp. I:13-6 through I:13-12. Tax Strategy Problems I:13-65 a. The $20,000 Sec. 1231 loss in 2011 is an ordinary loss in 2011, and the $20,000 Sec. 1231 gain in 2012 is ordinary income. Since the Sec. 1231 gain is ordinary income because of the nonrecaptured net Sec. 1231 losses at the beginning of 2012, there is no difference in total taxes paid for the two years.

b. The Sec. 1231 gain recognized in 2011 is a LTCG, and the $20,000 Sec. 1231 loss recognized in 2012 is an ordinary loss. This alternative may be preferable because the NLTCG is taxed at a lower rate than the ordinary income. The net capital gain of $20,000 in 2011 is taxed at a maximum rate of 15%, or 25% if the 1231 gain is unrecaptured Sec. 1250 gain, although the time value of money should be considered. p. I:13-3. I:13-66 Holly's 2011 taxes do not increase if she recognizes the $5,000 Sec. 1231 gain in 2011. The Sec. 1231 gain is a LTCG that is offset by her $9,000 STCL. $3,000 of the STCL reduces gross income, and she has a $1,000 STCL carryforward. If she does not recognize the $5,000 Sec. 1231 gain in 2011, $3,000 of the STCL reduces gross income, and she has a $6,000 STCL carryforward. p. I:13-3.


Tax Form/Return Preparation Problems I:13-67 (See Instructor’s Resource Manual) I:13-68 (See Instructor’s Resource Manual) Case Study Problems I:13-69 a. Kent prefers Sec. 1231 gain instead of ordinary income. The first $450,000 of gain due to the sale of the equipment is ordinary income, but gain on the sale of land is Sec. 1231 gain possibly taxed at 15%. He wants to allocate more of the sales price to land instead of equipment. All gain due to sale of inventory is ordinary income. The gain due to the sale of the building is Sec. 1231 gain. The first $406,000 of Sec. 1231 gain resulting from sale of the building is unrecaptured Sec. 1250 gain taxed at a maximum rate of 25%. Any Sec. 1231 gain in excess of $406,000 may be taxed at 15%. b. Although the presence of capital losses usually makes taxpayers want to recognize

capital gain instead of ordinary income, the presence of the preferential tax rates as described above already creates a strong preference for Sec. 1231 gains. The presence of capital losses may make his preference for Sec. 1231 gains even stronger because he will be able to use the capital losses to offset capital gain. The use of capital losses to offset ordinary income is restricted to $3,000 per year. To illustrate the different results, assume the following two allocations:

Allocation of Sales Price

Ordinary Income

Sec. 1231 Gain

Equipment Building Land Inventory

$ 250,000 500,000 140,000 110,000

$1,000,000

$100,000 0 0 60,000 $160,000

0 $ 6,000 40,000 0 $46,000

Allocation of Sales Price

Ordinary Income

Sec. 1231 Gain

Equipment Building Land Inventory

$ 225,000 525,000 151,000 99,000

$1,000,00

$75,000 0 0 49,000 $124,000

0 $31,000 51,000 0 $82,000


Note, in the second allocation, 10% of the amount allocated to equipment was allocated to the building and 10% of the amount allocated to inventory was allocated to the land. With the first allocation, Kent has $160,000 of ordinary income and $46,000 of Sec. 1231 gain with $6,000 taxed at 25% and $40,000 taxed at 15%. With the second allocation, he has $36,000 less ordinary income and more Sec. 1231 gain taxed at 15%.

c. Tom will prefer to have greater amounts of the purchase price allocated to

depreciable property as opposed to allocating to the land which is not depreciable. The building will have a longer recovery period than the equipment, thus he will prefer to allocate more of the purchase price to the equipment than to the building. Since the inventory is likely to be sold soon and deducted as cost of goods sold, he will prefer to have a large amount allocated to the inventory.

d. There is probably a good business reason for having Kent sign a covenant not to compete, since Tom does not want Kent to build a new bowling alley and compete with him. Amounts allocated to a covenant not to compete may be amortized by Tom. Amounts received as payment for a covenant not to compete constitute ordinary income for Kent. If the FMV of the tangible assets is less than $1 million, an allocation to intangible assets must be considered. There is some indication that the business does have goodwill (i.e., loyal group of customers). Prior to the Revenue Reconciliation Act of 1993, amortization of goodwill was not allowed for taxes. If goodwill was not amortizable, Tom would prefer to allocate amounts to amortizable intangibles such as a covenant not to compete. For Kent, amounts received for goodwill represent capital gain thus he prefers an allocation to goodwill. Since the transaction occurs after August 10, 1993, both goodwill and the covenant not to compete are Section 197 intangibles and are amortizable over 15 years.

e. Since the taxpayers may have conflicting positions, especially in the case where Kent has a preference for Sec. 1231 gain instead of ordinary income, it may be difficult to advise both individuals at the same time. At a minimum, you should make Kent and Tom aware of the potentially conflicting objectives. For allocation rules for certain asset acquisitions, see Secs. 1060 and 338(b)(5). I:13-70 The allocation of the purchase price should be the same for the buyer and the seller. Sec. 1060 specifies that any written agreement as to the allocation or the FMV of the assets is binding on both parties unless the Secretary determines that such allocation or FMV is not appropriate.

Mr. Earl’s tax liability will probably increase by $8,000 ($14,000 - $6,000) because the ordinary income is taxed at 35% while the $40,000 gain on the sale of the land is probably taxed at 15%. However, he may be willing to agree to the reallocation to make the sale.

Before complying with Mr. Quick's request to make the reallocation, the accountant should have substantive evidence to indicate that the appraisal is not correct and the FMV of the inventory and the land are $150,000 and $100,000, respectively. If the accountant complies without the existence of such evidence, Mr. Quick may request additional reallocations.

The accountant should review Sec. 6662 pertaining to accuracy-related penalties, although it would not appear that the reallocation as Tom requests is a substantial valuation misstatement.


The accountant should recall that buyers and sellers of businesses must file Form 8594 with their tax return to summarize the purchase price allocation if the seller enters into an employment contract, covenant not to compete, royalty or lease arrangement or other such agreement with the buyer. [Sec. 1060(e)] Since the seller does not appear to be entering any such arrangement, Form 8594 would not have to be filed.

Tax Research Problem I:13-71 The automobiles provided by the Berkeley Corporation for the use of the head basketball coach for short periods of time are not likely to qualify as Sec. 1231 property. The automobiles are held primarily for sale to customers in Berkeley's trade or business. Rev. Rul. 75-538 [1975-2 C.B. 34] states: "A taxpayer engaged in the trade or business of selling motor vehicles is presumed to hold all such vehicles primarily for sale to customers in the ordinary course of the taxpayer's trade or business. To overcome this presumption, it must be clearly shown that the motor vehicle was actually devoted to use in the business of the dealer and that the dealer looks to consumption through use of the vehicle in the ordinary course of business operation to recover the dealer's cost. A vehicle is not property used in the business if it is merely used for demonstration purposes, or temporarily withdrawn from stock-in-trade or inventory for business use." Rev. Rul. 89-25, 1989-1 C.B. 79 refers to Rev. Rul. 75-538 in ruling that a builder's new houses temporarily used as models and/or sales offices are not subject to depreciation. The new houses temporarily used as models or sales offices are not Sec. 1231 properties.

Pope Phft2012 Ind Sm 13

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