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Acc351ch11.pptxTaxation of Individuals and Business Entities
Property
Dispositions
2021 Edition
Chapter 11
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Copyright ©2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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.
Calculate depreciation recapture.
Describe the tax treatment of unrecaptured §1250 gains.
Describe the tax treatment of §1231 gains or losses, including the §1231 netting process.
Explain common deferral exceptions to the general rule that realized gains and losses are recognized currently.
Learning Objectives
11-2
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; they may also accept marketable securities, notes receivable, similar assets, or any combination of these items as payment.
Amount realized = Cash received + Fair market value of other property + Buyer’s assumption of liabilities − Seller’s expenses
Dispositions (1 of 6)
11-3
The adjusted basis for determining gain or loss on the sale of an asset
Initial basis reduced by depreciation or other types of cost recovery deductions allowed (or allowable) on the property.
Adjusted basis = Initial basis − Cost recovery allowed (or allowable)
Dispositions (2 of 6)
11-4
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.
Gain or (loss) realized = Amount realized − Adjusted basis
Dispositions (3 of 6)
11-5
EXHIBIT 11-1 Summary of Formulas for Computing Gain or Loss Realized on an Asset Disposition
Gain (loss) realized = Amount realized − Adjusted basis; where
Amount realized = Cash received + Fair market of other property + Buyer’s assumption of seller’s liabilities − Seller’s expenses
Adjusted basis = Initial basis − Cost recovery deductions
Dispositions (4 of 6)
11-6
EXHIBIT 11-2 Teton’s Asset Dispositions: Realized Gain (Loss) for Tax Purposes
Dispositions (5 of 6)
11-7
| Asset | (1) Amount Realized | (2) Initial Basis | (3) Accumulated Depreciation | (4) [(2) − (3)] Adjusted Basis | (5) [(1) − (4)] Gain (Loss) Realized |
| Machinery | $300,000 | $610,000 | $381,342 | $228,658 | $ 71,342 |
| Office furniture | 23,000 | 20,000 | 14,000 | 6,000 | 17,000 |
| Delivery truck | 2,000 | 25,000 | 17,500 | 7,500 | (5,500) |
| Warehouse | 350,000 | 275,000 | 15,000 | 260,000 | 90,000 |
| Land | 175,000 | 75,000 | 0 | 75,000 | 100,000 |
| Total gain realized | $272,842 |
Recognized Gain or Loss on Disposition
Gains (losses) that increase (decrease) taxpayers’ gross income
Taxpayers must immediately recognize the vast majority of realized gains and losses; they may be allowed to permanently exclude the gains from taxable income.
Dispositions (6 of 6)
11-8
An asset’s initial adjusted basis depends on how the asset was acquired. Generally, a purchased asset’s initial basis is its initial cost.
Gifts
If, at date of gift, FMV > donor’s basis, then donee’s basis is a carryover basis.
If, at date of gift, FMV < donor’s basis, then donee uses a carryover basis if the asset is later sold for a gain. If asset is later sold for a loss, the donee uses the FMV as of the date of gift for the basis.
Determination of Adjusted Basis (1 of 3)
11-9
Inherited Property
The heir’s basis in property passing from a decedent to the heir is the FMV on the date of the decedent’s death.
An alternative valuation date (six months after date of death) may be used to determine the basis to the heirs if elected by the estate.
Determination of Adjusted Basis (2 of 3)
11-10
Property Converted from Personal Use to Business Use
Basis depends on whether the property appreciated or declined in value during the time the property was used personally.
Appreciated: taxpayer uses the basis.
Declined in value: taxpayer uses FMV at the date of conversion for calculating loss.
Determination of Adjusted Basis (3 of 3)
11-11
Scrap-Happy owns a computer (five-year MACRS recovery period) that it purchased two years ago for $1,200. For financial statement purposes, the computer depreciates over three years using the half-year convention and straight-line method, with no salvage value. What are the adjusted book and tax bases for the computer (after two years of depreciation)?
Answer:
Example: Adjusted Basis
11-12
| Book | Tax | |
| Cost Basis: | $1,200 | $1,200 |
| Yr Dep. (HY): | (200) | (240) |
| Yr Dep.: | (400) | (384) |
| Adjusted Basis: | $ 600 | $576 |
Scrap-Happy sells the computer in the previous example (adjusted tax basis = $576) for $400. What is the realized gain or (loss) on the sale?
Answer:
$400: Amount realized
(576): Adjusted basis
($176): (loss) realized
Example
11-13
EXHIBIT 11-3 Character of Assets Depending on Property
11-14
Character of Gain or Loss (1 of 6)
*Gains on the sale of personal-use assets are taxable capital gains, but losses on the sale of personal-use assets are not deductible.
†As we describe later in the chapter, gain or loss is eventually characterized as ordinary or capital (long-term).
| Holding Period | Property Use: Trade or Business | Property Use: Investment or Personal-Use Assets* | Property Use: Inventory and Accounts Receivable |
| Short-term (one year or less) | Ordinary | Short-term capital | Ordinary |
| Long-term (more than one year) | § 1231† | Long-term capital | Ordinary |
Ordinary Assets
Assets created or used in a taxpayer’s trade or business
Business assets held for less than a year
Example—inventory, accounts receivable, machinery, and equipment
If taxpayers sell ordinary assets at a gain, they recognize an ordinary gain that is taxed at ordinary rates.
If taxpayers sell ordinary assets at a loss, they deduct the loss against other ordinary income.
Character of Gain or Loss (2 of 6)
11-15
Capital Assets
Assets held for investment, for the production of income, or for personal use
Qualification as capital asset depends on the purpose for which taxpayer uses the asset.
Both individual and corporate taxpayers prefer capital gains to ordinary income.
Character of Gain or Loss (3 of 6)
11-16
EXHIBIT 11-4 Review of Capital Gains and Losses
Character of Gain or Loss (4 of 6)
11-17
| Taxpayer Type | Preferential Rate | Loss Limitations |
| Individuals | Net capital gains on assets held more than one year are taxed at 15 percent (0 percent to the extent taxable income including the gain is below the maximum 0 percent threshold and 20 percent to the extent taxable income including capital gains is above the maximum 15 percent threshold). When determining which capital gains tax rate applies, capital gains that fall within the range of taxable income specified in the Tax Rate tables are included in taxable income last. Unrecaptured §1250 gains on real property held more than one year remaining after the netting process are taxed at a maximum rate of 25 percent. Net gains on collectibles held for more than a year and qualified small business stock are taxed at a maximum rate of 28 percent. Net capital gains on assets held one year or less are taxed at ordinary rates. | Individuals may annually deduct up to $3,000 of net capital losses against ordinary income. Losses can be carried forward indefinitely but not carried back. |
Character of Gain or Loss (5 of 6)
11-18
| Taxpayer Type | Preferential Rate | Loss Limitations |
| C Corporations | No preferential rates; taxed at ordinary rates. | No offset against ordinary income. Net capital losses can generally be carried back three years and forward five years to offset net capital gains in those years. |
§1231 Assets
Depreciable assets and land used in a trade or business held for more than one year
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.
Character of Gain or Loss (6 of 6)
11-19
Potentially applies to gains (not losses) on the sale of depreciable or amortizable business property
When applied, it recharacterizes the gain on the sale of a §1231 asset.
Does not affect §1231 losses.
Computation depends on the type of §1231 assets the taxpayer is selling (personal or real property).
Changes only the character but not the amount of gain that taxpayers recognize when they sell a depreciable asset.
Depreciation Recapture (1 of 6)
11-20
EXHIBIT 11-5 §1231 Asset Types
Depreciation Recapture (2 of 6)
11-21
§1245 Property
Personal property and amortizable intangible assets are §1245 assets.
The lesser of
Gain recognized or
Total accumulated depreciation (or amortization) on the asset.
Any remaining gain is §1231 gain.
There is no depreciation recapture on assets sold at a loss.
Depreciation Recapture (3 of 6)
11-22
When taxpayers sell or dispose of §1245 property, they encounter one of the following three scenarios of gain or loss:
Recognize a gain created solely through depreciation deductions.
Recognize a gain created through both depreciation deductions and actual asset appreciation.
Recognize a loss.
Depreciation Recapture (4 of 6)
11-23
EXHIBIT 11-6 Machinery §1245 Depreciation Recapture Scenarios 1, 2, and 3
Depreciation Recapture (5 of 6)
11-24
§1250 Depreciation Recapture for Real Property
Depreciable real property (such as an office building or a warehouse) sold at a gain is not subject to §1250 depreciation recapture.
A modified version of the recapture rules called §291 depreciation recapture applies to C corporations but not to other types of taxpayers.
Under §291, C corporations selling depreciable real property recapture as ordinary income 20 percent of the lesser of the recognized gain or the accumulated depreciation.
Depreciation Recapture (6 of 6)
11-25
Scrap-Happy 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?
Answer:
§1231 ASSETS: §1245 Recapture Example (1 of 2)
11-26
| $10,000 | Selling price |
| −6,000 | Adjusted basis |
| $4,000 | Gain realized |
Depreciation recapture = Lesser of:
Depreciation taken: $2,500
Gain realized: $4,000
Depreciation recapture (ordinary income) = $2,500
§1231 ASSETS: §1245 Recapture Example (2 of 2)
11-27
| §1231 gain (capital gain) = | $4,000 | Gain realized |
| −2,500 | Depreciation recapture | |
| $1,500 | §1231 gain |
Unrecaptured §1250 Gain for Individuals
Depreciable real property sold at a gain is §1250 property, but is generally no longer subject to §1250 recapture.
The gain that would be §1245 recapture if the asset were §1245 property is called unrecaptured §1250 gain.
Unrecaptured §1250 gain is §1231 gain that, if ultimately characterized as a long-term capital gain, is taxed at a maximum rate of 25 percent.
Other Provisions Affecting the Rate at Which Gains are Taxed (1 of 3)
11-28
Characterizing Gains on the Sale of Depreciable Property to Related Persons (§1239)
All gain recognized from selling property, i.e., a depreciable asset, to a related-person buyer is ordinary income.
Seller is required to recognize ordinary income for depreciation deductions the buyer will receive in the future.
The tax laws are designed to provide symmetry between the character of deductions an asset generates and the character of income the asset generates when it is sold.
Other Provisions Affecting the Rate at Which Gains are Taxed (2 of 3)
11-29
Includes an individual and his or her controlled (more than 50 percent owned) corporation or partnership or a taxpayer and any trust in which the taxpayer (or spouse) is a beneficiary
Also includes two corporations that are members of the same controlled group, a corporation and a partnership if the same person owns more than 50 percent of both entities, two S corporations controlled by the same person, and an S corporation and a C corporation controlled by the same person
Other Provisions Affecting the Rate at Which Gains are Taxed (3 of 3)
11-30
Taxpayer could benefit from this strategy in three ways:
Accelerating losses into year 1
Deferring gains until year 2
Characterizing the gains and losses due to the §1231 netting process
Calculating Net §1231 Gains or Losses (1 of 5)
11-31
§1231 Look-Back Rule
A nondepreciation recapture rule
Affects the character but not the amount of gains on which a taxpayer is taxed
Gains and losses from individual asset dispositions are annually netted together.
Net §1231 gains may be recharacterized as ordinary income under the §1231 look-back rule.
Calculating Net §1231 Gains or Losses (2 of 5)
11-32
EXHIBIT 11-7
Calculating Net §1231 Gains or Losses (3 of 5)
11-33
EXHIBIT 11-8 §1231 Netting Process
Calculating Net §1231 Gains or Losses (4 of 5)
11-34
EXHIBIT 11-9 Summary of Teton Gains and Losses on Property Dispositions
11-35
Calculating Net §1231 Gains or Losses (5 of 5)
*Because the warehouse is §1231 property, the $90,000 gain is included in the §1231 gain (loss) column. Further, $15,000 of the $90,000 gain is considered unrecaptured §1250 gain (see Example 11-11).
†This exhibit assumes that Teton had $10,000 of net §1231 losses in the prior five years.
Like-Kind Exchanges
For an exchange to qualify as a like-kind exchange for tax purposes, the transaction must meet the following three criteria:
Real property is exchanged “solely for like-kind” property.
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.
The exchange must meet certain time restrictions.
Nonrecognition Transactions (1 of 10)
11-36
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
Nonrecognition Transactions (2 of 10)
11-37
Property Ineligible for Like-Kind Treatment
Includes real property held for sale,
Property used outside the United States, and
Domestic property exchanged for property used in a foreign country
Nonrecognition Transactions (3 of 10)
11-38
Property Use
Timing Requirements for a Like-Kind Exchange
Like-kind property exchanges may involve intermediaries.
Taxpayers must identify replacement “like-kind” property within 45 days of giving up their property.
“Like-kind” property must be received within 180 days of when the taxpayer transfers property in a “like-kind” exchange.
Nonrecognition Transactions (4 of 10)
11-39
EXHIBIT 11-12 Diagram of Deferred or Starker Exchange
Nonrecognition Transactions (5 of 10)
11-40
Tax Consequences When Like-Kind Property is Exchanged Solely for Like-Kind Property
Tax Consequences of Transfers Involving Like-Kind and Non-Like-Kind Property (Boot)
Non-like-kind property is known as boot.
When boot is given as part of a like-kind transaction
The asset received is recorded in two parts: property received in exchange for like-kind property and property received in a sale (bought by the boot).
Nonrecognition Transactions (6 of 10)
11-41
When boot is received
Boot received usually creates recognized gain.
Gain recognized is lesser of gain realized or boot received.
Adjusted basis of boot received is the fair market value of the boot.
Adjusted basis of like-kind property surrendered + Adjusted basis of boot given + Gain recognized − Fair market value of boot received − Loss recognized = Basis of like-kind property received.
The basis of boot received is the fair market value of the boot.
Nonrecognition Transactions (7 of 10)
11-42
Reporting Like-Kind Exchanges
Involuntary Conversions
Gain is deferred when appreciated property is involuntarily converted in an accident or natural disaster.
Basis of property directly converted is carried over from the old property to the new property.
In an indirect conversion, gain recognized is the lesser of gain realized or amount of reimbursement the taxpayer does not reinvest in qualified property.
Qualified replacement property must be of a similar or related use to the original property.
Nonrecognition Transactions (8 of 10)
11-43
Installment Sales
Sale of property where the seller receives the sale proceeds in more than one period
Must recognize a portion of gain on each installment payment received
11-44
Nonrecognition Transactions (9 of 10)
Inventory, marketable securities, and depreciation recapture cannot be accounted for under installment sale rules.
Does not apply to losses
Gains Ineligible for Installment Reporting
Other Nonrecognition Provisions
Related-Person Loss Disallowance Rules
Tax laws essentially treat related persons as though they are the same taxpayer.
Related persons are defined in §267 and include certain family members, related corporations, and other entities (partnerships).
Losses on sales to related persons are not deductible by the seller.
Related person may deduct the previously disallowed loss to the extent of the gain on the sale to the unrelated third person.
Nonrecognition Transactions (10 of 10)
11-45
End of Presentation
11-46
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