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Chapter 16

PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES

LEARNING OBJECTIVES

Upon completion of this chapter you will be able to:

" Define a capital asset and use this definition " Explain the differences in tax treatment of the to distinguish capital assets from other types capital gains and losses of a corporate of property taxpayer versus those of an individual " Explain the holding period rules for taxpayer classifying a capital asset transaction as either " Identify various transactions to which capital short-term or long-term gain or loss treatment has been extended " Apply the capital gain and loss netting " Discuss the tax treatment of investments in process to a taxpayer’s capital asset corporate bonds and other forms of transactions indebtedness " Understand the differences in tax treatment of an individual’s capital gains and losses

16–1 Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

16–2 PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES

CHAPTER OUTLINE

General Requirements for Capital Gain 16-4 Incentives for Investments in Small Capital Assets 16-4 Businesses 16-26 Definition of a Capital Asset 16-4 Lo on S Inventory 16-5 § 1244 Disposition of a Business 16-6 Qualified Small Business Stock Sale or Exchange Requirement 16-7 (§ 1202 Stock) 16-27 Worthless and Abandoned Property 16-7 Rollover of Gain on Certain Publicly Certain Casualties and Thefts 16-9 Traded Securities 16-30 Other Transactions 16-9 Dealers and Developers 16-30 Holding Period 16-10 Dealers in Securities 16-30 Stock Exchange Transactions 16-10 Subdivided Real Estate 16-31 Special Rules and Exceptions 16-11 Other Related Provisions 16-32 Treatment of Capital Gains and Losses 16-13 Nonbusiness Bad Debts 16-32 The Process in General 16-13 Franchise Agreements, Trademarks, Netting Process 16-14 and Trade Names 16-32 Dividends Taxed at Capital Gain Short Sales 16-33 Rates 16-18 Options 16-34 Corporate Taxpayers 16-19 Corporate Bonds and Other Indebtedness 16-36 Calculating the Tax 16-20 Original Issue Discount 16-37 Reporting Capital Gains and Market Discount 16-39 Losses 16-24 Conversion Transactions 16-40 Capital Gain Treatment Extended Bond Premium 16-40 to Certain Transactions 16-25 Tax Planning Considerations 16-41 Patents 16-25 Timing of Capital Asset Transactions 16-41 Lease Cancellation Payments 16-26 Section 1244 Stock 16-42 Problem Materials 16-42

The final piece of the property transaction puzzle concerns the treatment of the taxpayer’s gains and losses. In the infancy of the tax law, solving this puzzle was relatively easy. Taxpayers who sold or otherwise disposed of property needed only to determine their gain or loss realized and how much, if any, they had to recognize. The actual treatment of the gain or loss recognized—or more precisely, the rate at which it was taxed—was identical to that for other types of income. The simplicity of treating all income and loss the same was short-lived, however, lasting a mere eight years, from 1913 to 1921. Since 1921, the taxation of property transactions has been complicated by the additional need to determine not only the amount of the taxpayer’s gain but also its character. Virtually all of this complication can be traced to one source: Congress’s desire to provide some type of preferential treatment for capital gains. Whether capital gains should be taxed more leniently than wages and other types of income is the subject of what seems to be a never-ending debate. When the first income tax statute was enacted, there was nothing in the definition of income to indicate that gains on dealings in property were taxable. Seizing on the omission, taxpayers relied on somewhat abstract tax theory and ingeniously argued that a gain on a sale of property (e.g., a citrus grove) was not the same as income derived from such property (e.g., sale of the fruit) and should not be taxed at all. Moreover, taxpayers who sold property and reinvested in similar property argued that they had not altered their economic position and that taxation was therefore not appropriate. While detractors cried ‘‘nonsense!’’ champions of favorable treatment offered additional justification, explaining that capital gain is often artificial, merely reflecting increases in the general price level. Perhaps the most defensible argument can be found in the Ways and Means Committee Report that Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

GENERAL REQUIREMENTS FOR CAPITAL GAIN 16–3 accompanied the Revenue Act of 1921. As the following quotation shows, Congress believed that the progressive nature of the tax rates was unduly harsh on capital gains, particularly when the rate (at that time) could be as high as 77 percent.

The sale of ... capital assets is now seriously retarded by the fact that gains and profits earned over a series of years are under present law taxed as a lump sum (and the amount of surtax greatly enhanced thereby) in the year in which the profit is realized. Many of such sales ... have been blocked by this feature of the present law. In order to permit such transactions to go forward without fear of a prohibitive tax, the proposed bill ... adds a new section [providing a lower rate for gains from the sale or dispositions of capital assets].1

Although the top rate is currently much lower than it has been historically, the bunching effect is still cited as one of the major justifications for lower rates for capital gains. Proponents also reason that taxing capital gains at low rates encourages taxpayers to make riskier investments and also helps stimulate the economy by encouraging the mobility of capital. Without such rules, taxpayers, they believe, would tend to retain rather than sell their assets. Of course, opponents of special treatment are equally vocal in their objections to the benefits extended capital gains. They reject the proposition that capital gain should not be taxed. They maintain that income is income regardless of its form. Opponents also doubt the stimulus value of preferential treatment and complain about the uneven playing field that such treatment creates. Finally, opponents offer one argument for which there is no denial. As will become all too clear in this and the following chapter, the special treatment reserved for capital gains and losses creates an inordinate amount of complexity in the tax law. Despite the various objections, Congress has generally sided with those in favor of preferential treatment. But, as history shows, there is little agreement on exactly what that treatment should be. From 1922 to 1933, taxpayers were given the option of paying a flat 12.5 percent tax on their capital gains and the normal rate on ordinary income. From 1934 to 1937, the treatment was altered to allow an exclusion for capital gains ranging from 20 to 80 percent, depending on how long the asset was held. After some tinkering with the exclusion in 1938, Congress moved again in 1942. This time it replaced the exclusion with a deduction equal to 50 percent of the gain. The 50 percent deduction—increased in 1978 to 60 percent—made capital gains the most popular game in town for almost 45 years. In 1986, however, Congress had a complete change of heart. After lowering the top rate on ordinary income to 28 percent, it apparently believed that special treatment for capital gains was no longer needed. Accordingly, favorable capital gain treatment was repealed. This period of low rates, however, proved to be only temporary, as Congress raised the top rate to 31 percent in 1991 and 39.6 percent in 1993. The increase prompted Congress to resurrect favorable treatment for capital gains, in this case providing that the gains of an individual would be taxed at a maximum rate not to exceed 28 percent. In 2003, Congress decided, once again, to improve the tax advantage extended to capital gains. Under the new rules, capital gains qualifying for special treatment can be taxed at one of four different rates (28 percent, 25 percent, 15 percent, or 5 percent). The current rates applying to capital gains, like their predecessors, can produce sub- stantial savings. The table below illustrates the benefit of the 15 percent capital gains rate (5 percent for taxpayers in the 10 percent or 15 percent brackets).

1 House Rep. No. 350, 67th Cong. 1st Sess., pp. 10–11, as quoted in Seidman, Legislative History of the Income Tax Laws, 1938–1961, 813 (1938). Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

16–4 PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES

Ordinary Capital Gains Differential Percentage Rate Rate Rate Savings

35.0% 15.% 20.0% 57.14% 33.0 15 18.0 54.55 28.0 15 13.0 46.43 25.0 15 10.0 40.00 15.0 5 10.0 66.67 10.0 5 5.0 50.00

As should be apparent capital gain treatment is clearly desirable. But as the remainder of this chapter explains, this favorable treatment is not extended to just any gain. The taxpayer must jump through a few hoops, turn a couple of cartwheels, and clear innumerable hurdles before he or she reaches the pot of gold at the end of the capital gains rainbow.

GENERAL REQUIREMENTS FOR CAPITAL GAIN

A gain or loss is considered a capital gain or loss and receives special treatment only if each of several elements is present. The asset being transferred must be a capital asset and the disposition must constitute a sale or exchange. In addition, the exact treatment of any net gain or loss can be determined only after taking into consideration the holding period of the property transferred. Each of these elements is discussed below.

CAPITAL ASSETS

DEFINITION OF A CAPITAL ASSET

In order for a taxpayer to have a capital gain or loss, the Code generally requires a sale or exchange of a capital asset. Obviously, the definition of a capital asset is crucial. Sales involving property that qualifies as a capital asset are eligible for a reduced tax rate while sales of assets that have not been so blessed may not be as lucky. The Internal Revenue Code takes a roundabout approach in defining a capital asset. Instead of defining what a capital asset is, the Code identifies what is not a capital asset. Under § 1221, all assets are considered capital assets unless they fall into one of five excluded classes. The following are not capital assets:

1. Inventory or property held primarily for sale to customers in the ordinary course of a trade or business 2. Accounts and notes receivable acquired in the ordinary course of a trade or business for services rendered or from the sale of inventory 3. Depreciable property and land used in a trade or business 4. Copyrights, literary, musical, or artistic compositions, letters or memoranda, or similar property held by the creator, or letters or memoranda held by the person for whom the property was created; in addition, such property held by a taxpayer whose basis is determined by reference to the creator’s basis (e.g., acquired by gift), or held by the person for whom it was created 5. Publications of the United States Government that are received from the Government by any means other than purchase at the price at which they are offered to the public, and which are held by the taxpayer who received the publi- cation or by a transferee whose basis is found with reference to the original recipient’s basis (e.g., acquired by gift) Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

CAPITAL ASSETS 16–5 Before looking at some of these categories, one should appreciate the statutory scheme and the rationale behind it. As noted above, the Code starts with the very broad premise that all property held by the taxpayer is a capital asset. Thus the sale of a home, car, jewelry, clothing, stocks, bonds, inventory, and plant, property, and equipment used in a trade or business would produce, at least initially, capital gain or loss since all assets are by default capital assets. However, § 1221 goes on to alter this general rule with several significant exceptions. It specifically excludes from capital asset status inventory, property held for resale, receivables related to the sales of services and inventory, and certain literary properties. As may be apparent, the purpose of these exclusions, as the Supreme Court has said, ‘‘is to differentiate between the Ôprofits and losses arising from the everyday operation of businessÕ on the one hand ... and Ôthe realization of appreciation in value accrued over a substantial period of timeÕ on the other.’’2 In essence, the statute is drawn to deny capital gain treatment for income from regular business operations. Income that is derived from the taxpayer’s routine personal efforts and services is treated as ordinary income and in effect receives the same treatment as wages, interest, and all other types of income. In contrast, capital gain, at least in the general sense, is limited to gains from the sale of investment property. Based on the above analysis, it might seem strange that § 1221 also excludes from capital asset status a class of assets that most people would consider capital assets: the fixed assets of a business (depreciable property and land used in a business). Although it is true that these assets are not ‘‘pure’’ capital assets, as will be seen in Chapter 17, these assets can, if certain tests are met, sneak in the back door and receive capital gain treatment. Also observe that this rule does not exclude intangibles from capital asset treatment even though they may be amortizable. For example, goodwill is a capital asset even though it may be amortized. One final note: it should be emphasized that the classification of an asset as a capi- tal asset may affect more than the character of the gain or loss on its sale. For example, the amount of a charitable contribution deduction also may be affected in certain instan- ces. Recall that the deduction for charitable contributions of appreciated capital gain property is generally based on fair market value, but is limited to a percentage of adjusted gross income.3

INVENTORY

The inventory exception has been the subject of much litigation and controversy. Whether property is held primarily for sale is a question of fact. The Supreme Court decided in Malat v. Riddell4 that the word ‘‘primarily’’ should be interpreted as used in an ordinary, everyday sense, and as such, means ‘‘principally’’ or of ‘‘first importance.’’ As a practical matter, such interpretations provide little guidance. In many cases, it simply boils down to whether the court views the taxpayer as a ‘‘dealer’’ in the particular property or merely an investor. Unfortunately, the line of demarcation is far from clear. The determination of whether an item is inventory or not frequently arises in the area of sales of real property. In determining whether a taxpayer holds real estate, or a particular tract of real estate, primarily for sale, the courts seem to place the greatest emphasis on the frequency, continuity, and volume of sales.5 Other important factors

2 Malat v. Riddell, 66-1 USTC {9317, 17 AFTR2d 604, 383 U.S. 569 (USSC, 1966). 3 See § 170(e)(1) and Chapter 11 for a discussion of these charitable contribution limitations. 4 Supra, Footnote 2. 5 See, for example, Houston Endowment, Inc. v. U.S., 79-2 USTC {9690, 44 AFTR2d 79-6074, 606 F.2d 77 (CA-5, 1979) and Reese v. Comm., 80-1 USTC {9350, 45 AFTR2d 80-1248, 615 F.2d 226 (CA-5, 1980). Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

16–6 PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES

considered by the courts are subdivision and improvement,6 solicitation and advertising,7 purpose and manner of acquisition,8 and reason for and method of sale.9

DISPOSITION OF A BUSINESS

The treatment of the sale of a business depends on the form in which the business is operated and the nature of the sale. If the business is operated as a sole proprietorship, the sale of the proprietorship business is not, as one taxpayer argued, a sale of a single integrated capital asset.10 Rather, it is treated as a separate sale of each of the assets of the business. Accordingly, the sales price must be allocated among the various assets and gains and losses determined for each individual asset. Any gain or loss arising from the sale of inventory items and receivables would be treated separately as ordinary gains and losses. Gains and losses from the sale of depreciable property and land used in the business would be subject to special treatment discussed in Chapter 17 and may qualify for capital gain treatment. Finally, gains and losses from capital assets would of course be treated as capital gains and losses. If the business is operated in the form of a corporation or partnership, the sale could take one of two forms: (1) a sale of the owner’s interest (e.g., the owner’s stock or interest in the partnership) or (2) a sale of all the assets by the entity followed by a distribution of the sales proceeds to the owner. An owner’s interest—stock or an interest in a partnership—is a capital asset. Consequently, a sale of such interest normally produces capital gain or capital loss (although there are some important exceptions for sales of a partnership interest). On the other hand, a sale of assets by the entity would be treated in the same manner as the sale of a sole proprietorship, a sale of each individual asset.

3 CHECK YOUR KNOWLEDGE

Review Question 1. Lois Price operates an office supply store, Office Discount, and owns the property listed below. Indicate whether each of the following assets is a capital asset. Respond yes or no.

a. Refrigerator in her home used solely for personal use b. The building that houses her business c. A picture given to her by a well-known artist d. 100 shares of Chrysler Corporation stock held as an investment e. Furniture in her office f. A book of poems she has written g. The portion of her home used as a qualifying home office h. 1,000 boxes of 3½-inch floppy disks i. Goodwill of the business

The following are capital assets: (a), (d), and (i). All assets are capital assets except inventory (item h), real or depreciable property used in a trade or business (items b, e, g), literary or artistic compositions held by the creator (item f ), or property received by

6 See, for example, Houston Endowment, Inc., and Biedenharn Realty Co., Inc. v. U.S., 76-1 USTC {9194, 37 AFTR2d 76-679, 526 F.2d 409 (CA-5, 1976). 7 See, for example, Houston Endowment, Inc. 8 See, for example, Scheuber v. Comm., 67-1 USTC {9219, 19 AFTR2d 639, 371 F.2d 996 (CA-7, 1967), and Biedenharn Realty Co., Inc. v. U.S. 9 See, for example, Voss v. U.S., 64-1 USTC 9290, 13 AFTR2d 834, 329 F.2d 164 (CA-7, 1964). 10 Williams v. McCowan, 46-1 USTC {9120, 34 AFTR 615, 152 F.2d 570 (CA-2, 1945); Rev. Rul. 55-79, 1955-1 C.B. 370. Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

SALE OR EXCHANGE REQUIREMENT 16–7 gift from the creator (item c). Note that the Code does not exclude intangible assets from capital assets status. Such assets as goodwill are treated as capital assets.

Review Question 2. Slam-Dunk Corporation manufactures collapsible basketball rims in Houston, Texas. Because of its tremendous growth, Mr. Slam and Ms. Dunk, the owners of the company, brought in a highly skilled executive to manage it, the famous Sam Jam. As part of the employment agreement, the company agreed to buy Sam’s house if it should terminate his contract. As you might expect, Slam and Dunk did not get along with Sam and his creative management techniques. Consequently, the corporation dismissed Sam after two years and purchased his house at Sam’s original cost of $300,000. Needing the cash, the corporation decided to unload the house immediately. Unfortunately, in the depressed housing market of Houston, the corporation sold the house for only $200,000. Explain the tax problems associated with the sale by the corporation. What important issue must be resolved and why?

In this situation, the corporation has realized a loss of $100,000. The critical issue is deter- mining whether the loss is an ordinary or capital loss. The treatment, as explained below, is quite different. If the loss is ordinary, the corporation may deduct the entire loss in com- puting taxable income. In contrast, if the loss is a capital loss, the corporation can deduct the loss only to the extent of any capital gains that it has during the year or a three-year carryback and five-year carryforward period. The determination turns on the definition of a capital asset.

SALE OR EXCHANGE REQUIREMENT

Before capital gain or loss treatment applies, the property must be disposed of in a ‘‘sale or exchange.’’ In most cases, determining whether a sale or exchange has occurred is not difficult. The requirement is met by most routine transactions and as a practical matter is often overlooked. Nevertheless, there are a number of situations when a sale or exchange does not actually occur but the Code steps in and creates one, thus converting what might have been ordinary income or loss to capital gain or capital loss. Several of these are considered below.

WORTHLESS AND ABANDONED PROPERTY

When misfortune strikes, leaving the taxpayer with worthless property, the taxpayer normally has a loss equal to the adjusted basis of the property. Note, however, that the loss in these situations does not technically arise from a sale or exchange, leaving the taxpayer to wonder how the loss is to be treated.

Worthless Securities. The Code has addressed this problem with respect to worthless securities (e.g., stocks and bonds). In the event that a qualifying security becomes worthless at any time during the taxable year, the resulting loss is treated as having arisen from the sale or exchange of a capital asset on the last day of the taxable year.11 Losses from worthlessness are then treated as either short-term or long-term capital losses depending on the taxpayer’s holding period.

Example 1. After receiving a hot tip, N bought 200 shares of Shag Carpets Inc. for $2,000 on November 1, 2005. Just three months later, on February 1, 2006, N received a shocking notice that the company had declared bankruptcy and her investment was worthless. Because of the worthlessness, N is treated as having sold

11 § 165(g). Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

16–8 PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES the stock for nothing on the last day of her taxable year, December 31, 2006. Because the sale is deemed to occur on December 31, 2006 (and not February 1), N is treated as if she actually held the stock for more than a year. As a result, she reports a $2,000 long-term capital loss.

The sale or exchange fiction applies only to qualifying securities. To qualify, the security must be (1) a capital asset and (2) a security as defined by the Code. Under § 165, the term security means stock, stock rights, and bonds, notes, or other forms of indebtedness issued by a corporation or the government. When these rules do not apply (e.g., property other than securities), the taxpayer suffers an ordinary loss. Whether a security actually becomes worthless during a given year is a question of fact, and the burden of proof is on the taxpayer to show that the security became worthless during the year in question.12

Worthless Securities in Affiliated Corporations. The basic rule for worthless securities is modified for a corporate taxpayer’s investment in securities of an affiliated corporation. If securities of an affiliated corporation become worthless, the loss is treated as an ordinary loss and the limitations that normally apply if the loss were a capital loss are avoided.13 A corporation is considered affiliated to a parent corporation if the parent owns at least 80 percent of the voting power of all classes of stock and at least 80 percent of each class of nonvoting stock of the affiliated corporation. In addition, to be treated as an affiliated corporation for purposes of the worthless security provisions, the defunct corporation must have been truly an operating company. This test is met if the corporation has less than 10 percent of the aggregate of its gross receipts from passive sources such as rents, royalties, dividends, annuities, and gains from sales or exchanges of stock and securities. This condition prohibits ordinary loss treatment for what are really investments.

Example 2. Toy Palace Corporation is the parent corporation for more than 100 subsidiary corporations that operate toy stores all over the country. Each subsidiary is 100 percent owned by Toy Palace. This year the store in Chicago, TPC Inc., declared bankruptcy. As a result, Toy Palace’s investment in TPC stock of $1 million became totally worthless. Toy Palace is allowed to treat the $1 million loss as an ordinary loss since TPC was an affiliated corporation (i.e., Toy Palace owned at least 80 percent of TPC’s stock and TPC was an operating corporation). Observe that without this special rule, Toy Palace would have a $1 million capital loss that it could deduct only if it had capital gains currently or within the three-year carryback or five-year carryforward period.

Abandoned Property. While the law creates a sale or exchange for worthless securities, it takes a different approach for abandoned business or investment property. When worthless property (other than stocks and securities) is abandoned, the abandon- ment is not considered a sale or exchange.14 Consequently, any loss arising from an abandonment is treated as an ordinary loss rather than a capital loss, a much more propitious result. Note, however, that the loss is deductible only if the taxpayer can demonstrate that the business or investment property has been truly abandoned and not simply taken out of service temporarily.

12 Young v. Comm., 41-2 USTC {9744, 28 AFTR 365, 123 F.2d 597 (CA-2, 1941). Code § 6511(d) extends the statute of limitations from three years to seven years because of the difficulty of determining the specific tax year in which stock becomes worthless. 13 § 165(g)(3). 14 Reg. §§ 1.165-2 and 1.167(a)-8. Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

SALE OR EXCHANGE REQUIREMENT 16–9

CERTAIN CASUALTIES AND THEFTS

Still another exception to the sale or exchange requirement involves excess casualty and theft gains from the involuntary conversion of personal use assets. As discussed in Chapter 10, § 165(h) provides that if personal casualty or theft gains exceed personal casualty or theft losses for any taxable year, each such gain and loss must be treated as a gain or loss from the sale or exchange of a capital asset. Each separate casualty or theft loss must be reduced by $100 before being netted with the personal casualty or theft gains.

Example 3. T had three separate casualties involving personal-use assets during the year:

Fair Market Value Adjusted Before After Casualty Property Basis Casualty Casualty

1. Accident Personal car $12,000 $ 8,500 $ 6,000 2. Robbery Jewelry 1,000 4,000 0 3. Hurricane Residence 60,000 80,000 58,000

T received insurance reimbursements as follows: (1) $900 for repair of the car; (2) $3,200 for the theft of her jewelry; and (3) $21,500 for the damages to her home. Assuming T does not elect (under § 1033) to purchase replacement jewelry, her personal casualty gain exceeds her personal casualty losses by $300, computed as follows:

1. The loss for the car is $1,500 [(lesser of $2,500 decline in value or the $12,000 adjusted basis ¼ $2,500) $900 insurance recovery $100 floor]. 2. The gain for the jewelry is $2,200 ($3,200 insurance recovery $1,000 adjusted basis). 3. The loss from the residence is $400 [(lesser of $22,000 decline in value or the $60,000 adjusted basis ¼ $22,000) $21,500 insurance recovery $100 floor].

T must report each separate gain and loss as a gain or loss from the sale or exchange of a capital asset. The classification of each gain and loss as short-term or long-term depends on the holding period of each asset.

It is important to note that this exception does not apply if the personal casualty losses exceed the gains. In such case, the net loss, subject to the 10 percent limitation, is deductible from A.G.I. Recall, however, that casualty and theft losses are among those itemized deductions that are not subject to the 3 percent cutback rule imposed on high- income taxpayers. (See Chapter 11 for a discussion of this cutback rule.)

Example 4. Assume the same facts in Example 3 except the insurance recovery from the hurricane damage to the residence was only $11,500. In this case, the loss from the hurricane is $10,400 ($22,000 $11,500 $100), and the personal casualty losses exceed the gain by $9,700 ($1,500 þ $10,400 $2,200). T must treat the $9,700 net loss as an itemized deduction subject to the 10% of A.G.I. limitation, but not subject to the 3% cutback rule.

OTHER TRANSACTIONS

There are still other situations where the sale or exchange requirement is an important consideration. For example, foreclosure, condemnation, and other involuntary Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

16–10 PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES events are treated as sales even though they may not qualify as such for state law purposes. Similarly, as discussed in greater detail later in this chapter, the collection of the face value of a corporate bond (i.e., bond redemption) at maturity is treated as a sale or exchange.

HOLDING PERIOD

The exact treatment of a capital gain or loss depends primarily on how long the taxpayer held the asset or what is technically referred to as the taxpayer’s holding period. The holding period is a critical element in determining which of the various tax rates will apply. As might be expected, the longer the holding period is, the lower the applicable tax rate will be. A short term gain or loss is one resulting from the sale or disposition of an asset held one year or less.15 A long-term gain or loss occurs when an asset is held for more than one year. In computing the holding period, the day of acquisition is not counted but the day of sale is. The holding period is based on calendar months and fractions of calendar months, rather than on the number of days.16 The fact that different months contain different numbers of days (i.e., 28, 30, or 31) is disregarded.

Example 5. P purchased 10 shares of EX, Inc. on March 16, 2006. Her gain or loss on the sale is short-term if the stock is sold on or before March 16, 2007 but long-term if sold on or after March 17, 2007.

Example 6. T purchased 100 shares of FMC Corp. stock on February 28, 2006. His gain or loss will be long-term if he sells the stock on or after March 1, 2007.

The holding period runs from the time property is acquired until the time of its disposition. Property is generally considered acquired or disposed of when title passes from one party to another. State law usually controls the passage of title and must be consulted when questions arise.

STOCK EXCHANGE TRANSACTIONS

The holding period for securities traded on a stock exchange is determined in the same manner as for other property. The trade dates, rather than the settlement dates, are used as the dates of acquisition and sale. Generally, both cash and accrual basis taxpayers must report (recognize) gains and losses on stock or security sales in the tax year of the trade, even though cash payment (settlement) may not be received until the following year. This requirement is imposed because the installment method of reporting gains is not allowed for sales of stock or securities that are traded on an established securities market.17

Example 7. C, a cash basis calendar year taxpayer, sold 300 shares of ARA stock at a gain of $5,000 on December 29, 2006. The settlement date was January 3, 2007. C must report the gain in 2006 (the year of trade).

15 § 1222. 16 Rev. Rul. 66-7, 1966-1 C.B.188. 17 § 453(k)(2). See Chapter 14 for a detailed discussion of the installment sale method. Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

HOLDING PERIOD 16–11

SPECIAL RULES AND EXCEPTIONS

Section 1223 contains a number of special provisions that must be used for determining the holding period of certain properties. The rules address the holding period of property acquired (1) in a tax-deferred exchange; (2) by gift; (3) by inheritance; (4) in a wash sale; (5) as a stock dividend; or (6) by exercising stock rights or options.

Property Acquired in Tax-Deferred Transaction. The holding period of property received in an exchange includes the holding period of the property given up in the exchange if the basis of the property is determined by reference, in whole or in part, to the basis in that property given up (e.g., a substituted basis in a like-kind exchange).18 This rule applies only if the property exchanged is a capital asset or a § 1231 asset (e.g., real or depreciable property used in a trade or business) at the time of the exchange. For this purpose, an involuntary conversion–where the taxpayer normally purchases replacement property for that which was involuntarily converted—is treated as an exchange.19 As suggested above, this rule commonly can be found operating when there is a like- kind exchange. For example, if a taxpayer purchased land on May 16, 1981 and swapped it for other land in 2006, the taxpayer’s holding period for the new land would begin in 1981 since the basis of the new land is the same as the old land, $50,000, (i.e., the basis of the new land was ‘‘determined by reference’’ to the property given up). Normally, if any gain or loss is deferred, the holding period of the replacement property includes the holding period of the property that was converted or exchanged.

Example 8. In 2005, the city of Milwaukee condemned 10 acres of M’s farm land (a § 1231 asset) in order to build an exit for an interstate highway. M had acquired the land on May 1, 1993 for $20,000. M received $120,000 for the land and therefore realized a gain of $100,000. On July 7, 2007 M replaced the property by purchasing new land for $120,000. As a result, he was able to defer all of the realized gain, producing a basis for the new property of $20,000 ($120,000 cost less $100,000 deferred gain). Since an involuntary conversion is treated as an exchange, M’s holding period begins on the date that he acquired the original property, May 1, 1993.

Property Acquired by Gift. Another exception provides that if a taxpayer’s basis in property is the same basis as another taxpayer had in that property, in whole or in part, the holding period will include that of the other person.20 Therefore, the holding period of property acquired by gift generally will include the holding period of the donor. This will not be true, however, if the property is sold at a loss and the basis in the property for determining the loss is fair market value on the date of the gift.

Example 9. G received a gold necklace from her elderly grandmother as a birthday gift on August 31, 2006. The necklace was worth $5,200 at that time and had a basis to the grandmother of $1,300. Grandmother had bought the necklace in 1976. Contrary to her grandmother’s wishes, G sold the family heirloom for $5,000 on December 13, 2006. G will recognize a gain of $3,700 ($5,000 $1,300). Her holding period will begin in 1976 since her $1,300 basis is determined (under § 1015) by reference to her grandmother’s basis, and her holding period includes the time the necklace was held by her grandmother.

18 § 1223(1). 19 § 1223(1)(A). 20 § 1223(2). Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

16–12 PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES Example 10. If G’s grandmother had a basis in the necklace of $6,000, G’s basis for determining loss would be $5,200, the fair market value at the date of the gift (see discussion in Chapter 14). Because G’s basis is not determined by reference to her grandmother’s basis, the grandmother’s holding period is not added to G’s holding period. Since G only held the necklace for three months, she will have a $200 short-term capital loss ($5,200 basis $5,000 sales price).

Property Acquired From a Decedent. A special rule is provided for the holding period of property acquired from a decedent. The holding period formally begins on the date of death. However, the Code provides that, if the heir’s basis in the property is its fair market value under § 1014 and the property is subsequently sold after the decedent’s death, the property is deemed to have a long-term holding period.21

Example 11. P sold 50 shares of Xero Corp. stock for $11,200 on July 27, 2006. The stock was inherited from P’s uncle who died on May 16, 2006, and it was included in the uncle’s Federal estate tax return at a fair market value of $12,000. Since P’s basis in the stock ($12,000) is determined under § 1014, the $800 loss on the sale will be a capital loss from property deemed to be held more than 12 months. This would be the case even if P’s uncle had purchased the stock within days of his death. The decedent’s prior holding period is irrelevant.

Other Holding Period Rules. There are various other provisions that contain special rules for determining holding periods. The holding period of stock acquired in a transac- tion in which a loss was disallowed under the ‘‘wash sale’’ provisions (§ 1091) is added to the holding period of the replacement stock.22 Also, when a shareholder receives stock dividends or stock rights as a result of owning stock in a corporation, the holding period of the stock or stock rights includes the holding period of the stock already owned in the corporation.23 The holding period of any stock acquired by exercising stock rights, however, begins on the date of exercise.24 The holding period of property acquired by exercise of an option begins on the day after the option is exercised.25 If a taxpayer sells the property acquired by option within one year after exercising the option, then he or she will have a short-term gain or loss.

Example 12. N owned an option to purchase ten acres of land. She had owned the option more than one year when she exercised it and purchased the property. Her holding period for the property begins on the day after she exercises the option. Had she sold the option, her gain or loss would have been long-term. If she had sold the property immediately, her gain or loss would have been short-term.

The holding period of a commodity acquired in satisfaction of a commodity futures contract includes the holding period of the futures contract. However, the futures contract must have been a capital asset in the hands of the taxpayer.26

21 § 1223(11). 22 § 1223(4); Reg. § 1.1223-1(d). 23 § 1223(5); Reg. § 1.1223-1(e). 24 § 1223(6); Reg. § 1.1223-1(f). 25 See, for example, Helvering v. San Joaquin Fruit & Inv. Co., 36-1 USTC {9144, 17 AFTR 470, 297 U.S. 496 (USSC, 1936), and E.T. Weir, 49-1 USTC {9190, 37 AFTR 1022, 173 F.2d 222 (CA-3, 1949). 26 § 1223(8); Reg. § 1.1223-1(h). Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

TREATMENT OF CAPITAL GAINS AND LOSSES 16–13

TREATMENT OF CAPITAL GAINS AND LOSSES

The Taxpayer Relief Act of 1997 and the amendments of the Jobs and Growth Tax Relief Reconciliation Act of 2003 significantly cut the tax rates on capital gains but not without introducing an inordinate amount of complexity. The adventure begins below.

THE PROCESS IN GENERAL

The first step in determining the treatment of a taxpayer’s capital gain or loss is identifying the applicable holding period. Once the holding period is determined, the gain or loss can normally be assigned to an appropriate group to determine its taxation. Historically, there have only been two groups: short-term and long-term. However, beginning in 1997, the law made the classification process a bit more cumbersome, producing the following groups for individual taxpayers.

" Short-Term group. Gains and losses from properties held not more than one year " Long-Term group. Generally gains and losses from properties held more than one year. However, individual taxpayers must subdivide the long-term group into additional subgroups according to the rate at which they are to be taxed. The long- term group includes:

1. The 28% group

" Capital gains and losses from collectibles (e.g., works of art, antiques, gold and silver bullion, etc.)27 " Capital gains from qualified small business stock (taxable portion of § 1202 gains discussed below)

2. The 25% group.

" Capital gains (and only gains) from the sales of depreciable real estate (e.g., office buildings, warehouses, apartment buildings) that are held for more than 12 months but only to the extent of any unrecaptured straight- line depreciation on such property (25CG). (See Chapter 17 for discussion of depreciation recapture.)

3. The 15% group

" Capital gains and losses from the dispositions of other assets held more than 12 months (15CG and 15CL).

The effect of the new rules is to require taxpayers to assign their capital gains and losses into one of four different groups and net the amounts to determine the net gain or loss in each group as shown below.

Short-Term Long-Term

Holding period (months) 12 Collectibles & § 1202 stock > 12 Realty > 12 > 12A Ordinary 28% 25% 15% Gains $xx,xxx) $x,xxx) Gains only $xx,xxx) Losses (xxx) (x,xxx) — (x,xxx) Net gain or loss ????) ????) Gain only ????)

27 § 1(h)(1)(C) and (h)(4). Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

16–14 PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES As a practical matter, the capital gains of most individuals arise from the sales of stocks and bonds and mutual fund transactions. Rarely do individuals have gains from collectibles, § 1202 stock, or depreciable realty. Consequently, for most individuals, the classification and netting process will indeed be much easier.

NETTING PROCESS

Generalizations about the treatment of capital gains and losses are difficult because the actual treatment can be determined only after the various groups (i.e., the four groups above) are combined, or netted, to determine the overall net gain or loss during the year. This process is described below.28

Netting Within Groups. The first step in the netting process is to combine the gains and losses within each group to produce one of the following:

1. Net short-term capital gain or net short-term capital loss (NSTCG or NSTCL). 2. Net 28% capital gain or net 28% capital loss (N28CG or N28CL). 3. Net 15% capital gain or net 15% capital loss (N15CG or N15CL).

Note that the first step requires no netting in the 25% group since this group initially con- tains only gains.

Netting Between Groups. The second step requires the combination of the net capital loss positions in any particular group against any net capital gain positions. The treatment of these different groups is explained below.

1. Short-Term Capital Gains and Losses. A NSTCG receives no special treatment and is taxed as ordinary income. If a NSTCL results, it may be used to offset net gains of the long-term group in the following order: (1) the net 28% gains; (2) any 25% gains; and (3) the net 15% gain. Any remaining NSTCL not absorbed by the capital gains in the groups above is deductible subject to limitations on the deduction of capital losses discussed below. 2. 28% Group. A N28CG is taxed at a maximum 28%.29 Any net loss in the 28% group (N28CL) is applied in the following order: (1) 25% gains; (2) net 15% gain; and (3) NSTCG. Any remaining N28CL that is not absorbed is deductible subject to limitations on the deduction of capital losses discussed below. 3. 25% Group. The 25% group generally includes only capital gains from the sales of depreciable real estate held for more than 12 months. Such gains are generally only included to the extent of any unrecaptured straight-line depreciation on such property. The net 25% capital gain (N25CG) is taxed at a maximum rate of 25%.30 Note that there can be no net loss in the 25% group. 4. 15% Group. A N15CG is taxed at a maximum of 15%. However, if the taxpayer’s tax bracket (determined by including the N15CG) is only 10 or 15%, the net gain falling into these brackets is taxed at 5%.31 Any N15CL is applied in the following order: (1) the net 28% gains; (2) any 25% gains; and (3) any NSTCGs.

28 § 1(h)(1). 29 § 1(h)(1)(C). 30 § 1(h)(1)(B). 31 § 1(h)(1)(D) and (E). Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

TREATMENT OF CAPITAL GAINS AND LOSSES 16–15 Any remaining N15CL not absorbed is deductible subject to limitations on the deduction of capital losses discussed below.

It should be noted that the three long-term groups (the 28%, 25% and 15% groups) are always netted together before taking into accounting any short-term items. Also observe that Congress has generally given taxpayers the best possible treatment of net capital losses in that a NSTCL offsets the net capital gain from the highest taxed group, then the next highest taxed and so on.

Example 13. During the year, T, who is in the 35 percent tax bracket, reported the following capital gains and losses.

Long-Term Short-Term 28% 15% Gains $10,000 $5,000 $8,000 Losses (4,000) (1,000) (1,000) Net $ 6,000 $4,000 $7,000

In this case, T first nets the items within each group. She nets the $10,000 STCG and $4,000 STCL to arrive at a NSTCG of $6,000; she nets a $5,000 28CG and a $1,000 28CL to produce a N28CG of $4,000; and she adds the $8,000 15CG and the $1,000 15CL resulting in a N15CG of $7,000. No further netting of these groups can occur since they each group contains a positive amount. T’s NSTCG of $6,000 will receive no special treatment and is taxed as ordinary income. T’s N28CG is taxed at 28% while her N15CG is taxed at 15%.

Example 14. This year, L, who is in the 28% tax bracket, reported the following capital gains and losses.

Long-Term Short-Term 28% 15% Gains $10,000 $5,000 $8,000 Losses (15,000) (1,000) (1,000) Net ($5,000) $4,000 $7,000

Netting 5,000 (4,000) (1,000) Net $ 0 $ 0 $6,000

Here L has a NSTCL of $5,000 which is netted first against N28CG of $4,000, reducing it to zero. The remaining NSTCL of $1,000 would next be offset against N25CG, if any. In this case, there is no N25CG, therefore the remaining NSTCL of $1,000 is offset against the N15CG of $7,000, reducing it to $6,000 which would be taxed at a rate of 15%. Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

16–16 PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES Example 15. This year, X, who is in the 35% tax bracket, reported the following capital gains and losses

Long-Term Short-Term 28% 25% 15%

Gains $14,000 $1,000 $1,000 $6,000 Losses (4,000) (9,000) — (1,000) Net $10,000 ($8,000) $1,000 $5,000

Netting (2,000) 8,000 (1,000) (5,000) Net $ 8,000 $ 0 $ 0 $ 0

Here X has a N28CL of $8,000 which is netted first against the 25CGs of $1,000, reducing this group to zero. X next uses the remaining $7,000 N28CL to offset his $5,000 N15CG, reducing it to zero. The remaining N28CL of $2,000 ($7,000 $5,000) is offset against NSTCG, producing a NSTCG of $8,000 which will be treated as ordinary income. Note that the effect of the rules is to net the long-term groups before considering any short-term items. Absent these rules, X would prefer to use the N28CL loss against the NSTCG which would leave $5,000 to be taxed at 15% and $2,000 to be taxed as ordinary income, a far more beneficial result. X must net the long-term groups first.

Treatment of Capital Losses. While capital gains receive favorable treatment, such is not the case with capital losses. As can be seen above, capital losses are first netted with capital gains within the same group (rather than reducing ordinary income). A net capital loss from a particular group can then be combined with net capital gains from the other groups as explained above. If after netting all of the groups together, the taxpayer has an overall net capital loss, the loss is deductible against ordinary income. This deduction is limited to the lesser of (1) $3,000 ($1,500 in the case of a married individual filing a separate return) or (2) the net capital loss. In either case, the capital loss deduction cannot exceed taxable income before the deduction.32 The deductible capital loss is a deduction for adjusted gross income. Any losses in excess of the annual $3,000 limitation are carried forward to the following year where they are treated as if they actually occurred in such year. In effect, an unused capital loss can be carried over for an indefinite period.33 However, should the taxpayer die, any unused capital loss is normally lost. If the netting process results in a NSTCL and either a N28CL or N15CL or both, the NSTCL is applied first toward the maximum $3,000 limit. For example, if the taxpayer has a NSTCL of $5,000 and a N15CL of $4,000, the NSTCL is used first. Any NSTCL in excess of the $3,000 limit along with any other unused losses may be carried forward to subsequent years indefinitely. In this case, the NSTCL carryover retains its character to be treated just as if it had occurred in the subsequent year. The N15CL or N28CL are both carried over as N28CLs. In other words, any long-term capital loss carryover is carried over as a 28CL. In the example above, $3,000 of the $5,000 NSTCL would be used first against ordinary income and the $2,000 remaining would be carried over as a STCL while the $4,000 N15CL would be carried over as a 28CL. In the absence of a NSTCL or, if after deducting any existing NSTCL, the taxpayer has not reached the an- nual $3,000 limit for the capital loss deduction, the taxpayer uses any other net capital losses (e.g., the excess of N15CL over N28CG and N25CG or the excess of N28CL

32 § 1212(b). 33 Reg. § 1.211-1(b)(4)(i). Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

TREATMENT OF CAPITAL GAINS AND LOSSES 16–17

over 25 CG and N15CG) to reduce ordinary income up to the $3,000 limit.34 In this regard, the order in which the remaining net capital losses are used is irrelevant since any remaining losses (i.e., the long-term losses) are carried over as a N28CL which is treated as if it occurred in the subsequent year.

Example 16. During the year, B reported the capital gains and losses revealed below. B’s only other taxable income included his salary of $50,000. He had no other deductions for A.G.I. The combination of gains, losses, and ordinary income is shown in the following table.

Long-Term Short-Term 28% 15%

Gains $10,000 $5,000 $9,000 Losses (18,000) (7,000) (6,000) Net ($ 8,000) ($2,000) $3,000

Netting (long-term against long-term) 2,000 (2,000) $ 0 $1,000 Netting (long-term against short-term) 1,000 (1,000) ($ 7,000) $ 0 Deduction 3,000 Carryover ($ 4,000)

B first nets the long-term items, that is, the N28CL of $2,000 is netted against the N15CG of $3,000. This produces a N15CG of $1,000 ($3,000 $2,000). B then combines the $8,000 NSTCL and the remaining N15CG of $1,000, leaving a NSTCL of $7,000. In determining his A.G.I., B may deduct only $3,000 of the NSTCL. Therefore his A.G.I. is $47,000 ($50,000 $3,000). The unused NSTCL of $4,000 ($7,000 $3,000) is carried forward to future years as a STCL where it is treated as if it arose in the subsequent year.

Example 17. This year, Q reported the capital gains and losses as shown below. He had no other deductions for A.G.I. The combination of gains, losses, and ordinary income is revealed in the following table.

Long-Term Short-Term 28% 15%

Gains $1,000 $5,000 $4,000 Losses (2,000) (3,000) (9,000) Net ($1,000) $2,000 ($5,000)

Netting (long-term against long-term) 0 (2,000) 2,000 Net ($1,000) $ 0 ($3,000) Deduction 1,000 2,000 Carryover $ 0 ($1,000)

Here Q has a NSTCL of $1,000 and a net $5,000 N15CL. He first combines the long- term groups, using $2,000 of the $5,000 N15CL to offset the N28CG of $2,000, reducing it to zero. The remaining $3,000 normally would be netted against 25CG if

34 § 1211(a). Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

16–18 PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES there were any. No further netting is allowed. Therefore, J first uses the NSTCL of $1,000 and then $2,000 of the $3,000 N15CG remaining toward the $3,000 offset against ordinary income. The remaining N15CL of $1,000 is carried over and is treated as a 28CL. It should be emphasized that the N15CL of $1,000 does not retain its character but becomes a capital loss in the 28% group. Note that the carryover rule is quite favorable. If next year J had $1,000 of N28CG and $1,000 of N15CG, the carryover would wipe out the N28CG, leaving the most favorable gain to be taxed.

Example 18. W’s records for 2005 and 2006 revealed substantial ordinary income and the following capital gains and losses.

Long-Term Short-Term 28% 15%

2005 gains $ 1,000 $ 5,000 $ 4,000 2005 losses (2,000) (9,000) (9,000) $ (1,000) $ (4,000) $ (5,000)

2006 $10,000 $12,000 $15,000

In 2005, there can be no further netting. Therefore, W first uses the NSTCL of $1,000 against ordinary income and then uses $2,000 of the $9,000 in long-term losses, leaving a long-term capital loss carryover of $7,000. Note that it makes no difference which long-term loss is used (i.e., the 28% loss or the 15% loss) since all long-term capital loss carryovers are treated as 28CLs. In 2006, W treats the $7,000 long-term capital loss carryover as a N28CL. As a result, W would report a N28CG of $5,000 ($12,000 the $7,000 loss carryover), N15CG of $15,000 and a NSTCG of $10,000.

DIVIDENDS TAXED AT CAPITAL GAIN RATES

In negotiations related to the Jobs and Growth Tax Relief Reconciliation Act of 2003, Congress and the Bush administration considered a number of alternative statutory schemes to reduce or eliminate the double taxation of corporate dividends. Somewhat as a surprise, apparently in the interest of simplification, the 2003 Act allows noncorporate taxpayers to treat qualifying dividends similarly to long-term capital gains when calculating their tax. The dividends are now taxed at the reduced 15 percent capital gain rate (5 percent for lower bracket taxpayers) and appears to reduce significantly the toll of the double tax. The new law provides that most dividends received after 2002 will be subject to the revised capital gains rates35: 15 percent generally and 5 percent for dividends that would otherwise be taxed at an ordinary rate of 15 percent or lower. The qualifying dividend is added to the net capital gain and is not subject to the capital gain and loss netting process. As a result, the dividends are subject to capital gains treatment regardless of whether the taxpayer has other capital gains or losses.36 Qualified dividends are dividends from domestic corporations and qualified foreign corporations.37 Qualified foreign corporations are those that are incorporated in

35 § 1(h)(11). 36 Like other long-term capital gains, dividends qualifying for capital gain treatment are not investment income for purposes of the investment interest limitation. However, a taxpayer can elect to treat the dividends as investment income and forego the capital gain treatment. See § 1(h)(11)(D)(i). 37 § 1(h)(11)(B). Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

TREATMENT OF CAPITAL GAINS AND LOSSES 16–19 possessions of the United States, those subject to a treaty with the U.S. (involving the exchange of tax information by the governments) and others, the stocks of which are traded on a U.S. stock exchange (certain foreign corporations that are not subject to U.S. tax are not included).

CORPORATE TAXPAYERS

The capital gains and losses of corporate taxpayers are treated a bit differently from those of individual taxpayers. Corporations separate all of their capital gains and losses into only two groups: short-term and long-term (holding period of more than one year). Unlike individuals, there is no further subdividing of the long-term group. Items within the groups are then netted, producing one of the following: NLTCG, NLTCL, NSTCG or NSTCL. If the taxpayer has a NSTCG and a NLTCG, no further netting is allowed. However, if the taxpayer has either a NSTCL and NLTCG or a NSTCG and a NLTCL, these results can be combined to produce a final position. This can be illustrated as follows:

Short-Term Long-Term Result

Holding period (months) 12 >12

Gains $xx,xxx) $xx,xxx) Losses (xxx) (x,xxx) Net gain or loss ???? ???? Possibilities NSTCG NLTCG No further netting NSTCG NLTCL NLTCL or NSTCG NSTCL NLTCG NSTCL or NLTCG NSTCL NLTCL No further netting

A corporate taxpayer receives no special treatment for either a NSTCG or NLTCG. They are treated just like ordinary income. If after netting, the corporation has a NSTCL or a NLTCL, such losses receive special treatment. Unlike an individual taxpayer, a corpora- tion is not allowed to offset capital losses against ordinary income. A corporate taxpayer’s capital losses can be used only to reduce its capital gains.38 Any excess losses are first carried back to the three preceding years as short-term capital losses and offset against any net short-term capital gains and then any net long-term capital gains. Absent any capital gains in the three prior years, or if the loss carried back exceeds any capital gains, the excess may be carried forward for five years.39

Example 19. An examination of C Corporation’s records for 2006 revealed $200,000 of net ordinary taxable income, a long-term capital loss of $9,000 and a short-term capital gain of $2,000. The corporation nets the loss against the gain to produce a NLTCL of $7,000. The corporation cannot offset the loss against ordinary income and, therefore, reports $200,000 of taxable income (undiminished by the NLTCL). Instead the NLTCL is carried back to the third prior year, 2003, as a STCL where it can be used to first offset any NSTCG and then any NLTCG. If there are no capital gains in 2003, the corporation would carryover the loss, now a STCL of $7,000, to 2004 to use against capital gains. This process would continue until the loss is entirely used or it expires at the end of 2011. Note that when the loss is used in prior years, a refund can be obtained.

38 § 1212(a). 39 Ibid. Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

16–20 PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES

CALCULATING THE TAX

Section 1(h) provides a special tax calculation to ensure that an individual’s capital gains will not be taxed at a rate greater than the applicable preferred rate (i.e., in 2005 the 28%, 25%, 15%, 10% or 5% rate). This calculation can only reduce the tax, not increase it.

Example 20. H and W are married. For 2006, their sole source of income was a 15CG of $79,000 from the sale of assets held five years. Their taxable income is computed as follows:

15CG $79,000 Standard deduction (10,300) Exemption deduction (6,600) Taxable income $62,100

The 10% and 15% bracket for taxpayers filing jointly in 2006 runs to $61,300 at which point any dollar of income in excess of that amount is taxed at 25%. Since all of the couple’s income is from capital gain, however, none of it is taxed at the 15% or 25% brackets. The effect of the special capital gains calculation is to tax the portion of the N15CG that falls into the 10% and 15% bracket at a 5% rate and the portion that falls into the 25% bracket at 15%. Therefore, $61,300 of the N15CG is taxed at 5% and the remaining $2,900 is taxed at 15%. The total tax is $3,200 [($61,300 5%) þ ($2,900 15%)].

It may be clear from the above example that whenever an individual’s ordinary taxable income exceeds the amount that would be taxed at 10 or 15 percent (e.g., $61,300 in 2006 for a joint return), none of the N15CG is taxed at 5 percent. In such case, the taxpayer computes the tax liability by first calculating the regular tax on ordinary taxable income and adding to that a tax of 15 percent on the N15CG. On the other hand, if ordinary taxable income does not exceed the amount that is taxed at 10 or 15 percent, a portion of the N15CG is taxed at the 5 percent rate until the 10 and 15 percent brackets are exhausted. A similar approach applies for N25CGs and N28CGs. Before proceeding, it is important to understand some statutory terms. The first term is net capital gain—the excess of the net long-term capital gain over the net short-term capital loss for a year. If there is no net short-term capital loss, the net capital gain is simply the net gain from the 15 percent group, the 25 percent group, and the 28 percent group combined. If there is a short-term loss, it is the excess of the combined long-term gains minus the net short-term capital loss. The second term is adjusted net capital gain—the net capital gain reduced (but not below zero) by the 25 percent gain and the net 28 percent gain (reduced by any net short-term capital loss). The actual steps to compute the capital gains tax are built into Schedule D of Form 1040. They are also summarized in Exhibit 16-1. Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

TREATMENT OF CAPITAL GAINS AND LOSSES 16–21

EXHIBIT 16-1 Tax Computation Involving Capital Gains

Step 1. Calculate the regular income tax using the regular rates on the taxpayer’s taxable income Step 2. Determine the tax on the ordinary income a. Select the greater of— " Ordinary taxable income (taxable income net capital gain), or " The lesser of— " The maximum amount that would be taxed at 15 percent, or " Taxable income the adjusted net capital gain b. Compute the regular income tax on this amount Step 3. Determine the tax on the net capital gain by adding the following together a. Tax on 5 Percent Gains—5 percent of the portion of the adjusted net capital gain that would have been taxed at 10 or 15 percent when added to ordinary income [i.e., the lesser of (1) the adjusted net capital gain or (2) the maximum amount that would normally be taxed at 10 or 15 percent minus the amount of ordinary income]. b. Tax on 15 Percent Gains—15 percent of (the adjusted net capital gain minus any 5 percent gains). c. Tax on 25 Percent Gains—The lesser of " 25 percent of the 25 percent gains, or " If less, (1) 10 or 15 percent (respectively) of the amount of the 25 percent gains that, when added to ordinary income and any 5 percent gains, would be taxed at 10 or 15 percent*, plus (2) 25 percent of any remaining 25 percent gains. d. Tax on 28 Percent Gains—The lesser of " 28 percent of the 28 percent gains, or " If less, (1) 10 or 15 percent (respectively) of the amount of the 28 percent gains that, when added to ordinary income, any 5 percent gains, and any 25 percent gains, would be taxed at 10 or 15 percent**, plus (2) 28 percent of any remaining 28 percent gains. Step 4. Add the tax on the ordinary income (Step 2) to the tax on the net capital gain (Step 3) to get the total capital gains tax. Step 5. The final tax is the lesser of the taxes computed in Step 1 and Step 4.

*This is the amount that would otherwise be taxed at 10 or 15 percent when added to ordinary income and any 5 percent gains (or stated differently, it is the maximum amount that would be taxed at 10 or 15 percent minus the amount of ordinary income and the amount of 5 percent gains).

**This is the amount that would otherwise be taxed at 10 or 15 percent when added to ordinary income, any 5 percent gains, and any 25 percent gains (or, stated differently, it is the maximum amount that would be taxed at 15 percent minus the amount of ordinary income and the amount of 5 percent gains). Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

16–22 PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES Example 21. J and K are married and file a joint return for 2006. They have taxable income of $76,300, including a N15CG of $15,000. Thus they have ordinary taxable income of $61,300. Their tax is computed as follows:

Step 1: Regular tax on $76,300 ¼ $12,190

Regular tax on $76,300: Tax on $61,300 (10% and 15% brackets) $ 8,440 Plus: Tax on excess at 25% [($76,300 $61,300) 25%] þ3,750 Equals: Total tax $12,190

Step 2a: Ordinary income ¼ $61,300 ($76,300 $15,000) Step 2b: Regular tax on ordinary income of $61,300 ¼ $8,440

Regular tax on $61,300 ...... $8,440

Step 3: Tax on the net capital gain ¼ $2,250

a. Tax on 5% Gains ¼ 5% of zero (All of the net capital gain would have been taxed at a rate exceeding 15% since V’s ordinary income plus 25% gains and 28% gains equaled or exceeded $61,300—the limit of the 15% bracket) b. Tax on 15% Gains ¼ 15% $15,000 ¼ $2,250 c. Tax on 25% Gains ¼ 25% of zero d. Tax on 28% Gains ¼ 28% of zero

Step 4: Total capital gains tax ¼ $10,690 ($8,440 þ $2,250)

Step 5: The final tax is $10,690. The savings is $1,500 ($12,190 $10,690). Note that this $1,500 is the 10% difference (25% 15%) on the $15,000 gain.

Example 22. V is single for 2006 and has taxable income for the year of $100,000 including the following:

Loss from stock held 11 months ($2,000) Gain from gold bullion held 3 years 3,000 Gain from land held 9 years 16,000 Loss from stock held 2 years (3,000)

V would summarize his gains and losses as follows:

Long-Term Short-Term 28% 15%

($2,000) $3,000 $16,000 — — (3,000) ($2,000) $3,000 $13,000 Netting 2,000 (2,000) — $ 0 $1,000 $13,000 Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

TREATMENT OF CAPITAL GAINS AND LOSSES 16–23 The loss is a STCL since it was held for not more than a year. The gain on the sale of the gold bullion is treated as a 28CG since it is a collectible. Collectibles are treated as 28CGs even though they may have been held more than 12 months. The gain and loss from the land and stock are both classified as 15% items since they were held more than 12 months. Thus V’s overall capital gain is $14,000, consisting of a N28CG of $1,000 and a N15CG of $13,000. V’s tax is computed as follows.

Step 1: Regular tax on $100,000 ¼ $22,332

Tax on $74,200 (10%, 15% and 25% bracket) $15,108 Plus: Tax on excess at 28% [($100,000 $74,200) 28%] 7,224 Equals: Total tax $22,332

Step 2a: Ordinary income ¼ $86,000 ($100,000 $14,000) Step 2b: Regular tax on ordinary income of $86,000 ¼ $18,412

Tax on $74,200 $15,108 Plus: Tax on excess at 28% [($86,000 $74,200) 28%] 3,304 Equals: Total tax $18,412

Step 3: Tax on the net capital gain ¼ $2,230 ($280 þ $1,950)

a. Tax on 5% Gains ¼ 5% of zero (All of the net capital gain would have been taxed at a rate exceeding 15% since V’s ordinary income exceeded $30,650—the limit of the 15% bracket) b. Tax on 15% Gains ¼ 15% $13,000 ¼ $1,950 c. Tax on 25% Gains ¼ 25% of zero d. Tax on 28% Gains ¼ 28% $1,000 ¼ $280

Step 4: Total capital gains tax ¼ $20,642 ($18,412 þ $2,230) Step 5: The final tax is $20,817 (the lesser of Step 1 or Step 4). The difference between the regular tax and the capital gains tax is $1,690 ($22,332 $20,642). Note that this $1,690 is the 13% difference (28% 15%) on $13,000 (13% $13,000 ¼ $1,690).

Example 23. Same as Example 21, except V’s total taxable income is $35,000.

Step 1: Regular tax on $35,000 ¼ $5,308

Tax on $30,650 $4,220 Plus: Tax on excess at 25% [($35,000 $30,650) 25%] 1,088 Equals: Total tax $5,308

Step 2a: Ordinary income ¼ $21,000 ($35,000 $14,000)

Step 2b: Regular tax on $21,000 ¼ $2,773 ($7,550 10% þ $13,450 15%)

Step 3: Tax on the net capital gain ¼ $1,235 ($483 þ $502 þ $250)

a. Tax on 5% Gains ¼ $483 [$9,650 5%—The N15CG is taxed at 5% to the extent the limit on the 15% tax bracket exceeds the ordinary income ($30,650 $21,000 ¼ $9,650)] Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

16–24 PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES

b. Tax on 15% Gains ¼ $502 [($13,000 $9,650 ¼ $3,350) 15%—The adjusted net capital gain reduced by the portion taxed at 5% multiplied by 15%] c. Tax on 25% Gains ¼ 25% of zero d. Tax on 28% Gains ¼ 25% $1,000 ¼ $250 [Since ordinary income plus the 5% gains, 15% gains, and 25% gains are more than the limit on the 15% tax bracket ($21,000 þ $8,050 þ $4,950 > $30,650) but less than the top of the 25% bracket amounts, the 28% gains are taxed at 25%.]

Step 4: Total capital gains tax ¼ $4,008 ($2,773 þ $1,235) Step 5: The final tax is $4,008 (the lesser of Step 1 or Step 4). The difference between the regular tax and the capital gains tax is $1,300 ($5,308 $4,008). Note that this $1,300 is the sum of the 10% difference (15% 5%) on $9,650 and the 10% difference (25% 15%) on $3,350 [10% $9,650 þ 10% $2,350 ¼ $1,300], but there is no difference on the 28% gain that was taxed at the ordinary income rate.

REPORTING CAPITAL GAINS AND LOSSES

Individual taxpayers report any capital gains or losses on Schedule D of Form 1040.40 This form is designed to facilitate the netting process, with one part used for reporting short-term gains and losses and another part used to report long-term transactions. A third part of the form is available for the second step of the netting process in the event the taxpayer has either NSTCGs and NLTCLs or NLTCGs and NSTCLs. Regular corporations must report capital gains and losses on Schedule D of Form 1120 in much the same manner as individual taxpayers. Partnerships and S corporations must also report capital gains and losses on a separate schedule (Schedule D of Form 1065 for partnerships and Schedule D of Form 1120S for S corporations). However, these conduit entities are limited to the first step of the netting process. Each owner (partner or S corporation shareholder) must include his or her share of the results from the entity with the appropriate capital transactions being netted on the owner’s Schedule D, Form 1040.

3 CHECK YOUR KNOWLEDGE

Review Question 1. For 2006 Ms. Reyes earned a salary of $70,000 from her job as an art curator. In addition, she sold stock, realizing the following capital gains and losses:

15CG $10,000 15CL (7,000) STCL (11,000)

In 2006 she changed jobs, becoming a tax accountant and earning a salary of $300,000. In addition, she realized a 15CG of $12,000.

Compute Ms. Reyes’s adjusted gross income for 2006 and 2007 and indicate the amount, if any, that is eligible for preferential treatment as long-term capital gain.

40 See Appendix for a sample of this form. Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

CAPITAL GAIN TREATMENT EXTENDED TO CERTAIN TRANSACTIONS 16–25 Her adjusted gross incomes for 2006 and 2007 are $67,000 and $307,000, respectively. After netting her capital gains and losses in 2006, Ms. Reyes has a net capital loss of $8,000, all of which is short-term. The deduction for capital losses of an individual is generally limited to $3,000. As a result, her adjusted gross income is $67,000 ($70,000 $3,000). She is entitled to carry over the remainder of her short-term loss of $5,000. In 2007, she nets the $5,000 short-term capital loss against her $12,000 15CG to produce a N15CG of $7,000. The $7,000 is combined with her other $300,000 of salary income to produce an adjusted gross income of $307,000. Of this amount, her N15CG of $7,000 is taxed at a preferred rate of 15 percent.

Review Question 2. True-False. This year Mr. and Mrs. Simpson retired. The couple’s only income was a capital gain from the sale of stock held three years. Assuming the Simpsons file a joint return, all $100,000 of their taxable income is taxed at a rate of 15 percent.

False. The tax computation operates to ensure that the 15CG is taxed at 5 percent to the extent that ordinary income does not absorb the 10 and 15 percent brackets. For 2006 the 15 percent bracket for a joint return extends to taxable income of $61,300. Therefore, $61,300 is taxed at a 5 percent rate and the remaining $41,900 is taxed at a 15 percent rate.

The Simpsons should have considered making the sales in two separate years (perhaps 2006 and 2007) if they have no other income in either year. That would allow them to double the benefit of the 5 percent rate.

Review Question 3. True-False. An individual taxpayer is generally entitled to deduct any capital loss recognized during the current year to the extent of any capital gains recognized plus $3,000. Any capital loss in excess of this amount retains its charac- ter and may be used in subsequent years until it is exhausted.

True.

CAPITAL GAIN TREATMENT EXTENDED TO CERTAIN TRANSACTIONS

The Internal Revenue Code contains several special provisions related to capital asset treatment. In some instances the concept of capital asset is expanded and in others it is limited. Some of the provisions merely clarify the tax treatment of certain transactions.

PATENTS

Section 1235 provides that certain transfers of patents shall be treated as transfers of capital assets held for more than one year. This virtually assures that a long-term capital gain will result if the patent is transferred in a taxable transaction, because the patent will have little, if any, basis since the costs of creating it are usually deducted under §174 (research and experimental expenditures) in the tax year in which such costs are incurred. Any transfer, other than by gift, inheritance, or devise, will qualify as long as all substantial rights to the patent are transferred. All substantial rights have been described as all rights that have value at the time of the transfer. For example, the transfer must not limit the geographical coverage within the country of issuance or limit the time application to less than the remaining term of the patent.41

41 Reg. § 1.1235-2(b). Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

16–26 PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES The transferor must be a holder as defined in § 1235(b). The term holder refers to the creator of the patented property or to an individual who purchased such property from its creator if such individual is neither the employer of the creator nor related to such creator.42 The sale of a patent will qualify for § 1235 treatment even if payments are made over a period that ends when the purchaser’s use of the patent ceases or if payments are contingent on the productivity, use, or disposition of the patent.43 It also is important to note that §§ 483 and 1274, which require interest to be imputed on certain sales contracts, do not apply to amounts received in exchange for patents qualifying under § 1235 that are contingent on the productivity, use, or disposition of the patent transferred.44

Example 24. K, a successful inventor, sold a patent (in which she had a basis of zero) to Bell Corp. The sale agreement called for K to receive a percentage of the sales of the property covered by the patent. All of K’s payments received in consideration for this patent will be long-term capital gain regardless of her holding period.

LEASE CANCELLATION PAYMENTS

Section 1241 allows the treatment of payments received in cancellation of a lease or in cancellation of a distributorship agreement as having been received in a sale or exchange. Therefore, the gains or losses will be treated as capital gains or losses if the underlying assets are capital assets.45

INCENTIVES FOR INVESTMENTS IN SMALL BUSINESSES

Congress has frequently provided incentives for investment in general or for specific investments. The Subchapter S election, for example, was intended to remove any impediment for small business owners who were not incorporating because they believed there was a double tax on corporate profits. Other incentives provide special treatment upon the disposition of certain business interests. The following sections deal with various prominent examples.

LOSSES ON SMALL BUSINESS STOCK: § 1244

Losses on dispositions (e.g., sale or worthlessness) of corporate stock are generally classified as capital losses. For a year in which a taxpayer has no capital gains, the deduc- tion for capital losses would be limited to $3,000 annually. In contrast, a loss on the dispo- sition of a sole proprietorship would be recognized upon the disposition of the assets used in the business. Losses on the sale of many (if not most) of the assets would be treated as ordinary losses, thereby avoiding (or partially avoiding) the $3,000 limit. Similarly, proper planning could result in ordinary loss treatment upon the disposition of interests in businesses operated in the partnership form. Without special rules, the limitation on deductions for capital losses might discourage investment in new corporations. For example, if an individual invested $90,000 in stock of a new corporate venture, deductions for any loss from the investment, absent offsetting gains, would be limited to $3,000 annually.46 Thus, where

42 For definition of ‘‘relative,’’ see § 1235(d). 43 § 1235(a). 44 §§ 483(d)(4) and 1274(c)(4)(E). See Chapter 14 for a discussion of the imputed interest rules. 45 See Chapter 17 for treatment if the asset is a § 1231 asset. 46 A taxpayer can offset any capital losses against capital gains, if any. Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

INCENTIVES FOR INVESTMENTS IN SMALL BUSINESSES 16–27 the stock becomes worthless it could take the investor as long as 30 years to recover the investment. This restriction on losses also is inconsistent with the treatment of losses resulting from investments by an individual in his or her sole proprietorship or in a partnership. In the case of a sole proprietorship or a partnership, losses generally may be used to offset the taxpayer’s other income without limitation. For example, assume a sole proprietor sank $150,000 into a purchase of pet rocks that he ultimately sold for only $100,000. In such case, he would have an ordinary loss of $50,000, all of which could be used to offset other ordinary income. Assume the same individual invested $150,000 in a corporation that had the same luck. If the taxpayer could at best sell the stock for $100,000, he would realize a capital loss of $50,000. Obviously the sole proprietor is in a much better position. To eliminate these problems and encourage taxpayers to invest in small corporations, Congress enacted § 1244 in 1958. Under § 1244, losses on ‘‘Section 1244 stock’’ generally are treated as ordinary rather than capital losses.47 Ordinary loss treatment normally is available only to individuals who are the original holders of the stock. If these individuals sell the stock at a loss or the stock becomes worthless, they may deduct up to $50,000 annually as an ordinary loss. Taxpayers who file a joint return may deduct up to $100,000 regardless of how the stock is owned (e.g., separately or jointly). When the loss in any one year exceeds the $50,000 or $100,000 limitation, the excess is considered a capital loss.

Example 25. T, married, is one of the original purchasers of RST Corporation’s stock, which qualifies as § 1244 stock. She separately purchased the stock two years ago for $150,000. During the year, she sold all of the stock for $30,000, resulting in a $120,000 loss. On a joint return for the current year, she may deduct $100,000 as an ordinary loss. The portion of the loss exceeding the limitation, $20,000 ($120,000 $100,000), is treated as a long-term capital loss.

Stock issued by a corporation (including preferred stock issued after July 18, 1984) qualifies as § 1244 stock only if the issuing corporation meets certain requirements. The most important condition is that the corporation’s total capitalization (amounts received for stock issued, contributions to capital, and paid-in surplus) must not exceed $1 million at the time the stock is issued.48 This requirement effectively limits § 1244 treatment to those individuals who originally invest the first $1 million in money and property in the corporation.

Example 26. In 2003 F provided the initial capitalization for MNO Corporation by purchasing 700 shares at a cost of $1,000 a share for a total cost of $700,000. In 2006 G purchased 500 shares at a cost of $1,000 per share or a total of $500,000. All of F’s shares otherwise qualify as § 1244 stock. Only 300 of G’s new shares qualify for § 1244 treatment, however, since 200 of the 500 purchased caused the corporation’s total capitalization to exceed $1 million.

QUALIFIED SMALL BUSINESS STOCK (§ 1202 STOCK)

As part of the Revenue Reconciliation Act of 1993, Congress created a new tax incentive to stimulate investment in small business. By virtue of this special rule, individuals who start their own C corporations or who are original investors in C corporations (e.g., initial public offerings) may be richly rewarded for taking the risk of investing in such enterprises.

47 § 1244(a). 48 § 1244(c)(3)(A). Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

16–28 PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES

Fifty Percent Exclusion. Under § 1202, noncorporate investors (i.e., individuals, partnerships, estates, and trusts) are allowed to exclude 50 percent of the gain on the sale of qualified small business stock (QSB stock or § 1202 stock) held for more than five years.49 The balance of this gain is treated as a 28 percent gain. The effect of this provision is to impose a maximum tax of 14 percent (50% 28% maximum capital gain rate) on the gains from such investments,50 a far lower rate than the 35 percent that may apply to other types of income received by the taxpayer.

Example 27. On October 31, 1999 N purchased 1,000 shares of Boston Cod Corporation for $10,000. The stock was part of an initial public offering of the company’s stock that was designed to raise $30 million to open another 200 fast fish restaurants. On December 20, 2006 N sold all of her shares for $50,000. As a result, she realized a capital gain of $40,000, her only gain or loss during the year. Since N was one of the original investors and the stock qualified as § 1202 stock at the time of its issue (assets at that time were less than $50 million), she is entitled to exclude 50 percent of her gain, or $20,000. The maximum tax on the $20,000 gain is $5,600 ($20,000 28%).

In determining net capital gain and capital losses, the taxpayer does not consider any gain excluded on the sale of § 1202 stock.

Example 28. Assume the same facts as above, but assume that in addition to the $40,000 gain on § 1202 stock, N also has other long-term capital gains of $10,000 and short-term capital losses of $5,000. N first applies the 50% exclusion and then nets the remainder with the other capital gains and losses. Therefore, N’s net capital gain for the year is $25,000 [($40,000 $20,000 ¼ $20,000) þ $10,000 $5,000].

Example 29. Assume N has a gain on § 1202 stock of $40,000 and a short-term capital loss of $23,000. N first applies the 50% exclusion and then nets the remaining gain with the capital loss. As a result, N has a net capital loss of $3,000 ($20,000 $23,000).

Rollover Provision. An individual who realizes a gain on the sale of QSB stock held for more than six months can defer recognition of the gain by reinvesting in other QSB stock within 60 days of the sale. Note that the stock qualifies for the rollover provision if it is held more than six months (not five years). The individual must recognize gain to the extent that the amount reinvested is less than the sales price of the original stock. If the taxpayer uses the rollover provision, the basis in the newly acquired QSB stock is reduced by the deferred gain. The holding period of the new QSB stock includes the holding period of the old QSB stock.

Example 30. D purchased Netbrowser stock two years, for $10,000. The stock quali- fied as § 1202 stock. After rising dramatically, the stock started to fall so D sold it for $14,000 before he lost all of his profit. He realized a $4,000 gain on the sale. D wanted to preserve the special treatment for § 1202 stock so 45 days after the sale, he reinvested in MMX Inc., another issue of § 1202 stock, for $15,000. D recognizes no gain on the sale since his holding period of two years exceeded the required six months and he reinvested all $10,000 received from the sale of § 1202 stock. His basis in the replacement stock is $11,000 ($15,000 $4,000) and the two-year

49 Special rules apply for computing the exclusion on the sale of stock in a specialized small business invest- ment company (see following discussion). 50 § 1h. Recall that the § 1202 gain on the sale of qualified small business stock is excluded from the adjusted net capital gain. Therefore, the 15 percent rate does not apply. Path: K:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_016.3d Date: 22nd February 2006 Time: 09:29 User ID: 40480

INCENTIVES FOR INVESTMENTS IN SMALL BUSINESSES 16–29 holding period of the old stock attaches to the new. Had D reinvested only $13,000, he would have recognized a gain of $1,000 ($14,000 $13,000) and have a basis in the replacement stock of $10,000 ($13,000 deferred gain of $3,000). Note that this rollover provision enables the taxpayer to move in and out of positions in QSB stock so long as QSB is repurchased.

§ 1202 Requirements. Stock qualifies as § 1202 stock if it is issued after August 10, 1993 and meets a long list of requirements.

1. At the time the stock is issued, the corporation issuing the stock must be a qualified small business. A corporation is a qualified small business if " The corporation is a domestic C corporation " The corporation’s gross assets do not exceed $50 million at the time the stock was issued (i.e., cash plus the fair market value of contributed property measured at the time of contribution plus the adjusted basis of other assets)

2. The seller is the original owner of the stock (i.e., the stock was acquired directly from the corporation or through an underwriter at its original issue) 3. During substantially all of the seller’s holding period of the stock, the corporation was engaged in an active trade or business other than the following: " A business involving the performance of providing services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any other business where the principal asset is the reputation or skill of one or more of its employees " Banking, insurance, financing, leasing, or investing " Farming " Businesses involving the production or extraction of products eligible for depletion " Business of operating a hotel, motel, or restaurant

4. The corporation generally cannot own " Real property with a value that exceeds 10 percent of its total assets unless such property is used in the active conduct of a trade or business (e.g., rental real estate is not an active trade or business) " Portfolio stock or securities with a value that exceeds 10 percent of the corporation’s total assets in excess of its liabilities

Note that the active trade or business requirement and the prohibition on real estate holdings severely limit the exclusion. These conditions effectively grant the exclusion to corporations engaged in manufacturing, retailing, or wholesaling businesses. The new provision also imposes a restriction, albeit a liberal one, on the amount of gain eligible to be excluded on the sale of a particular corporation’s stock. The maximum amount of gain that may be excluded on the sale of one corporation’s stock is the larger of

1. $10 million, reduced by previously excluded gain on the sale of such corporation’s stock; or 2. 10 times the adjusted basis of all qualified stock of the corporation that the taxpayer sold during the tax year. Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

Chapter 17

PROPERTY TRANSACTIONS: DISPOSITIONS OF TRADE OR BUSINESS PROPERTY

LEARNING OBJECTIVES

Upon completion of this chapter you will be able to:

" Trace the historical development of the " Explain the purpose of the depreciation special tax treatment allowed for dispositions recapture rules of trade or business property " Compute depreciation recapture under " Apply the § 1231 gain and loss netting §§ 1245 and 1250 process to a taxpayer’s § 1231 asset " Explain the additional recapture rule transactions applicable only to corporate taxpayers " Determine the tax treatment of § 1231 gains " Identify tax planning opportunities related to and losses sales or other dispositions of trade or business property

CHAPTER OUTLINE

Introduction 17-2 Related Business Issues 17-36 Section 1231 17-2 Installment Sales of Trade or Historical Perspective 17-2 Business Property 17-36 Section 1231 Property 17-3 Intangible Business Assets 17-37 Other § 1231 Property 17-4 Dispositions of Business Assets Section 1231 Netting Process 17-7 and the Self-Employment Tax 17-37 Look-Back Rule 17-11 Tax Planning Considerations 17-37 Applicability of Lower Rates 17-12 Timing of Sales and Other Depreciation Recapture 17-15 Dispositions 17-37 Historical Perspective 17-15 Selecting Depreciation Methods 17-38 When Applicable 17-16 Installment Sales 17-39 Types of Depreciation Recapture 17-16 Sales of Businesses 17-39 Full Recapture—§ 1245 17-16 Dispositions of Business Assets and Partial Recapture—§ 1250 17-19 the Self-Employment Tax 17-39 Additional Recapture—Corporations 17-28 Problem Materials 17-40 Other Recapture Provisions 17-34

17–1 Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

17–2 PROPERTY TRANSACTIONS: DISPOSITIONS OF TRADE OR BUSINESS PROPERTY

INTRODUCTION

As is no doubt clear by now, the treatment of property transactions is a complex story that seeks to answer three questions: (1) What is the gain or loss realized? (2) How much is recognized? and (3) What is its character? This chapter, the final act in the property transaction trilogy, addresses the problems in determining the character of gains or losses on the dispositions of property used in a trade or business. In an uncomplicated world, it might seem logical to assume that gains or losses from property dispositions—be it stock, equipment, buildings, or whatever—would be treated just like any other type of income or deduction. But, as shown in the previous chapter, treating all items alike apparently was not part of the grand plan. Congress forever changed the process with the institution of preferential treatment for capital gains in 1921. Since that time taxpayers have been required to determine not only the gain or loss realized and recognized but also whether a disposition involved a capital asset. It is important to understand that these rules did not simply tip the scales in favor of capital gain. In the interest of fairness and equity, they also established a less than friendly environment for capital losses. The limitations on the deductibility of capital losses is clearly a major disadvantage, particularly considering that ordinary losses are fully deductible. The end result of Congress’s handiwork was the creation of a system in which the preferred result is capital gain treatment for gains and ordinary treatment for losses. This chapter contains the saga of what happens when Congress attempts to provide taxpayers with the best of both worlds.

SECTION 1231

The road to tax heaven—capital gain and ordinary loss—begins at § 1231 (in tax parlance properly pronounced as ‘‘twelve thirty-one’’). While § 1231 can be a completely bewildering provision, its basic operation is relatively simple. At the close of the taxable year, the taxpayer nets all gains and losses from so-called § 1231 property (e.g., land and depreciable property used in a trade or business). If there is a net gain, it is treated as a long-term capital gain. If there is a net loss, it is treated as an ordinary loss. In short, § 1231 allows taxpayers to have their cake and eat it, too. Unfortunately, this is accomplished only with a great deal of complexity, much of which makes sense only if the historical events that shaped § 1231 are considered.

HISTORICAL PERSPECTIVE

At first glance, it seems that the productive assets of a business—its property, plant, and equipment—would be perfect candidates for capital gain treatment and would therefore be considered capital assets. Indeed, that was exactly the case initially. From 1921 to 1938, real or depreciable property used in business was in fact treated as a capital asset. At that time, the classification of such property as a capital asset seemed not only appropriate but desirable—particularly as the economy grew during the early 1920s and taxpayers were realizing gains. However, the opposite became true with the onset of the Great Depression. As the economy deteriorated, businesses that had purchased assets at inflated prices during the booming 1920s found themselves selling such properties at huge losses during the depression-plagued 1930s. To make matters worse, the tax law treated such losses as capital losses, severely limiting their deduction. But Congress apparently had a sympathetic ear for these concerns. Hoping that a change would help stimulate the economy, Congress enacted legislation that removed business properties from the list of capital assets. The legislative history to the Revenue Act of 1938 provides some insight into Congressional thinking, explaining that ‘‘corporations will not, as formerly, be deterred from disposing of partially obsolescent property, Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

SECTION 1231 17–3 such as machinery or equipment, because of the limitations imposed ... upon the deduction of capital losses.’’1 With the 1938 changes in place, business got the ordinary loss treatment it wanted but at the same time was saddled with ordinary income treatments for its gains. Although these rules worked well during the Depression years as businesses were reporting losses, they produced some unduly harsh results once the country moved to a wartime economy. By 1942 the build-up for World War II had the economy humming and inflation had once again set in. Businesses that earlier had sold assets for 10 cents on the dollar now found themselves realizing gains. Of course, under the 1938 changes these gains no longer benefited from preferential treatment but were taxed at extraordinarily high tax rates (88 percent for individuals and 40 percent for corporations). The shipping industry was particularly hard hit by the new treatment. Shippers not only had gains as the enemy destroyed their insured ships but also profited when they were forced to sell their property to the government for use in the war. Other businesses that had their factories and equipment condemned and requisitioned also felt the sting of higher ordinary rates. Although these companies could have deferred their gains had they replaced the property under the involuntary conversion rules of § 1033, qualified reinvestment property was in short supply, making § 1033 virtually useless. Understanding the plight of business, Congress once again came to the rescue. In 1942 Congress enacted legislation generally reinstating capital gain treatment but preserving ordinary loss treatment. The changes in 1942 stemmed primarily from a need to provide relief for those whose property was condemned for the war effort. But in the end they went much further. For consistency, capital gain treatment was extended not only to condemnations of a business property but to other types of involuntary conversions as well. Under the new rules, casu- alty and theft gains from business property and capital assets also received capital gain treatment. In addition, the new legislation unexpectedly extended capital gain treatment to regular sales of property, plant, and equipment. Apparently, Congress felt that capital gain treatment was also appropriate for taxpayers who were selling out in anticipation of condemnation or simply because wartime conditions had made operations difficult. While Congress thought capital gain treatment was warranted for these gains, it also knew that other businesses had not profited from the war and were still suffering losses from their property transactions. Accordingly, it acted to preserve ordinary loss treatment. The end result of these maneuvers was the enactment of § 1231, an extremely complex provision that provides taxpayers with the best of all possible tax worlds: capital gain and ordinary loss. The product of Congressional tinkering in 1942 still remains today. To summarize, real and depreciable property used in a trade or business is specifically denied capital asset status. But this does not necessarily mean that such property will be denied capital gain treat- ment. As explained at the outset, § 1231 generally extends capital gain treatment to gains and losses from these assets if the taxpayer realizes a net gain from all § 1231 transactions. On the other hand, if there is a net loss, ordinary loss treatment applies. But this summary lacks a great deal of precision. The specific rules of § 1231 are described below.

SECTION 1231 PROPERTY

The special treatment of § 1231 is generally granted only to certain transactions involving assets normally referred to as § 1231 property.2 Section 1231 property includes a variety of assets, but among them the most important is real or depreciable property that is used in the taxpayer’s trade or business and that is held for more than

1 House Ways and Means Committee, H.R. Rep. 1860, 75th Cong., 3d Sess. (1938). 2 As explained below, § 1231 also applies to involuntary conversions of pure capital assets held more than one year that are used in a trade or business or held for investment. Involuntary conversions by theft or casualty of personal assets are not included under § 1231 but are subject to a special computation. Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

17–4 PROPERTY TRANSACTIONS: DISPOSITIONS OF TRADE OR BUSINESS PROPERTY

one year.3 This definition takes in most items commonly identified as a business’s fixed assets, normally referred to as its property, plant, and equipment. For example, the reach of § 1231 includes depreciable personal property used in business, such as machinery, equipment, office furniture, and business automobiles. Similarly, realty used in a business, such as office buildings, warehouses, factories, and farmland, is also considered § 1231 property. The Code specifically excludes the following assets from § 1231 treatment:

1. Property held primarily for sale to customers in the ordinary course of a trade or business, or includible in inventory, if on hand at the close of the tax year; 2. A copyright; a literary, musical, or artistic composition; a letter or memorandum; or similar property held by a taxpayer whose personal efforts created such prop- erty or by certain other persons; or 3. A publication of the United States Government received from the government other than by purchase at the price at which the publication is offered to the gen- eral public.4

Note that the excluded assets are also excluded from the definition of a capital asset. As a result, gains or losses on the disposition of inventory, property held primarily for resale, literary compositions, and certain government publications always yield ordinary income or ordinary loss. One of the critical conditions for § 1231 treatment requires that the property be used in a trade or business. Although this test normally presents little difficulty, from time to time it has created problems, particularly for those with rental property. As an illustration, consider the common situation of a taxpayer who sells rental property such as a house, duplex, or apartment complex. Is the property sold a capital asset or § 1231 property? If a taxpayer sells rental property at a gain, the gain would normally receive capital gain treatment regardless of whether the property is a capital asset or § 1231 property. On the other hand, if the taxpayer sells the rental property at a loss, § 1231 treatment is usually far more desirable. Although the Code does not provide any clear guidance on the issue, the courts have generally held that property used for rental purposes is considered as used in a trade or business and is therefore eligible for § 1231 treatment.5

OTHER § 1231 PROPERTY

From time to time, Congress has been convinced that particular industries deserve special tax relief. As a result, it has added a number of other properties to the § 1231 basket. Those eligible for capital gain and ordinary loss are

1. Timber, coal, and iron ore to which § 631 applies;6 2. Unharvested crops on land used in a trade or business and held for more than one year;7 and 3. Certain livestock.8

3 The holding period is determined in the same manner as it is for capital assets. See § 1223 discussed in Chapter 16. 4 § 1231(b)(1). 5 See, for example, Mary Crawford, 16 T.C. 678 (1951) A. 1951-2 C.B. 2, and Gilford v. Comm., 53-1 USTC {9201, 43 AFTR 221, 201 F.2d 735 (CA-2, 1953). 6 § 1231(b)(2). 7 § 1231(b)(4). 8 § 1231(b)(3). Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

SECTION 1231 17–5

Timber. Under § 631, the mere cutting of timber by the owner of the timber, or by a person who has the right to cut the timber and has held the timber or right more than one year, is to be treated, at his or her election, as a sale or exchange of the timber that is cut during the year. The timber must be cut for sale or for use in the taxpayer’s trade or business. In such case, the taxpayer would report a § 1231 gain or loss and potentially receive capital gain treatment for what otherwise might be considered the taxpayer’s inventory—a very favorable result. It may appear that the timber industry has secured an unfair advantage, but timber’s eligibility is arguably justified on the grounds that the value of timber normally accrues incrementally as it grows over a long period of time. The amount of gain or loss on the ‘‘sale’’ of the timber is the fair market value of the timber on the first day of the taxable year minus the timber’s adjusted basis for depletion. For all subsequent purposes (i.e., the sale of the cut timber), the fair market value of the timber as of the beginning of the year will be treated as the cost of the timber. The term timber not only includes trees used for lumber and other wood products, but also includes evergreen trees that are more than six years old when cut and are sold for ornamental purposes (e.g., Christmas trees).9

Example 1. B owned standing timber that he had purchased for $250,000 three years earlier. The timber was cut and sold to a lumber mill for $410,000 during 2006. The fair market value of the standing timber as of January 1, 2006 was $320,000. B has a § 1231 gain of $70,000 if he makes an election under § 631 ($320,000 fair market value of the timber on the first day of the taxable year less its $250,000 adjusted basis for depletion). The remainder of his gain on the actual sale of the timber, $90,000 ($410,000 selling price $320,000 new ‘‘cost’’ of the timber), is ordinary income. Any expenses incurred by B in cutting the timber would be deductible as ordinary deductions.

An election under § 631 with respect to timber is binding on all timber owned by the taxpayer during the year of the election and in all subsequent years. The IRS may permit revocation of such election because of significant hardship. However, once the election is revoked, IRS consent must be obtained to make a new election.10 Section 631 also applies to the sale of timber under a contract providing a retained economic interest (i.e., a taxpayer sells the timber, but keeps the right to receive a royalty from its later sale) for the taxpayer in the timber. In such a case, the transfer is considered a sale or exchange. The gain or loss is recognized on the date the timber is cut, or when payment is received, if earlier, at the election of the taxpayer.11

Coal and Iron Ore. When an owner disposes of coal or domestic iron ore under a contract that calls for a retained economic interest in the property, the disposition is treated as a sale or exchange of the coal or iron ore. The date the coal or ore is mined is considered the date of sale and since the property is § 1231 property, the gain or loss will be treated under § 1231.12 The taxpayer may not be a co-adventurer, partner, or principal in the mining of the coal or iron ore. Furthermore, the coal or iron ore may not be sold to certain related taxpayers.13

9 § 631(a). 10 Ibid. 11 § 631(b). 12 § 631(c). 13 §§ 631(c)(1) and (2). Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

17–6 PROPERTY TRANSACTIONS: DISPOSITIONS OF TRADE OR BUSINESS PROPERTY

Unharvested Crops. Section 1231 also addresses the special situation where a farmer sells land with unharvested crops sitting upon the land. In this case, it seems logical that the farmer should allocate the sales price between the crops and the land to ensure ordinary income or loss for the sale of the farmer’s inventory and capital gain or ordinary loss on the sale of the land. While this may be the theoretically correct result, Congress wanted to eliminate potential controversy over the allocation. Accordingly, for administrative convenience it brought the entire transaction into the § 1231 fold in 1951. Currently, whenever land used in a trade or business and unharvested crops on that land are sold at the same time to the same buyer, the gain or loss is subject to § 1231 treatment as long as the land has been held for more than a year.14 It is worth noting that the benefits of § 1231 were not extended to farmers free of charge. At the same time, Congress eliminated the current deduction for production expenses. The law now provides that any expenses related to the production of crops cannot be deducted currently but must be capitalized as part of the basis of the crops.15 Such treatment, in a year when land and crops are sold, reduces the farmer’s capital gain on the sale rather than any other ordinary income.

Example 2. F sold 100 acres of land that she used in her farming business just days before the corn on the land was harvested. For the ‘‘package’’ deal, she received $600,000, including an estimated $70,000 for the unharvested crops that she figured had cost her $20,000 to produce. F had purchased the land many years ago for $200,000. In determining the character of her gain, F is not required to allocate the sales price between the crops and the land since she sold both at the same time to the same buyer, therefore qualifying for § 1231 treatment. As a result, she reports a § 1231 gain of $380,000 computed as follows:

Sales price ...... $600,000 Adjusted basis ($200,000 þ $20,000)...... 220,000

§ 1231 gain...... $380,000

Note that in the year of the sale F has effectively turned the $50,000 ($70,000 $20,000) profit from the sale of her crops from ordinary income into potential capital gain.

Livestock. As a general proposition, livestock that are used for breeding and other purposes are depreciable assets much like machinery and equipment and therefore qualify for § 1231 treatment. In many situations, however, livestock is used for these purposes for only a short period of time and then sold. If this is the farmer’s or rancher’s normal practice, the IRS is inclined to argue that the animals are held primarily for resale, in which case the law specifically denies § 1231 treatment. To help end this controversy, Congress specifically made all livestock (other than poultry) used for draft, breeding, dairy, or sporting purposes eligible for § 1231 treatment as long as they are held for over a year.16 In the case of cattle and horses, however, the holding period is extended to two years. Note that this treatment is extremely beneficial since the taxpayer effectively gets capital gain from animals pulled out of the breeding process and sold. Moreover, the farmer or rancher is allowed to deduct the costs of raising such animals currently against ordinary income. The extension of the holding period for cattle and horses was in part, an attempt to cut back on the benefits of this favorable treatment.

14 § 1231(b)(4). 15 § 268. 16 § 1231(b)(3). Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

SECTION 1231 17–7

SECTION 1231 NETTING PROCESS

The treatment of § 1231 gains or losses ultimately depends on the outcome of a netting process that is far more complicated than outlined earlier.17 As can be seen from the flowchart in Exhibit 17-1, the taxpayer must first identify all of the gains and losses that enter into the netting process. As might be expected, these include gains and losses from what has been described above as § 1231 property. In addition, the § 1231 hodgepodge includes involuntary conversions of certain capital assets. Surprisingly, gains or losses recognized from casualties, thefts, or condemnations of capital assets that are used in a trade or business or held for investment are part of the § 1231 netting process. Involuntary conversions of capital assets that are held for personal use are not considered under § 1231 but are subject to special rules. After identifying all of the § 1231 transactions, the taxpayer must segregate the § 1231 gains and losses arising from casualty and theft from those attributable to sale, exchange, and condemnation. The end result is that there are two sets of § 1231 transactions:

1. Involuntary conversions due to casualty and theft of " § 1231 property " Real and depreciable property used in business and held more than one year " Timber, coal, iron ore, unharvested crops, and livestock " Capital assets " Used in a trade or business or held for investment in connection with business and held more than one year 2. Sales and exchanges of " § 1231 property " Real and depreciable property used in business " Timber, coal, iron ore, unharvested crops and livestock Involuntary conversion due to condemnation of " § 1231 property " Real and depreciable property used in business and held more than one year " Timber, coal, iron ore, unharvested crops, and livestock " Capital assets " Used in a trade or business or held for investment in connection with business and held more than one year

17 § 1231(a). Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

17–8 PROPERTY TRANSACTIONS: DISPOSITIONS OF TRADE OR BUSINESS PROPERTY

EXHIBIT 17-1 Section 1231 Netting Process

Casualty and theft gains* Gains* and losses from sales or and losses from §1231 exchanges of § 1231 assets assets and specified and specified involuntary capital assets conversions

Net If Net (Step 1) Gain (Step 2)

If If If Loss Loss Gain

Treat net result Look-Back Rule: Treat gains and losses as an ordinary Did the taxpayer separately: gains are deduction ordinary income: business deduct any net losses are deductions § 1231 losses in for A.G.I.: other the last five losses are deductions taxable years? from A.G.I.

If If Ye s No

Treat as ordinary income Treat entire the lesser of net gain as a (1) unrecaptured § 1231 15% or 28% losses, or (2) the current capital gain year’s net gain. Treat any excess § 1231 gain as 15% or 28% capital gain

* Gains remaining after reduction for any depreciation recapture

Within each of these two categories, each gain and loss must be assigned to one of the three potential long-term capital gain groups and netted just as if they had been 28%, 25% or 15% capital gains or losses (see Chapter 16). This means that each § 1231 gain or loss is assigned to one of the following three categories: (1) 15% group for § 1231 gains and losses (15G or 15L); (2) 25% group for unrecaptured § 1250 depreciation related to gains from § 1231 assets (25G discussed below); and (3) 28% group for gains and losses from collectibles (28G or 28L). Once all of the appropriate transactions have been poured into the § 1231 process, the netting process can begin. There are three steps.

1. First, all of the gains and losses in the first category of § 1231 transactions (casualties and thefts) are netted. Specifically, gains and losses within the 15% and 28% groups are netted to arrive at one of the following: (1) a net gain or loss on 15% § 1231 assets (N15G or N15L); and (2) a net gain or loss on 28% § 1231 assets (N28G or N28L). Any net loss positions are then combined with the net Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

SECTION 1231 17–9 gain positions using the rules discussed for netting the three groups for capital asset transactions:

" A N28L first offsets 25G, then N15G. " A N15L first offsets a N28G, then 25G. " There can be no net loss in the 25G group since this group contains only gains.

This netting process is summarized as follows:

Section 1231 Gains and Losses from Casualty and Theft Unrecaptured Collectibles Depreciation Other

28% 25% 15% Gains ...... $x,xxx). Gains only $xx,xxx) Losses ...... (x,xxx) – X(x,xxx) Net gain or loss ...... ???? Gain only Xz????) Possibilities: 1...... N28G 25G N15G 2...... N28G 25G N15L 3...... N28L 25G N15G 4...... N28L 25G N15L

If the netting process results in a net gain position(s) (e.g., a N28G, N25G, and a N15G) the net gains from casualties and thefts become § 1231 gains and become part of the second category of other § 1231 transactions (each assigned to either the 28%, 25%, or 15% groups).

Example 3. During the year, T, who is in the 35% tax bracket, reported the following § 1231 gains and losses from casualties of § 1231 assets (including casualties of capital assets used in a trade or business) and netted them as shown below.

Section 1231 Gains and Losses Unrecaptured Collectibles Depreciation Other

28% 25% 15% Gains ...... $10,000 $4,000 $2,000 Losses ...... (4,000) — (7,000) Net gain or loss ...... $ 6,000 $4,000 ($5,000) Netting ...... (5,000) — 5,000 To Section 1231 Other ...... $ 1,000 $4,000 $ 0

In this case, T has a N28G of $1,000 and a N25G of $4,000. Since the end results are net gains, each of these net gains is assigned to its appropriate group in the second cat- egory of other § 1231 transactions. If a net loss results, the casualty and theft gains and losses are removed from the § 1231 process and treated separately. The gains are treated as ordinary income, and the losses on business use assets are deductible for A.G.I. Any other casualty and theft losses are deductible from A.G.I. Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

17–10 PROPERTY TRANSACTIONS: DISPOSITIONS OF TRADE OR BUSINESS PROPERTY 2. The second step of the process is to combine any net casualty or theft gains from the first step with the gains or losses in the second set of § 1231 transactions. In this regard, the net casualty and theft gains must be assigned to the appropriate group (15%, 25%, or 28% group) in the second category of § 1231 transactions (sales and exchanges of § 1231 assets and certain condemnations). For example, if the taxpayer had a net 15% gain from § 1231 casualties, this gain would become a 15% gain in the second category of § 1231 transactions. These transactions are then netted just as if they had been 28%, 25%, or 15% capital gains or losses to determine if there is a net gain or loss. 3. The third and final step in the § 1231 netting process is to characterize the gain or loss resulting from netting the transactions in the second step. If the net result is a loss, the net loss is treated as an ordinary deduction for adjusted gross income. It is not treated as a capital loss. If the net result is a gain (e.g., a N25G and a N15G), these gains are normally treated as capital gains and become part of the capital gain and loss netting process.

The § 1231 netting process is illustrated in Exhibit 17-1 and the following examples.

Example 4. During the current year, D sold real estate used in her business for $45,000. She had purchased the property several years ago for $36,000. D also sold a business car (held for more than 15 months) at a loss of $1,200. D’s gain on the real estate is computed as follows:

Selling price ...... $45,000 Less: Adjusted basis ...... (36,000)

Gain realized and recognized ...... $ 9,000

D nets the gain and loss as follows:

15% Gain from sale of § 1231 asset ...... $ 9,000 15% Loss from sale of § 1231 asset ...... (1,200)

Net 15% § 1231 gain for year...... $ 7,800

D’s net 15% § 1231 gain of $7,800 is treated as a 15% capital gain. If she had other capital gains or losses during the year, they will be subject to the capital gain and loss netting process discussed in Chapter 16.

Example 5. During the year R, a sole proprietor, sold a business computer for $32,000. His basis at the time of the sale was $44,000. He also sold land used in his business at a gain of $1,400 and had an uninsured theft loss of works of art used to decorate his business offices (i.e., capital assets held in connection with a trade or business). R had purchased the artwork for $1,500 and it was valued at $5,000 before the burglary. All of the assets were acquired more than 12 months ago. R nets his gains and losses as follows:

Step 1: The net loss from the casualty is $1,500 (adjusted basis). Since R has a net 15% casualty loss, it is not treated as a § 1231 loss. Instead, the loss is treated as an ordinary loss (which is fully deductible for A.G.I. since the art works were business property). Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

SECTION 1231 17–11 Step 2: Combine gains and losses from sales of § 1231 assets:

15% loss from sale of business computer...... ($12,000) 15% gain from sale of business land ...... 1,400 Net § 1231 loss for year ...... ($10,600)

Step 3: A net § 1231 loss is treated as an ordinary deduction. Thus, R’s $10,600 loss can be used to offset other ordinary income.

Note that the theft loss of the works of art is included in the first step of the netting process even though these items are capital assets. This loss would have offset, dollar for dollar, any casualty or theft gains (net of depreciation recapture) from § 1231 assets as well as any casualty or theft gains from other capital assets held in connection with R’s business. Also note that the current year’s deductible § 1231 loss may result in a change in the character of any net § 1231 gains in the next five years due to the look-back rule.

LOOK-BACK RULE

For many years, taxpayers took advantage of the § 1231 netting process. For example, assume a taxpayer in the 35 percent tax bracket currently owns two § 1231 assets, both held for 15 months. One asset has a built-in gain of $3,000 and the other has a built-in loss of $2,000. If both assets are sold during the year, the loss offsets the gain and the taxpayer pays a capital gain tax of $150 [($3,000 $2,000 ¼ $1,000) 15%]. If the taxpayer had sold the assets in different years, the loss would not have reduced the gain, and the tax after both transactions would have been $450 in one year ($3,000 15%) and $700 ($2,000 35%) of savings in the other year, for a net tax savings of $250 ($700 $450). As might be imagined, taxpayers carefully planned their transactions to maximize their tax savings. In an effort to prevent taxpayers from cleverly timing their § 1231 gains and losses to ensure that § 1231 losses reduced ordinary income and not potential capital gain, Congress enacted the so-called look-back rule in 1984. Under this rule, a taxpayer with a net § 1231 gain in the current year must report the gain as ordinary income to the extent of any unrecaptured net § 1231 losses reported in the past five taxable years.18 In recapturing the § 1231 gains, recapture occurs in the following order: 28% gains, 25% gains, and 15% gains. Unrecaptured net § 1231 losses are simply the net § 1231 losses that have occurred during the past five years that have not been previously recaptured (i.e., the excess of net § 1231 losses of the five preceding years over the amount of such loss that has been recaptured in the five prior years).

Example 6. Assume the same facts in Example 5 and that R’s 2006 net § 1231 loss of $10,600 is the only loss he has deducted in the past five years. In 2007 R has a net 15% § 1231 gain of $15,000. R is subject to the look-back rule since in the prior year he reported a § 1231 loss of $10,600 that has not been recaptured. He must report $10,600 of ordinary income and $4,400 of net 15% § 1231 gain. Should R have a § 1231 gain in the following year, he will not be subject to the look-back rule since he has recaptured all prior year’s net § 1231 losses.

18 § 1231(c). Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

17–12 PROPERTY TRANSACTIONS: DISPOSITIONS OF TRADE OR BUSINESS PROPERTY

APPLICABILITY OF LOWER RATES

Five potential tax rates apply to long-term capital gains; six, to ordinary income, which includes short-term capital gains. How can the calculation of the capital gains tax, including any § 1231 gain, be completed in such a way as to arrive at a single right answer? Caution must be exercised so as to complete the netting process in the prescribed order, as elaborated so far in this chapter and in Chapter 16.

" The first step is to complete the § 1231 netting process.

If there is a net § 1231 loss, that loss must be treated as an ordinary loss and it is left out of the capital gain and loss netting process entirely. If there is a net § 1231 gain, it is treated as a long-term capital gain and is entered into the capital gain and loss netting process in the next step. In order to do this, a determination must be made as to which part of the gain, if any, is 25% gain, and which part, if any, is 15% gain.

" Netting of capital gains and losses occurs in each of the various groups of assets.

Short-term gains are netted against short-term losses and long-term gains are netted against long-term losses. Within the long-term netting process, gains and losses are further broken down in the various sub-groups with 15% gains and losses, and 28% gains and losses being netted. Since there are no 25% losses, the 25% gains are not reduced. The net gains and losses from these three groups are netted against one another as prescribed in Chapter 16 (e.g., 28% losses are first offset against 25% gains, then 15% gains, and 15% losses are first offset against 28% gains, then 25% gains.

" Short-term gains and losses are netted/combined with long-term gains and losses. Short-term losses are first netted against 28% gains, then 25% gains, and finally 15% gains. Net long-term losses are netted against short-term gains. " The net results are subject to the capital gain tax.

Short-term gains are treated like ordinary income Long-term gains are subject to tax at the appropriate specified capital gains rates (5%, 10%, 15%, 25%, and 28%) Losses are subject to the $3,000 annual limit with the excess being carried forward.

Numerous possibilities exist, therefore, for any net § 1231 gain. Perhaps, the gain would be offset by capital losses, receiving no favorable treatment at all. However, if the § 1231 gain survives the netting process to be included in a net capital gain, it is subject to the preferred rates right along with any other long-term capital gains with surviving unrecaptured § 1250 gain being treated as 25% gain and any other surviving gain treated as 15% gain.

3 CHECK YOUR KNOWLEDGE

Review Question 1. Indicate whether the following gains and losses are § 1231 gains or losses or capital gains and losses or neither. Make your determination prior to the § 1231 netting process and assume any holding period requirement has been met. Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

SECTION 1231 17–13 a. Gain on the sale of General Motors stock held as a temporary investment by Consolidated Brands Corporation. b. Gain on the sale of a four-unit apartment complex owned by Lorena Smith. This was her only rental property. c. Loss on the sale of welding machinery used by Arco Welding in its business. d. Loss on theft of welding machinery used by Arco Welding in its business. e. Gain on sale of diamond bracelet by Nancy Jones. f. Income from sale of electric razors by Razor Corporation, which manufac- tures them. g. Gain on condemnation of land on which Tonya Smith’s personal residence is built. h. Gain on condemnation of land owned by Tonya Smith’s business. i. Loss on sale of personal automobile.

Answer. The § 1231 hodgepodge contains not only gains and losses from § 1231 property but also those from involuntary conversions by casualty, theft, or condemnation of capital assets that are used in a trade or business or held as an investment in connection with a trade or business. a. The sale of the GM stock is not included in the § 1231 pot since it is a sale of a capital asset and not an involuntary conversion. b. The rental property is generally considered property used in a trade or busi- ness and thus § 1231 property even if the owner owns only a single property. c. The welding machinery is depreciable property used in a business and is therefore considered § 1231 property. d. The theft of the welding machinery is also a § 1231 transaction. Note, however, that in processing the § 1231 gains and losses, the casualties must be segregated from the sales. e. The sale of the diamond bracelet produces capital gain since it is a pure capital asset and not trade or business property. f. The razors are inventory and are therefore neither capital assets nor § 1231 property. g. The condemnation of the land near the residence is considered a personal involuntary conversion gain. Since the land is not held in connection with a trade or business, it does not qualify as § 1231 property, but it is a capital asset. h. The condemnation of the land held for business does enter into the § 1231 hodgepodge as a regular § 1231 gain. i. Although the personal automobile is a capital asset, no loss is allowed from the sale.

Review Question 2. During his senior year at the University of Virginia, Bill decided that he never wanted to leave Charlottesville. After some thought, he opened his own hamburger joint, Billy’s Burgers. That was 20 years ago and Bill has had great success, owning a number of businesses all over Virginia and North Carolina. Not believing in corporations, Bill and his wife, Betty, operate all of these as partnerships.

a. Information from the partnerships and his own personal records revealed the following transactions during the current year:

1. Sale of one of 50 apartment buildings that one of their partnerships owns: $50,000 gain (ignore depreciation) 2. Sale of restaurant equipment: $20,000 loss Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

17–14 PROPERTY TRANSACTIONS: DISPOSITIONS OF TRADE OR BUSINESS PROPERTY Assuming both assets have been held for several years, how should Bill and Betty report these transactions on their current year return?

Answer. Under § 1231, the taxpayer generally nets gains and losses from the sale of § 1231 property. If a net gain results, the gain is treated as a long-term capital gain, while a net loss is treated as an ordinary loss. For this purpose, § 1231 property generally includes real or depreciable property used in a trade or business. In this case, both the apartment complex and the restaurant equipment are § 1231 property and both are in the 15 percent group. As a result, the couple should net the gain and loss and report a 15 percent capital gain of $30,000.

b. The couple’s records for the following year revealed several gains and losses:

1. Office building burned down: $20,000 loss 2. Crane for bungee jumping business stolen: $35,000 gain (assume no depre- ciation had been claimed) 3. Parking lot sold: $14,000 loss 4. Exxon stock sold: long-term capital loss of $10,000 5. Condemnation of Greensboro land held for use in the business: $15,000 gain.

Assuming each of the assets was held for several years, determine how much 15 percent capital gain or loss as well as the amount of ordinary income or loss that Bill and Betty will report for the year.

Answer. The § 1231 netting process requires the taxpayer to separate § 1231 casualty gains and losses from other § 1231 transactions (sometimes referred to as regular § 1231 items). The casualty loss on the office building and the casualty gain on the crane are both considered § 1231 15 percent casualties since they involve § 1231 property (i.e., real or depreciable property used in business). Note that the condemnation—even though it is an involuntary conversion—is not treated as a § 1231 casualty. The casualty items are netted to determine whether there is a net gain or loss. Here, there is a net casualty 15 percent gain of $15,000 ($35,000 $20,000). This net gain is then combined with any ‘‘regular’’ § 1231 items, in this case the $14,000 loss on the sale of the parking lot (real property used in a business) and the $15,000 gain on the condemnation of the land (a capital asset). Note that both ‘‘regular’’ § 1231 items are also in the 15 percent group. After netting these items, the partnership has a net gain of $16,000. This $16,000 net § 1231 gain is treated as a 15 percent capital gain and is combined with $10,000 15 percent capital loss on the sale of the stock. The end result is a $6,000 15 percent capital gain. This process can be summarized as follows (see also Exhibit 17-3): Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

DEPRECIATION RECAPTURE 17–15

c. Same as in (b), except Bill and Betty reported a net § 1231 loss of $3,000 in the previous year.

Answer. In this case, the look-back rule applies, causing $3,000 of the net 15 percent § 1231 gain to be treated as ordinary income. As a result, the couple’s 15 percent capital gain from the § 1231 netting process is $13,000 and their net 15 percent capital gain is only $3,000.

DEPRECIATION RECAPTURE

HISTORICAL PERSPECTIVE

For many years, taxpayers have taken advantage of the interaction of § 1231 and the depreciation rules to secure significant tax savings. Prior to 1962 there were no substantial statutory restrictions on the depreciation methods that could be adopted. Consequently, a taxpayer could quickly recover the basis of a depreciable asset by selecting a rapid depreciation method such as declining balance and using a short useful life. If the property’s value did not decline as quickly as its basis was being reduced by depreciation deductions, a gain was ensured if the property was disposed of at a later date. The end result could be quite beneficial.

Example 7. During the current year T purchased equipment for $1 million. After two years, T, using favorable depreciation rules, had claimed and deducted $600,000 of depreciation, leaving a basis of $400,000. Assume that the property did not truly depreciate in value and T was able to sell it in the third year for its original cost of $1 million. In such case T would report a gain of $600,000 ($1,000,000 $400,000). Except for time value of money considerations, it appears that the $600,000 gain and the $600,000 of depreciation are simply a wash. However, the depreciation reduced ordinary income that would be taxed at ordinary rates while the gain would be a § 1231 gain and taxed at capital gain rates. As an illustration of the savings that could be achieved, assume that the law at this time provided for a top capital gain rate of 20% and the taxpayer’s ordinary income was taxed at a 40%. In this case the depreciation would offset ordinary income and provide tax savings of $240,000, but the $600,000 gain on the sale would be treated as a capital gain and produce a tax of only $120,000. Thus, even though the taxpayer has had no Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

17–16 PROPERTY TRANSACTIONS: DISPOSITIONS OF TRADE OR BUSINESS PROPERTY economic gain or loss with respect to the property—he bought and sold the equipment for $1,000,000—he was able to secure a tax benefit of $120,000 ($240,000 $120,000).

The above example clearly illustrates how taxpayers used rapid depreciation and the favorable treatment of § 1231 gains to effectively convert ordinary income into capital gain. In fact, this strategy—deferring taxes with quick depreciation write-offs at ordinary rates and giving them back later at capital gains rates—was the foundation of many tax shelter schemes. Legislation to limit these benefits came in a number of forms, but the most important was the enactment of the so-called depreciation recapture rules. These rules strike right at the heart of the problem, generally treating all or some portion of any gain recognized as ordinary income, based on the amount of depreciation previously deducted. Thus, in the above example, the taxpayer’s $600,000 gain, which was initially characterized as a § 1231 gain, is treated as ordinary income because of the $600,000 of depreciation previously claimed. In this way, all of the tax savings initially given away by virtue of the ordinary depreciation deductions are recaptured. Unfortunately, much like § 1231 in general, the recapture rules can become quite complex. The operations of the specific provisions are discussed below.

WHEN APPLICABLE

Before specific recapture rules are examined, there are two very important points to keep in mind. First, depreciable assets held for one year or less do not qualify for § 1231 treatment. Thus, any gain from the disposition of such assets is always reported as ordinary income. Second, the depreciation recapture rules do not apply if property is disposed of at a loss. Remember that losses from the sale or exchange of depreciable assets are treated as § 1231 losses if the property is held more than a year. In addition, casualty or theft losses of such property are included in the § 1231 netting process. Any loss from a depreciable asset held one year or less is an ordinary loss regardless of whether it was sold, exchanged, stolen, or destroyed.

TYPES OF DEPRECIATION RECAPTURE

There are essentially three depreciation recapture provisions in the Code. These are

1. Section 1245 Recapture—commonly called the full recapture rule, and applicable primarily to depreciable personalty (rather than realty) 2. Section 1250 Recapture—commonly called the partial recapture rule, and applicable to most depreciable realty if a method of depreciation other than straight-line was used 3. Section 291 Recapture—commonly called the additional recapture rule, and applicable only to corporate taxpayers

Each of these recapture rules is discussed below.

FULL RECAPTURE—§ 1245

The recapture concept was first introduced with the enactment of § 1245 by the Revenue Act of 1962. Section 1245 generally requires any gain recognized to be reported as ordinary income to the extent of any depreciation allowed on § 1245 property after 1961. Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

DEPRECIATION RECAPTURE 17–17

Definition of § 1245 Property. The recapture of depreciation under § 1245 applies only to § 1245 property, normally depreciable personal property.19 Because the definition of personal property itself is so broad, § 1245 generally covers a wide variety of depreciable assets such as:

" Machinery and equipment used in production of goods and services " Office furniture and equipment " Automobiles, vans, trucks, and other transportation equipment " Livestock used for breeding or production " Intangibles such as patents, copyrights, trademarks, and goodwill that have been amortized under § 197 or otherwise.

Essentially the amortization is treated the same as depreciation, just like any portion of the cost of a depreciable asset that is expensed under § 179 is treated as depreciation allowed.20 It is important to understand that § 1245 applies only if the property is depreciable or amortizable. Consequently, it pertains only to property that is used in a trade or business and property held for the production of income. For example, livestock that are considered inventory are not subject to depreciation and are therefore not § 1245 property, although any gain or loss from the disposition of inventory is ordinary income. Although the above definition is usually sufficient, § 1245 property actually includes a number of other assets besides depreciable personalty, including the following:21

1. Property used as an integral part of manufacturing, production, or extraction, or in furnishing transportation, communications, electrical energy, gas, water, or sewage disposal services.

a. However, any portion of a building or its structural components is not included. b. A research facility or a facility for the bulk storage of commodities related to an activity listed above is included.

2. A single-purpose agricultural or horticultural structure (e.g., greenhouses). 3. A storage structure used in connection with the distribution of petroleum or any primary product of petroleum (e.g., oil tank). 4. Any railroad grading or tunnel bore. 5. Certain other property that is subject to a special provision allowing current deductibility or rapid amortization (e.g., pollution control facilities and railroad rolling stock).

Operation of § 1245. Section 1245 generally requires any gain recognized to be treated as ordinary income to the extent of any depreciation allowed.22 To state the rule in another way: any gain on the disposition of § 1245 property is ordinary income to the extent of the lesser of the gain recognized or the § 1245 recapture potential, generally the depreciation claimed and deducted. Although both statements say the same thing,

19 § 1245(a)(3). 20 See § 197(f)(7) for intangibles and § 1245(a)(3)(D) for expensed property and certain other properties subject to unique expensing rules. 21 The definition parallels that of § 38 property, which qualified for the investment tax credit. § 48(a)(1). 22 § 1245(a). Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

17–18 PROPERTY TRANSACTIONS: DISPOSITIONS OF TRADE OR BUSINESS PROPERTY the latter helps focus attention on two points and eliminates some misconceptions. First, a taxpayer is never required to report more income than the amount of gain realized regardless of the amount of depreciation claimed and deducted (i.e., regardless of the amount of recapture potential). For example, if the taxpayer realizes a gain of $10,000 and has deducted depreciation of $15,000, the taxpayer reports only $10,000 of income, all of which would be ordinary. Note that the depreciation recapture rules do not affect the amount of gain or loss, only the character of any gain to be recognized. Second, using the term recapture potential helps emphasize that sometimes the amount that must be recaptured may include more than mere depreciation. Section 1245 recapture potential includes all depreciation or amortization allowed (or allowable) with respect to a given property—regardless of the method of depreciation used. This is why § 1245 is often called the full recapture rule. Recapture potential also includes adjustments to basis related to items that are expensed (e.g., under § 179 expense election) or where tax credits have been allowed under various sections of the Code.23 To summarize, determining the character of gain on the disposition of § 1245 property is generally a two-step process:

1. The gain is ordinary income to the extent of the lesser of the gain recognized or the § 1245 recapture potential (all depreciation allowed or allowable). 2. Any recognized gain in excess of the recapture potential retains its original char- acter, usually § 1231 gain.

Recall that there is no § 1245 depreciation recapture when a property is sold at a loss, so any loss is normally a § 1231 loss.

Example 8. T owned a printing press that he used in his business. Its cost was $6,800 and T deducted depreciation in the amount of $3,200 during the three years he owned the press. T sold the press for $4,000 and his realized and recognized gain is $400 ($4,000 sales price $3,600 adjusted basis). T’s recapture potential is $3,200, the amount of depreciation taken on the property. Thus, the entire $400 gain is ordinary income under § 1245.

Example 9. Assume the same facts as in Example 8, except that T sold his press for $7,000. In this case, T’s realized and recognized gain would be $3,400 ($7,000 $3,600). The ordinary income portion under § 1245 would be $3,200 (the amount of the recapture potential), and the remaining $200 of the gain is a § 1231 gain. Note that in order for any § 1231 gain to occur, the property must be sold for more than its original cost since all of the depreciation is treated as ordinary income.

Example 10. Assume the same facts as in Example 8, except that the printing press is sold for $3,000 instead of $4,000. In this case, T has a loss from the sale of $600 ($3,000 $3,600 adjusted basis). Because there is a loss, there is no depreciation recapture. All of T’s loss is a § 1231 loss.

Exceptions and Limitations. In many ways, § 1245 operates much like the proverbial troll under the bridge. It sits ready to spring on its victim whenever the proper moment arises. Section 1245 generally applies whenever there is a transfer of property. However, § 1245 does identify certain situations where it does not apply, most of which

23 See § 1245(a)(2) for a listing of these adjustments and their related Code sections, including the basis adjustment related to the earned portion of any investment credit. Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

DEPRECIATION RECAPTURE 17–19 are nontaxable events. For example, there is no recapture on a transfer by gift or bequest since both of these are nontaxable transfers.24 In involuntary conversions and like-kind exchanges, the depreciation recapture under § 1245 is limited to the gain recognized.25 Similarly, in nontaxable business adjustments such as the formation of partnerships, transfers to controlled corporations, and certain corporate reorganizations, § 1245 recapture is limited to the gain recognized under the controlling provisions.26 In any situation where recapture is not triggered, it is generally not lost but carried over in some fashion.

PARTIAL RECAPTURE—§ 1250

As originally enacted in 1961, the concept of recapture as set forth in § 1245 generally applied only to personalty. Gains derived from dealing in realty were not subject to recapture. In 1963, however, Congress eliminated this omission by enacting § 1250, a special recapture provision that applied to most buildings. Since that time § 1245 has generally been associated with depreciation recapture for personal property while § 1250 served that role for buildings. Although the two provisions are similar, § 1250 is far less damaging. Specifically, § 1250 calls for the recapture of only a portion of any accelerated depreciation allowed with respect to § 1250 property. Note that while §§ 1250 and 1245 are essentially the same—they both convert potential capital gain into ordinary income—§ 1250 differs from § 1245 in several important ways: (1) it applies only if an accelerated method is used; (2) it does not require recapture of all the depreciation deducted but only a portion—generally only the excess of accelerated depreciation over what straight-line would have been; and (3) it applies to a different type of property, buildings and their components, rather than personal property. Each of these aspects is considered below.

Section 1250 Property. Section 1250 property is generally any real property that is depreciable and is not covered by § 1245.27 For the most part, § 1250 applies to all of the common forms of real estate such as office buildings, warehouses, apartment complexes, and low-income housing. As explained earlier, however, nonresidential real estate (e.g., warehouse and office buildings) placed in service after 1980 and before 1987 for which an accelerated method was used is covered by the full recapture rule of § 1245.28

Depreciation of Real Property. Section 1250 applies only if an accelerated method of depreciation is used. If the straight-line depreciation method is used, § 1250 does not apply and there is no depreciation recapture for noncorporate taxpayers.29 For this reason, a critical first step in determining the relevance of § 1250 is determining how the taxpayer has depreciated the realty. For many years, taxpayers could choose to use either an accelerated or straight-line method to compute depreciation for realty. This was an extremely important decision, for it affected not only the amount of depreciation the taxpayer claimed but also the

24 §§ 1245(b)(1) and (2). Recapture of depreciation under § 1245 is required, however, to the extent § 691 applies (relating to income in respect to a decedent). 25 § 1245(b)(4). 26 § 1245(b)(3). See Chapter 19 for further discussion of nontaxable business adjustments. 27 § 1250(c). 28 It is important to note, however, that such properties are § 1250 property if the optional straight-line method is used. § 1245(a)(5). 29 As explained within, corporate taxpayers are still required to recapture 20 percent of any straight-line depreci- ation under § 291. Also, any unrecaptured straight-line depreciation is taxed at a maximum rate of 25 percent. Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

17–20 PROPERTY TRANSACTIONS: DISPOSITIONS OF TRADE OR BUSINESS PROPERTY character of any gain on a subsequent disposition of the property. For example, a taxpayer could accelerate depreciation deductions but only at the possible expense of recapture. Alternatively, the taxpayer could accept the slower-paced straight-line method and avoid the § 1250 recapture rules. But the Tax Reform Act of 1986 ended this flexibility and at the same time simplified the law. Taxpayers who place realty in service after 1986 must use the straight-line method. As a result, § 1250 does not apply to property acquired after 1986. However, much of the existing inventory of real property was acquired before 1987 and may therefore be subject to § 1250, depending on the depreciation method used.

Realty Placed in Service from 1981 through 1986. For real property acquired between 1981 and the end of 1986, the taxpayer could either use the accelerated depreciation method allowed under ACRS or elect an optional straight-line method. Of course, a taxpayer would normally select the accelerated method. In fact, that was the normal recommendation with respect to residential property. However, with respect to nonresidential property, electing to use the accelerated method resulted in the property that would normally be § 1250 property being classified as § 1245 property—subject to full, rather than partial, recapture.

Realty Placed in Service before 1981. All depreciable real property acquired before 1981 is classified as § 1250 property. For such property acquired before 1981 (non-ACRS property), taxpayers were required to estimate useful lives and salvage values. Although various methods could be used, the annual deduction (during the first two-thirds of the useful life) generally could not exceed that arrived at by using the following maximum rates and methods:30

Maximum Allowable Deduction Type of Property Method/Rate

New residential real estate Declining-balance using 200% of the straight-line rate Used residential real estate: If estimated useful life at least 20 years Declining-balance using 125% of the straight-line rate If estimated useful life less than 20 years Straight-line New nonresidential real estate Declining-balance using 150% of the straight-line rate Used nonresidential real estate: Straight-line

Operation of § 1250. The two critical factors in determining the amount, if any, of § 1250 recapture are the gain realized and the amount of excess depreciation. Excess depreciation refers to depreciation deductions in excess of that which would be deductible using the straight-line method. For property held one year or less, all depreciation is considered excess depreciation.31 As a general rule, § 1250 requires recapture of the excess depreciation, that is, the excess of accelerated over straight-line. Consequently, even if the taxpayer uses an accelerated method to compute the amount of depreciation deducted on the return, the hypothetical amount of straight-line depreciation must still be computed in order to determine the excess of accelerated over straight-line when the property is sold. In determining the hypothetical amount of straight-line depreciation, the taxpayer uses the same life and salvage value, if any, that were used in computing accelerated depreciation.32 Because of this approach, a taxpayer who uses the straight-line method

30 § 167(j). 31 § 1250(b). 32 § 1250(b)(5). Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

DEPRECIATION RECAPTURE 17–21 would have no excess depreciation and no recapture. Because the § 1250 recapture rule applies only to any excess depreciation claimed by a taxpayer, it is sometimes referred to as the partial recapture rule. However, it should be emphasized that beginning in 1997, the unrecaptured § 1250 depreciation (e.g., the straight-line depreciation) on § 1250 property held more than 12 months is subject to a special 25 percent tax rate (assuming it survives the § 1231 netting process). Determining the taxation of any gain recognized on the disposition of § 1250 property is a three-step process:

1. The gain is ordinary income to the extent of the lesser of the gain recognized or the § 1250 recapture potential (generally the excess depreciation allowed).33 2. Any recognized gain in excess of the recapture potential is usually treated as § 1231 gain. 3. Any gain recognized on § 1250 property held more than 12 months that is due to depreciation that is not recaptured and which survives the applicable netting processes is taxed at a maximum rate of 25 percent to the extent of any unrecaptured depreciation. Any additional gain is generally 15 percent gain.

There is no § 1250 depreciation recapture when a property is sold at a loss, so any loss is normally a § 1231 loss.

Unrecaptured § 1250 Gain. As may be apparent from step 3 above, under § 1250, taxpayers are required to recapture depreciation only if an accelerated method is used to depreciate the property. Consequently, individual taxpayers never recapture depreciation on § 1250 property if the straight-line method is used. Without some special rule, any gain attributable to straight-line depreciation for § 1250 property held more than 12 months would normally qualify for taxation at a 15 percent rate. However, Congress felt this treatment was too generous and created a special rule for unrecaptured § 1250 gain. The unrecaptured § 1250 gain is the lesser of (1) the gain recognized, or (2) the depreciation allowed after each (the gain recognized and the depreciation allowed) is reduced by any § 1250 recapture. The resulting amount will equal the amount of straight-line depreciation that was claimed or would have been claimed had the straight-line method been used (or, if less, the gain recognized minus the § 1250 recapture).

Example 11. About 10 years ago, F purchased some residential rental property for $100,000. This year he sold the property for $110,000. He had claimed straight-line depreciation of $30,000 over this time, resulting in a basis of $70,000 (do not attempt to verify this amount). As a result, F recognized a gain of $40,000. Since the property is realty and a straight-line depreciation method was used there is no § 1250 recapture. Consequently, the entire gain is a § 1231 gain. However, the § 1231 gain will be treated as a 25% gain to the extent of any straight-line depreciation claimed. Therefore, $30,000 of the gain is a 25% § 1231 gain while $10,000 is a 15% § 1231 gain (i.e., in the capital gain netting process these will be 15% and 25% long-term gains, respectively). If F had sold the property for $90,000, he would have had a gain of $20,000, all of which would have been a 25% gain (i.e., the lesser of the gain realized, $20,000, or the unrecaptured straight-line depreciation, $30,000).

Example 12. Same facts and $110,000 sales price from Example 11 above, except that F also has a $400 gain on the sale of K Corporation stock held 26 months. F is

33 See § 1250(a) and discussion following dealing with recapture of only a portion of the excess depreciation for certain properties. Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

17–22 PROPERTY TRANSACTIONS: DISPOSITIONS OF TRADE OR BUSINESS PROPERTY single and has taxable income, excluding these transactions, of $76,000. F’s tax would be computed as follows (using the 2006 tax rates for single taxpayers):

Regular tax on $76,000: Tax on $74,200 ...... $15,108 Tax on excess at 28% [($76,000 $74,200 ¼ $1,800) 28%] ...... 1,504 $15,612 Tax on 15% gains (15% $10,400) ...... 1,560 Tax on 25% gains (25% $30,000) ...... 7,500 Total tax ...... $24,672

Combined Results. The net gain from the disposition of § 1250 property can be treated as ordinary income subject to the regular tax rate, 15 percent capital gain, and/or 25 percent capital gain (and rarely 28 percent capital gain). Each step in the netting and tax calculation processes has been covered. 13 through Example 16 and Comprehensive Example 18 illustrate how they work in combination.

Example 13. During the current year, L sold a small office building for $38,000. The building had cost her $22,000 in 1980, and she had deducted depreciation of $12,000 using an accelerated method. Straight-line depreciation would have been $10,600. L’s gain recognized on the sale is $28,000 ($38,000 amount realized $10,000 adjusted basis). Of that amount, $1,400 ($12,000 $10,600 ¼ $1,400 excess depreciation) is ordinary income under § 1250 and the remainder, $26,600, is § 1231 gain. Of the $26,600 § 1231 gain, the unrecaptured depreciation of $10,600 is a 25% gain. The $16,000 excess of the amount realized over the original basis is 15% gain. Example 14. M purchased a rental duplex during 1986 for $60,000. He deducted $36,500 depreciation using the 19-year realty ACRS tables. Depreciation using the straight-line recovery percentages for 19-year realty would have resulted in total depreciation of $31,440. On January 3, 2006 M sold the property for $87,000. His gain is reported as follows:

Sales price ...... $87,000 Less: Adjusted basis Cost...... $60,000 Depreciation (accelerated) (36,500) (23,500)

Gain to be recognized...... $63,500

Accelerated depreciation claimed and deducted ...... $36,500 Straight-line depreciation (hypothetical) ...... (31,440) Excess depreciation subject to recapture ...... $ 5,060

Character of gain: ...... Ordinary income (partial recapture)...... $ 5,060 § 1231 gain subject to 25% rate ...... 31,440 § 1231 gain subject to 15% rate ...... 27,000

Total gain recognized ...... $63,500 Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

DEPRECIATION RECAPTURE 17–23 Note that without a special rule, the gain not recaptured under § 1250 might be subject to the 15% capital gains rate. However, the balance of the depreciation that has not been recaptured $31,440 ($36,500 $5,060) is carved out and is considered a 25% § 1231 gain. Also observe that the $31,440 of 25% § 1231 gain is the amount of straight-line depreciation. The remaining gain (i.e., the amount above the original cost) of $27,000 is a 15% § 1231 gain. Example 15. Assume the same facts as in Example 14, except that M elected to recover his basis in the duplex using the 19-year straight-line method. Consequently she recognizes gain of $58,440 computed as follows:

Sales price ...... $87,000 Less: Adjusted basis Cost ...... $60,000 Depreciation (straight-line) ...... (31,440) (28,560) Gain ...... $(58,440)

None of the gain is subject to § 1250 recapture since M used straight-line depreciation (a requirement after 1986). However, the amount representing the unrecaptured depreciation (i.e., the straight-line depreciation) of $31,440 is considered a 25% § 1231 gain and the $27,000 balance is considered a 15% § 1231 gain.

Example 16. Assume the same facts as in Example 14, except that the property is an office building rather than a duplex. In this case, because the property is nonresidential real property and the accelerated method was used, the asset is treated as § 1245 property rather than § 1250 property. Thus, M is subject to full rather than partial depreciation recapture. All of the $36,500 depreciation is recaptured and treated as ordinary income. The balance of the gain, $27,000 is treated as a 15% § 1231 gain.

History of § 1250. Over the years, § 1250 has been changed frequently, with a general trend toward an expanded scope. The rules explained above apply only to depreciation allowed on nonresidential property after 1969 and residential property (other than low-income housing) after 1975. Only a portion of any other excess depreciation on § 1250 property is included in the recapture potential. The following percentages are applied to the gain realized in the transaction or the excess depreciation taken during the particular period, whichever is less:

1. For all excess depreciation taken after 1963 and before 1970, 100 percent less 1 percent for each full month over 20 months the property is held.34 Any sales after 1979 would result in no recapture of pre-1970 excess depreciation since this percentage, when calculated, is zero. 2. For all excess depreciation taken after 1969 and before 1976, as follows:

a. In the case of low-income housing, 100 percent less 1 percent for each full month the property is held over 20 months. b. In the case of other residential rental property (e.g., an apartment building) and property that has been rehabilitated [for purposes of § 167(k)], 100 percent less 1 percent for each full month the property is held over 100 months.35

34 § 1250(a)(3). 35 § 1250(a)(2). Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

17–24 PROPERTY TRANSACTIONS: DISPOSITIONS OF TRADE OR BUSINESS PROPERTY All sales from this group of real property after August 1992 will have no recapture of excess depreciation claimed before 1976.

3. For excess depreciation taken after 1975 on low-income housing and property that has been rehabilitated [for purposes of § 167(k)], 100 percent less 1 percent for each full month the property is held over 100 months.36

In summary, 100 percent of the excess depreciation allowed with respect to § 1250 property after 1975 is subject to recapture unless it falls into one of the above categories. Any gain recognized to the extent of any unrecaptured depreciation will be considered 25% gain. The rules for the various categories are provided in § 1250(a).

Exceptions and Limitations under § 1250. Generally, the exceptions and limitations that apply under § 1245 also apply under § 1250. Thus, gifts, inheritances, and most nontaxable exchanges are allowed to occur without triggering recapture.37 This exception is extended to any property to the extent it qualifies as a principal residence and is subject to deferral of gain under § 1034 or nonrecognition of gain under § 121.38 In such nontaxable exchanges, the excess depreciation (that is not recaptured) taken prior to the nontaxable exchange on the property transferred carries over to the property received or purchased.39 Similarly, in the case of gifts and certain nontaxable transfers in which the property is transferred to a new owner with a carryover basis, the excess depreciation carries over to the new owner.40 In the case of inheritances in which basis to the successor in interest is determined under § 1014, no carryover of excess depreciation occurs.41 Certain like-kind exchanges and involuntary conversions may result in the recognition of gain solely because of § 1250 if insufficient § 1250 property is acquired. Since not all real property is depreciable, it is possible that the replacement property would not be § 1250 property and would still qualify for nonrecognition under the appropriate rules of §§ 1033 or 1034. In such situations, gain will be recognized to the extent the amount that would be recaptured exceeds the fair market value of the § 1250 property received (property purchased in the case of an involuntary conversion).42

Example 17. D completed a like-kind exchange in the current year in which he trans- ferred an apartment complex (§ 1250 property) for rural farmland (not § 1250 property). The apartment had cost D $175,000 in 1980 and depreciation of $89,000 has been taken under the 200% declining-balance method. D would have deducted $62,000 under the straight-line method. The farm land was worth $200,000 at the time of the exchange. There were no improvements on the farm property. D’s realized gain on the exchange is $114,000 ($200,000 amount realized $86,000 adjusted basis in property given up). If there had been no § 1250 recapture, then D would have had no recognized gain. Because the property acquired was not § 1250 property, § 1250 supersedes (overrides) § 1031. D has a recognized gain of $27,000 [($89,000 $62,000), the amount of excess depreciation], which is all ordinary income under § 1250.

36 § 1250(a)(1). 37 §§ 1250(d)(1) through (d)(4). 38 § 1250(d)(7). 39 Reg. §§ 1.1250-3(d)(5) and (h)(4). 40 Reg. §§ 1.1250-3(a), (c), and (f). 41 Reg. § 1.1250-3(b). 42 § 1250(d)(4)(C). A similar rule is provided for rollovers (deferral) of gains from low-income housing under § 1039 [see § 1250(d)(8)]. Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

DEPRECIATION RECAPTURE 17–25 Exhibit 17-2 provides an overview of the handling of sales and exchanges of business property. Exhibit 17-3 provides a chart that may be useful in summarizing property transactions. Note that for purposes of this Exhibit 17-3, no distinction is made between 15%, 25% and 28% § 1231 gains and losses or 15%, 25% and 28% capital gains and losses. A comprehensive example of sales and exchanges of trade or business property is presented below.

EXHIBIT 17-2 Stepwise Approach to Sales or Exchange of Trade or Business Property—An Overview

Step 1: Calculate any depreciation recapture on the disposition of § 1245 property and § 1250 property sold or exchanged at a taxable gain during the year. Step 2: For any remaining gain (after recapture) on depreciable property held for more than one year, add to other § 1231 gains and losses and complete the § 1231 netting process.

" The § 1231 gain must be broken down into the portions that qualify as 15%CG and 25%CG (and rarely 28%CG).

Step 3: Complete the netting process for capital assets, taking into consideration the net § 1231 gain, if any.

" The § 1231 gain is combined with other long-term capital gains and losses (with separate netting for 15%CG, 25%CG, and 28%CG. Then the long-term capital gain or loss is combined with the short-term capital gain or loss.

Example 18. Ted and Carol Smith sold the following assets during the current year:

Holding Selling Adjusted Recognized Description Period Price Basis Gain (Loss)

Land and building (straight-line depreciation) 3 years $14,000 $9,000 $5,000 Cost, $13,000 Depreciation allowed, $4,000 Photocopier 14 months 2,600 2,000 600 Cost, $2,500 Depreciation allowed, $500 Business auto 2 years 1,800 1,920 (120) Cost, $4,000 Depreciation allowed, $2,080

In determining the tax consequences of these sales, the Smiths must start with gains and losses from § 1231 transactions. The ultimate treatment of the gains, the character of the gain and any possible depreciation recapture must be considered.

" On the sale of the land and the building, there is no depreciation recapture for the building since straight-line depreciation was used. However, there is unrecaptured depreciation of $4,000 which is accounted for as a 25% § 1231 gain. The balance of the gain on the land and building, $1,000, is a 15% § 1231 gain. Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

17–26 PROPERTY TRANSACTIONS: DISPOSITIONS OF TRADE OR BUSINESS PROPERTY " On the sale of the photocopier, $500 of the § 1231 gain of $600 is recaptured and treated as ordinary income. The balance of the gain, $100, is a 15% § 1231 gain. " On the sale of the automobile, there is no recapture since it is sold at a loss. The $120 loss is treated as a 15% § 1231 loss. This information can be summarized as follows:

Section 1231 Gains and Losses Unrecaptured Collectibles Depreciation Other

28% 25% 15% Land and building ...... $0 $4,000 Photocopier ...... $1,000 Automobile ...... 100 Capital gains from § 1231...... $0 $4,000 (120) $ 980

In this situation, the Smiths net the various groups, resulting in net gains in each of the groups as shown above. These amounts are then combined with the appropriate capital gain groups to determine the final treatment. Note that if the Smiths had unrecaptured § 1231 losses, they would first offset the 28% gains, then 25% gains, and finally 15% gains. The information is summarized in Exhibit 17-3. Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

DEPRECIATION RECAPTURE 17–27

EXHIBIT 17-3 Summary of Property Transactions

Example 19. Assume that the Smiths, from the previous example, had the following capital asset transactions during the same year:

Holding Selling Adjusted Description of Description Period Price Basis Gain or (Loss)

100 shares XY Corp. 4 months $ 3,200 $4,200 $(1,000) STCL 100 shares GB Corp. 3 years 3,200 4,600 (1,400) LTCL 1 acre vacant land 5 years 12,000 5,000 7,000 LTCG Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

17–28 PROPERTY TRANSACTIONS: DISPOSITIONS OF TRADE OR BUSINESS PROPERTY Taking into consideration the § 1231 gains from Example 18, the Smith’s summarize their transactions as follows.

Short- Term Capital Gains and Losses Unrecaptured Collectibles Depreciation Other

Ordinary 28% 25% 15% Capital gains from § 1231...... $0 $4,000 $ 980

XY stock loss ...... (1,000) GB stock loss...... (1,400) Vacant land gain ...... 7,000 $(1,000) $0 $4,000 $6,580 Netting ...... 1,000 (1,000) Total ...... $ 0 $0 $3,000 $6,580

Ted and Carol Smith would report a $3,000 N25CG and a $6,580 N15CG.

A Form 4797 and Schedule D containing the information from Examples 18 and 19 are included in Exhibit 17-4 which follows. In using the forms, it should be pointed out that neither the Form 4797 nor Schedule D Parts I, II, and III (i.e., the form for reporting capital gains and losses) require the taxpayer to distinguish 25% gains from 28% or 15% gains. The 25% distinction comes into play only when the taxpayer computes the tax as can be seen on Schedule D, Part IV, Lines 25 and 47. The tax is computed assuming the taxpayers have taxable income of $126,830 (including the capital gains).

ADDITIONAL RECAPTURE—CORPORATIONS

Corporations generally compute the amount of § 1245 and § 1250 ordinary income recapture on the sales of depreciable assets in the same manner as do individuals. However, Congress added Code § 291 to the tax law in 1982 with the intent of reducing the tax benefits of the accelerated cost recovery of depreciable § 1250 property available to corporate taxpayers. For sales or other taxable dispositions of § 1250 property, corporations must treat as ordinary income 20 percent of any § 1231 gain that would have been ordinary income if § 1245 rather than § 1250 had applied to the transaction.43 The effect of this provision is to require the taxpayer to recapture 20 percent of any straight-line depreciation that has not been recaptured under some other provision. Technically, the amount that is treated as ordinary income under § 291 is computed in the following manner:

Amount that would be treated as ordinary income under § 1245 ...... $xx,xxx) Less: Amount that would be treated as ordinary income § 1250...... (x,xxx)

Equals: Difference between recapture amounts ...... $xx,xxx) Times: Rate specified in § 291 ...... 20%

Equals: Amount that is treated as ordinary income ...... $xx,xxx)

43 § 291(a)(1). Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

DEPRECIATION RECAPTURE 17–33 Example 20. This year K Corporation sold residential rental property for $500,000. The property was purchased for $400,000 in 1986. Assume that K claimed ACRS depreciation of $140,000 (i.e., do not attempt to verify this estimate). Straight-line depreciation would have been $105,000. K Corporation’s depreciation recapture and § 1231 gain are computed as follows:

Step 1: Compute realized gain: Sales price ...... $500,000 Less: Adjusted basis Cost ...... $400,000 ACRS depreciation ...... (140,000) (260,000)

Realized gain ...... $240,000 Step 2: Compute excess depreciation: Actual depreciation ...... $140,000 Straight-line depreciation ...... (105,000)

Excess depreciation ...... $ 35,000 Step 3: Compute § 1250 depreciation recapture: Lesser of realized gain of $240,000 or Excess depreciation of $35,000 § 1250 depreciation recapture ...... $ 35,000 Step 4: Compute depreciation recapture if § 1245 applied: Lesser of realized gain of $240,000 or Actual depreciation of $140,000 Depreciation recapture if § 1245 applied ...... $140,000 Step 5: Compute § 291 ordinary income: Depreciation recapture if § 1245 applied ...... $140,000 § 1250 depreciation recapture ...... (35,000)

Excess recapture potential...... $105,000 Times: § 291 rate 20%

§ 291 ordinary income...... $ 21,000

Step 6: Characterize recognized gain: § 1250 depreciation recapture ...... $ 35,000 Plus: § 291 ordinary income...... 21,000

Ordinary income ...... $ 56,000

Realized gain ...... $240,000 Less: Ordinary income ...... (56,000)

§ 1231 gain...... $184,000

Note that without the additional recapture required under § 291, K Corporation would have reported a § 1231 gain of $205,000 ($240,000 total gain $35,000 § 1250 recapture). If the property had been subject to § 1245 recapture, K Corporation would have only a $100,000 § 1231 gain ($240,000 $140,000 § 1245 recapture). Section 291 requires that the corporation report 20% of this difference ($205,000 $100,000 ¼ $105,000 20%), or $21,000, as additional recapture. Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

17–34 PROPERTY TRANSACTIONS: DISPOSITIONS OF TRADE OR BUSINESS PROPERTY Note that this is 20% of the straight-line depreciation that is normally not recaptured on the disposition of nonresidential or residential real estate.

Example 21. Assume the same facts as in Example 20, except that the property is an office building rather than residential realty and straight-line depreciation was elected. An individual taxpayer would report the entire gain of $205,000 [$500,000 ($400,000 basis $105,000 straight-line depreciation)] as a § 1231 gain. However, the corporate taxpayer must recapture $21,000 (20% $105,000 depreciation) as ordinary income under § 291. The remaining $184,000 ($205,000 $21,000) would be a § 1231 gain.

OTHER RECAPTURE PROVISIONS

There are several other recapture provisions that exist. They include the recapture of farmland expenditures,44 recapture of intangible drilling costs,45 and recapture of gain from the disposition of § 126 property (relating to government cost-sharing program payments for conservation purposes).46 Another type of recapture is investment credit recapture.47 This is discussed in detail in Chapter 13.

3 CHECK YOUR KNOWLEDGE

Review Question 1. True-False. This year T sold equipment for $6,000 (cost $15,000, depreciation $10,000), recognizing a gain of $1,000 ($6,000 $5,000). To ensure that all of the ordinary deductions obtained from depreciation are recaptured, T must report ordinary income of $10,000 and a capital loss of $9,000, ultimately producing net income of $1,000.

False. This novel approach may seem consistent with Congressional intent, but it is incorrect. Under § 1245 any gain realized is treated as ordinary income to the extent of any depreciation allowed. As a result, the entire $1,000 is ordinary income. It may be useful to think of the depreciation recapture as an adjustment to the depreciation claimed. Depreciation of $10,000 was claimed, but the value of the equipment dropped by $9,000 ($15,000 cost $6,000 sales price). T claimed an ordinary depreciation deduction of $10,000, and recognized ordinary income of $1,000, for a net ordinary deduction of $9,000.

Review Question 2. True-False. This year L sold a machine and recognized a small gain. Assuming L claimed straight-line depreciation, there is no depreciation recapture.

False. The machine is § 1245 property since it is depreciable personalty. Under the full recapture rule of § 1245, all depreciation is subject to recapture regardless of the method used.

Review Question 3. Several years ago Harry purchased equipment at a cost of $10,000. Over the past three years he claimed and deducted depreciation of $6,000. Assuming that Harry sold the equipment for (1) $7,000, (2) $13,000, or (3) $1,000, determine the amount of gain or loss realized and its character (i.e., ordinary income or § 1231 potential capital gain).

44 § 1252. 45 § 1254. 46 § 1255. 47 § 47. Path: k:/THC-ARC-05-1101/Application/THC-ARC-05-1101-IT_017.3d Date: 9th March 2006 Time: 11:43 User ID: 40459

DEPRECIATION RECAPTURE 17–35

123

Amount realized...... $ 7,000 $13,000 $ 1,000 Adjusted basis ($10,000 $6,000) ...... 4,000 4,000 4,000

Gain (loss) recognized ...... $ 3,000 $ 9,000 $(3,000)

The equipment is § 1245 property since it is depreciable personalty. As a result, the full recapture rule operates and any gain recognized is ordinary income to the extent of any depreciation deducted. In the first case, the entire $3,000 is ordinary income (the lesser of the gain recognized, $3,000, or the recapture potential, $6,000). In the second situation, $6,000 is ordinary income (the lesser of the gain recognized, $9,000, or the recapture potential, $6,000) and $3,000 is § 1231 gain. In the final case, § 1245 does not apply because the property is sold at a loss. Therefore, Harry has a § 1231 loss that is potentially an ordinary loss. Its ultimate treatment depends on the outcome of the § 1231 netting process.

Review Question 4. True-False. In 1990 Sal purchased an office building to rent out. This year she sold the building, recognizing a large gain. The entire gain is a § 1231 gain since there is no recapture under either § 1245 or § 1250.

True. The office build is § 1250 property. The recapture rules of § 1250 apply only when the taxpayer uses an accelerated method, in which case the excess of accelerated depreciation over straight-line is treated as ordinary income. However, since 1987 taxpayers have been required to use the straight-line method in computing depreciation on real estate. As a result, § 1250 is inapplicable and Sal’s gain retains its original § 1231 character. Nevertheless, the gain will not be treated as a 15 percent gain to the extent of any unrecaptured § 1250 depreciation (i.e., all of the straight-line depreciation) but rather 25 percent gain.

Review Question 5. True-False. In 1992 Z Corporation purchased an office building to rent out. This year the corporation sold the building, recognizing a large gain. The entire gain is a § 1231 gain since there is no recapture under either § 1245 or § 1250.

False. There is no recapture under § or § 1250. However, under § 291, corporate taxpayers are required to recapture up to 20 percent of any straight-line depreciation. The 25 percent rate does not apply to corporate taxpayers.

Review Question 6. True-False. In 1984 the Rose Partnership purchased a new office building to use as its headquarters. This year the partnership sold the building, recognizing a gain of $100,000. The partnership claimed and deducted accelerated depreciation of $40,000. Straight-line depreciation would have been $15,000. The partnership will report ordinary income of $25,000 and § 1231 gain of $75,000.

False. This would be true if the building were § 1250 property, but § 1250 does not apply. Nonresidential real estate such as this office building that was acquired from 1981 through 1986 is treated as § 1245 property and is subject to the full recapture rule if accelerated depreciation was used. In this case, the taxpayer opted for accelerated depreciation, so $40,000 is ordinary income and the remaining $60,000 is a 15% § 1231 gain.

Review Question 7.