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Fundamentals of Capital Gains: Identifying Section 1231, 1245 and 1250 Gains, 0% Bracket and Form 4797
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If the sound quality is not satisfactory, please e-mail [email protected] immediately so we can address the problem. Fundamentals of Capital Gains: Identifying Section 1231, 1245 and 1250 Gains, 0% Bracket and Form 4797
January 21, 2020
Riley Adams, CPA, Senior Financial Analyst Michael Plaks, Enrolled Agent Google REI Tax Firm [email protected] [email protected]
Dawn Polin, CPA, Senior Manager Cherry Bekaert [email protected] Notice
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials.
The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. Capital Gain Overview Sale of Assets Sale Price – Purchase Price = Loss or Gain
Purchase Manufacturing Equipment for $10,000 Use it is the business for 2 years Expense depreciation in the amount of $2,000 Sell in year 3 for $12,000 $12,000 - $8,000 = $4,000 Gain on Sale
6 Considerations for application of tax rates to apply to gain
Capital Ordinary Long Term Short Term
7 Current Tax Rates
Type Ordinary Capital Individual 37% 20% C Corp 21% 21%
8 Sale of Business Assets
Falls into 3 Categories ▪ §1231 Assets - operating assets of the business ▪ Capital Assets (Investments) ▪ Ordinary Income Assets (assets held for resale such as inventory)
9 It ain’t what you know that gets you into trouble. It’s what you know for sure that just ain’t so.
- Mark Twain
10 Proprietary + Confidential
0% Capital Gains Tax Rate
11 0% Capital Gains Tax Rate
▪ Long-term capital gains tax rates on taxable income: 2019
Marginal tax rate Single Married, filing Head of Married, filing jointly household separately 0% $0-39,375 $0-78,750 $0-52,750 $0-39,375
15% $39,376-434,550 $78,751-488,850 $52,751-461,700 $39,376-244,425
20% $434,550+ $488,850+ $461,700+ $244,425+
▪ Modified Adjusted Gross Income (MAGI) above $200,000 (single) and $250,000 (MFJ) is also subject to the 3.8% net investment income tax
▪ With planning, can harvest tax-free gains on invested capital held more than a year or qualified passive income sources
12 How the 0% Rate Works
For 2018-2025, 0% tax rate applies to:
▪ Married tax filers with taxable income up to $78,750 ▪ Single filers with taxable income up to $39,375
Most Common Tax Opportunities
▪ Temporarily unemployed/out of labor force ▪ Variable income (e.g., salesperson) ▪ Between ages 55-70 and beginning to transition into retirement / are already retired
13 0% Capital Gains Examples
Item Description Filing Status Married Filing Jointly Taxable Income $60,000 (a) Example 1 Capital Loss Carryover? No 15% LTCG Threshold $78,750 (b) Max LTCG with 0% tax $18,750 [(b)-(a)]
How to Take Advantage:
▪ If you have unrealized long-term gains in assets (e.g., stocks, mutual funds, etc.) in a taxable account, can sell these investments and recognize $0 in tax liability <$18,750
▪ Consider exchanging for similar investments to harvest unrealized gain without tax impact
14 0% Capital Gains Examples Item Description Filing Status Married Filing Jointly Taxable Income $80,000 (a) Example 2 Capital Loss Carryover? Yes, $3,000 (b) 15% LTCG Threshold $78,750 (c) Max LTCG with 0% tax $1,750 [(a)-(b)-(c)]
How to Take Advantage:
▪ Minimal space, but loss carryover provides room to take <$1,750 in realizable gains with 0% tax impact
15 0% Capital Gains Examples
Item Description Filing Status Married Filing Jointly
Example 3 Taxable Income $60,000 (a) LT Capital Gains $40,000 (b) 15% LTCG Threshold $78,750 (c) LTCG Tax $3,187.50 [(a)+(b)-(c)]*15%
How to Take Advantage:
▪ While taxed, still done so at second tier of long-term capital gains tax rates (15%)
16 What Qualifies for LTCG?
▪ Assets held for longer than 1 year and sold for a gain
▪ Qualified dividends received
Generally considered “qualified” if the company pays a dividend on stock investor has held more than 60 days during the 121-day period that began 60 days before the ex-dividend date
17 What is Not Considered Qualified Passive income?
▪ Master limited partnerships (MLPs) - Exists in the form of a publicly traded limited partnership. Combines the tax benefits of a private partnership—profits are taxed only when investors receive distributions—with the liquidity of a publicly-traded company.
▪ Real estate investment trusts (REITs) - Company owning and typically operating real estate which generates income. One benefit of REITs for everyday investors is that they provide the opportunity to own a portion of real estate which generates dividend-based income. Must return a minimum of 90% of its taxable income in the form of shareholder dividends each year.
▪ Dividends paid on employee stock options - Considered nonqualified dividends, taxed at marginal rate.
▪ Dividends paid by tax-exempt companies - Considered nonqualified dividends and pay tax at marginal income tax rate.
▪ Dividends paid on savings or money market accounts - Like any other payment received from an asset.
18
Three asset types and two rate categories?
The sale of business assets can result in the application of the capital gain rates or the ordinary income rates depending on the facts and circumstances. Sales of 1231 assets slide between the tax rates
20 Distinguishing and calculating 1231, 1245, and 1250 Gain
21 1231 Assets Defined
depreciable property used in the capital assets held for more than one taxpayer’s trade or business and held year in connection with a trade or more than one year, other than (i) business or a transaction entered into property includible in inventory, (ii) for profit, and compulsorily or property held primarily for sale to involuntarily converted; customers, (iii) intangibles an unharvested crop on land used in the real property used in the trade or trade or business and held for more than business and held for more than one one year, if the crop and land are sold, year, other than property that is exchanged, or involuntarily converted at includible in inventory or held primarily the same time to the same person; for sale to customers; certain livestock, but not poultry ( trade or business property held for more ¶1750); and than one year and compulsorily or involuntarily converted (¶1748); timber, domestic iron ore, and coal ( ¶1772) ( Code Sec. 1231(b); Reg. §§1.1231-1 and 1.1231-2).
22 Treatment of 1231 Asset Sales
Gains are treated as capital in nature Losses are treated as ordinary in nature
23 1231, 1245, 1250?
1231 Gain Rate
1231 1245 Depreciation Recapture Gain (Ordinary Rate)
1250 Depreciation Recapture (preferential rate)
24 §1250 Real Property
Code Sec. 1250 real property, such as a building or a structural component of a building, and most land improvements.
Residential rental property that is depreciated over 27.5 years using the straight line method.
Nonresidential real property that is depreciated over 39 years using the straight line method.
25 §1245 Personal Property
Code Sec. 1245 personal property (Code Sec. 1245(a)(3)(A)), which consists of items such as business machinery and equipment, office furniture and fixtures, and appliances that are furnished to tenants. The principal characteristic of Code Sec. 1245 personal property is that it is readily moveable rather than permanently affixed.
Property of Cherry Bekaert LLP 26 1231 Gains in Depth
A gain on the sale of the To the extent the asset capital asset can be took prior straight-line subject to the capital gains depreciation expense as a rates, and the 1245 and 1250 asset, 1250 1250 recapture rates. recapture will be To the extent the asset applicable took prior accelerated depreciation expense as a 1245 asset, 1245 recapture will be applicable
27 What about capital losses?
Capital Losses are ordinary to the extent of the in nature. However, net unrecaptured net section section 1231 losses must be 1231 losses for the five recaptured by treating the previous tax years ( Code current year's net section Sec. 1231(c)). 1231 gain (section 1231 gain that exceeds current- year section 1231 loss) as The losses are recaptured on a first-in, first-out (FIFO) ordinary income basis ( IRS Pub. 544).
28 Example
§1231 Gain (Loss) Each Looking back 5 years, Year: this taxpayer must treat $33,000 of the gain in year 3 as Year 1 = ($10,000) ordinary. The remaining gain of Year 2 = ($23,000) $14,000 can be treated Year 3 = $47,000 as capital
29 REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com
Section 1231 lookback Why is this an issue? Because Sec. 1231 offers the best of both worlds: 1. Losses are ordinary and unrestricted by the $3,000 capital loss limitations 2. Gains are capital at preferential rates
Unintended result: clever timing could (if not for the lookback rule) take advantage of both sides.
30 REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com
Section 1231 lookback Example: milking Sec. 1231 if we could
2019: Sold business equipment at a $20k loss Ordinary loss at 24% bracket: $4,800
2020: Sold business land at a $30k gain Long-term capital gain at 15%: $4,500
Net result: we’re at $10,000 gain, yet $300 tax 31 drop! REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com
Section 1231 lookback The 5-year lookback rule:
If you took Sec. 1231 ordinary losses within the last 5 years – put it back!
3-step process: 1. Figure out how much ordinary losses to return 2. Sec. 1231 gains up to that amount will be ordinary gains 3. Whatever is left is capital gains
32 REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com
Section 1231 lookback Example: Sec. 1231 gains altered by lookback
2019: Sold business equipment at a $20k loss Ordinary loss at 24% bracket: $4,800
2020: Sold business land at a $30k gain Ordinary loss recovery - $20k at 24%: $4,800 Long-term capital gain - $10k at 15%: $1,500 Total: $6,300 i.e. $1,800 higher than we wished
33 REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com
Section 1231 lookback Lookback challenge #1: Tracking
There’re no IRS forms or other mechanisms to keep track of the prior Sec. 1231 ordinary losses.
Intuit tax preparation software – TurboTax and ProSeries – does not track it, either.
Prior 5 years of tax returns are often unavailable or unreliable.
Clients do not want to pay us to do extra work that will end up hurting them.
34 REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com
Section 1231 lookback Lookback challenge #2: Character of gains
The lookback has consequences beyond merely rate difference:
Carryforward capital losses NIIT Suspended Sec. 469 losses (PAL) Section 199A – QBI deduction Opportunity Zone Funds
35
Proprietary + Confidential
Investment Interest Deduction Election
37 Investment Interest Deduction Election
What is Investment Interest?
• Interest paid by individuals on a loan where the proceeds were used to purchase property held for investment.
• Property held for investment includes property which produces interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business
• Interest paid on loans used to buy property held for investment count as investment interest (e.g., margin loans)
• Can be claimed as an itemized deduction on Schedule A of Form 1040
38 Investment Interest Deduction Election
What Limitations Apply?
• Deduction for individuals for investment interest expense is limited to net investment income, which is calculated as:
Net Investment Income (NII) = Investment Income - Investment Expenses
• You can determine your NII by subtracting investment expenses not including interest from investment income
• Investment expense deductions can include the following: ✓ Accounting fees ✓ Legal Fees ✓ Fees for automatic investment services (e.g., fees for using a robo-advisor) ✓ Fees for investment advice ✓ Safe deposit box costs
39 Net Investment Income Example
Net Investment Income (NII) = Investment Income - Investment Expenses 1. Subtract all investment expenses not including interest from investment income • (a) - (b) - (c) = $5,000 - $500 - $250 = $4,250 2. Subtract all investment interest expense up to investment income • $4,250 - $5,000 = ($750) NII • Cannot deduct more than investment income, therefore $0 NII with $750 investment interest expense rollover 40 What Does NII Not Include?
● NII does not include qualified dividends or net capital gains ○ Taxpayer may elect to include these items in NII if advantageous for maximizing investment interest deduction
● If making this election, taxpayer waives the right to the lower tax rates on LTCG on the amount included in NII ○ This amount is taxed as ordinary income
● This election to include net capital gains is limited to the lesser of: ○ Net Capital Gains from Investment Property, or ○ Net Gains from Investment Property
● Include amount desired to be considered part of NII on line 4(g) of Form 4952, Investment Interest Expense Deduction
● Taxpayers can amend previously filed returns to make this election within 6 months of original due date
● Any unused investment interest expense can be carried forward to future tax years 41 Investment Interest Deduction Election
Which Trade-Offs Exist for Making this Election?
● Investment expenses still appear as a miscellaneous itemized deduction on Schedule A of Form 1040 after tax reform ○ Still subject to the 2% floor (can only claim deduction for expenses exceeding 2% of AGI)
● You must forego the Standard Deduction ○ Can only itemize or claim standard deduction- can’t do both! ○ Itemizing only makes sense if total itemized deductions > standard deduction
42 Investment Interest Deduction Election
What About the Medicare Contribution Tax (NII Tax)?
● Modified AGI above $200,000 (single) and $250,000 (MFJ) is also subject to the 3.8% net investment income tax
● When taxpayer has investment interest to be used as an itemized deduction, the taxpayer should also deduct this when calculating the 3.8% Medicare Contribution Tax (NII Tax) on unearned income
● Types of unearned income: ○ Pension income ○ Capital gains ○ Interest income ○ Dividends
43 REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com
Capital gains - Tax planning
1. Timing of sale 2. Capital gains allocations 3. Installment sales 4. Like-kind (Sec. 1031) exchanges 5. Qualified Opportunity Zone Funds
44 REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com
Capital gains - Tax planning
Timing of sale – A: fluctuating AGI
Everything else being equal (is it ever ?), try to sell in the year with low AGI. Reasons: tax bracket, LTCG, NIIT, AMT
Higher rates of depreciation recapture tax make this consideration more important than 15% LTCG.
45 REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com
Capital gains - Tax planning
Timing of sale – B: Carry-forward capital losses
Do you have incoming carry-forward capital losses? If yes, then maybe extra taxes will be absorbed
Do you have assets that need to be sold at a loss? If yes, then do not wait until the next tax year!
46 REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com
Capital gains - Tax planning
Timing of sale – C: ordinary v. capital gain netting
Section 1231 recovery (5-yr lookback) and Depreciation recapture on Section 1245 is treated as ordinary income. In contrast, 25% unrecaptured 1250 gain is considered capital gain income.
While the rates and resulting taxes can be the same, only capital gain income can offset capital losses.
Why would that matter? Because of $3,000/yr limit on capital losses
47 REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com
Capital gains - Tax planning
Timing of sale – D: Passive Activity Losses
Passive activity losses (PAL) could be suspended under Section 469. Two common sources of PAL: - rental (Schedule E) properties - K-1s without material participation
Suspended PAL losses from prior years are carried forward, so the client might have a reserve.
Do you have current or carry-forward PALs? If yes – they could be netted against gains!
48 REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com
Capital gains - Tax planning
Timing of sale – E: unlocked PALs
PALs previously suspended due to high AGI, are released when the property is disposed – regardless of the AGI.
Suddenly, the taxpayer has Sch. E losses, possibly significant, that were not available in the past.
It can wildly swing the overall tax situation. Make sure to consider the impact.
49 REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com Capital gains - Tax planning Land allocation
Purchased $200k house; 25% allocated to land $50k land; $150k building (27.5-yr asset). $50k depreciation Sold for $300k => $150k gain
Standard calculation of tax: $50k depr. recapture x 25% = $12,500 $100k cap. gain x 15% = $15,000 Total tax: $27,500
50 REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com
Capital gains - Tax planning
Land allocation But what if the appreciation of the property is due to the increase in land value, and the current value allocation is 2/3 land ($200k) and 1/3 building ($100k)?
Revised calculation of tax: $0 gain on the building => $0 depr. recapture $150k cap. gain (land) x 15% = $22,500
Tax savings: $27,500 - $22,500 = $5,000
51 REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com
Capital gains - Tax planning
Section 1245/1250 allocation
If the property consists of both 1245 and 1250 assets, allocation matters.
Gain on Sec. 1245 property is taxed higher for those above the 24% bracket. Depreciation recapture on Sec. 1245 property cannot offset capital losses. It also matters for like-kind exchanges, especially after the tax reform! Only real property can be exchanged!
52 REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com
Capital gains - Tax planning
Installment sales (aka owner-financing)
You receive down payment + regular payments consisting of principal and interest.
Under Section 453, with installment sale treatment, part of the down payment and each principal payment is considered return of the basis, and part is taxed as gain.
Economic advantages: - above-market interest rate - often higher sales price - regular income stream - payments are secured (sort of) by the property
53 REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com
Capital gains - Tax planning
Installment sales (continued)
Tax advantages: - time value of money, as gains are deferred - usually lowers AGI in each year - unrecaptured 1250 gains are part of the deal!
Risks: - future payments are at risk - foreclosing is a hassle, and property value can drop - may push some gain into a high-AGI future year
54 REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com
Capital gains - Tax planning Like-kind (Section 1031) exchanges
Concept: deferring capital gain. Gain is not recognized at the time of disposition and instead is rolled into the replacement property. Great news: unrecaptured 1250 gain included! Warning: this is a highly complicated transaction with lots of conditions and traps. Warning: only real property (Sec. 1250) can be exchanged after the tax reform! Cost segregation complicates 1031 exchanges!
55 REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com
Capital gains - Tax planning Qualified Opportunity Zones Funds
Concept: attract capital to develop distressed communities in exchange for tax benefits. Inception: 2017 Tax Cuts and Jobs Act, aka GOP tax reform Where? designated zones in all 50 states plus US territories Zone map and details: www.cdfifund.gov/Pages/Opportunity-Zones.aspx
56 REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com
Capital gains - Tax planning Qualified Opportunity Zones Funds
Can be funded with any capital gains, but only gains, not the principal (unlike 1031 exchanges) 180 days after the sale or after the end of the tax year of sale (watch for the small print and traps!) Restrictions on what is allowed as an investment, including real estate and businesses Real estate: initial use or “substantial improvement” A QOZ fund is a self-certified entity, such as an LLC, filing as a partnership or corporation – Form 8996
57 REI Tax Firm - Michael Plaks, EA www.MichaelPlaks.com
Capital gains - Tax planning Qualified Opportunity Zones Funds Triple tax benefit: ▪ 2010 stock $400k sold in 2019 for $1 Mil ▪ $600k invested in a QOZ fund in Feb. 2020 ▪ Grew into a $6 Mil between now and 2046 1. Capital gain tax on the $600k is deferred until 2026 tax return 2. Capital gain on the $60k (10%) is waived (5+ yrs) 3. No taxes on the $600k -> $6 Mil growth !!! (10+ yrs) Warning: a lot of restrictions and traps – don’t DIY!!!
58 Q&A Disclaimer:
59