Chapter 11
Tax Consequence of Property
Disposal
Computation of Realized
Gain or Loss
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Everything of economic value
received in exchange for a
property comprises the
consideration
If seller receives other property or
services as part of the transaction,
these must be included at their fair
market value
Difference between consideration
received and the adjusted tax
basis at the time of the transaction
is the realized gain or loss on
disposal
Tax Treatment of
Realized Gain or Loss
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Gains are ordinary income
when they result from recapture
of depreciation allowances.
Gains are also ordinary income
when they result from selling
real estate that has been held
for resale in the normal course
of business (dealer property).
Gains on the sale or exchange
of real estate held for business
or investment purposes are
capital gains. If the holding
period exceeds one year, the
gain is a long-term capital gain.
Tax Treatment of
Realized Losses
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Real estate used in a trade or
business (includes actively
managed rental property) and held
for more than one year are called
Section 1231 assets. Gains on
their disposal are treated as capital
gains, losses are treated as offsets
against ordinary income.
Losses on real estate held for
investment purposes are capital
losses. If the real estate is held for
more than one year, the loss is a
long-term capital loss
Computing Net Gain or Loss
on Sale of Assets Held for
Use in Trade or Business
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Offset Section 1231 gains and
losses against each other.
Offset long-term capital gains
against long-term capital
losses
Offset short-term capital
against against short-term
capital losses
If there are net losses in one
category and gains in the
other, offset the two
Tax Consequences Depends
Upon Outcome of Offsetting
Gains and Losses
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If outcome is net short-term gains,
lump them with ordinary income
If outcome is net long-term gains,
they are taxed at the maximum
rate of 15%, regardless of
taxpayer’s marginal tax bracket.
Recaptured depreciation is taxed
at 25%
If outcome is net losses, they are
offset against ordinary income on a
dollar-for-dollar basis, but only to
the extent of $3,000 per year
When Realized Gains or
Losses Are Recognized
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Gains are realized when a
transaction is completed
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They may be recognized (and
tax consequences
experienced) in that year or at
another time
Use of the Installment
Method
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If seller takes back a promissory
note in part payment for property, it
may be possible to defer
recognition of part of the taxable
gain until principal amount of the
note is collected
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Gain that may be deferred is the
installment method gain –total gain
minus any portion that represents
recapture of accelerated
depreciation allowances
Use of the Installment
Method
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Contract price is total selling
price, less balance of any
mortgage note payable by the
purchaser to a third party
Each year, recognized gain is
determined by multiplying the
amount of the sales price
actually collected by the
seller, multiplied by the ratio of
the installment method gain to
the contract price
Use of the Installment
Method
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Installment note must include a
provision for reasonable rate of
interest—otherwise, IRS imputes a
reasonable rate and recalculates
the tax consequences of the
transaction
Complex tax rules limit the extent
to which a taxpayer can defer a
gain by using the installment
method when they themselves own
substantial amount of mortgage
indebtedness
Like-Kind Exchanges
(1031 Exchanges)
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An otherwise taxable gain
realized on an exchange of
like-kind assets need not be
recognized in the year of the
transaction. Tax liability is
postponed until a future,
taxable transaction occurs
with respect to the newly
acquired property.
Like-Kind Exchanges
(1031 Exchanges)
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Enabling legislation for likekind exchanges (called taxfree exchanges) is contained
in Section 1031 of the Internal
Revenue Code.
Like-Kind Exchanges
(1031 Exchanges)
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To qualify under Section 1031:
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Must have been bona fide
exchange of assets involved
Property conveyed must have
been held for productive use in
a trade or business or an
investment and must be
exchanged for like-kind property
that is also to be used in a trade
or business or held as an
investment
Property must be of like-kind
Like-Kind Exchanges
(1031 Exchanges)
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Certain types of property are
specifically excluded form
Section 1031
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Foreign real estate is never
considered like-kind with
domestic real estate
Tax Consequences of
Like-Kind Exchanges
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If all property involved in an
exchange qualifies as like-kind and
all parties qualify, then no party to
the exchange may recognize any
gain or loss on the transaction.
Should some of the property
involved in an exchange fail the
like-kind test, then some portion of
a gain must be recognized in the
year of the transaction.
Receipt of property that does not
meet the like-kind definition has
the effect of partially disqualifying a
gain from deferral under Section
1031.
Gifts of Property
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Gifts and legacies are
subjected to a unified,
graduated gift and estate tax
that is imposed on the person
who makes a gift or to the
estate of a decedent
Gifts of Property
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Exemptions and exclusions
from the gift and estate tax:
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One may give as much as
$11,000 each to as man
persons as one wishes each
year with no gift tax implications
($22,000 for spouses)
Unlimited exemption for gifts or
legacies to a spouse who is a
United States citizen
Unlimited exemption for
payment of tuition and medical
expenses for others
Gifts of Property
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Gifts are cumulative over the
giver’s lifetime for purposes of
determining the graduated tax
rate, but gift taxes are due in
the year the gift is made
Each taxpayer has a lifetime
credit against the unified gift
and estate tax. The amount
of the credit will shelter
$1,000,000
Gifts of Property
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Gift of property that is subject
to a mortgage will have sale
as well as gift elements
The tax basis of a recipient’s
interest in property received
as a gift is the same as the
basis of the giver’s, unless the
giver incurred a gift tax
liability.
Letting title pass as a legacy
rather than a gift works better
for highly appreciated
property