individual income taxes c17-1 chapter 17 property transactions: § 1231 and recapture provisions...

C17-C17-11Individual Income TaxesIndividual Income TaxesIndividual Income TaxesIndividual Income Taxes

Chapter 17Chapter 17

Property Transactions: §1231 and Recapture Provisions

Property Transactions: §1231 and Recapture Provisions

Copyright ©2009 Cengage Learning

Individual Income Taxes


§1231 Assets(slide 1 of 4)


• §1231 assets defined– Depreciable and real property used in a business or for

production of income and held greater than 1 year

– Includes timber, coal, iron, livestock, unharvested crops

– Certain purchased intangibles

• §1231 assets defined– Depreciable and real property used in a business or for

production of income and held greater than 1 year

– Includes timber, coal, iron, livestock, unharvested crops

– Certain purchased intangibles




• §1231 property does not include the following:– Property not held for the long-term holding period– Nonpersonal use property where casualty losses exceed

casualty gains for the taxable year– Inventory and property held primarily for sale to

customers– Copyrights, literary, musical, or artistic compositions

and certain U.S. government publications– Accounts receivable and notes receivable arising in the

ordinary course of a trade or business

• §1231 property does not include the following:– Property not held for the long-term holding period– Nonpersonal use property where casualty losses exceed

casualty gains for the taxable year– Inventory and property held primarily for sale to

customers– Copyrights, literary, musical, or artistic compositions

and certain U.S. government publications– Accounts receivable and notes receivable arising in the

ordinary course of a trade or business




• If transactions involving §1231 assets result in:– Net §1231 loss = ordinary loss– Net §1231 gain = long-term capital gain

• If transactions involving §1231 assets result in:– Net §1231 loss = ordinary loss– Net §1231 gain = long-term capital gain




• Provides the best of potential results for the taxpayer– Ordinary loss that is fully deductible FOR AGI– Gains subject to the lower capital gains tax

rates

• Provides the best of potential results for the taxpayer– Ordinary loss that is fully deductible FOR AGI– Gains subject to the lower capital gains tax

rates


Special Rules For Certain §1231 Assets (slide 1 of 4)


• Timber-Taxpayer can elect to treat the cutting of timber held for sale or for use in business as a sale or exchange

• If elected, transaction qualifies under §1231 • Recognized §1231 gain or loss is determined at the

time the timber is cut– Equal to difference between timber's FMV as of first day of

tax year and the adjusted basis for depletion– If sold for more or less than FMV as of first day of tax year

in which it is cut,difference is ordinary income or loss

• Timber-Taxpayer can elect to treat the cutting of timber held for sale or for use in business as a sale or exchange

• If elected, transaction qualifies under §1231 • Recognized §1231 gain or loss is determined at the

time the timber is cut– Equal to difference between timber's FMV as of first day of

tax year and the adjusted basis for depletion– If sold for more or less than FMV as of first day of tax year

in which it is cut,difference is ordinary income or loss




• Livestock– Cattle and horses must be held 24 months or

more and other livestock must be held 12 months or more to qualify under §1231

• Livestock– Cattle and horses must be held 24 months or

more and other livestock must be held 12 months or more to qualify under §1231




• Casualty gains and losses from §1231 assets and from long-term nonpersonal use capital assets are determined and netted together

• If a net loss, items are treated separately – §1231 casualty gains and nonpersonal use capital asset

casualty gains are treated as ordinary gains– §1231 casualty losses are deductible FOR AGI– Nonpersonal use capital asset casualty losses are

deductible FROM AGI subject to the 2% of AGI limitation

• If a net gain, treat as §1231 gain

• Casualty gains and losses from §1231 assets and from long-term nonpersonal use capital assets are determined and netted together

• If a net loss, items are treated separately – §1231 casualty gains and nonpersonal use capital asset

casualty gains are treated as ordinary gains– §1231 casualty losses are deductible FOR AGI– Nonpersonal use capital asset casualty losses are

deductible FROM AGI subject to the 2% of AGI limitation

• If a net gain, treat as §1231 gain




• The special netting process for casualties & thefts does not include condemnation gains and losses– A § 1231 asset disposed of by condemnation receives

§ 1231 treatment

• Personal use property condemnation gains and losses are not subject to the § 1231 rules– Gains are capital gains

• Personal use property is a capital asset

– Losses are nondeductible • They arise from the disposition of personal use property

• The special netting process for casualties & thefts does not include condemnation gains and losses– A § 1231 asset disposed of by condemnation receives

§ 1231 treatment

• Personal use property condemnation gains and losses are not subject to the § 1231 rules– Gains are capital gains

• Personal use property is a capital asset

– Losses are nondeductible • They arise from the disposition of personal use property


General Procedure for § 1231 Computation (slide 1 of 3)


• Step 1: Casualty Netting– Net all recognized long-term gains & losses from

casualties of § 1231 assets and nonpersonal use capital assets

• If casualty gains exceed casualty losses, add the excess to the other § 1231 gains for the taxable year

• If casualty losses exceed casualty gains, exclude all casualty losses and gains from further § 1231 computation

– All casualty gains are ordinary income

– Section 1231 asset casualty losses are deductible for AGI

– Other casualty losses are deductible from AGI

• Step 1: Casualty Netting– Net all recognized long-term gains & losses from

casualties of § 1231 assets and nonpersonal use capital assets

• If casualty gains exceed casualty losses, add the excess to the other § 1231 gains for the taxable year

• If casualty losses exceed casualty gains, exclude all casualty losses and gains from further § 1231 computation

– All casualty gains are ordinary income

– Section 1231 asset casualty losses are deductible for AGI

– Other casualty losses are deductible from AGI




• Step 2: § 1231 Netting– After adding any net casualty gain from previous step

to the other § 1231 gains and losses, net all § 1231 gains and losses

• If gains exceed the losses, net gain is offset by the ‘‘lookback’’ nonrecaptured § 1231 losses from the 5 prior tax years

– To the extent of this offset, the net § 1231 gain is classified as ordinary gain

– Any remaining gain is long-term capital gain

• If the losses exceed the gains, all gains are ordinary income– Section 1231 asset losses are deductible for AGI– Other casualty losses are deductible from AGI

• Step 2: § 1231 Netting– After adding any net casualty gain from previous step

to the other § 1231 gains and losses, net all § 1231 gains and losses

• If gains exceed the losses, net gain is offset by the ‘‘lookback’’ nonrecaptured § 1231 losses from the 5 prior tax years

– To the extent of this offset, the net § 1231 gain is classified as ordinary gain

– Any remaining gain is long-term capital gain

• If the losses exceed the gains, all gains are ordinary income– Section 1231 asset losses are deductible for AGI– Other casualty losses are deductible from AGI




• Step 3: § 1231 Lookback Provision– The net § 1231 gain from the previous step is

offset by the nonrecaptured net § 1231 losses for the five preceding taxable years

• To the extent of the nonrecaptured net § 1231 loss, the current-year net § 1231 gain is ordinary income

– The nonrecaptured net § 1231 losses are those that have not already been used to offset net § 1231 gains

• Only the net § 1231 gain exceeding this net § 1231 loss carryforward is given long-term capital gain treatment

• Step 3: § 1231 Lookback Provision– The net § 1231 gain from the previous step is

offset by the nonrecaptured net § 1231 losses for the five preceding taxable years

• To the extent of the nonrecaptured net § 1231 loss, the current-year net § 1231 gain is ordinary income

– The nonrecaptured net § 1231 losses are those that have not already been used to offset net § 1231 gains

• Only the net § 1231 gain exceeding this net § 1231 loss carryforward is given long-term capital gain treatment


Lookback Provision ExampleLookback Provision Example

• Taxpayer had the following net §1231 gains and losses:

2006 $ 4,000 loss2007 10,000 loss2008 16,000 gain

– In 2008, taxpayer’s net §1231 gain of $16,000 will be treated as $14,000 of ordinary income and $2,000 of long-term capital gain

• Taxpayer had the following net §1231 gains and losses:

2006 $ 4,000 loss2007 10,000 loss2008 16,000 gain

– In 2008, taxpayer’s net §1231 gain of $16,000 will be treated as $14,000 of ordinary income and $2,000 of long-term capital gain


§1231 Netting Procedure (slide 1 of 2)

§1231 Netting Procedure (slide 1 of 2)

§1231 asset and long-term nonpersonal use capital asset casualty gains

minus

§1231 asset and long-term nonpersonal use capital asset casualty losses

§1231 asset and long-term nonpersonal use capital asset casualty gains

minus

§1231 asset and long-term nonpersonal use capital asset casualty losses

Net Gain

(add to §1231 gains)

Net Gain

(add to §1231 gains)

Items treated separately: Gains are ordinary income, §1231 asset

losses are deductible for AGI, Other losses deductible from AGI

Items treated separately: Gains are ordinary income, §1231 asset

losses are deductible for AGI, Other losses deductible from AGI

§1231 gains minus

§1231 losses

§1231 gains minus

§1231 losses

Net GainNet Gain

Net LossNet LossNet GainNet Gain

NNet LossLoss


§1231 Netting Procedure(slide 2 of 2)

§1231 Netting Procedure(slide 2 of 2)

Lookback Provision:

Net gain is offset against nonrecaptured net §1231 losses

from 5 prior tax years

Gain offset by lookback losses is ordinary gain

Gain offset by lookback losses is ordinary gain

Remaining gain is LTCG

Remaining gain is LTCG

Net GainNet Gain


Depreciation Recapture(slide 1 of 3)


• Assets subject to depreciation or cost recovery may be subject to depreciation recapture when disposed of at a gain– Losses on depreciable assets receive §1231

treatment• No recapture occurs in loss situations

• Assets subject to depreciation or cost recovery may be subject to depreciation recapture when disposed of at a gain– Losses on depreciable assets receive §1231

treatment• No recapture occurs in loss situations


Depreciation Recapture (slide 2 of 3)

Depreciation Recapture (slide 2 of 3)

• Depreciation recapture characterizes gains that would appear to be §1231 as ordinary gain– The Code contains two major recapture

provisions• §1245

• §1250

• Depreciation recapture characterizes gains that would appear to be §1231 as ordinary gain– The Code contains two major recapture

provisions• §1245

• §1250




• Depreciation recapture provisions generally override all other Code Sections– There are exceptions to depreciation recapture

rules, for example: • In dispositions where all gain is not recognized

– e.g., like-kind exchanges, involuntary conversions

• Where gain is not recognized at all – e.g., gifts and inheritances

• Depreciation recapture provisions generally override all other Code Sections– There are exceptions to depreciation recapture

rules, for example: • In dispositions where all gain is not recognized

– e.g., like-kind exchanges, involuntary conversions

• Where gain is not recognized at all – e.g., gifts and inheritances


§1245 Recapture(slide 1 of 3)


• Depreciation recapture for §1245 property– Applies to tangible and intangible personalty,

and nonresidential realty using accelerated methods of ACRS (placed in service 1981-86)

• Recapture potential is entire amount of accumulated depreciation for asset

• Method of depreciation does not matter

• Depreciation recapture for §1245 property– Applies to tangible and intangible personalty,

and nonresidential realty using accelerated methods of ACRS (placed in service 1981-86)

• Recapture potential is entire amount of accumulated depreciation for asset

• Method of depreciation does not matter




• When gain on the disposition of a §1245 asset is less than the total amount of accumulated depreciation:– The total gain will be treated as depreciation

recapture (i.e., ordinary income)

• When gain on the disposition of a §1245 asset is less than the total amount of accumulated depreciation:– The total gain will be treated as depreciation

recapture (i.e., ordinary income)




• When the gain on the disposition of a §1245 asset is greater than the total amount of accumulated depreciation:– Total accumulated depreciation will be

recaptured (as ordinary income), and– The gain in excess of depreciation recapture

will be §1231 gain or capital gain

• When the gain on the disposition of a §1245 asset is greater than the total amount of accumulated depreciation:– Total accumulated depreciation will be

recaptured (as ordinary income), and– The gain in excess of depreciation recapture

will be §1231 gain or capital gain


Observations on § 1245Observations on § 1245

• Usually total depreciation taken will exceed the recognized gain– Therefore, disposition of § 1245 property usually results in ordinary

income rather than § 1231 gain– Thus, generally, no § 1231 gain will occur unless the § 1245 property is

disposed of for more than its original cost• Recapture applies to the total amount of depreciation allowed or

allowable regardless of the depreciation method used• Recapture applies regardless of the holding period of the property

– If held for < the long-term holding period the entire recognized gain is ordinary income because § 1231 does not apply

• Section 1245 does not apply to losses, which receive § 1231 treatment• Gains from the disposition of § 1245 assets may also be treated as

passive activity gains

• Usually total depreciation taken will exceed the recognized gain– Therefore, disposition of § 1245 property usually results in ordinary

income rather than § 1231 gain– Thus, generally, no § 1231 gain will occur unless the § 1245 property is

disposed of for more than its original cost• Recapture applies to the total amount of depreciation allowed or

allowable regardless of the depreciation method used• Recapture applies regardless of the holding period of the property

– If held for < the long-term holding period the entire recognized gain is ordinary income because § 1231 does not apply

• Section 1245 does not apply to losses, which receive § 1231 treatment• Gains from the disposition of § 1245 assets may also be treated as

passive activity gains




• Depreciation recapture for §1250 property– Applies to depreciable real property

• Exception: Nonresidential realty classified as §1245 property (i.e., placed in service after 1980 and before 1987, and accelerated depreciation used)

– Intangible real property, such as leaseholds of § 1250 property, is also included

• Depreciation recapture for §1250 property– Applies to depreciable real property

• Exception: Nonresidential realty classified as §1245 property (i.e., placed in service after 1980 and before 1987, and accelerated depreciation used)

– Intangible real property, such as leaseholds of § 1250 property, is also included




• Section 1250 recapture rarely applies since only the amount of additional depreciation is subject to recapture– To have additional depreciation, accelerated

depreciation must have been taken on the asset• Straight-line depreciation is not recaptured (except for

property held one year or less)– Depreciable real property placed in service after 1986

can generally only be depreciated using the straight-line method

• Therefore, no depreciation recapture potential for such property

– § 1250 does not apply if the real property is sold at a loss

• Section 1250 recapture rarely applies since only the amount of additional depreciation is subject to recapture– To have additional depreciation, accelerated

depreciation must have been taken on the asset• Straight-line depreciation is not recaptured (except for

property held one year or less)– Depreciable real property placed in service after 1986

can generally only be depreciated using the straight-line method

• Therefore, no depreciation recapture potential for such property

– § 1250 does not apply if the real property is sold at a loss


Real Estate 25% Gain(slide 1 of 4)


• Also called unrecaptured §1250 gain or 25% gain– 25% gain is some or all of the §1231 gain

treated as long-term capital gain– Used in the alternative tax computation for net

capital gain

• Also called unrecaptured §1250 gain or 25% gain– 25% gain is some or all of the §1231 gain

treated as long-term capital gain– Used in the alternative tax computation for net

capital gain




• Maximum amount of 25% gain is depreciation taken on real property sold at a recognized gain reduced by:– Certain §1250 and §1245 depreciation recapture

– Losses from other §1231 assets

– §1231 lookback losses

• Limited to recognized gain when total gain is less than depreciation taken

• Maximum amount of 25% gain is depreciation taken on real property sold at a recognized gain reduced by:– Certain §1250 and §1245 depreciation recapture

– Losses from other §1231 assets

– §1231 lookback losses

• Limited to recognized gain when total gain is less than depreciation taken




• Special 25% Gain Netting Rules– Where there is a § 1231 gain from real estate and that

gain includes both potential 25% gain and potential 0%/15% gain, any § 1231 loss from disposition of other § 1231 assets

• First offsets the 0%/15% portion of the § 1231 gain• Then offsets the 25% portion of the § 1231 gain

– Also, any § 1231 lookback loss • First recharacterizes the 25% portion of the § 1231 gain • Then recharacterizes the 0%/15% portion of the § 1231 gain as

ordinary income

• Special 25% Gain Netting Rules– Where there is a § 1231 gain from real estate and that

gain includes both potential 25% gain and potential 0%/15% gain, any § 1231 loss from disposition of other § 1231 assets

• First offsets the 0%/15% portion of the § 1231 gain• Then offsets the 25% portion of the § 1231 gain

– Also, any § 1231 lookback loss • First recharacterizes the 25% portion of the § 1231 gain • Then recharacterizes the 0%/15% portion of the § 1231 gain as

ordinary income




• Net § 1231 Gain Limitation– The amount of unrecaptured § 1250 gain may not

exceed the net § 1231 gain that is eligible to be treated as long-term capital gain

– The unrecaptured § 1250 gain is the lesser of• The unrecaptured § 1250 gain, or • The net § 1231 gain that is treated as capital gain

– Thus, if there is a net § 1231 gain, but it is all recaptured by the 5 year § 1231 lookback loss provision, there is no surviving § 1231 gain or unrecaptured § 1250 gain

• Net § 1231 Gain Limitation– The amount of unrecaptured § 1250 gain may not

exceed the net § 1231 gain that is eligible to be treated as long-term capital gain

– The unrecaptured § 1250 gain is the lesser of• The unrecaptured § 1250 gain, or • The net § 1231 gain that is treated as capital gain

– Thus, if there is a net § 1231 gain, but it is all recaptured by the 5 year § 1231 lookback loss provision, there is no surviving § 1231 gain or unrecaptured § 1250 gain


Related Effects of Recapture(slide 1 of 8)


• Gifts– The carryover basis of gifts, from donor to

donee, also carries over depreciation recapture potential associated with asset

– That is, donee steps into shoes of donor with regard to depreciation recapture potential

• Gifts– The carryover basis of gifts, from donor to

donee, also carries over depreciation recapture potential associated with asset

– That is, donee steps into shoes of donor with regard to depreciation recapture potential




• Inheritance– Death is only way to eliminate recapture

potential– That is, depreciation recapture potential does

not carry over from decedent to heir

• Inheritance– Death is only way to eliminate recapture

potential– That is, depreciation recapture potential does

not carry over from decedent to heir




• Charitable contributions– Recapture potential reduces the amount of

charitable contribution deductions that are based on FMV

• Charitable contributions– Recapture potential reduces the amount of

charitable contribution deductions that are based on FMV




• Nontaxable transactions– When the transferee carries over the basis of the

transferor, the recapture potential also carries over• Included in this category are transfers of property pursuant to

the following:– Nontaxable incorporations under § 351– Certain liquidations of subsidiary companies under § 332– Nontaxable contributions to a partnership under § 721– Nontaxable reorganizations

– Gain may be recognized in these transactions if boot is received

• If gain is recognized, it is treated as ordinary income to the extent of the recapture potential or recognized gain, whichever is lower

• Nontaxable transactions– When the transferee carries over the basis of the

transferor, the recapture potential also carries over• Included in this category are transfers of property pursuant to

the following:– Nontaxable incorporations under § 351– Certain liquidations of subsidiary companies under § 332– Nontaxable contributions to a partnership under § 721– Nontaxable reorganizations

– Gain may be recognized in these transactions if boot is received

• If gain is recognized, it is treated as ordinary income to the extent of the recapture potential or recognized gain, whichever is lower




• Like-kind exchanges and involuntary conversions– Property received in these transactions have a

substituted basis• Basis of former property and its recapture potential

is substituted for basis of new property– Any gain recognized on the transaction will

first be treated as depreciation recapture, then as §1231 or capital gain

• Any remaining recapture potential carries over

• Like-kind exchanges and involuntary conversions– Property received in these transactions have a

substituted basis• Basis of former property and its recapture potential

is substituted for basis of new property– Any gain recognized on the transaction will

first be treated as depreciation recapture, then as §1231 or capital gain

• Any remaining recapture potential carries over




• Installment sales– Recapture gain is recognized in year of sale

regardless of whether gain is otherwise recognized under the installment method

• Installment sales– Recapture gain is recognized in year of sale

regardless of whether gain is otherwise recognized under the installment method




• Property Dividends– A corporation generally recognizes gain on the

distribution of appreciated property to shareholders

– Recapture applies to the extent of the lower of the recapture potential or the excess of the property’s FMV over its adjusted basis

• Property Dividends– A corporation generally recognizes gain on the

distribution of appreciated property to shareholders

– Recapture applies to the extent of the lower of the recapture potential or the excess of the property’s FMV over its adjusted basis




• Sales between related parties– Sales of depreciable assets between related

parties can cause the total gain to be recognized as ordinary income

• Applies to related party sales or exchanges of property that is depreciable in hands of transferee

• Sales between related parties– Sales of depreciable assets between related

parties can cause the total gain to be recognized as ordinary income

• Applies to related party sales or exchanges of property that is depreciable in hands of transferee


If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA [email protected]

SUNY Oneonta

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA [email protected]

SUNY Oneonta

individual income taxes c17-1 chapter 17 property transactions: § 1231 and recapture provisions...

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