Taxation of Business Entities C8-1 Chapter 8 Property Transactions: Capital Gains and Losses,...
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Transcript of Taxation of Business Entities C8-1 Chapter 8 Property Transactions: Capital Gains and Losses,...
C8-C8-11Taxation of Business EntitiesTaxation of Business Entities
Chapter 8
Property Transactions: Capital Gains and Losses, Section
1231, and Recapture Provisions
Copyright ©2010 Cengage Learning
Taxation of Business Entities
C8-C8-22Taxation of Business EntitiesTaxation of Business Entities
Taxation of Capital Gains and Losses
• Capital gains and losses must be separated from other types of gains and losses for two reasons:– Long-term capital gains may be taxed at a
lower rate than ordinary gains– The deduction of a net capital loss may be
limited
C8-C8-33Taxation of Business EntitiesTaxation of Business Entities
Proper Classification of Gains and Losses
• Depends on three characteristics:– The tax status of the property
• Capital asset, §1231 asset, or ordinary asset– The manner of the property’s disposition
• By sale, exchange, casualty, theft, or condemnation– The holding period of the property
• Short term and long term
C8-C8-44Taxation of Business EntitiesTaxation of Business Entities
Capital Assets(slide 1 of 5)
• §1221 defines capital assets as everything except:– Inventory (stock in trade)– Notes and accounts receivables acquired from
the sale of inventory or performance of services– Realty and depreciable property used in trade or
business (§1231 assets)
C8-C8-55Taxation of Business EntitiesTaxation of Business Entities
Capital Assets(slide 2 of 5)
• §1221 defines capital assets as everything except (cont’d):– Certain copyrights; literary, musical, or artistic
compositions; or letters, memoranda, or similar property when created by taxpayer (or for which taxpayer takes a carryover basis from the creator)
• For tax years beginning after May 17, 2006, taxpayers may elect to treat a sale or exchange of musical compositions or copyrights in musical works as the disposition of a capital asset
– Supplies of a type regularly used or consumed in the ordinary course of a business
– Certain publications of U.S. government
C8-C8-66Taxation of Business EntitiesTaxation of Business Entities
Capital Assets(slide 3 of 5)
• Thus, capital assets are:– Assets held for investment (e.g., stocks, bonds,
land)– Personal use assets (e.g., residence, car)– Miscellaneous assets selected by Congress
C8-C8-77Taxation of Business EntitiesTaxation of Business Entities
Capital Assets(slide 4 of 5)
• Dealers in securities– In general, securities are the inventory of
securities dealers, thus ordinary assets– However, a dealer can identify securities as an
investment and receive capital gain treatment• Clear identification must be made on the day of
acquisition
C8-C8-88Taxation of Business EntitiesTaxation of Business Entities
Capital Assets(slide 5 of 5)
• Real property subdivided for sale– Taxpayer may receive capital gain treatment on the
subdivision of real estate if the following requirements are met:
• Taxpayer is not a corporation • Taxpayer is not a real estate dealer• No substantial improvements made to the lots• Taxpayer held the lots for at least 5 years• Capital gain treatment occurs until the year in which the 6th lot
is sold– Then up to 5% of the revenue from lot sales is potential ordinary
income– That potential ordinary income is offset by any selling
expenses from the lot sales
C8-C8-99Taxation of Business EntitiesTaxation of Business Entities
Sale or Exchange(slide 1 of 11)
• Recognition of capital gains and losses generally requires a sale or exchange of assets
• Sale or exchange is not defined in the Code• There are some exceptions to the sale or
exchange requirement
C8-C8-1010Taxation of Business EntitiesTaxation of Business Entities
Sale or Exchange–Worthless Securities (slide 2 of 11)
• A security that becomes worthless creates a deductible capital loss without being sold or exchanged– The Code sets an artificial sale date for the securities on
the last day of the year in which worthlessness occurs• Section 1244 allows an ordinary deduction on
disposition of stock at a loss– The stock must be that of a small business company– The ordinary deduction is limited to $50,000 ($100,000
for married individuals filing jointly) per year
C8-C8-1111Taxation of Business EntitiesTaxation of Business Entities
Sale or Exchange(slide 3 of 11)
• Worthless securities example:– Calendar year taxpayer purchased stock on
December 5, 2008– The stock becomes worthless on April 5, 2009– The loss is deemed to have occurred on
December 31, 2009• The result is a long-term capital loss
C8-C8-1212Taxation of Business EntitiesTaxation of Business Entities
Sale or Exchange–Retirement of Corporate Obligations (slide 4 of 11)
• Collection of the redemption value of corporate obligations (e.g., bonds payable) is treated as a sale or exchange and may result in a capital gain or loss– OID amortization increases basis and reduces
gain on disposition or retirement
C8-C8-1313Taxation of Business EntitiesTaxation of Business Entities
Sale or Exchange–Options (slide 5 of 11)
• For the grantee of the option– Sale of an option results in capital gain or loss if the
option property is a capital asset to the grantee– Lapse of an option on a capital asset is considered a
sale or exchange resulting in a capital loss • For the grantor of an option, the lapse creates
– Short-term capital gain, if the option was on stocks, securities, commodities or commodity futures
– Otherwise, ordinary income
C8-C8-1414Taxation of Business EntitiesTaxation of Business Entities
Sale or Exchange–Options (slide 6 of 11)
• Exercise of an option by a grantee increases the gain (or reduces the loss) to the grantor from the sale of the property– Gain is ordinary or capital depending on the tax
status of the property• Grantee adds the cost of the option to the
basis of the property acquired
C8-C8-1515Taxation of Business EntitiesTaxation of Business Entities
Sale or Exchange–Patents (slide 7 of 11)
• When all substantial rights to a patent are transferred by a holder to another, the transfer produces long-term capital gain or loss– The holder of a patent must be an individual,
usually the creator, or an individual who purchases the patent from the creator before the patented invention is reduced to practice
C8-C8-1616Taxation of Business EntitiesTaxation of Business Entities
Sale or Exchange–Franchises, Trademarks, and Trade Names
(slide 8 of 11)
• The licensing of franchises, trade names, trademarks, and other intangibles is generally not considered a sale or exchange of a capital asset– Therefore, ordinary income results to transferor
• Exception: Capital gain (loss) may result if the transferor does not retain any significant power, right, or continuing interest
C8-C8-1717Taxation of Business EntitiesTaxation of Business Entities
Sale or Exchange–Franchises, Trademarks, and Trade Names
(slide 9 of 11)
• Significant powers, rights, or continuing interests include:– Control over assignment, quality of products and
services– Sale or advertising of other products or services– The right to require that substantially all supplies and
equipment be purchased from the transferor– The right to terminate the franchise at will, and – The right to substantial contingent payments
C8-C8-1818Taxation of Business EntitiesTaxation of Business Entities
Sale or Exchange–Franchises, Trademarks, and Trade Names
(slide 10 of 11)
• Noncontingent payments are ordinary income to the transferor– The franchisee capitalizes the payments and
amortizes them over 15 years• Contingent payments are ordinary income
for the franchisor and an ordinary deduction for the franchisee
C8-C8-1919Taxation of Business EntitiesTaxation of Business Entities
Sale or Exchange–Lease Cancellation Payments
(slide 11 of 11)
• Lessee treatment– Treated as received in exchange for underlying leased
property• Capital gain results if asset leased was a capital asset (e.g.,
personal use )• Ordinary income results if asset leased was an ordinary asset
(e.g., used in lessee’s business and lease has existed for one year or less when canceled)
• Lessor treatment– Payments received are ordinary income (rents)
C8-C8-2020Taxation of Business EntitiesTaxation of Business Entities
Holding Period (slide 1 of 3)
• Short-term– Asset held for 1 year or less
• Long-term– Asset held for more than 1 year
• Holding period starts on the day after the property is acquired and includes the day of disposition
C8-C8-2121Taxation of Business EntitiesTaxation of Business Entities
Holding Period (slide 2 of 3)
• Nontaxable Exchanges – Holding period of property received includes holding
period of former asset if a capital or §1231 asset
• Transactions involving a carryover basis– Former owner’s holding period tacks on to present
owner’s holding period if a nontaxable transaction and basis carries over
• Inherited property is always treated as long term no matter how long it is held by the heir
C8-C8-2222Taxation of Business EntitiesTaxation of Business Entities
Holding Period (slide 3 of 3)
• Short sales– Taxpayer sells borrowed securities and then repays the
lender with substantially identical securities– Gain or loss is not recognized until the short sale is
closed– Generally, the holding period for a short sale is
determined by how long the property used for repayment is held
• If substantially identical property (e.g., other shares of the same stock) is held by the taxpayer, the short-term or long-term character of the short sale gain or loss may be affected
C8-C8-2323Taxation of Business EntitiesTaxation of Business Entities
Tax Treatment of Capital Gains and Losses (slide 1 of 6)
• Noncorporate taxpayers– Capital gains and losses must be netted by holding
period• Short-term capital gains and losses are netted• Long-term capital gains and losses are netted• If possible, long-term gains or losses are then netted with
short-term gains or losses– If the result is a loss:
– The capital loss deduction is limited to a maximum deduction of $3,000
– Unused amounts retain their character and carryforward indefinitely
C8-C8-2424Taxation of Business EntitiesTaxation of Business Entities
Tax Treatment of Capital Gains and Losses (slide 2 of 6)
• Noncorporate taxpayers (cont’d)– If net from capital transactions is a gain, tax
treatment depends on holding period• Short-term (assets held 12 months or less)
– Taxed at ordinary income tax rates
• Long-term (assets held more than 12 months)– An alternative tax calculation is available using
preferential tax rates
C8-C8-2525Taxation of Business EntitiesTaxation of Business Entities
Tax Treatment of Capital Gains and Losses (slide 3 of 6)
• Noncorporate taxpayers (cont’d)– Net long-term capital gain is eligible for one or
more of four alternative tax rates: 0%, 15%, 25%, and 28%
• The 25% rate applies to unrecaptured §1250 gain and is related to gain from disposition of §1231 assets
• The 28% rate applies to collectibles• The 0%/15% rates apply to any remaining net long-
term capital gain
C8-C8-2626Taxation of Business EntitiesTaxation of Business Entities
Tax Treatment of Capital Gains and Losses (slide 4 of 6)
• Collectibles, even though they are held long term, are subject to a 28% alternative tax rate
• Collectibles include any:– Work of art– Rug or antique– Metal or gem– Stamp– Alcoholic beverage– Historical objects (documents, clothes, etc.)– Most coins
C8-C8-2727Taxation of Business EntitiesTaxation of Business Entities
Tax Treatment of Capital Gains and Losses (slide 5 of 6)
• When there are both short and long-term capital gains and losses, a complicated ordering procedure is required because the long-term capital gains may be taxed at various rates
C8-C8-2828Taxation of Business EntitiesTaxation of Business Entities
Tax Treatment of Capital Gains and Losses (slide 6 of 6)
• Corporate taxpayers– Differences in corporate capital treatment
• There is a NCG alternative tax rate of 35 %– Since the max corporate tax rate is 35 %, the
alternative tax is not beneficial• Net capital losses can only offset capital gains (i.e.,
no $3,000 deduction in excess of capital gains)• Net capital losses are carried back 3 years and
carried forward 5 years as short-term losses
C8-C8-2929Taxation of Business EntitiesTaxation of Business Entities
§1231 Assets(slide 1 of 4)
• §1231 assets defined– Depreciable and real property used in a business or for
production of income and held greater than 1 year– Includes timber, coal, iron, livestock, unharvested crops– Certain purchased intangibles
C8-C8-3030Taxation of Business EntitiesTaxation of Business Entities
§1231 Assets(slide 2 of 4)
• §1231 property does not include the following:– Property not held for the long-term holding period– Nonpersonal use property where casualty losses exceed
casualty gains for the taxable year– Inventory and property held primarily for sale to
customers– Copyrights, literary, musical, or artistic compositions
and certain U.S. government publications– Accounts receivable and notes receivable arising in the
ordinary course of a trade or business
C8-C8-3131Taxation of Business EntitiesTaxation of Business Entities
§1231 Assets(slide 3 of 4)
• If transactions involving §1231 assets result in:– Net §1231 loss = ordinary loss– Net §1231 gain = long-term capital gain
C8-C8-3232Taxation of Business EntitiesTaxation of Business Entities
§1231 Assets(slide 4 of 4)
• Provides the best of potential results for the taxpayer– Ordinary loss that is fully deductible for AGI– Gains subject to the lower capital gains tax
rates
C8-C8-3333Taxation of Business EntitiesTaxation of Business Entities
Special Rules For Certain §1231 Assets (slide 1 of 2)
• Casualty gains and losses from §1231 assets and from long-term nonpersonal use capital assets are determined and netted together
• If a net loss, items are treated separately – §1231 casualty gains and nonpersonal use capital asset
casualty gains are treated as ordinary gains– §1231 casualty losses are deductible for AGI– Nonpersonal use capital asset casualty losses are
deductible from AGI subject to the 2% of AGI limitation
• If a net gain, treat as §1231 gain
C8-C8-3434Taxation of Business EntitiesTaxation of Business Entities
Special Rules For Certain §1231 Assets (slide 2 of 2)
• The special netting process for casualties & thefts does not include condemnation gains and losses– A § 1231 asset disposed of by condemnation receives
§ 1231 treatment• Personal use property condemnation gains and
losses are not subject to the § 1231 rules– Gains are capital gains
• Personal use property is a capital asset– Losses are nondeductible
• They arise from the disposition of personal use property
C8-C8-3535Taxation of Business EntitiesTaxation of Business Entities
General Procedure for § 1231 Computation (slide 1 of 3)
• Step 1: Casualty Netting– Net all recognized long-term gains & losses from
casualties of § 1231 assets and nonpersonal use capital assets
• If casualty gains exceed casualty losses, add the excess to the other § 1231 gains for the taxable year
• If casualty losses exceed casualty gains, exclude all casualty losses and gains from further § 1231 computation
– All casualty gains are ordinary income– Section 1231 asset casualty losses are deductible for AGI– Other casualty losses are deductible from AGI
C8-C8-3636Taxation of Business EntitiesTaxation of Business Entities
General Procedure for § 1231 Computation (slide 2 of 3)
• Step 2: § 1231 Netting– After adding any net casualty gain from previous step
to the other § 1231 gains and losses, net all § 1231 gains and losses
• If gains exceed the losses, net gain is offset by the ‘‘lookback’’ nonrecaptured § 1231 losses from the 5 prior tax years
– To the extent of this offset, the net § 1231 gain is classified as ordinary gain
– Any remaining gain is long-term capital gain• If the losses exceed the gains, all gains are ordinary income
– Section 1231 asset losses are deductible for AGI– Other casualty losses are deductible from AGI
C8-C8-3737Taxation of Business EntitiesTaxation of Business Entities
General Procedure for § 1231 Computation (slide 3 of 3)
• Step 3: § 1231 Lookback Provision– The net § 1231 gain from the previous step is
offset by the nonrecaptured net § 1231 losses for the five preceding taxable years
• To the extent of the nonrecaptured net § 1231 loss, the current-year net § 1231 gain is ordinary income
– The nonrecaptured net § 1231 losses are those that have not already been used to offset net § 1231 gains
• Only the net § 1231 gain exceeding this net § 1231 loss carryforward is given long-term capital gain treatment
C8-C8-3838Taxation of Business EntitiesTaxation of Business Entities
Lookback Provision Example
• Taxpayer had the following net §1231 gains and losses:
2007 $ 4,000 loss2008 10,000 loss2009 16,000 gain
– In 2009, taxpayer’s net §1231 gain of $16,000 will be treated as $14,000 of ordinary income and $2,000 of long-term capital gain
C8-C8-3939Taxation of Business EntitiesTaxation of Business Entities
§1231 Netting Procedure (slide 1 of 2)
§1231 asset and long-term nonpersonal use capital asset casualty gains
minus§1231 asset and long-term nonpersonal use
capital asset casualty losses
Net Gain
(add to §1231 gains)
Items treated separately: Gains are ordinary income, §1231 asset
losses are deductible for AGI, Other losses deductible from AGI
§1231 gains minus
§1231 losses
Net GainNet Gain
Net LossNet LossNet GainNet Gain
NNet LossLoss
C8-C8-4040Taxation of Business EntitiesTaxation of Business Entities
§1231 Netting Procedure(slide 2 of 2)
Lookback Provision:
Net gain is offset against nonrecaptured net §1231 losses
from 5 prior tax years
Gain offset by lookback losses is ordinary gain
Remaining gain is LTCG
Net GainNet Gain
C8-C8-4141Taxation of Business EntitiesTaxation of Business Entities
Depreciation Recapture(slide 1 of 3)
• Assets subject to depreciation or cost recovery are subject to depreciation recapture when disposed of at a gain– Losses on depreciable assets receive §1231
treatment• No recapture occurs in loss situations
C8-C8-4242Taxation of Business EntitiesTaxation of Business Entities
Depreciation Recapture (slide 2 of 3)
• Depreciation recapture characterizes gains that would otherwise be capital or §1231 as ordinary income– The Code contains two major recapture
provisions• §1245 • §1250
C8-C8-4343Taxation of Business EntitiesTaxation of Business Entities
Depreciation Recapture(slide 3 of 3)
• Depreciation recapture provisions generally override all other Code Sections– There are exceptions to depreciation recapture
rules, for example: • In dispositions where all gain is not recognized
– e.g., like-kind exchanges, involuntary conversions
• Where gain is not recognized at all – e.g., gifts and inheritances
C8-C8-4444Taxation of Business EntitiesTaxation of Business Entities
§1245 Recapture(slide 1 of 3)
• Depreciation recapture for §1245 property– Applies to tangible and intangible personalty,
and nonresidential realty using accelerated methods of ACRS (placed in service 1981-86)
• Recapture potential is entire amount of accumulated depreciation for asset
• Method of depreciation does not matter
C8-C8-4545Taxation of Business EntitiesTaxation of Business Entities
§1245 Recapture(slide 2 of 3)
• When gain on the disposition of a §1245 asset is less than the total amount of accumulated depreciation:– The total gain will be treated as depreciation
recapture (i.e., ordinary income)
C8-C8-4646Taxation of Business EntitiesTaxation of Business Entities
§1245 Recapture(slide 3 of 3)
• When the gain on the disposition of a §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 §1231 gain or capital gain
C8-C8-4747Taxation of Business EntitiesTaxation of Business Entities
Observations on § 1245 (slide 1 of 3)
• Usually total depreciation taken will exceed the recognized gain– Therefore, disposition of § 1245 property
usually results in ordinary income rather than § 1231 gain
– Thus, generally, no § 1231 gain will occur unless the § 1245 property is disposed of for more than its original cost
C8-C8-4848Taxation of Business EntitiesTaxation of Business Entities
Observations on § 1245 (slide 2 of 3)
• Recapture applies to the total amount of depreciation allowed or allowable regardless of the depreciation method used
• Recapture applies regardless of the holding period of the property– If held for < the long-term holding period the
entire recognized gain is ordinary income because § 1231 does not apply
C8-C8-4949Taxation of Business EntitiesTaxation of Business Entities
Observations on § 1245 (slide 3 of 3)
• Section 1245 does not apply to losses which receive § 1231 treatment
• Gains from the disposition of § 1245 assets may also be treated as passive activity gains
C8-C8-5050Taxation of Business EntitiesTaxation of Business Entities
§1250 Recapture(slide 1 of 3)
• Depreciation recapture for §1250 property– Applies to depreciable real property
• Exception: Nonresidential realty classified as §1245 property (i.e., placed in service after 1980 and before 1987, and accelerated depreciation used)
C8-C8-5151Taxation of Business EntitiesTaxation of Business Entities
§1250 Recapture(slide 2 of 3)
• Depreciation recapture for §1250 property– Recapture potential is limited to excess of
accelerated depreciation taken on asset over depreciation that would have been deductible if straight-line depreciation had been used
C8-C8-5252Taxation of Business EntitiesTaxation of Business Entities
§1250 Recapture(slide 3 of 3)
• Straight-line depreciation on real property– If straight-line depreciation has been taken on
real property, no depreciation recapture potential exists under §1250
– All real property acquired after 1986 must use straight-line depreciation
• Therefore, no depreciation recapture potential for such property
C8-C8-5353Taxation of Business EntitiesTaxation of Business Entities
Real Estate 25% Gain(slide 1 of 2)
• Also called unrecaptured §1250 gain or 25% gain– 25% gain is some or all of the §1231 gain
treated as long-term capital gain– Used in the alternative tax computation for net
capital gain
C8-C8-5454Taxation of Business EntitiesTaxation of Business Entities
Real Estate 25% Gain(slide 2 of 2)
• Maximum amount of 25% gain is depreciation taken on real property sold at a recognized gain reduced by:– Certain §1250 and §1245 depreciation recapture– Losses from other §1231 assets– §1231 lookback losses
• Limited to recognized gain when total gain is less than depreciation taken
C8-C8-5555Taxation of Business EntitiesTaxation of Business Entities
Additional Recapturefor Corporations
• Corporations that sell depreciable real estate face an additional amount of depreciation recapture– Section 291(a)(1) requires recapture of 20% of
the excess of the amount that would be recaptured under § 1245 over the amount actually recaptured under § 1250
C8-C8-5656Taxation of Business EntitiesTaxation of Business Entities
Related Effects of Recapture(slide 1 of 5)
• Gifts– The carryover basis of gifts, from donor to
donee, also carries over depreciation recapture potential associated with asset
– That is, donee steps into shoes of donor with regard to depreciation recapture potential
C8-C8-5757Taxation of Business EntitiesTaxation of Business Entities
Related Effects of Recapture(slide 2 of 5)
• Inheritance– Death is only way to eliminate recapture
potential– That is, depreciation recapture potential does
not carry over from decedent to heir
C8-C8-5858Taxation of Business EntitiesTaxation of Business Entities
Related Effects of Recapture(slide 3 of 5)
• Charitable contributions– Recapture potential reduces the amount of
charitable contribution deductions that are based on FMV
C8-C8-5959Taxation of Business EntitiesTaxation of Business Entities
Related Effects of Recapture(slide 4 of 5)
• Nontaxable transactions– When the transferee carries over the basis of the
transferor, the recapture potential also carries over• Included in this category are transfers of property pursuant to
the following:– Nontaxable incorporations under § 351– Certain liquidations of subsidiary companies under § 332– Nontaxable contributions to a partnership under § 721– Nontaxable reorganizations
– Gain may be recognized in these transactions if boot is received
• If gain is recognized, it is treated as ordinary income to the extent of the recapture potential or recognized gain, whichever is lower
C8-C8-6060Taxation of Business EntitiesTaxation of Business Entities
Related Effects of Recapture(slide 5 of 5)
• Like-kind exchanges and involuntary conversions– Property received in these transactions have a
substituted basis• Basis of former property and its recapture potential
is substituted for basis of new property– Any gain recognized on the transaction will
first be treated as depreciation recapture, then as §1231 or capital gain
• Any remaining recapture potential carries over
C8-C8-6161Taxation of Business EntitiesTaxation of Business Entities
If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:
Dr. Donald R. Trippeer, CPA [email protected]
SUNY Oneonta