Property Transactionssection 1231 and Recapture

Chapter I13

Property Transactions-Section 1231 and Recapture

Discussion Questions

I13-1 Gain on the sale or exchange of land held as inventory is ordinary while the gain is a Sec. 1231 gain if the land is used in a trade or business and held more than one year. If the land is used in a trade or business and held for one year or less, the gain is ordinary. If the land is held as an investment, the gain is LTCG if held more than one year, and may be adjusted net capital gain if held more than 18 months. pp. I13-4 and I13-5.

I13-2 The gain was classified as ordinary income. In 1942, Congress created the predecessor of Sec. 1231, which allowed taxpayers to treat net gains from the sale of business property as capital gains and net losses as ordinary losses. p. I13-2.

I13-3 Yes, $140,000 of the gain may be treated as Sec. 1231 gain if Alice elects to treat the cutting of timber as a sale or exchange. The gain is determined by comparing the timber's adjusted basis for depletion with its fair market value on the first day of the taxable year in which it is cut. The remaining gain of $10,000 is ordinary. pp. I13-5 and I13-6.

I13-4 Gains and losses due to the condemnation of business assets held more than one year are classified as Sec. 1231 gains and losses. Gains and losses due to casualties or thefts of business assets held more than one year are combined with gains and losses due to casualties or thefts of nonpersonal use capital assets held more than one year. If the result is a net gain, the gains and losses are treated as Sec. 1231 gains and losses. If the result is a net loss, the gains and losses are ordinary. pp. I13-5 through I13-7.

I13-5 Livestock held by the taxpayer for draft, breeding, dairy, or sporting purposes for more than one year is considered to be Sec. 1231 property. Cattle and horses must be held for 24 months or more. p. I13-6.

I13-6 Net Sec. 1231 gain is treated as ordinary income to the extent of any nonrecaptured net Sec. 1231 losses for the five most recent preceding years. pp. I13-7 and I13-8.

I13-7 When the net Sec. 1231 gain is recharacterized as ordinary income due to the five-year lookback rule, the net Sec. 1231 gain that is mid-term gain taxed at 28% is considered to be ordinary income before the 1231 gain that is adjusted net capital gain taxed at 20% is considered to be ordinary income. p. I13-4.

I13-8 Equipment is Sec. 1245 property and gain to the extent of total depreciation is ordinary income but limited to the amount of realized gain. Generally, the amount of depreciation is greater than the gain realized. p. I13-8.

I13-1 I13-9 If the holding period is one year or less, the $500 loss is ordinary. If the holding period is more than one year, the loss is a Sec. 1231 loss that may offset other Sec. 1231 gains which would otherwise be granted LTCG treatment (i.e., if Sec. 1231 gains exceed Sec. 1231 losses). p. I13-4.

I13-10 If the straight-line method is used, the amount of the gain will be smaller than if an accelerated method is used. It may be advantageous for Jackie to have smaller deductions in years one and two with a smaller gain in year three than have higher deductions in years one and two, when her tax rate is lower, with a higher gain in year three, when her tax rate is higher. Consideration should also be given to the time value of money. pp. I13-9 and I13-10.

I13-11 The entire realized gain of $1,622 ($1,622 - $0) is Sec. 1245 ordinary income. pp. I13-9 and I13-10.

I13-12 The motel must have been placed in service after 1980 and before 1987 and the ACRS statutory rates were used. p. I13-10.

I13-13 A taxpayer may avoid having additional depreciation by using the straight-line method of depreciation or holding the property until it is fully depreciated. p. I13-12.

I13-14 None of the gain is recaptured as ordinary income due to Sec. 1250 since there is no additional depreciation. Marty is not a corporate taxpayer and, therefore, Sec. 291(a) does not apply. p. I13-11.

I13-15 The inventory and marketable securities do not qualify as Sec. 1231 property. pp. I13-4 and I13-5.

I13-16 An office building is subject to the depreciation recapture rules of Sec. 1245 if the building is placed in service after 1980 and before 1987 and the ACRS statutory rates are used to determine the cost recovery deductions. p. I13-10.

I13-17 No. The building is not residential rental property. For a building to qualify as residential rental property, 80% or more of the gross rental income from the building must be rental income from dwelling units. p. I13-13.

I13-18 Zero. The estate's basis for the apartment complex will be $2 million. p. I13-17.

I13-19 Rashad should never have to recognize any Sec. 1245 ordinary income as a result of selling residential rental property even if the property is placed in service after 1980 and before 1987. p. I13-13. I13-20 John will pay $10,000 (20% x $50,000) which is less than what Karen will pay because some or all of her Sec. 1231 gain is unrecaptured Sec. 1250 gain taxed at 25%. If all of the gain is Sec. 1250 gain, she pays $12,500 (25% x $50,000). If straight-line depreciation amounted to $40,000, Karen pays $12,000 [(25% x $40,000) + (20% x $10,000)].

I13-2 pp. I13-4 and I13-12.

I13-21 A corporate taxpayer must apply the recapture rules of Sec. 291(a). If a corporate taxpayer disposes of Sec. 1250 property, 20% of the excess of the amount that would be recaptured if the property was Sec. 1245 property over the amount recaptured as ordinary income under Sec. 1250 is ordinary income. pp. I13-15 and I13-16.

I13-22 No. Given the same sale, the corporate taxpayer and the individual taxpayer should have the same amount of Sec. 1245 ordinary income. Sec. 291 does not trigger additional recapture for the corporation because Sec. 1250 does not apply to equipment. pp. I13-15 and I13-16.

I13-23 a. There is no recapture to the donor. The recapture potential carries over to the donee. b. There is no recapture to the donor. However, the donor's charitable contribution deduction is reduced by the amount of ordinary income that would have been recognized if the property were sold. c. Dale must recognize $40,000 of ordinary income if he disposes of the equipment in an installment sale despite the fact that Dale only receives $10,000. p. I13-17.

I13-24 Without considering any limitations due to his adjusted gross income, his charitable contribution deduction is $390,000, the FMV ($500,000) less the amount of gain that would be ordinary income if he sells the property ($110,000). p. I13-17.

I13-25 Ted may elect to defer $150,000 of the realized gain of $210,000 ($510,000 - $300,000). He must recognize $60,000 of Sec. 1245 ordinary income. The cost of the replacement property ($450,000) is $60,000 less than the amount received due to the involuntary conversion. If Ted does not make the election to defer, the $210,000 gain is ordinary under Sec. 1245. p. I13-18.

I13-26 The amounts subject to recapture include both the amounts deducted as IDC and for depletion. The amount of ordinary income due to the recapture of IDC and depletion is not more than the realized gain. p. I13-20.

I13-27 Yes, gain resulting from the sale of the building is ordinary income under Sec. 1239 because the building is depreciable property, and William owns more than 50% of the corporation. The land is not subject to recapture under Sec. 1239 because it is not depreciable. pp. I13-20 and I13-21.

I13-3 Issue Identification Questions

I13-28 What is the character of the gain or loss resulting from the sale of the 11 chinchillas from her breeding stock? Sec. 1231 should apply. Sec. 1231 does apply to livestock held for breeding if the holding period is 12 months or more (24 for cattle and horses), and Revenue Ruling 57-588 [1957-2 CB 305] include chinchillas as livestock. In Cedarburg Fox Farms, Inc. [60-2 USTC 9760, 283 F2d 711] the 7th Circuit stated that culled breeding stock qualified as Sec. 1231 property. All of the sales from the market group would result in ordinary income or loss. pp. I13-5 and I13-6.

I13-29 The primary tax issue for Green Acres is whether the $130,000 represents amounts received from the sale or exchange of property used in a trade or business under Sec. 1231. The facts in this question are similar to those in R.T. Watts v. U.S., 10 AFTR 2d 5832, 62-2 USTC ¶ 9778 (D.C. Ore., 1962) which held that the proceeds came under Sec. 1231. The principal issue for Stanley is whether the payments are deductible as an ordinary and necessary business expense which should be the case. p. I13-5.

I13-30 The primary tax issue for Sarah is the character of the gain that would be recognized if she sells her business (i.e., what type of property is structure x and structure y)? The facts in this question are similar to those in Rev. Rul. 80-151, 1980-1 C.B. 7 which held that both types of properties are Sec. 1231 properties since they both represent depreciable property used in a trade of business. Structure X is Sec. 1245 property and structure Y is Sec. 1250 property because it is a permanent structure. Key issues considered when determining if property is tangible personal property or inherently permanent structures:

1. Is property capable of being moved and has it been moved? 2. Is property designed or constructed to remain permanently in place? 3. Do circumstances suggest that property will have to be moved? 4. How difficult is it to remove the property? 5. How much damage will the property sustain upon its removal? 6. What is the manner of affixation of the property to the land? pp. I13-5, I13-9, and I13-11.

I13-31 The key issue is whether the transfer of the automobile from business use to personal use constitutes a disposition resulting in Sec. 1245 ordinary income of $1,620 to Sylvester. The facts in this question are similar to those in Rev. Rul. 69-487, 1969-2 C.B. 165 which held that the conversion is not a disposition for purposes of Sec. 1245 but Sec. 1245 may apply to a subsequent disposition of the automobile. pp. I13-9 and I13-12.

I13-4 Problems

I13-32

Sec. 1231 Sec. 1245 Sec. 1250 Land on which factory is located yes ------Equipment yes yes --- Inventory ------Patent yes yes --- Land held primarily for sale* ------Factory building yes --- yes

*Gain or loss is ordinary because the land is held for sale. pp. I13-5, I13-9 and I13-11.

I13-33 AGI A. $50,000 ($40,000 + $10,000 NLTCG) B. $32,000 ($40,000 - $ 8,000 ordinary loss) C. $39,000 ($40,000 + $ 4,000 NLTCG - $5,000 ordinary loss) D. $30,000 ($40,000 - $ 3,000 LTCL - $7,000 ordinary loss) pp. I13-7 and I13-8.

I13-34 a. $840. The net Sec. 1231 gain of $3,000 is mid-term gain and taxed at 28%. The $12,000 loss from the sale of Asset #2 is first offset against the $5,000 gain because they are both in the 20% class. b. $600. The net Sec. 1231 gain of $3,000 is adjusted net capital gain taxed at 20%. p. I13-4.

I13-35 a. Sec. 1231 does not apply to personal use assets b. Sec. 1231 gain c. Sec. 1231 loss d. All of the $4,000 gain is Sec. 1245 ordinary income. pp. I13-5, I13-6 and I13-8.

I13-36 a. $57,000 ($60,000 - $3,000) b. $52,000 ($60,000 - $8,000)

If the $8,000 realized loss ($19,000 - $27,000) is a capital loss, only $3,000 of the loss may be deducted in the current year. $5,000 of the loss is carried forward for an indefinite period. If the $8,000 realized loss is a Sec. 1231 loss and there are no Sec. 1231 gains, the $8,000 loss is an ordinary loss and is deductible. Vicki is assumed to be in an active trade or business and the passive loss limitations do not apply. p. I13-3.

I13-5 I13-37 a. $80,000. The gain is a Sec. 1231 gain that is classified as a LTCG since the corporation does not have any Sec. 1231 losses. b. Zero. The capital loss carryforward may be used only to offset capital gain income. pp. I13-7 and I13-8.

I13-38 a. Since the $50,000 gain due to the casualty exceeds casualty losses (zero), the $50,000 gain is combined with the $60,000 Sec. 1231 gain and Sean has net capital gain of $110,000. b. As in case a, the $50,000 gain is combined with other Sec. 1231 gains and losses. Since the $60,000 Sec. 1231 loss exceeds the Sec. 1231 gain of $50,000, Sean does not have net capital gain. He may deduct $10,000 as ordinary loss. c. The $50,000 casualty gain is combined with the $200,000 casualty loss. Since the net amount is a loss, the gain and loss are not treated as Sec. 1231. Sean has net capital gain of zero. He has an ordinary loss of $150,000 ($200,000 - $50,000). pp. I13-7 and I13-8.

I13-39 1993 $2,000 NLTCG 1994 Zero - $4,000 ordinary loss 1995 Zero - $8,000 ordinary loss 1996 Zero - The $4,000 net Sec. 1231 gain is ordinary income since there is $12,000 of nonrecaptured net Sec. 1231 losses at the beginning of the year. The nonrecaptured net Sec. 1231 losses at the end of the year are $8,000. 1997 $5,000 NLTCG and $8,000 of ordinary income 1998 Zero - $7,000 ordinary loss. pp. I13-7 and I13-8.

I13-40 $16,200. The $24,000 gain from the sale of Asset #2 and $16,000 of the gain from the sale of Asset #1 are recharacterized as ordinary income due to the five-year lookback rule, thus $40,000 is taxed at 31%. The remaining gain of $19,000 is taxed at 20%. pp. I13-7 and I13-8.

I13-41

Case Gain (Loss) Ordinary Sec. 1231 a $195,000 $195,000 --- b 480,000 450,000 $ 30,000 c ( 55,000) --- ( 55,000) pp. I13-9 and I13-10.

I13-42 a. $230,000. The maximum selling price that Elizabeth could sell the equipment for without having to recognize Sec. 1245 ordinary income is $230,000, the adjusted basis. b. $291,000. The first $270,000 of gain resulting from the sale of the equipment is Sec. 1245 ordinary income. If she sells the property and has a $61,000 gain, the gain is Sec.

I13-6 1245 ordinary income. If SP - $230,000 = $61,000, then the selling price is $291,000. pp. I13-9 and I13-10.

I13-43 a. $160,000. Sale of the racehorse results in Sec. 1245 ordinary income. b. Zero. c. No. The pony is a personal-use asset. d. Yes. The casualty gain is netted against casualty losses of Sec. 1231 property and non-personal use capital assets held more than one year. Since there are no such losses, the $200,000 gain is combined with Sec. 1231 gains and losses. After all Sec. 1231 gains and losses are netted, a net Sec. 1231 gain of $565,000 ($585,000 - $20,000) exists, thus all Sec. 1231 gains and losses are treated as LTCG and LTCL. However, $170,000 of the net capital gain is unrecaptured Sec. 1250 gain taxed at 25%. e. $565,000. The net Sec. 1231 gain exists because of four transactions:

$200,000 casualty gain - building 35,000 condemnation of land 350,000 sale of racehorse for more than original cost ( 20,000) loss on exchange of equipment f. $395,000. The holding period for all of the assets is more than 18 months. $170,000 of the $565,000 is unrecaptured Sec. 1250 gain taxed at 25%. pp. I13-5 through I13-8, I13-10 through I13-13.

I13-44 a. Depreciation of $403 ($4,200 x 0.1920 x 0.5) is allowed in 1997. The 50% results from the half-year convention.

Business Portion Personal Use of Truck Portion Amount realized $2,100* $ 900 Minus: Adjusted basis (1,613)** ( 1,800) Realized gain (loss) $ 487 ($ 900)

* (0.70 x $3,000) ** ($4,200 - $2,587)

The $487 gain is ordinary income under Sec. 1245. The $900 loss is a capital loss, but is not deductible since that portion of the truck is a personal use asset. pp. I13-9 and I13-10.

I13-45 a. Realized gain is $34,000 ($65,000 - $31,000). b. Recognized gain is $20,000 since the boot received is less than the realized gain. c. The $19,000 gain is Sec. 1245 ordinary income. d. $1,000 of the gain is Sec. 1231.

I13-7 e. Basis of the marketable securities is $20,000 f. Basis of equipment received is $31,000 ($31,000 - $20,000 + $20,000). pp I13-17 and I13-18.

I13-46 a. $6,000. ($40,000 - $34,000). b. Zero. The exchange is a like-kind exchange. c. $34,000. d. $20,000. ($41,000 - $21,000) of Sec. 1245 ordinary income. e. The gain is $31,000. ($52,000 - $21,000). $29,000 of Sec. 1245 ordinary income and $2,000 of Sec. 1231 gain. pp. I13-17 and I13-18.

I13-47 a. $28,000. ($110,000 - $40,000) x 0.40. If Sec. 1245 did not exist, the gain would be a Sec. 1231 gain and treated as a LTCG. Since 60% of a net capital gain was allowed as a deduction in 1986, the AGI is increased by $28,000 [$70,000 -(0.60 x $70,000)]. b. $70,000. The realized gain is $70,000 ($110,000 - $40,000). c. Martin's increase in AGI is $70,000 in both (a) and (b) ($110,000 - $40,000). A 20% maximum tax rate would apply to the net Sec. 1231 gain if Sec. 1245 recapture did not exist. pp. I13-9 and I13-10.

I13-48 a. $105,000 ($720,000 - $615,000) b. $65,000 ($185,000 - $120,000) is Sec. 1250 ordinary income and $40,000 is Sec. 1231 gain. The $40,000 gain is unrecaptured Sec. 1250 gain taxed at the rate of 25%. c. $80,000 ($180,000 - $100,000) Sec. 1231 gain d. More ordinary income must be recognized in (b) since Sec. 291(a) must be considered. Total ordinary income is $73,000 {$65,000 + [0.20 x ($105,000 - $65,000)]} and Sec. 1231 gain is $32,000. The answers for (a) and (c) would not change. For corporations, none of the gain is unrecaptured Sec. 1250 gain. pp. I13-13 and I13-14.

I13-49 a. $375,000 ($975,000 - $600,000) b. None c. Sec. 1250 ordinary income is $205,000 and the Sec. 1231 gain is $170,000. The $170,000 gain may be taxed at a 25% rate. pp. I13-13 and I13-14.

I13-50 Additional depreciation is $79,200 ($226,800 - $147,600). Straight-line depreciation for 18 years is $147,600 (18 x $8,200) Annual straight-line depreciation is $8,200 ($328,000 divided by 40 years).

I13-8 Amount realized $340,000 Minus: Adjusted basis (133,200) ($360,000 - $226,800) Realized gain $206,800

Total Sec. 1250 ordinary income is $79,200 and Sec. 1231 gain is $127,600. pp. I13-13 and I13- 14.

I13-51 The realized gain is still $206,800 but ordinary income is increased because of Sec. 291(a). The ordinary income portion is $104,720 ($79,200 + 0.20 x [($206,800 - $79,200)] and Sec. 1231 gain is $102,080. pp. I13-15 and I13-16.

I13-52 Same answer as in I13-50. pp. I13-11 and I13-12.

I13-53 Same answer as in I13-51. pp. I13-14 and I13-15.

I13-54 a.

Building-90% Land-10% Amount realized $112,500 $12,500 Minus: Adjusted basis ( 54,000)* (10,000) Realized gain $ 58,500 $ 2,500 Ordinary income 11,000** Sec. 1231 gain 47,500 2,500

* $90,000 - $36,000. ** $36,000 - $25,000.

b. Jesse must recognize the $11,000 of Sec. 1250 ordinary income in the year of sale. The gross profit ratio of 40% ($50,000 divided by $125,000) is computed after allowing for the income recaptured as ordinary income and is used to determine the $10,000 Sec. 1231 gain (0.40 x $25,000) that is recognized in the year of sale.

Amount realized $125,000 Minus: Adjusted basis ( 64,000) Ordinary income ( 11,000) Gross margin $ 50,000 p. I13-13.

I13-55 a. $227,000. The maximum selling price that Rosemary could sell the building for without having to recognize Sec. 1250 ordinary income is $227,000, the adjusted basis. b. $278,000. The first $73,000 (i.e., the additional depreciation) of gain resulting from the sale of the building would be Sec. 1250 ordinary income. If SP - $227,000 = $51,000, then the selling price is $278,000. pp. I13-13 and I13-14.

I13-9 I13-56 a. The recognized gain is $225,000 ($825,000 - $600,000), and $40,000 (0.40 x $100,000) is ordinary income. b. The recognized gain is $15,000 and all of the gain is ordinary income since it is less than the amount of soil and water conservation expenditures recaptured. p. I13-20.

I13-57 The recognized gain is $100,000 ($900,000 - $800,000) and all of the gain is ordinary income since the gain is less than the amount of IDC ($300,000) subject to recapture. p. I13-20.

I13-58 a. The realized gain is $250,000 ($950,000 - $700,000) and all the gain is ordinary income under Sec. 1254. All gain to the extent of depletion ($200,000) and IDC that was expensed ($170,000) is recaptured as ordinary income. b. Jack must sell the property for more than $1,070,000 ($700,000 + $370,000) before he has a Sec. 1231 gain since the first $370,000 ($200,000 depletion + $170,000 IDC that was expensed) is ordinary income. p. I13-20.

I13-59 a. The $290,000 gain ($500,000 - $210,000) due to the sale of the building is ordinary income since Ed and the Crane Corporation are related parties and the building is depreciable property. b. The $125,000 gain ($200,000 - $75,000) due to the sale of the land is a Sec 1231 gain. pp. I13-20 and I13-21.

I13-60 a. The $20,000 Sec. 1231 loss in 1998 is an ordinary loss in 1998, and the $20,000 Sec. 1231 gain in 1999 is ordinary income. Since the Sec. 1231 gain is ordinary income because of the nonrecaptured net Sec. 1231 losses at the beginning of 1999, there is no difference in total taxes paid for the two years. Considering the time value of money, the taxpayer may prefer to recognize the loss in 1998 and the gain in 1999. b. The Sec. 1231 gain recognized in 1998 is a LTCG, and the $20,000 Sec. 1231 loss recognized in 1999 is an ordinary loss. This alternative may be preferable because the NLTCG is taxed at a lower rate than the ordinary income. The net capital gain of $20,000 in 1998 would be taxed at a maximum 28% rate, and possibly at 25% or 20%, although the time value of money should be considered. pp. I13-7 and I13-8.

I13-61 Holly's 1998 taxes do not increase if she recognizes the $5,000 Sec. 1231 gain in 1998. The Sec. 1231 gain is a LTCG that is offset by her $9,000 STCL. $3,000 of the STCL reduces gross income, and she has a $1,000 STCL carryforward. If she does not recognize the $5,000 Sec. 1231 gain in 1998, $3,000 of the STCL reduces gross income, and she has a $6,000 STCL carryforward. pp. I13-2 and I13-3.

I13-10 Tax Form/Return Preparation Problems

I13-62 (See Instructor's Guide).

Case Study Problems

I13-64 (See Instructor's Guide)

I13-65 (See Instructor's Guide)

Tax Research Problem

I13-11