Chapter 13 - Weber PDF

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Tax – Review Tax 1. Source of Rules? IRC  Congress  Treasury Department Regulations  Interpret & “Codify” Court cases  Interpret Other Admin. Pronouncements 2. Raise revenue for government  social engineering  Only deduct expense when incurred

Financial Accounting 1. FASB (SEC) Financial performance  Best measure of economic performance 2. Audit Standards  Enron  PCAOB

Chapter 13 FIXED year) -

ASSETS (§1231 – held > 1 Land Buildings Equipment/machines Cars/vans/busses Computers

Real Estate (§1250) - Land - Buildings

Personal Property (§1245) - Equipment/machi nes - Cars - Furniture - Computers

Calculation of Gain or Loss Amount Realized (Adjusted Basis of Property Sold/Exchanged) Realized Gain or Loss

RECOGNIZED GAIN OR LOSS???? To Calculate Amount Realized: Selling Price* (Costs of Sale)** Amount Realized

*Selling Price = Cash received + FMV of property received + debt assumed by buyer **Costs of Sale = commissions, legal fees, escrow fees, title transfer fees To Calculate Adjusted Basis: Initial Basis* + Capital Additions** (Capital Recoveries)*** Adjusted Basis *Initial basis = more on that later **Capital additions – expenditures that add value to the property, prolong the life of property, or adapt the property to new/different use Capital Asset  Is NOT: o Inventory o Accounts receivable o Literary, artistic, musical composition held by taxpayer that created property o Depreciable property, or land, used in a trade or business (in other words, Fixed Assets)  3 Uses of Property EXCLUDED 1. Business useX Capital 2. Personal use Assets 3. Investment  28% LTCG Collectible  28% LTCL  LTCG  0%/15%/20%  LTCL  Net Losses limited to $3,000  STCG  Ordinary Income rate  STCL  Net Losses limited to $3,000 (for NET CAPITAL LOSS)  RATHER HAVE AN ORDINARY LOSS Example of Netting 28% LTCG 50,000 26,00 28% LTCL (24,000) 28% LTCG 0/15/20 LTCG 8,000 19,000 28% Net LTCG (7,000 LTCL (15,000) 15,000 STCG 10,000 STCL (14,000) (4,000 Example of Netting 28% LTCG 50,000 26,00 26,000 28% LTCL (24,000) 0/15/20 LTCG 15,000 7,000 22,000 28% LTCG 7,000 LTCL (8,000) 7,000 0/15/20 LTCG STCG 10,000 STCL (14,000) (4,000 Examples of Netting 28% LTCG 24,000 (26,000

28% LTCL 0/15/20 LTCG LTCL STCG STCL

(50,000) 15,000 7,000 (8,000) 10,000 (14,000) (4,000

28% LTCL (19,000)

(19,000) Net LTCL 28% (4,000) Net STCL Deduct $3,000 out of ST 1st Carry $20,000 forever

§1231 Property  Depreciable (real or personal) property used in a trade or business, held for > 1 year, AND “real property” (land) used in a trade or business and held for > 1 year  Federal tax treatment of §1231 property provides the VERY BEST of potential results for the taxpayer o Ordinary loss that is fully deductible FOR AGI o Capital gains subject to the lower capital gains tax rates  WIN-WIN for taxpayers  §1231 is a VERY taxpayer-friendly provision  Note that to determine capital gain v. ordinary loss treatment, we ONLY look at NET §1231 gains/losses  We do NOT characterize the gain/loss on sales of individual assets. Before netting, the gains/losses are simply known as a §1231 gains or losses…we determine the character only after netting §1231 Example Example: Taxpayer A had the following gains/losses from the sale of Section 1231 assets during the year: Asset #1: $40,000 Asset #2: Asset #3: $12,000 Netting these three, net GAIN = $7,000. So, $40,000 and $12,000 gains are LTCGs, and the $45,000 loss is a LTCL, netting to a net LTCG of $7,000, subject to the exceptions coming… Eroding Benefits of §1231  §1231 is such a win-win for taxpayers, Congress has “chipped away” at its benefits over the years.  Five key provisions that erode §1231 benefits: o 5-year look-back rule (1985) ONLY WITH CURRENT YEAR LTCG 2019 – Net §1231 GAIN 15,000 --- 6,000 OI 9,000 LTCG 2018 (4,000)  OL 2017 (2,000)  OL 2016 3,000  Ordinary Gain (to extent of past unrecaptured loss) 2015 (2,000)  OL 2014 (1,000)  OL 2019 – Net §1231 GAIN 15,000 --- 7,000 OI 8,000 LTCG 2018 (4,000)  OL (7,000)

2017 2016 2015 2014

(2,000)  OL 2,000  OI (2,000)  OL (1,000)  OL

(3,000) (1,000) (3,000) (1,000)

In 2019, taxpayer has $15,000 of NET Sec. 1231 gains. In addition, the taxpayer has the following NET §1231 gains and losses from prior years: 2018 $ 2,000 gain 0 2017 8,000 gain (1,000) 2016 6,000 loss (9,000) 2015 3,000 loss (3,000) 2014 12,000 gain What is the character of the $15,000 NET Sec. 1231 gain in 2019? ALL CAPITAL GAIN

o

In 2019, taxpayer has $15,000 of NET Sec. 1231 gains. In addition, the taxpayer has the following NET §1231 gains and losses from prior years: 2018 $ 2,000 loss (10,000) 2017 8,000 gain (8,000) 2016 6,000 loss (16,000) 2015 10,000 loss (10,000) 2014 3,000 gain What is the character of the $15,000 NET Sec. 1231 gain in 2019? 10,000 OI 5,000 LTCG §1245 depreciation recapture (1962) Motivation: To the extent  Applies to tangible and intangible that the taxpayer received depreciable personal property ORDINARY depreciation held more than one year deductions, which in turn  Nonresidential realty using reduced the assets’ bases, accelerated methods of ACRS the taxpayer should not placed in service 1981-86 recognize a capital gain  Overrides §1231  Characterizes as Section 1245 depreciation recapture (ORDINARY INCOME) that portion of the gain attributable to prior depreciation deductions (A/D for asset)  Method of depreciation does not matter  Section 179 deductions and “bonus” depreciation treated just like any other depreciation  Compute the gain or loss. If it's a gain, that gain is ordinary to the extent of prior depreciation. In other words, to the extent of accumulated depreciation. Everything else is 1231 gain.

Example #1: Machinery is purchased for $20,000 in 2015. It is sold for $8,000 in 2019 when accumulated depreciation is $14,000. What is the character of the gain/loss? AR 8,000 (AB) (6,000) [20,000-14,000] R & R GAIN 2,000 §1245 OI Dep. Recap. Example #2: Machinery is purchased for $20,000 in 2015. It is sold for $5,000 in 2019 when accumulated depreciation is $14,000. What is the character of the gain/loss? AR 5,000 (AB) (6,000) [20,000-14,000] R & R LOSS (1,000) §1231 Loss (DO NOT KNOW IF IT IS ORDINARY OR CAPITAL) Example #3: Machinery is purchased for $20,000 in 2015. It is sold for $23,000 in 2019 when accumulated depreciation is $14,000. What is the character of the gain/loss? AR 23,000 (AB) (6,000) [20,000-14,000] R & R GAIN 17,000 14,000 §1245 OI, 3,000 §1231 o §1250 depreciation recapture (1964)  Applies to depreciable real property held more than one year  Except nonresidential realty using accelerated methods of ACRS placed in service 1981-86  Overrides §1231  Depreciation recapture (ORDINARY INCOME) that portion of the gain attributable “excess depreciation”  “Excess depreciation” is the excess of accelerated depreciation taken on an asset since it was placed into None in this service over what would have been deductible if straightl line depreciation had been used o If straight-line depreciation has been taken on real property, no depreciation recapture potential exists under §1250 o All real property acquired after 1986 must use straight-line depreciation  Therefore, no depreciation recapture potential for such property  A/D (ACTUAL) - A/D (AS IF S/L)  Real Estate depreciated  straight-line  Real property placed in service before 1987 is generally fully depreciated. Therefore, there is no excess

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accelerated depreciation over straight-line for these older assets.  Post-1986 MACRS rules for using straight-line depreciation for real property eliminate possibility of Section 1250 recapture  Unlikely to occur except for certain leasehold improvements Anything within the last 39 year years does not have excess depreciation Example: Building was purchased in 2002 for $800,000. It is sold in 2019 for $1,200,000, when accumulated depreciation (MACRS – 39 year straight line) is $350,000. What is the character of the gain/loss? AR 1,200,000

o

(AB) (450,000) [800,000-350,000] §1231 GAIN R & R GAIN 750,000 Unrecaptured §1250 gains/25% gains (1997)  Applies only to individual taxpayers  Applies only to the sale of real property held > 1 year  Still considered Section 1231 gain  Does not change character of gain, instead changes MAXIMUM TAX RATE applied  Any gain on sale of real estate that would have been Section 1245 ordinary income depreciation recapture if the property was PERSONALTY rather than real estate is unrecaptured Section 1250 gain, subject to a maximum tax rate of 25% (ordinary rates up to 25%) Example: Building was purchased in 2002 for $800,000. It is sold in 2019 for $1,200,000, when accumulated depreciation (MACRS – 39 year straight line) is $350,000. What is the character of the gain/loss? (IF INDIVIDUAL) AR 1,200,000 (AB) (450,000) [800,000-350,000] R & R GAIN 750,000 §1231 GAIN 0/15/20 25% 400,000 350,000 

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%/20% gain, any § 1231 loss from disposition of other § 1231 assets: o First offsets the 0%/15%/20% portion of the § 1231 gain

o

Then offsets the 25% portion of the § 1231 gain

R & R GAIN 750,000

§1231 GAIN 0/15/20 25% 400,000 350,000 (150,000) **TAKE OUT OF

0/15/20 Other Asset  §1231 LOSS of (150,000) Net §1231 GAIN = 600,000 

Also, any § 1231 lookback loss o First recharacterizes the 25% portion of the § 1231 gain o Then recharacterizes the 0%/15%/20% portion of the § 1231 gain as ordinary income

R & R GAIN 750,000 §1231 GAIN 0/15/20 25% 400,000 350,000 275,000**TAKE OUT OF 0/15/20 Lookback LOSS of (75,000) Example #1: Building was purchased in 2002 for $800,000. It is sold in 2019 for $1,200,000, when accumulated depreciation (MACRS – 39 year straight line) is $350,000. What is the character of the gain/loss and, if a gain, at what rate will it be taxed, assuming $1 million of taxable income, no NONRECAPTURED Section 1250 losses in the past five years, and no other Section 1231 transactions this year? AR 1,200,000 (AB) (450,000) (800,000-350,000) GAIN 750,000 §1231 GAIN 0/15/20 25% 400,000 350,000 1,750,000 TI 400,000 20% 350,000 25% Example #2: Building was purchased in 2002 for $800,000. It is sold in 2019 for $700,000, when accumulated depreciation (MACRS – 39 year straight line) is $350,000. What is the character of the gain/loss and, if a gain, at what rate will it be taxed, assuming $1 million of taxable income, no NONRECAPTURED Section 1250 losses in the past five years, and no other Section 1231 transactions this year? AR 700,000

(AB) GAIN

(450,000) (800,000-350,000) 250,000 §1231 GAIN 0/15/20 25% -0250,000

1,750,000 TI 250,000 o

25%

§291 depreciation recapture (1982)  Provision applies only to C corporations  Provision applies only to sale of depreciable real property  § 291 Recap=20 % ( “ As if ” § 1245 of Recap – Actual § 1250 Recap ) ↑ Always 0 Example: In 2019, Orange Corporation sold a building for $2,000,000. The building had been purchased for $1,500,000 in 2002, and at the time of the sale had $600,000 of accumulated depreciation. What is the character of the gain? AR 2,000,000 (AB) (900,000) (1,500,000 – 600,000) R & R GAIN 1,100,000 §291 Recap §1231 120,000 980,000 @ 21% @ 21% LTCG

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Installment Sales of Depreciable Assets o All recapture gain (Section 1245) is recognized in year of sale regardless of whether gain is otherwise recognized under the installment method. Example: Equipment with a cost of $100,000 and accumulated depreciation of $60,000 is sold for $85,000. $20,000 is received immediately, and $20,000 (plus interest) per year will be received over the next three years. In the year of sale, the entire gain of $45,000 (all Section 1245 ordinary income recapture) must be recognized in the year of sale. AR 85,000 (AB) (40,000) (100,000 – 60,000) R & R GAIN 45,000 §1245 OI GAIN

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§1239 o Sales between related parties o Sales of depreciable assets between related parties can cause the total gain to be recognized as ordinary income o Applies to related party sales or exchanges of property that is depreciable in hands of transferee o Provision exists to prevent taxpayers from selling depreciable assets to related parties, thus paying capital gain rates to “step up” basis of

assets for the related party, resulting in higher depreciation (ordinary) deductions 

See folder for notes on loose leaf (you were a dumbass and forgot your backpack that day)...