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Chapter 10

Property Dispositions

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Learning Objectives
1.
2.
3.
4.

5.
6.

Calculate the amount of gain or loss recognized on the


disposition of assets used in a trade or business
Describe the general character types of gain or loss
recognized on property dispositions
Explain the rationale for and calculate depreciation
recapture
Describe the tax treatment of unrecaptured 1250
gains and determine the character of gains on property
sold to related parties
Describe the tax treatment of 1231 gains or losses,
including the 1231 netting process
Explain common exceptions to the general rule that
realized gains and losses are recognized currently
10-2

Dispositions

The basic formula:


Amount realized from property disposition
Less: Adjusted basis of property disposed
Gain/Loss realized from property disposition

10-3

Dispositions

Amount Realized

Amount realized by a taxpayer from the sale or other


disposition of an asset is everything of value received
from the buyer less any selling costs.
Taxpayers typically receive cash when they sell
property, but they may also accept marketable
securities, notes receivable, similar assets, or any
combination of these items as payment.

10-4

Example: Amount Realized

10-5

Dispositions

Adjusted Basis

Original basis reduced by depreciation or other types


of cost recovery deductions taken against the
property.

10-6

Example: Adjusted Basis


Teton bought a machinery at the cost of $510,000 three years
ago. Over the three years, he depreciated the asset using
MACRS method with a total depreciation of $318,827. What
is the adjusted basis of the machinery after depreciation?
A/B = Original basis total accumulated depreciation
= 510,000 - 318,827
= 191,173

10-7

Dispositions
Realized

Gain or Loss on Disposition

The amount of gain or loss taxpayers realize on a


sale or other disposition of assets is simply the
amount they realize minus their adjusted basis in
the disposed assets.

Different

from Gain or Loss recognized

10-8

Example
Suppose Teton sold the machinery for a total amount of
$200,000 and the basis of the machinery is $191,173.
What is the realized gain or loss on the sale of machinery?
Gain realized = Amount realized Adjusted basis
= 200,000 191,173
= 8,827

10-9

Dispositions

10-10

Dispositions
Recognized

Gain or Loss on Disposition

Gains (losses) that increase (decrease)


taxpayers taxable income.
Taxpayers must immediately recognize the vast
majority of realized gains and losses, but they
may be allowed to defer or permanently exclude
the gains from taxable income.

10-11

Dispositions

Realized Gain or Loss = Amount realized A/B

Mathematical calculation
No direct impact on taxable income

Recognized Gain or Loss on Disposition

The amount and character of gain or loss recognized


depends on asset type and disposition transaction
(vary with law)
Gains (losses) that increase (decrease) taxpayers
taxable income

10-12

Character of Gain or Loss


(adapted from Exhibit 10-3)
Holding period

Short-term (one
year or less)

Assets used in trade or business

Ordinary
Inventory and
Accounts
Receivable

Long-term (more
than one year)

Depreciable
assets

Investment
assets
ST Capital Gains

Ordinary

1231 gain
Gain: capital gain
Loss: ordinary
loss

LT Capital Gains

10-13

Type of assets

Capital assets

Assets held for investment, for the production of


income, or for personal use, but not in trade of
business
Gain is recognized as capital gain at preferential tax
rates for individuals

Assets created or used in a taxpayers trade or


business.

Ordinary assets: Inventory and Accounts Receivable


and depreciable assets that are held for less than a
year.

Gain/loss is recognized as ordinary income/loss

1231 Assets
10-14

1231 Assets

Depreciable assets and land used in a trade or business


held for more than one year.
When taxpayers sell multiple 1231 assets during the
year, they combine or net the gains and losses together.
If the taxpayer recognizes a net 1231 gain, the net gain
is treated as a long-term capital gain.
If the taxpayer recognizes a net 1231 loss, the net loss
is treated as an ordinary loss.
1231 gains on individual depreciable assets may be
recharacterized as ordinary income under the
depreciation recapture rules.

10-15

Depreciation Recapture
Why?

The tax favored MACRS and ACRS depreciation


Accelerated depreciation reduces adjusted basis
of assets
Prevent the gain based on accelerated
depreciation from getting tax favored treatment

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Depreciation Recapture

General principle: When applied, depreciation recapture


recharacterizes the gain on the sale of a 1231 asset
from 1231 gain into ordinary income. It only changes
the character but not the amount of gain that taxpayers
recognize when they sell a depreciable asset.

Does not affect 1231 losses.


Computation depends on the type of 1231 assets the taxpayer is
selling (personal or real property).

10-17

Depreciation Recapture

10-18

Depreciation Recapture

1245 Property

Personal property and amortizable intangible assets are 1245


assets.
The gain is characterized as ordinary income to the extent the
gain was created by depreciation or amortization deductions.

Step one: The amount of 1245 gain (Ordinary Income) is the


lesser of:
Gain recognized (realized) on the sale, or
Accumulated depreciation
Step two: If Realized Gain - 1245 Ordinary Income > 0, then
(Realized Gain - 1245 Ordinary Income) is recognized as 1231
capital gain

There is no depreciation recapture on assets sold at a loss.


10-19

Example 10-6/7/8
For a machinery with an original basis
of 510,000 and accumulated
depreciation of 318,827, Teton sold the
machinery for a) $200,000, b) 520,000
and c) 180,000. What is the amount
and character of the gain Teton
recognizes in each scenario?
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Depreciation Recapture

1250 Depreciation Recapture for Real Property held for


one year or less

Depreciable real property (an office building or a warehouse), sold


at a gain is subject to recapture called 1250 depreciation
recapture.
When depreciable real property is sold at a gain, the amount of
gain recaptured as ordinary income is limited to the excess of
accelerated depreciation deductions over the amount that would
have been deducted under the straight-line method.

291 depreciation recapture applies to corporations but not


to other types of taxpayers.

Corporations selling depreciable real property recapture as ordinary


income 20 percent of the lesser of (1) the recognized gain or (2) the
accumulated depreciation.
10-21

Calculating Net 1231 Gains or


Losses

10-22

Calculating Net 1231 Gains or


Losses

Step one: for each 1231 asset, apply depreciation


recapture to characterize gain from sale as ordinary
income

Recapture gain as ordinary income = lesser of 1) gain realized,


or 2) accumulated depreciation.

Step two: net all remaining 1231 gains and losses from
assets sold in the same year

If this generates net losses, then ordinary loss. Use ordinary loss
to offset other ordinary income if possible.
If this generates net 1231 gains, then apply 1231 look-back
rule.

10-23

Calculating Net 1231 Gains or


Losses

What is 1231 Look-Back Rule?

Requires taxpayers with net 1231 gains in the current year to


recapture (recharacterize) those gains as ordinary to the extent
they recognized ordinary 1231 losses in the past five years.

Why 1231 Look-Back Rule?

Prevent taxpayers from opportunistically accelerating losses and


deferring gains.
Affect the character but not the amount of gains on which a
taxpayer is taxed.

10-24

Calculating Net 1231 Gains or


Losses

10-25

Example 10-13 (recapture rule)


Suppose that Teton began business in year 1 and
that it recognized a $7,000 net 1231 loss in year 1.
Assume that the current year is year 6 and that
Teton reports a net 1231 gain of $25,000 for the
year. Teton did not recognize any 1231 gains or
losses in years 25. For year 6, what would be the
ultimate character of the $25,000 net 1231 gain?
Assume the same facts as above, except that Teton
also recognized a $2,000 net 1231 loss in year 5.
For year 6, what would be the ultimate character of
the $25,000 net 1231 gain?
10-26

Example 10-13
Suppose that Teton began business in year 1 and
that it recognized a $7,000 net 1231 loss in year 1.
Assume that the current year is year 6 and that
Teton reports a net 1231 gain of $25,000 for the
year. Teton did not recognize any 1231 gains or
losses in years 25. For year 6, what would be the
ultimate character of the $25,000 net 1231 gain?
Assume the same facts as above, except that Teton
also recognized a $2,000 net 1231 loss in year 5.
For year 6, what would be the ultimate character of
the $25,000 net 1231 gain?
10-27

Example

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Nonrecognition Transactions
Taxpayers

realizing gains and losses when


they sell or exchange property must
immediately recognize the gain for tax
purposes unless a specific provision in the
tax code says it can be deferred or delayed
(nonrecognition transactions).

Like-kind exchanges.
Involuntary conversions.
Installment sales.
Other business-related transactions.
10-29

Nonrecognition Transactions

Like-Kind Exchanges or 1031 Exchanges

Can defer recognizing gain (or loss) realized on the


exchange if they meet certain requirements.
For an exchange to qualify as a like-kind exchange for
tax purposes, the transaction must meet the following
three criteria.

The property is exchanged solely for like-kind property.


Both the property given up and the property received in the
exchange by the taxpayer are either used in a trade or
business or are held for investment, by the taxpayer.
The exchange must meet certain time restrictions.

10-30

Nonrecognition Transactions

Definition of Like-Kind Property

Real Property

Used in a trade or business or held for investment is considered


like-kind with other real property used in a trade or business or
held for investment.

Personal Property

Considered like-kind if it has the same general use (in the


same general asset class in Rev. Proc. 87-56) and is used in a
business or held for investment.
Property Ineligible for Like-Kind Treatment

Includes inventory, most financial instruments, partnerships interests,


domestic property exchanged for property used in a foreign country and all
property used in a foreign country.

10-31

Nonrecognition Transactions

Property Use

There are two parties in a property transaction.


For each party, property exchanged and received must both be
used in a trade or business or held for investment.
Example: if Bill hotdog exchanges a business computer for
Steves personal computer (mainly used to paly video games). For
Bill, it is a like-kind transaction, but for Steve, it is not.

Timing Requirements for a Like-Kind Exchange

Only apply when the exchange involved with third-party


intermediaries.
Taxpayers must identify replacement like-kind property within 45
days of giving up their property and must receive the replacement
property within 180 days.
10-32

Nonrecognition Transactions
Tax

Consequences When Like-Kind Property


Is Exchanged Solely for Like-Kind Property
(No Boot)

No gain or loss is immediately recognized


(realized gain or loss is deferred)
Old basis will carry over to the new property

10-33

Adapted Example 10-15 (No boot


received)
Teton would like to trade an old machinery worth $29,500
(adjusted basis of $18,742), for a new machinery worth
$35,000 (adjusted basis of $20,000). 1) How much gain
does Teton recognize on this exchange? What is the basis
of the new machine?

10-34

Nonrecognition Transactions

Tax Consequences of Transfers Involving Like-Kind and


Non-Like-Kind Property (Boot)

The problem with like-kind exchanges is that the value of the likekind property transferred may differ from the value of the like-kind
property received.
The party transferring the lesser-valued asset must also transfer
additional non-like-kind property.
Non-like-kind property is known as boot.
When boot is given as part of a like-kind transaction:
Immediately recognize gain as the lesser of (1) gain realized
or (2) boot received.
Defer the rest of realized gain to future

10-35

Nonrecognition Transactions
Calculate

the basis of like-kind property

received
FMV of like-kind property received
Less: deferred gain
Add: deferred loss
A/B of like-kind property received

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Example 10-16/17 (boot received)


Suppose that Teton trades its used machinery with a
value of $29,500 and an adjusted basis of $18,742
($30,615 historical cost less $11,873 of accumulated
depreciation) to the dealer for new machinery valued
at $27,500. To equate the value of the property
exchanged, the dealer also pays Teton $2,000. A)
What gain or loss does Teton realize on the exchange
and what gain or loss does Teton recognize on the
exchange? B) What is the character of Teton's $2,000
gain? C) What is Teton's basis in the new machinery it
received from the dealer?
10-37

Nonrecognition Transactions

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.
Gain is deferred on direct or indirect conversions.

Taxpayers might experience a tremendous financial


hardship if they were required to recognize the gain
immediately in these circumstances.

10-38

Nonrecognition Transactions

Involuntary Conversions

Direct conversions involve receiving a direct property


replacement for the involuntarily converted property.

No gain recognized.
Adjusted basis from old asset is carried over to new asset.

Indirect conversions involve receiving money for the


involuntary conversion (boot involved).

Recognize gain as the lesser of 1) the gain realized on the


conversion or 2) the amount of reimbursement the taxpayer
does not reinvest in qualified property.
Adjusted basis of replacement property is the fair market
value of the new property minus the deferred gain on the
conversion.
10-39

Example 10-18
If one of Teton's employees was involved in a traffic accident
while driving a delivery van. The employee escaped without
serious injury but the van was totally destroyed. Before the
accident, Teton's delivery van had a fair market value of
$15,000 and an adjusted basis of $11,000 (the cost basis
was $15,000 and accumulated depreciation on the van was
$4,000). Teton received $15,000 of insurance proceeds to
cover the loss. Teton was considering two alternatives for
replacing the van: Alternative 1 was to purchase a new
delivery van for $20,000 and Alternative 2 was to purchase a
used delivery van for $14,000. What gain or loss does Teton
recognize under Alternative 1 and Alternative 2?What is
Teton's basis in the replacement property it acquired under
Alternative 1 and Alternative 2?
10-40

Nonrecognition Transactions
Installment

Sales

Sale of property where the seller receives the sale


proceeds in more than one period.
Inventory, marketable securities, and depreciation
recapture cannot be accounted for under
installment sale rules.
Does not apply to losses.

10-41

Nonrecognition Transactions
Installment

Sales

Gain realized=Selling price-A/B in the property


sold
Must recognize a portion of realized gain on each
installment payment received.

For each installment payment received, gain


recognized = the installment payment received *
gross profit percentage
10-42

Example 10-19
Suppose Teton decides to sell 5 acres of
land adjacent to the warehouse for
$100,000. The cost basis for the land is
$37,500. Teton agrees to sell the property
for four equal payments of $25,000one
now (in year 1) and the other three on
January 1 of the next three yearsplus
interest. What amount of gain does Teton
realize on the sale and what amount of gain
does it recognize in year 1?
10-43

Nonrecognition Transactions
Installment

For 1231 property, installment gain is


recognized after depreciation recapture

Sales

Step one: calculate realized gain/loss


Step two: Classify realized gain as ordinary income to
the extent of depreciation recapture
Step three: use the remaining gain (realized gain
ordinary income) for gross profit calculation

The income from depreciation recapture is not


taxed twice.
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Example 10-20
Assume that Teton agrees to sell some of its
machinery for $90,000 for two equal payments
of $45,000 plus interest. Teton's original basis
was $80,000 and accumulated depreciation on
the machinery was $30,000. Teton will receive
one payment in year 1 (the current year) and
the other payment in year 2. What is the
amount and character of the gain Teton
recognizes on the sale in year 1?
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Nonrecognition Transactions

Other Nonrecognition Provisions

Related-Party Loss Disallowance Rules

Tax laws essentially treat related parties as though they are


the same taxpayer.
Related parties are defined in 267 and include certain family
members, related corporations, and other entities
(partnerships).
Losses on sales to related parties are not deductible by the
seller.
Related party may deduct the previously disallowed loss to the
extent of the gain on the sale to the unrelated third party.

10-46

Homework
Problems:

32, 34, 41, 50 (part a), 51, 55, 56, 62, 64.

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