E ate PROPERTY TRANSACTIONS: SECTION 1231 AND RECAPTURE LEARNING OBJECTIVES After studying this chapter, you should be able to D> Identify Sec. 1231 property D> Understand the tax treatment for Sec. 1231 transactions D> Apply the recapture provisions of Sec. 1245 D> Apply the recapture provisions of Sec. 1250 P> Describe other recapture applications13-2 Individual ¥ Chapter 13 CHAPTER OUTLINE Chapter 1:5 states that all recognized gains and losses must eventually be designated as History of See 1231..13-2 either capital or ordinary. However, gains or losses on certain types of property are desig- Overview of Basic Tax Treatment nated as Sec. 1231 gains or losses, which are given preferential treatment under the tax for Sec. 1231..133 law. Sec. 1231 property primarily is business property, either real or depreciable property Hee ae eet g used in a trade or business.! A net Sec. 1231 loss, defined as the excess of Sec. 1231 losses Peseta Aalbers over Sec. 1231 gains, is treated as an ordinary loss. Net Sec. 1231 gain, the excess of Sec. ‘Treatment 137 1231 gains over Sec. 1231 losses, is generally treated as long-term capital gain.’ However, Recapture Provisions of See the preferential treatment of Sec. 1231 gains is diminished, principally by the so-called pees depreciation recapture rules and the five-year lookback rule. This chapter discusses the Recoohare onmons of sec important rules dealing with Sec. 1231 gains and losses and depreciation recapture. ‘Aadtional Recaptue for Corporations.13-16 Recapture Provisions—Other ‘Applications. 13-18 Tax Planning Considerations..13-23, Compliance and Procedural CConsiderations.13-24 MONT story oF sec. 1231 During the depressed economy of the early and mid-1930s, business property was classi- fied as a capital asset. Many business properties were worth less than their adjusted basis. Instead of selling business properties, taxpayers found it advantageous to retain assets that had declined in value because they could recover the full cost as depreciation. Capital losses had only limited deductibility during this period. To encourage the mobility of cap- ital (ie., the replacement of business fixed assets), the Revenue Act of 1938 added bus ness property to the list of properties not considered to be capital assets. KEY POINT From 1938 to 1942, gains and losses on the sale or exchange of business property were Taxpayers normally prefer to have treated as ordinary gains and losses. Favorable capital gain treatment was eliminated and fans weated as aptal gains and taxpayers with appreciated business properties were reluctant to sell the assets because of Because See 1231 property the high tax cost. This restriction on the mobility of capital was more significant than ecevs he preferable ventment usual because business assets had to be shifted into industries that were more heavily for both net gains and owes. © involved in the production of military goods. Furthermore, taxpayers were often forced 0 ‘enjoysthe best of both words, recognize ordinary gains because the government used the condemnation process to “obtain business property for the war effort. In 1942, Congress created the predecessor of See. 1231, which allowed taxpayers to treat net gains from the sale of business property as capital gains and net losses as ordinary losses. Before 1987, only 40% of an individ- ual’s net capital gain might be subject to tax because of the 60% long-term capital gain deduction. ‘The Tax Reform Act of 1986 eliminated the 60% long-term capital gain deduction for net capital gains. Favorable long-term capital gain treatment was reinstated into the tax law in 1991 in the form of a 28% maximum tax rate applying to net capital gains for noncorporate taxpayers. The Taxpayer Relief Act of 1997 significantly increased the pref- erential tax treatment by reducing the maximum rate to 20% for net capital gain that is adjusted net capital gain. The maximum rate was reduced by the Jobs and Growth Tax Relief Reconciliation Act of 2003 (2003 Tax Act) to 15%, for sales after May 5, 2003. It may also be advantageous to have gains classified as capital or Sec. 1231 if taxpay- ers have capital losses or capital loss carryovers because of the limitations imposed on the deductibility of capital losses. Furthermore, there are other situations where it may be important for the property to be Sec. 1231 property (e.g.. a contribution of appreciated property to a charitable organization). # (Seepage 13-5 fora more complete definition of Sec. 1231 property) 3 Sees, 12313) anda) There are several exceptions o this role hat are 2 Secs 1231(644) and (a2) covered ae in this chapterProperty Transactions: Section 1231 and Recapture ¥ Individuals 13-3 Overview OF BASIC TAX EXAMPLE [:13-2 > EXAMPLE I: EXAMPLE 1:13-4 TYPICAL MISCONCEPTION tis sometimes erroneously thought that each Sec. 1231 gain ‘should be treated as LICG and teach See. 1231 loss as an ordinary loss. However all Se. 1231 gains {and losses must be combined to determine whether the Sec. 1231 ‘gains and losses are LTCGs and EtcLs or ordinary gains and loses. ADDITIONAL COMMENT A taxpayer's share ofa Sec. 1231 foss rom a partnership or $ Corporation may be subject to the passive activity loss ules EXAMPLE 1:13-5 > 4 Sec, 1231), S See 12311021 TREATMENT FOR SEC. 1231 NET GAINS Ac the end of the tax year, Sec. 1231 gains are netted against Sec. 1231 losses. Ifthe over- all result is a net Sec. 1231 gain, the gains and losses are treated as long-term capital gains (LTCGs) and long-term capital losses (LTCLs), respectively.* For the sake of expediency, it is often stated that a net Sec. 1231 gain is treated as a LTCG. For tax years beginning after 1984, however, a portion or all of the net Sec. 1231 gain may be treated as ordinary income because of a special five-year lookback rule (see discussion below). Dawn owns a business that has $20,000 of Sec. 1231 gains and $12,000 of Sec. 1231 losses dur- ing the current year. Because the Sec. 1231 gains exceed the Sec. 1231 losses, the gains and. losses are treated as LTCGs and LTCLs. After the gains and losses are offset, there is an $8,000, net long-term capital gain (NLTCG). < ‘Assume the same facts as in Example I:13-1 except that Dawn also recognizes a $7,000 LTCG from the sale of a capital asset. After considering the $8,000 net Sec. 1231 gain, whichis treated as a LTCG, Dawn has a $15,000 NLTCG ($8,000 + $7,000) < NET LOSSES If the netting of Sec. 1231 gains and losses at the end of the year results in a net Sec. 1231 loss, the Sec. 1231 gains and losses are treated as ordinary gains and losses.’ For expedi- ency, itis often stared that the net Sec. 1231 loss is treated as an ordinary loss. David owns an unincorporated business and has $30,000 of Sec. 1231 gains and $40,000 of Sec. 1231 losses in the current year. Because the losses exceed the gains, they are treated as ordinary losses and gains. < ‘Assume the same facts asin Example I:13-3 except that David receives a $37,000 salary asa cor- porate employee. David has no other income, losses, or deductions affecting his adjusted gross income (AGI). The Sec. 1231 gains and losses are treated as ordinary gains and losses, and David's AGI is $27,000 ($37,000 salary — $10,000 of ordinary loss). The $40,000 of ordinary losses offsets the $30,000 of ordinary gains and $10,000 of David's salary. < One important advantage of Sec. 1231 is illustrated in Example I:13-4. Because the Sec. 1231 gains and losses are treated as ordinary, the $10,000 net Sec. 1231 loss is fully deductible in the current yeat. If the gains and losses were classified as long-term capital gains and losses, David would have a $10,000 net long-term capital loss (NLTCL). Only $3,000 of the $10,000 NLTCL would have been deductible against David's other income. As explained in Chapter 1:5, only $3,000 of net capital losses may be deducted from non- capital gain income per year. FIVE-YEAR LOOKBACK RULE. Beginning in 1985, the benefits of Sec. 1231 were reduced. For tax years beginning after 1984, any net Sec. 1231 gain is ordinary gain to the extent of any nonrecaptured net Sec. 1231 losses from the previous five years.® This pro- vision is referred to as the five-year lookback rule. In essence, net Sec. 1231 losses previ- ously deducted as ordinary losses are recaptured by changing what would otherwise be a LTCG into ordinary income. In 2008, Craig recognizes $25,000 of Sec. 1231 gains and $15,000 of Sec. 1231 losses. In 2004, Craig reported $14,000 of Sec. 1231 losses and no Sec. 1231 gains. No other Sec. 1231 gains or losses were recognized by Craig during the prior five-year period, 2003-2007. The $10,000 Sec, 1231