Business Sale of Equipment Capital Gains Tax by moj39425


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									                                Chapter 8

               Property Transactions:
      Capital Gains and Losses, Section 1231,
              and Recapture Provisions

Taxation of Business Entities                   C8-1
                     Taxation of Capital
                      Gains and Losses
      • Capital gains and losses must be separated
        from other types of gains and losses for two
          – Long-term capital gains may be taxed at a
            lower rate than ordinary gains
          – The deduction of a net capital loss may be

Taxation of Business Entities                            C8-2
                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

Taxation of Business Entities                                         C8-3
                          Capital Assets
                                (slide 1 of 5)

      • §1221 defines capital assets as everything
          – 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)

Taxation of Business Entities                                  C8-4
                          Capital Assets
                                   (slide 2 of 5)

      • §1221 defines capital assets as everything except
          – 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
Taxation of Business Entities                                                       C8-5
                          Capital Assets
                                (slide 3 of 5)

      • Thus, capital assets are:
          – Assets held for investment (e.g., stocks, bonds,
          – Personal use assets (e.g., residence, car)
          – Miscellaneous assets selected by Congress

Taxation of Business Entities                                  C8-6
                          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

Taxation of Business Entities                                     C8-7
                            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
                    – That potential ordinary income is offset by any selling
                      expenses from the lot sales

Taxation of Business Entities                                                             C8-8
                       Sale or Exchange
                                (slide 1 of 11)

      • Recognition of capital gains and losses
        generally requires a sale or exchange of
      • Sale or exchange is not defined in the Code
      • There are some exceptions to the sale or
        exchange requirement

Taxation of Business Entities                         C8-9
              Sale or Exchange–Worthless
                    Securities (slide 2 of 11)
      • A security that becomes worthless creates a
        deductible capital loss without being sold or
          – 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

Taxation of Business Entities                                             C8-10
                       Sale or Exchange
                                (slide 3 of 11)

      • Worthless securities example:
          – Calendar year taxpayer purchased stock on
            December 5, 2007
          – The stock becomes worthless on April 5, 2008
          – The loss is deemed to have occurred on
            December 31, 2008
              • The result is a long-term capital loss

Taxation of Business Entities                              C8-11
          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

Taxation of Business Entities                              C8-12
               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

Taxation of Business Entities                                          C8-13
               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

Taxation of Business Entities                                  C8-14
              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
          – 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

Taxation of Business Entities                                  C8-15
            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

Taxation of Business Entities                                       C8-16
            Sale or Exchange–Franchises,
            Trademarks, and Trade Names
                                (slide 9 of 11)

      • Significant powers, rights, or continuing interests
          – Control over assignment, quality of products and
          – 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

Taxation of Business Entities                                          C8-17
            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
Taxation of Business Entities                             C8-18
                  Sale or Exchange–Lease
                   Cancellation Payments
                                   (slide 11 of 11)

      • Lessee treatment
          – Treated as received in exchange for underlying leased
              • 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)

Taxation of Business Entities                                                     C8-19
                         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

Taxation of Business Entities                          C8-20
                         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

Taxation of Business Entities                                        C8-21
                         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
          – The holding period for a short sale is determined by
            how long the property used for repayment is held

Taxation of Business Entities                                        C8-22
               Tax Treatment of Capital
               Gains and Losses (slide 1 of 6)
      • Noncorporate taxpayers
          – Capital gains and losses must be netted by holding
              • 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

Taxation of Business Entities                                                 C8-23
               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

Taxation of Business Entities                                           C8-24
               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
              • The 28% rate applies to collectibles
              • The 0%/15% rates apply to any remaining net long-
                term capital gain

Taxation of Business Entities                                       C8-25
               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

Taxation of Business Entities                                 C8-26
               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

Taxation of Business Entities                        C8-27
               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

Taxation of Business Entities                                             C8-28
                           §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

Taxation of Business Entities                                           C8-29
                           §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
          – 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

Taxation of Business Entities                                         C8-30
                           §1231 Assets
                                (slide 3 of 4)

      • If transactions involving §1231 assets result
          – Net §1231 loss = ordinary loss
          – Net §1231 gain = long-term capital gain

Taxation of Business Entities                           C8-31
                           §1231 Assets
                                (slide 4 of 4)

      • Provides the best of potential results for the
          – Ordinary loss that is fully deductible FOR AGI
          – Gains subject to the lower capital gains tax

Taxation of Business Entities                                C8-32
                    Special Rules For
                   Certain §1231 Assets
      • 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
              • If a net gain, treat as §1231 gain

Taxation of Business Entities                                                C8-33
                Special Rules For
           Certain §1231 Assets (slide 4 of 4)
      • 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

Taxation of Business Entities                                              C8-34
                  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
              • 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

Taxation of Business Entities                                                     C8-35
                  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

Taxation of Business Entities                                                            C8-36
                  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

Taxation of Business Entities                                                 C8-37
          Lookback Provision Example
      • Taxpayer had the following net §1231 gains
        and losses:
                    2006         $ 4,000 loss
                    2007          10,000 loss
                    2008          16,000 gain
          – In 2008, 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

Taxation of Business Entities                               C8-38
                 §1231 Netting Procedure
                                         (slide 1 of 2)

                             §1231 asset and long-term nonpersonal use
                                    capital asset casualty gains
        Net Gain                               minus
                                                                               Net Loss
                             §1231 asset and long-term nonpersonal use
                                    capital asset casualty losses

           Net Gain                                           Items treated separately: Gains are
                                                                 ordinary income, §1231 asset
      (add to §1231 gains)                                       losses are deductible for AGI,
                                                               Other losses deductible from AGI

                                     §1231 gains
                                        minus                   Net Loss
                                     §1231 losses

                                      Net Gain

Taxation of Business Entities                                                                   C8-39
               §1231 Netting Procedure
                                    (slide 2 of 2)
                                              Net Gain
                                   Lookback Provision:
                                Net gain is offset against
                             nonrecaptured net §1231 losses
                                  from 5 prior tax years

                  Gain offset by lookback                Remaining gain
                  losses is ordinary gain                  is LTCG

Taxation of Business Entities                                             C8-40
                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
              • No recapture occurs in loss situations

Taxation of Business Entities                            C8-41
                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
              • §1245
              • §1250

Taxation of Business Entities                         C8-42
                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

Taxation of Business Entities                                            C8-43
                       §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

Taxation of Business Entities                                         C8-44
                       §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)

Taxation of Business Entities                                C8-45
                       §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

Taxation of Business Entities                              C8-46
                 Observations on § 1245
      • 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
      • 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
      • 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

Taxation of Business Entities                                                          C8-47
                       §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)

Taxation of Business Entities                                          C8-48
                       §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

Taxation of Business Entities                                 C8-49
                       §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

Taxation of Business Entities                                        C8-50
                  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

Taxation of Business Entities                                 C8-51
                  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

Taxation of Business Entities                                C8-52
                  Additional Recapture
                   for Corporations
      • Corporations that sell depreciable real estate
        face an additional amount of depreciation
          – 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

Taxation of Business Entities                                C8-53
           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

Taxation of Business Entities                                 C8-54
           Related Effects of Recapture
                                (slide 2 of 5)

      • Inheritance
          – Death is only way to eliminate recapture
          – That is, depreciation recapture potential does
            not carry over from decedent to heir

Taxation of Business Entities                                C8-55
           Related Effects of Recapture
                                (slide 3 of 5)

      • Charitable contributions
          – Recapture potential reduces the amount of
            charitable contribution deductions that are
            based on FMV

Taxation of Business Entities                             C8-56
           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
              • If gain is recognized, it is treated as ordinary income to the
                extent of the recapture potential or recognized gain, whichever
                is lower

Taxation of Business Entities                                                     C8-57
           Related Effects of Recapture
                                (slide 5 of 5)

      • Like-kind exchanges and involuntary
          – 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

Taxation of Business Entities                                          C8-58

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