Module 6: Tax Consequences of Property Transactions Flashcards
Two categories of property that financial planners should identity when analyzing that property
- Characteristics or attributes of the property itself
2. The activity in which the property is used, or the purpose for which it is held by the taxpayer
Capital Assets
Personal use assets and most investment assets.
What type of Capital Assets are deductible
generally personal use asset losses are not deductible but investment assets losses are.
Capital Assets are defined by exclusion, so what is considered a Noncapital asset/ordinary income asset?
- Accounts receivable or notes receivable of a trade or a business
- Copyrights and creative works held by the creator
- Inventory or property held for sale to customers in a taxpayer’s trade or business
- Depreciable personal and real property used by a business (section 1231 property)
Other “Section 1231” property
timber, coal, and iron ore, livestock, unharvested crops and goodwill and intangibles
Holding Period
the length of time that a taxpayer has owned an asset of any type
What days are counted and not counted in the holding period?
- Day of disposition is counted, day of acquisition is not
Recovery of Capital Doctorine
allows taxpayers to recover the cost or other original basis of property tax free.
Gift Property Holding Period Issues
- if the donor’s basis carries over to the donee, the donor’s holding period is added to the donee’s holding period.
Inherited Property Holding Period Issues
Treated as LT regardless of the actual original holding period
Section 1031 Nontaxable Exchange holding period issues
The holding period of the property surrendered int he exchange carries over to the holding period of the like-kind property received
Mark-to-market rules Holding Period Issues
- regulated futures contracts and certain other contracts are treated as though they were sold on the last day of the taxable year; capital gains or losses are treated as 40% ST and 60% LT
Worthless Securities Holding Period Issues
If securities that are capital assets become worthless, they are treated as though they were sold or disposed of on the last day of the tax year.
Qualified Dividend Criteria
- the dividend is declared and paid by a domestic or qualified foreign corporation
- The stock is held for more than 61 days during the 121 day period beginning 60 days before the ex-dividend date
- the dividend must generally be paid from a stock or regulated investment company
Cost Basis
The amount that was paid for an assed
Carryover Basis
The basis tied to the donor that had the asset before the gift
Stepped-Up Basis
The fair market value of the asset on the date of death
What does it mean to capitalize costs?
It means to include the cost in basis rather than deduct the cost as an expense.
Examples of Capitalized costs?
Sales tax, freight costs, setup and installation of an asset must be included in the basis of the asset and recovered through depreciation, if the asset is depreciable
Establishing a Gifts cost basis
The basis of an asset acquired by a gift is generally the donor’s basis. Unless the FMV on the date of the gift is less than the donor’s basis in the asset, the donee’s basis in the asset for purposes of determining a loss on the sale of the asset will be thea sset’s fair market value on the date of the gift.
Establishing Inheritance Cost Basis
Generally the basis in the aset if the FMV on the date of death. The basis may also be stepped-down to FMV in the case of an asset that has lost value since purchase.
Adjusted Basis
Refers to the original basis in the property, increased by any adjustments such as acquisition cost or improvements, and reduce by any adjustments ot basis, such as depreciation deductions taken and the Section 179 adjustment.
Substituted Basis
The propertys FMV less any deferred gain or plus any postponed loss; its most notable application is a nontaxable exchange of qualifying real property (like an in-kind exchange).
Improvements vs. Repairs for Basis
Improvements increase original basis while repairs do not add to or impact the original basis
Types of expenditures when you purchase or hold an asset
- Non-deductible (personal)
- currently deductible (Section 162)
- Not currently deductible BUT can be recovered over a specified period (Capital Expenditure)
Depreciation/Modified Accelerated Cost Recovery System (MACRS)
This is a broad heading of depreciation, the method that fall under this broad head include:
- bonus depreciation
- accelerated depreciation
- straight line depreciation
- Section 179 expensing
What does it mean to be a “wasting” asset
One that decreases in value over time, due to exhaustion, wear and tear or obsolescence.
The four periods/useful lives under MACRS to which assets are assigned:
5 years, 7 years, 27.5 years and 39 years
Determining Depreciation Percentages
10 years or less: 200% declining balance
15 and 20 year properties: 150% declining balance
27.5 and 39 year properties: the cost recovery percentages are calculated using a straight-line method.
The 200% Declining Balance Method
Unlike other methods, this method states that we must reduce the basis before computing next years depreciation.
The 200% Declining Balance Method Calculation
- find the straight line rate for this property
- double the straight line rate
- take the straight line rate * the property value * 1/2 = first year deduction
Second Year deduction:
Start with basis of 75k and reduce that by the first years depreciation number
- then multiply that by twice the straight line method for the first year
repeat the second year deduction continually
Straight-line depreciation method
Assumes that depreciation is uniform throughout the useful life of the asset. The cost or adjusted basis of the asset is deducted in relatively equal installments over the asset’s useful life
Straight-Line Depreciation Method Calculation
SL = cost basis / useful life
The first year may be reduced by half due to the half-year convention
Mid-Quarter Convention
This is used to reduce the benefits of the half-year convention for personal property (not real property) placed in service late in the year of acquisition.
Mid-Quarter Convention Calculation
If, during the tax year, the total basis of depreciable personalty placed in service during the last three months of the year exceeds 40% of the total basis of all depreciable personalty placed in service during that year, the taxpayer must use mid-quarter convention. A quarter of convention consists of three months.
Alternative Depreciation System (ADS)
This must be used when the listed property is used 50% of less in business.
- ADS must also be used for puro=poses of making certain alternative minimum tax adjustments, assets used outside the US, tax-exempt bond financed assets, and assets imported from certain countries that maintain discriminating trade restrictions.
Examples of Property that would use ADS
- Automobiles, entertainment assets, computers and phones
Section 197 assets
Intangible assets of a trade or business are amrotizable over a period of (useful life) of 15 years
Examples of Section 197 assets
- goodwill
- trademarks.
- covenants not to compete
- copyrights
- patents
Depletion
Natural resources are subject to depletion. The owner is entitles to a deduction for AGI to recover the costs of exchausting the natural resources
Types of depltion methods
Cost Depletion
Percentage depletion
Cost Depletion
The asset basis is divided by the total number of recoverable units of the asset and then multiplied by the number units sold (not produced) to determine the amount of the deduction in for the year.
Percentage Depletion
A statutory percentage is applied to the gross income from the property (limited to 50% of gross income); this method is unrelated to the cost basis of the asset. PErcentage depletion is the more aggressive of the two depletion methods. Therefore, the portion of percentage depletion that is more than the adjusted basis of the property owned by the taxpayer is the tax preference item for purposes of the individual AMT.
Bonus Deprecation
“additional first year depreciation” This provision allows taxpayers to claim 100% first-year depreciation, or bonus depreciation of 100% of the basis of the asset purchased.
What qualifies property for Bonus Deprecation?
New and used property that will qualify even if the taxpayer didn’t use the property at any time before acquiring it and did not acquire the property from a related party or from a controlled corporation or business.
What does it mean to “Recapture” depreciation?
When a taxpayer purchases real or personal property for use in business and takes cost recovery deductions, it offsets ordinary income, but when they sell the property for a gain, they must look back and recapture all or part of those previous cost recovery deductions.
Section 1231 Property
Any depreciable real property or personal property used in a trade or business or for the production of income. AS such, it encompasses both SEction 1250 property and SEction 1245 property.
Special Tax Rules Associated with the sale or disposition of Section 1231 Property
- Any such property sold at a gain above the purchase price may be afforded capital gain tax treatment. If previous depreciation has been taken exceeding any recognized gain, this portion is ordinary income to the extent of the previous depreciation taken.
- Any such property sold at a loss if afforded ordinary loss tax treatment (rather than capital loss tax treatment with the 3k limit.
- A taxpayer who has a net Section 1231 gain for the current year must report the gain as ordinary income to the extent of any section 1231 losses reported within the past five taxable years
Section 1245 Property
Depreciable tangible personal property used in a trade or business. Section 1245 recapture requires any recognized gain on the sale of Section 1245 property to be treated as ordinary income to the extent of any depreciation taken. It’s also termed “full recapture” for this reason.
Section 1250 Property
Applies to depreciable real property used ina. a trade or business or for the production of income, that is, real estate that is a section 1231 asset.
How is section 1250 property taxed?
- the gain attributable to straight-line depreciation is treated as long-term capital gain, subject to a special LTCG tax rate and is taxed at a maximum 25%.
- any gain not attributable to straight-line depreciation will be subject to LTCG rates
- any losses on Section 1250 property do not have any depreciation recapture and are usually treated as section 1231 (ordinary) loss
Section 179 Expense Treatment
Allows for a much larger deduction that would otherwise have been available in the year the property is acquired, but given the 100% bonus depreciation provision, the necessity of it has greatly diminished.
Section 179 Expense Calculation
Allows a dollar-for-dollar taxpayer deduction without reference ot any depreciation percentage. Must use at least 50% for business in the first year that it is placed into service.
What is the maximum deduction
- if the total amount of qualifying property placed in service for a given year is more than 2,620,000 the allowance is reduced dollar-for-dollar for any amount more than that. No carryover is allowed.
- the amount of the deduction cannot exceed the taxable income form the trade or business of the taxpayer (although a carryover is allowed here). A loss cannot be created.
- The taxable income used is without regard to any of the following:
- Section 179 deduction
- The SE tax deduction
- Any net operating loss carryback or carryforward
Section 179 Qualifying Property
- office equipment
- computers
- off-the-shelf computer software
- automobiles and trucks
- office machinery; and
- sports utility vehicles
Realty Property
Land, Anything permanently affixed or attached to the land, and certain items that cannot easily be moved.
Personalty (“personal property”)
Any type of property that is not realty, including items such as automobiles, jewelry, clothing, equipment, and furniture
Long-Term Capital Gains Groups
- collectibles
- unrecaptured Section 1250 gains
- and securities and other gains and losses
How to net capital gains and losses
- group the gains and losses by their respective brackets
- net same kinds gains and losses
- take left over losses and net them against the highest gains
When you have STCL and LTCL carryforwards, what happens?
The STCL are used first and the remaining losses carryforward
1031 Exchanges
The IRA provides that no gain or loss is recognized where investment property or business property in exchange solely for property of a like-kind.
What qualifies for a like-kind exchange?
Realty, personalty no longer qualifies for like-kind exchange treatment
Who much ike-kind exchanges go through
It’s important to understand that like-kind exchanges must go through a qualified intermediary, failure to procure the services of such an intermediary will disqualify the exchange for tax purposes
Boot
Typically, cash or other property is involved int e exchange to benefit one party and equalize the exchange, this cas, including an assumption of liabilities or receipt of other property, is known in the tax law as boot and is taxable
Real Estate Example of Boot
In a situation where parties are exchanging real estate, if someone assumes a mortgage they have been given boot, and the party relieved of the debt has received boot in the amount of the liability.
Boot Taxability
- recognition of gain if there is a realized gain
- no recognition if there is a realized loss
Calculating Boot Tax Liability
Set up a table:
Seller 1 Seller 2
FMV
Adjusted Basis
Boot
**Calculate the gain of each seller, the gain is the FMV received MINUS adjusted basis of the property GIVEN UP. Recognized gain is the lesser of the gain realized or boot RECEIVED.
Tax Basis of New Property in a 1031 Exchange
- the adjusted basis of the property sold plus any boot paid
Giving appreciated property as boot
If you give boot not in cash but appreciated other property, the other property is treated as though it had been sold and the gain must be recognized by the first seller.
Calculating Basis in Exchanged Property
Adjusted Basis in Property surrendered \+ Boot given \+ gain recognized - FMV of boot received - loss recognized = new basis in property
Related Party In-Kind Transactions
The taxpayer and the related party must not dispose of the like-kind property received until after two years following the exchange. If the related party transferee does dispose of the property within two years following the exchange, all previously deferred gain is recognized immediately.
Involuntary Conversion
The destruction, theft, seizure, condemnation, sale or exchange of the taxpayer’s property under threat of condemnations. The taxpayer is allowed to postpone recognition of the gain, but they must invest the money in a similar property as a replacement property to defer or postpone the recognition of any gain that is inherent in the amount the taxpayer was paid for on the involuntarily converted property.
Involuntary Conversion Calculation
Amount received from the property minus the amount paid for a similar property = the taxable amount.
What is considered a replacement property for Involuntary Conversion?
Must be similar in service or use to the original property. There are two tests that are used:
- Functional-use Test
- Taxpayer-use test
Functional-use Test
The taxpayer’s use of the replacement property and of the involuntarily converted property must be the same.
Taxpayer-Use Test
The owner-investor’s properties must be used in similar endeavors as the previously held properties. Thus, there is more flexibility with this test than with the functional-use test. For example, the proceeds from a condemned office building may be used to acquire any investment real property (not just another office building)
Time limitation for a condemned replacement property
two year period from the end of the taxable year in which any gain is realized from an involuntary conversion to replace the property, however if it is condemnation of real property by a governmental authority is the reason for the conversion, this period is extended to three years from the end of the taxable year in which any gain is realized.
Replacement Property Time Period for Theft
begins on the date of the property being damaged or stolen and ends on the day of the second taxable year after the year in which the taxpayer realizes a gain with respect to the property
The replacement period for condemnation begins on the earlier of and ends on
the date on which the condemned property was disposed of; or
the date on which the threat of condemnation first occurred
Ends on the last day of the second taxable year following the year in which any part of the gin on the condemnation is realized.
Installment Sale Method of Accounting
Any sale of property in which the seller receives at least one payment after the year of sale. As such, the installment method permits the taxpayer to spread out the taxable gain as payments are received
Installment Sale Method of Accounting Formula
profit/total contract price = gross profit percentage
Under the installment sale method, immediate recognition of remaining gain occurs
- at any time an installment sale is cancelled
- when there is a gift of an installment sale to the obligor-debtor
- when there is a sale of the installment note to another party; or
- when an installment note is pledged as collateral for a loan
Test Tip on Calculating Installment Sale
- The seller has no taxable interest income on the down payment
What is Installment Sale Treatment not Available for?
- property held for sale in the ordinary course of business (inventory); and
- securities traded in the secondary market
Installment Sale Recapture
Gain recapture is taxed as ordinary income and is not eligible for installment sale treatment. These amounts are fully recognized as ordinary income in the year of sale.
Installment Sale Recapture Calculation
- ordinary income recognized in the year of the sale is added to the property’s basis
- this adjusted tax basis is used in determining gross profit in sale.
- If a portion of the gain is attributable to a 25% gain (SL depreciation on real property) then it is recognied before the 20/15/0% gain
Personal Residence Exclusion
Allows a gain exclusion of up to 250k or 500k for any taxpayer who satisfies certain tests.
Ownership Test
The home must have been owned and used as a principal residence for at least two of the five years preceding the date of sale.
Use Test
Either spouse can meet the ownership test, but oth must meet the use test. This is likely not difficult for most married couples, but it can be burdensome for individuals who are divorced or in the process of a divorce
Primarily Personal Use
If the property is rented for fewer than 15 days a year, it is considered a personal residence only, and all rent (without limit) generated during this time ie excluded from the taypayer’s income
Primarily Rental Use
If the residence test is not met this classifies it as a primarily rental use and permits the taxpayer to deduct expenses associated with the rental on Schedule E of IRA 1040 and allows for a possible deduction of rental losses up to $25,000
Mixed Use
if th vacation home meets the residence test then the rental expenses can be deducted only to the textnt of rentla income; no loss may be generated.
