PROPERTY TRANSACTIONS: CAPITAL GAINS AND LOSSES, SECTION 1231, AND RECAPTURE PROVISIONS | CPA Exam Regulation

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These lectures cover capital assets, capital gain, capital loss, section 1231 assets, section 1245 assets, section 1250 depreciation recapture, netting and lookback period.

Capital Gains and Capital Losses and Section 1231 Assets

Capital Gains and Losses

Netting and Lookback Period for Section 1231 Assets

Example: Netting capital Gains and Losses and Lookback period

Section 1245 Assets

Section 1250 Depreciation Recapture

Capital Gain Netting

Example: Section 1231, 1245 and 1250 Depreciation Recapture

GENERAL SCHEME OF TAXATION

Recognized gains and losses must be properly classified. Proper classification depends on three characteristics:
• Thetaxstatusoftheproperty(capital,§1231,orordinary). • The manner of the property’s disposition (sale, exchange, casualty, theft, or
condemnation).
• The holding period of the property (short-term: one year or less; long-term: more than one year).
A major focus of this chapter is capital gains and losses. In addition, § 1231 assets and ordinary gains and losses are discussed.

Capital Assets

Personal use assets and investment assets are the most common capital assets owned by individual taxpayers. Personal use assets usually include things like a residence, fur- niture, clothing, recreational equipment, and automobiles. Investment assets usually include stocks, bonds, and mutual funds. Remember, however, that losses from the sale or exchange of personal use assets are not recognized.
The crux of capital asset determination hinges on whether the asset is held for personal use (capital asset), investment (capital asset), or business (ordinary asset). How a taxpayer uses the property typically answers this question.

Since capital assets are provided preferential tax treatment, taxpayers prefer capital gains rather than ordinary gains. So the definition of a capital asset is critically important. As discussed next, this definition has been the subject of many court cases and rulings.

Definition of a Capital Asset (§ 1221)
Capital assets are not directly defined in the Code. Instead, § 1221(a) defines what is not a capital asset. In general, a is property other than inventory, accounts and notes receivable, supplies, and most fixed assets of a business.
Specifically, the Code defines a capital asset as property held by the taxpayer (when it is connected with the taxpayer’s business) that is not any of the following:
• Inventory or property held primarily for sale to customers in the ordinary course of a business.1
• Accounts and notes receivable generated from the sale of goods or services in a business.
• Depreciablepropertyorrealestateusedinabusiness. • Certain copyrights; literary, musical, or artistic compositions; or letters, memo-
randa, or similar property created by or for the taxpayer.2 • CertainU.S.governmentpublications. • Suppliesusedinabusiness.
Often, the only business asset that is a capital asset is “self-generated” goodwill (purchased goodwill is a § 1231 asset). The following discussion provides further detail on each part of the capital asset definition.

Inventory
What constitutes inventory is determined by the taxpayer’s business

No asset is inherently capital or ordinary.
Accounts and Notes Receivable
Accounts and notes receivable are often created as part of a business transaction. These assets may be collected by the creditor, be sold by the creditor, or become completely or partially worthless. Also, the creditor may be on the accrual or cash basis of accounting.
Collection of an accrual basis account or note receivable does not result in a gain or loss because the amount collected equals the receivable’s basis. If sold, an ordinary gain or loss is generated if the receivable is sold for more or less than its basis (the receivable is an ordinary asset). If the receivable is partially or wholly worthless, the creditor has a “bad debt,” which may result in an ordinary deduction.

Collection of a cash basis account or note receivable does not result in a gain or loss because the amount collected is ordinary income. In addition, a cash basis receivable has a zero basis since no revenue is recorded until the receivable is collected. If sold, an ordinary gain is generated (the receivable is an ordinary asset). There is no bad debt deduction for cash basis receivables because they have no basis.

Business Fixed Assets
Depreciable personal property and real estate (both depreciable and nondepreciable) used by a business are not capital assets. The tax law related to this property is very complex; most of these rules are discussed later in this chapter. Although business fixed assets are not capital assets, a long-term capital gain can sometimes result from their sale.

SALE OR EXCHANGE
Recognition of capital gain or loss usually requires a sale or exchange of a capital asset. The Code uses the term , but does not define it. Generally, a property sale involves the receipt of money by the seller and/or the assumption by the purchaser of the seller’s liabilities. An exchange involves the transfer of property for other property. Thus, an involuntary conversion (casualty, theft, or condemnation) is not a sale or exchange.
In several situations, Congress has created rules that specifically provide for sale or exchange treatment. For example, assume that the expiration of a right to personal property (other than stock) that would be a capital asset in the hands of the taxpayer results in a recognized gain or loss. This is a capital gain or loss.4 Several of these special rules are discussed below, including worthless securities, the retirement of corporate obligations, options, patents, franchises, and lease cancellation payments.

Worthless Securities and § 1244 Stock
Occasionally, securities such as stock and, especially, bonds may become worthless due to the insolvency of their issuer. If such a security is a capital asset, the loss is deemed to have occurred as the result of a sale or exchange on the last day of the tax year.5 This last-day rule may have the effect of converting what otherwise would have been a short-term capital loss into a long-term capital loss. Section 1244 allows an ordinary deduction on disposition of stock at a loss. The stock must be that of a small business corporation, and the ordinary deduction is limited to $50,000 ($100,000 for married tax- payers filing jointly) per year. See Chapter 7 (and text Sections 7-2a and 7-2b) for a more complete discussion of these rules.

Capital Gain and Loss Netting Process
Net short-term capital gain is not eligible for any special tax rate. It is taxed at the same rate as the taxpayer’s other taxable income.

Capital Loss Deduction
A net capital loss is deductible for AGI, but limited to no more than $3,000 per tax year.29 So although a net capital gain receives favorable tax treatment, there is unfavor- able treatment for capital losses due to the $3,000 annual limitation. If the NCL includes both long-term and short-term capital loss, the short-term capital loss is counted first toward the $3,000 annual limitation.
SECTION 1231 ASSETSRelationship to Capital Assets Because depreciable property and real property used in business are not capital assets,
the recognized gains from the disposition of this property would appear to be ordinary income rather than capital gain. Due to § 1231, however, net gain from the disposition of this property is sometimes treated as long-term capital gain.Section 1231 may also apply to involuntary conversions of capital assets even though such a disposition, which is not a sale or exchange, normally would not result in a capital gain.
If the disposition of depreciable property and real property used in business results in a net loss, § 1231 treats the loss as an ordinary loss rather than as a capital loss. Ordinary losses are fully deductible for adjusted gross income (AGI). Capital losses offset capital gains, and if any loss remains, the loss is deductible to the extent of $3,000 per year for individuals and currently is not deductible at all by regular corporations. In general, § 1231 provides the best of both potential results: net gain may be treated as long-term capital gain, and net loss is treated as ordinary loss.
The net § 1231 gain from step 2a is offset by the nonrecaptured net § 1231 losses for the five preceding taxable years (the provision).