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Chapter 8: Property Transactions Capital Gains and Losses, Sec. 1231 and Recapture Provisions Learning Objectives: • • • • • •

updated: January 2, 2007

Understand how the type of property, the type of disposal, and the holding period effect the character of gains and losses. Distinguish capital assets from ordinary assets, and understand the netting process for capital assets. Distinguish Sec. 1231 assets from ordinary assets, and compute the net Sec. 1231 gain or loss. Determine when Sec. 1245 recapture provisions apply and derive their effects. Determine when Sec. 1250 recapture provisions apply and derive their effects. Understand the additional recapture for corporations (Sec. 291).

I. The Character of Gains & Losses (it depends on…) A. Why does the character of the gain or loss matter? 1. capital gains may be taxed at a lower rate (15% or 5%); while ordinary income is taxed at the taxpayer’s marginal tax rate 2. a net capital loss • • is only deductible up to $3,000 per year by individuals can only be used to offset capital gains of corporations

while ordinary losses are (usually) fully deductible

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B. Proper classification depends on three characteristics: 1. the type of property – is it… • • • a capital asset? Sec. 1231 property (business property)? ordinary income property?

2. the type of disposal – is it… • • a sale or exchange? a transaction that is treated “as if it were a sale or exchange”? (e.g., worthless security, retirement of corporate obligations, etc.) a transaction that is NOT treated “as if it were a sale or exchange”; all other disposals – casualty & theft, and condemnations are generally

3. the holding period of the property – is it… • • short term (held for one year or less)? long term (held for more than 1 year)?

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II. Property Transactions – Capital Gains and Losses A. Definition of a capital asset (Sec. 1221) – ANY property help by the taxpayer that is NOT: 1. inventory or property held for sale to customers in a trade or business 2. accounts & notes receivables acquired from the sale of inventory or the performance of services in a trade or business 3. depreciable property & real property used a trade or business (Sec. 1231 property) 4. creative works (art, music, copyrights & letters) created through taxpayer’s efforts 5. most U.S. government documents & publications Note: The classification of an asset is often determined by its purpose and use, or by statute (& statutory expansions). Subject of much controversy. B. Thus, capital assets are: 1. assets held for investment (e.g., stocks, bonds, land) 2. personal use assets (e.g., residence, car, truck, boat, motorcycle) 3. miscellaneous assets designated by Congress (e.g. patents)

C. Capital gains/losses must be separated into two groups 1. long-term group – capital assets held for more than one year • • long-term capital gains (LTCG) long-term capital losses (LTCL)

2. short-term group – capital assets held for one year or less • • short-term capital gains (STCG) short-term capital losses (STCL)

Note: Holding period starts on the day after the property is acquired and includes the day of disposal.

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D. Simplified netting process (a two-step process): Step 1 – net gains and losses within each group • short-term gains vs. short-term losses • long-term gains vs. long-term losses Step 2 – net across the two groups – short vs. long (if opposite signs)

Gain Short-term

Loss

Long-term

Note: There is some additional netting (complexity) in the long-term group (see Section “G” on page 8-7). In the end, net long-term capital gains are eligible for one or more of four alternative tax rates: 5%, 15%, 25%, and 28% • • • • • the 25% rate applies to unrecaptured Sec. 250 gain and is related to gain from disposition of buildings the 28% rate applies (primarily) to “collectibles” and Sec. 1202 “small business” stock the 5/15% rates apply to any remaining net long-term capital gain (called “regular” LTCG’s) netting between long-term “buckets” is done based on what is most favorable to the taxpayer if the net gain is in more than one long-term “bucket”, any STCL is netted against highest rate “bucket” first.

Note: The 2003 Tax Act lowered the tax rate on long-term capital gains for individuals in the top four tax brackets to 15%, and to 5% for taxpayers in the lowest two tax brackets (the rate drops to 0% for tax years beginning after 2007 for taxpayers in the lowest two tax brackets). The lower tax rates apply to most “qualified” dividends received. The TIPRA of 2005 (signed into law on May 17, 2006) extend the reduced rates to 2010 (they were set to expire in 2008).

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E. For noncorporate taxpayers, possible outcomes include . . . 1. Net STCG – the gain is taxed as ordinary income (all tax rates apply)

2. Net LTCG – the gain is usually taxed at a maximum 15% tax rate [5% for taxpayers in the 10% & 15% tax brackets]

3. Net STCL a. the loss reduces ordinary income b. the deduction is limited to $3,000 per year c. the unused portion is carried forward indefinitely (retains character – short term)

4. Net LTCL a. the loss reduces ordinary income b. the deduction is limited to $3,000 per year c. the unused portion is carried forward indefinitely (retains character – long term)

5. Both are losses – Net LTCL and Net STCL a. the loss reduces ordinary income b. the STCL must be used first, then the LTCL c. the maximum capital loss = $3,000 per year (combined from both types) d. the unused portions are carried forward (both retain character)

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F. Differential tax treatment for corporate taxpayers 1. maximum corporate tax rate = 35%

2. maximum corporate capital gain tax rate = 35% – so provides little tax benefit

3. capital losses only offset capital gains (not available to offset ordinary income)

4. three-year carryback and five-year carryforward period

5. carrybacks and carryforwards are always treated as short-term (regardless of original nature)

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G. Complicating factors – the 25 and 28-percent groups 1. 25% group – unrecaptured Sec. 1250 gain – depreciable real property (see Section V on page 8-12) 2. 28% group – collectibles (art, antiques, coins, stamps etc.) and Sec. 1202 “small business” stock Gain 28% property Loss

unrecaptured Sec. 1250 property

“regular” (15/5%) long-term property

3. more on the netting process – designed to help taxpayers (note: in general losses are first netted against highest tax rate gains) Step 1 – group all gains and losses by group (short-term, unrecaptured Sec. 1250 property, 28% property, and regular long-term) Step 2 – net gains and losses within each group • short-term gains vs. short-term losses • unrecaptured Sec. 1250 gain • 28% property gains vs. 28% property losses • regular long-term gains vs. regular long-term losses Step 3 – combine (if same sign) or offset (if opposite signs) the • • 28% property group and any unrecaptured Sec. 1250 gains

then combine (if same sign) or offset (if opposite signs) the • • amount from step 3 above and the regular 15/5% long-term property

Step 4 – offset (if opposite signs) the • • amount from Step 3 (above) and the short-tern capital gain or loss

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III. Tax Treatment: Sec. 1231 Property (fixed assets) A. Sec. 1231 property defined: 1. depreciable property (machinery, equipment, cars, trucks, office furniture etc.) 2. real property (warehouse, factory, building, apartment, land, etc.) 2. that is used in a trade or business 3. that is held for more than one year (long term)

Note: Compare with Sec. 1221, which defined properties that are NOT capital assets: • inventory bought/sold in a business • depreciable property, or real property used in a business • accounts and notes receivable acquired in a business • copyrights, literary, musical and artistic compositions • US government publications

4. Sec. 1231 also includes • • • • business casualty & thefts condemnations timber, coal, iron ore, livestock & unharvested crops, some purchased intangibles that are eligible for amortization

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B. Type of disposal & the netting process 1. sale or exchange a. if held for more than 1 year & used in a trade or business b. then gains and losses are classified as Sec. 1231 gains and losses 2. involuntary conversion – due to seizure, condemnation a. if held for more than 1 year & used in a trade or business b. then gains and losses are classified as Sec. 1231 gains and losses 3. “other” involuntary conversion – casualty and thefts a. tax treatment • if losses > gains – both are classified as ordinary gains and losses • if gains > losses – both are classified as Sec. 1231 gains and losses

Note: Sec. 1231 deals with the character of recognized gains & losses, and since taxpayers may elect to defer gains from “involuntary conversions” (i.e., the recognized gain = 0), Sec. 1231 may not apply to some involuntary conversions. Note: Amount of gain recaptured under Secs. 1245, 1250, and 291 is determined first. Any remaining gain is considered Sec. 1231 gain.

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C. The NETTING process – the Sec. 1231 “bucket” 1. if Sec. 1231 gains < Sec. 1231 losses, then a. net Sec. 1231 loss is treated as an ordinary loss

b. fully deductible for AGI

c. not subject to the $3,000 limitation

2. if Sec. 1231 gains > Sec. 1231 losses a. net Sec. 1231 gain is treated preliminarily as a long-term capital gain

b. however, some, or all, of the Sec. 1231 long-term gain may be recaptured as ordinary income under the “5-year lookback rule” – nonrecaptured net Sec. 1231 losses (that were treated as a fully deductible ordinary losses) from the previous 5 years are treated as ordinary income

Note: The Sec. 1245 and Sec. 1250 recapture rules are applied first, without considering the other Sec. 1231 transactions that occurred during the year. Sec. 1245 and Sec. 1250 reclassifies some, or all, of the gain as ordinary income before the netting process of Sec. 1231 begins.

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IV. The Sec. 1245 Recapture Rules A. Sec. 1245 property defined: 1. depreciable personal property (e.g., machinery, equipment) 2. some intangibles subject to amortization under Sec. 197 (e.g. goodwill, patents) 3. professional player contracts (NFL, NBA, MLB, NHL) 4. some very limited and narrowly defined real property (most real property is Sec. 1250 property) B. tax treatment (full recapture) 1. gain is treated as ordinary income to the extent of depreciation/cost recovery taken (includes any Sec. 179 expensing election & bonus depreciation) 2. when gain on the disposition of a Sec. 1245 asset is less than the total amount of accumulated depreciation – the total gain will be treated as depreciation recapture (i.e. ordinary income) 3. when the gain on the disposition of a Sec. 1245 asset is greater than the total amount of accumulated depreciation – total accumulated depreciation will be recaptured (as ordinary income), and the gain in excess of depreciation recapture will be Sec. 1231 gain (and go in the bucket) 4. recapture only affects the character of the gain, not the amount of the recognized gain 5. method of depreciation does NOT matter 6. Sec. 1245 does not apply to losses C. purpose – since depreciation is an “ordinary” deduction taxpayer must recognize “ordinary” income on disposal

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V. The Sec. 1250 Recapture Rules A. Sec. 1250 property defined: 1. depreciable real property (other than the limited amounts specifically identified as Sec. 1245 property)

B. tax treatment (partial recapture) 1. gain is treated as ordinary income to the extent of the EXCESS depreciation/cost recovery taken

2. excess depreciation is the amount of a. accelerated depreciation taken (MACRS or ACRS) over b. the straight-line depreciation that would have been deductible 3. does not apply to real property acquired after 1986 (since MACRS real property rates are based on a straight-line method; excess depreciation = 0)

4. only affects the character of the gain, not the amount of the gain recognized

5. does not apply to losses

6. often leads to “unrecaptured Sec. 1250 gain” a. any gain not recaptured under Sec. 1250 (= depreciation other than excess depreciation) b. is a LTCG to be included in the 25% group Note: A disposal may result in Sec. 1250 recapture, unrecaptured Sec. 1250 gain and Sec. 1231 gain C. purpose – since depreciation is an “ordinary” deduction taxpayer must recognize “ordinary” income on disposal

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VI. Additional Recapture Rules for Corporations – Sec. 291 A. While Sec. 1245 & Sec. 1250 recapture applies to all taxpayers, Sec. 291 recapture applies only to corporations

B. Sec. 291 applies to the sale of real estate (Sec. 1250 property)

C. the amount of Sec. 291 recapture = 20% of the difference between: • the amount that would have been recaptured as ordinary income under Sec. 1245 (up to 100% of the depreciation) – the lesser of the recognized gain or the depreciation taken on the asset the amount recaptured under Sec. 1250 (more often this = $0)

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