Chapter 14
Property Transactions: Capital
Gains and Losses, § 1231, and
Recapture Provisions
Comprehensive Volume
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1
The Big Picture (slide 1 of 3)
• Maurice has come to you for tax advice regarding his
investments.
– He inherited $750,000 from his Uncle Joe and, following
the advice of a financial adviser, made the following
investments 9 months ago.
• $5,000 for 100 shares of Eagle Company stock.
• $50,000 for a 50% interest in a patent that Kevin, an
unemployed inventor, had obtained for a special
battery he had developed to power ‘‘green’’ cars.
– To date, Kevin has been unable to market the battery to an auto
manufacturer or supplier.
2
The Big Picture (slide 2 of 3)
• $95,000 to purchase a franchise from Orange, Inc.
• $200,000 in the stock of Purple, a publicly held bank
that does not pay dividends.
– At one time, the stock had appreciated to $300,000, but
now it is worth only $210,000.
• Maurice is considering unloading this stock.
• $50,000 in tax-exempt bonds.
– The interest rate is only 3%.
– Maurice is considering moving this money into taxable
bonds that pay 3.5%.
• $100,000 for a 10% limited partnership interest in a
real estate development.
– Lots in the development are selling well.
3
The Big Picture (slide 3 of 3)
• Maurice read an article that talked about the
beneficial tax rates for capital assets and dividends.
– He really liked the part about ‘‘costless’’ capital gains,
although he did not understand it.
• Maurice has retained his job as a toll booth operator
at the municipal airport.
– His annual compensation is $35,000.
• Respond to Maurice’s inquiries.
– Read the chapter and formulate your response.
4
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
– A net capital loss is only deductible up to $3,000
per year
5
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
6
Capital Assets
(slide 1 of 6)
• §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 a trade or
business (§1231 assets)
7
Capital Assets
(slide 2 of 6)
• §1221 defines capital assets as everything except
(cont’d):
– Certain copyrights; literary, musical, or artistic
compositions; or letters, memoranda, or similar property
• Taxpayers may elect to treat a sale or exchange of certain musical
compositions or copyrights in musical works as the disposition of a
capital asset
– Certain publications of U.S. government
– Supplies of a type regularly used or consumed in the
ordinary course of a business
8
Capital Assets
(slide 3 of 6)
• Thus, capital assets usually include:
– Assets held for investment (e.g., stocks, bonds,
land)
– Personal use assets (e.g., residence, car)
– Miscellaneous assets selected by Congress
9
Capital Assets
(slide 4 of 6)
• 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
10
Capital Assets
(slide 5 of 6)
• 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
11
Capital Assets
(slide 6 of 6)
• Nonbusiness bad debts
– A nonbusiness bad debt is treated as a short-term
capital loss in the year it becomes completely
worthless
• Even if outstanding for more than one year
12
Sale or Exchange
• 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
13
Sale or Exchange–Worthless Securities and
§ 1244 Stock (slide 1 of 2)
• 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
14
Sale or Exchange–Worthless Securities
(slide 2 of 2)
• Worthless securities example:
– Calendar year taxpayer purchased stock on
December 5, 2013
– The stock becomes worthless on April 5, 2014
– The loss is deemed to have occurred on December
31, 2014
• The result is a long-term capital loss
15
Sale or Exchange
Retirement of Corporate Obligations
• 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
16
Sale or Exchange–Options
(slide 1 of 2)
• For the grantee of the option, if the property subject
to the option is (or would be) a capital asset in the
hands of the grantee
– Sale of an option results in capital gain or loss
– Lapse of an option 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
17
Sale or Exchange–Options
(slide 2 of 2)
• 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
18
The Big Picture - Example 13
Options (slide 1 of 4)
• Return to the facts of The Big Picture on p. 14-1.
• On February 1, 2014, Maurice purchases 100 shares
of Eagle Company stock for $5,000.
– On April 1, 2014, he writes a call option on the stock,
giving the grantee the right to buy the stock for $6,000
during the following six-month period.
– Maurice (the grantor) receives a call premium of $500 for
writing the call.
19
The Big Picture - Example 13
Options (slide 2 of 4)
• Return to the facts of The Big Picture on p. 14-1.
• If the call is exercised by the grantee on August 1,
2014, Maurice has $1,500 of short-term capital gain
from the sale of the stock.
– $6,000 + $500 − $5,000 = $1,500
• The grantee has a $6,500 basis for the stock.
– $500 option premium + $6,000 purchase price
20
The Big Picture - Example 13
Options (slide 3 of 4)
• Return to the facts of The Big Picture on p. 14-1.
• Assume that Maurice decides to sell his stock prior to exercise
for $6,000 and enters into a closing transaction by purchasing
a call on 100 shares of Eagle Company stock for $5,000.
– Because the Eagle stock is selling for $6,000, Maurice must pay a call
premium of $1,000.
• He recognizes a $500 short-term capital loss on the closing
transaction.
– $1,000 (call premium paid) − $500 (call premium received)
• On the actual sale of the Eagle stock, Maurice has a short-term
capital gain of $1,000
– $6,000 (selling price) − $5,000 (cost)
21
The Big Picture - Example 13
Options (slide 4 of 4)
• Return to the facts of The Big Picture on p. 14-1.
• Assume that the original option expired unexercised.
– Maurice has a $500 short-term capital gain equal
to the call premium received for writing the option.
• This gain is not recognized until the option expires.
– The grantee has a loss from expiration of the
option.
• The nature of the loss will depend upon whether the
option was a capital asset or an ordinary asset.
22
Sale or Exchange–Patents
• 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
23
The Big Picture - Example 14
Patents (slide 1 of 2)
• Return to the facts of The Big Picture on p. 14-1.
• Kevin transfers his 50% rights in the battery
patent to the Green Battery Co.
– In exchange, he receives $1 million plus $.50 for
each battery sold.
24
The Big Picture - Example 14
Patents (slide 2 of 2)
• Assuming Kevin has transferred all substantial rights,
Kevin automatically has a long-term capital gain.
– Both the $1 million lump-sum payment and the $.50 per
battery royalty qualify (less his basis in the patent).
– Kevin also had an automatic long-term capital gain when
he sold 50% of his rights in the patent to Maurice.
• Whether Maurice gets long-term capital gain
treatment on the transfer to Green Battery will depend
on whether he is a holder (see the discussion below
and Example 15).
25
The Big Picture - Example 15
Holder Of A Patent (slide 1 of 2)
• Return to the facts of The Big Picture on p. 14-1 and
continuing with the facts of Example 14
• Kevin is clearly a holder of the patent
– He is the inventor and was not an employee when
he invented the battery.
26
The Big Picture - Example 15
Holder Of A Patent (slide 2 of 2)
• When Maurice purchased a 50% interest in the patent, he
became a holder if the patent had not yet been reduced to
practice.
– Since the patent was not being manufactured at the time of the
purchase, it had not been reduced to practice.
• Consequently, Maurice is also a holder.
– He has an automatic long-term capital gain or loss if he transfers his
50% interest to Green Battery Co.
• Maurice’s basis for his share of the patent is $50,000, and his
share of the proceeds is $1 million plus $.50 for each battery
sold.
• Thus, Maurice has a long-term capital gain even though he has
not held his interest in the patent for more than one year.
27
Sale or Exchange–Franchises, Trademarks, and
Trade Names (slide 1 of 3)
• 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
28
Sale or Exchange–Franchises, Trademarks, and
Trade Names (slide 2 of 3)
• 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
29
Sale or Exchange–Franchises, Trademarks, and
Trade Names (slide 3 of 3)
• When the transferor retains a significant power, right,
or continuing interest, the transferee’s noncontingent
payments are ordinary income to the transferor
– The franchisee capitalizes the payments and amortizes
them over 15 years
• Whether the transferor retains a significant power,
right, or continuing interest, contingent payments are
ordinary income for the franchisor and an ordinary
deduction for the franchisee
30
The Big Picture - Example 16
Sale of Franchise
• Return to the facts of The Big Picture on p. 14-1
• Maurice sells for $210,000 to Mauve, Inc., the
franchise purchased from Orange, Inc., nine months
ago.
– The $210,000 received by Maurice is not contingent, and
all significant powers, rights, and continuing interests are
transferred.
– The $115,000 gain ($210,000 proceeds − $95,000 adjusted
basis) is a short-term capital gain because Maurice has held
the franchise for only nine months.
31
Sale or Exchange
Lease Cancellation Payments
• 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)
• Lease could be a § 1231 asset if the property is used in lessee’s
trade or business and the lease has existed for > a year when it is
canceled
• Lessor treatment
– Payments received are ordinary income
• Considered to be in lieu of rental payments
32
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
33
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
• Certain disallowed loss transactions
– Under several Code provisions, realized losses are disallowed.
– When a loss is disallowed, there is no carryover of holding period.
• e.g., Related party losses, sale or exchange of personal use assets
• Inherited property is always treated as long term no matter
how long it is held by the heir
34
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
35
The Big Picture - Example 21
Holding Period
• Return to the facts of The Big Picture on p. 14-1
• Assume that Maurice purchased the Purple
stock on January 15, 2013.
– If he sells it on January 16, 2014, Maurice’s
holding period is more than one year.
– If instead Maurice sells the stock on January 15,
2014, the holding period is exactly one year, and
the gain or loss is short term.
36
Tax Treatment of Capital
Gains and Losses (slide 1 of 7)
• 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
37
Tax Treatment of Capital
Gains and Losses (slide 2 of 7)
• 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
38
Tax Treatment of Capital
Gains and Losses (slide 3 of 7)
• Noncorporate taxpayers (cont’d)
– Net long-term capital gain is eligible for one or
more of five alternative tax rates: 0%, 15%, 20%,
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%/20% rates apply to any remaining net
long-term capital gain
– Under the American Taxpayer Relief Act of 2012, the 20%
rate applies beginning in 2013 when the taxpayer’s regular tax
bracket is 39.6%
39
Tax Treatment of Capital
Gains and Losses (slide 4 of 7)
Income Layers for Alternative Tax on Capital Gain Computation
40
Tax Treatment of Capital
Gains and Losses (slide 5 of 7)
• 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
41
Tax Treatment of Capital
Gains and Losses (slide 6 of 7)
• Qualified dividend income paid from current or acc.
E & P is eligible for the 0%/15%/20% long-term
capital gain rates
– After determining net capital gain or loss, qualified
dividend income is added to the net long-term capital gain
portion of the net capital gain and is taxed as 0%/15%/20%
gain
– If there is a net capital loss, it is still deductible for AGI
• Limited to $3,000 per year with the remainder of the loss carrying
over
• In this case, the qualified dividend income is still eligible to be
treated as 0%/15%/20% gain in the alternative tax calculation
– It is not offset by the net capital loss
42
Tax Treatment of Capital
Gains and Losses (slide 7 of 7)
• The alternative tax on net capital gain applies only if
taxable income includes some net long-term capital
gain
– Net capital gain may be made up of various rate layers
• For each layer, compare the regular tax rate with the alternative tax
rate on that portion of the net capital gain
– The layers are taxed in the following order:
• 25% gain, 28% gain, the 0% portion of the 0%/15%/20% gain, the
15% portion of the 0%/15%/20% gain, and then the 20% portion of
the 0%/15%/20% gain.
• This allows the taxpayer to receive the lower of the
regular tax or the alternative tax on each layer of net
capital gain
43
The Big Picture - Example 37
Qualified Dividend Income
• Return to the facts of The Big Picture on p. 14-1
• After holding the Purple stock for 10 months,
Maurice receives $350 of dividends.
– If Purple is a domestic or qualifying foreign
corporation, these are qualified dividends eligible
for the 0%/15%/20% tax rate.
44
Tax Treatment of Capital
Gains and Losses - 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
45
§1231 Assets
(slide 1 of 4)
• §1231 assets defined
– Depreciable and real property used in a business or
for production of income and held >1 year
– Includes timber, coal, iron, livestock, unharvested
crops
– Certain purchased intangibles
46
§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
47
§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
48
§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
49
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
50
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
51
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
52
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
53
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
54
Lookback Provision Example
• Taxpayer had the following net §1231 gains
and losses:
2012
2013
2014
$ 4,000 loss
$10,000 loss
$16,000 gain
– In 2014, 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
55
Section 1231 Netting Procedure
56
Depreciation Recapture
(slide 1 of 3)
• Assets subject to depreciation or cost recovery
may be subject to depreciation recapture when
disposed of at a gain
– Losses on depreciable assets receive §1231
treatment
• No recapture occurs in loss situations
57
Depreciation Recapture
(slide 2 of 3)
• Depreciation recapture characterizes gains that
would appear to be §1231 as ordinary gain
– The Code contains two major recapture provisions
• §1245
• §1250
58
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
59
§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
60
§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)
61
§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
62
§1245 Recapture Example
(slide 1 of 2)
• On January 1, 2014, Jake sold for $26,000 a machine
acquired several years ago for $24,000. He had taken
$20,000 of depreciation on the machine.
Amount Realized
$26,000
Adj. Basis-Cost
$24,000
Acc. Depr.
-20,000
4,000
Realized Gain
$22,000
Sec. 1245 – Ordinary Income
20,000
Sec. 1231 Gain
$ 2,000
63
§1245 Recapture Example
(slide 2 of 2)
Same as previous example except Jake sold
the machine for $18,000.
Amount Realized
Adj. Basis-Cost
$24,000
Acc. Depr.
-20,000
Realized Gain
Sec. 1245 – Ordinary Income
Sec. 1231 Gain
$18,000
4,000
$14,000
14,000
$ -0-
• The § 1231 gain is $0 because the selling price ($18,000) does
not exceed the original purchase price ($24,000).
64
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
65
Observations on § 1245
(slide 2 of 3)
• Recapture applies to the total amount of
depreciation allowed or allowable regardless
of
– The depreciation method used
– 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
66
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
67
§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)
– Intangible real property, such as leaseholds of
§ 1250 property, is also included
68
§1250 Recapture
(slide 2 of 3)
• Section 1250 recapture rarely applies since only the
amount of additional depreciation is subject to
recapture
– To have additional depreciation, accelerated depreciation
must have been taken on the asset
• Straight-line depreciation is not recaptured (except for property
held one year or less)
– Depreciable real property placed in service after 1986 can
generally only be depreciated using the straight-line
method
• Therefore, no depreciation recapture potential for such property
– § 1250 does not apply if the real property is sold at a loss
69
§1250 Recapture
(slide 3 of 3)
• The § 1250 recapture rules also apply to the
following property for which accelerated depreciation
was used:
– Additional first-year depreciation [§ 168(k)] exceeding
straight-line depreciation taken on leasehold improvements,
qualified restaurant property, and qualified retail
improvement property.
– Immediate expense deduction [§ 179(f)] exceeding straightline depreciation taken on leasehold improvements,
qualified restaurant property, and qualified retail
improvement property.
70
Real Estate 25% Gain
(slide 1 of 4)
• 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
71
Real Estate 25% Gain
(slide 2 of 4)
• 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
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Real Estate 25% Gain
(slide 3 of 4)
• Special 25% Gain Netting Rules
– Where there is a § 1231 gain from real estate and that gain
includes both potential 25% gain and potential
0%/15%/20% gain, any § 1231 loss from disposition of
other § 1231 assets
• First offsets the 0%/15%/20% portion of the § 1231 gain
• Then offsets the 25% portion of the § 1231 gain
– Also, any § 1231 lookback loss
• First recharacterizes the 25% portion of the § 1231 gain
• Then recharacterizes the 0%/15%/20% portion of the § 1231 gain
as ordinary income
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Real Estate 25% Gain
(slide 4 of 4)
• Net § 1231 Gain Limitation
– The amount of unrecaptured § 1250 gain may not exceed
the net § 1231 gain that is eligible to be treated as longterm capital gain
– The unrecaptured § 1250 gain is the lesser of
• The unrecaptured § 1250 gain, or
• The net § 1231 gain that is treated as capital gain
– Thus, if there is a net § 1231 gain, but it is all recaptured by
the 5 year § 1231 lookback loss provision, there is no
surviving § 1231 gain or unrecaptured § 1250 gain
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Related Effects of Recapture
(slide 1 of 8)
• 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
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Related Effects of Recapture
(slide 2 of 8)
• Inheritance
– Death is only way to eliminate recapture potential
– That is, depreciation recapture potential does not
carry over from decedent to heir
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Related Effects of Recapture
(slide 3 of 8)
• Charitable contributions
– Recapture potential reduces the amount of
charitable contribution deductions that are based
on FMV
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Related Effects of Recapture
(slide 4 of 8)
• 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
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Related Effects of Recapture
(slide 5 of 8)
• 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
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Related Effects of Recapture
(slide 6 of 8)
• Installment sales
– Recapture gain is recognized in year of sale
regardless of whether gain is otherwise recognized
under the installment method
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Related Effects of Recapture
(slide 7 of 8)
• Property Dividends
– A corporation generally recognizes gain on the
distribution of appreciated property to shareholders
– Recapture applies to the extent of the lower of the
recapture potential or the excess of the property’s
FMV over its adjusted basis
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Related Effects of Recapture
(slide 8 of 8)
• Sales between related parties
– Sales of depreciable assets between related parties
can cause the total gain to be recognized as
ordinary income
• Applies to related party sales or exchanges of property
that is depreciable in hands of transferee
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Refocus On The Big Picture (slide 1 of 3)
• Maurice is correct that certain capital gains and
dividends are eligible for preferential tax treatment
– Tax rates of 0%, 15%, or 20% may apply rather than
regular tax rates.
• You then discuss the potential tax consequences of
each of his investments.
– Purple stock and Eagle stock- To qualify for the beneficial
tax rate, the holding period for the stock must be longer
than one year.
• From a tax perspective, Maurice should retain his stock investments
for at least an additional three months and a day.
• To be eligible for the ‘‘costless’’ capital gains, his taxable income
should not exceed $36,900 for 2014.
• The dividends received on the Purple stock are “qualified
dividends” eligible for the 0%/15%/20% alternative tax rate.
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Refocus On The Big Picture (slide 2 of 3)
• Patent - Since he is a ‘‘holder’’ of the patent, it will
qualify for the beneficial capital gain rate regardless
of the holding period if the patent should produce
income in excess of his $50,000 investment.
– However, if he loses money on the investment, he will be
able to deduct only $3,000 of the loss per year (assuming
no other capital gains).
• Tax-exempt bonds.
– The after-tax return on the taxable bonds would be less
than the 3% on the tax-exempt bonds.
– In addition, the interest on the taxable bonds would
increase his taxable income, possibly moving it out of the
desired 15% marginal tax rate into the 25% marginal tax
rate.
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Refocus On The Big Picture (slide 3 of 3)
• Franchise rights.
– The franchise rights purchased from Orange, Inc., probably require the
payment of a franchise fee based upon sales in the franchise business.
– Maurice should either start such a business or sell the franchise rights.
• Partnership interest.
– The tax treatment related to his partnership interest depends on whether
he is reporting
• His share of profits or losses
– Ordinary income or ordinary loss, or
• Recognized gain or loss from the sale of his partnership interest
– Capital gain or capital loss.
• You conclude your tax advice to Maurice by telling him that
his investments should make economic sense.
– There are no 100% tax rates.
– For example, disposing of the bank stock in the current market could be
the wise thing to do.
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If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta
© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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