McGraw-Hill’s Taxation Of Business Entities 2018 Edition 9th Edition By Brian – Test Bank

Lecture Notes

• Dispositions
  1. Every asset disposition triggers a realization event for tax purposes.
  2. To calculate the amount of gain or loss taxpayers realize when they sell assets, they must determine the amount realized on the sale and their adjusted basis in each asset they are selling.
  3. Amount realized
     1. The amount realized by a taxpayer from the sale or other disposition of an asset is everything of value received from the buyer less any selling costs.
     2. Taxpayers selling assets such as real property subject to loans or mortgages must increase their amount realized by the amount of debt relief (the buyer’s assumption of the seller’s liability increases the seller’s amount realized).

• Amount realized = Cash received + Fair market value of other property + Buyer’s assumption of liabilities – Seller’s expenses

1. Work through Example 11-1

1. Adjusted basis
   1. An asset’s cost basis is the amount subject to cost recovery
   2. Initial basis is generally its cost. Exceptions apply for gifts, inherited property and property converted from personal to business use.

• Adjusted basis = Initial basis – Cost recovery deductions

1. Work through Example 11-2 and 11-3

1. Realized gain or loss on disposition
   1. Gain or (loss) realized = Amount realized – Adjusted basis
   2. Work through Example 11-4

• Refer to Exhibit 11-1 for Summary of Formulas for Computing Gain or Loss Realized on an Asset Disposition.

1. Refer to Exhibit 11-2 for Teton’s Asset Dispositions:* Realized Gain (Loss) for Tax Purposes.
2. Recognized gain or loss on disposition
   1. Recognized gains or losses are gains (losses) that increase (decrease) taxpayers’ gross income.
   2. Taxpayers must report recognized gains and losses on their tax returns.

• In certain circumstances taxpayers may be allowed to defer recognizing gains to subsequent periods, or they may be allowed to permanently exclude the gains from taxable income.

1. Taxpayers may also be required to defer losses to later periods and, in more extreme cases, they may have their realized losses permanently disallowed.

• Character of Gain or Loss
  1. Taxpayer must determine the character or type of gain or loss recognized which affects the taxpayer’s income tax liability.
  2. Every gain or loss is characterized as either ordinary or capital (long-term or short-term).
  3. Refer to Exhibit 11-3 for Character of Assets Depending on Property Use and Holding Period.
  4. Ordinary assets
     1. Assets created or used in a taxpayer’s trade or business.
     2. Business assets held for less than a year.

• Examples of ordinary assets – inventory, accounts receivable, machinery and equipment if they have used in business for one year or less

1. Capital assets
   1. Assets held for investment purposes for production of income.
   2. Assets held for personal-use purposes.

• Refer to Exhibit 11-4 for Review of Capital Gains and Losses.

1. 1231 assets
   1. Depreciable assets and land used in a trade or business held for more than one year.
   2. Work through Example 11-5

• Depreciation Recapture
  1. Potentially applies to gains (but not losses) on the sale of depreciable or amortizable business property.
  2. Recharacterizes the gain on the sale of a §1231 asset (all or a portion of the gain) from §1231 gain into ordinary income.
  3. The method for computing the amount of depreciation recapture depends on the type of §1231 assets the taxpayer is selling (personal property or real property).
  4. Refer to Exhibit 11-5 for §1231 Asset Types.
  5. 1245 property
     1. The gain from the sale of §1245 property is characterized as ordinary income to the extent the gain was created by depreciation or amortization deductions.
     2. The lesser of (1) gain recognized or (2) accumulated depreciation is recaptured (characterized) as ordinary income under §1245.

• Any remaining gain is §1231 gain.

1. There is no depreciation recapture on assets sold at a loss.
2. When taxpayers sell or dispose of §1245 property, they encounter one of the following three scenarios involving gain or loss:
   • Gain created solely through cost recovery deductions
     • Most §1231 assets that experience wear and tear or obsolescence generally do not appreciate in value.
     • When a taxpayer sells these types of assets at a gain, the gain is usually created because the taxpayer’s depreciation deductions associated with the asset reduced the asset’s adjusted basis faster than the real decline in the asset’s economic value.
     • The entire gain is artificially generated through depreciation the taxpayer claims before disposing of the asset (i.e., absent depreciation deductions; the taxpayer would recognize a loss on the sale of the asset).
     • Work through Example 11-6
   • Gain due to both cost recovery deductions and asset appreciation
     • Assets subject to cost recovery deductions may actually appreciate in value over time.
     • When these assets are sold, the recognized gain must be divided into ordinary gain from depreciation recapture and §1231 gain.
     • The portion of the gain created through cost recovery deductions is recaptured as ordinary income and remaining gain (the gain due to economic appreciation) is §1231 gain.
     • Work through Example 11-7
   • Assets sold at a loss
     • Many §1231 assets, such as computer equipment or automobiles, tend to decline in value faster than the corresponding depreciation deductions reduce the asset’s adjusted basis.
     • When taxpayers sell or dispose of these assets before the assets are fully depreciated, they recognize a loss on the disposition.
     • Because the depreciation recapture rules don’t apply to losses, taxpayers selling §1245 property at a loss recognize §1231 loss.
     • Work through Example 11-8
   • Refer to Exhibit 11-6 for Machinery §1245 Depreciation Recapture Scenarios 1, 2, and 3.
3. Work through Example 11-9

1. Depreciation recapture for real property
   1. Depreciable real property, such as an office building or a warehouse, sold at a gain is not subject to §1245 depreciation recapture.Rather, it is subject to a different type of recapture called §1250 depreciation recapture.
   2. Thus depreciable real property is frequently referred to as §1250 property.

• When depreciable real property is sold at a gain, the amount of gain recaptured as ordinary income is limited to the excess of accelerated depreciation deductions on the property over the amount that would have been deducted if the taxpayer had used the straight-line method of depreciation to depreciate the asset.

1. 1250 recapture generally no longer applies to gains on the disposition of real property.Instead, a modified version called §291 depreciation recapture applies to corporations but not to other types of taxpayers. §1250 recapture applies to the gains on real property held one year or less even if the taxpayer used straight-line depreciation.
2. Under §291, corporations selling depreciable real property recapture as ordinary income 20 percent of the lesser of (1) the recognized gain or (2) the accumulated depreciation.
3. Work through Example 11-10

• Other Provisions Affecting The Rate At Which Gains Are Taxed
  1. Other provisions, other than depreciation recapture, may affect the rate at which taxpayer gains are taxed.
  2. Unrecaptured §1250 gain for individuals
     1. A gain resulting from the disposition of §1250 property is a §1231 gain and is netted with other §1231 gains and losses to determine whether the taxpayer has a net §1231 gain for the year or a net §1231 loss for the year.
     2. Unrecaptured §1250 gain is §1231 gain that, if ultimately characterized as a long-term capital gain, is taxed at a maximum rate of 25 percent.

• When an individual sells §1250 property at a gain, the amount of the gain taxed at a maximum rate of 25 percent is the lesser of the (1) recognized gain or (2) the accumulated depreciation on the asset and the remainder of the gain is taxed at a maximum rate of 15 percent.

1. Work through Example 11-11

1. Characterizing gains on the sale of depreciable property to related persons
   1. All gain recognized from selling property that is a depreciable asset to a relatedbuyer is ordinary income (regardless of the character of the asset to the seller).
   2. Related persons include family relationships, including siblings, spouses, ancestors, lineal descendants, corporations in which the individual owns more than 50 percent of the stock and see §267(b) for more related-person relationships.

• Work through Example 11-12

• Calculating Net §1231 Gains Or Losses
  1. After recharacterizing §1231 gain as ordinary income under the §1245 and §291 (if applicable) depreciation recapture rules and the §1239 related-person rules, the remaining §1231 gains and losses are netted together.
  2. If the gains exceed the losses, the net gain becomes a long-term capital gain (a portion of which may be taxed at maximum rate of 25 percent) and if the losses exceed the gains, the net loss is treated as an ordinary loss.
  3. A taxpayer could gain significant tax benefits by discovering a way to have all §1231 gains treated as long-term capital gains and all §1231 losses treated as ordinary losses.
  4. The annual netting process makes this task impossible for a particular year.
  5. A taxpayer who owns multiple §1231 assets could sell the §1231 loss assets at the end of year 1 and the §1231 gain assets at the beginning of year 2.
  6. The taxpayer could benefit from this strategy in three ways:
     1. Accelerating losses into year 1,
     2. Deferring gains until year 2,

• Characterizing the gains and losses due to the §1231 netting process.

1. 1231 look-back rule
   1. Anondepreciation recapture rule that applies in situations like the one we just described to turn what would otherwise be §1231 gain into ordinary income.
   2. The rule affects the character but not the amount of gains on which a taxpayer is taxed.

• 1231 gains and losses from individual asset dispositions are annually netted together.

1. The §1231 look-back rule is designed to require taxpayers who recognize net §1231 gains in the current year to recapture (recharacterize) those gains as ordinary gains to the extent they recognized §1231 losses that were treated as ordinary losses in prior years.
2. Without the look-back rule, taxpayers could carefully time the year in which the §1231 assets are sold to maximize the tax benefits.
3. Determine whether the taxpayer recognized any nonrecaptured §1231 losses (losses that were deducted as ordinary losses that have not caused subsequent §1231 gains to be recharacterized as ordinary income).

• Work through Example 11-13

1. Refer to Exhibit 11-7 for a flow chart to explain entire classification process for taxable sale of assets used in a trade or business.
2. Refer to Exhibit 11-8 for §1231 Netting Process.
3. Gain or loss summary
   1. Refer to Exhibit 11-9 for Summary of Teton Gains and Losses on Property Dispositions.

• Non Recognition Transactions
  1. Like-kind exchanges
     1. Taxpayers exchanging property realize gains (or losses) on exchanges just as taxpayers do by selling property for cash.
     2. Taxpayers exchanging property for property are in a different situation than taxpayers selling the same property for cash.

• Taxpayers exchanging one piece of business property for another haven’t changed their relative economic position in the sense that both before and after the exchange they hold similar assets for use in their business.

1. Exchanges of property do not generate the wherewithal (cash) for the taxpayers to pay taxes on the gain they realize on the exchanges.
2. While taxpayers selling property for cash must immediately recognize gain on the sale, taxpayers exchanging property for assets other than cash must defer recognizing gain (or loss) realized on the exchange if they meet certain requirements. This is commonly known as like-kind (§1031) exchange.
3. Refer to Exhibit 11-10 for Teton’s (On Steve’s return) Form 4797.

• Refer to Exhibit 11-11 for Steve’s Schedule D (Assumes Steve had no other capital gains and losses other than those incurred by Teton).
• For an exchange to qualify as a like-kind exchange for tax purposes, the transaction must meet the following three criteria:
  • The property is exchanged “solely for like-kind” property.
  • Both the property given up and the property received in the exchange by the taxpayer are either “used in a trade or business” or are “held for investment” by the taxpayer.
  • The “exchange” must meet certain time restrictions.

1. Definition of like-kind property
   • Real property
     • All real property used in a trade or business or held for investment is considered “like-kind” with other real property used in a trade or business or held for investment.
   • Personal property
     • Personal property is considered “like-kind” if it has the same general use and is used in a business or held for investment.
   • Property ineligible for like-kind treatment
     • Certain types of property such as inventory, most financial instruments, partnerships interests, domestic property exchanged for property used in a foreign country, and all property used in a foreign country.

1. Property use
   • Timing requirements for a like-kind exchange
     • It may involve intermediaries.
     • Taxpayers must identify replacement “like-kind” property within 45 days of giving up their property.
     • “Like-kind” property must be received within 180 days of when the taxpayer transfers property in a “like-kind” exchange.
   • The tax laws do not require a simultaneous exchange of assets, but they do impose some timing requirements to ensure that a transaction is completed within a reasonable time in order to qualify as a deferred like-kind exchange—often referred to as a Starker exchange.
   • Refer to Exhibit 11-12 for Diagram of Deferred or Starker Exchange.
   • Work through Example 11-14
2. Tax consequences when like-kind property is exchanged solely for like-kind property
   • Work through Example 11-15

• Tax consequences of transfers involving like-kind and non-like-kind property (boot)
  • Non-like-kind property is known as boot.
  • When boot is given as part of a like-kind transaction, the asset received is recorded in two parts: property received in exchange for like-kind property and property received in a sale (bought by the boot).
  • When boot is received:
    • Boot received usually creates recognized gain.
    • Gain recognized is lesser of gain realized or boot received.
    • The basis of boot received is the fair market value of the boot.
    • Work through Example 11-16
    • Work through Example 11-17
  • Basis in like-kind property = Fair market value of like-kind property received (–) deferred gain (+) deferred loss
  • When no gain is recognized on the exchange, the basis of the new property is the same as taxpayer’s basis in the old like-kind property.
• Reporting like-kind exchanges
  • Involuntary conversions
    • Gain is deferred when appreciated property is involuntarily converted in an accident or natural disaster.
    • Basis of property directly converted is carried over from the old property to the new property.
    • In an indirect conversion, gain recognized is the lesser of:
      1. Gain realized, or
      2. Amount of reimbursement the taxpayer does not reinvested in qualified property.
    • Qualified replacement property must be of a similar or related use to the original property.
  • Refer to Exhibit 11-13 Form 8824, Part III (From machine exchange in Example 11-15).
  • Work through Example 11-18
• Installment sales
  • Sale of property where the seller receives the sale proceeds in more than one period.
  • Must recognize a portion of gain on each installment payment received.
  • Gains from installments sales: Gross profit percentage = Gross profit/Contract price.
  • Inventory, marketable securities, and depreciation recapture cannot be accounted for under installment sale rules.
  • Does not apply to losses.
  • Work through Example 11-19

1. Gains ineligible for installment reporting
   • Work through Example 11-20

• Other non-recognition provisions.
• Related-person loss disallowance rules
  • The tax laws essentially treat related parties as though they are the same taxpayer.
  • Related persons are defined in §267 and include certain family members, related corporations, and other entities (partnerships).
  • Losses on sales to related persons are not deductible by the seller.
  • The related person may deduct the previously disallowed loss to the extent of the gain on the sale to the unrelated third person.
  • Work through Example 11-21
  • Work through Example 11-22
• Conclusion
• Summary
• Key Terms