Chapter 9: Transactions in Property

How does a taxpayer calculate gain or loss on a property transaction?

Creative, Inc., a scrapbooking retail chain, owns a warehouse which is subject to a $50,000
mortgage. A manufacturing company offers to purchase the warehouse for $15,000 cash and a
$30,000 note receivable, as well as assume the mortgage. If Creative accepts this offer, and pays
$1,500 in selling expenses, what is the amount realized?

Define tax basis; is tax basis the same as adjusted basis?

 In order to determine how a recognized gain or loss affects a taxpayer’s income tax liability,
the taxpayer must determine the character or type of gain or loss recognized
o Ultimately, each gain or loss will be characterized as either ordinary or capital
o Ordinary income is generally taxable at ordinary rates, and ordinary losses are
generally fully deductible against ordinary income
o For individual taxpayers, long-term capital gains are taxed at preferred tax rates (0%,
15%, 20%, depending on the taxpayer’s taxable income), and capital losses can only
offset capital gains, although individuals can use $3,000 of a net capital loss to offset
ordinary income

There are three main classifications of assets:

 Capital Assets

 Ordinary Assets

 Section 1231 Assets

 An asset that is used in the taxpayer’s trade or business, is subject to
depreciation, and has been held by the taxpayer for more than one year
 Land used in a trade or business can be a Section 1231 asset even though land
is not subject to depreciation
 Business assets held for one year or less are ordinary assets, generating
ordinary income
 When a taxpayer sells a Section 1231 asset, the taxpayer recognizes a Section
1231 gain or loss, BUT, ultimately, Section 1231 gains and losses will be
characterized as ordinary or capital
 If the taxpayer recognizes a net Section 1231 gain, the net gain is
treated as a long-term capital gain
 If the taxpayer recognizes a net Section 1231 loss, the net loss is
treated as an ordinary loss
Chapter 21: Special Issues in Property Transactions
The tax treatment of Section 1231 gains/losses appears very taxpayer friendly, as taxpayers
prefer capital gains and ordinary losses
But…we need to consider recapture
Depreciation Recapture:
 Depreciation recapture only applies to gains, never to losses
 When applied, recapture rules change the character of Section 1231 gains FROM capital
gains to ordinary income
o Recapture rules change the character of the gain from a more favorable character
(capital) to a less favorable character (ordinary)

 DEPRECIATION RECAPTURE DOES NOT CHANGE THE AMOUNT OF THE

RECOGNIZED GAIN!

Section 1245 Recapture

 When does it apply?

 What happens when it applies?

Section 1245 Recapture Examples:
Creative, Inc. sells a machine with an adjusted basis of $8,000 for $10,000. Depreciation taken
on the machine amounts to $2,500. What amount of gain is recaptured as ordinary and what
amount is §1231 gain?

Creative, Inc. sells a machine with an adjusted basis of $6,000 for $10,000. Depreciation taken
on the machine amounts to $2,500. What amount of gain is recaptured as ordinary and what
amount is §1231 gain?

Creative, Inc. sells a machine with an adjusted basis of $6,000 for $5,000. Depreciation taken on
the machine amounts to $2,500.
Section 1231 Look-Back Rule:

 This is recapture unrelated to depreciation

 Affects the character but not the amount of gain on which a taxpayer is taxed
 Net §1231 gains may be recharacterized as ordinary income under the §1231 look-
back rule
 The Section 1231 look-back rule mandates that for each year a taxpayer recognizes a
net Section 1231 gain (general rules says this is a capital gain), the taxpayer must
look back to five previous tax returns
 The taxpayer must recharacterize as ordinary income the amount of any previously
reported net Section 1231 losses (that were treated as ordinary losses in the year
reported)
 Once a net Section 1231 loss is recaptured once, it does not cause further recapture in
later years
 Again, we are NOT changing the amount of the gain, just the character, from capital
to ordinary.

Section 1231 Look-back rule example:

A taxpayer has a net Section 1231 gain of $35,000 for 2019. The taxpayer reported the following
on its past five tax returns:

2014 2015 2016 2017 2018

1231 Gain 0 20,000 30,000 0 20,000
1231 Loss 0 0 (36,000) 0 (24,000)
Net 1231 Gain/Loss 0 20,000 (6,000) 0 (4,000)

A taxpayer has a net Section 1231 gain of $35,000 for 2019. The taxpayer reported the following
on its past five tax returns:

2014 2015 2016 2017 2018

1231 Gain 0 20,000 30,000 10,000 20,000
1231 Loss 0 0 (36,000) 0 (24,000)
Net 1231 Gain/Loss 0 20,000 (6,000) 10,000 (4,000)
Like-Kind Exchanges
 When taxpayers trade real property used in their business or for investment purposes for
other real property to be used in their business or for investment purposes
o Taxpayers realize gain, but the gain is not recognized (the gain is not taxed when
the exchange occurs)
o This results in deferred gain recognition
 The taxpayer does not pay tax now, BUT
 The taxpayer will have a tax liability when the newly acquired property is
sold for cash, or traded for dissimilar property
o This is very favorable tax treatment!
o Why? The taxpayer may not have the wherewithal (cash) to pay a tax liability
when the exchange occurs

 For an exchange to qualify as a like-kind exchange for tax purposes, the transaction must
meet the following criteria:
o Both the real property given up and the real property received in the exchange by
the taxpayer are either “used in a trade or business” or are “held for investment,”
by the taxpayer
o The “exchange” must meet certain time restrictions

 Property Ineligible for Like-Kind Treatment

o Personal use assets - a primary residence
o Real property held primarily for sale to customers in the taxpayer’s ordinary
course of business

Qualified Intermediary:
Tax Consequences When Like-Kind Property Is Exchanged Solely for Like-Kind Property
 No gain or loss is recognized
 A taxpayer should not engage in a like-kind exchange if he or she realizes a loss
 Basis in the newly acquired property is the same basis as the property exchanged

Taxpayer A Taxpayer B
Office Building Residential Duplex
FMV = 200,000 FMV = 200,000
A/B = 140,000 A/B = 185,000
Tax Consequences of Transfers Involving Like-Kind and Non-Like-Kind Property (Boot)
 What happens if you find another taxpayer with like-kind property, but the FMVs are not
equal?
 The taxpayer with the property with the lesser FMV will have to throw in some boot
(non-qualifying property, usually cash)

When boot is received:

 Boot received triggers gain recognition (but not loss recognition)
 Gain recognized is the lesser of gain realized or boot received
 New Basis Calculation if you receive Boot:

Basis of qualifying property surrendered

+ Gain recognized
- Boot received
= Basis of qualifying property acquired.

 The basis of boot received is the fair market value of the boot

When boot is paid:

 Boot paid does not trigger gain or loss recognition
 New Basis Calculation if you paid Boot:

Basis of qualifying property surrendered

+ Boot paid
= Basis of qualifying property acquired.
Taxpayer A Taxpayer B
Office Building Residential Duplex
FMV = 200,000 FMV = 192,000
A/B = 140,000 A/B = 185,000
Cash = 8,000
Involuntary Conversions:
 Occur when property is partially or wholly destroyed by a natural disaster or accident,
stolen, condemned, or seized via eminent domain by a governmental agency
o A gain might be realized if a taxpayer receives replacement property or
insurance proceeds in excess of their basis in the property that was taken or
destroyed
o Congress provides special tax laws to allow taxpayers to defer the gains on such
involuntary conversions
 Direct conversions – taxpayers receive a direct property replacement
o Tax consequence similar to like-kind exchanges: no gain recognition, adjusted
basis in new same as adjusted basis in old property
 Indirect conversions – taxpayer receives money through insurance reimbursement or
some other type of settlement
o Taxpayer may elect to either recognize or defer realized gain on the conversion
o Taxpayers defer gain if they acquire qualified replacement property within two
years (three in the case of condemnation)
 Qualified replacement property is defined more narrowly compared to
like-kind property
o Taxpayers recognize realized gain to the extent that they do not reinvest the
reimbursement proceeds in qualified property
 Taxpayers never recognize more gain than they realize