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7 - Property Dispositions Chapter 7

Property Dispositions

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Property Dispositions. Chapter 7. Tax Impact on Cash Flow. Taxes paid on a recognized gain reduce net cash flow Tax savings generated by a recognized loss increase net cash flow Tax impact on cash flow is affected by the Type of asset and its holding period Type of taxpayer - PowerPoint PPT Presentation

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Page 1: Property Dispositions

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PropertyDispositions

Chapter 7

Page 2: Property Dispositions

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Tax Impact on Cash Flow

Taxes paid on a recognized gain reduce net cash flow

Tax savings generated by a recognized loss increase net cash flow

Tax impact on cash flow is affected by the Type of asset and its holding period Type of taxpayer Taxpayer’s marginal tax rate

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Types of Dispositions

Sale – seller receives cash or cash equivalents in return for asset

Exchange – taxpayer receives property other than cash or cash equivalents in return for property transferred to the other party

Involuntary conversion – complete or partial destruction due to events not under control of taxpayer (condemnations, thefts, and casualties)

Abandonment – property is permanently withdrawn from use (loss = basis of asset)

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Amount Realized

Cash + FMV of property received + Seller’s liabilities assumed by the buyer - Buyer’s liabilities assumed by the seller- Selling expensesAmount Realized

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Realized Gain or Loss

Amount realized - Adjusted basis of property given up

Realized gain or loss

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Recognized Gain or Loss

Almost all realized gains are recognized (taxable)

Losses are usually only recognized (deductible) if they are Incurred in a business Incurred in an investment activity Casualty or theft losses

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Holding Period

Holding period The period of time the taxpayer is credited

with owning the property Usually begins on date of acquisition unless

there is a carryover or substituted basis for the asset acquired

Property held for more than one year receives favorable tax treatment if Section 1231 assets Capital assets

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Holding Period

Gifts – holding period carries over from donorException – when FMV at date of gift is used

for basis, holding period begins on date of gift Inherited property – always long-term holding

period

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Types of Assets

Section 1231 assets – fixed assets (property, plant, and equipment) used in a trade or business and held for more than one year

Capital assets – investment and personal-use assets

Ordinary income assets – inventory, accounts receivable, and all other assets that are neither Section 1231 nor capital assets

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Section 1231 Property

Property used in a business that is subject to cost recovery deductions and is held for more than one year (long-term holding period)

Land used in a business that is held for more than one year

Gains (after recapture provisions are applied) and losses on individual Section 1231 property dispositions are subject to a netting process to determine tax treatment

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Determining Net Section 1231 Gain/Loss Treatment

Step 1: Determine the gain or loss for each Section 1231 asset

Step 2: Reduce the gains for depreciation recapture (depreciation

recapture included in ordinary income)

Step 3: Net the remaining gains and losses

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Determining Net Section 1231 Gain/Loss Treatment

Step 4: If the result is a net loss, deduct it in full from ordinary income

Step 5: If the result is a net gain, apply the 5-year look-back rule

Gains up to the amount of previously unrecaptured Section 1231 losses are included in and taxed as ordinary income

Step 6: The remaining net Section 1231 gain is treated as a net long-term capital gain and included in capital gain netting process

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Depreciation Recapture

Depreciation recapture converts part or all of the gain recognized on the sale of depreciable assets to ordinary income to the extent of the reduction in basis attributable to depreciation expense previously claimed

The amount of income recaptured as ordinary income can never exceed either the realized gain or prior depreciation deductions

Recapture rules do not apply to assets on which there is a realized loss

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Section 1245 Full Recapture

Applies to machinery, equipment, furniture, and fixtures (but not to buildings or structural components)

Any gain on the sale of section 1245 property is ordinary income to the extent of all depreciation allowed or allowable for the property Any amount expensed under section 179 is

included in the depreciation allowed The income recaptured is the lesser of all

depreciation taken or the realized gain

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Section 1250Partial Recapture

Applies to realty Section 1250 recaptures the excess of

accelerated depreciation over straight line depreciation

For realty placed in service after 1986, for which straight-line depreciation must be used, there is no Section 1250 recapture for noncorporate taxpayers Section 291 for corporations Section 1250 unrecaptured gain for

individuals

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Additional Section 291 Recapture for Corporations

Section 291 applies to corporate dispositions of realty (Section 1250 property)

Converts to ordinary income (as Section 1250 recapture) 20% of any Section 1231 gain that would have been ordinary income if Section 1245 full recapture applied For realty acquired after 1986, Section 1245 full

recapture x 20% = Section 1250 recapture Eliminates some of the capital gains that would

otherwise be available to offset corporate capital losses

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Unrecaptured Section 1250 Gain

For individuals, unrecaptured Section 1250 gains are those long-term capital gains on realty that would be taxed as ordinary income if the Section 1245 full recapture rules applied

These long-term capital gains attributable to prior depreciation deductions are taxed at a maximum rate of 25%

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Section 1231 Netting

Step 1: Net casualty and theft gains (after recapture) and losses on Section 1231 assets and investment assetsIf a net loss, all gains and losses are ordinary

except investment losses of individuals (miscellaneous itemized deductions)

A net gain is included in Step 2

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Step 2: Net gains (after recapture) and losses from all other Section1231 assets and involuntary conversions of investment assets with net gain from step 1If a net loss, treat as described under step 1If a net gain, apply Section 1231 look-back

rules

Section 1231 Netting

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Section 1231 Netting

Step 3: Any net gain remaining after the Section 1231 look-back rules are applied is treated as a long-term capital gain and included in the capital asset netting processThis netting process allows taxpayers to claim

ordinary loss treatment for net losses and favorable capital gains treatment for net gains after application of the recapture provisions

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Section 1231 Look-Back Rules

Net Section 1231 gains are taxed as ordinary income to the extent of any unrecaptured net Section 1231 losses in the five preceding years This prevents taxpayers from generating tax

savings by bunching their Section 1231 gains into one year (to receive tax-favored long-term capital gains treatment) and losses into alternate years (deducting the Section 1231 losses in full against ordinary income)

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Capital Assets

Capital assets include stocks, bonds, land held for appreciation, collectibles (coins, art), and personal-use assets

Long-term holding period is more than one year

Short-term holding period is one year or less

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Capital Gain and LossNetting Process

Step 1: Subtract long-term capital losses from long-term capital gains (including net Section 1231 gains)

Step 2: Subtract short-term losses from short-term gains

Step 3: Continue netting (subtracting losses from gains) until only gains or only losses remain

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Capital Gain and LossNetting Process

A (net) short-term capital gain resulting from this process is taxed at ordinary income rates

Taxation of (net) long-term capital gains and all capital losses differs for corporations and individuals

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Capital Gains and Lossesof C Corporations

No current deduction for capital losses; carry back 3 years and forward 5 years to use only against capital gains

Both long-term and short-term capital gains taxed as ordinary income

Benefit of capital gains is limited to ability to offset capital losses

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Capital Losses for Individuals

$3,000 per year deduction against other income for capital losses; (net) short-term capital losses deducted before (net) long-term capital losses

Remaining (net) capital losses are carried forward indefinitely (no carry back permitted)

Losses on personal-use assets are not recognized (deductible) even though gains are recognized (taxable)

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General Capital GainsRates for Individuals

15% rate applies to most long-term capital gains for individuals

Zero rate may apply to low income individuals (in the 10% and 15% tax brackets)

Rates of up to 28% may apply in some cases

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Ordinary Income Property Ordinary income property includes:

Business assets that do not meet the more-than-one year holding period under Section 1231

Inventory Accounts and notes receivable arising from sale

of goods or services by a business Any other asset that is not a capital or a Section

1231 asset Ordinary gains are taxed as ordinary income

and losses are fully deductible as ordinary losses

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Mixed-Use Property

Property that is used partly for business and partly for personal use must be divided into Section 1231 property and personal-use propertyGain or loss determined separately for

business and personal-use partsCharacter of each part dictates treatment

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Section 1244 Stock

Losses on stock are usually capital losses; individuals are limited to an annual $3,000 deduction against ordinary income after netting losses against capital gains

Section 1244 permits an ordinary loss deduction of up to $50,000 ($100,000 if a joint return) annually for losses on qualified stock Individual must be the original investor in a

domestic small business corporation Any excess loss is a capital loss

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Section 1244 Stock

Total capitalization cannot exceed $1 million For the 5 preceding years

The corporation must be an operating company deriving 50% or more of its annual gross revenues from the sale of goods or services

Income from rents, royalties, dividends, interest, annuities and gain on sales of securities is limited to 50% or less

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Section 1202 Stock

To be a qualified small business corporation it must 1) Be a domestic C corporation, 2) Have no more than $50 million in assets, and 3) Be an active business engaged in

manufacturing, retailing, or wholesaling Seller of stock must be the original owner who

acquires the stock in exchange for money, property, or services

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Section 1202 Small Business Stock Gain Exemption

Taxpayers may exclude up to 50% of the gain realized on the disposition of qualified small business stock held for more than 5 years (for stock acquired before 2/18/09 and after 12/31/10) Remaining taxable portion of the gain is taxed

at the 28% long-term capital gain rate For small business stock acquired after

2/17/09 and before 1/1/11, 75% of the realized gain may be excluded

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Section 1202 Stock

Gain eligible for the exclusion cannot exceed the greater of10 times the adjusted basis of qualifying stock sold in

the tax year or$10,000,000 less any eligible gain on qualifying stock in

the preceding tax years by the taxpayer If taxpayer holds stock at least 6 months and

invests all proceeds in another qualified small business corporation’s stock, no gain recognized If all proceeds not reinvested, only gain proportionate to

the reinvested proceeds can be excluded

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Sale of Principal Residence

An individual who has owned and occupied a home as a principal residence for at least 2 of the 5 years before the sale can exclude up to $250,000 of gain ($500,000 for qualified married taxpayers filing a joint return)

The full exclusion can only be used once every 2 years

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Sale of Principal Residence

Married taxpayers filing jointly can exclude up to $500,000 of gain if:1) Either spouse owned the home for at least 2

of previous 5 years, and2) Both spouses used the home as a principal

residence for at least 2 of previous 5 years, and

3) Neither spouse is ineligible for the exclusion because of the once-every-2-year limit

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Sale of Principal Residence

For sales after 2007, a surviving spouse can qualify for the up-to-$500,000 exclusion if the sale occurs not later than 2 years after the

spouse’s death the requirements for the $500,000 exclusion were

met immediately before the spouse’s death and the survivor has not remarried as of the date of

sale

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Sale of Principal Residence

Partial exclusion available if failure to meet two-year time period requirement is due toA change in place of employmentHealth (moving into nursing home)Other unforeseen circumstances including

divorce, death of spouse or co-owner, unemployment, disasters, and involuntary conversion of residence

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Sale of Principal Residence

Partial exclusion is calculated by dividing the number of qualifying months by 24 and then multiplying this fraction by $250,000 ($500,000 if qualifying jointly)

The number of qualifying months is the shorter of: The use and ownership during the 5

preceding years or The period of time that has passed since the

taxpayer last claimed the exclusion

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Sale of Principal Residence

The exclusion does not apply to any gain attributable to depreciation claimed for rental or business use of the residence The 25% rate for unrecaptured Section

1250 gain applies to gain up to the previous depreciation deductions

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Sale of Principal Residence

For sales after 2008, the exclusion will not apply to any gain attributable to periods (after 2008) when the home was not used as the principal residence of the taxpayer or the taxpayer’s spouse or former spouse

Nonqualified use would include time it was used as a vacation home or rental property

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Sale of Principal Residence

Gain allocated to periods of nonqualified use is the total amount of gain multiplied by a fraction The numerator is the aggregate period of

nonqualified use (starting after 2008) during the period the property was owned by the taxpayer

The denominator is the period the taxpayer owned the property

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Sale to Related Party

Losses on sales to related parties are disallowed Related parties include brothers, sisters,

spouse, ancestors and lineal descendents, as well as a more-than 50% owned corporation

If related buyer later sells property at a gain, this gain can be reduced (not below zero) by the seller’s previously disallowed loss

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General Capital GainsRates for Individuals

15% rate applies to most long-term capital gains Zero rate applies to taxpayers whose ordinary

income is taxed at the 10% and 15% marginal tax brackets to the extent their long-term gains fall within these marginal tax brackets

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Special Capital Gains Rates for Individuals

25% rate applies to Sec. 1250 unrecaptured gain on realty Gain in excess of the recapture amount is taxed

at 15% rate 28% rate applies to collectibles (such as

antiques, art objects, and rare coins) due to potential personal enjoyment of asset For both 25% and 28% rate gains, if taxpayer’s

ordinary tax rate is 10% or 15%, then the lower ordinary rate applies to gain that falls within that tax bracket

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The End