Solutions Chapter 12 - What is an ordinary income asset?...

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Unformatted text preview: What is an ordinary income asset? Ordinary income assets, including accounts receivable, copyrights in the hands of the creator, and inventory, generate gains that will be taxed at ordinary income tax rates. Describe the taxation of ordinary income assets. When a taxpayer generates ordinary income, it is taxed at ordinary income tax rates, which, under current law, are the highest tax rates in our income tax system. If a loss is incurred when engaged in business, the loss may be deducted as an ordinary loss to be taken against ordinary income and is not subject to limitations. In some cases, the loss may even be carried back to prior tax years to generate an income tax refund for those years! While generating losses is not the objective of a well—run business, if a loss does occur, a taxpayer would prefer to have that loss be treated as an ordinary loss so that he or she can make filll, current use of that loss to offset other income. In the realm ofordi- nary income assets, speaking strictly from an income tax perspective, ordinary losses are good and ordinary gains are bad. Losses are unlimited, but ordinary gains are subject to tax at the highest rate. What is a Section 1231 asset? A Section 1231 asset is depreciable property or real property used in a trade or business. What is the advantage of being classified as a Section 1231 asset? The advantage of Section 1231 is that once an asset is categorized as a Section 1231 asset, gains generated From the sale of the asset are treated as capital gains for income tax purposes, and losses generated from the sale of the asset are treated as ordinary losses for income tax purposes. Therefore, gains will qualify for the favorable long-term capital gains tax rate, and losses will not be subject to the limitations that typicaily apply to cap- ital assets. 109 10. How are corporations affected by Section 1231 assets? C corporations do not qualify for the lower, favorable tax rate on capital gains that is applicable to individuals. Therefore, the generation of a Section 1231 gain will not result in a tax benefit for the corporation, since it pays the same tax rates on its ordinary income and capital gains. If a corporation generates a Section 1231 loss, however, the loss will be considered an ordinary loss, and may be deducted in full against other income (or carried back if the carrybacit rule is invoked). For corporations, capitai losses may not be deducted against other forms of income — capital losses can only be used to offset capital gains. Categorizing an asset as a Section 1231 asset, therefore, allows the corporation to recognize losses without having to generate capital gains to offset them. What is the purpose of depreciation recapture? The sole purpose of depreciation recapture is to ensure that, when an asset is sold, the taxpayer receives his or her capital back tax-free — no more, and no less. Since depreciation is an estimate, the recapture results in the correct economic reality since it is after the economic reduction is actually known. What is the difference between real and personal property? Real property is land and anything permanently attached to the land (such as buildings, trees, and swimming pools). Personal property is everything else in the world (i.e., anything other than land or things permanently attached to the land). Used in this context, personal property does not imply that the property is used for personal, as opposed to business, purposes. What are the four possible results when personal property used in a trade or business or for the production of income is sold? If the amount realized is equal to the adjusted basis of the asset, there is no gain or loss, no depreciation recapture, and no tax consequences. If the amount realized is less than the adjusted basis of the asset, the resulting loss is always treated as an ordinary loss. If the amount realized is greater than the adjusted basis, but the amount of the gain is less than the amount of depreciation taken, then Section 1245 treats the gain as ordinary gain. if the amount realized is greater than the adjusted basis, and the amount of gain is greater than the depreciation deduce tions taken, then the gain up to the amount of depreciation taken is treated as ordinary gain under Section 1245. Gain in excess of depreciation taken is treated as capital gain under Section 12.31. How is depreciation recaptured under Section 1250? If real property used as a Section 1231 asset is sold, the recapture rules are a bit different. IRC Seetion 1250 gov— erns recapture of depreciation on real Section 1231 assets. When real property that was depreciated on an acceler- ated basis is soid, Section 1250 requires the excess depreciation, calculated by subtracting straight—line depreciation from accelerated depreciation, to be recaptured at ordinary income tax rates. \What is the difference between straight-line depreciation and accelerated depreciation? Straight—line depreciation allows the owner to talte a constant aliowance for depreciation during the recovery period. Accelerated depreciation allows the owner of the property to front—load the depreciation deductions so that more of the depreciation deduction is taken in the early years, and less is taken in later years. Real estate that was purchased and placed in service for production of income or business use before 1980 or after 1986 must be depre— ciated on a straightdline basis. Between 1980 and 1986, real estate placed in service for business or production of income use qualified for accelerated depreciation. “Christen"1'2&""B'uasess assets ' ' ‘ 11. 12. 13. 14. 15. 16. 17. Why is Section 1250 not as important to tax planning as it used to be? Only real property that could have been depreciated on an accelerated basis will be affected by the provisions of Section 1250. Since 1986, real estate does not qualify For accelerated depreciation. In addition, as time goes by, the total depreciation taken on an accelerated basis approaches the total depreciation taken on a straight—line basis, so that at the end of the recovery period, the total cumulative depreciation deductions taken by the taxpayer under either system are the same. By 2016, the recovery period for almost all pieces of real property for which accelerated depreciation could have been claimed will have expired, at which time the imposition of Section 1250 will not result in additional tax revenue. It is a rare occurrence where a planner will have to deal with Section 1250. What is unrecaptured Section 1250 depreciation and how is it taxed? Under Section 1250, depreciation in excess of straight-line depreciation is recaptured at ordinary income rates. Depreciation that is not recaptured under Section 1250 (aka. “unrecaptured Section 1250 depreciation”), is straight-line depreciation. As a result ofTRA 97, straight-line depreciation taken after 1997 on real estate used as a Section 1231 asset is taxed at a flat 25% rate upon the sale or exchange of the asset. How is gain from the sale of a Section 1231 real property asset treated? 1. The lesser of the gain or the difference between depreciation taken and straight—line depreciation will be taxed as ordinary income. (This is recapture of “excess” depreciation under Section 1250). 2. If the gain exceeds the amount in (1), the lesser of the remaining gain or the straightdine depreciation taken on the property will be taxed at 25% (this is the “unrecaptured section 1250 depreciation”). 3. Any gain in excess of (1) and (2) is taxed at capital gains tax rates (0% or 15%). How is depreciation recapture affected when a Section 1231 asset is gifted? If the donor held the asset for productive use in a trade or business or for the production of income, and deprecia— tion was allowed on the asset, any recapture potential will carry over to the donee. How is depreciation recapture affected by a nontaxable exchange of a Section 1231 asset? When property is transferred for another property in a nontaxable exchange (such as a Section 1031 like—kind exchange, or a Section 1034 involuntary conversion), potential recapture on the asset carries over to the replace— ment property. What happens to potential depreciation recapture when the owner of a Section 1231 asset dies? Property transferred through the estate of a decedent receives a step to fair market value in basis under IRC Section 1014, and, by receiving the step to fair market value, depreciation recapture is extinguished. How can a charitable contribution be affected by potential depreciation recapture? When property subject to depreciation recapture is given to a charitable organization, and the deduction would otherwise be based on the fair market value of the property, to determine the taxpayer’s deduction for income tax purposes the potential depreciation recapture on the asset must be deducted from the fair market value. 18. 19. 20. What are the tax consequences when a Section 1231 asset is sold in an installment sale? The installment reporting provisions do not apply to potential ordinary income depreciation recapture on Section 1231 property sold in return for an installment note. The ordinary income depreciation recapture, to the extent of the gain, must be recognized in the year the gain is realized. The unrecaptured Section 1250 depreciation may be deferred under the installment reporting provisions, but all of the gain in each installment reporting year will be taxed at the 25% unrecapturecl Section 1250 rate until all of the straight—line depreciation has been recaptured. Once the portion of the gain representing unrecaptured Section 1250 depreciation has been fully reported, any remaining gain will be taxed at 15% or 0%. How can potential depreciation recapture create a cash-flow problem for the seller of an asset in an installment sale? If the purchaser only pays a portion of the purchase price plus interest to the seller each year, but the seller has to pay up to 35% on the recaptured depreciation in the year of sale, plus tax on the interest and a 25% tax on part of the unrecaptured Section 1250 gain received in this year’s installment payment, the seller may not have enough money to meet the tax obligation. Describe the impact of the 5-year lookbaclt rule. The lookback rule states that a net Section 1231 gain in the current tax year (which should be taxed at capital gains tax rates) will be taxed at ordinary income tax rates to the extent of any Seetion 1231 losses claimed during the last five years. The lookback rule forces the netting process to occur over a five year period. Note that for the lookback rule to apply, (1) there must be a net Section 1231 gain in the current year, and (2) there must have been Section 1231 losses in the last five years. If there is a net Section 1231 loss in the current year, or if there are no Section 1231 losses in the last five tax years, the lookback rule does not apply. "1'12" “entertain“a'usmr'ss'Assns'" " i i s i Rennie, a 12 year old middle school student, just agreed to take over a paper route to deliver Newsday to his extended neighborhood on a daily basis. To deliver the papers, he purchases a new bike with a specially equipped basket to transport the papers each morning. How is the bike classified for income tax purposes? a. The bike is an ordinary income asset. b. The bike is a capital asset. c. The bike is a Section 1231 asset. d. The bike is a personal asset. The correct answer is c. Since the bike is depreciable personal property used in the conduct of trade or business activity, the bike is consid— ered a Section 1231 asset. Even though it is used to generate ordinary income, the fact that Rennie could claim depreciation on the bike makes it a Section 1231 asset. Which of the following statements properly describes the income tax treatment of asset sales? a. The sale of classic movies on DVDs by Movie Emporia (a retail movie distributor) will generate income subject to capital gains tax. b. The sale of Big Box Mart stock by an individual investor generates ordinary income. c. The sale of a desk used for 10 years in a business at a loss will result in a capital loss. d. The sale of a typewriter used for 10 years in a trade or business at a gain (after recapturing any depreciation) will generate a capital gain. The correct answer is d. A typewriter used in a trade or business is a Section 1231 asset, and the sale ofa Section 1231 asset at a gain is treated as a capital gain. The sale of DVDs by a retail distributor is a sale of inventory, which generates ordinary incorne. Big Box Mart stock held by an individual investor is a capital asset, which will generate a capital gain or loss upon sale. While short—term capital gains are taxed at ordinary rates, the gain/loss is still considered a capital gain/loss and is subject to special limitations. Finally, the sale Ufa desk used for 10 years in a business at a loss will result in an ordinary loss, since the desk is a Section 1231 asset. .. . TI. .1. 3.. i i i : 3. Custom Framing, Inc., a C corporation, sold a machine used to cut wood used in their picture frames for $2,700. They originally purchased the machine for $2,000 and had taken $1,400 in depreciation deductions. When the company that made the machine went out of business, the machine became a collectors item, and the company sold the machine for more than they paid for it to purchase other equipment. Which of the following statements concerning the tax impact of the sale transaction is correct? a. The company will recognize $2,100 of ordinary income. The company will recognize $1 ,400 of ordinary income. c. The company will recognize a capital gain of $700 that will be taxed at the favorable long—term capital gains tax rate. d. The company will recognize a short-term capital gain of $700. The correct answer is a. C corporations do not qualify for the favorable capital gains tax rate, so any gain on the sale or disposition of prop— erty is taxed at ordinary rates. In this case, the adjusted basis of $600 is deducted from the amount realized of $2,700 resulting in a gain of $2,100 which will be taxed at ordinary income tax rates. 4. James sold a lathe that was used in his business operations (that he ran as a sole proprietor) for $5,000. The machine was originally purchased for $12,500 and James had claimed $6,000 of depreciation deductions over a span of four years. What will James include on his tax return as a result of the sale? a. $1,500 capital loss. b. $1,500 ordinary loss. c. $7,500 long—term capital loss. d. $7,500 ordinary loss. The correct answer is b. The lathe is a Section 1231 asset. Losses on Section 1231 assets are treated as ordinary losses for income tax pur- poses. 5. Twenty years ago, William purchased a desk that he used in his law practice for $8,000. The desk has been fully depreciated and when he retired, William sold the desk to Harry for $3,000. What will William include on his tax return as a result of the sale? a. $3,000 taxed at ordinary rates. b. $3,000 taxed at long—term capital gains rates. c. $5,000 ordinary loss. d. $5,000 long—term capital loss. The correct answer is a. The desk is a Secrion 1231 asset. The amount realized of $3,000 less the adjusted basis of $0 equals a gain of $3,000. Section 1231 gains are usually taxed as long—term capital gains, but before capital gains tax rates can apply the depreciation recapture rules. of Section 1245 must be taken into consideration. Section 1245 requires the tax- payer to recognize the gain to the extent of the depreciation as ordinary income, resulting in a recapture of depre- ciation claimed over the years. In this case, the total depreciation claimed was $8,000 and the gain was $3,000. Since the gain was less than the depreciation taken, the full gain is taxed at ordinary rates due to the imposition of the Section 1245 depreciation recapture rule. Ten years ago, Chelsea purchased an indusrrial sewing machine used in her business, Froggie Dolls, LLC, for $10,000. She had taken depreciation deductions of $9,000 over this period, and sold the machine for $12,000 after she purchased a new state-of-the-art industrial sewing machine. How much ordinary income will Chelsea recognize on the sale of the machine? a. $0. b. $1,000. c. $9,000. d. $1 1,000. The correct answer is c. The sewing machine is a Section 1231 asset. The amount Chelsea realized on the sale was $12,000, and after sub— tracting her adjusted basis of $1,000 we find her gain to be $11,000. The sewing machine was personal property, so the recapture rules of Section 1245 apply. Section 1245 requires the gain, to the extent of depreciation claimed, to be reported as ordinary income on the taxpayer’s return. The total depreciation that Chelsea claimed on the asset was $9,000 and her gain was $11,000 so all of the depreciation is recaptured, and will be taxed at ordinary rates. ' Mark purchased an apartment building for $1.5 million several years ago. He has claimed depreciation deductions totaling $750,000 during the holding period, and straight—line depreciation would have been $700,000. How much ordinary income will Mark recognize for income tax purposes if he selis the building for $2 million? a. $0. 1). $50,000. C. $1,150,000. (1. $1,200,000. The correct answer is b. The apartment building is a Section 1231 asset, which generally means that gains from the sale or disposition of the property are capital gains, and losses are treated as ordinary losses. Before capital gains tax treatment can be applied, however, depreciation recapture must be taken into account. Since an apartment building is real property, the recapture rules that apply may be found in Section 1250. Section 1250 states that the gain on the sale of real Section 1231 property is taxed at ordinary rates to the extent that the depreciation claimed exceeds straight—line depreciation. In this case, the gain is $1,250,000 ($2 million amount realized less $750,000 adjusted basis). The depreciation in excess of straight-line depreciation is $50,000 ($750,000 - $700,000). Therefore, $50,000 of the gain will be taxed at ordinary rates pursuant to the depreciation recapture rules of Section 1250. ""115 8. Michael purchased an apartment building for $2 million several years ago. He has claimed depreciation deductions totaling $950,000 during the holding period, and straight-line depreciation would have been $900,000. What is Michael’s long—term capital gain (taxed at the favorable 15% capital gains tax rate) that will be recognized for income tax purposes if he sells the building for $2.5 million? i l l r l . i i i a a. $0. b. $50,000. c. $500,000. d. $1,450,000. The correct answer is c. The apartment building is a Section 1231 asset, which generally means that gains from the sale or disposition of the property are capital gains, and losses are treated as ordinary losses. Before capital gains tax treatment can be applied, however, depreciation recapture must be taken into account. Since an apartment building is real property, the recapture rules that apply may be found in Section 1250. Section 1250 states that the gain on the sale of real Section 1231 property is taxed at ordinary rates to the extent that the depreciation claimed exceeds straight-line depreciation. The straight—line depreciation claimed is treated as “unrecaptured Section 1250 gain” and is taxed at a flat 25% rate. Any gain remaining after the ordinary income recapture and the unrecaptured Section 1250 gain is taxed at long—term capital gains tax rates. In this case, the gain is $1,450,000 ($2.5 million amount realized less $1,050,000 adjusted basis). The depreciation in excess of straight-line depreciation is $50,000 ($950,000 - $900,000), which is taxed at ordinary tax rates. The straight-line depreciation, or unrecaptured Section 1250 gain, of $900,000 is taxed at a flat 25%, and the remaining $500,000 of the gain will qualify as a long-term capital gain. 9. Rich sold his home this year, and is preparing his income tax return. He sold the house for $650,000. It was purchased for $250,000 20 years ago after he was married to Mary Jane, and they have used it as their principal residence ever since. Rich ran a business from the home, using one room regularly and exclusively for business purposes. Over the 20 year holding period, Rich had claimed $15,000 of depreciation deductions on the home office. What portion of the gain, if any, will be subject to income tax? a. $0. 1:). $15,000. C. $385,000. cl. $400,000. The correct answer is b. Even though the home was Rich and Mary Jane’s principal residence, and they otherwise meet the qualification rules for the Section 121 exclusion of gain on the sale of a home, Rich depreciated the property. Real property that has been depreciated on a straightvline basis is subject to recapture at a flat 25% rate (and is referred to as unrecap- tured Section 1250 depreciation). Therefore, $15,000 will be subject to income tax at a 25% rate, and the remain- ing gain will be eligible for the Section 121 exclusion. 10. John owns a building in a blighted downtown area that, until recently, served as his principal residence. He originally purchased the building for $200,000. When he moved out and converted the building to an office building, the fair market value of the building was $150,000. What is John’s basis For purposes of determining his depreciation deductions on the building? a. $0. b. $100,000. c. $150,000. d. $200,000. The correct answer is c. John can claim the lower of his cost basis or the fair market value at the date of conversion as his basis for depreci— ation purposes. 11. After 35 years in business for herself, Daisy retired and closed the doors of her office. She gave her desk to her niece, Molly, who recently completed her degree in a similar field and is opening up her practice. Daisy originally paid $12,000 for the desk, and it was hilly depreciated by the time she gave it to Molly. Molly used the desk for two years, and then sold it (for $6,000) when she decided to redecorate her office. How will Molly treat the proceeds from the sale of the gift for income tax purposes? a. Since Molly received the desk as a gift, there is no need to pay taxes on the proceeds from the sale. b. Since the desk was given to Molly when it was fully depreciated, it is “loss property," and the $6,000 proceeds will not be taxable because it fell between Molly’s gain basis and loss basis in the transaction. c. Molly will recognize $6,000 of ordinary income on the sale. d. Molly will recognize $6,000 oflong—tertn capital gain on the sale. The correct answer is c. When a gift of Section 1231 property is made, the depreciation recapture potential, as well as the taxpayer’s basis, is carried over to the new owner. Molly received the desk with a basis of zero, and a potential for up to $12,000 of depreciation recapture. Since Molly sold the desk for $6,000 the entire sales proceeds will constitute depreciation recapture and will be taxed at ordinary income tax rates. . . 2W. 12. Earlier this month, Jennifer’s apartment house in California was completely destroyed by a forest fire that found its 13. way into the city. She had originally purchased the apartment house for $500,000, and had claimed $100,000 in straight-line depreciation deductions. At the time of the fire, the fair market value of the building was $750,000 and the insurance company gave her a check for the full value. Instead of building on the same site, about 6 months after the fire Jennifer used the insurance proceeds to purchase a new apartment building for $800,000. Within two weeks of purchasing the new building, a real estate investor offered to purchase the new building from her for $1 million. If Jennifer sells the new building to the investor, what is her long-term capital gain for income tax purposes? a. $0- b. $200,000. c. $450,000. d. $550,000. The correct answer is c. The apartment building is Section 1231 property (real depreciable property used in a trade or business). When a nontaxable exchange occurs, the basis and recapture potential in the original property is carried over to the new property. Jennifer’s basis in the new property is $450,000 (her original cost basis of $500,000 less $100,000 in depreciation plus the $50,000 that she added in addition to the insurance proceeds). If she sold the building for $1 million, she would have realized a $550,000 gain. This gain, however, is subject to the depreciation recapture pro- visions of Section 1250, and un—recaptured Section 1250 depreciation. There was no accelerated depreciation on the property, so there will be no ordinary income triggered under Section 1250. The straight-line depreciation of $100,000 however will be subject to tax at 25%, leaving the remaining $450,000 gain available For long‘term cap— ital gains tax treatment. During her working years, Marge ran an antique sales and appraisal service which was very successful in the local community. When she retired, she kept some of the display cases in order to display her Own collections in her home. The display cases were originally purchased for the business at a cost of$15,000 and were fillly depreciated by the time Marge retired. Marge died last month, and the display cases were valued in her estate at $8,000. If Marge’s daughter, Kelly, inherits the display cases, and sells them for $8,500 two months after Marge’s death, what is the income tax treatment on the sale? a. $500 ordinary income. 13. $500 long—term capital gain. c. $500 short~term capital gain. d. $8,000 ordinary income. The correct answer is b. Even though the display cases were Section 1231 assets in Marge’s hands, and were subject to depreciation recap- ture, once they ran through Marge’s estate, they qualified For a Section 1014 step-to fair market value in basis, which eliminates the recapture potential. if Kelly sells the cases for $8,500 two months after Marge’s death, her gain is $500 due to the step-up in basis. Since all assets passing through an estate and receiving a step-up in basis qualify for long-term capital gains treatment, the gain will be characterized as a long-term gain. 14. 15. Prior to returning to work for a Fortune 500 company, Randy ran a consulting practice. He had purchased office furniture and modern artwork for his office, and when he closed the practice to return to the corporate world, he kept the furniture and art, which was fully depreciated. One painting that he used in the busineSS has recently gone up substantially in value. Randy purchased it for $400, depreciated it fully, and the fair market value of the painting is now $10,000. The local art museum has an exhibit dedicated to the artist that created the painting, and since he was not using the art, Randy donated the painting to the museum. What is Randy’s charitable deduction (without taking into consideration any ceiling imposed by his contribution base) for income tax purposes? a. $0. b. $400. c. $9,600. d. $10,000. The correct answer is c. Randy is generally entitled to a fair market value deduction for contributions of artwork to a charitable organiza— tion that will use it in its tax—exempt purpose. The potential depreciation recapture, however, must be subtracted from the fair market value to determine the tax deduction. Since the artwork was fully depreciated, Randy must deduct $400 from the fair market value of $10,000 to arrive at the charitable deduction of $9,600. Edward was winding down his business, and sold a machine that he used in the business to a former business associate, Philip, for $40,000. The machine originally cost $100,000 and Edwards adjusted basis in the machine was $20,000. The sale agreement requires Philip to pay for the machine in five equal annual installments, plus interest. Which of the following statements concerning this transaction is correct? a. Out of each installment sale payment, the gain on the sale will be treated as ordinary income until all of the depreciation recapture has been accounted for. b. Edward may recognize any depreciation recapture over the term of the installment note in the same proportion as recognition of gain. Edward must recognize all depreciation recapture immediately as ordinary income. 9.? The installment reporting provisions exempt Edward from ordinary income tax treatment of depreciation recapture. The correct answer is c. When an asset subject to depreciation recapture is sold on an installment note basis, the ordinary income depreci- ation recapture, to the extent of the gain, must be recognized in the year of sale regardless of when the payments on the note are received. ""119 i s i i i l 2 a i 1 i i ...
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Solutions Chapter 12 - What is an ordinary income asset?...

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