Tax 3-6 Analyze a situation to calculate the amount of cost recovery recapture, or unrecaptured Section 1250 income.

Question 1

Section 1250 income

Certain sales of business and rental assets may also receive favorable capital gain treatment under Internal Revenue Code Section 1231. On the sale of an asset, only _____ is reported on the tax return.

(3-6, pg 44)

Answer 1

the gain or loss

The full proceeds of a sale are generally not taxable.

Question 2

Section 1250 income

12. Cindy Hoffman purchased manufacturing equipment several years ago at a cost of $16,000 to use in her business. She claimed $9,716 of cost recovery deductions. She sold the equipment for $8,000.

What is the amount and character of the gain or loss resulting from this disposition?

a. $8,000 ordinary loss
b. $8,000 capital loss
c. $1,716 of ordinary income, $0 long-term capital gain
d. $1,716 long-term capital gain, $0 of ordinary income

(LO 3-6)

Answer 2

c. $1,716 of ordinary income, $0 long-term capital gain

$16,000 Cost Basis
- $9,716 Straight-line Depreciation
= $6,284 Adjusted Basis

$8,000 Amount Realized
- $6,284 Adjusted Basis
= $1,716 Gain Realized and Recognized

Lesser of
$9,716 Straight-line Depreciation
$1,716 Gain Realized and Recognized
= $1,716 Unrecaptured Section 1250 Income

$1,716 Gain Realized and Recognized
- $1,716 Ordinary Income (Unrecaptured Section 1250 Income)
= $0 LTCG (Section 1231 Income)

Question 3

Section 1250 income

13. Julian Kleinrock owns and operates a manufacturing plant as a sole proprietor. He purchased a specialized machine used in the manufacturing process at a cost of $20,000 several years ago. Julian sold the machine for $24,000 after claiming $9,505 of cost recovery deductions.

What is the amount and nature (character) of the gain or loss resulting from this disposition?

1. $9,505 ordinary income, $4,000 long-term capital gain
2. $4,000 ordinary income, $9,505 long-term capital gain
3. $13,505 of ordinary income
4. $13,505 of long-term capital gain

(LO 3-6)

Answer 3

1. $9,505 ordinary income, $4,000 long-term capital gain

$20,000 Cost Basis
- $9,505 Straight-line Depreciation
= $10,495 Adjusted Basis

$24,000 Amount Realized
- $10,495 Adjusted Basis
= $13,505 Gain Realized and Recognized

Lesser of
$9,505 Straight-line Depreciation
$13,505 Gain Realized and Recognized
= $9,505 Unrecaptured Section 1250 Income

$13,505 Gain Realized and Recognized
- $9,505 Ordinary Income (Unrecaptured Section 1250 Income)
= $4,000 LTCG (Section 1231 Income)

Question 4

Section 1250 income

21. Martin Crane owns and operates a business as a sole proprietor. Three years ago, at a cost of $10,000, he purchased an antique desk for his office. He used the straight-line method to recover the cost of the desk. Martin recently sold the desk for $12,500, after taking $5,000 of cost recovery deductions.

What is the amount and nature of the gain resulting from this disposition?

a. $0 of cost recovery recapture, $7,500 of Section 1231 gain
b. $5,000 of cost recovery recapture, $2,500 of Section 1231 gain
c. $10,000 of cost recovery recapture, $2,500 of Section 1231 gain

(LO 3-6)

Answer 4

2. $5,000 of cost recovery recapture, $2,500 of Section 1231 gain

$10,000 Cost Basis
- $5,000 Straight-line Depreciation
= $5,000 Adjusted Basis

$12,500 Amount Realized
- $5,000 Adjusted Basis
= $7,500 Gain Realized and Recognized

Lesser of
$5,000 Straight-line Depreciation
$7,500 Gain Realized and Recognized
= $5,000 Unrecaptured Section 1250 Income

$7,500 Gain Realized and Recognized
- $5,000 Ordinary Income (Unrecaptured Section 1250 Income)
= $2,500 LTCG (Section 1231 Income)

Question 5

Section 1250 income

28. In March of 2016, Jennifer sold her residential rental property for $325,000. Jennifer acquired the property in May 2003 for $225,000, and has been depreciating it using the straight-line method for realty. Assume that the amount of depreciation taken is $90,000. Jennifer is in the 35% marginal income tax bracket.

What is the amount and character of the gain or loss resulting from the sale?

a. $90,000 loss
b. $90,000 unrecaptured Section 1250 income, $100,000 Section 1231 gain
c. $90,000 Section 1231 income, $100,000 unrecaptured Section 1250 income

(LO 3-6)

Answer 5

2. $90,000 unrecaptured Section 1250 income, $100,000 Section 1231 gain

$225,000 Cost Basis
- $90,000 Straight-line Depreciation
= $135,000 Adjusted Basis

$325,000 Amount Realized
- $135,000 Adjusted Basis
= $190,000 Gain Realized and Recognized

Lesser of
$90,000 Straight-line Depreciation
$190,000 Gain Realized and Recognized
= $90,000 Unrecaptured Section 1250 Income

$190,000 Gain Realized and Recognized
- $90,000 Ordinary Income (Unrecaptured Section 1250 Income)
= $100,000 LTCG (Section 1231 Income)

Question 6

Section 1245 Property

To illustrate the Section 1245 rules, assume that Lexicon Inc. purchased office furniture several years ago for $13,000. This year, it sells the office furniture for $12,000. There has been $4,000 of depreciation taken on the furniture. The character of the gain resulting from the sale can be determined as follows:

1. Calculate the gain realized and recognized on the sale:
2. Calculate the Section 1245 recapture—ordinary income:
3. Calculate the Section 1231 gain:

3-6

Answer 6

Step 1:
Calculate the gain realized and recognized
$13,000 Cost Basis
- $4,000 Subtract Straight-line depreciation
= $9,000 Adjusted Basis

$12,000 Amount Realized
- $9,000 Subtract Adjusted Basis
= $3,000 Gain Realized and Recognized

Step 2:
Lower of straight-line depreciation taken or Gain realized and Recognized = Unrecaptured Section 1250 income
$4,000 Straight-line depreciation taken
Or
$3,000 Gain Realized and Recognized
The lower is…
$3,000 Unrecaptured Section 1250 income

Step 3:
Calculate the Section 1231 Gain (“regular” long term capital gain)
$3,000 Gain Realized and Recognized
- $3,000 Subtract Unrecaptured Section 1250 income
= $0 Regular long term capital gain (Section 1231 Income) subject to 15%/20% rates

$3,000 Cost recovery recapture taxed at a ordinary income rates (maximum of 25%)
$0 Section 1231 gain taxed at LTCG rates (usually 15%/20%)

Question 7

Section 1245 Property

To illustrate the Section 1245 rules, assume that Lexicon Inc. purchased office furniture several years ago for $13,000. This year, it sells the office furniture for $15,000. There has been $4,000 of depreciation taken on the furniture. The character of the gain resulting from the sale can be determined as follows:

1. Calculate the gain realized and recognized on the sale:
2. Calculate the Section 1245 recapture—ordinary income:
3. Calculate the Section 1231 gain:

3-6

Answer 7

1. Calculate the gain realized and recognized on the sale:

$13,000 Cost Basis
- $4,000 Straight-line Depreciation
= $9,000 Adjusted Basis

$15,000 Amount Realized
- $9,000 Adjusted Basis
= $6,000 Gain Realized and Recognized

Lesser of
$4,000 Straight-line Depreciation
$6,000 Gain Realized and Recognized
= $4,000 Unrecaptured Section 1250 Income

$6,000 Gain Realized and Recognized
- $4,000 Ordinary Income (Unrecaptured Section 1250 Income)
= $2,000 LTCG (Section 1231 Income)

Question 8

Section 1250

Assume that Dave Garrity sells his residential rental property in March 2016 for $275,000. Dave acquired the property in May 2003 for $200,000, and has been depreciating it using the straight-line method for realty, under MACRS (Table A-6 in Appendix A). The amount of depreciation taken is $95,760. Thus, the property has an adjusted basis of $104,240. The amount and character of the gain is computed as follows:

1. Calculate the gain realized and recognized:
2. Calculate the unrecaptured Section 1250 (25% LTCG) income:
3. Calculate the Section 1231 gain (“regular” long-term capital gain):

(3-6, pg 45 of text)

Answer 8

1. Calculate the gain realized and recognized:

$200,000 Cost Basis
- $95,760 Straight-line Depreciation
= $104,240 Adjusted Basis

$275,000 Amount Realized
- $104,240 Adjusted Basis
= $170,760 Gain Realized and Recognized

Lesser of
$95,760 Straight-line Depreciation
$170,760 Gain Realized and Recognized
= $95,760 Unrecaptured Section 1250 Income

$170,760 Gain Realized and Recognized
- $95,760 Ordinary Income (Unrecaptured Section 1250 Income)
= $75,000 LTCG (Section 1231 Income)

In this example, we have total gain recognized (Section 1231 gain) of $170,760, comprised of $95,760 of unrecaptured Section 1250 income, taxed at a maximum rate of 25%, and $75,000 of “regular” long-term capital gain, eligible for the maximum 15% or 20% long-term capital gain rate. Note that there is NO recapture here. The entire gain is treated as long-term capital gain under Section 1231. Remember that “recapture” means to treat a portion of the gain as ordinary income. If the straight-line method was used to depreciate the property, or if the property is fully depreciated, there is no recapture, and the entire gain is long-term capital gain income. The “un” in “unrecaptured Section 1250 income” is to indicate that there is no recapture—no ordinary income.

Question 9

Section 1250 income

End of Chapter Questions

1. Mary Grey owns and operates a business as a sole proprietor. She purchased office furniture several years ago at a cost of $4,500 to use in her business. She used the MACRS seven-year percentages to recover the cost of the furniture. Mary claimed $3,295 of cost recovery deductions. She sold the
   furniture for $3,000.

Calculate the amount and nature (character) of the gain or loss resulting from this disposition.

3-6 pg 48

Answer 9

$1,795 of Section 1245 gain (ordinary income); $0 of Section 1231 gain

$4,500 Cost Basis
- $3,295 Straight-line Depreciation
= $1,205 Adjusted Basis

$3,000 Amount Realized
- $1,205 Adjusted Basis
= $1,795 Gain Realized and Recognized

Lesser of
$3,295 Straight-line Depreciation
$1,795 Gain Realized and Recognized
= $1,795 Unrecaptured Section 1250 Income

$1,795 Gain Realized and Recognized
- $1,795 Ordinary Income (Unrecaptured Section 1250 Income)
= $0 LTCG (Section 1231 Income)

The gain attributable to the depreciation is “recaptured” as ordinary income under Section 1245.

Question 10

Section 1250 income

End of Chapter Questions

2. John Heinz owns and operates a dry cleaning business as a sole proprietor. He purchased new pressing equipment (seven-year property) several years ago at a cost of $6,750 to use in his business. He used straight-line cost recovery to recover the cost of the pressing equipment. John sold the pressing equipment for $5,000 after claiming $1,929 of cost recovery deductions.

Calculate the amount and nature (character) of the gain or loss resulting from this disposition.

3-6 pg 48

Answer 10

$179 of Section 1245 gain (ordinary income); $0 of Section 1231 gain

$6,750 Cost Basis
- $1,929 Straight-line Depreciation
= $4,821 Adjusted Basis

$5,000 Amount Realized
- $4,821 Adjusted Basis
= $179 Gain Realized and Recognized

Lesser of
$1,929 Straight-line Depreciation
$179 Gain Realized and Recognized
= $179 Unrecaptured Section 1250 Income

$179 Gain Realized and Recognized
- $179 Ordinary Income (Unrecaptured Section 1250 Income)
= $0 LTCG (Section 1231 Income)

Note that under Section 1245, it does not matter whether the depreciation is calculated under the accelerated or straight-line method. The depreciation is still subject to recapture.

Question 11

Section 1250 income

End of Chapter Questions

3. Louise Neri owns and operates a kennel and veterinary hospital as a sole proprietor. She purchased a new computer several years ago at a cost of
   $7,000 to use in her business. She used the MACRS five-year percentages to recover the cost of the computer. Louise sold the computer for $1,000 after
   claiming $4,312 of cost recovery deductions. Calculate the amount and nature (character) of the gain or loss resulting from this disposition.

3-6 pg 48

Answer 11

$1,688 of Section 1231 loss—this is treated as an ordinary loss

Calculate the gain realized and recognized on the sale:

$7,000 cost basis
- $4,312 recovery deductions
= $2,688 adjusted basis

$1,000 Amount realized
- $2,688 adjusted basis
= $1,688 Loss realized and recognized

Question 12

Section 1250 income

End of Chapter Questions

4. Julio Gallardo owns and operates a manufacturing plant as a sole proprietor. He purchased a machine used in the manufacturing process at a cost of
   $12,000 several years ago. He used the MACRS seven-year percentages to recover the cost of the machine. Julio sold the machine for $16,000 after claiming $3,184 of cost recovery deductions.

Calculate the amount and nature (character) of the gain or loss resulting from this disposition.

3-6 pg 48

Answer 12

$3,184 of Section 1245 gain (ordinary income); $4,000 of Section 1231 gain

$12,000 Cost Basis
- $3,184 Straight-line Depreciation
= $8,816 Adjusted Basis

$16,000 Amount Realized
- $8,816 Adjusted Basis
= $7,184 Gain Realized and Recognized

Lesser of
$3,184 Straight-line Depreciation
$7,184 Gain Realized and Recognized
= $3,184 Unrecaptured Section 1250 Income

$7,184 Gain Realized and Recognized
- $3,184 Ordinary Income (Unrecaptured Section 1250 Income)
= $4,000 LTCG (Section 1231 Income)

Question 13

Section 1250 income

End of Chapter Questions

5. Mark Johnson owns and operates a business as a sole proprietor. He purchased antique office furniture several years ago at a cost of $8,000 to use in his business. He used the MACRS seven-year percentages to recover the cost of the furniture. Mark claimed $5,858 of cost recovery deductions. He sold the furniture for $11,500.

Calculate the amount and nature (character) of the gain or loss resulting from this disposition.

3-6 pg 48

Answer 13

$5,858 of Section 1245 gain (ordinary income); $3,500 of Section 1231 gain

$8,000 Cost Basis
- $5,858 Straight-line Depreciation
= $2,142 Adjusted Basis

$11,500 Amount Realized
- $2,142 Adjusted Basis
= $9,358 Gain Realized and Recognized

Lesser of
$5,858 Straight-line Depreciation
$9,358 Gain Realized and Recognized
= $5,858 Unrecaptured Section 1250 Income

$9,358 Gain Realized and Recognized
- $5,858 Ordinary Income (Unrecaptured Section 1250 Income)
= $3,500 LTCG (Section 1231 Income)

The gain created by the depreciation ($5,858) is “recaptured” as ordinary income under Section 1245. The gain created by actual appreciation of the property ($3,500) is potential long-term capital gain under Section 1231.

Question 14

Section 1250 income

End of Chapter Questions

6. Lucy Young sells her residential rental property in March 2016 for $350,000. Lucy acquired the property in May 2003 for $250,000 and has been depreciating it using the straight-line method for realty, under MACRS (Table A-6 in Appendix A). The amount of depreciation taken is $119,700.

Determine the amount and character of the gain recognized as a result of the sale.

3-6 pg 48

Answer 14

$119,700 of unrecaptured Section 1250 income (25% long-term capital gain); $100,000 of “regular” long-term capital gain

$250,000 Cost Basis
- $119,700 Straight-line Depreciation
= $130,300 Adjusted Basis

$350,000 Amount Realized
- $130,300 Adjusted Basis
= $219,700 Gain Realized and Recognized

Lesser of
$119,700 Straight-line Depreciation
$219,700 Gain Realized and Recognized
= $119,700 Unrecaptured Section 1250 Income

$219,700 Gain Realized and Recognized
- $119,700 Ordinary Income (Unrecaptured Section 1250 Income)
= $100,000 LTCG (Section 1231 Income)

Question 15

Section 1250 income

End of Chapter Questions

7. David Christy sells his commercial rental property in July 2016 for $575,000. David acquired the warehouse in May 1998 for $185,000 and has been depreciating it using the straight-line method for realty, under MACRS (Table A-7 in Appendix A). The amount of depreciation taken is $85,980.

Determine the amount and character of the gain recognized as a result of the sale.

3-6 pg 49

Answer 15

$85,980 of unrecaptured Section 1250 income (25% long-term capital gain); $390,000 of “regular” long-term capital gain

$185,000 Cost Basis
- $85,980 Straight-line Depreciation
= $99,020 Adjusted Basis

$575,000 Amount Realized
- $99,020 Adjusted Basis
= $475,980 Gain Realized and Recognized

Lesser of
$85,980 Straight-line Depreciation
$475,980 Gain Realized and Recognized
= $85,980 Unrecaptured Section 1250 Income

$475,980 Gain Realized and Recognized
- $85,980 Ordinary Income (Unrecaptured Section 1250 Income)
= $390,000 LTCG (Section 1231 Income)

Question 16

Practice Exam 2

Section 1250 income

2. Suzy Oldman, a single taxpayer, sells her residential rental property in March 2016 for $400,000. Suzy acquired the property in July 2006 for $300,000 and has been depreciating it using the straight-line method for realty, under MACRS. Assume that the amount of depreciation taken is $114,000. Suzy has taxable income of $225,000, and is in the 33% marginal income tax bracket.

What is the amount and character of the gain recognized as a result of the sale?

a. $114,000 gain taxed at 25%, $100,000 gain taxed at 15%
b. $114,000 gain taxed at 28%, $100,000 gain taxed at 15%
c. $214,000 gain taxed at 15%
d. $214,000 gain taxed at 25%

(LO 3–6)

Answer 16

$114,000 gain taxed at 25%, $100,000 gain taxed at 15%

$300,000 Cost Basis
- $114,000 Straight-line Depreciation
= $186,000 Adjusted Basis

$400,000 Amount Realized
- $186,000 Adjusted Basis
= $214,000 Gain Realized and Recognized

Lesser of
$114,000 Straight-line Depreciation
$214,000 Gain Realized and Recognized
= $114,000 Unrecaptured Section 1250 Income

$214,000 Gain Realized and Recognized
- $114,000 Ordinary Income (Unrecaptured Section 1250 Income)
= $100,000 LTCG (Section 1231 Income)

Question 17

Practice Test 2

Section 1250 income

29. Mary Johnson owns and operates a business as a sole proprietor. Several years ago, she purchased office furniture at a cost of $9,000 to use in her business. She used the straight-line method to recover the cost of the furniture. She claimed $3,214 of cost recovery deductions. She sold the furniture for $10,500.

What is the amount and nature (character) of the gain resulting from this disposition?

a. no Section 1245 gain, $4,714 Section 1231 gain
b. $1,500 Section 1245 gain, $3,214 Section 1231 gain
c. $3,214 Section 1245 gain, $1,500 Section 1231 gain
d. $4,714 Section 1245 gain, no Section 1231 gain

(LO 3–6)

Answer 17

c. $3,214 Section 1245 gain, $1,500 Section 1231 gain

$9,000 Cost Basis
- $3,214 Straight-line Depreciation
= $5,786 Adjusted Basis

$10,500 Amount Realized
+ $5,786 Adjusted Basis
= $4,714 Gain Realized and Recognized

Lesser of
$3,214 Straight-line Depreciation
$4,714 Gain Realized and Recognized
= $3,214 Unrecaptured Section 1250 Income

$4,714 Gain Realized and Recognized
- $3,214 Ordinary Income (Unrecaptured Section 1250 Income)
= $1,500 LTCG (Section 1231 Income)

Therefore:
$3,214 Cost recovery recapture taxed at a ordinary income rates (maximum of 25%)
$1,500 Section 1231 gain taxed at LTCG rates (usually 15%/20%)

Question 18

Practice Test 2

Section 1250 income

30. Two years ago, Morton Andreson purchased equipment (seven-year property) for use in his business at a cost of $12,000. Cost recovery deductions total $7,392. The equipment was sold for $13,000.

What is the amount of cost recovery deductions, if any, that must be recaptured?

$1,392

$4,608

$6,000

$7,392

(LO 3–6)

Answer 18

$7,392

$12,000 Cost Basis
- $7,392 Straight-line Depreciation
= $4,608 Adjusted Basis

$13,000 Amount Realized
- $4,608 Adjusted Basis
= $8,392 Gain Realized and Recognized

Lesser of
$7,392 Straight-line Depreciation
$8,392 Gain Realized and Recognized
= $7,392 Unrecaptured Section 1250 Income

$8,392 Gain Realized and Recognized
- $7,392 Ordinary Income (Unrecaptured Section 1250 Income)
= $1,000 LTCG (Section 1231 Income)

Therefore:
$7,392 Cost recovery recapture taxed at a ordinary income rates (maximum of 25%)
$1,000 Section 1231 gain taxed at LTCG rates (usually 15%/20%)

Question 19

10. Two years ago, Maxwell Anderson purchased a computer (five-year property) for use in his business at a cost of $12,000. Cost recovery deductions total $7,392. The computer was sold for $6,000.

What is the amount of cost recovery deductions, if any, that must be recaptured?

$0

$1,392

$4,608

$6,000

$7,392

(LO 3-6)

Answer 19

$1,392

$12,000 Cost Basis
- $7,392 Straight-line Depreciation
= $4,608 Adjusted Basis

$6,000 Amount Realized
- $4,608 Adjusted Basis
= $1,392 Gain Realized and Recognized

Lesser of
$7,392 Straight-line Depreciation
$1,392 Gain Realized and Recognized
= $1,392 Unrecaptured Section 1250 Income

$1,392 Gain Realized and Recognized
- $1,392 Ordinary Income (Unrecaptured Section 1250 Income)
= $0 LTCG (Section 1231 Income)

Therefore:

$1,392 Cost recovery recapture taxed at a ordinary income rates (maximum of 25%)
$0 Section 1231 gain taxed at LTCG rates (usually 15%/20%)

Question 20

Practice Test 1

14. Three years ago, Sammy Jurgenson purchased specialized manufacturing equipment (seven-year property) at a cost of $56,000. He paid an additional $4,000 to have the equipment installed in his plant. Cost recovery deductions total $40,935. This type of specialized equipment became more and more scarce, and this year, Sammy sold the equipment for $73,000.

What is the amount and character of the gain resulting from this sale?

a. no Section 1245 gain, $53,935 Section 1231 gain
b. $40,935 Section 1245 gain, $13,000 Section 1231 gain
c. $40,935 Section 1245 gain, $17,000 Section 1231 gain
d. $57,935 Section 1245 gain, no Section 1231 gain

(LO 3-6)

Answer 20

b. $40,935 Section 1245 gain, $13,000 Section 1231 gain

$60,000 Cost Basis
- $40,935 Straight-line Depreciation
= $19,065 Adjusted Basis

$73,000 Amount Realized
- $19,065 Adjusted Basis
= $53,935 Gain Realized and Recognized

Lesser of
$40,935 Straight-line Depreciation
$53,935 Gain Realized and Recognized
= $40,935 Unrecaptured Section 1250 Income

$53,935 Gain Realized and Recognized
- $40,935 Ordinary Income (Unrecaptured Section 1250 Income)
= $13,000 LTCG (Section 1231 Income)