Chapter 14
Property Transactions:
Capital Gains and Losses, §1231,
and Recapture Provisions
Comprehensive Volume
Copyright ©2010 Cengage Learning
Comprehensive Volume
C14-1
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
Comprehensive Volume
C14-2
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
Comprehensive Volume
C14-3
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)
Comprehensive Volume
C14-4
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
Comprehensive Volume
C14-5
Capital Assets
(slide 3 of 6)
• Thus, capital assets are:
– Assets held for investment (e.g., stocks, bonds,
land)
– Personal use assets (e.g., residence, car)
– Miscellaneous assets selected by Congress
Comprehensive Volume
C14-6
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
Comprehensive Volume
C14-7
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
Comprehensive Volume
C14-8
Capital Assets
(slide 6 of 6)
• Nonbusiness bad debts
– A nonbusiness bad debt is treated as a shortterm capital loss in the year it becomes
completely worthless
• Even if outstanding for more than one year
Comprehensive Volume
C14-9
Sale or Exchange
(slide 1 of 11)
• 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
Comprehensive Volume
C14-10
Sale or Exchange–Worthless
Securities and § 1244 Stock (slide 2 of 11)
• 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
Comprehensive Volume
C14-11
Sale or Exchange
(slide 3 of 11)
• Worthless securities example:
– Calendar year taxpayer purchased stock on
December 5, 2008
– The stock becomes worthless on April 5, 2009
– The loss is deemed to have occurred on
December 31, 2009
• The result is a long-term capital loss
Comprehensive Volume
C14-12
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
Comprehensive Volume
C14-13
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
Comprehensive Volume
C14-14
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
Comprehensive Volume
C14-15
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
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
Comprehensive Volume
C14-16
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
Comprehensive Volume
C14-17
Sale or Exchange–Franchises,
Trademarks, and Trade Names
(slide 9 of 11)
• 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
Comprehensive Volume
C14-18
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
Comprehensive Volume
C14-19
Sale or Exchange–Lease
Cancellation Payments
(slide 11 of 11)
• 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 (rents)
Comprehensive Volume
C14-20
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
Comprehensive Volume
C14-21
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
Comprehensive Volume
C14-22
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
Comprehensive Volume
C14-23
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
Comprehensive Volume
C14-24
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
Comprehensive Volume
C14-25
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 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
assets
• The 28% rate applies to collectibles
• The 0%/15% rates apply to any remaining net longterm capital gain
Comprehensive Volume
C14-26
Tax Treatment of Capital
Gains and Losses (slide 4 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
Comprehensive Volume
C14-27
Tax Treatment of Capital
Gains and Losses (slide 5 of 7)
• Qualified dividend income paid from current or
acc. E & P is eligible for the 0%/15% 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% 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% gain in the alternative tax calculation
– It is not offset by the net capital loss
Comprehensive Volume
C14-28
Tax Treatment of Capital
Gains and Losses (slide 6 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% gain, and then the 15%
portion of the 0%/15% gain
• This allows the taxpayer to receive the lower of the regular tax
or the alternative tax on each layer of net capital gain
Comprehensive Volume
C14-29
Tax Treatment of Capital
Gains and Losses (slide 7 of 7)
• 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
Comprehensive Volume
C14-30
§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
Comprehensive Volume
C14-31
§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
Comprehensive Volume
C14-32
§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
Comprehensive Volume
C14-33
§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
Comprehensive Volume
C14-34
Casualty Gains And Losses From
§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
Comprehensive Volume
C14-35
Casualty Gains And Losses From
§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
Comprehensive Volume
C14-36
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
Comprehensive Volume
C14-37
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
Comprehensive Volume
C14-38
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
Comprehensive Volume
C14-39
Lookback Provision Example
• Taxpayer had the following net §1231 gains
and losses:
2007
$ 4,000 loss
2008
10,000 loss
2009
16,000 gain
– In 2009, 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
Comprehensive Volume
C14-40
§1231 Netting Procedure
(slide 1 of 2)
Net Gain
§1231 asset and long-term nonpersonal use
capital asset casualty gains
minus
§1231 asset and long-term nonpersonal use
capital asset casualty losses
Net Loss
Items treated separately: Gains are
ordinary income, §1231 asset
losses are deductible for AGI,
Other losses deductible from AGI
Net Gain
(add to §1231 gains)
§1231 gains
minus
§1231 losses
Net Loss
Net Gain
Comprehensive Volume
C14-41
§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
losses is ordinary gain
Comprehensive Volume
Remaining gain
is LTCG
C14-42
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
Comprehensive Volume
C14-43
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
Comprehensive Volume
C14-44
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
Comprehensive Volume
C14-45
§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
Comprehensive Volume
C14-46
§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)
Comprehensive Volume
C14-47
§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
Comprehensive Volume
C14-48
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
Comprehensive Volume
C14-49
Observations on § 1245 (slide 2 of 3)
• 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
Comprehensive Volume
C14-50
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
Comprehensive Volume
C14-51
§1250 Recapture
(slide 1 of 2)
• 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
Comprehensive Volume
C14-52
§1250 Recapture
(slide 2 of 2)
• 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
Comprehensive Volume
C14-53
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
Comprehensive Volume
C14-54
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
Comprehensive Volume
C14-55
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% gain, any § 1231 loss from disposition of other
§ 1231 assets
• First offsets the 0%/15% 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% portion of the § 1231 gain as
ordinary income
Comprehensive Volume
C14-56
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 long-term 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
Comprehensive Volume
C14-57
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
Comprehensive Volume
C14-58
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
Comprehensive Volume
C14-59
Related Effects of Recapture
(slide 3 of 8)
• Charitable contributions
– Recapture potential reduces the amount of
charitable contribution deductions that are
based on FMV
Comprehensive Volume
C14-60
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
Comprehensive Volume
C14-61
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
Comprehensive Volume
C14-62
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
Comprehensive Volume
C14-63
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
Comprehensive Volume
C14-64
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
Comprehensive Volume
C14-65
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
Comprehensive Volume
C14-66