Tax Consequences of the Disposition of Property

Question 1

What is Depreciation?

Answer 1

Depreciation is the systematic allocation of the cost of an asset over its estimated economic life. Using depreciation, taxpayers can deduct a reasonable allowance for the exhaustion, wear and tear, and obsolescence of property.

Question 2

What is ACRS?

Answer 2

Accelerated Cost Recovery System - The term cost recovery rather than depreciation was used under the Accelerated Cost Recovery System (ACRS) system because the costs could be recovered ahead of the economic useful life of the asset.

Question 3

What is Net capital gain

Answer 3

Net capital gain (NCG), which may receive favorable tax treatment, is defined as the excess of net long-term capital gain over net short-term capital loss.

Question 4

Taxation for Capital Gains for artwork etc.

Answer 4

As a general rule, gains resulting from the sale of collectibles such as artwork, rugs, antiques, stamps and most coins are not taxed at the lower tax rates of 0%, 15%, and 20% but may be taxed at a maximum rate of 28%.

Question 5

Capital Loss deduction level

Answer 5

If total short-term capital losses (STCLs) for the tax year exceed total short-term capital gains (STCGs) for that year, the excess is defined as a net short-term capital loss (NSTCL). If the NSTCL exceeds the NLTCG, the capital loss may be offset, in part, against other income. The NSTCL may be deducted in full (that is, on a dollar-for-dollar basis) against a non-corporate taxpayer’s ordinary income for amounts up to $3,000 in any one year.

Question 6

When does the Holding Period qualify as long term?

Answer 6

If the date of disposition is the same date as the date of acquisition, but a year later, the asset is considered to have been held for only one year. If the property is held for an additional day, the holding period is more than one year. For example, Arnie purchased a capital asset on April 20, 2023, and sells the asset at a gain on April 21, 2024, the gain is classified as a long-term capital gain (LTCG). If the asset is sold on or before April 20, 2024, the gain is a short-term capital gain (STCG).

Question 7

Comparing Donee Holding Periods

Answer 7

If an individual receives property as a gift and uses the donor’s basis to determine the gain or loss from a sale or exchange, the donor’s holding period is added to the donee’s holding period

If an individual receives property as a gift, and the donee’s basis is the fair market value (FMV) of the gift less than the donor’s basis and later sold at a loss, the donee’s holding period starts on the date of the gift.

Question 8

Property Received from a Decedent

Answer 8

Property owned by a decedent is typically valued at fair market value (FMV) as of the date of death. That is because the property receives a new federal income tax basis equal to the property’s FMV. The property’s FMV is the amount included in the decedent’s estate for estate tax purposes and becomes the new basis in the inherited property. When the FMV of the property is higher than the pre-death basis, the old basis is “stepped-up” to FMV or is “stepped-down” if the original basis was higher than the date of death value. A sale of the inherited property results in no taxable gain if the new adjusted basis is equal to the amount realized on the sale.

Question 9

Nontaxable Exchanges

Answer 9

In a nontaxable exchange, the basis of the property received is determined by taking into account the basis of the property given in the exchange. If the properties are capital assets or Section 1231 assets, the holding period of the property received includes the holding period of the surrendered property.

Question 10

Receipt of Nontaxable Stock Dividends or Rights

Answer 10

If a shareholder receives nontaxable stock dividends or stock rights, the holding period of the stock received as a dividend or the stock rights received includes the holding period for the stock owned by the shareholder. However, if the stock rights are exercised, the holding period for the stock purchased begins with the date of exercise.

Question 11

Sale of Principal Residence

Answer 11

Taxpayers may elect to exclude up to $250,000 ($500,000 on a joint return) of gain from the sale of a principal residence.

Individuals who sell or exchange their personal residence after May 6, 1997, may exclude up to $250,000 of gain if it was owned and occupied as a principal residence for at least two years of the five-year period before the sale or exchange. A married couple may exclude up to $500,000 when filing jointly if both meet the use test, at least one meets the ownership test and neither spouse is ineligible for the exclusion because he or she sold or exchanged a residence within the last two years.

The Section 121 exclusion is available regardless of age, and taxpayers do not have to purchase a replacement residence. Any gain not excluded is capital gain because a personal residence is a capital asset. A loss on the sale or exchange of a personal residence is not deductible because the residence is personal-use property.

Question 12

Which costs are included in the Realized Gains?

Answer 12

The amount of gain on the sale of the property is called realized gain. Gain realized is the excess of the amount realized over the property’s adjusted basis. The amount realized on the sale of the property is equal to the selling price less selling expenses. Selling expenses include commissions, advertising, deed preparation costs, and legal expenses incurred in connection with the sale.

Question 13

Sale of More Than One Principal Residence

Answer 13

The new exclusion provided by Section 121 applies to only one sale or exchange every two years. A portion of the gain may be excluded in certain circumstances even if the two-year requirement is not satisfied.

If a principal residence is sold within two years of a previous sale or exchange of a residence, part of the gain may be excluded if the sale or exchange is due to a change in employment, health or unforeseen circumstances. The portion of the gain excluded is based on a ratio with a denominator of 730 days and the numerator being the shorter of:

the period during which the ownership and use tests were met during the five-year period ending on the date of sale, or

the period of time after the date of the most recent prior sale or exchange for which the exclusion applied until the date of the current sale or exchange.

The amount excluded is $250,000 or $500,000 times the above ratio.

Question 14

Involuntary Conversion of Principal Residence

Answer 14

For example, the Koch’s principal residence, with an adjusted basis of $200,000, has been used and owned by them for nine years. The house is destroyed by a hurricane and the Koch’s receive insurance proceeds of $820,000. Four months later, they purchase another residence for $900,000. The Koch’s have a realized gain of $620,000 and may exclude $500,000 under Section 121. The remaining $120,000 gain may be deferred and the basis of their replacement residence is $780,000 ($900,000 − $120,000).

Question 15

Section 1231 Property

Answer 15

The Internal Revenue Code (IRC) defines Section 1231 property as real or depreciable property that is held for more than one year and is either used in a trade or business or is held for the production of income. Certain property such as inventory, U.S. government publications, copyrights, literary, musical or artistic compositions, and letters are excluded from the definition of Section 1231 property.

Furthermore, Section 1245 and Section 1250 are subsections under Section 1231. In other words, all 1231 property is further defined as either 1245 or 1250 property. For this curriculum, the rather extensive history of 1231 property going back to the 1960s is unimportant. For our purposes, we can think of 1250 as realty (property held for the production of income), and 1245 property as personality (tangible property used in a trade or business).

Example of 1250 is a property held for rent. example of 1245 are furniture and carpets in the building.

Question 16

Recapture Provisions of Section 1245

Answer 16

All 1245 property will be tangible depreciable property held for more than one year and used in a trade or business.
All depreciation that is recaptured will be taxed and ordinary income and subject to the taxpayer’s marginal tax rate.
The maximum amount of depreciation recaptured is the total amount of the depreciation that was taken.
If the selling price is more than the adjusted basis but less than the original cost basis, the recapture of depreciation will amount to the selling price minus the adjusted basis.
The only time a 1231 gain will occur, is if the asset is sold for a price that is higher than the original in-service cost of the asset. In this case, as well as reporting the 1231 gain, the entire amount of depreciation taken will be recaptured under Section 1245 as ordinary income.
If the asset is sold for an amount less than the adjusted basis, then a 1231 loss will occur. 1231 losses are ordinary losses; not capital losses, and therefore they are not subject to yearly limitation.

Question 17

Recapture Provisions of Section 1250

Answer 17

Under current tax code, all real estate used in a trade or business or held for the production of income is Section 1250 property. Historically, there were two issues under Section 1250. The first issue was known as Section 1250 recapture. The second issue is known as Section 1250 unrecaptured gain. At this point in time, the recapture provisions under Section 1250 have expired. Any residential rental property placed in service prior to 1987 has been fully depreciated even if the straight lime method was used so therefore the incremental amount between accelerated depreciation and the straight-line method is zero.

§1250 unrecaptured gain – these rules apply to real estate that was placed in service after 1986. Similar to Section 1245 in structure, the amount of the gain that is attributable to the depreciation, is taxed at a special rate of 25%. Any gain beyond the total depreciation taken (selling price above the original cost basis), is taxed as a 1231 gain.
If the selling price is below the adjusted tax basis, the result is a 1231 loss. This loss is taxes as an ordinary loss rather than a capital loss.

Question 18

Wash Sales

Answer 18

Section 1091 disallows losses incurred on wash sales of stock or securities in the year of sale. For purposes of Section 1091, a wash sale occurs when:

a taxpayer realizes a loss on the sale of stock or securities, and
the taxpayer acquires “substantially identical” stock or securities within a 61-day period of time that extends from 30 days before the date of sale to 30 days after the date of sale.